Of rescues and diminishing returns: James Saft

-- James Saft is a Reuters columnist. The opinions expressed are his own --

By James Saft

LONDON (Reuters) - The market's reaction to the new super bailout follows a familiar pattern: relief, disappointment and the need for a higher dose of the same medicine.

Don't expect risk appetite in most financial markets to be sustained; the "make it better" narrative many investors were betting on ignores an extremely difficult outlook for earnings and what amounts to a global recession of unknown depth and duration.

The equity market never truly got to grips with exactly how bad the banking crisis was, so looking to it to mark its end probably doesn't make sense.

In the market that matters most -- short term loans between banks -- the international plans to inject capital and guarantee liquidity show promising signs of success on narrow but important grounds. Interbank lending premiums are coming down and the banking system did not fail.

The scope of the plans is simply amazing. A hodgepodge of measures in Britain, the U.S. and Europe include equity injections into banks, varying guarantees of bank liabilities like deposits and interbank lines and, breathtakingly, unlimited provision of liquidity to the banking system.

Even with all that it is difficult to expect investors to continue to take on more risk.

Since the beginning of the crisis, through multiple rescue plans, interest rate cuts and culminating in the historic injection of state capital into banks and the guarantee of much of their operations, the market has greeted each new initiative with joy only to swing lower as concerns about the capital base of the financial system again grew.

"Like any addiction, the more you get it the bigger the next fix has to be," said Daragh Maher, a foreign exchange strategist at Calyon in London.

"One, markets are greedy and two, they are impatient. No one can hope to deliver a speedy turnaround. You are back looking at the real economy and earnings prospects."

And the real economy is not looking so healthy: U.S. September retail sales fell by 1.2 percent, far more than forecast, because consumers have been spooked by rising job losses and blood chilling financial headlines.

A measure of risk aversion calculated by Calyon using commodities prices, emerging markets bond spreads, credit spreads, the Swiss franc and volatility in the equity market fell by 10 percent in reaction to the weekend news of the bailout. Don't get too excited - the measure had surged by 90 percent since the beginning of September to lifetime highs.

SOME IMPROVEMENT

The absolutely untenable situation in the interbank markets seems to be easing.

The Libor/OIS spread, a measure of the amount over anticipated central bank rates that banks demand in extra interest from one another, has moved gently but decisively downward. The Libor/OIS spreads for December in dollar, euros and sterling now stand below where they were before Lehman Brothers failed.

This spread indicates that banks are slightly less wary of the failure of other banks, and slightly less concerned about conserving their own balance sheets.

Bank credit default swaps, a pure measure of the perceived likelihood of more failures, have dropped even more sharply, as investors bet that government measures mean fewer go to the wall.

Some longer term lending costs are still very high, and by most measures the market portrays a banking system in extreme distress.

Laurence Mutkin, head of rates strategy at Morgan Stanley in London, thinks that once begun progress could be rapid. "It's a bimodal outcome; financial markets are either open or shut."

As indeed are banks, and it now appears that more will be open and fewer will shut.

Getting banks to lend to one another is, however, a different thing from getting them to lend to consumers, house buyers and corporations. Even though some of the bailout plans, notably Britain's, have provisions asking banks to maintain certain levels of lending, that is not true in the United States and there are very good reasons for banks to think now is a good time to cut back, even with extra capital from the government on board.

The U.S. mortgages market is particularly distressed.

Yields on Fannie Mae and Freddie Mac bond issues are up about 80 basis points in the past week, despite the fact that they are in government conservatorship. Average 30-year fixed mortgage rates surged by almost a half a percentage point to 6.47 percent.

This is another great example of the fallout from the death of leverage. Many buyers of mortgages and Fannie and Freddie debt use borrowed money, money that is no longer on offer or too expensive.

One effect of higher mortgage rates is more defaults, which will further impair bank capital. There are similarly compelling arguments for an increase in credit card, auto loan and corporate loan defaults.

In short, it's great that the governments are standing behind the banks, but neither the bailout or the market falls will stop here.

-- At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund --

(Editing by Ruth Pitchford)