For one thing, if the Federal Reserve is going to act as a lender of last resort to broker-dealers facing liquidity problems, which is pretty much what it has been doing for the last six months, then the Fed will have to play a role in supervising them, too.
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The end of Wall Street as the bankers knew it
Tom Holland
16 September 2008
Hong Kong’s financiers must have been grateful that yesterday was a holiday, although few can have enjoyed their day off.
With local markets closed for the Mid-Autumn Festival, bankers and brokers based in the territory were spared the mass selling that crushed other markets following the weekend’s implosion of Lehman Brothers, the sudden sale of Merrill Lynch, and news that insurance giant AIG was seeking a US$40 billion emergency lifeline.
Missing yesterday’s market bloodbath will have been small comfort, however. Despite the supportive effect of a mainland interest rate cut, Hong Kong’s share prices will play catch-up today.
Worse, financiers will be left calculating the scale of the losses likely on Lehman’s US$157 billion in unsecured debts. Initial projections put the damage at somewhere around US$60 billion, but in truth any figures being bandied around at this stage are guesses rather than informed estimates.
Even scarier, bankers, brokers and investors will all be contemplating the possibility that the forced liquidation of Lehman’s assets, including its US$60 billion real estate portfolio, will exacerbate market volatility and further drive down prices across the board.
That will erode the value of assets on the balance sheets of other Wall Street houses. Clearly Merrill Lynch chief executive John Thain doubted whether his investment bank could survive the probable damage, prompting him to clinch a US$50 billion deal with Bank of America.
Other banks are worried too. Yesterday, ten of the biggest got together to create a US$70 billion fund to help them ride out the storm. Coupled with Federal Reserve credit lines of unprecedented generosity, that should help Wall Street’s remaining investment banks overcome any temporary liquidity problems.
Whether they will able to survive in their present form over the longer term is doubtful, however.
When the financial dust clouds have settled, there will still be a reckoning. Stung by the United States property market crash and the string of subsequent bank collapses, the American people and their leaders will step up their search for scapegoats. Wall Street’s investment banks are the obvious target.
Legislation is inevitable, and while its exact shape is not yet clear, the early signs are that it may make life very difficult for independent broker-dealers like Goldman Sachs and Morgan Stanley. For one thing, if the Federal Reserve is going to act as a lender of last resort to broker-dealers facing liquidity problems, which is pretty much what it has been doing for the last six months, then the Fed will have to play a role in supervising them, too. In the current climate, that supervision is hardly likely to be hands-off.
First to go is likely to be the present model of securitisation, in which banks can package up and sell on credit risk for a fee, with little thought about the creditworthiness of the borrowers.
Expect new rules that will force banks to keep at least a portion of that risk on their balance sheets. That would make credit-fuelled asset bubbles like the subprime boom unlikely, but it would also make investment banking less attractive as a business.
There could also be regulation to rein in the over-the-counter market in derivatives, standardising contracts and forcing them to be traded through a clearing house. Again, that would cut counter-party risk, but it would reduce investment banks’ margins too.
On top of that, there will certainly be new rules governing the way securities are valued on banks’ books. Current “mark to model” methods that give theoretical values for illiquid instruments will be banned, slashing the profits banks can make by structuring complex financial products.
Finally, banks will be allowed less leeway to determine how much capital they need to hold. Tighter standards look certain, with broker-dealers, which rely on short-term money market funding potentially required to hold significantly more capital than are deposit-taking banks.
That would bump up investment banks’ costs and could fatally undermine their whole business model, forcing the remaining independent broker-dealers into the arms of commercial banks.
The process will take a couple of years, but after last weekend it looks unstoppable. So although Hong Kong’s financiers may have escaped yesterday’s blood-letting, many will not be able to avoid the industry shake-out that will follow.
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