Friday, September 19, 2008

What the world will do to stop the 'paradox of delevering"

The formation of a new financial entity to buy illiquid assets which will be financed by the government, The Troubled Asset Relief Program helps to break the cycle of price declines in asset markets. Being a buyer of assets is one solution to the "paradox of delevering". More delvering causes greater overall pain in the markets. As the firms delever, they have to shed assets. The process of shedding assets forces prices lower which encourages more delevering. The cycle continues until there are found buyers for the assets who do not need to lever their portfolios. Cash buyers are necessary and if the assets need special skills to review, the cash buyers are going to have to ask for a further discount on the price. Hence, you need investors who have cash like the Treasury. The delevering story hits all assets because because firms have to shed any liquid asset to raise cash. This makes for a widening program by the Treasury.

The Treasury plan solves the problem of providing a buyer with enough cash but creates another. Firms would be able to end the uncertainty about what is in their portfolios and the prices that these securities are worth, but losses will have to be taken. Any sale will lead to a final accounting for the securities. There will be no fair market pricing or uncertainty on their value. Market downs will have to be taken. Liquidity will be restored, but there will still have to be adjustments in the portfolio which will affect the capital for firms and the value of portfolios for funds. The Treasury plan does not solve the problem of a shortage pf capital.

Money funds will will be insured by US. This is included in the Treasury plan through using funds in the Exchange Stabilization Fund at Treasury. $50 billion will be used to rescue these funds so they do not break the buck. As they sell off the poor assets, the potential for loses increase. The plan will be available for funds through a special fee and is expected to be temporary. While this is an important safeguard for the financial markets there is an interesting question is how this will relate to the deposit insurance for depositors of banks. You do not have a cap in the money funds.

The government also cut short selling for financial institutions and limit the ability to short any stock. If the market is going down, do not allow people to profit from it.

The bail-out has not been just a US driven solution though it sounds like all of the problems re centered on Wall Street. Russia closed the market and is willing to provide $20 billion in liquidity. If you do not like the prices on stocks close the market.

China will scrap its stamp tax and buy bank shares through the China Investment Corp. If they were planning on buying Morgan Stanley, the purchase in local banks would seem to be a natural action. Interest rates were also lowered to make funds more readily available.

The fundamentals of the markets are being changed as interventionist government is now directing the levels of equities. The excesses of greed are now going to be controlled by the government and taxpayers will be responsible for investors to receive a "fair" rate of return on their money. Panic has been averted but it is unclear what the new financial order will bring.

It was not surprising to see the market up on this news but the real work is at hand. The devil is in the details and the dollar will be stressed as a reserve currency with this massive change in the deficit.

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