Panic is not a pretty sight, whether it involves disco-goers trying to escape a burning building through a narrow locked door or financial lemmings rushing for an exit at any price. But panic we we have in the financial markets. Banks are unwilling to lend to each other and no-one is willing to lend to banks. Libor-OIS spreads (even overnight) have gone through the roof. Fear of counterparty risk is has spread far and wide among financial market participants. Liquidity is being hoarded instead of traded to those most in need of it. A growing number of financial institutions have been confronted with the reality of Keynes’s saying that “the markets can stay irrational for longer than you can stay solvent”. Even fundamentally sound institutions (that is, institutions whose assets, if held to maturity would be more than sufficient to finance all outstanding obligations) are experiencing the truth of the corollary to Keynes’s saying: “the markets can stay irrational for longer than you can stay liquid”.
The monetary authorities are doing the right thing by drowning the markets in central bank liquidity. In New York, London, Frankfurt, Tokyo and Moscow they are injecting large amounts of liquidity into the overnight and longer-term money markets, often against a wider range of collateral than in the past. I expect to see increased cooperation of swap lines among central banks, especially swaps between the Fed and the main European central banks to make US dollar liquidity available to banks domiciled in Europe before the US markets open.More may have to be done. For a while, the interbank markets may have to be de facto replaced by a hub-and-spoke system of borrowing and lending with the central bank in the centre and private banks at the spokes. If the banks don’t trust other banks as counterparties, direct lending and borrowing between banks may have to yield, until confidence is restored, by indirect inter-bank lending and borrowing via the central bank, with the direct transaction between bank A and bank B replaced by a sequence of transactions between bank A and the central bank and bank B and the central bank.
Governments and regulators are bending, relaxing or suspending the rules to prevent fresh financial disasters. Some of this makes sense. The Fed as regulator suspended a regulation that prevented a commercial bank from making a loan to its investment bank subsidiary. This was clearly necessary for the take-over of Merrill Lynch by Bank of America to go ahead. The British government waived the competition policy (anti-trust) impediments to Lloyds -TSB’s take-over of HBOS.
Some of it makes no sense. The closing of the stock market in Moscow suggests that the authorities there believe that if you cannot observe the valuations put by the markets on Russian listed companies, these valuations will go away or could even improve spontaneously. It may of course be a wheeze to stop marking to market of the shareholdings of the new nomenklatura.
The proliferation of restrictions on short selling are another triumph of populism over sense. Not for the first time, the collapse in the share price of a number of politically well-connected banks and other financial institutions has raised an outcry about short selling – the practice of selling shares you don’t own in the expectation of buying them back in the future at a lower price. A regular short seller borrows the shares he sells, hoping that the future spot price of the shares will be sufficiently below the current price to cover the carry cost of borrowing the shares. A naked short seller doesn’t even borrow the shares he sells. That sale then obviously cannot be a spot sale of shares, because you don’t own any, you haven’t borrowed any and therefore cannot deliver any. It is instead a forward sale, a commitment today to deliver a certain number of shares at some future date at a price fixed today. You hope to buy, in the spot markets between today and the delivery date, at a price below the agreed forward price, the shares you have sold forward.
Are short sellers greedy pigs? No more than ‘long buyers’ (e.g. all home owners) are greedy pigs. They are just normal, naturally greedy mammals. Should collusion between short sellers be banned? Of course it should, like all forms of collusive behaviour aimed at influencing prices, unless explicitly authorized by the authorities. Trash and trade tactics (spreading rumours you know to be untrue in the hope of benefiting from any resulting price movements) should also be illegal. In most countries such behaviour is in fact illegal. The offense is, however, very hard to prove. Any interference with the freedom to speculate should be symmetric, applying equally to short sellers and to those taking long positions.
The fiscal authorities are dipping into the deep pockets of the tax payers to find resources to back up guarantees or to recapitalise failing systemically important banks and other financial institutions.
It is key that this be done in a way that saves the institution assumed to provide the public good, while minimising the adverse effect on future incentives for risk taking. Things are improving here. The £85 billion bridge loan from the Fed to AIG is both expensive (850 basis points over Libor for a 2-year facility) and overcollateralised. The shareholders have been comprehensively diluted. There will be no dividend payments and control over all major decisions rests with the government, which owns 79.9 percent of the shares (the highest fraction that does not trigger a legal event of default, which would have nasty implications for the CDS markets). The management is gone. The only feature missing from a moral hazard perspective is a charge on or haircut for AIG’s creditors. There should be a cost to all providers of funds to AIG, not just to the shareholders. But that’s a rather minor blemish in an otherwise quite elegant design.
From a long-run financial stability perspective, the decision not to put public money behind a bail-out of Lehman Brothers also would seem to be the correct one. While it may well have increased short-term volatility and uncertainty, the deleterious effect of tax payer support for a bank that was not systemically significant on incentives for future investment, lending and borrowing would have been horrendous – an open invitation for excessive risk taking.
The creation of a $70 bn private liquidity support fund by 10 large banks (Bank of America, Barclays, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, JP Morgan Chase, Merrill Lynch, Morgan Stanley and UBS, each of which pledged $ 7 bn to the scheme) will also be helpful from a short-run stability perspective, although the arrangement is fraught with risk of abusive collusion. Each bank (though not, I assume, more than three banks at a time) will be able to borrow up to a third of the $70 billion. The absence of Japanese and Korean banks is striking. I expect some of them to join the scheme before long. Other large European banks may also sign up.
Beyond flooding the markets with liquidity, recapitalising systemically important institutions with tax payers’ money (while wiping out their shareholders, imposing a charge on their creditors and firing the top management), lending their good offices for putting together defensive mergers and take-overs of vulnerable institutions, there isn’t much the authorities can do for now.
If things fail to improve, the central bank may, as discussed above, take over the role of the interbank market. It at least it is an acceptable counterparty for all private banks. If that does not do the job, a more comprehensive socialisation of the key institutions in the financial sector may have to be contemplated. Societies cannot afford to let financial sector paralysis cripple the real economy.