Ruth Williams and Peter Martin in the Insight section of Saturday's Age
Think back almost a week ago. On Sunday afternoon, as Melburnians enjoyed a few hours of sunshine before the inevitable evening clouds, the financial world order was about to change in the most dramatic fashion. By Monday morning, as the Australian stockmarket reacted violently to the news from New York, the damage was clear. And throughout the week, it got progressively worse, leaving investors reeling and Australians concerned about what it meant for them.
It was a week that broke records as well as banks, and prompted intense soul-searching on how the subprime mortgage crisis in the US could cause so much pain...
The bad news came thick and fast. Venerable Wall Street investment bank Lehman Brothers collapsed. Rival Merrill Lynch was sold off at bargain basement prices. American International Group, the world's biggest insurer, survived only after being given an $US85 billion ($A105 billion) lifeline from the US Federal Reserve. There was a shotgun merger between HBOS and Lloyds TSB in Britain, and $US180 billion was heaved into markets after a terrifying pause in global commerce on Thursday evening. That funds injection sparked yesterday's dramatic turnaround.
In Australia, news of the impending crisis spread quickly, and had fast and evident results. On Monday, as Australian shares fell almost 2%, Treasurer Wayne Swan and Prime Minister Kevin Rudd spoke to Glenn Stevens and Ken Henry, heads of the Reserve Bank and Treasury, then briefed cabinet later that day.
On Tuesday, the benchmark index sank another 1.4%, its lowest since Christmas 2005, and ANZ chief executive Mike Smith cut his holiday short, arriving back in Melbourne on Tuesday night. On Wednesday and Thursday markets fell still further. Before yesterday's rally, Australian shares were worth 6% less than they were at the start of the week. Super returns have been hit, share portfolios of investors big and small substantially deflated.
And the global flow of money, which keeps the world's economy going and upon which our banks rely for access to wholesale funds, sits almost as stagnant as parts of the Murray-Darling basin.
Last Sunday evening, as Victorians drifted off to sleep, events taking place in New York were to radically alter the world's financial system, and with it, Australia's. The implications - financial, economic and even political - will be far-reaching.
"From a historical perspective, there has been nothing like this since the Great Depression," says Patrick de Fontenay, adjunct professor at Australian National University's Crawford School of Economics and Government. "The problem is that all financial institutions that rely on debt for their operations are having trouble rolling over their debt. And whenever a financial institution gets in trouble, there's contagion."
What we are seeing is contagion on a huge scale, and it has terrified investors. AIG was, to use the cliche, "too big to fail". But Lehman, which the US Federal Reserve allowed to fall into bankruptcy, was not. Investors are now fearing - indeed, expecting - more collapses of financial institutions that are also not too big to fail. What investors do not know is how far the contagion will spread. That makes them scared, which makes them panic.
And nowhere was panic more evident this week than on global sharemarkets. Wall Street fell 4% in one day, and Australian shares, despite a 4.3% rally yesterday, will finish the week at levels last seen 2½ years ago. Yesterday's bounce was more evidence of raw emotion at work as panic selling gave way to panic buying.
Even those who have been in the market for a long time - who worked through the 1987 stockmarket crash - are stunned. "The events of this week have been extraordinary," says David Evans, managing partner of stockbrokers Evans & Partners.
"It has been a historic week. It could be that all of the major American investment banks as they stood a week ago, by the end of next week or next month will have different letterheads."
The sell-off in Australia, as elsewhere, has been most dramatic in financial stocks - traditionally a haven for investors. Macquarie Group, which once traded for $97, lost almost a quarter of its value in one day on Thursday, falling to $26.05 before an extraordinary rebound yesterday. This week, the S&P-ASX financial index dropped 1.4%, with the big four banks all hit.
In Australia, the biggest sharemarket victims during the week would have been those who borrowed to invest, who found their share portfolios were worth less than the debt outstanding on them.
"People who are highly geared have more to be concerned about," Evans says.
Thousands are facing margin calls - a demand to pump more money into their loan accounts. These forced sellers drive prices down further, building, and building, on the downward momentum.
