While everyone is focused on what the Fed will or won’t do on December 11, a far more significant event is happening right now: Lenders are Rapidly Tightening the Flow of Credit.
Credit flowing to American companies is drying up at a pace not seen in decades, threatening the creation of jobs and the expansion of businesses, while intensifying worries that the economy may be headed for recession.
The combined value of two leading sources of credit — outstanding commercial and industrial bank loans, and short-term loans known as commercial paper — peaked at about $3.3 trillion in August, according to data from the Federal Reserve. By mid-November, such credit was down to $3 trillion, a drop of nearly 9 percent.
Not once in the years since the Fed began tracking such numbers in 1973 has this artery of finance constricted so rapidly. Smaller declines preceded three recessions going back to 1975; at other times such declines tended to occur in conjunction with an economic downturn.
While the amateurs are pouring over every word the Fed says on interest rates policy as if any of it could be believed, the pros are watching LIBOR. In case you missed it Professor Depew addressed the question Why Should You Care About LIBOR? on November 16.
In a nutshell, LIBOR is about bank to bank willingness to lend. Increasing LIBOR rates show decreasing willingness to lend and/or an inability to lend (a lack of cash).
For more on the lack of cash theme, please see Where’s the Cash?
With all the above in mind it should not be a shock to see LIBOR rising given that credit is contracting at the fastest rate ever going all the way back to 1973.
But it’s not really the rate itself, but the spread between LIBOR and the Fed Funds Rate that shows stress. I talked about this idea on November 26 in LIBOR Rates Show Stress.
Here is a chart from that post.
click on chart for a sharper image
My comments on November 26 were as follows.
Six months ago the spread between the 1 month LIBOR and the Fed Funds Rate was a mere 7 basis points. The spread between the 3 month LIBOR and the Fed Funds Rate was a mere 11 basis points.
Today, the spreads are 30 basis points and 55 basis points respectively. They are also headed the wrong way compared to a month ago.
This is a sign that banks are reluctant to lend overnight to one another. They are holding onto to cash and treasuries which is driving up costs of overnight lending. Real cash is in short supply.
November 29 LIBOR
click on chart for a sharper image
The 1 month and 3 months spreads to the Fed Funds Rate are now 72 basis points and 62 basis points respectively with the yield on the 1 month higher the three month.
Inquiring minds may be asking “If LIBOR showed stress at 30 basis points what does 72 basis points show?” The answer is increasing risk of a major bank failure or major market dislocation.
As long as LIBOR stays elevated, this market is at extreme risk.
Dollar & Euro LIBOR Spreads
The LIBOR issue goes beyond the US.
In fact, it is worse in Europe as the following chart from the Financial Times shows.
That chart is now a few days old and LIBOR is higher today, however a quick glance is all it should take to see a nice correlation between LIBOR and stock market action. Right now, either LIBOR is wrong or the stock market is wrong because it is highly unlikely that the stock market keeps shooting up along with the recent increase in LIBOR spreads.
Text from the Financial Time article is interesting. It shows how twisted financial thought became.
The feverish financial innovation seen this decade has enabled banks to turn corporate and consumer loans into securities that have then been sold all over the world. Until recently it was presumed that this innovation had made banks stronger than before, because they had passed credit risk on to others.
Consequently, regulators and investors tended to presume that the main threats to stability in the modern financial world came not from banks but risk-loving players such as hedge funds. Recent events have, however, turned these assumptions on their head.
Instead, share prices of the banking groups have slid as it became clear that banks had offloaded less risk from their books as investors and regulators had presumed.
When the credit crisis first emerged this summer, many economists initially thought it would have limited impact on US growth. Some cited parallels with the events of 1998 surrounding Long Term Capital Management, a hedge fund that imploded: that an event shocked Wall Street but barely affected the wider American economy, let alone that of the world.
But it is now clear that the 2007 credit shock has implications that extend well beyond hedge funds or Wall Street. As the credit losses pile up, the banks’ capital resources are being squeezed – and that is forcing them to cut lending, particularly to riskier companies and consumers.
It is simply impossible for every player to offload risk, especially when risk was so embraced with leverage as it has been. Greenspan pounded the table on the virtues of offloading risk, but the miracle never came. In fact, the opposite has happened and as a result the entire financial system is at risk.
Long Range Affects Of Raining Liquidity
I happened to stumble on something that Professor Succo wrote in a buzz on 12/28/2006 that is very pertinent to this discussion:
As central banks rain liquidity (credit) down on markets, its long range effects eventually cause the very thing central banks are trying to avoid: deflation. The reason people don’t understand this is that it is cumulative; the accumulation of debt is in itself inflationary, but at a certain point it becomes unmanageable. Why is this?
Easy or free money (when central banks drive real interest rates below inflation rates) is irresistible. It wouldn’t be if people managed risk properly but they do not. Easy money causes competition for “projects” to increase; companies with free money take risk with it for less and less return. I am seeing deals getting done in LBO land and commercial real estate being built using very aggressive assumptions and low cap rates. With all that “money” out there, rates of return drops dramatically. Everyone is starved for income.
At the very time income and returns are dropping, debt is increasing. Less income with more debt means that eventually it gets impossible to service that debt.
Well here we are. It has become impossible to service that debt. Massively rising foreclosures in the residential sector should be proof enough. And the downturn in commercial real estate has just started. Bank capital is severely impacted already and supposedly we are not even in a recession yet. We soon will be and watch what happens to unemployment rates and additional credit impairments when we do.
The problems are now so huge that it does not matter what the Fed does with interest rates. Asset prices are dropping like a rock even though the stock market has not yet gone down for the count. With the enormous leverage in the system, credit and capital is being destroyed at a very fast clip and it will be destroyed at an even faster clip once the stock market and corporate bond market head south in a major way. Both will.
A key point in this mess is the Fed cannot provide capital (drop money out of helicopters) all it can do is provide liquidity. However, liquidity is not the problem here, solvency is.
Mike Shedlock / Mish
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