The rejection of the $700 billion rescue package by the US House of Representatives last night means that Tuesday, 30th September 2008 will go down as one of those days when the course of history changed.
Willem Buiter, as usual, gets it exactly right:
What is likely to happen next? With a bit of luck, the House will be frightened by its own audacity and will reverse itself. If a substantively similar bill (or a better bill that addresses not just the problem of valuing toxic assets and getting them off the banks’ books, but also the problem of recapitalising the US banking sector) is passed in the next day or so, the damage can remain limited. If the markets fear that the nays have thrown their toys out of the pram for the long term, the following scenario is quite likely:Today will not be pretty. Anyone with a pension, savings or investments has got a ringside seat, and is going to get splattered. Bring a towel.
- The US stock market tanks. Bank shares collapse, as do the valuations of all highly leveraged financial institutions. Weaker versions of this occur in Europe, in Japan and in the emerging markets.
- CDS spreads for banks explode, as will those of all highly leveraged financial institutions. Credits spreads generally take on loan-shark proportions, even for reputable borrowers. Again the rest of the world will experience a slightly milder version of this.
- No US bank will lend to any other US bank or any other highly leveraged institution. The same will happen elsewhere. Remaining sources of external finance for banks, other than the facilities created by the central banks and the Treasuries, will dry up.
- Banks and other highly leveraged institutions will try to unload assets at fire-sale prices in illiquid markets. Even assets not viewed as toxic before will become unsaleable at any price.
- The interaction of a growing lack of funding liquidity and increasing market illiquidity will destroy the banks’ business models.
- Banks will stop providing credit to households and to non-financial enterprises.
- Banks will collapse, both through balance sheet insolvency and through liquidity insolvency. No bank will be safe, not even the household names for whom the crisis has thus far brought more opportunities than disasters.
- Other highly leveraged financial institutions collapse on a large scale.
- Households and non-financial businesses revert to financial autarky, among wide-spread defaults and insolvencies.
- Consumer demand and investment demand collapse. Unemployment shoots up.
- The government suspends all trading in financial stocks until further notice.
- The government nationalises all US banks and other highly leveraged financial institutions. The shareholders get nothing up front and have to wait for an eventual re-privatisation or liquididation to find out whether they are left with anything at all. Holders of bank debt get a sizeable haircut ‘up front’ on the face value of the debt and have part of the remainder converted into equity that shares the fate of the old equity.
- We have the Great Depression of the 2010s.
None of this is unavoidable, provided the US Congress grows up and adopts forthwith something close to the Emergency Economic Stabilization Act as a first, modest but necessary step towards re-establishing functioning securitisation markets and restoring financial health to the banking sector. Cutting off your nose to spite your face is not a sensible alternative.
PS My remaining financial wealth is now kept in a (small) old sock in an undisclosed location.
PPS The conduct of both US Presidential candidates in this matter makes them unfit for purpose.
POSTSCRIPT - 20.13 GMT
The markets are up - all of them. I hang my head in shame, sackcloth and ashes have been donned. I fell victim to my own Narrative Fallacy: as if billions of decisions by millions of people to buy or not buy stocks could be reduced to a story about a vote by a handful of politicians in the USA. When will I ever learn? Mind you, the Irish Government's decision to guarantee all deposits did lead to a rally in the ISEQ, and maybe all the other stock markets - oops, there I go again: slap-wrist! Man, it's hard to lose that god-damn Narrative Fallacy habit: think I'll stick to weather forecasting and the 3.15 at Chepstow - way better odds of getting it right ...