The Australian Business News

The credit crisis continues in big bank failure

Adele Ferguson | September 27, 2008

THE high drama of the global credit crisis continued unabated yesterday with the US suffering its biggest banking failure in history and the $US700 billion ($843 billion) bailout to restore credit markets going from the sublime to the ridiculous.

Until the bailout issue is resolved, everything else will remain a sideshow with investors steering clear of debt and equity markets until some semblance of a decision is made.

The gravity of the situation was highlighted by the collapse of Washington Mutual, which was seized by regulators without the knowledge of the board or chief executive and sold to one of the country’s largest banks, JP Morgan Chase & Co.

That regulators took such draconian action speaks volumes about the power regulators will assume in this new world of deleveraging. It also says a lot about Washington Mutual’s financial situation that it should warrant such action.

As Simon Bond, a dealer at ABN Amro Morgans says: "How do companies with such great assets go belly up within days once a cascade of bad things start happening?"

At the outset of 2008 there were five major independent investment banks and now there are two. A core reason is that the leveraged finance business model is a very poor one. "It allows you to make a killing when times are good, but on the flip side it can bankrupt you within days when the tide turns. That is not a risk-reward scenario that companies should embrace," Bond says.

It is no surprise that, amid such uncertainty, investors in the debt and equity markets are running scared. In Australia, the banning of short selling for 30 days has been blamed on the lack of volume in the market, but the reality is nobody has the stomach to invest in stocks in such uncertain times.

Indeed, the biggest traders of equities are believed to be the debt-swollen hedge funds as they liquidate their positions in equities and commodities following the ban on short selling and ahead of a spike in quarterly redemptions by investors in the remaining days of September.

Too many redemptions will put hedge funds in the danger zone. The reason is simple: hedge funds are so highly leveraged and have so many positions in equities and commodities, many of which are illiquid, that it is hard to estimate the magnitude of the damage they could do as they are forced to unwind their positions.

Any hedge funds with big exposures to stocks that have been the subject of takeover rumours will hurt even more.

For instance, Babcock & Brown, which is one of the most shorted stocks on the ASX, has witnessed a share price rise of more than 200 per cent in the past few days.

The rumour that it was going to be sold to European interests for $2.50 a share would have crippled hedge funds trying to buy the stock as cheaply as possible to cover their position.

Likewise, any hedge funds trying to unwind their position in Foster’s would have been hurt by the rumour that Deutsche Bank had built a significant stake in Foster’s Group on behalf of Molson Coors Brewing Co.

Foster’s jumped 5.8 per cent to $5.66 a share.

While these rumours are helping volumes in these stocks, the overall market is almost dead. This will undoubtedly hurt the broking industry. Low volume means low fees.

But one of the biggest victims of the great deleveraging are the wholesale funding markets. The many business models that were spawned in recent years evolved on the assumption that wholesale fund markets would always be open and always deep, liquid and cheap.

According to a note to clients from Southern Cross Equities, the top six Australian banks have wholesale funding requirements of $129 billion in the full year to 2009. "Banks have started to find other ways of filling the short-term funding gap, such as underwritten dividend reinvestment plans (which are dilutionary) through to hybrid issues and even tapping the Future Fund for help," the note says.

To try to ease the situation in funding for banks and non-banks, Treasurer Wayne Swan announced yesterday that the Government’s Australian Office of Financial Management would invest $4 billion in the domestic residential-backed mortgage market in an attempt to boost competition in home lending amid the global credit crisis.

The Treasurer said that Australian banks did not have significant exposures to troubled mortgage-related assets.