Will the G7 Prevent Dow 3600?

In another roller coaster session today as the Dow Jones industrials came back from an early loss of nearly 700 points to a 100-point late-session advance, only to close down 128 points as investors still worried about credit markets that remain near paralysis.

Will we get a crash next week? I sure hope not, but irrational pessimism rules and who knows how things will play out after this weekend's G7 meeting where Japan is set to propose a bailout fund:

Japanese Finance Minister Shoichi Nakagawa said he is set to make the proposal at the Group of Seven meeting of finance and central bank officials that he is attending in Washington.

"Japan would like to see what it can do to work with other countries to ensure ample capital supply," he said on nationally televised NHK news.

He did not give details of the plan. But he said Japan's experience in dealing with its bad debt crisis in the 1990s may offer lessons for the other G-7 nations.

He said he hopes to tell others how Japan injected public money into banks at that time to bolster their capital after the so-called bubble economy of soaring land and stock prices burst and banks got stuck with mountains of bad debt.

His comments come at a time when Washington, which is implementing a $700 billion bailout, mainly to buy bad mortgages and mortgage-related securities from banks and financial institutions, may also need to inject capital in them and take partial ownership.

Britain is moving to pour cash into troubled banks in exchange for stakes in them -- a partial nationalization. In Iceland, the government now has control of all three of the country's major banks as it struggles to contain the troubles there.

Japan's proposal will call for setting up a cooperative scheme through the International Monetary Fund to dole out emergency lending to nations whose financial systems run out of cash, The Nikkei, Japan's top business daily, reported in its Friday's editions, without citing sources.

China and Middle Eastern nations will also be asked to contribute money to the fund, the report said, in an effort to prevent the further spread of the global fallout from the U.S. credit crisis.

The G7 should seriously consider Dr. Doom's prescription:

• Another rapid round of policy rate cuts of the order of at least 150 basis points on average globally;
• a temporary blanket guarantee of all deposits while a triage between insolvent financial institutions that need to be shut down and distressed but solvent institutions that need to be partially nationalized with injections of public capital is made;
• a rapid reduction of the debt burden of insolvent households preceded by a temporary freeze on all foreclosures;
• massive and unlimited provision of liquidity to solvent financial institutions;
• public provision of credit to the solvent parts of the corporate sector to avoid a short-term debt refinancing crisis for solvent but illiquid corporations and small businesses;
• a massive direct government fiscal stimulus packages that includes public works, infrastructure spending, unemployment benefits, tax rebates to lower income households and provision of grants to strapped and crunched state and local government;
• a rapid resolution of the banking problems via triage, public recapitalization of financial institutions and reduction of the debt burden of distressed households and borrowers;
• an agreement between lender and creditor countries running current account surpluses and borrowing, and debtor countries running current account deficits to maintain an orderly financing of deficits and a recycling of the surpluses of creditors to avoid a disorderly adjustment of such imbalances.

And I would add that they should guarantee all interbank lending and criminally prosecute the CEO of any major bank that continues to hoard cash!

This last recommendation is draconian but as Bloomberg reports, the value of U.S. and European high risk, high-yield loans fell to a record low as banks tried to sell holdings of the debt.

Markit LCDX, a benchmark credit-default swap index used to hedge against losses on U.S. leveraged loans, which falls as credit risk increases, dropped 2.5 percentage points to a mid- price of 82.75 percent of face value, paring an earlier decline to 82, according to Goldman Sachs Group Inc. The Markit iTraxx LevX index of European loans fell 2 to 86.5, Deutsche Bank AG prices show.

Prices of leveraged loans tumbled on concern that banks and hedge funds are being forced to sell assets in the wake of the collapse of Iceland's banks this week and the failure of Lehman Brothers Holdings Inc. in New York. Rapid declines in the value of loans will make it more expensive for companies to raise capital.

``Selling pressure is likely to continue as nobody really knows how many more loans are going to be dumped on the market,'' said Robert Jaeger, a high-yield debt analyst at Societe Generale SA in London.

Loan prices fell yesterday as Iceland took control of Kaupthing Bank hf, the nation's biggest lender, completing the nationalization of the country's top three banks. The seizure came as brokers sent details of loans used to fund leveraged buyouts for sale to investors and traders, according to four people who saw the lists.

``We are seeing the continued forced selling of leveraged loans across Europe,'' said Raja Visweswaran, a London-based trader at Asteri Capital Ltd. ``There is no credit-specific news out today, this is more the sign of a systemic meltdown.''

Meanwhile, currency markets were reeling today as the Canadian dollar suffered its biggest decline since 1971 as oil prices fell below $80 for the first time in a year and copper headed for its biggest weekly drop in more than 20 years on concern that the deepening financial crisis will push the global economy into a recession.

