News / US Equities

US Financials: No Pain, No Gain? By Fitz Aclan September 26, 2008

We all know by now what is going in the US financial market. As traders, we should keep our eye out on the effects of the recent bailouts of Lehman Brothers and AIG on the market. Looking forward, where are the markets headed?

We all know that equity and assets of these companies are leveraged many times over. We also know that asset prices are collapsing.

As a sort of aside, what I am worried about is the credit default swap (CDS) market. A CDS is a credit derivative contract between two counterparties, whereby the “buyer” or “fixed rate payer” pays periodic payments to the “seller” or “floating rate payer” in exchange for the right to a payoff if there is a default or “credit event” in respect of a third party or “reference entity”.

A credit default swap resembles an insurance policy. It can be used by a debt holder to hedge or insure against a default under the debt instrument. However, because there is no requirement to actually hold any asset or suffer a loss, a credit default swap can also be used for speculative purposes.

Credit default swaps are the most widely traded credit derivative product. In the US and other international markets, the CDS market is reportedly worth a whopping US$ 62 trillion. If the CDS market tanks, that would really complicate things.

Back to the topic, what needs to be done?

First is to isolate the disease, so to speak, and not to make it worse that it is. There is a need to calm the markets down by not making the problem systemic.

Second, let the whole thing unwind, let it deflate. This would probably mean the possibility of the painful process of write-downs, a lot of write-downs. In conjunction, there is a need to reduce speculation while the unwinding is going on. A radical approach to this has partially been adopted, that is the banning of short selling.

The next step would be to recapitalize troubled financial companies, something that can be done simultaneous to the unwinding. The US government will have to assure buyers of certainty in terms of asset valuation.

But the question then is, who will fund the recapitalization or who will buy the bad assets of troubled companies? Do the shareholders have the funds? Other corporations? Maybe, but on a limited capability only. Foreign funds? Also maybe, but will the Americans really want major chunks of their companies owned by Arabs or Chinese maybe? American taxpayers? That would be complicated being an election year. And who will fund the so-called $700 billion “Super Fund” bailout?

What is sure is that regulations must be put in place to avoid a repeat of the recent financial meltdown. Whether this can be reality is another thing altogether.
What we already know is that measures already adopted look like “stop-gap” measures which we hope can calm down the markets.

What we really need to see is more details and clarity on the “game plan” for the bailout. This is what the markets are looking and this is the reason why the US markets are dipping.
For sure, companies like Morgan Stanley and Goldman would be bought out, signaling the probable death of the investment banks.

My best bet is that the “Super Fund” would be funded by a lot of quarters, including sovereign funds who really have a lot of funds available. But mostly, it looks like the American taxpayers are footing the bill. This would mean the US fiscal position would weaken, and so will the US dollar.