The Bumpy Ride Ahead

Dealbreaker has a most germane chart of what happened when Pakistan banned short selling: a brief and large rally, followed by a slow and devastating collapse.

Could the same thing happen with the US stock market? Absolutely, yes. Banning short-selling is a way of buying time -- but if the mooted RTC II isn't up and running very quickly, the stocks which went up today are liable to go straight back down to where they were -- and, probably, further, given that each successive stock-market low is lower than the last.

It's surely no coincidence that the short-selling ban was unveiled at exactly the same time as politicians started talking in public about a huge government bailout fund. The problem with the fund is that it will require time-consuming legislation to set up, and time was the one thing which Morgan Stanley (MS), in particular, didn't have.

And so the short-selling ban is a stopgap measure, designed to artificially boost stock prices until Congress can get its act together and throw a few hundred billion dollars at the market in a more substantive attempt to stop it from imploding.

Those kind of measures actually can work: I'm thinking here of when the Hong Kong government started simply buying all the stocks on the Hang Seng index during the Asian financial crisis, and ended up making a fortune.

Whether it's the government's job to intervene in the markets, however, is another question entirely. If it were just stocks falling, no one would ever suggest the Treasury should start propping up the equity markets, but somehow if those stocks are financial then that seems to change the moral calculus substantially.

It's certainly hard to imagine a Treasury secretary more well-disposed towards Wall Street than Hank Paulson, who was CEO of Goldman Sachs (GS) up until the minute he moved to Washington. Paulson, in turn, gave Morgan Stanley the mandate of advising on the Frannie bailout. You can look at Morgan Stanley's payment for that job in one of two ways: either it was very, very small (the headline figure), or else it was very, very large (tens of billions of dollars of Federal money being used to take toxic assets off Morgan Stanley's balance sheet).

What's more, if Morgan Stanley imploded, Goldman Sachs would surely have been next in the firing line -- Goldman needs Morgan to survive, there's safety in numbers, there can't be only one. Does Hank Paulson overestimate the systemic importance of Goldman Sachs to the US economy? Almost certainly, yes -- he could hardly have been CEO of Goldman if he didn't.

On the other hand, he's a decisive dealmaker who understands finance, knows what he's doing, and still retains the confidence of the market. His attempts to stop the financial system from collapsing might not be working very well, but he's certainly no laughingstock in the way that, say, John Snow might have been if he'd attempted something similar.

The upshot is that it's still far too early to tell whether any of Paulson's decisions will actually work. But even the best-case scenario is unattractive at this point: financial disaster averted, but a massive increase in government debt, the moral hazard associated with a brand-new Treasury put, and a discredited SEC which looks like it's taking policy advice from Pakistan.

As for the worst-case scenario, well, for that, I'll send you over to Nouriel. Credit losses of $2 trillion, half the US banking system nationalized, municipal defaults, house price declines accelerating, a sudden stop in consumer spending, global contagion, stagflation, you name it. Nouriel concludes:

At this point the perfect financial storm of the century cannot be contained. The only light at the end of the tunnel is the one of the coming financial and economic train wreck.

So brace yourselves: Whatever happens, it's going to be a bumpy ride for a while yet.

Comments

[whidbey:]

You might have added that your assessment of the situation is seemingly widely shared by those who work in Wall Street, not that they are talking about it very much, but It is there. The knowledge that Congress will play with an already bad bargain has most skeptical that the deal will even come out of the oven and be served on the world. The dollar is in dream land, super dollar!

This set of events might be a factor in the political tilt this November and no right-thinking pol is going to give that one away, although I can not recall why anyone wants the job, unless it is preside over the creation of the Infinite State which lives in a world of its own making; one where money is worth what the Treasury says it is worth each morning, and needs and wants are satisfied with songs and dances. Hank is credible only until the someone notices he is playing for time, not a final solution. But a good analysis.

2008 Sep 19 02:35 PM

[Wriiight:]

Other than the very positive reaction to the new RTC, so far the market gets worse with everything the treasury does. Lets hope this latest effort actually does some good.

2008 Sep 19 03:16 PM

[Kelly Liebe...:]

"Lets hope this latest effort actually does some good."

It won't. The dominos are falling. Turn on CNN. Panic buying in Nashville..no gas.... States budgets collapsing, hurricane relief still not in sight for many, mortgages defaulting, job losses rising, banks failing, people in debt up to their necks, our govt "days away from financial collapse"....just turn on the news....

2008 Sep 20 12:32 PM

[YoYoMama:]

Better to turn off the news. They are in the business to sell advertising, and sensationalism will keep your attention until the next commercial.

Listen, I'm in Houston, and we are recovering from Hurricane Ike just fine, thank you. We have gas, and most of us now have electricity. Texas has also been more fortunate than most states in terms of housing values. As to bank failures, during the Great Depression, we have 3,000 banks fail. This time, 38 banks. And I have compassion on anyone in debt because of health issues or job loss. But let's face it, most people in America are in debt because of greed and credit cards, not because of the economic climate.

We all just need to take a DEEP breath, and see how that market plays out recent events. NO ONE can predict the future.

2008 Sep 20 05:18 PM

[Don't get n...:]

Custer's assesment at Little Big Horn was flawed although the "facts" were there for the finding. He might have chosen differently if he looked at "all his cards"
Captain Smith's (Titanic) assessement was also "flawed" in the fact he put personal greed in front of "the facts"

. . . . list goes on. . .
My point is that if "all considerations" (which I trust the "experts" (insert list of reputable sources) can be brought to bear on this "battle", that maybe the analysis won't be that flawed and that we have grown as a country.
CNBC/ etc can make the fact a spider crawled across the floor into something to disect and analyze with anyone for hours. . . .its sensationalizim and it attracts viewers/ad revenue. I've always found if you put 100 economists in a room and hash this proposal out that if you were like Ronald Regan (God Bless his soul) you could get a "feel" for what is the right thing to do.

I just remember when Jimmy Carter said to Fidel. . .send us your poor, tired, hungry and "we will give them shelter" and what is sent. . .and the problems it ensued.
This "bailout" is similiar but the "stuff" the US will take in has "some value" and be it over time, it may probably pay back be it may take a long time but I think it, like its predessors, will make money. I like the idea

2008 Sep 21 10:12 AM