Financial Pandemonium

Metastasis

What began as a housing bust and credit crunch has metastasized into a full-scale financial meltdown. Banks have found that the securities they bought with depositors’ money are now worth far less than they could imagine. Bank write-downs have reached $792 billion offset by $826 billion in capital raised. ^ $380 billion of the capital raised represents public monies. ^

Lender of Last Resort

Several first-round investors, including sovereign wealth funds, billionaire financiers, private equity and hedge funds have lost their investments. It now appears no one will give financial companies any more money. As a result, the taxpayers, through their proxies – the Treasury and the Fed – are the ‘lender of last resort’.

Shouldn’t We Just Let Them Fail

The alternative to the lender of last resort is to allow the financial system to implode and see what rises from the wreckage. This solution may not be particularly palatable as the adjustment could be harsh (riots, populism, massive layoffs, deflation, hyperinflation) and what could emerge on the other side is a much smaller economy, lower incomes, higher unemployment, and potentially a much different political landscape.

Seizure and Liquidation

When a bank’s reserves fall below a certain level we have instructed the FDIC to seize those banks and liquidate the assets. When this happens to our biggest banks, we have to decide if this liquidation process would heighten the level of anxiety, induce further financial pandemonium and potentially compound the problems in the economy.

Capital Injections and Nationalization

The alternative to seizure and liquidation is for the taxpayer to inject capital into these institutions. Nationalization is the process where the taxpayer takes ownership stakes in systemically important financial firms. The dilution of the existing shareholders is good because it essentially makes them pay dearly for their foolishness.

Eatin’ Boiled Crow

Hopefully, we are getting closer to the beginning of the end of this mess. A healthy and efficient financial system enables our economy to be far more productive than otherwise. To return to health will likely mean that the so-called toxic assets are quarantined. The quicker we ‘eat crow’ – i.e. the banks clean up their balance sheets -- the sooner the economy can begin a recovery.

Written by Jason McMillen, Chief Investment Strategist, PPWM

^ International Monetary Fund, Global Financial Stability Report, Update, January 2009, Updated as of January 26^th, 2009.