Sudden draw down in the CP market and the effect on banks

Some other serious stuff that’s happening:

When Lehman filed $63 billion of commercial paper simply disappeared. Now firms are worried and are drawing down on their CP programs. This hits the banks very badly because CP facilities aren’t heavily counted in their capital adequacy requirements. However when the lines are drawn it hits the capital chain all the way up forcing banks to restrict their lending even more to other areas. Therefore the credit multiplier simply stops like a pump that is supposed to be pumping out water has air going through it. The banks simply don’t have any money to lend as they don’t have the funds to meet demands. This could be the reason dollars are so tight seeing US dollar for overnight loans went as high as 11% in Asia this week and didn’t fall below 7% from what i saw.

This is where we could get to Armageddon and we see wholesale firings as firms can’t meet payrolls simply because the banks can’t give them the cash. Some of you guys think this shit isn’t serious but it is. If they don’t get the support package, its over. I don’t think the Fed has the balance sheet to meet such a sudden demand for funds.

I don’t normally make these comments and I always wanna see markets do all the work. But this is so friggen serious it scares the shit outta me.

Update 29 Sept.

Another day another banks goes under:

Wachovia. Gone to Citigroup.

19 thoughts on “Sudden draw down in the CP market and the effect on banks

  1. Investors are pulling out of the short-term money markets in a big way.

    The Economist has thrown its support behind a bailout. The way they describe it makes it sound reasonably sensible.

    Debt Market Distress Spreads
    WSJ, SEPTEMBER 26, 2008

    Short-term money markets remained in turmoil, heightening the likelihood the credit pullback may harm the broader economy.

    Inside markets that are hidden to most Americans — the overnight Treasury repo market, the short-term commercial-paper markets and the floating-rate municipal bond markets — action was unfolding that will soon affect how companies meet payroll, pay vendors and make investments.

  2. Likewise – I don’t like intervention in principal. However, the reality is that we are dealing with the failure of previous interventions, not a failure of an already free system. That makes all the differencefroma pragmatist viewpoint.

    It also shows up the inability of a political process to behave rapidly in a crisis of its own making. This article is insightful.
    http://www.newsweek.com/id/160948

    Unfortunately, we are all junkies at the spigot of the collective fractional reserve banking system. We have already seen yesterday those collective reserves release more funds even underneath this proposed bailout. I don’t believe they have enough cash capacity to resolve the crisis without the bailout, and you might say that the bailout saves the massive inflation that would occur if it was to be resovled solely by the Fed releasing a massive amount of cash.

  3. “Some of you guys think this shit isn’t serious, but it is. If they don’t get the support package, its over.”

    The “uneducated” amongst us (of whom I include myself) aren’t really sure what to think. I’d be lying if I said I understood half the factors at play here. I hear doomsday stuff from JC, less pessimistic stuff from others, whilst business (for me at least) still seems to be booming – albeit under a cloud of anxiousness over “What Will Happen Next”

    I find it hard not to be optimistic, but I like to hedge my bets. So, just how worried should I be? Will the finance sector drag us down? What should I be buying/selling? What should I be doing with my money? Is it safest in certain stocks, banks, property, gold, under the mattress?

  4. JC,

    what’s your estimate that the support package won’t work anyway? It’s all very well to go about peddling what a good idea it is, but if it doesn’t happen to work (and no-one seems to have bothered to say what probability it will have of working) then it’s just a sunk cost effect that’s turning the US government into the equivalent of GM. Why arn’t we going to see exactly what happened to some countries in the Asian financial crisis, where, as it turned out, spending your way of things wasn’t the answer.

  5. Conrad:

    I dunno if it will work. I have some doubts. In fact some estimates put the total clean out at $5 trillion.

    However I think it ought to be tried as the credit markets have seized up.

  6. Charles:

    There has never been a free market in banking. It’s over-clogged with regulation up the warzoo. The central basically determines the short term rate. In the US the mortgage market was corrupted by both parties in their quest for home ownership at any cost.

    Look dude, if Wall Street goes down the gurgler it’s going to take Main street with it. So don’t wish for it, Charles we may end up getting it good and hard.

  7. I’m calling “bullshit” on this. I think JC is seeing things from the perspective of someone who is closely linked to this industry. Like a nurse talking about healthcare or a teaching talking about education.

    There is no doubt that we’re facing a liquidity problem. But that’s not the end of the world. The response is for the fed to temporarily add liquidity to the market. That’s all.

