“Today is the day of fear and capitulation“; that’s how a trader in London described the market pulse on Tuesday 16th of September 2008, almost exactly half a year after the sudden death of Bear Stearns.

Some had not even fully digested Bear’s demise. Fannie Mae & Freddie Mac? Hey, no-one had come to terms with the fact that Lehman had ceased to exist at the early hours of Monday. Merrill Lynch being taken-over by Bank of America -for about half what was its market cap in May- was still waiting to be processed. And while traders, investors, central bankers and politicians were struggling to keep their head above the water, three letters were looming in everyone’s mind: AIG

-”Could it be possible that Paulson & Bernanke let the insurance giant follow Lehman to Chapter 11?”

-”Well, they let Lehman go under, didn’t they?”

-”But if they do, they take the system with them! Everyone has huge counterparty exposure to them!”

Numbers were flying around and simple maths sufficed to convince those at trading floors around the world that -even if half of those were right- no-one was safe. This was the moment of fear and capitulation. There was no institution too big to fail. Suddenly even Citi, trading at levels not seen since 1997, was not immune. Mentioning Citi and default risk in the same sentence, without laughing, is scary.

But the worse was yet to come. Hank & Ben buckled under the pressure from the free-falling market and announced a USD85bn rescue plan for AIG, effectively putting it in a state-sponsored Chapter 11-like cocoon. So that should be good news, right?

If Tuesday was the day of fear, Wednesday 17th of September was the day that the asteroid heading towards Wall Street -and any street for that matter- could be seen with a naked eye. The AIG rescue did not change the mood. Goldman Sachs, the last bastion of the Street, was down by 25%. Morgan Stanley was free-falling, exceeding -40% on the day. I was seriously contemplating the ‘exit scenario’. Retiring (a bit early) and becoming a free-range farmer back home. Gold was the only asset performing well. Half-joking, half-seriously I was recommending gold bars as the only safe haven. Oh, and not in any Bank vault, but kept at home -you never know..

At that point capitalism was on the brink of collapse. The system was looking like a house of cards ready to tumble down. The destruction in stock market value was driven by the seizure of the capital markets. There was no credit available. The interbank market had dried out completely, with the Fed and other central banks around the globe unable to kick-start it with massive injections of liquidity. The TED spread (3m Libor – 3m Treasuries, an indicator of the willingness of banks to lend to each other) exceeded 300bps, surpassing the record set in the crisis of 1987. The taps have been closed. There was no credit flowing in the system. The capitalist engine was about to seize. We were officially in deep, deep trouble.

At that point, there was not much of an alternative. I was arguing to a trader friend of mine that there was no moral hazard issue any more. That is, using taxpayers money to prop up the system by effectively bailing out private institutions, was now justified. Under normal conditions, such an abuse of public funds, especially when used to salvage banks that were showing billions of profits and multi-million bonuses to employees a year ago, would be a scandal. But the conditions were far from normal. The system was fighting for survival and the alternative was just too bad. As I argued, if Citi and the rest of Wall Street were to go down, the Main Street and John & Jane Doe would go with them. What will you get if hundreds of thousands of people become unemployed, have to liquidate assets, default on mortgages, loans, credit cards? What will happen to consumption? Who will give capital to corporates to grow? What about a super recession and a deepening the housing crisis? How much will USD fall down? How many more redundancies and corporate defaults will follow?

I suppose, Paulson, Bernanke -hey even Bush- realised this and had no option but to throw all their resources to stop the avalanche:

• ban naked short-selling (until October 2nd, although the date may be extended if required)
• throw more billions of liquidity to prevent banks & even money-market mutual funds going under
• propose setting up a Mega-Fund to buy all impaired assets at an estimated cost of USD 700 billion from any US-domiciled financial institution and hold them to maturity
• Global central banks followed suit with injections of liquidity and short-selling bans in the case of the UK

So where do we stand? What is next? Are things rosy from here on?

The global markets certainly gave a collective sound of relief on Thursday and Friday, staging an almost vertical recovery under the combined effect of technical short-covering (the shorts had to buy shares to cover their naked positions thus boosting prices) and sheer optimism mixed with bargain hunting among the battered financial (and not only) stocks. 50%+ returns were registered over two days of trading! But, keep calm and stay focused; there are many questions to be answered yet:

• Short-selling will resume sooner or later
  • The ban was -arguably- necessary to avoid the derailment of a very fragile market. However, a well-functioning market requires that such a ban is lifted as soon as the conditions permit. Short sellers, under normal circumstances, are a healthy force, keeping under-performers in check
  • The massive boost in stock prices over Thursday and Friday leaves them at a vulnerable position if there is no serious solution to the current crisis. That is, if nothing substantial happens, the current levels of stocks are attractive to short-sellers, so a further sell-off is possible
• There are no infinite funds available to central funds -especially after the pledged USD700bn
  • USD700 billion is a whole lot of money. Not even the US government has infinite funds; some already argue that the AAA rating of US debt needs to be sense-checked following the endless outflow of public funds
  • This money may eventually hit the economy; such a commitment will leave little if any extra funds to be spent towards spurring growth at a time that it is much needed. That is very likely to lead to a slow or even recessionary 1-2 years with a knock-on effect on the duration of the housing crisis, potential spill-over to consumer credit, corporate results and even defaults
• The USD700bn Fund needs to be ratified by Congress
  • The plan is just a plan right now. The Congress needs to approve it. It needs to approve it fast. Remember, there are a lot of Democrats there and political games may be played. To add extra spice to this last point, this is an election year. The Republicans cannot afford to have any more turmoil in the markets -let alone any big defaults- a few months before the elections. Having said that, there seems to be a unison in this subject as both camps realise the urgency of the situation

So where does all this leaves us? Well, if anyone claims to know what will happen next, he/she is either a time traveller or a lunatic. As I write this, the Dow trades 200 points down for Monday’s open. There is unease regarding the speed and nature of the salvation plan. There are questions on the moral hazard of such a plan and demands that it is accompanied with transformational regulatory updates that will change the current banking status quo. There are question marks on the future of Goldman & Morgan Stanley. I believe that, despite Morgan’s bravado that it still contemplates remaining independent -boosted by the surge of its share price on Friday- there is going to be a merger early this week (Wachovia?). Goldman may also be forced to merge (Wells Fargo?) if the downtrend restarts. If such a sell-off happens again, what is left to stop it?

And here I stop, because frankly 1,400 words are more than I had intended to write. But, hey, let’s start the debate and open the forum for views, comments and local color!

•nikosgi