Black Friday?

By Mike Whitney

10/10/08 ICH -- -Panic has spread to stock markets around the world. A massive sell-off, which began when Henry Paulson announced a $700 billion bailout for the banking system, has turned into a global stampede. Shares fell sharply across Europe and Asia for fifth straight day following a 679 drop on the Dow Jones. Nearly $900 billion was wiped off the value of U.S. equities in just one trading day. The Chicago Board Options Exchange Volatility Index, the "fear index", soared to a record 64. Credit markets remain frozen. Libor, London interbank offered rate, nudged up slightly on Thursday night, signaling even greater resistance to lending between the banks. Until there is relief in the credit markets, stocks will continue to slide. But trust has vanished. The 50 basis points rate cut that was coordinated with foreign central banks has had no effect. The market is being driven by fear and pessimism. Friday is shaping up to be a bloodbath on Wall Street.

White House press secretary, Dana Perino said yesterday that President Bush will address the country on Friday morning:

"He will assure the American people that they should be confident that economic officials are aggressively taking every action to stabilize our financial system. The Treasury Department is moving quickly to use new tools to improve liquidity, which is the root cause of this problem."

Bush still believes that the problem is "liquidity" rather than "insolvency". When liabilities vastly exceed assets, liquidity does not help. The bad banks need to be closed so the good ones can be strengthened with capital injections.

New York Times columnist Paul Krugman said, "Last month, when the U.S. Treasury Department allowed Lehman Brothers to fail, I wrote that Henry Paulson, the Treasury Secretary, 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."

Lehman's credit default swaps, (the derivatives which Warren Buffett calls "financial weapons of mass destruction") will be "unwound" on Friday. It could be a "non event" or it could trigger another sell off; it is impossible to know. If tens of billions of dollars are drained from already weakened balance sheets in counterparty deals that have turned sour, the market will react violently. Wall Street is on tenterhooks waiting for the news from Lehman.

There is general agreement among economists about what needs to be done to stabilize the financial system. The banks have to be recapitalized, deposits have to be guaranteed (beyond the $100,000 FDIC limit) and additional stimulus has to be provided to increase consumer demand. Otherwise the United States will face another Great Depression. Too much time has been wasted on Paulson's failed bailout for G-Sax and his friends on Wall Street. Buying the bad assets of underwater banks does not fix the problem. The banks need capital so they can resume lending and transmit credit to consumers and businesses.

Former head of the FDIC, William Isaac summed it up like this:

"I was opposed to the bailout bill, mostly because I don't think it will work. The banks -- taking $700 billion of bad loans out of the banks doesn't help get banks lending again. It just solves some problems in some banks. And it doesn't have any leverage to it. If the Treasury were to put that same $700 billion and used that to invest in bank capital, the banks can loan $10 for every dollar of capital, roughly, which means that the Treasury would be creating $7 trillion of new lending capacity in the banks. And that is vastly superior to buying $700 billion of problem loans. It just -- it will really give some punch to the economy. It will get banks back into the lending business..... And to do that we need to get some capital back in there."

Isaac added: "The other major thing they really need to do... They really need to have the FDIC declare that there is a financial emergency. And when the FDIC does that, the FDIC should announce that during this period of crisis, all general creditors, all depositors, insured and uninsured, bondholders in our banking system, will be protected if a bank fails. And that, I think, will get the inter -- the financial markets working again and get banks willing to loan to each other again."

Nearly one third of all deposits ($2.5 trillion) are not insured under present FDIC guidelines. If these deposits are not insured, as Isaac says, there will continue to be a slow run on the banks which is why the credit markets are paralyzed.

Much of this week's volatility in the market is the result of program trading (many sell orders were automatically executed when the Dow hit 9,000) and massive deleveraging in the hedge funds, the secretive $1.7 trillion industry. As credit gets tighter, the funds are unable to roll over their short term debt and have been forced to dump their assets in an illiquid market at firesale prices. This explains the recent see-saw motion in the stock market; the huge 2 to 3 percent intraday swings (positive/negative) This has added to the fear of smaller investors who have left the market in droves for the safety of US Treasuries or cash. That's why the dollar has strengthened even though the Federal Reserve is printing money at a furious pace. The inflationary effects will not be apparent until the destruction of credit abates.

The biggest danger we face in the short term, is a run on the financial system. Calm must be restored if we want to avoid another depression. Investors have already pulled a record $72 billion from stock and mutual funds, and put the money in US Treasurys and government-insured bank deposits. If the trend continues, the financial system will collapse. This is where leadership and credibility really matter. The Bush administration's record on these issues is dismal. If the government overreacts and limits bank withdrawals or closes the stock market; the sense of desperation and panic will only grow. That increases the likelihood of rioting and violence, which is what took place in China just this week.

The falling stock market reflects the mood of the country as a whole. Confidence in the system is at an all-time low. The government has lost the moral authority to rule. People have lost faith in everything. Bush has created a tinder box which could explode in flames at any time. It is a dangerous situation.

BLACK FRIDAY: False alarm or Armageddon?

The econo-blogs were abuzz all night Thursday. The prevailing feeling is that Wall Street will suffer historic losses on Friday and that this will mark the end of America's dominance as the lone superpower. As always, economist Nouriel Roubini provided a chilling analysis of the present financial malaise:

Nouriel Roubini: "The US and advanced economies’ financial system is now headed towards a near-term systemic financial meltdown as day after day stock markets are in free fall, money markets have shut down while their spreads are skyrocketing, and credit spreads are surging through the roof. There is now the beginning of a generalized run on the banking system of these economies; a collapse of the shadow banking system... and now a roll-off of the short term liabilities of the corporate sectors that may lead to widespread bankruptcies of solvent but illiquid financial and non-financial firms.

At this point the risk of an imminent stock market crash – like the one-day collapse of 20% plus in US stock prices in 1987 – cannot be ruled out as the financial system is breaking down, panic and lack of confidence in any counterparty is sharply rising and the investors have totally lost faith in the ability of policy authorities to control this meltdown....

When... even the most radical policy actions don’t provide rallies or relief to market participants, you know that you are one step away from a market crack and a systemic financial sector and corporate sector collapse. A vicious circle of deleveraging, asset collapses, margin calls, cascading falls in asset prices well below falling fundamentals and panic is now underway." (Nouriel Roubini's Global EconoMonitor)

There's a way forward but it will take a lot of digging out and a vision of the future that doesn't center on Wall Street.