Some of the best performers in world markets during the past month were the CDX of the largest industrial nations. That’s right: the collapse in the price of insuring against default on the likes of the United Kingdom was one of the most dramatic market moves. The fate of the banks and the credit of industrial nations are joined at the hip, as I’ve been warning since January.

The cost of insuring the UK against default for five years dropped from LIBOR +145 basis points to LIBOR +97 basis points, or about a third. Other industrial nations followed suit. Why did the UK do so well? Because among the Group of Seven it has the largest exposure to bank troubles. Barclay’s alone has liabilities larger than Britain’s GDP. In percentage terms, guess who was the biggest gainer? The United States of America. Credit protection on the US fell by 42 basis points to LIBOR +48 basis points.

G7 Industrialised Countries CDS

Source: Markit Partners

The nightmare scenario for governments would have been (and luckily wasn’t) assumption of bank liabilities while the price of bank assets collapsed. Let’s say that regulators in the UK and the US had taken the advice of irresponsible academic tinkers like Joseph Stiglitz, Nourel Roubini and Paul Krugman, and announced that they were seizing and liquidating a couple of the largest banks (Citigroup and Bank of America, for sake of argument). They would have to guarantee at least the senior debt of banks to avoid all-out financial panic, as well as deposits.

The market value of all the banks’ assets would collapse to near-zero levels as the market anticipated a flood of official auctions at extremely distressed prices. The governments would be stuck with institutions whose assets had collapsed instantly by dint of the simple fact of government seizure, but whose liabilities governments still had to make good.

That would have crushed the finances of the UK instantly, and endangered the creditworthiness of the United States itself. Remember that that the Federal Reserve has or is in the process of committing $4 trillion worth of its own balance sheet to the same assets that Citigroup and B of A own. The Treasury has guaranteed additional trillions of such assets.

For all the chatter about “zombie banks” (including some from people who should know better, like George Soros), the alternative to zombie banks was a general liquidation of the banking system that well might have taken down the credit of the United States itself, and surely would have swamped the credit of the United Kingdom, in emulation of Iceland and Ireland. Investors (including some sovereigns) would have exited the banks and the government debt market for gold or other stores of value. The crisis would have become unmanageable.

Perhaps if the government had started liquidating banks rather than committed trillions of dollars in central bank balance sheet and guarantees, a different scenario might have been possible. That is the “lost oppotunity” to which George Soros refers. Once the Fed was all in with trillions of dollars of loans, however, the Treasury shared the fate of the banks, and there was no way to go except to rig their books and make them look profitable.

This entry was posted on Sunday, April 12th, 2009 at 7:34 pm and is filed under General. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.