Down the drain
From The Economist print edition
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The money markets are still blocked. Do central banks have the right tools?
“NOTonly is there no God,” said Woody Allen, “but try getting a plumber onweekends.” That just about sums up the problems of today's financialmarkets. The plumbing is badly blocked, and nobody seems able to fixit, not even the central banks, the market's immortals.
The problemis the apparent reluctance of banks to lend to each other, particularlyover three months. That problem arises, in part, from uncertainty aboutwho will pay the bill for America's subprime-mortgage collapse. But italso results from the need for banks to protect their ownbalance-sheets in the face of some unexpected claims on their capital.
The result isthat banks are paying much more to borrow than normal, particularlycompared with governments. According to Goldman Sachs, one measure ofthis gap between American Treasury bills and interbank rates, nicknamedthe “Ted spread”, is at a 20-year high. And like other plumbingproblems, this could have severe consequences, because when banks paymore to borrow they pass the cost on to consumers and companies.
On September5th the Bank of England got its monkey wrench out and tackled oneissue, the half-percentage-point gap between overnight lending ratesand its official benchmark. The Bank promised to lend more money to themarket, if necessary, to bring overnight rates down.
Criticsargue that the Bank has been time-wasting. The European Central Bankand the Federal Reserve made similar moves last month, and the ECBdid so again on September 6th. But the Bank of England's failure to actsooner seems to be part of a general reluctance to be seen to be savingspeculators from their mistakes. The Bank made it clear that it was notaiming to bring down three-month lending rates, which are the markets'most acute pressure point. A bank may be good for its money in themorning, but who knows what will have happened by December?
Perhapscentral banks cannot solve the problem on their own anyway. They haveoffered to provide finance to any bank that needs it via mechanismssuch as the discount window operated by the Federal Reserve. But banksare understandably reluctant to show any hint of desperation. Borrowingfrom a central bank in the middle of a liquidity crisis is rather likea schoolboy agreeing to have a sign saying “Kick me” pinned to hisshirt-tails.
Even a cut inofficial rates, as is expected in America later this month, may notclear the blockage. The fundamental problem is that the banks madepromises that they did not expect to have to keep. These “contingentliabilities” require banks to take the strain when their clients faceproblems in finding funding elsewhere. Suddenly, a lot of these billshave come due at once.
According toDealogic, more than $380 billion of loans and bonds linked to pendingleveraged buy-outs need to be shifted now that Wall Street bankers havereturned from their holidays. The speed of the market deterioration hasbeen a big part of the problem. Banks made short-term or bridge loansto private-equity buyers with a typical 30-60 day holding period. Whenthe markets were buzzing earlier this year, they assumed nothing couldgo wrong in such a short time. But they were wrong, and now they facethe prospect of having to keep large chunks of the debt on their ownbooks indefinitely, marked at a loss.
How big aloss is hard to gauge. One indication is the discounted price at whichleveraged loans are trading in the secondary market (see chart).Another is the tussle over the financing for the takeover of FirstData, a transaction-processing company. This has already been postponedonce. Banks will try to syndicate it again soon. Investors seemunwilling to pay more than 94-95% of par value for the $14 billion ofloans in the package. That would wipe out the banks' fees on the dealand leave them with further losses of 3-4%. One banker involved in thedeal says its fate is still clouded in uncertainty: “We still don'tknow if an avalanche is going to fall on our heads.”
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First Data will set the tone for other deals, such as the takeovers of TXU,a utility, and Alltel, a mobile-phone firm. The main obstacle is thatthe First Data deal “has all the bells and whistles of the bubble era”,says another banker: it is, for instance, “covenant-lite” and offerslenders little protection.
Banks wouldlove to wriggle out of the most egregious deals, or at least get betterterms. But that is proving hard. They painted themselves into a cornerwhen the market was booming. Previously, many deals included a“material adverse change” clause that cancelled the financing if severeturbulence hit the markets. These would have been handy today, but thebanks stopped insisting on them.
As if thebuy-out issue was not bad enough, banks face a bigger danger elsewhere,linked to the subprime-mortgage crisis. This threat involves a seriesof specialist investment vehicles known as conduits and structuredinvestment vehicles (SIVs). Conduits were mainlyset up by banks as “off-balance-sheet” vehicles for themselves andtheir customers that allowed them to invest in slightly riskier assets.SIVs tend to be independent. Both borrowedpartially (but not exclusively) in a form of short-term debt known asasset-backed commercial paper.
The investors who bought this paper are now deciding it is not worth the risk. That gives the conduits and SIVsa problem. Moody's, a rating agency, says many have found funding“either impossible or achievable only at exorbitant levels”. OnSeptember 5th the agency downgraded (or placed on review) some $14billion-worth of bonds as a result.
Some SIVshad back-up banking facilities; some did not. But avoiding this directliability may be of little help for the banking industry as a whole,since when SIVs cannot get funding, they areforced to sell assets. This pushes down prices and increases thechances of the banks suffering losses elsewhere.
Banks are nowfinding that these risks are coming racing back onto theirbalance-sheets. It is an ugly prospect since Tim Bond of BarclaysCapital estimates that $1.4 trillion-worth of conduits are out there.Either the banks will have to lend money directly to them, or they willend up owning a ragbag of securities—including some dreadedmortgage-linked bonds.
What seemed aclever wheeze to avoid the scrutiny of the regulators and auditors nowlooks foolish, since no bank knows the exposure of any other. Worse,none knows the extent to which it will end up on the hook itself. As aresult, banks are hoarding their capital rather than lending it in themoney markets.
If banks haveto borrow at penal rates for some time, the poison will spread.Investment banks, for instance, do not rely on consumer deposits forfunding, but on borrowing from commercial banks and others. If the costof their finance goes up, they will have either to cut the supply, orraise the cost, of finance to important investors such as hedge funds.Those hedge funds will then have to sell assets, which might give thewhole system another downward lurch. Where's that plumber when you needhim?
