‘As we wait nervously to see what is next to unfold …’

This was a concluding statement made in our previous issue, which we have undoubtedly lived over the last three months and it continues on. Despite the efforts of the U.S. Congress passing the $700bn revised government rescue plan on October 3rd 2008, following the shock rejection of the earlier version, a chain of significant events continued to unfold. To mention a few…

Iceland was threatened with national bankruptcy

Bankruptcy is when a country can not pay back external debts and when the currency of the country, such as the Icelandic Krona, becomes essentially valueless to the rest of the world, meaning they can no longer pay for imports. Iceland was at terrifying risk of becoming bankrupt due to its banking sector having a heavy exposure to the global financial turmoil and consequent credit squeeze. The value of the Krona had depreciated to incomprehensible levels, imports were falling, and inflation was soaring. The government has since seized control of two of the three largest banks in the country, Landsbanki and Glitnir, leaving only one in private hands, Kaupthing.

Domestic and global sharemarkets hit new lows
Following a week of turmoil for troubled U.S. banking giant Citigroup, which saw it lose 60 per cent of its value in a week, U.S. and Australian sharemarkets posted new bear market lows. The Dow Jones Index fell 444 points on 21 November 2008 to 7552 and the following Monday, the Australian market hit an intraday low, falling 54 per cent since the November 2007 high.

These numbers make the current bear market the second worst in history, with the market falling 50.1 per cent in the 1987 crash and 50 per cent in the Great Depression. The 1973-74 bear market is still proving the worst, where shares fell 59.3 per cent.

The U.S. Fed continued to slash the key interest rate
Over three moves, from 10 April 2008 to 16 December 2008, the U.S. Fed. cut its interest rate from two per cent to a range of zero per cent to 0.25 per cent in a desperate attempt
to help stimulate their economy. At this level, it is the lowest U.S. rates have been since records began.

Europe, U.S. and the U.K. declare recession
On 14 November and 1 December 2008, respectively, Europe and the U.S. officially declared they were in recession. Official data
in Europe showed that the 15-nation euro zone economy had contracted by 0.2 per cent for the second quarter in a row; therefore, was technically in recession. In the U.S. the National Bureau of Economic Research concluded that the U.S. economy had started to contract in December 2007. More recently the U.K. also declared they were in a recession.

U.S. car makers run out of cash
Claiming that the global financial crisis has left them in dire straits, two of the three biggest car-makers in the U.S., General Motors and Chrysler, warned that without the aid of a bailout package that they would run out of cash by the end of the year. Ford said it could survive; however, may need funds later. Whilst approved by the House of Representatives, the top three car makers failed in their bid to get congressional approval for a $14bn lifeline. With no further action expected from Congress until the new year, President George W Bush said on 19 December 2008 that the U.S. Government would use up to $17.4bn of the $700bn meant for the banking sector to help the big three car makers.

Unemployment accelerates
Following the crash in the U.S. housing market and the resulting financial crisis, the impact on global economies has been immense and now we are seeing a surge in unemployment. Following 423,000 and 584,000 job losses in the U.S. for October and November 2008 respectively, the unemployment rate has reached a 16 year high of 7.2 per cent and an astonishing total of 11.1 million people were officially unemployed at December. Here in Australia, we have just hit a two year high with a further 44,000 jobs lost in December increasing the number of those unemployed to more than 500,000 people.
This highlights just a few of the major world events that have occurred since October 2008. There has been immense central bank and government intervention from all major economies, providing liquidity and stimulus packages to help mitigate future occurrences. But to what end?

A year on…
The question that many are beginning to ask themselves, is why the crisis has continued to worsen, a year after it essentially began? The financial crisis became critical on 9-10 August 2008, when money market interest rates rose significantly forming the basis of the credit crisis. It was at this point that the spread between the three month LIBOR (London Interbank Offered Rate) and the
three month OIS (Overnight Index Swap) jumped to extraordinarily high levels.

The LIBOR - OIS spread is the difference between the LIBOR and the OIS rate and measures the amount of perceived credit risk between banks. Generally, when the central banks lower their rates of interest, both LIBOR and OIS decline with it.

However, when banks are uncertain of the credit-worthiness of other banks, they charge higher interest rates to compensate them for the perceived higher risk inherent in that bank. Because the OIS is based on rates set by central banks, subtracting this from the LIBOR shows the amount of interest that is being charged for the credit risk between banks. Before the onset of the credit crisis the LIBOR - OIS spread
was around 10 basis points (averaging 6 basis points from January 2006 to the beginning of August 2007).

