Crossing The Line - Cutting "The Line"

The ECB yesterday had to provide 348 billion euro ($500 billion) at 4.21% to cover its unprecedented promise to supply the market with unlimited funds in the two week period, which included the turn of the year. The bank had never before committed to satisfy all requests in any of its liquidity operations. This action crosses the line between "lender of last resort" and "major lender to the market". That it would do so reveals the increased pressure building inside the global financial system, ever since the credit problems surfaced in the interbank money market last summer.

At that time most analysts expected the troubles to quickly go away after central banks injected liquidity, in a repeat of the LTCM bailout of 1998. When that did not work, all manner of schemes were announced: MLEC to save SIVs, ARM freezes and TAF operations from a group of five central banks working in concert (FRB, ECB, BoC, BoE and SNB). None have so far succeeded in reversing the freeze gripping the interbank money market, the single most important financial market for the day-to-day workings of the economy.

Banks are presently unwilling to lend to one another. This has resulted in central banks having to raise the scope, size and frequency of their liquidity operations, increasingly assuming responsibility for the entire money market - not only as setters of interest rates, but as ultimate arbiters of who gets how much liquidity. This is an extraordinarily uncomfortable, unsuitable and unfamiliar position for central bank bureaucrats to find themselves in.

Some people are hoping that things will change for the better after the New Year, but I fail to see it. Given current conditions, banks' credit departments are surely already working at revising trading limits ("lines") to other banks and many of their trading customers. Such lines are usually reviewed annually and cuts are uncommon, at least amongst the major institutions. They are considered a slap in the face and are most commonly answered by retaliatory cuts. While this may sound childish, it is in fact very serious business reserved for the grown-ups in the banks' credit committees.

A bank faced with decreased lines from other banks cannot maintain its own lines to them at high levels. If it keeps providing more liquidity than it has access to, it simply won't have enough to run its own business - i.e. to fund its customers. Multiply this across the system and you have a shrinking of the overall credit available in the interbank market. This will immediately migrate to the customer side, first affecting the large speculators who depend on prompt access to margin funds (e.g. hedge funds). No need to spell out what this reduction in available credit means for securities markets.

The process of reducing risk in professional investment portfolios has already begun, judging from the sudden plunge in the State Street Investor Confidence Index, "a quantitative measure of the actual and changing levels of risk contained in investment portfolios representing about 15% of the world's tradable assets." State Street is one of the world's largest custodians ($15 trillion in custody), so they have a pretty clear picture of what is going on inside institutional accounts.

Data: State Street

Where does this leave the central banks vs. the money markets? Obviously, their relative importance will rise temporarily, tempting some participants to expect them to become perennial providers of massive liquidity. This is impossible, for two reasons:

• They do not have the necessary monetary resources and suasion is powerless when everyone is scrambling for hard cash. Notice how it took the ECB "unlimited" amounts to finally bring rates down, instead of a simple round of calls to dealing rooms (known as "checking rates").
  

• Their acts cannot overcome the commercial and investment banks' own credit committee decisions to cut credit lines to other banks and customers.
  

The one thing that will eventually restore order to the interbank market is its gradual deflation to a more manageable size. I believe this process is already in the works.

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In a separate development dealing with the herein oft-discussed issue of Credit Default Swap (CDS) counter-party risk, the NY Times has a revealing article about ACA Capital Holdings. Notice, in particular, the booking of basis trade profits. Well worth a read.