What To Do About The Global Financial Crisis
FORECASTS & TRENDS E-LETTER
IN THIS ISSUE:
1. BaselineScenario.com Urges Larger Bailout
2. “The Next World War? It Could Be Financial.”
3. My Initial Thoughts & Analysis On The Above
4. Huge Recapitalization Plan For Major Banks
5. Progress Report On The Larger Bailout Plan
6. Conclusions & What To Do Now
The global market plunge over the last few weeks has been nothing less than stunning. The Dow Jones Industrial Average and the S&P 500 Index have plunged 36.2% and 38.8% respectively so far this year. From their all-time highs one year ago last Thursday, the Dow was down over 40% and the S&P 500 was down over 43% as of the close last Friday.
It is estimated that pension funds and retirement accounts have lost well over $2 trillion in value this year in the US alone, most of it as the markets have collapsed in the last month or so. Worldwide, stock market losses were estimated at $8 trillion by the end of the day on Friday. Fortunately, equity markets around the world rebounded strongly on Monday, with the Dow Jones soaring 936 points in the single largest up day in history.
Banks continue to fail, major corporations are teetering and trust among financial institutions has evaporated. This despite the fact that the government passed the massive $700+ billion bailout just over a week ago. Earlier this morning President Bush and Treasury Secretary Paulson announced a new plan that will have the government take direct equity stakes in major banks to the tune of up to $250 billion of the $700 billion rescue plan.
The latest plan to inject capital in the major US banks in return for equity stakes was part of an international plan whereby governments in Europe, Japan and elsewhere made similar equity infusions in their major banks. The question remains, however, whether this latest huge step will stem the crisis in the credit markets until the remainder of the $700 billion bailout plan can be implemented.
Some analysts believe that more government assistance will be needed. This week, we look at one such analysis from BaselineScenario.com that calls for significantly more bailout efforts by the government to free up the credit markets. While I am not ready to endorse such an expanded rescue plan, it is something we should at least be aware of, especially now that both John McCain and Barack Obama are calling on the government to buy up troubled mortgages en-masse and restructure them so that people can stay in their homes.
I know that many of my clients and readers don’t agree with the government bailout plan and whatever else is to come. Normally, I wouldn’t either. But these are not normal times, and this is the greatest global financial crisis since the Great Depression, potentially even greater. Thus, unprecedented actions need to happen, and they need to happen fast. We can sort out the details, such as increased regulation, who is to blame and who potentially gets punished, later.
BaselineScenario.com Urges Larger Bailout
BaselineScenario.com is a very useful website/webblog that was founded by Peter Boone, an Associate at the Centre for Economic Performance at the London School of Economics, Simon Johnson, former chief economist of the International Monetary Fund and current professor at the MIT Sloan School of Management, and James Kwak, a former McKinsey consultant and co-founder of Guidewire Software.
On their website, they have a lot of useful information, including an article entitled Financial Crisis For Beginners, which I am reprinting separately for clients and readers. This article explains in understandable language many of the intricacies of the credit markets and the financial crisis, along with some of the technical terms such as CDOs, CDSs and others. If you want to better understand the credit crisis, this is a good place to start. I will send a SPECIAL ISSUE of Forecasts & Trends E-Letter later today or tomorrow.
Last Sunday, the editors at BaselineScenario.com published the article reprinted below with their ideas for how to solve the global financial/credit crisis. Their urgings go well beyond the $700 billion government bailout and other actions the US has taken to date, and would involve a huge coordinated global response.
This article was picked up over the weekend by the Washington Post, Forbes and RealClearPolitics.com, so it is getting some serious attention, and I expect we will be hearing more about it just ahead. Just to be clear, I am not endorsing this plan, at least not yet. I present it only as something that serious investors should at least be thinking about as a possibility in a worst-case scenario.
