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Tuesday, September 30, 2008


central banks crowding out interbank lending

via barry ritholtz -- the record quote for LIBOR is all but fiction, however high, as no one is lending to anyone. the rate is an irrelevant. central banks are the lender of first, last and only resort.

"The money markets have completely broken down, with no trading taking place at all. There is no market any more. Central banks are the only providers of cash to the market, no-one else is lending.''

-Christoph Rieger, a fixed- income strategist, Dresdner Kleinwort.

the commercial paper market is seizing up as well as money is getting scarce -- see china's withdrawal of short-term funding from american banks -- and this is extremely bad news if it lasts for any length of time.

The CP market not functioning is a big deal. What is surprising is that it is continuing not to function. The big buyers of CP are money market funds (corporate treasurers are also major players). The backstop to the money market funds last week should have taken care of this problem. Clearly it hasn't.

in the cited london times article from friday:

Industrial and commercial companies outside the financial sector have been caught out by the sudden drying-up of investor appetite for commercial paper (CP), the standard way for large companies to borrow for a few days to a few months.

this adds stress to the banks as corporations draw on backup facilities to make up for the CP they can't sell.

in short -- central bank liquidity -- which has gone well beyond enormous -- is becoming a problem, as was noted in the ft last week and relayed by naked capitalism.

It looks like central banks are worried that the only thing keeping banks up now is the fragile commercial paper market, which banks have been desperately tapping in the past few days as a source of overnight funding.

Liquidity is being thrown at the system, but it’s just making things worse.

By pumping in more money central banks aren’t addressing the fundamental concerns of the banks at all. Going cold turkey is a very unpleasant thing, but the solution isn’t more drugs, even if they alleviate short term pain.

In assuming they can rely on central bank money market operations - which will be expanded (as is the case) when the going gets tough - banks are naturally avoiding lending to each other.

solvency has become a monster problem in light of the lehman and washington mutual collapses, each of which surprisingly revealed that there was not capital enough in liquidation to pay out even senior bondholders. the revelation, in combination with access to central bank lines, has killed both interbank lending and private recapitalization of banks. instead, central bank lending is crowding out all other forms of financing for banks. and this may get even worse as the fed moves to pay interest on reserves, as noted by a reader of yves smith:

This is one of the things I have heard being discussed, although I can see the law of unintended consequences coming into play here: if anything, the way I see it, it makes matters worse, as banks with excess reserves are less likely to lend them if they can earn interest at the Fed.

so extensive has fed lending become that the fed itself, though rightfully nervous of taking on credit risk by lending so much to so many banks against suspect collateral, is becoming illiquid. more from brad setser:

Right now, the US is relying a bit too heavily on the Fed to keep this crisis from spiraling truly out of control. That avoids hard political choices –notably hard choices about how best to recapitalize the financial system — but it also creates some long-term risks for the Fed.

the paulson TARP was, in some sense, perhaps designed to relieve the fed from this role. its failure at the hands of john mccain and house republicans in a belated attempt at populist vote-grabbing has thrown that plan into question for the time being. without such a program, it's questionable how banks could be weaned from the central bank teat -- and further how the inevitable bank failures would not compromise the fed's balance sheet.

funding concerns are particularly acute today, the quarter-end. there will probably be some relief tomorrow, but pressure continues to ramp up in the most important markets in the world.

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