How to get things working again? It isn’t actually that difficult, but the big risk is that politicians are fumbling.

The things that need to be done, the UK has shown the way:

1. Provide liquidity
2. Re-capitalize the financial system
3. Guarantee inter-bank loans

Liquidity versus capital

You can read headlines, on a daily basis, that central banks all over the world are ‘injecting’ great sums of money in the banking system. Under normal circumstances, banks can either lend from other banks to fund their short-term needs (via the money market), or from the central bank.

Since they hardly lend out to one another because trust that the (very short-term) borrowings will be paid back doesn’t exist, especially after the collapse of Lehman brothers (which turned out to be the biggest policy mistake so far), they all go to the central bank.

These routine money market interventions by the central bank happen under normal circumstances, but, as you guessed by now, circumstances are hardly normal any more, so they gotten an order (or two) of magnitude bigger:

• Banks’ discount window borrowings averaged $367.80 billion per day in the week ended October 1, nearly double the previous record daily average of $187.75 billion last week, Federal Reserve data released on Thursday showed. [humblestudentofthemarkets Oct 3]

Further liquidity provision is foreseen (at least in the Paulson plan in the US) through the purchase (by the Treasury) of toxic assets (mostly mortgage related derivatives), to:

• get them of bank’s balance sheets
• to get the markets for these products going again which, it is supposed, will lead to a revaluation of them, as the markets are unduly pessimistic.

That was the theory behind that plan, but that plan has come under severe criticism which, luckily enough, at least opened the way for other types of interventions.

The fact that these really huge money market interventions have not been enough to get banks lending to one another again is already an important sign that the problem is not liquidity, it’s confidence and capital.

But before we go on to those issues, liquidity does matter. De-leveraging means that a lot of people and institutions are selling, and to sell they need buyers, who need liquidity.

However, as we also stressed numerous times before:

• The overwhelming issue is solvency in the banking system and not liquidity. So far the economic consensus concurs with that view. A partial list include the following:  BCA Research,  John Cochrane , Paul Krugman, Greg Mankiw,  Nouriel Roubini, and Luigi Zingales and Diamond et al. Warren Buffett also agrees with the approach. [Seeking Alpha]

• If the government wants to save dying banks before they take others down with them, it should choose the clean and direct path: Inject capital into them. Take ownership stakes in return. And, where that’s not feasible, seize them and sell their assets in an orderly way, just as the Resolution Trust Corp. did after the 1980s savings-and-loan crisis.
• Only after a company’s shareholders and debtholders have been flattened should taxpayers take a hit. And for a $700 billion investment, U.S. taxpayers should get a lot more in return than a gargantuan pile of toxic waste.
• For that much money, at yesterday’s prices, the government could buy 23 of the 24 banks in the KBW Bank Index, including Bank of America Corp. and Wells Fargo & Co. And it still would have money left to buy a stake in JPMorgan Chase & Co., the largest company in the index. [Bloomberg Oct. 1]

We provided a quote from George Soros in an earlier article saying how much more effective it would be to directly inject capital into the banking system, compared to just buying dodgy assets from them at above market prices:

• “Funds injected at the equity level are more high-powered than funds used at the balance sheet level by a minimal factor of 12,” Soros writes in the Financial Times

We’re mystified why Paulson hasn’t thought of this, and seems very reluctant to steer the TARP fund in this direction. It’s not rocket science. Perhaps, coming from Goldman Sachs, he really doesn’t like even part nationalization of financial institutions. We cannot think of any other argument that makes sense.

Guaranteeing bank loans

They’re going to do it in Britain. It’s a good idea, an instant confidence booster and not necessarily terribly expensive. Jim Cramer had a similar, but more far-reaching ideas:

• Cramer said he would have the Federal Reserve take the initiative by inviting to the meeting the CEOs of large financial institutions such as Citigroup, Bank of America, Wells Fargo, JP Morgan, Morgan Stanley, and Goldman Sachs, the latter three of which he owns for his Action Alerts PLUS portfolio.
• Cramer said the Fed would tell the CEOs that it would not repeat the mistake it made when it allowed Lehman Bros to fail. Instead, he said, the Fed would do all that it can to get the financial institutions “open for business” again.
• He said the Fed would guarantee all their debts as well as their brokerage, savings and corporate accounts. Furthermore it would allow them to pay off their bonds with federal money, permit them to sell their credit default swaps lower and provide them $100 billion each to lend.
• In return, these financial institutions would have to live up to their end of the bargain by “opening the spigots” and make loans again. He said the loans will be targeted to corporations, small businesses and individuals — but not hedge funds.
• He also said the Fed would have the financial institutions divvy up the “bad banks” among themselves, with the aim of having them assume the good deposits while selling the bad assets to the federal government’s newly created Troubled Asset Recovery Program. [The street Oct. 10]

We’re not entirely sold on this Cramer plan. Banks get a relatively free deal here (they should also pay for their mistakes, in our view). And the only obligation seems to be that they just have to promise they loan again (but not to hedge funds, we sort of like that), that might be a little bit too freewhealing. Who is going to control that?

It also comes on top of the $700B TARP fund and provides them with $100B each to lend, so it’s certainly not cheap either, although that really isn’t the biggest worry right now.

We think the combination of capital injections and guaranteeing of inter-bank loans might be a better step, but if that still not get lending going and interbank rates back to normal, then this is certainly something to consider.

We should also stress that the large cost should be the least of our worries, for a couple of reasons:

• It could at least partly be financed with money creation, inflation danger is subsiding rapidly (and deflation dangers are looming), so that’s not going to be a near-term problem.
• Even if it did create some inflation, that might help to inflate some of those debts away, Federal and private ones. That’s what the UK did after the Second World War, when their national debt stood at three times their GDP.

What has been concluded so far at the G7

• Late on Friday, US Treasury Secretary Henry Paulson said the US planned to invest directly in banks for the first since the 1930s, following a similar UK programme of partial bank nationalisation.
• The G7 had earlier not ruled out adopting another part of the British plan – to guarantee borrowing between banks – as they issued their plan in Washington.
• The G7 also left the door open to further reductions in interest rates, which six central banks this week jointly cut by half a percentage point.
• But our correspondent says there is some disappointment that the G7 plan lacks detail. [BBC]

So things are shifting a little in the right direction, but whether it will be enough to calm the markets on Monday, we are not at all sure..

Before we end, where is the IMF in all this?? Shouldn’t they have the expertise to design bail-out packages and the leverage to get a more coordinated response? They are conspicuous by their absence.

For the long-run, we got to have better regulated financial markets, leading to:

• less one-sided bets
• less exploitation of information advantages
• less leverage

We part on a note of optimism, we would almost forget, but Governments have the power at their disposal to end all this, it should be stressed:

• I’m betting that, in the end, the world’s governments will win this battle against fear. They have potentially unlimited tools at their disposal, especially if they act in concert. They can nationalize firms, call bank holidays, suspend trading for weeks, buy up debt and equity, and renegotiate home mortgages. Most important, the American government can print money.
• All of these tools have long-term effects that are extremely troublesome, but they are nothing compared with the potential collapse of the financial system. And Washington seems to have recognized that it must do whatever is required to shore up that system. Big questions remain. What will it take to stop the fall?
• How costly will it be? How long before the rescue plan starts to have an effect? But at some point, the panic that gripped world markets last week will end. Of course, that will not mean a return to growth or a bull market. We’re in for tough times. But it will mean a return to sanity. [Zakaria in Newsweek]