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Credit Markets Threaten Retail Banking, Bank Runs Next?

The share market is not the most important story today. That may be tough for you to believe. After all, the 777 point figure decline on the Dow is the most visible symptom of what’s killing the market.

But in terms of percentages, Monday’s 6.9% decline in the U.S. doesn’t even rate as one of the top ten worst one day percentage declines in history. Maybe that will come later this week. It might come in emerging markets.

The big story, though, is in the credit markets, which are in as bad a shape as they’ve been since the credit crisis began. The credit markets are vital to the banking system and the banking system is vital to anyone with deposits in the bank. This is how the credit crisis intersects with the real economy.

Remember, the whole target of the Paulson plan was to relieve pressure on banks. That pressure is right back on, following the failure of the U.S. House to sign on to the deal. That pressure threatens to spill over into the commercial banking sector, where we wonder what it will do the confidence of people who have money in the bank and not a lot of a confidence in the financial system at the moment.

Let’s be clear about what we think the last two days mean: the Fed and Treasury are worried about the viability of the banking system. Why? Well, another bank was taken over in the U.S. (Wachovia by Citibank) and four European banks were effectively nationalised.

The trouble is as simple as it is intractable. The banks have heaps of assets on the balance sheet they can neither sell nor price. That alone is bad news. Write downs on those assets threaten to wipe out equity capital.

But if it were just a case of allowing a few institutions to fail, you’d have a run of the mill crisis. Not an epic one. After all, three out of Wall Street’s five investment banks were allowed to collapse or forced to reorganise.

Officials and regulators might have been worried about the investment banks in terms of their counter-party risk in the credit-default-swap market. But Paulson and Bernanke let Lehman fail, arranged a marriage of Bank of America and Merrill Lynch, and threw Goldman Sachs and Morgan Stanley a lifeline by allowing them to become commercial banks.

Now, they must fear that the credit markets are threatening the retail banking sector. But how? Banks fund their operations by either deposits or loaning to one another. Those loans are sometimes overnight, sometimes longer. But the inter-bank lending market only works if banks believe that one another’s collateral is good and loan to one another.

Much of the financial sector’s collateral, though, is precisely the stuff that’s falling value, namely securities backed by residential American real estate. Banks need each other to meet their funding obligations. But with the collapse in value of their main collateral, no one wants to lend. They all doubt each other.

The Paulson plan aims to cut the bad collateral out of the system like a cancer and replace it with Treasury bonds. But with the plan in tatters, the market is already anticipating more trouble and taking action. This action is removing another key source of bank funding: the money market. It’s being taken because investors are beginning to wonder which retail banks might go under if the credit markets don’t thaw.

With more and more investors doubtful about the bank’s ability to survive write downs in their assets, or to secure funding, money is fleeing the money market for the short-term Treasury market (yields on 30-day Treasuries are just 0.066%).

This flight from the money market removes another key source of short-term bank funding, and puts the banks under even more pressure. This is why the Treasury moved to back-up money market funds last week. It was effectively asking investors not to remove money from the money- market by giving that money a Federal guarantee.

We’re not certain the guarantee is going to ease anyone’s mind in the current situation. We’d expect more money market outflows, further putting the screws to the banks. And though the Fed unleashed a torrent of overnight money to prevent a total drought of liquidity (nearly US$600 billion), the market is slowly coming to the realistation that more banks are going to fail as their assets reflect the market price.

There is a certain symmetry between Wall Street’s behaviour and Main Street’s behaviour. At the household level, some sellers refuse to lower prices on their homes because they do not want to take a loss. They believe the market will recover. But in the meantime, banks are selling foreclosed homes as quickly as they can. Prices continue to fall (affecting all those bank assets/collateral).

Meanwhile, financial institutions could probably unload a lot of their housing-backed debt on private equity and hedge funds-but only if they were willing to take a big haircut. That haircut would wipe out equity capital.

The banks want a deal that keeps them in business. They want the Paulson deal. But the U.S. taxpayers don’t want the Paulson deal. They’ve said so all week. So where does that leave us?

It leaves us exactly where we’ve always had to be: the continued de- leveraging of the global financial system. That means more asset-write downs, more bank failures, and sooner or later, a run on a few banks as depositors begin to realise that the frozen credit markets are going to lead to the death of some over-leveraged banks unable to fund their operations or roll over their debts.

We may get Paulson Two, of course. Congress will cook up some other version of the plan that addresses things like equity warrants or taxpayer protection. But none of that solves the problem at the heart of the financial system: a tremendous amount of borrowed money has been invested in assets that are falling in value. The inevitable result is a credit deflation. There is no way of improving the quality of the assets.