    There is no need for nationalisation or bail-outs. If we don’t have the bail-out, some businesses will go bust. Some people will lose their jobs. We may see a recession… but quite frankly that recession has been on the cards for a long time. And it won’t be that bad. Liquidity will return and within a few years America will be richer than ever.

    What we’re seeing is more mild that 1929. And back then the problem was that when the financial crisis hit, the fed decreased money supply. They will do the opposite this time.

    So, everybody, calm down. Take a bex. Sit down, read a book, have a cuppa. It’s all going to be OK.

    Here’s another libertarian take on the crisis & bail-out, from http://www.reason.tvhttp://reason.tv/video/show/546.html

  8. Even Mr Kling in his video is not advocating doing nothing. He is advocating changing capital requirements…which effectively means lodging more risky assets with the Fed as security for cash that the Fed makes available to that bank.

    This is the inflationary path, especially when all the banks out there with risky assets suddenly realise they can borrow more freshly minted cash from the Fed.

    Personally, I am not a fan of the wealth destruction that accompanies massive inflation. Unless of course I can find a way to earn a rate of return above risk free + inflation.

    Transacting on the risky assets might be difficult – but if you subscribe to subjective value theory, exchange can occur inspite of the difficulties in modelling and ascribing “true” values.

  9. Robbie… it’s hard to have inflation when we’re seeing a dramatic decrease in broad money supply.

    I think some non-economists who follow Austrian economics are having trouble understanding the underlying factors at play in monetary economics. Broad money is decreased when people start hording. At the moment, people are hording. Therefore… (you work it out)

    It is appropriate for the fed to be adding money in the current environment.

  10. Was that a deliberate spelling of hording?

    Hoarding = Saving up for future use
    Hording = err… being part of a horde?

    The hordes are hoarding their money!

    The invading hordes (treasury) are trying to take our money (no doubt, so they can hoard it).

    Banks might be hoarding, but I think the reason the US hasn’t had a recession yet, is that people just keep on spending. I’d say that’s a good thing, but I’m wondering how long that will keep up with the Fed scaring the crap out of everybody. “Give me a trillion dollars, or the economy gets it!”

  11. Temujin, sorry, I cannot remember my M1’s from my M2’s! I am probably going to confuse myself trying to work through this…so please correct me if I am making errors.

    I acknowledge the deleveraging that is going on – and by “broad” measures of money supply, the reduction in credit is a reduction in money supply. However, by and large, it is more difficult for “main street” to deleverage when their largest asset is their home, and their largest debt is their mortgage. My guess is that the biggest deleveraging that is occurring is in the Wall Street and interbank finance markets.

    Furthermore, the capacity for “main street” to contribute to a reduction in the deposits component of money supply is defined by an upper limit. At maximum, the upper limit would be the sum of everyone’s net income…but more realistic is a savings portion…say 10% of net for an unrealistic high number. It would take a pretty massive run on the banks to see the accumulated deposit savings reduced, and while there are some instances of this in the US, it doesn’t seem to be too widespread, and there appears to be no evidence of it here in Australia.

    Let’s grant that a reduction in deposits has occurred. Let’s also grant that a reduction in asset values has occurred. With fractional reserve, the credit that could be loaned against that has gone down by, say 10 times that (I don’t know what the current multiple is). What we are seeing is a huge drying up on the credit side…if I am not mistaken this has dried up by more than 10 times the reduction in deposits and asset values.

    So, if the Fed were to issue cash to replace the reduction in deposits and asset values, it would be insufficient to replace the lost supply of credit (even if the capacity for such credit has been expanded by 10 times the amount of cash pumped in). Then, say things do stabilise, and deposits are returned and asset values restored…slowly…there is still the hangover of the 11xCash injected into the overall broad money supply system. [11x = Cash + credit@10xCash].

    Unless there is a suction pump to withdraw what has been injected as it is replaced by returning deposits, we are left with inflation to flow through the economy for the next few years.

    I am prepared to grant the Fed a bit of leeway (and they have already been doing so, with coordinated injections)…the Austrian school will tell us the consequences of doing that (a boom and then another bust in the future)…

    However, I’d prefer to see such injections limited, and I’d prefer to see some form of exchange transactions used to reset the capital base on which the credit side of money supply is built. At the moment, fear is driving everyone to assume it may be less than it really is, and only an exchange transaction can reset it.

    Sorry for the length of teh post to clarify my thoughts for myself as much as anything else. I’d appreciate your thoughts, comments, corrections.

