BRICs need credit too, but less so than the US ... Europeans balk at collective action ... Hypo rescued

As the Latin Americans discovered in the 1980s and the Asians in the late 1990s, being dependent on foreign funding of a deficit position has never been a comfortable place to be. In 1914 the Euroean countries which had invested heavily in the then emerging market of the United States repatriated their investments to pay for what would soon become the First World War. Faced with such an outflow of capital, and of gold which backed the international currency regime of the day, such a panic gripped the stock market that Washington simply closed it for four months. 

A few decades later the roles were reversed. In 1929, it was America which was the distressed debtor nation pulling its money from foreign markets to shore up the liquidity crisis at home caused by the Great Crash. One of the countries most destabilised by this was Weimar Germany whose economic desperation was so utterly complete they voted in Hitler. So as things stand today, we should be rooting for the financers of the US deficit. 

But this morning the Korean Finance Minister Kang Man Soo urged banks to sell overseas assets so that they can use the money to boost domestic lending. The government will provide won-dollar swaps and will use foreign currency reserves to support lenders if necessary. Meanwhile, the Kuwait Investment Authority, that countries sovereign Investment Authority, is considering in vesting $5.6bn into the Kuwait Stock Exchange. And in Brazil, the Treasury is having to inject funds into BNDES - a government sponsored development bank - which has seen applications for loans spike in the absence of market liquidity. The most recent firm to recieve funding from this route was Petrobras ... 

In Europe, the summit of leaders in Paris failed to produce any committment to coordinated action. Merkel said "Each country must take its responsibilities at a national level." The politicians still managed to use the crisis to grandstand to their own voters though. Sarkozy said he wanted a new workd to come out of this, "We want to set up the basis for a capitalism of entrepreneurs, not speculators." 

But what exactly are speculators? Risk-takers? What the difference - entrepreneurs are risk-takers and therefore speculators too, surely. Wasn't it entrepreneurs who ran HBOS, Northern Rock and AIG? I think Sarkozy just doesn't want bad entrepeneurs ...  

No wonder though.  There are as many bad entrepreneurs in Europe as the US, it seems. The bailout of Germany's second biggest property lender Hypo Real estate collapsed over the weekend because it turned out, in an echo of Lehmans, the estimated EUR 35bn Hypo had initially said they needed was wide of the mark. The bailout is now back on with a EUR 50bn rescue. The German has govenment moved to fully gurantee personal savings accounts, while in France BNP (entrepreneurs, not speculators) are taking over the Belgian units of Dexia after a govt rescue failed ... 

... Fingers crossed for everyone in Iceland too, where their own lender of last resort just doesn't seem big enough. According to the Telegraph at the weekend, the Icelandic central bank is trying to cut a deal with other Nordic central banks to help them stave of a complete collapse of their financial system.

What was wrong with the Paulson plan ... companies starved of credit, Fed governors see lost of stimulus ... grains should be higher ... S&P value tra

The S&P closed down 4% last night now and now trades close to where it did when the bail out plan was first rejected by the House of Reps ... deflation is the new inflation. Orders data yesterday was weak, as was the weekly employment data and commodity prices took a bath across the board. They are currently heading for their biggest weekly decline in 50 years. Dollar is stronger while Asian equity markets are softer by a couple of percent overnight, although one market notable for its relative strenth this week is Shanghai, which is up by nearly 3% ...  

The House of Reps are due to vote on TARP again today. It looks as though the plan will be passed this time too, after lengthy and tiring discussions seem to have got to the bottom of what was wrong with the first proposal. Some of the new provisions include the "extension and modification of duty suspension on wool products; wool research fund; wool duty refunds", a "7 year cost recovery period for motor sports racing track facility" and "exemption from excise tax for certain wooden arrows designed for use by children." 

So while the bill in its ealier form was a bail out of Wall St, socialism for the rich and an immoral bequest to the country's grandchildren, its now good for America. And there was me thinking the US wouldn't ever be in a position to pass the bank recapitalisation bill it will ultimately require because it was ideologically constrained ... actually its all about wool and wooden arrows. Why didn't anyone tell Paulson and Bernanke? Whoever drafts the next bail out bill should take note and save us all a lot of trouble ... to think that these people are in charge ... of course, the bill hasn't been passed yet ... I dread to think what will happen if it isn't. 

