What the Government bailout means for the markets

By Associate Editor David Stevenson Oct 13, 2008

David Stevenson
Branch of RBS

RBS: now 63% state-owned

The world is "on the brink of financial meltdown", says the head of the IMF. And the weekend brought news of eye-watering amounts of state cash to be spent.

An emergency EU summit decided to spend $400bn on a Euro-bank bailout. And Gordon Brown has thrown British banks a £39bn 'lifeline', which could mean government control of RBS and HBOS.

It seems the planet is now set to get a massive dose of socialism. So does that make it time to buy shares again…?

Here at MoneyWeek we've been expecting the biggest credit bubble in history to burst with a very loud, unpleasant bang. But even we didn't expect the disintegration to happen so quickly.

Senior bankers have lost the battle to prevent "a collapse of faith in modern finance", says Gillian Tett in the FT, but now, in "a new and potentially more dangerous phase, the great unspoken fear is: can we really trust that governments actually have the power to stop this panic?"

The markets clearly don't believe so.

The US government has vowed to plough taxpayer's money into a "broad array" of financial companies and to underwrite virtually everything, yet the Dow has still tumbled. Meanwhile Messrs Brown and Darling have promised to "invest" more in British banks, and all we've seen is short-term lending rates going up – another sure sign of massive stress in the system.

The man who predicted the crisis two years ago

But back in September 2006, a New York University economics professor cautioned an IMF audience that the US was set to face a once-in-a-lifetime housing bust, oil shock, collapsing consumer confidence and a deep recession. Homeowners would default on mortgages, trillions of dollars of mortgage-backed securities would unravel worldwide and the global financial system would shudder to a halt, destroying a raft of major financial institutions.

His name was Nouriel Roubini.

"The audience seemed sceptical, even dismissive", says Stephen Mihm in the New York Times. When Roubini finished speaking, the moderator quipped that everyone needed a stiff drink, "and people laughed".

Over the past year, plenty of optimists with impressive-sounding titles have been claiming that the worst of the credit crisis was over, and that after the US Federal Reserve's cash handout to Wall Street, a recession had been avoided. Yet Roubini dismissed this as "delusional complacency" encouraged by a "bunch of self-serving spinmasters", and warned of further corporate bankruptcies, collapses in commercial real estate and that at least one major bank would go "belly up".

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Understandably, many people now want to hear what Roubini sees next. The answer is more of the same, but worse. Here's what he says:

"Financial systems are now headed towards near-term systemic financial meltdown", the shadow banking system - market players who are borrowed up to their eyeballs - will collapse, and "in the biggest deleveraging (debt reduction) since the Great Depression", companies will run out of cash, which "may lead to widespread bankruptcies of solvent but illiquid firms".

We could even see a decade-long recession like Japan suffered after its property bubble burst. And soon we'll all be worrying about savage deflation.

Roubini's solution to the crisis

So what would Roubini do to sort things out?

Funnily enough, pretty much what the politicians produced over the weekend: "Radical, coordinated policy actions… blanket guarantee of all deposits…massive and unlimited provision of liquidity…public recapitalisation of financial institutions… partial nationalisation." More or less anything, at any cost, to try to steady the ship.

It now looks inevitable that the financial 'authorities' will be taking over most of the world's banking system with taxpayers' cash, or on borrowed money. (See what we said about that last week). An EU emergency summit is planning to recapitalise banks in a scheme that could cost $400bn, says Goldman Sachs. Meanwhile the UK Treasury is preparing to pump £39bn into three of the country's biggest banks, which could mean government control of RBS and HBOS.

And having acquired so much debt, the authorities will clearly be tempted to print money like there's no tomorrow, to push prices back up again and so to devalue their borrowings.

What will be the effect on markets?

Yet will these moves 'work' in bringing down the markets' temperature? And is it the time to buy? Well, there's almost bound to be an immediate bounce in stock prices, which could run through to the end of the year. But looking further out, we're not too optimistic.

To have Governments in control of bank managements, and of their ability to pay dividends to shareholders, is an unknown quantity. And that's unlikely to prove good news for the share prices of the banks - nor of the companies who will need to borrow from them.

Our recommended article for today

Why the world's new rules will punish us all
The scale of banks' recklessness means any new regulatory regime will penalise everyone – even investors who have been models of prudence.

Published in Economics | More articles by David Stevenson

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