Shares surge on US bail-out plan

Wall Street shares have rebounded sharply after a proposed US government plan to buy billions of dollars of US banks’ bad mortgage-related loans.

The Dow Jones index jumped 3.8% in early trading, while London’s FTSE 100 index was up 8.6%. In Paris, the Cac 40 was 7.6% higher.

US Treasury Secretary Henry Paulson said the bad debts were “clogging up” the financial system.

He said more details of the rescue package would be announced next week.

“To restore confidence in our markets and our financial institutions, so they can fuel continued growth and prosperity, we must address the underlying problem,” Mr Paulson said.

Financial stocks have gained the most from the rise in confidence on the markets. In London, the Royal Bank of Scotland and HBOS rose as much as 50%.

Moves to restrict short-selling in the US and UK also helped to boost financial shares.

Short-selling occurs when a trader borrows shares from another to sell them with the hope of buying them back at a lower price, thereby profiting from the difference. It has been blamed for the recent sharp falls in some banking shares.

Crisis of confidence

The proposed US government rescue plan comes at the end of a week of almost unprecedented turmoil on world financial markets:

• Central banks around the world have pumped billions of dollars of extra funding into money markets on Thursday and Friday to ease the liquidity crisis
• The US Treasury also said it would guarantee US money market funds – mutual funds that typically invest in low-risk credit such as government bonds and are often used by pension funds – up to a value $50bn to further restore confidence

• Stock markets in Russia have been suspended for the second time on Friday at the end of a week of wild swings and stop-go trading

• The US financial regulator the Securities and Exchange Commission banned short-selling in the stock of 799 financial companies until 2 October
• The move followed similar moves by the UK’s City watchdog on Thursday
• Nervous traders turned on the last independent US Wall Street giants Morgan Stanley and Goldman Sachs on Thursday sending their shares lower
• There are rumours that Morgan Stanley is looking for a partner. Reports have cited talks with US bank Wachovia and the possibility that China Investment Corp – China’s sovereign wealth fund – could buy a major stake

Dramatic measures

News of a US bail-out emerged after a meeting with Congress members late on Thursday, when Mr Paulson announced plans to introduce new laws to buy hundreds of billions of dollars of bad debt from banks.

There will be serious long-term damage to the ability of the US to export its way of doing business to the rest of the world. Robert Peston, BBC Business Editor

This, he said, was at the heart of the almost unprecedented malfunction of the banking system, which has caused havoc in world stock markets this week.

“We talked about a comprehensive approach that will require legislation to deal with illiquid assets on financial institutions’ balance sheets,” he said.

Mr Paulson and Federal Reserve Chairman Ben Bernanke are expected to thrash out the details of the plan over the weekend.

It is thought options under consideration include establishing a government agency that would buy bad loans to allow troubled Wall Street banks to clear their balance sheets.

Reports said Mr Paulson was looking into setting up something akin to the Resolution Trust Corp (RTC), which was formed after savings and loans banks collapsed in the 1980s.

The RTC took over most of the smaller banks in the US at a cost of $400bn – about $1 trillion (£550bn) in today’s money – and then tried to sell off their assets.

The cost of such a bailout would probably be higher this time, with bad mortgage debt believed to be around $2 trillion.

Some analysts welcomed the news.

“It’s a relief, it allows for an orderly workout for the impaired assets and it will help the banking sector get back to business,” said Hans Kunnen of Colonial First State Fund Managers in Australia.

Howard Wheeldon, senior strategist at London-based BGC Partners, also welcomed the market rally after a “torrid week”.

But he added: “We still face many problems not least the threat of recession because of the fallout of the banking crisis.

And he cautioned against central banks flooding the financial system with too much liquidity.

“In a way we are now paying the price for the liquidity-boosting measures taken after the September 11 atrocities. We can’t afford to have a short-term fix and then in three or four years have an even bigger bubble explode,” he warned.

BBC Business Editor Robert Peston said that the taxpayer funded bail-out “represents a massive humiliation for Wall Street” and will severely dent the ability of the US to export its way of doing business to the rest of the world.

