Central Bank Impotence and Market Liquidity

By
Henry C.K. Liu

This article appeared in AToL on August 24, 2007

 

After months of adamant official denial of any potential threat of the subprime mortgage meltdown spreading to the global financial system, the US Federal Reserve (Fed) on Friday, August 17, a mere 10 days after declaring market fundamentals as strong and inflation as its main concern, took radical steps to try to halt financial market contagion worldwide that had become undeniable. The Wall Street Journal reports that the emergency measures were hastily taken to promote what the Fed publicly referred to as “the restoration of orderly conditions in financial markets.”  The telling words were “restoration of orderly conditions” in a market that had failed to function orderly. The Fed let the market know that it has shifted to panic mode. 

Restoring Disorderly Market Conditions

The WSJ reports that the crisis of disorderly conditions began two days earlier on August 16 in London where $45.5 billion of short-term commercial paper issued by US corporations overseas was maturing but traders had difficulty selling new paper to roll them over as they normally would have by noon time in London, or 7 a.m. in New York. Demand for commercial paper had dried up suddenly in a tsunami of risk aversion. Less than half of the paper was eventually sold at distressingly high interest rates by the end of the trading day. At 7:30 a.m. in New York, Countrywide Financial Corp., the largest home mortgage lender, announced that it was drawing all of its $11.5 billion of bank credit lines because it had difficulty rolling over its commercial paper IOU.

By noontime in New York, near the end of the trading day in London, the dollar fell against the yen by 2% within minutes to cause traders to rush to unwind their yen carry trade positions. Money rushed into 3-month US Treasury bills, pushing the yield down from 4% to 3.4%, sharply widening the spread with corporate commercial paper, with some GE paper moving as high as 9.5%, which in normal times would be close to the Fed Funds rate which now stands at 5.25%. By evening, Chairman Bernanke of the Fed convened a conference call of board members. The next morning, Friday, August 17, the Fed capitulated. 

To ward off a market seizure, the Fed cut the discount rate at which cash-short US banks and thrift institutions can borrow directly from the central bank as a lender of last resort. The Fed announced that it would grant banks and thrifts such loans from its discount window against a liberal range of collateral, including technically unimpaired triple-A rated subprime mortgage securities of uncertain market value and liquidity. The discount rate was cut from 6.25% to 5.75%, making it merely 50 basis points above the Fed Funds rate target, half of the normal spread for a neutral monetary policy. The Fed also extended the period for loans at the discount window from one day to up to 30 days, renewable by the borrower. These changes “will remain in place until the Federal Reserve determines that market liquidity has improved materially” and “are designed to provide depositories with greater assurance about the cost and availability of funding.”

The New York Fed, which has the responsibility of operating the Open Market Committee to keep inter-bank rates close to the Fed Funds rate target by buying or selling securities and by making overnight loans in the repo market (see: The Repo Time Bomb), had injected substantial amounts of liquidity, $62 billion up to the time of the discount rate cut, by such means into the banking system in previous days.  Earlier, the effective Fed Funds rate had traded at 6%, 75 basis points above Fed target, as banks demanded higher rates to lend to each other.

The Fed then convened an extraordinary conference call for major money center banks to explain its latest moves. It tried to encourage banks to use the discount window, saying to do so would be a “sign of strength” under current circumstances, not a sign of distress as in normal times where banks are conventionally reluctant to use the discount window, fearing that going to the Fed for cash might be interpreted by the market as a sign a distress.

The Fed said in a policy statement on the same day of the unusual discount window moves that financial market conditions had deteriorated to the point where “the downside risks to growth have increased appreciably”. The Fed said it is monitoring closely market situations and is “prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets”.

The language of the 2007 Fed statement is an echo of Greenspan-speak. Notwithstanding his denial of responsibility in helping through the 1990s to unleash the equity bubble, Alan Greenspan, the then Chairman of the Fed, had this to say in 2004 in hindsight after the bubble burst in 2000: “Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences, we chose, as we noted in our mid-1999 congressional testimony, to focus on policies to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.”

I wrote in AToL on September 14, 2005: “Greenspan's formula of reducing market regulation by substituting it with post-crisis intervention is merely buying borrowed extensions of the boom with amplified severity of the inevitable bust down the road. The Fed is increasingly reduced by this formula to an irrelevant role of explaining an anarchic economy rather than directing it towards a rational paradigm. It has adopted the role of a cleanup crew of otherwise avoidable financial debris rather than that of a preventive guardian of public financial health. Greenspan's monetary approach has been "when in doubt, ease". This means injecting more money into the banking system whenever the US economy shows signs of faltering, even if caused by structural imbalances rather than monetary tightness. For almost two decades, Greenspan has justifiably been in near-constant doubt about structural balances in the economy, yet his response to mounting imbalances has invariably been the administration of off-the-shelf monetary laxative, leading to a serious case of lingering monetary diarrhea that manifests itself in runaway asset price inflation mistaken for growth.”
(http://atimes01.atimes.com/atimes/Global_Economy/GI14Dj01.html)

Chairman Bernanke has now summoned his own clean-up team into action. The Fed hopes that by assuring banks that they can now access cash on less punitive terms from the Fed discount window, collateralized by the full “marked to model” face value of mortgage-backed securities, rather than the true distressed value as “marked to market”, for which they could find no buyers at any price in recent weeks as the market for such securities has seized up, it can jumpstart market seizure for mortgage-backed commercial paper and securities.

The Fed announced the discount rate and maturity changes a day after a video conference of its Open Market Committee in which the emergency action was “unanimously” endorsed by all voting committee members, except William Poole, president of the St Louis Fed, who had argued publicly a few days earlier against an emergency rate cut short of a “calamity” and who did not take part in the vote.

By its emergency actions, the Fed conceded the existence of a market “calamity”. Equity markets around the world interrupted their week-long losing streak and rose reflexively on the news on the last trading day of the week, albeit doubt remains on the prospect that such market adrenaline is sustainable. The Dow Jones Industrial Average (DJIA) gained 233.30 points, or 1.8%, edging back to 13,079 on hope that the Fed has now finally come to the rescue of a collapsing market.

Still, the yield on the two-year US Treasury note fell 4 basis points to 4.18%, signaling continuing risk aversion in the credit markets and investor flight to safety, not even just to quality. Fed Funds futures indicate that the market expects several quarter-point cuts from the current 5.25 per cent by the end of the year to keep the troubled economy afloat.

Unsustainable Adrenaline

By Monday, August 20, the adrenaline already wore off and the DJIA turned negative by noon on the first trading day after the Fed emergency actions. The flight to safety pushed the 3-month treasury yield to 2.5% at one point. It can be expected that sharp volatility in the equity markets will continue as announcements of assurance are issued by the Fed, the Treasury and key Congressional Committee chairmen to temporarily boost the market on false hopes only to be brought back down later to reality. The market is casting a vote of no confidence in the Fed’s ability to save the market. At best, the Fed can slow down the credit meltdown by extending it out into years rather letting the market execute a needed catharsis. It is not a scenario preferred by true free marketers.

