What This Central Bank Plan Means

[Extradry Martini]

I thought it might be worth telling you guys what this concerted central bank action is all about, as very few people (especially financial journalists!) seem to understand it.

Firstly, the plan marks an important change in attitude by the central banks – especially by the BoE. They are no longer pompously lecturing everybody about moral hazard while allowing the financial system to collapse (and, additionally in the case of the BoE, pompously lecturing everybody about moral hazard 24 hours before bailing out the worst run bank in the UK), but have realised the seriousness of the situation and have realised that things need to be done about it. However, the plan only helps in a small way and is no fix for the problem, nor are the central banks claiming that it is.

So what, exactly, are they doing? Essentially, as the text of the Fed statement says, they are helping banks finance themselves over the turn of year. There was a great risk that some banks would not be able to find even overnight funding at the turn (i.e. suffer the same fate as NR) and the fact that the central banks will lend to them against a wide range of collateral should prevent this happening. Additionally, the currency swap agreements allow banks to borrow in other currencies from their domestic central bank. This means that a European bank without a US branch can borrow USD directly from the ECB, who then borrows the USD from the Fed and lends them EUR in return (i.e. as collateral).

What this doesn’t do is fix the underlying problem. The inter-bank money market is dry not because (as some - badly-informed - people believe) the banks do not trust each other, but because banks are unable to lend because they have limits on how large their balance sheets can be compared to their capital. The reason the banks are at their limits is that they have had to lend to all the conduits and SIVs they set up: mostly under stand-by credit facilities set up at inception, but in some cases taking the assets of the conduits or the conduits themselves on their own balance sheet. Unfortunately for the banks, lending assets as collateral in repurchase agreements does not remove those assets from their balance sheets - which means that the banks will still not be lending to each other.

An interesting feature of the central bank lending facilities is that the minimum bid accepted for money will be the prevailing OIS rate in the market for that lending period. As I have explained in other threads, an OIS (overnight index swap) is the exchange of a fixed rate for all the compounded overnight rates in the period, so represents the expected compounded central bank rates over the period. In most markets (with the exception of EUR), people believe that the central bank will be cutting rates again soon, so the OIS rate is below the current official base rate. This means that there is the potential for banks to be borrowing money under these facilities at a rate below the central bank base rate. More importantly, however, it demonstrates that banks are not being “penalised” for using the facilities as they were in previous measures set up by central banks.

I think I need to underline how serious this problem is because most people have no idea. I’m not just talking about the man on the street, I include most market professionals in that. Actually, I have been shocked not only by the ignorance of many market professionals, but by the fact they haven’t even been bothered to try to understand what is going on. Very few people I have spoken to who work outside of the money market itself or its derivatives markets (e.g. interest rate swaps) understand the problem, despite it impacting their businesses hard and despite having had 4 months to find out. OK: What is happening is that the heart of the financial system is no longer functioning. Put simply, if banks cannot lend money, the whole economy grinds to a halt. This failure of the money market has not happened since the Great Depression, and while this does not mean we are necessarily heading for a similar downturn (though that outcome has a far higher probability than most people realise), all other financial crises since that one pale in comparison to what is happening now. Certainly in the 20 years I have been working in these markets there has not been anything in any asset class with remotely this kind of scope (both breadth and depth), nor has there been anything with more potential to trigger a deep economic downturn than this.

So, how can it be fixed? Ultimately, these assets need to be taken off the banks balance sheets and free them – either by writing them down to their true value or by selling them and then re-capitalising. However, both of these options require finding out what that “true value” is. In the case of mortgages normally, one would make some kind of estimate based on past default rates, maybe taking into account the point in the business cycle. However, that process is actually the cause the problem itself: In the past, people did their due diligence on borrowers, and recently they haven’t meaning that past statistical default rates are no longer valid. So, in order to find out a true value for these securities we have to wait until a large proportion of those going to default have done so, their houses repossessed and sold in auction. This not applies to the US but to the UK and Europe as well, so could take up to a couple of years.

In the meantime, current estimates of bank losses (around $300bn) are being based on assumptions of recovery rates which may well be way off the mark. The way to think of it is this: Imagine a typical US sub-prime borrower who has been lent money with no questions asked. Imagine the kind of area in which he lives and then imagine how many other sub-prime mortgage holders there are in the area. Next, think of several of these house being auctioned at once. Who are the potential buyers? Only other sub-prime borrowers - but sub-prime borrowers are no longer being lent money, so no buyers. Extend this to the UK, Spain, Australia, Netherlands (whose housing bubbles were/are larger by far than the US), and you get the picture of not only what might happen to real estate prices, but also the resulting extent of potential bank write-downs.

After all of this is done, the banks will need to issue more shares to raise capital (as UBS has done with GIC of Singapore) to start doing business again. However, they will be smaller banks than they once were, meaning that there will be a lot less money being lent for a long time. A lot less money means that we are unlikely to see real estate bubbles like the one we have just seen again for at least a generation.

