English
• "The central bank governors are a very impressive brotherhood of mutual admiration."
The three little pigs knew that the big bad wolf would come one day. But only one of them decided it was necessary to build his house out of bricks in order to withstand the threat. Central banks, much like the two little careless pigs, were taken by surprise by the economic and financial hurricane which is now threatening the world economy. They built they houses out of paper and thought they could control a financial structure erected with unprecedented leverage.
After decades of speculative abuses, the big bad wolf did come, even if no one was still expecting him, and central banks are now trying to stop him by building the same paper castles. And, in order not to shake the public"s confidence in their ability to manage crisis, the defenders of monetary stability are trying to cover the "walls" with wallpaper with bricks painted on it.
Can this strategy still work? Not really, especially considering that Bloomberg News has sued the Federal Reserve in order to obtain access to the content of the Fed"s balance sheet and the nature of the securities accepted as collateral in exchange for the money injected into banks. The overall volume of the loans that the Fed has given to the banks has reached some 1.5 trillion USD, according to Bloomberg. Richard Fisher, President of the Federal Reserve Bank of Dallas, said he would not be surprised if the FED balance reached 3 billion by the year-end. Several months ago, Fed"s balance sheet was some 800 billion (!!). Matthew Winkler, the Editor-in-Chief of Bloomberg News, believes that "The American taxpayer is entitled to know the risks, costs and methodology associated with the unprecedented government bailout of the U.S. financial industry."
The shower of programs started by the Fed has also created a new class of entrepreneurs in the United States. They are promising the public access to financing facilities that do not exist in Fed"s portfolio, at least for the time being. The Fed was therefore forced to publish a disclaimer on their website, warning about the new type of fraud.
After the Federal Reserve lowered the key interest to 1% last week, the leading European central banks, too, made a move towards zero. The Bank of England exceed all expectations with the 1.5 percentage point cut, and the government is pressing commercial banks to lower their rates, too. Such pressure comes at a time when the interest rates on the interbank market have already been significantly reduced. Will there be any positive effects any time soon? Unfortunately not, and banking analysts can also say why. Sandy Chen of Panmure Gordon explains that, when rates decrease fast, the reduction of the interest margin is usually offset by an increase in lending, which is not going to happen under the current circumstances. The negative impact on profit will be substantial, too, according to the Panmure Gordon analyst, quoted by The Telegraph.
Maybe the central banks should better explain how it is possible that a problem caused by low rates be solved also by low rates. Federal Reserve data show that commercial banks have severely reduced lending for all categories of customers, especially because of the major recession risk.
How are the stock exchanges reacting? The main indexes rose by nearly 3% on Friday, amid disastrous economic data. Besides an official unemployment rate of 6.5% (index U-3), the Bureau of Labour Statistics also released a much more representative index for the status of the labour market (U-6), which points to an unemployment rate of 11.8%. Then why did the stock exchanges go up? Because the Federal Reserve will reduce the key rate, according to several news agencies. If successive cuts of over 5% in total to 1% led to no effect, why should further cuts have any effects from now on?
The problem with the capital markets is that investors continue to desperately cling on to any hope, even though Pandora"s box, recently opened by the central banks, is quite empty. Why would further reduction of Fed"s rate from 1% to 0.5% or even 0.25% lead to no result? Because the effective key rate, reported on the website of the Federal Reserve Bank of St. Louis is already 0.23% and has been so for about a week (see the chart).
The key rates are no longer efficient, because investors are focusing on other indicators of economic developments. Risk premiums would be first on the list. This component of the cost of money is not influenced by central banks. Secondly, the markets are waiting for the start of a competition between governments eager to find investors for the bonds they intend to issue in order to finance the recently announced rescue plans. The competition will not involve just the United States and Europe, but also various countries of the Euro Zone. Among them, Ireland, Italy and Greece are quite vulnerable. Despite the decline of last week, the spread of the 10-year bonds issued by these countries compared to that of the 10-year bonds issued by Germany remains quite high. That is, 104 bp for Ireland, 140 bp for Greece and 92 bp for Italy.
The offered returns need to be increasingly higher in order to ensure the funding that governments need nowadays. What will the private companies do? They will pay more for financing, or they will be eliminated from the race for new loans.
The same will happen to banks, when they go to the market to attract new capital. Morgan Stanley believes that European banks will need another 83 billion EUR in addition to all the capital injections made so far, if the ongoing crisis turns out to be as severe as that in the early "90s. The decrease in the key rates has had no positive influence on the cost of capital, which still remains on an upward trend. They how can banks lower the rates for loans? Morgan Stanley further indicates that all the governments" interventions led nowhere, as far as the lending deadlock is concerned, according to an article published by the Financial Times. Morgan Stanley"s forecast for 2009 is not optimistic either, as they say that lending will continue to be scarce and expensive, for both individuals and companies.
The latest ECB poll conducted among European banks supports Morgan Stanley"s view. In the third quarter of 2008, 65% of the banks reported tougher lending conditions, up from 43% in Q2, 2008. The main cause is, according to ECB, the negative outlook of economic activities. The banks" increasingly difficult access to financing or re-financing also had a significant impact.
The new accounting regulations adopted by IFRS, which allow major international banks to move assets around in their balance sheets is not helping hedging funds either. Despite massive losses in the past quarter, they continue to face massive fund withdrawals. Platinum Grove Asset Management LP, a hedging fund set up by one of the authors of the Black-Scholes model, stopped withdrawals after having lost 29% of the assets in the first half of October, Bloomberg reports. Myron Scholes is also known for the collapse of Long-Term Capital Management LP in 1998. Hedging funds are forced to sell assets in their portfolio to reduce the leverage, and the prices they get will also probably be extended to the assets in the banks" portfolio.
The big bad wolf came and also blew the straw houses of the emergent little pigs in Eastern Europe. Our Government and National Bank became upset with Standard & Poor"s for nothing because investors have new references in evaluating the stability and performance of emergent economies. Data release by MarkIt on 6 November place Romania once again on the list of countries for which crediting perception has deteriorated. The price of CDS contracts for bonds issued by Romania has reached 501 bp, after an increase by 69 bp in 28 days. No wonder that the Treasury had to pay up to 13% for bonds maturing in 5 years and obtained much less than the 700 million RON target.
Some of the emergent little pigs in Europe are now trying to run faster towards the euro and seek haven there. Even the trouble-making little pigs in Western Europe and knocking on the door of the brick house of the Euro Zone.
But will that offer them the necessary protection? It is useless to seek something like that on financial markets nowadays. The brotherhood of central banks, as the ECB president described the special relationship between them, is ready to march in the Emperor"s new clothes in front of the entire world.
Disclaimer: The article is the author"s own point of view, does not reflect or engage the opinions of the institution where he works and do not constitute an investment recommendation.
Euro
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