The Fed is not waiting to see what Congress does to respond. It’s about to grow its balance sheet in a monstrous way. It will take on new liabilities and create new money to do so if it must. That’s why the only exception to yesterday’s commodity sell-off was gold. We’ll have more on this latest phase of the crisis in a special mid-week edition. Until then…

Dan Denning
The Daily Reckoning Australia

17 Comments

  1. David Hodge says:

    Your article of today raises a concern I have re the banking system.
    I deal through BullionVault which is fine so long as I can trade and access funds via LLOYDS TSB BANK PLC.
    Question 1. What if Lloyds ‘closes the door’ to trading?
    Question 2. Do you have a risk strategy for this possibility?

    Read your articles each day and value highly.

    David Hodge

  2. Coffee Addict says:

    Unfortunately an epic crisis is very likely.

    I don’t have a reliable crystal ball but I can safely assume that most credit default swaps will now be obliterated along with the financial institutions that offered protection mechanisms with these instruments. If this happens the DOW would certainly drop another few thousand.

    Commercial paper defaults are likely to quadruple (globally) over the next 12 months. Losses have to be realised. Most asset class values will drop (quickly) – but with both upwards and downwards pressures on gold. Shaky politics in South Africa may also impact gold supply.

    Unlike some commentators I don’t assume that the Asian Tigers because they hold a lot of the the garbage debt and are also sitting on top of some real estate bubbles.

    What actions could put the breaks on the start of another Great Depression? Perhaps nothing! The choice is whether on not to allow a quick adjustment (and associated civil chaos) or do drag it out over many more years with the Paulson package (again with some civil chaos in tow). If I had a choice I would vote for the Paulsin package (and the associated inflation) because it may limit the immediate prospect of global food riots. But on the other hand, everyone needs a solid base upon which to rebuild lost wealth. Who knows?

    OK enough of the prattle and gloom. Focus on the upcoming resource bargains in companies with little (if any) debt. Do the research. As the penguins say in the Madagascar — Smile and Wave — as thats the only reliable advice anyone can give to anyone on Main Street at the moment.

  3. Curt says:

    Excellent article. I think the time to pass any type of bailout has passed. The administration and congressional leaders will not be able to revise the bill before the election. Nobody wants the bailout. The ensuing economy disaster will likely follow with a political disaster. Ron Paul just may be the only Senator that keeps his job.

  4. Doc Holliday says:

    This has been a long time coming and instead of staving off this credit crisis over three years ago, King Bush used this timing right before elections. It is no surprise considering Enron and other crooks were having their way with other peoples money! I say the hell with a bailout or rescue. Let the chips fall as they may and if the government wants to bailout somebody and stimulate the economy, let them(Gov) give every person 18+ a stimulus package of about $500,000 or even a million dollars. People will stimulate the economy from the bottom up where it is well needed.

  5. brisa says:

    Uh….Curt….as a Ron Paul economic theory supporter, I feel compelled to correct you. Ron Paul is a Republican member of the House of Representatives from Texas.

    Now that his campaign to win the Republican nomination for President has been deep sixed by our corrupt electoral process, the talking heads in the corporate media are referring to him as an “economic genius”. How typical.

  6. jack carter says:

    Why do you not talk more about the lynch pin of the whole damned system: that would be Commercial paper. As you know the commercial world manages it cash requirements by borrowing for 30,60, 90 days from commercial lenders; it cuts the capital required to do business and it allows the float to grow to whatever can be sold. And the mass of commercial paper to be rolled is the life blood of manufacturers, credit cards, retailers etc., to a lesser degrees, and of course the ever hungry US TREASURY with its lovely 91 day T bills. If this paper does not roll weekly, monthly and quarterly it is over to put it politely. The Treasury gets its money because they always give something back. The rest of the borrowers? Will that is where the rubber meets the road. Dear Hank knows this and it is making him nervous. I mean things could go straight to hell and jobs would be lost and the sins of the banks and who all would be laid open to smell and fester in the sun light. It is likely unconstitutional if we only had copy to check it.

  7. Clifford Decker says:

    Baloney. The existing financial system as the system stands and has stood for over 200 years really only rewards the wealthy, holds down the poor and keeps them down, and “marginalizes” the upper-middle, middle-middle and lower-middle class. Those who occupy those supposed three statuses wishfully rate their status depending upon how financially well-off that they think they are relative to their actual wealth or their supposed comfort quotient. Pure nonsense. Most of them are hanging on by the skin of their teeth, and only pride keeps them admitting that fact. Those two groups, the poor and the so-called middle class, make up the majority of the people.

    The rest are wealthy, some beyond belief, including Paulson with his 500 million. Those others who have billions have absolutely no worry about how they will survive. Is this the only way to conduct the world in the 21st century? The existing banking model does not work, and neither does the abysmal American political system, as this present “crisis” proves. What happens when the now three largest banks in America collapse?

    Those large majority of Americans, and others, who just want to let the markets fall where they might because they do not want a bail-out using the tax-payer’s money are ostrazised by the so-called educated others who say that they have no knowledge of how the markets work and they will be sorry when they have no pay-checks or homes. Those Americans have listened to the scare tactics of the bush government for eight years and are by now desensitized to those tactics. There is little remaining belief in the American political systsm.