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Edit: “banks…. doing business”, not “banks…. doping business”. That was, erm, a slip.

Edited December 14, 2007 by Extradry Martini

[The Colour]

Thanks extradry. Clear as a bell. However, what will be the impact of this latest central bank concerted effort on the average man on the street?

Edited December 13, 2007 by The Colour

[munimula]

In the meantime, current estimates of bank losses (around $300bn) are being based on assumptions of recovery rates which may well be way off the mark. The way to think of it is this: Imagine a typical US sub-prime borrower who has been lent money with no questions asked. Imagine the kind of area in which he lives and then imagine how many other sub-prime mortgage holders there are in the area. Next, think of several of these house being auctioned at once. Who are the potential buyers? Only other sub-prime borrowers - but sub-prime borrowers are no longer being lent money, so no buyers. Extend this to the UK, Spain, Australia, Netherlands (whose housing bubbles were/are larger by far than the US), and you get the picture of not only what might happen to real estate prices, but also the resulting extent of potential bank write-downs.

After all of this is done, the banks will need to issue more shares to raise capital (as UBS has done with GIC of Singapore) to start doping business again. However, they will be smaller banks than they once were, meaning that there will be a lot less money being lent for a long time. A lot less money means that we are unlikely to see real estate bubbles like the one we have just seen again for at least a generation.

Northern Rock has required £30B(?) to date in funding which goes someway to illustrating how the banks can't be saved.

The banks are likely to borrow the money available to shore up their own finances, they won't be lending it to other banks.

[Sinking Feeling]

Very good explanation. If I were you I would consider sending a similar explanation to one of the better newpapers, they might well publish it.

[Moo]

Splendid post Extradry.

[okaycuckoo]

I thought it might be worth telling you guys what this concerted central bank action is all about, as very few people (especially financial journalists!) seem to understand it.

After all of this is done, the banks will need to issue more shares to raise capital (as UBS has done with GIC of Singapore) to start doping business again. However, they will be smaller banks than they once were, meaning that there will be a lot less money being lent for a long time. A lot less money means that we are unlikely to see real estate bubbles like the one we have just seen again for at least a generation.

Thanks for the post, very good.

It's hard to believe this unwinding will be gradual - surely the prospect of the second wave of resets in the US, and losses in the UK etc coming in to play, will soon push some major players in to outright bankruptcy.

[benj]

Very interesting. Thanks for posting that.

Aren't the Basel-II credit risk models all designed with quite short time horizons? Does this mean that as bank lending goes into reverse and institutions start forecasting big losses, that the credit tightening will be accelerated by the very regulatory framework that is supposed to ensure the stability of the system? From what you say, it sounds to me like this is starting to happen already. What I mean is: is this balance-sheet 'ceiling' now going to act as the trigger for a rapid deterioration in the banks' business, and thus, as you say, the wider economy?

[Methinkshe]

Thank you so much for taking the time and making the effort to post this explanation - it is so helpful to those of us who do not have your financial knowledge but are keen to learn. Much appreciated.

I can see how the underlying problem is not fixed, and that long term the banks are going to have retrench as you describe, which will be deflationary, but is this concerted action by the banks likely to have any effect in the short to medium term or do you think it will be totally ineffective? If so, what happens next?

[FreeTrader]

Good post EDM.

I'll only add that it cannot be stressed enough that this is a dynamic situation. It's not as if all the asset price declines have finished and now all we have to do is mop up the mess. The decline of house prices in the UK has barely begun yet, and as prices continue to fall both in Europe and the US, capital constraints on the banks increase.

It's the old 'imploding balance sheet' problem - it's very difficult to contain it.

[jazza]

Nice to read a sensible and well thought out post on this forum for a change.

[Guest vicmac64]

EDM good post - but could it not be summarised thus - we're bust!!

Its over - the country is insolvent, the people are in debt to the eyeballs... MAXED OUT!!

Its soooo OVER!!

[Austin Allegro]

Extradry, good post. Can you sum up a bit more succinctly for financial thickos like me.

As I can see it, this injection has been a desperate attempt to shore up interbank lending which may or may not work.

However, the BBC seemed to be reporting it as a 'boost to the economy' which would keep HPI and the credit bonanza going, almost seeming to say 'nothing to worry about folks!'

Which one is closer to the truth?

[microbe]

After all of this is done, the banks will need to issue more shares to raise capital (as UBS has done with GIC of Singapore) to start doping business again. However, they will be smaller banks than they once were, meaning that there will be a lot less money being lent for a long time. A lot less money means that we are unlikely to see real estate bubbles like the one we have just seen again for at least a generation.

Thanks for the explanation.

