Day: October 15, 2008

Where Do We Go from Here?

(Which is, of course, a song from the great Buffy episode, “Once More, with Feeling.”)

After the last week, it was a relief to have a relatively slow news day, at least compared to the preceding days, to catch our breath and take stock of things (and get over my cold). American and European policy makers decided they needed to use overwhelming force to stop the panic in its tracks. It will take some time to see if they used enough; the credit markets have certainly not opened up, although some indicators have gotten marginally better (the TED spread is slightly down; T-bill yields are slightly up).

There are two directions things could go. First, it is possible that the credit markets will not come unstuck, and even more force will be required; blanket loan guarantees (for all bank obligations) and large recapitalizations (more than 3% of assets) would then be called for. Second, and more likely, we think, credit will gradually start flowing again. But even in that case, the global economy will be far from out of the woods. Here are the top issues that will still need to be faced:

  • Implementing the Paulson plan, including both bank recapitalization and, if still included, asset purchases. This will require dealing with all of the issues of governance and pricing that we have commented on previously.
  • Containing the damage of falling housing prices and foreclosures. Asset prices do need to fall to reasonable levels – trying to prop them up at artificially high levels will only hurt the economy in the long run – but limiting an overcorrection and limiting the collateral damage have to be priorities.
  • Stimulating the real economy. Even if the credit crunch eases in, say, the next few weeks, the last month has already done significant damage to the global economy (which was already in the midst of a slowdown). For starters, just think of all the uncertainty and anxiety that have been generated in the last month, and the impact that will have on spending and investment by consumers and businesses. The fall in the stock market will also add to the negative wealth effect of falling housing prices.
  • The international dimension and emerging markets. We could be moving to a situation where core banks in wealthy countries are considered safe, while banks in emerging markets are still considered shaky. This could trigger a repeat, on a larger scale, of the emerging markets crisis of 1997-98. And severe economic dislocation can always have political consequences as well.
  • Update: How did I forget … financial sector regulation?

These are some of the major issues we will be thinking about over hte next few weeks and months (and possibly years). Let us know what else you think should be on the agenda.

The Bailout: Yes, But Will It Work?

Every week, it seems, we see a new high-water mark for government intervention in the financial sector, culminating (?) in today’s announcement that the government is buying $125 billion of preferred stock in nine banks, with another $125 billion available for others. The recapitalization, loan guarantees, and expanded deposit insurance are the most aggressive steps taken yet in the U.S. and were all on on our list of recommendations.

I think it is highly likely that today’s actions will boost confidence in the banking sector. First, the banks involved have fresh capital; second, they can raise new debt more easily thanks to the loan guarantees; and third, because the U.S. government is now a major shareholder, it is even less likely that the government will let one of them fail. I could be wrong, but I think worries about bank defaults, at least for participating banks, will start to recede.

The next question, however, is what the impact will be on lending to the real economy, and here the outlook is less certain. In a press conference today, Paulson said, “The needs of our economy require that our financial institutions not take this new capital to hoard it, but to deploy it.” However, it’s not clear that he has the tools to compel the banks to increase lending. The terms of the investment are relatively favorable to the banks – 5% dividend, no conversion to common, no voting rights (unless the dividends are not paid for several consecutive quarters). So the self-interested thing for banks to do may be to take the cash and pay down higher-yielding debt on their books. Hopefully as the financial system returns to normal banks will go back to doing what they usually do, which is lend money.

All that said, I think we’re still in better shape than two days ago.

Some people have asked me how you can tell if the bailout, or anything else the government is trying, is working, since the stock market is largely noise. I’m no expert here, so I’ll point you to a couple of other measures of the credit market that people have recommended. One is the TED spread (3-month LIBOR minus 3-month T-bills; explanation here), a measure of banks’ willingness to lend to each other as opposed to buying Treasury bills, which came down today (which is good). The blog Calculated Risk also recommends a few metrics you can look at.