Financial landscape to change forever

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The initial reaction to AIG’s rescue was positive. But the feel-good factor lasted a nanosecond. The authorities were caught between the devil and the deep blue sea. If AIG had gone bust, there would have been mayhem. As it is, the US authorities have looked desperate. As Wednesday wore on, Uncle Sam looked more and more like a tired sheriff who was running out of bullets to shoot the bad guys. The US treasury even had to “bail out" the Federal Reserve by giving it extra cash.

What’s more, the consequences of the last week’s events are only just becoming apparent. The initial reaction to Lehman’s liquidation and Merrill Lynch and Co. Inc.’s takeover was shock. But there are also multiple other effects.

For a start, there are perhaps more than $100 billion (Rs4.67 trillion) of losses on Lehman’s debt. That has caused some money market funds, which investors believe are as good as bank deposits, to “break the buck". It means investors may not get back the money they put in. That realization has helped accelerate the flight to safety — a rush to buy US treasury bills.

The overall risk aversion, meanwhile, has drained cash from money markets as everybody tries to hoard cash. Banks don’t want to lend to each other. They are also wary of lending to funds, and vice versa. Hence, the central banks’ decision on Thursday morning to flood the market with liquidity that, at least temporarily, stopped the downward spiral.

In addition to money market turmoil, the week’s events have also given another twist to the deleveraging ratchet. Lehman, Merrill Lynch, AIG and Halifax Bank of Scotland each had huge balance sheets. These haven’t entirely disappeared. But they are all now, to a greater or lesser extent, likely to shrink.

Then there’s the impact on capital raising. The financial system needs more long-term capital. But after Lehman and AIG shareholders were wiped out, it is even harder to raise it.

There are a few lifeboats out there. Merrill clambered aboard Bank of America Corp. and HBOS Plc. has huddled together with Lloyds TSB Group. But even these deals don’t provide new capital. Indeed, the enlarged groups may need further capital to steady their ships. And there aren’t many other strong rescuers out there. Reports that Morgan Stanley has engaged in merger talks with Wachovia Corp., a bank with its own share of troubles, hint at desperation.

Finally, there’s the psychological impact of Lehman’s failure and Merrill’s takeover. It’s bad enough if institutions are cutting jobs; it’s another matter if they go under or lose their independence. This has led to a pervasive sense of gloom among those who make their livelihood in the industry. There are precious few optimists left.

Of course, the darkest hour is before dawn. But when the light starts to shine, the financial landscape will be very different from the one on which it set.

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