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Strategies & Market Trends : Contrarian Investing

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From: pcyhuang	8/9/2007 11:23:32 PM
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Liquidity Demand vs. Credit Crunch There has been some confusion in the market between the increased liquidity demands and the presence of a credit crunch. Liquidity demands are easy for the Fed to address. Credit crunches are far more devastating and far harder to offset, but as of yet we haven't seen evidence that one exists. Liquidity Demand Liquidity -- or cash -- demand was clear Thursday morning as the European Central Bank provided the equivalent of $130 billion to meet market demand. The Fed came in later with larger than expected repos for the U.S. banking system as cash demand had driven the cost of overnight funds a quarter percent above the 5.25% policy target. As an aside, repos are used by the Fed to provide reserves (money) to the banking system day to day. The Fed borrows collateral (say Tbills) as it provides the banking system with dollars. The tremendous European demand for liquidity is tied to the U.S. subprime mortgage collapse. The inability to accurately price the mortgage-backed securities with various risks leave banks wary of valuing counterparty credit which ultimately squeezes those borrowing in the inter-bank market. BNP Paribas stopped withdrawals from 3 funds with about 35% related to subprime given its inability to price the funds. The simple solution is for central banks to provide enough liquidity to satisfy demand and calm a fearful market -- just as they did earlier Thursday. Central banks provide liquidity to the market every day. In the U.S. it's through the daily Fed repos and the occasional coupon passes that are largely ignored given their regularity. Credit Crunch A credit crunch is far more troublesome and telling of financial troubles. What they reflect is less willingness on the part of banks to lend money. Less bank lending in turn leaves less spending and a slower economy. Banks are less willing to lend during tough economic periods as default risks rise. Other sources of bank caution can come from bad loans such as the current subprime mess or the Savings and Loan excesses which brought its collapse. The Q2 quarterly data showed only a small 4% of banks were tightening commercial and industrial lending standards. That was lower than the prior three quarters and compares to the 2001 peak near 60%. More frequent weekly data show commercial and industrial loans growing substantially. There is no evidence yet of a credit crunch, only the need for cash to stand in for the subprime assets less able to be valued and used as collateral. Finally, though credit spreads have widened given the re-assessment of credit risks, the spreads are only back in line with the 2005-06 averages. While the sharp deterioration of credit quality in the mortgage markets is appropriate, the slippage in other debt markets doesn't seem exaggerated -- currently. The road ahead is full of potential risks as a clear eye on credit risks is key in keeping the current situation limited to liquidity rather than an outright credit crunch. Full story: briefing.com

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