A Long Article about the Credit Markets

OK, here is my take on the current goings on in the financial markets. I want to preface this with the fact that this is not investment advise and it is my opinion. I do not have the time to provide backup for all of the numbers but they are readily available from current news sources. Where I don’t know the exact number I tried to be conservative. It is very difficult to try to boil this down to any reasonable length so a lot is left unsaid and what is said is meant to stress the risks we currently face. Many if not most professional economists believe we will have a mild recession and return to growth in the second half of 2008. That said, here goes:

1. The US has relied on foreign capital to support a large and long-term trade deficit. As we consume more than we produce, the net difference is imported from overseas. At the same time we export dollars to pay for these things we import. Those dollars often find their way back here in the form of investors looking for return. With all of these dollars looking for investments added to the normal amount of available investment capital, the markets work their way down the food chain. First they make good investments until those run out, then they make mediocre investments until they run out, then they make bad investments until the cracks begin to show as with the subprime mortgage meltdown. While this is going on the economy is booming because people are buying things, in fact, spending even more than they are making. Once investors realize they have made some very bad investments, however, they do exactly the opposite and run from these investments. Foreign investors take their money out of the US and bring it home or invest it elsewhere. This causes the value of the dollar to fall as everyone is trying to sell it in exchange for their own currency, and it reduces the amount of financing available to support asset prices and economic activity in the US.

2. As foreign investors pull their money out of the US and domestic investors run from financial assets prices of financial assets in the US fall because there is less demand for them. This is especially true when investors realize that the assets they invested in are not of the quality they expected. Mortgage backed securities, private equity buyout loans, and so on are all worth less than they were last year, not just because of defaults but because there is just less money around looking to buy these assets. This is referred to as re-pricing of risk. This flight to quality is seen in the dramatically low interest rates on Treasury securities that fall as demand for these safe investments increases – investors are selling riskier assets and purchasing safer ones. They are also purchasing hard assets as seen in the recent explosion of commodity prices.

3. As asset prices fall and capital flows out of the country and out of certain financial assets, banks begin to feel pressure. They need to raise funds to meet the demands of deposit withdrawals and to fund loans to customers who can no longer raise money in other markets such as the commercial paper market (again because the flow of money has reversed from in to out). Normally banks will borrow from other banks or depositors, and/or sell assets to raise the liquidity necessary to meet these demands. Today, however, they cannot do enough of either because they are all in the same boat and because there is a lack of demand for their assets – remember the capital is going out, not coming in. In order to sell assets and raise liquid funds the banks would be forced to take big losses on their assets, and that would reduce bank capital. The more they have to sell the lower the price they will get and the more bank capital is reduced. This could ultimately lead to insolvency of the banks, which is worse than illiquidity because it means that even if the banks had liquidity, they could not make any loans. No loans, investment plummets and employment follows. Of course, if this happens the loans on the banks’ balance sheets get even worse because as employment falls loan defaults increase in this downward spiral.

4. The Fed is using all kinds of tools, new and old, to prevent the system from collapsing under the weight of this de-leveraging (the term for when investors who provide capital leave the markets). First, it is lowering interest rates rapidly, with the federal funds target rate down from 5.25% in September to 3.0% now and another cut expected on Tuesday. Lowering interest rates is targeted at two things: lower rates in general means the rates on investments should go down and the re-pricing of assets should be less severe; and lower rates should support additional investment and consumption assuming those rates make it to the borrowers. The problem is that the lower rates are not making it to the borrowers and so the intended effect is not yet being felt. One reason this is happening could be that the banks are, in fact, insolvent based on current asset prices so they cannot make loans even if they have the liquidity. The other reason this could be happening is that the liquidity crisis is so severe that the banks are simply keeping up with their own balance sheet changes without making many new loans. Either way this is very troubling.

5. In addition to lowering interest rates, the Fed normally acts as lender of last resort to commercial banks. If a bank has a liquidity problem it can pledge collateral to the Fed and the Fed will then make a short-term loan to the bank through the discount window. This has also run into to trouble, however, because none of the banks want to borrow from the Fed this way. They are worried that if they do it will signal a problem and everyone will withdraw their funds from the bank – a classic run-on-the-bank scenario. To deal with this, the Fed created a new program called the Term Auction Facility, or TAF. Under this $100 billion facility the banks bid for loans from the Fed, and if they win they pledge collateral and get a loan for 28 days. The Fed has opened up the collateral pool to include basically anything the banks have to pledge (they can pledge anything they could have pledged for a discount window loan). The names of borrowing banks are not made public, and there is no schedule of the collateral the Fed takes to secure these loans released to the public.

