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As Washington Mutual became America’s biggest bank failure and politicians argue over the terms of a $700bn rescue plan, a solution to the global credit crisis looked more remote than ever.
It has already become an iconic moment. On Thursday, Henry 'Hank’ Paulson, the US Treasury Secretary and a man with a personal fortune estimated at $700m (£380m), bent down on one knee before the most powerful woman in Congress, Nancy Pelosi, and begged her to save his plan to rescue Wall Street.
It didn’t work. Ten days after America announced a $700bn bailout for its stricken banks, weary financiers on both sides of the Atlantic went home for the weekend convinced their futures were in the hands of a group of American politicians whose priority was an election in a month, not the markets on Monday.
President Bush repeatedly pleaded with Congress to back the deal. “This sucker could go down,” Bush told them, apparently referring to the teetering US economy.
Congressional staff worked until 2am on Saturday morning and resumed again at 7am in an attempt to reach an agreement on the bailout – which could be the most extensive peacetime state intervention in the financial system since the Great Depression – by the time the markets open in Asia tomorrow.
However, Congressmen were under intense pressure to reject the bailout, which would allow the US government to buy toxic housing-related investments from banks.
A source close to the meetings said: “American Congressmen are being lobbied by voters at a scale of nearly 100 to 1 to vote against this bailout. It could be politically lethal to be seen as the ones taking the side of Wall Street against the people.”
Not, screamed Wall Street, as dangerous as the impact on financial markets if it were not granted. Last week Warren Buffett, America’s richest man and most famous investor with a huge retail following, tried to impress the importance: “This is sort of an economic Pearl Harbor we’re going through. I’m sure we didn’t want to go to war in 1941. There are times when events force a timetable on you and force action. If they think about it for three weeks, it will be very different and more difficult.”
Bob Diamond, boss of Barclays Capital and new owner of Lehman Brothers in America, told The Sunday Telegraph: “The reality is that the world needs a functioning financial system and it’s up to everyone involved to make sure this happens.”
Another senior banker said: “I don’t think people realise how serious this is. We are facing a full-scale meltdown of the financial system and liquidity is drying up. Imagine not being able to withdraw cash from the banks to buy food. This, in financial terms, is what’s happening. There is no way this bailout can’t happen. It’s about confidence and the blow would be huge.”
Bankers pointed to the events of last week as proof. While the markets had soared last Friday on news of the bailout, within days the uncertainty surrounding it had again unleashed fresh fear into the markets.
Overnight last Sunday, Morgan Stanley and Goldman Sachs were converted from independent to ordinary regulated banks, adding shocking emphasis to the depth of the crisis: Wall Street as it had long been known ceased to exist.
Then as politicians wrangled, the interbank lending market froze.
On Thursday, regulators seized control of Washington Mutual, making it the biggest banking failure in US history. Then shares in Wachovia, the fourth largest bank in the US, fell 27 per cent on Friday. In the panic, fresh doubts were poured on the future of Morgan Stanley as its credit default swap rate widened dramatically, a sign of extreme distress.
By now all eyes were fixed on the bailout as the market’s only hope.
Yet this weekend, City pessimists argued that Paulson’s plan might not work, even if it does get through Congress. They said confidence in the banks was shattered beyond repair when Paulson let Lehman Brothers fail and that no amount of US taxpayer money set aside to buy toxic assets from banks will get banks to start lending to one another again. Neither will it get investors to start buying bank shares again.
Instead, they argued, investors and banks themselves will keep scouting for – and steering clear of – institutions perceived to be the weakest links in the financial system. This self-fulfilling process could well lead to a 1930s-style domino effect of failing banks.
“I think Paulson has gone for the wrong model,” a senior London banker said on Friday. “The model he chose was the one used to bail out bankrupt US building societies in the 1980s. The model he should have chosen was used to inject government funds directly into banks in the 1930s.”
