Of the derivatives, credit default swaps are clearly destabilizing and will be tightly regulated. Many of the new market participants, such as hedge funds and private equity funds, should disappear, since they merely represented conduits through which higher fees could be charged rather than truly innovative investment choices. It is thus likely that the financial services business will revert to close to its previous share of GDP. That would involve a downsizing of its 2007 capacity by 50%.

The automobile industry, on the other hand, has no obvious need to become smaller. With global warming now high on the political agenda, its products need to change radically, employing new technologies that greatly reduce carbon emissions. However, the basic demand for personal transportation has not gone away.

Indeed, it is still expanding rapidly in the growth economies of emerging markets such as China and India. And U.S. urban geography, with its widely spread suburban developments, is wholly incompatible with a sharp drop in automobile usage and would be impossibly expensive to modify except over a very long term.
Why Citi Should Fail

Allowing a large bank such as Citigroup to disappear is probably beneficial. It reduces competition for other major banks, allows medium-sized banks to expand into the space opened up, and provides an appropriate penalty for decades of bad management. Citi was a leader in the Latin American loan crisis of the 1980s; its then-Chairman Walter B. Wriston famously opined that “countries don’t go bust,” a sentiment that has been repeatedly disproved.

Wriston got his succession wrong in 1984, choosing the overaggressive retail banker John Reed (who had pioneered the unsolicited credit card offer in 1978 and lost $100 million – real money back then – in 1980 by doing so) over the capable corporate banker Tom Theobald.

Citi almost went bust in 1991, but was bailed out by Saudi Prince Alwaleed bin Talal. It assembled a financial services conglomerate in 1998 that proved unmanageable, and from 2003-2005 was prevented from making any more acquisitions because of its shaky position.

In short, Citi has been a classically mismanaged behemoth that, in any other industry would, have already collapsed.

Yet, its bailout risks more than $300 billion of taxpayer money, and to no obvious economic benefit.

Meanwhile, General Motors has been damaged by two factors: Misguided government regulation of the automobile industry, and a drastic societal shift away from unionized labor.

CAFÉ Backfires

GM had a 60% share of the U.S. market in the 1950s, and was recognized for large cars that performed distinctly better than their imported competitors and were well suited to U.S. driving conditions. Some expansion of foreign competition was inevitable, as Europe recovered and Japan became a major automobile producer, but GM was particularly hard hit by the Corporate Average Fuel Economy (CAFÉ) legislation. CAFÉ, which mandated fuel economy standards instead of simply raising the gasoline tax, put GM’s large models at a disadvantage to their smaller imported competitors.

However, U.S. automobile companies found a loophole, which is that its standards were limited to automobiles. Vehicles built on a truck chassis were exempt. That gave rise to the sports utility vehicle. Now, higher fuel costs, environmental concerns, and tighter CAFÉ standards have made the SUV an endangered species, but it was a Frankenstein’s monster that only existed because of government meddling.

If GM and the other U.S. automobile manufacturers go out of business, only their foreign competitors will benefit. Furthermore, they have an interdependent network of suppliers, with a total of 3 million employees, which could easily be forced into bankruptcy by the disappearance of their major customers. U.S. automobile manufacturers have important, and in some areas unique technological capabilities, whose loss would severely damage the U.S. economy as a whole.

The automobile business is unprofitable now, but will eventually return its previous size in the United States, as well as expand worldwide. So, while there is no capacity downsizing needed, capacity restructuring, away from SUVs and towards smaller cars, hybrids and innovative power technologies, is essential.

Ultimately, the right decision would have been to bail out General Motors and allow Citi to go to the wall.

The Case for Citi

Of course, there are important modifiers to this recommendation. In Citi’s case, its interconnection with the financial system as a whole is such that an immediate bankruptcy followed by years-long court proceedings could render many of its counterparties unviable and damage the global economy badly. Hence, an orderly liquidation is needed, with a receiver appointed to wind down Citi’s positions and sell the viable portion of its operations, making good on those obligations incurred by Citi that appear to have systemic importance. Even if the taxpayer made Citi’s counterparts completely whole, however, it would not have been as expensive as the bailout.

As for GM, it has labor costs and pension obligations making it uncompetitive with foreign-owned producers. Those “legacy” costs can most efficiently be removed through a Chapter 11 bankruptcy filing. The pension obligations will then fall on the taxpayer through the Pension Benefits Guaranty Corporation, while the labor contracts can be rewritten in a way that is competitive with the market in which GM operates. If a government subsidy is then needed to cover GM’s operating cash deficit during the recession, and the investment costs of transforming GM into a producer of environmentally friendly automobiles, it should be provided through a post bankruptcy “debtor-in-possession” financing.

