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Sunday, 21 September 2008

10 things you should know

Couldn't keep up with the twists and turns that took place in the financial world last week? Here's a primer
By Ann Williams

1 THE FALL OF LEHMAN BROTHERS

The week that broke Wall Street began with Lehman Brothers. On Sept12, news broke that the fourth- largest investment bank in the United States was on the brink of collapsing due to bad mortgage assets. Lehman was scrambling for a buyer as customers and trading partners fled.

No deal, however, was reached during that desperate weekend. Lehman's chief executive had waited too long to sell the firm, and everyone was now afraid to buy.

The US government, its last hope, kept to its word and refused to bail Lehman out.

Just after midnight last Sunday in New York, Lehman announced it would file for bankruptcy, the biggest in history.

It was around midday last Monday in Asia, and immediately the carnage on stock markets began as investors dumped bank shares.

Lehman's fall showed that the US government would not automatically prevent big banks from failing. It also showed how much worse the financial crisis had become even after the government had rescued mortgage finance giants Fannie Mae and Freddie Mac earlier this month and investment bank Bear Stearns six months ago.

2 SAVE AIG, SAVE THE WORLD... NOT

Two days after allowing Lehman to fail came bigger news that the US government would bail out American International Group (AIG), one of the world's biggest insurers. It would give the company an US$85 billion (S$122 billion) loan for an 80 per cent stake.

AIG was hit by a big shortage of cash triggered by US$18 billion of losses over three quarters, a sinking stock price and cuts in its credit ratings.

The insurer, with US$1.1 trillion of assets, however, was deemed too big to fail. The US government said unlike with Lehman, it had to rescue AIG because of the insurer's extensive ties to businesses and ordinary people throughout the world through a host of insurance products.

The bailout, though, failed to calm the markets. Instead, it led investors to wonder what other companies might suddenly plunge towards insolvency.

3 CRISIS HITS HOME

For ordinary people around the world, the credit crisis, which has been playing out for the last 15 months, may have really hit home only with the fall of AIG.

Newspapers in Singapore, Hong Kong and Taiwan splashed pictures and carried stories of hundreds of worried people queuing up to cash out on their insurance policies held with AIA, a unit of AIG.

For many ordinary investors in Asia, it was the first time their faith in American assets and the financial system was well and truly shaken.

Even after the US government stepped in to take over AIG and AIA put advertisements assuring policyholders that it could meet all claims, the queues continued.

4 THE BANK SALE WORTH WAITING FOR

Banks, meanwhile, were spooked by what was happening to Lehman. Merrill Lynch, the biggest brokerage in the US, wasted no time in finding a buyer.

It announced last Monday in New York that Bank of America would take it over for US$50 billion in a deal stitched together in just 48 hours.

And by last Wednesday, Britain's Barclays Bank, which had walked away earlier from buying up Lehman for the price its chief executive wanted, ended up with Lehman's core investment banking operations for just US$250 million.

With their shares plunging by the minute, other banks hung out 'For Sale' signs.

Lloyds of Britain rescued the country's biggest mortgage lender, HBOS, last Thursday in a US$22 billion takeover. At least five companies, including HSBC and Citigroup, were said to be looking at buying Washington Mutual.

Morgan Stanley bought time by exploring a possible merger with a smaller American bank, Wachovia, and more investment from a Chinese state-owned investment group.

With share prices bouncing back last Friday, banks like Morgan Stanley may no longer need a buyout or merger, so the Great Bank Sale may be over - for now.

5 CREDIT SQUEEZE TURNS INTO FREEZE

For 15 months, banks and other companies have suffered from a credit crunch as lending slowed. In the last week, however, as Lehman, then AIG and then Merrill went down, investors lost all confidence in the financial system.

The result was that all sorts of lending or credit froze, as the costs of short-term borrowing soared by as much as 30 per cent, hurting banks and other companies.

No corporate bonds were sold in the US in the last week - the first time that has happened since at least 1999 - while sales in Europe dropped 98 per cent.

Things reached crisis proportions when banks and investment firms simply stopped making loans to each other, as they hoarded cash to protect against any sudden need for it themselves.

