The financial system is faced with a meltdown

September 18, 2008

What we are now facing is a general extension of last year’s collapse in commercial paper to all other kinds of funding sources in the wider economy. Short term, long term, capital markets, money markets, financial, and non-financial, nominal and derivative, every kind of asset and funding source except federal government paper is facing contraction, posing severe and unprecedented risks to both the global and US economies.  That many banks and corporations will declare bankruptcy or be sold is beyond doubt. The markets have finally realised how serious the problems are, and while temporary relief is possible, the tensions of the past week will continue to deepen and cause shrinking economic activity for a long time to come. Unemployment will reach double digits, and consumption will shrink for at least a year. The chain reaction will cause bankruptcies worldwide, and many emerging markets will probably go through banking and currency crises as well.


The root of the problem lies in the fact that the arteries that allow financing to flow through the economy are clogged. Even as central banks add hundreds of billions of dollars, banks cannot consider lending, because they are having difficulty financing their day-to-day operations through the money markets. Lehmans collapse has caused losses to several money market funds, and in turn, the unprecedented run on money market funds has cut off a major source for short term funding for corporates and financials. To repeat, not a single market is functioning properly at the moment. Last night there was a report that Deutsche Bank was greatly tightening the risk controls of its CDS desk; as the very large widening in the CDS spreads for many corporations and sovereigns show, liquidity is fleeing this market too. As the CDS spreads widen, financials firms cannot gain insurance on corporate bonds at reasonable prices, so they’re refraining from buying corporate paper. In short, a vicious circle has been created, andThe situation can only be compared to the 1930’s. The Wall Street Journal agrees, here.


Voluntarily, or otherwise, the banking system is attempting to bankrupt a number of institutions, to allow the cascading effect to take place, so that the remaining institutions can trust that the surviving counterparties do not present a large risk. In other words, there’s a desire to kill the weaker players, so that the survivors can have confidence in each other. This is an irrational desire, because the cascade of bankruptcies, instead of allowing any confidence, will cause the public to panic, and will bring about a general meltdown. Central Banks are trying to fight this development, but they’re fighting against the banking system, so they’re unlikely to succeed. To repeat, at the moment the banking system has no desire to function until some major players have fallen.


Meanwhile, with respect to Wall Street, it now seems like a certainty that Morgan Stanley will need to be sold, and it’s probable that Goldman Sachs will not survive this debacle either. The problem is that the market has zero confidence in any financial firm that has leverage in the double digits at this time, and as Morgan and Goldman are both highly leveraged firms as a definition of their business model, they will not be able to survive this period in an independent form.


Asian acquirers would suit the present scheme of events, since even US commercial banks have very high levels of exposure to all the domestic problems, and are not as well-placed to absorb the losses and writedowns that some Asian firms can endure without facing severe balance sheet problems. There’s no certainty that Wachovia, with large amounts of subprime exposure, can itself survive this crisis; it’s highly doubtful that it will be able to bailout Morgan Stanley. That KDB was the only firm that was willing to acquire Lehman without seeking government backing from the US is a sign that those institutions with sufficient fundamental strength to deal with the problems of subprime are those beyond the ocean.


There’s essentially no money in the US to bail out anyone. As I have written many times before, the US government itself is in a desperate need of creditors, and the belief that it can absorb the problems of the private sector is absurd. If the Asians continue to support the US government through increasing purchases of US government paper that is in danger of becoming worthless in the long run,  then the government can keep buying time, only to possibly default at some point in the future, since it has no real source of increasing revenues with which to pay for the ever increasing size of its sovereign debt, and its continued bailouts.   Moreover, there’s a significant possibility that as soon as the immediate shock of this crisis dissipates, people and institutions will demand much greater interest to hold US government debt; CDS on US sovereign debt is already strongly signalling this possibility. What the government will then do is not clear.


Today’s picture is very different from that of a week ago. Sooner or later, the dollar is going to pay a very severe price for the government’s actions.









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