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.