| U.S. government bailout fails -- Financial panic ensues
September 29, 2008
Since Lehman Brothers went bankrupt on September 15, global financial markets have entered a panic-stricken free fall.
Banks are afraid to lend to each other, driving the LIBOR rate up to 5.22, more than 3 points above the Fed Funds rate.
European governments have rescued four banks in two days:
- The Netherlands, Belgium and Luxembourg injected €11.2 billion ($16.37 billion) into Fortis NV.
- The U.K. sold Bradford & Bingley to Spains' Banco Santander for £612 million ($1.1 billion). The government had to pay £18 billion ($33 billion) to sweeten the deal.
- This follows the government-assisted sales of HBOS to Lloyds and the nationalization of Northern Rock in February.
- Iceland nationalized Glitner Bank for €600 million ($878 million).
In the U.S., the FDIC brokered the sale of Wachovia and Washington Mutual, while the Federal Reserve nationalized AIG after the nationalization of Fannie Mae and Freddie Mac.
The Lehman failure meant that bondholders of bank debt were no longer safe. This increased the cost of bond insurance, which meant that the banks, hedge funds and insurance companies who sell the insurance had to raise cash as collateral to prove they can cover potential bond defaults. The credit-default-swap market (CDS) froze up as a result, forcing global central banks to add over $300 billion in cash to keep them working.
The rejection of the U.S. $700 billion bailout bill caused global stock markets to plummet, with the MSCI World Index dropping 6% in one day, the most since its creation in 1970. Furthermore,
- The Dow dropped 770 points.
- Brazil's Bovespa was halted after dropping 10%.
- The FTSE dropped 15%.
- Gold soared to over $900 an ounce,
- Oil dropped to $95 a barrel.
What it means:
To try and restore financial stability, the Federal Reserve doubled its currency swaps with foreign central banks in Europe, England and Japan to $620 billion. The governments of the world are being forced to provide all the liquidity for frozen credit markets.
The meltdown has been caused by banks who are afraid to purchase more bad debt from each other by lending to each other. They are also afraid to disclose their bad debt, because it would lead to a downgrade in their debt rating, which would then lead to a decline in their stock price. This would then lead to their inability to raise capital, resulting in bankruptcy. This fear of disclosure has led to an overall panic, fed by rumor, which has locked up the credit markets.
Without credit market functioning, businesses will not be able to get the capital they need to run their day-to-day business. This could ultimately lead to a shut-down of business. Furthermore, it also means no credit for people to buy homes, cars, furniture and consumer electronics.
However, it is expected that the U.S. Congress will develop a bailout package by the end of the week to reverse this trend. Regardless, this has damaged the credibility of the U.S. political process. If the bailout passes, it will increase U.S. debt to almost $11 trillion. Both hamper the ability of the U.S. to remain the premier financial center for the global economy.
(Source: Bloomberg, Fed Pumps $630 Billion into Financial System, September 29, 2008; Stocks Plunge After Congress Rejects Bailout,September 29, 2008; CNNMoney, Bank bailouts sweep Europe, September 29, 2008)
Action steps:
The best way to withstand market volatility is with a well-diversified portfolio. Find out how to protect yourself with my home study course, “Retirement Planning 101.”
Other than that, U.S. citizens call your Congressman and urge that the bailout bill be passed.
For more on the the Mortgage Crisis, see the WorldMoneyWatch Top Trend: U.S. Economic Decline.
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