Markets Hope For A Measure Of Stability
September 29th, 2009 - Turmoil on the financial markets has yet to die down. The politicians in Washington, after much wrangling, have come to a modicum of agreement on the main features of the rescue plan. There was resistance from some politicians, but saving the banks from their own folly is as nauseating as it is necessary.
Unfortunately, the rescue plan is not a final solution to problems in the financial system. The banks may require further capital injections and homeowners with troubled mortgages may need to be saved - - in a deteriorating economy. So the costs will continue to mount.
The administration’s initial attempt to push their plan rapidly through Congress, giving minimal details and asking for broad powers, was evidently unacceptable to lawmakers. Scare tactics that the financial system was about to flounder didn’t frighten knowledgeable people, either.
The system does indeed have serious problems, but the situation was not so desperate that a few extra days couldn’t be spent by legislators to bash out a plan that assigns responsibility, sets limits and protects taxpayers. Of course, the bankers who stand to gain from the largesse of the public purse were not averse to playing up the dire state of the credit market.
Under questioning, comrades Bernanke and Paulson (that’s how they are referred to in the financial press) admitted that they intended to be very generous to the banks, in the matter of pricing their toxic assets. Essentially, they wanted to give the banks lots of cash in exchange for their trash, and imposing little in the way of oversight.
However, the American public is in an angry mood, and the politicians have to respond to their current state of mind. A plumber, speaking to a BBC reporter in Virginia, got it just right. He said it was all about accepting responsibility, those who had bought houses that they could ill afford and those on Wall Street who had mucked up.
Well, many of the fat cats on Wall Street haven’t exhausted their nine lives. One such is Goldman Sachs which has been saved from a crash landing, not so much because of the astuteness of its executives as the warm embrace of Uncle Sam. Liquidity provided by the Fed, and the ban on short selling, helped a lot to resuscitate the bank.
Also, the government’s rescue of AIG saved Goldman’s skin because of their exposure to the insurance giant. And when things looked a little safer, the canniest investor around, Warren Buffett, bought a piece of the Goldman pie on extraordinarily favourable terms, particularly since his downside risk is well protected.
And, of course, the two remaining investment banks have now been transformed into deposit-taking institutions to give them a more stable capital base. Official approval of their new status came in record time. But the two banks, along with a whole host of other financial firms, will need additional capital. And eyes have turned towards Asia as a source of capital injection.
A Japanese bank has already taken a stake in Morgan Stanley, evidently with the approval of the US government. It is less likely that the administration will look as favourably towards participatory capital from Chinese entities. China is considered a rival for great power status, while Japan is a docile ally, partnering the Americans in their struggle against the great dragon’s rising power.
We talk about the rescue plan’s cost to the taxpayer. In reality, it is unlikely that the government will raise taxes to fund the rescue package. What will happen is that they will issue more debt. But government debt merely constitutes deferred taxes. And, of course, the hope is that foreigners will buy much of the issuance.
This may prove something of a challenge in the future as potential buyers become concerned about payback and look towards diversifying their portfolios. In the short term, though, demand for Treasuries is unlikely to dry up. Returns on Treasuries may be dismally low but, to the Japanese, rates are still more attractive than what they can get back home.
The Chinese authorities are showing signs of unease about the size of their holdings of US- issued debt. In the short run, they want to initiate some sort of entente among Asian countries to prevent major moves to sell such debt instruments. In the longer run, they are keen on diversifying their export markets as well as relying increasingly on domestic demand as an engine of growth. A declining trade surplus with the US would mean fewer extra dollars to invest.
The deleveraging process is hurting hedge funds badly. Many have been caught in an awful squeeze, particularly the ones with relatively illiquid assets. Unlike the banks, they do not have direct access to funds provided by the central bank. Meanwhile, many governments have multiplied their pains by suddenly changing the rule on the short-selling of financials, and there are concerns that in order to goose up the stock market the ban may be extended to other stocks. In any case, the damage has already been done, affecting even relatively risk-averse strategies such as market-neutral. With redemptions on the rise, prospects are bleak for many hedge funds.