Like children at a funfair with a few quid in their pockets, Gordon Brown and Alistair Darling have dropped their latest coin (this one’s worth 100 billion pounds, or $146 billion) into the whack-a-mole game that is the UK financial market.
And with the Treasury's expensive mallet, Brown & Darling are whacking the head of bank capital. But as anyone who's played this game before knows, once you've whacked one head, another quickly pops-up demanding attention.
That's pretty much what the market reaction this morning has shown to the Treasury's complicated plan to backstop toxic assets in the nation’s banks, purchase more assets in the open market, increase its equity stakes in the more troublesome institutions and ignite lending in an economy that’s sinking more and more rapidly towards recession.
Soon after details began to drip through, we saw instant asset price reaction illustrate that the Treasury's work is far from through. Ten-year Gilt prices fell as traders ditched government bonds (with limp yields) in favor of buying assets like commercial paper, syndicated loans and corporate bonds – in hopes of selling them later on down the line to the Bank of England (at higher prices, natch).
The knock-on effect was to lift Gilt yields, thus making the Debt Management Office's task of Gilt sales (expected to reach a record GBP146 billion this year) that much more challenging. The pound also fell further against the dollar and the euro , as traders grew more concerned about the size of the Treasury’s balance sheet (and that of the Bank of England).
Equity market reaction was perhaps more easy to understand. With the government converting its preference shares in Royal Bank of Scotland to ordinary stock, the bank is cut-loose from the 12 percent albatross hung round its neck back in October (the coupon cost of the preference shares). Good news. However, in classic whack-a-mole fashion, conversion of the preference shares dilutes existing ordinary stock holders in RBS. They were down 35 percent by mid-morning.
Just as the planets re-align to their natural order if one orbit is disturbed, asset prices quickly re-adjust once one it artificially supported (or suppressed) by hands outside of the marketplace. You put your thumb on one side of the scale, the other side rises.
Fair enough, and easily understood. But what are the alternatives? I'm not sure there are many left on the table, to be honest. I firmly believe both the UK and the U.S. (by some distance the two biggest markets in the world for mortgage-backed assets) missed a trick by not simply purchasing those “toxic” bonds and ring-fencing them in what the press is calling the “bad bank”. This was the original idea behind the Hank Paulson “TARP”: cut out the cancer (toxic bonds) and let the banking sector heal itself with the healthy cells it had left.
Now, of course, we can't do that: the toxic assets have infected the healthy cells, and even the banks themselves can't distinguish between performing and non-performing loans. Yet, somehow, the government (through the Bank of England) is going to have to bid for them and, one hopes, pay some form of "fair" value. Good luck.
Of course, all of this is designed not simply to address the needs of the banks (despite what you’re likely to hear or read from some of our more excitable commentators). It's designed to re-establish some form of normalcy in the "real world" credit markets. Mortgage approvals are at decade lows. In 2006, nearly $2.5 trillion worth of new mortgages were arranged. Last year, that number was $700 billion. And corporate lending is declining at a annualized rate of more than 70 percent.
The banks are dying.
Yes, we could let them fail, deliver comeuppance to the "greedy" bankers who steered us into this mess and feel much better about ourselves and our moral clarity in the process. But I don't see the purpose in that.
If the house is on fire, the fact that the owner fell asleep with a cigarette in his hand wouldn't justify letting it burn to the ground.
Our banks, and our very financial system, is now ablaze. We're too late to fix it properly, and our efforts now are going to have unintended consequences, but I'd rather deal with those than the smoldering embers.
So keep thumping the mallet, Mr. Brown and Mr. Darling. Eventually the moles might stop popping up. But keep your pocket full of coins. You're going to need them.