Others argued, the panic was being overblown by self-important bankers who ought to take responsibility for their own mistakes during what Gordon Brown has condemned as the “age of irresponsibility”. They pointed to the fact that plenty of banks have managed the downturn perfectly well and are now in a position of strength.
Barclays, which made write-downs early in the crisis, has bought Lehman Brothers’ US operations from administration in a move that propelled the British bank up the table of global powerhouses.
This weekend, Diamond said: “All banks have assets they’d prefer not to have on their balance sheets. If you’d asked me a month ago if we were going to buy an investment bank, the answer would be very, very unlikely. This unique opportunity came very quickly. Opportunities only come along in crises.”
Similarly, Deutsche Bank has quietly made four acquisitions over the summer.
But even the strong banks recognised the importance of the US bailout to the wider economy.
Michael Cohrs, head of global banking at Deutsche Bank said: “Our losses, while modest are not acceptable. But we continuing to work hard to ensure we are in the best shape to cope with this crisis. Ensuring stability in the US markets is important for us all. The bailout will not solve the problems but if doesn’t happen it will be yet another negative. There’s a psychology to a crisis and more bad news compounds the problems.”
Last week was meant to be a fresh start. After the collapse of Lehman, the fire sale of Merrill Lynch and HBOS and the nationalisation of AIG, news of the Fed’s planned bailout announced on Thursday was supposed to be the bottom line. On Friday soaring markets reflected a new optimism in the financial system .
Instead, on Monday morning, the two last remaining investment banks, Morgan Stanley and Goldman Sachs, admitted they had been forced to seek humbling rescue measures too.
The most prestigious titans of finance had relinquished their independent status and became standard, regulated banks. Wall Street as it has long been known ceased to exist.
Morgan Stanley then rapidly announced talks to sell a stake to Mitsubishi UFJ Financial while it emerged that Warren Buffett had bought a stake in Goldman on very favourable terms.
One rival said: “The real shock was Goldman. If Goldman were in trouble, we all were.”
It was a reality Goldman’s chief executive Lloyd Blankfein had been fighting for nearly two weeks.
On Friday, September 12 Blankfein joined 30 other bosses for a crisis meeting called by the Fed in New York. They had been told that Lehman was in big trouble and would probably collapse if a buyer could not be found .
Blankfein was considered a leader of the pack, not just because he was the boss of Wall Street’s smartest bank, but he was old chums with the chairmen of the meeting, Paulson, from the US Treasurer’s Goldman days.
He was also on the 'strong side’ of the room – among those considered to have best withstood the financial maelstrom of the past year .
While Bear Stearns went bust and others haemorrhaged unprecedented losses, Goldman adopted the lofty role of adviser and stabiliser.
Yet it was in this meeting that a new reality was realised. The dire problems of Lehman, AIG and Merrill made it clear that this was no longer about weak or strong institutions but about a huge crisis of confidence from which none of them were safe.
One Goldman insider said: “In days after that meeting the atmosphere in the bank changed very quickly from the normal bravado to horror. The worst part was when our share price hit 80p. It was truly frightening.”
More threatening for the bank’s senior management was the distinct possibility that credit rating agencies would downgrade Goldman. The move would mean the cost of borrowing money would soar, putting severe pressure on the lifeblood of the bank.
Arch-rival Morgan Stanley was similarly panicked and abandoned all pretence, loudly searching for a buyer or an investor.
In the middle of the mayhem, Blankfein turned to Buffett, the one man in America who commanded both capital and, more importantly, confidence.
Initially, Buffett said he wasn’t interested. For six months he had rejected similar pleas for help from a raft of other embattled financial institutions, starting with Bear Stearns in March. But on Tuesday last week, his position changed. Just before lunch, Buffett said he was sitting with his feet on his desk in Omaha sipping a Cherry Coke and nibbling at some mixed nuts when he received a desperate call from Byron Trott, head of Goldman in Chicago and charged by Blankfein to secure a deal.
