Saving the Worldwide Financial System


(B) The US Dow Jones (DJI) has its worst week in its 112-year history down 18% just this week and, 40% lower from its peak in October 2007, having destroyed $8.5T in wealth over a year. On Friday, October 10, the DJI traded in a 1,000 range pushing the S&P 500 Volatility Index (VIX) to 75 while its normal range is between 12 and 25! All markets around the world crashed with the Tokyo’s Nikkei 225 losing 24.3%, London’s FTSE 100 21% and Paris’ CAC 40  22% this week only. We are now in the midst of a financial crisis that has not been seen since the Great Depression.

The Crash of the US Stock Market

The crash of the US stock market was probably initiated by a lack of confidence in policymakers last week. But forced liquidations and margin calls to raise capital have amplified this week “insane” sell-off.

At the market close on October 10, 2008, the Dow Jones’ DJI is now traded at 8,451, 40% from its peak of 14,168, while the NASDAQ is traded at 1,649, 42% from its peak of 2,861. Both the Dow Jones and the NASDAQ have not been traded as those levels since Spring 2003, therefore erasing five years of wealth creation from the last bull market!

The iShares MSCI’s EFA (Non-US Developed Countries Stock Market Index Fund) is traded at $42.36, 51% from its peak of $86.5, while the iShares MSCI’s EEM (Emerging Countries Stock Market Index Fund), is traded at $24.55, 56% from its peak of $55.8.

And, with the slow down in worldwide economies, commodity prices have significantly declined over the last few months. The PowerShares Deutsche Bank Commodity Index’s DBC is traded at $27.36, 41% from its peak of $46.63.

Reinventing the Rules Between Governments and Financial Markets:

This extraordinary financial crisis is pushing worldwide governments to redefine the rules of the financial industry.

Treasury Secretary Henry Paulson has kicked-off this week his $700B TARP program to buy distressed mortgage-related assets while announcing the acquisition of equity into financial institutions in order to provide them the capital needed (probably a more effective measure than the TARP).

In the meantime, Federal Reserve Ben Bernanke increased to $900B the cash available for emergency loans to financial institutions and announced lending directly to non-financial companies for their commercial papers or short-term borrowing. In addition, the Federal Reserve was part of a global coordinated interest-cut by major central banks from North America and Europe and is considering with the US Congress a second stimulus package close to $1T for the economy.

Unfortunately, the G-7 leaders in Washington on Friday did not come up with a joint plan to address further the financial crisis!

But French Economy Minister Christine Lagarde committed that on Sunday European leaders will meet “not to talk about it but to put meat, muscles on the bones of that skeleton and to develop, follow up and execute upon it”. Britain Prime Minister Gordon Brown has already announced many new measures this week, in particular, the injection up to 50B British pounds ($87B) into British banks in return for preference shares. So, France President Nicolas Sarkozy,  German Chancellor Angela Merkel, and other European leaders are likely to announce similar measures in the coming weeks.

The sooner early and decisive policies are implemented, the lower will be the cost to the taxpayer and the damage to worldwide economies.  Worldwide governments are definitely now moving from being reactive to being proactive.

Urgent Recapitalization of the US and European Financial Institutions

The collapse of major US financial institutions (IndyMac, Countrywide, WaMu, Wachovia, Bear Sterns, Lehman Brothers, Merrill Lynch…) has now spread like a virus to continental Europe in particular in Belgium, France, Netherlands (Fortis, Dexia) and Germany (Hypo Real Estate) while the UK was already affected (Northern Rock bankruptcy).

Both Spain and France have a strong banking system. However, Spain, Britain, and Ireland were part of the housing bubble and are now facing significant house price declines.

Worldwide estimate of the losses in the credit market has ranged from $1 to $2T with roughly half of those losses in the United-States. According to the Economist, globally banks have reported just under $600B of credit-related losses and have raised some $450B in new capital.

Therefore, more write-downs and more need for new capital are still to be expected for the financial industry. So, it is important for the consumer both in the US and in Europe that governments guarantee their bank deposits and money funds at least for a temporary period to avoid any further panic (such measures are already being adopted by many countries, in particular, Germany and Australia).

Frozen US and European Credit Markets

Another root cause of the stock market crash for the last two weeks is the state of the interbank lending market. Banks are not lending to each other and when they don’t, they do not lend to consumers and businesses. Credit markets are frozen! Rich banks (banks with cash) are not lending to poor banks (banks without cash).

The 3-month Libor or interbank rate has soared to 4.82% while the US Federal Reserve fund rate is 1.5%.

Coordinated efforts from the US and Europe to lowering the Libor is paramount to stop further damages.

How Severe the Recession Will Be?

According to Professor Nouriel Roubini from New York University and Chairman of RGE Monitor:

“The delusion that the US and advanced economies contraction would be short and shallow – a V-shaped six month recession – has been replaced by the certainty that this will be a long and protracted U-shaped recession that may last at least two years in the US and close to two years in most of the rest of the world. And given the rising risk of a global systemic financial meltdown the probability that the outcome could become a decade long L-shaped recession – like the one experienced by Japan after the bursting of its real estate and equity bubble – cannot be ruled out.”

Most of the recent economic growth in the US has been fueled by excessive credit that was enabled by significant capital inflows from emerging countries. According to the IMF, central banks from emerging countries now hold $5T in reserves.

In the short term, it will be harder both for US consumers and businesses to get credit. Consumers will have to manage for the soon future with no increased incomes, lower house prices, and lower savings and 401K while businesses will have limited credit options for their investments.

While China will grow, according to the IMF, only by 6.9% in 2008 and 6.1% in 2009, Asian and emerging economies will unlikely rescue the US and European economies. They will be less exporting to the US and European economies. In particular, commodity-driven economies might enter a more severe slowdown.

However, capital from Asian and emerging economies will likely be more “wanted” by the US and Europe.

In the meantime, the effects of the worldwide destruction of the financial system are now particularly felt in countries dependent on external capital inflows such as Iceland on the verge of bankruptcy.

Note: The picture above is an Icelandic town close to Reykjavik.

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Categories: Financial Markets