Fear Itself

Richard DeKaser

The definitive financial history of the past two months has yet to be written. But any interpretation must ultimately address the negative feedback loop in which fear begat more fear, leading to an outright financial panic. Akin to the speculative frenzies that gave us bubbles in equity, house and commodity prices earlier this decade - except in reverse - this moment was defined by an intense, and arguably irrational, aversion to risk.

After Fannie Mae and Freddie Mac were nationalized and Lehman Brothers failed, even the fabulously profitable Goldman Sachs went scrounging for funds as investors grew phobic about financial company risks. One measure of this angst is the difference between 3-month London Inter-Bank Borrow (LIBOR) interest rates and expectations for the federal funds interest rate over the same period. Each of these rates is for unsecured, short-term lending among financial institutions, though LIBOR applies to a broad class of intermediaries and is determined by market forces alone. The fed fund rate, alternatively , applies only to U.S. banks trading in excess reserves (funds held at the Federal Reserve) and is determined largely by the Fed itself.

Historically this spread averaged a measly 10 basis points (hundredths of a percent), with negligible variation. The rationale for this narrow spread is simple: if LIBOR climbed much over the fed funds rate, banks had every incentive to borrow in on market and lend in the other. Beginning in August of 2007, however, as subprime mortgage problems became increasingly obvious, this spread climbed into a range of 50-100 basis points. Clearly banks grew wary of lending to one another and other financial intermediaries. Beginning this September, however, the spread soared to an astronomical 370 basis points as near paralysis took hold.

The freeze in inter-bank lending rapidly spread to other credit markets. Money market mutual funds took losses on Lehman debt and suffered extraordinary redemptions. And because money market funds provide funding to the commercial paper market (where the most creditworthy of firms borrow on a short-term basis), that market seized up as well, forcing companies to turn to their bank lines for desperately needed financing. But a shortage of liquidity among banks was where this all began, so they rationed credit on an increasingly restrictive basis.

Ultimately, the "credit crunch" (a descriptor I rejected until recently) hits the economy, where spending, investing and hiring all suffer. These consequences are evidence in other spheres of our financial markets, like the 33 percent decline in the S&P 500 index, along with the greatest uncertainty (measured by implied volatilities), this market has ever recorded. Even the difference in yield between intermediate-grade corporate bonds and comparable maturity Treasuries is at an all-time high.

While these extraordinary financial market conditions are leaving a severe mark on the economy, I do not expect them to last. I'll elaborate my reasoning in this space next month, but the short explanation is this: public policy has been bold and well targeted toward addressing the specific areas where confidence is in short supply, and, the financial losses so desperately feared are unlikely to meet those dire forecasts. (10/31/08)

Copyright 2008


Richard DeKaser is the Chief Economist for National City.


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