Dangling On A Thread Whilst Pushing On A String

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

The financial crisis has now reached an undeniable inflection point. No one—no one–can simply assume any longer that the threat of potentially serious wealth destruction doesn’t hang directly overhead, poised to be snapped in an instant, especially given the next round of speculative assault on any policy turnarounds that will inevitably accompany the failure of another big player (some still remain which are considered too interconnected to fail, even though their numbers have been considerably reduced by the events of the last two weeks), on the one hand, or sign of pronounced economic weakness on the other. And instances–possibly occurring at an increased rate—of both now seem to be bound to occur. Central banks, regulatory authorities and finance ministries around the world are now focusing as much attention as they can (given those annoying bailouts) on getting the money markets unclogged; and this, in turn, will require them, somehow, to figure out a way—“quasi-socialistic” or not, monopoly-enabling or not, protective of national [elite] interests/competitive advantages or not, to separate tainted assets from dud ones once and for all, so that all assets can find a price and get money market and housing markets—both indispensable to economic recovery–moving again. Needless to say, this is a truly Herculean task, one the market has been spectacularly unable to carry out more-or-less on its own in the last year, and will only get all the more difficult as other firms fail and economic conditions continue to deteriorate (which will lead to more failures, which will make assets fall more in value and resistant to stabilization at some level, which will lead to yet more failures, etc.). But at this point we have to begin to wonder: if they do not fully succeed, and fast, will things like pensions, and even accounts dedicated to payment of wages and benefits, necessarily continue to be turned over? This question, one would think, must be settled before we can believe the wider economy will definitely avoid a shutdown along the lines of one which has, so far, seriously impacted the functioning of financial sector alone.

Why the switch from severe caution to open alarm? Well, events on the money market in the last week have clearly shown that, in spite of bailouts and support programs of more than historic size and scope, the appetite for risk has only declined—and precipitously. The always rather optimistic hope that losses on the subprime mortgage market, which, it is true, constituted only a small part of the US mortgage market a year ago, has been replaced by a realization by everyone (with the exception of George W. Bush and possibly John McCain) that mere subprime debt in arrears is compounded by the bets taken out it by insurers (like an AIG, which might not be able to pay out the enormous losses on misplaced bets by huge firms it insures, like Lehman), and that vast areas of the financial universe that even regulators know little about may consequently have to be carefully and slowly bled of tainted assets and nursed back to health, nationalized outright, or liquidated altogether. Accordingly, whoever has cash is hoarding it, because there is no one to deal with who either holds tainted assets, or does business with firms who may hold such risky securities. So, even profitable Morgan Stanley (one of the two remaining investment banks, along with Goldman Sachs) is finding it hard to do business, because questions not so much about its finances, but concerning the firms which sold it insurance on Morgan’s winning bets, but may not be able to pay these bets off, are putting pressure on Morgan’s share price (it is so bad that Morgan is now looking to Wachovia, a mere regional bank, as a buyer, after considering a bid from a CIC of China). And, for many firms, such pressure in the stock market leads to the danger of ratings downgrades, which makes it more expensive to borrow (and to insure their debt): more and better-quality collateral is required and often at higher interest rates. This prompts further asset sell-offs (as firms try to raise capital and thereby, theoretically, regain the confidence of equity investors), which decreases asset prices. Both of these influences (increased costs of financing and falling asset prices) make investors or their bankers all the less likely to want to put hard cash out.

Because of all this, huge open market operations (in which they sell bonds to banks to keep interest rates at target levels, in this case 2%) by central banks like the Federal Reserve, the Bank of England, the Bank of Japan and the European Central Bank over the last few days have been singularly unable—up to now–to induce banks to lend to each other: instead, banks and funds are hoarding the cash, thus forcing the Fed to pump still more money into the system. One measure of how desperate the situation has become is the yield in 3-month Treasury securities (which are considered the safest possible investments): yesterday (Wednesday, September 17th), it hit .02 % a level unseen in this country since 1941, when the country, and the world, was directly threatened by fascism. And today, there have been reports of Treasuries being bought at a loss. And, again, the glut in the interbank market (in which banks lend to each other; they have to observe reserve requirements, so when they lend a lot they often have to borrow, often overnight, to keep reserve levels up) is serving to depress share purchases severely. Or at least it was until late Thursday: news is just coming in that Treasury Secretary Henry Paulson has devised a Resolution Trust Fund type plan to provide a comprehensive solution to the crisis. Shares have rebounded from a deficit of about 1% to a gain of about 2% (with S&P financials up 8%) at 3.30 pm Eastern time, about half hour before closing. Early indications show strains on money markets are beginning to ease a bit. But we’ll have to see what Paulson’s plan actually involves, especially since it’s an election year, and Paulson belongs to an extremely unpopular lame-duck administration which doesn’t control Congress. And all the other plans considered thus far have been staggeringly inadequate.

To close out this rather meandering post, two other alarming factors must be mentioned: a US money market fund yesterday became the first since 1994 to “break the bank,” or become worth less than the amount of money invested in it. Now this is just one fund (though Putnam has just announced it will liquidate another), and its parent company has pledged to cover the shortfall, but considering that these funds are considered almost equivalent to cash, and have seen huge inflows in the past year due to the financial crisis, that’s cause enough for concern. Needless to say, money market funds have invested in a lot of senior asset-backed securities of the type that everyone else mistakenly thought was safe, and are in a rush to sell them for whatever they can. And then there’s the emerging market meltdown: the much heralded “BRICs”-Brazil, Russia, India and China—not to mention other emerging markets, especially commodity producers) are seeing huge capital flight, with a significant amounts going into that barbarous relic, gold, which rose some 11% yesterday. The Japanese Yen is rising against the dollar as risky carry trades (borrowing in low-yielding currencies, as the Yen was, to invest in higher yielding ones, like the dollar, or euro) unwind. All this evidences a complete lack of confidence in the sustainability of investment, all over the world. And this will just enable the speculators to become more dependent on regulatory arbitrage (challenging authorities to create policies the funds, with their huge leverage and market power, can profitably exploit) to make up for
the big losses they’ve taken in commodities over the last two months.

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