Job No. 1 for central bankers: restore confidence in markets.
The new challenge for the world's central bankers is not saving another bank or financial institution. It's restoring confidence in world markets.
Just like August 2007 when the US housing debacle began, investors and bankers are now distrustful of lending money even to fellow bankers. When giant insurance company AIG needed help, no one except the Federal Reserve was willing to come to the rescue. The US stock market, sometimes considered a barometer of confidence in the economy, is slipping further into the red. Overseas, market losses are steeper.
The short-term implications of the void in confidence is skyrocketing short-term interest rates, which have prompted central banks to inject billions of dollars to try to calm world markets. Longer term, unless confidence returns, the world's economic prospects could dim further.
In the US, the financial events of the past few weeks hit a dizzying pace. On Sept. 7, the US government took over Fannie Mae and Freddie Mac, both major players in the mortgage market. Then on Monday, Lehman Brothers filed for bankruptcy after the government refused to bail it out and Merrill Lynch was purchased by Bank of America. On Tuesday night, the US Federal Reserve agreed to give insurer AIG a short-term bridge loan of $85 billion so it can begin to sell some of its assets. At the same time, there were reports that regulators are gauging interest among other banks in buying Washington Mutual.
Globally, there are reports of major changes as well. In London, Britain's largest mortgage lender, HBOS, saw its stock lose 30 percent of its value in two days and there are reports it will be acquired by Lloyds TSB.
The authorities in London have already stepped in on one occasion to save a failing bank, Northern Rock. Britain acted after depositors lined up around the block to get their money, the first run on a British bank in 150 years. The government finally decided it would have to effectively nationalize Northern Rock, at a cost of around $100 billion to the taxpayer. Chancellor Alistair Darling explained the British rationale on BBC Radio this week: "The test that we apply, and the test that I think the Americans apply, in relation to any institution, is if it went down, would there be a systemic risk – in other words, would it have a knock-on effect into the rest of the system."
The massive financial changes are prompting investors to shift to US Treasury securities, considered ultrasafe. However, this has also left many banks and financial institutions struggling to raise short-term cash.
In Portland, Ore., John Lekas, portfolio manager of Leader Short-Term Bond Fund, says he has been buying depressed bonds from regional financial institutions and getting returns of 13 percent to 21 percent. "No question, we've got a panic going on right now," says Mr. Lekas. "It's actually worse than last August."
In the past, the financial markets leaned on foreign investors to provide capital for financial firms. But Mr. Sohn, former president of Hanmi Bank, a Korean-American institution, says he doubts Asian investors will come piling in since they have already lost too much sleep over their investments in Fannie, Freddie, and Lehman Brothers. "They are scared to death," he says. "I don't think the Asians have any inclinations to invest in the US or come to the rescue."
Some analysts in China echo that view. China's sovereign wealth fund, China Investment Corp. (CIC), has lost so much on US investments in the past 18 months – notably in Morgan Stanley and Blackstone – that "it has been bitten several times and is shy," says Andy Xie, an independent financial analyst in Shanghai.
Shares of Blackstone, a private equity fund, and Morgan Stanley, an investment bank, have fallen more than 50 percent since Beijing bought in to them.
Chinese officials are also unlikely to allow a Chinese bank to buy a US institution outright, since running such a complex company would be too technically challenging for inexperienced Chinese bankers, says Mr. Cavey. "It is not impossible that the CIC or a big Chinese bank might buy a stake in a struggling US institution."
Other Asian and Middle Eastern sovereign wealth funds will probably be equally wary, says Mr. Xie. "The Wall Street guys have a credibility problem."
When those funds threw lifelines to Western financial institutions last time "they were convinced that these were still good businesses that had temporary problems" says Xie, pointing to the $4.4 billion dollars that the Singapore government's sovereign wealth fund invested in Merrill Lynch in December 2006.
"They've lost tons of money," Xie points out. "They are less eager to get involved this time in a recapitalization effort."
Some Japanese analysts take a somewhat longer-term view. "The next six to nine months will continue to be difficult," says Hiromichi Shirakawa, chief economist at Credit Suisse in Toyko. "People are seeing the US markets as not a great place to invest, but that's a short-term thing."
In the meantime, he says, "investors are stepping back and watching to see if things stabilize."
One positive aspect, he says, is that the US is tackling the financial problems much faster than Japan did when it had banking problems in 1991. It took the Japanese 12 years. "The US is much more flexible," he says.
Some Japanese economists say they were encouraged by the AIG bailout. "If they hadn't done that, international investors would have been anxious about the US market," says Yoshimasa Maruyama, an economist at BNP Paribas Securities Japan Ltd. in Toyko. "The action was key to reassuring international investors."
In fact, some foreign analysts believe the financial turmoil may be close to ending. "Big players like Lehman, AIG, Merrill Lynch, I don't feel there are a good many more of these in the pipeline," says Mike Lenhoff, chief strategist at Brewin Dolphin in London. But, he adds, "Everyone is cautious right now. We will need to see stability."