Seriously, Finally

By:  Dr. Charles Lieberman

Date:  10/13/2008

Central bankers and Treasury Secretaries around the world are now trying to get ahead of the global credit crisis by recapitalizing their major financial institutions, while injecting liquidity into their financial systems. Press reports suggest that the Europeans would also guarantee interbank lending for some period. Such strong steps should quickly reduce counterparty risk, which would lower risk spreads and enable lending activity to resume. Since the system is being undermined mostly by a lack of confidence, these policy actions should restore healthier market conditions.

Credit market conditions have been worsening mostly due to a loss of confidence in counterparties and creditworthiness. As asset prices fall, even if the borrowers are performing, the owners of these assets must report losses under mark-to-market rules, thereby forcing them to raise more capital in a highly inhospitable market. As their stock prices fall, the credit rating agencies add insult to injury by downgrading their credit rating. I cannot imagine a more dysfunctional system that takes away capital from firms only when they need it.

(Contrast these conditions with the accounting treatment of the same assets when held by a life insurance company. MetLife reported gross unrealized portfolio losses of $17 billion, up from $10 billion a quarter before. However, they expect actual losses of less than $500 million and they don't need to raise capital to offset these losses. They did raise $2.5 billion, but apparently to set up for an acquisition. It pays to be an insurance company and not an investment bank.)

Europeans have taken the strong steps to support their banks definitively. No large bank will be permitted to fail, capital will be injected via new preference share issues, banks have been told to ask for more than they need to show the market they have more than enough capital, interbank lending is being guaranteed, and government bonds are being swapped for mortgages. If Paulson takes similar policy actions here, without inflicting harm on shareholders, confidence should recover in our own financial system, which would set the stage for a strong rebound in equities.

Our equity market has experienced a real crash. Stocks are down more than 22%, about the same as in 1987, just in eight days instead of one. In 1987, the Fed was raising interest rates, stocks were overvalued, and labor costs were rising. This time, investor confidence has been undermined by bookkeeping losses. Finally, governments are taking the policy actions that are needed.

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