No doubt the Fed has an arsenal of offensive monetary tools at its disposal. But just like the war on terrorism in which all the guns of the Pentagon can have no effect unless the military can find real terrorist targets, the Fed’s monetary tools remain useless unless the Fed knows where to intervene effectively. Just as terrorists morph into the general population to make themselves difficult to identify, the problem with structured finance is that by transferring unit risk to systemic risk, it deprives the Fed of effective targets to intervene on a systemic re-pricing of risk. When contagion has already spread risk aversion to all vital components of the credit market, containment is no longer an effective cure. Financial health will continue to decline in the entire system until the risk appetite virus works its natural cycle. Excess liquidity is like a drug addiction. It cannot be cured with another stronger addictive drug by adding more liquidity. What the Fed is trying to do is not merely to restore market liquidity, but to preserve excess liquidity in the market. It is trying to avoid a crisis by setting the stage for a bigger future crisis.

Low Interest Rates Hurts the Dollar

The problem with the single-dimensional prognosis on the curative power of policy-induced falling interest rates on the ailing economy is that it ignores the adverse impact such interest rate cuts will have on the exchange value of the dollar which has already been falling in recent years beyond levels that are good for the economy.

How the Discount Window Works

Eligible depository institutions are allowed to borrow against high-grade collaterals directly from the Fed’s discount window to meet short-term unanticipated liquidity needs. One category of these collateralized loans, termed “adjustment credit,” comprises loans that are usually overnight in maturity and are made at an administered discount rate. However, banks traditionally only make sparing use of the discount window for adjustment credit borrowing. The discount window is also used for seasonal borrowings, mostly associated with agricultural production loans, and for “extended credit” for banks with longer-maturity liquidity needs resulting from exceptional circumstances.

The most potent power bestowed by Congress on the Federal Reserve System is the setting of the discount rate. Raising the discount rate generally increases the cost of bank borrowing and slows the economy, while lowering it stimulates economic activity, since banks set their loan rates above the discount rate, and not by market forces. In contrast, while the Fed Funds rate is also set by the Fed, it is implemented by the Fed Open Market Committee participating in the repo market to keep the short-term rate close to the Fed’s target. The discount rate affects cost of funds without affecting money supply while the Fed Funds rate changes the level of the money supply. Both rates are set by fiat by the Fed based on the Fed’s best judgment within its theoretical preference. The difference between the two rates is that the discount rate is set independently of market forces while the Fed Funds rate acts through market forces. With the discount rate, the Fed sets the rules of the money market game while with the Fed Funds rate, the Fed acts as a key money market participant.

In response to the October 19, 1987 crash, Alan Greenspan, as the newly appointed Fed chairman, lowered the Fed Funds rate from 7.25% set on September 4, 1987, 45 days before the crash, to 6.5% by early February, 1988, while keeping the discount rate at 6%. On February 23, the Fed increased the spread to 3-1/8 percentage points with the Fed Fund rate at 9-5/8% and the discount rate at 6-1/2%.  The Fed then lowered both rates gradually to 3% with zero spread by September 4, 1992 below the inflation rate for August which was 3.15%. The negative interest rate launched the debt bubble that first fueled the tech bubble which peaked on March 10, 2000 and burst in subsequent months when Greenspan raised the Fed Funds rate to 6.5% on May 16 and the discount rate to 6% before lowering rates starting January 3, 2001 to save the market. By November 6, 2002, the Fed Funds rate was 1.25% and the discount rate was 0.75% to fuel the housing bubble which was also turbocharged by subprime mortgage securitization. That housing bubble is now bursting.

Until January 3, 2003, the discount rate normally was set at 25 to 50 basis points below the Fed Funds rate.  On that historic day, the discount rate was reset by policy to be 100 basis points above the Fed funds rate. On June 25, 2003, when the Fed Funds rate was at a historical low of 1%, the discount rate was set at 2% when the inflation rate was 2.11%. Negative interest rate expanded the housing bubble in a frenzy rate.

Before 2003, to prevent banks from exploiting the spread between the Fed Funds rate and the then lower discount rate, the Fed required banks to document any need for funds as appropriate to the discount facilities’ policy intent. Discount window loans would not be granted as bridge loans to enable banks to wrap up planned investment or to exploit loan opportunities beyond the bank’s normal liquidity range. In addition, banks were expected to have first exhausted all other reasonable sources of credit before borrowing from the discount window and should expect to face greater regulatory scrutiny if they borrow at the window too frequently. These non-pecuniary penalties made many banks reluctant to borrow at the discount window for adjustment credit, concerned over a perceived “negative signal” that such action would send. The volume of borrowed reserves was generally less than 1% of total reserves.

Setting the discount rate above the federal funds rate target was an important change in the administration of the discount window to allow for more reliance on explicit market pricing to determine the volume of discount window borrowing and to remove the perceived stigma to discount borrowing. Eligibility requirements would be streamlined and rendered consistent with reliance on the discount window as a relatively unfettered source of liquidity for financially sound banks during tight money market conditions that would otherwise result in a spike in the Fed Funds rate.

The initial proposal set a cap for the discount rate at 100 basis points above the federal funds rate target. Historically, this cap would have been breached by the average daily federal funds rate only about 1% of the time, with roughly half of those days coming on bank settlement days. However, the frequency with which individual trades throughout the day would have exceeded the cap was significantly higher. The closing Fed Funds rate would have exceeded this cap approximately 4% of the time. As banks adjusted their reserve management practices under the new operating procedures, this cap became binding more frequently than history would suggest. In any case, the average daily cost of federal funds to banks should be reduced and the Federal Funds rate should remain closer to the Fed’s target.

This rule change on the discount rate was expected to have several benefits. First, providing a cap on the federal funds rate by endogenously supplying reserves to meet high periods of demand should reduce interest rate volatility. This might become more significant as continual financial innovation would otherwise further reduce banks’ required reserves and render the demand for reserves more interest inelastic, as required clearing balances assume a larger share of the total demand for reserves. Second, the simplification of discount window borrowing procedures should lead to reduced administrative costs and streamline operations. Third, these simplifications also will help clarify the intent of individual discount window regulatory decisions, since less subjective assessment is required. Finally, monetary policy could be rendered more effective, to the extent that the discount rate could become a tool for capping the federal funds rate. This cap could be adjusted to keep the Fed Funds rate close to the target value, where “close” is determined as a matter of monetary policy decisions that reflect current market conditions. In Fed newspeak, the “discount” rate then becomes more expensive than full price inter-bank borrowing.

Primary and Secondary Credit

On January 9, 2003, the Fed adopted this procedure and introduced two levels of discount rate: primary and secondary. Primary credit is available to generally sound depository institutions on a very short-term basis, typically overnight, at a rate above the Federal Open Market Committee’s target rate for federal funds. Depository institutions are not required to seek alternative sources of funds before requesting occasional short-term advances of primary credit. The Fed expects that, given the above-market pricing of primary credit, institutions will use the discount window as a backup rather than a regular source of funding. In reality, as the debt economy developed, banks were able to use the discount widow without regulatory scrutiny to fund planned investment or loan opportunities that yielded returns higher than the punitive discount rate. The Fed in effect became a funding agency of last resort for the debt bubble.

