The Guarantee Plan

The bad news is that Hank Paulson seems to have run out of ideas. The good news is that, with no bright ideas of his own, he's turning to the bright ideas of Gordon Brown: first direct equity injections into troubled banks, and now a blanket government guarantee on bank debt, as well as insuring all deposits.

I like this idea, because it's more likely to bring down Libor than any other plan I've heard. TED's at 446bp this morning: banks simply aren't lending to each other at the benchmark 3-month maturity. And one of the reasons is that three months from now takes us into January, which is after a big upcoming funding crunch:

In the U.S., some $99 billion in just one type of bank debt is coming due between now and the end of the year. Hundreds of billions of dollars will need to be paid in the U.S. and Europe.

Given the global nature of the financial crisis and the international nature of the major banks, it makes sense that UK Chancellor Alistair Darling is trying to get G7 finance ministers to agree to a coordinated guarantee this weekend. And with European stock markets down somewhere between 8% and 9% today, now's no time for half measures: there's simply no light at the end of the tunnel at all.

One of the problems is that stock-market falls are feeding back into credit spreads. Normally lenders pay very little attention to stocks: they do their own fundamental analysis of whether they're likely to be repaid, and that suffices. But especially when you're dealing with financials, stocks are a key indicator of confidence, and confidence is a prerequisite for survival. So spreads widen when stocks fall, and stocks fall because spreads are widening: I don't know if concerted government action can put an end to this vicious cycle, but nothing else can.

So the best-case scenario right now is that the Lehman CDS auction goes smoothly, and that a big G7 announcement over the weekend puts a floor under stocks come Monday, thereby ending the erosion in credit. And let's all be thankful there's an IMF meeting this weekend, bringing everybody together: that helps a lot.

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