The start of the week saw a banking earthquake, a Jet-Black Monday after a Black Sunday -- at least for the financing sector. Monday's opening on Wall Street saw Bank of America stocks tumble 13 percent, and shares of Citigroup lose 6 percent of their value. Washington Mutual, America's largest savings bank, lost over 15 percent of its market value, and Switzerland's UBS dropped over 20 percent. The biggest loss by far was suffered by the American International Group (AIG); in a single day, America's largest insurance company lost almost half of its market value.
The epicenter of the banking and market earthquake was in New York in the headquarters of a venerable banking establishment with German roots. On Monday morning, after a desperate fight for survival, Lehman Brothers, America's fourth-largest investment bank, declared bankruptcy. At the same time, people learned that Merrill Lynch -- America's third-largest and likewise crippled investment bank -- would be rescued by Bank of America.
In conversations with SPIEGEL ONLINE, finance experts have confirmed the seriousness of the situation -- and described the risks for Germany as well. "Lehman poses a risk for the international financial world," said Hans-Peter Burghof, professor of banking at the University of Hohenheim. "It's irresponsible to let a bank of this caliber simply go broke. That sends shockwaves all the way to Frankfurt (Germany's financial capital)."
In light of this new turbulence, even German Finance Minister Peter Steinbrück has been forced to evoke unusually clear images when he speaks. As he sees it, the very people who had prematurely spoken about there being a light at the end of the tunnel will now be forced to realize "that, in reality, it was the light of an oncoming train."
SPIEGEL ONLINE has compiled a brief overview of the origins of the current banking crisis and how it could affect Germany.
How Lehman Bros. Could Vanish into Thin Air in a Single Week
Within a single week, the price of Lehman Brothers shares went through the floor. According to one investor, the institution had been trying for weeks to get hold of some fresh capital. In the second quarter, the financial crisis had seen the investment bank forced to accept $2.87 billion (€2.01 billion) in losses. But by Monday, Lehman had run out of time.
Investors were originally hoping for a stake acquisition from the Korean Development Bank (KDB), but this hope was dashed by last Wednesday. Already a day before KDB's official announcement that the deal had fallen through, the price of Lehman stock had already nose-dived a further 46 percent. On that day, Lehman announced record losses of $3.9 billion for the third quarter.
From that point on, the institution's stock had double-digit losses in value almost daily. Of course, people still harbored the hope that the US government would bail the company out. But as it started to become clear that the government wasn't planning to intervene, both Barclays and Bank of America jumped ship as potential rescuers. On Monday, the Wall Street institution -- with 26,000 employees and a total of $786 billion in debt on its balance sheets -- declared bankruptcy.
"All the way up to the last moment, many were hoping that Lehman would somehow be rescued by the US government," said Wolfgang Gerke, a retired professor of banking and stock-market finance, who has been president of the Bavarian Finance Center since 2006. "Now the financial world is experiencing what it's like for one of the biggest banks in the world to be forced to file for Chapter 11 (bankruptcy protection)."
If you ask Dirk Schiereck, however, professor of finance at the Technical University of Darmstadt near Frankfurt, Lehman's crash comes as no real surprise. "Lehman had been teetering on the brink for a long time," Schiereck told SPIEGEL ONLINE. "For six months now, there had been more and more rumors that the institution had much more serious liquidity problems than had been previously known. The collapse of the KDB deal was only the last nail in the coffin."
Which Other US Financial Institutions Are in Acute Danger of Collapse
Since mid-2007, 11 small US banks have been forced to close their doors. Christopher Whalen from Institutional Risk Analytics has even predicted that, by July 2009, almost 110 of the 8,400 banks in the US might have to call it quits. And while the financial world is processing the collapse of Lehman Brothers, other financial institutions are coming under pressure:
- Washington Mutual, America's largest savings bank, finds itself in a downward spiral that is threatening its very survival. Since the intensified outbreak of the credit crisis a year ago, the company's stocks have fallen by over 90 percent.
