Europe Opens Ugly

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The central bank increased the monetary base, which was what it controlled, but with banks failing and funds being withdrawn by worried depositors, money supply nevertheless contracted.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:


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.

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  1. Richard Smith

    Absolutely excellent comment from reader Dan. This is what the money markets look like when everyone knows that (to a first approximation) all the particpants are hopelessly bust.

  2. russell1200

    All the talk about market confidence just leads to more ra-ra type cheer leading.

    The market needs to replace the people who are broke with people who are not broke.

    Since the US housing bubble issue alone is generally stated as a problem of over $1 Trillion dollars, and there are a number of other financial bubbles out there, it is highly propping up the current players with 3/4 of a Trillion dollars is a workable solution.

  3. eh

    Absolutely excellent comment from reader Dan.

    Yes, definitely.

    Have not seen much about what’s being uncovered during the LEH bankruptcy proceedings.

  4. ScottH

    Major European markets are off less than 2%.

    Dow futures off 170, about 1.5%.

    The dollar is climbing.

    Oil is down. Gold steady.

    Hardly a rout. The TED spread is high, but that is Wall Street worrying about having to eat its own tail.

    Would you like cake with that?

  5. Richard Kline

    Napalm in the morning?: I _love_ it, and it’s the best way to roast Rocky Mountain oysters!.

    Yves sez: “Banks have quit lending to each other because they know they can go to their friendly monetary authority instead.” Tacticly, the emergency auction facilities were a good idea and a success, but their deployment was strategically stupid and has backed the credit system into a corner risking catastrophe. The point of those auctions was to effect _a temporary stabilizing action_ while concurrently seizing and taking out insolvent firms. Which latter actions is exactly what Hank and Ben DID NOT have the balls or brains to effect. Hence the result is exactly what Yves says: rather than accept a quanta of risk or more to the point rather stiff short rates against crap assets no one wants the Big Boys can sally on down to the Fed and get cheap quality for mid-term against spoilt trash in a program without an expiration date. In short, a significant part of the present credit spike is _self-induced_ courtesy of Hank and Ben because they signed the chit without getting control of the outcome. _This_ will be the central criticism of their actions prior to Sep 08.

    We need, more than anything, to get the insolvent banks out of the credit pool. WaMu’s boo-hoo is only a year overdue. And it takes all the capital they raised over that term down the drain with them. Let’s get ON with this.

  6. Anonymous

    “Banks have quit lending to each other because they know they can go to their friendly monetary authority instead.”

    A more fundamental cause in my estimation is that during a panic, risk increases. Lenders in the overnight market naturally want higher compensation. A billion dollars lent overnight at Ben’s centrally-planned rate of 2% yields only about $55,000. Who wants to risk losing a billion lending it to WaMu overnight, for a lousy $55,000 payoff?

    If Ben insists on lending at a patently below-market rate, of course he’s going to be the only lender. The banking system would be better off, I contend, by letting the overnight rate seek its natural level, as it did in pre-1913 crises. Try telling that to a central planner, though.

    “The central bank increased the monetary base [in 1930], which was what it controlled, but with banks failing and funds being withdrawn by worried depositors, money supply nevertheless contracted.”

    Let’s recall that we’re all post-monetarists now. It’s not clear that the 1930s Fed understood the implications of letting M1 fall by almost a third, owing to deposit redemptions. Otherwise, it might have done more to boost the monetary base.

    The Fed’s H6 release of last night shows that M1 rose 6.9% over the last 3 months, a higher rate than over the 6 and 12-month trailing periods.

    More astounding is the H.4.1 release, which now has THREE new lead paragraphs. Remember the old rule of thumb about too many paragraphs in the auditor’s opinion of a financial statement? I’m getting the same feeling here.

    What also leaps out is that the Fed’s former $900 billion balance sheet is now pushing $1.2 trillion, having rocketed by $203 billion just in the past week. Quite aside from ‘pushing on a string’ notions (which I don’t fully accept), we can all agree that Weimar Ben has the pedal to the freakin’ metal like never before in history.

