The G7's Unified Approach and Market Implications
While the G7 did not provide a unified plan to deal with the credit crisis (because no one plan can be made applicable to all countries at the same time), it is clear that U.S. and European Union, in part as a response to the U.K. plan, are shifting their major focus towards a policy of bank recapitalization. Such plans will likely also include some type of guarantees for bank debt (the British will guarantee certain forms of debt for up to 36 months). Also left to be worked out, among other details, is to what extent such capital injections will involve ownership (nationalization) and other forms of taxpayer protection.
What has also become very clear is that a major mistake was made by letting Lehman Brothers go bankrupt. The resulting credit default swap settlement could go into the 100's of billions (no one can know at this point) and while no one event can be singled out for causing the present financial crisis, the Lehman bankruptcy is the direct cause of its latest intensification. This has led to an obvious conclusion:
Any financial firm which has issued debt for which credit default swaps were sold, or any entity which has sold credit default swap protection (such as AIG) on such debt, cannot be allowed to fail. In fact, it's critical at this juncture to protect financial firms in such as a way as to prevent their debt from being further downgraded.
The current crisis involves issues of severe asset depreciation and capital loss (insolvency), which cannot be fully addressed by central bank liquidity measures or interest rate reductions. Insolvency can only be dealt with by provisions of new capital (recapitalization), which at this time can only be provided on a governmental level since capital markets are presently constrained.
The G7 did agree to adhere to a set of principles which include:
- Preventing systemically important financial institutions from failing.
- Ensuring that bank-deposit insurance programs are solid
- Ensuring that banks can raise capital from private and/or government sources.
- Take steps to unfreeze credit and money markets
- Ensure that financial institutions have access to liquidity.
After the G7 meeting on Friday, Secretary Paulson outlined the shift in U.S. policy towards one of recapitalization when he said the administration is developing a "standardized program" that would allow the U.S. government to purchase equity in "a broad array of financial institutions." Such authority was recently granted with the passage of the Trouble Asset Relief Program (TARP).
Mr. Paulson said the Treasury was working to get the program under way as soon as possible. "We are not wasting time," he said.
On Wednesday, British authorities unveiled their own plan which includes the injection of tens of billions of pounds, a guarantee of bank debt for up to three years and an expansion of the present Bank of England program for swapping assets for government bills.
In Europe, the Germans have apparently made a complete about-face in policy, in part as an apparent response to the British plan. "We need a level playing field," Bundesbank President Axel Weber told reporters in Washington, saying that an ad hoc approach to rescuing individual banks when they get in trouble, Germany's stated policy until now, wasn't sufficient.
Until now, German authorities have maintained that its financial sector was in good shape and have discouraged efforts at forming a joint EU bailout fund. However the Wall Street Journal, citing German officials and finance executives, is saying that "Germany is preparing a bailout plan for its financial sector that could include recapitalizing banks and guaranteeing their access to liquidity."
The article went on to say that "officials from German Chancellor Merkel's office and the finance ministry have drawn up a list of options that includes the German state injecting capital into some banks, and state guarantees for banks' borrowing."
Meanwhile, a second special meeting of European Union finance ministers has been scheduled for Sunday in Paris. At a similar meeting set up by French President Nicolas Sarkozy last week, a coordinated bailout plan that included a recapitalization program floated by France was rejected.
While there is unlikely to be a region-wide strategy, European nations will announce their intention to implement a plan for recapitalization which will likely include a form of debt guarantees.
"Germany and France are united in that we need an agreed upon, coherent reaction in the euro-zone to the international financial crisis,'' Merkel told reporters.
Merkel said on Saturday that Germany will unveil its strategy to assist banks Sunday evening. The German plan involves "providing banks with sufficient capital so that they are able to operate on their own, and I don't rule out that there could be capital support,'' Merkel said. The government may provide up to 100 billion euros ($134 billion) to recapitalize private banks, state banks and insurance companies.
Market Implications
Whether or not stock markets can first stabilize and begin to react positively depends heavily on the banks' response. The interbank lending markets for anything other than overnight loans are virtually frozen so step one is to look at the various term interbank lending rates. The extent for which those markets can begin the normalization process (the decline in term interbank rates) will govern the extent for which equity markets can do the same.
Written by TheLFB Trade Team, © 2007-2008 LFB Services, LLC. All rights reserved. http://www.TheLFB-Forex.com
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