Primary credit may be used by banks for any purpose, including financing the sale of federal funds. By making funds readily available at the primary credit rate when there is a temporary shortage of liquidity in the banking system, thus capping the actual federal funds rate at or close to the primary credit rate, the primary credit program complements open market operations in the implementation of monetary policy.

Primary credit may be extended for up to a few weeks to depository institutions in sound financial condition that cannot obtain temporary funds in the market at reasonable terms; normally, these are small institutions. Longer-term extensions are supposedly subject to increased administration. It is not clear if the Fed’s new term of up to 30 days involves increase administration to subject borrowing banks to face greater regulatory scrutiny.

Secondary credit is available to depository institutions not eligible for primary credit. It is extended on a very short-term basis, typically overnight, at a rate that is above the primary credit rate. Secondary credit is available to meet backup liquidity needs when its use is consistent with a timely return to a reliance on market sources of funding or the orderly resolution of a troubled institution. Secondary credit may not be used to fund an expansion of the borrower’s assets. The secondary credit program entails a higher level of Reserve Bank administration and oversight than the primary credit program. The Fed will require sufficient information about a borrower’s financial condition and reasons for borrowing to ensure that an extension of secondary credit is consistent with the purpose of the facility.

Effect of Discount Borrowing Controversial

Discount window borrowing is sensitive to the spread between the Fed Funds rate and the discount rate. As the spread narrows, discount window borrowing can be expected to increase. Hence, discount window borrowing would offset, at least in part, the effect of open market operations on reserve supply. The effect of this feature of discount window borrowing remains controversial even after an indeterminate debate in 1960 among economists on whether the discount mechanism offsets, as argued by Milton Friedman, or reinforces, as counter-argued by Paul Samuelson, the monetary policy objectives of the Fed.

Discount Borrowing Stigma

During the early 1990s, borrowing from the discount window fell significantly, averaging only $233 million, even though this was a period of banking system stress. Stavros Peristiani, Assistant Vice President in the Banking Studies Function at the Federal Reserve Bank of New York, whose primary areas of research include housing finance, mortgage-backed securities, bank mergers and acquisitions, discount window borrowing, and initial public offerings, argues that this decline may have been due to banks refraining from requesting discount loans because of the perception that it would send a negative signal to the Federal Reserve, bank supervisors, and eventually the market at large. Even when banks’ financial conditions improved in the mid-1990s, banks remained reluctant to borrow from the Fed.

Partly to address this reluctance, the Fed replaced its adjustment and extended credit programs with the new primary and secondary credit facilities. Now, banks in good financial condition could borrow from the Federal Reserve capped at 100 basis points above the Fed Funds rate target. The above-market price of funds serves as a rationing mechanism that dramatically reduces the need for supervisory review of the potential borrower. Because use of the new primary credit facility would not necessarily imply anything negative about a borrower, banks should be more willing to use the facility if market or bank-specific conditions warrant. In fact, since the implementation of this new facility, banking supervisors have specifically announced that “occasional use of primary credit for short-term contingency funding should be viewed as appropriate and unexceptional by both [bank] management and supervisors.”  Still, banking being a traditionally conservative industry, such stigma persists about discount window borrowing. The above-market price of the discount rate has been cut on August 17, 2007 by the Fed by half from its100 basis points cap to 50 basis points over the Fed Funds rate target to facilitate discount borrowing had to be qualified with a public repeat of Fed policy that such borrowing does not reflect weakness in the borrowing banks. Yet the cut in the discount rate reflect weakness in the entire banking system, a message not missed by astute market participants.

When a bank borrows from the Fed’s discount window, it increases the funds it has in its reserve account held at the Fed, which the bank can apply towards meeting its reserve requirement. Thus, ceteris paribus, one would expect that when required reserves are higher, discount window borrowing would be higher.

Reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities. Within limits specified by law, the Federal Reserve Board of Governors has sole authority over changes in reserve requirements. Depository institutions must hold reserves in the form of vault cash or deposits with Federal Reserve Banks. The dollar amount of a depository institution’s reserve requirement is determined by applying the reserve ratios specified in the Federal Reserve Board’s Regulation D to an institution’s reservable liabilities which consist of net transaction accounts, non-personal time deposits, and euro-currency liabilities.

Since December 27, 1990, non-personal time deposits and euro-currency liabilities have had a reserve ratio of zero. The reserve ratio on net transactions accounts depends on the amount of net transactions accounts at the depository institution. The Garn-St Germain Act of 1982 exempted the first $2 million of reservable liabilities from reserve requirements. This “exemption amount” is adjusted each year according to a formula specified by the act. The amount of net transaction accounts subject to a reserve requirement ratio of 3% was set under the Monetary Control Act of 1980 at $25 million. This “low-reserve tranche” is also adjusted each year. Net transaction accounts in excess of the low-reserve tranche are currently reservable at 10%.

Reserve Balance Driven by Interbank Payments

The demand for reserve balances is increasingly being driven by growth in interbank payment activity rather than by minimum reserve requirements.  Interbank payments are processed over Fedwire, the large-value payment system owned and operated by the Fed. The value of aggregate Fedwire payments increased from roughly $1.3 trillion a day in 1992 to roughly $3 trillion a day in early 2004. These payments are funded from an aggregate reserve balance that, as of the first quarter of 2004, averaged only $11.5 billion.

To facilitate an efficient payment system, the Fed allows banks to maintain limited negative reserve balances during the business day at a low cost, currently 27 basis points at an annual rate, but imposes a stiff 400-basis-point penalty on negative balances held overnight. Before 2003, hanks faced with an unexpected negative balance late in the day might have gone to the discount window, but they might have remained reluctant. The new primary credit facility reduces the perceived stigma of borrowing from the Fed, and banks in this situation would borrow from the central bank and pay a penalty capped at 100 basis points over Fed Funds rate.

The Clearing House Interbank Payments System (CHIPS) is a privately operated, real-time, multilateral, payments system typically used for large dollar payments, owned by financial institutions, and any banking organization with a regulated US presence may become an owner and participate in the network. The payments transferred over CHIPS are often related to international interbank transactions, including the dollar payments resulting from foreign currency transactions, such as spot and currency swap contracts, and Euro placements and returns. Payment orders are also sent over CHIPS for the purpose of adjusting correspondent balances and making payments associated with commercial transactions, bank loans, and securities transactions. Since January 2001, CHIPS has been a real-time final settlement system that continuously matches, nets and settles payment orders. In June 2007, CHIPS processed $2.645 trillion of payments. CHIPS typically handles about 300 payments ($90 billion in gross, $36 billion net) in its queue at the end of the day.

