Enzio's Clock

Background

1. Why the Economic Time™ is what it is

When we were in Eastern Europe, we wrote for you a piece about US yields and The Economic Time. In its first section, we gave you a brief rundown of how our Economic Clock™ works (please double click "Economic Clock '101' " so as to refresh memories.)

In said piece,  we suggested that it is the Clock's "monetary arm" that really  runs the economic cycle. In particular, we noted that "...today, however, the private sector is running the monetary arm: nobody wants to lend money...This is creating an excess demand for money..."

It might be instructive for your protection of your own money  that  we drill deeper concerning these "private sector" monetary matters: profit motives are longer-term than (monetary) policy motives!. (We work with two articles in particular: The Economist's "Blocked pipes" of 4th October 2008, p. 70-72, and the South China Morning Post's (SCMP) various articles in today's issue)

Commercial banks  include deposit-taking, retail, investment and the like, i.e. NOT the Federal Reserve and Central Banks, but banks that are privately-held either as a quoted group (say: HSBC), or as an unquoted one (say: Germany's Merck, Fink & Co., which is owned by a big Belgian group if my memory serves me).

As in any crises of this nature, roles get reversed. Since July 2007,when two Bear Sterns hedge funds started shaking because of ricochet effects from subprime mortgages

• CENTRAL BANKS started to lend massively to commercial banks, but
  
• COMMERCIAL BANKS curtailed lending to each other as well as to non-bank customers.

Just to drive this crucial point home:

• when CENTRAL BANKS create an excess demand for money, they can change that official policy in one board meeting,quickly deciding to "flood the system" with cash, but 
• when COMMERCIAL BANKS create an excess demand for money, they will change that profits policy only once their confidence has returned, i.e. once their fear has reverted back to greed - and they have to confidence (greed) to resume lending.We trace this path from an  excess demand for money to an excess supply of goods in part 4 below.

That reversion from fear back to greed will take a long time among commercial, suggesting that the Excess Demand for Money is going to accompany us for a long time. Of course, it has to magnify th nemesis of an excess supply of goods: consumers, too, revert from greed to fear... and belt-tightening starts.

In review: the Economic Time is what it is because privately-held banks won't lend, thereby creating an excess demand for money.

2. How banks fund themselves

The have four routes:

• borrowing from Central Banks, collateralized by high-quality paper
  
• deposits of customers (private and corporate)
  
• raising equity and debt, and
• borrowing from other banks in the interbank markets

Today's focus is on the third funding source: how the seizure in the interbank markets is exacerbating an excess demand for money.

 

3. Excess demand for money via  the interbank market

Having worked in the treasuries of banks, when looking at interbank funding woes, it strikes me that current problems smack of  a classical "maturity mismatch" problem: banks are borrowing short-term funds from the interbank market with which to fund long term loans.  That is a "no no" in "Risk 101"!

The result is what Walter Bagehot ascertained years ago: the Central Banks will fund the commercial banks, but these won't fund anybody -neither other banks, nor non-bank customers such as companies and consumers.

To avoid obfuscation, let's just stick with the business of banks lending to each other. 

Because banks don't want to lend to each other, here is what has happened for the past 18 months - i.e. since those two Bear Sterns related hedgies had problems:

• OFFICIAL rates, like Fed Funds, remain very low - because the Fed wants to keep supplying banks with cheap funding at the policy rate, the Fed Funds rat, but 
• INTERBANK rates keep rocketing - because banks don't want to lend to each other at very high profit rates, at rates  in the LIBOR markets.

On 29th September, i.e. way ahead of yesterday's Congressional approval of the $700 billion bail-out package, the Fed - along with the Bank of Japan, the European Central Bank the the Bank of England - engineered lending another $620 billion to banks. Interestingly, this action of nearly equal size to the Congressional $700 billion bail-out)  required absolutely no Congressional approval: it was a monetary policy decision! 

But banks lend to each other because of profit concerns, not because of policy concerns. When banks lend to each other, they do this via the interbank market. The rate that is calculated in this interbank market is calculated by surveying 16 top banks daily. The results determine the LIBOR (London Interbank Offered Rate) and the EURIBOR (Euro Interbank Offered Rate): these rates span overnight to 12 month maturities.

Virtually all debt is priced off these LIBOR rates. Indeed, according to the SCMP, LIBOR rates "...determine prices for financial contracts valued at US 393 trillion as of December 31 last year, or $60,000 for every person in the world and helps set the consumer interest rates on everything from home loans to credit cards."  I have italicized in this quotation because you see the double-barrelled effects of LIBOR rates. (I think that they are kind of the opposite to commodities: until they peaked, we saw derivatives contracts very much driving spot commodity prices; now, it is LIBOR rates very much driving all derivatives rates, along with all lending rates...)

The SCMP journalist goes on to write that "From 2004 to 2006, more than 50 percent of the US subprime mortgages ... had adjustable rates linked to LIBOR."

Of course, LIBOR also affects the price of credit card debt, something that has not even surfaced in the press. 

In closing: why don't banks want to lend/ ware they putting their money only with Central Banks such as the Fed and ECB? Why has, according to said issue of The Economist, "...the relative cost of raising money...risen sixfold in the past 18 months."?  Fear has out-sized greed. typical when the Economic Time gets this ugly and Prof. Kindleberger's crisis cycle goes into panic mode.

 

More specifically, banks won't lend to each other or to non-bank customers including consumers, because they have to keep more cash. Here are their fears:

• Scared depositors & lenders. Just watch newspaper photos of those flocks of depositors wanting to withdraw their money. Just observe the "stealth run" (said The Economist) of banks not lending to each other in the interbank markets. Both know that the coming excess supply of goods is going to result in financial Armageddon;

• Cash calls. Just like fund managers have to sell stock in order to have to cash with which to pay redemptions of unit holders, banks have to keep cash on hand in case these  depositors want their money back;
• Back-up loans. According to said Economist, "In the good times they <i.e. bank lenders: your author> promised to provide back-up loans  to companies..."
• Racing for the barn door. While the supply of credit has shrivelled, the demand for credit has swollen: individuals and corporates want to tap bank as well as bond and other debt/capital markets before they, too, shrink!

Do you  now understand why higher LIBOR rates, reflecting an excess demand for money stemming from commercial banks' profit policies, are so vital to the real economy?

 

 

 

4. How to Save Money Off This Idea

1. If you have read this far and instinctively don't know, please unsubscribe. If I have not driven you to a simple investment conclusion, stop wasting your subscription money, please. You know which sector has to be avoided at all costs to yourself, no?