Friday, October 10, 2008

What to Watch? Deflation? Banks?

Brief item at RedState:

...The most disturbing new sign this morning is in the bond market. US Treasury debt has not rallied strongly this week, as you expect it to when times are tough everywhere else. The very front end of the yield curve is sharply lower, with T-bill rates again nearing historic lows.

But farther out the curve, Treasury securities are mostly flat to lower. In some cases, yield spreads between Treasuries and swap interest rates at equivalent points on the yield curve have become negative.

That is portentous and hard to explain. It could be nothing. It could be the market trying to digest a lot of new and unusually-structured issuance by the Treasury this week.
Or it could be the start of a global deflation. Pray that we’re not seeing the latter

The "D"-word has been batted around by a few folks--notoriously the gold-bugs--in the last few months. Curious that gold-bugs would be playing with it, as it's INflation which usually drives people to purchase the yellowmetal.

But why not deflation? Housing in the US is deflating rapidly, dragging mortgage-assets down along with it. Labor-cost pressures have deflated the cost of goods (see PRChina.) The Dow was certainly INflated when it was selling at 20x earnings, where the historical norm is 7x. (Big difference there, folks.)

Interesting times.

Now comes Ritholtz:

...Consider the way fractional banking works. Depositors open accounts with banks, earning interest, along with ready access to their accounts at any branch or ATM. The bank leaves a small fraction of the money on deposit, and uses the rest for loans, either to businesses or consumers. The smaller the fraction retained on deposit by the banks, the more money they have to lend out, and in theory, the greater their potential profits.

This is a quaint, 18th-century system. It worked well—at least before the modern era of derivatives and excess leverage

In recent years, banks ran into three kinds of trouble: They made loans to people who failed to repay them; they did not keep adequate capital on reserve; they compounded their problems by borrowing money from each other to buy back all of those loans after they had been repackaged as fancy securities.

If it sounds ridiculous, it is only because it was.

What makes the current crisis so dangerous is that all these complex financial maneuvers have left the institutions themselves shell shocked. They no longer know who to trust. When Banks cannot tell if the other bank across the street has enough money to survive through tomorrow, they cease credit operations. As long as this condition exists, banks will be reluctant to lend money to anyone but the strongest financial institutions, who of course, do not need it.
Hence, a credit freeze.

His thoughts? Kill off the weak banks, gently but firmly. Recapitalize the survivors by Treasury buying preferred, matching dollar-for-dollar with private purchases of same.

What Ritholtz discounts is the 'original' TARP--buying the dodgy assets from banks, which has the effect of 'recapitalizing' by reducing the capital requirements to support those assets.

One wonders why he blows off that plan, which would SEEM to have the same effect (albeit indirectly rather than directly.)


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