The Financial Times reports a rare bit of encouraging news on the credit crisis front, namely, that investment banks have been making less use of the Fed’s liquidity facilities of late:
Direct borrowing from its new primary dealer credit facility fell $8bn from $34bn (£17bn) to $26bn in the week to April 9, the Fed said. Meanwhile, the central bank also said that its latest swap auction of Treasury securities was undersubscribed.
But should we then conclude that investment banks are in improved health? After all, Goldman CEO Lloyd Blankfein asserted that the industry is more than half way through the debt contraction.
This optimistic assessment seems at odds with facts on the ground. Yes, we in a period of relative calm, but each time this has happened of late, a new eruption of problems has led to panic, worries of systemic collapse, and new moves by the Fed, And even more worrisome, each time the intensity of the outbreak has increased.
Let’s consider some less than pretty realities. Some investment banks have been classifying more and more assets as Level 3. That gives them lots of freedom in how they value them. The markets appear to be tolerating this expedient, even though the sources who speak to me about the industry view the firms as being considerable weakened and at risk. For instance, it seems to be a commonly held view that Lehman is in every bit as bad shape as Bear was, but Lehman is a better citizen than the soon-to-be-history trading firm and the Fed wasn’t going to let two firms go under (in other words, the industry participants I’ve been in contact with are not of the view that Bear was solvent. That admittedly may be sample bias, since this blog no doubt appeals to cynics).
Moreover, there are plenty of shoes yet to drop. Interbank cash hoarding is on the rise despite the Fed’s heroic efforts; a bottom of the housing market is nowhere in sight (and we won’t know how low it will go in the mortgage market until we know the end game for residential real estate); commercial real estate losses have only started. But scariest by far is the credit default swaps market.
I happened to meet with a hedge fund yesterday (unlevered, BTW) and it comments in passing were telling. They are seeing very large volumes of mortgage paper even though, this fund has not bought a single mortgage and expect that there is even more that would be offered if buyers were stepping forward. In addition, credit default swaps traders tell them that that market is in perilous shape. A great deal of the protection was written by hedge funds, who were typically levered. When they get into trouble, their problems will redound to the investment banks, both through their exposure as CDS counterparties and as lenders to failed hedge funds.
The fact that CDS traders are discussing such a grim viewpoint with people outside their firms (let’s fact it, most businesspeople don’t go around saying their product is about to implode) suggests that it is a common knowledge in the dealer community. I wonder if this topic is getting short shrift for a reason. The media has been known to overlook the foibles and failings of public figures until they are on the ropes. There may be similar self-censorship operating here, since the press probably does not want to be accused of fomenting panic.