In order to ease concerns, President Bush made another appearance today to ask people to remain calm because "anxiety can feed anxiety." [no comment!]

Now CNBC reports that "radical measures" may be in the wings:

With the legislation’s main mechanism—an auction system to purchase bad mortgage-based securities—still weeks away from implementation, Paulson may have to inject capital into any number of financial institutions—even non-depository ones like investment banks, insurers and hedge funds.

“I don't wish to spread alarm on the line people but the big issue confronting the market is I'm afraid the health and sustainability of Morgan Stanley and Goldman Sachs," Hugh Hendry, Partner and CIO at Eclectica, told CNBC. "It is unimaginable that they can be allowed to go, I suspect that they will be nationalized at some point today or over the weekend," he add.

Some say the Emergency Economic Stabilization Act of 2008’s vague language gives Paulson almost unlimited power to intervene.

“He’s free to just strike deals, to do special deals,” says Lawrence White, a former White House economist and savings and loan regulator, who adds Congress was aware of the powers being given to Paulson and thus pressed hard for an oversight board.

Like the auction process, however, that board has yet to be set up, and with developments in the financial markets moving much faster than the Washington bureaucracy it might not be long before Paulson takes action.

Not everyone wants G7 action or any type of government action. Legendary investor Jim Rogers prefers that G7 officials "do nothing", but Ken Rogoff thinks that policy makers need to "get ahead of the turmoil". Meanwhile Roubini told Bloomberg that if policy makers do not act, he sees risks of a severe global depression.

Time is running out fast. If they do not restore confidence in the financial system, we are starring at Armageddon.

Confidence is the key here. I urge you to take the time to watch Charlie Rose's excellent interview with former Fed Chairman Paul Volcker (click here to watch the entire interview).

Volcker goes at lengths to discuss the importance of restoring confidence. He understands how left to their own devices, the savageness of "animal spirits" can destroy the financial system.

A few things Volcker said in that interview caught my attention. First, how did the credit derivative market mushroom to $62 trillion to cover $10 trillion in loans? (Remember CDO Squared and Cubed?!?!?)

Second, Volcker referred to the 1933 banking crisis and how President Roosevelt restored confidence in the banking system by proclaiming "these banks are safe to do business with". And little by little, people started doing business with a few banks and the system got going again.

Third, Volcker thinks "Wall Street's magnetism will decline," which is good because according to him we need "less financial engineers and more electrical engineers, mechanical engineers and civil engineers." [here, here!!!]

Finally, I got an email telling me that this is the buying opportunity of a lifetime. One person wrote me the following:

As Junius Morgan (JP's father) said: "Remember, my son, that any man who is a bear on the future of this country will go broke.

Nathaniel Rothschild: "The time to buy is when there is blood on the street, even if it's your own blood."

Time for long-term money to go to work!

But as I read this I recalled Keynes' famous statement that "markets can stay irrational longer than you can stay solvent."

My father who has practiced clinical psychiatry for over 40 years, and continues to do so at the tender age of 76, told me he likes Keynes' warning because he always said "if you are not prepared for the unthinkable and the unbelievable, you are bound for a rude awakening."

Sound advice from a man who has seen a lot of crazy things in his career but none as crazy as what is going on in the financial markets these days.

I will end this entry with a little humor.

I remember a long time ago my father got a phone call from the emergency room, interrupting our dinner.

I listened to him replying in a concerned tone: "....hmmm...hmmm...I see...I see....I see..."

And finally he blurted out: "OK, increase the dosage"

Till this day I keep bugging my dad that it must be easy to be a psychiatrist because all you have to do is "increase the dosage" when things are not working.

I expect the G7 and central banks will "increase the dosage" over the next few days, but I am preparing for the "unthinkable and unbelievable."

***Update: U.S. Treasury Will Buy Financial Stocks

Bloomberg reports that the U.S. Treasury will buy equity in banks and other financial institutions to restore market stability and revive economic growth:

The Treasury is ``working to develop a standardized program that is open to a broad array of financial institutions,'' Paulson said at a press conference after a meeting in Washington of finance ministers and central bankers from Group of Seven countries.

The injection of equity would be aimed at sustaining banks and other financial institutions through the worst credit crisis in seven decades. Paulson declined to give a timetable or details about the purchases, and signaled that markets may be in for turmoil ahead.

``We're going to do it as soon as we can do it and do it properly and do it effectively and right,'' Paulson said. ``Trust me, we are not wasting time; people are working around the clock to deal with this.''

This is the first time since the Great Depression that the U.S. government will buy an ownership stake in a broad array of American banks.

