Monday, August 20, 2007

Panic, or the lack of it, will be measure of Fed success

Panic, or the lack of it, will be measure of Fed success
By Krishna Guhain Washington
Copyright The Financial Times Limited 2007
Published: August 20 2007 03:00 | Last updated: August 20 2007 03:00

The coming days will test whether the Federal Reserve's emergency action on Friday will be enough to arrest the spread of financial contagion and stop extreme nervousness in credit markets turning into full-blown panic.

The US central bank made direct loans available to banks on favourable terms and hinted at a possible interest rate cut after policymakers concluded that a sharp deterioration in market conditions on Wednesday and Thursday threatened to develop a momentum of its own and run out of control.

At this stage, policymakers are first and foremost concerned with doing what they can to ensure there will be no self-perpetuating crisis of confidence.

They still believe that fundamentals are good outside subprime mortgages. But they understand they are now grappling with a much bigger challenge that has as much to do with internal market dynamics as with economic fundamentals.

In short, the Fed is trying to restore some semblance of confidence in the system. To see whether its approach is working, officials will monitor a wide range of market metrics.

These include: the bid-ask spreads on high-quality commercial paper; short-term Treasury rates; on-the-run/off-the-run spreads (the difference in price between securities that have the same economic characteristics but different trading volumes); margin terms between high-quality counterparties; credit spreads and conditions in the interest rate and currency swaps markets.

In many cases, the data suggest that the markets are in the grip of a liquidity crunch and pull-back in risk appetite comparable to that of 1998 (see charts). Taken together, these metrics might be considered as crudely indicating the general level of confidence as well as specific technical conditions.

The Fed is anxious to ensure that these measures do not deteriorate much further. However, it does not expect rapid improvement either and policymakers are working on the assumption that there might be more bad news in the pipeline.

The process of discovering where subprime losses lie is by no means complete. Hedge fund liquidations may have further to go and other strategies could come unstuck as "quant" funds have done in recent weeks.

The repatriation of risk to banks' balance sheets is also likely to continue, with banks having to take on more risks that were earlier held off balance sheet and honour contingent credit lines to troubled clients.

Over-arching all of this is a wave of deleveraging (reducing borrowing to reduce exposure to risk) that also shows no sign of abating. The Fed believes there is not much it can do about the adjustment process, other than try to ensure it does not trigger a market panic. It sees its actions as bolstering the system against further possible tremors, not a wave of the wand to end the turmoil.

The steps taken on Friday will help in a mechanical sense if banks can be persuaded to make use of the Fed's direct "discount window" loans. This is not guaranteed, since banks may still fear, in spite of the Fed's assurances, that this may be seen as a sign of financial distress. But the true measure of success will not be how much banks use the facility, but whether knowledge that it is there makes them more willing to take part in the asset-backed commercial paper market and the jumbo (large-denomination) mortgage market.

There are further steps the Fed could take to boost liquidity short of cutting interest rates, including arranging currency swaps, altering collateral requirements and even lending direct to non-banks.

But at a time when what really matters is the signal the Fed sends, some officials are likely to feel wary of a succession of baby steps.

If market conditions deteriorate further, and there are renewed signs of a brewing market panic, the Fed will be forced to consider cutting interest rates. It is not yet agreed on the need to do so now. But events are moving in financial market time measured in seconds, rather than economic time, measured in months.


Post a Comment

<< Home