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We’ve moved from the imminent collapse of bank balance sheets and trade credit to the work-out phase, both in the real economy and for the national debt now underpinning the banks.

Tim Duy via Economist’s View says:

Once the deleveraging is complete, foreign investors will realize they are now awash in Dollar denominated assets at a time when the US Treasury is expected to unleash an unprecedented quantity of such assets on global financial markets. The Dollar and commodities will reverse direction accordingly… I admit to being sympathetic to this story, but would note that sufficient slack looks to be opening up in the global economy to absorb these assets (especially if China continues to backstop the US economy). I assume this is the Fed’s view as well. If the Fed is in error, the yield curve should steepen dramatically in coming months.

Some amusing graphics - the first on who is going to rescue whom…

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Greg Ip quantifies the level of intervention thus far, and warns that there could be far more to come.

Before the crisis began, the Fed had $868 billion of assets, 91 percent of them in innocuous Treasury bills and bonds. Now it has $1.6 trillion in assets, with less than 30 percent of them in Treasuries… $1.8 trillion in assets is equal to just 12 percent of America’s gross domestic product… At its peak, the Bank of Japan’s balance sheet amounted to 30 percent of GDP…

Paulson has managed to take the UK inspired (perhaps by Buffet) recapitalisation plan and weaken the impact while increasing the benefits to bank management. Willem Buiter, always good, points out that Paulson is screwing US taxpayers on the terms he is dictating with the banks.

The US tax payer is getting a terrible return on the $125bn worth of capital that was injected on his behalf by US Treasury Secretary Paulson into the nine largest US banks… In the case of the Fortunate Nine, the injection of capital is through (non-voting) preference shares yielding a ridiculously low interest rate (5 percent as opposed to the 10 percent obtained by Warren Buffett for his capital injection into Goldman Sachs). Without voting shares, the government has no voice in the running of these banks. It also has no seats on their boards… The UK preference shares have a 12 percent yield and come with government-appointed board members… In addition, in the the case of the Fortunate Nine, there are no attractively valued warrants (options to convert, at some future time, the preference shares into ordinary shares at a set price or at a price determined by some known formula). Quite the opposite, the preference shares purchased by the US state, can be repurchased after three years, at the banks’ discretion, on terms that are highly attractive to the banks… That, I would argue, is scandalous, both from a fairness perspective and from the point of view of the moral hazard this creates, by boosting the incentives for future reckless lending…

Stiglitz thinks the same.

Paulson figured he could reshape the UK approach in a way that was even better for America’s banks than his original cash strategy. The fact that US taxpayers might get trashed in the process is simply part of the collateral damage that has been a hallmark of the Bush administration…

It’s almost as if Paulson cares more about his friends and business associates than he does about the average taxpayer…

Update 13 Nov 08

Washington Post reports the Bush administration has taken no action to fill congressionally-mandated independent positions to oversee how the bailout is used. A deadline for the first bailout monitoring report has already passed. The Treasury has committed $290 billion in taxpayer money so far. Eric Thorson, the Treasury Department’s inspector general, said, “It’s a mess. I don’t think anyone understands right now how we’re going to do proper oversight of this thing.”

I apologize to regular readers (if any) but I’ve been on the road for more than a week. Meetings and keeping up with the game of musical markets combined with some too-good-to-miss leisure activities to keep me from putting finger to keypad.

I’m currently in Manila for an ASEAN workshop/conference which was meant to be about globalisation, global warming, expensive oil, challenges to democracy, politics of Islam and such; but I have a feeling the conversations in the corridors will be mostly about the banks, central and otherwise, and those pesky bi-modal markets and nasty hedge funds.

From my conversations with all manner of investors in Sydney I came away with a couple of new thoughts on the crisis. For one thing, I thought back to a year or so ago, when Citibank and some others started purchasing equity stakes in the Chinese banks. I’ll bet most observers at the time were like me in expecting these banks to look a lot more like Western banks by now. Instead, we have many Western banks government owned, with balance sheets full of non-performing loans and increasingly permissive “cosmetic” accounting. This world is funny, isn’t it?

