The Asset Shuffling Game

Financial Times writer John Authers passed along an interesting observation from UBS’s George Magnus (the man who popularized “Minsky moment”) about the credit crisis:

Issuance of commercial paper – short-term borrowing central to many financial institutions – is drying up, while Libor, reflecting the interest rates at which banks lend to each other, is spiking upwards.

This is because, as George Magnus of UBS puts it, the market is trying to transfer various bad assets from the “secondary sector” – hedge funds, private equity groups, and the various specialist vehicles that banks set up to service them – to the “primary sector”. Those bad assets will have to move to banks’ balance sheets.

Once there, they will be transparent and confidence can be restored. But putting them there requires huge amounts of cash. That has pushed up Libor rates.

If Magnus is correct (ie, assets have to move to entities that have access to central bank discount windows), this is going to be messy indeed.

Authers also invoked a clever turn of phrase:

Another risk is that the Fed refuses to cut rates. Chris Watling, of Longview Economics in London, says this would be a “Volcker Moment”. Former Fed chairman Paul Volcker decided to make a stand in the 1980s and squeeze inflation out of the system, even at the cost of a recession. Similarly, Bernanke could decide to squeeze asset bubbles out of the system once and for all.

His rhetoric (or lack of it) of late suggests this is unlikely. But he knows what happened in 1999 as well as anyone else. If the Fed does have to ease, and crisis is averted, it might act aggressively to stop another bubble developing.

My view is somewhat different. I think it’s likely that Bernanke will succumb to the pressure from the financial markets and politicians. However, if he stands firm, I don’t imagine that it will be out of a Volcker-esque “slay the dragon” resolution, but a calculation that that the howls of impending doom from financiers are overdone. He will let them take a bit of pain, both as a lesson, and out of a belief that the markets will muddle through, perhaps with some help via more active daily operations.

If he starts down the path of denying the market what they want and they act up, he then may reach a “Volcker moment.” But at this point, like Authers, I don’t see him seeking one.

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