The deflation of the debt bubble and the resulting liquidity squeeze will go on for a while, since as discussed in
Comment 46 the deflation of the debt bubble is due to the stagnation of the US trade deficit. There is
little prospect for the US trade deficit to renew its rapid expansion in near future, considering the steadily weakening dollar in recent years.
The mortgage bubble has been the largest component of the debt bubble, so it is natural that the mortgage market is the one hardest hit in this
liquidity squeeze. We should note that the total amount of debt outstanding is not going to decrease even in this liquidity squeeze. The squeeze
of our concern is really about the slow down of the growth rates of the debts. To help the discussion here, some important aspects of the growth
rates of debts, taken from the most recent report of The Federal Reserve Board (abbreviated as FED),
are summarized in the following table:
|Domestic financial sector||10.7%||9.5%||10.7%||9.1%||9.0%||10.1%||8.2%||9.8%||15.6%|
The growth rate of the total debt has been above the normal growth rate of the nominal GDP since 2003. This is the manifestation of the debt bubble. The growth rate of the total debt peaked in 2005 at 9.1% and has declined to the annual rate of 7.2% by the second quarter of 2007. This stream of decline of the growth rate of the total debt is exactly the liquidity squeeze that we are talking about. This liquidity squeeze finally touched off the financial panic of the mid August. Since then, thanks to the massive liquidity infusion of FED, the growth rate of the total debt has jumped back to 8.9%, and has generated an impressive bounce of the GDP growth in the third quarter of 2007. Judging from the reasonably strong consumer spending in October and the phenomenal growth of the consumer spending in November, FED seems to be inclined to re-inflate the debt bubble by injecting whatever amount of liquidity required to bail out the financial institutions that are caught in the web of their own making. This kind of re-inflation of the debt bubble at the time of stagnating US trade deficit carries a substantial risk of rekindled inflation later on.
From the table it is easy to observe that the growth rate of the mortgage debt is steadily declining. However, in compensation consumer credits that includ credit card borrowings, and business borrowings are growing smartly. This means that the liquidity injected by FED are fueling consumer's borrowing through credit cards and the expanded business borrowings. It is also worth to note the phenomenal growth of the debt incurred by the domestic financial sector in the third quarter of 2007. This growth of debt in the financial sector, of course, is the result of the massive infusion of liquidities into the financial system by FED. Those massive amount of new liquidities are used only partly to fuel the enormous jump of consumer spending in October and November. Banks seem to keep a substantial part of the new liquidity at hand in order to weather the financial fire storm that is blowing with full strength presently at the turn of the year.
In Comment 49 we have said that financial panics and crises are like violent turbulences appearing suddenly on the background of a steadily advancing liquidity squeeze. In order to analyze such financial turbulences we have used the interest rate spread between one month CD and one month T. Bill. This interest rate spread is replotted in the graph at the right as the red curve but with time scale expanded from May to December. To look into the situation further, the interest rate spread between one month CD and the federal funds' rate is plotted as the green curve. The interest rate of one month CD itself is plotted as the blue curve, and the federal funds' rate is drawn as the purple curve respectively. The graph shows that there was already a scare in June as money escaped into the safe haven of treasuries. At that time the red curve jumped but the rate of one month CD hardly moved at all. The mid August panic was quite different. As the commercial papers collateralized by mortgage backed securities are shunt by investors, investors poured their money into the safe haven of treasuries, forcing down the yields of one month T. Bill sharply. As the result the red curve, the spread between CD and T. Bill, shot up suddenly. It is quite obvious that banks will inevitably be pulled into the quick sand of mortgage woes as their sponsored mortgage related entities run into troubles. The suspicion about the credit worthiness of some banks spread. Such suspicions damped the lending among banks, and have forced cash strapped banks to borrow from high yielding CD's in spite of falling federal funds rate as FED injects massive amount of liquidities in order to stop the panic. Thus the green curve, the interest rate spread between CD and federal funds' rate, also jumped. From the mid August financial market panic until late November the jagged behavior of the green curve mainly reflects the volatility of the federal funds' rate, implying that banks are far more jumpy than other players about the credit risks facing their peers. During that period the red curve, that is, the spread between the rates of CD and T. Bill, was strangely synchronized with stock markets. As money parked in the short-term treasuries flows into stocks, treasury yields rise and the red curve comes down, whereas treasury yields fall and the red curve shoots up as stock prices fall and money escapes back into treasuries. During this period interest rate of one month CD came down smoothly as the federal funds' rate continued its jagged ups and downs. This trend was the result of a strange kind of euphoria in the markets with the wishful thinking that the troubles of banks were over, and the stocks of banks rallied when they announced mortgage-woe related write downs. However, this kind of premature optimism has been dashed as the severity of the mortgage market woes become apparent and as the losses of financial institutions exceeds market anticipations. Starting from November, banks become more cautious in lending to their peers. Though the federal funds' rate has continued to slide down as FED injects more and more liquidities, troubled entities still cannot borrow easily from the market of federal funds. The troubled ones are forced to pay high interest rate and get finance through CD's. The rate of CD has thus shot up at the time when the rate of federal funds is falling. The interest rate spread between CD and federal funds, that is, the green curve, has risen substantially as the consequence. On the other hand the liquidity injected by FED is simply parked in the treasuries, causing treasury yields to plummet and the red curve to rise, too. The present situation can be described as a banking system crisis since if nothing is done, quite a few large financial entities will run into real troubles from a typical cash squeeze.