Asian interbank markets are siezing up too now. Bloomberg reports this morning that Hong Kong's interbank rate jumped 41bps to 3.81 even though the HKMA has since Monday been accepting more securities as collateral in its repo transactions. Last week there was a run on Bank of East Asia, this week Hang Seng Bank said it had "exposure" to debt issued by WaMu .... the Fed data meanwhile showed that the CP market had collapsed, the bond market is effectively closed and financial institutions are now using the Fed for nearly all their liquidity needs. Yesterday they borrowed $348.2bn. Needless to say, non financial institutions just have to do without. Caterpillar and GE are struggling to sell commercial paper at economically viable rates, while the state of Massachusetts pulled a sale ... likewise for Fortescue metals yesterday put a mine expansion on hold because it wouldn't be able to raise the funds. 

Not to worry though. St Louis Fed president Bulllard and Kansas City Fed counterpart Hoenig both said yesterday that "there was very strong stimulus in the economy" and that lowering interest rates would be the wrong response because of an "inflation problem" ... to think that these people are in charge ...

The effect of the recession on the commodity markets is intuitively what you'd expect with the commodity shares currently taking the brunt of the pessimism. But there are some anomolies beginning to develop. Yesterday, for example, gold fell by nearly 5% even though there appears to be a widespread shortage of bullion at the retail level. Agricultural commodities too were down by around 5% yesterday. But will a recession cause people to stop eating? I know there's a biofuel link via sugar and corn but does this justify a near 50% correction? 

Yesterday Mosaic fell by an eyewatering 42% (!!) on an earnings miss and a cut in posphate production, the company cited growing posphate inventories and weaker pricing. Monsanto actually raised its guidance but noone seems to have noticed, and all agricultural stocks in all markets fell heavily. Annecdotally, farmers are scaling back on fertilisers because they can't get the credit for the upfront payments required to purchase. Arable land remains uncultivated for the same reason - banks can't lend the necessary upfront capital. All of these factors suggest farmers are spending less on bringing new supply to the market and while that should explain why agricultural companies might struggle, the same logic should also argue for higher grain prices ... 

There is clear value emerging in large parts of the market as evidenced by Buffet's large and high profile recent investments (although the sage is still manageing to buy at levels of cheapness ordinary people won't be able to buy at). Meanwhile, credit spreads are trading at a 12.2% spread over treasuries, the widest since Merrills started calculating the index and the VIX is trading at levels last seen in the aftermath of 9/11. 

It S&P actually trades on 20x the last 12m earnings which sounds rather rich given the sickness of the credit-desert economy we face. Yet high multiples are normal in recessions. In December 2001, for example, the 12 trailing PE ratio rose to 60x as eaernings collapsed according to Bloomberg so there is plenty of scope to go higher.  Nevertheless, for the losers amongst us, forced into playing the timing game, it is worth bearing in mind that as the US economy entered into recession in 2001, the S&P's PE ratio rose to the high 20s just as it is doing now. Then, the S&P was at around 1300. A year and half later it was trading below 800. 

Why anyone follows the collective wisdom of a group of analysts with no investment experience and little apparent understanding of basic financial analysis I'll never know. As if another example of mass incompetence was needed, the consensus earnings estimate for the S&P500 has earnings rising from the current $52.6 in 2008 to $84 in 2009 - a 60% increase, which would be a fair old performance given the credit desert we now live in.  Who was it that said about analysts that in a bull market you don't need them, in a bear market you don't want them? ... to think that these people are in charge  ...  hang on, they're not - hooray!

We're witnessing a huge policy mistake ...

Last night the Senate sent the amended TARP proposal to the House of Reps who are expected to vote on Friday. It now contains provisions for a temporary increase in the amount of bank deposists insured by the FDIC, a temporary extention of tax breaks and concessions on mark-to-market accounting, which is being blamed for the current mess. 

