Company default rates will undoubtedly rise somewhere along the 300% lines anticipated by Economy's chief economist Mark Zandi. Risk of Default is simply part of the capitalist processes of "creative destruction." The only way to avert the rising default rates would be for the Fed and other central bankers to orchestrate a "bailout" for all the over-levered players in the game involved in excessive risk taking.
Even if the Fed and other central bankers could successfully pull off another bailout strategy, the Fed and their central banker counterparts at the ECB and BOE are striving diligently to avoid the moral hazards that would come with the requisite aggressive easing.
On that note, however, it was interesting to find the Bank of England Governor Mervyn King charging this morning that his central bank counterparts in the US and Europe are right now entertaining those very moral hazards which would threaten to sow "the seeds of a future financial crisis." This was "pure poppycock" from Mr. King to coin an old English phrase. Each of the three central bankers are lending freely but not excessively - to manage the present financial crisis.
Notwithstanding the BOE's allegations today, each central bank appears to be deploying slightly different monetary tools to abate the liquidity risks in the unregulated "shadow banking system." However, they can not be said to be attempting to abate default risks inherent in the financial system. While the Federal Reserve, ECB and the BOE have all pumped unusually high amounts of liquidity into the financial system to reduce the unusually high overnight rates since the crisis began to evolve on August 9th, their actions and words can be viewed as carefully attempting to avoid the "moral hazards" of excessive risk taking that aggressive rate cuts lead to.
On August 17th, the Federal Reserve took the unusual step of cutting the discount rate 50 bps. However, the efficacy of that particular monetary tool will not have the impact that it once had in years past when the Fed funds rate and the discount rate window could be used almost interchangeably.
A month ago, the Fed's discount window rate was a full 100 bps above the Fed funds rate on August 17th when they cut it to 5.75% from 6.25%. Today, it is still 50 bps over the 5.25% rate, and today, the discount rate is largely considered only a penalty rate today (see Pimco McCauley's Teton Reflections for further explanation.).
Why would anyone access the rate at discount window and pay a penalty rate if they didn't have to? You wouldn't, thus the only explicable reason the discount window would be tapped is for window dressing purposes. By cutting the discount 'penalty' rate only, the Fed sidestepped the inherent moral hazards that would potentially sow "the seeds of a future financial crisis."
Meanwhile the ECB has pumped more billions of dollars into the financial system than any other central banker to date - $352 billion so far, but they have exercised restraint on cutting the refi rate by leaving it unchanged at 4% at their September 6 meeting. At that same meeting, the ECB still viewed their monetary policy as "still on the accommodative side." For that very same reason, ECB president Trichet told the European Parliament on Sept 11 that "risks to price stability remain on the upside" and that the ECB's main goal was to deliver price stability with financial stability being a secondary goal. Blurring those two distinctly different goals he said would "deteriorate the present situation of the market." In other words, bailouts of companies at risk of default is a secondary consideration. There is no moral hazard being ventured by the ECB president in these statements.
Turning to the Bank of England (BOE), they have had much to say this September about the financial turmoil as they began injecting cash into the markets to reduce pressure on the overnight rates on Sept 5 and Sept 11. ``These measures are not intended, nor can be expected, to narrow the spreads between anticipated policy rates and the 3 month interbank rate." Again, we have here another instance of a major central bank seeking to avoid the moral hazards of bailing out companies at risk of default.
However, just two days later on Sept 13th, the BOE did reduce the reserve requirements obstensibly to encourage financial institutions "to lend more money to each other" as the BOE "tries to reduce overnight borrowing costs." If anything action to date amongst the these three major central banks were to attempt a bailout which would subsequently encourage the excessive risk taking that put us here in the first place, it would be this action taken by the BOE today to reduce both the overnight rates and the reserve requirements.
Perhaps, methinks, that the BOE should revisit Walter Bagehot's "Lombard Street" on financial crisis management. Bagehot's model for handling financial panics (which are constantly present in markets anyways) is as straightforward as it is simple. To end financial panics without entertaining moral hazards, authorities must lend freely, but must do so at higher interest rates.
Bagehot's prescription for managing financial crises is an aside. Returning to what the Federal Reserve has been doing in recent days has been even more intriguing.
On top of some recent hawkish overtones, the Federal Reserve has been busy for the past several days employing their Marcoeconomic and Quantitative analysts (dubbed MAQS) to study a "series of what-if scenarios on the US economy." These scenarios a.k.a. "alt sims" or alternative simulations will influence the decision making process at next weeks FOMC meeting to determine the size and quantity of Fed funds rate cuts which will ultimately be required. These 'alt sims" will be "adjusting for such things as higher financing rates...or a sharp decline in home prices" to catch a glimpse of possible future outcomes by leaving rates unchanged or relatively unchanged.
Fed officials under the Bernanke Fed now feel in hindsight that Greenspan's third rate cuts in 1998 as well as the aggressive easing in 2001-2003 were a bit excessive and that "the Fed overpaid for risks that the turned out to be less severe."
San Francisco President Janet Yellen noted "a good example is the aftermath of the Russian debt default in 1998. Many forecasters predicted a sharp economic slowdown as a result but growth turned out to be robust." The third cut in November 1998 occurred when GDP growth in Q4 1998 came in at 6.2%. Former Fed Vice Chairman Alice Rivlin echoing Janet Yellen's concerns that the 3rd rate cut in Nov 1998 might have been a mistake observed that "It might have been smarter to try what they trying" now with their use of the alternative simulation models.
In sum, we find the three major central bankers willing to lend freely and to purchase some insurance for the liquidity risks that remain out there. But none of them want to "overpay" for those risks. In fact, the Fed's Quant analysts are actively seeking just the right temperature for their porridge - not too hot, not too cold, but just right. None of them are willing to entertain the moral hazards that come with excessive easing, and none of them willing to jeopardize their price stability goals which for the ECB clearly trump their financial stability goals.
And so, it appears the major central banks have indeed learned something from LTCM bailout and the aggressive easing of 2001-2003 and are thus motivated to profit from those lessons and now apply them to the current financial turmoil. Bagehot's prescription 135 years later has been modified to "lend freely, but at the right strike price" - not so cheaply that it leads to a bail out of all the over-levered players in the game.
My name is John Bougearel. I am Director of Futures and Equity Research at Structural Logic with over 12 years of experience across a broad array of financial and securities markets.
I consult with and provide research for hedge funds, wealth management firms, brokerages, and banks on the US and global equity indexes, individual equities, US Treasuries and global fixed income markets, as well as the energy, precious metals, and grain markets.
[http://www.structurallogic.com]
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