However, in just over a month the spread rose to 85 basis points on 14 September 2007, at a time when the Bank of England announced emergency funding to rescue troubled Northern Rock, one of the UK’s largest mortgage lenders.

It then increased further, exceeding 100 basis points on the 6th of December 2007 and hit a high of over 350 basis points (3.5%) on 13 October 2008.

Beginning in 2007, bringing this spread down, became a major priority, because not only is it a measure of financial stress, but it also affects how official interest rates are passed onto consumers (and the economy as a whole) because trillions of dollars of loans and securities have their rates calculated with reference to LIBOR. Without a corresponding reduction in this rate, the effects of interest rate reductions from central banks is blunted, as we saw when the major banks did not pass on the full rate cuts because of the higher costs of wholesale funding.

So why did things get worse?
In trying to solve the problem the emphasis was on liquidity and the perception that liquidity in the market, in all its forms, was becoming increasingly scarce. Therefore, the steps put in place focused on providing more liquidity, with three of the major monetary policy interventions being:

• The Term Auction Facility
• Cash Infusions
• Interest Rate Cuts.

However, a recent paper written by John B Taylor , Professor of Economics, Stanford University and Senior Fellow, Hoover Institute, contends that liquidity was not the core issue behind the increase in interest rate spreads and thus, was not the underlying reason for the deterioration in the crisis. What Taylor’s research indicates is that the issue was counterparty risk, and that government
actions and interventions to produce more liquidity instead prolonged the crisis.

In addition to this he goes on to explore what, on top of focusing on liquidity rather than risk, has contributed to the worsening of the crisis. While some commentators suggest that this worsening occurred at the point when the U.S. Government did not intervene to prevent the bankruptcy of Lehman Brothers over the weekend of 13-14 September 2008, there is no empirical analysis to suggest that at this stage.

In his analysis, Taylor focused on the key events from the beginning of September through to mid October 2008, namely: Lehman’s Bankruptcy (15 September 2008) the date of the TARP (Troubled Asset Relief Program) announcement (19 September 2008); Federal Reserve Board, Chairman Ben Bernanke and Treasury Secretary Henry Paulson’s Congressional Testimony (23 September 2009); and the date when the TARP Equity Plan was actually detailed (13 October 2008).

What Taylor identifies is that upon Lehman’s announcing bankruptcy, whilst the LIBOR – OIS spread jumped slightly, it was by no means out of the ordinary and still hovered between the 50 to 100 basis points range, which it had been prior to the announcement.

The significant event resulting in a blow out of the spread occurred on 23 September 2008, after Ben Bernanke and Henry Paulson testified at the Senate Banking Committee. As their testimony wore on, it became clear that they were asking for $700bn with no real plan of how they were going to effectively apply it.

It was at this point which we saw economic conditions deteriorate and the crisis deepened with the spread exceeding 350 basis points in the following three weeks after their testimony. It appears it was this lack of certainty about what the government intended, how they would aid financial institutions and under what circumstances that drove the market and made the public aware that conditions were worse than they had previously believed. It was not until the full details and framework of TARP had been announced that the LIBOR – OIS spread began to fall. (The fact that the money was not actually used as intended is perhaps the subject of another article!).

Taylor suggests that the lack of a predictable framework for interventions and the problem of uncertainty as to what procedures and criteria be adopted for government intervention to prevent financial institutions from failing, was key to the worsening of the crisis. By way-of-example, he highlights that there is no rational explanation as to why intervention was adopted for Bear Sterns, but not Lehman Brothers, but later for AIG, Fannie Mae and Freddie Mac. Since the start of the new year we have seen further propping up of struggling Bank of America and Citigroup, which is clearly now the policy being adopted but at the time of the crisis this was not apparent, adding further uncertainty to already skittish markets.

The history pages of the Credit Crisis of 2008 have yet to be written in stone and there will be significant amounts of research time dedicated to examining and breaking down the individual factors and how their interaction contributed to the unfolding crisis. Why do we do this? For that answer, we rely on George Santayana who famously said that ‘Those who do not learn from history are doomed to repeat it’...

Tara Jones
Senior Consultant
tjones@moorestephens.com.au