Let me first say that I am an economical pragmatist, and that I subscribe to no ideology. I believe that government intervention, and even state corporatism can have a role to play in certain circumstances, but I also believe that a nation should always aspire to be as free as possible, culturally, politically, and economically, simply because an efficient dictatorship is always harder to create. In general, people know and do their own business better, and survival and prosperity are the business of all human beings, wherever they live, whatever tongue they speak.

 

In this context, I’d like to emphasise that I have no grudge against the government, and even sympathise with their difficult situation. There’s no question, in my mind at least, that Mr. Paulson is a respectable and decent individual, that Mr. Bernanke is a brilliant economist, and that both of them have the best intentions in this very severe crisis.

 

But truth must be spoken. There’s a lot to be criticized about their actions, but time is limited, so I’ll only deal with the CPFF, and what it is doing for the economy, in this post, briefly, but hopefully also succinctly.

 

Now, we have recently seen the Fed intervening in the commercial paper market, and buying practically unlimited amounts of all sorts of CP (commercial paper), in accordance with the belief that panic in markets is causing an illogical and unjustifiable contraction in issuance. Numbers released by them show the commercial paper outstandings expanding in the last week, as the impact of the heavy hand of the government hits the market.

 

Let us consider this graphic, which shows data as of November 5th.

 

outstandings

 

 

 

It  shows outstandings, that is, the total amount of commercial paper, in different categories. What do we see here? First of all, the yellow line, which shows asset-backed commercial paper including suprime and alt-A mortgage backed paper, has been collapsing since August 2007, and its precipitous contraction was the starting bell of this crisis. The red line shows financial commercial paper, which includes paper issued by investment banks, and others, and which rang the bells for the second, panic phase of this crisis in September, with the collapse of Lehman. The third, blue line shows the issuance of non-financial corporations, like automotive firms or computer manufacturers, in other words, it shows the real economy.

 

What do we notice here? And what do we discern with respect to Federal policy?

 

In a sense, this is a typical graphic which demonstrates increased correlation  across asset classes and convergence of risk perception for different classes financial assets. We see clearly how the panic of last year has been spreading across sectors of the economy, causing financial actors to treat all counterparties in a single category of risk, and eventually inhibiting activity, and preventing ever larger parts of the economy from functioning. We also see that the changes in attitude do not occur gradually, but with leaps and bounds. In other words, people often refuse to adjust their positions to account for changes in economical data and risk perception, but rather choose to be crushed by the data, following the stampeding crowd once panic forces everyone to adjust, regardless of whether they believe or understand the changes or not.

 

So much for the efficient market hypothesis…

 

And what does it tell us further about Fed policy, how efficient, prudent, or meaningful it is?

 

First of all, a careful analysis of the data shows that the recent rapid correction in outstandings of commercial paper should not be unwelcome. The graphic clearly shows that there was an enormous bubble in financial CP outstandings in the period of 2003- 2008, and ABCP issuance in the period 2004-2007. The burst of this bubble, and the subsequent contraction in issuance is not only natural, but it is also entirely natural, and should be welcomed by every prudent regulator. There was never any financial discovery, any economical development in the US in these periods to justify the massive expansion in commercial paper issuance. The financial sector had overexpanded by speculative activity in an easy money environment, and as it, so does it’s issuance of commericial paper.

 

If this is the case, what is the Federal Reserve gaining by inflating a market which, due to the most basic tenets of free market principles, should contract? What is the Federal Reserve achieving by irrationally sustaining a market which has been exceedingly overextended in the past years, and only has to contract so that it readjust and reform itself?

 

Of course the Fed is gaining nothing, and by trying to inflate a market, which should and undoubtedly will contract in the future,  is only throwing public money away into the gutter. What the experience of the Stock market bubble, and the housing bubble of the last ten years has thought us is that it is not possible to contain or prevent the bursting of a bubble. Attempts directed to toward sustaining a bubble are usually counterproductive, and eventually increase the severity of the crisis, rather than easing it.

 

The Fed justifies its actions by citing the blue line in the graphic, and the massive rise in spreads in the period that led to its interventions. While it is true that some intervention was necessary, the swooping scoop method that the Fed has used is so indiscriminate about what it saves that it will, in the end, almost undoubtedly cause much harm to the economy, and will probably prolong the healing process, if it at all works, and I don’t think it will. We will see more collapses and more panic in the coming weeks. It will last until some firms are allowed to go bankrupt.    

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Activity in the financial markets continues to contract:

Banks have reported $687 billion of credit losses and writedowns since the start of last year as the worst U.S. housing slump since the Great Depression battered credit markets.

