It’s a slow burner, but is it a fuse? Or just the fag-end of a cigar smoldering in the ashtray while finance reaches for another? There are a lot of doomsayers, and a lot of positive thinkers. The truth is that nobody really knows what is going on or where it is leading because the critical links in the chains are not visible.
“The fundamentals are sound”: At his testimony to a parliamentary committee hearing on Friday, Reserve Bank Governor Glenn Stevens gave the central bankers’ line, heard the world over: global growth is strong, too strong even; inflation remains the threat; profitability is high; investors’ reaction to credit market difficulties was “bordering on irrational”.
Yet surprises keep popping up. If this post can bear another metaphor, it’s like a whack-a-mole game – you never know where in the world trouble is going to rear its head next. The real story is not the sharemarket. The sharemarket fall is not all that big at this point. What is freaking people out is debt, and the sharemarket plunge is only reflecting that, with banks and financial institutions taking the biggest hits.
For example, the mole that popped its head up in Australia last week was RAMS Home Loans. It makes its money by lending for mortgages, packaging up these loans and reselling them on capital markets, thus funding another round of mortgage lending. It has run into trouble now that the packages cannot be resold on the markets, at least not for a profitable price, thanks to what has happened to American sub-prime mortgage-backed securities. The company (and others like it, such as Aussie Home Loans) tread water by issuing short-term paper into the money markets, but the price is high. This seriously hurts profits and scares investors that the company will go bust. So RAMS share prices fell by almost a third at one point last week.
Total collapse, though, is not the result. Institutions that relied on continually rolling over short-term paper in the markets are now invoking their back-up lines of credit, previously negotiated with banks. These are like overdrafts – it’s the limits that are negotiated, and they don’t show up on bank balance sheets until the money actually flows.
Banks assume that in normal times, like overdrafts, not everyone is going to be invoking them at once. But at a time like the present, a lot are being called on at the same time. How do the banks cover this? They go back to the money markets. It seems circular since it was trouble in the money markets that forced the finance companies back to the banks. But since the banks are not considered risky borrowers, they are able to access funds at rates the finance companies cannot. But not without cost. Now it is banks competing with one another for funds in their own markets. This drives up the cost of funds for them, too.
This is where central banks come in. These days monetary policy works by targeting the rate banks pay to borrow reserves, which is exactly the rate being bid up. A central bank targets this rate by buying and selling in this inter-bank market. So if there is upward pressure on this rate, central banks are buying paper off the banks to bring it back down, thus providing the reserve funds the banks need. This is what was happening on a grand scale last week in the US and Europe.
So that is where things are at. It is hard to get an overall sense from what is reported as a series of loosely-related anecdotes. The finance section of last week’s Economist was full of stories from all over the world of separate-but-related consequences and causes: postcards from the edge. The Federal Reserve refuses to lower interest rates. A bank in Dusseldorf gets a bail-out after revealing a hemorrhaging, off-balance-sheet, offshore portfolio of American mortgage-backed securities. Big-name Wall Street investment banks beg in the market for injections to save their hedge funds. A French bank suspends withdrawals from certain funds after finding “the complete evaporation of liquidity in certain market segments”. And so on.
Summing up, the Economist‘s anonymous finance columnist concludes:
The financial system will probably survive this sell-off: the global economy looks resilient enough. But the market turmoil may be a dress rehearsal for the real crisis that will emerge when the economy is in poorer shape.