Blankfein knew Buffett – sources say the pair had been introduced by Paulson. But Buffett was close to Trott, whom he had once described in an investment letter as a “rare investment banker who puts himself in his client’s shoes . . . I trust him completely”.
In this phone call Trott simply asked Buffett to name the terms under which he would invest in Goldman and the bank would try to hammer out a deal. Hours later, Buffett’s Berkshire Hathaway had pledged to invest $5bn in Goldman. He also received the right to buy $5bn worth of Goldman shares at $115 per share.
Later Buffett said: “The price was right, the people were right, the terms were right and I decided to write a cheque.” He joked he had lots of cash which had to be spent. “Otherwise, it’s a bit like saving up sex for your old age – at some point you’ve got to use it.”
Within hours, the 'Buffett effect’ had sent Goldman shares soaring and netted him millions of dollars in paper profit.
But it was clear that Buffett recognised the situation was bigger than a single deal or a single bank. The next day he went on CNBC, the American cable channel, to stress the importance of the proposed bailout, and said the financial system was in grave danger and could take “years and years to repair”.
Although America listened to its most admired investor, he still failed to satisfy their increasingly angry question: why?
The financial system was structured after the 1929 Wall Street Crash and in the light of the Great Depression that followed.
Beforehand the banks had been run as an old boys’ club: when problems arose, the weakest institutions were helped along by the strongest, mostly to save their collective good names.
As the Great Depression set in, greedy bankers were blamed for taking too much risk and jeopardising the world economy.
Even so it was accepted that investment banking played a crucial role in the economy .
Peter Hahn of CASS business school said: “Investment banks were, as they are now, crucial for facilitating business and disseminating wealth. As security traders they allow company owners to sell part of their shares, freeing up money to spend and invest while allowing other to share in the growth of their company. To this day, countries with no securities system often have a big concentration of wealth in a few families – in the Middle East, for instance.”
Even so the US government decided the system needed to be properly controlled .
The Securities Act of 1933 brought standardisation to the securities industry, in particular disclosure to the equity and bonds markets, while the SEC was created as the watchdog. In addition, the Glass-Steagall Act divided firms into commercial banks, who took deposits and offered loans to companies, and securities firms that traded on the markets and kept their risks entirely separate from retail savers.
As such, firms such as Goldman Sachs were not really banks but securities dealers.
Hahn said: “In return for the privilege of being able to raise deposits from the public, the banks were heavily regulated and as such grew with a reputation of prudence, safety, watched by the strongest government institutions. The securities banks with their higher risks were kept away from savings.”
But in the following decades and with the onset of globalisation, the burgeoning financial system began to outgrow this structure.
The UK, for instance, had developed in a broadly two-tier sense. The merchant banks, such as Barings, Schroders, Hambros, were small but offered everything from deposits to securities trading to the rich while the clearing banks developed for mass savings.
American securities banks were quick to see the advantage of the more integrated and efficient rules in London.
Hahn said after Big Bang, the integrated system in London allowed for far greater competition and securities trading was “far more efficient and cheaper than New York”.
In 1990 the Rule 144A was passed to introduce competition into securities market and started the erosion of the Glass-Steagall Act by allowing institutional trading of unlisted and unregistered securities. The next big landmark was 1998 – Travellers Group bought Citicorp to add to Salomon Brothers creating an integrated bank which swept away the separation.
By now American regulators were more interested in formulating international banking rules being drawn up in Basel.
But when these rules were introduced, they were aimed at retail banks leaving the burgeoning investment banks to grow relatively unchecked. One expert said: “The only real monitors were credit rating agencies, dominated by Moody’s and Standard & Poor. These were ill-equipped to understand the radically changing products.”
Another oversight was the US insurance market where there has never been a national regulator only state ones.
One insurance expert said: “Essentially insurance went unchecked by professionals. It all worked fine for small players. But huge firms like AIG were becoming international. How was the New York State insurance guy supposed to understand a credit default instrument sold in London?”
