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October 10, 2008

One Step Closer to Nationalization of the Banking Sector

Paul de Grauwe in the FT:

The essence of what banks do in normal times is to borrow short and lend long. In doing so, they transform short-term assets into long ones, thereby creating credit and liquidity. Put differently, by borrowing short and lending long, banks become less liquid, thereby making it possible for the non-banking sector to become more liquid; that is, have assets that are shorter than their liabilities. This is essential for the non-banking sector to run smoothly.

This credit transformation model performed by banks only works if there is confidence in the banks and, more importantly, if banks trust each other. This confidence has now evaporated and, as a result, the model fails. The generalised distrust within the banking system has led to a situation where banks do not want to lend any more. That means that they continue to borrow short but lend equally short; that is, acquire the most liquid assets.

The result is a massive destruction of credit and liquidity in the economy. The non-banking sector cannot borrow long so as to acquire liquid assets that they need to run their business, because banks do not lend long anymore. This risks bringing the economy to a standstill. A depression is looming.

It is important to realise that this liquidity crisis is the result of a co-ordination failure: bank A does not want to lend to bank B, not necessarily because it fears insolvency of bank B but because it fears other banks will not lend to bank B, thereby creating insolvency of bank B out of the blue. Thus bank lending comes to a standstill because banks expect bank lending to come to a standstill.

Posted by Robin Varghese at 04:50 PM | Permalink

Comments

From the Automatic Earth--

It's a beautiful fall day here, the sun reflects off the barn roofs and the remaining tree leaves, and there's a very sweet little black cat lying next to me in perfectly peaceful slumber. It makes me think of how grateful I am that I have been able to warn so many people ahead of time of what would happen, of what is unfolding right now.

There are tons of people around me who say I’m an idiot for spending all these thousands of unpaid hours in doing so, while I'm already too poor to light a single candle with, but given the choice, I would do it again, no questions asked.

I don’t mean to say that I want to stop doing this, but I must admit, I am starting to have doubts about the impact I can still have when it comes to my readers moving their money into safer havens. Things are moving at lightning speed.

There are so many events seeing daylight all at the same time, it looks, at times, impossible to choose where to start. Then again, once I gaze across the battlefield, it gets much easier. Swaps, my sweets, swaps.

The G7 finance ministers meet this weekend. Now, I don’t think for a second that they all know what is on their plates. They are not smart enough, simple as that.

Look, the main event today is the auction of Lehman derivatives. It will take $100’s of billions out of the markets, and make the next auction that much harder. That is the biggest story, never mind another 10% drop at the Dow. Italy’s PM Berlusconi had a slip of the tongue, he mentioned "freezing the markets". Don’t be surprised if that is what you will see Monday morning.

The very dipsticks who gave you this crisis now promise to solve it for you. I told you: this is not an economic crisis anymore, it’s a full-blown political emergency, and they’re all trying to hang on to "power". They can’t, so prepare for the sound of goose-stepping boots in your streets.

Lehman swap issuers and insurers will lose 90%+ on their swaps, and that will set the trend for subsequent auctions. The US has bought AIG, for what now amounts to $123 billion and rising, and that is by no means the end. I bet insurance companies all over the globe are at risk of simply not being around anymore Monday morning.

They would have already died if mark to market were applied, the only instrument to solve anyting in this crisis. But no, the FASB accounting rules are to be changed, so US firms can hide their losses till the cows come home. Or can they? Methinks, once more, that the cows are home, fed, bathed, deeply drunk, and have long ago left the premises.

Trillions of dollars are being spent to delay the only thing that could solve this bleeding, and it boggles my humble mind. Promoting interbank lending in the face of promoting more interbank mistrust, call me crazy....

Banks won’t trust each other till they know what each has in their vaults. Yes, that will cause a lot of them to topple, but hey, that’ll happen regardless.

Speaking of which, Morgan Stanley lost 26% yesterday, and today stands at minus 35%. Will it live through Sunday? Wait, that would leave just one investment bank, wouldn’t it? Paulson’s Goldman Sachs! Oh, ye mother of coincidence, thou’st tickling me manly parts. Halt, I can take no more...

Sean Egan-Jones, the one reliable rating agent left, said yesterday that MS need $30 billion in added capital. This morning he raised it to $60 billion. Morgan Stanley, nice knowing ya. I’ll send flowers.

Ford and GM and all of Detroit are outtahere. As I predicted years ago, no president wants to have US carmakers fail on their watch. So there is a window from November 4 to January 20, where the old and new can blame each other. Geez, am I going to be right on that as well? What a surprise.....

The whole fantasy was based on the yen carry trade from the start. That is over, no matter what they throw at it. The world will be a wholly different place by Monday.

Good Night America. Nice knowing Ya.

Posted by: Dave Ranning | Oct 10, 2008 10:24:39 PM

"They would have already died if mark to market were applied, the only instrument to solve anything in this crisis."

As I understand it. Mark-to-Market was a new accounting regulation applied in November of last year. It seems to have been the cause of this mess, at least of the risk management asset collapse portion.

As far as "reliable" rating agents go, where were they when the now clearly unacceptable risks of mortgage backed securities came into the market back in the 90s. AAA my ass.

Posted by: Carlos | Oct 11, 2008 11:56:44 AM

This is giving me a headache, but anyway:


nybooks

Posted by: CriticalMassI | Oct 11, 2008 11:14:36 PM

Last week initiated "The Great Unwind" as hedge funds started selling assets. Stocks and commodities plummeted...it's a buyers market. More sales this week, a tsunasmi of sales as they unwind derivative positions.

See:

Posted by: Henry Barth | Oct 13, 2008 3:35:22 AM

The URL was omitted.

See:

http://www.independent.co.uk/news/business/news/a-163516-trillion-derivatives-timebomb-958699.html

Posted by: Henry Barth | Oct 13, 2008 3:37:02 AM

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