Fixing the finances

Governments around the world are convinced that a mixture of capital injections, debt guarantees and sterner oversight will tide markets over until animal spirits return. But how are we supposed to know if those plans are actually working? Share prices, the most widely watched barometer, don’t help much.  Stocks are undergoing a massive recalibration as investors weigh a slimmer chance of failure against scrapped dividends, huge dilution through new issuance and fundamentally lower returns on equity.

The one constant of the various aid packages is that bondholders benefit at the expense of shareholders. But prices on the protection of that debt are also misleading. Credit default swap (CDS) prices will surely fall, just as the Irish banks’ spreads have eased since Dublin broke ranks a fortnight ago to guarantee all debt out to a two-year maturity. But the credit risk has simply been transferred to the supporting sovereign, which is now more hamstrung than before. What British Prime Minister Gordon Brown has glossed over, for example, is that he has just added almost half as much again to the U.K.’s borrowing requirement this year.

That leaves interbank lending rates as the most obvious index of stress relief. But even they don’t illuminate. With guarantees now available for new bank debt, rates should, in theory, be tumbling. That they aren’t – three-month dollar Libor on Tuesday was down only a few basis points from last week’s record high of 4.82% – suggests the fear of counterparty risk lurking elsewhere in the system. Non-bank counterparties such as hedge funds and insurers account, on a gross basis, for about half of buyers and sellers in the CDS market.

Longer-term funding markets, meanwhile, remain frozen. No bank wants to set a pricing benchmark this side of year-end, and all are hoarding cash to ensure they don’t have to. Until more institutions tiptoe back in, judging the success, or otherwise, of these initiatives will remain difficult.

Meanwhile, markets are clapping their hands, if no longer roaring their approval, at the latest proposals to end the financial crisis. Yet policy is still being made on the hoof. Optimists hope that, after a number of false starts, authorities around the world are closer to finding the right means to restore calm. Learning from their mistakes, officials are adapting. But that is hubris. The reality is that questionable decisions are just as likely now as three months ago.

Worse, experience risks being swamped by rushed initiatives as the sense of panic builds. Just imagine how many communiqués are being written deep into the night in order to hit the TV screens before the opening bell. Certainly, the latest announcements in the U.S. that the Treasury will start buying equity stakes in banks seem to be a reaction to the stock market plunge last week, not to mention the praise for a similar move in the UK.

Sure, the authorities have to help restore confidence in financial markets. But worrying about stock prices is a mistake however nice it is to reassure taxpayers that they may share in any gains. After all, companies, including banks, can technically exist with negative shareholders’ equity. And perspective has been lost amongst all the huffing. The U.S. government only proposes to own stakes in banks equivalent to between 1% and 3% of their risk weighted assets. With asset prices still falling, that can be wiped out in no time.

As before, then, only banks with the strongest balance sheets will survive. More important is that the state guarantees of senior debt and loosening of collateral rules required to borrow from central banks will help lending. Besides that, banks were up in the U.S. on Tuesday, but the market as a whole was not. This suggests that the broader economy remains the bigger concern.