JPMorgan Chase & Co., the largest U.S. bank by market value, will shut down a global proprietary trading desk and shed some of the unit’s employees as the firm braces for a recession, a person familiar with the matter said.

“It’s been a very difficult trading environment,” said Jeffery Harte, a financial analyst at Sandler O’Neill & Partners in Chicago. “In the wake of that, everyone on the street is probably reevaluating capital commitments in regards to trading operations.”

Credit Suisse Group AG, Switzerland’s second-biggest bank, lost 609 million francs ($523 million) from proprietary trading, the firm said Oct. 23. The money-losing trading books will be reduced “significantly,” the firm said. Deutsche Bank AG, Germany’s largest lender, said Oct. 30 it lost 386 million euros betting on equities for the firm’s account.

Swiss Reinsurance Co., the world’s second-biggest reinsurer, posted its first loss in almost six years and suspended a share buyback program after wrong-way bets on credit-default swaps.

The third-quarter loss was 304 million Swiss francs ($259 million) after net income of 1.47 billion francs a year earlier. Swiss Re booked 289 million francs of writedowns on CDS in the third quarter, bringing losses in the past year to 2.81 billion francs.

Today’s writedown is “only the tip of the iceberg,” said Fabrizio Croce, an analyst at Kepler Capital Markets in Zurich who has a “reduce” rating on the stock.

And the contraction in the commercial real estate market is only at its beginning stages. Commercial real estate is a business that is by definition highly leveraged, and there’s no reason to think that the losses here will be less severe than in auto loans, or credit cards. While CRE is not the same as subprime, the very lax lending standards caused errors here too:

New York City commercial real estate transactions plunged 61 percent in 2008 through October as the global credit crisis roiled lending and sidelined buyers.

About $17 billion of transactions have closed so far and the market is headed for its worst year since 2004, according to data from Real Capital Analytics Inc. of New York. Sellers have made 237 deals of $5 million or more, a four-year low in a market that posted a record $51 billion in sales in 2007.

“The banks are not lending, and most of them are saying we’re done for the year,” said Scott Latham, executive vice president for New York investment sales at Cushman & Wakefield Inc., the largest closely held commercial brokerage. “In all likelihood, you will see next to no transactions between now and the end of the year.”

The office market will likely get worse in 2009 and may not improve for at least another year, said Andrew Simon, a managing director for NAI Global, a network of 325 independent commercial property brokerages.

No Rosy Outlook

“I don’t think the first half of 2009 is going to be very rosy,” said Simon. “I believe you’re talking about a year from now before you see more movement toward normalcy.”

Buyers and sellers are looking for a bottom, he said. .

Vornado Realty Trust said today the credit crisis and the slowing economy may lower profit in future quarters, while reducing the volume of real estate sales and reducing property values.

“Our existing real estate portfolio may be affected by tenant bankruptcies, store closures, lower occupancy and effective rents,” which may cut net income, Vornado said. Circuit City Stores Inc., the electronics retailer that announced 155 store closings this week, leases 12 locations from Vornado and pays $8.1 million in annual rent, Vornado said in a regulatory filing.

Global commercial sales fell 57 percent this year through August, Real Capital said in an Oct. 9 report. In the third- quarter, they fell 64 percent from the same period a year ago, according to preliminary data from the company.

In the U.S., sales have declined 72 percent this year through October, the biggest drop since the firm’s recordkeeping began in 2001, Real Capital said. Starting in 2004, property investors, fueled by cheap and abundant debt, began an unprecedented run to $514 billion of U.S. deals in 2007, said Dan Fasulo, Real Capital’s director of market analysis.

“I think it will be a while before we get to that figure again,” Fasulo said. “We’re going to do less than half of that in 2008.”

Sales involving New York real estate investor Harry Macklowe accounted for more than two- fifths of New York’s year-to-date dollar figure through October.

Macklowe paid $6 billion last year for seven Midtown skyscrapers, primarily using short term debt. His lender, Deutsche Bank AG, took control of the towers in February and sold five of them for $2.83 billion. Macklowe also sold the General Motors Building and three other buildings for $3.97 billion to Mortimer Zuckerman’s Boston Properties Inc.

Second-quarter commercial and multifamily mortgage originations tumbled 63 percent in the second quarter from the same period a year earlier, according to the Mortgage Bankers Association in Washington.

Office property loans fell 65 percent, retail property loans fell 63 percent and industrial property loans slid 57 percent, the MBA said. Loans slated for the commercial mortgage- backed securities market declined 98 percent in the second quarter from a year earlier, the group said.

