Thursday, October 30, 2008

Down the Drain

The Fed continues to flush its balance sheet down the toilette to support our ailing financial institutions. The chart above shows Treasuries as a % of total assets at the Fed. The Fed started as a "reserve" for gold, then held only Treasury debt. Now, its main assets are loans to the country's banks.

I am not sure what will happen if some of these loans go bad for the Fed. Would it do any harm for them to just print more money and say it never happened? I am not sure.

What I am sure of is that the Paulson/Bernanke team have turned our financial market into a scrabble-like crisscross of mixed incentives. Banks have made major mistakes and inflicted a disaster of leverage on this country, and now our first priority is to help them? Hank Paulson forces them to take large amounts of easy money, Ben Bernanke coddles them with commercial-paper facilities and Sheila Bair comforts them with debt guarrantees.

These are the same banks like Citigroup that ran huge SIVs, which rammed hundreds of billions of dollars of extra debt into our economy just so they could make money. These companies stood at the central of the financial whirlwind that has shaken our land and pushed us towards something you might call socialism. Why do they deserve any support right now?
We've given them public money with no strings attached, and even now cannot force them to extend credit. Taking a page from the Bush tax cuts, we're insuring their debt for the next 8 months, and then it just stops?

The next problem is that they have failed to understand what hurt the interbank market. Everyone just assumes there is something deeply wrong when Libor stays significantly above the "official" rate like Fed funds or t-bills. But they forget that Libor is linked to a credit, and very real market prices exist for that credit.

Amid the meltdown on September 17th, yields of all financial sector corporate bonds spiked about 100bp. At the same time, panicked buyers pushed 3-month Treasury yields near 0%. Financials had major credit risk, so there's no surprise their yields were higher. At the same time, riskless yields plunged. Unlike in previous downturns, the fate of banks and the Treasury diverged.

Instead of recognizing this obvious reality of the market, the authorities have taken several actions to force interest rate unnaturally lower. They are spending billions to help the commercial paper market and insuring bank liabilities.

The interesting thing is that financial sector CP rates didn't move considerably during this period. In fact, the overnight, 15 and 90 day rates FELL... That means more people were buying those notes than selling that day.

What did move? Long-term corporate bonds and Libor -- the products that trade in the capital market.

What didn't move? Commercial paper.

Between Sept. 10 and Oct. 1, non-Treasury money market funds lost $440bln of their funds, or about 19%, according to AMG Data Services. That's why Sept. 17 was such a key date.. It was right at the start of a big liquidation that dumped billions of dollars in short-dated financial paper to be dumped on the market.

Bank of America's 1.5-year notes (BAC 7.800 02/15/2010) fell 3 points on Sept. 16.

The next day, its 10yr notes (BAC 5.650 05/01/2018) fell about the same amount. (Stocks also sold off.)

Many short-term financial sector bonds are linked to Libor -- "floating rate notes." These FRNs would have fallen when the market was flooded with other short-term debt.

When they fell, their yields rose. Because their yields are linked to Libor, Libor also was forced higher.

That's why Libor (and the TED spread) rose the following 1-2 days. Lots of floating-rate debt was trading cheap, with higher yields. With the market setting a price, Libor had to rise:
Eurodollar deposits (London)" ,Maturity,"3-month" (source)
09/12/2008, 3.00
09/15/2008, 3.00
09/16/2008, 3.20
09/17/2008, 3.75
09/18/2008, 5.00
09/19/2008, 5.00
09/22/2008, 5.00

Once again, we find the problem in the capital markets, not within the banks. This is not a banking crisis.

While we're talking about things in the capital markets, it appears there will be many headwinds in the credit market. It is clear that any improvements will be met with huge amounts of corporate bond sales.

Once the rallying in spreads ends, it might be hard for the stock market to keep moving higher. Looking purely at the chart, I would doubt the S&P500 could break through 1000. But, the election will probably have a positive impact. If Obama wins decisively and makes good actions right away, people might get excited about the end of the Bush reign -- which represented 8 years of lousy stock markets.

Even if things go perfectly for Obama and stocks go on a rally, I think the S&P 500 won't be able to make it through 1,200.

Getting back to banks: Once again, the problem began in the bond market, and then spread to the banks. After all, banks have grown more dependent on the capital markets during the last 20 years, using structured vehicles and corporate debt sales to fund operations.
Foriegners have also gotten much more involved in the credit market:
Here, the blue line shows the percent of U.S. corporate bonds owned by overseas investors vs those owned by life insurance companies. It's important because overseas investors will make decisions based on their own interests. They all had a single reason to buy U.S. corporates, so they all did the same thing. It's likely that if something bad happens, they will ALL become sellers as well. Their decisions are all based on trade and inflation.

Once again, a potential danger is lurking in the in the credit market -- the capital market. This is where problems START.

This is why I support a system that would bypass the banks by having the government buy corporate bonds and asset-backed securities. This would allow credit to flow to the economy and take pressure off the banks to lend.

Policy needs to focus on the capital market rather than the banks.

And, it needs to think about the health of the economy, not the health of the banks. But then again, who owns the Fed, but the banks?

Interest rates cannot be low forever. It seems that stocks do best when interest rates decline. At some point they have to rise. We might as well increase them as soon as possible, unless we want to suffer Japan's fate.

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