System in Cardiac Arrest

And to confirm the near systemic collapse of the system of financing of both financial firms and corporate firms Warren Buffet declared yesterday, as reported by Bloomberg:

“In my adult lifetime I don’t think I’ve ever seen people as fearful, economically, as they are now,” Buffett said today in an interview with Charlie Rose to be broadcast tonight on PBS. “The economy is going to be getting worse for a while.’ …The credit freeze is “sucking blood” from the U.S. economy, Buffett said.

We are indeed at the cardiac arrest stage and at risk of the mother of all bank and non-ban runs as:

– A silent run on the commercial banks is underway. In Q2 of 2008 the FDIC reported $4462bn insured domestic deposits out of $7036bn total domestic deposits; thus, only 63% of domestic deposits are insured. Thus $ 2574bn of deposits were not insured. Given the risk that many banks – small, regional and national – may go bust (as even large ones such as WaMu and Wachovia went recently bust) there is now a silent run on parts of the banking system. Deposit insurance formally covers only deposits up to $100000. Thus any individual, small or large business and/or foreign investor or financial institution with more than $100000 in a FDIC insured bank is now legitimately concerned about the safety of its deposits. Even if as likely the deposit insurance limit will be temporarily raised to $250000 by Congress there will be about $1.5 trillion of uninsured deposits; a mass of uninsured deposits will remain at risk as even small businesses have usually more than $250K of cash while medium sized and large firms as well as any domestic and foreign financial institution or investor with exposure to US banks has average exposure in the millions of dollars. Particularly at risk are the cross border interbank lines of US banks with their foreign counterparties that are estimated to be close to $800 billion.

– The money markets and interbank markets have shut down as – despite the Senate passing the bail-out bill – yesterday USD Overnight Libor was still at 268bp after reaching an all-time high of 6.88%; the USD 3m Libor-OIS spread widened to record 270 basis points; EUR 3m LIBOR-OIS spread is at record 130bp; the TED spread is at record 360bps (TED was 11bps one month ago); Money and credit markets are dysfunctional also in emerging markets ; and agency bond spreads are also at highs again. 

– a run on most of the shadow banking system (300 non bank mortgage lenders now bust; SIVs and conduits now all bust; major brokers dealers bust (Bear and Lehman) or under severe stress even while converted into banks (Merrill, Morgan, Goldman); a run on money market funds; a serious run on hedge funds; a looming refinancing crisis for private equity firms and LBOs);

– a total seizure of the interbank and money markets.

So what needs to be done? Even several hundred of billion dollars in emergency liquidity support to the financial system by the Fed and other central banks in the last week alone have not been enough to stop the seizure of liquidity in interbank markets and the shut down of financing for the corporate sector as counterparty risk is now extreme (no one trusts any more in this crisis of confidence even the most reputable and trustworthy financial and corporate counterparties). Thus, emergency times where we are at risk of a systemic meltdown require emergency measures. These include:

– A temporary six-month blanket guarantee on all US deposits (not just those below $250k) combined with a rapid triage between insolvent banks that should be quickly closed and distressed but solvent – conditional on liquidity and capital injections – banks that should be rescued. To stop the silent run on the banking system you do need now such blanket guarantee on all (insured and uninsured) deposit regardless of their size. To minimize lender moral hazard from such action the blanket guarantee needs to be followed by a very rapid triage and shut-down of insolvent institutions. Of course the currently uninsured deposits of such insolvent institutions will need to be made whole once such banks are shut down (otherwise the run would continue); once the rotten apples (insolvent banks) that are infecting the good apples (the solvent banks) are eliminated the blanket guarantee will be lifted as the uninsured depositors of surviving banks can be assured that the remaining banks (the good apples) will not go bust. The extra fiscal cost of bailing out the uninsured depositors of failed banks can be addressed with FDIC recapitalization or increase in deposit insurance premia or by whacking further unsecured creditors of failed banks as the government should have first claim on the remaining assets of failed banks if uninsured depositors are made whole in such banks. Anything short of this blanket guarantee cum triage will not be enough as the silent run on the banks will soon become a roaring tsunami of an open run. Solution a la Korea 1997 – where the cross border interbank run was solved via a bail-in rather than a bailout of the foreign cross border interbank creditors of Korean banks via an effectively forced conversion of short term interbank lines into one to three years claims guaranteed by the Korean government – would be too risky as such effective capital controls and coercive stretching of maturities of cross border interbank lines would dramatically scare foreign investors placing funds in US banks.

– Some members of the shadow banking system will not receive such liquidity support of the Fed (hedge funds and private equity funds) as – fairly or unfairly – there is no political sympathy for such institutions. This means that the demise of hundreds – and possibly thousands – of hedge funds will occur as redemptions and roll off of overnight repo financing for leveraged investments will cause a massive liquidity – and thus solvency – crisis for such institutions. If hundreds of smaller hedge funds collapse the systemic consequences would be limited (even if in the aggregate hedge funds provide significant financing to the corporate sector). If larger and systemically important hedge funds were at risk of failing the Fed will have to engineer a massive private sector bail-in of such hedge funds (a larger scale rescue a la LTCM) where the prime brokers of such funds are forced to maintain repo exposure to such funds rather than be allowed to shut off such exposure. This is a radical suggestion but the alternative of a Fed liquidity bailout of systemically important hedge fund is not politically feasible given the little sympathy that such funds enjoy in Congress. The refinancing crisis of private equity firms and their LBOs is a longer fuse run as covenant-lite clause and PIK toggles will postpone such financing crisis but make the harder the fall as zombie corporations that postpone restructuring will have a bigger collapse once the financing crisis eventually occurs. But since many of these LBOs should have never occurred in the first place any financing crisis for such buy-outs should be dealt with in bankruptcy court; no public funds should be used to rescue such LBOs and the reckless private equity firms that designed such schemes.

– Have a coordinated 100bps reduction in policy rates by all major advanced economies central bank and, possibly, even some emerging market economies central banks. While this policy rates may not directly resolve the insolvency issues in financial markets and in the corporate sector it may ease liquidity pressures and it would signal that global policy makers are serious about addressing together this most extreme liquidity and financial crisis.