The credit markets had a seizure on Wednesday. To recap the mind-numbing events:
Three month T-bills finished at a two basis point yield, and may even have traded at negative yields. Signs of ZIRP.
Gold rose $68 and is still going up in Asia. The dollar fell against the yen, a sign of continued carry trade unwinds.
Credit default swaps on financials blew out, with Morgan Stanley hard hit: Spreads on protection for its bonds rose 220 basis points to over 900.
The TED spread, an indicator of stress in the interbank lending markets, shot upwards to 238 basis points.
CDS spreads on Treasuries rose to 30 basis points. Nine months ago, CDS on Treasuries were an oddity rather than an actively written contract, and the spread was 2 basis points.
Swap spreads widened considerably.
Today’s TSLf auction was, as Alea put it, a “disaster” with prices and bid to cover up big time.
And the commentary was far from cheery. Kenneth Rogoff, in a Financial Times commentary, said that the US needed a trillon to two trillion dollar bailout. That may seem like a made-up number, and any estimate of the outcomes of an eruption this large is bound to be plenty approximate. However, Rogoff has made an extensive study of financial crises, so it would be a mistake to assume that he made this estimate casually. From the Financial Times:
Were the financial crisis to end today, the costs would be painful but manageable…. Unfortunately, however, the financial crisis is far from over, and it is hard to imagine how the US government is going to succeed in creating a firewall against further contagion without spending five to 10 times more than it has already, that is, an amount closer to $1,000bn to $2,000bn…..
It is hard to predict exactly how and when the mega-bail-out will evolve. At some point, we are likely to see a broadening and deepening of deposit insurance, much as the UK did in the case of Northern Rock. Probably, at some point, the government will aim to have a better established algorithm for making bridge loans and for triggering the effective liquidation of troubled firms and assets, although the task is far more difficult than was the case in the 1980s, when the Resolution Trust Corporation was formed to help clean up the saving and loan mess.
Of course, there also needs to be better regulation. It is incredible that the transparency-challenged credit default swap market was allowed to swell to a notional value of $6,200bn during 2008 even as it became obvious that any collapse of this market could lead to an even bigger mess than the fallout from subprime mortgage debt.
It may prove to be possible to fix the system for far less than $1,000bn- $2,000bn. The tough stance taken by regulators this past weekend with the investment banks Lehman and Merrill Lynch certainly helps.
Yet I fear that the American political system will ultimately drive the cost of saving the financial system well up into that higher territory.
An interesting observation in comments at Nouriel Roubini (hat tip Megan):
….the situation in the markets right now reminds me a lot of the time back in 1987 before the big October crash. At that time, during Sep and Oct there were some big swings in volatility in the Dow. The swings came about because investors were very nervous about a possible collapse, then every so often the market would decide that “everything is alright” and bounce up again. We’re seeing that phenomenon again now. Back in 1987 one of the big drivers of the crash was “portfolio insurance”. Brokers had implemented a scheme whereby stock portfolio’s were supposedly insured in value through hedging transactions in the futures markets. Of course, the whole scheme only works if losses can be kept modest and predictable in nature. The market tore apart initially in the Chicago futures markets when the scheme began to break down. This time in 2008 the issue is not stock insurance … it’s bond insurance. The market is now very nervous about a possible collapse in the CDS market. Different asset – but the same underlying issue. The insurance on bond values just can’t be paid up when losses become large and unpredictable in the system. (Pete)CA)
From Ambrose Evans-Pritchard at the Telegraph:
Bernard Connolly, global strategist at Banque AIG, said the Fed and the Treasury were doing too little, too late, to stave off disaster. Interest rates need to be cut immediately and dramatically, while Washington must prepare for a wholesale takeover of large parts of the lending system along the lines of the Scandinavian bank rescues in the early 1990s.
“Unless there is a very rapid change of mind, depression – with all its horrors and consequences – will be inevitable. The judgment that letting Lehmans go would not create systemic risk depended, if it was ever going to be anything other than ludicrous, on very rapid action to shore up the financial system. Instead, Hank Paulson seems to be adding to the risk in the system,” he said.
“We fear that a virtual nationalisation of the financial system will now be necessary,” he said….
Albert Edwards, global strategist at Société Générale, said Washington’s serial bail-outs are the inevitable result of the credit bubble of preceding years. “This was all baked in the cake long ago. What we have seen so far is just a dress rehearsal for the deep recession that is coming. America is going to be losing 500,000 jobs a months. That is when we will see interest rates go to zero. The deficit will be covered with printed money as it was in Japan. The endgame will be helicopters full of cash dropped by Ben Bernanke,” he said.
And from the Financial Times:
Andrew Brenner, co-head of structured products and emerging markets at MF Global, said: “It feels like no one wants to take anyone’s credit…it feels like we are on a precipice.”