The Lady or the Tiger?

Its not that Paulson and Bernanke are following a 'liquidationist" philosphy in the spirit of Hoover and Mellon. Hardly, given the enormous amounts of liquidity that the Fed and Treasury are making available to the banks in many innovative and non-traditional ways.

Rather, we have a 'selective liquidity crisis' because the situation has not become broadly dire enough to frighten the bankers out of their usual gamesmanship and maneuvering for quick profits. Thinking longer term and for the greater good is not a natural reflex with this crowd.

The Fed and Treasury will have to make the pain great enough for the system to move forward without becoming more dependent on subsidies than they already have been. There has been little downside under Greenspan's long reign, and the bankers have been able to keep what they kill.

The failure here was the government's, in allowing the banks to subvert the system through influence-peddling and the dismantling of the regulatory process. We think the NY Fed would have a stronger hand to play if he were able to throw a file of wiretaps, bank records, and subpoenas on the table when lecturing the US banks on mutual benefits.

The governments of the world are also responsible for this because of their monetary policies for so many years, pandering to the sole superpower, and their artificial support for the dollar. They turned the world's economy into an artificial construct hopelessly addicted to easy credit, weak regulations and market manipulation.

Things change slowly. Ben and Hank have a tough job. If they take the patient off too quickly in a cold turkey, and put it into systemic shock.

There is a profound difference between insolvent and illiquid. Let's hope wisdom prevails. And let's never forget who and what caused this problem in the first place.


Who's next after Lehman Brothers is fed to the wolves?
By Ambrose Evans-Pritchard
Last Updated: 2:47pm BST 16/09/2008
UK Telegraph

One can date the onset of the Great Depression from December 1930 with the collapse of the Bank of the United States, a mid-size lender to the Jewish community in New York.

It is often alleged that the Anglo elites let the bank fail from motives of anti-semitic malice.

True or not, the consequences were dire for almost everybody. The failure set off a worldwide run on US gold deposits (ie, the dollar), and forced the Federal Reserve to raise interest rates into the slump. Some 4,000 lenders were ultimately driven to the wall.

We will find out soon enough whether the decision to throw Lehman Brothers to the wolves over the weekend was any wiser. Princeton economist Paul Krugman has accused the US Treasury and the Fed of playing "Russian roulette" with the financial system, warning that the shadow banking network could disintegrate within days.

The hunting packs switched instantly to AIG yesterday, driving down its shares by 70pc in early trading. The world's biggest insurer is suddenly on the brink of collapse as well. The killer virus is striking deep into a whole new sector of the financial system.

"This is a potentially very dangerous situation," said Professor Tim Congdon from the London School of Economics.

"Banking system capital is being wiped out. The risk is that this could lead to a contraction of credit and set off a self-reinforcing downward spiral, leading to the sort of debt-deflation we saw in the 1930s.

"It is already clear that money growth has ground to a halt over the past three months. We must prevent it from actually contracting. If the Fed and European Central Bank don't cut interest rates soon, it is going to be a problem," he said.

When creditors cut off funding to Bear Stearns in March, the Fed reacted with dramatic speed. It invoked nuclear powers under Article 13 (3) of its charter, allowing it - in "unusual and exigent circumstances" - to take credit liabilities on to its own books for the first time since the Roosevelt era.

It was fiercely criticised for rescuing Wall Street from its own folly, but the risk was a meltdown in the vast, untested market for derivatives. Bear Stearns alone had over $13 trillion in contracts, with heavy exposure to the turbo-charged CDS credit swaps that so terrify the New York Fed.

Nobody was ready for a derivatives shock at that time. This time, hopefully, they are. The Bear Stearns bail-out gave the banks an extra six months to clean up their positions and lower exposure. Hence the orderly unwinding of trades at an emergency session of the International Swaps and Derivatives Association on Sunday afternoon.

With the tail risk of a derivatives Chernobyl out of the way, the Fed and the Treasury at last feel safe enough to strike a blow against moral hazard. The line has to be drawn somewhere.

Unlike mortgage giants Fannie Mae and Freddie Mac, broker dealers are not crucial pillars of the US housing market. Lehman is an optimal candidate for ritual sacrifice.

While the appearances of free market discipline have been upheld, the reality of the weekend events is a further lurch towards socialism, or state capitalism if you prefer.

The Fed's lending window has been widened, allowing all forms of investment grade paper to be used as collateral in exchange for taxpayer credit.

Even equities are now admitted, though under a disguised formula. "With investment banks falling like ninepins, the Fed may have decided that it would be prudent to provide some official underpinning for equity market values and hope to avoid a stockmarket collapse," said Stephen Lewis, chief economist at Insinger de Beaufort.

Yet the dangers remain acute, even after the move to shield Merrill Lynch from contagion by orchestrating a shotgun wedding with Bank of America.

The credit crunch is about to bite deeper. The interest rate on Tier 1 debt for typical banks has jumped by 125 basis points since Friday. "This is a violent effect," said Willem Sels, credit strategist at Dresdner Kleinwort.

The closely-watched Libor/OIS spread on three-month money in the US has risen to 105 basis points, pointing to a lending crunch over the winter. Europe's iTraxx Crossover index measuring default risk on junk debt has surged to over 600.

"There is a flight to quality. People are hoarding liquidity and this is going to prove very damaging. What concerns me is that the banks refused to take on Lehman's bad assets even at a low valuation, and that tells you they still don't know where the clearing level is for this mortgage debt," he said.

As this newspaper has long feared, the world is now faced with both a tightening credit squeeze and a synchronised hard-landing across most of the world economy.

The eurozone and Japan are almost certainly in recession already. Britain will follow soon.

America is plummeting into a second downward leg as the fiscal stimulus package fades and the exports mini-boom stalls. China cut interest rates yesterday following a sharp fall in property prices over the summer.

Superficially, one can blame Lehman and its ilk for the excesses that led to this crisis.

However, the root cause lies in the actions of governments across the Western world. They held interest rates too low for much of the past two decades, and encouraged the debt burden to explode to unprecedented levels.

This reckless experiment has left our societies acutely vulnerable to a sudden reversal of debt issuance, or ''deleveraging" as it is known. The ferocious purge now under way will come at a high human cost. Millions in Britain, Europe, the US, and the rest of the world will lose their jobs over the next two years, through no fault of their own.

Having caused this crisis, it would now be remiss for governments to pursue a policy of strict debt liquidation in the name of capitalist purity.

As the bankruptcies mount, the state will have an obligation to step in to preserve social stability. If that means the temporary nationalisation of large chunks of the Western economy, so be it.

This is too grave a crisis for ideological preening and free market infantilism. May those calling for debt liquidation ''a l'outrance" be the first in line to lose their jobs.