Frantic efforts to stem the ongoing collapse of the financial system are continuing.

October 6, 2008

Damage from the credit crunch accelerated last week as Washington Mutual collapsed, and Wachovia was sold. In Europe, BNP Paribas agreed to buy Fortis’s units in Belgium and Luxembourg for 14.5 billion euros after the failure of a government rescue, while the German state and financial institutions formed a 50 billion euro package to save Hypo Real Estate. Germany also declared on Sunday a guarantee on all private German bank accounts – currently worth €568bn – to prevent panic withdrawals, covering existing accounts and others which savers will open in the future. Germany’s previous protection scheme had guaranteed 90% of all bank deposits but only up to €20,000 per account. Ireland last week also guaranteed the liabilities of six of its banks.

Libor is slightly down today (one month dollar at 4.09 per cent vs 4.11 per cent), though the dollar-OIS spread is at about 290 — way above historical levels. Three-month Libor is at 4.29 percent, the biggest premium over the Fed’s benchmark since the FED began using a target for the overnight federal funds rate between banks as its main tool around 1990.

In response, the Federal Reserve will double its auctions of cash to banks to as much as $900 billion and is considering other ways to unfreeze short-term lending markets. Since the collapse of Lehman, around 2 trillion dollars have been injected into the system, with barely any effect.

“The Federal Reserve stands ready to take additional measures as necessary to foster liquid money-market conditions,” Fed and Treasury officials are “consulting with market participants on ways to provide additional support for term unsecured funding markets”.

Also, Fed will increase its auctions under the 28-day and 84-day Term Auction Facility operations to $150 billion each. The two forward TAF auctions in November will be increased to $150 billion each, obviously in preparation for the year-end cash squeeze.

Assets on the Fed’s balance sheet expanded $285 billion last week to $1.498 trillion, the biggest one-week increase ever, according to JPMorgan Chase & Co. The Fed’s loans to commercial banks through the discount window rose about $10 billion to $49.5 billion last week. Borrowing by securities firms totaled $146.6 billion, up from $105.7 billion. American International Group Inc., the largest U.S. insurer, drew down $61.2 billion of its $85 billion credit line from the Fed.

“For the most part this is the Fed acting as a replacement for private banks,” said Lou Crandall, chief economist at Wrightson ICAP LLC, in Jersey City, New Jersey. “It is moving private-market functions into the public sector because the private market has reduced capacity.”

Meanwhile, to finance the Treasury’s new rescue plans, officials are considering changes to federal government debt sales, including a reintroduction of three-year notes. Changes will be released at the Treasury’s Nov. 5 quarterly announcement on sales of long-term debt.

The Treasury also said that some of its cash-management bills may be “longer-dated.” The expansion in issuance is needed to “allow Treasury to adequately respond to the near- term increase in borrowing requirements”. Treasury officials last month also started a special program of bill auctions to help the Fed expand its balance sheet.

In yet another step announced today, Fed will also begin to pay interest on the reserves it holds for banks, and payments on required reserves will be made at the average targeted federal funds rate established by the Federal Open Market Committee over each so-called reserve maintenance period less 10 basis points.

In addition to the cash banks must hold at the Fed, lenders also sometimes place excess reserves. The central bank said today it will pay interest on those funds at the lowest targeted federal funds rate for each period less 75 basis points. That will put a floor under the actual fed funds rate each day and let the Fed “expand its balance sheet as necessary to provide the liquidity necessary to support financial stability.”

The New York Fed has been having difficulty controlling the overnight federal funds rate – while the target is 2 percent, the effective rate was below that level every day from Sept. 19 to Sept. 29.

In the CDS markets, Monday saw price-setting for settling up to $500bn of contracts related to Fannie Mae and Freddie Mac. This price is called the recovery value, and will determine the payouts to be made by insurers and banks that offered credit cover on the mortgage financiers in recent months. Unwinding and settling these derivatives is expected to be the biggest test yet for the thus-far unregulated $54,000bn credit derivatives market. The Fannie/Freddie payouts could amount to $75bn, assuming a recovery value of 85 cents in the dollar, but the exact number of credit default swaps which reference Fannie and Freddie is not known, although analysts estimate a range from $200bn to $500bn.

The Federal Reserve Bank of New York will meet tomorrow with banks and investors in credit-default swaps to gauge progress on an initiative to create a clearinghouse to curb risks in the market, a spokesman said. The Clearing Corp., a Chicago clearinghouse owned by some of the biggest credit-default swap market-makers, has faced delays in setting up a system for guaranteeing trades as the Fed pushed it to obtain a banking license that would place it under the central bank’s watch. The company and the banks are “moving aggressively to launch the CDS clearing platform by the end of this year,” Clearing Corp. said in a Sept. 29 statement.


Jim “Mad Money” Cramer today has urged investors to get out of the stock market, as the DOW fell below 10000, and VIX reached levels above 50:

“Whatever money you may need for the next five years, please take it out of the stock market right now, this week. I do not believe that you should risk those assets in the stock market right now I don’t care where stocks have been, I care where they’re going, and I don’t want people to get hurt in the market,”

“I’m worried about unemployment, I’m worried about purchases that you may need. I can’t have you at risk in the stock market.”

With respect to the Treasury’s plan, the so-called TARP, a lot is unclear, but the chief economist of BNP-Paribas has some pithy points:

1. Participation is voluntary. As with the 1992 Cooperative Credit Purchasing Corporation in Japan, some potential participants may not offer assets for fear of having to crystallise losses. Side conditions such as the restrictions on executive pay may reduce participation further.

2. Despite its gargantuan size and massive grant of powers to the Treasury Secretary, it has failed to convince the markets it will break the back of the crisis.

3. The mechanism to set prices remains obscure. If auctions are restricted to single assets then there may be very few bids because there are very few holders (one or two in some cases). If heterogeneous assets are included in the same auction then setting a price becomes very difficult.

4. There is no clear idea how the cut off price will be calculated or what proportion of offers will be accepted and other aspects of the pricing mechanism.

5. Capital will be injected to firms who may not need it and to those who may not survive in any case. This is poor value for money indeed.

6. There is no matching requirement for shareholders to inject capital or to suspend dividends to match the capital put in by the public sector. Warrants are a poor substitute.

7. The plan does not tackle the fundamental source of the bad loans afflicting the system – falling house prices and an excessive debt burden being faced by US households.


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