FYI | Aug 12 2007
By Greg Peel
At 10.30am on Friday, the Dow was down 212 points on the day. At 12.30pm, it was up 36 points on the day. At 3pm it was down 130 and just before the close, unchanged. At the bell it marked down 31. The low in the Dow coincided with the closing of European markets. The FTSE 100 was down 3.7%.
On Friday the New York Federal Reserve (it is the New York Fed that handles open market operations) injected US$24 billion into the banking system. On Friday it added US$19 billion in the morning, another US$16 billion later in the day and a further US$3 billion towards the end. The European Central Bank, which injected an extraordinary E95 billion on Thursday, added a further E61 billion.
The Fed was forced to make its abnormal injections as the overnight cash rate – the rate at which banks and financial institutions borrow and lend to square their books for the night – pushed up over 6%. The current Fed funds rate target is 5.25%. The reason the rate pushed up is because liquidity is rapidly drying up in the system. The reason liquidity is drying up is because nobody can be sure just how many distressed mortgage securities are being held by various institutions and if so, whether or not they are actually worth anything. As no one is prepared to buy them at any price right now (and under normal circumstances, there is always a buyer of everything at some price) then they effectively have no price. Banks are thus terrified that if they lend money to an institution overnight it might close its doors the next day. This might be irrational, but when are financial markets ever rational?
When the Fed, and particularly the ECB, injected funds on Thursday, the stock markets collapsed. When the ECB made another big injection on Friday, and the Fed stepped up its activities, the market fell but recovered. Why the change?
There are possibly two arguments to put forward here. When the ECB made its E95bn injection on Thursday, more than its post-9/11 injection, the markets worried that something was wrong – really, really wrong. The freezing of BNP Paribas’ hedge funds didn’t seem wrong enough. And then a rumour went around the market that Germany’s third largest bank – WestLB – was bankrupt. This would be akin to Australia’s ANZ Bank announcing it had closed its doors.
Like most rumours at the moment, it proved to be false. Indeed WestLB did announce it had E1.25bn exposure to subprime securities in its hedge funds but no – the German central bank meeting called on Thursday morning was to discuss the already flagged bailout of corporate lender IKB, and not anyone else.
The other factor occurring on Friday was related to the collateral the Fed announced it would accept against its fund injections. Normally it accepts US T-bills and T-bonds and the like, but on Friday, in a move which had economists scratching their heads to remember if it had ever happened before, it accepted mortgage-backed securities. Give me your tired, your poor, and your huddled subprime paper, said the Fed.
But this is not an indication that the US government is stepping in to buy up those distressed securities that presently have no market and probably little value. The Fed simply accepted the mortgage securities as collateral for one to three day loans. They still have to go back into the system. It is for this reason that many commentators are screaming for the Fed to stop mucking around and simply ease the cash rate. This is exactly what it did after the collapse of LTCM in 1998. But the Fed and the government have suggested they will not actually intervene. This is not a “solvency” crisis but simply a “liquidity” crisis. The markets still have to take the losses and fight their way back to normal credit risk pricing.
Nevertheless, interest rate futures markets are beginning to factor in the chance of a Fed easing as early as September, and more definitively by year end.
It may come somewhat as a surprise, but the Dow actually finished up for the week – the first time it has done so for a month.
This column has noted several times recently that the gold price now reacts in two steps in the event of a crisis. The first is to fall as investors look to liquidate for cash to pay margin calls on stock market and other asset leverage, and the second is to rise as concerned investors look for a currency safe haven. If ever there was a day for gold to be a safe haven, it was Friday. Global central banks entered their second round of furiously adding liquidity into the system – liquidity which as good as comes off the printing press. Were the liquidity crisis to intensify into anything more dramatic, the whole notion of global fiat currencies comes into question. For the preservation of wealth, the only option is to buy gold (and silver).
Gold rose US$9.60 to US$670.40/oz. The US dollar eased slightly against most major currencies except the yen. Carry trade unwinding hit the Aussie hard once more, sending it spiralling down to US$0.8438. Oil was off slightly once more, and base metals played their usual mixed game.
The SPI Overnight was down 3 points.
