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Throwing markets a lifeline

Fri, Sep 19 2008, 12:59 GMT
by HVB Group Global Markets Research

HVB Group

• Escalation. The financial market crisis has recently escalated dramatically. The casualties kept piling up, and the losses were increasing steadily. As financial markets appeared to be close to a meltdown, the Fed and the Treasury decided to throw markets a lifeline.

• Change in strategy. Lehman's collapse, the controlled bankruptcy of AIG, and above all the recent proposal to transfer impaired assets to an agency like the Resolution Trust Corporation, however, demonstrate that US authorities are now willing to act strategically (pages 2).

• Chances. We think the new approach is indeed a lifeline, and contains elements that will boost investor confidence and thus stabilize markets. The financial crisis is, however, not yet over; the risks remain high.

• Risks. The Damocles Sword of a credit crunch is, therefore, hanging over the US economy, and the risk of recession is still with us. The recent weak economic and financial market data have already pushed our recession indicator to critical levels (pages 7-8 & chart below).

• Fed. The Fed remained steadfast in its interest rate policy. It has almost never responded to bankruptcies with rate cuts, and only occasionally to major equity market sell-offs. Distortions in the financial system, coupled with rising recession and moderating inflation risks, suggest monetary policy will remain accommodative well into next year. We do not expect the first rate hike until late summer 2009 (pages 3-6).

• Further topics:
  

  – 2008 Oktoberfest: Party mood despite higher prices (page 9).

  – Data outlook: Eurozone purchasing managers bearish (page 10).

  – Market outlook: High volatility to persist (page 18).

The cavalry rides to the rescue

In a dramatic climax to a week that has marked the end of the financial world as we knew it, US policymakers announced they have agreed on the rapid launch of a plan to take impaired assets off the balance sheets of troubled financial institutions. This will be supported by measures to ensure deposits in money market funds and to temporarily stop short selling of financial institutions shares. Faced with a systemic collapse in confidence in the financial system, policymakers are now responding with a systemic solution aimed at ensuring the survival of the financial system. The cavalry is on its way. Expect things to move very quickly now, in line with the frantic pace of events in the last few days. A detailed plan could be presented to Congress already today, and the urgency of the situation in my mind virtually guarantees a quick approval. This is positive for stocks and positive for the USD, much less friendly for government bonds. The immediate market impact is already proving to be extremely powerful, partly because it is lifting investors out of a dangerous slump of pessimism and desperation. It will take longer for markets to work out the full implications, and the extent to which the plan can offset the risks emanating from the global slowdown already underway. But this is an extremely momentous development. The endgame is in full swing, and the end of the crises is now in sight.

Policymakers were clear and emphatic in indicating that the solution will be systemic in scope and quick in its implementation. This is exactly what was needed to stabilize markets and boost investor confidence. As the pace of events accelerated dramatically with the bankruptcy of Lehman Brothers, over the last couple of days markets were overcome by fears that no financial institution could be considered safe. Perceived counterparty risk surged to unprecedented levels, paralyzing money and interbank markets and triggering a near-meltdown in the share prices of financial institutions, which in turn dragged broader equity indices down. Yesterday, central banks first reacted with a coordinated injection of USD liquidity on a vast scale, which immediately helped to alleviate the liquidity crunch. However, the experience of the last twelve months warned that concerns about the solvency of financial institutions would not be eliminated by liquidity provisions alone. With financial markets gripped by panic on an unprecedented scale, policymakers decided the deleveraging and consolidation process could no longer be credibly managed on a case by case basis.

The plan will be broadly along the lines of the Resolution Trust Corporation, with impaired assets transferred to a new special institution – the first figure being mentioned is about USD 800 bn. The effort would involve the issuance of government bonds to replace illiquid securities with liquid ones. This would ensure the viability of the financial institutions involved and strengthen their balance sheets. Moreover, as the government-sponsored RTC-style vehicle would represent a strong pair of hands able to hold on to the impaired assets for as long as necessary, it would eliminate the risk of assets being dumped into the market triggering waves of mark-downs and forced sales. Further measures under considerations might include separating a USD 400 bn pool within the FDIC to ensure investors in money market funds; as well as further tightening of measures to prevent short selling in the shares of financial institutions.

The immediate market reaction is a testimony to the extraordinary situation we are experiencing; with US stocks bouncing to record the strongest rally in six years. Asian stocks are now rallying strongly as well. This gives us the measure of the deep relief brought to a market that had come to doubt the very survival of the financial system.

The announcement does not immediately eliminate all problems. Definition and implementation of the plan will be far from easy, given the magnitude of the challenge. Identifying the assets and institutions to be involved in the rescue plan, valuing the assets and working out a gradual disposal plan will be a daunting task. Moreover, uncertainty over the implementation will in the short term leave room for concern over the fate of some individual institutions, with the consequent potential volatility. Next, the issuance of government bonds needed to fund the plan is already raising some concerns over the US public debt outlook and even the possibility that the sovereign might lose its triple-A rating, both with potential adverse consequences on appetite for USTs and USD. I believe these concerns are exaggerated—the US starts off with a very low debt stock, and the positive impact of the plan on the country’s economic and financial prospects should easily outweigh concerns over the fiscal impact. Of greater importance are persisting concerns about the global growth outlook. While a systemic financial rescue plan will alleviate downside risks, especially as regards a possible credit squeeze, it will not immediately halt the ongoing slowdown, and it will not eliminate at a stroke the key fragilities of the US economy, namely the housing market and the labor market. But do not get me wrong—my baseline scenario was already that the US economy would muddle through to reach a modest recovery next year, and a rescue plan for the financial sector obviously bolsters my confidence in this scenario.

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Published on  Fri, Sep 19 2008, 13:07 GMT