Reaction to the G7 Communique
The loss of an estimated $25 trillion of global stock market capitalization thus far in 2008 drove home to leaders of the G7 the gravity of the financial crisis as they met in Washington D.C. over the last three days. We argued that three things ideally needed to emerge from the G7 meeting: (i) a plan to recapitalize the banking system; (ii) a plan to guarantee all interbank lending for a period of at least one year; and (iii) a term lending program for private capital to buy troubled assets. Analytically we argued that the problem was no longer a lack of liquidity but a lack of confidence. Central banks could inject all the liquidity into the money markets that they wanted but unless financial institutions were adequately capitalized and interbank lending was guaranteed, we felt that a lack of confidence threatened to deepen the freeze in the money markets with institutions unwilling to lend to each other.
The events of the weekend can be broken up into (i) the G7 communiqué; (ii) U.S. Treasury Secretary Paulson's press confidence on Friday night; (iii) the plan announced by the Euro-15 nations after the G7 communiqué; (iv) the further broadening of access to liquidity for financial institutions by global central banks; (v) other developments and announcements. Where do we stand relative to our wish list? The truth of the matter is that there was good news (e.g. the focus on the need to recapitalize financial institutions) and not so good news (particularly the lack of a coordinated guarantee of interbank lending and, contrary to Paulson's assessment at the press conference on Friday, we do not consider ourselves "naïve" in looking for such an outcome). On balance, however, there appears to be more good news than bad news and we would look for some easing in LIBOR pressures and some stabilization in equity values in the days ahead. However, we are disappointed that the G7 did not announce a plan that looked like a global version of the U.K. plan developed by Chancellor Darling and announced last week.
(i) The G7 Communiqué
The G7 communiqué was a statement of principles rather than a plan. However, the principles were at least focused on how to tackle the financial crisis. Below is the full text of the statement (we have broken up the bullet points for clarity):
"The G-7 agrees today that the current situation calls for urgent and exceptional action. We commit to continue working together to stabilize financial markets and restore the flow of credit, to support global economic growth. We agree to:
1. Take decisive action and use all available tools to support systemically important financial institutions and prevent their failure.
2. Take all necessary steps to unfreeze credit and money markets and ensure that banks and other financial institutions have broad access to liquidity and funding.
3. Ensure that our banks and other major financial intermediaries, as needed, can raise capital from public as well as private sources, in sufficient amounts to re-establish confidence and permit them to continue lending to households and businesses.
4. Ensure that our respective national deposit insurance and guarantee programs are robust and consistent so that our retail depositors will continue to have confidence in the safety of their deposits.
5. Take action, where appropriate, to restart the secondary markets for mortgages and other securitized assets. Accurate valuation and transparent disclosure of assets and consistent implementation of high quality accounting standards are necessary.
The actions should be taken in ways that protect taxpayers and avoid potentially damaging effects on other countries. We will use macroeconomic policy tools as necessary and appropriate. We strongly support the IMF's critical role in assisting countries affected by this turmoil. We will accelerate full implementation of the Financial Stability Forum recommendations and we are committed to the pressing need for reform of the financial system. We will strengthen further our cooperation and work with others to accomplish this plan."
These principles are comprehensive and, if policies are designed with them in mind, we should see a significant easing in the credit and money market freeze over the next few weeks. We are pleased that the G7 members are seeking to prevent the failure of financial institutions and the key phrase is "Take all necessary steps to unfreeze credit and money markets."
(ii) Paulson's Press Conference
We were disappointed that Paulson did not embrace the notion of guarantees of interbank loans. Indeed, he suggested that some commentators were "naïve" if they expected a coordinated plan in this regard. Perhaps it was naïve of us to expect the G7 to follow the outline of the terrific plan formulated by the U.K. government. The U.S. TARP plan, however, looks likely to be reworked to inject capital into U.S. financial institutions. However, in a global capital market, individual country solutions may be suboptimal to a global solution. One of the things to key on this week is the fate of Morgan Stanley and the proposed capital injection from Mitsubishi UFJ is reportedly being renegotiated (hardly surprising given the near-60% drop in Morgan Stanley's stock price last week). One of the sticking points appears to be the concern on the part of the Japanese that if Morgan Stanley has to be put into conservatorship (like AIG and the GSEs), the holders of preference shares could suffer severe losses. However, more encouragingly, Dallas Fed President Fisher told the IIF this weekend that "the Federal Reserve will do whatever it needs to do to be a credible backstop for the financial system" and added that the Fed will explore every avenue and option to ease credit conditions in the current crisis. We hope one thing that the Fed does is to include wholesale bank CDs (an important source of bank funding) in its CPFF program. Bank wholesale CDs carry similar ratings as bank CP and we hope the Fed will correct this potential oversight.
(iii) Euro 15 Actions
Following the G7 meeting, a summit of the leaders of the Euro 15 nations, chaired by French President Nicolas Sarkozy, worked on a plan for the European financial system. Sarkozy said "we need concrete measures, we need unity, which is what we achieved." The key measures were: (i) a promise to guarantee through end 2009 bank debt with maturities of up to five years; (ii) approval for governments to buy bank stakes (a necessary exemption given European competition rules); and (iii) a commitment to recapitalize systemically important banks in distress. This meeting went much better than the summit that took place eight days earlier and suggests that European leaders appreciate the importance of the problem. We would also argue that this plan is more concrete than the G7 communiqué.
iv) Early Monday morning, major global central banks announced further measures to provide access to liquidity and funding to financial institutions. The ECB, Bank of England and Swiss National Bank will offer unlimited U.S. dollar funding via 7-day, 28-day, and 84-day auctions. These funds will be provided at a fixed interest rate, set in advance of each operation. To support these auctions, the sizes of the reciprocal currency arrangements between the Fed and the ECB, BoE, and SNB will be increased to accommodate whatever quantity of U.S. dollar funding is demanded. In addition, the Bank of Japan will considering introducing similar measures.
(iv) Other Developments
Other countries outside the U.S. and Euro-15 are taking steps to address the crisis. Oil-rich Norway, for example, announced a plan to swap up to 350 billion kroner ($55 billion) of government debt for mortgage assets, which can then be used as collateral for borrowing (this appears to be similar to the TSLF). It appears in the U.K. that HBOS and RBS are at the top of the action list, with some reports suggesting that the U.K. government may take majority stakes in both firms.
Despite our disappointment at U.S. resistance to guarantee interbank loans, it appears that a lot of action is being taken to stabilize the financial system on an unprecedented scale. Moreover, if at first policymakers do not take dramatic enough action, they seem capable of revising their plans. We said the markets needed shock and awe tactics and the steps that have been taken so far are very significant. If markets continue to melt down, we would not be surprised by a global guarantee of interbank lending.
Many of these programs will take time to implement and there may well be a few rough trading sessions over the next few weeks. Nonetheless, it is our hunch that the scale of the promised interventions may put the worst of the market drops behind us. Indeed, European equities markets and U.S. equity futures have rallied strongly on these announcements. Confidence will take time to restore but this is an entirely different response than met the Wall Street Crash of 1929 and the risk of an extreme economic outcome has, in our view, diminished significantly. We are still in a U.S. and (likely) a global recession, but the equity markets have discounted an awful lot of bad news and we are feeling more neutral on the outlook for stocks. We will be watching LIBOR and EURIBOR resets carefully over the next few days as an important barometer of the progress that is being made in stabilizing the financial system. This morning, LIBOR rates were little changed as, for example, three-month U.S. dollar LIBOR fell to 4.75% from 4.82%. We expect the Fed to follow up these measures with a rate cut on October 29th and we have a year-end funds target forecast of 1%.