    What the so-called educated fail to realize is that the people have seen what has happened in their, their father’s and grandfather’s lifetimes and they know that the system does not work for them. So, why allow the mess to continue, at their, their children’s, and their grandchildren’s expense to prop-up the weathly status-quo? I share the same question.

    The Rothchilds banking system should be replaced and these so-called “instruments” that those of you who are quoting and going-on about should be dissolved. Yes, there will be loss. Life is about loss.

    When everyone is in the same financial boat, someone will realize that a new model that recognizes everyone is needed. Otherwise, this bail-out by US taxpayers is just more of the same to keep a failed system alive, until the next time that the fat-cats are hurting.

  8. Ross says:

    Perhaps Clifford is seeking redress through what is technically regarded as the least regressive form of taxation.

    In order to mop up decades of excess they can re-implement death duty equivalent to the highest marginal tax rates on all heritable assets. Get congress to append that one to TARP with those supposed “anti-populists” Paulsen & Bush & Biden & the neo-cons to sign on.

    And even though South Sea and Caribbean islands may beckon a bubble of asset transfers for a short while …. they never last out there.

  9. The website — larouchepac dot com — may be able to save you some time.

  10. Coffee Addict says:

    My take on Dan’s 2 October Email:

    1. INCREASED DEPOSIT INSURANCE
    Reasonable step but at least some of the cost (and risk) for this should be transferred through to depositors. Businesses will like it as they won’t have to operate as many multiple accounts. Funds will now shift further into cash deposits (and away from equities and higher risk options including gold.)

    (Australian Situation)
    If conditions worsen, expect the some of Australian Government to offer some protection for bank, credit union and building society deposits. A benchmark is the 90c in the dollar paid by through the Victorian Government to ordinary depositors after the collapse of the (aptly named) Pyramid Building Society. Most of the smaller Australian financial institutions who can’t keep going will get swallowed before they go bust.

    2. MARK TO MARKET RULES

    It probably doesn’t matter either way. Mark-to-market rules will be irrelevant to the many holders of commercial paper and SIVs that will fail over the next 12 months.

    Optimal policy action should depend on whether the financial garbage deserves to go in the little green bin of the big yellow recycle bin. If the asset has little chance of regaining value it should be written off in the small green smelly bin.

    Six months ago I would have been happy to relax mark to market rules on the grounds that actual default rates remained low and because SIV’s held to maturity were likely to be paid in full. This is no longer the case. A rapid increase in commercial paper defaults is happening and it is now apparent that many collateralised SIVs are leveraged to the point that only a small default rate – often under 5% – is required for investors to lose all of their capital and interest.

    OTHER PREDICTION
    Five years of double digit inflation in debtor countries at the very least.

    More focus will soon shift to impacts in other debtor countries (including Australia), Europe, Russia, the Sub-Continent and China. The media continues to wrongly portray the crisis as a North American problem, not withstanding the observation that easy credit, asset bubbles and deleveraging are global problems.

    Dan’s post today indicates that a lot stocks are over sold. This may be true but only very good day traders can make any money at the moment. I’m lying low (except for a tiny continued investment in some gold juniors).

  11. william yeager says:

    THE MAGNIFICENT 171. J .P. Morgan supposedly caused a “panic” in 1907 to ease the way for passage of the federal reserve act of 1913. Scare tactic…it worked then and it worked again on Friday.
    263 to 171 was the final vote. 171 found a way to vote against this bailout. Their reasoning was diverse, but they none the less arrived at the correct conclusion. We must find some ways to help these “good” people lest we miss an opportunity to sharp stick old crooked finger on his return…and return he will..again and again. That is what wolves do with sheep.
    So..what can we do? Lets start with reelecting all 171. Maybe some bumper stickers ” vote FOR the 171″ Lean on everyone to make this a ONE issue election regardless of party. Did you vote YAY or NAY?
    Think about it. If we could take out even half of the YAY’S, we would now have a bunch of newbies who will be far more likely to give the returning 171 a listen too.
    We can not afford to miss these precious few opportunity’s that come our way.

    Bill Yeager 10/04/08

  12. Prateek says:

    Now we are in middle of the Crisis,which was started due to the mistakes of Worlds Smartest peoples,And at that time worlds most powerful govt. was sitting on beach and enjoying the sunset and suddenly it got up with the money of TAX PAYER and started saving the smart people.

  13. This says:

    GFC has continued, after a small comeback, and now we are running worse than ever, with no relief in sight. Interesting to look back at older articles and see what predictions were – now that we’re 4 years down the road.

  14. karen patrick says:

    Mobile payments also threaten retail banks. New non banking payment systems using RFID, mobile devices, personal organisers, mobile phones can process remittances, ticketing, retail payments, passports and travel documents. Paying bills, foreign currency transactions, loan agreements. End of back-end processing for banks. End of credit cards and direct debit cards.

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