Globally Contained Liquidity Crunch

In Sudden Demand For Cash we discussed Major Liquidity problems in the ECB.

The European Central Bank, in an unprecedented response to a sudden demand for cash from banks roiled by the subprime mortgage collapse in the U.S., loaned 94.8 billion euros ($130 billion) to assuage a credit crunch.

Intervention on that scale had not been seen since the aftermath of the terrorist attacks on New York in 2001.

"This liquidity-providing fine-tuning operation aims to assure orderly conditions in the euro money market. The ECB intends to allot 100 per cent of the bids it receives," the central bank said.

US Liquidity Crunch

But the liquidity crunch was not contained to the EU. The Herald Tribune reported Fears about a U.S. liquidity crunch roil markets.

During a "liquidity crisis," the big banks get nervous about risk and become more cautious about doing deals and making trades. They're less likely to extend the easy credit that has fueled the economy in the past few years, and that makes it more difficult to match buyers with sellers. That is what happened to markets around the world Thursday.

The fallout from a liquidity crunch causes a ripple effect. The most immediate impact is that loans could become harder to get. But troubles can spread to the wider economy, hurting peoples' investments and endangering their long-term financial plans. If banks are not lending and no one will extend credit to anyone else, markets seize up and economic growth disappears.

Major financial institutions can absorb hefty losses without toppling. However, liquidity concerns cause institutions to become reluctant to lend money to other banks. Loans between banks on an overnight basis, one of the primary ways they fund their operations, have become more expensive as concerns arise about their ability to repay the loans — and that forces costs up.

In addition, banks also bring debt offerings to the market on behalf of their clients. But, if investors are reluctant to buy them, many times the banks will be left holding the debt.

Q. What did the big government banks do on Thursday to ease the problem?

A. The U.S. Federal Reserve pumped $24 billion (€17.48 billion) into the U.S. banking system. Meanwhile, The European Central Bank made a record cash injection of $130 billion (€94.69 billion) into its markets to increase liquidity and shake off credit fears.

Canada to Provide Liquidity

Bloomberg reported the Bank of Canada to 'provide liquidity'.

The Bank of Canada said it will "provide liquidity'' to support financial markets after the European Central Bank loaned money to ease a credit crunch that started with the U.S. subprime mortgage collapse.

The central bank will "support the stability of the Canadian financial system and the continued functioning of financial markets,'' the bank said today from Ottawa in a statement on its Web site, without disclosing a specific course of action.

The benchmark London interbank offered rate for overnight loans between banks in Canadian dollars rose to 4.74 percent today from yesterday's 4.53 percent, mirroring increases in rates for loans in euros and U.S. dollars. The Bank of Canada's target rate for overnight loans between banks is 4.5 percent.

Japan, Australia, South Korea, and Singapore

Canada's actions were rather mild compared to elsewhere. But liquidity concerns were not contained to the Western Hemisphere as Asia central banks join bid to calm money markets.

Central banks from Tokyo to Sydney injected extra cash into banking systems or pledged to do so on Friday, as Asia joined a global campaign by monetary authorities to calm panicky credit markets.

"What the central banks are doing is a concerted effort to inject liquidity. And the worrying thing is that they do that when the system is not functioning the way it should," said Jimmy Koh, a currency strategist at United Overseas Bank.

The moves came after the European Central Bank injected record amounts of cash to prevent a financial system seizure after European banks essentially stopped providing short-term funds to one another on Thursday. The U.S. Federal Reserve also injected cash on a smaller scale.

The bank for the world's second-largest economy offered to supply 1.0 trillion yen ($8.45 billion) in funds. Traders said the amount was at the higher end of market expectations, but was not a major surprise.

The Reserve Bank of Australia (RBA) on Friday added more than twice the usual amount of money into the banking system, injecting A$4.95 billion ($4.19 billion) in its regular morning money market operation.

Elsewhere in the region, central banks pledged to open the tap on additional liquidity on the first signs of a seizure in money markets.

Liquidity Issues and Deflation

This question about deflation came up on my blog.

Q: "Ok, I have a question. The hedgies use leverage, make a wrong bet, and owe people money they do not have. The ECB loans out 130 billion spanking brand new dollars (Euros) to pay these people. How exactly is this brand new money deflationary?"

A: For starters there was no brand new money created by these central bank actions. There were, however, huge emergency repos but those are temporary loans. What happened is that banks fearing a need for capital would not lend money to each other like they normally would. This caused overnight rates to shoot sky high.

In the US, the Fed foolishly defends an interest rate target as does the ECB. To defend that interest rate target, repos or reverse repos (draining money) are used to keep the rates where the Fed / ECB wants them. Of course neither the Fed or the ECB has any real idea where interest rates should be and that is one of the reasons we are in the mess we are in.

