The Central Banks are Worried, or at Least, They Should Be Worried
Asset Backed Commercial Paper [ABCP]. We’re going to hear a lot more about this, and soon. The Wall Street Journal leads off today with an article on how money market funds are scampering to buy T-bills, and don’t want to touch A2/P2 paper, or any ABCP, no matter how high quality, which is half of the CP market. Bloomberg provides this summary as well, highlighting that as ABCP conduits collapse the relatively high quality securities that they are financing will need to make their way onto the balance sheets of other investors. The ABCP conduits can extend their maturities 30-45 days or so, but unless conditions improve in a month or two, there will be a lot of paper brought to the market as the ABCP conduits collapse. Some of those assets can be financed at 5.75% at the discount window, so maybe the Fed can brake some of the damage. On the other hand, the National Bank of Canada bought C$2 billion of ABCP from its company’s money market funds. Much of the rest of ABCP in Canada is converting the obligations into long-dated floating rate notes, which is a correct way to finance longer dated paper.
Yesterday, the Wall Street Journal explained why the FOMC moved the discount rate. A large portion of the argument is the demand for T-bills from money market funds sending T-bill yields temporarily below 1%, and settling yesterday a little above 3%. Anytime the spread between Treasury bill yields and Eurodollar yields (offshore dollar bank lending rates) gets too great, there is a lack of confidence in the banking system. The discount rate will do something to help here, but only a cut in Fed funds will get the speculative juices going, for good and for ill. As it stands, yesterday, at 2.40%, the TED [Treasury-Eurodollar] spread is the highest it has been since the crash in 1987, when it hit nearly 3%.
Now, why did Deutsche Bank borrow at the discount window? Borrowing hardly strikes me as supporting the actions of the Federal Reserve, regardless of what DB says. Now the ECB at this point is in no mood to raise rates. As it is, the ABCP problem has forced the bailout of the Sachsen Landesbank. What will break next?
This isn’t pretty, and while I think Jim Griffin is being too optimistic about how this crisis will turn out, it is worth noting that when lots of stocks hit new lows, it is often a good time to be investing.
One final note: orthodox economic theory says that crises can be stopped by a large economic actor (today, a central bank) being willing to lend unlimitedly with good collateral at a penalty rate. What that implies is that some parties will go under, for whom the penalty rate is too high. This keeps discipline in the system, while still rescuing the system. Unfortunately, that is not true today. 5.75% is inadequate compensation for many of the risks taken on by the Federal Reserve through the discount window. It may rescue some marginal entities, but it will promote inflation and moral hazard.
That’s all for tonight, I’m beat.
Full disclosure: long DB
August 21st, 20079:17 am at
Doug, You used to like NAHC. Do you have any recent update since the stock is pretty weak. Thanks
August 22nd, 200712:25 am at
Interesting post. The move in the treasury bills is staggering and certainly needs to be paid attention to. There has been no move like this in short-term treasuries in the past 20 years. The flight to quality trade is huge right now for money market managers.