Why the Financial Markets Haven't Responded

by: John M. Mason

The stock market has experienced a serious decline since the passage of the Paulson Plan. The money and bond markets still seem to be frozen in spite of a coordinated cut in world central bank target rates. The only way that this behavior can be explained in my mind is that without strong leadership -- from the very top -- the financial markets will continue to be weak. Even though others -- Paulson and Bernanke -- have tried to provide some form of leadership, the leadership that must be exhibited from the very top continues to be missing. (See my post of September 25, The Absence of Leadership.)

Missing this leadership, members of the Bush 43 administration were hoping and praying that events would be relatively quiet until they were able to sneak out of Washington in January 2009 and let someone else handle the situation.
They didn’t make it.

And, like any other organization that does not have a leader, good people with good intentions when faced with calamities try to come up with some plan or some action that will plug the hole in the dike. The problem with this is that when they have to work around the leader, there is no unifying force present in such situations, no calm hand on the tiller listening to alternatives, asking questions, and guiding responses. And there is no one around to punish dissidents.

Up until a couple of weeks ago, Treasury Secretary Paulson and Fed Chairman Bernanke tried to band-aid the system, proposing temporary responses to the growing crises that would tide things over until the new government came into office to deal with the problems. It seemed as if Paulson and Bernanke had reached a game plan; a bailout took place for Fannie (FNM) and Freddie (FRE),  Lehman (LEH) was to fail with no help, and nothing would be done for [[]AIG].

Then, it appears by all reports, Bernanke reached a turning point.

Bernanke called Paulson and indicated that the financial markets were falling apart and that if nothing were done the economy might not be there the next Monday. The Congressional leadership had to be informed of this development and brought on board for a major flood of liquidity. In no instance could the financial system and the economy come up short of liquidity. Paulson set up the meeting with the Congressional leadership, and at that meeting Bernanke poured out his story of woe. According to some of the members of Congress that were there, Bernanke scared the life out of them!

One question needs to be asked at this point: Where was the “decider”?

The Treasury plan was assembled as quickly as possible for passage by Congress as quickly as possible -- no hearings, really, no questioning, things were so bad that there was no time for these niceties that could take place when things were not so dire.

And, then the financial markets froze!

Why not?

Here was the Chairman of the Board of Governors of the Federal Reserve System saying that the economy might not be there on Monday. What did he know that market participants didn’t? What was going on in Europe and elsewhere? Here was a major case of asymmetric information. And the people who were without information were the suppliers of funds.

Bear Stearns had failed. Merrill Lynch (MER) had failed. Fannie and Freddie had failed. Lehman had failed. Washington Mutual (NYSE:WM) had failed. AIG had failed. Wachovia (WM) was failing. Who was going to be next? What did the Fed and the Treasury know that market participants didn’t know?

The initial effort to get “the bill” through Congress failed too. There was no one in a leadership position who could call the troops to order. (Even presidential candidate John McCain rode out at the head of his cavalry to lead the charge to get the bill passed, only no one followed him. Paulson could not do it, he was not the leader; there was no leader.

The “decider” was marched out -- but he  only mouthed the words that were given. Why should anyone have any confidence in what was being done?

So, is the bill passed last Friday any good? After what went on in the two previous weeks, the bill seems somewhat irrelevant-- a very costly irrelevance. There is still no vision going forward. There is no strategy. There is no structure. There is little or nothing. At best we are told that maybe in four weeks the “Paulson Plan” will be up and running.

That will be after the election and we will have a president-elect. But the president-elect will have to wait for over two months before he can do anything about the financial crisis.

Meanwhile the Fed floods world financial markets with liquidity.

Bernanke’s study of the Great Depression taught him that during such a crisis, the world cannot have too much liquidity. And so, “Helicopter Ben” is acting on that premise. Total reserves in the United States banking system, for the two weeks ending September 10, averaged about $44 billion on a non-seasonally adjusted basis. For the two weeks ending September 24, the total reserve figure was about $111 billion. Never has the United States banking system received so many reserves so rapidly. And look at the sources and uses statement of the Federal Reserve System (the H.4.1 release). In the last three weeks the sources of reserves in the banking system increased by more than 50%!!!!!

Never have we seen anything like this! Never!

This is what happens when there is no leadership. One cannot blame this situation on previous administrations or other conditions within the world. The current leader of the free world is MIA.

Unfortunately for the financial markets, for the economy, for workers, for families, for everyone else, there will not be a new president for several months yet. And, we still have to uncertainty with respect to what the newly elected president will do. Will he, when in office, be able to provide the leadership that is so badly needed?

So, there is still an enormous amount of uncertainty with respect to the future, and this enormous amount of uncertainty will reign in the markets until such leadership surfaces. Meanwhile, the financial markets will still remain tentative as they attempt to discern who will fail next…and then next after that…and then next after that…