More on the credit markets, courtesy of Minyanville. This article is extremely helpful in understanding of the consequences of a frozen credit market. Regardless of what economic/political system we choose to believe in, this is key:
"Now, we’re not talking about bailing out financial institutions. We’re literally talking about saving the world economic system. Failed bank lending and a large decrease in letters of credit would guarantee a deep world recession. The last depression produced severe political backlash and a world war.
Frankly, it’s simply not worth the risk to say that we should sit back and let the markets work. They are not working, and there are no signs they will…"
Thawing the Markets, Part 2
By John Mauldin, at Minyanville.
Letters of Credit: Going, Going Gone?
Just as the business world is dependent upon commercial paper as its life blood, the world of global trade depends on letters of credit (LOC). Without LOCs, the world of trade quickly freezes up.
If you’re a manufacturer of a product and want to sell to someone outside your borders, you typically require a letter of credit from the buyer before you load any cargo at a port. A letter of credit from a prime bank is considered to be proof of your ability to pay. It not only can be a source of ultimate payment, it can be a source of inventory financing while goods are in transit.
And if you’re a business that is buying a product, you don’t want to release money until you know the product is on the way. There are buyer’s and seller’s agents who make sure these things happen seamlessly, and world commerce had grown because of it.
Now we are starting to get anecdotal evidence that this extremely vital market is also freezing up. If you think the problems stemming from a meltdown with the commercial paper markets are threatening to the world economy, they are small potatoes when compared to a seizure in the letter of credit markets.
I had been thinking about this for a few weeks. Then an article posted on Naked Capitalist caught my eye. Quoting:
"At the end of the day, if every counterparty is bad then you don’t have a market and you don’t have an economy. I spoke to another friend of mine this afternoon, whose father has been in the shipping business forever. Pristine credit rating, rock solid balance sheet. He says if he takes his BNP Paribas letter of credit to Citigroup (C) today for short term funding for his vessels, they won’t give it to him. That means he can’t ship goods, which means that within the next 2 weeks, physical shortages of commodities begin to show up. THE CENTRAL BANKS CAN’T LET THAT HAPPEN OR WE HAVE NO ECONOMY, LET ALONE A CREDIT SYSTEM."
If banks are refusing to go into the LIBOR market and lend to each other, then why would they want to take a letter of credit either? At first, it will be a small trickle, which is how the commercial paper meltdown started. Then it will be a flood.
The one good sector in the US is its export sector. Start slowing that down due to a lack of ability to ship or receive payments and see what happens to an already shrinking economy. If anyone wants to see how the credit crisis can affect Main Street, look no further.
What to Do and Where Do We Go from Here?
The credit markets are frozen. Period. The chart below shows one week LIBOR going back for four years. Notice the gradual rise into 2005? It was a lock-step move with the Fed funds rate. And the less smooth drop was also in concert with the Fed funds rate. The recent spike is not responding to this week’s Fed funds cut. The spreads are wider than ever. The problem is not just the price of LIBOR. There is no trading at any price. The LIBOR market is a fiction today. And left unchecked, this lack of dealing with other banks will spread to letters of credit and the international trade markets.
The G-7 group of nations is holding an emergency meeting this weekend [last weekend]. As I write this, reports are coming in that there are serious disagreements as to what to do. They cannot even agree on a press release.
The real leadership and innovation in the banking crisis seems to be coming from London. UK Chancellor of the Exchequer Alistair Darling told Bloomberg Television that "it is absolutely essential that the world’s largest economies act together, and act together now."
Darling wants countries to guarantee lending between banks, either by turning central banks into clearing houses for the loans or having governments back them.
Sadly, he’s right. Now, we’re not talking about bailing out financial institutions. We’re literally talking about saving the world economic system. Failed bank lending and a large decrease in letters of credit would guarantee a deep world recession. The last depression produced severe political backlash and a world war.
Frankly, it’s simply not worth the risk to say that we should sit back and let the markets work. They are not working, and there are no signs they will. As with a patient whose heart has stopped, it is time to apply the shock treatment.
What should we do? First, we must simply guarantee LIBOR (interbank) lending worldwide for some period of time (say 3-6 months), or until banks can trust each other’s balance sheets. With the Lehman crisis going on and with more mortgage credit problems being revealed, no one knows what their own exposure is, let alone what the exposures are of other banks. Until that dust settles, the LIBOR market will remain frozen. The longer this is allowed to continue, the worse the problems will be. And it needs to be handled on a coordinated basis.
Banking is truly global. The system cannot just be guaranteed by England or the US. It must be done in concert with all major nations contributing their share. Businesses must be able to trade across borders through banks that will accept one another’s letters of credit.
Second, we must consider direct investment in some banks. This should be done as preferred shares, with the view to eventually selling the paper back into the market. To make sure that money is not invested poorly or on bad terms, the various governments should invest alongside private investors on the same terms. If a bank cannot find private investors willing to invest alongside the government, then they should be quietly assisted into the arms of stronger banks. Banks that are too big to fail must be taken over.
Third, for a short period of time, all bank deposits in the US must be guaranteed. Weak banks must be absorbed into stronger banks as soon as possible. There are banks with large construction loan books in the hardest-hit parts of the US housing crisis, and they need to be put down as quickly as possible. We are already seeing deposits leave banks, many of them small, due to depositor concerns that small banks will not be seen as too big to fail. This must stop. A blanket guarantee will help.
Fourth, mark-to-market rules must be reconsidered. A blanket one-size-fits-all rule clearly doesn’t work and is part of the problem. As I’ve said for the last month, there are numerous assets that have a market price far below their intrinsic value. That’s because there are simply no buyers. If everyone is selling in order to raise capital, then that will drive down prices to bargain levels below intrinsic value. That does not mean the asset in question would not have a higher value in a market not in crisis.
We are already in what will prove to be one of the longer recessions on record. If we look at the Leading Economic Indicators, which have about a 9-month forward-looking view, it will be late next year before we start to grow once again. Given that everything peaked last October through January (sales, employment, etc.), it’s likely that the recession will be dated from the beginning of this year.
Long-time readers know I’ve been wary of the stock market for several years, suggesting that investors either avoid stocks or have close stop losses. as it turns out, I was right on this one.
I have been fielding calls all week asking me if I think we are close to a bottom in the stock market. And my answer is, we are close to a short-term bottom, but I think we will trade lower over time due to what I think are going to be poor earnings for the next few quarters. If you’re a trader (and that means you have been doing it for some time – not the time to get on the job training!), then maybe you can catch a rebound, which is overdue. But (and here is the big caveat), if there is no global coordination on some or all of the recommendations I made above, this is not going to be pretty. It will end in tears. Let’s hope the authorities can get their collective act together.
