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WHEW ! Glad That's Over: Global Intervention and Market Recovery

Whew - 10% + bounce in the SP500 ! I'll take it - the best thing on offer and it began on Friday. But what just happened ? At least three things, which lead to some key questions about what's next. But let's start with what just happened. As you can see from the chart not only did the markets self-arrest but we got a major bounce (the largest since the GD ?) in the equity markets.

1) Coordinated Global Intervention: After the feckless recklessness and ignorant ideology of the US House of Representatives triggered a loss of confidence and a genuine market crash on a worldwide basis coordinated worldwide intervention by all the major developed countries has restored some confidence.

2) Action Under Pressure: That intervention is not some dry academic affair, obviously. It was the actions under enormous pressures by key groups of leaders. Somewhere in Churchill's writings are his biographical sketches of Sir John Jellicoe, Grand Admiral of the British Fleet in WW1. Jellicoe was widely criticized after Jutland for not winning a decisive victory which misses a key point. As Winston pointed out he was the only man on either side who could have lost the war in an afternoon, literally. And he lived under that incredible pressure of having to be prepared to act decisively and correctly for years until he managed to win a strategic victory by not losing. Adm. James Stockdale in his book, "Reflections of a Philosophical Fighter Pilot" talks about his experiences of seven years in a prison camp in solitary confinement, torture and horrible conditions as a laboratory of human performance. Several of his writings focus on the ability of key players, e.g. the American commanders at Midway, to have functioned well and at the top of their game in the afternoon that really mattered. We've just seen, and will hopefully continue to see, that kind of improvisation in crisis when no clear answers are provided yet decisive action is required. The ability to function under that kind of remorseless pressure is the product of years of preparation and be very glad the people in the hot seats were prepared. The consequences bear thinking about.

3) Wheels on the Wagon: as part of that intervention, and thru the leadership of the Prime Minister of Great Britain, the Rescue Package has morphed from using the acquisition of bad assets to get the credit markets unfrozen to direct re-capitalization of the banks, the guarantee of accounts and direct lending. While these actions are well within the authorities of the Bill they represent fundamental changes in emphasis. All the pretty packaging wrapped around the Bill to get it past the idiots and self-servers didn't affect the core content as much as the last few days. The vidclip will take you to the CSpan video of Kashkari's discussion and outlook.

4) Next Steps: the key test will be whether or not the banks start lending to one other again and thereby free up the credit markets from their lockdown. One wants to carefully monitor the LIBOR and TED spreads. But it looks like it's going to work.

  • We're likely to get a serious bounce which may even turn into a bear rally. But it will be a bear rally since the fundamental weaknesses of the economy are still waiting to greet us. If you look back to the last recession the hunt for the bottom was a process that went on for almost three years with rallies interspersed thruout.
  • You very much need to consider how to best re-structure your portfolio - which the readings in the last post started to lay out btw. (Whistling Past the Graveyard: Market Assessment and Outlook)

 Strategic Outlook

On a strategic policy level we're still faced with a more severe economic downturn than anything we've seen since the '80s or the mid-'70s. The accompanying chart lays out some alternative scenarios which we'll discuss more fully in a follow-up post. Two major economic policy initiatives are required at minimum.

1. Fiscal Stimulus - to mitigate the unavoidable downturn serious stimulus is required. During this last "recovery" consumption was sustained largely thru borrowing against home equity - the Housing ATM - and it was pumping $700-800B/year into the economy at the peak. The stimulus needs to be of that order of magnitude.

2. Housing - the biggest drag on the beginnings of a recovery is still. What we need is for all the bad mortgages to be re-structured. Which means that both banks and homeowners need to take some serious haircuts, write it down and move on. Fortunately that seems to be more widely recognized.

We are and will get thru this not an economic collapse has been averted but we want to minimize the damage as much as possible. Interestingly this means that political considerations are now major economic and investment considerations. For the foreseeable future we're going to continue to be in an event-driven, macro environment. At the same time micro-performance on the individual firm level will have a level of criticality we haven't seen in decades. In addition to the rest of the readings which'll read you into the sequence of things as we've summarized it pay really close attention to Nouriel Roubini's outlook: Our Choice: Recession or Depression !!!

We truly are finding out who's been swimming naked. And we're going to find out who the good leaders are. Your lesson here is that not paying attention to the economy and the markets is truly dangerous.

 

 

 

Policy and Outlook.