There is nothing magic about banking that should allow the industry to be uniquely permitted access to taxpayer money when disaster hits. Only bank customers and the market should be protected. Conversely, the automobile industry plays an important role in the U.S. economy that is unlikely to be significantly downsized. So, there is considerable justification for assistance to GM and Ford Motor Co. (F), which have valuable capabilities and long-term competitiveness, though less for a bailout of the smaller and less industrially valuable Chrysler Corp.

James Owers, Professor of Finance at Georgia State University, said: “The market expects that regulations will be tightened more quickly and aggressively by Obama than by McCain, which is generally bad for company profits. But then it was lax regulation that got us into this mess and Obama has some very astute economic advisers. It is a question of who can get the best balance between regulation and economic stimulation.” Hugh Johnson, founder and head of Johnson Illington, a US fund manager, thinks that a McCain victory would be better for the stock markets in the short term, but that US shares would fare better under Obama long term. He said: “Although both candidates wanted to keep taxes low, Obama wanted to increase capital gains and dividend tax and to roll back the Bush tax cuts for the highest two income brackets. So McCain’s proposals will provide a greater stimulus to the economy than Obama’s, putting upward pressure on US shares. But in the longer term, the US deficit will go up and the economy will suffer.”

Analysts say that an Obama victory had been priced into the markets in recent weeks. However, the recent share rally is down to the likelihood of a further economic stimulus package rather than the prospect of an Obama presidency, they say.

Pete Najarian, an options trader in New York, said: “Whoever has been named president-elect, the fact that the decision has finally been made will bring a huge degree of relief. The market has been in such a volatile state in the past few months and we just wanted an answer on who the new president would be. In the past week and two days, share price volatility has dropped by about half and it should fall further now.” Jeremy Siegel, of the Wharton Business School in Pennsylvania, said that shares usually perform better on the day after a Republican president is elected, as investors, who are generally conservative, celebrate but in the long run, Democrats have had better returns. Professor Siegel studied stock returns in the days surrounding US presidential elections between 1888 and 2004.

From Monday morning to Wednesday night, US stocks rose by an average of 0.7 per cent in the event of a Republican victory. They dropped by 0.5 per cent, on average, over the equivalent periods of Democrat victories.

In 1967, Yale Hirsch released data based on the previous 134 years, which determined that, on average, shares performed better in the final two years of a presidential term, a trend he attributed to manoeuvring by the party in power to increase its chances of reelection.

“As presidents and their parties get anxious about holding on to power, they begin to prime the pump in the third year, fostering bull markets, prosperity and peace,” according to a recent edition of the Stock Trader’s Almanac, the monthly newsletter set up by Mr Hirsch, which covers the financial markets.

However, with stock markets down by 30 per cent this year, it would be unwise to put too much store in the long-held theories on the stock market’s relationship with the president.

Source: http://business.timesonline.co.uk/tol/business/economics/article5084111.ece

It took a while before it became clear (or at least, accepted) that the problem was system-wide. Initially, it was smaller, local banks that got into difficulty.

The first Japanese bank failed in August 1995 (the first since the war). This was dismissed as a local difficulty because it was Hyogo Bank, a regional bank affected by the Kobe City earthquake in that year.

The blanket deposit guarantee was introduced in June 1996, but it did not prevent runs on the banks for two reasons. One was credibility. Saying the money was safe was one thing; proving it was another. Second was practicality. Imagine your bank does go bust. Even if there is no question about whether you will get your cash back, you are faced with complete uncertainty. Far better to get it out straightaway.

The specifics of every banking crisis vary by country and by cycle, but the general forces are the same. When expanding gearing gives way to contracting debt, the stage is set for a liquidity crisis.

For Japan, this occurred in 1997-98. Two large brokers and one big money-centre bank failed, followed a few months later by the nationalisation of two long-term credit banks. A similar liquidity crisis has struck the West.

It is not obvious that the process in the US and the UK has been shorter. If you define the stock-market peak as 1999-2000 and the rally since early 2003 as no more than a relief rally (analogous to Japan’s recovery from 1992 to early 1996), then the timetable is actually similar.

A liquidity crisis has a sharp impact on lending to other parts of the economy. As a result, the economy slows and the debt built up by households and businesses becomes harder to support. This gives rise to the third and final phase: a solvency crisis. Japan’s big banks reached that point about five years after the liquidity crisis.

Three kinds of adjustment are needed before stability can return. First, asset values must discount the credit- constrained world. That is already happening with a vengeance, but take care not to assume too quickly that the process is complete.

A sucker rally (or three) should be expected, to make sure that hope is extinguished before share and house prices can return to any sustainable rising trend.