    When Ben came on board as chairman, I forecasted on another forum that he would kick up the Fed’s balance sheet growth from a crummy $50 billion a year to hundreds of billions a year. But I was flat wrong — he did it in a WEEK! Mwa ha ha ha …

    Getting back to the 1930s redemption of deposits issue — Bloomberg reported that some $16 billion was withdrawn from WaMu before it went down. Clearly, some of it simply went to other banks. But what percentage of deposits was withdrawn from the banking system, and converted to cash, gold coins, and (whisper it, friend) capital flight? Even a sampling survey of a few hundred depositors would be vital information. Consumer behavior will be at least as dispositive as the authorities’ actions in determining how this crisis plays out.

    I would humply suggest that some of the Federal Reserve’s army of PhDs devote themselves to this task, or hire a third-party research firm to do so. What is the “marginal propensity to redeem” of worried depositors, Ben? If you don’t know, you’d better find out, buddy.

    Me, I’m sticking with my “too big to fail,” government errand boy, money center bank. If they go down, so does USGOV. And history offers no example of a stable, perpetual Ponzi scheme. Gulp!

    — Juan Falcone

  7. Richard Kline

    Look y’all, there should be no fears regarding the solvency status of C, UBS, or any of the other MaxLever users: they are insolvent and dead. Goodness, where y’all been for fifteen months? Sober up, fellas, and demand that the Guvmint charter $150B worth of publicly ownde Clean Slate Credit Unions who stand ready to lend and acquire _good_ assets. Your world may begin and end with the present major financials you have come to know and profit from—but our world doesn’t. Banks, we need; those banks, not so much.

    Don’t bail ’em, fail ’em. The _real_ crisis shortage we have at present is bank examiners with Federal credentials.

  8. fresno dan

    Nice insight by Dan. In general, everybody named Dan is rather smart and virtuous – and good looking!

  9. a

    “If dollar Libor spreads blow out to that level, it will be a truly incredible move.”

    Repeat after me: Libor is meaningless, Libor is meaningless. The real rate of borrow has been around 5% all week. It’s a little north of that now, but it hasn’t changed too much from yesterday.

    Basically people still expect a deal from Congress.

  10. Capt Dave

    Somebody on CNBC yesterday spent a long time explaining that the bail-out was necessary to keep interest rates from rising. Lending is dead because interest rates are too low to reflect 11% inflation and default risk. I have a LOC on commercial property with a 5.5% rate tied to prime. Why would a bank willingly lend to me at that rate? When the return is too low, credit has to disappear.
    By the way, I bought that property in 1983, at a mortgage interest rate of 12.5%. The world didnt end.

  11. foesskewered

    if Dan ‘s scenario plays out, would it mean that the only solution that could possibly work for such banks is tonhave the central banks issue a fiat guarantee that the banksv are solvent?

    as for the assets, since no one seems to be working according to any gentlemen’s rules; why not offer a “recourse” option; let the banks have an option of buying back these “distressed assets” at x price (midrange of historical cost or the last price at which the asset appeared in the company’s books and current market value or the price at which the authorities are buying the asset) + penalty charges (to be determined by the authorities)

    that gives the banks recourse should they think their asset is worth much more than present prices and some (weak) recourse for the taxpayers.

    ok, ok, that’s simplistic /silly but could it work?

  12. Anonymous

    No comments on the ‘possible fraud at LEH’ that Yves included in the blog entry?

    A $110 billion hole in LEH’s balance sheet probably deserves a look…I think that the FBI will be checking it out but doubt we will ever hear of the findings.


  13. Matt Dubuque

    Matthew Dubuque

    It will likely take a Depression to eliminate inflationary expectations for generations to come.

    So be it. I have done my best to warn everyone of the dangers of deflation.

