Because of the efforts of Hank and Ben the US is experiencing a selective liquidity crisis in addition to, or perhaps because of, the solvency crisis.
It is fair to say that the banking system is preoccupying the thoughts and actions of our money men. They are attempting to selectively add significant liquidity to banks through special facilities to help them through their problems, without triggering a more serious general inflation in the economy.
This looks like the classic policy error of placing the system in a slow death spiral out of an aversion of allowing markets to clear.
Theoretically at some point if the banks are restored to health, they can once again become a means of transmitting that liquidity to the general industry of the economy.
But in the short term, the banks which are struggling, being literally kept alive by enormous infusions of capital from the Treasury, are also occupying most of the available capital in the private markets.
There is also a secondary effect of inhibition of private funding because of fears and the unknowns associated with a massive government intervention. This has created an environment that is heavily biased towards speculation, bordering on gambling, when capital is willing to venture into the markets.
Which banks will fail and which will survive? Where will the Fed and Treasury draw the line? Can we invest in the common stock of this institution, only to be wiped out in two weeks when the Treasury delivers a conservatorship that renders it effectively worthless?
The second tier of the financial system, the private equity and hedge funds, the regional banks with leveraged debt exposure, are being slowly strangled. They are liquidating positions and raising liquidity at a panic rate, and there is little in the way of help for them because the 'trickle down' effect is not working, as the solvency crisis is not resolved, only being propagated forward.
The plan to shore up the financial system was wobbling along since last August, but the breakdown occurred with failure of Fannie and Freddie in July 2008, and the discovery of their massive accounting frauds, although serious people will question how much of a revelation that could have been.
The sheer size of the rescue plan outdoes anything that we have seen since the days of Franklin Delano Roosevelt.
Now we have a powerful deleveraging liquidation occurring in the private side of the markets. The sell off in commodities and stocks and other discretionary assets is best described as a classic financial panic.
The Treasury is being particularly aggressive in trying to fix the banking system, but as a side effect they are roiling the more general markets and crushing the real economy, in spite of obviously negative real interest rates. The money is available, but only if you are 'on the list' to be saved.
The power of the Treasury, the Federal Reserve, and the primary dealer banks in the markets is greatly amplified, not because they have so much discretionary capital, but because all the other players in the system have so much less.
This will result in increased volatility and wild swings in asset prices. The markets will rise and fall on every word from Treasury because Hank Paulson has essentially taken the markets in hand, as in the days of the banker barons, except he is doing it as the head of the largest financial institution in the world. And they rolled it out with some shock and awe.
J. P. Morgan was hailed as a hero for halting the Panic of 1907. Hank and Ben could get lucky and succeed; they might also fail and be demonized. We are not trying to judge motives, only to attempt to put things into an understandable framework. There is always plenty of corruption to go around when the government gets involved, but we prefer to think it is not a motive in the principals.
The actions of the official sector to save the banks will temporarily paralyze decision-making and capital allocation in the real economy.
The foreign central bankers are frightened beyond description since they are heavily complicit in this strutturale tradimento della fiducia, but for now are following the axiom "in for a penny, in for a pound."
Unintended consequences, a kind of financial blowback, will eventually occur. It will most likely take the form of a market dislocation followed by a severe stagflation. And it may be of epic proportions, "terrific," in the classic defintion of the word.
The case for a hyperinflation in the dollar remains a possible outlier, as does the case for a protracted deflation as was experienced in Japan following a similar slow death policy error. The reasons for this are too complex to go into at this time, but as we have always allowed it is a possibilty as it is a policy decision.
The classic prescription for the individual is to reduce spending to essentials, improve your cash flows, deleverage by eliminating debt and margin, and diversify your savings. We all may need to redefine the term "essential."
So, let's see what happens.
Fed May Expand Funding Aid to Banks in a `Mother of Year-Ends'
By Craig Torres and Liz Capo McCormick
Bloomberg
Sept. 11 (Bloomberg) -- The Federal Reserve may have to increase the cash it provides to banks and brokers, already a record, to help them balance their books at the end of the year.
Six bank failures in the past two months and rising concern about Lehman Brothers Holdings Inc.'s capital levels pushed lenders' borrowing costs to near a four-month high yesterday. They may climb further as companies rush for cash to settle trades and buttress their balance sheets at year-end.
``This could be the mother of year-ends,'' said Brian Sack, vice president of Macroeconomic Advisers LLC in Washington, who used to serve as head of monetary and financial market analysis at the Fed. ``The markets will need extraordinary actions to get through it.''
One option is for banks and brokers to increase the loans they take out directly with the Fed; the central bank reports on the figures today. Officials could also offer options on its biweekly loan auctions or introduce special repurchase agreements to straddle the end of the year, economists said.
When policy makers sought to head off a potential funding crunch with the year 2000 changeover, they auctioned liquidity options to the primary dealers of U.S. Treasuries.
The central bank's latest weekly report on direct loans is scheduled for release at 4:30 p.m. New York time. Lending to commercial banks from the so-called discount window averaged $19 billion in the week through Sept. 3, the fifth record in seven weeks.
Funding Costs
Traders in the forward markets, where financial instruments are sold for future delivery, are pricing three-month cash from December to March at 90 basis points over expectations for the federal funds rate. That's up from 85 basis points at the start of the week and an average of 7 basis points in 2006.
``If banks are unwilling to lend to other banks, then they are unwilling to lend to you and me,'' says Stan Jonas, chief executive officer at Axiom Management Partners LLC, a New York investment firm. ``The market anticipates that we will be in a heightened state of credit risk.''
As the credit crunch erupted a year ago, Fed officials introduced new tools to stem a jump in borrowing costs. In December, they created the Term Auction Facility to inject cash to commercial banks.
The Term Securities Lending Facility was unveiled in March as a resource for primary dealers of Treasuries, and offers a loan of U.S. government bonds in exchange for collateral including asset-backed debt. After Bear Stearns Cos.'s collapse, the Fed the same month gave dealers access to direct loans.
January Extension
Acknowledging persistent funding strains, policy makers in July extended the programs through January. They also introduced sales of options on the TSLF to help brokers get through quarter-ends.
``We will continue to review all of our liquidity facilities to determine if they are having their intended effects or require modification,'' Fed Chairman Ben S. Bernanke said Aug. 22.
Even if the Fed succeeds in easing the liquidity squeeze, it can do little to alleviate the underlying problem about the solvency of companies that invested in securities whose values are sliding. Worldwide, financial firms have posted $510 billion of writedowns and losses in the crisis, and raised just $359 billion of capital.
``Liquidity tools by definition can only have so much impact,'' said Dino Kos, former head of financial markets at the New York Fed and now a managing director at Portales Partners LLC, a New York research firm.
`Solvency Problem'
The Fed ``can alleviate the problem by helping institutions finance these bad assets,'' Kos said. ``But by itself, that doesn't lift the price of these assets. You still have an underlying solvency problem.''
The need for cash is exacerbated by rising credit losses and difficulty in obtaining capital to offset them.
The government seizure of Fannie Mae and Freddie Mac this week may have heightened perceptions of risk in investing in U.S. financial firms. The two companies failed to raise capital even after the Treasury won unlimited powers to inject funds as a backstop in July. After the Sept. 7 takeover, shareholders were nearly wiped out.
``Why would anyone inject equity capital into a financial institution if a few weeks later the government comes in and renders it worthless?'' said Axel Merk, president of Merk Investments, a Palo Alto, California-based fund manager. ``The slope of bailouts is slippery and expensive.''
