Early this morning key global central banks poured an unprecedented USD180 Billion of temporary liquidity into the global banking system to keep the wheels from coming off. While this will not alleviate the fundamental solvency problems of many institutions, the added liquidity will forestall disaster for a time.

It was about a year ago that we began to make occasional reference to “zombie” financial institutions. [“Zombies” are institutions whose equity and debt is trading at levels that make the continued viability of their business models uneconomic (equity too cheap to issue in needed amounts to re-float the business and debt trading at yields that do not allow their asset portfolios to be financed at a positive spread). Unless they are rescued or re-financed by stronger institutions, insolvency is the unavoidable outcome.]

In regards to the list of thirteen “Notable Zombies” that we set out in our last blog entry on September 8th, so far two of the firms on that list have gone out of existence; and AIG  has now been nationalized backed by an initial USD 85 Bn. of public funds. Our long-held views that the GSE’s were insolvent has also been proven out.

There are more bailouts in the pipeline and what is of some concern is that by now it should be clear to everyone that the US authorities have no plan, no roadmap, out of this mess. Recall that a year ago Bernanke and Paulson were reassuring markets that there really wasn’t a crisis at all; six months ago they were touting the GSE’s as part of the solution to the sub-prime mortgage crisis; and as at last Friday, AIG was not going to fail, it was going to be rescued by private sector firms.

Please click here for an extremely useful representation of the value destruction that has occured in the year to date, courtesy of the New York Times.

Through all of this, Paulson has reverted to type as an investment banker, whipping and driving deals, arranging shotgun marriages, doling out dollops of public sector funding for zombies on the verge, and trying to jawbone markets higher, while ignoring the public policy and government finance dimensions and longer term impacts of what he and the rest of the current Administration are doing.

In fact that the practical outcome of the use of public funds so far is far from certain in part because the process of rehabilitating the failed institutions that have been rescued, but remain unstabilized is going to take a very long time. In addition, in a normal transaction environment it usually takes months and quarters of due diligence before a successful change of control can be valued and implemented. For these and other reasons, success is far from guaranteed if we stay on this risky path.

This, in particular view of the fact that there are perhaps hundreds of smaller institutions that are also now on the zombie list that will eventually fail. Will the arranged marriage approach work; does Wachovia/Morgan Stanley make sense; or will some or a large proportion of these deals come apart and/or end up costing significantly more than the markets are being told?

To us it is very worrying that other means of support and other more comprehensive remedial approaches are not being explored and implemented and why confidence boosting measures that include more stringent regulation and oversight of the financial services industry are not now being signalled as part of the eventual solution to the problem. For example, the imposition of leverage caps for financial services companies – including hedge funds; more stringent and transparent reporting requirements; the more stringent enforcement of existing securities laws, and the rollback of some of the anti-regulation signed into law by Clinton in 1999 should all be on the table for discussion. Unfortunately this thinking goes against the grain of the non-interventionist orthodoxy in DC – in this case to the longer term detriment of the country and the planet, we believe.

Even though they are not saying it, the current behaviour of the Treasury and Fed indicates that the Administration believes that the band-aid remedies are appropriate, that they represent durable solutions, and that life can go on as before.

We do not agree. Our belief is that the current course of action has used up valuable public sector financial resources and reduced future options and flexibility for dealing with what is going to be a very long drawn-out crisis. And, as we have seen over the past few days, contagion to other markets has become more than a possibility.

Apart from the irony of having the world’s largest free market economy nationalize some of its most sizable companies, the heavy reliance of the Government’s balance sheet is only a few more bailouts away from exhausting existing resources. The jousting by Obama and McCain regarding tax policy is painful to watch as it describes almost total ignorance of the fact that whoever becomes President, in the very near future he will be faced with an economy saddled with what will prove to be near-Trillion Dollar budget deficits, near-Trillion Dollar external deficits, and no fiscal room to manoeuvre.

In the end, this may leave only the printing press with Helicopter Ben on the button to inflate away the excesses………with all that that implies.

This entry was posted on Thursday, September 18th, 2008 at 12:56 pm and is filed under Bank Loans, Bankruptcy, Banks, Bond Market, Crisis, Economy, Fed Policy, Restructuring, Sovereign Debt, Sub-Prime, USA. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.