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To be sure, the Credit Crisis has accelerated to a ferocious clip. Last week it was a “white shoe” hedge fund leveraged in “AAA” securities that imploded. Earlier this week, a “white shoe” firm listed (in Europe) fund that had been leveraging in “AAA” Fannie and Freddie securities imploded. Today, one of Wall Street’s white shoe firms required a Fed-assisted “bailout” to at least temporarily ward off implosion. It is neither hyperbole nor fear mongering to warn that scores of players throughout the expansive U.S. financial sector are now in jeopardy of finding themselves engulfed in a liquidity crisis.
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The Fed is in a real quagmire here. Because of the “daisy-chain” nature of contemporary risk intermediation (specifically in the derivatives and securities financing marketplaces), a failure these days in one of any number of institutions would quickly reverberate throughout the entire (frail) system. As such, today virtually any player of significant presence in the derivatives and “repos” markets is likely to be perceived by the Fed as “too big to fail.
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There are now forecasts for a 100 basis point cut in the Fed funds rate for next Tuesday. Many are arguing that financial and economic developments support more aggressive Fed rate slashing. I am reminded of the joke of the entrepreneur that loses money on every sale but is determined to make it up on volume. At this point, it should be apparent that rate cuts are destabilizing the system. They not only damage Federal Reserve credibility, they are battering confidence in the dollar and U.S. financial assets more generally. With the financial crisis having reached the “core” of the U.S. Credit system and the currency markets having turned “disorderly,” we’re now on Dollar Crisis Watch. One of my greatest fears has always been an unwieldy dislocation in the currency derivatives market.”
Wishing for Another Z.1By Doug Noland
March 14, 2008
SourceThis week offered further disconcerting confirmation that the 20 Year Experiment in “Wall Street finance” is failing miserably. Tuesday, the Federal Reserve was compelled to announce the implementation of an extraordinary $200bn liquidity facility for the Wall Street “primary dealer” community. Despite this action, it was necessary this morning for our central bank to orchestrate emergency funding for troubled Bear Stearns. We’re now clearly in the midst of a precarious systemic crisis. I concur with the characterization made this morning by former Treasury Secretary Robert Rubin: We’re in “uncharted waters.”
To be sure, the Credit Crisis has accelerated to a ferocious clip. Last week it was a “white shoe” hedge fund leveraged in “AAA” securities that imploded. Earlier this week, a “white shoe” firm listed (in Europe) fund that had been leveraging in “AAA” Fannie and Freddie securities imploded. Today, one of Wall Street’s white shoe firms required a Fed-assisted “bailout” to at least temporarily ward off implosion. It is neither hyperbole nor fear mongering to warn that scores of players throughout the expansive U.S. financial sector are now in jeopardy of finding themselves engulfed in a liquidity crisis.
I found the opening question from this afternoon’s Bear Stearns conference call quite telling: “What is your current gross notional non-exchange traded derivative exposure?” The executive’s response - “To be honest with you, I don’t know this number off the top of my head…” - was not comforting. But to be fair, the company’s derivative obligations are not today the most pressing issue facing management. It is, however, a deep concern for an increasingly panicked marketplace. The Bear Stearns funding crisis certainly brings somewhat to a head the market’s festering worries with regard to the daisy-chain of derivative and counter-party exposures, liquidity risk, and a complete lack of transparency. Bear Stearns’ management was quick to blame “false rumors and innuendo” for the funding crisis. Yet, how sound are the underpinnings for Bear Stearns, the U.S. Credit system, or the markets overall when market chatter can have such destabilizing effects?
Candidly, I wish I had another of the Fed’s Z.1 “flow of fund” reports to grind through this evening - conveniently providing the opportunity to keep most of my thoughts and fears to myself. Most unfortunately, we’ve been witnessing the worst-case scenario unfold before our very eyes - and it all imparts a bad feeling deep in my gut. Marketplace liquidity is all about confidence. Confidence that held sway for years can turn so fleeting, while once Revulsion takes hold, it tends to linger. That Tuesday’s Fed announcement did not forestall a run on Bear Stearns suggests to me that this unfolding crisis has attained alarming momentum. At this point, confidence in leveraged securities finance appears to have been irreparably damaged.
