In the article I posted last week, "Banks Are a Ticking Time Bomb," I mentioned some of the capitalization problems banks should be facing due to rising unemployment and delinquencies rate.
Colonial BancGroup's failure revealed that, without accounting games, banks balance sheets are highly deteriorated and it's more than likely that more bankruptcies will occur. An industry insider, Bank United CEO John Kanas, predicts 1,000 new bank busts in the next two years.
The market had a steep selloff this Tuesday; most headlines blamed rumors of an important bank bust plus overall weakness in the financial sector as the catalysts of the fall. Financials have led the market down (and up) during the last 12 months and they could easily lead the way down again, if major new failures occur.
Last year, bank failures caused a massive credit contraction and almost caused a systemic implosion. The stock market reacted by having its sharpest sell off since the Great Depression, fear took hold of investors, and economic production suddenly came to a halt.
That scenario could easily shake the confidence of a quick recovery and wither the so called "green shoots" the economy is currently displaying. In my view, this is the most probable scenario if the government and the Fed do not intervene.
On the other hand, in order to prevent another stock and financial collapse plus stimulate a sagging economy, the government and the Fed could engage in policies that would prevent this. This is the course of action that noted economist Marc Faber suggests the government will take.
To prop up the economy, government might create new and bigger bank bailouts, new stimulus packages, continued low interest rates and more money printing via monetization of all kinds of assets and treasury debt.
These types of actions, which helped the market stabilize and rally since March, might be the most likely course of actions politicians would take. It is bad for politics to have a recession, even if it is necessary to clean up an economic mess. And politicians might take this course of action, even though they will probably be more costly in the long run, leaving the problems to the next people in office.
This type of intervention isn't free and would require further fiscal deficits and would lead to a weak dollar. Under this scenario, the stock market uptrend could remain in place, as the huge liquidity pool that is created seeks returns in a speculative environment.
Emerging markets and commodities, the asset classes that have benefited the most since March due to these policies, would probably keep being the best-performing assets.
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