Europe looking to behave more like the US to solve credit crisis

Peer Steinbrück, Germany’s finance minister, has noted, Europe is not so much seeing a little light at the end of the tunnel but rather the headlights of an oncoming train.

Bail-out discussions are now going on across Europe and there is no consensus on what should be the best solution. Ireland has provided deposit insurance on all monies which in effect semi-nationalizes the banking system on the downside for depositors. The Dutch have bailed out Fortis Bank. There is talk of a new bailout package in Great Britain after taking over Bradford & Bingley. There as been put forth a support program in France. Iceland has been having discussions on helping banks. The Germans have been trying to help restructure Hypo Real Estate though there are complaints about the French program.

There is a new focus on stopping any contagion coming from the United States with direct intervention now being considered as a primary tool. Until recently, the focus has just been on injecting reserves through the ECB.

What a change in just two weeks. ECB chief Jean-Claude Trichet stressed that it was not the role of central banks to rush to the rescue of commercial banks: "We have a responsibility as regards the provision of liquidity, we have no responsibility as regards the solvency issue that might emerge here and there. So, this is clear: we have to face up to all our responsibilities and, like other central banks all over the world, the liquidity responsibility is ours. The solvency responsibility is the responsibility of the executive branches."

The ECB is taking a more passive approach than the Fed, but it seems there is a clear turn toward more aggressive solutions.

Beggar-thy-bail-out: Other countries have to jump in

The dollar is rallying because funds are coming back to the US as a safe haven. The fund flows include equity liquidation of foreign stock holdings in mutual funds as well as foreign investors. If you are a US investor better to take US bank risk than European risk. If you want to attract capital, bail-out banks and the housing market. If you do not bail-out your banks, you are at a global financial flow disadvantage.

On the surface, this seems crazy given the fall-out in the US banking system. Dollar versus the euro is higher than the beginning of the month. It has rallied 4 big figures in the last week. The DXY index is at levels seen a year ago.

The only explanation is that investors believe that the US government is ahead of the curve relative to their European and British counterparts. The ECB has kept rates stable to fight inflation and the MPC has also still focused on inflation with their rate setting. The British housing market and bank exposures look vulnerable given the current loses and failures. The bail-out help for Fortis Bank suggests that to stem the outflow of capital there will have to put forth capital infusion plans in other parts of the globe. The dollar movement is not about interest differentials or economic models but policy expectations which can only be captured in short-term trends.

What Congress cannot do, the Fed can do with a stroke of the pen

The following was the announcement by he Fed to inject reserves into the global financial system. This is a staggering number yet we still have Fed funds up at 7% this morning. The number comes close to what the total TARP bill would allow. Certainly, this places more money in the system than what would initially be applied through TARP. Yet, the dollar is rallying.

The monetary statistics is where all the action will be. Watching the Fed funds and the TED spread are more important than anything in the housing market in the short-run.

Federal Reserve Actions
The Federal Reserve announced today several initiatives to support financial stability and to maintain a stable flow of credit to the economy during this period of significant strain in global markets.

We will continue to adapt these liquidity facilities as necessary and will keep them in place as long as circumstances require.

Actions by the Federal Reserve include: (1) an increase in the size of the 84-day maturity Term Auction Facility (TAF) auctions to $75 billion per auction from $25 billion beginning with the October 6 auction, (2) two forward TAF auctions totaling $150 billion that will be conducted in November to provide term funding over year-end, and (3) an increase in swap authorization limits with the Bank of Canada, Bank of England, Bank of Japan, Danmarks Nationalbank (National Bank of Denmark), European Central Bank (ECB), Norges Bank (Bank of Norway), Reserve Bank of Australia, Sveriges Riksbank (Bank of Sweden), and Swiss National Bank to a total of $620 billion, from $290 billion previously.

Short selling and market liquidity - law of unintended consequences

A number of option market makers are going to stop making markets in banks stocks that have short selling restrictions, 799 names.The option market makers need to sell stock to lay-off risk when they are long calls. Without the ability to sell stock, you cannot structure hedges for your option book. You cannot make two-way markets if you have one leg of your hedging strategy taken away. For some the answer will be who cares, but at this time options are a critical source of liquidity. The short selling restriction also have hurt high frequency traders who add liquidity. When the market wants to go down, no amount of short selling restrictions will stop it.

Perhaps the better rule would have been to re-institute the uptick rule, or allowing short sales for market makers. This would have allowed for shorting but not a punishing raid on stocks where shorts could force down stocks.