Mark to market accounting is preferable to any alternative. The Japanese credit crisis lasted for over a decade because they didn't have to value bad loans at realistic prices and so were under less pressure to come clean on the lowered value of the collateral held, or on the solvency of their organisation. So they told everyone that everything was fine because there was no pressure to own up to a failure they could simply deny. The same managers who made the mistakes remained at the helm of the same institutions who were horribly clogging up banking system. And they really did clog up the banking system. Actions spoke far louder than words in revealing how distressed Japanese financial institutions were. They refused to lend any of the liquidity created by the BoJ to anyone other than the government in the form of massive JGB purchases. This cycle led to zero interest rates and, at one point following the tech bust (a staggering 12 years after the banking crisis), 40bp 10y yields! The credit mechanism remained blocked, the velocity of money circulation collapsed as monetary policy became ineffective and the economy slumped into what became known as the lost decade. 

To an extent, therefore, the prolonguation of the Japanese crunch was caused by the absence of the discipline imposed by mark to market accounting. It does help though, if there is a functioning market to mark to which is why the TARP will be a huge step in the direction of ultimate stabilisation and unambiguously, therefore, a good thing. 

But will it provde the banks with adequate capital? In last week's FT Martin Wolf wrote this: 

"The aggregate stock of US debt rose from a mere 163 per cent of gross domestic product in 1980 to 346 per cent in 2007. Just two sectors of the economy were responsible for this massive rise in leverage: households, whose indebtedness jumped from 50 per cent of GDP in 1980 to 71 per cent in 2000 and 100 per cent in 2007; and the financial sector, whose indebtedness jumped from just 21 per cent of GDP in 1980 to 83 per cent in 2000 and 116 per cent in 2007 (see charts). The balance sheets of the financial sector exploded, as did the sector’s notional profitability. But leverage, alas, works both ways.

Since US net international debt was 39 per cent of GDP at the end of 2007, virtually all of this debt is an asset of another domestic entity ... when the gross debt stock is huge and economic conditions difficult, the chances that many entities are bankrupt is high. When people fear mass insolvency, lenders stop lending and the indebted stop spending. "

So probably not. Banks will likely remain undercapitalised. It is possible that the Asian sovereign wealth funds will be able participate in this recapitalisation. But is it likely? They are already heavily underwater with stakes taken too early in the crisis and indeed, in many cases (China) may yet find themselves with domesitic concerns where that capital could be deployed with higher priority before this crisis has run its course. An undercapitalised US banking system will be a vulnerable one, and one which is incapable of lending at anything like the rate the current generations of Americans have been used to. 

And this will be democracy in action. As banking crises have shown in the past, when the problem becomes so great that private-sector recapitalisation is impossible, only the government is left. This is the direction in which Europe is headed. The decisiveness of European govenrments is in stark contrast to the cack-handed and reactive handling of crisis by the US authorities. But Europe has no ideological constraint on state intervention in such matters and can therefore act preemptoraly. As the current mess in Congress is showing the world, America's ideological constraint is very real and very binding. Americans will only sanction the steps the Europeans are now being forced into after they've seen the economic consequences of a disfunctional credit mechanism. The outlook for the US is bleak indeed even with the passing of TARP. Failure by the House of Reps tomorrow will all but guarantee a depression ... 

... the central banking policy mistake we're currently witnessing won't help either. One of the lessons from the Great Depression, and from Japan's experience with its real estate bust is that monetary policy has to be adjusted quickly and decisively lower. Instead we've had the opposite. The BoE and the ECB have been unimaginative at best in recognising the deflationary effects of this crisis and history will show they kept interest rates too high for too long because they were concerned by late cycle inflation. 

But central banks always make this mistake. The larger error has been in allowing monetary conditions to tighten so dramatically. The world is deleveraging. In the US the mortgage market is now largely nationalised. In the UK, where there were ten mortgage lenders last year, there are now seven (and mortgage approvals have fallen 95% YoY). The rest of Europe is catching up and loan books everywhere are being wound down. Reduced credit supply means a higher cost of credit so mortgage rates are significantly higher than last year, as are interest rate costs for business are higher than last year. Central bank cuts would have kept the monetary stance unchanged. Instead, it has been allowed to tighten. This is a policy mistake which will exacerbate the deflationary effects of this crisis. 

