What the Wall Street crises means for the Australian economy, interest rates and SMEs

The collapse of investment bank giant Lehman Brothers, the fire-sale of its rival Merrill Lynch and concerns over the fate of big insurer American Insurance Group have sent global financial markets into meltdown.

So what exactly has happened? And what will the impact be on the Australian market?

We’ve tried to answer some of the big questions around the Wall Street crises:

Q. What exactly do these big banks do and why are they so important?

A. Lehman Brothers and Merrill Lynch are not deposit-taking banks rather investment banks that concentrate on trading financial instruments and financing and structuring deals – in Australia, think Macquarie Bank rather than a retail bank like Westpac or ANZ.

Their importance relates to their sheer size – Lehman Brothers has $US693 billion in assets, which makes this the biggest bankruptcy in history in terms of assets – and the way its operations extend into ever corner of the financial system.

Q. So how did Lehman and these other banks get into so much trouble?

A. Lehman specialised in risky debt deals, via which the banks were able to package up and then trade big parcels of loans, particularly sub-prime mortgage debt. As the US housing market crashed, the value of this debt has plunged, leaving Lehman and the other big banks desperate for funding. Problem was, no-one wanted to lend them any money against their crappy assets.

Q. Everyone keeps mentioning this “shadow” banking system, but what is it? I have enough trouble dealing with my real bank manager.

A. The shadow banking system refers to the huge, secretive market on which debt instruments like credit default swaps, CDOs (collateralised debt obligations) and SIVs (structured investment vehicles). The size of this market is put at $US500 trillion – and yet it is completely unregulated. Don’t worry, you won’t need a shadow banking manager any time soon, but it’s important to realise just how big this part of the financial system is.

Q. So what immediate problems has the collapse of Lehman Brothers caused?

A. The big problem is that banks are extremely nervous about lending to each other, which means that financial institutions around the world are struggling to get finance. To ease these funding pressures, the 10 big remaining banks on Wall Street have agreed to make $US70 billion available. Central banks are also helping out by pumping more money into their local markets. For example, the RBA pumped $2.1 billion into the local market to ensure there was plenty of capital floating around.

Investors around the globe are also very nervous. The Australian market fell 1.8% yesterday and is almost certain to fall further in the next week after Wall Street plunged 4.7%.

Q. So what are the main implications for Australia?

A. Australian banks were sold off heavily in yesterday’s trade as they are the most exposed to this crisis. Our banks rely heavily on securing funding from overseas and with the collapse of Lehman putting the brakes on global credit markets they are going to find it even harder and more expensive to get money to lend.

The other impact will be on commodity prices, one of the cornerstones of the Australian economy. Traders will be worried that the Wall Street crisis is going to lead to slower global growth, which will reduce demand for commodities. That will push commodity prices down, which will weigh heavily on the share prices of the giants of the Australian sharemarket, BHP Billiton and Rio Tinto.

Q. If the banks are struggling to get funding, how will SMEs be able to get cash for their businesses?

A. That’s the bad news from this crisis for Australian SMEs – the banks’ already tight lending criteria are likely to get even tighter in the next few months as lenders ration credit. If you need funding, it’s time to take your bank manager out for a long, expensive lunch and a drink or 10. You’re going to need him on your side.

Q. What’s the outlook for interest rates? Surely this turmoil makes an interest rate cut more likely?

A. There’s plenty of talk that the US central bank will cut rates in the short-term to ease the liquidity pressures in the market, and certainly the RBA – which most economists believe is poised to cut rates before Christmas – will have the Lehman collapse in the front of its mind when the board meets on 7 October. If things are looking really bad by then, the RBA could decide to bring its next cut forward.

But be warned. The banks will want to recoup the higher cost of funding they will face as a result of this new crisis and they may not automatically pass on a fall in official interest rates.