It's A Wonderful Life: Crisis of Confidence

As I noted at the end of an earlier note, the passage of the bailout package would likely not spark a surge in stock prices. In fact, it is less the equity markets that are causing the symptoms rippling through the economy and more the credit markets. The below comment comes from the post, More Discussion of Why the Bailout Bill Will Not Help Money Markets, Commercial Lending, at the website, Naked Capitalism.

"...the market has lost about 2/3s of its ability to convert liquidity to 30-day loans. 90-day is probably similar although there are technical issues with analyzing the chart because 90-day would expire during the end of year crunch so there probably isn't much demand. Next week we'll be able to look at 90-days again.

One of the most critical functions of the banking system is converting short-term deposits into longer-term loans for businesses. Much of the working capital market, for decades has come via money market funds (MM). Joe public or Joe CFO deposits money into a MM. That MM loans it to a bank (usually by buying paper, and usually at a medium duration) and then that bank loans it out to business for inventory, payroll or whatever. The MM has converted Joe's demand deposit into a fixed-duration loan.

The problem we're having is that people are fleeing commercial MM for treasury MM. Those are buying treasuries and thus converting the money to the desirable medium duration BUT that money is loaned to the Fed, and the Fed doesn't make working capital loans. So the deposited money that had been made into working capital has been diverted into the Fed and lost to working capital.

The Fed is kind of trying to address this by loaning out money via various auction/discount windows. BUT, those loans have been overwhelmingly overnight - a particularly nasty demand deposit because it goes back so fast. For a bank to convert that to a 90-day loan it's got to win 90 auctions in a row - a very risky deal with a crunch on. So the Fed undoes the duration conversion, and then some, converting the liquidity into a form that the banks can't make into useful-duration loans.

Right now we have both commercial and treasury MMs. Deposits have shifted from commercial MMs to treasury MMs, and consequently we have less working capital (a commercial MM product) and better credit for the Fed (a treasury MM product). But, treasury MM rates are now very low and the gap between treasury and commercial fairly high, which creates an incentive for depositors to put money into commercial funds, producing some working capital..."

So what we have is a crisis in the public's confidence in the financial system.

In the movie, It's A Wonderful Life, George Bailey's (Jimmy Stewart) bank faced funding issues as depositors became concerned about the bank' viability after the loss of a large deposit. Initially, many depositors wanted to withdrawal funds from the bank. In the end, the community realized the importance of the bank and came in droves to return their funds to Bailey's institution.

The message in the movie is one of courage and sacrifice for the greater good as George Bailey, a man with big ideas about seeing the world, continually forsakes his own desires to do what is right for the town. No matter how insignificant we feel we are, we are all inextricably linked to each other and play an important part in the fabric of one another's lives.

Although investing seems more complex today given the different investment vehicles, the funding of financial institutions is essentially unchanged. We need leadership and legislation from Congress that will rekindle depositor confidence in the financial system. The way this can be done is for the government/FDIC to guaranty 100% of all depositor funds for at least two years. The country of Ireland has implemented such a system. During this time period, the government can arrange bank mergers between the strong and the weak, effectively eliminating weak institutions.

One thing is certain though, it appears increasingly more attractive investment opportunities are being made available on a daily basis. If one has a five year or longer time horizon, prices of equity and some debt (bonds) are at levels that create nice entry points for beginning to build positions in various investments.

Source:

More Discussion of Why the Bailout Bill Will Not Help Money Markets, Commercial Lending
naked capitalism
By: Yves Smith
October 2, 2008
http://www.nakedcapitalism.com/2008/10/more-discussion-of-why-bailout-bill.html