I’ll assume that two of the Critical Fault Lines for the Rapidly Escalating Crisis reside in the securities financing “repo” market and the Credit default swap (CDS) marketplace. Leading the list of companies that saw the prices of their CDS (default protection) surge significantly this week were GMAC, Bear Stearns, Ford, Sallie Mae, Countrywide, and Lehman Brothers. These six companies combine for (as of their most recent financial statements) Total Assets almost $2.0 TN, supported by Shareholders Equity of about $75bn. Or, stated differently, these six companies are leveraged (mostly in financial assets) to “capital” at a ratio in the neighborhood of 25 to 1.
In the context of the current backdrop, fear of default for such highly leveraged companies is more than justified. Expectations for contagion effects throughout the securities lending arena are similarly rational. We can safely assume that the marketplace has accumulated enormous CDS positions protecting against default for all six of these companies (and many others). I’ll also presume that a default by any one of these companies (or a number of others) would pose a severe problem for the CDS market and for systemic stability overall. It is also likely that heightened counterparty fears will add a problematic dimension to those managing large “books” of offsetting Credit exposures. Evidence mounts by the day supporting the view of a problematic unfolding dislocation in the Acutely Fragile and Untested CDS Marketplace.
The Fed is in a real quagmire here. Because of the “daisy-chain” nature of contemporary risk intermediation (specifically in the derivatives and securities financing marketplaces), a failure these days in one of any number of institutions would quickly reverberate throughout the entire (frail) system. As such, today virtually any player of significant presence in the derivatives and “repos” markets is likely to be perceived by the Fed as “too big to fail.”
The dollar sank to a record low against the Euro and to the weakest level against the Japanese yen since 1995. As far as I’m concerned, the currency markets this week “officially” attained the status “disorderly.” Not surprisingly, the dollar responded quite poorly to the Fed’s plan to accept $200bn of risky collateral from the “primary dealer” community, as it did to today’s financing arrangement for Bear Stearns. The $200 billion is certainly only an opening “ante” and Bear the first of many bailouts.
Undoubtedly, currency markets have begun to increasingly discount the “nationalization” of U.S. Credit risk – both by the Federal Reserve and the federal government. The Fed may plan on 28-day terms for its exchange of Treasuries for other “street” collateral. Yet, the way things are developing, I see little prospect anytime soon for an environment conducive to the Fed reversing course and transferring such risk back to Wall Street. Indeed, this week likely marks a key inflection point for what will soon evolve into a huge expansion of Fed holdings (and various guarantees) of U.S. risk assets. And, at some point, the federal government will be similarly forced into accepting Trillions of “financial guarantee” obligations – for mortgages, municipal debt, student loans, various “deposits” and who knows what.
In past analyses, I have differentiated between the Financial Sphere and the Economic Sphere. At the Fed and throughout the markets, the current focus is on Financial Sphere developments and possible policy responses. Even assuming that the funding crisis at Bear Stearns and elsewhere is resolved in short order (a huge assumption at this point), I doubt even this would restrain the head winds now buffeting the Economic Sphere. Understandably, the focus now will be on inter-“bank” and securities financing markets. Meanwhile, recent developments will ensure a further tightening in already taut mortgage, municipal, and corporate lending markets. The economy will suffer mightily.
The release this week of Dataquick’s California housing data (see “California Watch” above) provided strong support for our view that the Golden State housing market is crashing. Anecdotal accounts have markets throughout the state basically shut-down because of the inability to obtain mortgage Credit. And with liquidity quickly drying up for various endeavors including student loans, auto finance, small business lending, and business finance more generally, our dire economic prognosis is regrettably coming to fruition.
There are now forecasts for a 100 basis point cut in the Fed funds rate for next Tuesday. Many are arguing that financial and economic developments support more aggressive Fed rate slashing. I am reminded of the joke of the entrepreneur that loses money on every sale but is determined to make it up on volume. At this point, it should be apparent that rate cuts are destabilizing the system. They not only damage Federal Reserve credibility, they are battering confidence in the dollar and U.S. financial assets more generally. With the financial crisis having reached the “core” of the U.S. Credit system and the currency markets having turned “disorderly,” we’re now on Dollar Crisis Watch. One of my greatest fears has always been an unwieldy dislocation in the currency derivatives market.