The Nikkei plunged about 40% in 1990-92, rallied by about one third, then traded between 15,000 and 20,000 from 1992 to early 2000. This range included three rallies of more than 30%.

Second, the banking sector needs to write off bad debts, consolidate (a polite way of saying shrink), and rebuild its capital base. In banking terms, completing the MUFG merger in October 2005 marked the end of the crisis.

Third, the real economy must also adjust to the new credit constraints. In Japan’s case, car sales, land prices, bank lending and the household spending index have, like share prices, returned to the levels of the early 1980s.

Corporate gearing ratios are at levels not seen for 40 years. Its economy has been through a wrenching adjustment over a long time.

Could it take this long in the West? Experience has taught that we should not rule out such a possibility. You could argue that the imbalances in the West are greater and have been allowed to build for longer than in Japan. It is that build-up of imbalances which will determine the scale and duration of this adjustment period rather than the actions of politicians and regulators (who have a tendency first to deny, then to fight the last battle rather than this one).

The author heads the Société Générale Asset Management Japan Core Alpha team

Source : http://www.timesonline.co.uk/tol/money/investment/article5061770.ece

Second, liquidity conditions now may actually be worse than when the entire credit-crisis mess began to unravel this time last year. For example, the benchmark London Interbank Offered Rate (LIBOR) remains higher than so-called “policy rates” and U.S. Treasuries of comparable maturities.

This suggests that banks still don’t trust each other and therefore are keeping so-called “Interbank” borrowing rates high in order to reflect what they perceive to be the added risk of doing business. We’ve been warning investors to watch out for this since as far back as April, and have generally been preaching caution since the credit crisis began last year.

In other words, the fact that Libor-Treasury spreads are wider today than they were a year ago suggests that the banks really don’t know who continues to hold the toxic debt instruments the entire world has come to fear – despite a recent earnings parade of CEOs making claims to the contrary.

The upshot: Many institutions are hoarding cash - something you’d hardly expect to see if the credit crisis were really on the mend.

Third, judging from recent reports, it’s beginning to dawn on financial regulators that this crisis was never about a lack of liquidity in the first place, which is something I suggested in an open letter to U.S. Federal Reserve Chairman Ben S. Bernanke some time ago.

Instead, this crisis is about three things:
• Too much liquidity.
• Fundamental structural problems in the credit industry, including the almost-total lack of regulation.
• And the lack of transparency of complex financial instruments for which there is no public market, making them tough to value and nearly impossible to trade.

It is becoming clearer by the day that – partly because of these three factors – a good deal of money has been made fraudulently, if not illegally.

Granted recent changes surrounding the “mark-to-market” accounting of so-called “Level 3” assets are a step in the right direction. But what few people realize is that, in the short-term, these new requirements could involve the immediate recognition of even larger losses than we’ve seen to date.

The reason is that many of the firms involved – think Merrill Lynch & Co. Inc. (MER), Lehman Brothers Holdings Inc. (LEH) and Citigroup Inc. (C), for example – will no longer be able to hide their losses in Level 3 assets, as they have in the past.

As you might expect, there’s a counterargument to this, and it’s a highly popular one on Wall Street - especially inside the CEO set, whose members desperately want to stop the financial hemorrhaging their firms are enduring. They claim they’re “selling” risky assets and “de-leveraging” their balance sheets.

But here’s what they are not telling you.

Even though these folks are technically “selling” assets – particularly the distressed “Level 3” assets I mentioned a bit earlier – what they are really doing is assigning the upside to hedge funds, private equity firms, and sovereign wealth funds in exchange for cash.

And here’s the kicker: The banks actually are holding onto the downside liability in the event the underlying securities go bad. That brings us back to the start of this commentary, when I said that I expect more securities to go bad.

No matter how you look at it, these financial institutions are playing a vicious shell game, hoping all the while that they’re not the loser who is taken to the cleaners when he picks up the wrong shell.

Where this goes from bad to worse is that at the same time they’re playing more fancy accounting tricks, these firms continue to pony up to the Fed’s private backdoor lending window for sweetheart financing. After all, they can’t get the financing anywhere else.

That means that every taxpayer in this country is involuntarily being put in the bailout business. As for whether or not we’re near the end of the credit crisis as a whole, it depends on whom you ask.

When this crisis started a year ago, I was asked a similar question and answered it by saying that we would not even begin to approach the end of the line until the total losses exceeded $1 trillion.

My audience chuckled politely.

