This Mess We’re In

Wow.  These are definitely some interesting days in global economics.  Just this morning, a coordinated 0.5% rate-cut was announced by the Fed, European Central Bank, the Bank of England, and a few smaller central banks.  Yesterday, the Fed announced that it would start buying up commercial paper in an attempt to reinvent this market for short-term corporate debt.  Governments across Europe are announcing plans to guarantee deposits with the hopes of preventing bank runs.  Global equity markets are taking a major beating; the Dow Jones has lost an impressive 15% of its value in the past month, resetting approximately to 2004 levels.  Oh yeah, and last week the American congress passed a 700 billion dollar bail-out plan, which may or may not work.

Banks are simply not loaning money to each other at reasonable prices … the commonly cited LIBOR rate, a measure of the price of money between banks, has spiked in an unprecedented way.  Take a look at this chart for overnight LIBOR.

Notice that the rate that banks charge each other to borrow money moves fairly smoothly for the majority of the last 5 years.  Then compare that graph with this one, which shows the effective Federal Funds rate, the target interest rate set by the Fed for banks to borrow from each other, for the same 5 year term.

Notice a pattern?  Yep, they look essentially the same for much of the 5 year term.

And this is certainly not unintentional.  The Federal Funds rate serves as the foundation for all interest rates in the American economy.  Even interest rates for credit cards and car loans are based on this rate … only they are way down (or up, depending on how you look at it) the chain of interest rates because there are further removed from government’s target interest rate.  But banks are not far removed at all.  They are the ones who are being directly targeted by the Federal Funds rate, so it makes sense that LIBOR essentially mirrors the Federal Funds rate.  Recently, as the charts clearly demonstrate, this has not been the case.  LIBOR has moved erratically upward, while the target rate set by the Fed has actually dropped.  So we’ve got a disconnect.  What happened?  Well, thanks to some creative finance guys, banks are holding a bunch of toxic assets that have the potential to make them insolvent.  The greatest part is: since these deals were private agreements between institutions, there was (and is still) no public exchange that allows everyone to know what everyone else holds.  In other words, banks don’t know if they can trust each other … maybe the 1 month loan Bank A makes today will not be repaid because the toxic assets of Bank B will have dragged Bank B under.  Without trust between these institutions, the central bank can do little to affect the money supply with its target Federal Funds rate.

A hint of good news in the face of all of this gloom: this is the BEST time to learn about and understand our economic system thanks to the amazing case study at hand and a huge amount of quality analysis on the subject.  Two pieces that I highly recommend are:

1. This recent radio piece aired on “This American Life.”  The analysis is very good and very easy to understand.  It is an hour long, I think, but well worth every second.

2. The current issue of The Economist has a fantastic article on the money markets.  It’s definitely not an easy read, but I understand the subject much more after digesting this thang.

Some day soon, I’m hoping to have a guest post by a real-life banker/economist (i.e.  someone who actually has a right to talk about all this stuff).

~Chaz

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~ by jazzychaz on October 8, 2008.

4 Responses to “This Mess We’re In”

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