And not a moment too soon as rumors are swirling this weekend that Morgan Stanley is in trouble beset by doubts on the MUFG deal:

Morgan Stanley is valued at about $10.3 billion, after its shares plunged 22% on Friday. Japanese bank Mitsubishi UFJ Financial Group has agreed to pay $9 billion for what was a 21% stake when the deal was announced last month.

The stock's freefall during the past four weeks leaves Morgan Stanley facing what it is likely to be the most fateful weekend in the investment bank's 73-year-history. Doubts that the MUFG deal will be completed ...

Along with the G7 meeting and the U.S. Treasury's announcement that they will recapitalize banks, I am feeling (more like hoping) that the seeds are in place for a nice rally next week.

As such, I will focus on buying opportunities over the weekend for those of you who have money left over and are looking to dip your toes into stocks or for those of you who want to reallocate your portfolios.

***Update on the G7 (12-10-2008)

So far I have to agree with Paul Krugman that policymakers are falling short:

Wouldn’t it be nice if, just once, policy makers exceeded expectations instead of falling short? Actually, it would be more than nice: until that starts happening, policy will keep losing credibility.

But it’s apparently not to be. The IMF ministers have endorsed the G7 plan — but there isn’t any plan, just a vague statement of principles.

Krugman also had an excellent NYT op-ed piece, Moment of truth, where he questioned U.S. Treasury Secretary Henry Paulson for letting Lehman fail:

Last month, when the U.S. Treasury Department allowed Lehman Brothers to fail, I wrote that Treasury Secretary Henry Paulson was playing financial Russian roulette. Sure enough, there was a bullet in that chamber: Lehman's failure caused the world financial crisis, already severe, to get much, much worse.

The consequences of Lehman's fall were apparent within days, yet key policy players have largely wasted the past four weeks. Now they've reached a moment of truth: They'd better do something soon - in fact, they'd better announce a coordinated rescue plan this weekend - or the world economy may experience its worst slump since the Great Depression.

Krugman was part of the round table this morning on ABC's This Week, where once again he said that unless the G7 comes up with concrete, comprehensive measures, they will only exacerbate the "cumulative crisis of confidence".

He corrected George Will's assertion that this is only a "psychological problem" and said that the U.S. Treasury's better takes it cue from Gordon Brown to recapitalize banks quickly because "two weeks is an eternity".

Again from Krugman's op-ed piece:

But on Wednesday the British government, showing the kind of clear thinking that has been all too scarce in America, announced a plan to provide banks with £50 billion in new capital - the equivalent, relative to the size of the economy, of a $500 billion program here - together with extensive guarantees for financial transactions between banks. And U.S. Treasury officials now say that they plan to do something similar, using the authority they didn't want but Congress gave them anyway.

The question now is whether these moves are too little, too late. I don't think so, but it will be very alarming if this weekend rolls by without a credible announcement of a new financial rescue plan, involving not just the United States but all the major players.

Why do we need international cooperation? Because we have a globalized financial system in which a crisis that began with a bubble in Florida condos and California McMansions has caused monetary catastrophe in Iceland. We're all in this together, and need a shared solution.

Why this weekend? Because there happen to be two big meetings taking place in Washington: a meeting of top financial officials from the major advanced nations on Friday, then the annual International Monetary Fund/World Bank meeting on Saturday and Sunday.

If these meetings end without at least an agreement in principle on a global rescue plan - if everyone goes home with nothing more than vague assertions that they intend to stay on top of the situation - a golden opportunity will have been missed, and the downward spiral could get even worse.

What should be done? The United States and Europe should just say "Yes, Prime Minister." The British plan isn't perfect, but there's widespread agreement among economists that it offers by far the best available template for a broader rescue effort.

And the time to act is now. You may think that things can't get any worse - but they can, and if nothing is done in the next few days, they will.

I am still waiting from something concrete to come out of the G7 meeting, but I am getting increasingly worried that their vague statements will only accelerate the market's death spiral.

Meanwhile, this morning Richard Fisher, president of the Dallas Fed bank said that the Federal Reserve will consider all policy options necessary to stabilize financial markets and limit damage to the economy:

``We can and we will restore order to the credit markets,'' Fisher said during a panel discussion sponsored by the Institute of International Finance in Washington. He said the U.S. faces a period of ``negative growth'' and pledged that the Fed would do ``whatever'' is necessary to ease strains on markets and the economy.

Fisher didn't offer details on what options may be under consideration. He said he was breaking from Fed officials' public-speaking tradition of not talking on behalf of the entire policy-making Federal Open Market Committee.

``This morning I am casting that convention aside,'' he said. ``I speak for all of us when I say that the Federal Reserve will continue to explore every avenue and consider every option to see the credit markets through the credit crisis.''

Regardless of what happens this week, my next post will look at beyond the crash, focusing on global stocks you should be watching - and there are plenty of them.