Thursday, September 25, 2008

New world (dis)order

(FT Alphaville) Conditions more or less resemble a bank run on the system.

As the freeze in the money markets persists, credit is rapidly becoming either completely unavailable or punitively expensive. This presents the world with an immediate risk of a surge in defaults as borrowers are unable to refinance. Needless to say, without an ability to lend, an economic depression threatens, as defaults erode bank capital and lending ability further. The countdown to a dramatically bad economic outcome is therefore running at very high speed. Unchecked, the current crisis would turn into a self-reinforcing vortex of defaults, bank capital contraction and deep recession within a matter of weeks.

From the man at Barcap, Tim Bond.

The numbers on which Bond bases his analysis couldn’t really be clearer. Interbank lending really has collapsed on all but the shortest maturities of debt.

The commercial paper markets have choked off the supply of credit to America’s corporations.

Unless the TARP plan is instigated within the next few days, a systemic crisis could well be realised.

Even if the TARP is launched, however, the outlook is not positive. As Bond notes, the process of recapitalisation will be a lenthy and convoluted affair for banks.

Consider, for example, the significance of Goldman Sachs and Morgan Stanley reclassifying as commercial banks and Merrill Lynch being taken over by one.

Bank of America’s leverage ratio - similar to most commercial banks’ is 11:1. In contrast, Goldman Sachs runs a ratio of 24:1, MS 30.9 and Merrill Lynch 46:1.

To comply with regulatory requirements all of those banks are going to have to go through a very significant deleveraging process. As Gillian Tett noted in the FT earlier this week:

Some industry analysts estimate, for example, that if investment banks were to cut leverage ratios from 30 times (or recent levels) to 20 times, this would trigger $6,000bn worth of asset sales, excluding likely deleveraging by hedge funds too.

That process will now have to happen regardless of whether the TARP restores liquidity to the system. The TARP’s role will be simply to smooth the path as best it can.

As Bond concludes:

The banking system will remain very conservative for some time - years, not months - to come.

And with the US government and economy effectively being tied inextricably to that deleveraging process, there is a growing sense that this crisis will usher in a global rebalancing. These words from Germany’s finance minister Peer Steinbr├╝ck today:

The US will lose its status as the superpower of the world financial system… The world will never be the same again

Update Another article worth reading- this - from Bloomberg. It’s an interview with an adviser to China’s central bank. The implications of what’s being said are pretty far ranging. Take these two pars:

The U.S. financial crisis had taught China a lesson and that was: “Why are we piling up these IOUs if they may default?” China’s economic expansion strategy, which emphasizes export growth that has led to trade surpluses and the accumulation of $1.81 trillion in foreign-exchange reserves, is the main problem, said Yu.

“Our export-growth strategy has run its natural course,” he said. “We should change course.”

Yves Smith has a more nuanced take on the implications.

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