SERIOUS MONEY:AMERICA'S AILING financial system was shaken to its core at the weekend as actions by the Federal Reserve and the US treasury demonstrated that the authorities would not backstop beleaguered institutions on demand.

The rescue of Bear Stearns, orchestrated by the Fed in March, alongside the quasi-nationalisation of Fannie Mae and Freddie Mac last week created the impression that the authorities would backstop any financial institution of sufficient size that might falter.

The authorities thought otherwise, refusing to risk taxpayer funds to save Lehman Brothers against a background of mounting concerns about moral hazard and reduced political appetite in the face of rising unemployment.

The Fed chose instead to provide additional support to financial markets primarily via the acceptance of a broader range of collateral in return for money through the various new credit facilities created by the Fed since last summer in an effort to ease the logjam in credit markets.

The refusal to save Lehman plunged the 158-year-old investment bank into bankruptcy and pushed troubled Merrill Lynch into the arms of Bank of America.

It was a brave decision but, predictably, chaos reigned across financial markets on Monday as stock prices experienced the largest one-day percentage drop since the attacks of September 11th, 2001.

Volatility in credit markets was even more pronounced and debt spreads soared as market participants sought out the safety of treasury bonds.

Furthermore, a surge in liquidity demand saw the overnight Fed funds rate – at which banks borrow reserves from each other – soar to 6 per cent, or four percentage points above the target rate, while the spread between three-month dollar Libor and overnight index swaps, a measure of interbank funding pressures, jumped to a cycle high of almost 120 basis points.

The Fed responded quickly via the provision of $120 billion in funds over Monday and Tuesday and spreads remain at record levels.

The Fed and the US treasury were correct in refusing to save Lehman as, unlike Bear Stearns six months ago, the investment bank has had plenty of time to put its own house in order, and the moral hazard embedded in a government-sponsored rescue would have sent the wrong message to Wall Street.

Banks such as Lehman Brothers have so far avoided the balance sheet restructuring necessary to reduce leverage and chose instead to hoard liquidity via the Fed’s credit facilities.

In the process, they have passed risky assets to the authorities. This game is now up and financial institutions have little option but to deleverage through asset sales and the issue of new equity, but this process is not without risk.

The deleveraging process has already begun, but the banking system still remains undercapitalised with the ratio of equity to assets dropping half a percentage point over the past 18 months, despite significant new share issuance.

Balance sheets will continue to weaken as sustained economic malaise leads to deteriorating asset quality across mortgages, motor loans, credit cards and leveraged debt, while asset sales will cause further deflation of asset prices and writedowns thereof.

Cumulative asset writedowns in the US alone are likely to come to $400 billion and, even allowing for the boost to capital provided by retained earnings and the issue of equity, the decline in credit to households and firms could still easily reach $1 trillion, given that leverage ratios are sure to fall in a post-Wall Street world.

This will deliver a sharp blow to the real economy and therefore cannot be allowed to happen.

The Fed is well aware that it faces an unenviable task of jump-starting the economy in the face of money supply destruction and declining velocity.

Indeed, money supply has been contracting in real terms for almost six months and the scarcity of funds has contributed to recent dollar strength, the deflation of commodity prices and a sharp drop in inflation expectations.

Unfortunately, the scarcity has also resulted in continued stress across the credit markets and further bank failures.

The decline in inflation expectations, combined with the rapid deterioration in economic conditions overseas, means that the Federal Reserve is likely to turn on the monetary spigots in order to prevent outright contraction in the money supply and the economic morass that would inevitably follow through uncontrolled banking failures and further money supply

destruction.

The Fed has elected, for now, to leave its target policy rate unchanged because it is largely irrelevant at present, given the current scarcity of funds and the dislocation of credit markets thereof.

The increased availability of money, and not policy rates, is critical to alleviating the stress, so quantitative measures are likely to be the Fed’s preferred option.

In essence, it’s all about the supply of money.

The US authorities are moving in the right direction and, in refusing to save Lehman Brothers, have demonstrated intent to allow insolvent institutions to fail, unlike the Japanese experience of the 1990s.

The credit crisis has entered a new phase of deleveraging and consolidation that will involve economic pain and continued market volatility.

The stock market is exhibiting signs of capitulation but now is not the time to be brave.

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