The Bald and The Beardful

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Highly unsettled and extremely volatile conditions continued to rock world equity and commodity markets for a second day, as central banks pulled out the big guns and prepared to fire a near quarter trillion dollar round at the system in order to avert a bigger meltdown that that which has already taken place to date. The headlines continued to pour onto front pages of every publication out there and new names were added to the list of takeover/merger/default and/or plain old shaky candidates. WaMu put itself up for sale, Morgan Stanley 'spoke' with Wachovia, Lloyd TSB took over HBOS and no one dared mention the unmentionable one that starts with the letter "C" as averting one's eyes from the carnage becomes the safer thing to do. Of late, the mere mention of a name has seemed enough to send it into liquidation mode.

New rules regarding "naked" short-selling and the forced disclosure of short positions were among the new generation of weapons which became visible in the arsenal of regulators as they cut the amount of euphemisms in their speeches to a minimum. The FTC, SEC, and Fed have stepped up their frontal assault squarely aimed at neutralizing some of the component factors which have contributed to the recent bloodletting. In addition, and RTC-style clearing house entity is apparently in the works, and Mr. Paulson might unveil it soon. Pension funds in various states are going to stop lending shares for the purposes of short-selling. The UK has banned shorting of financial shares through year-end. Welcome to the disciplined new world of semi-free markets.

New York spot dealings traded over another $90 range today - but not in the upward direction this time. From a high of $918 to a low of $831 per ounce, spot gold had a dramatic session as it followed the gyrations in oil, the Dow, and the US dollar. Stocks finished with a 410-point gain upon learning that a mortgage clearing house was being assembled and also benefited from the calming effect of a group effort by six central banks to douse the markets with nearly a quarter of a trillion dollars in liquidity. Silver was off by 15 cents at $11.91 while platinum lost $40 at $1077 and palladium fell $12 to $232 per ounce. The pumping of money continued, at rates not seen since the levees gave out in New Orleans. The US administration is curiously absent from the picture, as it was back then as well. The job has been left up to two men. Paulson & Bernanke. What might they be thinking about doing? We offer you a clue or five, from Dr. Andreas Hoefert, Economist at UBS Wealth Management:

"The ongoing financial crisis reached a peak, with the de facto disappearance of two of the remaining four independent brokers (i.e., bankruptcy filing of Lehman and Bank of America's takeover of Merrill Lynch) and the Fed helping AIG. While the financial crisis is still not over yet, we want to take a bird’s eye view and discuss it in a broader perspective.

Financial crises seldom die of old age (with the possible exception of Japan). At some stage, the crisis is over and a couple of years later books and pamphlets are written, which usually start with the "the market have learned from this experience" introduction. Then, because "this time it is different," the next financial bubble, burst and crisis occurs. In his investment classic Manias, Panics, and Crashes, the late US economist and historian Charles Kindleberger listed 38 major financial crises between 1800 and 2000, i.e., one every five years and three months, on average, with a tendency to come at a much faster pace over the last 50 years.

Crises: More alike or different? All the crises have common characteristics, the most important being the common origin of the frenzy or bubble that usually led to the crisis - an extraordinary expansion of liquidity, which in turn expands the credit activity and ultimately creates a bubble in a specific asset or as-set class, where the price of the asset is blatantly higher than a fundamental (or rational) value. For example, during the hype of the Japanese real estate bubble, the 3.4 square kilometers of Tokyo Imperial Palace and Gardens (roughly the size of Central Park) were valued at more than all of the real estate in California.

There are also differences. The objects of bubbles have historically been very varied, ranging from such exotic things as tulip bulbs, canals, cotton, railways or technology stocks to broader assets like real estate and housing, commodities or specific types of debt.

Another difference is the extent - both from a location and an asset perspective of the bubble, burst and crisis. Japan's stock and real estate market bubbles were almost exclusively contained to that country. The tech market bubble and burst, even though one of the causes of the shallow recession in the US in 2000 and 2001, was mainly unfolding in an important but not vital sector of the economy. In retrospect, it can therefore be seen as benign compared to the crisis that is currently unfolding, despite having been qualified in 2002 at a Congressional hearing by then-Fed Chairman Alan Greenspan as a "once-in-a-generation frenzy of speculation that is now over."

Today’s crisis is at the heart of not only the US but also the international financial system, putting both at risk. Nevertheless it still remains debatable whether the current crisis qualifies as "a once-in-a-half-century, probably once-in-a-century type of event," to quote the same

Alan Greenspan in an interview last Sunday with WABC-TV. The aftermath of the 1929 stock market crash leading to the Great Depression by far tops what is happening today in terms of worst case scenario.

How to solve a crisis?

There are roughly two ways to solve a crisis - first by doing nothing and just letting it solve itself, and second, by providing a lender of last resort. Which way is chosen depends on both the philosophical view of the institutions, which could potentially play the role of a lender of last resort, and the size of the potential damages, ripple and contagion effects (also called systemic risk), which could happen if the crisis would just peter out.

The philosophical view is not as innocuous as it seems and has two sides: a value aspect and a game theory aspect.

