ECB Takes Action, Injects Massive Liquidity
A: This credit crisis is just as much a liquidity crunch as it is a credit one. To break such a complex environment down to its core, there just isn't the liquidity in the secondary mortgage markets as their used to be; and that means trouble for those holding big time mortgage backed securities assets in their bag. While the problem stemmed from the spike in defaults of subprime borrowers leading to lack of interest for the securities backed by lower quality mortgages, one solution may lie in providing sufficient liquidity to corporations that need to raise capital but can't by selling their assets into a healthy marketplace; because the marketplace isn't functioning properly. In comes the European Central Bank with solid action.
I think this is fairly big news on the credit front given the deal that is being offered (low rate) and the time that it is being offered for (two weeks). Lets get right into it.
According to Bloomberg:
Money market rates tumbled after the European Central Bank injected an unprecedented $500 billion into the banking system as part of a global effort to ease gridlock in the credit market.I bolded what I thought were some of the more important points. In my view, one of the clear signs of distress in the credit markets lies in the LIBOR rate, which is the rate at which banks participating in the London money market offer each other for short term deposits. The action by the ECB brought relief to rising LIBOR rates.The amount banks charge each other for two-week loans in euros dropped a record 50 basis points to 4.45 percent, the European Banking Federation said today. The rate had soared 83 basis points in the past two weeks as banks hoarded cash in anticipation of a squeeze on credit through the year-end. The ECB loaned a record 348.6 billion euros ($501.5 billion) for two weeks at 4.21 percent today, almost 170 billion euros more than it estimated was needed. Bids were received from 390 banks, ranging from 4 percent to 4.45 percent.
According to Financial Times (via Calculated Risk):
"This is basically Father Christmas to those who have access," said Erik Nielsen, economist at Goldman Sachs. "They are bailing out people who have not really adjusted their balance sheets to the new reality."Last week I discussed this in my post, "Fed Action Coming; LIBOR Targeted?" where I stated:But Julian Callow, economist at Barclays Capital in London, said the funds injected today would later be "mopped up" by the ECB, which was "simply doing their job at being lender of last resort".
"It seems a co-ordinated effort with International central bankers is underway to help the credit markets and specifically the LIBOR rates which have drifted to a 85 basis point spread from fed funds rate. That widening spread is a clear signal of distress in the credit markets showing that banks are risk averse in their lending habits.I also put a chart up showing you the widening spread between the Fed Funds Rate & the LIBOR rate since August 1st, about the time when this credit crunch hit mainstream media.Getting LIBOR back in line, within 10-12 basis points of fed funds rate historically, should be a top priority to soothing the pain in the credit markets and ultimately for consumers."
So, if I were a central banker and knew that rate cuts in a pipeline inflation world may not be the best thing, why not try some reverse thinking. We know LIBOR is disconnecting from fed funds rate because of distress in the credit markets. We also know that tons of adjustable rate loans (ARM's) are tied to this LIBOR rate. So, we know we need to get LIBOR back in line. Hmmm, how do we do this when banks themselves set this rate and its clear there is anxiety about lending right now? Perhaps we should provide MASSIVE AMOUNTS OF LIQUIDITY to the banks in need who can't raise enough capital because of the distressed state of the secondary markets where billions worth of mortgage backed securities holdings are traded! That way, banks can tap into this liquidity to raise capital from us, rather than from a fire sale of distressed assets! That should help the liquidity problem & confidence at the same time!
That is exactly what is happening and as a result, LIBOR and other money market rates have been heading lower!
According to Forbes:
Interbank lending rates in the euro zone fell today in the wake of a liquidity injection by the European Central Bank.This action has been a TARGETED ACT towards the credit markets and getting LIBOR back in line to a more normal spread with the fed funds rate.The three-month euro London Interbank Offered Rate (Libor) fell almost 10 basis points, the largest drop in six years, to 4.85 pct from 4.95 pct yesterday.
You can look at it like I just described OR you can break it down further and see some acts of desperation. You can also look at it as "geez, look how many banks tapped into this cash injection; that can't be good!". Time will tell whether this action eases the crisis we are in, but all in all, I think its a very solid move by the European Central Bank. Now, will it be enough, will banks get too used to this act of kindness and not bother to clean up their books, or will it prove to be too little too late?
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