Friday, August 10, 2007

Another day without book writing 

Thought I would do that, but the darn financial markets aren't agreeable to this. I suspect a few people woke up this morning, grabbed their New York Times and actually read Krugman this time. I will tell you what I think of Krugman -- the closer he gets to his field of specialization, international economics, the better he is. This means that about every two weeks you get a column that is good, and twice a year you get one that you should keep. This is one. (Free copy courtesy Mark Thoma.)

But yesterday�s announcement by BNP Paribas, a large French bank, that it was suspending ... three of its own funds was, if anything, the most ominous news yet. The suspension was necessary, the bank said, because of �the complete evaporation of liquidity in certain market segments� � that is, there are no buyers.

When liquidity dries up ... it can produce a chain reaction of defaults. Financial institution A can�t sell its mortgage-backed securities, so it can�t raise enough cash to make the payment it owes to institution B, which then doesn�t have the cash to pay institution C...

And here�s the truly scary thing about liquidity crises: it�s very hard for policy makers to do anything about them.

Not that they haven't been trying. William Polley has been watching the Fed put money out in the market today -- $38 billion all told, and all in return for mortgage-backed securities -- along with a statement about providing sufficient liquidity to financial markets to maintain the current 5.25% Fed funds target. He also recommends this article for a review of how central banks provide liquidity; I admit I hadn't read it before, but did while prepping for the WCCO radio interview. (It is amazing, by the way, how much of what I prepare for those things get left on the desk. I get two more chances tomorrow, with David Strom and Margaret Martin on Taxpayers League Live at 10-11am CT and then on our own NARN The Final Word at 3-5pm. Both will stream from here.)

More evidence of the seizing up of credit markets comes from Felix Salmon:

Today's WSJ fronts a long explanation of how obscure German bank IKB blew up; the short version is, basically, that it suddenly found itself unable to roll over its CP [commercial paper--kb]. Other problems in recent days have been CP-based, too, such as WestLB Mellon's Brightwater vehicle. And commenter Ken Houghton has a long memory:

Drexel didn't go out of business because their liabilities exceeded their assets; they went out of business because no one would roll over their CP.

A quick introduction to CP, for those of you unfamiliar with it. Think of a conversation like this:

A: Can I borrow $10 till tomorrow?
B: Sure.
A: I'm good for it, you know.
B: But you're not earning any money tomorrow, how will you pay me back?
A: Oh, there's lots of liquidity at the short end of the yield curve.
B: In English, please?
A: You're going to lend it to me.
B: Lend what to you?
A: The $10 I need to pay you back.
B: Ah.

This is the kind of scheme which works until it doesn't. CP is a safe investment, because it's maturing very soon � often, literally, tomorrow. On the other hand, the entire CP edificie � which is mind-bogglingly enormous � is predicated on CP issuers being able to roll over their debts, and borrow what they have to repay. When that's no longer the case, and lenders start shying away, very nasty consequences indeed can ensue.

If you look at those two things, you'd say pretty much it's a liquidity crisis. And for some of these markets, unlike the banks and securities industries, there isn't necessarily a lender of last resort. Floyd Norris notes the vulnerability of hedge funds, wondering whether it's unreasoning fear or the these funds are holding more bad paper than we realized. Nouriel Roubini says it's worse than that.
Insolvent and bankrupt households, mortgage lenders, home builders, leveraged hedge funds and asset managers, and non-financial corporations. This is not just a liquidity crisis like in the 1998 LTCM episode. This is rather a liquidity crisis that signals a more fundamental debt, credit and insolvency crisis among many economic agents in the US and global economy. Liquidity runs can be resolved by the liquidity injections by a lender of last resort: in the cases of the liquidity crises of Mexico, Korea, Turkey, Brazil that international lender of last resort was the IMF; but in the insolvency crises of Russia, Argentina, and Ecudaor the provision of the liquidity by the lender of last resort � the IMF � only postponed the inevitable default and made the eventual crisis deeper and uglier. And provision of liquidity during an insolvency crisis causes moral hazard as it creates expectations of investors� bailout. Thus, while the Fed and the ECB had no option today but to provide massive liquidity in the presence of a most severe liquidity crunch and run, they should not delude themselves that this liquidity injections can resolve the deep insolvency problems of many overstretched borrowers: households, financial institutions, corporates. Insolvency/credit crises lead to financial and economic distress � hard landing of economies � and cannot be resolved with liquidity injections by a lender of last resort. And now the vicious circle of a weakening US economy � with a housing recession getting worse and a fatigued consumer being at the tipping point - and a generalized credit crunch sharply has increased the probability that the US economy will experience a hard landing.
I was asked today how likely this hard landing possibility is; as much as I'd like to say zero, I can't. I think it's unlikely still, but given what I've said before about the probability of recession, it would be folly to completely discount Roubini now. James Hamilton doesn't think the administration's use of the economy's fundamentals necessarily helps calm markets. Salmon appears to also be with the unlikely but not unreasonable camp. Liquidity will help enough, particularly if we can keep the housing market from crashing. It will also help if it turns out other parts of the financial markets don't have too much of these mortgage instruments (to that end, this article about money market funds has to be worrying.)

Nonetheless, the Federal Reserve is doing what it can.
Early Friday, the Fed accepted a larger-than-expected $19 billion in three-day repurchase agreements, a way to inject liquidity into the banking system. The federal-funds rate -- the rate at which banks make overnight loans to each other -- had risen to 6% early Friday, sharply above the Fed's 5.25% target rate, suggesting demand for reserves ahead of the weekend, according to John Silvia, chief economist at Wachovia Corp. After the $19 billion injection, the rate fell back toward the target. Later in the morning, the Fed accepted another $16 billion in repurchase agreements.
And another $3 billion after that was written. (Mark Thoma has the analytics for the macroeconomics-minded.) That's just a weekend injection, meaning the Fed is still treating this as a liquidity problem for the time being. The key will be to monitor this page on Monday and Tuesday to see if the Fed is having to put in as much. The market close today would indicate to me that investors may have been calmed.

Going forward as well will be the discussion whether we have really reached the end of our concerns about inflation.
Until the past few days, most monetary policymakers were emphasizing their concerns about mounting inflation pressures rather than problems emanating from the troubles of the U.S. subprime mortgage market. But that may be changing . "This is a disinflationary event," said Richard Berner of Morgan Stanley. "If it continues, inflation risks are mitigated. That gives the Fed and other central banks latitude to step up the timetable for moving rates back to neutral or below neutral if necessary." A neutral rate neither stimulates nor dampens economic growth.
I think the Fed can do that in September at its regular meeting, but to move before then would indicate something far more dire. Besides, do we really want to make Jim Cramer happy?

Key stat coming up? Consumer confidence. What this does to the consumer in my mind will matter quite a bit. So far, they've born up pretty well.