A vote for a Depression ...

The rejection of the TARP by the House is a turning point not only in this financial crisis, or even in the global economic downturn, but in the life of the Aging Empire itself. Ideological dogma has trumped common sense and if this plan isn't sucessfully revived, the calamity will go down in history with the same infamy as the Smoot-Hawley Tariff Act of 1930, which put up international trade barriers and helped turn a US recession into the worldwide Great Depression. 

Following the debate over the last few days had depressed me. Not because I thought they'd actually be brave/stupid enough block it (how embarassingly naive), but because I though Paulson's TARP plan might not be enough. If the bill that wasn't a bank recapitalisation and that would have made the taxpayer money was so difficult to pass, what chance passage of the future one which would be needed to recapitalise the banks and at a very real cost to the taxpayer? Not for the first time during this bailout episode, I was jumping the gun ... 

The House of Reps voted down the bill because their constituents were apoplectic about a bail out of Wall Street, about the prudent saver paying for the reckless speculator, about something worse even than socialism - socialism for the rich. And so this is democracy in action. As the stock market market falls by 9%, oil by 10%, as Gold trades 3% higher and the Ted Spread widens to a never-seen-before and deeply distressed 359bps, a crash followed by an economic depression is now likely. The American taxpayer has just voted for it. 

What happens next? There is still a chance that after realising what they've done, the Republicans fall into line for a revote. Paulson said he was working on a new proposal last night. That's the only hope. That the economy is going into recession is a given. With no second proposal this continued and intensified freezing of credit markets will make it deeper still. As recent events at Fortis, Glitner and Bradford & Bingley have shown, the financial implosion is now global and rates will be cut very aggressively around the world. That will help liquidity, but it won't solve the bank's solvency problem. The Europeans will organise their own financial system bailouts and, unencumbered by ideological qualms that any form of state involvement amounts to socialism, they are likely to come up with something which works, as the Swedes did in the early 1990s.

In the US the problems of failure to deal with the banking crisis will be more acute though, as will the political ramifications. Soon when the economy is on its knees the finger pointing will begin.  Some will blame the Republican's for not voting this bill through. That may be the point at which they pass a proper bailout package. Others will blame the rich bankers, who will be punitively taxed. But if nothing is done, sooner or later they will start blaming foreigners and the Aging Empire will begin a long disengagement from the outside world to a more comfortable place within. 

Ill today ... Congess botch the botch job ... the irony of the Republican Rebellion ...WaMu no more ...

Short blog this moring as I have a horrible cold - stiff neck, sore throat, runny nose and I'm going to moan about it all day ... mkts rallied nicely yesterday on the expectation that the bill was going to be passed but are now lower again because the plan is bumping up against what looks like a fledging Republican rebellion. 

It all looked good when Senator Dodd said last night that they had an agreement in principle and that Congress would act expeditiously ... in fact, the "agreement in principle" is apalling ... it includes the govt taking an equity stake in participating banks, stronger oversight of the Treasury Secretary's use of the funds, modifying govt made mortgages and drip feeding the funds into the scheme rather than making one upfront payment ... in otherwords, is far removed from what Paulson wanted and in all likiehood would massively reduce the already questionable chances of the plan succeeding ... they all sounds reasonable, but the reality is these measure will screw up the plan. 

The whole idea is about creating a transparent market in these illiquid securities. But making equity sacrifice a condition of participation in that market will just act to put banks off participating. It therefore risks preventing the scheme from getting off the ground. Similarly, drip feeding the cash to the plan in installments will prevent the scheme being properly independent from political interference. 

Of course, its not clear Paulson's plan will work. Liquifying the toxic part of their balance sheet is important but it won't be the final chapter in this crisis if the banks remain undercapitalised afterwards, which looks likley. And the assumption that the banking system will go out and recapitalise itself in the private sector flies in the face of historical experience where only the public sector has been able to recapitalise banks. Given the magnitude of the plan and the fuss it has created, Paulson's plan may yet go down as the biggest botch job of all time. But Congress botching the botch job is even less encouraging ...

