It is not the end game yet. But we are getting closer to an important inflection point in the credit crunch. The investment banks are capitulating. And none too soon, considering the whole financial system is galloping off a cliff.
The current investment banking model is, quite obviously, not built to withstand a credit crunch. Why? Investment banks borrow short term so they can buy long-term assets. So far so good. When interest rates are low, borrowing is easy and tempting.
The trouble is that asset prices can fall while liabilities remain fixed. When asset prices fall, the creditors to the investment banks demand more collateral on their loans. And here comes the other flaw in the investment banking model.
Not only have the investment banks borrowed short-term (with lots of exposure to unexpected rises in short-term interest rates, which make it a lot more expensive to refinance your debt) they don’t really have liquid assets to sell in order to post new collateral. Can’t borrow cheap. Can’t sell quickly.
Commercial banks have deposits. Investment banks do not. That’s why the last year saw Wall Street Investment banks trolling through global financial markets looking for new capital. All they had were assets. And those assets were either falling in value, or so dangerous in market conditions that a price for them couldn’t be established.
The banks did have some good assets. But the management was reluctant to sell those, hoping the crisis would pass. And there were a few suckers out there who traded billions in capital for equity. They also thought it was a liquidity crisis instead of a solvency crisis.
Well, the solvency crisis is upon us. And part of the endgame is that the investment banks are forced into shotgun marriages of convenience with commercial banks. Lehman waited too late and was not only left at the altar. The doors to the church were locked while the building was set on fire. Barclay’s is now picking through the rubble.
Merrill wised up early and fell into the arms of Bank of America. And now it is Morgan Stanley’s turn. It was jilted by investors today and fell 24%. This must’ve caught the eye of another spurned financial, Wachovia Bank. It looks like an arranged marriage is in order.
Do you, remaining but humbled investment bank, take you, struggling commercial bank, to be your lawfully wedded financial partner, for richer or for poorer, until bankruptcy do you part?
We hope you’ll forgive us for dwelling on U.S. markets today. But we do so for a simple reason. While we take Reserve Bank Governor Glenn Stevens at his word that the Australian banking sector is in better regulatory shape (the commercial banks will take losses on U.S. investments but have deposits to fall back on as capital), it is obvious that the carnage in the Aussie market will not end until it ends in America.
Indeed, Australian indexes have fallen further from the market highs than the Dow. So we need to know if there any other big shoes to drop out there. After all, the world’s largest insurance company has been nationalised. The two largest mortgage players in the world’s largest mortgage market have been nationalised. Bear is gone. Lehman is going. Merrill is married. Morgan is betrothed. How many feet does this bear market have?
Maybe it’s not a bear. Maybe it’s a spider. If that’s the case, there still are some big financials that could run into trouble this week. On the investment bank side, you have JP Morgan and Goldman Sachs. In the mortgage lending world, there’s Washington Mutual. And when it comes to money center banks, they don’t get much bigger than Citibank. Let us not mention the regional banks. We’ll be hearing from them soon enough.
Our point? The mighty have fallen. But there are still dozens of institutions out there that could fail. Should the market be relieved that the big casualties are most likely over? Or will it be worried about the smaller fry? The Fed has its eye on the big players with huge balance sheets that threaten the financial system.
The Fed reckons it is better off being a matchmaker between commercial and investment banks than it is trying to bail everyone out. Even though there is no limit on what the Fed can add to its balance sheet, the bond market is starting to notice. And that, as we predicted earlier this week, is setting off a massive rally in things that are not paper (like gold).
Bloomberg reports that, “The Treasury is selling $100 billion in short-term debt to enable the Federal Reserve to expand its balance sheet, a sign of the strains created by the biggest extension of central-bank credit to financial companies since the Great Depression.”
Since the credit crunch began last August, the Fed has depleted its reserves of Treasury bond, bills, and notes from US$741 billion to $478 billion. Today, it called on the Treasury Department for reinforcements.
According to a press release, “The Treasury Department announced today the initiation of a temporary Supplementary Financing Program at the request of the Federal Reserve. The program will consist of a series of Treasury bills, apart from Treasury’s current borrowing program, which will provide cash for use in the Federal Reserve initiatives.”
“Hank, this is Ben.”
“Ben I’m a little busy right now. What do you need?”
“More bonds and notes. We can’t keep this stuff on the shelves. The banks love it. We’re definitely gonna need more.”
“No problem. It’s not real anyway.”
There may be some universe in which this new Supplementary Financing Program does not lead to an increase in the money supply. But we suspect we are not living in that universe. In fact, we suspect the bond market and the gold market are on to the game.
If the Fed needs new bonds, bills, and cash management instruments from Treasury to accommodate all the folks lining up for its various lending facilities, how does that not lead to an increase in the money supply? The word sterilisation comes to mind.
But we won’t get into that today. For now we’ll simply point out that the gold price went up nearly 9% and US$70. Meanwhile, investors are “flying to safety” in the three- month Treasury market, where prices soared and yields plummeted to just 0.02%.
With a yield like that, why not just take your money out of your wallet and burn it? When the Native Americans herded bison over the cliff as a hunting technique, do you suppose the bison thought they were fleeing to safety too? But wait! Bison can’t fly!
Gold is rather heavy to be airborne too. But it has one thing going for it right now. It’s not anyone else’s liability. It’s just a heavy yellow metal. Even Alan Greenspan has always thought gold was real money.
Markets and Money