Rumours direct the market, overnight spreads easing

September 17, 2008

As expected, the bailout of AIG has given a temporary relief to short term markets, with less central bank activity today. The ECB will not be conducting any special one day operation, allowing yesterday’s 70 billion to mature and be taken out of the system, but in its usual weekly auction it will offer 39 billion more than what it estimates to be the banks’ liquidity need.


From Reuters:


“Overnight dollar funds were borrowed at rates as high as 8 percent earlier in the European session, according to prices indicated on Reuters screens, before easing back to anywhere between 3.00 percent and 5.00 percent later in the session.

There were some signs of relief in that rates were not as high as Tuesday’s extraordinary peaks above 10 percent and market participants said liquidity was flowing through the system a little more easily than Tuesday.

But conditions remain strained.

Overnight funds are well above the Fed’s target rate, and the cost of interbank three-month dollar funds was indicated on Wednesday at its highest level since January.

In addition, activity was still being carried out on a discreet basis, with no benchmark pricing and banks dealing with counterparties only on an ad-hoc basis.” 

Of course, after a period of extreme pessimism and panic in financial markets, a period of relaxation and maybe even euphoria is natural. Both of the major issues that have been guiding speculators have been resolved, with Lehman banrupt, AIG and GSE’s nationalised. I have already been hearing speculation that the worst of the crisis is over, that the worst risks have been eliminated, and unless more shocks befall the financial system in the short term, a rally is quite possible.


In the medium and longer term, however, Lehman’s collapse will cause the already tight financial markets to become even more constricted, as perception of counterparty risk becomes more acute, and the anticipation of who will be next leads the stock market to prevent an orderly resolution of the crisis. As I have pointed out repeatedly here, in a crisis environment such as this, everything that contributed to the bubbling up of the financial markets in the past years will revert to become negative factors for the health of the economy, and lead it to the deteriorate faster and deeper, snowballing on impulse. Again, this is only a mirror image of the rising market, only that all the positive aspects are present in equal force, but in the opposite direction. 


Today the stock market has the will and the means to bring down anyone it sets its eyes on, and as it has been noted by others, the behaviour of speculators has recently been quite similar to pack animals. In the cases of Bear, Lehman, and AIG, speculators first identified who was perceived as the weakest of the lot, and then grouped to attack and batter it until it was bankrupt. This phenomenon has important implications: First, rumours will matter more than fundamentals, even more so than usual. No one knows the true content of any bank’s balance sheet, and naturally, rumours will direct the markets. Second, what the management does for any company is now less relevant, as we observed when Lehman was essentially punished for announcing measures to improve its balance sheet. That is, its fall accelerated after it declared that it would take measures to better its situation. Third, government officials will feel even more cornered, as the burden on their shoulders and the stress this creates, along with the paradoxical nature of their responsibilities, lead them to errors. Mr. Paulson has been quite candid about the extreme stress under which he has been operating.


There’s no easy resolution to this crisis. It’s very similar to the position of an individual, who, after borrowing much more than he could pay, contemplates a quick exit from his troubles upon facing bankruptcy. However, one can’t leave a plane after it has taken off, and this fact, I suspect, is what the financial system must contemplate today. 



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