Hope you like the smell of napalm in the morning. Otherwise, this will not be your sort of day.
I have to turn in, but the early morning sightings, as expected, are not at all pretty. What is particularly troubling is that central bank interventions may have become unproductive. Banks have quit lending to each other because they know they can go to their friendly monetary authority instead.
We had warned of the difficult of weaning financial firms off of facilities like the Term Auction Facility, but we never envisaged a problem of this scale. This is troublingly like 1930, when money supply in the US fell, turning a recession into a depression. Conventional wisdom has it that the Fed goofed, but in fact, it did what it could.
The central bank increased the monetary base, which was what it controlled, but with banks failing and funds being withdrawn by worried depositors, money supply nevertheless contracted. The fact set is different now, but we may be getting a similar outcome. The open question is whether this hoarding will be reversed to some degree once a bailout or some other form of assistance calms frazzled nerves.
From Sam Jones at FT Alphaville:
US 3-DOLLAR INTERBANK RATES INDICATED AT UPPER END OF 3.7-4.8 PCT RANGE IN EARLY LONDON TRADE.
Despite a $30bn repo auction to be held by the BoE today.
If dollar Libor spreads blow out to that level, it will be a truly incredible move. We’re on the point of running out of adjectives – yesterday’s move in the Libor OIS spread was incredible too.
It looks like central banks are worried that the only thing keeping banks up now is the fragile commercial paper market, which banks have been desperately tapping in the past few days as a source of overnight funding.
Liquidity is being thrown at the system, but it’s just making things worse.
By pumping in more money central banks aren’t addressing the fundamental concerns of the banks at all. Going cold turkey is a very unpleasant thing, but the solution isn’t more drugs, even if they alleviate short term pain.
In assuming they can rely on central bank money market operations – which will be expanded (as is the case) when the going gets tough – banks are naturally avoiding lending to each other.
Despite the signs that their efforts are becoming counterproductive, central banks continue to throw money at the problem. From Bloomberg:
With the cost of borrowing dollars over three months yesterday jumping by the most since 1999, the European Central Bank, Bank of England and Swiss National Bank said today they will auction a total of $74 billion in one-week funding. The Federal Reserve assisted by providing the ECB and SNB with access to $13 billion more of its currency, boosting the amount of dollars it makes available to counterparts to $290 billion.
Hoisted from comments (forgive me if you saw this already), reader Dan points out that financial players have plenty good reason to be spooked. And his reasoning suggests that liquidity measures and rescue packages will have little to no impact:
I understand that the explosion in the OIS spread is a reflection of the fear banks have for each others solvency. And it makes sense that it exploded right after the bankruptcy of LEH–it was not the bankruptcy per se, IMO, but the that $110b of senior LEH debt went from trading .95 to .12 in a matter of days that concentrated the market’s attention. If you include the less senior debt that is trading at essentially zero, LEH had $110b hole in its balance sheet. And just days before this, the market was being told and was believing that the $10b disposition of Neuberger was going to solve their funding problems.
Now is there a precedent in this history of bankruptcy–excluding cases of accounting fraud–where bonds collapsed like this once a bankruptcy court opened up the books? I’m thinking the answer is ‘no.’ Which then makes you re-evaluate the premise that there wasn’t fraud at LEH in marking the value of their assets.
Now extrapolate this reasoning across the entire banking system and, voila, you have the seizure of the interbank lending market.
Now this leads me to the question: if the OIS spread represents eminently legitimate fears of inaccurate marks on banks books, how is a commitment from the treasury to buy hundreds of billions of distressed assets from the banks any assurance to a counterparty that that bank will not still become insolvent. Obviously it helps on the margin, but the staggering hole in LEH’s balance sheet that was revealed after bankruptcy creates profound fears about the true solvency of C or UBS. Until the market is convinced they are solvent–and TARP does not do this–the OIS spread will remain elevated and lending will remain frozen.