Over the last two weeks, we have said that central bank liquidity measures had become counterproductive. Throwing more liqiudity at banks made it more viable for them to depend on monetary authorities and not rely on private sources for funding, and in turn extend credit to them.
One contributing factor not mentioned in many of today’s media reports is that today is the settlement day for Lehman credit default swaps. The auctions are expected to produce losses to protection writers or 80 to 85 cents on every dollar of guarantee provided. Banks are believed to be hanging on to cash both to pay for their own settlement and out of fear that their counterparties may take irreperable damage in the Lehman settlement process. There may be some relief if the financial community passes this test, but with another big settlement, WaMu, later this month, banks are still likely to remain on high alert.
From Bloomberg:
The cost of borrowing in dollars for three months in London soared to the highest level this year as coordinated interest-rate reductions worldwide failed to revive lending among banks for any longer than a day.
The London interbank offered rate, or Libor, for three-month loans rose 23 basis points to 4.75 percent today, the British Bankers’ Association said. That’s the highest level since Dec. 28. The Libor-OIS spread, a measure of cash scarcity, widened to a record 350 basis points. The overnight rate fell 29 basis points to 5.09 percent. That’s still 359 basis points more than the Federal Reserve’s target rate of 1.5 percent.
“To see little or no reaction in the fixings is very disappointing and reinforces the fact that Libor is broken and that the transmission mechanism from central banks isn’t working,” said Barry Moran, a Dublin-based currency trader at Bank of Ireland, the country’s second-biggest bank. “Things are still very stressed and we don’t know what’s going to fix it in the short term.”
The European Central Bank today offered banks as much cash as they need for six days at its benchmark rate of 3.75 percent, bringing forward new measures to soothe money markets. It also loaned banks a record $100 billion in overnight dollar funds, allotting most of the cash at 5 percent, down from 9.5 percent yesterday…
The difference between what banks and the Treasury pay to borrow money for three months, the so-called TED spread, widened to a record 412 basis points.
“Libor spreads are still wide, which suggest offshore banks are not willing to take more risks lending to other banks,” said Cezar Bayonito, a liquidity trader at Allied Banking Corp. in the Philippines. “Interest-rate cuts will be of little help in the near term because the issue is trust, not rates.”…
Overnight rates on dealer-placed commercial paper rose 56 basis points to 3.5 percent yesterday, while investors seeking a haven for their money pushed the yield on three-month Treasury bills down 15 basis points to 0.6 percent. Bill yields rose 3 basis points today, to 0.65 percent.
The Financial Times mentioned a particularly troubling development, that banks are not even lending to each other on a repo. In a repo, a bank sells liquid, high credit quality securities under an agreement to repurchase, and gets cash in the interim. The fact that they will not lend in return for collateral is mind-boggling.
From the Financial Times:
Stress across money markets intensified yesterday in spite of the unprecedented round of co-ordinated interest rate cuts by central banks aimed at helping banks gain access to funds.
In recent days, central banks have pumped vast amounts of liquidity into the short-term lending markets, only for banks to hoard the cash and not lend to other banks. As well as the rate cuts, the US Treasury tried to alleviate lending problems in government bond markets by making more of its bonds available for collateral.
“The concerted central bank rate cuts should provide some relief in [Thursday’s] fixings, but the funding will remain very tight, with negative effects on the economy mounting,” said TJ Marta, strategist at RBC Capital Markets.
The breakdown in trust between lenders and borrowers since the bankruptcy of Lehman Brothers in mid-September has paralysed short-term funding markets. Institutional investors are unwilling to risk lending unsecured funds to banks, or even buy commercial paper beyond one day issues by highly rated companies.
The reluctance to lend between banks and other investors has also created chaos in the government repurchase or repo market, another important source of short-term funds for banks. In a repo transaction, sellers of debt securities promise to buy them back later for an agreed price.
Investors have stopped lending cash to banks even in return for collateral such as US Treasuries. That has broken the chain of lending between numerous banks to such an extent that borrowed securities have not been returned. These so-called “repo fails” prompted the US Treasury yesterday to re-open various Treasury issues and sell more debt yesterday.