When fortune frowned AFTER the stockmarket crash of October 1929 it took over three years for America’s government to launch a series of dramatic efforts to end the Depression, starting with Roosevelt’s declaration of a four-day bank holiday in March 1933. In-between, America saw the worst economic collapse in its history. Thousands of banks failed, a devastating deflation set in, output plunged by a third and unemployment rose to 25%. The Depression wreaked enormous damage across the globe, but most of all on America’s economic psyche. In its aftermath the boundaries between government and markets were redrawn. During the past month, little more than a year after the financial storm first struck in August 2007, America’s government made its most dramatic interventions in financial markets since the 1930s. At the time it was not even certain that the economy was in recession and unemployment stood at 6.1%. But history teaches an important lesson: that big banking crises are ultimately solved by throwing in large dollops of public money, and that early and decisive government action, whether to recapitalise banks or take on troubled debts, can minimise the cost to the taxpayer and the damage to the economy. For example, Sweden quickly took over its failed banks after a property bust in the early 1990s and recovered relatively fast. By contrast, Japan took a decade to recover from a financial bust that ultimately cost its taxpayers a sum equivalent to 24% of GDP. All in all, America’s government has put some 7% of GDP on the line, a vast amount of money but well below the 16% of GDP that the average systemic banking crisis (if there is such a thing) ultimately costs the public purse. For the time being, that offers a reason for optimism. So, too, does the relative strength of the biggest emerging markets, particularly China. These economies are not as “decoupled” from the rich world’s travails as they once seemed. Their stockmarkets have plunged and many currencies have fallen sharply. Domestic demand in much of the emerging world is slowing but not collapsing. The IMF expects emerging economies, led by China, to grow by 6.9% in 2008 and 6.1% in 2009. That will cushion the world economy but may not save it from recession.

What Will Break the Worldwide Panic Reaction?  Call it capitulation: around the world, traders spooked by no end of bad news are dumping shares wholesale. That process continued on Friday as indexes in Asia and Europe opened trading with breathtaking falls of up to 10%. Though most markets partially rallied to limit losses to single digits, it represented only the most recent in a series of bearish days that threaten to transform a global credit crisis into a global economic crash. Does this make sense? "The markets have gone completely crazy and are reacting in fear to a bad situation in a way guaranteed to make it far worse," says Marc Touati, deputy executive manager of the French economic- and finance-research group Global Equities. "We once had 'irrational exuberance' pushing markets ever higher; now we have irrational pessimism running them into the ground. People have to calm down, or we're in for big trouble."

All that money you've lost — where did it go? Trillions in stock market value — gone. Trillions in retirement savings — gone. A huge chunk of the money you paid for your house, the money you're saving for college, the money your boss needs to make payroll — gone, gone, gone. Whether you're a stock broker or Joe Six-pack, if you have a 401(k), a mutual fund or a college savings plan, tumbling stock markets and sagging home prices mean you've lost a whole lot of the money that was right there on your account statements just a few months ago. But if you no longer have that money, who does? The fat cats on Wall Street? Some oil baron in Saudi Arabia? The government of China? Or is it just — gone? If you're looking to track down your missing money — figure out who has it now, maybe ask to have it back — you might be disappointed to learn that is was never really money in the first place. Robert Shiller, an economist at Yale, puts it bluntly: The notion that you lose a pile of money whenever the stock market tanks is a "fallacy." He says the price of a stock has never been the same thing as money — it's simply the "best guess" of what the stock is worth.

The International Currency Crisis Europe does therefore not need any bail-out plan, but a plan that specifically addresses the capitalisation problem. Concretely, three things are needed: the first and most important is money. A sum of €300bn will not cover the EU in a worst-case scenario, but it is a sensible number to start with; secondly, you need a semi-permanent crisis committee empowered to take decisions; and finally you need a strategy to apply symmetrically and based on clear rules about when to recapitalise, and when not. If you pursue a strategy of taking purely national decisions, you run the risk that at least one government will hit its own financial ceiling before this crisis is over, or that decisions have negative spillovers on the banking systems of other countries. Moreover, you end up with a beggar-thy-neighbour regulatory race, as we saw last week when Ireland and Greece unilaterally issued blanket guarantees for large parts of their banking sector. Last night, Germany was preparing a full deposit guarantee for its own banking system. Last but not least is the risk of violent political setback against a process that lacks transparency.
For Europe, this is more than just a banking crisis. Unlike in the US, it could develop into a monetary regime crisis. A systemic banking crisis is one of those few conceivable shocks with the potential to destroy Europe's monetary union. The enthusiasm for creating a single currency was unfortunately never matched by an equal enthusiasm to provide the correspondingly effective institutions to handle financial crises. Most of the time, it does not matter. But it matters now. For that reason alone, the case for a European rescue plan is overwhelming.

