Teetering At The EDGE Of A Market Meltdown, Global Central Banks To The RESCUE!

``Financial panics don’t happen during depressions…They happen on the brink of depressions. The claim the world is prosperous is beside the point.”-James Grant, the editor of Grant’s Interest Rate Observer.

In a span of 48 hours, global central banks in an apparent series of coordinated moves, under the threat of a market meltdown, conducted the LARGEST open market operations to inject liquidity into the world’s financial system since September 11, 2001.

The European Central Bank initiated the actions following a dramatic spike in overnight interest rates seemingly in reaction to a freeze on investor redemptions by France’s largest bank BNP Paribas on three of its investment funds that were invested in asset-backed securities (ABS) with significant exposures to US subprime mortgages. Asset backed securities is a type of bond collateralized by the cash flows from a specified pool of underlying assets (wikipedia.org) such as credit cards, auto loans and etc.

According to the Washington Post, ``The bank injected the equivalent of $84 billion into the financial system Friday "to assure orderly conditions in the euro money market," it said in a statement. The Federal Reserve added $38 billion to markets, the Bank of Japan $8.5 billion and the Reserve Bank of Australia $4.2 billion, signaling broad concern among central bankers. On Thursday, the European bank made a $130 billion infusion and the Fed added $24 billion.”

From Scott Lanman and Christian Vits of Bloomberg, ``Central banks in Norway and Switzerland also injected money into the financial system and countries including Denmark, Indonesia and South Korea said they're ready to provide cash.”

Let us hear from BNP Paribas the reason it suspended withdrawals (highlight mine), ``The complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly regardless of their quality or credit rating."

Figure 1: New York Times: Spike in Interest Rates and Risk Aversion

Figure 1 from New York Times demonstrates how the markets suddenly seemed to have suddenly lost access to funding aggravated by a reversal in sentiment which appears to have raised risk awareness. How market psychology can swiftly change with a snap of the finger!

For instance, even when the FED rate is pegged at 5.25%, Bank of America had to add for its reserves last Thursday at 6%! In other words, because of the need by some banks to immediately secure reserves, they had to aggressively bid up the price of money. And only from open market operations by the FED did it normalize the rates.

This illustrates the implied “tightening” seen in the financial system as a consequence to the previous easy money policies which have likewise spawned financial engineering that resulted to the excessive leverage and speculation. The New York Times quotes Mr. Robert Barbera, the chief economist of ITG, a research firm (highlight mine), ``The Fed tightened in 2005 and 2006, but creative financing on Wall Street blunted the impact…The collapse of that option in the last 90 days means the entirety of that tightening is arriving now, and there is a violent tightening going on.”

Now what used to be restricted to the confines of US mortgage lenders have now spread to the entire spectrum of international finance; from hedge funds to insurance companies (AIG) and now to banks! As Chris Hancock of Penny Sleuth aptly describes (highlight mine), ``The fear seems to be… No one really knows what these collateralized debt obligation (CDOs) are really worth. No one really knows who owns what. A farmer in France knows he holds a pension, but what that pension may be worth is anybody’s guess.”

Again this has not been limited mortgage issues as the credit woes has spread to the broader financial market, this excerpt from the New York Times (highlight mine), ``High-quality bonds issued by companies with sterling credit have not been immune to the rout either. Investment-grade bond issues fell to $30.4 billion in July — the lowest monthly total in five years — from $109 billion in June, according to Thomson.”

And since even the highest quality debts instruments had not been spared from the snowballing liquidity crunch, the diminishing appetite to take risks has started to curb activities even in the NON-FINANCIAL world.

In Asia alone, FinanceAsia identifies some of the emergent symptoms (highlight mine), ``Sure enough, Pakistani textile and fertilizer manufacturer Azgard Nine’s scheduled $260 million offering was postponed on Friday. Other companies in the pipeline such as Chinese property developer Hong Long Holdings, Indonesian mobile phone operator PT Mobile-8 Telekom, and Indonesian power company PT Cikarang Listrindo are also likely to experience considerable difficulties clearing their high-yield transactions. Nevertheless, chief investment officer Asian fixed-income and portfolio manager at Fidelity Funds, Andrew Wells says that credit spreads on Asian high-yield securities are now lower than for US high-yield. This indicates that investors view US high-yield as more risky than Asian high-yield.”

Naturally, with the epicenter of the credit tremors situated in the US, the perception of risk seen in the Asia-US yield curve is to be expected, although the contamination of the recent deterioration of credit conditions has obviously diffused to a broader segment of the global economy.

Ok, the basic dilemma in today’s setting is that with the recent financial alchemy, many portfolios of financial institutions around the world contain HIGHLY LEVERED instruments that are NOT openly traded or are highly illiquid. Such instruments in the past valuations had been DETERMINED by the ratings assessed by the credit rating agencies or by institutions that sold or distributed these, known as “Mark-to-Model”. Simply stated, many financial institutions who bought into these presumed that the US housing market had only ONE direction, never questioned on the financial INCENTIVES of the agencies that sold these products and most importantly never CONTEMPLATED on exit strategies or contingent actions arising from a reversal in the markets.

