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  On the Verge of Collapse: Can the State Save Banks?

On the Verge of Collapse Can the State Save Banks?

By SPIEGEL Staff

Part 4: A Bomb Striking the Financial Markets

The shrapnel from this bomb striking the financial markets could also affect small investors. Certificates issued by Lehman are practically worthless. In addition, money market funds, in particular, often contain shares of Lehman bond issues, which have brought in especially high interest payments in recent months.

But there are also winners. Speculation isn't dead! It has merely sought a new victim: the financial industry itself.

Those filling their pockets this time are the ones who bet on the credit debacle early on. William Ackman, founder of the Pershing Square Capital fund, bet on the crash of the two mortgage giants Fannie Mae and Freddie Mac, now nationalized, in the spring. Fund manager John Paulson earned close to $4 billion (€2.8 billion) last year alone by betting against subprime mortgages.

Soon investment companies will begin buying up bad debt at bargain-basement prices and selling it at a profit. Some funds have already collected billions to do so and are lurking, vulture-like, on the sidelines of the battlefield.

These days, however, David Einhorn is seen as the king of speculators. For months Einhorn, who heads the hedge fund Greenlight Capital, was convinced that Lehman was on its way out, and he was even telling everyone what he believed. Last Monday Einhorn was proven right.

Einhorn did what hedge funds often do. He borrowed Lehman shares months ago, sold them immediately and bet -- correctly so, as it turned out -- on a sharp drop in the share price. Then he repurchased the shares at a low price and returned to them to their original owner. The difference between the selling and buying price was Einhorn's profit.

This miraculous way of growing assets is called short selling. Funds, often acting as a pack, drive down the prices of ailing companies, thereby maximizing their own profits.

But those days are over. To protect the banks' stock prices, American, British and German regulatory agencies promptly banned or heavily restricted short selling.

There is a certain irony to the fact that the investment banks are supposed to be protected against the excesses of turbo-capitalism. The revolution, it appears, is consuming its children.

For decades, investment banks like Lehman Brothers and Goldman Sachs were satisfied with their classically sold core business. They invested in stocks and bonds for institutional investors -- insurance companies, mutual funds and pensions funds. They advised corporations during mergers and acquisitions, as well as handling initial public offerings.

The profits were considerable, and yet they were not enough. When exclusive partnerships prompted the investment banks to go public, the profit squeeze grew tremendously -- as did the fantasies of investment bankers.

First they began speculating with their own money, and later they began borrowing outside capital, as well. In the end, they were borrowing 30 times as much as they had invested themselves. In industry slang, this orgy of borrowing was politely referred to as leverage.

Returns well in excess of 30 percent were considered par for the course. Goldman Sachs alone paid its 26,000 employees a total of $16 billion (€11 billion) in compensation in 2006. At Lehman, CEO Richard Fuld earned close to $500 million (€347 million) in 15 years.

Only when American real estate plunged did the fantasy world of the Wall Street investment banks fall apart.

Suddenly, even Americans are talking about the need for more stringent financial oversight, more control and more transparency. "We need new government agencies," Paulson recently said. This is an unusual admission for an American. For years, US and British government representatives favored self-regulation of the financial sector.

Peer Steinbrück and German Chancellor Angela Merkel were forced to learn the same lesson during Germany's chairmanship of the Group of Eight industrialized nations (G8) last year. They proposed, at the time, stronger government regulation of hedge funds, which had been more or less unregulated until then. Their goal was to make it possible to recognize and avert risks to the global economy as early as possible.

But the German effort was doomed in the face of concerted resistance from Washington and London. The Anglo-Saxons viewed fears as eccentricity bordering on hysteria.

A year and a financial crisis later, the British and Americans have changed their minds, and Steinbrück feels vindicated, even though banks, not hedge funds, triggered the current crisis in the global financial system.

Banks are at least partially regulated, commercial banks more so and investment banks to a lesser degree. In the United States alone, it is a job shared by several government agencies, but supervision is often not very efficient.