Breakng the buck for money funds is the problem

Mark Twain - "I am more concerned with the return of my money than the return on my money"

Twain must have been a holder in a money market mutual fund and was worried about breaking the buck. The money market funds are the shadow banking system. This is where corporate lending is done on a grand scale through the commercial paper market. This is also where banks get a lot of funds, yet the potential for failure in the money market area is what is driving the movement to government Treasury bills.

Assume a bank takes a loss on a loan. It will be taken out of reserves and earnings. What happens if the money fund takes a loss? It potentially breaks the buck and there will be a potential run on the fund. The money market fund does not have a reserve. It may not have the capital to offset a loss if there is a systematic failure; therefore,the fund builds a Treasury cash reserve and waits for normalcy to return. The result is the freezing of the commercial market.

The bail-out may or may not solve this problem and there has been little discussion of how we are going to link the bail-out to the money fund issue. What is the first step to a solution in problem management? Determining who or what has the problem

Dollar intervention and cross purposes

``At the end of the day, the financial sector is our flagship,'' Kenneth Rogoff, a professor of economics at Harvard University, and a former chief economist at the International Monetary Fund, said in an interview on Bloomberg Radio Sept. 19.
``It has been crushed, and that's going to have a big impact on international capital flows. That's going to affect the positions of the dollar in the global financial system.''

The capital flow impact is going to be significant but that is based on the idea that the problem is localized to the US. The US is the epicenter for the crisis, but we are seeing that the bank problems also include Europe. Fortis is being bailed-out to the tune of $16 billion, Bradford and Bingley, the British lender, was seized by the government and a Hypo Real Estate Holding loan is being guaranteed by Germany. Currency trading is based on relative prices and if the European market gets the same sickness as the US, the currency price may not change. The dollar is up on the bail-out announcement. If the perception is that the US is ahead of the curve in solving the problem, then a flight to quality to the dollar may occur. This is a rosy forecast which seems unlikely given the ambiguous nature of the TARP plan.

Intervention will not be necessary because joint banking problems will not radically change the capital flows. Note that it will change capital flows for other countries which have been less affected by the crisis. Nevertheless, we would argue that given the large financing needs maintaining existing capital flows into the US may not be enough.

A dollar decline is more likely because of the massive extension of swap lines to other central banks from the Fed which is flooding the market with liquidity. It is this dollar liquidity which could send the currency lower. So, in fact, there is dollar intervention through the swap lines. A currency problem exists if there is a dollar decline in response to the flood of liquidity which will then have to be offset by dollar purchases in the currency market, a form of sterilization. This type of intervention will not change the underlying dynamics of the currency market but will send a warning to traders to slow their dollar sell-off. Sterilized intervention without a change in underlying policy or economics will not be effective.

Intervention can only be analyzed in the context of what will be the credit extension of the Fed to other central banks because this is the action which will really drive dollar behavior. Intervention discussion because of high volatility are misplaced. The high volatility in the markets is a result of the high market uncertainty and should be expected. If you want dollar volatility to decline, provide clarity on what policies will be implemented during this crisis.

The cost of the bail-out will be massive

The cost of the bail-out will be massive as measured by the percent of GDP. The United States will be looking at close to 6% of GDP not including the Fannie and Freddie relief or the cost of the recent home owners bill which would total another $300 billion. This is also without the impact on potential GDP as the economy slows from its long-term growth of 3%.

On a relative basis, the cost of this bail-out will be cheap with the exception being Sweden which nationalized the banking system.If history is a guide, we can expect that the costs will keep rising. A $700 billion package may not be enough.

A need to look beyond the Treasury bail-out

While the focus of Washington and the public has been on the Wall Street bail-out and the potential recession impact on American workers, there has been little discussion on the issues of globalization and the place of the United States as a global economic power. The true power of the United States is not with its military muscle but with its ability to impact other regions through trade and economic might. American hegemony is based on its ability to influence and affect trade. The United States will prosper when it produces gains in world trade and influences the agenda of global economic and financial development.

A costly bail-out diminishes America’s economic power and further shifts the global economic discussion further to an axis around China and other emerging countries. This shift has been happening for some time but has clearly accelerated with the costly war in Iraq and with the faltering of finances on Wall Street. Economic power is diminished if the financing needs of a country are controlled by savers in other parts of the world.

