Concerted Action Creates A Few Glimmers Of Hope In Crisis Of Confidence

The Age

Friday October 10, 2008

Malcolm Maiden

The markets were calmer after the intervention than they were before it.

EVENTS in the next few days will determine whether the markets can rebuild confidence following Britain's extraordinary bank support package and the co-ordinated round of rate cuts. The Australian sharemarket's 1.5% fall yesterday was part of a complicated matrix of responses to the British intervention and the rate cuts that were, on balance, positive.

Other Asian markets rose, and Taiwan, South Korea and Hong Kong followed China in cutting rates after Wednesday night's half a percentage point rate cuts by the US Federal Reserve, the European Central Bank, the Bank of England, the Bank of Canada and Sweden's Riksbank.

Another mildly encouraging note was sounded by the Reserve Bank's second US dollar swap auction yesterday, which put $US10 billion ($A14.6billion) into the system for 95 days (a term designed to push the liquidity injection into the new year, to ease year-end funding needs) at an average yield of 3.487%. Similar central bank auctions overseas earlier this week produced yields above 4%: the lower yield on yesterday's auction suggests there is less stress, here at least.

Since the Wednesday night intervention, northern hemisphere interbank rates (the rates the private-sector banks are charging each other for funds) have not fallen from highs that equal those set in late December and January, when the crisis escalated.

But even that superficially bearish fact has a silver lining: interbank rates have not yet moved down, but there was an improvement yesterday in the actual amount of bank-to-bank lending.

That is a crucial qualifier, because the real aim of central bank and government efforts is to unlock the northern hemisphere debt market (Australian interbank lending has not frozen in this crisis, which is a measure of the relatively higher quality of its participants). So much liquidity has now been injected into the system worldwide that there is no longer a liquidity shortage overall. Rather, there is a liquidity drought in the parts of the system that need it most, as those with higher-quality assets convert them to cash in swaps with central banks, but then hoard the dough, out of fear that banks seeking to borrow it will not be good for their debts.

And that fear of lending stems from the core problem: uncertainty inside the private-sector banks about how much junk other banks are holding - uncertainty, in the end, about whether their balance sheets are in the black.

We now have two converging plans to deal with this core problem. The first is the US Government's $US700billion bad-debt bail-out, which would literally lift junk debt out of the American banks and place it onto the Government balance sheet, where it would be managed on a life-of-loan basis.

The second is the British variant unveiled on Wednesday night, in which the Government takes direct equity in the banks, up to #50 billion ($A127billion) worth in Britain's case, supplies immediate liquidity of at least #200billion by whatever means are necessary, and stands behind the banks, if asked, at a commercially negotiated price, as guarantor for debt issues. The British Government estimates that program could run to another #250 billion.

The US plan actually cuts bad debt out of the banks but the British plan does not. Given that the crisis revolves around uncertainty about how much bad debt the private-sector banks are holding, America's plan scores on that point. But it looks lightweight compared with the British response and, after a week of congressional meddling before its passage, is complicated.

But there are signs that the US plan is gravitating towards Britain's plan B. The bill creating the $US700 billion buy-out fund gives the US Treasury the ability to inject cash into banks in return for equity, and it is reported to be considering doing so on a wide front. Treasury Secretary Henry Paulson says he will use all the bullets in his belt, "including strengthening the capitalisation of financial institutions of every size".

Each escalation in government support creates a new benchmark that other governments are pressured to match, of course.

There is hope of a co-ordinated response emerging from the Group of 7 meeting that starts later today, but it is no vaulting hope. G7 meetings tend to produce outcomes of the lowest common denominator, and each country faces specific issues that would not uniformly respond to omnibus prescriptions.

And there is still the overarching question of what economic damage this crisis has wrought, with the International Monetary Fund weighing in to predict that the big northern hemisphere economies will either be in recession or flirting with it next year, with offsetting but reduced positive impetus coming from Asia and its quarry, Australia.

Still, the Wednesday night intervention did appear to have done something worthwhile. The markets were calmer after the intervention than they were before it. Given what has happened in the past month, that was an achievement and, hopefully, something to build on.

MY REMARKS yesterday about how Commonwealth Bank is paying relatively less for BankWest than Westpac will pay for St George prompted a Westpac groupie to point out that the market's plunge has improved Westpac's share-swap deal, pulling the historical price-earnings ratio down from 16.8 times to less than 14 times, and the price-to-book value ratio down from 2.7 times to about 2.2 times.

St George also appears to have better earnings momentum, but BankWest is still a crisis cracker for CBA, changing hands at 80% of book value and 11.2 times earnings.

mmaiden@theage.com.au