Tuesday, October 7: A bad day for CEOs. Psychological barriers are breached

Tuesday, October 7: A bad day for CEOs. Dick Fuld faces Congressional grilling. Ken Lewis announces BofA’s capital raising exercise

Tuesday began with another meeting with a banker that failed to inspire confidence in the Tarp. "At the first auction only the desperate will come forward," said the banker. "Tarp exists to create a reasonable market price and avoid the negative consequences of forced firesales."

At least this investment banker was hopeful that the systemic issues would be resolved by the end of the year, as he listed the innovations in the Fed’s window, support for the CP market, the Tarp and the Federal Deposit Insurance Corp, and the fact that the brokers were now bank holding companies. "I’m slightly optimistic," he conceded. "The market has fallen a lot in the last year. Once sentiment changes you’ll have an $80 billion month in new issues like this!" He snapped his fingers for emphasis.

But after offering the promise of some normality in financial markets once the new year was in, he then offered a frightening prospect of yet another shoe that could drop. He forecast that between a quarter to one-third of hedge funds would fail during the next six months. "It’s the next financial run," he explained. "It’s a big issue for the financial system – forced liquidations of assets."

The blame game, which is inevitable during times such as these, had the credit derivatives sector and the rating agencies in the dock. "It is very easy to manipulate the share price of a firm by hitting the bid for [credit] protection in size," he said. "As soon as equity market traders see the CDS level widen, the share price tanks. It is then a self-fulfilling prophecy because the rating agencies will then put the rating on negative watch, citing reduced or increased cost to accessing the capital markets!"

How apt it was that the next meeting was with a credit structurer. What defence would he bring? "We don’t create the companies that default," he said.

Euromoney contended: "But detractors would argue that structured credit provided financing and leverage that helped create the sub prime bubble."

The banker responded: "If you didn’t make the sub-prime loan you wouldn’t have the problem." This ignored the fact that, during the housing boom, CDO structurers were sucking in sub and mezz tranches of RMBS with little or no concern for the credit risk. It’s not all one-way traffic. He said that while derivatives allow you to separate liquidity, credit and interest rate risk it’s clear that credit markets didn’t fully understand liquidity and vice-versa. The creation of an exchange and a central counterparty was welcomed.

He then made a contentious statement about why Lehman was allowed to fail. "If they didn’t let a bank fail, how were they going to prove there was a serious problem? You kill a chicken to scare the monkey..."

But he was dismissive of the proposed Tarp cure. "It’s the worst $700 billion that the government will ever spend! It will be good for strengthening banks’ balance sheets but will they actually lend? If they want to stop the liquidity crisis with regard to corporates they should try to replicate something like Brady bonds." Unfortunately, Euromoney did not have time to go through the mechanics of how these debt-for-equity swaps might work, as lunch with two debt originators was looming.

These bankers were at a firm that had avoided much of the pain that competitors had suffered. That did not mean lunch was a lighthearted affair. They, like almost all bankers, were sure that there would be a deep recession and possibly more bank failures. Thinking the unthinkable, was it possible that Morgan Stanley would go?

In the afternoon, a fixed-income strategist offered more thoughts on how tough markets will be even if Tarp avoids a systemic meltdown.

"Securing the short-term debt markets buys us time before Tarp gets going and possibly provides a capital solution," he said hopefully. "It could be mid-2010 before deleveraging is over – 2009 will be about banks’ continuing conservatism ahead of a major recession."

The final meeting of the day was with an industry body specialist. He spelled out the reality of what the crisis meant in operational terms. "Failed settlements in the US treasury market are a daily occurrence," he said. "There is a massive flight to quality and that has hit the repo market. If this lasts for a long time, there may be challenges to the overall liquidity of the treasury market. For the buyers of treasuries, such as central banks, seeing failed settlements could lead them to reduce their securities lending activities." Put simply, they will not be inclined to lend out treasuries if they don’t think they will get the securities back or are unhappy with the counterparties’ credit risk – which includes just about everyone.

That day, more psychological levels were breached: the S&P 500 fell below 1000 to 996, and the key indices were at five-year lows. The next day (October 8) started with grim news from Asia where the Nikkei fell by 9% – its largest one-day fall since 1987. Even global coordinated interest rate cuts did little to ease the gloom. This is not 1998. But there was some good news from the credit markets, which rallied on the back of UK government guarantees for bank debt and a partial nationalization of several banks.

Wednesday, October 8: Looking into the black hole
"The financial structure has changed, ending credit-led financing and disintermediation, and into a funded model"

Thursday, October 9: It feels like capitulation
"Enough! Just sell my stock, sell me anything with credit risk and buy T-bills – at least I know I’ll get my money back"

Post-script: Washington DC, Friday, October 10 to Monday, 13
"Either we get a coordinated response from the world’s leaders by the end of the weekend, or we might as well give up and go home"