Sticking with the Short End, or, The Short End of the Stick

Banks lend to each other short-term in several ways.  For banks in the Federal Reserve System, they lend through Fed Funds, of which the Federal reserve provides more or less liquidity as it sees fit.  Bigger banks can lend/borrow in the overseas euro-markets at LIBOR [the London Interbank Offered Rate].  This market is unregulated — outside the direct control of the Federal Reserve.  It is an independent source of US Dollar liquidity limited only by the willingness of banks to grow/shrink their balance sheets.

The willingness of major banks to grow their balance sheets is in short supply today, so LIBOR is rising.  Commercial banks like Barclays have a greater need for short term liquidity at present because they have to bring some short-term financing back onto their balance sheets because of failed conduits.  In the bank of England’s case, it was enough to force them to inject some temporary liquidity.  There is a secondary relationship between a central bank’s policy rate (like Fed funds) and LIBOR: as a central bank injects more liquidity, the less excess demand there is to borrow at LIBOR by banks.  So, as the Fed stays tight, and the need for short term finance grows, LIBOR rises.  And as I have mentioned before, the gap between LIBOR and T-bills [the TED spread] is very wide at over 1.5%.  Anytime the TED spread exceeds 1%, there is significant worry in the euro-markets over credit concerns.  Spreads of around 0.2-0.3% are more normal.

The short end of the credit markets is undergoing the most stress at present.  Asset backed commercial paper on ultra-safe collateral is getting refinanced at penalty rates, while ABCP on questionable collateral is not getting refinanced.  The reverse repo market is affected as well, as many mortgage REITs have found out, as haircuts on collateral have increased.  Even Citigroup could be affected, if they have to collapse some conduits, and bring the assets onto their own balance sheet.  The ratings agencies are awake, and are actually downgrading some conduit structures here and there.  The ratings agencies do that every now and then, when their franchises are threatened.

With this much pressure on the short-term debt markets, it is my belief that the Fed will do more than they have.  Maybe they will cut the discount rate again, or allow even more marginal collateral to be used.  On the other hand, since such subtleties are wasted on the public, they will likely have to grab the blunderbuss of lowering the Fed funds target, and fire a few times. It won’t solve the problems of those who are under heavy credit stress, but it will eliminate problems for those with light to moderate credit stress, and begin the overstimulation of a new part of the US economy.