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Yves
I am first time poster although I do try and check out your web site each day. I work in field of civil engineering and don’t claim to have any great expertise in economics. Therefore, sites like this are invaluble in trying to explain what is currently going on in economy. I have been reading for past 2 or 3 years about what the experts are predicting for us. Most people are following this continuing disaster in the mainstream media. Unfortunately for them the experts do their best to submerge their views under a thick layer of technical jargon. This is done intentionally as they know full well that over 90% of population have a 30 second attention span. I suppose that with general population waking up to what is going it must be a shock to them and thus an explanation for decline in civility. There is an old saying,
Ignorance is bliss, however once roused from their slumber the ignorant tend to march in protest. Unfortunately for society even then they don’t have a plan.
cheers
rt from Nova Scotia Canada
Could this be due to Lehman’s CDS being settled today? Or AIG having to settle transactions with big losses?
If anyone knows, please comment.
LEH CDS settlement today? I thought tomorrow. Will check it out.
Besides: IF they are settled is payment due immediately or on Monday or even later? Might make some difference in these times.
Any experts here on this?
Oct 8 (Reuters) – The value of credit default swaps backed by defaulted Lehman Brothers bonds will be set on Friday, with protection sellers expected to face massive losses of around 90 percent of the insurance they sold.
Bondholders have seen their investments virtually wiped out by Lehman’s bankruptcy filing on September 15, with most of the defaulted bonds which will be used to settle the swaps trading in the area of 12-to-13 cents on the dollar, according to MarketAxess.
The auction to settle credit default swaps on this debt will likely be the second-largest settlement of the contracts in the $55 trillion market, following an auction to settle swaps on Fannie Mae and Freddie Mae on Monday.
Twenty-two dealers will participate in the auctions, which will determine how much protection sellers will recover after paying out the insurance. The timeline for the auctions follows, according to JPMorgan.
9:45 a.m.-10 a.m. Auction participants will submit bids and offers for the debt backing the credit default swaps, which will be used to determine the initial recovery rate of the swaps.
10:30 a.m. Auction administrators Creditex and Markit will publish the initial recovery price and the open interest for the contracts will be published. The open interest reflects the amount of bids and offers that have been made, and will show if there are more buyers than sellers, or vice versa.
12:45 p.m. -1 p.m. Participating dealers will submit limit orders for the debt on behalf of themselves and their clients to fill the open interest
2 p.m. The final price of the auction will be published. (Reporting by Karen Brettell; Editing by Chizu Nomiyama)
It is not surprising that banks are not lending. Those who want to borrow are bad risks. Those who are qualified to borrow are not interested.
Let us focus on the finances of households because that is where everything starts: A high percentage is in very bad shape. This is not a personal or political opinion, I am just referring to data and facts. Look at the work of Austrian (economics, not country) Paul Kasriel and liberal Dean Baker. It is unlikely that consumer spending can increase (except with money that is borrowed but not repaid). It is highly likely that massive defaults will continue for several more years, until somehow incomes and spending equilibrate.
The fix so far has been to add liquidity but this does nothing to solve the underlying problem. If anything, it may delay the process of arriving at the destination.
There are so many crosscurrents, surges and backwash in these turbulent markets that interpretation of data can be highly problematic.
One thread among the data seems consistent however, and it is a central theme.
On the whole, loan activity among economic actors is being drastically reduced AND it is becoming much more expensive to obtain loans.
The persistent elevated levels of LIBOR are one clear example of this. Because so much of our lending activity is tied to that rate, it has very broad implications for future economic activity.
The quarterly survey of lending forecasts among senior banking officials conducted by the Federal Reserve should be released soon. That will likely confirm this ominous trend of sharply reduced credit at a much higher price.
In real economic terms, that points to dramatically lower economic activity in an accelerating fashion.
Matt Dubuque
Hi Matt,
I agree with all your economic observations. However, I still think a TED spread of 412bps is extreme and will come back down over the next few months. Even with dratically lower economic activity and overall tighter credit into the future.
