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The cavalry

Fri, Sep 19 2008, 07:24 GMT
by Yapi Kredi Bank Economic Research Department

UniCredit Group

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 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 USD800bn. 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, strengthening their balance sheets.

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Published on  Fri, Sep 19 2008, 07:31 GMT