Finally, since the BaselineScanario.com website is also a blog, it is updated regularly with new information. Thus, I would suggest that you visit the website at least occasionally to keep up with their latest thinking on the global credit crisis, and that of others who post there. With that introduction, here is the article we will focus on this week. Read it carefully.
Note that some of the recommendations in the report below were taken on Monday and Tuesday with the international plan for governments to take equity stakes in their major banks.
The global financial outlook grows more dire by the day: The United States has been forced to shore up Wall Street, and European governments are bailing out numerous commercial banks. Even more alarmingly, the government of Iceland is presiding over a massive default by all the country’s major banks. This troubling development points not only to an even more painful recession than anticipated, but also to the urgent need for international coordination to avoid something worse: all-out financial warfare.
The ramifications of Iceland’s misery are probably more serious than people realize. The country’s bank assets are more than 10 times greater than its gross domestic product, so the government clearly cannot afford a bailout. This is going to be a large default, affecting many parties. In the United Kingdom alone, 300,000 account holders face sudden loss of access to their funds, and the process for claiming deposit insurance is not entirely clear.
But there’s a broader concern. With European governments turning down his appeals for assistance, Iceland’s prime minister, Geir Haarde, warned last week that it was now “every country for itself.” This smacks of the financial autarchy that characterized defaulters in the financial crisis in Asia in the late 1990s. Similarly, when Argentina defaulted on its debt in 2001-‘02, politicians there faced enormous pressure to change the rule of law to benefit domestic property holders over foreigners, and they changed the bankruptcy law to give local debtors the upper hand. In Indonesia and Russia after the crises of 1998, local enterprises and banks took the opportunity of the confusion to grab property, then found ways to ensure that courts sided with them.
This is a natural outcome of chaotic times. Iceland’s promise to guarantee domestic depositors while reneging on guarantees to foreigners may be just a first step. British Prime Minister Gordon Brown’s decision last week to sue Iceland over this issue may escalate the crisis. The use of counterterrorist legislation to take over Icelandic bank assets and operations in the United Kingdom also has a potentially dramatic symbolic effect.
Most of the time, financial war of this kind is painful and costly. It will lead to decades of lower international capital flows and could have other far-reaching effects on politics and global peace. Unless the leading industrial countries take concerted action, there’s a very real danger that we will all suffer more.
In addition, we’re now likely to see substantially more defaults and credit panics in smaller countries and emerging markets. After Iceland’s fall, every creditor to other nations with large deficits and substantial external debt must be looking for ways to reduce its exposure. The obvious risks include much of Eastern Europe, Turkey and parts of Latin America. Russia’s difficulties show that seemingly solvent countries can be high-risk: While the Russian central bank has gold and foreign exchange reserves of $556 billion, the private sector has recently built up an estimated $450 billion of debt. Creditors don’t want to roll over the debt, so the government is using its reserves to do it. It has already ordered $200 billion channeled through state banks to companies repaying debt. If oil prices fall [and they are], a seemingly highly solvent country [Russia] could quickly look nearly insolvent. Some other rising stars, such as Brazil and even India, may have similar problems.
Added to this are worrying signs that the credibility of U.S. authorities is on the decline. Despite Washington’s moves to stabilize the financial system, credit and equity markets continue to drop. This pattern is reminiscent of the 1997-98 Asian crisis, when successive International Monetary Fund programs provided briefer and briefer respites from market routs in emerging economies.
There is now a risk that continued corporate and bank defaults within nations, matched by large shifts in capital flows across nations, will lead to a chaotic series of national and local defaults. If governments don't respond with sensible, coordinated policies, there’s a risk of financial war. [Emphasis included, GDH.]
Here are six steps toward avoiding a situation of “each nation for itself”:
1. The world’s leading financial powers -- at a minimum, the United States, the United Kingdom, France and Germany -- should jointly announce national plans to require recapitalization of banks (i.e., restructuring their debt and equity mixture) so that they have sufficient capital to weather a major global recession. How this is done can be determined internally by each nation, but this should be a common goal, so that citizens and companies can again trust their banks.
