Hangover from the banking crisis will be long and profound

Paul Niven, Head of Asset Allocation at F&C, comments: In less than three weeks the credit crunch has been transformed into a financial maelstrom, destroying some of the best known and longest established names on Wall Street and, over recent days, taking some large European casualties on the way. Popular press and investment professionals alike have been transfixed by the speed and brutality of the shakeout in the financial sector as names such as Lehman, Merrill Lynch and Washington Mutual have been consigned to history.

The Darwinian approach which markets have taken has seen weak financial institutions being targeted and pummelled until either government or market forces ensure their failure, consolidation, or nationalisation. It had been claimed that short sellers were the villains of the piece, shorting targeted financial stocks to squeeze profits and undermining financial stability. The fallacy of this notion has been sorely tested in recent days as markets have plumbed the depths despite a ban on short sales by investors. The braying over the pain of burnt short sellers has been replaced by disbelief as markets have continued to melt down on a torrent of negative news and ongoing stress in money markets.

The most recent catalyst for sharp declines, through to new lows, for equity markets has been the House of Representatives voting down the Paulson Plan. It was the seeds of this plan, revealed ten days ago, which caused initial euphoria on markets when, combined with a ban on short selling, authorities seemed to be getting control of the rapidly spiralling situation, with a concerted effort to remove toxic credit waste from the financial sector and ensure that the credit markets began to function in a more normal manner. Since this initial elation, which was fuelled by covering of short positions, the Plan was diluted to ensure buy-in from the political spectrum but, perhaps, undermining the strength of the initial proposal. $700bn would no longer be delivered in one go but a third would be forthcoming, with Congress having to approve further tranches. Greater oversight of the operation, caps on Executive compensation, and governmental ownership of participating institutions were all adopted, amongst other measures. The markets disliked some of the compromises, concluding that, what may have been a flawed plan, may now not function effectively, with many institutions disincentivised to participate. Now, with the House voting 228-205 against, markets have posted their biggest losses for over twenty years, reaching new multi-year lows..

From here, investors will attempt to assess what the ‘end game' will be. Money markets are highly dysfunctional and the huge injections of liquidity seen in recent days ($630bn on Monday) seem to have had little impact as banks continue to hoard cash and perceived counterparty risk remains extremely high. The markets have been moving and forcing action so quickly that it is likely that this further destabilisation will trigger further action in the near term. More institutional casualties in coming days will likely be seen, however, as weak financials are squeezed further as their lifeblood of access to credit is withdrawn.

Banking crises typically require government intervention and banks currently desperately need recapitalisation. There is a chance that the Plan may be rethought to ensure that losses are recognised effectively in the banking system and steps taken to ensure effective recapitalisation. This element of the ‘bailout' was missing and, arguably, was a significant flaw in the original proposal which would have materially reduced the efficacy on the Paulson Plan. In that sense the Plan may have been doomed to failure from the outset. Nonetheless, an effective and targeted recapitalisation program is required, and could result.

It is highly likely that a modified form of the Paulson Plan will be agreed upon in coming days but, in the meantime, the Fed may decide to take matters into their own hands. Bernanke noted that a failure of the plan would trigger a deep recession and, given today's events, this must now be considered to be on the cards. There is a reasonable possibility that monetary policy may be used to bring some relief to markets.

As usual, at times of extreme stress, it often pays to take a detached approach and assess whether opportunities present themselves. In our view, we are now entering panic territory and capitulation from investors. For all the hysteria over recent weeks this will be the first time that it has become clear that investors are really throwing in the towel on equity markets. This may give some hope for a relief rally when good news finally emerges. In addition, equity markets need fall only several more percentage points before we would view investors as well to take the risk by buying the asset. These elements are positive for those looking for a short term rally who can foresee a catalyst or who have the duration to take a position based on value. Government bond investors concerned by possible losses caused by rising supply can take cold comfort from the dim economic prospects and lessons from Japan, where yields remained low despite a ballooning budget deficit.

Unfortunately, the deleveraging process which underpins the great credit unwind will not be resolved in weeks or months. The impact on the global economy of recent events, traced back to last summer, will last for years. Credit will be expensive and constrained for some time. Consumers will not demand it as asset prices continue to decline and incomes are threatened and banks will be unwilling to supply it as efforts to rebuild capital base are ongoing. Authorities will pass resolutions to tackle the crisis, hopefully effectively, but the hangover from the banking crisis will be long lasting and profound.