So since Dodd's optimism equity markets have fallen back again, and Asia is trading softer overnight. Not because market thinks that we have a double botch on our hands, but because a section of the Republican party, increasingly emboldened by public cycnicism - welfare for the rich - appears to be staging some sort of a rebellion ... 

... Senator Shelby has apparently received a letter from "leading economists in America" too, saying the plan is premature and would not help. Banks should be failing before the government gets involved apparently ... Nobel Prize winning Robert Lucas of rational expectations fame is among the strongly libertarian leaning list of economists, game theory guys and behavioralists arguing that the government has no role in interfering in what is a private sector affair. 

Meanwhile the House Republicans, led by Eric Cantor and appalled that any tax payers money is being used at all, have thrown a spanner in the works with an alternative mortgage backed insurance plan which they argue wouldn't put the taxpayer at risk. They want a system put in place to charge premiums to mortgage-backed security holders which would finance insurance on those securities. I haven't seen any details on this yet but although the self-insurance idea along FDIC line is an interesting idea I can't see how it will solve the immediate problem, which is to recapitalise the banking system.  

But what sticks out is that most people, including the politicians, don't understand what the plan is. They think it's some sort of $700bn net injection into the financial system when it's actually a $700bn swap of liquid assets on the governments balance sheet for a bunch of illiquid assets on the private sector balance sheet at a price close to, but probably below those assets' economic value.  

The irony is that the $700bn net injection plan - which this isn't - would recapitalise the banks and would therefore probably work, while the $700bn market creation plan - which Paulson's plan is - doesn't recapitalise the banks and so probably won't. So the rebel Republicans are trying to vote down the one that won't work because they think its the one that will ... 

Washington Mutual went down last night with JPM taking over their deposits and their branch network. They now become the biggest US bank by deposits as well as by exposure to the unregulated $60tr CDS market ...

Lots of the talking heads on CNBC were asking how the stock market could be rallying yesterday while the credit markets remained frozen - the TED spread was unchanged on the day, but spiked as high as 337bps early on. As anyone who is actually involved in markets, rather than just being a clever sounding pundit knows, one market is usually a view on another. Gold stocks, for example, are a view on the gold price. But it doesn't work the other way - gold doesn't care about what gold stocks are doing. So at turning points you often see the two behaving differently, with gold stocks rallying even as gold continues to fall because the equity market is in effect making a judgement that gold is going to rally. That doesn't always mean it's right, but it's what you're seeing right now. The stock market is a currently a view on the credit markets, and the view of the stock market right now is that if the Paulson plan is passed the credit markets will unfreeze ... that may or may not be the correct view and I'm still not sure that this plan will work because it doesn't address the issue of capital inadequacy, but that's why the stock market isn't waiting for the credit markets for permission to rally at the moment.

Do congress get it? ... TED spread above 3 as Chinese banks favour domestic counterparties ... more oil in Brazil ... buy beef

Market's fell yesterday on McCain's offer to suspend the campaign, including tomorrow's scheduled debate with Obama, until the TARP is passed. McCain, who is now nine points behind Obama in the capmpaign and presumably desperate said for any kind of favorable attention said:

"It’s become clear that no consensus has developed to support the administration’s proposal. I do not believe that the plan on the table will pass as it currently stands and we are running out of time.”

Most other members of the house, including majority leader in the Senate Nanci Pelosi appeared to indicate a narrowing of differences, citing agreement on increased oversight, executive compennsation and taxpayer protection. John Kerry said there was now a consensus on equity participation in those banks using the scheme. So notwithstanding McCain's attentions seeking it still looks to me as though a bill will be passed. 

