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Liquidity Pump Runs Dry


Slashing rates to 1% was what created this mess. Cutting them to 1% again can hardly be the solution.


Many seem to think the Fed is pouring on the liquidity. In Critical Point, John Hussman makes a case otherwise.

Rising delinquency and foreclosure rates, which are very predictably in the early stages because the spike in mortgage resets only started in October of this year, suggesting that the real surge of delinquencies won't be seen until the first quarter of 2008, with foreclosures surging even later.

Despite hopes that the Fed can reverse these pressures, the fact is that the entire amount of "liquidity" added to the banking system by the Fed in the past four months amounts to about $15 billion (in a banking system with a thousand times that in loans and assets). On Thursday, several news stories reported that the Fed "pumped $47.25 billion of liquidity into the banking system," the highest total since September 2001 - but you'll find once again that $40.5 billion of that was pure rollovers of existing repos (which Thomson Financial noted in a news story the day before as my ballpark expectation). The rest is pre-holiday liquidity to accommodate demand for cash. Investors are deluding themselves when they count each rollover of a 3-day, 7-day or 14-day repo as new money. It's the same stuff, rolled over to retire the maturing stuff. The amount of outstanding repos is currently only about $15 billion more than its lowest 30-day average over the past year.

In Problems with Financials, Hussman states:

The FDIC notes "for the fifth quarter in a row, reserves failed to keep pace with the increase in non-current loans." If we're already seeing these signs of credit stress at the peak of an economic expansion, the figures we observe in a recession are likely to be a lot worse.

As of June 30, 2007, the net income of all FDIC insured banking institutions totaled $36.8 billion. At an annual rate, that represents about 2% of all loans outstanding. Meanwhile, net charge-offs for bad loans were already running at an annual rate of about 0.50% in June. That's in a strong economy, before the recent problems, and loan loss reserves didn't even budge from a 32-year low. Net charge offs could easily quadruple in a mild recession.

Quadruple is probably being optimistic as this is the biggest financial experiment in credit bubble blowing the world has ever seen. Even AAA rated paper is carrying significant discounts.

Bernanke's comments that the risks are balanced strikes me as somewhere between disingenuous and pure lunacy given events that are now happening at a rapid pace.

Let's take a look at a sampling of eight headlines from the last eight days.

Eight Headlines for Eight Days

Key points from Slamming On the Brakes In China (November 22):

  • China is overheating and is mandating a lending freeze to curb investment frenzy.
  • US slowdown threatens Chinese Export Growth.
  • One day after the freeze is announced a "credit heart attack" engulfs China and Korea.

Key points from European Interbank Covered Bond Trading Halted (November 21):

  • European Covered Bond Council (ECBC) suspended inter-bank market-making in covered bonds until Monday, Nov. 26 at the earliest and possibly through the end of the year.
  • The move is a sign of the stress in the covered bond market, which is dominated by German institutions that have almost a trillion euros of covered bonds outstanding.

Key points from Bankruptcy Rumors at Countrywide (November 21):

  • Countrywide (CFC) denies bankruptcy rumors and claims to have "ample liquidity" even while stating that a downgrade in its debt would affect liquidity.
  • The credit default swaps market does not agree with Countrywide about "ample liquidity."

Key points from Fannie & Freddie Clobbered Over Need to Raise Capital (November 20):

  • Freddie Mac (FRE), the nation's No. 2 buyer and guarantor of home loans, lost $2 bln in the third quarter and said Tuesday it must raise fresh capital to meet regulatory requirements.
  • Shares of Freddie Mac fell more than 26 percent.
  • Freddie Mac is "seriously considering" cutting in half its dividend in the fourth quarter and has hired Goldman Sachs (GS) and Lehman Brothers (LEH) as financial advisers to help it examine possible new ways of raising capital in the near future.
  • Similar concerns are raised about Fannie Mae (FNM).

Key points from Broken Deals Aplenty (November 20):

  • United Rentals Inc. (URI) filed a lawsuit seeking to force Cerberus Capital Management LP to complete its $4 bln leveraged buyout of the equipment rental company.
  • Cerberus pulled its takeover offer of $34.50 per share, a move that sent the rental company's stock down 31% on the day.
  • Cerberus is citing uncertainty in the credit and financing markets as a reason for backing out.

Key points from Credit Woes at GM, Cerberus, and Residential Capital (November 19):

  • As much as $16 billion in ResCap bonds are in the process of blowing up.
  • Professor Fil Zucchi pointed out "the problem does not necessarily lie in a RESCAP bankruptcy filing and the consequent restructuring of its $16 bln in debt, but in the payouts on its CDs should the bonds default. That payout is probably multiples of the $16 bln in debt face-value and someone out there is on the hook for it as we speak."

Key points from Bank Borrowing Costs Rise (November 17):

  • The cost of credit is going up for banks as corporate bond yields for financial institutions rise above industrial companies.
  • Investors are demanding extra compensation for the risk of owning Citigroup (C), Merrill Lynch (MER) and Barclay's (BCS) on concern that the $50 billion in losses already reported from subprime mortgages will increase.
  • The total damage may reach $400 billion worldwide, Deutsche Bank AG analysts said in a report.
  • Wells Fargo (WFC) Chief Executive Officer John Stumpf said the housing market is the worst since the Great Depression.

Key points from GE's "enhanced" cash fund breaks the buck (November 15):

  • Bank of America (BAC), Wachovia (WB), and Legg Mason (LM) all injected cash to prop up money market funds caught up in the SIV asset backed commercial paper mess.
  • A short term institutional bond fund run by General Electric (GE) (not a money market fund) decides to break the buck. Assets are worth 96 cents on the dollar.
  • GE made an extra .1%+- or so for three years (.3%+- total) and now will back 4% in one fell swoop.

Whether or not one believes the Fed is pouring on liquidity, whatever it is doing (mostly yapping nonsense about risks being balanced while proving otherwise by cutting the Fed Funds rate) sure is not working.

50 basis points in interest rate cuts and an additional 25 basis point cut in the discount rate have not helped. I am willing to bet that further cuts of another 100 basis points will not help either. Slashing rates to 1% was what created this mess. Cutting them to 1% again can hardly be the solution.

It will be interesting to watch how fast Bernanke fires his blanks.

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