Streetwise Professor

I had a front-row seat during the Crash of ’87, working as I did at the time for a clearing member on the Chicago Merc and Chicago Board. My boss, Brian Monieson, was on the CME board, and on the morning of the 20th (the day after the Crash) he told me the harrowing story of how the CME clearinghouse had almost failed at 0600.

That was a very sobering experience, but it pales in comparison to what is going on now. In ’87, the solvency of the banking system really wasn’t in question (Greenspan flooded the market with liquidity, and rapidly calmed fears about the banks). Now, the viability of banks around the world is in doubt. In ’87, although Monday the 19th and Tuesday the 20th were very wild rides, things had settled down by Friday, and by the next week there was a palpable sense that the worst was over. The present crisis has been metastasizing for well over a year, and shows no sign of going into remission.

Every day, it seems that another shoe–or 10–drops. And I have the sinking feeling that we are locked in Imelda Marcos’s closet during an earthquake, so we haven’t seen the end of that.

The “bailout” did little to stem the tide. And no surprise, really. As I wrote (and many others have written and said), the Paulson plan does not address directly the needed recapitalization of the banking system. It is the financial analog of military strategist Liddell Hart’s “indirect approach.” The problem is that there are several hypothesized causal connections that have to be true for the plan to work. If any one of those connections is in fact absent, the plan will fail. The government purchases of troubled assets have to generate information about the value of these assets; the additional information must be sufficiently salient to mitigate information asymmetries in the private market; the reduction in information asymmetries must be sufficient to improve substantially liquidity in the private market; the increase in liquidity must reduce the illiquidity discount in the prices for the troubled assets; the reduction in the discount must be large enough to restore banks to solvency or to allow them to attract equity capital from investors. Each of these steps is problematic in itself. Collectively, given that each must hold for the plan to work, I put a very, very low probability on a favorable outcome. It is the financial equivalent of drawing a couple of inside straights in a row.

In my more cynical moments, I think that it would have been better to choose some bankers at random, put them on a football field, and drop $700 billion on them by helicopter. That way, at least some banks would be recapitalized.

And speaking of Black Monday (remember that’s how I started this epistle)–Russia experienced its own version today, and on a Monday in October no less. The benchmark RTS and MICEX indices were down about 19 percent–close to the magnitude of the drop of the US market on 10/19/87, and far larger than today’s 3.85 percent drop in the S&P. The conjunction of the tumult in the credit markets, the continuing steep decline in oil, and Russia’s own special risks combined to cause the Russian market to plunge far more than any index in the world today.

A person whom I trust, who is very savvy, and who is in a position to know, assures me that the Russian banking system is in no danger because the government has a lot of money, and has made it clear that it will spend that money to keep the banking system from imploding. There is a liquidity problem, yes, but there will be no bank runs. The government will let some poorly run banks fold, but protect the depositors. The big banks will survive. “Financial crisis is bad but not a hurricane yet” he wrote.

Then again, my friend wrote this to me on my Friday, Saturday morning Moscow time. The winds have strengthened since.