Can't We All Just Get Along on Economy? The global economy is a ship quickly taking on water, but not all its crew members are bailing with equal fervor. Finance ministers and central bankers from the Group of Seven leading nations will meet in Washington, D.C., this weekend to discuss the global financial crisis. So will the Group of 20, which includes developing nations such as China and Russia. It isn't a bad time for a get-together. One might wonder why they haven't been thick as thieves for months now, as a crisis that started in the U.S. has steadily squeezed the world's financial system. Instead, a coordinated response has been lacking, at least until this week's unprecedented global interest-rate cut. More such "Kumbaya" moments might be rare. There has been almost as much sniping among nations as unity, and some still seem to consider the crisis mostly a U.S. or European problem. By now, it should be clear that all are in this together, as exemplified by Iceland. Its woes are sending shudders around the world. If corrective measures are taken in some nations and not others, those other nations will suffer and the overall problem will worsen. "Policies at least have to be consistent, and there needs to be more consultation," said Global Insight chief economist Brian Bethune. "The absence of that has really been limiting the effectiveness in dealing with contagion." A detailed global response won't come quickly. But a group of economists associated with London's Centre for Economic Policy Research this week urged the G-7 to at least agree to recapitalize the global banking system and raise the guarantee on global bank deposits. That seems manageable, and will have to be done eventually. Better to do it right away, and hand-in-hand, than in piecemeal fashion stretched out over weeks or months.

History Isn't About to Repeat Itself The year, of course, was 1929, though it sounds just enough like today to make us wonder if we should stock up the pantry, take the cash out of the bank and hunker down for a 21st-century Great Depression. No doubt, the parallels are stark and frightening. But the differences between now and then are even greater. Let's start with lending. In the late 1920s, as the stock market took off, banks expanded their loans for those most unpredictable of assets: stocks. Investors could easily borrow up to 75% of the value of a stock purchase. By 1929, almost $4 of every $10 in bank loans went to buy shares. In addition, Chrysler, General Motors and Standard Oil of New Jersey all made tens of millions of dollars available for stock loans. In one of the most egregious examples, an energy company called Cities Service sold stock and then used the cash to make loans for people to buy more shares. When the market started to fall, however, brokers had to call clients for more cash to secure their loans -- a so-called margin call. Because they had seen short downturns before, customers weren't eager to bail out. Initially, the Federal Reserve did nothing. To try to keep speculative borrowing on stocks from continuing, it declined to reduce interest rates, choking off credit. Unemployment climbed toward 25% at a time when there was no unemployment compensation. In the Prohibition era, those without jobs couldn't even legally drown their sorrows in beer. Most striking was the long reluctance to acknowledge a serious problem. During the crash, President Herbert Hoover insisted that "the fundamental business of the country ... is on a sound and prosperous basis."

Progress Amid the Ruins It may not look like it amid the wild markets, but the world's political leaders are making progress against the global financial panic. The biggest problem continues to be that no one in authority seems able to explain what is happening and why, so all of this feverish government action is scaring everyone to death. The world is nonetheless making intellectual strides, not least in London with yesterday's announcement that the British government will inject up to £50 billion into eight major banks and others that may qualify. France also said it will set up a legal body so the state can intervene swiftly to take stakes in banks that run into trouble. And late Tuesday, the Spanish government said it will set aside a €30 billion fund, which may increase to €50 billion, to buy illiquid but healthy assets. The London move goes to the heart of the problem, which is the capital hole in the financial system that is fueling the global panic. Private capital won't fill that hole with fear so rampant, so some public capital is going to have to serve as a temporary life preserver -- in the U.S. and Europe. The U.K. government plans to inject up to £50 billion in return for preferred shares -- giving taxpayers some upside once the panic passes. London will further guarantee £250 billion in new debt issuance for those banks that participate in the recapitalization plan in order to secure their short- and medium-term funding. Britain has thus helped to shore up its own banks, moving beyond the ad hoc crisis management after individual bank failures. Meanwhile, in the U.S., Treasury Secretary Hank Paulson signaled that his new rescue power includes the ability to do something similar. "It is the policy of the federal government to use all resources at its disposal to make our financial system stronger," Mr. Paulson said, "including strengthening the capitalization of financial institutions of every size." We take -- and hope -- that this means Mr. Paulson is willing to use some of his new $700 billion Troubled Asset Relief Program (Tarp) to inject capital into individual banks if needed to prevent failures. Treasury would still move ahead with its auctions to purchase toxic bank securities, but amid a panic more urgent action may be necessary. Mr. Paulson is right to interpret his mandate broadly, and to show that he is willing to use it. In essence, he is saying the Tarp could be used as a larger, better capitalized version of the Federal Deposit Insurance Corp., injecting capital into banks in return for preferred stock to protect the taxpayer. This is a policy breakthrough.

