Is the worst over? For the first time since financial turmoil began in August last year, some respected experts are beginning to speculate that the worst of the credit crisis may now be past.
Stanley Fischer, governor of the Bank of Israel, says the Bear Stearns rescue might be a “turning point”.
His view is shared by Larry Summers, the former US Treasury secretary, who wrote in the FT last week: “It is not unreasonable to hope that, in the US at least, the financial crisis will remain in remission.”
Some analysts also agree. “Increase risk exposures,” JPMorgan advised clients in their latest research. The US stock market is up 8.6 per cent from its March low.
This turn in sentiment is based on the idea that radical action by US authorities has put a floor under the financial system.
Even before the Bear Stearns rescue, US policymakers were ramping up efforts to boost market liquidity. But the Bear action demonstrated that they were willing to take on not just liquidity risk but also credit risk rather than see Bear default.
The market concluded that if Bear was too inter-connected to fail when markets are fragile, all other large commercial and investment banks are too, and the US government is now in effect providing a credit backstop to all of them.
Policymakers dispute this, arguing that the Bear rescue was only possible because JPMorgan was willing to acquire the company.
But the market view is clear. Since the Bear rescue the perceived riskiness of lending to US financial institutions as measured by the credit default swaps (CDS) market has fallen sharply.
Meanwhile, international discussions about possible public intervention in financial markets – while only at the brainstorming stage – have increased confidence such actions would be forthcoming if markets took another turn for the worse.
The “tail risk” of a disastrous outcome – involving a collapse of the US financial system – looks greatly reduced. Appetite for risk could gradually return. The reduction in risk of lending to US financial institutions could lead to broader easing in credit market strains.
The unusually high rates charged by banks on loans to each other in the interbank money market could come down, while the reduced likelihood of a severe credit crunch might in turn improve prospects for non-financial companies.
However, since the Bear rescue, interbank lending rates and credit spreads on corporate debt have not improved much.
Perhaps it is a matter of time. But there are reasons why the broad credit market may not improve in tandem with the bank CDS market.
While investors in Bear Stearns’ debt were made whole by the rescue, its shareholders lost heavily. Executives at US financial institutions may still hoard cash to minimise the risks to their shareholders.
Balance sheets remain clogged up with loans that cannot be sold at reasonable prices. If the secondary markets for loans remain dysfunctional, lenders may scale back new credit regardless of their cost of funds.
Meanwhile, deleveraging is likely to continue, especially among hedge funds put at a competitive disadvantage by the support for investment banks.
Moreover, the downturn in the US economy is only in its early stages. Job losses so far are not disastrous and many mortgage-backed securities already discount high default rates.
But the US consumer faces rising unemployment, energy- and food-price increases, falling housing wealth and tight credit conditions.
“This recession could end up being worse and more protracted than ones most recently experienced,” says Brian Belski, strategist at Merrill Lynch.
As the economy weakens, defaults on non-housing loans could rise more rapidly than expected, putting stress on the largely untested bilateral CDS market.
Even if the worst of the market-generated stress is over, the feedback loops that link the financial system and the economy may start running in reverse – from a deteriorating economy to the markets rather than vice-versa.
“The events of mid-March probably marked a peak in the financial firestorm,” says Richard Berner, chief US economist at Morgan Stanley. “Now comes the economic fall-out.”
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