Signs of Life

Story Highlights:

• It's still too early to call an end to market volatility, but there are positive developments in the beleaguered Financials sector worth noting.
• Government action has boosted confidence worldwide.
• The orderly settling of credit default swaps has removed much uncertainty.
• The Fed has increased liquidity by doubling its balance sheet and harmful accounting rules have been rolled back.
• With such widespread action, we've finally seen some key indicators loosening.

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It's still too early to call an end to market volatility, as demonstrated by recent swings in both directions (particularly Tuesday's 11% up move). But there are a number of positive developments in the beleaguered Financials sector (the very heart of the bear) worth noting. We've talked about some of these points as the story's unfolded, but sometimes it takes an aggregate viewing to see what's abstract in pieces.

Erratic government actions arguably exacerbated the crisis, but whether you agree with the chosen methods or not, coordinated government action has boosted confidence worldwide. Several weeks ago, central banks cut interest rates simultaneously. Shortly thereafter, following the UK's lead, governments announced capital infusions to support the banking sector. Other varied solutions differ in scope and strategy country to country. But global governments have clearly prioritized supporting the banking system—and that's very reassuring.

The Lehman Brothers' bankruptcy sent waves of uncertainty through the financial system, as market participants scrambled to tie up many hundreds of billions of dollars worth of credit default swaps (CDS) on defaulted Lehman (and later, Washington Mutual) debt. Some speculated a disorganized settling of the swaps would deal a death blow to the already weakened system. But the actual liabilities borne by financial institutions turned out to be far less than initial estimates indicated. And over the weeks it became apparent that the contracts would be settled in an orderly fashion—removing much uncertainty over what was lurking unseen around the bend. That confidence may only grow as a centralized CDS exchange is proposed and implemented in the coming months.

To increase liquidity, the Fed more than doubled its balance sheet. Where liquidity was missing, the Fed stepped in and shored up the market. Its loans, notably in exchange for commercial paper, ensured key economic players continued functioning normally (or some approximation of normally) in the short term. Moreover, FAS 157, the stringent accounting rule that led to waves of write-downs earlier this year, was finally lifted, aiding many financial companies. Firms are now free to remove highly illiquid, long-term investments from their balance sheets to more easily manage risk going forward.

And just as a painting's subject takes form from negative space, the distinct lack of remaining outsized risks in Financials paints a picture of eventual recovery. The biggest investment houses, who were so leveraged to mortgage-related investments, have gone bankrupt, been acquired, or been bailed out by the feds—bringing much that was opaque into the light. With such widespread action, we've finally seen some key indicators loosening. The spread between Libor (interbank lending rate) and government treasuries (risk-free rate) is narrowing and commercial paper rates have eased, indicating that credit markets continue to thaw.

This crisis has been nothing if not consistently surprising. Its final throes may yet shake out further down the road. But it's more important for investors to see that the world hasn't ended.