The value aspect needs to answer the question: How much does one believe in the self-correcting forces of the market? Or to put it another way: Does one think that privatizing profits but socializing losses is acceptable? Of course the political orientation of a government will play a big role, in this respect. With the US in a presidential election year, it has been fascinating to see how much both candidates rallied to the notion that Fannie Mae and Freddie Mac needed to be rescued, while at the same time insisting that no taxpayer money should be involved -two almost mutually exclusive objectives.

The game theory aspect is based on the fact that knowledge of an explicit or implicit safety net will induce market participants to react dif-ferently than they would in its absence. The technical term is "moral hazard." A person or financial institution will take much more risk if it knows it will only have to pay a part of the price if the outcome of its actions goes wrong. The more often institutions have been bailed out in the past, the riskier the attitude of the remaining institutions may become in the future once the crisis is over.

The second question looks at the risk of allowing a crisis to take its own course, without intervening. The risks are macroeconomic (What are the consequences of a bankruptcy for the overall economy?) and systemic (Who’s next in line? Could it lead to a snowball effect?).

Those short-term risks have to be outweighed by the longer-term reflection of values and moral hazard. And in this regard, there is no universally applicable answer. Sometimes, as in 1987, a stock market crash doesn’t lead to anything and therefore doing almost nothing is the right approach, whereas other times, such as in 1929, it leads to the Great Depression and the advantages of doing nothing are clearly dwarfed by its costs.

Are there some basic rules of conduct?

The fact that there is no universally applicable answer doesn’t necessarily imply that there is not a certain set of rules, which must be ap-plied in order to solve a crisis. In their seminal work on the Panic of 1907, US economists Robert Brunner and Sean Carr stressed out over the failure of collective action which could worsen and deepen a crisis.

In a nutshell, the Panic of 1907 was a financial crisis in the US and especially in New York City, which was characterized by numerous runs on banks and trust companies. It started with a failed attempt of some investors to corner the copper market, leading to a first run on the Knickerbocker Trust company - the very bank that was backing the rogue investors and loaning them money for their scheme. The crisis then spread to several other banks. Back in 1907, the Fed didn’t exist, so there was no clear lender of last resort or an obvious way to stem the crisis.

In that particular case, it took the leadership of the legendary banker John Pierpont Morgan. He gathered a circle of influential New York bankers and forced them to form an association aimed at supporting the distressed financial institutions. Moreover, once this group was in place, there was a very strong commitment to draw a line in the sand: "the trouble stops here." And the crisis ultimately ceased at the Trust Company of America, which was fully backed by this informal group.

What are the lessons for today?

The current crisis started to unfold more than a year ago. In a first step both the Federal Reserve and the European Central Banks provided ample amounts of liquidity to mitigate the most immediate liquidity problem. Moreover, the Fed slashed its fed fund rates quite significantly, bringing them down by 325 basis points from 5.25% in Sep-tember 2007 to 2% by the end of April 2008. Finally, the Fed greatly expanded the space of collaterals, which financial institutions can use to draw upon Fed facilities. Last September, US treasuries were amounting to 85% of all assets of the Fed; a year later, we estimate they only account for roughly 43%. This past Sunday's announcement that, under specific conditions even equities could be used as collateral now, will further dilute the Fed’s balance sheet.

The level of intervention from the authorities to solve or at least mitigate the current crisis is therefore beyond any critique (of course, unless you think that nothing should be done at all). However, the les-son from the past shows that we must see rule-based action, clear communication, a credible leading coalition and a collaboration of private and public forces in an internationally coordinated fashion.

Consistency: Some distressed financial institutions were rescued (Bear Stearns, the housing GSEs and AIG); others were not (Leh-man). Either way, there were dismal consequences for the equity holders, but bond holders were treated differently. Of course, there were good reasons to act in a case by case. Nevertheless, an explicit rule covering which institutions are deemed too big to fail and which ones are not could certainly diminish the nervousness of the market participants. As in 1907, there must be some "line in the sand" somewhere, which needs to be clearly communicated.

Strong coordination and coalition between the private and the public sector: The interplay between the US government, the Fed and the major banks must work in a clear and transparent manner. Bank of America and Barclays pulled out of a possible Lehman deal on Sunday and the private sector was not able to find a solution for AIG. At the same time, a consortium of major banks (including Bank of America and Barclays) were building up a fund of USD 70 billion to help distressed financial institutions. Therefore, there is a lot of goodwill from all sides here, but in our view, the communication of it is not loud and clear enough to reassure the markets.

International coordination: The crisis originates in the US, which is likely seen both abroad and by the international organizations that would usually tackle this sort of crisis elsewhere (especially the International Monetary Fund or the Bank of International Settle-ments) as being "big" enough to solve it on its own. But there is also an international dimension to it. Non-US financial institutions are involved. Moreover, as we stressed in our Research Focus, "Cur-rencies: a delicate imbalance" at the beginning of this year, the crisis has much deeper roots than in just the US financial system and other influences are currently taking place, like the unwinding of carry trades.

Financial crises seldom die of old age but it takes leadership, will and loud and clear communication as well as some costs and losses to stop them, or else they will be destined to run their course.

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