There are clear winners and losers with trade and the main winners have been the emerging markets and the majority of the world population. The relentless power of world trade is shifting the gains more toward the East. This relentless shift of economic power cannot be stopped through economic isolationism or a desire to politically recast the terms of trade. Growth in trade is occurring whether the US likes it or not. Trade will grow from the East and competition will come from the other powers of the West. The trade needs of the South will be taken on by others if the US is unwilling to play the game and compete. This fight over the transfer of wealth is only exacerbated when the growth in the US is low and the potential for a greater economic tax burden is raised.

Two recent books from authors outside the US provide an interesting perspective on the directions of global trade, The War of Wealth: The True Story of Globalization or Why the Flat World is Broken by Gabor Steingart, a senior correspondent for Der Speigel and The New Asian Hemisphere: The Irresistible Shift of Global Power to the East by Kishore Mahbubani, the dean of the public policy school at the National University of Singapore.

Steingart presents a bleak outlook for the West if there is not a change in behavior and a full realization of the size and scope of the rest of the world. The Western centric view of both America and to a less extent Europe has to change and acknowledge the ascent of the East as a major global partner otherwise there will be an further erosion of wealth as it shifts East. Think how little discussion has occurred about China in the presidential election cycle. Who is going to be the “partner” that is going to take on the debt of the United States?

For Mahbubani, the shifting of power is displayed in the gleaming skylines of the major cities in Asia. The gains from trade have been extraordinary in lifting up the East and it has been at the expense of the West which does not hold the same allure for many that existed in decades past.

In both cases, the world is not flat but in a war of trade capitalism which does not have a moral code but is only about winning. Trade does not lift all boats the same way. There will be winners and losers and governments affect the outcome of who will gain.

So what does the bail-out mean for globalization? The march of trade will continue but a big gainer may not be the US if resources have to be used to prop up consumers and financial institutions that have made bad choices. The world will not stop while America cleans its house.

Cost of financing will have to increase in the US. Crowding out is real. The confidence in the banking system will not be regained from any bail-out announcement. The changing of taxes for US businesses and consumers will hurt the competitive opportunities for the US. A bail-out will delay decisions that have to made on other important issues in the US economy. All of this will not be positive for the long-run direction of the dollar and for its role as a reserve currency.

Strange but true events in the credit crisis

I guess it will be harder for the Treasury secretary to lecture other countries on currency matters after this display of negotiating tactics.

From the could-not-make-it-up department (well, the New York Times actually):

In the Roosevelt Room after the session, the Treasury secretary, Henry M. Paulson Jr., literally bent down on one knee as he pleaded with Nancy Pelosi, the House Speaker, not to “blow it up” by withdrawing her party’s support for the package over what Ms. Pelosi derided as a Republican betrayal.“I didn’t know you were Catholic,” Ms. Pelosi said, a wry reference to Mr. Paulson’s kneeling, according to someone who observed the exchange.

Attempts to build confidence with US investors may be failing.

And from George Bush: "If money isn’t loosened up, this sucker could go down."

Banking crises - A lot going on under the surface

The FT presents some good work from ML on Banking crises. We have been talking about the link between banking and currency crises and the US problem will be no different from other banking crises. Taxpayers will not get a windfall. The economy will be affected for years. The cost will be higher than anticipated and the currency should fall as investors walk away from the dollar.

27 things you may not have known about banking crises

Brought to you by Merrill Lynch economist Alex Patelis and the IMF Working Paper, “Systemic Banking Crises: A New
Database.”

The paper tallies 124 banking crises over the past 27 years. These are ML’s key points:

1. In 55 per cent of cases, the banking crisis coincides with a currency crisis.

2. Bank runs feature in 62 per cent of the crises.

3. Banking crises are often preceded by credit booms, in 30 per cent of the cases.

4. Non-performing loans average about 25 per cent of loans at the onset of the crisis.

5. Macroeconomic conditions are often weak prior to a banking crisis.

6. Extensive liquidity support is used in 71 per cent of crises.

7. Peak liquidity support tends to be sizeable and averages about 28 per cent of total deposits.

8. Blanket guarantees are used in 29 per cent of crises, often introduced to restore confidence even when previous explicit deposit insurance arrangements are already in place, lasting for an average of 53 months.

9. Prolonged regulatory forbearance - where banks, for example, are allowed to overstate their equity capital in order to avoid the costs of contractions in loan supply - occurs in 67 per cent of crises.

10. In 35 per cent of cases, forbearance takes the form of banks not being intervened despite being technically insolvent, and in 73 per cent of cases prudential regulations are suspended or not fully applied. Existing literature on forbearance shows it is counterproductive, with banks taking on additional risks at the future expense of the government.

