Saturday, September 12, 2009

"Things were right on the edge" - the crisis as it unfolded one year ago, revealed

Phil Coorey, with the inside story one year on:

"Steve Morling's job was to monitor events in the United States and keep the Treasurer, Wayne Swan, informed. His language was not typical of the impenetrable terminology used by economists, but the frank vernacular of crisis.

At 6.51am (Australian time) on December 10, Morling emails that Lehman's shares had fallen by 45 per cent and the company could be forced to sell its assets at "fire sale prices".

"It's dilemma is that no one wants its crappy assets but if it sells off its good assets, then it hasn't got too much left of any value and it might go under anyway."

Two days later, on September 13, there are two cables. The first, sent at 5.06am, is brief and blunt.

"Lehman continues to be under extreme pressure - prices are continuing to fall and it is down 94 per cent over the past year."

Two hours later, Morling warns of a looming disaster with AIG: "Shares in AIG - a huge insurance and financial services company (and the 18th-largest company in world) - are falling sharply (31 per cent today)."

Two days later, on September 15, at 7.54am - Sunday evening in Washington - Morling all but reads Lehman Brothers the last rites.

"Barclays and BA have walked away. Speculation that Lehman may now go into bankruptcy. Something may still happen tonight; othwise [sic] it's going to be an interesting morning!"...

It's here.

Also Tim Colebatch:

"IT FELT like a financial earthquake, in slow motion. You could feel the financial ground giving way beneath you. You could see the money you had saved over the years sliding into the abyss. And you could do nothing to stop it.

We lost $1 of every $3 we owned in financial assets - despite all the money we poured into our bank accounts and superannuation in that time. Around the world, people thought we could be facing a Great Depression like the 1930s.

But a year later, it hasn't turned out like that. Why has this crisis proved so much milder than we expected? Why has Australia escaped so much of the fallout? And what lies ahead?...

In a nutshell, stimulus worked. When the markets failed, governments came to the rescue on a scale never seen before.

To restore trust, they guaranteed bank lending and borrowing. To prevent banks collapsing, they injected hundreds of billions of dollars in capital. And to put a floor under the economy's fall, they started spending trillions of dollars in economic stimulus measures, and slashed interest rates to minimal levels.

Treasurer Wayne Swan says they were working in a sense of crisis. ''I remember clearly thinking, 'This thing is going to be bigger than Ben Hur','' he says. ''It quickly became apparent that we were looking at something not seen in our lifetimes.

''It seemed there was a daily torrent of catastrophic news. I would come in at around 5.30 in the morning, and get briefed about some new collapse or bail-out on such a massive scale that it was scarcely believable.''

In the markets, trust broke down. Fear ruled. Some markets stopped operating; sellers could not rely on buyers being able to pay. Banks saw their capital eroded by heavy losses, but were helpless to save themselves, because investors were too afraid of buying a dud asset. Lending froze, because banks feared borrowers might not repay them. Insolvencies and defaults mounted. In the end, only one thing stood between markets and total collapse - and that was government.

This week Kevin Rudd and John Howard each claimed paternity of Australia's relative escape and, sure, there are lots of reasons why our slump has been mild. But the most crucial is that, in one way, Australia was never part of the global financial crisis.

Our financial system did not collapse. Our banks needed government guarantees to keep borrowing, but did not need to be bailed out. The big four remain obscenely profitable. Of just 11 banks worldwide to still have AA credit ratings, four are ours.

Why? Our banks refused to follow their US counterparts into the risky swamps of derivatives and credit-default swaps. They stuck largely to home lending, and Australia's real-estate boom gave them lots of opportunity for that.

It was partly good management by bank chiefs already burnt by risky lending in the '80s. It was partly good regulation by the Australian Prudential Regulation Authority under chairman John Laker, who ignored the mantra of ''light-handed regulation'' and kept nipping at the heels of the banks to head them away from risk.

And it was partly luck, that we had had our own smaller crises to learn from, and that strong population growth combined with low levels of home building to create a housing shortage, holding up prices.

Population growth also helped keep the economy growing. The Bureau of Statistics estimates that last year Australia grew by 406,000 people - the highest number ever. You can see it in Melbourne's trains and on the streets, and it's kept up demand for housing, consumer goods and services, muting the downturn.

But economists also see the Federal Government's fiscal stimulus measures as crucial. The $21.5 billion handed out to households has helped prop up retail sales, even if half of it was saved. The first home buyers' grants and investments in school buildings and public housing have turned around the outlook for construction. And exports were propped up by the Chinese Government ordering its firms and local councils to borrow and invest.

And where will we be in a year's time?

If the markets are right, Australians will be deep into recovery, at the cost of higher interest rates: up 1.5 percentage points, implying mortgage rates of 7.3 per cent, from 5.8 per cent now.

