“Now, this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”—Winston Churchill, November 10, 1942
When Churchill made his famous statement following the allied victory at El Alamein in North Africa, he was warning the public not to be too optimistic, and to expect the war to continue for a long time. It now seems clear that the financial crisis will last a long time. I want to suggest here that we are at the “end of the beginning” of the financial crisis, about to enter a new phase. Unfortunately, this is not an optimistic statement, merely an assessment. The government is fast running out of policy options that bear any resemblance to “free market” policies. What remains is for the federal government to run everything. And this is what is gradually occurring. The challenge will then be for the government to undo all of its intervention as quickly as possible.
Consider (if you can bear it) the situation this week:
- Banks have stopped dealing with each other, with the Fed serving as primary lender to banks.
- Financial firms are not making loans.
- Credit default swap (CDS) prices for financial firms remain at record levels. (Corresponding to the high CDS quotes, the debt of these firms is trading at very low prices.)
- Commercial paper outstanding is falling and the bulk of issuance is at very short maturities.
- California, unable to borrow in municipal markets, may ask to borrow $7 billion from the federal government. Massachusetts also faces borrowing difficulties, as presumably do other states.
- AIG was granted an additional $37.8 billion to stave off default.
- European governments are now facing similar situations, increasing insurance on bank accounts, rescuing financial institutions, and (in the case of Iceland) trying to stave off national bankruptcy..
You’ll notice that I didn’t even mention the stock market.
Two other news items in the last week make me think we have finally reached the end of the beginning.
First, the Federal Reserve has created a facility to buy 3-month commercial paper (short-term bonds issued by firms). The fed will essentially swap Treasury bills for commercial paper (CP), doing exactly what my colleague Arvind Krishnamurthy described in his blog entries (here and here). Firms issue commercial paper and the government buys it, effectively replacing the commercial paper with government bonds. Most importantly, this will prevent a major firm from going bankrupt simply because it cannot issue CP to pay off CP coming due. General Electric, for example, had $63 billion of commercial paper outstanding in June. As that paper comes due, GE must issue new paper (or sell assets) to pay it off. The government will have to do whatever is necessary to keep the CP market running.
Second, the Treasury is seriously considering taking ownership stakes in banks, which it is permitted to do under the bailout bill. The purpose will be to provide capital to weak institutions, and the Treasury will presumably then be in a position to urge these banks to resume lending.
The executive summary is this: the federal government is taking over US credit markets. We are no longer talking about technical hacks and tweaks such as lowering the discount rate, the Fed accepting risky collateral when lending to banks, or the Treasury buying mortgage-backed securities. We are talking about direct federal intervention, with the government buying and selling assets and taking ownership. What else is left? We have to hope that once the government has fully intervened, stabilized the situation, and can do no more, then capital markets will start working again.
There is an irony and a danger here. At this time, the government is the only agent in a position to intervene, but the government is also part of the problem. No private solution will emerge with the government hovering in the background, making decisions on the fly (will a particular institution be rescued or abandoned?) and essentially commandeering markets. This is not to criticize the Fed and the Treasury, but we must recognize that commitments of private capital will require clear ground rules. At the moment, with the situation fluid and constantly changing, only the government can act. Having acted, the government will then quickly need to stabilize the rules that enable and encourage private action.
[Update: Mitsubishi UFJ Financial Group has reached agreement to invest $9 billion in Morgan Stanley. In order for the deal to go through, US government officials had to assure Mitsubishi that their interest would be protected in the event of a future Morgan Stanley bailout. I’ll emphasize two points here: first, fear of government action almost prevented a deal, and second, the US government is now a contingent equity holder in Morgan Stanley. ]