The US banking crisis has intensified with the resignation of a second investment bank chief executive, writes Justin O'Brien
In July the chief executive of Citigroup, Charles "Chuck" Prince, captured the hubris of a market dangerously addicted to debt. "When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing," he told the Financial Times.
Prince justified his confidence on modelling systems that had diversified risk. "The depth of the pools of liquidity is so much larger than it used to be that a disruptive event now needs to be much more disruptive than it used to be," he said. "At some point, the disruptive event will be so significant that instead of liquidity filling in, the liquidity will go the other way. I don't think we're at that point."
If we are not at that point now we are close to it. Over the past two weeks major banks in the United States and Europe have reported cumulative losses of more than $27 billion (€19 billion). In the process, two of Wall Street's most influential chief executives have been forced from office.
Citigroup's third-quarter disastrous results demonstrated how far the contagion has spread beyond the subprime mortgage sector, the ostensible trigger for global investor retreat from esoteric debt instruments and those most closely associated with their provision and marketing.
Citigroup posted $1.561 billion in losses associated with mortgages repackaged through a process called securitisation and made available on global markets or "warehoused" for future delivery. The bank's leveraged buyout loan portfolio was marked back by a further $1.352 billion. In a clear sign that the subprime crisis shows no sign of dilution, the bank noted "accelerating delinquencies in September in our US mortgage portfolio".
Prince accepted that the poor performance was "surprising". More revealing, in a conference call with analysts, he said the scale of losses was at "the far end" of outcomes modelled by the bank's risk management systems. He suspected in this "we are not alone". The sad reality is that Prince had a point.
Bank of America announced trading losses of $1.45 billion, "two-thirds [of which] was just mistakes we made in judgment", its chief executive, Ken Lewis, admitted candidly, saying he had had "as much fun" as he could take with investment banking.
"Clearly, we bear a lot of the blame, much more so than just market conditions," Lewis said.
Merrill Lynch stunned the market by announcing an even bigger loss, setting aside $7.9 billion to cover a shortfall in the valuation of its asset-based securities portfolio. Its chief executive, Stan O'Neal, was forced out by a board indignant about the scale of the losses. The resignation intensified the pressure on Chuck Prince precisely because Citigroup has by far the most exposure to the Special Investment Vehicles that are at the centre of the maelstrom.
The bank's off-balance sheet liabilities total $80 billion. Finally, on Sunday, Prince accepted the inevitable. "It is my judgment that given the size of the recent losses in our mortgage-backed securities business, the only honourable course for me to take as chief executive officer is to step down," he said in a statement.
The bank announced that it will make a further provision of between $5-7 billion in the next quarter as the value of its asset-backed portfolio continues to decline. This ritual cleansing may demonstrate resolve but it also reflects panic. The Securities and Exchange Commission is investigating the legality of the accounting devices used. Just as significantly, despite these markdowns, buyers remain elusive.
Major structural problems are now apparent in what one senior investment banker described to me in New York recently as a "market of incendiary toxicity". While the global parameters of the securitisation crisis are beginning to come into view, what the policy response should be is far from certain.
At the bottom of the market, mortgage providers are under significant pressure to accept refinancing arrangements to offset the calamitous effect caused by automatically readjusting mortgages moving from low introductory rates to punitive levels.
The political necessity for market-based renegotiation becomes clear when the mortgage default map is superimposed on to the electoral one. The highest rates of foreclosure are occurring in states such as California, Ohio and Florida, each pivotal in the race for the presidency.
In the medium term, proposals to ban or curtail predatory lending have gained traction at state and federal level. The threat may help to concentrate lenders' minds and introduce some flexibility but it is too little, too late. Faced with an accelerating housing market downturn, property owners across the country are simply handing in their keys in record numbers.
The problem for policymakers is that reducing delinquencies by lowering interest rates further risks a moral hazard. In a speech to the Economic Club of New York, the Federal Reserve chairman Ben Bernanke hinted that the markets should not expect further decreases. "One must also take seriously the possibility that policy actions that have the effect of reducing stress in financial markets may also promote excessive risk-taking and thus increase the probability of future crises," Bernanke said.
While sympathetic to the plight of those facing ruin, the Federal Reserve chairman acknowledged a deeper structural crisis. "The ultimate implications of financial developments for the cost and availability of credit, and thus for the broader economy, remain uncertain," he said.
This state of affairs could be attributed to the fact that investors have not "fully regained confidence in their ability to accurately price certain types of securities". This makes the timing and nature of a proposed $100 billion superfund brokered, but not financially underpinned, by the US treasury all the more surprising. The Master Liquidity Enhancement Conduit, which is to be led by Citigroup, is designed to energise the stalled short-term commercial paper money market.
It serves a further purpose. It will allow the banks most exposed to progressively unwind more than $400 billion in outstanding debt without triggering market panic. It is unclear, however, what price the securities will achieve. The market stalled precisely because investors lost confidence in valuations made by the banks and legitimated by rating agencies operating under a structural conflict of interest.
The US treasury secretary, Hank Paulson, now says that future regulation may be required because "regulators didn't have clear enough visibility with what was going on" within off-balance sheet Special Investment Vehicles. His department's role in brokering the deal essentially legitimates a model that led to the artificial inflation of asset prices and operates suspiciously like the special purpose entities used by Enron to mask the true ownership of risk.
If the plan works, the banks will beat an orderly retreat from a now discredited form of financial engineering. It may even preserve or enhance the supply of credit. It will not, however, deal with more fundamental operational and structural problems associated with financialisation of the global economy.
Nor will it deal with the abdication of responsibility that saw investment bankers create conduits to introduce and disseminate toxicity with careless disdain. The plan may preserve financial capital; it in no way compensates for the loss to reputation such abandon has caused to either the banks or the integrity of contemporary markets.
• Justin O'Brien is Professor of Corporate Governance at the Centre for Applied Philosophy and Public Ethics in Canberra, Australia