Last week experts said that, in hindsight, the lax rules allowed the financial system to completely reinvent itself given a strong enough catalyst. This came in the form of the telecoms and media boom at the turn of the millennium.
A senior London banker said: “During the tech bubble the value of securities was rising so fast that it no longer became good enough for investment banks to just trade on behalf of clients, they wanted to own the securities too. Margins were particularly small in the debt markets – you could do a £10bn eurobond trade for BT and take away a tiny margin. Banks bought debt but also started creating more complicated financial instruments and derivatives that became part of financing. Hybrid capital was born and the 'off-balance sheet vehicles’ were designed to hold the risk.”
The risk systems at the credit rating agencies were not sophisticated enough to keep up and, despite their complexity, many were given AAA ratings. As well as the bank, insurance companies, which were searching for yield enhancing products to match their increasingly liabilities due in part to the ageing population, started lapping them up.
Experts argue that it was at this time that renumeration policies also started encouraging huge risk appetites at the banks.
Peter Hahn : “Bank bosses have been incentivised like tech bosses. If you’re a shareholder in Intel, you want the management to pull all the stops into developing the next chip because if they don’t and Samsung produces a better chip which captures the market, Intel could be bust. If it does go bust, it doesn’t effect anyone else.
“The difference with a bank is a boss can say: 'you want me to make more profits? No problem, I can just go out and buy more risk and deal with the problems later’.” One top UK investor agrees: “At RBS, Fred Goodwin was paid a bonus for doing the ABN deal. Actually, the board should have said, by doing the deal you have radically increased the risk profile of the bank, you’ll get the bonus when the acquisition has proved itself. The pay structure has rewarded risk taking rather than solid, tangible success.”
The hubris reached its zenith with the development of sub-prime mortgages in the US. The ease of originating loans was matched by a hunger to take them on and package them within the banks. Cheap credit flooded the markets and was eagerly taken up by the soaring ambitions of corporates, private equity firms and hedge funds.
One banker said: “The cycle was bound to turn eventually but since it did last summer, it’s the structural problems that have proved to be the real danger.”
Every day for the past two weeks, bosses at the investment banks in London and New York have been meeting to discuss the future of their businesses.
One said: “Large parts of the system are simply gone. Today the wholesale funding market is broken. Securitisation is shut, the bond markets are difficult and costly and other creditors are unreliable.”
Without the funding, the independent investment banks who relied on it must find another source. It is expected that Goldman and Morgan Stanley will buy big retail banks in the US to secure a deposit base.
A far higher level of regulation also seems likely, both from central banks and legislators.
One banker said: “We must accept large-scale intervention. The ban on short-selling is just an example. Perfectly ordinary practices will be banned or regulated into expediency until the system is back to health. This will hit banks, hedge funds, private equity firms and then have a knock-on effect on accountants and lawyers.
“We’re entering a whole new world. The question is, when it is safe to start building it?”
Who said what about the financial meltdown
US Treasury Secretary Hank Paulson on why the $700bn bailout package must be passed: “We must do so in order to avoid a continuing series of financial institution failures and frozen credit markets that threaten American families’ financial wellbeing, the viability of businesses both small and large, and the very health of our economy.”
Federal Reserve chairman Ben Bernanke: “Action by Congress is urgently required to stabilise the situation and avert what otherwise could be very serious consequences for our financial markets and for our economy.”
George W Bush : “Our entire economy is in danger.”
Democratic Congressman Mike McNulty on the rush to approve the bailout fund: “We have been told repeatedly by this administration that the economy is fundamentally sound and then, all of a sudden, they say the economy is going to collapse. That is unacceptable.”
Warren Buffett, after investment in Goldman Sachs: “You can’t keep money around for ever. It’s like saving sex for your old age.”
Dominique Strauss-Kahn, head of the IMF: “The consequences for some financial institutions are still in front of us.”