And Commercial real estate activity in New York seems to be especially hard hit:

Financing of deals by so-called portfolio lenders, companies like commercial banks and life insurers that originate loans and keep them on their books, was also down. Loans by banks fell 29 percent and 27 percent for insurers, the MBA said.

The few deals being made usually require sellers to either provide financing or allow buyers to take over their existing loans, said Howard Michaels, chairman of the New York-based Carlton Group LLC, a real estate investment banking firm, which arranged the recapitalization of the GM Building for Macklowe in 2004, and Chicago’s Sears Tower in 2007.

“Most people are waiting to see how 2009 shakes out. Until then, nobody’s putting any buildings on the market unless they have to,” he said. “I don’t think that anybody would voluntarily sell into this market right now.”

Two properties remain on the market five months after they went up for sale. They are Worldwide Plaza on Eighth Avenue, a 1.7 million square-foot tower, and 1540 Broadway in Times Square, the former Bertelsmann Building. The seller of both buildings: Harry Macklowe’s lender, Deutsche Bank.

Meanwhile Fed’s balance sheet continues to grow, as it adds commercial paper to its portfolio of stocks, CMBS, MBS, bonds, and others:

The Fed’s balance sheet may expand to $3 trillion by year’s end, reflecting growth of various liquidity measures supporting banking institutions, Dallas Fed chief Richard Fisher said. As of Oct. 29, the Fed’s balance sheet was $1.97 trillion.

Still, the U.S. faces “an epic challenge,” Fisher said. “We are navigating the mother of all financial storms.” A recovery in the U.S. economy “will take time,” Fisher said in response to an audience question. “I don’t see any economic growth in 2009. None.”

Labor Department figures are expected to show a drop of 200,000 jobs in October, according to a Bloomberg News survey of economists. A report showed Oct. 3 that payrolls fell by 159,000 in September, the biggest drop in five years. The unemployment rate held at 6.1 percent, up from 5 percent as recently as April.

Commercial paper rates are falling, for now, as the Fed’s intervention brings much needed temporary relief to the market:

Interest rates on U.S. commercial paper fell to the lowest in four today. Rates on the highest-ranked 30-day commercial paper fell 0.27 percentage point to 1.74 percent, the lowest since Sept. 22, 2004. Yields on 90-day paper fell 0.06 percentage point to a three-month low of 2.62 percent.

The Fed set the rate it’s willing to accept for 90-day commercial paper at 2.6 percent, down 0.01 percentage point, including a 1 percentage point unsecured credit surcharge. The 90-day secured asset-backed rate was set at 3.6 percent, according to Fed data compiled by Bloomberg. The rates are set under the Fed’s Commercial Paper Funding Facility and are available on CPFF.

The following companies are among those that have registered with the CPFF: American Express Co.; American International Group Inc.; Chrysler Financial Corp.; Ford Motor Credit Corp.; GMAC LLC; General Electric Co.; General Electric Capital Corp.; Harley-Davidson Inc.; Kookmin Bank; Korea Development Bank; Morgan Stanley; Prudential Financial Inc. and Torchmark Corp.

Australia reduced its main rate today, and Libor continues to retreat, although it’s still at phantastically high rates compared with where it was a short time ago:

Tocday  the Libor-OIS spread narrowed 13 basis points to 210 basis points today. That still compares with 87 basis points on Sept. 12, the last working day before Lehman Brothers Holdings Inc. collapsed.

Interbank rates have tumbled worldwide as central banks slashed borrowing costs and governments pledged as much as $3 trillion of emergency funds to kickstart lending.

Australian central bank Governor Glenn Stevens lowered the overnight cash rate target to 5.25 percent from 6 percent in Sydney today, adding to last month’s 1 percentage point reduction. Fifteen of 16 economists in a Bloomberg survey forecast a half-point cut and one expected a quarter-point drop.

The European Central Bank and Bank of England are forecast to cut rates when they meet on Nov. 6.

As bankers see ongoing deleveraging everywhere:

UBS agreed last month to a $59.2 billion aid package from the government and central bank that will split off risky assets. Switzerland’s largest bank is seeking to halt client redemptions, which amounted to 83.6 billion francs at its money-management units in the third quarter.

UBS plans to transfer as much as $60 billion of debt assets to a fund backed by the Swiss National Bank, leaving it with “essentially zero” risk related to U.S. subprime, Alt-A, prime, commercial real estate and mortgage-backed securities, as well as student loan-backed securities and reference-linked notes, CEO Marcel Rohner said last month.

Since the rescue plan was announced, there have been “encouraging signs” for net new money flows, UBS Chief Financial Officer John Cryan told reporters on a conference call today.

