Is Uncle Sam embracing market again? /谢国忠

balto

The US government is trying to draw a line at Lehman on bailouts. If it sticks with its new attitude, it marks the beginning of a financial storm. The one-year long crisis has been slow motion, because there hasn't been deleveraging. The financial sector debt rose from $14.8 trillion in 2Q07 to $15.9 trillion in 1Q08. A normal financial crisis means deleveraging in the financial system. The US gov guarantee has allowed the failing financial institutions to hold onto their assets at fictitious valuation. If deleveraging really happens in the US, we must ask three questions: liquidity for unwinding Lehman, re-pricing of risk assets, and a severe economic downturn.



The market storm now is really about liquidity worry over unwinding $600 bn of Lehman's assets and possibly AIG's too. I don't think that the unwinding will take down everyone. The Fed has expanded its role of the lender of the last resort so much that it is hard to see that liquidity problems could bring down the system like one century ago. But, the fear factor will stick with us.



Asset repricing will cast doubts on solvency of several financial institutions. If Lehman sells its CDO's and other toxic assets, the prices will be market prices, possibly quite close to zero. That could force other institutions to mark to market. How many institutions would fail? We don't know. Also, $70 trillion CDS's out there need to be repriced. If Lehman bondholders take a steep haircut, it could break the phalanx of financial institutions that are locked together by the market.



Asset re-pricing would have a big effect on the economy. Cheap credit has fueled the US's consumption. Credit has been cheap because the Fed has been easy and Wall Street has created hard-to-understand products to under-price the risk. The re-pricing means a big reduction in credit to the US's households. The US economy could go through what happened in Asia one decade ago: 4-5% contraction in GDP.



The US's financial system as a whole may have negative equity, I believe. If its leverage assets depreciate 10%, it doesn't have equity anymore. The US's financial system is too leveraged to sustain a significant drop in asset prices. The financial sector's leverage is 137% of GDP compared in 2007 to 100% five years ago and 70% ten years ago. We can argue if leverage should go back to 100% or 70%. The figure is probably between the two. The amount of deleveraging, hence, is over $6 trillion, ten times Lehman's unwinding. That much deleveraging could mean a major reduction in asset prices. But, the US's financial system is too leveraged to sustain a major reduction in asset prices. It may mean the whole financial system is bankrupt.



There are two ways to deal with a financial crisis. The right approach is to let market clear and establish liquid market for bad assets. Markets and economies bottom quickly. That is what happened in Asia ten years ago. The alternative is to hoard bad assets and to allow financial institutions recover slowly from accumulating profits to offset the hidden losses. So far, the US has been on the second path like Japan 15 years ago. The difference is that the US has inflation and Japan deflation due to the US's trade deficit or low savings rate.



Allowing Lehman to fail seems to indicate that the US government wants a market solution. I'm not convinced. The amount of deleveraging is too big for market to swallow. The US gov may be back to the bailout circuit again. Would they let AIG fail? If they bail out AIG, we are back to where it was.



The bottom line: the only solution for the US is to print money to cover up liquidity problems at financial institutions and let them sort out their losses overtime. The market implications are sell dollar, buy gold.