Just Another Wacky Day In Finance

by Dollars and Sense

This posting is from D&S collective member and frequent blogger Larry Peterson. To see more of his posts, click here.

Stock markets worldwide fell again Tuesday as attempts by Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke encountered considerable resistance in Congress. The gains from the announcement of the bailout plan late last week have now been more than reversed, and conditions in money markets, and mutual fund redemptions haven't improved much, if at all. So the Fed continues to pump liquidity into a system that shows no sign, as yet, of recovery.

Congressional objections center on two things: the unprecedented--indeed, almost unthinkable--amount of power the Treasury's plan places in the hands of the unelected Treasury Secretary, and the amount of assistance ordinary borrowers can expect in return for the bailout. Many Republicans, needless to say, fret about an more money being spent on irresponsible mortgage-buyers, after so much has already been forked out in the heroic endeavor to bail out Bear Sterns, Fannie Mae and Freddie Mac, and now the entire shadow banking system (not to mention paying for a useless war, tax cuts for the incredibly wealthy, etc.); while Democrats worry that the plan doesn't do enough about foreclosures that could exacerbate the problem, despite all the money that's being thrown at it to keep the bankers in business.

These political problems are daunting enough; but the real problem lies in the fact that there's a contradiction in the very heart of the plan as it stands now. If banks and other finance firms (and lobbyists are hard at work as I write trying to make that designation as wide as possible) sell their dud securities to the government for less than they may be worth, they may require more "assistance" to become profitable again and, more to the point, get the money markets working by resuming lending. But if they sell the loans for too much, the taxpayer will have to take the loss. And there isn't much time to settle on prices: any delay in selling these assets will mean that prices for them will almost certainly go down, which means possible ratings downgrades for the banks, which means potential attacks--though not by short-sellers, at least until they and their hot-shot lawyers can think of a way around the recent ban--on share prices, which means...yet another bailout or bankruptcy. That may be the worst-case scenario: but it's little better than the fire sales that will result if banks have to sell because the premature attempt to set a price fails. And, needless to say, the extent of losses still isn't even known yet: $700 billion never was anything but a guess (and a politically-inspired one at that).

Meanwhile, hedge funds are finding themselves under fire. Many of these funds employed short-selling on a large scale, and are facing a bleak future deprived of this strategy on one hand, and, if that weren't enough, are facing serious delays being paid the money they are owed from former counterparties like Lehman Brothers. Nouriel Roubini, in a guest opinion piece in the Financial Times, thinks this is what we're in store for:

The next stage will be a run on thousands of highly leveraged hedge funds. After a brief lock-up period, investors in such funds can redeem their investments on a quarterly basis; thus a bank-like run on hedge funds is highly possible. Hundreds of smaller, younger funds that have taken excessive risks with high leverage and are poorly managed may collapse. A massive shake-out of the bloated hedge fund industry is likely in the next two years.

Even private equity firms and their reckless, highly leveraged buy-outs will not be spared. The private equity bubble led to more than $1,000bn of LBOs that should never have occurred. The run on these LBOs is slowed by the existence of “convenant-lite” clauses, which do not include traditional default triggers, and “payment-in-kind toggles”, which allow borrowers to defer cash interest payments and accrue more debt, but these only delay the eventual refinancing crisis and will make uglier the bankruptcy that will follow. Even the largest LBOs, such as GMAC and Chrysler, are now at risk.

Seeing that it was the collapse of a hedge fund, Long Term Capital Management, that caused a panic in 1998, and required an historic (by the standards of the time) bailout by Wall Street firms in 1998, it's indeed possible that the bailout of the entire shadow banking system may not be enough. And remember, the situation with commercial and regional banks is also very sensitive, and will become more so as economic conditions (especially credit card payments) deteriorate. On top of this, Detroit automakers and other industrial firms are looking for bailouts and subsidies to get them through hard times. These and other worries (not to mention some pretty unusual technical considerations, as well as the impact of recent hurricanes on refineries in the Gulf of Mexico) caused oil to stage it's largest one-rise since June (and that means ever), jumping $25 a barrel to $130.00, before settling down at $120.92 (it declined again today), revealing considerable doubts amongst international investors on the Treasury plan. Congress isn't the only body that has to be sold on this.

To (mercifully) sum up the two surviving investment banks, Morgan Stanley and Goldman Sachs, were permitted to change their structure to holding companies, bringing the era of independent investment banks to a close, only a fortnight after five of them stood tall on Wall Street. As holding companies, they will have to rely more on taking deposits, and submit to regulations (especially regarding reserve requirements) that investment banks didn't bother with. But this (Tuesday) morning brought yet one more little jest from fate: Morgan Stanley and Lehman both had turned to Japanese banks to buy stakes in them. Japan, the laughing stock of the banking world, and recipient of God-knows how many lectures on the superiority of the American banking model from officials, bankers (probably Paulson, no less) and pundits during the lost decades of the ‘90s and ‘00s, is now looking to expand its overseas operations by moving in where the old titans roamed. One hopes they have a better business model. 

Please consider donating to Dollars & Sense and/or subscribing to the magazine (both print and e-subscriptions now available!).
9/23/2008 07:33:00 PM