Jeremy Warner's Outlook: More action needed as market crash threatens meltdown

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The Independent Online

Crash, bang, wallop. Is this capitulation, the point at which the last bull turns tail and flees before the marauding bears? Only a fool would attempt to call the bottom when a crash is in full motion. Nobody can know how low the stock market will go.

Equities are being sold right now because they are one of the few things that investors can sell. You cannot sell houses or commercial property, and you cannot sell corporate bonds, still less mortgage-backed securities and other forms of securitised commercial debt.

Nor is anyone selling government debt, other than governments themselves, who are shipping it out by the lorry load to satisfy the insatiable appetite of those who think, almost certainly mistakenly, of governments as the only safe place left to stick your money. Even here, investors are beginning to worry about the solvency of nations.

Government debt is only as safe as the ability of taxpayers to pay it back, which is why nations nearly always end up rendering the debt worthless by inflating their way out of it.

But whatever else you can't or won't sell, you can still sell equities, one of the few asset classes that remains relatively liquid. In anticipation of a prolonged and deep recession, share prices are plummeting.

There are also some key short-term worries that are driving equities lower. One is the auction that began yesterday of the credit default swap (CDS) exposure to the Lehman Brothers collapse. This has the potential to wreak merry havoc in already-shot-to-pieces capital markets. CDSs are a form of insurance, only it is not cars, property and valuables they insure, but the risk of someone defaulting on their borrowings. They are also tradable in themselves, but through entirely unregulated markets with no central clearing house to record who owns what.

As a consequence, there are a lot more of them in existence than there are bonds to insure. Such was the insanity of credit markets. Lehmans went down with some $400bn (£236bn) to $600bn of liabilities, most if not all of which would have been insured through CDSs. The auction amounts to an attempt to settle these claims. The process has been so long in the anticipation that you have to assume that all those on the hook for a payout have lined up the money they need. Yet because there are more CDSs in existence than there are bonds to back them, the auction is capable of unanticipated outcomes.

If the counterparty doesn't have the money to pay, then he may be forced into default too, creating a chain reaction of bankruptcies and a subsequent firesale of assets. At the time of writing, the outcome of the Lehman CDS auction wasn't known.

The other key short-term worry for the UK stock market is the banks, which were again some of the heaviest fallers yesterday. Banking profits are going to be clobbered anyway over the next few years, but the dilution involved in the proposed government recapitalisation will completely poleaxe the read-through from profits to earnings per share. The curbs on banking dividends that the Government wants to impose as a quid pro quo for taxpayers' money is all very well, but in recent years the banking sector has provided about a third of the dividend income of the entire FTSE100. Most of this money would have gone not to City fat cats but to pension funds and other savings accounts, which are correspondingly undermined. As in all things the Government does, the law of unintended consequences is already all too apparent.

Just to set yesterday's plunge in share prices in its full, grim context, the stock market is now lower than it was when Labour came to power more than 11 years ago. Anyone investing in equities through a pension plan over that time frame would thus be quite a lot down on the money put aside, as most of the monthly payments would been invested at significantly higher levels.

The events of the last year have depressed equity valuations to levels which are now lower than any of the last three recessions. To justify lower still, we'd need to be heading into a 1970s-style contraction, or even a repeat of the Great Depression. Unfortunately, these outcomes cannot yet be entirely discounted, which is why investors are still running for the hills.

There are a number of worrying parallels between now and the toxic cocktail of ingredients that led the crash of 1929 to turn into the Great Depression, but there is also one key difference.

The policy response to the 1929 crash was the exact opposite of what was required. Monetary conditions were kept tight, banks were allowed to go bust, and the Federal government attempted to run a balanced budget. Ben Bernanke, the chairman of the Federal Reserve, made his name through academic study of the Great Depression, and he is not about to make the same mistakes as his forebears.

Most of what President Bush says can reasonably be ignored, but his assertion yesterday that the US has the tools necessary to halt the meltdown is undoubtedly correct. But will the US use them? There's not much wrong as such with the policy action taken in the US and Europe thus far. This week in particular there has been a step change in the willingness to act. But still policymakers are behind the curve.

Nothing is going to get fixed until they get ahead of events. Much more needs to be done. The monetary size of the bailouts already looks humongous, but America has the capacity to go a great deal further, and indeed must go further if it is to douse the flames. Hank Paulson's $700bn fund to buy up bad debts is already self-evidently not enough. Following Britain by committing taxpayers' money to the recapitalisation of US banks is the obvious next step.

There has never been a more important meeting of the IMF and World Bank than the one being held in Washington this week. Political leaders need to match words with deeds.

RBS again at the centre of banking sell-off

Confusion reigns over the Government's plans for recapitalising the banks, with the result that the proposals are having the opposite effect to the one intended. As evident in yesterday's renewed slump in bank share prices, the proposal has so far only added to the uncertainty and thereby further damaged confidence.

This is particularly the case with the beleaguered Royal Bank of Scotland, which after yesterday's battering to the share price is worth less than the £12bn it raised from shareholders just six months ago.

The betting is that RBS will become the first bank to fall back on the Government's recapitalisation facility. Lack of clarity over how seriously this might dilute shareholders has contributed to the fall in the share price.

This is partly the fault of the Government, partly the fault of the banks. Everyone seems to have a different idea of what the plans entail, which is indicative of the haste with which they were thrown together. What we do know is that nobody gets access to the bailout package's £250bn of term lending until they have agreed with the FSA satisfactory plans for recapitalisation.

Plainly the need for more capital is greater in some banks than others, but there is a wide divergence of views in the City about who requires what, and by how much this might dilute earnings per share, if at all. There is also a wide divergence of views among banks themselves. HSBC believes it has already satisfied the Treasury's demands by simply switching capital out of its international operations into the UK bank.

Barclays wonders whether the £6.8bn it has added to capital since the half-year statement might not count towards the recapitalisation plan, negating the need for any more capital raising at all. And so on.

The bottom line is that the whole thing was rushed out ahead of schedule because two of Britain's major banks, HBOS and Royal Bank of Scotland, were about to go the same way as Northern Rock. All banks were forced to sign up to the recapitalisation plan as a way of avoiding the stigma of some banks being bailed out with government money, but not others.

Yet in practice, stigmatisation is proving impossible to avoid. The stronger banks are now running for the hills, saying either they don't need any net addition to capital or that they don't need the Government's support in raising it. That leaves those that are forced to go cap in hand to the Government looking weak and feeble. Markets will punish them accordingly. If shareholders want to avoid wipeout, they must again come to RBS's rescue.