11. In 86 per cent of cases, government intervention takes place in the form of bank closures, nationalizations, or assisted mergers.

12. 51 per cent of crisis episodes have experienced sales of banks to foreigners.

13. The more bank closures there are, the higher the fiscal costs.

14. A blanket guarantee, however, reduces the instances of bank closures.

15. Bank restructuring agencies are set up in 48 per cent of crises.

16. Asset management companies are set up in 60 per cent of cases to manage distressed assets.

17. In 76 per cent of episodes, banks were recapitalised by the government, mostly with cash, government bonds or subordinated debt.

18. Recapitalisation programs are usually accompanied with some conditionality.

19. To the extent that debt relief schemes are discretionary, they run the risk of moral hazard as debtors stop trying to repay in the hope of being added to the list of scheme beneficiaries.

20. Average net recapitalisation costs to the government amounts to 6 per cent of GDP.

21.On the bright side, recapitalisations tend to be associated with lower output losses.

22. Monetary policy tends to be neutral during crisis episodes, while fiscal policy tends to be expansive.

23. Average fiscal costs, net of recoveries, associated with crisis management average 13.3 per cent of GDP.

24. The average recovery rate is just 18 per cent of gross fiscal costs.

25. Real GDP losses average 20 per cent relative to trend during the first four years of the crisis.

26. There is a negative correlation between output losses and fiscal costs: the higher the fiscal costs, the smaller the loss of output

27. Inflation and currency devaluation help reduce the budgetary burden and thus have been a feature of the resolution of many crises in the past.

And here are ML’s conclusions:

Implications: Past banking crises suggest that fiscal costs are likely to be substantial and the government is highly unlikely to make a profit on any recapitalization program. Fiscal packages do positively help the economy. Blanket government guarantees are sometimes necessary when previous liquidity provisions have failed.

What is different about this crisis: So far the US and the UK have not suffered from a sudden stop of capital inflows which has been the feature of many episodes in the past. We continue to remain concerned of the risk of a current account financing crisis. Note overnight an article in the South China Morning Post suggested that China’s regulators had told mainland banks to stop lending to US financial institutions. The article was later vehemently denied by the regulators.

The role of the international investor:
The international investor remains a significant holder and continued buyer of US assets. These have primarily been in recent years in the form of fixed income securities, particularly by foreign official institutions. Foreigners own 47 per cent of the Treasurys market; foreign official institutions have accounted for 91 per cent of flows into the agencies market. In order for foreigners to change their US fixed income reserve accumulation policies, they would have to substantially revise their existing exchange rate policies, acquiescing to currency strength. In our view, investors should start preparing themselves for the eventual shift in existing central bank reserve accumulation policies.

What can we learn from the Mexican debt crisis?

We can use the Mexican debt crisis as an example of what can go wrong with a bank bail-out. The Mexican economy needed to be bailed-out by the US Treasury in December 1994 after the serious devaluation and run on international reserves. The fall-out from the currency crisis was significant. The economy plunged into recession. Banks needed to be recapitalized by the the government.

The Mexican government set-up a special agency to buy loans at book value from the banks to save them form going under. The impact was severe. The banking sector consolidated. and taken over in many cases by foreign institutions. The loans from the banks held by the government were only paid out eventually as cents on the dollar. There still are bonds outstanding from this bank bail-out.

The law of unintended consequences made matters worse. Banks did not need to lend given they could hold safe Mexican treasury bonds. There was a strong crowding out effect, and more importantly there began a cultural epidemic of not paying your debt by consumers. The government when holding the paper was the lender to consumers. The consumer was not afraid of the government foreclosing on their loans. Why pay?

This bail-out is not going to last one year or two years but be measured in something like 5 to 10-years like the RTC. These mortgages especially if payments are adjusted down will have weighted average lives closer to 10-years. Get ready for a long process.

Money market instruments is where all the action is at

The Wall Street problem is not a equity crisis but a debt crisis. It is not even a bond crisis though that will come later. The real issue is financing in the money market area. Cash is flowing into money markets. Hedge funds are raising cash levels; there may be over $100 billion in funds that are being held back. Mutual funds are raising cash levels. Banks are hording cash and not lending to each other. In fact, it may actually be a portfolio rebalancing crisis.

