Liquidity Part of the Problem, Not the Solution

This is mostly the result of my efforts trying to make sense in my own head of what has been happening for the past few dizzying weeks. Some parts are nothing more than my own guesswork. All are based on public info I've been reading. I decided to share it here hoping readers could help put together a better picture. Critiques and alternate explanations are sincerely welcome.

1. First of all, it's clear that the latest round of the crisis, starting with the Fannie (FNM) bailout and Lehman bankruptcy, is different from the Bear Stearns crisis in March. Bear's was first and foremost a liquidity crisis (there was a serious capital issue behind it but that was not the direct trigger). Fannie and Lehman failed not for lack of liquidity, but due to capital insolvency. Fed data show that Lehman never went to the discount window to get liquidity. Fannie, Freddie (FRE), and Lehman fell because the market had decided they were insolvent, thus refusing to extend any credit or do any business with them.

This is a subtle but important distinction. The fact that Fannie, Freddie, and Lehman failed despite plenty of available liquidity from the Fed proves beyond doubt that all the liquidity-based emergency measures by the Fed and other central banks, including the $630B from the Fed last Monday, were wrong-headed. Besides not solving the problem, in fact they created a false sense of security. In retrospect, if the Fed didn't open up the discount window to investment banks and bail out Bear Stearns, maybe Lehman would've been scared into de-levering much more aggressively.

2. The underlying trigger this time is not subprime. Subprime and Alt-A mortgages are to a significant degree known problems, thus not capable of triggering another round of panic and crisis. The current trigger is the prime mortgage market. This is evidenced by the sudden collapse of Fannie and Freddie. They had little exposure to subprime or Alt-A. Yet their delinquency rates shot up in August. This forced the market to reevaluate its assumptions about prime. If you've experienced an earthquake, you know how it feels when the assumption that the ground beneath your feet is solid and stable is no longer valid. You stop taking anything for granted. You re-examine everything. You panic.

3. The report of interbank lending seizing up has been greatly exaggerated. Libor rates, as quoted in London, have indeed been very high for the past two weeks. So have interbank rates in New York at 11a.m. But the New York overnight repo rate has been very close to 0 for the last week. What does this mean? It's the European banks that have been in trouble lately. US banks, buried to the eyeballs with the massive liquidity injection from Fed and knowing their counterparts in the US are in the same ironic dilemma, are quite willing to lend out the cash for some return, no matter how small.

This ironic dilemma faced by US banks, even before the Bailout Pork Package, is yet another proof of the ills of the Fed's wrong-headed rescue.

Does this present arbitrage opportunities? Surely it does, and with it comes the danger of contagion, this time from Europe. We shall see this week how it plays out. For now, the Libor has become little more than a symbolic benchmark (well, except for those paying for debt indexed off Libor). Interbank lending in Europe has seized up and become irrelevant since banks could go to their central banks, or to the Fed, through some arbitrage channel.

By blindly providing liquidity (as opposed to capital), central banks of the developed world have made credit risk irrelevant. It's a panic response to the panic. Whereas the original panic valued credit risk at infinity, the panic response made (temporarily) credit risk 0 -- but only for banks, the privileged few direct recipients of liquidity injections.

Will this massive pile of short-term liquidity cash trickle down the money supply chain?

Not a chance until the banks have capital relief, which is the real problem. They cannot use the short-term cash to expand the asset side of the balance sheet. Would they trust each other any better? No, they know all this impressive-sounding short-term cash doesn't solve the problem for their counterparts, just as it doesn't for themselves.

But I say this hold-up of cash at the top-end of the money supply chain is actually a good thing. Some people are suggesting lowering capital requirements, as opposed to temporary relief from mark-to-market and some sensible form of capital injections (of which the Bailout Pork Package is not), should be the fix.

Couple that with the massive liquidity now available and guess what will happen? Banks would be out on a shopping spree for all kinds of junk. It'd be Credit Crisis 2.0 before you know it.

The Fed must suck out the senseless excess liquidity, and fast, before Paulson starts using his infinite power and swapping cash (capital cash, that is) for junk.