Liquidity Risk in the Interbank Payment System

Liquidity risk is the risk that the financial institution cannot settle an obligation for full value when it is due even if it may be able to settle at some unspecified time in the future. Liquidity problems can result in opportunity costs, defaults in other obligations, or costs associated with obtaining the funds from some other source for some period of time. In addition, operational failures may also negatively affect liquidity if payments do not settle within an expected time period. Until settlement is completed for the day, a financial institution may not be certain what funds it will receive and thus it may not know if its liquidity position is adequate. If an institution overestimates the funds it will receive, even in a system with real-time finality, then it may face a liquidity shortfall. If a shortfall occurs close to the end of the day, an institution could have significant difficulty in raising the liquidity it needs from an alternative source.

Systems that postpone a significant portion of their settlement activity in dollars toward the end of the day, such as CHIPS, may be particularly exposed to liquidity risk. These risks can also exist in Real Time Gross Settlement (RTGS) systems such as Fedwire. Systems or markets that pose various forms of settlement risk also pose forms of liquidity risk.

With the average daily turnover in global FX transactions at over US$2 trillion, the FX market needs an effective cross-currency settlement process. Continuous Linked Settlement (CLS) is a means of settling foreign exchange transactions finally and irrevocably. CLS eliminates settlement risk, improves liquidity management, reduces operational banking costs and improves operational efficiency and effectiveness.

CLS Bank based in New York is an Edge Corporation bank supervised by the Federal Reserve. CLS Bank is a multi-currency bank, holding an account for each Settlement Member and an account at each eligible currency’s Central Bank, through which funds are received and paid. Technical and operational support is provided by CLS Services, an affiliate of CLS Bank.

CLS Bank, while eliminating the bulk of principle risk through its payment-versus-payment design, retains significant liquidity risk, as funding is made on a net basis, and pay-in obligations may need to be adjusted in the event that a counterparty is unable to fund its obligations. Other systems, including securities settlement systems, may also be subject to liquidity risks.

To manage and control liquidity risk, it is important for financial institutions to understand the intraday flows associated with their customers’ activity to gain an understanding of peak funding needs and typical variations. To smooth a customer’s peak credit demands, a depository institution might consider imposing overdraft limits on all or some of its customers. Moreover, institutions must have a clear understanding of all of their proprietary payment and settlement activity in each of the payment and securities settlement systems in which they participate.

Clearing balance requirements represent obligations to hold reserves that are set at the discretion of a bank before each reserve maintenance period. Only balances held at the Federal Reserve during the two-week reserve maintenance period are eligible to satisfy clearing balance requirements. A bank is penalized for ending any day overdrawn on its account at the Fed, as well as for failing to meet its requirements by the end of the maintenance period. To obtain the necessary reserves to avoid these fees if unable to borrow the necessary amount of reserves from another bank, a qualifying bank may borrow reserves directly from the Federal Reserve at its discount window facility under the primary credit program, at a rate typically set not more than 100 basis points above the target Fed Funds rate. This spread between the primary credit rate and the Fed Funds rate target is generally viewed as representing a de facto penalty associated with being deficient. This penalty has been cut in half on August 18. The Federal Reserve does not pay interest on reserves held in excess of requirements. Thus, the opportunity cost of holding excess reserves is a bank’s marginal funding cost, which is represented by the Fed Funds rate.

To provide banks with some flexibility in meeting their requirements for avoiding these penalties and costs, the Fed allows banks to apply excess reserve balances held in one maintenance period to meet reserve requirements in the following period, in an amount up to 4% of reserve requirements in the second period. Similarly, a bank may end a period up to 4% short of its reserve requirements and pay no penalty, so long as it holds sufficient excess reserves in the following period to offset this deficiency.

Fed Actions aim at Mutually Contradicting Objectives

The Federal Reserve action on the discount rate tries to meet its short-term responsibility to keep financial markets functioning by injecting funds into the banking system. At the same time, the Fed tries also to macro manage the economy in containing inflation by tightening the money supply through interest rates increases. For almost a century since its establishment in 1913, the Fed has been engaged in a continuous battle between inflation and economic growth by standing on both sides of the conflict to keep a balance. This conflict is a structural malady of market capitalism. Recurring economic recessions or depressions lead to asset depreciation or disinflation or deflation which can only be cured by currency devaluation which translates into inflation. Some economists, including Ben Bernanke, the new Fed Chairman, support inflation targeting as a viable monetary policy option.

Fixing the Market Liquidity Drought

The cut of the discount rate is designed to tackle the liquidity drought in the banking system and to keep banks liquid to prevent financial markets from seizure.  The new policy statement signals that the Fed stands ready to cut interest rates if necessary to deal with the contagion effects of the subprime mortgage generated liquidity crisis on the real economy. The objective is to restore the flow of funds through the banks into the financial system to limit the damage to the real economy. Whether intended or not, the Fed’s new policy stance sparked speculation that the European Central Bank, which injected over 150 million euros into its banking system in previous days, might be forced to back off raising euro interest rates in September to prevent the euro from rising further.

Up to the time of the discount rate cut on August 18, the Fed had to repeatedly pumped liquidity ($52 billion) into the financial system through the repo market to keep the overnight Fed Funds rate from rising above its target of 5.25%. This Fed monetary market tactic has been described by market participants as the Fed practicing “stealth easing” or “synthetic easing”; that is, to inject funds without lowering the Fed Funds rate. But while the Fed hoped to restore liquidity to financial system with an injection of some $52 billion to the overnight money market, this injection failed to impress the market. Three-month lending rates remained high and the asset-backed commercial paper and jumbo mortgage market remained dysfunctional. The stock market continues to fall after a brief reprieve.

Ready investors for debt instruments of all sorts have become endangered species in this market seizure. The Fed is determined to restore liquidity in these seized markets to fulfill its mission of keeping markets functioning.  It also believes that the longer credit markets stay seized, the bigger the risk of disrupting the flow of credit to households and businesses in the economy to induce a recession or worse. Yet moving aggressively on the discount window front will ensure availability of funds to the banking system to keep banks solvent but it may not help to get markets working unless the Fed is prepared to drop massive amounts of dollars from helicopters on main street as Fed Chairman Bernanke once quipped before becoming chairman.

The Fed has not changed the nominal rating level of securities eligible for these operations even though the ratings have been decoupled from real market price of the securities. By reducing the penalty rate on discount window lending from 100 basis points over the federal funds rate to 50 basis points, and allowing banks to obtain 30-day loans rather than overnight money, the Fed ensures that banks encountering difficulties securing finance against mortgage-backed and other collateral have assured access to liquidity at reasonable rates. And many banks are encountering such difficulties as they fail to find buyers in the debt market for the asset-back securities they hold as collateral for bank loans made to hedge funds and private equity groups.

Central Bank Impotence

But the time has long passed when central banks adding liquidity to the financial system can help a liquidity crisis in the market. When the Fed injects funds directly into the money market through the repo window, banks and thrifts and other non-bank financial institutions that need funds can participate. With the daily volume of transaction in the hundreds of trillions of dollar in notional value of over-the-counter derivatives, the Fed would have to inject fund at a much more massive scale to affect the market. Such massive injection will mean immediate and sharp inflation. Worse yet, it will cause a collapse of the dollar.

