The danger comes because when money stops flowing the subsequent seizure in money and credit markets drains confidence rapidly. All too quickly a downward spiral in liquidity can emerge.
In the summer the Federal Reserve provided positive momentum by cutting rates, but that proved to be a short-lived rally. The TED spread – the difference between Libor and treasury bills – is widening again. This measure of investors’ risk aversion is not quite back to the 225 basis points seen in August, but at 160bp is substantially higher than the level it fell to during October of 100bp and way above the 40bp that applied before the credit crunch.
How can confidence, the lack of which is the real reason for continuing financial markets dislocation, return when news of yet more negative disclosure is bound to be around the corner? Remember that the real pain – waves of foreclosures, rising delinquencies and hundreds of thousands of householders coping with higher mortgage rate resets – is yet to be felt. In addition to the continuing downgrades of sub-prime ABS and ABS CDOs, there are worries about the monolines. ResCap and Freddie Mac’s latest woes are just the icing on the cake.
Under these conditions it is no wonder that banks are reluctant to lend to each other. And there appears to be no solution to the credit crunch on the horizon. Further interest rate cuts are inevitable but, apart from cushioning the blow of higher interest rate payments to those consumers fortunate enough to obtain credit, will they make it all better?
It seems unlikely that lower rates will help persuade money market fund managers to raise their exposure to ABCP. The risk of extension or, worse, default is rightly one they do not wish to bear. The impact on structured investment vehicles is stark. They have existed comfortably for 20 years but that business model is finished. That sector alone was worth $400 billion. Now it is gone.
The leverage that allowed the complete mispricing of credit risk is now being withdrawn, with several unforeseen and unfortunate effects. The most obvious is that both credit and liquidity are scarce, and that is not going to change soon.
For the first time in more than a decade, banks are finding it hard to finance themselves. Witness Citi paying 195bp over treasuries for $4 billion of 10-year money. It repriced the market for US bank holding company debt in the process: it had little choice. Citi has various SIVs to finance and a rather large sum of leveraged loan commitment. It is not alone.
Banks are asking their corporate clients “please don’t hit me with your line over the year-end”. The clear implication is that credit will be rationed.
Indeed so fragile is confidence in the financial system that banks are now having to pay as much if not more for term funding than comparably rated corporates. Perhaps the banks should try to borrow from those corporate treasurers who resisted their and shareholders’ urgings to leverage up and preserved instead their balance sheet ratios and hoarded cash. The collapse of the virtual lending system that banks pioneered in recent years – stepping out of credit extension themselves and placing credit risk in unregulated structured vehicles – now raises unwelcome existential questions. What are banks for? Who needs them?
Funding to the end of the year will be difficult. A severe liquidity squeeze is likely because it is always difficult over the year-end. Expect more central bank injections of liquidity. That covers much of the bad news. The limited good news is that there are still large pockets of cash squirrelled away. And once the new year is here it might be possible that some of that hidden cash will come out into the open.
