The unknowable future
We think it is likely that the US and world economies will be able to work through the current troubles. The Fed is finally showing a little creativity and an apparent awareness of the extent of the problems it faces. In addition, for example, S&P said today that “the end of write-downs is now in sight for large financial institutions.” But there are no assurances that everything will work out. We’ll quote a little from an analysis by Hegemony Capital:
In certain respects, the current crisis combines aspects of the three worst credit crises of the past two decades.
• Like the collapse of the savings and loans and the shutdown of the junk bond market in 1990-91, we are currently faced with a complete shutoff of credit to less-than-investment grade companies. The high yield bond market and leveraged loan market are closed for business.
• Like the implosion of Long Term Capital Management in 1998, hedge funds are being battered by a withdrawal of credit by prime brokers and other liquidity providers and will soon be buffeted by a flood of redemption requests due to poor performance.
• Like the deep credit collapse of 2001-2002 that was triggered by the failure of investment grade companies like WorldCom and Enron, the current crisis resulted from a complete loss of faith in the rating agencies and their so-called AAA ratings on mortgage-related securities.As a result, markets are facing a perfect storm that has not responded to traditional central bank remedies such as lowering interest rates. This is because the issue is not the price of credit but the availability of credit. In turn, this means that the issue for financial institutions, hedge funds and other economic actors has shifted from one of liquidity to a question of solvency. And solvency, to a far greater extent than liquidity, is a state of mind.
As a result, the Federal Reserve has been forced to reach into its tool chest and employ some unconventional methods to try to prevent a bad situation from turning dire. On March 12, 2008, the Federal Reserve decided to step up its attempts to act like the lender of last resort by agreeing to lend primary dealers in the bond market up to $200 billion in Treasury securities for a month at a time and accept ordinary AAA-rated mortgage-backed securities as collateral in exchange.
Considering that nobody believes that AAA mortgage-backed securities are anything of the kind, the central bank was essentially creating $200 billion of previously unavailable liquidity out of the air. The real question remains whether the primary dealers will actually utilize this new line of credit or continue what HCM can only describe as an indiscriminate, and therefore irrational, rationing of credit. The outcome of the current crisis will hinge on heavy lobbying by Federal authorities to convince the same institutions whose lax lending policies led the markets into this mess to begin loosening their purse strings in a reasonable and rational manner. In certain situations, that is going to require firms to put the interests of the system ahead of their own interests…
The risks of a systemic collapse have risen to uncomfortable levels. The complete withdrawal of credit from the financial system has led to a series of implosions of hedge funds and other leveraged investment vehicles. At some point – and nobody knows when that point is – the system is not going to be able to withstand further failures. It will not be the sheer volume of failures that brings the system to a standstill; the system is enormous and can sustain huge dollar losses before becoming impaired. The problem is that the global financial system is a case study in chaos theory. This is truly a case where a butterfly flapping its wings in West Africa could lead to a Category Five hurricane thousands of miles away. There are an incalculable number of derivative contracts and counterparty relationships on which the stability of the financial system hinges. All it would take is the collapse of the wrong firm or the wrong derivative contract at the wrong time to throw the wrong financial institution into crisis and force the entire system into a death spiral. As noted above in the discussion about Bear Stearns, we may not need the largest institution in the world to fail to cause the calamity – it may just be a matter of something bad happening at the wrong firm at the wrong time to trigger a systemic collapse. This is the risk implicit in a highly leveraged financial system financed by unstable financial structures.
If we make it through these terrible uncertainties over the next few months, that is no cause at all for complacency about the $45 trillion in unregulated counterparty obligations floating in the international financial ether. Dodging a bullet is no guarantee of dodging the next one.
March 14th, 2008 at 12:39 pm
I don’t think any rational person wants the entire financial system to collapse, and my understanding of the overal situation suggests that the Fed is doing what is probably needed.
However:
1. The effectiveness of lowering of discount rates seems doubtful to me
2. The effectiveness of accepting the highly suspect collateral in exchange for creating brand new money seems on first blush to be resting on a transfer of much risk from private hands (banks, etc.) to the Fed - a quasi-public body. Not good. In reality it is far worse though - essentially, the Fed is buying these probably fairly worthless assets at a high value in new money. The new money 1) sinks the dollar, causing accelerating inflation here at home, and 2) also increases inflationary pressures through an increased dollar supply.
So in the end, what effectiveness, if any, that the Fed’s action have depend on increasing inflation so that the US citizen (and other holders of US dollars) are in effect “buying” the worthless assets via inflation on everything else.
Although this may be the only set of solutions they can find, I don’t think we should be cheering the Fed’s inventive approaches — central banks typically try to inflate their way out of problems like this, and the Fed is simply using somewhat different ways of injecting more inflation. I guess that is innovative in a sense, but no more so than the idea of dropping dollars from that helicopter.