6 CENTRAL BANKS RACE TO CALM THE STORM

With a global crisis on their hands, the top central banks from the US, Europe, Japan, Britain and Canada moved together last Thursday to pump an extra US$180 billion into money markets to keep credit flowing and interest rates down.

Many more billions were spent individually during the week.

The US Treasury also used US$50 billion to support money-market mutual funds and even lent more money directly to banks and other financial institutions, so they could buy certain assets from money-market funds.

With US$3.3 trillion in assets, money- market funds in the US are key in providing loans to companies so they can buy supplies and pay their employees.

With fund managers rushing to the safety of US Treasury bonds, corporations could not find buyers for their short-term loans. Making things worse, ordinary people who invest in these funds started pulling money out after one fund turned out to be not as super-safe as thought.

7 STOP THE LOOTING

They have been compared to looters after a hurricane, who are out to plunder. Short-sellers borrow stock to sell, then buy it back when the price drops, making a gain on the price difference.

Short-sellers, many of them huge hedge funds, have sought to profit from the financial crisis by betting against bank shares. In normal times, short-sellers add volume to share trading and help stocks find their true worth. When there is a crisis, on the other hand, unrestrained short-selling can make shares plunge even faster.

In response, the US and Britain slapped a temporary ban on the short-selling of financial stocks last Friday. Russia, whose stock markets plunged by more than 20 per cent last week, banned the shorting of all shares.

The ban on short-selling caused bank shares around the world, which had suffered big falls earlier in the week, to jump as much as 40 per cent last Friday.

8 THE MOTHER OF ALL BAILOUTS

After months of fighting each new emergency as it flared up, the US government announced last Friday a plan to once and for all deal with the bad mortgages and mortgage-linked assets at the root of the credit crisis by buying them all up from US banks.

The hope is that by helping banks get rid of bad mortgage debt, the government can avert a total meltdown of stock and credit markets around the world and free banks to make new loans to keep US businesses running and workers employed.

By taking on the actual mortgages and changing their terms, the government can also make it easier for home owners to pay back their home loans, thus helping the housing market to recover.

The cost: No official word has been given but estimates put it at US$500 billion to US$1 trillion.

There are no details yet on how the plan will work but the US government will likely buy the assets at a big discount and hold on to them until the US housing market recovers. Ideally, these loans could then be sold at a profit so US taxpayers, who are ultimately paying for the bailout, will get some money back.

The US Congress, which has to pass laws for the plan to be implemented, is looking at it now and will hold hearings this week. A deal must be hammered by the end of this week, when Congress adjourns because of the US presidential elections.

9 FLIGHT TO SAFETY AND BACK

Until last Thursday, panicked investors rushed to dump any asset seen as risky, especially stocks, as they piled into gold or US government bonds, seen as safe bets. Some just wanted plain cash.

But then the flight to safety reversed itself last Friday with news of the US government's sweeping plan to stem the crisis.

As investors poured their money back into stocks and investment funds, the price of gold fell by US$32 last Friday after soaring by US$116 in the previous two days.

The price of US Treasury bonds also tumbled. As a measure of how bad the fear was earlier in the week, investors piled into these bonds even though they were offering practically nothing in interest income.

Oil prices shot up by more than US$6 to over US$106 a barrel last Friday on hopes that the plan to resolve the bank crisis will spur economic growth, which is good for oil demand.

10 WHAT A RIDE

And so, investors all over the world went on the wildest ride of their lives last week.

To illustrate how volatile global markets had been, Russia suspended all stock market trading when shares plunged by 20 per cent to 25 per cent last Wednesday - and did so again when they rocketed up by 30 per cent last Friday.

The Irish stock exchange, with its biggest burst in history, jumped more than 25 per cent in the first hour of trading last Friday on news of the giant bailout.

Likewise in Asia and Europe, stock markets swung wildly up last Friday after plunging to dramatic lows earlier in the week.

In the US, the heart of the crisis, big plans to purge banks of bad assets and curb short-selling sent the Dow Jones Industrial Average, a key market index, soaring by 780 points in two days.

Because the Dow had plunged by about the same amount earlier in the week, however, the index actually ended the week where it started - pretty much like a real roller coaster.

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