    Let the markets determine now who was correct.

    Matthew Dubuque

  14. S

    agree with commenter about wall street working itsel into a frenzy. The reality is everyone outside of Wall Street doesn;t give a hoot. As for lending, the bank have to lend to make money. Sure they can reign it in, but that hist EPS and stock price. Business will go on and the world will go on. This isn’t about manin street getting along it is about wall street accepting that it has been permanently downgraded by main street. Truth hurts. Let’s hope congress has the stones to stay the course. WThe wamu deal is a screaming example of exactly what should occur. Fire Ben Bernankle and let hiom go back and think more about the depression. Paulson should go too. Obama should pre annoucne his financial team and it would seem someone like Dimon fits the bill notwithstanding his JPM gig. outsider would be nice, but needs someone with knowledge of inner workings. JPM is already an organ of the state.

  15. Anonymous

    A revealing slip of the tongue during Bush’s press conference: ” … something suspe[ct] … uhhh, SUBSTANTIAL, must be done.”

    Something “suspect,” indeed! Those darting eyes remind one of Nixon’s penultimate days.

    As always, the final act of a corrupt government is to loot the Treasury. Only suckers and rent-seekers will fall for this brazen swindle.

    — Juan Falcone

  16. Anonymous

    An addict will lie, steal, cheat, even kill to get his hands on one last fix.

    Doesn’t mean we should give it to him.

    We’ll all be better off when this is over.

    People who managed their resources and capital prudently will fare much better.

    Bring it on. I’m tired of being told to be afraid by my ‘leaders’.

  17. Lewis B. Sckolnick

    State and Fed regulators see themselves on the side of the bank thus preferring to look the other way as often as possible.

  18. Anonymous

    ‘The American way of life is not negotiable’…in the words of Cheney.

    Hmmm…Which Americans was Cheney talking about?


  19. Ping

    From another basic common sense pov, TARP dosn’t make sense. It sounds like creating another beauracratic goliath, like Homeland Security to untangle, manage and dispose of such assets including helfy fees paid to the same managers and brokers who created it in the first place.

    Of course the acronmyn mortgage instruments are a mess to get to the bottom of equity but bad car loans, furniture loans, student loans, bad credit card debt????

    It’s going to require mounds of legislation and beauracracy to politically dispense with that….

    To me, common sense dictates modifying exhisting mechanisms keeping more accountabiltiy in place.

  20. Francois

    “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.”

    If I am reading this correctly, there is strong suggestion of widespread fraud, deception whatever one wants to call it, in the banking system.

    Should the problem be that bad, shouldn’t it be the time to seriously examine an overt nationalization of the banking system a la Swede circa 1990?

  21. Anonymous

    At the most basic level, the issue comes down to trust. Paulson is proposing a plan to buy up assets at above-market prices. Same approach he attempted last year with the failed MLEC (master enhanced liquidity conduit). If he succeeds in implementing this now, the unintended and inevitable consequence will be that investors’ confidence in the system will, quite rightly, be even less than it is now. It is corrupt and awful. We have reached the point at which the benefits of opacity and BS, if there ever were any benefits, have reached their limit and are backfiring massively. It reminds me of how underwriters “stabilize” public offerings of securities like common stock by putting in bids to keep them from falling below the offering price. It helps sell stocks and the regulations, sadly, explicity permit it. Keeps confidence up, you could say. Hank seems to be thinking like an investment banker, time after time. That’s not a compliment, incidentally.

  22. doc holiday

    Re: "central banks continue to throw money at the problem"

    >> Yah, IMHO, central banks are collectively acting like Japan 13 years ago, as they globally, all remain in denial as to what the problem is, and thus, as bankers they use the fuel of cash to put out a synthetic debt and credit fire.

    The obvious solution is to shut down synthetic derivative casino chips and thus enhance an environment where real assets are backed by real credit, versus the global illusion of being in denial about debt, and then printing more money and bailing out fraud.

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