- Even Merrill Lynch, the third-largest investment bank in the US, has taken the full impact of the credit crisis. On Monday, it fled for shelter under the roof of Bank of America. With a sale price of $50 billion, yet another reputable financial institution lost its independence.
- Among the giants of US insurance companies, American International Group (AIG) has also announced its own drama. According to the New York Times, AIG has asked the US Federal Reserve Bank ("the Fed") for a $40-billion line of credit in order to stave off an imminent downgrading of its credit rating. If the credit agencies lower the company's rating, lenders might recall their funds. The newspaper quotes a source close to the firm saying that, if were that to happen, the firm might only have 48 hours to 72 hours to live. The Fed has yet to react to AIG's request. On Monday, the insurer lost almost half of its market value.
According to banking expert Wolfgang Gerke, the end of the crisis isn't in sight yet. "Other banks will probably be left in ruins," Gerke told SPIEGEL ONLINE. "At the same time, though, I am convinced that the investment banks that manage to weather this storm will already be making money again already by the end of the year. And their profits will probably be even bigger than they are today because some of their competitors will no longer be there."
Indeed, the US financial sector has already undergone a dramatic transformation. Now Wall Street is only home to two independent investment banks: Goldman Sachs and Morgan Stanley. Six months ago, there were five.
What Are the Dangers for German Banks
In a joint statement released on Monday morning, the German Finance Ministry, the country's central bank, the Bundesbank, and the Bafin financial supervisory authority tried to restore calm in the German financial industry. The statement asserted that the level of involvement of German credit institutions in Lehman Brothers was within manageable limits and that they would be able to cope with its crash.
In fact, the immediate losses in the portfolios of German banks will only be limited. "The banks are sufficiently diversified so as to absorb share-price losses," Hans-Peter Burghof, professor of banking at the University of Hohenheim, told SPIEGEL ONLINE. Burghof added, however, that that did not necessarily mean that the damage suffered by the financial sector would be meager.
In fact, the crash of the Lehman stocks threatens to cause other bank assets to slide as well. The reason for this lies in the fact that it continues to be unclear how many billions in losses are hidden in the balance books of other large financial institutions whose shares are held by German banks. Citigroup is rumored to be keeping even steeper losses in the background, and some insiders have claimed that even Switzerland's UBS isn't out of the woods yet.
"If Lehmen can't find a solution in which its customers and creditors get their money back, it would also be an enormous loss in confidence for the customers, too," said Burghof. "One result could be that customers withdraw their money from banks in masses and the entire financial system falls into a slide."
Threats to the German Economy
Germany's Finance Ministry hasn't ruled out the possibility that the US crisis could put further pressure on the German economy. "Of course it could have an impact on the economy," a Finance Ministry spokesperson said. And it could also affect the German federal budget. "We're in the midst of a crisis that hasn't been born out yet."
TU Darmstadt's Schiereck said: "There is in fact a threat that the Lehman bankruptcy could be reflected in the federal budget. Turbulence in the financial markets inevitably leads to a climate in which businesspeople and companies are more cautious with investments. They borrow less and get involved in fewer dealings. In the end, the state also receives fewer tax revenues."
Schiereck said he believed the Finance Ministry's recent economic forecasts have been overly optimistic, adding that the current turbulences are a "welcome occasion to correct the pervious estimates without a loss of face."
Why the Crash Is Hitting Germany's DAX so Hard
The declines on Germany's DAX index are largely attributable to steep losses in the financial industry. The share price of Commerzbank temporarily fell by close to 12 percent, with Deutsche Bank declining by 8.5 percent and Allianz by 7.9 percent.
But more than anything, the skittishness on the stock market in Germany is being caused by the fact that the Lehman bankruptcy threatens to create fresh losses for German banks. "Lehman is the world's biggest bonds trader," said Schiereck. Because the bank isn't being bailed out, it's likely that the bonds from the bank's holdings will be sold to pay back creditors.
