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Shock Therapy

Tue, Sep 16 2008, 08:45 GMT
by Yapi Kredi Bank Economic Research Department

UniCredit Group

We are seeing history in the making and it is a scary sight. Three major brokers have now disappeared from the scene. Two of them (Bear Stearns and Merrill) had been around for almost a century; the third (Lehman) for a century and a half. The US Treasury’s decision to opt for shock therapy, allowing Lehman to go bankrupt, has pushed us into uncharted waters and markets are grappling with the potential impact of unwinding Lehman’s positions. If the Treasury’s gamble succeeds, and the market absorbs Lehman’s failure without systemic disruption, this should have a powerful confidenceboosting effect, bolstering investors’ faith in the self-healing ability of the financial system. But the risks are enormous. Nobody really knows how the unwinding of Lehman’s operation will unfold, and there is an obvious risk that it might cause pressure on asset prices and waves of forced selling. Moreover, perceived risk on the financial sector has risen considerably—AIG has already moved centerstage— which will exacerbate funding difficulties for financial institutions and therefore heighten the danger of a credit squeeze. Risks to global growth have increased, and will put further downward pressure on commodity prices. Concerns on second round effects are in my view well behind the curve at this stage, and pressures on the ECB and BOE to cut sooner rather than later are increasing. By contrast, I do not think the Fed will cut rates tomorrow, even though markets seem to take a cut almost for granted. However, we no longer believe the Fed will move to normalize rates already at the end of the year. We now see rates on hold through June next year, and then rising gradually to 3.0% by end-2009. I believe this might be the beginning of a crucial phase of consolidation that will open the way for a long-awaited recovery—but it promises to be nerve-wrecking and painful.

US authorities have decided it was time for shock therapy, and have opened a brand new phase of the financial turmoil. During a weekend of frantic negotiations, and with widespread expectations that a deal on Lehman would somehow be brokered, the US Treasury adamantly refused to put taxpayer’s money at risk to guarantee potential buyers against losses on Lehman’s portfolio. Both Barclays and Bank of America walked out, and Lehman filed for bankruptcy protection.

Already on Sunday the focus quickly shifted to containing the fallout: there was a special trading session to allow banks and brokers to offset and partially hedge their exposure to Lehman; The Fed increased its UST lending to brokers by USD25bn to USD200bn and widened the acceptable collateral to include stocks; Ten global banks have set up a special USD70bn fund to ensure liquidity on the market; And perhaps most importantly, Bank of America agreed to buy Merrill Lynch, in a deal that takes off the table what would probably have been the next target of bankruptcy rumors.

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Published on  Tue, Sep 16 2008, 08:52 GMT