When the Fed adds liquidity directly into the banking system through the discount window, it injects high-power money into banks by making interest rate for overnight interbank banks loans within its set target. The theory is that banks will in turn be able to make loans at interest rates deemed appropriate by the Fed, thus relaying the added liquidity to the market in multiple amounts because of the mathematics of partial reserve.

But just because banks are able to make loans at low interest rate does not mean banks can find borrowers with credit ratings to justify the low rates. John Maynard Keynes' concept of a liquidity trap is that market preference for cash positions can outweigh interest rate considerations. In a financial crisis, there may simple not be enough credit-worthy borrowers at any interest rate level and the number of sellers stay stubbornly larger than the number of buyers because sellers need to sell precisely because they do not have credit worthiness to borrow even at low interest rates and buyers stay on the sideline waiting for even lower prices.

Even when the Fed lowers the discount rate, banks will only see their threat of insolvency reduced. Banks will still be sitting on piles of idle cash that they cannot lend. This is known as banks pushing on a credit string. Keynes insightfully observed that the market can stay irrational longer than most participants can stay liquid. Since central banks are now mere market participants because of the enormous size of the debt market due to the wide-spread use of structured finance with derivatives whose notional value adds up to hundreds of trillion of dollars, the market can stay irrational longer than even central banks can stay liquid, if central banks do not want to drive their currencies to the ground. With deregulated global financial markets, central bank capacity for adding liquidity to the banking system is constrained by its need to protect the exchange value of its currency. For the US, which depends on foreign central banks to fund its twin deficits, any drastic fall of the dollar will itself create a liquidity crisis from foreign central banks shifting out of dollar in their foreign exchange reserves.

Federal Reserve flow of funds data shows outstanding home mortgages in Q1 2007 to be at $10.4 trillion. About $1 trillion in mortgages are due for a reset by the end of 2007 alone. A 4% reset of interest rates on $1 trillion of mortgages would require addition payments of $40 billion. Agency-and GSE-backed mortgage asset amounts to $3.9 trillion. Issuers of asset-backed securities home mortgages asset amounts to $1.9 trillion. The numbers are further magnified hundred of folds by structured finance with high leverage which magnifies the cash flow caused by even the slightest interest rate volatility. Liquidity problem associated with counterparty default could quickly run up to trillions of dollars. What does the Fed hope to accomplish with injecting a mere $50 or 100 billion in the banking system, except to show its impotence? The Fed can keep the banks from failing, but it cannot prevent the harsh reckoning of the debt bubble economy.

What is Market Liquidity?

After all, what is market liquidity? Economists refer frequently to liquidity in the abstract, yet in reality, liquidity is difficult to define and even more difficult to measure and almost impossible to restore because it is hard to know where the weak links are. On Wall Street, liquidity refers to the ability to buy or sell an asset quickly and in large volume without substantially affecting the asset’s price. Shares in large blue-chip stocks like General Electric used to be considered liquid, a description long since rendered invalid because of market volatility.

Of the several dimensions of market liquidity, two of the most important are tightness and depth. Tightness is a market’s ability to match supply and demand at low cost (measured by bid-ask spreads) quickly, while market depth relates to the ability of a market to absorb large trade flows without a significant impact on prices (approximated by volumes, quote sizes, on-the-run/off-the-run spreads and volatilities). When market participants raise concerns about the decline in market liquidity, they typically refer to a reduced ability to deal without having prices move against them, that is, about reduced market depth.

Cycles of liquidity crises have been a recurring feature of financial markets. Commonly used indicators of market liquidity are notoriously imperfect as reliable measures of liquidity conditions. While conditions in the autumn of 1998 were indeed identified as reflecting the adverse shock of the 1997 Asian Financial Crisis to liquidity in financial markets, liquidity indicators seemed to suggest that, with the notable exception of the US government bond market, liquidity conditions were broadly restored to pre-crisis levels within a short period in the US. However, the usual indicators typically capture only a single dimension of market liquidity and none of them were forward looking in nature, making it difficult to draw any conclusions as to how long-term future liquidity conditions were being shaped by responses to current liquidity stress. Bubbles are the bastard children of liquidity overshoots.

While idiosyncratic factors might be cited as being responsible for the perception of low liquidity in specific markets, reduced market liquidity is unlikely to be a purely conjuncture phenomenon. From a financial stability perspective, some of the structural factors at work can be highlighted, focusing on developments bearing on liquidity conditions in the integrated global financial system at three different levels, namely:
(i) Firms: developments at the level of major financial firms participating in the core financial markets;
(ii) Markets: developments in the structure and functioning of markets themselves; and
(iii) System: developments across the global financial system as a whole, such as the systemic effects of credit derivatives.

Liquidity and Credit Risks

Such structural developments may have served to reinforce the links between liquidity and credit risks, but also the distinction between normal conditions and abnormal conditions and between normal times and times of stress when confidence declines.  The current challenge is one of returning an abnormal economy of excess liquidity to an economy of normal liquidity without extinguishing the flame of liquidity entirely. The period of stress will be the time it will take to work off the excess liquidity, to turn the liquidity boom back to a fundamental boom. It is not possible to preserve abnormal market prices of assets driven up by a liquidity boom if normal liquidity is to be restored.  All the soothing talk about the fundamentals of the economy being strong notwithstanding the debt bubble is insulting to the thinking mind. This is a debt economy fed by a liquidity boom. When the liquidity boom turns to bust, all the strong fundamental indicators such as corporate earnings will wilt from a debt crisis. Asset value cannot be held up by simply adding excess liquidity forever without creating hyper inflation. Also, some liquidity problems, such as those caused by a loss of market confidence, cannot be solved by merely injecting money into the financial system which in fact will only add to the problem. Restoring market confidence requires a rational restructuring of the economy to absorb excess liquidity.

Liquidity Risks Under-priced

Many market participants had felt that pre-LTCM (a major hedge fund that collapsed in Sept 1998 from wrong bets on Russia sovereign bonds rising in value above US sovereign bonds) liquidity risk in many credit markets had been under-priced, and that the under-pricing led financial institutions to underestimate liquidity risks with a “liquidity illusion” mentality. Such under-pricing inhibited developments that would enhance the market’s ability to retain liquidity in times of sudden stress. There were indeed several occasions since the LTCM crisis, such as the September 2006 collapse of Amaranth Advisors, which lost nearly $6 billion in a single week after a highly leveraged bet on the future price of natural gas prices blew up, when conditions in some markets turned adverse but liquidity, which typically declined sharply in the midst of the crisis, proved to be rather resilient.

The trading strategies employed by LTCM's highly leveraged portfolio were generally uncorrelated with each other in order to benefited from diversification. However, a sudden rise in liquidity preference in the market in late summer of 1998 led to a sharp marketwide repricing of all risk leading these positions to all move in the same direction. As the correlation of LTCM's positions increased, the diversified aspect of LTCM's portfolio vanished and large losses to its equity value occurred. Thus the primary lesson of 1998 is more than one of liquidity which the the effect rather thn the cause of the crisis. Fundamentally, it was a problem of paradign shift that changed the underlying Covariance Matrixused in Value at Riak (VaR) analysis fromstattic to dynamic.