2. The countries should announce a temporary blanket guarantee on all existing bank deposits and debts. This will, in effect, promise creditors that they can safely expect the institutions to function until the recapitalization takes place, and it will help prevent the large flows of funds that could occur as some banks or countries conduct recapitalizations earlier than others. This guarantee should only be temporary (say, for six months).
3. The monetary authorities of these countries need to lower interest rates dramatically. Europe, Canada and the United States recently announced a coordinated 0.5 percent reduction in rates. This is a good start, but only a start. More will be needed, and it won't stop the credit crunch within or across countries. The events of the last nine months have set us on course for a global recession in which commodity prices will continue to fall and demand will remain weak. Inflation will be low, and deflation (falling prices) is a risk. More interest-rate cuts will be needed.
4. The monetary authorities also need to remain committed to pumping liquidity into the financial system as long as credit markets and interbank lending remain weak. This should be promised for at least one year.
5. All industrialized countries and most leading emerging markets should commit to a sizable fiscal expansion [increased government spending] (at least 1 percent of GDP), structured to work within the local political environment, to offset the coming large decline in global demand.
6. Many families worldwide are going to have negative equity (i.e., mortgages larger than the value of their homes) due to declining home prices. There are going to be large-scale recriminations against lenders and politicians. The most affected nations, including the United States, the United Kingdom, Ireland and Spain, urgently need to develop programs to provide relief for homeowners, both to offset real hardship and to prevent a vicious downward cycle in home prices.
It’s important to prepare properly: Partial and piecemeal actions will no longer work. Actions by one country alone, and the current pattern of small steps, are no longer credible enough to change the tide: Markets need to be jolted out of their panic. It’s worth bringing a sufficient mass of economic power to bear in a comprehensive program to unfreeze the markets. If the major powers of Europe and the United States were to implement such a program, we can be sure that other countries would follow suit, dramatically relieving fears of bank failure in these countries.
We also need to let [equity and real estate] prices move to a level supported by the market, which unfortunately means that wealth is likely to decline even further. The events of the last six months will almost surely cause a recession, and large downward revisions in earnings estimates are a near certainty. The crisis has undoubtedly changed investors’ perception of the risks of investing in equities and real estate. As we saw after the Asian crises, this can mean that stocks, bonds and other assets become very cheap, and it takes a long time for values to recover. Fiscal expansion and help to homeowners will reduce the pain from these losses, but it’s important to be clear that the success of the program should not be measured by rising asset prices.
Finally, it's important for everyone to recognize that we are well past the days where even dramatic steps could have stopped the panic and prevented a major recession. A successful program will not prevent recession, and we will still see many personal, corporate and perhaps even national bankruptcies. Once the genie of panic and uncertainty is unleashed, it takes years to put it back in the bottle. What we need to do is to prevent a chaotic collapse arising from incomplete policies, lack of credibility and international financial warfare. END QUOTE
My Initial Thoughts & Analysis On The Above
The suggestions from the gentlemen of BaselineScenario.com are very bold and politically challenging on various levels. At first blush, their sweeping plan of global government interventions in the credit markets, with potentially massive capital injections for banks and across-the-board guarantees of depository accounts in full, may sound overblown to many readers. However, as noted above, on Monday and earlier today, the US and governments in Europe, Japan and elsewhere announced plans to inject hundreds of billions of capital into major banks in return for equity stakes in their stock.
Why would they do this? The credit markets remain frozen, many major corporations are teetering on the brink of failure, and we may have been facing another week or two of stock market collapse, with the commensurate plunge in pension and retirement savings. The major governments felt they had no choice but to directly recapitalize the major banks in an effort to unfreeze the credit markets and avoid, hopefully, a continued stock market collapse.
