In my judgment we’re now at a point where fear and uncertainty are worse than they were during the depths of the Bear Stearns scare last March.
The combination of investment bank failures, the nationalization of America’s largest insurer, and most especially the disruption of money markets have brought us to a very delicate moment.
Which shoe will drop next? There are at least two possibilities. That’s one question. Another question is: how many bullets does the Fed have left in its gun?
Read this through to the end, because that’s where the good news is.
Update: I started writing this piece around 3AM. At just about that moment, the Federal Reserve announced the coordinated liquidity actions I mention at the bottom of this piece. As of 7:45AM EDT, these actions have added a certain amount of calm to credit markets, with overnight dollar LIBOR falling from 5% yesterday to below 4%. We're expecting a stock market rally in New York of perhaps 200 points on the open.I’ve often mentioned that to me, the most important signals of financial distress are to be found in the money and overnight-repo markets. These markets rarely break through to the headlines, but they’re the groundwater of the financial system.
You yourself are a participant, if you own shares in a so-called money market fund. These funds take your extra cash and invest them in a range of vehicles ranging from short-term Treasury securities to high-grade commercial paper and many things in between. They’re supposed to give you a little bit more interest than you can get from a passbook savings account. They’re also nearly as liquid, meaning you can redeem your shares and get your money out quickly.
Most importantly, money market investments are supposed to be 100% safe. Yesterday, however, a large money market fund announced that it was writing down to zero its investment in almost $800 million in debt issued by the now-bankrupt Lehman Brothers.
As a result, the fund’s share price dropped below the magic one-dollar level. That means that you would receive less money than you put into the fund, were you to redeem your shares yesterday. Except that you wouldn’t have been able to do that, because the fund froze redemptions for seven calendar days.
This threw every market into a very dark place yesterday. Why? Because the money markets are huge. About $3.5 trillion huge. As I said, they’re part of the groundwater of the financial system.
The great fear is that you, the public, will become so spooked at the thought that your supposedly 100%-safe money-market funds will actually lose money, that you’ll bail out and park your cash in your friendly, neighborhood, FDIC-insured bank account.
If that were to happen, there’s no sugarcoating the immediate effects. Commerce would be severely impacted across the whole economy. We’re not talking anymore about the failure of a few Wall St. firms that no one really understands anyway, or about a huge insurance company that is making money hand over fist in its core businesses but still managed to go bankrupt.
This could affect everything. And I really don’t know how the regulatory authorities could respond to it. I’ll try to make my next point calmly.
The last time the government had to respond to a system-wide loss of confidence in key financial institutions, it did so by closing every bank in America for ten days. That was in March 1933.
I’m not sure which regulatory body would have the authority, but it may be necessary to freeze redemptions from money market funds for some period of time. That’s one of the most extreme things I’ve ever said in this space, and I have no idea if the likelihood of our needing to do that is zero, one percent, somewhere in between, or something higher.
Yesterday, the Treasury auctioned off $40 billion in new three-month bills. In late June, the interest rate on these bills was usually just under 2%. Yesterday, they were sold to yield 30 basis points, or 0.3% That’s the lowest rate since shortly after World War II. The median bid in the auction was five basis points, and there were many zero bids. Interest rates on Treasury debt have fallen sharply across the yield curve in recent days.
When everyone wants to own discount Treasury paper so badly that they’re willing to receive no interest at all for doing so, that tells you that nothing is safe. This is a moment of extreme fear.
The last time we came to this point was a couple of weeks after the demise of Bear Stearns. At that time, ironically enough, the big question on everyone’s mind: was when would Lehman Brothers collapse? The exceptionally disordered conditions lasted about two days, and then the fear abated.
Now, as utterly unthinkable as it was mere days ago, there is talk surrounding Morgan Stanley, Wall Street’s second-largest investment bank. (I’m not talking about JP Morgan Chase, the commercial bank. This is a different Morgan.) Credit-default swaps (a measure of the possibility that an institution will default on its debt) are now trading at a higher price for Morgan Stanley than they were for Lehman Brothers last Friday.
And rumor has it that Morgan is informally talking merger with the Wachovia bank. If anything like that happened, it would leave Goldman Sachs standing alone, with vultures circling overhead. Remember, we started this year with five major Wall Street sell-side firms.
What can be done to address this immediate crisis?
Well, that’s what we have the Federal Reserve for. It’s there to be a lender of last resort when no one wants to own anything with even the slightest amount of risk in it. Not even things that millions of people normally consider rock-solid safe, like a money-market fund.
About an hour ago, at 3am EDT, the Fed announced that it had made arrangements with other major central banks, including the ECB and the Swiss National Bank, to greatly expand the availability of dollar liquidity through January 2009. The world’s central banks will act in a coordinated way to relieve the pressure for short-term funding in markets around the world.
The Fed had no need to inject additional reserves yesterday, finding that reserve levels were adequate. The Fed Funds rate for the previous night centered around 1.98%, about normal. We’ll see what happens this morning.
When you’re this far out there, you keep taking deep breaths and waiting for things to calm down. The mood in many markets now is waiting for a break, or as one trader told me, “calm before the storm.” Ben Bernanke’s helicopters are flying.
We have to hope that the creation of large amounts of temporary liquidity over the next few days are enough to relieve the pressure in the system. The fact that we’ve been through so many crises in the past thirteen months and got through every one without a major disaster is reason for hope in the Fed’s aggressive and creative approach.
Another extremely important point I need to make is this: the distress is confined largely to Wall Street. America’s industrial businesses are in exceptionally good financial health. They’ve been building their balance sheets for at least two years now, and they’re well-positioned to come roaring back as soon as the financial system and the economy stabilize. And there is an enormous amount of capital lying fallow right now, in hedge funds and private-equity firms. That money will come flooding out to revive the financial system, as soon as Wall Street finishes dying.
I have two recommendations for you, ladies and gentlemen:
First, don’t panic. The true state of the economy is weak but not terrible. The true state of the financial system is extremely weak but not fatal. What we all need is enough time to breathe deeply and assign logical valuations to our portfolios. This is the normal work that markets do every minute of every day, except when people get crazy and irrational. As long as the Fed provides enough temporary liquidity to remove the threat of imminent failures, we should get the time we all need to calm down.
Second, do NOT take your money out of the bank or out of your money market funds. Unless you’re a senior guy at a Wall Street firm, your money is not at risk. SO DON’T WORRY ABOUT IT.
Finally, keep repeating this to yourself: this is a Wall Street problem, not an economic problem. We’re in a storm now, but it won’t last forever. And when it ends, the resources will be there to rebuild quickly.