The high leverage employed by the LTCM in order to maximize gain made it highly vulnerable to volatility and credit risk even though the logic of  LTCM's directional bets was valid in thinking that the values of government bonds should  converge. But the high leverage deprived an undercapitalized LTCM the luxuary of needed staying power to benefit from the eventual convergence.

Hidden Relays of Counter-party Risk 

However, some elements of recent developments, such as widespread financial consolidation, the increasing use of non-government and synthetic securities, particularly collateralized debt obligation (CDO) instruments, as hedging and valuation benchmarks, might influence the behavior of market participants in a way suggesting that market dynamics in times of extreme stress can change significantly and abruptly. This has heightened concerns about credit risk, particularly the hidden relay of counter-party risk, which can undermine market participant willingness to enter into transactions and thus weaken market liquidity in market environments of heightened uncertainty. Other elements, such as aggressive collateralization practices and overdevelopment in risk management policies, which generally enhance market stability in normal times, could add pressure in times of extreme stress. 

Price as a Function of Liquidity

Price is a function of liquidity which can be quite detached from normal value. Liquidity conditions offer a new paradigm as the key to understanding why and how the markets move. Liquidity is consistently a reliable indicator on which to base the timing of trading and investment decisions. Liquidity is the key determinant of the direction of the stock market, but it does not inform on fundamental value. The aggregate capitalization of any market or market sector, whether stocks, real estate, precious metals, commodities, debt instruments etc., is a function primarily of liquidity, with the economic value having only secondary impacts except when liquidity is neither excessive nor scarce. The total value of any market is impacted by its current liquidity trend as technical analysts know.

Changes in The Trading Float 

Liquidity can also been measured by the relationship between changes in the total trading float of shares or debt instruments in the entire stock and credit markets and the change in cash available for investment. Market liquidity has two components: the change in the trading float and the change in the cash available to buy. Liquidity analysis, in essence, is measuring change in the trading float of assets and tracking the movement of cash.

For the equity market, some analysts offer a daily liquidity number (Daily Liquidity Trim Tabs) that is determined by adding US equity fund inflows, 2/3 of newly announced cash takeovers, 1/3 of completed cash takeovers and subtracting new offerings. Their longer term analysis of the underlying trends in liquidity takes in account stock buybacks, insider selling and margin debt.  Mutual Fund Trim Tabs survey over eight hundred and fifty equity and bond funds daily. US stock market liquidity looks at flows into equity mutual fund that are not international specific. International equity and bond funds flow are determined separately. Trim Tabs Market Capitalization Index measures the market value for all NYSE, NASDAQ and AMEX stocks. The AMEX is included but not listed. Trim Tabs Market Cap Index does not include ADR’s. 

Liquidity and Income Distribution

Liquidity analysis starts with the overall economy’s cash flow. The best way of watching US cash flow is daily and month income tax collections. Higher income tax collections suggest higher incomes. The Internal Revenue Service reports that while incomes have been rising since 2002, the average income in 2005 was $55,238, nearly 1% less than in 2000 after adjusting for inflation. The number of tax payers reporting income of over $1 million grew by 26% to 303,817 in 2005 from 2000. This group, representing less than 0.25% of the population, reaped 47% of total income gain in 2005 compared with 2000. This group also received 62%of the tax savings on long-term capital gain and dividends of the 2003 Bush tax cut. Those making over $10 million received tax savings of nearly $2 million each. This group enjoyed a tax saving of $21.7 billion on their aggregate investment income. Some 90% of the working population made less than $100,000 in 2005. They received $318 each on average in tax savings from investment. Nearly 50% of the working population reported income of less than $30,000.  Liquidity in US markets is driven by debt, not income, and most of the debt is sourced from foreign central banks. 

Liquidity and Market Capitalization

The conventional "value" paradigm says that the overall market capitalization is a function of the growth of aggregate cash flow of all stocks, and that the stock market discounts future earnings. This has never worked in reality. Market capitalization derived from price levels is always a function of liquidity as it is almost impossible for any central bank to match money supply growth with economic growth perfectly in the short term.

The conventional value paradigm is unable to explain why the market capitalization of all US stocks grew from $5.3 trillion at the end of 1994 to $17.7 trillion at the end of 1999 to $35 trillion at the end of 2006, generating a geometric increase in price earnings ratios and the like. Liquidity analysis provides a ready answer. Between the end of 1994 and the end of 1997 the trading float of shares shrank, and from early 1998 through the end of 1999 the trading float was unchanged. Over those same five years the amount of money looking to buy that shrinking or stagnant pool of shares kept growing. The result was that market cap kept rising regardless of economic value, with a stock market up more than over three times in five years.  It is a clear evidence of the Quantity Theory of Money at work. It is called a liquidity boom, which also fed the housing bubble in the recent years.

Money Flow and Liquidity

Money flows from buyers to sellers. If the buyers retired the shares or debt instruments purchased and the sellers, mostly portfolio managers, had to replace their holdings from a smaller market float (the number of shares outstanding in the market); that adds liquidity. If the sellers vend newly printed shares and used the cash for anything other than buying other shares; that reduces liquidity. If sellers suffer losses, liquidity is reduced by the transaction. A Federal fiscal deficit reduces liquidity, particularly if the spending is overseas, such as foreign war.

Liquidity and the Impact of News

Liquidity determines how strongly news will affect stock prices. Positive liquidity can spur the market significantly higher when other indicators are positive and cushion the fall when those indicators are negative. Conversely, negative liquidity can dampen the effect of good news. When liquidity contracts on hopeful news, as the current market indicates, risk aversion is the driving force. Liquidity almost always stays in step with the market and visa versa.

Keynes' Concept of Liquidity Trap

For an economy subject to business cycles, the lower the present rate of interest, the larger, ceteris paribus, would be a future rise, the larger the expected capital loss on securities, and the higher, therefore, the preference for liquid cash balances. As an extreme possibility, Keynes envisaged the case in which even the smallest decline in interest rates would produce a sizable switch into cash balances, which would make the demand curve for cash balances virtually horizontal. This limiting case became known as a liquidity trap.

In his two-asset world of cash and government bonds, Keynes argues that a liquidity trap would arise if market participants believed that interest rates had bottomed out at a “critical” interest rate level, and that rates should subsequently rise, leading to capital losses on bond holdings.  The inelasticity of interest rate expectations at a critical rate would imply that the demand for money would become highly or perfectly elastic at this point, implying both a horizontal money-demand function and LM (liquidity preference/money supply) curve.  The monetary authority, then, would not be able to reduce interest rates below the critical rate, as any subsequent monetary expansion would lead investors to increase their demand for liquidity and become net sellers of government bonds. Money-demand growth, then, should accelerate when interest rates reach the critical level.

