Friday, August 24, 2007

A turn-around in the credit crisis?

Some events are often catalysts that change the direction of markets. At this time, three actions have lead to a reduction in the dangers from the credit crunch crisis. Each of these events is not large by itself but all serve to change the tide of credit panic in the debt markets. Their signaling effect has calmed the markets.

  • Four large banks borrowed money from the discount window. The problem with using the discount window is that it may be perceived by the market as a weakness in the financial stability of the borrowing bank. Do you want to be the first institution to borrow large sums from the Fed? Four money center banks banded together and each borrowed $500 mm from the discount window and jointly announced their actions. There is less shame in this action and it sends a signal that the Fed is willing to provide liquidity. It can also lead to profitable business for the banks. Take the simple case of borrowing from the discount window and posting commercial paper as collateral which was bought at a discount. If the underlying collateral is good, then the banks can be virtually assured a profit on this transaction. Liquidity is restored and the Fed provides an avenue for funds to the market. The system is improved and the credit crunch is diminished.
  • The ECB provided further liquidity in Europe to reduce continued concern about the banking environment in Europe. The further injection of funds into the market provides needed liquidity which will further stabilize the credit markets. The ECB has not stated that they will lower rates but they are willing to provide funds at the current levels. This short-term action has been helpful.
  • Bank of America invested in Countrywide Financial. BofA buying into the largest originator of home mortgages sends a message that the home mortgage market is still a good business in the long-run even with the current rash of lay-offs in the industry. A savvy aggressive bank is stating that values for these companies are out of line with reality. Could other investors be far behind after this action?

None of these actions solve the credit crisis, but each provides some positive signal in an otherwise dismal market environment. The problem is not solved but there is now more breathing space for markets to achieve order.

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