Now recognizing that some of these investments have been INFECTED by the US subprime problems, these financial entities are at a loss on how to value them since these have not been priced through the open markets. Since as we previously said, that losses on such levered positions necessitate margin calls, the corollary to this is the “COMMON FACTOR PROBLEM” where these financial institutions had no option but to sell assets that are most liquid (stocks or high quality debt) to cover their margins or borrow from another institution, ergo the contagion.

Moreover, there is the issue of RATING CREDIBILITY, some of the recently engineered financial products had been an amalgamation of inferior products (e.g. subprime) with that of mostly high quality debt products and had been eventually RATED as high quality ones. In short, there is also the issue of implied deceit or chicanery.

Considering the mounting losses, credit agencies have effectively been DOWNGRADING on a slew of such instruments, where markdowns constitute REVALUATIONS of portfolio values. For the others, losses would translate to large “haircuts” or even insolvencies. Therefore, one can expect losses on MORE institutions to crop up, and credit spreads to rise, as portfolios get “re-priced”. We borrowed Dennis Gartman’s quote last week, there is never one cockroach, now it appears that cockroaches have been appearing worldwide.

Essentially, all these show that many are today paying for the price of GREED, which had been stimulated by government inflationary monetary policies.

And because of the current dispersion of risk products into a WIDER pool of investors globally, the predicament of not knowing the worth of their portfolio assets have likewise led to the CLOSING of some credit channels and thus the liquidity crunch driven market carnage.

This is a very important germane insight lifted from the Financial Times (highlight mine), ``Marc Ostwald, fixed income strategist at Insinger de Beaufort, said: "There is huge pressure on money rates due to an apparent sense of mistrust. Following BNP Paribas' statement, very few institutions appear willing to lend. If you kill off the inter-bank market and the asset- backed commercial paper market has effectively collapsed, then we look to be heading for a serious liquidity crunch."

So fundamentally we have a crisis of confidence brought about by too much leverage that has incited to this panic. This is how Walter Bagehot in his book Lombard Street described panic (highlight mine), ``A panic grows by what it feeds on. . . . . A panic, in a word, is a species of neuralgia, and according to the rules of science you must not starve it. . . . . In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure, which causes them.”

If you think that the recent activities of global central banks will ARREST this unfortunate development, THINK AGAIN. Even as the ECB infused massive doses of liquidity to its starved markets for the second day, Washington Post describes the Friday’s outcome, ``European stock markets tumbled sharply. London's FTSE 100 index lost 3.7 percent, its largest drop in four years; France's CAC 40 fell 3.1 percent; and Germany's DAX dropped 1.5 percent.”

Yes, the US markets did rally from the chasms to close marginally lower (on Friday the Dow dropped 213 points but closed 31 down), but I highly suspect that these had been due to possibly more direct intervention from the President’s Working Group or as wikipedia.org explicates of the said highly secretive agency, ``The Group was established explicitly in response to events in the financial markets surrounding October 19, 1987 ("Black Monday") to give recommendations for legislative and private sector solutions for "enhancing the integrity, efficiency, orderliness, and competitiveness of [United States] financial markets and maintaining investor confidence" or subtly known as the Plunge Protection Team. But conspiracy theories are not our cup of tea.

The IMPORTANT POINT to understand is that with the series of seemingly coordinated government interventions around the world, such underlying motions acknowledges the severity of the problem largely underestimated by the world financial markets. The markets are only BEGINNING to adjust to the realization that they had applied leverage to the extreme levels, conditioned by monetary stimulus, which has resulted to the overestimation of business conditions or malinvestments in the terminology of the Austrian School of Economics. And it appears that the credit expansion cycle has turned.

In addition, since the present credit woes emanates from the US housing markets, then the ongoing HUGE ARM resets (as previously discussed) are likely to continue to hound the financial markets as foreclosures accelerate.

A further growing downside risk is that the US economy could enter into a RECESSION soon as consumers (estimated 76% of GDP) get tapped out from a 1-2-3 combo punches of DECLINING asset values of real estate and stocks and FESTERING credit conditions unmatched by any significant improvements in business investments and/or employment conditions, enhancing the odds of more downward financial markets readjustments.

Recently the US FEDERAL Reserves in its FOMC maintained that inflation was their main concern as a reason to maintain its present rate level. This will change soon.

Even hawks like St. Louie FED President Mr. William Poole, who recently denied that the FED would come to the rescue of the markets, or of FED Chief Ben Bernanke and US Treasury Secretary Paulson, both of whom claimed that the subprime worries would be limited have proven to be wrong, as rhetoric has NOW given way to palliatives.

The FED has two more tools left at its disposal the discount rates and the Federal Funds rate and would be used soon. And if the FED enacts a series of cuts, this underscores the risks of what we had mentioned above.

During the last two days, unknown to the public, the world financial markets teetered at a brink of a collapse.

Analyst John Maudlin quotes anonymously a financial expert (highlight mine) who piquantly describes the present situation, ``We came to the edge of the abyss in the financial markets this week, and then we looked over. The world does not understand how close we came to a total meltdown of the markets.”