Monday, October 6, 2008

Plan 'D': Desperation



Fears that the credit crisis will not be contained sparked panic selling across global stock markets:

European shares posted their worst day on record and the Dow slipped below 10,000 points for the first time since October 2004 as markets reeled on news of the growing toll from the credit crisis and widespread fears of a looming global recession.

The rescue of two big European banks and a decision by several European governments to guarantee bank deposits in emergency moves to prop up investor confidence triggered the wave of selling, spreading from Europe to Asia before engulfing the United States and Latin America later in the day.

The U.S. stock market cut almost half its losses in the last hour of the session, as traders speculated the sell-off might trigger a coordinated global response to thaw credit markets. The Dow, however, still closed down at a four-year low.

In both Russia and Brazil, selling was so heavy that stock exchange officials halted trading. Russia's benchmark RTS index closed down 19.1 percent, its biggest daily percentage fall in its 13-year history. The Bovespa index in Brazil fell 15 percent before paring losses.

"We're clearly in the panic zone now. We've tipped over from bear market to panic," said John Schloegel, vice president of investment strategies for Capital Cities Asset Management in Austin, Texas.

...

U.S. crude settled down $6.07 at $87.81 a barrel after hitting an eight-month low of $87.56. London Brent crude fell $6.57 to settle at $83.68 a barrel.

December gold futures settled up $33 at $866.20 an ounce in New York.

Asian stocks dropped overnight by about 5 percent and the yen surged to a two-year high against the euro as investors doubted the U.S. and European response to the financial crisis could prevent a deeper slump in the global economy.

Japan's Nikkei share average slumped 4.25 percent to mark its lowest close since February 2004. MSCI's index of Asia-Pacific stocks outside Japan slid 6.6 percent to the lowest since December 2005.

There is no question that this global crisis will require a global coordinated response.

Paul Krugman is right, it's a small world after all with a a different kind of linkage which he calls the international finance multiplier:

Back in the day, economists used to talk about the foreign trade multiplier — international business cycle linkages via flows of goods and services. The basic idea was that since one country’s imports are other countries’ exports, a recession in one country would be transmitted to the rest of the world as slumping demand here led to an export plunge abroad.

That’s not what’s happening now, or at least not yet. We’re experiencing a global crisis, but a different kind of linkage is at work — call it the international finance multiplier. It operates through the balance sheets of highly leveraged financial institutions, which do a lot of cross-border investment.

When these institutions lose heavily in one market — say, US mortgage-backed securities — they find themselves undercapitalized, and have to sell off assets across the board. This drives down prices, putting pressure on the balance sheets of other HLIs, and so on.

And so a crisis originating in Florida condos and San Diego McMansions is causing havoc for Greek banks. Financial globalization, it turns out, means globalized financial crises.

So what is the next move? How will government officials restore confidence?

According to the International Herald Tribune, the Federal Reserve is now considering a radical new plan to jump-start the engine of the financial system:

Under a proposal being discussed with the Treasury Department, the Fed could buy vast amounts of the unsecured short-term debt that companies rely on to finance their day-to-day activities, according to officials familiar with the discussions. If this were to happen, the central bank would come closer than ever to lending directly to businesses.

While the move would put more taxpayer dollars at risk, it underscores the growing sense of urgency felt by policy makers in a climate where lending has virtually dried up.

The plan was being formulated amid cascading losses in global stock markets, as the banking crisis spread across Europe and investors feared dire consequences for the world economy. The Dow Jones industrial average fell as much as 800 points before a late recovery, finishing down 369.88, below 10,000 points for the first time since 2004.

...

The United States government appears to be pressing ahead with other radical efforts to shore up the financial system, even wading into corners of the markets where it has rarely interfered.

Buying commercial paper could open the Fed to difficult conflicts of interest, because it would be juggling the goals of protecting its investment portfolio with its traditional goals of promoting stable prices and low unemployment.

"The Federal Reserve really would become the buyer of last resort, trying to jump-start the commercial paper market by taking on credit risk," said Vincent Reinhart, a former top Fed official who worked under Alan Greenspan, a former Fed chairman, and Ben Bernanke, the chairman now.

...

But the possibility of propping up the vast market for commercial paper could represent an undertaking even broader than the Treasury Department's plan to buy as much as $700 billion in mortgage-backed securities.

In statements on Monday morning, the Federal Reserve and the Treasury said they were "consulting with market participants on ways to provide additional support for term unsecured funding markets."

By referring to "unsecured funding markets," policy makers signaled that they wanted to intervene directly in the credit markets. Officials said on Monday evening that they wanted to finish a plan as quickly as possible, perhaps as early as Tuesday.

But the effort is fraught with legal complexities. Though the Federal Reserve has sweeping power to create money and lend it out, experts said it was normally prohibited from buying assets that could lose money.

One way around that legal limitation would be to provide money to a separate legal entity that would do the buying and investing on the Fed's behalf. That would be similar to Maiden Lane Funding, a special-purpose entity that officials created last spring to hold $29 billion in hard-to-sell securities from Bear Stearns.

But so far, the myriad efforts by government regulators to shore up confidence have seemed to yield little relief among investors, some of whom believed the actions have taken on a haphazard air.

"People are slowly but surely coming to the realization that playing 'Whack-a-Mole' with each of these issues as they arise, on an ad hoc basis, doesn't get the job done," said Max Bublitz, chief strategist at SCM Advisors, an investment firm in San Francisco.

So the Fed is now resorting to buying commercial paper that is losing money.

Desperate times call for desperate measures. Let's see if Plan D will be better than Plans A (AIG), B (Bailout), and C (Cut interest rates).

***Morning Update

European stocks and U.S. index futures rose as Australia's bigger-than-expected interest-rate cut spurred speculation central banks around the world will reduce borrowing costs to unlock frozen credit markets.

You can call this Plan "CC" for coordinated cuts from worried central banks. We can expect another bear market rally to develop before the final plunge. Read Tim Knights latest blog entry, My Game Plan for the Rest of October.

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