We continue to see the wreckage caused by Greenspan’s no-regulations, cheap money, extreme right-wing Ayn Rand philosophy. I remember being at a client, a precious metals dealer, during the peak of his regime, and being baffled at why the traders treated his deliberately indecipherable pronouncements with such awe. He was then, and remains, an extremist charlatan who believes greed is good and the common good should be ignored, if not spat upon. (He was an early disciple of Rand, part of her inner circle, and that was her philosophy.)
The credit markets are still dangerously frozen. One reason: Credit default swaps from Lehman and WaMu settle this month. Institutions who sold these financial instruments of mass destruction, which pretended to be insurance on what is now toxic waste, may face losses of 80-85 cents on the dollar. $400 bn of Lehman swaps unwind on Friday, so losses for some could be catastrophic (assuming they even have the money to pay, if not, then the other side on the transaction gets hurt.)
Banks are believed to be hanging on to cash both to pay for their own settlement and out of fear that their counterparties may take irreparable damage in the Lehman settlement process. There may be some relief if the financial community passes this test, but with another big settlement, WaMu, later this month, banks are still likely to remain on high alert.
TED Spread at record. Translation: The big banks don’t even trust each other for short-term loans.
Take a bow, Mr. Greenspan. Your policies led inexorably to this day.
“The big banks don’t even trust each other for short-term loans.”
How about the big banks would take it in the shorts loaning at 1.5% because inflation is (offically) running at 5.7%? They’re in business to make money. What insane idiot would loan money at a 4.2% LOSS? Only Benanke’s Fed.
Well, they can borrow from the Fed at 1.5%, then loan it overnight to another bank at 4%. Which would seem a no-brainer, but no one is lending now.
That only works if there’s an endless supply of 1.5% money– THAT’S what they don’t trust, and rightfully so.
It’s supposed to work such that the Prime Rate is slightly higher than inflation. Bank 1 borrows at 2.5% when inflation is 2%. They reloan to consumers at 5%. Good business deal. And if they need extra cash, they borrow from Bank 2 at 2.75% or 3%. Everybody’s happy because there’s little risk. Even if Bank 1 fails to repay its overnight loan, Bank 2 has plenty of sources for extra cash because everyone’s making money. They’ll lend not only Fed money, but depositors’ money, and they’ll make a profit doing it.
But consider the present situation: Bank 2 can borrow money from the Fed at 1.5%. But if they can’t repay it, there’s NO supply of cheap money in the market because the Fed is the ONLY source of funds below inflation. Let’s say Bank 2 relends its 1.5% funds to Bank 1 at 2%. Good deal, right? But Bank 1 loans it out at 6% for residential mortages that are slow to pay, and it can’t repay Bank 2 on time. Where does Bank 2 go to repay its overnight loan? No one but the Fed will loan money at below inflation.
If the Fed has an unlimited supply of money, everything’s groovy. But everyone knows the Fed can’t do that without creating hyperinflation– something even Bernanke isn’t stupid enough to encourage. So there’s a limited supply of cheap money in the market. This is key: if I’m a bank that runs out of 1.5% money, I WON’T LOAN YOU MY OWN MONEY because I’d lose 4.2% on it. So why take the risk? That’s exactly what happened to the Icelandic banks: the supply of cheap money dried up and they couldn’t repay their short-term loans.
Extend that outward: Corporations use to be able to get cheap short-term loans. Now they can’t. They have to borrow at a rate that is far enough above inflation to limit the risk of the lending bank from current and future inflation. These days, that’s 6.5% or more instead of 2%. That’s NOT cheap money.
Another big problem right now is counterparty risk. Banks don’t know if a financial institution they are lending to is solvent.
$400 billion in Lehman CDS settled today at less than 9 cents on the dollar. So, some entities are out $360 billion. But no one knows who because the transactions are private. Hence the risk level. WaMu CDS settled in a week or so.