FWIW. As far as real estate goes, it is worth noting that (RPI adjusted) house prices stagnated in the 1930s (CLG figures go back only to 1930) trended down until 1938, then after 6 years without a property market at all, doubled in the post war boom (housing stock had been substantially reduced) before slumping again and only returning again to the 1947 level in 1966. The surge in 1947 looks kind of more like a temporary supply side blip and it looks like it tailed rapidly as postwar housebuilding started to fill demand. If this is a fair interpretation, the first property boom after 1930 was that of 1973. That seems to fit well with your prediction.

[leedsproperty]

What this doesn’t do is fix the underlying problem. The inter-bank money market is dry not because (as some - badly-informed - people believe) the banks do not trust each other, but because banks are unable to lend because they have limits on how large their balance sheets can be compared to their capital

Fascinating.

So even if the estimated $300bn loss doubles, is this such a big deal?

[Fishfinger]

Quality post much appreciated.

I shall have my Martini with Vodka from now on and very much shaken it will be as well!

[A.steve]

I thought it might be worth telling you guys what this concerted central bank action is all about, as very few people (especially financial journalists!) seem to understand it.

Spectacular explanation. Thanks!

One area on which I'd love to expand is this: On what time scale are we expecting this to play out? Are there any even vaguely relevant precedents that can make even a very approximate guess?

For how long can the UK economy survive without new credit?

[ParticleMan]

EDM - on the ball once again, thanks.

Now, a question for ya, if you've got the time. Is there any reason on this good green Earth why Treasuries won't start discounting on the back of this exactly the way that the ABX market has been this Autumn?

What I'm getting at is - where the ABX has been trying to price default risk and failing dismally, Treasuries will (I think?) need to start pricing exchange rate risks. Because the latter appear to have been swapped with the former, but, the risk is still present in the system (ie, defaults have barely got going, yet).

Over to you...

[REP013]

Spectacular explanation. Thanks!

One area on which I'd love to expand is this: On what time scale are we expecting this to play out? Are there any even vaguely relevant precedents that can make even a very approximate guess?

For how long can the UK economy survive without new credit?

Surely the only "real" precedent is JAPAN?

[Guest Shedfish]

Extradry Martini - the best post i have ever read on here, and better than much of the waffle written in the media.

i'd be interested to know your instinctive opinion on the outcome of all this. the more hyperinflationary theories represented on here just don't ring true for me - i see too much money disappearing, and the velocity of what remains reducing dramatically, for hyperinflation to be "100% certain, guaranteed", or even 50%.

[A.steve]

Surely the only "real" precedent is JAPAN?

I've wanted to read a book about the Japan situation for a while (I didn't pay attention at the time - too busy being a teenager) and now I'd like to be educated, I'm hunting for recommendations.

Anyone read a good book detailing the history surrounding the 1990 Japanese incident?

[Lone_Twin]

Excellent post EDM thankyou.

.

ST

[ParticleMan]

Anyone read a good book detailing the history surrounding the 1990 Japanese incident?

This Japan meme, reminds me of something, what was it now...

It's turning Japanese, I really think so.

Oh yes, that's what it was...

[DTMark]

Very good post. Wonder if I can tease a little more information

I had thought that the Banks managed to lend extraordinary multiples and at levels of risk they would not normally take by simply providing the high street service to the customer, and then sold all the loans on to hedge funds, etc.

This made some sense, so that when the proverbial hit the fan the only people hit would be the people who invested in these packaged mortgage conduits, it would not affect the Bank.

Which bit isn't right here, what have I missed?

[sossij]

Thanks for the high quality post EDM. Can I ask a question related to this bit:

The inter-bank money market is dry not because (as some - badly-informed - people believe) the banks do not trust each other, but because banks are unable to lend because they have limits on how large their balance sheets can be compared to their capital.

If this is the case (and I don't doubt it is!) how does the interbank interest rate get set? If they can't lend at all, what does the libor rate signify.... if anything? Thanks.

Edit: FTSE not happy today, down 2.4%

Edited December 13, 2007 by sossij

[Flat Bear]

A good comprehensive explaination of the credit crisis/banking system, thanks

The facts about how the banking sector complicates credit and debt so to create paper money will not give answers to the problem though.

The simple facts are very large amounts of cheap finance became available to the western world which was then used to inflate everything from bank balance sheets to asset values to governmental spending.

As asset values went up banks created complicated "products" that put premium values on debt to the extend a simple loan is extrapolated, twisted, compounded to finally become a "financial package" where the value is based mainly on future prospects at large multiples of the original simple loan.

Even now people talk about "putting a value on" or selling these packages, but no one wants them, they are worth nothing. The only value was in the creators mind. Once these bonds/cdus/etc have been given the total junk status they really are the financial world comes back to earth. But this will destroy much of the global financial infastructure as I think most of us are really aware of but too bewildered/frightened to want to believe.