Many Americans still remain dead-set against the Treasury’s $700 billion bailout plan, and presumably the latest announcement that the US government will buy shares of banks. Likewise, I would assume there will also be significant resistance to the even larger bailout plan as suggested above by the gentlemen at BaselineScenario.com. While I’m not ready to endorse their plan, I would also contend that public support for such a broader rescue plan could swing quickly in favor – if the stock market collapse continues for another week or two.
Finally, there is a growing consensus that the US government’s piecemeal, one-at-a-time, financial crisis rescue efforts – Bear Stearns, Merrill Lynch, AIG, et al – and of late the $700 billion bailout bill, is simply not enough. So, it will be interesting to see if the latest international plan to recapitalize the major banks will work and stem the carnage in the stock markets. If the markets continue to collapse just ahead, expect every possible rescue option to be put on the table.
Huge Recapitalization Plan For Major Banks
This morning, President Bush announced a $250 billion plan by the government to directly buy shares in the nation’s leading banks, saying the drastic steps were “not intended to take over the free market but to preserve it.” Treasury Secretary Paulson specified that the $250 billion will come from the $700 billion rescue package approved by Congress just over a week ago.
The Treasury is set to buy equity stakes in Bank of America\Merrill Lynch, Wells Fargo, Citigroup, JPMorgan Chase, Goldman Sachs, Morgan Stanley, Bank of New York\Mellon Corp. and State Street Bank. Bloomberg reports the Treasury plans to spend $25 billion each for stakes in Citigroup and JPMorgan. Another $25 billion will be divided between Bank of America and Merrill, which agreed last month to be acquired by Bank of America. Wells Fargo is to get at least $20 billion, Goldman and Morgan Stanley will each get $10 billion, and State Street and Bank of New York will get about $3 billion each.
Some of the big banks had to be pressured to participate in the program by Treasury Secretary Paulson, who wanted healthy institutions that did not necessarily need capital from the government to go first, as a way of removing any stigma that might be associated with banks getting bailouts directly from the government in return for an equity stake in their stock.
Incidentally, Secretary Paulson said the executive compensation rules that were a part of the $700 billion rescue plan passed by Congress will apply to the top executives at the banks that are receiving the capital injections.
According to Paulson, the initial injection into the largest banks will be on the order of $125 billion, with the remaining $125 billion to be used as needed for other smaller banks and financial institutions.
Paulson also announced that the Treasury Department will insure new bank debts in an effort to get banks lending to each other once again. Insuring loans among the banks is a huge step to take. This comes after the announcement late last week that the Fed will backstop the commercial paper market as needed. If these bold actions don’t free up the commercial credit markets, I don’t know what will.
Paulson also announced this morning that FDIC coverage for non-interest-bearing commercial bank accounts will be unlimited. This action is primarily targeted for businesses that must hold more than $250,000 in banks to meet payrolls and other obligations.
Progress Report On The Larger Bailout Plan
President Bush and Treasury Secretary Paulson said this morning that the latest $250 billion bailout package for banks would come out of the $700 billion rescue package approved by Congress on October 3. If so, that would leave only $450 billion in the rescue kitty.
You may recall from last week’s E-Letter that the final rescue package passed by the Congress stipulated that the Emergency Act will make only $250 billion available in the first tranche, with the next $100 billion coming upon the President’s request, and the final $350 billion subject to a joint resolution of Congress. Since President Bush has committed the first $250 billion to the banks, it will be interesting to see how they get at the remaining $450 billion in the weeks ahead.
Many investors are rightfully concerned that the massive Treasury rescue plan will not get up to speed in time to begin settling down the markets. Some have suggested that the Treasury won’t begin buying up troubled assets until after the new administration takes office on January 20. But apparently, the Treasury is steaming ahead and may be making purchases fairly soon.
The following is from TheStreet.com this morning.
The Treasury has selected the law firm Simpson Thatcher to advise on structuring a program to acquire equity stakes in banks, as well as the consultancy Ennis Knupp to hire asset managers.