Cash is moving from money market funds which include LIBOR and commercial paper to Treasury funds. This has pushed down the Treasury rates while keeping risky paper at higher levels. Look at the the commercial paper offerings.The ABS numbers tell a story of massive deleveraging. The financial paper is flat and the non-financial paper is growing but it is all at short maturities. Money is moving out of stocks into cash but the cash is not being put to work in risky assets

Funds are only taking on short term risk because of the expectation that there will be a run on the funds. If there is a shadow banking system through the mutual funds market, then the firm is a run on shadow bank. This is a problem with providing instant liquidity without breaking the buck.

The issue of portfolio rebalancing to safe assets is an international problem because the Bank of England will cut liquidity offerings because the money being lent is being put back into low interest rate accounts at the central bank. The banks are not lending the funds they are borrowing but reserving them as a cash hoard.

The uncertainty is the current environment is not measurable so it becames a true unknown. Hence, hold the risk free asset. The unknown has to be converted to something that is measurable.

What price for the bail-out? Hold to maturity or market prices

Chairman Bernanke made some interesting comments on the proposed Treasury bail-out or TARP. He suggested that it would be better for the Treasury to buy the assets not at current market levels or fire sale prices but at prices close to what would be considered the value if held to maturity. He stated that this would provide "substantial benefits" and that "we cannot impose punitive measures on the institutions that choose to sell assets".

In fact, this would be a potential windfall of the owners of the securities. What happened to air value pricing? what happened to market efficiency? Granted the price of these securiies are depressed because of a lack of liqudity but they are also depressed because it is uncertain what are their values.

The whole purpose of mark to market accounting is to provide investors with transparency of what is actually on the balance sheet of firms. Would it be easier to change the accouning rules associated with the pricing of these securities? If you price at hold to maturity, a term that does not have a clear meaning, there certainly will be no windfall for the government. There will be no concession to the government for financing or providing liquidity. Now there is a moral hazard problem because those that picked bad securities will receive a benefit. There is a benefit to using this pricing. It maximizes the amount of money that will go to help the bank portfolios. It may be easier to price, or at least it may seem to be easier.

A key problem with mortgage securities is that you may not know when the cash flows will come. There are large changes in the weighted average life of the securities that are affected by delinquencies, defaults, foreclosures and structure. All of these issues make the value of these securities difficult in the best of times but especially difficult in uncertain times. The best alternative would be to try and buy securities at the price that currently prevails in the market. Of course, the presence of the government as a buyer distorts the value of securities but that cannot be helped.

In some sense, the current program of holding assets as collateral at a haircut in exchange for lending is a better solution. The borrower still owns the security and would be responsible for selling or finding the best price when he determines that there is a an appropriate buyer.

Crude oil squeeze one more speculation problem

As Daniel Drew was once supposed to have said,"He who sells what isn't his'n, must buy
it back, or go to prison." The crude oil market saw a significant increase in price before the October expiration contract. The price went from $105 in the overnight market to a high of $130 only to settle back down at $120 at the end of the day. This is unusual but not extraordinary in markets that have physical delivery. There have been squeezes in many markets often when hedgers get caught with a position that cannot be unwound quickly enough before expiration. This hurts price discovery but most of the speculative positions and index positions had been rolled out out the curve.

The positions of hedgers going into expiration are monitored by exchanges and the CFTC and there are position limits that decrease as you move to the expiration period. While this is something that should be reviewed, physical settlement at delivery points causes the potential for congestion. If the physical oil cannot be made in delivery positions have to be covered before expiration. If this occurs more frequently, then there has to be a review of the contract term and the exchange upon review with market participants has to adjust the contract expiration process.

Politically, this is not something that is needed for the futures markets right now and sends up a red flag for further regulation. Nevertheless, a thorough review of the facts are necessary before there is a rush to judgment.

What are the choices for the financial bail-out?

"There are no atheists in foxholes, and no Libertarians in economic chaos."

A quip to remember when thinking about this Wall Street bail-out. The discussion is to about whether it should be done but how it should be done. the discussion is whether strings should be attached or not. There is limited discussion whether this is the right time or whether this plan is the best approach to the market. The real issue is whether these securities have been properly marked in the portfolio of investors. If they are properly priced, then the loses are already on the balance sheet. A major concern is that assets have not been properly priced and the Bail-out may not solve this problem even if they are purchased.

The most important issue is the financing of the real economy and not the repositioning of bad assets between portfolios. The real question is whether there are good assets that can be financed at this time or is there a spillover that has created a gridlock of financing. This is the issue that has to be more clearly addressed

CDS market driver of Wall Street problems

This has been a unregulated market and perhaps may be the cause of the greatest amount of pain on Wall Street. It also is the area which has been least talked about by regulators. The rules are not clear. There is no centralized clearing. There is no accounitng for the overall size of the market and the extent of its use is vast.

