Treasury subprime plan much to do about nothing

A close review of the Treasury “plan” for the subprime mess suggests that not much is going to happen. The Treasury through its “Hope Now” plan facilitated some arrangements with banks to help standardize adjustments to loan arrangements through allowing for no change to lending rate. The number of borrowers this plan affects will actually be small. Also, the arrangement could have been made without the help of the Treasury and there is no current relieve planned for the billions that will be adjusted in 2008. In short, the financial system will have to work this problem out on its own. Foreclosures are going to build and home inventories in many markets are going to increase.

Paulson, who comes from Wall Street, will not take a populist approach of forcing moratoriums on investors as a solution. He is well aware that government intervention in the contracting of lending arrangements will not just hurt investors and affect the working of capital markets. At this point in time, protecting the capital markets from moral hazard problems is more important. This approach may change as we move through 2008 and get closer to the election, but right now, Treasury wants to look like they are doing something without being heavy handed.

This means that this crisis is going to continue for a long time and it will be the burden of the Fed to solve the problem through the use of the ineffective tool of lowering rates. Lowering rate is generally ineffective when there is an unwillingness to lend and the credit of borrowers is impaired. This solution also may be gradual because the lowering of interest rates will have negative ramifications on the dollar and we have not seen the signs of a recession in the rest of the economy. Expect the slow process of 25 bps cuts. The credit crisis will be one of the main themes of 2008

Dollar is driven interest differential expectations

The dollar has come off its lows since the middle of November because of changing expectations about the direction of interest rates outside of the United States. Up until recently, the United States was alone with its active policy of reducing rates. This lowering of interest rates by the Fed along with the lower rate expectations by fixed income investors caused the interest differential to move either against the US or to less favorable terms. A loose monetary policy in the US relative to the rest of the world will have the impact of increasing relative money supply which will lead to dollar depreciation. The economics are straightforward and transparent. However, the credit issues of the US have spilled over to other countries. In particular, the UK is seeing its own credit crisis issues as measured by short-term LIBOR rates. Consequently, there has been policy change by the Bank of England with a cut of 25 bps by the MPC for the first time in two years. This closes some of the gap that formed between the UK and US. There is similar talk of cutting rates in Europe based on slower growth and there are the longer-term expectations in the US that the economic outside of the housing is doing better than expected.

All these policy adjustments change the future expectations of interest rates which really drive the interest differentials or more precisely the expected interest differentials. If there is less drag from interest differentials, there will be greater opportunity for more dollar upside.

Shadow financial system seeing the potential for runs

The financial system has fragmented from the days when banks were the dominant force in financial markets. This is the shadow financial system which is not controlled by the Fed. Money funds clearly have an important role in short-term lending. Now we see state money funds, who have been the aggregators of smaller pools of cash being affected by the SIV crisis. With smaller investors pulling funds from larger pools like in the state of Florida, there are bank runs. The only way to solve the problem is to close the window to withdrawals.

Assume that there is some small percentage of a large pool holding sub-prime SIV commercial paper. You are a small investor in the fund and decide to pull your money. The percentage that SIV commercial paper represents in the fund will then increase which may lead to greater withdrawals. Who want to be the small investors left in the larger pool that is getting riskier? Florida may not be alone in the bank run scenario. If fact, this could be a problem in a number of states and could spill over to retail money funds. This would be a blow to investor confidence which will have a strong impact on the rest of the markets. The herd can move fast once it hears shots.

LIBOR does not follow the Fed

The monetary policy response to the credit crisis has been to lower the Fed funds rate. The monetary channel for increasing credit is to lower rates to cheapen the costs of banks to lend longer-term. A steep curve is a license to print money for most financial institutions. There is only one problem with this scenario, higher risks associated with banks themselves and the risk of lending. If lending is considered riskier, then the rate on LIBOR will increase. This increase in risk premium may be greater than what stimulus the Fed provides.

There also is a strong desire for window dressing at the end of this year. Who wants to hold risky assets at the turn of the year? This is why we currently see one-month LIBOR at 5.25% and yet one-year LIBOR is at 4.43%, an 80 basis point difference. Now if credit is cut-off over the turn of the year, there will have to be liquidation of assets from balance sheets which will lead to depressed prices for end of year price marks. There could be some wild fluctuation of prices with December 31, on a Monday. This end of the year financial zaniness may not be controlled by the Fed regardless of what they do over the next four weeks.