Keynes argued that there were three reasons why market participants hold money. They hold cash for pending transactions purposes, which is what the quantity theory had always said. They also hold money for precautionary reasons, so that in an emergency they would have a ready source of funds. Finally, they hold money for speculative purposes. The speculative motive arose from the effects of interest rates on the price of bonds. When interest rates rise, the price of bonds falls. Thus when people think interest rates are unusually low, they would prefer to hold their assets in the form of money. If they invested in bonds and the interest rate rose, they would suffer a loss. Hence the amount of money market participants would want to hold should be inversely related to the rate of interest. Market participants will want to hold more money (liquidity) when interest rates are low than when they are higher, despite a loss of interest income.

Keynes’ introduction of the interest rate into the demand for money has survived in modern finance, but not for the reasons he gave. Keynes was thinking in terms of a two-asset world: money, which earned no interest but which was liquid and had no danger of a capital loss, and bonds, which earned interest but which were not as liquid and which has a risk of capital loss. If one thinks not in terms of a two-asset world, but in terms of the range of assets which actually exist in the current financial world, there is no reason to hold cash balances for either precautionary or speculative purposes. These are assets that are both very liquid and interest bearing, such as money market accounts and Treasury bills, plus all forms of options in structured finance.

Though Keynes' two-asset-class explanation of why interest rates influence the demand for money is outdated by developments, his other explanations are still sound. Money held for transactions purposes is much like inventory which businesses hold. A rise in interest rates will decrease the optimal amount of money as inventory, and a rise in the cost of re-monetizing will increase the optimal amount. Modern management has introduced just-in-time inventory which renders this argument mute. Most chief financial officers have also perfected just-in-time cash management schemes. The exception is that holders of money can live on it, which is not true for holders of most other inventories.

Liquidity and Money Velocity

When market participants hold cash balances, they may no longer hold their assets in a form that earns no interest, yet interest rates does generally tend to increase with less liquidity. If interest rates rise on non-money assets relative to money, the cost of holding money in terms of interest foregone rises, and one would expect market participants to try to economize on cash. A business, for example, could shift money from checking accounts into treasury-bills, or resort to loans instead of selling assets with high future value. It would be worthwhile to make more transactions into and out of interest-bearing assets to take advantage of the higher interest rates. When interest rates are very low, these transactions may not be worthwhile, and the business may be willing to let money lie idle for short periods in checking accounts.  High interest rates thus increase the velocity of money. Interest payments do not disappear from the system; they go into the lenders’ pocket thus increasing liquidity. A liquidity trap tends to develop in a price deflation environment.

Liquidity and Monetization of Assets

Liquidity is the ability to monetized assets without causing prices to fall. Liquidity thus depends on more than just the availability of cash. It depends also on the availability of demand for assets, i.e. willing buyers. A liquidity crunch can develop even if there is plenty of zero-interest rate cash in buyers’ pockets but every buyer is waiting for lower prices, causing assets to be illiquid, i.e. unable to be monetized without lowering prices. It can also develop if buyers lose confidence in the future of the economy. Distressed assets cannot exit to cut losses at any price and they bring down prices of even otherwise good assets. This is what causes contagion which can start a downward spiral of self-fulfilling fear.

Liquidity and Money Depreciation

The ultimate effect of central banks injecting money into the banking system is the depreciation of money which now is fiat currency in all countries. When the European Central Bank (ECB) injects euros into its banking system, the euro will fall against other fiat currencies, including the dollar, forcing the Fed to also inject money into the US banking system. This can quickly turn into a competitive currency depreciation game. For all central banks facing a liquidity crisis, the option is a market crash or a currency crash, or if central bankers are not careful, it can easily become a crash of both equities and currencies.

Unpaid Debt Destroys Economic Value

When debts are not repaid, financial value is destroyed which will be expressed in falling asset prices.  This loss of value will need to be reckoned in the economy. When individual market participants lose in a normal transaction, other participants normally gain from their losses. But when value is lost by debts unpaid, the creditor loses while the debtor gains by reducing his liability. And if default debtors are bailed out as a class by the central bank, the issuer of money, creditors as a class lose relative to their position to debtors before debtor default, albeit the face value of the loss is reduced by the amount of the bailout. The cost of the debtor’s virtual gain and the reduced loss suffered by the creditor is passed onto the financial system by the central bank bailout.  It is more than a moral hazard problem of encouraging debtor future adventurism. The economy actually pays by accepting excess liquidity and financial friction against real growth.

Falling prices can be slowed down somewhat by the depreciation of money but only up to a point, after which worthless money can add to the fall of real asset prices after inflation. That point is dangerously near at this very moment in the global economy to usher in a period of sustained deflation. The Federal Reserve added $52 billion in temporary funds to the money market through the repurchase agreement of securities including mortgage-backed debt to meet demand for cash amid a rout in bonds backed by home loans to risky borrowers. The Fed’s additions were the biggest since the September 11, 2001 terrorist attacks. The additions came in three repo transactions of $19 billion, $16 billion and $3 billion. Losses in U.S. subprime mortgages have been rippling through credit markets, driving interest rates higher and sinking stocks and seizing credit markets.

The Fed accepted mortgage-backed debt issued or guaranteed by federal agencies, so-called agency debt and Treasuries as collateral for the repos. Normally, the Fed does not accept mortgages as collateral for repo transactions but the move signals an attempt by the central bank to alleviate financing fears. Wall Street dealers are seeking the sanctuary of government bonds and are trying to sell their holdings of riskier assets such as mortgages if buyers can be found. Until then, they may keep going to the repo market for overnight funds.

Hedge Fund Woes

In the past three weeks, the computer models that some hedge funds use to make trades to implement their strategies have been victimized by paradigm shifts. These models typically scan markets to spot tiny price discrepancies under normal conditions, and then place highly leveraged large orders to capture gains that add up to outstanding returns on capital. With unusual market volatility and disorderly markets, highly leveraged hedge funds can face margin calls from brokers that develop into fire sales of good assets in their portfolios.

Hedge funds with market-neutral strategies have been wagering on high-quality stocks, or stocks that trade at low valuations based on various metrics, and betting against stocks that appear overpriced. The relatively conservative approach enables traders to feel comfortable in using leverage to boost returns. With unexpected margin calls from banks, were forced to sell their holdings of high-quality stocks to raise cash, and closed out short trades by buying back shares of companies identified by models as overpriced. Others sold positions simply to become more conservative, in a volatile market.

Since market-neutral funds often are guided by similar computer models and share similar holdings, the actions magnified moves in asset prices. Funds that are normally pillars of stability in normal markets become detonator of instability in disorderly markets.

Concern Shifted from Hedge Funds to Banks

However, the Fed’s actions reflected a shift of the focus of concern from hedge funds towards banks who loaned the hedge funds money to trade with leverage. Banks are also exposed to the problem of having committed credit lines to financial institutions with subprime exposure, such as mortgage lenders or specialist investment vehicles. Banks have also arranged loans to risky firms such as buy-out groups, which they had planned to sell into a debt market that had evaporated overnight.  An estimated $300 billion of unsold loans are sitting on bank balance sheets, gobbling up funds pushing up reserve requirements. Banks themselves are facing problems raising funding in the money markets where investors are very nervous about lending money to anybody who might be potentially exposed to subprime losses. And since it is hard to know who is holding subprime exposure, because these securities have been scattered around, banks are being blackballed in an indiscriminate fashion. The is a confidence problem that the Fed cannot do much about, short of offering to buy worthless securities that even a liquidity boost cannot restore fully.

