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The cavalry (part II)

Mon, Sep 22 2008, 08:25 GMT
by Yapi Kredi Bank Economic Research Department

UniCredit Group

As a follow up to my note early this morning, here are a few more considerations on the rescue operation announced by the US authorities. In particular: (1) after the impressive relief rally enjoyed by markets that have seen their death sentence rescinded as they walked to the guillotine, we now need to focus on the design and implementation details, especially what assets will be taken over by the government; from which institutions; and at what price/haircut. (2) A key challenge will be to strike the right balance between leaving financial institutions sufficiently capitalized to keep credit flowing, and limiting the cost and risk to taxpayers. (3) The events of the last 24 hours, while extremely positive, also underscore the limits to coordinated intervention: coordinated liquidity provisions are now an established practice, coordinated rate cuts are feasible but unlikely, a coordinated RTC-style rescue appears infeasible. (4) This opens the question of what if anything we might see in Europe. The Paulson plan will indirectly benefit European institutions as well, but the cavalry cannot cross the ocean, and the risk of a credit event in Europe remains—albeit most likely outside the Eurozone—and could spark a new surge in risk aversion, although not a systemic threat. I remain of the view that this week will prove to be the turning point in the crisis, the time when the global financial system was pulled back from the brink and the painful healing process began. There is more consolidation and deleveraging ahead, more mergers and more failures, but now we are starting to climb out of this deep hole. Paulson’s performance in the last two weeks has been impressive in my view, decisive, courageous, and clear-headed. He quickly realized the system was at breaking point and acted accordingly. Hats off, and good luck.

A sweeping government intervention to take bad assets off the private sector’s balance sheet was inevitable—that much was clear once the magnitude of the problem became obvious. It is a dramatic step with far-reaching consequences, and the authorities were right in delaying it as much as possible. With the benefit of hindsight, the way events unfolded looks perfectly logical: after months of stress, the most vulnerable financial institutions came under unbearable pressure one at the time. The Fed and US Treasury tackled them on a case-by-case basis, trying to keep public support to the minimum needed to forestall systemic instability. As of last Wednesday, however, the entire financial sector was at risk of collapse, with share prices in free fall, interbank markets frozen by a dramatic surge in perceived risk aversion, and the first cracks appearing even in money market funds. The risk of a widespread collapse in confidence in the financial system was palpable. Extreme danger called for extreme measures, and there was no time to spare.

The simultaneous decision to temporarily prohibit short selling in shares of financial institutions was equivalent to declaring a state of emergency,-like the imposition of a curfew.

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Published on  Mon, Sep 22 2008, 08:30 GMT