October Surprise

This posting is from D&S collective member and frequent blogger Larry Peterson. To see more of his posts, click here.

The race is on. And it’s going to be a short, but intense race. Central banks throughout the world (including the People’s Bank of China) implemented co-ordinated interest-rate hikes today, while huge swathes of banking systems in a number of key countries have been reinforced with large injections of public funds and the extension of deposit insurance guarantees, or even semi-nationalized. But the most important–and timely–development concerned the $1.6 trillion (but falling fast) commercial paper market, that weird little corner of the financial world which regular companies (not banks, or even “shadow-banks”) worldwide have been increasingly tapping in the last few decades to meet their everyday expenses, and even payrolls. The Federal Reserve, in conjunction with the Treasury Department, is establishing a fund to buy up these very short-term bonds, in an attempt to breathe some life back into this clinically-dead market. This is unprecedented: it means the Fed will be pretty much lending money directly to private companies. Still, equity prices continued to fall all over the world (though Tokyo’s Nikkei has just opened in positive territory, after sustaining major losses over the last few days), in spite of these huge, even historic interventions. But the variable everyone is looking at, the cost of commercial paper, reacted favorably only for overnight transactions: for anything longer-term, it has continued its relentless rise. As did interbank lending rates (though this looks like it’s beginning to change, too).

So this is where we are: because the commercial paper and interbank markets are dormant, companies are desperately pursuing other funding options: those lucky enough to have (generally when times were very good) been extended emergency credit lines by their banks are taking the banks up on their offers, at a time when the banks are scrambling to conserve capital. But as lending costs increase, and despite interest rate cuts and massive monetary injections (precisely because banks are hoarding the money that gets pumped into the system), the banks are chasing a moving target. This is all the more the case when one remembers that many of the banks started the race well behind the starting line, if you consider the quality of capital they were allowed to book as reserves by regulatory regimes dedicated to, well, deregulation, and that the banks didn’t provision properly for much of the bad debt that’s coming due now in the lead up to the crisis (in fact, many banks stashed money away in Structured Investment Vehicles–SIVs–to get around reserve provisioning altogether, and when the underlying loans went bad, they had to, as is the case now with the emergency credit lines, take such loans back on their books).

And the situation cascades through the whole economy: suppliers, customers, you name it: at virtually every point, short-term but essential funding is something that can no longer be taken for granted. This, on top of expected economic weakness, has contributed to a universal flight from risk. And that means the desperate hoarding of capital, prohibitively higher lending costs, and significantly less equity finance. This is especially destructive for the banks: they have to compensate for falls–sometimes dramatic ones, like Bank of America’s, which has lost a third of its value in the last two days–in share prices, but interbank borrowing costs (not to mention insurance against default) rise as equity prices decline: it’s a vicious cycle. And that’s the cycle governments are trying to break, with all the means they can conjure up at this point. But something has to give, soon. If, somehow, the commercial bank and interbank markets don’t stabilize by the end of the month, expect governments to take extremely (even beyond the scope of the historic ones we’ve seen already) drastic measures. And expect economic damage to expand exponentially for every few weeks this situation isn’t resolved.

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