But if the economists are right, our recovery will be slow and unsteady, held back by the ongoing weakness of US, European and Japanese banks, firms and households paying back debt rather than borrowing, and the backwash as government stimulus is withdrawn, especially in China.

And David Uren:

What recession? Despite the pain suffered by those who have lost jobs and assets, little like the dire forecasts of last year has occurred

TWELVE months after the failure of the US investment bank Lehman Brothers, kicking off what became known as the global financial crisis and the Great Recession, the world looks little like the Great Depression of the 1930s despite the many dire warnings.

No major banks have failed in recent months, car sales are improving worldwide and world trade grew 2per cent in the June quarter.

In Australia, conditions remain far from normal. The recently completed round of annual company profits was down about 12 per cent, the biggest drop since the 1990-91 recession. There are about 220,000 fewer full-time jobs now than there were a year ago.

But in the Depression, unemployment hit 32 per cent in Australia, while it rose above 10 per cent in the recessions of the early 1980s and 90s. Retail sales figures out the other day showed food sales dipped 1 per cent in July, but we're not reduced to hunting rabbits.

The Australian economy is performing much better than any of the other advanced economies. But the rest of the world is also not conforming to the more pessimistic forecasts. Indeed, across the world, economic news has consistently been coming in better than expected since the beginning of the year as the chart, which measures the balance of positive and negative surprises on new economic releases.

It remains the most serious post-war recession, with unemployment about 10 per cent in Europe and the US, but recovery is in the air across the world.

WHEN the news flash reporting the collapse of Lehman Brothers hit the screens of local financial market operators on the Australian east coast about lunchtime on September 15 last year, there was the wincing relief of a boil being lanced.

The fate of the fourth largest investment bank in the US had been hanging in the balance over the previous week, its plunging share price bringing world markets down with it.

The Australian sharemarket, which had lifted 69 points on the previous Friday in hope of a rescue over the weekend, gave up 87 points that Monday (September 15) on the news of the failure.

On the Tuesday, it emerged that legendary US broker Merrill Lynch had been sold for a pittance, at the point of the US banking regulators' shotgun, to the Bank of America while shares in the world's biggest insurer, AIG, were in free-fall as banks started withdrawing their credit lines to it. When it was taken over by the US government on the Tuesday night, markets plunged amid wild speculation on what would be the next financial domino to fall.

"When I first learned that Lehman had gone down, I remember clearly thinking, `This thing is going to be bigger than Ben Hur'," Treasurer Wayne Swan recalls. "I was getting frequent briefings from my senior Treasury guy in the Washington embassy and it just seemed there was a daily torrent of catastrophic news.

"I would come in at around 5.30 in the morning, and shortly after get briefed about some new collapse or bailout on such a massive scale it was scarcely believable.

"Over that week, it became quickly apparent that we were looking at something not seen in our lifetimes."

The implications of Lehman's collapse began to sink in. No one knew who had what exposure to Lehman's $US613 billion debt, because so many of its deals were insured against the possibility of the bank failing, using a credit instrument invented in the late 1990s called a credit default swap.

These products had mushroomed with the value of debt securities insured rising from $US6 trillion in mid 2004 to reach a peak of $US60 trillion in 2007. More alarmingly, no one had any idea of the financial standing of either the intermediaries providing the insurance, or of the value of many of the underlying loans.

As the credit bubble inflated by these products burst, debt securities that supposedly had a one in 100,000 chance of defaulting did the unthinkable. The world's major banks became alarmed about the plummeting value of assets on their own balance sheets and then lost faith in the value of the assets held by other banks.

The rivers of money flowing between the world's banks started to slow, with banks demanding an ever larger premium to cover the risk of lending to each other.

UBS bank interest rate strategist Matthew Johnson says the nightmare moment came about October 10 when the market premium or extra rate that banks demanded for interbank lending blew out to about 4percentage points, at which point trade froze.

The only financial market that was working was foreign exchange futures, where traders were demanding a premium of 11 percentage points to deal in US dollars. Bond markets froze worldwide.

The commercial paper markets, which companies worldwide use to finance their working capital, stopped working. Sharemarkets plummeted worldwide, with Australian investors losing 30 per cent of their wealth between September and mid-November.

The world was staring into a financial abyss where business could not be funded, no investment undertaken and no global trade shipped.

Weird things started happening: the interest rate on short-term US treasury bonds went negative, with hedge funds paying the US government to look after their cash, while, at the same time, the credit default swap market was putting the chance of the US government defaulting on its long-term bonds at about 40 per cent.

Reflecting on the crisis after launching this year's budget, Swan recalled that as cabinet's budget subcommittee gathered on October 11 and 12 to consider what should be done, there was a consciousness of the plight of the Scullin Labor government in the wake of the 1929 sharemarket crash.