LEH CDS auction is tomorrow, October 10. It goes throguh a two stage process, as explained here
http://www.creditfixings.com/information/affiliations/fixings/auctions/current.html
The Fanny/Frerddy settlment went quite smoothly, and the agreed bond values came somewhere betweeen 91 and 99. According to my calculations (no expert), net amount that had to be paid out i.e. loss to protection writers was $1.2 billion. Divide that by 13 active participants, per participant the Fannie/Freddy CDS loss was average under $ 100 million. The Lehman auction clearing price will come out some where between 15 to 20, hopefully higher between 20 and 30. So the loss will be 85% to 70& of NET notional. Although the gross notionals in these CDS contracts are huge, net is usually smaller ( no one knows for sure how much smaller for the market as a whole although each house knows its own position. If Mack knows he has a big exposure on LEH CDS, would he be putting out "we are ok" call to all his boys yesterday?). Freddie/ Fannie Net settlement was $1.2 billion, and the average price was say 96. so the net exposure was approx $30billion. Fannie and Fredddy were the biggest insured names in the CDDS market. So for the Lehnam name, the NET exposure may be much smaller, but the loss per contract would be higher. If we say the Lehman Net Exposure is 20% to 25% of Freddie/Fannie net exposure of $30 billion, it would be around $6 billion to $7.5 billion, and with recovery at say between $50 and $60 billion total systemwide loss. Spread over the 13 major deealers, average is $4 to $ 5 billion, but the spread may be wide I dont know the bank equity analysts and the market has already factored such numbers in, but if the expectation is for lower number, than this may surprise on the upside. If the not, market may take a sigh of relief that the LEH CDS damnage is not so bad,
The only risk is that in the case of Lehman, there is much less netting i.e. the protection writers have huge one sides positions, and my estimates start blowing out.
Not an expert, just trying to decipher the numbers with some commonsense reasoning.
Singapore Don
market ticker has this in a nutshell too…” In that market credit is available but it does not matter, as you can’t make enough profit to generate a positive carry on the borrowed money, and consumers in that environment fall into a vortex of interest payments that spiral faster than they can borrow to stay ahead of them.”
http://market-ticker.denninger.net/archives/603-What-The-Media-Didnt-Cover.html
Singapore Don,
I believe that your estimates are decent. I am no expert either but I don’t think Hank and Ben would have allowed LEH to fail otherwise. Just contrast it with the treatment AIG is getting.
The problem is that the market does not have that kind of confidence in Hank and Ben at the moment. I think that things will become better after Friday.
Let’s not forget that previous to 2008 the Fed’s open market operations, by which it manages the fed funds rate, have been quite puny. Generally they have monetized a few tens of billions each year and had outstanding repos of less than $75 billion. Private money markets have typically fallen in line with the fed’s lead much like a marching band following a drum major. It’s been more the force of habit than the fed’s open market operations that have moved the money markets.
Now that the fed has something on the order of $1.4 trillion lent out, the tiny scale of open market operations can’t move the markets. They are marching to the beat of their own drummers.
Why should private market participants lend to each other at steeply negative real rates simply because the, uh, fine fellows at the U.S. Fed desire them to do so? The U.S. Fed has proven itself to be both radical and incompetent and it should be no real surprise that the private markets are now declining to be led by it.
“Things are still very stressed and we don’t know what’s going to fix it in the short term.”
Stop investing in overpriced property loans and try paying your debts.
You might find people more willing to advance you money.
if the governement backs the interbank lending market defacto in theory the Ted should converge to Funds max, no?
Deflation helps bernanke and the treasruy at the moment as per financing costs. TIPS spreads as JJ says indicate a 1% inflation rate for a decade. The Treasury is smart to trade this for as long as it can. Agree that what everone is wishing for, unlocking hording, has the pernicious efect of unleashing the opposite. There truly is no plae to hide…
One of the greatest tells is that Treasury has suggested to curb TIPS issuance (I belive it was Rubin who promoted their issuance as a way to save taxpayers money). That they want to curb them tells you what they think about inflation – not that CPI is any measure anyway
Singapore Don, Thx for the link:
Each Adhering Party agrees that the Cash Settlement Date or the Cash Settlement Date in respect
of the Lehman Portion, as applicable, is October 21, 2008 (the “Cash Settlement Date”).
Here's one confirmation of the freeze-out on repos with AIG, as well as other financials:
http://www.bloomberg.com/apps/news?pid=20601109&sid=a6.wGKIe.RGg&refer=home
Late on Oct. 7, as U.S. stock indexes tumbled to their biggest annual declines since 1937, Axa Investment Managers, a unit of Paris-based Axa SA, sent out an updated list of acceptable counterparties to about 50 of the firm's most senior investors and traders.
The memo, obtained by Bloomberg News, barred all new trading with Royal Bank of Scotland Group Plc and ABN Amro Holding NV, even if the dealings were backed by collateral.
Money managers were also told to look for ways of cutting credit risk. Trading was also suspended “even on a collateralized basis'' with banks including Goldman Sachs Group Inc., Morgan Stanley, Merrill Lynch & Co., American Insurance Group Inc. and Macquarie Group Ltd.