The Australian Securities Exchange's latest information, from late 2006, shows that about 7.3 million people - about 46% of the adult population - owned shares directly or indirectly through a managed fund or self-managed super. But the survey doesn't track how many of those people borrowed to buy their portfolios. Just how many people out there are sweating on a margin loan, frantically clutching for cash to meet their obligations, is not known.
But while the threat of a margin call may hang over the heads of a minority of Australians, every working Australian is exposed to the market through their superannuation. And here is another local consequence of these global events.
Headlines this week warned of more negative super returns, coming after last year's average return of minus 6.4%. For the June quarter, super returns were the worst since compulsory super began in 1992.
Back in June, that negative symbol came as a shock to many investors, accustomed to their super funds delivering double-digit returns. Superannuation Minister Nick Sherry was moved to reassure super investors that despite last year's negative returns, super remained a sound investment.
It was a pre-emptive move, aimed at shoring up people's faith in super before it faltered too much. But he may well have to say it again in a few weeks' time when the September quarter statements go out, bearing once again a number with a negative symbol in front of it.
His central message has been that, even though returns are lower now, long-term averages remain strong. "Australians overwhelmingly do not access their superannuation at a single point in time; it is a long-term saving," Sherry told Parliament this week. "The most important rate of return to focus on is the five to seven-year rate at least, if not longer."
If it fell, in part, to Sherry this week to reassure super investors, it was also up to the super industry itself. Richard Gilbert, chief executive of the Investment and Financial Services Association, urged super investors not to be "like lemmings running off a cliff", advising them to call their super funds, or even get paid advice. "Don't make decisions based on your instinct alone," he said.
One group of people will face significant implications from the market slide - those about to retire. There are about 1.4 million Australians aged between 55 and 60, many of whom are considering retiring and accessing their super. Another 1.3 million are in their early 50s.
"If you are 55, or approaching 60, and thought you were going to retire next year, well perhaps you can't," Gilbert says. "It's going to affect a lot of people."
But for the rest of us, with a decade or more left on our super investments, the eventual super damage is unlikely to be severe. Super accounts are still buoyed by a decade of strong returns. Assuming markets eventually recover (and they always have in the past), everything that goes into super accounts now is buying at what may be close to the bottom.
But even those who escape relatively unharmed on their super are likely to feel a further consequence of this week's events - more pressure on bank mortgage rates.
Once upon a time, Australians who took out a mortgage might have been reassured that it had the words ANZ or National Australia Bank written on it. But these days, that doesn't mean that the money behind that loan came from ANZ or NAB depositors, or even that it came from Australia.
Roughly half of the money lent by the big four Australian banks comes from overseas. Almost all the money once put up by non-bank lenders such as Aussie and RAMS did. And although it looks the same to an Australian borrower, the price of that money to a lender - such as a bank - is beyond Australian control. Whenever the Reserve Bank cuts interest rates (which is likely at its next board meeting on October 7) it is only able to cut the price of the Australian money. The price of the other half is set in China or Europe or Japan, or wherever the ultimate lender lives - and it's soaring.
UNTIL the credit crunch began in August last year and foreign investors got nervous, they were happy to demand little more than the Australian wholesale interest rate to invest in Australian mortgages. But after August, when it became apparent that many of their loans to US borrowers were worthless, they started demanding a lot more to fund mortgages - even good quality Australian ones, if they would fund them at all.
RAMS folded, other non-bank lenders became shells of themselves and Australia's big banks aggressively pushed up their rates well beyond the rate rises sanctioned by the Reserve Bank. The Government could only look on helplessly as mortgage rates pushed through 8% into the nines - despite the official cash rate peaking at 7.25%.
In recent months, foreign lenders had relaxed, cutting the premium they demanded to fund Australian home loans to about 1 percentage point. But this situation ended late last week. So horrified were the lenders at what happened to even top-notch, AAA-rated US institutions, their asking prices to lend to Australian institutions are surely set to go through the roof.
What does all this mean? When the Reserve next cuts Australian interest rates, mortgage holders should not expect Australia's banks to pass all of it on. Too many of their other costs will be going up.
So, Australians will feel the impact of this week on their share portfolios, their super funds and their mortgages. It all amounts to a lot of bad news - and a delicate balancing act for the Government.