Many banks took advantage of this and shifted large parts of their business to so-called special purpose entities. As a result, highly speculative transactions never appeared on their balance sheets. A shadow industry developed. To avoid similar problems in the future, this loophole in the American financial system ought to be closed. In addition, risky bank deals could also be bolstered by more equity in the United States, as they are in Europe already.

But first the current crisis must be surmounted, and the government now plays the key role in this process. It must intervene now because, in years past, it failed to control the forces of turbo-capitalism.

While the US government is preoccupied with cleaning up the real estate and investment banking debacle, the insurance industry threatens to become the next trouble spot.

Financial instruments known as credit default swaps are considered especially risky. Not unlike an insurance policy, their purpose is to hedge against credit risk. Because regulation and transparency are also absent here, credit default swaps have developed into what are probably the most dangerous wagers in the global financial casino today.

At the same time, they have also experienced dizzying growth. In the past five years, the volume of these credit derivatives has grown by a factor of 30 -- to $62 trillion (€43 trillion), close to 20 times Germany's gross domestic product.

In the high-stakes bazaar of credit default swaps, default protection can be had for just about anything, including the debts of companies like Daimler, Deutsche Telekom and Goldman Sachs.

Panic in the financial market has led to widespread increases in premiums. The index for European corporate credit risk jumped considerably in recent days. "Investors in the credit markets should prepare for a tough winter ahead," says Philip Gisdakis, credit strategist with Unicredit, an Italian financial conglomerate.

The world is interconnected on a woven network of reciprocal payment obligations. In late 2007, the Bavarian State Bank alone had credit derivatives worth €136 billion ($196 billion) on its books. At the same time, Allianz was holding securities worth €1.14 trillion ($1.64 trillion).

Who has how much of whose debt on their books? And who will be the next to do down for taking on too much or because of a failed risk model?

Traders routinely pass on credit risks, which explains the immense market volume of more than $60 trillion (€42 trillion). No one knows where they end up.

Until recently, only a small circle of global financial jugglers cared. Actual effects on the real economy did not seem to exist.

For years, it seemed as though the financial markets were more or less disconnected from real life. The protagonists, in their office towards in Manhattan and Frankfurt, worked in a different world, clearly separate from the sphere of production in factories.

Many of their complicated financial structures paid for or insured completely normal deals involving ordinary goods. But a large share of the hard currency worth more than $3 trillion (€2.1 trillion), shifted from account to account around the globe every day, has only one goal: fast interest and turning a quick profit. This is capital that no longer funds exports, but is now pure speculation.

This impression was deceptive, as the crisis revealed. In fact, the turmoil in the financial markets is having a powerful effect on the real economy, at least in the United States. Unemployment is rising while real estate prices continue to decline. The willingness to invest capital is shrinking. The country is teetering on the edge of a recession.

Only by injecting $150 billion (€104 billion) into an economic stimulus program has the US government managed to keep the economy relatively stable until now. But this success is in jeopardy. Bank failure could further fuel the fears of consumers and companies. Besides, the government in Washington has little in the way of additional funds to encourage consumption and investment. And no one knows what the planned rescue solution will end up costing in the end.

The US crisis will not leave the German economy unaffected. Declining demand will affect the world's leading exporter in key markets. In addition to the United States, a number of European countries are also ailing, most notably Great Britain, Spain and France. Real estate bubbles in these countries have also burst, leading to slowdowns in consumption and investment.

Because of these factors, the German economy has contracted noticeably compared with the first three months. The government's economic experts have been unable to offer positive news for the current third quarter.

Things are not looking up for next year, either. The experts working for Economics Minister Glos are preparing to revise their already meager prognosis of 1.2 percent growth for the coming year downward -- to as low as 0.5 percent. Peter Bofinger -- a member of the German Council of Economic Experts, which advises the government in Berlin -- is even more skeptical. "I believe that stagnation is a possibility for next year," says the economic sage.

But all of these predictions are based on a relatively optimistic premise: That Paulson, Bernanke and associates will manage to prevent a meltdown of the financial sector.

BEAT BALZLI, FRANK HORNIG, CHRISTOPH PAULY, CHRISTIAN REIERMANN, WOLFGANG REUTER

Translated from the German by Christopher Sultan