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THE risk of a worldwide recession deepened yesterday after the financial crisis toppled giant US investment bank Lehman Brothers and threatened the survival of the world's biggest insurance company, AIG.
On one of the most tumultuous days ever seen on Wall Street, which also involved a $US50 billion ($61 billion) takeover to save Merrill Lynch from likely collapse, the Reserve Bank pumped an emergency $1.3 billion into the local banking system to support liquidity.
Wayne Swan moved to calm the markets last night, saying Australian banks did not share the problems of those in the US.
"The Government and the regulators are closely monitoring events in the United States," the Treasurer said. "It remains the case that Australia's banks are well-capitalised and well-regulated, and do not have the same problems as the US faces."
But his comments, the Reserve Bank's cash injection and the $US70 billion emergency fund created by 10 of the world's biggest banks to boost market liquidity failed to calm fears about the state of the global financial system after Lehman's bankruptcy, the biggest in corporate history.
The S&P/ASX200 index slumped 1.7 per cent to close at 4817.7 points as shares in the major banks were punished.
European markets were driven more than 3 per cent lower last night as investors took their first opportunity to react to the shake-out in the US banking sector, and trading in futures markets was pointing to a bloodbath on Wall Street when trading resumed last night.
Those fears initially appeared realised, with the Dow Jones industrials crashing 300.11 points, or 2.63 per cent, in early trading.
The prospect of global recession prompted a fall in short-term market interest rates worldwide, with financial markets expecting the central banks in Britain, Europe and the US to cut official rates.
In Australia, financial markets now consider another 0.25 percentage point interest rate cut next month a certainty, reducing the official rate to 6.75 per cent.
Markets are tipping five rate cuts, which would lower the official rate to 5.75 per cent, over the next 12 months.
The failure of Lehman - whose $US639 billion in assets and $US613 billion in debt make it about five times bigger than Westpac - and the sale of Merrill Lynch to the Bank of America mean just two of the top five Wall Street investment firms have survived the credit crisis that started with the collapse of the US sub-prime mortgage market 13 months ago.
Lehman filed for bankruptcy in the early hours of Monday morning in New York after last-ditch efforts to organise a sale collapsed when the US Federal Reserve refused to provide financial guarantees to cover losses.
A few hours earlier, Merrill Lynch, with assets of $US1.6trillion, was sold on the orders of the US Federal Reserve to the Bank of America. Central bankers expected it to go bankrupt within the week if it was not taken over.
The crisis has spread to the world's biggest insurance company, the American International Group, which was yesterday seeking an emergency $US40 billion loan from the US Federal Reserve.
The New York Times quoted company officials as saying AIG, with assets of $US1 trillion, was unlikely to survive more than 72hours if it lost its credit rating.
"The whole thing is a nightmare," ANZ international economist Amy Auster said yesterday. "This is the worst of the worst, and the only thing you can say is we are in a systemic crisis."
She said the biggest risk was that financial institutions would be forced into a vicious downward spiral as their efforts to offload assets at fire-sale prices forced even greater problems in their balance sheets.
The 158-year-old Lehman is a major financier of commercial property in the US, where prices that are already weak will be sent tumbling by foreclosures.
Worldwide bank losses and writedowns from the global credit crunch total $US620 billion, more than half from US institutions.
OECD deputy director of financial markets Adrian Blundell-Wignall said the world economy was threatened by the erosion of bank capital.
For years, money had been too freely available, leading financial institutions to take excessive risks with too little capital. "Now you have to pay the ferryman," Mr Blundell-Wignall said. "Now we're finding that a good part of this risk-taking starts to default and there is not enough capital."
Lehman and AIG have operations in Australia. Lehman employs about 130 people, although the company's subsidiaries were not included in the bankruptcy petition filed last night.
Lehman bought the Grange Securities business that sold exposure to the sub-prime mortgage market to a string of local councils.
AIG is a substantial insurer in Australia, with about 500 employees and offices in Melbourne, Sydney and Brisbane.
The Lehman bankruptcy spilled over onto Canada's financial sector, with Canadian Imperial Bank of Commerce (TSX: CM.TO) revealing it has about $25 million worth of exposure to the insolvent Wall Street brokerage.
The $25-million value is considered mark-to-market, which is the value of those assets at their current market worth, rather than its book value.
Meanwhile, Sun Life Financial Inc. (TSX: SLF.TO), a major Toronto-based life insurance company, said it holds $334 million of Lehman bonds and about $15 of Lehman derivative financial instruments. The company said it expects to take a charge to its earnings in the third quarter, but the amount is dependent on the amount of expected recoveries and other factors.