The last week or so has seen an extraordinary set of events which saw shares first plunge following the failure of Lehman Brothers and the “rescue” of AIG only to surge on the back of plans by the US Government to buy bad and illiquid debt from financial companies along with bans on short selling.
But the big question is – will the rescue efforts work, asks the AMP’s chief economist and strategist, Dr Shane Oliver.
A quick summary of what has gone down
The events of the last few weeks have their origin of course in the sub-prime mortgage crisis in the US which has led to massive financial losses so far – about $US521bn and still counting.
This has seen numerous flair ups starting in February 2007 when the problem first came to prominence, then in August last year when banks and other financial institutions first started to baulk at lending to each other for fear that their counterparties may have sub-prime skeletons in the closet, then in January this year as losses started to really mount, again in March when US investment bank Bear Stearns had to be rolled into JP Morgan and more recently in mid July.
The ongoing mortgage losses had all led to a situation where Fannie Mae and Freddie Mac, two US mortgage lenders and guarantors which are associated with 50% of US mortgages, had to be taken over by the US Government in early September as their capital was running down.
This “rescue” was well and good, but when another US investment bank, Lehman Brothers, filed for bankruptcy after US authorities refused to bail it out, Merrill Lynch put itself up for sale to Bank of America (presumably to avoid the same fate) and one of the world’s largest insurers AIG had to be granted a loan by the Fed it led to a perception that US authorities were losing control with some talking of a financial meltdown.
As a result of all this, shares plunged early last week, private sector borrowing rates surged and investors piled into government debt pushing government borrowing rates down (in fact to near zero in the case of US 3 month Treasury bills).
The upshot was that the credit crunch that has now been running for a year or more intensified and on many measures was looking more serious than ever. See the next chart
The initial reaction by US authorities was more of the adhoc responses seen over the last year such as the widening the collateral the Fed would accept in return for loans and a coordinated move by global central banks to increase the amount of US dollars they will lend.
However, when it became increasingly obvious these were not working US authorities announced that they were working on a plan to buy bad debts that no one wants from financial companies and warehouse them until they can be sold in more normal conditions in the years ahead.
This move is something like the Resolution Trust Corporation (RTC) did in response to the crisis in US Savings and Loans companies in the late 1980s or early 1990s.
Talk of this along with bans on short selling in financial stocks in the US, UK and several other countries (with Australia banning all short selling) saw shares rebound dramatically, with many developed markets up 8 to 9% over two days and the Chinese and Russian share markets up by far more (helped by moves to boost their markets).
Ideology
The extraordinary intervention by US authorities raises a number of issues from a philosophical point of few: some have said that we now seem to have “capitalism on the way up, but socialism on the way down”; why shouldn’t financial companies that take on too much debt and make bad investment decisions pay for their mistakes?; some complain that market forces should be left to run their course; what signal does it send in the future – that if you are too big to fail you will be rescued and the government will relieve you of your bad debts or ban investors from short selling your shares?; why just bailout financial companies – what about auto companies?; why are the authorities in so many countries so eager to ban people from short selling shares but didn’t stop people from buying shares with money they didn’t have on the way up?
But the US authorities would argue that if they didn’t move towards a bank bailout the money markets would continue to meltdown as they were starting to last week.
And this would have real economic consequences for Main Street as the cost of borrowing would have gone higher and the availability of money to borrow would have spiralled down.
This would be in no one’s interest. I agree.
Will it work?
As such, for pragmatic investors the real issue is: will it work? Our assessment is that it will.
Bad debt is the problem.
Right now it has to be sold at fire sale prices as no one wants it. And its presence is hindering normal interactions between financial institutions and their ability to raise necessary capital. So it makes sense to take it out of the system and warehouse it for a few years until the market calms down and only the Government can do this. Certainly it worked with the RTC in the early 1990s.
To be sure, the euphoric initial bounce in share markets proves nothing – we saw a similar post plunge rebound in late January only to see the bear market resume.
Several considerations will ensure a rough ride going forward:
• Firstly, the bailout itself has yet to pass Congress (and needs to do so quickly given the coming election) with Democrats already seeking to add provisions relating to areas such as executive pay and helping people stay in their homes. In the interim there could be more financial institutions that run into trouble.<
