The Financial Sector Becomes a Call Option
by Charles Lemos, Tue Jan 20, 2009 at 06:56:02 PM EST
It's a good thing that the US markets were closed Monday for the Martin Luther King holiday. Pity they weren't closed today. The DJIA fell below 8,000, losing 4%, its poorest performance on any Inauguration Day since the index was started 124 years ago. The tech-heavy Nasdaq and the broader Standard & Poor's 500-stock index both plunged more than 5%. The S&P is now down 49% since its peak and the DJIA is off 45% from its high.
Leading the collapse is the global financial sector which has in essence become a call option. The catalyst for the collapse was news out of the United Kingdom where shares of the Royal Bank of Scotland plunged 68% on Monday after the bank admits it was poised to report £28bn ($41 billion USD) in losses. The shares fell another 74% today. Stock markets around the world absorbed the news poorly. Sydney was off 4% on Monday. The Nikkei was off 2.3% on Monday and then another 2.6% on Tuesday. In early trading on Wednesday, the Nikkei is off another 1.9%. It has so far lost 10.7% for the year.
Here's the crux of the problem.
The federal government's promise to prevent the failure of large U.S. banks may be exacerbating their problems. As banks sink, financial analysts increasingly are warning that government intervention is inevitable and could come at the expense of shareholders, perhaps in the form of nationalization. This appears to be driving away investors and hastening the intervention. As with the government's summer promise to save Fannie Mae and Freddie Mac, but only if necessary, the last resort has become the expected outcome.
Until banks can attract fresh capital from debt or equity investors, it will be difficult to stabilize and jump-start lending, said Binky Chadha, chief U.S. equity strategist at Deutsche Bank in New York. But the government's patchwork approach to the bailout has would-be investors sitting on the sidelines, he said.
"In each episode of financial intervention, the rules have been a little different," Chadha said. "Hopefully [the new administration] will lay out the rules, and it will be a lot clearer. In the meantime, the textbook model of wiping out the equity holders is clearly a concern, and should be a concern."
The basic problem facing the financial industry, and the new administration, is that banks lack the money to cover their losses. The capital reserves that banks are required by regulators to maintain against losses have been badly eroded.
Financial markets like clarity and transparency and right now there isn't much of that or perhaps better put there hasn't been much as the Bush Administration struggled to find a message. But it is also clear that the level of "toxic waste" runs into the trillions. The US banking industry has acknowledged losses of roughly $1 trillion since the start of the financial crisis. Goldman Sachs last week projected that this total could more than double. Nouriel Roubini, a professor at New York University's Stern School of Business noted for his pessimism, said yesterday that losses could hit $3.6 trillion.
Cleaning this up requires having a team in place forthwith. The TARP has stemmed the market's panic in the Fall, but it has not succeed in stabilizing the financial industry. Timothy Geithner's hearings should proceed as quickly as possible.