The credit crisis is actually a combination of three crises from the same root cause. There is the mortgage crisis which is ongoing but has been lost in current the problems of the stock market. There is the the lending crisis or the seizing up of the credit markets for all normal bank lending. This may be the most important area for the good the economy. The third crisis is associated with swaps in the CDS market. This is the big unknown.

This problem of CDS was the driver of the AIG bail-out. It has been an issue with their financial products group and not the core insurance area. The size of the CDS exposure for AIG was greater than the amount of capital outstanding. If the buyers of these swaps want to unwind them and the other side cannot provide the cash, then we have a major liquidity problem. There is the counter-party risk, but the underlying risk that was being hedged is now an exposure to the holder of the swap protection.

The CDS market is the one to watch in the coming weeks and with corporate spreads rising it is only going to get worse.

Will the US be like the Japan of the 1990's?

The most important event to destroy the modern macro orthodoxy was the Japanese bust that became their lost decade. The idea of liquidity traps was almost thrown out of many textbooks as a Depression artifact and not relevant for thinking modern central banking. Japan tried to control interest rates and provide support for the economy but nothing worked until the rate targets were abandoned and a policy of inflating the economy was applied without any constraints. Government debt sky-rocketed during this period but it was a the reflation policy that made a difference. Zero interest rates were the target. It should be noted that it took years before the Japanese government tried to bail-out the banking system which was a contributor to the length of the crisis. Procrastination made matters worse.

Unfortunately, the reflation strategy with a slow bail-out was a long and hard road and should send sobering chills to American citizens. Housing values are only 40% of their 1990. The main Japanese stock index is still down 70% from its peak. Japan's national debt topped 100% of its overall economy. The debt of the US is now at about 40% of the total GDP ($9.5 trillion on a $14+ trillion GDP). The $700 billion bail-out actually will not be that large on a relative basis but that is assuming that the plan works.

The Japanese analogy is real but the hope is that faster action will mitigate some of the long-term harm of the current credit crisis.

Looking like a normal credit crisis - expect the Scandi scenario

Currency crises have been extensively analyzed over the last 30 years and a recurring conclusion is that these crises are often coupled with banking crises. In fact, many of the currency crises are precipitated by a internal banking crisis. The internal shock spills over to the demand for the currency through a change in expectations on the sovereign risk of the country and the expectation that a there will be a slowdown in growth.

The banking crises will have different lengths but the end result has often been the nationalization or recapitalization of the bank system. This government bail-out restores confidence for investors both domestic and foreign. We look like we are heading down this path in the US except the form of the bank bail-out is still not clear and we may not have not seen the end of the currency run.

A good example to compare the current US currency crisis is the Scandinavian banking and currency crisis of the early 1990's. There was a combination of an overheated real estate market, liberalization of financial regulation, and pro-cyclical government policies which led to overvaluation in real estate. When a recession hit the economy, the banking system especially for those institutions with heavy real estate exposure saw a huge erosion of capital. The bail-out cost approximately 3% of GDP.

The Swedish currency saw a 60% change in the currency in about 18 month. Now Sweden is a small open economy so that any shock may have a greater impact on the currency than what may occur in the US but we should not be at all surprised if we see a dollar slide that continues into 2009 if there is uncertainty on whether the current bail-out plan will work.

Fermi question and the credi crisis - how much will everyone have to pay?

An important skill in physics is the ability to approximate or to provide for a back of the envelope calculation. The game of trying to make these rough approximations is often referred to as a Fermi question and is a game played by many scientists to test their computational reasoning skills. For example, a simple Fermi question would be to determine what are the number of hairs on the scalp of an average head or how much pizza in square feet is consumed each year? 

It would be natural to start thinking about the Wall Street bailout as a Fermi question. How much will each person in the US owe for this bail-out problem? Assume this will cost the US $1 trillion and we have 300 million citizens, the cost of the bailout does not seem that large, about $3300 per person; however, if you divided that number by the number of taxpayers and then by the number who are expected to see their taxes rise, the numbers start to look grim. 

 The constraints on taxes and who can pay will bind the government and determine what will be possible over the next four years. If you assume that tax revenues should decline in a recession, the choices become even more constrained. One of the few choices for paying this debt is through inflating prices and debasing the nominal value of the debt. The only problem is that many of the key buyers of government debt are foreign investors who have choices. The biggest loser may then be the dollar.

