It was on 15 September, however, that the global financial disturbance became a crisis. It was well known that the major US merchant banks were highly exposed to the securitisation of loans that should not have been issued. This concern came to a head within two days with the demise of three giants of US commerce: merchant banks Merrill Lynch and Lehman Brothers, and the insurance company American Insurance Group (AIG). Merrill Lynch was the first to suffer the wrath of the market. The Federal Reserve and the US Treasury arranged for the company to be taken over by the Bank of America as a merged entity. However, nothing could be done for Lehman Brothers, as no other entity was large enough or robust enough to take on the risk of its bad debts. Lehman Brothers went broke, the largest insolvency in US history. This was the event that captured the world’s attention. The fact that the US Government was unwilling or unable to save an institution that many other governments around the world regarded as ‘too big to fail’ underlined for many the fact that the US economy could very quickly spiral into recession, or worse.
AIG was the insurance firm most exposed to dubious home lending practices, and the US administration decided it was worth saving. The original bailout announced was a massive US$85 billion, but this increased to US$170 billion when AIG was nationalised.
Economist Ross Garnaut well describes the impact of those few days:
The carnage in the shadow banking system wrought over September now sliced through the major arteries of equity markets, company and mainstream bank lending. Lehman Brothers had lines of credit open to more than 100 hedge funds, many of which were highly leveraged players in the equity markets. Its sudden bankruptcy meant that all these lines of credit were called in at once. Desperate to raise cash, the funds sold equities and pushed prices lower. Risk aversion surged across the spectrum of other banks.4
Swan has expressed the impact in similar terms: ‘Lenders across the world were paralysed by fear and anxiety as their previous complacency about risk was shattered into pieces.’5
Australia was particularly exposed to the financial meltdown as its banks were (and still are) more reliant than most around the world on wholesale borrowing to fund their outward loans. The amount of deposits in Australia has never been enough to fund the lending of domestic banks. Banks big and small need to renew loans very regularly in order to keep their loan books flowing. So the seizure of international lending markets had dire ramifications for Australian banks. This situation was made even more serious when there was a rush of withdrawals from the smaller Australian banks, which were seen as being more exposed than the ‘Big Four’. Urgent government intervention was necessary to avoid a real threat to the existence of a bank or building society. And so, on Sunday, 28 September, Swan announced that the federal government would buy up to $4 billion worth of mortgage securities to keep the money flowing to the smaller mortgage providers.
As the world markets went into meltdown, Swan, by coincidence, was in Washington for a meeting of IMF governors. This was both a disadvantage and an advantage. The obvious downside was that Swan was removed from the immediacy of the Treasury’s advice and real-time interaction with regulators in Australia. But his immediate exposure to the concerns of his fellow finance ministers and regulators did mean that he was able to emphasise the seriousness of the situation to his Cabinet colleagues. Indeed, there were plenty of parallels with the early period of the Depression to give policymakers pause for thought. On 29 September, the Dow Jones index fell by 7 per cent off the back of Congress’s rejection of the Bush administration’s rescue package for distressed lenders. This was a bigger decline than that of the Wall Street Crash, which had triggered the Depression.
Swan’s announcement of the mortgage securities purchase was not enough to stem the pressure on Australia’s mid-tier banks. Government ministers (myself included) received reports of massive withdrawals from ATMs around the country, as people took their cash out as insurance against a worsening situation. Armaguard and other security companies reported a record demand for the replenishment of ATMs. The RBA’s supply of $50 and $100 notes began to run low. This could only get worse when the banks actually opened their doors the following day, a Monday. The prospect of a fatal run on a mid-tier bank was very real.
To avoid a fatal cash-flow crisis, Swan and Rudd took the decision to announce two bank guarantees. The government would guarantee the borrowings of Australian banks on wholesale markets, meaning that the banks would still have access to finance in overseas lending markets. It was also decided to guarantee the bank deposits of Australians with regulated deposit-taking institutions, which gave depositors the reassurance they needed.
The financial meltdown was always going to have a dramatic impact on economic activity and growth. The IMF, which has the most comprehensive global growth forecasting capacity in the world, issued two significant growth forecast downgrades between October and November 2008—many more would follow in quick succession. As it was, the decline in global production for the 2008 September quarter to halfway through 2009 was the fastest slowdown ever experienced, and our region was dramatically affected. As Garnaut says in relation to trade:
The contraction in trade was initially most severe in East Asia. In the first six months of the Asian Financial Crisis the contraction was proportionately greater than for the world in the Great Depression. For East Asia the decline in the first six months after the Great Crash of 2008 was greater than in the corresponding period of the Asian Financial Crisis.6
At the IMF meeting,
