Thursday, October 2, 2008

Why It’s a Bad Day

Today was a bad day.

First, the credit markets are screaming. The TED Spread is at historic highs. If you don’t know what the TED Spread is, it measures the difference between the interest rate paid on Treasury securities and the LIBOR rate. LIBOR is the London Interbank Offer Rate, and that is the rate banks offer to lend dollar reserves to one another in London. So why is the difference between these two rates important?

Rates on Treasuries are staying way down because investors don’t know where to put their money to keep it safe, let along make a return. So they run to the safest investment they can find – Treasuries. This is called a flight to quality. On the other side, banks don’t want to lend to each other. This is in part because they are afraid they will not get paid back and in part because they are concerned their funding sources may dry up so they are hording reserves. This is a sign that the banks are very nervous. The bigger the difference between these two rates, the more fear in the markets.

The other very troubling sign is the concurrent declines in oil, stocks, gold, and other metals on the heels of an already declining housing market. Usually, when the stock market is down, you can watch the funds flowing into gold or oil or some other investments. Now, however, that’s not happening. Stocks are being sold off and the money is going out of the markets, perhaps into Treasuries and perhaps under the mattress. This could be a sign that large investors such as hedge funds are selling to raise cash for distribution to withdrawing investors or meeting margin calls. It could also be a sign that investors appear to be coming to terms with a very poor global economic outlook. In any event what we are seeing is signs of deflation. If you have any doubts about why deflation is bad, think about paying off your mortgage as the value of your house, your wages, and everything else falls except the amount you owe. Think about a business investment when the value of the product you will produce is likely to decline while the loan you use to finance the investment does not. Deflation is a really bad thing because it hurts the wealth of anyone who is a net borrower (most households) and it discourages investment leading to more unemployment. More unemployment on top of an already weak labor market can result in a downward spiral as consumption shrinks due to job losses causing more job losses causing less consumption, etc.

Warren Buffet has been in the news lately. Many have felt comforted by his investments in Goldman and GE. I have not, because it tells us that the bluest of blue chip companies are now paying 10% plus equity warrants at or around current market prices to raise capital. This is to replace short term funding from sources such as commercial paper where rates are (or were) much lower. This tells us financing is very difficult to obtain and the higher cost of funds will likely have a negative impact on future earnings.

In the long run, it shows that Buffet has faith in the United States and that's good. What happens between now and the long term is what has me concerned. One day does not a trend make, but this is not a good day.

Sphere: Related Content

1 comment:

Palermo's Blog said...

I looked at the Fed's balance sheet - wow! As of yesterday the Fed owned $152 billion of commercial paper. TAF and other loans is over $550 billion (that includes the commercial paper). The list goes on, with the TSLF up about $86 billion from lat week from Wednesday to Wednesday. In short, we are on life support from the Fed.