Market Mania

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It didn’t take much to pop the euphoria that followed last weekend’s massive global bank bailout: a few bits of data that remind everyone that the American economy is rapidly contracting, and the stock markets head south with a vengeance.

How many times can Paulson’s bailout fail before any money has actually been spent?

Admittedly, that’s unfair; stock market surges or crashes are the wrong litmus test for what governments have done so far. At least the Americans and the Europeans acted, after months of hoping the problems would manage themselves.

But, we need to recognize that we are far closer to the beginning of the solution than to the end.

First, all the headline actions of the weekend (plus the $700 billion) had one purpose: to build a fence around maybe 20 major U.S. and European financial banks. Those banks—and some others, if possible—are the appointed survivors of the financial nuclear winter that continues to rage.

Since a week ago, several of those banks looked like they might follow Bear Stearns, Lehman Brothers, Merrill Lynch, Washington Mutual and Wachovia into extinction. That is an enormous accomplishment, but it could not possibly end a financial crisis whose root cause is a recklessly over-leveraged financial system. The ring fencing was no more than the first installment in an effort to manage the pace at which the de-leveraging is taking place.

Second, the rest of the financial system has, so far, been left to fend for itself. Insurance companies (other than AIG), pension funds, institutional investors and—above all—hedge funds are all potentially on the endangered species list. Many of them can’t wait for the government to act, as they desperately need cash to cover margin calls or fund withdrawals. That makes them motivated sellers—whether the market is going up or down.

The Financial Times is reporting that the $2 trillion hedge fund industry had withdrawals of at least $43 billion last month, and that outflows are probably running at a higher rate in October. According to a JP Morgan analysis, $43 billion in cash withdrawals would represent $115 billion in asset sales, since hedge funds used so much borrowed money to goose returns.

This means that every time the market tries to rally, there will immediately be sellers who simply need cash. Until that dynamic is exhausted (or the government changes the rules), it is hard to imagine any kind of sustained market recovery.

Third, the collapse of stock values around the world has real-life consequences. America may not have much of a savings rate, but millions of retired people have been living off of their savings, and millions more depend on investments to finance college costs and other extraordinary expenses. Those funds are badly depleted—but the needs remain. Again, whole classes of sellers who will sell at any price.

The point is that saving some banks is a good first step, but no more than a first step.

 

– Alan Stoga