Credit markets "crash" as bank lending is frozen. - 26-Sep-2008 - Generational Dynamics

Officials are bitterly divided over the $700 billion Bailout of the World (BOTW) plan, as meetings ran into the night on Thursday evening. The bailout plan appeared to be in disarray, as leading Republicans proposed an alternative plan.

The original plan, advocated by Secretary of the Treasury Henry M. Paulson Jr. and Federal Reserve chairman Ben Bernanke, gives the Administration authority to pay up to $700 billion for near worthless mortgage-back securities from financial institutions.

The theory is that, one day soon, the bubble will return, and the government can sell those securities and make money. (Please stop. I can't type when I have tears in my eyes from laughing so hard.)

The new plan, proposed by Alabama Sen. Richard Shelby, the ranking Republican on the Senate Banking Committee, would authorize the the Administration to loan $700 billion to financial institutions. Once the bubble returns, they would pay back the loans with interest, and the government would make money. (Once again, I can't stop laughing.)

The real news on Thursday is that people are now speaking of a "credit market crash." Banks simply are unwilling to lend money to each other at interest rates the borrower can afford.

Yesterday I posted a graph of the TED spread, which has risen again today. Here's a graph of the Libor-OIS spread posted Thursday on the FT site:

Libor measures the interest rate for bank to bank lending for 3 months; OIS (Overnight Index Swaps) measures the interest rate for overnight lending. Usually it's more risky to lend someone money for 3 months than for overnight, and so the interest rate is normally a little higher.

The above graph shows that this difference in interest rate is historically higher.

What all this means is that interbank lending is frozen. Bloomberg tv referred to it several times as a "credit market crash." A US News article uses the same words.

A USA Today article points out that many banks would now be collapsing, if it weren't for massive lending by the Fed.

Today's explanation is the same as yesterday's explanation: The leaking of the credit bubble is accelerating, the amount of money in the world is disappearing more quickly. The deflationary spiral is accelerating. The $700 billion from the Bail Out the World plan wouldn't even begin to keep up.

There are some people who, after many months and years, are finally beginning to understand this. The credit bubble was created by "leveraging" -- using a little money to borrow a lot. This was done by everyone: People bought homes with no money down, often lying about their income, or they used credit cards to pay their living expenses. And financial institutions would buy securities "on margin," often paying on 2-5% of the cost, and borrowing the rest. This means that they "leveraged" their money by 50 to 1 or 20 to 1.

Now everyone's talking about "deleveraging." Gillian Tett wrote a Financial Times article that summarizes this:

"A few years ago, senior officials at the Bank for International Settlements started ringing alarm bells about the scale of leverage that was quietly building up in the financial system. Back then, though, it was fantastically hard to get American policymakers - let alone bankers - to listen.

In the go-go days of the credit bubble, Washington policymakers blithely assumed that the Western financial system had plenty of capital to cope with any potential risks. Consequently, as one former BIS official admits: "Worrying about leverage wasn't fashionable at all - no one wanted to hear."

Fast-forward a couple of years and, my, how those Western financiers are having to eat humble pie (even to the point of accepting a helping hand from the once-ailing Japanese). After all, the events of the past year have now made it patently - horrifically - obvious that the Western banking system has become dangerously undercapitalised in recent years, to the point where even the Federal Reserve is having to shore up its defences.

Moreover, it is now also clear that Western policymakers are belatedly trying to correct this state of affairs. The days when high leverage, mega bonuses and wacky instruments were equated with financial virility have gone; instead a more humble, back-to-basics and slim-line approach is what investors are demanding. Thus, deleveraging is now all the rage - in whatever form it might take."

So far, so good. Tett points out that deleveraging must now occur for most firms. This is something that a lot of people are saying. But she added the following interesting paragraph:

In other words, suppose that investment banks cut their leverage ratios from 30 times to 20 times. That one action would cause $6 trillion dollars in assets to be sold, and since that money was essentially "created" from credit, there would be $6 trillion dollars less money in the world. And it would be much worse if the cut the leverage ratios to 10 times, or 5 times, or (gasp!) two times.

That's a good example of why money is disappearing in the world, and also explains why the $700 billion Bail Out the World plan doesn't have a snowflake's chance in hell of making much of a difference, whether it passes or not.

Thursday also saw the biggest bank failure in history: Washington Mutual Inc. has collapsed, and its assets will be acquired by JP Morgan Chase & Co.

The answer is that it means all of the above, if you don't have the very highest credit rating, and even then, you'll be paying sky-high interest rates. It's very hard to get credit now, but in a while it'll be almost impossible.

So we have two very different pictures here: On the one hand, we have the clown circus in Washington, with bickering politicians arguing over a plan that can't possibly work. Why are the circus clowns performing? Because they hope to get our votes in a couple of months. What a sad, pathetic bunch.

When the credit bubble was expanding, there was plenty of money around, and it was like a huge champagne party for the everyone from consumers who lied to get loans to investment executives who lied to investors that their mortgage-backed securities were "good as cash."

Now the champagne party is over, and a lot of people are going to be hurt badly, undoubtedly including many people reading this web site, unfortunately.

It's a very, very sad time. If you're nostalgic for the old days, whether for the champagne party or for your long-lost youth, then take a moment and relax, and listen to Judy Garland and Mel Tormé sing "The Party's Over" on the New Year's episode of the Judy Garland Show:

Generational Dynamics Web Log for 26-Sep-2008
Credit markets "crash" as bank lending is frozen.

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Generational Dynamics Web Log for 26-Sep-2008 Credit markets "crash" as bank lending is frozen.

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Generational Dynamics Web Log for 26-Sep-2008
Credit markets "crash" as bank lending is frozen.