But an even bigger risk could be a loss of confidence in the American government’s balance sheet, he said.

“This could ultimately undermine the dollar, push up inflation even more and raise the cost of servicing debt for the US authorities,” our correspondent explained.

Market moves

The UK’s FTSE 100 index of largest shares added 8.6% with banking stocks among the biggest gainers.

Halifax owner HBOS, which was forced into the arms of rival Lloyds TSB after its shares slumped this week, traded up 30.5%.

France’s Cac 40 and Germany’s Dax indexes joined in the rally, up 7.5% and 5.1% in afternoon trade.

Earlier, Japan’s Nikkei jumped 3.8%, while the Shanghai Composite recovered from 22-month lows to close up 9.5% and Hong Kong’s Hang Seng soared almost 10%.

Lehman set to go into insolvency

Preparations are being made for Lehman Brothers, the fourth-largest investment bank in the US, to file for bankruptcy.

The two strongest potential buyers appear to have pulled out of talks to rescue Lehman – the latest victim of the American credit crisis.

If no new financing comes before Wall Street opens, it will have to seek “Chapter 11” bankruptcy protection.

This could result in a severe shock to the global financial system, as banks unwind their complex deals with Lehman.

Late on Sunday the US central bank, the Federal Reserve, announced new moves to ease access to emergency credit for struggling financial companies.

The Fed said the step – which broadens the types of securities financial institutions can use to obtain emergency loans – was designed to mitigate the potential risks and disruptions to markets.

In a related move, a consortium of 10 investment banks announced a $70bn (£39bn) loan program that troubled financial companies can use to help ease the credit shortage.

The banks – Bank of America, Barclays, Citibank, Credit Suisse, Deutsche Bank, Goldman Sachs, JP Morgan, Merrill Lynch, Morgan Stanley and UBS – each agreed to provide $7bn (£4bn) to the pool.

On Monday, Asian stock markets fell amid concerns over the fate of Lehman Brothers.

Singapore stocks dropped 2.26% in morning trading and shares in Taiwan fell 1.83%.

Markets in Tokyo, Hong Kong, Shanghai and Seoul were closed for public holidays.

Lehman employs about 25,000 worldwide, including 5,000 in the UK.

Accountancy firm PWC has already been lined up to run the British operations of Lehman should the firm go into administration.

BBC business editor Robert Peston says UK bank Barclays’ decision to walk away from a Lehman deal was a huge setback for the effort to rescue the Lehman.

Barclays terminated the negotiations because it was unable to obtain guarantees in relation to financial commitments faced by Lehman when markets open on Monday.

Bad bank, good bank

The rescue effort for Lehman was being co-ordinated by the US Treasury and the New York Federal Reserve.

No other large firm should buy Lehman whole – its toxic real estate and securities are too difficult to value Peter Morici University of Maryland

The US government had hoped to arrange a bailout under which other US investment banks would finance a “bad bank” that would hold the most “toxic” investments of Lehman in the property and mortgage market.

The “good bank” or rest of the firm, including its investment and wealth management arms, would then be sold to another financial institution, for example Bank of America or the UK’s Barclays.

Although such a deal would have cost the other investment banks millions, it might have restored confidence in the sector and avoided a sharp drop in the share price of all banks.

However, it appears that this plan is falling apart.

“The only thing that can prevent Lehman collapsing would be a huge injection of taxpayers’ money,” a banker close to the talks told the BBC, but added that US Treasury Secretary “Hank Paulson has made it clear he doesn’t want to do that”.

Hard choices

Bank of America, meanwhile, is said to be unconvinced that buying Lehman would be in the interest of its shareholders.

Instead, according to a report in the New York Times, Bank of America is in “advanced talks” to buy investment bank Merrill Lynch for more than $38bn.

HAVE YOUR SAY

It’s amazing that companies which charge high interest to cover risk still need to be bailed out by the taxpayer.

Jack, Canada

Send us your comments

Like other US investment banks Merrill has suffered losses of tens of billions of dollars in the subprime crisis, and has seen its share price plummet during recent months.