In total, the market could be flooded with bonds valuing up to €50 or €60 billion. That will create a glut that will further depress prices internationally. "Ultimately, it's the banks that will be affected," Schiereck said.
Even without the latest episode in the global crisis, it is still unclear how many billions in losses are still hanging in the balance sheets of other large investment banks. Current speculation suggests losses at Citi Group will be even higher than previously reported. Insiders also say the worst isn't over yet at Switzerland's UBS. The Lehman bankruptcy could cause banks already hit by the crisis to collapse entirely.
German banks with shares from such financial institutions in their portfolios could now sell these shares as a precaution, thus further depressing shares in the country's blue chip DAX index.
Bringing the Crisis Back under Control
A group of 10 major international banks now want to create an emergency fund totalling $70 billion. Together, Bank of America, Deutsche Bank, Credit Suisse, UBS, Barclays, Morgan Stanley, Citigroup, Goldman Sachs, J. P. Morgan and Merrill Lynch all announced their intention to participate in the fund.
According to their statement, each bank plans to contribute $7 billion to the fund. If any of these banks has liquidity problems, it could borrow up to one-third of the fund's total assets.
Other banks could also join the consortium, thus increasing the total funds available for bailouts. By creating the fund, the banks are hoping to cushion themselves from the effects of the market distortions triggered by the bankruptcy of US investment bank Lehman Brothers.
Hans-Peter Burghof, a banking professor at Germany's University of Hohenheim, doubts whether the emergency fund can hinder the crisis. "The only thing a fund like that can do is to hinder liquidity shortfalls," he told SPIEGEL ONLINE. "In other words, it ensures that banks can continue to provide credit on the market even if they are short on cash. But it cannot compensate for the losses created by the banks' writeoffs. And every bank that has Lehman shares in its portfolio is threatened with losses."
Why the US Government Hasn't Intervened
After Washington moved last week to take over mortgage giants Fannie Mae and Freddie Mac, thus protecting them from collapse, political resistance mounted against bailing out yet another private bank at taxpayers' cost. In the cases of Fanny and Freddie alone, the government is providing an estimated $1.5 trillion dollars.
TU Darmstadt's Schiereck said he suspected the US didn't intervene with a Lehman Brothers bailout because it was unable to do so. "The fact that the US government didn't step in can be interpreted as a signal that the federal budget has exhausted its ability to absorb further bank risks," he told SPIEGEL ONLINE. "That would mean that all future insolvencies would hit the international financial system with unrestrained force."
The Cause of the Global Finance Crisis
The bursting of a speculative bubble in the US real estate market triggered the international finance crisis. With interest rates low in recent years, US banks frequently offered poorly secured loans for the purchase of homes or construction -- so-called subprime mortgages.
At the end of 2006, key interest rates began rising in the US. Demand sank and real estate prices began to slump -- by as much as 25 percent today. This created a situation in which a growing number of subprime borrowers were no longer able to make their interest payments.
Reckless constructs only served to exascerbate the situation. In order to refinance themselves, mortgage companies often bundled their loans with new forms of subprime bonds that were sold to investors worldwide -- to Chinese and European banks, for example.
The bundled loans were securitized and turned into assets that could be traded on stock markets. The problem was that these assets contained bad mortgage loans bundled in with the good ones. Buyers seldom knew the true content. Unable to assess the risk of the asset, they had to rely on the rating assigned to it by a rating agency.
Experts had warned about the danger of such financial constructions early on. As long as enough market participants believe in the value of such structured products, one can trade in them. But the system breaks down when confidence in the such products evaporates.
"It had to happen," former International Monetary Fund Chief Economist Kenneth Rogoff told SPIEGEL ONLINE. You can't just make money out of thin air like this."
Then in mid-2007 ever more subprime loans defaulted. Confidence in the paper which was supposedly covered by mortgage deals collapsed, as did their market value. As a result banks had to wrote down the value of those papers in their books, and thereby booked drastic losses.
Rogoff said the crisis wasn't over. But these finance products based on fancy rocket science and derivatives just aren't coming back, and that's very painful.