Look at a US $100 bill. Ben Franklin stares at you from one side; Philadelphia’s Independence Hall decorates the other side. British 10-pound notes depict the Queen on one side and Charles Darwin on the other. Twenty-euro notes have no pictures of people, only a map of Europe. Ten thousand Chilean peso notes feature Captain de Fragata Don Arturo Prat Chacon and his hacienda. Zimbabwe’s 25,000,000,000 dollar bill has two giraffes on each side and an expiration date of December 31, 2008.
These and many like them from around the world have two things in common. They are pieces of paper printed by central banks and offered by their respective governments. And they are non-interest-bearing liabilities of those governments. They only promise to replace the one you have with another one just like it. Their value or lack of same is determined by (1) what they will buy in the local region, (2) what each form of money can be exchanged for if one travels and wants to convert the currency into someone else’s currency, and (3) what interest rate you can obtain if you loan your piece of paper to someone else.
In Zimbabwe, the world’s current monetary basket case, a stack of these multi-billion bills may buy a loaf of bread. No one will loan anything to anyone. There is no interest rate which can clear the market. Paper money has been rendered essentially worthless by hyperinflation. It cannot be exchanged for any other currencies accept as a collector’s item.
In the United States, there has been a panicked flight to safety in the credit markets but not in the cash form of money. Massive demand for the interest-bearing monetary form (90-day Treasury bills) has driven that interest rate to near zero. Thus the interest rate paid on the interest-bearing form of money and the zero interest on cash money is about the same. Cash and US Treasury credit are priced at zero interest.
In America, people have cash and use it every day to transact business. Most also can use credit cards and electronic payments, so they do not have to carry huge numbers of “Franklins.” Our inflation rate is low and the buying power of our currency is trusted in daily life. We reaffirm that every day when we pay for food or fill our gasoline tank.
In America, the problem surfaces in the credit arena, not in the cash transaction arena. America is not Zimbabwe.
In America, people now are afraid to lend because they do not believe they will get repaid. In America, they are acting out of fear of default. Banks are afraid to lend to other banks. Pension funds and institutions are afraid to lend to corporations. Individuals are afraid to lend to their state and local governments. This is what a credit crunch looks like in America.
In America, the crunch has reached the extreme point where the credit mechanism is frozen. Once frozen it makes no difference how cold the ice becomes. Frozen is frozen. To get things moving again it takes a thaw. The measurement of how frozen things are is found in credit spreads. These are the numerical differences between the interest rate on one item and the interest rate on a corresponding maturity of another item of different credit quality.
In America these spreads have reached the point of absurdity. An example was recently discussed by my colleague John Mousseau. John showed how the interest rate on a TAX-FREE state or local government bond is now as much as 140% of the interest rate on a TAXABLE Treasury note. Normally the note yields more than the bond. Today the note yields less than the Muni bond. This makes no sense. We see this anomaly because of fear and panic in the markets.
Fear changes behavior, just like greed.
Nine years ago American investors were selling perfectly good-quality 6% tax-free municipal bonds and using the money to buy Cisco and Microsoft at 100 times earnings. These behaviors were motivated by greed.
A decade later the same Americans are avoiding 6% good-quality state or local tax-free municipal bonds in order to put their money in Treasury bills yielding near zero. They are now motivated by fear.
Both fear and greed lead to the same result. Investors make terrible judgments and do so at the wrong time in the cycle. In many ways that is the status of things today. That is why we have ice. That is why credit mechanisms are frozen. That is why it is time to focus on the thawing and not the freezing.
The thaw itself happens after the last investor or lender has become frozen; then the credit mechanism grinds to a full stop. We have reached that point in the last two weeks. Remember: once you have ice, it is a solid no matter how cold the temperature gets. You need to thaw to start the reversal and the healing process. So let’s get to how and when we will experience the thaw.
Thaw occurs when one investor or lender at a time gains enough liquidity to obtain some comfort instead of fear and then starts to use the zero-interest-rate cash to acquire some earning asset. The asset has to appear attractive and the investor has to have enough cash (zero-interest-rate money) to be willing to commit some of it to risk taking. We recently saw Warren Buffett do that with GE and Goldman Sachs. We see it again with Wells Fargo topping the Citi bid for Wachovia and doing so without federal assistance.
It takes three pieces of government policy to assist a thaw.
First we need infusion of a very large sum of cash. The Congress has just authorized that. We criticized the form of the package and believe it is seriously flawed. That said, it is now in the law and the amount of federal credit is huge.
More importantly, the Federal Reserve has nearly doubled the size of its balance sheet in a matter of weeks. This global infusion of cash is larger than the Congressionally authorized $700 billion plan. See www.cumber.com for a graphic depiction of this remarkable change.
The Fed will now reduce the policy-setting interest rate from 2% to 1.5% or even 1%. That will reinforce the very-low-interest yield on interest-bearing forms of cash.
So piece number one is in place and expanding. We are getting and will get a lot of money into the system.
Piece number two is transparency. We need to see the assets clearly and obtain market-based pricing discovery of their value. That process, too, is now underway. It is a long time in coming. We will see it in some of the government’s auctions. We will see it in the valuation of collateral used by the central banks as they attempt to liquefy the system. And we will see it in the disclosures that surround the forced mergers of firms like Bear Stearns and the liquidation of firms like Lehman. Transparency is coming because the market needs it to thaw, and therefore the market will get it because opacity is no longer a viable choice if you want to survive.
The third piece is a clearly understandable process of resolution. Here we are still in an opaque world. Perhaps the US Treasury will clarify this one when it starts the implementation process. It now has to disclose and report. It still has enormous power, and Congress did not put in an oversight and veto authority. The Federal Reserve’s role is consultative, and the Congressional directive is to report after the fact. Shame on the Congress: shame, shame, shame. As our national legislative body, they have affirmed their lack of willingness to accept responsibility for anything except getting re-elected to office.
The Treasury Secretary now has the greatest concentration of power in a cabinet officer in the financial history of the United States. All eyes that can do so must watch this cash register. And voters must hold this Congress responsible for the outcome, since they are the ones who empowered the Treasury Secretary.
When the market thaws we will immediately see it in the narrowing of credit spreads. That will remove some of the nonfunctioning elements in the financial markets. As this occurs it will pick up its own momentum, just as the freezing side led to an accelerating contagion. Thawing has an accelerator too.
In our view the US financial markets are in the process of marking a strategic turning point. They will not do it all at once, and the volatility at this turning point is enormous. But turning points also represent strategic entry opportunities. Only history will show you when an actual turning point occurred. It is visible only in retrospect.
I believe that two or three years from now we will be looking back and saying that the end of 2008 was one of them. I hope I’m right.