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Turmoil In The Financial Markets

September 22, 2008 - These are eventful and tumultuous times in the financial markets, as the deleveraging process continues.  The US government is intervening extensively in the markets, aiming for a semblance of calm.  Its actions may have prevented contagion but they have also exacerbated volatility.

Given investors’ fragile psychology and the general state of uncertainty, government actions have an exaggerated effect on market swings.  Many people have criticised the authorities for sending out inconsistent signals.  Why was Lehman allowed to fail, but AIG was bailed out?  The response that Lehman’s problems were well known and investors could prepare themselves for its possible demise is unconvincing.

The dire situation at AIG, Merrill and a host of others was also common knowledge.  Actually, the problems in the US financial system are so troublesome that the issue of moral hazard has been given a low order of priority.  When risk aversion spikes to such an extent that the interbank market virtually freezes and investors sell money-market funds massively, fearing they may contain tainted commercial paper, then the responsible thing to do is to furnish unlimited liquidity.

Obviously, the reason that banks are reluctant to deal with one another is because counterparty risk is very high.  Hoarding cash is a rational response when you don’t know if the borrower is creditworthy.  As for the credit default swap market, the cost of protection has spiked much higher.  And how viable is the entity providing the protection? 

At the time of writing, details are still being worked out regarding the government’s rescue plan to address the issue of distressed debt held by financial institutions.  Evidently, it involves a nationalisation of troubled assets, and is intended to make the banks more wholesome.  The Treasury has to decide how much of a subsidy they are willing to provide, and therefore the size of the potential hit to the taxpayer.  Congress is also involved.

It is not clear whether this will solve the capital adequacy predicament of the banks.  In addition, the problem of the underlying mortgages has to be addressed.  To what extent is the government willing to forgive the mortgages that are weighing down the borrowers?

Such large-scale action by the authorities will introduce distortions in the market system and exacerbate the problem of moral hazard significantly.  Just to remind the reader, moral hazard is created when repeated bail-outs encourage excessive risk taking.  If market discipline and fear of failure are removed, then there is a strong incentive for bank traders and managers to take larger risks.  There will be an expectation that the public purse will be used to pay for any failures.

The ban on short-selling financial stocks is an artificial manipulation of the market and results in stock prices that do not reflect market opinion.  It is astonishing to hear the CEO of Morgan Stanley complain about short selling.  In the world of investment banks, jungle rules apply; eat or be eaten.  Morgan Stanley never hesitated to pounce when presented with a profitable opportunity.  Shorting its stock has been a profitable trade and the CEO has no right to moan.

The deleveraging process is continuing in the United States and across the world.  There will be recognition of more losses on asset portfolios, which will erode the banks’ capital and lead to a reduction of credit extension to businesses and consumers.  Preservation of capital will be an important consideration and concerns about counterparty risk will take a good while to diminish.

Turmoil in the financial markets is spilling over into the real economy and, as a consequence, growth will suffer in the near term.  The costs of the current travails are also likely to reduce the trend rate of growth for the US economy for several years into the future. .  As for the regulatory framework, it is widely expected to undergo significant revisions that may place greater restrictions on financial firms.