At any rate, the money (credit really) the hedgies lost is in money (credit) heaven. It wasn't magically brought back by the ECB's or the Fed's open market operations. Those open market operations can help keep the interbank payment system afloat (at least for a while), but it can't persuade any new borrowers to borrow and it can't fix anyone's losses.

The ECB's Weber stated things incorrectly back on February 8 as I noted in Sudden Demand For Cash :

Weber: European Central Bank council member Axel Weber said investors shouldn't expect central banks to bail them out in the event of an "abrupt" drop in financial markets. "If you misprice risk, don't come looking to us for liquidity assistance."

The market came looking for "liquidity assistance" and got it in a flash. The Fed's Poole stated matters correctly.

Poole: "The Fed can provide liquidity support but not capital".

And that is what has transpired so far. There was no capital created in these operations, and even had the Fed done a coupon pass (created money), it would have been lent out not handed out.

It is the destruction of credit that is the deflationary phenomenon and that is happening at an increasing pace. It would happen at a far quicker pace if things were marked to market.

Credit Crunch Not Going Away

Once again Mr. Practical (aka Professor Succo) was right on top of things with a good explanation of what is happening in his article Credit Crunch Not Going Away.

Last night the European Central Bank issued a statement promising plenty of liquidity to banks. The Fed arranged a very large $24 bln in repos this morning, trying to get fresh credit in the hands of banks to deal with their current commitments. Even the Bank of Canada issued the same statement.

But all this misses the problem. The theory is flawed. Central banks promising new credit to strapped banks only helps them with their current problems. It will not get new credit into a system that can't take anymore. Banks, given their situation, are reducing drastically their new commitments, as they should. Borrowers can't afford to borrow more.

Sooner or later the market will realize that this is a credit crunch. We have not seen a real credit crunch since 1973. Go back to your history books to witness what a credit crunch does to asset prices. Pure and simple, when the borrowing dries up, there is no "money" to buy assets.

This is a process that is likely to take years to correct. It will not be a pretty process as debt gets destroyed (foreclosures) until enough of these excesses get wiped away to start anew. It was all caused by too-easy credit for too long by a Central bank not willing to let the market itself handle the allocation of capital. It insisted on providing credit cheaply when the market didn't deserve it.

So U.S. consumers have lived beyond their means for too long. They have wasted away their savings and are now in too much debt. Pure and simple

If you're not reading Professor Succo, Mr. Practical, Kevin Depew's daily dose of "Five Things", Bennet Sedacca, Jeff Macke, Greg Weldon, Jeffrey Cooper, (among many others) you are missing out.

In regards to the globally contained liquidity crunch, this statement by Mr. Practical sums it up nicely: Pure and simple, when the borrowing dries up, there is no "money" to buy assets.

Countless times over the past year I have been told that "Banks will always be ready to lend" ... "Consumers will be always be ready to borrow." ... "The US is nothing like Japan". Those theories have now (finally) been blown out of the water. Credit has dried up so fast that 46 IPOs have been pulled since June 22 (none were pulled last year), and all but prime borrowers are struggling to get mortgages, with many mortgage products totally removed. Fear has spread so much that banks are even afraid to lend to each other. The only missing ingredient now is duration. I believe it's coming.

By the way the Fed issued this statement just this morning: The Federal Reserve is providing liquidity to facilitate the orderly functioning of financial markets.

The Federal Reserve will provide reserves as necessary through open market operations to promote trading in the federal funds market at rates close to the Federal Open Market Committee's target rate of 5-1/4 percent. In current circumstances, depository institutions may experience unusual funding needs because of dislocations in money and credit markets. As always, the discount window is available as a source of funding.

The Fed statement today shows there are unusual funding needs. How enlightening. But here are a few things to remember about those funding needs.

• The Fed and ECB can provide liquidity support but not capital.
• That liquidity is primarily needed for prior obligations and prior commitments. As a result you can kiss future growth of IPOs, stock buybacks funded by debt, and mergers and acquisitions, goodbye.
• There is little desire anywhere (globally) to take on more debt or excessive risk.
  
• As asset prices sink the ability to pay back existing loans is going to get harder and harder.
• Bankruptcies and foreclosures will continue to soar. That's what happens in a liquidity crunch.
• Expect to see lots more hedge funds and lenders blow up too, and not just in the US.

The liquidity crunch is now globally contained.

One last thing: By providing emergency liquidity all the Fed is really doing is defending an interest rate target. It was the Fed defending interest rate targets way back when (say all the way down to 1%) that helped create this mess. If defending interest rate targets is the problem (and it indeed is) then defending interest rate targets cannot be the solution. It's time to abolish the Fed.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/