Money-Market Rates Decline After European Governments Step Up Bank Rescues Money-market rates in Europe fell after policy makers offered banks unlimited dollar funding and European governments pledged to take ``all necessary steps'' to shore up confidence among lenders. The euro interbank offered rate, or Euribor, for one-week loans dropped 26 basis points to 4.37 percent today, the biggest decline this year, according to the European Banking Federation. The London interbank offered rate, or Libor, for three-month dollar loans dropped 7 basis points to 4.75 percent, the largest drop since Dec. 28, the British Bankers' Association said. The Federal Reserve said today central banks around the world will offer banks as much dollar funding as required. Leaders of the 15 nations using the common currency agreed yesterday to guarantee new bank debt and use taxpayers' money to keep lenders afloat. The three-month rate banks charge for euro loans dropped by the most since Jan. 22. ``Taken together, the latest moves increase the chances that we will begin to see some relaxation of the intense funding stresses that have prevailed in commercial paper and inter-bank markets,'' a team including Dominic Wilson, senior global economist at Goldman Sachs Group Inc. in New York, wrote in an investor report today. ``This is because bank solvency risk should decline as the government offers protection.''

Rescue Plan Comes Around to Views of the Academics The government's plan to buy equity in financial institutions, announced Friday by Treasury Secretary Henry Paulson, is an idea that many academic economists have championed from the start of the crisis. Many economists believed that the heart of the government's initial plan to pay $700 billion for toxic assets was aimed at the wrong target. Purchasing mortgage securities from banks wouldn't do anything to kick-start lending and get credit flowing again, they said. Rather, banks would use the proceeds they got from the Treasury to pay off debtors, and those debtors would use the proceeds to buy safe assets. They said a wiser course -- the one the Treasury now seems to have come around to -- was for government to rebuild the badly depleted cash levels on bank balance sheets. That would cushion institutions against future losses, giving them the wherewithal to lend again. Other hitches in the original plan include coming up with a price for mortgage securities that is above the "fire sale" level they would draw on the open market, but not so high that taxpayers end up getting taken for a ride. The Treasury move is a sign of how, as international efforts to contain the crisis continue this weekend at meetings of the International Monetary Fund and World Bank, economists' ideas for solutions are influencing policy and entering the public discourse. Wednesday morning, Barry Eichengreen, an economic historian at the University of California, Berkeley, sent an email to VoxEU.org, the Internet portal of the Centre for Economic Policy Research, a European economic-research network, asking economists to submit brief essays on ways government leaders could tackle the financial crisis. By the next day, VoxEu had produced a booklet of 14 essays by 18 economists. As of Friday, when the Group of Seven finance ministers and central bankers met in Washington, the booklet had been downloaded more than 10,000 times. The economists came from different schools of thought and varying political stripes but all agreed that recapitalizing banks was a key initiative. A final step toward stabilizing the economy would be a large economic stimulus plan, said Berkeley economist Brad DeLong. He suggests that in the U.S. this could be two-tiered, with half the stimulus going toward a tax rebate and the other half dedicated to infrastructure spending. Mr. DeLong said he is encouraged by how quickly economists' thoughts on the crisis have made it into the public sphere. "Everything seems good in terms of people understanding the seriousness of the problem," he said. "I'm actually remarkably optimistic."

G-7 Pledges to Take `All Necessary Steps' to Stem Global Financial Crisis Group of Seven finance chiefs, meeting after stocks plunged and as a global recession looms, vowed to prevent the failure of vital banks while failing to unveil new initiatives for thawing credit markets. ``The current situation calls for urgent and exceptional action,'' the finance ministers and central bankers said in a statement after talks in Washington yesterday. They pledged to ``take all necessary steps to unfreeze credit and money markets'' without detailing how that would be accomplished. Signaling they would intervene to avoid a repeat of last month's collapse of Lehman Brothers Holdings Inc., the officials promised to ensure major banks have access to cash and are able to tap public funds for capital. By refraining from specific fresh measures such as embracing a U.K. plan to guarantee loans between banks, they still run a risk of disappointing investors. ``They've seen what Lehman did and the repercussions,'' said Jeff Pantages, chief investment officer at Alaska Permanent Capital Management in Anchorage, which oversees $2 billion. ``If you're a bondholder, you've got to feel better. If you're a shareholder, you're not so sure.'' A sign of the strains: The G-7 ministers today met with President George W. Bush, an echo of former President Bill Clinton's visit with the group in 1998 amid the Russian debt default and collapse of hedge fund Long Term Capital. ``This is a serious global crisis and therefore requires a serious global response,'' Bush said at the White House. The Group of 20, which includes emerging markets such as Russia and China, convenes later.

