Not Short of Mistakes

This week the Dow suffered its biggest one week loss ever and the S&P suffered its worst week since 1933. Some people are lambasting the shorts as the reason for the tanking markets and while we have no love lost for short positions taken by market manipulators, negative opinions are not without some justification, Besides, the short sale suspension came off last Thursday. It was not responsible for the first three days of the sell off. The real problem is our treasury secretary Hank Paulson.

Hank's missteps began with his handling of the GSEs. Short sellers, for a variety of reasons, were beating up share prices of financial institutions and the GSEs. This was making it very costly for them to raise capital in the open market. However, they were still able to do so. Mr. Paulson in an attempt to calm market fears over the GSEs asked for and received almost unlimited power to backstop the GSEs. The market was not convinced this was a good, thing. If Mr. Paulson used his powers and seized the GSEs, preferred holders could be wiped out and that would have locked up the capital markets.

Mr. Paulson dismissed this as an overreaction. However, this is exactly what has happened. Mom and Pop investors and banks (the biggest buyers of preferred - which give much-needed Tier-1 capital) have been scared away. Bond and commercial paper buyers were scared away as Lehman and Wamu were permitted to fail. In fact it is the inconsistency of government actions which has locked up the markets.

Why has poor government decision making locked up the markets? Because, in spite of what the government and CNBC guests tell us, banks and other institutions are LOADED with bad assets. Assests which will NEVER fully recover. Since banks know what toxic assets they have and have a good idea what their counterparties have, interbank lending has basically ceased. The markets want either a cleansing of balance sheets with institutions taking their medicine or a complete government bailout, explicitly guaranteeing banks. Anything else will leave the markets locked and make a deep recession or depression possible.