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October 7, 2008 Unbelievable Complexity
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The Fed and Treasury will do whatever it takes to unfreeze credit
markets. Today, the Fed announced it will buy commercial paper
(CP)—unsecured short-term debt that companies rely on to fund their
day-to-day operations. Not only is this crucial for business activity, but it
also impacts household finance. Many people hold short-term capital in money
market mutual funds (MMFs) that invest in commercial paper. MMF deposits have
been a large and growing component of the U.S. money supply for nearly 30
years. They are used by many households and small businesses as
interest-bearing checking accounts. MMF redemptions skyrocketed a few weeks ago
when a large fund ‘broke the buck’ (could no longer redeem a dollar
for a dollar) because of its losses on Lehman Brothers commercial paper, which
became virtually worthless when Lehman declared bankruptcy.
All financial markets are interconnected, increasing the complexity of the
crisis and often requiring the authorities to modify actions as they go. To
stem the run on MMFs, the Treasury guaranteed MMF deposits. The American
Bankers Association then warned the Treasury of a potential shift in deposits
from the banks to MMFs, which of course would have exacerbated the liquidity
problems of already-troubled banks. The Treasury quickly amended its guarantee
by imposing an ‘as-of’ date of September 19. Every Fed and Treasury
action (such as letting Lehman Brothers go under) has had unintended
consequences.
U.S. businesses and municipal governments normally finance their short-term
operating expenses by issuing CP. In recent weeks, CP spreads have widened
sharply reflecting rising (perceived and real) risk, in essence shutting down
this market. This has forced businesses and local governments to draw down
their credit lines at the banks; however, U.S. banks are reluctant to extend
credit, forcing businesses and local governments to cut or suspend operations.
Credit has virtually dried up in the United States and much of the rest of the
world. In Canada, the cost of credit has risen and the availability has
diminished, although to a lesser extent than in the U.S. As a result, economic
activity of all sorts is slowing. Consumers, businesses and provincial (and
state) and local governments are adversely affected and all are tightening
their belts, reducing expenditures and increasing savings. With the dramatic
plunge in stock, bond and commodity markets, individuals, financial firms and
nonfinancial entities are hoarding cash. The only safe haven has been the
federal government bill and bond markets. The flight to quality into the
deepest and most liquid market, the U.S. Treasury market, has been so enormous
that the U.S. dollar has risen and interest rate across the very steep Treasury
yield curve have fallen despite what will be a tripling in the U.S. budget
deficit. The bailout will be funded by massive new issues of Treasury debt, but
with the plunge in all other financial assets, there is tremendous demand for
U.S. Treasuries and, despite the economic and financial woes in the U.S., there
is no other reserve currency.
The Fed, for the first time in history, is now the lender of last resort to
the business and government communities, taking on more credit risk than ever
before as it continues to expand its balance sheet. These purchases will be
funded by the Treasury (taxpayers), therefore having no impact on the money
supply. Indeed, the U.S. money supply has been flat for some time, despite all
of the reserve injections; we are in a liquidity trap—cash is hoarded and
discretionary lending and spending shuts down.
The size and duration of the CP funding facility is not specified in the
press release; this omission is undoubtedly purposeful, signaling that the Fed
with provide whatever liquidity is necessary over whatever period it takes to
renew the flow of credit. CP rates relative to Treasuries fell in response to
this action. Stocks, however, continue to selloff, albeit more moderately than
yesterday. Hedge funds are posting record losses and many are shutting down.
Mutual funds are suffering net outflows for the first time in many years.
Iceland just had to borrow billions of dollars from Russia. Russia and Brazil
suspended trading in their stock markets again yesterday, and so on.
Today’s announcement is on the heels of yesterday’s Federal
Reserve initiatives: increasing the emergency credit facilities that make
short-term loans to banks and other financial firms by a whopping $900 billion;
and paying interest on excess reserves that banks keep on deposit at the Fed
(at a rate of 75 basis points below the fed funds rate, currently at 2%). The
credit crisis continues to widen despite the $800 billion bailout package and
the increase in the deposit insurance limit to $250,000 the Congress approved
last week. Earlier actions taken by the Fed and Treasury to allay credit
concerns includes the takeover of Fannie and Freddie, the enhanced provision of
liquidity to commercial banks, primary dealers, MMFs and AIG, as well as the
dramatic easing of collateral constraints.
Additional actions are required and will no doubt be forthcoming, the sooner
the better:
- Coordinated central bank action to cut overnight funding rates by
(at least) 50 basis points. The Reserve Bank of Australia cut rates a full
percentage point last night.
- Direct capital infusion into U.S. banks through the government
purchase of newly issued preferred shares. The FDIC already has the authority
to do this and was willing to do so to encourage Citigroup to buy Wachovia
(before Wells Fargo jumped in). The Treasury TARP facility also has the
authority to invest directly in bank preferred shares, which has thus far
received little attention.
- Direct government low-interest loans to households.
- Treasury loans to state governments. California, New York and
Massachusetts have already announced they are only weeks (days) away from
running out of operating funds to pay policemen, fire fighters and teachers.