Even so, clients may keep removing funds for some time as part of a “general trend of deleveraging,” he said. “That manifests itself in clients effectively selling investments and withdrawing proceeds to pay down debt.”

“It’s too uncertain” to give a long-term profitability outlook for the bank, Cryan said in an interview. “I don’t think any bank can say what its cost of funds is because markets aren’t standalone yet. And in an economic downturn no one knows what the revenue is going to be.”

All the news clips are gathered from Bloomberg.

The Fed has decided to buy commercial paper from firms, in another attempt to deal with the complete shutdown in financial markets. This essentially means that it is financing the day-to-day running of the US economy, and it is a positive step, as long as it is conducive to eliminating a bit of the panic and fear in the markets, but it will not address the basic insolvency and leverage issues, and will not prevent bankruptcies. From the Fed:

“For release at 9:00 a.m. EDT

The Federal Reserve Board on Tuesday announced the creation of the Commercial Paper Funding Facility (CPFF), a facility that will complement the Federal Reserve’s existing credit facilities to help provide liquidity to term funding markets. The CPFF will provide a liquidity backstop to U.S. issuers of commercial paper through a special purpose vehicle (SPV) that will purchase three-month unsecured and asset-backed commercial paper directly from eligible issuers. The Federal Reserve will provide financing to the SPV under the CPFF and will be secured by all of the assets of the SPV and, in the case of commercial paper that is not asset-backed commercial paper, by the retention of up-front fees paid by the issuers or by other forms of security acceptable to the Federal Reserve in consultation with market participants. The Treasury believes this facility is necessary to prevent substantial disruptions to the financial markets and the economy and will make a special deposit at the Federal Reserve Bank of New York in support of this facility.

The commercial paper market has been under considerable strain in recent weeks as money market mutual funds and other investors, themselves often facing liquidity pressures, have become increasingly reluctant to purchase commercial paper, especially at longer-dated maturities. As a result, the volume of outstanding commercial paper has shrunk, interest rates on longer-term commercial paper have increased significantly, and an increasingly high percentage of outstanding paper must now be refinanced each day. A large share of outstanding commercial paper is issued or sponsored by financial intermediaries, and their difficulties placing commercial paper have made it more difficult for those intermediaries to play their vital role in meeting the credit needs of businesses and households.

By eliminating much of the risk that eligible issuers will not be able to repay investors by rolling over their maturing commercial paper obligations, this facility should encourage investors to once again engage in term lending in the commercial paper market. Added investor demand should lower commercial paper rates from their current elevated levels and foster issuance of longer-term commercial paper. An improved commercial paper market will enhance the ability of financial intermediaries to accommodate the credit needs of businesses and households.”

It’s been a year since the financial crisis began in August of 2007. The February-March mini-panic of 2007 had presaged the oncoming troubles, but the crisis itself began in August, when the French bank BNP Paribas declared its inability to fairly value certain mortgage related assets. This has since been followed by a period of volatility in stock prices, currencies, bonds and other financial instruments; there have been periods of stability, and even euphoria, but it’s now clear to almost everyone that the financial markets are in a protracted period of risk aversion and deleveraging.

Almost immediately after the onset of the crisis central banks around the world intervened to make sure that the panic of financial participants did not lead to a severe withdrawal of liquidity from the real economy. Nonetheless, the true force of a credit squeeze on the real economy manifests itself with a lag of about nine to twelve months, and it’s fair to say that the world outside the US has so far suffered only modest consequences. Even in the US, the immediate impact has been moderate at worst, much better than what should have been expected in light of the severe nature of the unwinding: Commercial paper, especially ABCP, has suffered an unprecedented fall in issuance; the subprime mortgage has market all but evaporated; banks have had to recognise the losses of their off-balance sheet instruments early on, and gradually take massive write-downs as a consequence of deteriorating mortgage related assets. Libor rates also experienced far greater volatility than usual, before settling at the elevated levels of today.

Despite a number of very aggressive rate cuts by the US Federal Reserve which brought real rates to decisively inflationary levels, the markets continue to suffer from an increasing intolerance for risk. Meanwhile, consumer confidence has been suffering severely from rising unemployment, rising oil and food prices, and the generally pessimistic outlook, with house prices falling across the country, and stock prices collapsing. Home equity withdrawal is much harder, and the American consumer has since been readjusting himself to the difficulties of the new era. But so far the real economy has not been derailed as severely as some of us had expected.

This is mostly because the US government has been more than pro active in trying to avert a recession. And the rest of the world has also been growing at a healthy pace, at least until recently.

But it now seems that we are entering the period of maximal stress of the downturn.

I plan to take note of the developments in my journal.
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