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Friday October 10, 2008 - 14:01:17 GMT
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Forex Blog - It Can be Done

It Can be Done

 

By any measure Paulson and Co have made two significant policy mistakes in confronting the banking and soon to be economic crises.  Paulson let Lehman fall putting a premium on moral hazard and underestimating the interconnectedness of this investment bank and then addressed a solvency problem with a liquidity plan called TARP.  The question now is whether the policy missteps are fatal.  In my humble opinion the mistakes are not fatal.

 

As it turns out TARP allows the injection of capital (public funds) directly into banks va the purchasing of equity stakes – likely preferred shares a la Warren Buffet.  Politically turning a ship sailing to liquidity horizon (reverse auctions in heterogeneous ABS) is difficult to turn to the solvency horizon (buying equity stakes or nationalizing). 

 

But it is inevitable and we may get that message today from President Bush.  And delays in buying shares needs to end and will end.  I think by next week the US government will hold stakes in a number of financial institutions including investment banks (now bank holding companies), commercial banks and insurance companies. 

 

Let it also be said that the WSJ is reporting the US government is considering the Irish option (more or less followed by the UK this week)…guaranteeing all deposits in banks and guaranteeing all bank liabilities.  This may require the President declaring an emergency and warranting special executive powers to deal with the crisis…equivalent of declaration of war.  Frankly it may be optimal that Bush is a lame duck and no longer has much skin in the political game not to mention his utter abandonment of free market ideology.  I am not sure if Congress will need to pass emergency measures bill freeing up the executive branch to address the crisis – and there may be a way for the FDIC to do this indirectly without an act of Congress.

 

It is also clear that G7-G20 will need to pledge FX reserves to fund a clearing house or insurance pool to guarantee interbank lending.  Japanese officials seem to be floating this idea based on press reports.  Look for this measure to find traction at G7 today in Washington and over the weekend as G20 meets (presumably Saturday). 

 

I would also expect another joint rate cut next week though the holidays in the US (partial with the Fed and banks closed Monday for Columbus Day but stocks open) and Japan (closed for health and fitness day) – yes Japan will be involved in the next half point coordinated rate cut.

 

While I would not bank on a global bank holiday next week, it makes sense to me and especially so in light of what officials need to get organized this weekend in Washington and because of the scheduled holidays in the US and Japan.  Again this is a remote option, but not to be ruled out…all I am saying.

 

Finally I would take time to read Paul Volcker’s op-ed in the WSJ today (attached below).  At the end of the day governments are bigger than markets as they create fiat money.  Anyone who has taken a look at the Fed’s and ECB’s balance sheets in the last three weeks should have little doubt that central banks can keep banks (and some non-bank financials like AIG) liquid.  Governments however can and must keep banks and key non-bank financials solvent.  The central banks are holding up their half of the sky in this crisis in remarkable fashion and since Wednesday the ECB is fully on board signaling they get it…finally.  The governments need to show they can hold up their half of the sky and time is running out.  I am betting large that by Sunday, markets will have a greater appreciation for government action on solvency…Ireland, UK and Holland are already there…yes a small part of the global financial system but all large events in physics start with near imperceptible changes. 

 

So today is not about where Lehman CDS gets auctioned at – cents on the dollar and implying large writedowns – but on government efforts to restore solvency in the banking system and that event and process will be taking place in Washington not on Wall Street.

 

David Gilmore

 

 

We Have the Tools to Manage the Crisis (Volcker)

 

Now we need the leadership to use them.

  •  

Today, the financial crisis has reached a critical point. The sharp decline in the stock market and its volatility dramatically make the point. More important if less visible, the flow of credit through the banking system and the financial markets is seriously impaired -- even in part frozen.

For months, the real economy, apart from housing, had not been much affected by the developing crisis. Now, a full-scale recession appears unavoidable. Important state and local governments face deficits they may be unable to finance. Recessionary forces are apparent in other important countries and exchange rates are unstable.

Those are facts.

They are the culmination of economic imbalances, a succession of financial bubbles and financial crises that have been building for years. It's no wonder that confidence in markets, banks, and financial management has been badly eroded. Without effective action, fear might take hold, threatening orderly recovery.

Fortunately, there is also good reason to believe that the means are now available to turn the tide. Financial authorities, in the United States and elsewhere, are now in a position to take needed and convincing action to stabilize markets and to restore trust.

First of all, there is now clear recognition that the problem is international, and international coordination and cooperation is both necessary and underway. The days of finger pointing and schadenfreude are over. The concerted reduction in central bank interest rates is one concrete manifestation of that fact.

More important in existing circumstances is the clear determination of our Treasury, of European finance ministries, and of central banks to support and defend the stability of major international banks. That approach extends to providing fresh capital to supplement private funds if necessary.

In the U.S., with higher limits of deposit insurance in place, the FDIC has demonstrated its ability to protect depositors, to arrange mergers, and to provide capital for troubled banks. Most other countries now have a comparable capacity.

Recent U.S. legislation has provided authority for large-scale direct intervention by the Treasury in the mortgage and other troubled markets. Along with increased purchases by Fannie Mae and Freddie Mac, now under government control, means of restoring needed liquidity are at hand.

Other key sectors of financial markets are now protected or supported by either the Treasury or Federal Reserve, specifically by temporary insurance of money-market funds and by direct purchase of commercial paper.

Active efforts are underway to develop stronger netting, clearing and settlement arrangements for certain derivatives, in particular the notional trillions of credit default swaps, the absence of which has contributed to uncertainty and large demands for scarce collateral.

None of that is easy. Some of it poses risks for the taxpayer. All of it is decidedly unattractive in the sense of large official intervention in what should be private markets able to stand on their own feet. Unattractive or not in normal circumstances, the point is the needed tools to restore and maintain functioning markets are there. Now is the time to use them. To that end, the immediate and critical need is determined, forceful and persistent leadership -- extending across administrations and Congresses. Both the public and private sectors must be involved.

The inevitable recession can be moderated. The groundwork can be laid for reconstructing the financial system and the regulatory and supervisory arrangements from the bottom up. The extraordinary interventions by the government (and taxpayer) should be ended as soon as reasonably feasible.

That rebuilding will be the job of another day -- of a new administration here in the U.S., of finance ministries and central banks working together. It must draw upon the strength of the now chastened private sector. It will require more understanding of the risks embedded in so-called financial engineering and of the perverse compensation incentives that have exalted risk over prudence.

There is, and must be, recognition of the essential role that free and competitive financial markets play in a vigorous, innovative economic system. There needs to be understanding, in that context, that financial ups and downs -- and financial crises -- will be inevitable, even with responsible economic policies and sensible regulation. But never again should so much economic damage be risked by a financial structure so fragile, so overextended, so opaque as that of recent years.

Mr. Volcker was chairman of the Federal Reserve from 1979-1987.

 

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