Currency markets woke-up to the cost of bail-out

Simple models of currency behavior tell the story about where the dollar should be headed - down. First, look at a simple monetary model of exchange rates. In this case, a rise in the growth rate for money relative to other countries will lead to a decline in the exchange rate. The market will have to clear at a lower level with the money supply shock. Second, we can take a portfolio balance model and look at a shock to the amount of debt that will have to be issued to bail-out Wall Street. Again, the shock will be dollar negative, because the price of dollars will have to fall in order to hold the risky assets in a portfolio.

The dollar has already closed over 2 percent lower from Friday relative to the euro. Less for some of the other major G10 countries but a clear dollar rout. Coupled with an already high current account deficit and no change in recession forecasts, we are looking at a perfects storm of bad news for the dollar.

The dollar rally was based on three forces. The reduced uncertainty associated with the guarantee on Fannie and Freddie rescued the portfolio outflow problem in the debt markets. Second, the idea that the US economy was stronger than expected and that the US may have turned the corner on the credit crisis through aggressive monetary policy was causing interest in the US as a safe haven. Third, the European economic numbers fell off a cliff starting in July. Uncertainty has now returned to the debt markets of what will be the supply necessary to make the bail-out work. The US economy is not showing any good numbers, and Europe bad news has been discounted.

It is unlikely for this dollar decline to reverse given the Congressional review may not reduce the size of the bail-out. It is not improbable for the dollar to retrace much of the its gains from the summer.

What is the dance to the new song on Wall Street?

Charlie Prince the former CEO of Citigroup, had one of the best lines describing the behavior that lead to the credit crisis. "As long as they are playing music, you have to get up and dance." The mentality of following the herd and trying to not be left behind when there were profits to be made was a major contributor to the problem. Everyone wanted to get in on this dance from the homeowner, the mortgage banker, the GSE, the investment bank to the end investors.

So what is the new song? Regulation - so we are seeing Morgan Stanley and Goldman Sachs turning into bank holding companies. They will dance to the new regulation of being a bank. So much for independence as investment banks. Of course, they were behaving like commercial banks and commercial banks acting like investment banks. There is no reason for debate about what is the chicken or egg because now the key regulator will be the Fed and not the SEC.

It remains to be seen what the new dance will be because the tune is being rewritten in days not weeks. It will be unclear where the law of unintended consequences will take us.

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.

Turmoil in the FX market - watch the forward points

Even markets that are not sensitive to credit issues like foreign exchange are seeing significant spill-overs. The largest most liquid market is controlled through margin of credit or bank lines for trading. If some of the counter-parties go bankrupt like Lehman, there will be an impact in FX liquidity as traders find new bank lines and close positions. If you have a net credit with a forward trade done with a bad counter-party, you may be out the net credit from unrealized profits.

Additionally position traders have been facing significant risks in the forward market with forward points jumping in ways which have not been seen since the early 1990's. While spot prices have been in some cases relatively stable, forward volatility has spiked as traders making these markets are unclear where fund rates will be for short-term maturities. We have seen inversion of forward curves over the course of 2-3 days,significant moves in rates under one to three months, and a market that is jumping in the course of minutes where the spot rates are not seeing a change. These markets are priced off of cash lending rates, so it is not surprising that this would happen but a simple look at spot will not show the angst in the forward points. This is another reason for the coordination with other central banks. Seizing up in the FX market will be an unnecessary contagion to this crisis.

Coordinated central bank action can it work?

The Fed is increasing swap lines to major central banks around the globe to provide more credit to the global capital markets. It seems like as fast as the market delevers, the central bank is willing to add liquidity. Unfortunately, the speed of delevering is faster than the addition of credit. The addition of credit also has to find its way to those firms that need it most which are the ones that have the highest credit risk.

The real problem is lending uncertainty. How do you distinguish between a good firm or a bad firm. Goldman Sachs and Morgan Stanley, for example, have good capital ratios and have tried to deal with their credit problem, bu if you are not sure about the environment is it worth providing these firms credit at spreads that will not cover a default. When in doubt, buy Treasuries. Until this uncertainty is resolved coordinated action will not eliminate the crisis.

The finds are necessary as the lender of last resort because the Fed funds market is telling everyone that there is a shortage of cash. The target rate is 2% but the Fed funds market has been trading at 100 bps over the target. Banks are unwilling to give other banks funds. The Fed, if it wants to hit its policy targets has no choice. Given that the banks who are in the greatest demand for fund are also global, there is a need to make there is help from other central banks.