"That government was swamped by events it could neither understand nor control. Sitting around that cabinet table in October and by teleconference from [Washington] DC, we were determined that history would not repeat itself. We were determined to respond with immediacy, purpose and effect," he said.

As preliminary data started to emerge, the drumbeat of depression grew louder. Car sales dropped 40 to 50 per cent in the major economies raising the threat of widespread bankruptcies in the motor industry. Countries that had nothing to do with sub-prime lending, such as Japan, started reporting output from their factories falling 10 per cent a month. World trade plunged 25 per cent in three months.

Influential research exploring previous financial crises found they typically caused falls in gross domestic product of 9 percentage points and unemployment rising 7 percentage points. However this crisis, being global, had the potential to be worse.

At the annual International Monetary Fund meeting managing director Dominique Strauss Kahn observed: "We are living through the most dangerous financial crisis since the one that led to the Great Depression. Many people have observed that some aspects of the current crisis are similar to that terrible crisis: among the public, over-optimism followed by a faltering of confidence, in the markets, mania followed by panic. Many people fear that the economic consequences could be as important."

He did not agree, arguing that world leaders had learned from past mistakes and now possessed tools to intervene in their economies not available then.

A PERCEPTIVE speech by Reserve Bank Governor Glenn Stevens earlier this year underlined the stunning speed and simultaneity of the crisis, with production coming to a standstill in every major country including China in the final quarter of 2008. He suggested this may again be seen in the upswing.

Most people thought this unlikely because the collapse in wealth and the need for the private sector to cut debt would constrain both household demand and the ability of the banks to expand lending, he said.

"Yet the speed and size of the responses to the downturn by policy-makers around the world is just as unprecedented as the speed and size of the downturn itself. If there were an upside surprise on global growth, it would most likely be because the collective effects of all those policy responses turned out to be bigger than expected, perhaps because those expectations were formed by looking at a history where such simultaneous responses rarely occurred."

Governments across the world had responded to the IMF's clarion call to pump money into their economies with massive cash handouts and spending packages, while central banks slashed interest rates and took over the job of financing the private banks and, in several countries, private business as well.

Australia went into the crisis with the highest interest rates in the developed world, but it also cut them hardest, with rates dropping 3 percentage points between September and December.

The Australian government was first to respond with fiscal spending, with its first $10.4bn package dominated by cash handouts to families and pensioners, unveiled on October 14, responding to the advice of Treasury secretary Ken Henry of "go early, go hard, go households".

Followed by a second huge $42bn package in February, Australia's stimulus spending totals 4.9 per cent of GDP, which is one of the biggest stimulus investments in the world. However it is dwarfed by the 5.8 per cent of GDP package launched last November by the Chinese authorities, which was also supported by a massive surge in lending by China's banks.

In speeches late last year, both the RBA's Stevens and Treasury's Henry emphasised the role of confidence. "Fundamentally what is driving weaker economic outcomes globally at the moment is fractured confidence," Henry told the National Press Club.


The contribution of the stimulus delivered both by the government and the Reserve Bank to the strength of Australia's economy is widely debated, but it softened the collapse in household demand, supported business investment and boosted fragile housing markets.

Macquarie Bank senior economist Brian Redican says there are several elements to Australia's performance.

"There is our good fortune to have China as our major trading partner. It is also a good testament to the flexibility and responsiveness of policy makers, both the government and the Reserve Bank. It also reflects the fact that we didn't have the housing speculation of the US and other countries, mainly because the Reserve Bank was concerned about inflation and had been pushing up interest rates."

Opposition treasury spokesman Joe Hockey has his own list of reasons, starting with the strength of the economy going into the crisis, with 4 per cent growth, 4 per cent unemployment and strong public net assets.

Australia had no major financial collapses or banks in serious trouble requiring bailout, such as Citigroup in the US and Royal Bank of Scotland in Britain. Monetary policy was particularly effective with big rate cuts passing directly through to households because of the widespread use of variable rate mortgages.

The flexibility of a free floating currency also helped, with the value of the Australian dollar skittering from US85c to US65c in the space of six weeks.

Finally, Hockey acknowledges that the government's budget stimulus helped. "If you throw enough money at something, some of it will stick. Our argument was it was too much money and poorly targeted," he says.

Looking back on the most turbulent period managed by any treasurer since Ben Chifley during the war, Swan reflects on the turmoil of last September:

"A lot of water has gone under the bridge in the year since then, but I can honestly say I'm proud of the way we've come through the global recession that followed.

"Stimulus has meant we're basically the only advanced economy to avoid recession and we've got the lowest debt and deficit, unemployment is much lower than it would otherwise be, and the bank guarantees have helped our banking sector get through a very torrid time."