“No other large firm should buy Lehman whole – its toxic real estate and securities are too difficult to value,” said Peter Morici of the business school of the University of Maryland.

Lehman is up for sale after it reported a $3.9bn (£2.2bn) quarterly loss last week amid concerns over its long term financial viability.

The firm’s share price has plummeted as fears over its future have mounted.

Former Federal Reserve boss Alan Greenspan said the US government faced “very difficult decisions” over Lehman if it could not secure a rescue deal that did not involve public funds.

Yet Mr Greenspan said it would be “unsustainable” for the government to bail out every US bank that got itself into difficulty.

Predicting that Lehman would not be the last to require rescuing, Mr Greenspan added that this would not necessarily pose a problem.

“The ordinary course of financial change has winners and losers,” he said.

US lenders ‘face state takeover’

US mortgage giants Freddie Mac and Fannie Mae are set to be put under government control in an attempt to rescue the firms, media reports say.

Treasury Secretary Henry Paulson will outline government plans at a news conference at 1100 (1600 BST).

The move to shore up the shareholder-owned firms, which hold or guarantee half the US mortgage debt, would be the US’s largest ever financial bail-out.

In July, Congress approved a plan aimed

at offering them more liquidity.

This followed huge losses by the two firms as result of a big increase in defaults and repossessions in the US housing market.

‘Management told’

On Saturday, a senior politician, Barney Frank, chairman of the House Financial Services Committee, said US Treasury Secretary Henry Paulson had told him the government would use its powers to ensure the continued and stable functioning of the companies.

The Washington Post, quoting senior administration sources, said the firms would be put under a legal status known as “conservatorship” which would greatly reduce the value of the two companies’ common stock.

This is an event of profound significance for the global economy BBC Business Editor Robert Peston

Other securities – including company debt and preferred shares – would be guaranteed by the government, the paper added.

The New York Times reported that senior executives at Freddie Mac and Fannie Mae were informed about the plan on Friday.

The Wall Street Journal said it would include changes in the top management.

There would also be quarterly infusions of cash to keep both firms afloat, the papers say. The total cost to taxpayers is not known but could amount to billions of dollars, they add.

The government was being forced to step in because it was dangerous for the US economy for doubts to persist about the two firms’ viability.

Struggling homeowners

HAVE YOUR SAY

Government control over larger portions of the economy can only end badly

TB, US

Send us your comments

The two contenders for the US presidency, Barack Obama and John McCain, have been briefed on the takeover by Mr Paulson.

“We’ve got to keep people in their homes,” said the Republican candidate, John McCain.

“There’s got to be restructuring, there’s got to be reorganisation, and there’s got to be some confidence that we’ve stopped this downward spiral,” he added, saying that the takeover of Fannie Mae and Freddie Mac must not benefit executives at the two companies.

The Democratic Party candidate, Barack Obama, said any action should be focused “on whether it will strengthen our economy and help struggling homeowners”.

“We must not allow government intervention to protect investors and speculators who relied on the government to reap massive profits,” he said, adding “we must protect taxpayers, not bail out the shareholders and management of Fannie Mae and Freddie Mac”.

Fragile

On Friday, America’s Mortgage Bankers Association reported that at the end of June, about four million homeowners with a mortgage – representing a record 9% – either were behind in their payments or faced repossession.

In the past year, the financial crisis has taken a heavy toll on both Fannie Mae and Freddie Mac.

The country’s two largest buyers and backers of mortgages lost a combined $3.1bn between April and June.

Both companies say they have the resources to weather the losses, but their shares have fallen sharply on fears that they could go bankrupt as borrowers default.

The rescue plan passed by Congress in July gave the US government the authority to buy shares and offer liquidity to companies to keep them afloat.

Many analysts believe their collapse would be a major shock to the already fragile global financial system.

Together, the two firms own or guarantee about $5.3 trillion worth of home loans – about half the outstanding mortgages in the US.

That is about 25 times as big as the obligations of Northern Rock – which was nationalised by the UK government earlier this year, and twice the size of the UK economy.