Evercore Pan Asset

That was quite a week in financial markets. The US Administration has been trying everything to get the money markets and the market in credits to work again. They decided that they could draw a distinction between financial institutions that were too crucial to allow to be allowed to go into Administration – Fannie. Freddie and AIG – and those that should be put through bankruptcy or creditor protection to force them to restructure and revalue their assets – Lehman and maybe others to follow.

I guess it was worth trying. Unfortunately, the markets reacted very badly to the collapse of Lehman. Instead of market participants learning the lessons of past excess and coming to sensible judgements about risk, it invited two reactions. Firstly, everyone looked around to find out which large company might be the next to go down. Secondly, everyone decided to play it ultra safe, and only buy government backed securities, for fear of making a mistake.

It is another example of how important the work and words of the regulators are, and how they can have perverse consequences. The US had taken some action to control short-selling, but that didn’t stop big falls in shares of financial institutions. People who owned the shares decided to get out, seeing how a large and important institution like Lehmans could tumble in just a few days of reappraisal of their worth.

Now in the UK we have a ban for a few months on short selling shares in financial institutions. The general response of the press has been to say “shutting the stable door after the horse has bolted”. That is a false response. The experience elsewhere shows that banning short selling does not bolt the stable door. Doing it in one market still allows it in others, whilst the share movements in recent weeks where shares in some financial institutions have collapsed have been caused primarily by the owners of the shares wanting to get out. I speak as someone who never short sold a share all the time I was a professional investment manager, partly because your potential loss if you get it wrong is unlimited.

At the heart of the problems in the banking markets is fear of what the assets of each financial institution are truly worth. Normally markets are quite capable of putting a price on anything – that is all they do and they are usually quite good at it. Today market professionals who created large quantities of cleverly structured paper based on traditional mortgages or loans seem no longer able to come to a rational view of what it is worth. They no longer trust each other, and no longer want to hold all this paper they made a lot of money creating. As a result, instead of trading packages of mortgages or loans between themselves, one needing the money and the other prepared to take the risk to earn a better return, they will only buy bits of paper secured against the government revenues of a major country. Short term loans to government are now very highly prized, whilst loans to anyone else are undervalued.

It is curious that no new consensus emerges from the wreck of the mortgage securitisation movement about how to value all these loans in the new conditions. Packages of mortgages which were valued at 100 pence in the pound 14 months ago must be worth something today. It is true that people now think more of those taking out the mortgages will be unable to pay the interest, and true that in more cases when the home is repossessed to repay the mortgage there will be a shortfall because the house price has fallen. Even allowing for all that, most of these mortgage packages will still be worth considerable sums of money, especially the senior packages that were designed to avoid the worst of those two risks. The high risk packages may well be worthless, but people who bought them should have understood that could occur.

Meanwhile on both sides of the Atlantic the authorities have been involved as midwives to great new merged corporations that they think will withstand the difficult times better. We learn that Lloyds will merge with HBOS, and that famous Wall Street investment bank names are in talks to merge with deposit taking institutions to widen their capital base. The UK authorities who had been asleep at the wheel throughout 2007, allowing the run on the Rock to develop, are now awake to at least some of the dangers.

Yesterday the main Central banks of the world tried to jump start the markets with a huge injection of extra liquidity. $180 billion was made available. If all that remained was a liquidity problem it should have done the job. All it did was prevent the main share markets falling further. There was no sustained surge in shares prices. It was probably that disappointing response which decided the US authorities to try one more big move. They have now said they will take action to sort out the market in mortgage debt.

We await details of how this might work. For the sake of the US taxpayer, let us hope the people designing the scheme judge the right balance between toughness on those who made bad decisions to own all these packages of mortgages in the first place, and realistic valuation so it unblocks the market. In the longer term there should be money to be made for the taxpayer. The taxpayer can borrow short term money very cheaply, as the banks only want to lend to governments at the moment. There are many packages of mortgage loans and other loans on offer at giveaway prices. A patient owner could hold them until the markets have come to their senses and are able to value them more realistically, or if necessary own them until all the loans in the portfolio have matured and most repaid. The US government clearly now sees itself as a credible buyer with the capability to get some extra value out of what it buys.

I wish them well with it, as the good health of the world banking system currently depends on their actions. If they do it in order to make money for the taxpayer it might work. If they do it to offer subsidies to a banking industry which has got it hopelessly wrong it will stretch the taxpayer too far and create a new problem further down the track. Judging price and security will be most important. During this drama market players are ignoring the deteriorating numbers in government finance. That could become a story later, when the share prices of financial stocks no longer hog the headlines.