It is now clear that the US and global financial markets are experiencing their worst financial crisis since the Great Depression. And in spite of desperate and radical actions by the Fed this crisis is getting worse. A brief equity rally after the rescue of Bear Stearns, the 75bps Fed Funds and the announcement of new radical and unorthodox lending facilities (allowing non bank primary dealers access to the Fed discount window) has already completely fizzled today with US equities plunging over 2% while the severe crunch in money markets and credit market is becoming much worse.
Let me now flesh out how the crisis is becoming more severe and increasing the risk of the mother of all financial meltdowns…
First note that in spite of the most radical change in Fed policy since the Great Depression – i.e. the extension of the Fed’s lender of last resort support to non bank primary dealers and the announced swap of up to $400 bn of safe Treasuries for toxic agency and private label MBS again make available also to non bank primary dealers – the panic in money markets and interbank markets is now seriously worsening: today the yield on 3 month Treasuries plunged to 0.56, a level not seen since the 1950s; the TED spread (the difference between dollar Libor and 3 month T-bills) increased 32 basis points to 1.98 percentage points; swap spreads widened again; while the VIX spiked to a level close to 30; even off-the-run long dated Treasuries are becoming illiquid (as in the 1998 LTCM crisis). The situation in money markets is scary as there is a generalized flight to safety with investors avoiding everything but the most liquid and safe government bonds.
In the meanwhile the liquidity and credit crunch in the agency debt and MBS market is worsening in spite of all the Fed recent easing actions and in spite of the Fed decision to swap Treasuries for hundreds of billions of agency and private label MBS: the difference in yields for Fannie Mae's current-coupon, 30-year fixed-rate mortgage bonds and 10- year government notes widened again both yesterday and today. So the radical decision of the Fed to prop the agency and non-agency MBS market with $400 bn of swaps has done very little to affect the liquidity and spreads of these markets. This is no wonder as Fannie and Freddie are – on a mark to market basis – effectively insolvent and the widening in their debt and MBS spreads reflect the worsening credit outlook for their assets, not just a situation of illiquidity.
Today we are facing a massive margin call on highly leveraged US capital markets and a massive de-leveraging of the financial system following fire sales of marked to market assets in vastly illiquid money markets, credit markets and derivatives markets. We are thus close to the last steps of my 12 Steps to a Financial Disaster. Each of these 12 steps is now underway and the only question is not whether such steps will take place but rather how severe they will be and how big the losses will be. We are now observing – with the Bear Stearns episode as well as with the collapse of the SIVs, the losses on money market funds and the collapse of hedge funds and highly leveraged funds – the beginning of a generalized run on the shadow financial system.
And - as discussed in my 12 Steps to a Financial Disaster - the financial losses are now spreading from subprime to near prime and prime mortgages, to commercial real estate loans, to consumer debt (credit cards, auto loans, student loans), to leveraged loans, to muni bonds and writedowns from the impairment of the monolines' insurance, to corporate loans and bonds whose defaults will surge soon, to the massive losses in the CDS markets.
The Fed response to this run has been to provide the Bear Stearns bailout and provide both liquidity and swap of illiquid and toxic assets for safe Treasuries to the non-bank primary dealers. But these radical and risky actions of the Fed - as the collateral for this lending is now toxic – are not achieving their goals: in the short run the risk of a run on a Lehman may have been reduced; but what is happening in the money markets and in the agency markets shows that the Fed can only affect partially liquidity premia, not credit premia; and spreads are widening for a wide range of money markets and credit markets because of widening credit spreads driven by sharply rising counterparty risk.
The lack of trust of financial institutions in their counterparties is surging in spite of all the Fed actions as panic is setting in money markets and credit markets. Thus, providing access to a dozen broker dealers who are primary dealers does nothing to ease the credit risk and liquidity/rollover risk of thousands of US and global institutions that are part of the shadow financial system. In a mark to market world many of these highly leveraged institutions – including large broker dealers other than Bear Stearns – are effectively bankrupt and no Fed action can rescue them. And the run on the shadow financial system has barely started.
Claiming the Bear Stearns was not bailed out because the current shareholders got only $2 per share is disingenuous: this was a massive bailout as the Fed put $30 billion of cheap credits in the pot: without this massive financial support not only the shareholders would have been wiped out 100% as they deserved to (rather than keeping the option value that the government support will recover in due time the value of their shares); but also many of the creditors of Bear Stearns would have experienced massive losses as Bear was insolvent and unable to pay such creditors with its impaired assets. Instead the $30 bn Fed support represents a major subsidy for JPMorgan and a major bailout of Bear’s creditors.
Effectively the Fed has taken on its balance sheet the entire credit risk of $30 of toxic securities held by Bear Stearns. So, this Fed bail out is an explicit case of using the disastrous Japanese model of a “convoy system” (healthier banks taking over zombie banks with the help of lots of public money) that led to a decade of economic and financial stagnation. A market solution to this crisis does not exist; those who believe in such markets solutions are deluding themselves as markets left alone will melt down and enter into the mother of all meltdowns, margin calls, cascading collapse of asset prices, massive credit crunch and liquidity seizure and severe economic recession.
We are facing now the risk of the mother of all financial crises and meltdowns. Moral hazard can be realistically address by wiping out reckless investors and lenders, having the government buying assets that need to be restructured at low prices closer to their fundamental value and limiting the mortgage debt reduction to truly deserving borrowers who were victims of predatory lending practices. But radical and coherent policy action needs to be taken urgently and without further delay as there is now the risk that the US will experience its most severe recession in decades and that the US and global financial system may melt down.
I will flesh out in more detail in the near future the logic and specific elements of this radical plan to resolve this most severe and dangerous financial crisis.