Markets celebrating but hangover will continue for some time

Paul Niven, Head of Asset Allocation at F&C, comments: Following one of the most turbulent weeks in financial markets a relative sense of calm appears, for the time being, to have returned. Panic and fears of a downward spiral in the global financial system were quickly replaced on Friday with euphoria, as details of government action emerged which would aim to tackle the crisis. Record gains in stock market indices ensued, fuelled in part by spate of bans on short selling on certain financial stocks, as investors scrambled to cover their positions.

Full details on the ‘Paulson Plan' are not, as yet, clear but broad indications have emerged over the course of the weekend. It is expected that the sums involved will total over $700bn which will be used to purchase a broad range of mortgage backed assets from banks with substantial US operations (not just those which are de facto ‘US banks'). Paulson has encouraged other governments to consider their own solutions and initiatives. The capital to fund the purchase of the ‘toxic waste' will be delivered through the sale of US Treasuries, in tranches of $50bn and it is understood that there will be discretion on exactly what assets are eligible for purchase.

In addition to these US government and Federal Reserve initiatives, there have been surprise announcements from Goldman Sachs and Morgan Stanley that they will become bank holding companies. This will have regulatory implications for the firms and the move is significant, as it spells the end of these large investment banks as distinct corporate entities in the US, 75 years after the 1933 Glass-Steagall Act separated investment and commercial banking activity. The firms will now be regulated by the Federal Reserve and they will seek to build a base of deposits from retail customers, rather than solely using borrowed money.

The decisive action shown by the US looks to have stemmed the downward spiral in markets. It had become clear that, with market failure, government intervention was desperately needed. Indeed, examples of banking crises fixing themselves are unsurprisingly few and far between. The authorities invariably have to intervene in order to manage the exit of bad assets from banks' balance sheets. What is different this time, however, is that the assets which the proposed vehicle will take on are being transferred from going concerns, rather than failed companies. This is in contrast to the Resolution Trust Corporation (RTC) which took bad assets from failed Savings & Loans institutions and disposed of them.

The new RTC-type vehicle will have an extremely challenging task in taking assets (for which a price will have to be agreed) from functioning organisations and sitting on them until either maturity or such time as they can be fed back into the market. This is a very different proposition than the experience of the 1990s, when the RTC was key in resolving the Savings & Loans crisis, and which disposed of some $450bn of assets. It is too early to critique details of what will emerge but the challenge is on taking on assets for which there is essentially no market and no effective price. If the price of transferred assets is set too low then this will trigger further bank write-downs and further panic. Set the price too high and banks are allowed to exit from the illiquid waste at preferential terms, leaving the taxpayer to foot the bill. This is an extremely fine line to tread and this, coupled with the complexity of the instruments which are being taken into state ownership, means that the task this time is materially more complex and challenging than that which the RTC had to deal with.

Concerns over the mechanics and unintended consequences of the Plan should not be confused with criticism, however. The steps which are being taken to manage a way out of the crisis are absolutely necessary to prevent systemic financial collapse. Authorities have little choice but to step in and correct the market failure, despite protestations over the cost and impact of the bailout. From here, we must wait to see the details of the plan and also whether other authorities choose to heed Paulson's advice in setting their own plans and methods for cleaning up domestic banks as the infection is global and assets are held well beyond the shores of the US. Those in Europe cannot continue to rely on liquidity injections alone.

More regulation, bigger government, and a less laissez faire attitude will now prevail. Beyond the short term, where the rot has been stopped, it is our belief that we still have several years of workout from the credit crunch, as banks rebuild balance sheets, de-leveraging continues, credit is restricted, and the payback for the boom years drags on. Markets have been celebrating but the hangover will continue for some time.

Relative calm has been restored but, while value is prevalent, in risk assets we may well suffer a prolonged period of poor fundamentals which limit upside. For credit holders we are hopeful that credit markets can see some recovery. That said, defaults will be on a rising path as the economic background continues to deteriorate. For holders of government bonds startled at the prospect of large scale government funding they alone may draw some comfort from the lessons of Japan, which has seen an explosion in outstanding debt but a sustained environment of low interest rates.

Investors should not confuse current euphoria with an end to the crisis.