Wednesday, March 26, 2008

Is the latest liquidity crunch in remission?

(Naked Capitalism) CR at Calculated Risk yesterday pointed to an important sign of improving conditions in the credit markets. The fever chart of the so-called third wave of the liquidity crunch, the TED spread, showed signs of improvement. The TED is difference between the interest on three month Treasuries and Libor; the earlier acute episodes were August-September and November-December.

The Financial Times today, in "Hoarding by banks stokes fears on credit crisis, reads the tea leaves differently, finding evidence that banks are still hoarding cash. The two views aren't necessarily incompatible; we could be past the most acute phase of the current liquidity squeeze, but not see as rapid or even as much improvement as in past episodes. And, as Paul Krugman pointed out, the fact that more central bank firepower aimed at the problem each time is producing less in the way of results is worrisome.

From the Financial Times:
Central banks’ efforts to ease strains in the money markets are failing to stop financial institutions from hoarding cash, stoking fears that the recent respite in equity markets may not signal the end of the credit crisis.

Banks’ borrowing costs – a sign of their willingness to lend to each other – in the US, eurozone and the UK rose again even after the Federal Reserve’s unprecedented activity in lending to retail and investment banks against weaker than usual collateral and similar action in Europe....

In London, where the Bank of England has faced criticism for not being as proactive as other central banks, the three-month Libor rate was set on Tuesday at 5.995 per cent, its highest of the year. This is nearly 0.9 percentage points above the level investors demand for risk-free money, a spread nearly as high as that which led to central bank interventions in September and December.

The European Central Bank allocated €216bn ($337bn) in seven-day funds in its regular weekly operation on Tuesday – some €50bn higher than the amount it estimated would have normally been needed – at an average rate of 4.28 per cent, which was the highest since late September.

The Fed’s latest lending to banks under its Term Auction Facility was also in heavy demand, receiving bids for $88.9bn compared with the $50bn on offer, an excess of demand almost as great as the previous auction two weeks ago, before the collapse of Bear Stearns.

Accrued Interest gives an explanation of why the credit markets aren't getting better: it's the balance sheet damage, which has put the kibosh on normal bottom fishing and speculation. Like CR, however, he thinks recent improvements have the potential to become self-reinforcing, leading more investors back into the pool:
Right now we have two major themes in the credit markets. The first is a real economy recession, with a very weak housing market at its epicenter. The second is a battered financial sector, where strained capital and fear of spiraling contagion has caused a dearth of liquidity.

A real economy recession should legitimately cause the price of taking risk to rise. In the case of mortgage-related credit risk, for instance the ABX index, prices should obviously be drastically lower. This is the kind of risk pricing that capital markets can handle. In fact, that kind of risk pricing is exactly why capital markets are an important part of our free-market system. We need a market where various risks are correctly priced, as this helps to channel capital to areas where it is most needed.

But the second major theme is interfering with the market's ability to properly price risks. Potential buyers of risk, from hedge funds to banks to broker/dealers, became overextended during the credit bull market and now need to repair their their own balance sheets....

As a result, classic investment analysis, pouring over 10K's and analyzing cash flows, has not been a winning strategy. Until very recently, investors who dabbled in anything that looked fundamentally "cheap" got burned. Sector after sector suffered historic spread widening amidst persistent forced selling. This created a negative feedback loop, as real money investors sit on the sidelines waiting for some semblance of calm before putting their cash to work.

The never few weeks will test whether that negative feedback loop has broken. Municipal yields have been falling. 10-year Fannie Mae debt spreads have dropped about 35bps since Friday, and are now as tight as they've been since early February. Agency MBS spreads are about where they were at the beginning of March. Brokerage CDS are actually tighter month-to-date.

This is important because it means that there are investors who bought good bonds on recent dips and enjoyed good results. This is what it will take to break the negative feedback loop in the bond market.

I wish I could be so optimistic. I look at the ability to pay of the underlying borrowers, and the prospects are pretty poor independent of a recession. We have a large number of subprime ARM resets this year, followed by a not-quite-so-high but still pretty impressive level of Alt-A and option ARM resets through 2011. Many of these borrowers simply cannot afford the payments once the mortgages reset, and marginal borrowers are far more willing to walk than in the past if they have little or negative equity in the house. So the credit markets face a continuing deterioration of the underlying paper.

The housing market will look like a slow-draining bathtub for at least the next couple of years, with defaults and foreclosures likely to exceed new purchases. The unsold inventory will take a long time to recede to normal levels. And until the bottom in housing is visible, no one can be certain how bad the credit losses will be. We are so far outside any historical patterns that forecasts have become exercises in creative writing.

Reader Jeff sent along this cheery view from Ken Murray of Blue Planet Investing (the whole post is worth reading):
The current situation in the US banking market is without precedent. Never before in a time of near full employment and record corporate profitability have we seen such huge levels of bad debts. By our own estimates bad debts in the US banking market are likely to rise to somewhere in the order of $300bn to $450bn. Other estimates set the figure much higher. This is important because the bad debts that have been incurred so far are entirely due to poor underwriting as opposed to a downturn in economic activity. However, a downturn in economic activity is now occurring and, if the US economy is heading for recession as we forecast in 2007, it will give rise to a huge layer of additional bad debts. One that it simply cannot shoulder. It is perfectly conceivable that bad debts may rise to somewhere in the order of $500bn. To put the scale of these losses into perspective the total equity of the US’s top 100 banks stood at $800bn at the end of the third quarter 2007. Losses of $500bn would wipe out 63% of their capital bases and leave many of them insolvent.

To put it mildly, that doesn't exactly point to a lasting recovery in the credit markets.

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