Risk Of A Total Systemic Meltdown

The Risk Of A Total Systemic Meltdown Is Now As High As Ever.
The Us And Global Financial Crisis Is Becoming Much More Severe In Spite Of The Treasury Rescue Plan.

By Nouriel Roubini | 29 September 2008

It is obvious that the current financial crisis is becoming more severe in spite of the Treasury rescue plan (or maybe because of it, as this plan it totally flawed). The severe strains in financial markets (money markets, credit markets, stock markets, CDS and derivative markets) are becoming more severe rather than less severe in spite of the nuclear option (after the Fannie and Freddie $200 billion bazooka bailout failed to restore confidence) of a $700 billion package. Interbank spreads are widening (TED spread, swap spreads, Libo-OIS spread) and are at levels never seen before; credit spreads (such as junk bond yield spreads relative to Treasuries) are widening to new peaks; short-term Treasury yields are going back to near zero levels as the flight to safety mushrooms; CDS spreads for financial institutions are rising to extreme levels (Morgan Stanley was at 1200 last week) as the ban on shorting of financial stock has moved the pressures on financial firms to the CDS market; and stock markets around the world have reacted very negatively to this rescue package. (US market are down about 3% this morning at their opening.)

Let me explain now in more detail why we are now back to the risk of a total systemic financial meltdown.

It is no surprise as financial institutions in the US and around advanced economies are going bust: in the US the latest victims were WaMu (the largest US S&L) and today Wachovia (the sixth largest US bank); in the UK after Northern Rock and the acquisition of HBOS by Lloyds TSB you now have the bust and rescue of B&B; in Belgium you had Fortis going bust and being rescued over the weekend; in Germany HRE, a major financial institution is also near bust and in need of a government rescue. So this is not just a US financial crisis; it is a global financial crisis hitting institutions in the US, UK, Eurozone and other advanced economies (Iceland, Australia, New Zealand, Canada etc.).

And the strains in financial markets— especially short term interbank markets— are becoming more severe in spite of the Fed and other central banks having literally injected about $300 billion of liquidity in the financial system last week alone including massive liquidity lending to Morgan and Goldman. In a solvency crisis and credit crisis that goes well beyond illiquidity no one is lending to counterparties as no one trusts any counterparty (even the safest ones) and everyone is hoarding the liquidity that is injected by central banks. And since this liquidity goes only to banks and major broker dealers the rest of the shadow banking system has no access to this liquidity as the normal credit transmission mechanisms are blocked.

After the bust of Bear and Lehman and the merger of Merrill with BofA I suggested that Morgan Stanley and Goldman Sachs should also merge with a large financial institution that has a large base of insured deposits so as to avoid a run on their overnite liabilities. Instead Morgan and Goldman went for the cosmetic approach of converting into bank holding companies as a way to get further liquidity support— and regulation as banks— of the Fed and as a way to acquire safe deposits. But neither institution can create in a short time a franchise of branches and neither one has the time and resources to acquire smaller banks. And the injection of $8bn of Japanese capital into Morgan and $5bn of capital from Buffett into Goldman are but drops in the ocean as both institutions need much more capital.

Thus, the gambit of converting into a 'bank', while not being a bank has not worked and the runs against them has accelerated in the last week. Morgan’s CDS spread went through the roof on Friday to over 1200 and the firm has already lost over a third of its hedge funds clients together with their highly profitable prime brokering business (this is really a kiss of death for Morgan); and the coming roll-off of the interbank lines to Morgan would seal its collapse. Even Goldman Sachs is under severe stress losing business, losing money, experiencing a severe widening of its CDS spreads and at risk of losing most of its value, as most of its lines of business (including trading) are now losing money.

Both institutions are highly recommended to stop dithering and playing for time as delay will be destructive. They should merge now with a large foreign financial institution as no US institution is sound enough and large enough to be a sound merger partner. If Mack and Blankfein don’t want to end up like Fuld they should do today a Thain and merge as fast as they can with some other large commercial bank. Maybe Mitsubishi and a bunch of Japanese life insurers can take over Morgan; in Europe Barclays has its share of capital trouble and has just swallowed part of Lehman; while most other UK banks are too weak to take over Goldman.

The only institution sound enough to swallow Goldman may be HSBC. Or maybe Nomura in Japan should make a bid for Goldman. Either way Mack and Blankfein should sell their firm at a major discount to the current 'price' before they end up like Bear and be offered in a few weeks a couple of bucks a share for their faltering operation. And the Fed and Treasury should tell them to hurry up as they are both much bigger than Bear or Lehman and their collapse would have severe systemic effects.

When investors don’t trust even venerable institutions such as Morgan Stanley and Goldman Sachs any more you know that the financial crisis is as severe as ever and the fear of collapse of counterparties does not spare anyone. When a nuclear option of a monster $700 billion rescue plan is not even able to rally stock markets (as they are all in free fall today) you know this is a global crisis of confidence in the financial system. We were literally a hair's breadth from total meltdown of the system on Wednesday (and Thursday morning) two weeks ago when the $85bn bailout of AIG led to a 5% fall in US stock markets (instead of a rally).

Then the US authorities went for the nuclear option of the $700 billion plan, together with bans on short sales, a guarantee of money market funds and an injection of over $300 billion in the financial system, as a way to stave off the meltdown. Now the prospect of this plan passing (although there is some lingering deal risk as the votes in the House are not certain)— as well as the other massive policy actions taken, e.g., to stop short selling "speculation" and support interbank markets and money market funds— is not sufficient to make the markets rally, as there is a generalized loss of confidence in financial markets and in financial institutions that no policy action seems able to stem.

The next step of this panic could become the mother of all bank runs, i.e., a run on the trillion dollar plus of the cross border short-term interbank liabilities of the US banking and financial system as foreign banks are starting to worry about the safety of their liquid exposures to US financial institutions. A 'silent' cross border bank run has already begun, as foreign banks have become increasingly worried about the solvency of US banks and have started to reduce their exposure. And if this run accelerates— as it may— a total meltdown of the US financial system could occur.

We are thus now in a generalized panic mode and back to the risk of a systemic meltdown of the entire international financial system. And both US and foreign policy authorities seem to be clueless about what needs to be done next. Maybe they should start with a coordinated 100 bps reduction in policy rates in all of the major economies in the world to show that they are starting seriously to recognize and address this rapidly worsening financial crisis. [[That last would be worse than useless; the problem is not the cost of money, but the probability of the return of money. And no one doubts that the CBs are fully engaged with trying to forestall this looming catastrophe.: normxxx]]

Normxxx    
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