The Federal Reserve and the Treasury did what they had to do to stop the money market panic of 2008. Since then many commentators have taken comfort from indicators that in normal times would point to healthier credit markets: falling TED spreads, falling LIBOR, tighter A2/P2 spreads, etc.
To which I reply: not so fast. Without the continuing, massive, and unprecedented government interventions in the credit markets, one suspects that these spreads would zoom again. We do not have a self sustaining recovery in the credit markets, because the government refuses to address banking system’s longterm problems. So in the meantime, the Fed and the Treasury are essentially painting the tape. Yes, Virginia, even credit spread numbers can be made to lie.
Last year’s panic is over, to be sure. We’ve even seen tightening in longer term junk bond rates when compared with Treasurys of similar maturities. But would anyone buy debt from a major bank without Treasury guarantees? Does anyone think for a minute that commercial paper rates would stay so low without Fed purchases of commercial paper (or more precisely, backstopping SPVs that purchase commercial paper)?And given the Fed’s T-bond purchases, does anyone think that the free market now sets rates on longer Treasurys? These questions answer themselves, don’t they?
Here’s another reason why the falling rate graphs don’t tell the whole story: even with Fed support, the commercial paper market is shrinking. Total outstandings have dropped to $1.248 trillion, the lowest level since 2001. Is that because companies can’t get funding, or because they don’t dare to borrow? Probably some of both. The big banks don’t dare lend as much as they used to because the recession continues to produce increasing losses on residential and commercial real estate loans, credit cards, and toxic securities they can’t sell. Money market funds learned in 2007 that they actually have to do their own credit analysis before they buy anything that the Treasury does not guarantee, so they are pickier than they used to be. And why would corporations borrow more, when the profits of the S&P500 companies are down 90% year over year?
We are in trouble now partly because businesses and consumers couldn’t service pre-recession debt loads. Intelligent government policy would cushion the worst fallout from the inevitable deleveraging that is taking place, rather than try to keep total credit outstanding at June 2007 levels. But rather than tell us the truth, the government seems to be trying to encourage borrowing at prior levels in order to finance consumption we can no longer afford. This they do by keeping rates artificially low and by keeping weak institutions on life support.
While the Fed seemingly likes low commercial paper rates, making short term loans to private business (which is what the Fed does when it backstops facilities that buy commercial paper) is not normally thought of as part of the Fed’s mission. This was an unprecedented step last October, though arguably necessary to prevent a recurrence of the September panic. The Fed, however, doesn’t appear to be getting itself out of this business. Money market funds and banks are usual buyers for commercial paper, and if we repaired the financial system properly, they might do more of that business again.
Speaking of repairing the financial system: this year the FDIC has closed a small insolvent bank almost every week but somehow we don’t want to close the big banks that would seem to be troubled — banks like Bank of America, (BAC), Capital One Financial (COF), Citigroup (C), JP Morgan (JPM), and Wells Fargo (WFC). This does not make sense. I understand, some people are afraid that if the FDIC takes over big weak banks, the government would have to own them, or parts of them, for years while selling off the bad assets. After all, the FDIC needed seven years to wind up the business of Continental Illinois after it failed in 1984, and that rescue might eventually look like a walk in the park compared to fixing a complex institution like Citigroup.
On the other hand, the longer taxpayers continue to support these banks, the weaker these banks get, and the more we will have to pay later. Given the declines we’ve seen in corporate profits, businesses are laying off 600,000 employees a month in order to cut costs commensurately. Need we say that does not bode well for banks who lend to consumers? Banks that lend to companies who sell to shrinking businesses may not make out so well either.
Meanwhile, if the FDIC simply got on with the job, private investors and other banks would purchase pieces of the weak banks, new lending capacity would be created, and real confidence restored. Surviving financial institutions would find private funding without government guarantees, and there would be less need for government intervention in the credit markets.
In 1933 the government closed the insolvent banks but thereafter people believed in the surviving institutions’ solvency and were comfortable lending to them. On a smaller scale (relative to the economy, at least) the FDIC cleaned up the bad S&Ls in the early 1990s by closing them down and selling the impaired assets, which worked out pretty well in the end. Until the government helps to re-create a financial system that private business can believe in, the government will have to keep supporting the financial system with extraordinary actions by the Treasury and the Fed. And it will presumably do so until reality forces policymakers to change — either through horrendous bank credit losses that even the new accounting rules can’t hide, or when the bad dream of a failed Treasury auction actually comes true.