The global credit crisis appears to have intensified on Oct. 6, with equity indexes around the world suffering heavy losses and credit markets still frozen. The market difficulties have caused Wall Street strategists to downgrade their outlooks for the U.S. economy and the stock market.
What's the latest expert thinking on the crisis? Here's a sampling of insights from Wall Street economists and strategists on Oct. 6, as compiled by BusinessWeek and Standard & Poor's MarketScope.
Meyrick Chapman, UBS Investment Research (UBS)
European governments proved unable or unwilling to act together on the banking crisis and so will act apart, therefore potentially exacerbating existing tensions. Germany restarted the route to independent salvation with a unilateral unlimited guarantee of retail deposits over the weekend—after criticizing Irish unilateralism last week. The next stage now looks clear: government recapitalization of banks, each in their own way. But as we await this move, an intervening stage may be necessary to stabilize all patients—both those savable and those not savable.
Before governments finalize who is to survive and under what terms, central banks may have a role. We do not mean monetary easing—though that may occur as well—but a move to guide interbank money markets directly, on-demand and at a central rate. Term funding is a pressing requirement for the entire banking system, and maturing term funding is making the provision of term funding more pressing by the day. If banks will not do it themselves, it is incumbent upon central banks to do it for them with much more frequent term facilities—possibly provided on-demand.
Jan Hatzius, Goldman Sachs (GS)
With the boost from fiscal stimulus gone and the impact of tighter credit conditions working its way into the real economy, U.S. economic activity has decelerated sharply in recent weeks. The intense distress in financial markets—which seems unlikely to dissipate quickly—further darkens the outlook. As a result, we are marking down our forecasts for growth and interest rates substantially. The recession that we have been forecasting now looks likely to be deeper and longer, taking the unemployment rate to 8% by late 2009 and pushing the Fed to cut interest rates to 1% or lower.
The Treasury's Troubled Asset Relief Program (TARP), which was passed by the House of Representatives on Friday and signed into law, will have $700 billion in capacity to purchase and guarantee illiquid and distressed assets. The program should free up capacity on bank balance sheets and encourage the recognition of losses. However, the program does less to recapitalize banks directly, leaving a gap in the policy response. An important question is whether the government will formulate a recapitalization strategy as well, or whether it will pursue an informal approach led by the FDIC. Several questions remain. The most important is the pricing of the assets the program purchases. This will have a significant impact on the participation of the program, as well as the cost to the government. Details regarding the purchase mechanism and the range of assets to be purchased also remain undetermined.
Larry Hatheway, UBS Investment Research
Today, UBS economists published revised forecasts for 2009. The conclusion is clear: The world is entering a recession. The fundamental challenge is to earnings and cash flows. But perhaps the most important determinant of the investment call is what multiple investors are willing to assign to those earnings. Prevailing valuations—adjusted for likely earnings weakness—appear fair, but in the current uncertain environment, valuations alone are unlikely to be the catalyst for market recovery. Policy change could make a material difference.
The chief challenge now, however, is posed by dysfunctional interbank credit markets, which have yet to respond to liquidity injection. Until normalcy returns to the banking system, risk assets appear unlikely to sustain recoveries. The sole change in our allocations is to trim industrial metals to underweight and to add to U.S. Treasuries on expectations of economic weakness. We retain a preference for high-quality investment-grade corporate bonds and for U.S. equities among regional markets.
Michael Wallace, Action Economics
The U.S. financial rescue plan that passed with a healthy margin in the House and was signed into law by President George W. Bush on Friday represents the beginning of the next phase of the credit crisis rather than the end. To avoid a cascading collapse of the global financial system, Herculean efforts will be required to implement the plan and scour banks of their frozen mortgage assets, with the establishment of price discovery by the government as the primary measure of success. The Fed and Treasury will continue to have to train the full power of their broadening mandates on the liquidity crunch to keep the economic wheels greased to combat ever-tightening lending conditions. The risk of coordinated rate cuts remains elevated, with regularly scheduled policy meetings by central banks in England, Australia, Japan, and other Asian nations [providing] potential cover for a more aggressive monetary policy response to the global margin call.
David Wyss, Standard & Poor's (MHP)
The Federal Reserve announced an increase in the size of its 28-day and 84-day Term Auction Facility to $150 billion each. The two November auctions will be increased by the same amount. The move is intended to help bring down rates in the interbank market by providing an alternative source of term funding. The increases would add $600 billion by yearend. The Fed also announced it will begin paying interest on reserves held by member banks at the Fed. This change has been discussed for years and was approved to begin in 2011. The new legislation moved up the effective date. The actions are not major but are clearly intended to provide more liquidity and try to calm markets.
Tony Crescenzi, Miller Tabak
Counterparty risks would plunge if the Fed acted as a go-between on cash-for-collateral transactions. The Fed can accomplish this by acting as clearinghouse in intraparty repo transactions. For example, one solution to the confidence drought is for the Fed and other central banks to announce they will act as clearinghouses for regulated banks and securities firms for exchanges of cash-for-collateral. The Fed would take on a role often performed by large banks operating in the so-called tri-party repo market, wherein banks act as a go-between between counterparties. In a tri-party repo, banks not only know both sides of a repo transaction, they also hold the collateral put up by the dealer or bank seeking cash-for-collateral.
Trust has broken down so severely that only the Fed and other central banks can restore it, it seems. The main goal in having the Fed act as a clearinghouse would be to reduce or eliminate any fear that counterparties might have in dealing with each other. There is very little risk to the Fed in acting as a clearinghouse because the securities pledged in tri-party repos are free from a third-party lien, charge, or claim. Any securities the Fed takes in would be segregated from other securities the Fed might be holding.