EU Writes Menu of Options The euro zone's biggest economies prepared to unveil plans to spend tens of billions of euros in state funds to prop up their banking systems. The leaders of the 15 countries that use the euro said choices on the menu, to be implemented as governments see fit, included partial nationalization of banks and provision of state-guaranteed loans. The euro-zone leaders also agreed to loosen mark-to-market rules -- which force banks to book their assets at the price they would get if they sold them now."Under the current exceptional circumstances, financial and non-financial institutions should be allowed as necessary to value their assets consistently with risk of default assumptions rather than immediate market value which, in illiquid markets may no longer be appropriate," the leaders said in a statement. A decision on how to implement this might be made as early as this week. French President Nicolas Sarkozy, hosting a conference in Paris, said Germany, France and Italy would detail their national plans at about the same time on Monday. On Monday, the French government will indicate the amount of bank loans it is willing to guarantee. Mr. Sarkozy said France will also pass a bill in the coming days creating a special-purpose state vehicle that will raise enough money to nationalize any distressed bank. Germany's plan, according to people familiar with it, could include massive government guarantees for banks' debts and capital injections for some banks. Sunday's accord was an attempt to overcome the EU's recent disarray, as diverging national attempts to prevent banks from collapsing have failed to reassure financial markets. As the credit crunch spilled over into bourses, the pan-European Dow Jones Stoxx 600 index lost more than a fifth of its value last week. Suggestions by France and the Netherlands for a pan-European fund to rescue banks have been vetoed by Germany, which fears its taxpayers would have to pay for costly bailout schemes in other countries. The U.K., which doesn't use the euro but is a member of the 27-nation European Union, is also opposed. Participants in Sunday's summit tried to draw up a common European strategy by allowing each country to pick and choose which parts to implement -- without forcing neighbors to pay for others' choices. While there will be no common European bailout fund, governments have said they will rescue their own banks when needed. The "common basket of instruments," as German Chancellor Angela Merkel dubbed them, is roughly based on a plan the U.K. announced last week to stabilize its financial system.

Our Choice: Recession or Depression  Last week, I suggested the need for a coordinated monetary policy rate cut. That cut arrived yesterday, with the Fed, the European Central Bank and other central banks cutting their policy rates by 50 basis points (bps). This action is necessary, but only cosmetic, and it is too little too late. Policy rate cuts will have a limited effect as they don’t resolve the fundamental problem in markets--massive counter-party risk--that is keeping money-market spreads relative to safe rates so high. Yesterday’s plan to support the commercial paper market is a step in the right direction, but other, more radical policy actions are also needed now. Here are four suggestions for such additional policy action. --To reduce the counter-party risk in the money markets, a triage between insolvent banks that need to be shut down and a recapitalization of solvent banks is necessary, together with massive injections of liquidity in non-banks and the corporate sector. The flawed $700 billion Troubled Asset Relief Program (TARP) legislation will have to be modified in three ways to: a) allow for direct government injection of public capital in banks in the form of preferred shares, matched by private capital contributions by current shareholders (via suspension of all dividend payments and matching Tier 1 capital provided by private shareholders); b) implement a clear plan to reduce the face value of mortgages for distressed homeowners and avoid a tsunami of foreclosures; c) do a rapid and radical triage between solvent banks and insolvent banks that need to be rapidly closed. Since the private sector is not spending, and since the first fiscal stimulus plan (tax rebates for households and tax incentives to firms) failed miserably as households and firms are saving rather than spending and investing, it is necessary now to boost public consumption of goods and services via a massive spending program (a $300 billion fiscal stimulus). The federal government should have a plan to immediately spend on infrastructure and new green technologies; also unemployment benefits should be sharply increased, together with targeted tax rebates only for lower income households at risk; and federal block grants should be given to state and local government to boost their infrastructure spending (roads, sewer systems, etc.). If the private sector does not spend and/or cannot spend, old-fashioned traditional Keynesian spending by the government is necessary. It is true that we already have large and growing budget deficits; but $300 billion of public works is more effective and productive than spending $700 billion to buy toxic assets.

Posted by dblwyo on October 14, 2008 05:26 AM |

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