[UPDATE] — The end may be farther off than anticipated.
The Federal Reserve recently announced it will keep pumping liquidity into the repo market, at least until the end of the year.
But it may not be enough to stop more trouble in the market from brewing in the fourth quarter.
All signs point to the need to be prepared for a much weaker U.S. financial system!
Make sure you follow me on Twitter @TedBaumanGuru for my latest insights.
Wall Street ran out of money.
If the Federal Reserve hadn’t come running with bucketloads of cash, we’d all have been looking at 20% to 30% declines in our portfolios this morning.
Here’s how it happened.
Most of us know what it’s like to have a liquidity crunch. I know I do.
When I was just getting started as a postgrad, and in my early career in nonprofits, I experienced two kinds of liquidity “events.”
One is about cash flow. Bills are due midmonth, but payday is at month’s end.
Unless you’ve got some float available to cover your bills before your next cash injection, you run the risk of default.
That’s a temporary problem.
The other is about being overextended.
Your obligatory outlays, such as rent, car payments, insurance and so on, outrun your income. You don’t have enough left over to pay for food.
That’s a systemic problem.
Wall Street experiences liquidity crunches as well. Such an event prompted the collapse of Lehman Brothers in 2008, which precipitated the global financial crisis.
In fact, there’s another such event happening right now — and it’s a powerful reminder that as an investor, you must always be prepared for the unexpected.
Money Must Come From Somewhere
U.S. law requires banks and other large financial institutions to maintain reserves at the Fed.
The reserve requirement is a percentage of a bank’s deposit liabilities — the money it holds for its clients.
A bank’s deposit liabilities rise and fall every day as clients deposit and withdraw money. So at the end of every business day, the bank has to adjust its reserves at the Fed.
Transferring their own money in and out of the Fed’s reserve account is a hassle, so banks typically lend to and borrow from each other out of their reserves at the Fed. Banks with excess reserves lend to those with a shortfall.
When there’s a lot of money available in the financial system, the interest charged for these overnight loans is the Fed’s target funds rate, which is currently between 2% and 2.5%.
But when a substantial number of banks lack excess reserves to lend, the interest rates on overnight borrowing rise rapidly.
This forces banks with shortfalls to scramble to raise cash to meet their reserve requirements via direct deposits.
But that money must come from somewhere … and that has major implications for financial markets.
The Pool of Funds
In a liquidity crunch, banks draw money from the pool of funds they use for trading assets such as U.S. Treasury bills, derivatives and other financial instruments. That means they must reduce their purchases of these instruments.
But when the market for these financial instruments dries up, it becomes difficult to find an equilibrium price for them.
Such instruments form an enormous part of any bank’s balance sheet.
Illiquid markets mean that big chunks of those balance sheets have uncertain value … quickly leading to panic as investors worry about bank solvency.
NOW You Tell Me?
On Monday, liquidity in the overnight lending market dried up. Interest rates on overnight reserve loans rose to nearly 10%.
The last time that happened was in late 2008. At the time, the Fed’s policy framework didn’t allow it to step in to address the liquidity crisis.
Before the Bush administration could put a rescue package in place, a liquidity crunch starting with Lehman Brothers had spiraled out of control, becoming a global financial crisis.
But this time, the Fed was ready. On Tuesday, it pumped $53.2 billion into the market to calm everyone’s nerves and bring interest rates back down to its target rate.
It did this by buying up Treasury bills from banks, which allowed them to refresh their reserves. The Fed subsequently announced another repurchase action for this morning.
This isn’t the first time overnight lending markets have faced a liquidity crunch. A crunch occurred in December last year and in April this year.
In those cases, Wall Street tried to keep everything quiet to avoid a panic.
But it’s not a coincidence that both events were followed by significant drops in the overall level of the stock market:
Expect the Next Financial Crisis
This week’s liquidity crunch has been blamed on a combination of factors:
- Saudi Arabia’s withdrawals from its Wall Street accounts to raise cash to respond to the attacks on its oil fields.
- Corporate cash withdrawals to meet quarterly tax payments.
- And, ominously, a general shortage of cash resulting from the market’s need to absorb the masses of Treasury bills being issued to cover the government’s rapidly increasing budget deficits.
But in my view, that’s not a satisfactory explanation.
The fact remains that the U.S. financial system is overextended, and there isn’t enough liquidity to meet reserve requirements in a crisis.
That means that a full decade after the 2008 financial crisis, the Fed still must create money out of thin air to cover up for the weakness of the financial system. Instead of free market capitalism, we have socialism for the banks.
The lesson is this: As days go by where we focus on the ups and downs of our stock portfolios, black swans are circling in the distance.
Wall Street does its best to distract us so we won’t notice them. But one of these days, our strained financial system is going to suffer another crisis.
Are you ready? If not, it’s time to prepare.
Editor, The Bauman Letter
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This post was updated on October 8, 2019.