Commercial Paper Crisis

In the US, asset-backed commercial paper, which comprises about $1.15 trillion of the $2.16 trillion in commercial paper outstanding, is bought by money market funds with conservative investors. The cash enables some selling entities to buy mortgages, bonds, credit card and trade receivables as well as car loans.  The commercial-paper market, a critical source of short-term funding for an array of companies, was becoming inaccessible for a growing number of companies since the beginning of August. There were also signs of trouble in parts of the currency market. The asset-backed commercial paper market, a crucial arena where financial institutions raise funds, has had no buyers in recent days.

This has been a recurring problem in this debt economy. On March 13, 2002, GE Capital launched a multi-tranche dollar bond deal that was almost doubled in size from $6 billion to $11 billion, making it the largest-ever dollar-denominated corporate bond issue up to that time. Officially the bond sale was explained as following the current trend of companies with large borrowing needs, such as GE Capital, locking in favorable funding costs while interest rates were low. On March 18, Bloomberg reported that GE Capital was bowing to demands from Moody's Investors Service that the biggest seller of commercial paper should reduce its reliance on short-term debt securities. The financing arm of General Electric, then the world’s largest company, sought bigger lending commitments from banks and replacing some of its $100 billion in debt that would mature in less than nine months with bonds. GE Capital asked its banks to raise its borrowing capacity to $50 billion from $33 billion.

Moody's, one of two credit-rating companies that have assigned GE Capital the highest "AAA" grade, had been increasing pressure on even top-rated firms to reduce short-term liabilities since Enron filed the biggest US bankruptcy on December2, 2001. Moody's released reports analyzing the ability of 300 companies to raise money should they be shut out of the commercial paper market. GE Capital and H J Heinz Co said they responded to inquiries by Moody’s by reducing their short-term debt, unsecured obligations used for day-to-day financing. Concerns about the availability of such funds have grown that year after Qwest Communications International Inc, Sprint Corp and Tyco International Ltd were suddenly unable to sell commercial paper.

Moody’s lowered a record 93 commercial paper ratings in 2001 as the economy slowed, causing corporate defaults to increase to their highest in a decade. One area of concern for the analysts was the amount of bank credit available to repay commercial paper. While many companies had credit lines equivalent to the amount of commercial paper they sell, some of the biggest issuers did not. GE Capital, for example, had loan commitments backing only 33% of its short-term debt. American Express had commitments that cover 56% of its commercial paper. Coca-Cola supported about 85 percent of its debt with bank agreements, according to Standard & Poor’s, the largest credit-rating company, which said it was also focusing more attention on risks posed by short-term liabilities.

In the first half of 2002, companies sold $107 billion of investment-grade bonds, up from $88 billion during the same period in 2001. The amount of unsecured commercial paper outstanding fell by a third to $672 billion during the previous 12 months. PIMCO director Bill Gross disputed GE’s contention that the company’s new bond sales were designed to capture low rates, but because of troubles in its commercial paper market. If the GE short-term rate rises because of a poor credit rating, the engine that drives GE earnings will stall. Gross dismissed GE earning growth as not being from brilliant management, former GE chairman Jack Welch's self-aggrandizing books not withstanding, but from financial manipulation: taking on debt at cheap rates and using inflated GE stocks for acquisition.

GE had $127 billion in commercial paper as of March 11, 2002. That amounted to 49% of its total debt. Banks credit lines only covered one-third of the short-term exposure. GE capital core funds itself by borrowing commercial paper from investors in the marketplace, and the interest payments that it pays on those commercial paper instruments give it floating rate exposure, because they turn over frequently, short duration.

In Q4 2006, GE total commercial paper balance was a little over $90 billion, a quarter of its financing. GE makes loans to customers, and a significant part of its loans to customers include fixed rate payments of interest. So to match fund its assets, to have fixed rate interest costs to go with the fixed rate interest income, GE enters into a basis interest rate swap. GE offsets the floating interest rate exposure to the CP and pays a fixed rate of interest to the swap counter-party to match funds its asset.

As of June 30, 2007, the US Corporate Bond Market totaled $3.7 trillion in outstanding par value split 82% investment grade and 18% speculative grade. Across the pool of industrial bonds, the par value share of issues rated speculative grade is substantially higher at 31%. The par value of bonds maturing through the end of 2007 totals $194.9 billion. The bulk (95%) of this volume ($186.0 billion) consists of investment grade bonds with the remaining volume ($8.9 billion) residing at the speculative grade level.

Commercial paper outstanding fell $91.1 billion in the week ended Aug. 15 to a total of $2.13 trillion, a weekly plunge that captured both bond and stock markets attention.  The data, released on the Federal Reserve Board Web site, validated the trend that issuers were being forced to make orderly exits from the commercial paper market to obtain financing elsewhere.

CDO Illiquidity

Collateralised debt obligations (CDOs) are designed to let some high-risk tranches take the first loss if any of the underlying debt defaults, while other “senior” securities only suffer losses after the riskier tranches are wiped out. In a typical CDO, senior securities can achieve credit ratings much higher than those of the underlying debt, sometimes triple-A, the same rating as US government securities. The catch is that many CDO securities are infrequently traded and some are tailored by investment banks for specific clients, such as pension funds, and have never traded. Without a market price, valuation involves complex computer models and subjective assumptions. The credit crisis will hit the pension funds; it is merely in a matter of time.

Bear Sterns in July revealed large losses at two hedge funds that owned subprime-related CDOs, but had trouble quantifying the losses. Attempts to sell the instruments ran into trouble because few traders offered anything except very low, fire-sale prices.

This raised questions over whether hedge funds, investment banks and even pension and insurance groups know the market value of their structured credit holdings. As a result, the CDO market is closed, and access to credit, especially for leveraged buyout debt, has been severely curtailed. The news that BNP Paribas was suspending three funds underlined the valuation problem caused by a liquidity drought in the market.

Some senior US finance officials calculate losses in the subprime-related sector to be a containable $100 billion. The market seems to have a different opinon. The impact from uncertainty is now spreading to affect other debt markets, such as the corporate bonds and commercial paper market. That is creating severe trading losses and destroying confidence.

The Politics of Bailouts

Politicians are talking about taking measures to help households suffering from the subprime crisis to prevent as many as 3 million largely low-income households from losing their homes. However, that will not solve the crisis in the financial markets. In fact it may add to it. But with the central banks pumping in money to help banks from failing, while families are evicted from their homes is very bad politics in a election year. The central banks are giving financial institutions whose credit rating and cashflow are not much better than family with subprime mortgages, free credit cards with a subsidised interest rate and no spending limit for as long as needed, while these very same institutions are foreclosing on the homes of their customers. This crisis will likely build to a crescendo just before the November presidential election. Its going to be a very interesting election. Will the credit crisis of 2007 usher in an age of popularism in US politics?