  12. Robbie

    We saw an interesting bit of economics during the Japanese crisis. Zero interest rate policy was supposed to get the banking system to lend again. It didn’t because the banks were afraid of losing the money. So they parked the funds even at zero to avoid not lending it.

    This is why i think it’s critical that the package goes though. The banks need to be able to trust one another’s balance sheet in order to lend to themselves.

  13. JC: Well it looks like it may make it in time for the opening of Austrlaian and Asian markets tomorrow morning. In spite of my earlier comments about the political process in the US Congress, I might pass on a bit of credit for them putting in the work to negotiate the plan on a very hasty legislative timeframe. In this situation we have not been dealing merely with the rational world of academic economics, we have been dealing with the speed of market emotions and high stakes trading. Both reason and emotion have to be satisfied…and maybe the pressure cooker environment of congressional negotiations under a deadline and election pressure has achieved both.

    There are still a couple of risks associated with managing the plan. I hadn’t heard the story of Japan, and I am sure there is more than you have outlined here. It is a bit like this article I saw earlier in the week on Mexico.
    http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a995IUbqAcaM

    Mexican Risk 1: Banks may sit on bonds exchanged and earn the secure income rather than lend. This may be both a fear response and a rational response. The only answer to this may well be the pace with which US entrepreneurial spirit and confidence can be restored after this much of an emotional hit. That will be the demand side pulling Wall St back to supplying finance.

    Mexican Risk 2: A “don’t pay” culture. This one will be a danger, so it is good that they do not appear to have allowed altering mortgage terms. De Soto has an interesting theory out of his experiences in Peru (“The Mystery of Capital”). His theory is that the key to capitalism is first home ownership and then the mortgage to finance the budding entrepreneur’s first business. We have got to get “Main Street” back having confidence in the security of their home, the desire to own it for themseves, and then the desire to serve others by providing goods and services through a business.

    Tomorrow morning’s market will be very interesting!

  14. Robbie — yeah, the injection would have to be temporary. Economic growth and tight monetary policy in future years would offset the short-term addition of funds.

    JC — the Japanese is a good example of how there are other ways of injecting money into the economy. Ultimately, the BoJ switched from using a price mechanism (interest rates) to a quantity mechanism of monetary policy.

    I believe you and I agree that this might be a worthwhile reform more generally in monetary policy. One of the reasons for this is the Japanese example.

  15. John;

    I think the Japanese model works if the country is self financing. Most of the market economists at the time (when traders listened to them 🙂 were suggesting that it would work because they were running a C/A surplus.

    The US on the other hand has a C/A. Unfortunately the problem for the US is that it is running this deficit with countries that have fixed exchange rates linked to the dollar and are already unsettled because of US monetary/exchange rate policy.

    So a quantitative monetary policy would be seen as a substantial easing and devaluation policy. That would be a very dangerous game of brinkmanship that you don’t want to be playing just when you have a credit crunch.

    I believe you and I agree that this might be a worthwhile reform more generally in monetary policy. One of the reasons for this is the Japanese example.

    Absolutely, but not for the US right at this moment in a unilateral manner.

  16. John

    This is where I see the problem now. If the US went to quantitative easing the market would immediately read that as a renewed devaluation policy and cause a run of the dollar and therefore dollar assets. People would really stick it to them.

    Look, I’m really trying to figure this shit out. You’re better economist than me…. I slept through a lot of lectures 🙂 and take your word for it that increasing broad money would do the trick.

  17. There is a risk of the dollar devaluing… but that’s not the end of the world. There are also benefits from a falling dollar, and some reason to believe that the dollar is too high anyway.

    Sure, once again, there would be losers from a fall in the USD… but it doesn’t change the fundamentals of the economy (ie capacity to produce) and so I don’t see the basis for predictions of a “new great depression”.

    I accept there will be troubles in the market and broader economy. But these troubles have been a long time coming, and there is no avoiding them. The bail-out may help a few businesses, but it adds to the cancer that caused the problem in the first place.

    I think we all agree that the bail-out has significant negative consequences. The issue comes down to whether we believe the bail-out will prevent a “great depression”. I don’t think we’re facing a “great depression” type scenario, so I’m against the bail-out.

    But then again… I’ve always been quite an optimistic type of person. 🙂

    It’s going to be impossible to test my hypothesis now anyway, as the bail-out has been approved.

  18. Look it seems there are some better points added to it from what i see. The government is given equity stakes through warrants and there is the insurance provision that the GOP offered up in lieu a straight out purchase.

    Let’s watch and see what happens.

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