Liquidity boosts from the ECB and the Fed may not accomplish their goal: to loosen banks' purse strings
Half a trillion dollars' worth of euros is a lot of money even for a monetary authority. But that's how much the European Central Bank pumped out in short-term loans on Dec. 18 in an effort to alleviate a cash drought caused by banks dressing up their balance sheets for the close of their fiscal years.
The deluge of liquidity did the trick of rapidly lowering rates on short-term euro loans between banks by about half a percent. But it's going to take more than that to end the global credit crunch. Why? Because bankers are no different from squirrels before winter or Floridians before a hurricane. When times get tough, they hoard—in their case money, rather than acorns or bottled water. Bankers become unwilling to lend when they fear they might have a sudden need for funds because, say, their subprime-backed securities are worth billions less than they thought. "Central banks have virtually unlimited ability to extend credit, but they can't make bankers do something with it," notes Joshua N. Feinman, chief economist of Deutsche Asset Management, Americas.
A Measure of Craziness
In other words, it's wishful thinking to suppose the crunch will ease at the start of 2008. Traders are expecting stresses to continue into next year and even 2009. One key indicator is the elevated level of the so-called swap rate, which is tied to the willingness of banks to lend to one another. The 2-year swap rate, which currently reflects expectations for credit conditions out to the end of 2009, is now 0.82 percentage points above the yield on 2-year Treasury notes. While that spread is down from a peak of 1.04 percentage points on Dec. 11, it's still far above the typical spread of 0.36 percentage points that kicked off 2007. "The 2-year swap rate is the hallmark of how crazy things have gotten," says Mary Beth Fisher, an interest-rate strategist for UBS Securities.
Central bankers are attacking the credit crunch creatively by testing new tools to persuade the banks that they will be able to borrow as much as they need, whenever they need it. That's why the European Central Bank offered to lend banks an unlimited amount of euros for 16 days—enough to bridge into the new year—at a rate of 4.21%. The ECB, led by President Jean-Claude Trichet, made good on its promise by lending banks $500 billion worth of euros, twice what they had anticipated banks would ask for.
Central bankers on both sides of the Atlantic are also keeping world markets well-supplied with dollar loans. On Dec. 19, the Fed announced the result of its first use of the "Term Auction Facility," which led to loans of $20 billion to banks at a rate of 4.65%. Both central banks' actions were experimental. "These guys are flying by the seat of their pants," says Bert Ely, a banking consultant in Alexandria, Va.
Help Outside the Banking System
Trichet, Federal Reserve Chairman Ben Bernanke, and others have avoided using their big weapons—drastic cuts in their main policy rates—because they're concerned about inflation. On Dec. 19, for example, the ECB quietly mopped up about $200 billion in funds, partially offsetting its record lending of the previous day. In a speech to the European Parliament, Trichet said he's aiming to keep the money market functioning while also keeping inflation low: "I should like to underline, once again, that these two responsibilities are clearly distinct and should not be mixed."
What central banks can't provide is fresh capital to strengthen banks' damaged balance sheets. Much of that may have to come from players who aren't dependent on the banking system at all, such as sovereign wealth funds of Asia and the Middle East, says Lewis Alexander, Citigroup's (C) chief economist. His own bank recently got a $7.5 billion booster from Abu Dhabi Investment Authority. Meanwhile, as long as the U.S. housing market continues to sink, expect banks to hold their acorns close.