However, some of these details look far removed indeed from the recommendations put forward by Paulson and Bernanke. Bernanke's testimony yesterday was interesting. His view was that the $700bn was only being used to kick start a market where there isn't one. By shining some light into the darkest corners of banks' balance sheets uncertaintity would be removed as to exactly what capital posisions were. This would help in delevering, and to the extent that mismarked capital could marked up, in the recapitalisation process too. But the real intention would be to provide the transparency needed by the banks and potential investors to attract the fresh capital they needed to become economically viable once more. The key, then, is that the plan is primarily about creating a market.

The real risk in my mind is not that Congress don't pass something, but that they pass something stupid. The plan to create a market, rather than directly "bailing out the financial industry" seems too subtle a distinction for Congress to understand. Curbs on executive pay are fine if they are retrospective clawbacks of some of the most egregiosly golden parachutes (Stan O'Neil's $100m+ for leaving Merrill in a state which ultimately killed it as an independently viable institution springs to mind). But an incomes policy is crazy. Similarly, there appears to be mounting interest in drip feeding funding for the proposal rather than stump up the $700bn in one go. All this will do is politicise a process which will only work if it is run independently. Worst of all is the punishing of participating banks by taking equity stakes in their businesses which risks, I think, no banks actually participating and defeating the whole purpose of the bill. I watched Bernanke's pained attempts at trying to be understood by the point-scoring politicians yesterday and actually felt sorry for him ... like a guy herding cats with his life depending on it ... 

The TED spread spiked back above 3 yesterday, to where it was at the height of last week's panic, and higher than it was going into the 1987 crash ... Chinese banks, meanwhile, have stoped entering into interest rate swaps with internation finance companies favouring only domestic counterparties. The Chinese regulator has denied reports that it has been leaning on the countries banks ...

Amid the fixation with developments in the US, the HBOS Lloyds deal has attracted little attention. But it's surely another disaster for the reeling UK housing market? NRK was doing 20% of the volume of new mortgages in the first half of 2007. When it hit the skids last year and was ultimately nationalised it ceased new lending. What happens to any market when you take out 20% of the supply? Mortgage rates rose, certainly helped and possibly even triggered the increasingly vicious housing slump and have been higher ever since ... fast forward to now and note that while Lloyds’ Cheltenham & Gloucester offshoot is renowned in the industry for its aversion to lending to buy-to-let, and buyers purchasing new-build houses, HBOS has traditionally given generous valuations and therefore bigger mortgages to new home customers. They also have a much higher proportion of first-time buyers than everyone else. Already tight conditions in the UK mortgage market are set to become tighter still.

Hong Kong, meanwhile, saw its first bank run since the Asian crisis as depositiors lined up at the Bank of East Asia. The HKMA stepped in with emergency funding while Li Ka-shing and the bank's CEO made a show of buying stock ... an investigation is now underway as to how the, er ... "malicious rumours" that the bank was in trouble were spread ... 

On the bright side, Buffet clearly sees value in the market. Not only has spent $24bn in the past nine months but he's now taken this stake in Goldmans ... in an interview with CNBC he said he was approached by Lehman's in April's capital raising but wasn't comfortable with their marks. He is very happy with the Goldman Sachs marks. He is probably also very happy with the Goldman deal he just got. The $5bn paying 10% a year is senior to the other prefs. Not only that, but he gets a five year option on another $5bn of stock with a strike at $115 (current price $130). A large part of an options value is its time value, so a five year option is worth quite a lot. Plugging in the numbers to BBG's Black Scholes model gives those options a value of around $2.5bn. So the net outlay on the prefs is actually only $2.5bn, giving an effective yield of 20% ... nice work ...  

Petrobras, trading on a PE of 8x (energy bubble??!) confirmed that there are "large" deposits of natural gas in the Jupiter (which GALP have a stake in) well and will give more details upon further analysis. Brazilian offshore looks as though it may contain as many as 50bn barrels of oil, and most of that will go to Petrobras. Already, they are one of the few integrated oil companies to show any production growth, yet they trade on a PE of only 8x ... 

