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Friday September 19, 2008 - 16:37:59 GMT
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FX Blog - Fed, Treasury, Congress and Cavalry Ride to Rescue of Banks. What Next?

 Well yesterday was the worst day of the banking crisis by a long shot going back 13 months.  Actually it was worse than the 1987 stock market crash.  Well actually it was worse than the 1929 stock market crash.  There was (use past tense cautiously) a banking panic…an institutional run…which if not stopped would have led to a run on deposits at commercial banks too (WAMU has seen a run by depositors if not reported) by firms and households – FDIC insured or not.  The run on the US custodial banks Thursday as money market funds looked sure to uniformly break the buck dumping assets into a market already in lock down was frightening.  And no counterparties were taking trades from non-depository financial firms, including the remaining two US security houses Thursday, even on securities and cash/FX with one-day settlement as best I can tell.  And this was on top of record liquidity infusion by the central banks of the world.  It was Armageddon in the banking system globally on Thursday.


Well that was before Bruce Willis arrived on the meteor heading straight at planet earth with his team of MacGyvers and Scooby Dos to take care of business.


US Treasury, Fed and Congressional leaders finally got it…either commit the US government’s balance sheet to the problem in a completely sufficient way (i.e. whatever it takes) or it is lights out for the banks and the economy and likely capitalism. 


I am not ready to say the panic is over and the patient cured.  But it is looking far closer to a sufficient response to the panic (stop calling it a crisis) than anything to date. 


Perhaps the least effective and potentially most reversible measure announced today was the banning of short selling of financial stocks by the SEC (and mirrored in UK, Australia, Switzerland and Ireland and I would suspect other countries in due course).  But it has had the desired effect with financials roaring back to life and leading broad gains in key indexes.  Without a real cure soon, even with a ban on short selling will see stocks go to zero if the market determines the business is worth zero.


But the more significant news emerged well after the close Thursday and rumored well ahead of the close allowing for an explosive move up in stocks Thursday in late session trading and a global return of elements of risk taking behavior – yes the RTC solution for warehousing bad bank assets was being cooked up and appeared to have broad backing among political parties, elected officials and regulators.  While the details remain unclear, the choices are very clear…there are not many…do it on a grand and convincing scale or don’t so it at all.  CNBC reported that taxpayers will be on the hook up front for up to $500bln…I think that number should be doubled for starters.  Maybe $500bln gets to heart of bad MBS, but does not include bad everything else, and more of bad is in the cards ahead as the real economy does not hold up and any cleansed bad bank will have severe limitations on risk and lending. 


And today more news (apart from the banning of short selling) – US Treasury committed, with President’s approval, to use $50bln from the Exchange Stabilization Fund (mainly euros and yen and some dollar balances – euro and yen would be swapped with ECB and BOJ for their dollars rather than the Treasury using the Fed to sell euro and yen for dollars in the open market) to keep the money market funds from breaking the buck (NAV falling under $1.00 which would prompt asset sales, namely ABCP, prompting a black hole of falling prices and wealth for the millions of households and tens of thousands of firms that hold large (near) cash balances in these funds…that was behind the run on custodial banks Thursday as they are main manager of institutional money market accounts.


Then the Fed this AM said it would supply the banking system with funds (temporarily) to buy ABCP, providing a first line of defense for the money market world…so that US Treasury does not have to top up a money market account with ESF money. 


It is hard to keep up with all of the tricks Bruce Willis and his band are announcing – may even be more as I write this and take my eyes off the screens. 


Now for the however.   


There is a chance that Washington bungles it badly and allows politics of the moment – remember every member of the House and a third of the Senate face elections in November and Congress breaks for the November election at the end of next week – delay or derail a blank check answer for the banking panic.  My own personal view is more Nordic – just take over the weak institutions and then slowly sell them back to the private sector.  Republicans are in general opposed to government bailouts of the private sector and have the wherewithal to block legislation (needed for this level of response) authorizing a blank check for the banking system overhaul ahead that could run $1-2trln I think before it is resolved (and this number could, maybe even would, come down longer-term as even some of the most toxic of securities find buyers and or recover some value ad can be sold).   And Democrats eyeing the prize of the November general election could try and use the financial panic to promote its ticket in an election that at the Congressional level in particular is expected to go solidly blue (and at the executive level pre-Palin) – interim elections in places like Louisiana and Texas where safe Republican seats in Congress have gone to the Democrats in the last year surprising many.  In other words why put humpty dumpty back together again which might stabilize or even improve the erosion of support for the GOP.  There will be lots of hard bargaining between the two sides of the aisle in the next two weeks and unless partisan rancor and the election are clearly taken out of the picture, the arrival of the US Cavalry will quickly go the way of General Custer at the Little Bighorn (sorry for swinging between images of Bruce Willis in Armageddon and George Custer’s day of reckoning with the mighty Sioux nation).  


However, however.


The days of a hackneyed-finger-in-the-dike-bank-by-bank approach to “The Great Financial Panic of 2008” – my attempt to guess at what it will be called in 10 years – are over.  Washington, if not Senator McCain, is getting it.


Where from here?


Well banks – yes not just investment banks – will never be the same.  They will have large direct or indirect government stakes until they can be sold and they will operate in a tightly regulated world without leverage and without a no-risk-management policy.  For those that recall, Treasury Secretary Paulson gave his first speech on what he hoped to accomplish after being confirmed the new Secretary of the Treasury at Columbia University – he said the US must address making Wall Street competitive with the capital markets of London, Europe and soon to be Asia or New York in particular would no longer be a financial powerhouse…oh and the problem?...too much regulation – the Sarbanes Oxley hangover.


So we have a permanently handicapped US banking system (likely global banking system and for no one’s fault but their own) on the one hand and as the IMF astutely noted today a declining or stagnant economic backdrop in the developed economies.      The negative feedback loop is upon us and it is now how deep and how long a recession lies ahead…where we are now is just the beginning. 


The blank check Washington extends to the US banking system (maybe autos and airlines shortly too…and your averaged leveraged home owner) will bust the bond if not the buck.  There is a reflation world ahead and if you have to wait for S&P or Moody’s to tell you that the 30-year bond (which hit a 45-year low in yield this week) is not AAA, then I know where you can buy some option-Arm-backed securities cheaply. 


David Gilmore


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