6. The TAF was a very good idea, except it did not provide liquidity directly to the investment banks because they cannot borrow from the Fed without drastic action. In order to address this issue, last week the Fed announced a new $200 billion swap facility called the Term Securities Lending Facility. Under this facility an investment bank can give the Fed mortgage backed securities and other collateral and the Fed will give the bank Treasury securities from its own portfolio. The investment bank can then sell the Treasury securities for cash to get liquidity, and 28 days later it reverses the transaction by returning the Treasury securities for the collateral. Unfortunately this facility is not yet operational so it was too late for Bear Stearns. Bear experienced a run-on-the-bank Thursday and Friday of last week, and the Fed took that drastic action to lend directly to Bear Stearns through JP Morgan Chase. The Fed has not done this since the Great Depression.

So between lowering interest rates (the cost of funds to banks) and providing a source of liquidity (the loans and swaps) for the banks’ assets that are re-pricing, the Fed is hoping to avoid a major collapse of the system that could include runs on many institutions such as the one experienced by Bear Stearns last week. If the banks cannot raise liquid funds then they cannot meet the demands of depositors and borrowers and once this is known, there is a run on the bank. All told, the Fed has announced at least $400 billion in new facilities to provide liquidity to the banking system, which is about 44% of its entire balance sheet. Unfortunately interest rates to borrowers are still not declining signaling an even deeper liquidity crisis or an insolvency crisis. The falling dollar confirms the exodus of capital from the US markets and no one knows how far this will go. In the interim, the economy looks worse as banks do not extend credit for investment or consumption in large enough quantities to support economic growth. The very interesting and as yet unanswered question is what happens if the banks cannot repay the loans from the Fed and the pledged collateral ends up being worth less than the loan?

7. The Fed has a dilemma on its hands and there may be no solution available to it. On the one hand interest rates must be low to stimulate the economy by promoting borrowing and investment/consumption. If interest rates are high businesses will not invest and consumers will postpone purchases, so low rates traditionally help spur the economy. This is the standard policy response to a declining economy, and we are in a declining economy. On the other hand, however, low rates drive more capital out of the markets as it seeks better returns elsewhere. Witness the current boom in commodities, surely the next asset class to bubble over, and the continuing decline in the dollar. These trends are also leading to higher inflation as witnessed at the pump. So lower rates help to spur the economy and hopefully place some floor under the assets being re-priced, but at the same time chase away much needed capital (perhaps worsening the re-pricing because of lack of purchasers) and create a higher inflation risk. If the capital stays away because of the lower rates banks will not lend and we could have a severe economic downturn. Raising rates may help attract the much-needed capital, but it will slow the economy at a time when it is already vulnerable possibly resulting in a severe economic downturn. Therein lies the dilemma. It is very possible the Fed does not have a solution to the current problems.

8. Remember from number 1 above that this cycle of asset pricing and re-pricing was at least in part created by the unsustainable trade deficit of the US. The trade deficit reflects the fact that we have been consuming more than we have been producing, and paying for the difference by borrowing (and, in some cases, selling our assets). We have simply blown our credit beginning with the subprime mortgage meltdown, and it is now time to pay down some of the debt because our lenders are cutting off the flow of funds. That means a combination of selling our assets (as in Citigroup equity sold to foreign sovereign wealth funds) and saving. Saving is the opposite of consuming, so the more we need to save the less we can consume. The less we consume the lower the GDP, unless of course we cut all spending only on imports which is impossible, especially with our dependence on foreign oil. So I predict a fairly substantial slowdown in our immediate future as all of this works its way through the economy. If the flight of liquidity is severe enough we could also witness even more stress in our financial system, without which our economy comes to a halt. Because of this don’t be surprised if there is a large Federal bailout of the banking system on the horizon, regardless of what noise comes out of the White House about free markets and the like. If Bear Stearns is too big to fail so are all of the other major banks, both commercial and investment.

9. A taxpayer bailout of any magnitude is the last thing we need right now, especially with rising budget deficits, two wars, and ever increasing health care commitments. Tax increases may be unavoidable, even if they do further depress economic activity (though there is debate over whether this would be the case under these circumstances). The flight to commodities and resulting price pressure may or may not be sustained, depending in part on how long and how deep the economic downturn turns out to be. If the economy falls into a very deep recession, and especially if the global economy follows, we could see a reversal of the commodity price boom and, potentially, a period of deflation as all asset prices fall (this would be a worst case scenario).

10. How big of a crisis do we have on our hands? We can look at what the Fed and the Federal Government have done so far. At least $400 billion of liquidity facilities have been announced beginning in December and this does not include whatever loans have been made to Bear Stearns. Approximately $200 billion of mortgages have been funded by The Federal Home Loan Banks, an extraordinary increase on a historical basis. The FHA is in the process of refinancing defaulted subprime loans, and there are proposals in Congress to increase the total amount they can refinance to $300 billion. Congress and The President have passed an economic stimulus package estimated to cost approximately $160 billion. All the foregoing is taxpayer backed in one form or another. On the private side, banks have so far written off approximately $150 billion in losses on their assets and many expect another $135 billion to follow. Are we over $1.3 trillion yet? I think so. This sounds like a big problem.

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