Facing this banking crisis, FED has come up with another unusual idea, that is, the auction of loans in order to inject liquidity directly into troubled banks. At the time of the mid August financial panic, FED has changed the rule of discount window borrowing drastically. The borrowing period is extended to one month from overnight, and all kinds of mortgage backed securities are accepted as collaterals. FED even explicitly urged cash strapped banks to borrow through the discount window. The current interest rate of the discount window borrowing is 4.75% that is 0.5% above the FED's target rate of federal funds but is about 0.25% lower than the one month CD rate. The identities of the discount window borrowers are not revealed by FED. However, FED's attempt to inject liquidity into troubled banks through the discount window has not succeeded since troubled banks are not eager to borrow from the discount window. The precise reason why troubled banks are reluctant to go to the discount window but are struggling to borrow from higher interest rate CD is not well understood. Probably it is due to the historic stigma that most heavy borrowers from the discount window eventually failed. Due to the failure of the attempt to inject liquidity directly into the needy entities, FED has come up with the idea of auctioning fixed amount of loans. The collaterals used in those auctions are the same as those used in the discount window borrowings, and any member who is allowed to borrow from the discount window is qualified to participate in the loan auctions. Further more neither the identities of the ones submitted the bids nor the ones who win the bids in the auctions are disclosed, just as in the case of the discount window borrowing. Also the durations of both the auctions and the discount window borrowing are one month long. Only difference between the two methods of borrowing from FED are the interest rates. The interest rate of auctioned loans are determined by the auctions, whereas the interest rate of discount window borrowing is fixed at 4.75% at present. During December 2007, FED conducted two such auctions, each for 20 billion dollars. Troubled financial institutions participated eagerly. The interest rates of auctioned loans were only slightly lower than the discount window rate. It seems that by just changing the name from "DISCOUNT WINDOW" to auctioned loans, FED has removed the superstition of the "modern" financial system, and has succeeded injecting urgently needed liquidity into troubled financial entities. Thus FED has in effect bailed out the troubled financial entities for the time being. As the proof of this temporary relief, the interest rate of one month CD has come down in step with the rate of federal funds, and thus the green curve, the interest rate spread between CD and federal funds has leveled off. The interest rate spread between CD and T. Bill, the red curve, has also stopped rising as the drop of the yield of T. Bill has moderated.
The new auction scheme of FED has another twist built in, that is, the currency swaps with the European Central Bank (abbreviated as ECB) and the Swiss Central Bank respectively. The design is for ECB and the Swiss Central Bank to conduct dollar based loan auctions just as FED is doing in the US. The currency swaps are necessary for such dollar loan auctions in Europe since only FED has the authority to issue whatever amount of US dollar as deemed necessary. As has been mentioned in early discussions of this series, there are many mystery holders of risky mortgage backed securities beyond the disclosed holders in the US and related parties. A substantial part of the mystery holders are European financial entities and their sponsored investment trusts and vehicles. Quite a few of them are also borrowing short term dollars to buy those ill fated mortgage backed securities just as their US counter parts. Similar to their US siblings, those European speculators are also shut out of the short term financial markets and cannot roll over their short term dollar denominated debts. Their parents are Euro based financial entities. In order to save their troubled children those European parent entities are forced to sell Euro for dollar to repay the debts of their sponsored investment vehicles. That is the reason of the sudden swoop of the exchange rate of the mighty Euro. Since many of those European parent entities are not qualified to participate in the US auctions of FED, special arrangements for ECB and the Swiss Central Bank to auction dollar loans in Europe become necessary. If the speculators on the European side are not saved by this kind of swap operations and the auctions of dollar loans by ECB and the Swiss Central Bank, the mortgage backed securities in their possession must be dumped on the open market, and lower but realistic prices will be established for those ill fated securities. At that event US entities holding similar kind of securities must mark down their prices to the market prices. As the consequence those entities must realize much larger losses than their present disclosures at once. Many of them will go under, and FED's bailout plan will be shattered.