Russian stock market closed - get ready for contagion

The Russian stock market has been closed for the last few days as stocks went into free fall. The fall is not just a liquidity crisis but a confidence crisis given the political changes especially with Russian foreign policy. An environment unfriendly to foreign investors, a more aggressive policy asserting their statism, and climate where property rights are questioned made the Russian stock market a place to pull capital during a credit crisis.

This free fall shows how even an oil rich country which should have no equity problems can see a major decline if there is a change in sentiment and investing environment. It also places a warning for all other emerging markets that capital flight can happen quickly. We have to be prepared for contagion to other countries which may have an unfriendly financial environment.

Where does moral hazard end?

Moral hazard, the problem of behavior changing with the response of the government to the credit crisis, surrounds us as we swirl through this crisis, but at the same time there is a significant lack of clarity on when the government will step in a protect investors. The future actions on what type of risk taking should be undertaken is unclear.

If you are a broker-dealer there is no safety net unlike some of the help given institutions during the LTCM crisis. You are on your own. See Lehman brothers and Bears Stearns. If you are a bank, you have more protection because the Fed will provide you with funds. See the amount of liquidity provided through the Fed.There were some protections for financial institutions from naked short selling. A large insurance company, like AIG, gets taken over by the government. This one was too big to fail. Hard to say what will happen to other insurance companies. The large GSE's get the help of the government. Shareholders and top management hurt but the rest of the show goes on.

But what about GM or Ford who have thousands of workers? What about money funds? What about mid-tier banks? The issue with the term moral hazard is that it is not clear how some of the government actions will play out and with whom. The uncertainty is still present and the "bail-outs" do not solve the confidence problem.

Gut instinct and quant prowess may not be opposites

The general view is that those who have good quantitative skills are not the same people as those who use gut instinct or have better ability at gaining sense of relative magnitude or the ability to size things up. Intuitive counting is not the same as computational logic.

Recent research on learning behavior shows that there may actually be a connection with the primitive cognitive skill of making quick number judgments and the refined skills of computational math. These two maths systems, bestial or primitive versus celestestial or formal may be closely correlated. Those who have good primitive skills have shown to have good computational skills. This dichotomy is nicely described in a recent NYT science article by writer Natalie Angier,http://www.nytimes.com/2008/09/16/science/16angi.html?partner=rssnyt&emc=rss.

In some sense, better mathematician should be better at the simple non-symbolic skills of approximating. You can count trees but you also have to have some skill at approximating the size of the forest. Scientist do not know how our crude approximate skills are tied with the skills to do higher math or whether you can be trained in one area and improve in the other. Nevertheless there may be innate math or number skills which transcend both the high and low level versions of counting. Finding a ballpark figure, a Fermi problem solution, is a good skill to have and helps with other math.

I like to believe that intuition in thinking about approximate magnitude is an important skill for any investor which helps with computation skills. You need to have a good feel for numbers to be effective. For example, in forecasting the precision of the forecast i not as important as getting the direction right. Working on these directional skills is important as a first start before plowing into the specifics of econometric modeling. Knowing the trend is as important the precise number.

So thinking about how many Starbucks are there per person in the US is as important as estimating the expected earnings of the company. Thinking about the number of cars is China is relevant for forecasting the price of oil.

How risky are the debts markets?

This is like a bad joke - how risky are the debt markets? So risky that if you bought Treasury bills today you would get less than 25 bps for 3 months, four week bills were down to a 4 bps yield. You are getting nothing on your money except the promise that the government will return principal. This is the clearest indication of the extent to where the crisis of confidence is currently at. The stock market is just a signal for what is going on in the debt markets. If you do not want to lend to any firm that has credit risk the place to be is Treasuries. If there is no lending, then some of the basic functions of the financial economy cannot occur.

The action of the Fed to add more reserves does not matter if there reserves are kept in the vault an not used to make loans, and there is nothing the Fed can do to change this view except to provide some confidence by offering backstops to different critical firms. Unfortunately, this localized help in an attempt to provide confidence globally has not been working.

What would JP Morgan do?

When I think of financial crises, I remember the comments of JP Morgan founder of the great banking dynasty. He was asked if commercial credit was based primarily upon money or property, he denied it. “No, sir. The first thing is character,” he said. “Before money or anything else. Money cannot buy it.”

Morgan snapped during a crisis, "You’ve got your reserves. Use them! That’s what reserves are for.” It seems like the Fed has to remind banks of JP Morgan's reserve view.