http://www.bloomberg.com/apps/news?pid=20601087&sid=agAvq2LKKJTU&refer=home

An interesting line of thinking.

I’m not on a trading desk, so I can’t say for certain, but my quick reaction is these markets are normally too deep and liquid for that to be a significant component of what is happening.

In an earlier post, I noted that Treasury trading was down by as much as 80%. That’s staggering. Similarly, the fall in CP outstanding has been large, and much more matures in September than did in August.

Those factoids suggest to me that trader brinksmanship is likely to be only a marginal factor.

The quote you cited implies causality, that the problem starts with banks and gets amplified as banks cut/curtail credit to prospective borrowers. and you certainly read it that way too. But that isn’t the way this credit crunch is working.

The liquidity crisis is not taking place at banks. The immediate crisis is in the asset backed commercial paper market, which is about half the size of the CP market. Much of that paper cannot be rolled. Yes, there will be pressure on banks because many of the ABCP issuers have backup lines of credit and will draw on them. But the crisis is in full swing in the money markets and is roiling the US Treasury market as well. We aren’t yet seeing any serious impact at banks (the German bank failure, although dramatic, involved a very small player. The symbolism of the event, that a European bank was felled by US subprimes, was way out of proportion to the substance).

Similarly, there is a crisis of sorts in the leveraged buyout market. Investment banks made commitments to fund deals on terms that investors will no longer accept. The LBO firms are (so far) holding them to their agreements, which means they will have to increase the interest rate offered sufficiently to make the deal attractive. This means very large losses for the investment banks. Losses (and the general increase of volatility) will make them less willing to gear their existing capital bases (and big enough losses will reduce their capital).

The Bank of England listed 16 large complex financial institutions as effectively too big to fail. Were one to become seriously impaired, the BoE thought it could create a systemic event. The great majority of them aren’t banks (and in any event, the part the BoE was worried about was their securities operations).

In addition, the distress in the US housing market (and that is starting to appear in commercial real estate) is only indirectly caused by banks tightening their lending standards. They are doing so because they know mortgages, particularly subprime and Alt-A, will be more difficult to securitize than before and need richer coupons. Similarly investors have become much more stringent about commercial real estate paper. Highly leveraged players can no longer fund on terms competitive with buyers using more cash (this was not the case even a few months ago)

The housing bubble was fueled by investment banks letting banks know that their was high demand for mortgages at very attractive terms. That process has gone into reverse.

This is a long way of saying that a change in investor attitudes toward risk is driving this deleveraging. The impact on banks is a symptom, not a cause. And providing more liquidity will not, for example, create a sudden appetite for subprime paper or “cov lite” LBO financings.

And as we discussed, insolvency and uncertainty are two big contributors to the repricing of risk and the unwillingness of some investors to buy certain kinds of paper and assume counterparty risk. A cut in the Fed funds rate won’t solve those problems.

This chain of inferences does not seem valid to me. Cash on nonfinancial corporations’ balance sheet is really quite high at present. The liquidity issue is really limited to those who have short-term debt as a big part of their financing of long-term assets. That does not apply across all sectors.

Yes, no one really knows what the problem is but, in the most general sense, I believe we can say that there has been an ‘overproduction’ of debt, that this is global, and that it may well have reached maximium expansion as real economy limits have been coming into play.

slightly less generally, it stands out that ‘the’ problem is a complex of problems flowing from ignorance of where what risk is and how what is known should be priced. Years of risk displacement transformed into uncertainty that I doubt can be overcome other than through a generalized reduction of exposure.

yes, there’s a contradiction: how can exposure be reduced when the degree and extent are unknown, which is why I used the term ‘generalized’ (please recall that this does not mean smooth and even but combined and uneven).

In my opinion, Yves is exactly correct to bring out the fact that traditional banking has become secondary to a much larger, essentially unregulated, non-bank financial sector, and, from this, that central banks’ abilities to cotrol/mitigate have been very diminished.

Nouriel’s been writing about this for awhile, well ahead of the pack that now is picking up on this recently because the numbers have finally gotten so bad they’re unavoidable. And as Brad Setzer is fond of saying, Nouriel can be quite blunt, but I like what he says because it makes sense and I don’t have to wonder what he meant when he says something. Big plus.

Remember the reverence everyone accorded Mr Know-it-all Greenspan, even though he was quite unintelligible when he spoke and Republicans held him in awe because he was “serious”. Bring back Volcker; at least when he said something, people knew what he was saying.

I’ll check into Timothy Geithner & El-Erian. Thanks.

-A-

First, on the contagion from big to small, financial to corporate, MacroMan has some charts on CP oustandings and pricing which show containment to, his phrase..”turds”

http://macro-man.blogspot.com/2007/09/wheres-pain.html

I’m not saying that DeLong isn’t a well regarded economist. But he was assistant Treasury secretary under Clinton, which is when I imagine he developed his view of how finance and monetary management works, This would have put him there just as the changes in the role of markets were beginning to accelerate. And the Treasury supervises only banks.

The last credit crisis, the S&L-LBO bust period, were crises centered on the banking industry. The Treasury’s staff would also have had fresh memories of that period.

If you read the speeches of Timothy Geithner, President of the New York Fed, he essentially admits the Fed doesn’t understand the workings of our Brave New World of finance. The comment about not understanding what is under the hood by Greenspan is the same admission.

To extend the metaphor: why do you think putting more gas in the tank should work if what you have is no longer a car but a nuclear reactor?

El-Erian, BTW, is a professor of economics at Harvard, so he’s no mere trader but is also intellectually respectable. Roubini was a member of the Council of Economic Advisers. He is also a professor at Stern School, which (although it is a mere business school) is considered to be top notch in its finance faculty. But Roubini undermines himself by having an extreme, rather than measured, writing style. But his comments about insolvency and uncertainty have gotten widespread attention, and have been picked up by the Economist, the highly regarded Martin Wolf of the Financial Times, and other FT writers and guest contributors.