In the political world, if there is to be a winner of any sort from the market fallout, it may well be Malcolm Turnbull. As investors waited anxiously on Tuesday morning to see how much our sharemarket would fall, Turnbull emerged victorious from a Liberal leadership ballot. A former merchant banker, his economic and business credentials tower above those of his predecessor, Brendan Nelson. His first question to the Government as Leader of the Opposition?
"What concrete action is the Prime Minister now taking to further strengthen the Australian economy, in particular the financial sector, in response to the bankruptcy of Lehman Brothers investment bank?"
Rudd soon fronted the media to reassure the public of a capable Government, briskly dealing with the unfolding crisis.
"On a daily basis the Treasurer and myself have been in active conversation with both the secretary of the Treasury, the governor of the Reserve Bank, and … the head of APRA (the Australian Prudential Regulatory Authority). That close collaboration continues," he said.
One can only hope the politicians comprehend the magnitude of the crisis facing Australia and the world, because the immediate woes facing super funds, mortgages and share portfolios fade compared to what could really go wrong.
In a landslide, each time the earth moves and settles, people imagine the worst is over - until it happens again. In March there were five big investment banks in the US. Then Bear Stearns collapsed, sold in a forced rescue to a bank for a mere fraction of its value.
Then there were four - Lehman Brothers, Merrill Lynch, Goldman Sachs and Morgan Stanley. Like Bear Stearns, each had survived the Depression. But not all would survive this week - Lehman collapsed after its shares plunged 92% and the US authorities declined to intervene. Merrill Lynch sold to the Bank of America for one-third of its previous value on the same day.
And then there were two. A day later US authorities took over the world's biggest insurance company, American International Group, rather than allow it to collapse.
Every time another one falls, the other institutions with which it does business hurt too. They become less willing to lend or invest money, and the global flow of money dries up further.
And the next weakened institution, frantically trying to save itself by borrowing more money, finds that no one will lend to it. It topples, and the landslide resumes. No one can say when the landslide will end.
The direct effects are bad enough. Lehman used to employ 26,000 people - 140 of them in Australia. Merrill used to employ 60,000. The indirect effects are worse. US firms and US consumers are winding back spending and may well bring on a recession.
In normal times the US Federal Reserve would try to buoy things by cutting rates (it resisted temptation to cut this week), but with its official interest rate at 2%, it can't cut much further. Of course, a recession in the US needn't mean one in Australia. For five years Australia's prosperity has been underwritten by the extraordinary growth of China and its demand for raw materials. The big question now is whether that growth will continue without rising demand for Chinese goods from US consumers. China exports roughly half of everything it produces - mostly to the US and Europe, so a recession in the US would be expected to have an effect on Chinese economic growth.
But in July two economists from ANU reported that a US recession might not hurt China deeply, because the money that would have been invested in the US would instead be pumped into China, accelerating its development. The jury is out.
However, a recession, even one that does spread to Australia, is not the biggest threat concentrating the minds of those in Australia's Reserve Bank. Australia has, after all, survived recessions in the past.
On Thursday, after Kevin Rudd had tried to reassure Australians of the soundness of our banking system, of the Government's busyness as it managed the crisis, investors got a taste of the biggest threat to economies all over the globe.
For an hour or two on Thursday afternoon, an entity called the forward exchange foreign market in Asia stalled, and the heart of the world's financial system stopped beating.
No financial system can work unless the people and businesses that need access to money can get it. For a few hours on Thursday, the US dollar became completely unavailable for some purposes. No one who wanted to enter into a so-called forward contract - a commonplace and crucial part of international commerce - could do so using US dollars.
So frightened about the future had people with US dollars become that for a few hours they were unwilling to agree to part with them in the future at any cost.
British, European and other central banks couldn't wait for the US financial system to open at 11pm east Australian time, instead taking action at 5pm - which was 3am in New York.
They poured $US180 billion into global markets - almost enough to buy the entire output of Victoria for a year. They spent it in minutes.
It is possible to think of the financial system as the lubricant on the wheels of trade. Without that lubricant ("liquidity" in the economists' language) the wheels seize up.
If people with money become so worried about the future that they refuse to part with it, then commerce itself will seize up.
Regarded as a remote possibility throughout the US financial crisis, this scenario has become more real this week. And, as Australians ponder their super returns, their portfolios and their mortgages, this bigger threat looms.