The municipal bond market is in the same disarray as other credit markets.
After the U.S. election (and maybe even before the Inauguration):
- A government housing bailout including subsidized loans to
delinquent homeowners and government purchases of vacant housing.
- Fiscal stimulus for the economy, including stepped up government
spending for infrastructure, alternative energy, education and health
care.
- Massive enhancement and restructuring of financial market
regulation.
Many of these actions are anathema to free-market economists and cause moral
hazard, which is why they have been so long in coming. But after 14 months, the
situation is far too dire to worry about those issues now. The U.S. federal
budget deficit, already at about $450 billion, will explode; the government has
already poured more than $2 trillion (or is it $3 trillion, I’m losing
count) into emergency funding. Some of this money will come back once the free
flow of credit is reestablished. For sure, there will be many buying
opportunities out there in a wide array of asset classes.
Bottom Line: This crisis will end, but at the end there will be far
fewer financial firms, much more financial regulation, and much less leverage
in the system. With reduced leverage there will be reduced risk, but also
reduced returns. Households will be forced to save the old-fashioned way, by
spending less than they earn. The combined forces of deleveraging,
re-regulation and demographic shifts will reduce the long-term potential growth
of U.S. (G-7) domestic consumption. Offsetting this will be the growing
consumer markets of the emerging world.
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June 19, 2010
China Loosens Currency Peg
In a surprise announcement on Saturday, the People’s Bank of China
(PBOC) announced it would break the 23-month fixed peg in the yuan MOREJune 18, 2010
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The U.S. Dollar’s Decline Is Not Such a Bad Thing
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Unbelievable
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Post-Crisis Withdrawal
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fiscal stimulus can only ease the pain of the global recession and credit
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The latest jobs data signal that the year-long U.S.
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force MOREDecember 18, 2008
One Major Lesson
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Fed Slashes Rate to 0-to-25 bps Range; Historic Use of Fed Balance Sheet to Ease
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Forget Old-Time Fiscal Stimulus
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Tough Times, Aggressive Actions
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Urgent Action Needed
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GM Bailout - Part 2
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National Catharsis
President-elect Barack Obama has won a decisive victory, drawing support
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The Consumer Recession
The sizable decline in stocks in the past two days reflects the growing
awareness that the U.S. economy is going into a deeper and more protracted
recession than expected MOREOctober 10, 2008
Paulson and the G-7 Do the Right Thing
U.S. Treasury Secretary Hank Paulson just announced that the TARP would be
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and other financial firms directly MOREOctober 10, 2008
More Action-Crisis Intensifies
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The Wealthy Boomer interviews Sherry Cooper
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Global Rate Cuts... Finally!
In the face of intensifying financial market turmoil, major global central banks swooped in this morning with an unprecedented coordinated interest rate cut. MOREOctober 7, 2008
Unbelievable Complexity
The Fed and Treasury will do whatever it takes to unfreeze credit markets. MOREOctober 1, 2008
Quarterly Web Cast and Dividend Stock Screen
Sherry's latest web cast, and the latest update of the dividend stock screen featured in Sherry Cooper's book, The New Retirement MORESeptember 26, 2008
Economists Weigh In
There is nothing I could write at this moment that might not be superseded by events in the next few hours. MORESeptember 19, 2008
Stock Market Applauds U.S. Government Plan
What a week this has been. MORESeptember 16, 2008
No Rate Change, Easing Bias
In a unanimous decision, policymakers did not cut the benchmark fed funds rate, despite the market’s call for an easing move. MORESeptember 15, 2008
Fed Widens Collateral
Judging from my press calls early this morning, there appears to be a good deal of opacity in what the Fed has said regarding a broadening of the collateral it is willing to hold on short-term emergency loans to primary dealers. MORESeptember 14, 2008
Wild Day Tomorrow
Unfortunately, as of 4:00 p.m. today (Sunday) the news on an orderly takeover of Lehman Brothers does not look good. MORESeptember 11, 2008
Recovery Still a Year Away
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The New Cold War
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Hedge Funds Face Shock Waves
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Fed Policy Tighter than Normal at 2% Fed Funds
While the Fed decided to leave its benchmark interest rate at 2% this week, well below the level suggested by the Taylor Rule, credit conditions in the U.S. are much tighter than this rate would suggest. MOREAugust 1, 2008
Obama Just Found His Middle-America Appeal
With Obama still running behind McCain in the industrial heartland, among both male and female voters in states such as Pennsylvania, Ohio and West Virginia, news widely reported today that Wal-Mart has formally and officially informed managers that a vote for the Democrats is a vote for unionization will not sit well with America’s traditional middle class MOREJuly 18, 2008
A Global Presidential Campaign
What better evidence is there that globalization is real and permanent than the foreign trips of both presidential candidates? MOREJuly 15, 2008
Crisis Widens
The U.S. financial markets and the U.S. economy are in crisis and the ramifications for the rest of the world are enormous MOREJuly 7, 2008
Next Shock: Currency Crisis?
The malaise of the U.S. economy is palpable MORE
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