Now that the fed has something on the order of $1.4 trillion lent out, the tiny scale of open market operations can’t move the markets. They are marching to the beat of their own drummers
Precisely. It’s supply and demand. A lot of credit was lost by bad lending; so the supply is reduced and the price (real interest rate) should climb. The central banks are attempting to forestall this by lending their own reserves; but their reserves are less than the losses and so they can’t do it. Additional deposits of Treasury debt don’t help either (in aggregate credit) because the Treasury must borrow as much as it gives the central bank to lend. The market is failing because it’s used to setting most rates in relation to the central bank rates but now that those are fantasy numbers nobody knows what’s going on and the markets aren’t clearing.
A little global mark-to-market reality Friday, no big deal, this is just a derivative tsunami with a touch of lava and then a sudden nuclear winter.
FYI: The value of credit default swaps backed by defaulted Lehman Brothers bonds will be set on Friday, with protection sellers expected to face massive losses of around 90 percent of the insurance they sold.
Bondholders have seen their investments virtually wiped out by Lehman’s bankruptcy filing on September 15, with most of the defaulted bonds which will be used to settle the swaps trading in the area of 12-to-13 cents on the dollar, according to MarketAxess.
The auction to settle credit default swaps on this debt will likely be the second-largest settlement of the contracts in the $55 trillion market, following an auction to settle swaps on Fannie Mae and Freddie Mae on Monday.
Twenty-two dealers will participate in the auctions, which will determine how much protection sellers will recover after paying out the insurance. The timeline for the auctions follows, according to JPMorgan.
As most commercial paper is on a 30, 60 or 90 day cycle the longer the credit crisis freeze in the CP market continues – the bigger problems pile up. How long have we been on overnight funding only? A couple of weeks? If everyone thought Q3 end was tough then Q4 is going to be insane.
This should probably go under Bailout, but kinda related here IMHO, i.e, this background on how the bailout is not structured properly:
FYI: The primary purpose of the Net Worth Certificate Program was to provide capital forbearance to institutions that were not performing well in the new, competitive, deregulated environment.The FDIC’s program was restricted to institutions with insufficient net worths; that had recurring losses that were not caused by mismanagement; that would agree to establishing a comprehensive, goal-oriented business plan; and that would consider reasonable merger opportunities. The FDIC “bought” net worth certificates (NWC) from participating institutions in exchange for FDIC promissory notes with terms (such as interest rate, amount, and maturity) identical to those of the net worth certificates.
Averaging of Liabilities. Thrift capitalization allowed for five-year averaging of liabilities. Although this capital requirement had been in place long before the thrift crisis, it had the unintended effect in the mid-1980s of allowing aggressive thrifts to grow without a commensurate infusion of capital. That lack of capitalization in conjunction with more lending and investment freedom resulted in increased risk to the FSLIC insurance fund. Easing capital requirements can be a useful tool in allowing financial institutions to remain open through temporary periods of operating difficulties.
October 9, 2008
A sub-scholarly update to the common lexicon:
Title: “Liar, Liar, Pants of Fire.”
Webster: “Liar. One who tells lies.”
The cloud of smoke, and the stench, of burning high quality Zena wool has wafted from Wall Street, and combined with the Washington, DC conflagration of same, and has now reached what we call in California a “Wild Fire” status. Citizens across the nation are hereby forewarned as the winds are blowing from East to West, as usual, in what we used to call political chicanery now updated to political-national-world-wide-financial-deception-chicanery. There is a small, but welcome, humorous element to this new situation as we observers gain glimpses of the new “smoke filled rooms” loaded to the ceiling with liars lying to liars while the political liars attempt to negotiate a deal. Current case in point: Citi, Wells, Wachovia, Treasury, Fed, SEC, FDIC, and who knows whom, negotiations. Old and good principle of my mentor in business, George Quist: “Only do business with people you trust. It’s hard enough to do business with them.” In a normal business situation these “negotiators” wouldn’t have a chance, but hey, no skin off their backs, or money out of their pockets, they just take it out of our tax payers hide without so much as a blink of the eye. Reference: $38 billion “addition” to AIG bailout.
I had thought this little opus would cheer me up, but it has instead left me more depressed.
Earl L. Crockett
Santa Cruz, CA
The markets have no faith in Secretary Paulson’s plan to bailout the financial system by purchasing toxic waste from US and foreign banks, since its passage the DOW is down – 2212 points. Paulson’s expected number one priority is banking’s welfare, not the wellbeing of the USA. The implementation of a solution to the banking crisis is too important to be left to those with such close ties to Goldman Sachs. Paulson should resign immediately.