On a knife edge

The failure of Washington Mutual – the largest bank failure in US history by a very large measure – demonstrates that the US financial system, and probably the global system, is now balanced on a knife edge, with presidential hopeful John McCain apparently, and unwittingly, doing his best to topple it.

ANZ's Mike Smith warned on Thursday in a live KGB Interrogation in Sydney that if Hank Paulson's $US700 billion proposal for stabilising the US banking system failed, the US would plunge into depression. As the CEO for one of the 18 top-rated banks in the globe, that ought to carry some credibility.

The WaMu failure – its assets were seized by US federal regulators and sold to JP Morgan Chase for $US1.9 billion – is a preview of what might be in store for the US system if the politicians can't agree, within days, a package that stabilises the core of the system. The dominos in the US and Europe will start toppling rapidly if the US system isn't stabilised.

McCain is being blamed for the apparent sidelining of the Paulson plan, which would see the US taxpayer fund the acquisition of $US700 billion of illiquid assets from US financial institutions in an attempt to prevent the system from freezing through lack of balance sheet capacity and fear of counterparty risk.

With the political sentiment in the US against using taxpayer funds to bail out failing institutions, McCain appears to have joined a push by a splinter group of Republicans for measures that would involve less direct taxpayer participation.

The Wall St/Main St debate in the US bemuses most outside the US, who see the politics of blame as of less consequence than ensuring Wall St and Main St survive the crisis. The plight of the US system is so delicate that it has moved beyond issues of principle and debates over moral hazard.

Outside the US, the state of the US banking system is seen as dire and a regulatory response involving the injection of massive capital infusions is seen as an urgent necessity if the US system, and indeed the global system, isn't to descend into chaos. The Paulson plan, whatever its shortcomings, is regarded as the only available mechanism for stabilising the US system.

If McCain is responsible for fracturing Republican support for that plan (perhaps mindful of the imminent presidential election) he risks being regarded as the person who destroyed the last chance the US, and perhaps the rest of the world, had to avoid a financial and economic catastrophe.

Around the world, central banks, prudential regulators and governments will be desperately searching for ways to protect their own systems and economies from the fallout of a US failure to agree a plan within the next few days for avoiding an implosion in its banking system.

If the US system freezes – and Mike Smith suggested that it would without urgent measures – the rest of the world will thrown into chaos, given the inter-connectedness of the global system.

WaMu has been teetering and was pushed irretrievably to the brink earlier this week when the ratings agencies downgraded its debt.

Under the deal forced on WaMu by US authorities, which conducted a quiet auction for its sale, JP Morgan Chase will pay only $US1.9 billion to acquire the group's $US307 billion of assets. The claims of equity and debt holders have been left behind – under the deal, $US31 billion of WaMu's assets were written off.

Among the biggest losers in the transaction is private equity firm TPG, which injected $US1.4 billion of equity into the group in March as part of a $US7 billion equity infusion that failed to stabilise the biggest savings and loan institution in the US.

The biggest potential winner, depending on how the credit crisis unfolds, is JP Morgan Chase. Earlier this year it bought teetering Wall St investment bank Bear Stearns with the aid of a $US30 billion guarantee from the US taxpayer of that firm's worst exposures.

The WaMu acquisition will turn JP Morgan Chase from the fourth-largest bank in the US into the biggest deposit holder in the US and fill in major gaps in its network. JP Morgan has viewed the crisis as an opportunity.

Whether its calculated gamble pays off – and the near-term outlook for the global system – may depend on what US policy makers agree, or don't, in the next few days.