Crisis Note 2007-4: Where's the Balance Sheet? Or, In Whom Do We Trust?


I asked this question in Crisis Note II, and its still THE question to answer. I don't think ANYTHING the Fed and other central banks have done to date can have any impact on the funding freeze. We are all basically participants in a collateralized lending business. If our counterparties don't have sufficient fungible collateral, no one will lend to them. With rising Level 3 assets, the stated capital numbers of banks and brokers are rather meaningless, as level 3 assets are by definition non-funglible. And no one knows better what games are being played in Level 3 than the banks themselves. Thus the banks won't lend to each other, and LIBOR has become a quote, with no transactions in any size (we hear and read), and is not a market at present. Safe cash bonds are clearing well above libor. If and when the LIBOR market reopens, I think its yields will RISE to approach the cash bonds. The TED spread is likely to go to unprecendented levels in 2008 (350-400 wont surprise me).

What does it take for the LIBOR markets to restart? Collateral, in the form of real capital behind the banks and investment banks. This means they have to dilute their current shareholders and recapitalize in a big way. My recommendation for a safe level: 10% over and above their Level 3 assets. That may mean a 25% or greater dilution for many of these institutions.

So, what about the Fed and other central banks’ new pet project? Well, I don't think it can work, as it does not raise new capital for the banks. MLEC had a better chance of working, as it would take assets off balance sheets, leading to deleveraging. This maintains the size of balance sheets, and in fact lowers capital ratios as it increases liabilities instead of forcing sales and deleveraging. I don't think it will spur lending, as they still won't have free capital to leverage up.

If we're going to print dollars anyway (and the other central banks, euros), I think a better solution might be for the central banks to buy a 10-25% stake in the institutions that they deem to be worth saving and necessary for national security (yes, make them into an agency) (my nomination for the FED to buy into is BOA, as it has America in its name); and allowing the rest to be purchased by the sovereign wealth funds. This will give all the banks enough capital to start playing in the markets again, and give their counterparties comfort that their liabilities will not be worthless.

If this comes to pass, will LIBOR get renamed the London Inter Agency Rate? It already appears that way.

Note: These are solely my opinions, not those of my employer, MF Global Securities Inc.

Samir Shah, 12/13/2007