World - No end to the crisis

Two related developments over the week-end — the decision of Lehman Brothers to file for bankruptcy and the take over of Merrill Lynch by Bank of America — have shaken the United States’, and indeed the global, financial system. The collapse of the 158-year-old Lehman Brothers, one of the biggest names in investment banking around the world, comes after all efforts to salvage it failed. The troubles at Lehman and some other major investment banks includin g at Merrill Lynch, rooted in the 14-month-old sub-prime crisis, were fairly well known to the markets and the regulators. However, the realisation that these two institutions were worse off than what was indicated by their public posturing and disclosures dawned on them only recently. As their shares started sinking, it became clear that some exceptional efforts employing unconventional means were needed to retrieve it. Merrill Lynch, which retains its identity — though not its independent status — lost four-fifths of its market cap in less than a year and has been taken over in an all-share deal of approximately $50 billion.

An extreme loss of market confidence was also responsible for the downfall of Lehman, despite the last-minute efforts of the U.S. Treasury Secretary to work out an arrangement. That deal envisaged the takeover of a portion of the company by some of the better-placed financial institutions, with its doubtful assets transferred to them. In the event, the inability or unwillingness of the government to commit public money wrecked the salvage plan. Less than two weeks ago, the government virtually nationalised the two giant mortgage lenders, Fannie Mae and Freddie Mac, and six months earlier it had engineered the rescue of the much smaller Bear Stearns. Reckless dispensing of home loans to non-creditworthy borrowers by many of the best known names in American banking and their ingenious method of packaging and securitising these assets, which were then sold to other investors, had brought about the crisis that soon engulfed even the higher echelons of the country’s financial sector. Some complex financial engineering was resorted to for creating these mortgage-backed securities. One measure of their complexity and opacity was the inability of those who created them to recognise the underlying risks. As the map of Wall Street is being redrawn, the clear message is that the U.S. financial sector crisis will take more time to dissipate. The fall of two iconic institutions will naturally have a major, initially negative, impact on all financial markets.