The credit crisis that first broke in August 2007 deteriorated very quickly in September 2008. The month was dominated by bank failures and bailouts, a dysfunctional LIBOR market, free falling equity markets, failing credit markets and a general crisis of liquidity. Equities, bonds and commodities all sold off simultaneously as investors sought to reduce risk in any way shape or form. Below is a quick time line of the key events in September as the US financial system lurched precariously to the edge, where at the time of this writing, it remains.

• September 7: Federal takeover of Fannie Mae and Freddie Mac.
• September 14: Bank of America takeover of Merrill Lynch over fears of a liquidity crisis.
• September 15: Lehman Brothers files for Chapter 11 bankruptcy protection.
• September 17: Federal Reserve rescue finance of 85 billion USD extended to support AIG.
• September 19: Treasury Secretary Paulson announced the proposed “Troubled Asset Relief Program.”
• September 19: The US SEC leads a number of regulators around the world in establishing a ban on short selling.
• September 25: Washington Mutual is placed under receivership of the FDIC and its assets sold to JP Morgan.
• September 28: Fortis NV partially nationalized.
• September 29: Congress votes down the “Troubled Asset Relief Program.”

Money market stress increased to unprecedented levels with the TED spread widening from 1.09% at the end of August to 3.42% at the end of September. 3 month US T bills traded briefly with negative yield.

Currency markets gyrated significantly, with the EUR starting September at 1.463, weakening to 1.399, rebounding to 1.4866 and closing the month at 1.409. Similar trading patterns were seen in GBP and CHF. JPY traded from 109 to 104 then to 106.

· Equity markets were broadly weaker, the US markets losing between -6 to -10% depending on your benchmark. Small caps were more resilient as the sell off was driven by capital flows. European markets saw greater damage with European indices losing between -6 to -20%. Asia experienced even heavier losses, with Japan losing -14%, HK -19%, and various markets losing of the order of mid teens. Similar losses were recorded in Lat Am.

· In fixed income, the Lehman Aggregate lost -2% in the month. Credit spreads widened sharply in the final weeks of September, US AAA’s widening 1.6% on average, AA’s 1.9%, A’s 2.4%, Baa’s 3.2% and High Yield an alarming 9.5%.

· Commodities also fell as pricing started to reflect recession expectations. Crude futures fell -16%, driving the whole energy complex down by similar amounts. Base metals, softs and ags were all sharply weaker. Only gold was higher at +4.8% over August purely reflecting the degree of risk aversion in the markets.

The Fed and Treasury are putting their heads together to find a solution. They need to figure out first what the problem is beyond the symptoms we see. It is, however, a first step. Managing expectations at a time like this is as important as material policy.

It looks like they propose a system wide solution since their ad hoc measures are not working and the fairness of their process or lack of it has been called into question. It doesn’t mean that ad hoc solutions won’t be found for Goldman Sachs and Morgan Stanley. It certainly buys them time for a more orderly solution.

On the subject of bailouts, the US cried foul when Malaysia established currency controls, when HK spent 15 billion USD (1997 prices, in a much smaller market than it is today), to fend of the speculators, when Malaysia’s Khazanah bailed out the banks by buying their assets.

Academic purity reacts to all this by pointing out that:

Singapore did nothing during the 1997 crisis but emerged from recession ahead of Malaysia.

Bailouts sew the seeds of the next crisis.

The Greenspan put which was responsible in great part for the current crisis is now replaced by the Paulson put.

The intentions of the current plan look highly domestically focused and internationally myopic.

The intentions of the current plan look highly market focused and economically myopic.

The reality is that:

-Singapore was a sound economy and Malaysia wasn’t. Malaysia emerged stronger than Thailand which took the IMF’s prescribed hard medicine.

-Bailouts sew the seeds of the next crisis if lessons aren’t learnt. Bailouts are necessary so that there is enough residual industry to face the next crisis.

-The Paulson put has higher theta and omicron compared to the Greenspan put.

-It is likely that any bailout plan will be negative for the USD which would be positive for terms of trade

-It is likely that any bailout plan will be inflationary.

On the subject of banning shortselling, it will have the effect of:

-Impairing market efficiency by limiting the feasible set, this is mostly an academic objection.

-Forcing investors to sell long positions to scale risk instead of hedging whenever they want to reduce market exposure. This will have practical consequences.

-Making it hard for option holders and writers to hedge positions. The uncertainty that the restrictions introduce to derivative markets is significant.

-Lowering liquidity in the markets at a time when market liquidity is an important factor in the crisis.

Some conjecture:

The creation of some agency to purchase distressed assets from financial institutions has to be paid for. It will have to be paid for by the government. The government will have to raise cash. They will have to issue debt. Who will buy this debt? They could just auction new debt and see what the free market thinks of US sovereign risk. Given that the faith of the US government in the free market is not all that strong these days, its likely that they will need a backstop. Foreign investors may not be willing to take USD risk. US investors whether healthier corporates or individuals through asset management companies may not be willing to take that risk either. The financial institutions in receipt of aid may be asked to be that backstop resulting in a de facto swap of US Treasuries for risky assets. System wide, this would only defer the liabilities, not crystallize them. It would, however, reflate the financial institutions, providing them income bearing risk free assets in exchange for toxic waste, without relying on external price discovery.

In the US:

The consumer is quite broke. Unemployment is rising. Firms have no access to credit. And now the government is quite broke too. The cost of cleaning up the banking system will fall on the government first. A budget deficit would imply austerity and a severe limitation to government fiscal spend as well as possibly higher taxes down the road.

The Fed will have to cut rates or face deep recession. Normally this is highly inflationary but given that the BRICs are slowing down as well, inflation is likely not to be a problem.

The USD will come under pressure improving terms of trade and providing some relief to the economy in the form of export growth. This will be limited by the synchronized slow down in Europe and Asia.

The recovery will take multiple years depending on the approach taken. If the scale of the bailout is big enough and the time frame is short and decisive enough, this could take a further 2 years or so to work through.

Equity markets should begin to price this in earlier but no further than 1 year in advance. Credit markets may react more quickly.

This is the good case scenario.