Fast-forward 12 months, and nobody’s laughing anymore – especially when I say that I’m now raising my industry loss estimate to nearly $2 trillion.
Increasingly, other analysts are embracing a similar viewpoint. UBS AG (UBS) raised it’s estimate of the total cost of the credit crisis to $600 billion, while noted hedge fund manager John Paulson suggested $1.3 trillion is not unthinkable.

Meanwhile, in a report issued last May, the International
Monetary Fund (IMF) projected the bailout costs at $1 trillion.
All of this leads us to a single conclusion: At least for now, this is a “recovery” in name only.

[Editor’s Note: The “Super Crash” isn’t coming… it’s already here. Combined, the swirling forces of inflation, the credit crunch, exploding trade deficit, stagnate economy will cost the average American $85,000 dollars over the next 6 to 18 months. But over 50,000 investors are already using Peter Schiff’s unique strategy for profiting from the “Super Crash.” And now – for
the first time – you’ll be able to join them for free.]

Copyright 2008–present,Monument Street Publishing, LLC 105W.Monument St., Baltimore,MD 21201
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publisher. Information contained herein is obtained from sources believed to be reliable, but its accuracy cannot be guaranteed.

"The pace of economic activity has slowed markedly in recent months," the
Fed said "Moreover, the intensification of financial market turmoil is likely to
exert additional restraint on spending, partly by further reducing the ability
of households and businesses to obtain credit."

Although inflation has been high, the Fed believes that the recent drop in
energy prices and the weaker prospects for economic activity have reduced this
threat to the economy.

In Europe, which also has been hard hit by the financial crisis, the Bank of
England cut its rate by half a point to 4.5 percent, while the European Central
Bank sliced its rate to 3.75 percent.

In addition, the Fed reduced its emergency lending rate to banks by half a
percentage point to 1.75 percent. Given the intense credit crisis, banks have
been ramping up their borrowing from the Fed's emergency "discount" window.

In response, the prime lending rate for millions of borrowers will drop by a
corresponding amount. The prime rate applies to certain credit cards, home
equity lines of credit and other loans.

The hope was to spur nervous consumers and businesses to spend more freely
again. They clamped down as housing, credit and financial problems intensified
last month, throwing Wall Street into chaos. Many believe the country is on the
brink of, or already in, its first recession since 2001.

The Fed's last rate cut was in late April, capping one of the most
aggressive rate-cutting campaigns in decades as it scrambled to shore up the
faltering economy. After that, the Fed moved to the sidelines, holding rates
steady as zooming food and energy prices during that period threatened to ignite
inflation. In the past few months, energy prices have retreated from record
highs reached in mid-July, giving the Fed more leeway to drop rates again.

At its last meeting in September, the Fed struck a more dire tone about the
economy, hinting that a rate reduction once again could be in the offing.

Even with the unprecedented $700 billion financial bailout quickly signed
into law by President Bush on Friday, the failing economy and the jobs market
probably will get worse. Many believe the economy will jolt into reverse later
this year -- if it hasn't already-- and will stay sickly well into next year.

One of the most crucial pillars of the economy -- the jobs market -- has
cracked, and wage growth is slowing. This means that consumers will be even more
hard-pressed to spend in the fashion that helps grow the economy.

Increasingly skittish employers slashed payrolls by 159,000 in September,
the most in more than five years. A staggering 760,000 jobs have disappeared so
far this year. The unemployment rate is 6.1 percent, up sharply from 4.7 percent
a year ago.

The unemployment rate could hit 7 or 7.5 percent by late 2009. If that
happens, it would mark the highest rate of joblessness since the months
immediately following the 1990-91 recession. Some economists say the jobless
rate could rise even more before the situation starts to get better.

Mounting job losses, shrinking paychecks, shriveling nest eggs and rising
foreclosures all have weighed heavily on American voters. The economy is their
No. 1 concern, polls have shown.

Spooked consumers and businesses have pulled back so much that some analysts
fear the economy stalled -- or even worse, shrank -- in the July-to-September
quarter. Many predict the economy will contract in both the final quarter of
this year and the first quarter of next year, meeting the classic definition of
a recession.

The financial crisis that intensified in September is forcing a seismic
shake-up on Wall Street.

Lehman Brothers, the country's fourth-largest investment bank, filed for
bankruptcy protection. A weakened Merrill Lynch, deciding it couldn't go it
alone anymore, found help in the arms of Bank of America. American International
International Group was thrown a financial lifeline. And, the last two
investment houses -- Goldman Sachs and Morgan Stanley -- decided to convert
themselves into commercial banks to better weather the financial storm. The
number of banks that have failed this year are up sharply from last year. On
Friday, Wachovia Corp. said it will be acquired by Wells Fargo & Co. wiping out
Wachovia's previous plan to sell its banking operations to rival suitor
Citigroup Inc.