Photo by codaI've been looking in the wrong places for indications of improvements in our current financial mess. The Dow is not a good indicator because it only indirectly reflects the real problem: uncertainty as to the value of mortgages and MBS held by banks and other investors, and the effect of that uncertainty on lending markets. What we should be looking for is a sustained improvement at the source--lending markets themselves. When liqudity begins to flow again, beginning with bank-to-bank lending, then prime corporate lending, then small business and consumer lending, hopefully on more realistic and careful terms than before, we'll have a good indicator that we've succeeded (it seems to me).
These markets get much less press than the simple Dow Jones Industrial Average and are generally more difficult to understand, particularly with all the high-flying jargon that bond and money market traders use to express their ultra-cool and sophisticated understanding of finance. John Jansen's bond market blog is a great example of an extremely insightful and helpful source for this info that uses language so opaque as to barely qualify as communication (at least for non-cognoscenti like me). Thanks to a mention from Jonah Gelbach on Prawfsblawg, which led to a comment by Felix Salmon on Portfolio.com, I found Jansen's cut-to-the-quick blog, which despite its difficult language offers the info we really need to gauge a recovery/success.
Contrary to the comforting news on the Dow from Wall Street yesterday, lending markets are still seized up, and things don't appear to be getting much better. We should care that equity traders believe the bailout will succeed, but only because this indirectly suggests that they believe that lending will loosen up, financing for business will return, and the economy will get back on track rather than grinding to a painful halt with repercussions all the way down to Main Street.
Better to go to the source, it seems to me. What do banks (lenders) think? The news on that front yesterday was nothing short of terrifying. The London Interbank Offered Rate (LIBOR) for overnight dollar loans climbed on Tuesday to a record 6.88%. This is the rate that banks charge each other to lend money (overnight)--if a bank has to pay nearly 7% to get a loan, imagine what a corporation, let alone an individual would have to pay to cajole a loan out of these banks! Luckily, the huge spike on Tuesday (the last day of the third quarter) was largely a result of artificial funding constraints caused by the final day of the quarter, and the rate fell over 3% (!) the next day to 3.79%. This is stomach-churning volatility! Money markets that normally hover within half a point of the Federal Funds rate (2.0%) opened at more than triple that figure, between 6.5% and 7% on Tuesday. The lending markets are not as sanguine about the proposed bailout or economic fundamentals as Wall Street traders apparently are.
When the volatility and scary inflated rates in these markets settle down, we'll be able to breathe more easily. The Dow's ups and downs are not a great gauge, it seems, when the real problem is a lack of liquidity (caused in large part by a lack of certainty with respect to mortgage and MBS value). Find the source of the liquid, and see if the faucet has turned on. Only when banks get comfortable lending to each other again can we have any hope of a sustained recovery. What John Q Public needs to understand in evaluating the "bailout" is that its purpose (I believe and hope) is to offer banks certainty with respect to the value of mortgages and MBS, and therefore comfort to turn on the lending faucet. This is a liquidity recovery program--"bailout" is an inaccurate label and, it turns out, very poor choice of wording for political purposes!
I don't know if the Paulson plan will produce this result, but I now feel more comfortable about where to look to find out if it was successful.