On that question of what (if anything) governments should do, I’ve been trying to come up with a framework for thinking about why banking should be treated any differently than any other industry (autos?) that is close to failure. Because banking is ubiquitous it does deserve some special status, like telecoms or electrical utilities. The closest analogy I can come up is a scenario in which all of the power companies world-wide have leveraged up and blown their all of their equity and most of their borrowings on a speculative technology (cold fusion?), and are now no longer able to operate the grid connecting generators (savers) to consumers (borrowers). My conclusion is that the government should nationalise the grid. The grid cannot be allowed to fail or the economy will grind to a halt. But the government should NOT be buying up the dud cold-fusion investments, or shoring up the balance sheets of the leveraged entities. The government should be buying the operating assets - people, buildings, infrastructure - and leaving the balance sheets with those who created them.

In contrast, the Treasury efforts still seem primarily directed at preserving the banking management, both financially and leaving them in control. Incredibly, the only authority that Paulson even has to begin to do the right thing and recapitalise banks is a question and answer in the House before the vote clarifying that this power was included in one of the catchall “and whatever is necessary” phrases. But he is still resisting triage and attempting to cover up the actual damage. Hopefully the rest of the world will move on.

I couldn’t help picking up some great snippets through the week, and will add more to the comments on this post as I do some catching up. I’ve been getting my daily news feed on the iPod - RSS is the best newspaper in the world - and am posting on a 14″ iBook rather than my usual 2×24″ gear…

From 2008 Nobel Prize laureate Paul Krugman:

The only thing we have to fear is fear itself. Fear and negative equity… The two things we have to fear are fear itself and negative equity. And the depleted capital of financial institutions… Amongst the things we have to fear are fear itself, negative equity, and the depleted capital of financial institutions…

From Jeremy Grantham:

We will learn an enormous amount in a very short time, quite a bit in the medium term and absolutely nothing in the long term. That would be the historical precedent.

The New York Review of Books has an extensive review of Soros’ new book. Apparently the chaos has coaxed him back into the markets to make another billion or two. The stupidity must be irresistible.

The Milken Institute has a collected overview of the train wreck in slides. It is comprehensive, and devastating to expectations of a miracle recovery. download the original (pdf)

Stiglitz, with a modest plan:

A unique combination of ideology, special-interest pressure, populist politics, bad economics, and sheer incompetence has brought us to our present condition.

I almost missed this Warren Buffet interview, but it is amazing. He is ancient, absolutely without reservations in speaking the truth as he sees it, and seriously worried. His key points: TARP must use market pricing, and we must stick to reporting market values. I only wish he hadn’t likened the crisis to a “financial Pearl Harbour” quite so many times… In a world where the US may be relying on Japanese savers (and many others) for support of a coordinated bailout this struck a jarring note. Why not a “financial Three Mile Island”? It was self-inflicted, after all.

One of the problems with this credit collapse –- and peak oil, and global warming for that matter — is that they move like glaciers, slowly but inexorably, and humans generally don’t seem to be evolved to sustain attention on large things that take a long time. We gleefully scamper about, picking up pennies in front of the steamroller, because that suits our attention span and time scale, and the wider problems simply cease to be news because we cannot fix them rapidly enough to make it seem worthwhile.

Yves Smith posts a report from Merrill Lynch economist David Rosenberg which takes the longer view. It’s all about the real estate.

New home sales sank to 460,000 units in August, a fresh 17-year low, and the inventory-to-sales ratio gapped up to 10.9 months’ supply (MS) from 10.3 MS in July. There is no chance that home prices stabilize until this ratio moves convincingly below 8 months. In fact, our models suggest that there is another 15-20% downside in average home prices and they are already down 20% from the peak… Sales are down to 460,000 units and yet single-family starts, while down 35% from a year ago, are still running far ahead of demand at 630,000 units… homeownership rate is still near historic highs of 68%… our estimate of the expected total losses going forward are close to $1.5 trillion or double the size of the TARP… this entire credit collapse of the past 13 months has reflected one thing and one thing only, which is the unwinding of the greatest asset bubble in modern US history – residential real estate… we are at most 60% of the way though this down cycle in banking sector credit quality… So the way to think of this credit collapse is that it is secular in nature, not merely cyclical and also deflationary… The Fed and Treasury are merely cushioning the massive deflationary forces in the financial system…. If you go back to that 1989-93 experience with RTC… it took a full year for the equity market to bottom, two years for the economy to bottom, three years for the housing market to bottom, and four years for bond yields to bottom…