FED's action in essence is not so different from the abolished plan to establish a super SIV to prevent SIVs from dumping the mortgage backed securities on the open markets. The idea of the super SIV died naturally as the sponsors of SIVs have taken SIVs back into their own balance sheets and are paying back the maturing short term commercial papers from their own coffers. It is why FED is now busily bailing out those parent entities.
The bailout activity of FED is only a temporary measure. As those auctioned loans mature in one month, the loans must be refinanced since it is not possible for those troubled entities to regain their financial health in such a short time. FED seems to indicate that the auction may be continued as long as necessary, meaning that the auctioned loans can be rolled over repeatedly for quite a while. As more commercial papers backed by mortgages mature, FED needs to increase the size of auctions, too. As long as FED can prevent the dumping of those unwanted securities on the open markets, everyone can pretend that those troubling mortgage backed securities worth more than they really are. In essence the whole situation is like for FED to buy up all those ill fated securities from those troubled entities at artificially inflated prices.
Besides the liquidity squeeze discussed so far, there is also the problem of capital squeeze. As financial entities undertake their normal businesses, like making loans, underwrite securities and so on, they need to apply certain amount of their own capital to each transaction to cover its inherent risk. Thus more capital a financial entity has, more business it can conduct. As a financial entity write down the value of mortgage backed securities in its possession, they must apply their capital to cover the losses. With reduced capitals, those troubled entities will be forced to retreat from their normal business, and thus weaken them further. Those troubled entities are desperately trying to find new capital infusions. Where can they find new capitals? At the time that the whole financial system is tainted by their wanton and seemingly foolish behavior that have landed themselves in such deep troubles, not many prudent private capital wants to serve as white knights for those troubled entities. Also the required capital infusion is simply so large that is beyond the capability of private parties. The only source of funds that will serve as the messiah for the troubled entities is the foreign government controlled sovereign wealth funds. For a detailed discussion about such government owned funds, please see Comment 52. The current unspoken rule with regard to such foreign government capital infusion is to limit such foreign government related ownership to below 10%, and not to give any seat of the board to the respective foreign government related entities. Presently many Wall Street firms, one large US bank and one large Swiss bank have received such capital infusions from sovereign wealth funds. However, as the mortgage woes persists, the troubled entities will be forced to write down more and more the value of mortgage backed securities in their possession, and they will need more and more capital infusions from foreign governments. Thus the unspoken rule will be pushed aside, and the limit of foreign government ownership will be raised repeatedly, leading to the defacto nationalization of many Wall Street firms and large banks by foreign governments. The US society is certainly approaching step by step toward the picture as depicted in article 7.
Finally let us touch upon the US government's efforts to help distressed mortgage borrowers. At the time when the number of forelosures in coming years is estimated to be around 3 million, the anxiety of Washington DC is certainly understandable. The center piece of the effort by the public sector is to freeze the mortgage interest rate for roughly 1.2 million subprime borrowers at the current rates. Without this initiative, the mortgage rates will be adjusted substantially higher in coming months, and will induce many more foreclosures. We should understand that the basic rule in economics about interest rates of loans is that interest rates move higher as the credit ratings of borrowers move lower. Except for some cases of fraud, substantially higher interest rates for subprime mortgages simply reflect the poor credit ratings of subprime borrowers. By freezing the interest rates for a group of subprime borrowers, the basic rule of economics is violated; a group of lower credit rating borrowers will pay lower interest rates than another group of borrowers with higher credit ratings. The consequence of such distortion of free market rules is more reluctance for private capitals to be engaged in the mortgage market at the time when the withdrawal of private capitals from mortgage backed securities is causing such a commotion. Once the government takes market distorting initiatives, it must be prepared to provide mortgage money from the public sectors, and should realize that it is taking the first step toward the nationalization of the mortgage market with no way of return as has been pointed out in Comment 51.