2007 December 15 Saturday
Frozen Credit Markets Compel Central Banks To Operate In Unison

A group of central banks made up of the US Federal Reserve, the Bank of Canada, the European Central Bank, the Bank of England, and the Swiss National Bank tried to work in unison to inject cash into credit markets to try to unfreeze them.

The Bank of Canada joined the U.S. Federal Reserve and other central banks yesterday in an audacious attempt to ease choked credit markets without resorting to inflation-stoking interest-rate cuts.

Analysts said the moves, billed as the biggest act of coordinated economic co-operation since 9/11, could be a novel way to get borrowing rolling again or a costly mistake if markets fail to respond and the freeze in borrowing drags on.

Not much happening here kids. Just most of the big central banks trying to act in unison to reverse a worsening global financial crisis. What, me worry?

This action is apparently unprecedented in scope.

If there is a precedent for yesterday's joint operation to inject liquidity into the international finance system by the western world's five leading central banks, we have yet to find it.

There was some co-ordination of activity after 9/11 but this operation is of a wholly different magnitude. The new multi-billion dollar facility is the starkest illustration yet of the alarming scale of the collapse of credit - and a welcome sign that central banks are treating it with the seriousness it deserves.

We have this size of crisis and world oil production hasn't even started to decline rapidly. Wait till that happens and this crisis will seem like small potatoes in comparison.

They certainly gave it the good old college try. But oops, darn it, the attempt looks like a dud.

The biggest concerted effort by central banks in six years to restore confidence in global money markets is showing little sign of success.

The rates banks charge each other for three-month loans held at seven-year highs for a second day after policy makers in the U.S., U.K., Canada, Switzerland and the euro region agreed to ease the logjam in short-term credit markets. The cost of borrowing in euros stayed at 4.95 percent, the British Bankers' Association said today, up from last month's low of 4.57 percent and 3.68 percent a year ago.

Noone knows how to value huge quantities of SIVs and other obscure debt instruments. Any institution that holds lots of them has a balance sheet that can't be deciphered. What is Citibank worth? That's an extremely speculative question. Is Morgan Stanley or Chase solvent? Hard to tell. A lot of investors thought our markets are very transparent and now they discover they can't trust debt ratings issued by Fitch, Moody's or Standards & Poors.

The ratings agencies are paid by the very organizations that want their bonds to get high ratings.

Rating agencies face a similar conflict to that of independent experts – that is, they are paid by the very people upon whom they are assessing. Ratings agencies are paid hefty sums by bond issuers to assess the creditworthiness of the asset. Moody’s is a stand-alone publicly listed company on the NYSE, while S&P is part of publisher McGraw Hill – both have to earn a return for shareholders.

Regular (non central) banks are afraid to lend each other money.

While yesterday's joint move was sketched at the G20 a month ago, and fine-tuned in encrypted telephoned calls over the past month, the final trigger seems to have been the spike in the crucial three-month money rates that lubricate finance. Dollar and sterling Libor spreads have vaulted in recent days. Euribor spreads reached an all-time high of 99 yesterday morning.

"A co-ordinated move like this has the 'wow factor'," said Paul Mackel, currency strategist at HSBC. "But there's a lot of scepticism over whether this will be enough medicine to end the credit crisis. Is it already too late?"

It is unusual for so many banks to engender fear all at the same time.

Central banks in Europe and North America unleashed a powerful and rare arsenal of liquidity measures Wednesday meant to stave off the threat of a steep deterioration in credit conditions over Christmas.

But analysts fear the measures will only delay the inevitable balance sheet pain and market turmoil that is necessary to purge shaky debt securities from global markets. And Bank of Canada Governor David Dodge conceded he was unsure the measures would have a lasting effect.

“It's very unusual. But it's also very unusual to see all the world's banks at such risk,” said Sherry Cooper, chief economist at BMO Nesbitt Burns Inc.

“They wouldn't be doing this if they didn't know this situation is very serious.”

Dr. Irwin Kellner sees parallels with the 1930s liquidity trap.

Today there are some similarities to the liquidity trap of the 1930s. The credit crunch is clearly one of them. No matter what the Fed does on Tuesday, it will not be able to thaw out the frosty financial markets.

This is because the markets lack confidence. As I wrote two weeks ago, "fear, and not a lack of liquidity, is what's freezing up the credit markets ... and ... it's going to take a lot more than infusions of liquidity to thaw them." See Nov. 26 column

You know that fear is stronger than greed these days when banks refuse to lend to each other - never mind to businesses or to consumers.

A good indication of this is the three-month LIBOR spread against comparable maturity Treasuries. It's over 200 basis points (2 percentage points) today versus an average of about 25 bps between 2003 and this past spring.

The banking industry is experiencing a crisis in trust.

What scares the central bankers now is the evaporation of trust from the system. Banks don't believe each other's numbers; since nobody knows the real value of some of the mortgage-backed securities everyone is holding, they assume the worst. They start hoarding cash as a buffer against their own losses and because they're nervous about lending to anyone else.

I hope the central banks can prevent a much larger crisis and just limit the fall-out to a moderate recession.

Share |      By Randall Parker at 2007 December 15 02:25 PM  Economics Financial


Comments
John S Bolton said at December 15, 2007 4:50 PM:

If they really had fears as they decribe them above, I don't think they would advertise them. It could be that they need a reason to get Europe to do dollar support on a really large scale, imitating China, Japan etc. Europe is much less able to keep US government securities quarantined so as not to cause inflation there, as they otherwise turn into reserves supporting expansion of credit. America does not have good candidates for a new expansion of credit into the subprime categories. That's why we have this problem. When the low end of your real estate price structure was, at the margin, rising from illegal aliens being allowed to get mortgages with fake ID, it takes very little for all sorts of frauds to find their opening. The general revulsion against American mortgages is caused by too much, and too loose, credit of this kind. Confidence is not restored, but subverted further, by trying to fund a restart of the no-money down, no valid ID required, no job required, no verifiable source of income required, type of mortgage lending. Only rising standards can rebuild confidence.


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