The Australian Agricultural Co said the market conditions for cattle were now improving. High feed prices have seen high slaughtering of herds as current prices aren't economic, but that process may now be over. Flat or declining beef output in China, Russua and the US were cited, along with evidence that Brazilian exports have peaked

Bernanke doesn't know if the "bailout" will work ... Buffet takes stake in GS

Well it looks like I jumped the gun - Paulson's master plan is no RTC. In fact, I'm not sure what it is ... what is clear after yesterday's hearing is that the main problem with this crisis is the unprecedented and excessive complexity of the securities at the heart of the problem which precludes a simple solution. Understand that as presented, this is not a "deal" as such but an abstract concept. No one knows how much it will cost in the end, no one yet knows the mechanism for valuing illiquid assets and, unsurprisingly I guess in light of that no one even knows if it will work. Wheather or not Bernanke was afraid of putting his neck out and making a prediction, in the way that doctors are highly unwilling to offer proabilities on the success of an operation, I don't know. But I could have sworn he outright refused to vouch for its chances, saying only that it was the best they could come up with ... 

The plan seems to be to conduct a series of reverse auctions for the problematic illiquid securities. These auctions will be designed by egg-headed game theoriticians to establish fair prices where currently there are none. At the moment, there is no proper market for these securities so they are only sold at distressed levels. Once the sale has been done though, the seller and any other banks holding similar securities are forced to mark their capital to those distressed prices. In this way, I think the argument is, banks' capital is mismarked to give the appearance of being dangerously low when in fact it isn't. And if the scheme can establish a fair price and pay the banks slightly below that fair price but still considerably above the distressed price, then everyone is a winner. The bank wins because they get to mark up the value of their holdings and therefore their capital from the current deeply distressed level to one which is meaningfully higher.  Meanwhile the taxpayer benefits too because they will pay less than than fair value for the assets.

But will it work? What if the banks are still too levered even with a liquid market for assets which can be marked at fair value? Loads of the really toxic stuff is held as level 3 anyway and so not marked to market at all. Indeed, last I read Goldman Sachs - to take an example - had $96bn in Level 3 assets, three times its capital ... and what about commercial banks who don't trade as heavily as brokers and so aren't under the same pressure to mark to market? Don't they hold that stuff at model values anyway? Paulson said the heart of the problem was the real estate market. I actually think the heart of the problem is concern that the banking system is under capitalised and in a poor position to withstand the problems in the real estate market. And I'm not sure if the remarking of capital which will result from the greater liquidity and fairer pricing in the toxic areas of concern the scheme will provide will be enough to address that issue. 

Markets fell as the hearing progressed. The one month bill yield collapsed from 70 to 10bps ... according to the commentators it was because the bail out looked less likely to be approved ... I have no idea why this stress reapeared in the market, but my heart sank as I realised that any light at the end of the tunnel is distant indeed ... aside from concerns that the plan might not work, it's also clear that it's no quick fix. There will be an auction for each type of security and it will take months to work through each asset, starting with the simplest first according to Paulson. That means the money markets remain frozen for months. Which means no liquidity for the real economy for months. Which means continued deflationary pressure. 

I have no doubt that this bill will be passed. The posturing by senators yesterday with the world's gaze firmly on them would have been too good an opportunity to pass up on. It was clear that each one of them understood that the costs of doing nothing would enormous. You don't need to be a student of financial history to understand that the precedent for "letting it burn" was established in 1929/30 and led to the Great Depression and all that societal stresses which followed, including the rise to power of an Austrian oddball with a funny moustache. Which ones will be brave/stupid enough to take that risk? No, the bill will be passed and I'd expect some short term relief in the markets in response. But will it work? Hmmm ... still need to think.

Where does that leave us on the markets? ... Rogers, Chanos and Paulson have all recently restrained their bearishness on the financials. Now Buffet has added even more glitz to the already dazzling list ... futures are higher this morning on Buffet buying a $5bn stake in 30x levered with chunky Level3 assets Goldman Sachs ... hope its a better judgement than his one in Salomon Brothers ... it's being done on distressed terms to be fair, as you'd expect. Munger once said Berkeshire like to insure bridges against fire risk only if they're made of concrete and covered in water. Here, they get $5bn in preferred stock with a 10% dividend abd warrants to buy common stock at $115 at any time in the next five years. GS will also sell $2.5 in a public offering.