“[W]e have accomplished a great deal in just 10 days, but our work is only beginning,” he said in a speech at the Institute of International Bankers. “A program as large and complex as this would normally take months or even years to establish. We don't have months or years. Hence, we are moving to implement the TARP as quickly as possible while working to ensure high quality execution.”
Kashkari also said TARP was taking “aggressive steps” to combat potential conflicts of interest, since companies and individuals who can best help the Treasury are also those who will most need its help. “[F]irms with the relevant financial expertise may also hold assets that become eligible for sale into the TARP,” Kashkari noted.
Firms will be required to submit an outline of any potential conflicts of interest, and the Treasury will then perform its own independent investigation before hiring them. Treasury will only hire firms when “confident in our and their ability to manage any conflicts,” Kashkari said…
Kashkari said there are also provisions in place to protect taxpayers that are footing the TARP bill, including a goal to preserve homeownership, restrictions on executive compensation and strict compliance rules.
Kashkari outlined five key positions the Treasury has already filled, including chief financial officer, chief risk officer, chief of homeownership preservation, chief compliance officer and interim chief investment officer. Those officials have decades of experience in various regulatory arms domestically and abroad, including the Treasury, Federal Deposit Insurance Corp., Federal Reserve, Commerce Department, International Monetary Fund and World Bank, among others.... END QUOTE
So it does appear that the Treasury is moving full-speed ahead to get the TARP up and running as soon as possible.
Conclusions & What To Do Now
Many Americans (and most conservatives) would be outraged if the US government were to enact a bailout on the order of what is suggested above by the gentlemen at BaselineScenario.com. But as discussed above, this morning’s announcement of a $250 injection of capital (from the TARP) into banks in return for equity stakes is a big step in that direction.
It is too soon to gauge the public’s response to today’s big announcement, but I expect it to be very negative on balance. What I do believe, however, is that if the carnage in the stock markets continues for another week or two, most Americans might well change their minds and welcome such an expanded rescue effort aimed at the banks – if it stabilizes the markets.
Both Obama and McCain have come out in favor of the government buying up troubled home mortgages and restructuring them to allow people to stay in their homes. Thus, it would appear that such a plan is going to happen one way or the other, assuming the government has the money to do so.
Is that a good thing or a bad thing, given where we are in this global financial crisis? Think of the message it will send to hard working Americans who have sacrificed and kept their home mortgage payments current. I could see a great deal of animosity in neighborhoods where people have sacrificed to keep their payments current, while others get bailed out by the government.
However, such a rescue plan may be the only way to stop the downtrend in home prices that is clearly fueling the credit crisis and the economic downturn we are headed into.
Finally, everywhere I go people are asking me about what to do with their investments, including even people I don’t know. The question is, Should I sell now and take my losses? Obviously, I don’t know if the market meltdown is over. No one else does either, whether they admit it or not.
As noted earlier, we saw a huge rebound in the markets on Monday, and as I am about to hit the “send” button (noon today), the markets are holding the gains from yesterday. But this is no assurance that we’ve seen the bottom. A great deal depends on how the US government and other governments around the world react in the weeks ahead.
What I can tell you is that the stock market decline over the last few months has eclipsed the decline we saw in the 2000-2002 recession bear market and equaled the crash in October 1987. What I can also tell you is that the people who got hurt the worst in those bear markets were those that panicked and sold out near the bottom. Those who held on were eventually rewarded.
There is no doubt that the current global financial crisis is much worse than the recession and bear market of 2000-2002, and worse than the market meltdown in October 1987. The ultimate question is whether we believe the US and the stock markets will survive this credit crisis. I believe the answer is yes.
While most of my money is invested in actively managed strategies and alternative investments (futures funds, etc) that have lost a lot less than the market (and have actually made money in this decline in a few cases), I do have some money in passive buy-and-hold investments. I am not planning to sell these investments.
As always, past performance is not necessarily indicative of future results.
Wishing you better times,
Gary D. Halbert
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Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.