Saturday, December 15, 2007

Scamming Central Bankers

The Federal Reserve today announced a new scheme to inject more liquidity into the money markets. It cobbled together a partnership arrangement: the Canadian, UK and European central banks also agreed to participate in the scheme.

The process of 'injecting liquidity' is a euphemistic way of saying 'creating money out of thin air.' The Federal Reserve doesn’t need a printing press to do this. They simply create a book entry on its balance sheet, and presto, $40 billion (or whatever amount they deem appropriate) of new ‘money’ is created, which the Fed then lends to those bankers coming to it hat in hand.

Creating money this way is a barbaric process because it further debases currencies, but is hailed by the banking insiders and their apologists as a brilliant maneuver to fight the worsening liquidity crunch. Of course it is a view of those with vested interests, and bluntly, is just their selling pitch to the masses. It is a view so horribly misguided these insiders obviously realize it is wrong. They must know that the problem impacting banks today is insolvency, not liquidity.

Years of reckless credit expansion are coming home to roost. The boom is over, and since this past summer we have been in the bust, which is worsening day-by-day. Solvency is a problem of asset quality, not access to sources of funding. For example, Citibank didn’t have any trouble raising $7 billion of funding from a sovereign wealth fund at the right price, which was 11% – a rate far above the rates Citibank is paying to its depositors. This 11% rate reflects the risk of dollar inflation and the risk that Citibank has a lot of bad loans and other inferior assets on its balance sheet that will never be repaid.

There are gaping 'black holes' on the asset side of bank balance sheets. These black holes cannot be filled by creating money out of thin air. These black holes were created by assets that have 'disappeared'. In other words, bank balance sheets are loaded with assets that are not worth what they once were, or in the worst possible case, no longer have any value at all. The bank liabilities remain, but their assets have been reduced. If this gap is larger than bank capital, then bank solvency is called into question, and that is the process now being evaluated by the markets.

Even though they have already announced countless billions of write-offs, banks have a long way to go in toting up their total losses. They face a daunting task. Many – but in reality, probably most – of their assets are impossible to value.

Sub-prime paper no longer has a functioning market to provide even a nominal market price for these assets. As economic activity slows and unemployment rises, people who the banks now believe to be good borrowers will increasingly default on their loan obligations. For example, The Wall Street Journal reported on December 6th: "First came housing loans and the subprime-mortgage crisis. Now, signs of stress are creeping into another key consumer area: auto loans. Delinquencies in the auto-loan market are ticking up to their highest level in several years."

The economic boom-to-bust cycle caused by bank lending and their subsequent credit contraction is not rocket science, nor a startling revelation. The last banking bust occurred in the late 1980s and early 1990s. Before that, a much deeper bust occurred in 1973-1974, and it more closely mirrors the severity of the way the present bust is developing. Here’s how Ludwig von Mises described the process nearly one-hundred years ago, making clear the inevitable destruction of fiat currency from inflation.

"The course of a progressing inflation is this: At the beginning the inflow of additional money makes the prices of some commodities and services rise; other prices rise later. The price rise affects the various commodities and services … at different dates and to a different extent. This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people … who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices. These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and … increase their cash holdings.

But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. The crack-up boom appears. Everybody is anxious to swap his money against "real" goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time … the things which were used as money are no longer used as media of exchange. They become scrap paper.”

And scrap bank accounts. While paper was the predominant form of currency in Mises time, today bank deposits moved around by check, plastic cards and wire transfer are a much more significant form of currency than paper.



Never before have the central banks of North America, Europe, and Britain, acted together as such a unified phalanx, but never before have transatlantic credit markets seized up with such violent effect.

"This is a drastic action. The central banks want to place a fire-break to stop credit tensions spilling over into the broader markets and becoming the catalyst for a global economic crunch," said Ian Stannard, an economist at BNP Paribas.

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?"

Ben Bernanke, chairman of the US Federal Reserve, made his academic name studying the "credit channel" causes of depressions. He must have watched with growing alarm as the debt markets limped from one mini-crisis to another, failing to recover from their August heart attack despite three emergency rate cuts.

The asset-backed commercial paper market in the US has now shrunk for 17 weeks in a row, shedding almost $400bn (£196bn). Lenders are refusing to roll over short-term loans as they fall due, leaving borrowers desperately searching for other sources of money.

The crucial elements in the Fed's move yesterday is not so much the sum of money on offer - $20bn next week, $20bn the week after - but that all depository banks in America can draw from the tap anonymously, without the risk of being found out.

"People looked at what happened to Northern Rock in Britain and said we're not going to risk that, so hardly anybody has been using the Fed facilities," said Bernard Connolly, global strategist at Banque AIG.

The Fed is now spreading the net wider by allowing all US banks to use the Term Auction Facility, which offers secrecy and allows them to hand in a much wider set of investments as collateral to raise money, including mortgage securities. Perhaps some credit will at last reach those in urgent need.

The Bank of England's £20bn injection over the next two months has a different flavour. It fires a double-barrelled dose of liquidity: priced by auction at far below the penal rate of 6.5pc, and eligible to any lender with half-decent collateral and - crucially - securities backed by housing and credit card debt. Northern Rock might have escaped a deposit run if all this had been on offer in the summer.

Officials denied the worldwide action was orchestrated to pressure the Bank of England to open its credit spigot, giving Threadneedle Street global "cover" for what amounts to a major volte-face. The Fed vice chairman, Donald Kohn, said two weeks ago that "strong bids by foreign banks in the dollar-funding markets" had complicated efforts by the US authorities to manage the liquidity problems. It is unclear whether British lenders were the culprits.

In Frankfurt, officials are seething at the enormous scale of borrowing by British banks at the European Central Bank's window, calling much of it "central bank arbitrage". There is irritation the British are trying to have their cake and eat it, dipping in and out of the eurozone when it pleases them. The bad blood has undoubtedly strengthened the push by EU insiders for more EU-wide financial rules.

The ECB ($20bn) and the Swiss National Bank ($4bn) are playing a support-role in the latest joint action, backing the US move by offering dollar liquidity to European banks caught in the sub-prime mess. Part of the problem in August was that the Fed and ECB lacked swap arrangements, causing a mad scramble by European banks to obtain dollars. "The Europeans are acting simply as agents of the Fed," said Neil MacKinnon, a strategist at the ECU hedge fund group.

"There's a real danger that this may not work. Both the Fed and the ECB have injected a lot of liquidity before, but the banks are hoarding it. We're still seeing all the signs of stress with Libor and the VIX [fear gauge] at very elevated levels. The reason is that people still don't know where the bodies are buried," he said. "This may be a Made-in-America credit crisis but the Americans have cleverly exported their sub-prime cancer to pension funds all over the world. The risk now is a recession on both sides of the Atlantic," he said.

Julian Jessop, chief economist at Capital Economics, said the move was stop-gap measure. "These measures should tide the markets through the potentially awkward New Year period but do not and cannot address the underlying imbalances threatening the world economy. Risk premiums are likely to remain permanently higher after the excesses of the last few years, and it will still be harder to obtain credit," he said.

For now, investors and hedge funds are scrambling to buy risky assets again, renewing bets on the yen ''carry trade", piling back into equities and pushing up commodity futures. Gold jumped $12 to $814 an ounce. They forget that central banks are having to fight two battles at once: against the credit crunch and against inflation. The liquidity rescue has its limits.

Labels: ,


Post a Comment

<< Home