Commercial bank failures will follow Wall Street’s collapse.

September 15, 2008

Only Morgan Stanley and Goldman Sachs remain from the former powerhouses of US investment banking. These are stronger than their dead colleagues, and perhaps it is now fair to say that the lighter, more focused first phase of liquidation in the financial markets is over. The first phase was mostly focused on Wall Street; the second phase begins when commercial banks, with far greater size and significance in the wider economy, face the same problems that their more sophisticated peers have been facing for a whole year. With consumer defaults and prime mortgage defaults accelerating, with little in loss reserves, and an extremely difficult market for accessing capital, the liquidity measures of the Federal Reserve can delay the inevitable for only so long.


So far, September has brought the end of two giant governments-sponsored enterprises, and two giant investment banks. I did not expect Merrill to disappear as an independent firm so fast; the acquisition of Merrill Lynch by Bank of America deserves John Thain a lot of praise. Bank of America is not going to pay any cash for this settlement, it will be a stock swap at a ratio of 0.8595, with the deal closing during the first quarter of next year. This means that Merrill’s shareholders will get less than what they have now, as it’s likely that the share price of Bank of America will fall between now and then. It appears that they’re gaining the ownership of Merrill in exchange for protecting it from short sales, and therefore, bankruptcy.  Bank of America is an enormous institution, and as I noted here before, the herding behaviour of depositors is likely to make it even larger eventually. It may therefore be argued that it’s one of the best positioned institutions to absorb the coming losses at Merrill.


The questions to be asked are on whether Merrill can be a good choice for investment banking anymore, and if its reputation can survive the debacle of the subprime crisis. There’s no shortage of investment bankers in the US; there are likely to be even more of them idle as Bank of America and others shed their excess capacity in order to restructure and restrain costs. So one must ask if an investor, supposing he’s willing to take risks in this environment,  would choose failed Merrill as a manager for his investments, or another new firm untarnished by the excesses of the last years. My belief is that the few remaining players in the investment banking field have parted with their glory for a very long time to come: they’re extremely unlikely to be the dominant players again in the field of financial speculation, just like what happened to the savings and loans after the crisis of the 80s.


Bank of America’s chief Kenneth Lewis believes that acquisitions are crucial, in spite of the experience of its cousin Citigroup with scale. A focused, innovative, well-managed company is better than a less wieldy behemoth: management usually suffers when dealing with giants such as these. Nonetheless, Mr. Lewis seems convinced that his institution will survive these difficulties, and will emerge to become a hegemonic player in the US banking sector. One is tempted to question the wisdom of increasing risk and exposure to acquisitions in an environment where the survival of the present US financial model appears to be in jeopardy; increasing government involvement, and regulation are now the panacea, but those were until recently seen as the bane of properity and development. In any case, those who are willing to buy or merge can always do so at much lower prices. While the incentive for acting early is keeping the employees and expertise of these firms intact, the demand for financial services expertise appears to be diminishing, and employers probably are in a better position than they were a few quarters ago. 


So will the markets rally on this outcome after this week’s coming sell-off? There’s still a lot to be sorted out during this month apart from the immediate shock of Sunday’s double funerals. Earnings reports for third quarter may be less than delightful, and quarter-end funding problems are expected to be a preliminary for the arguably very nervous and chaotic year-end period. I expect the present downward movement to persist until the Federal Reserve is forced to cut rates by the markets. While it’s not clear that lower rates will reduce the problems of solvency that banks and others are facing, it does have a psychological role, and more importantly, in a situation as severe as this, the choice is usually to use every medicine that offers any possibility of cure. 


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