Today's Event of the Day

As you probably know by now, last night China lowered their banking sector RR ratios, this only a few months after tightening due to inflationary pressures that were causing riots in China. It is or was assumed that this was in reaction to the meltdown in Chinese real estate, however at 8 a.m. EDT, a Globally coordinated Central Bank intervention was announced with F_E_D, the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank all taking part.

The FED is loaning directly to the ECB so presumably there is no counter-party risk, however with the F_E_D's discount rate at 75 basis points and the swap line which was reduced today from 100 basis points to 50 basis points, add the OIS (Overnight Indexed Swap, which is an overnight rate calculated based on an index- which generally speaking is cheaper and less risky then the interbank lending rate known as LIBOR which is the rate banks charge each other for overnight loans) means that it is cheaper for European banks to borrow from the F_E_D then it is for US banks- by approximately 15 basis points, an odd detail.

Of course the whole purpose of the policy action taken today was to make bank borrowing in the EU cheaper as they face what we have been talking about for some time, a liquidity squeeze as the same dynamics from the US in 2008 replay, interbank lending has completely frozen in the EU due to 'counter-party risk” or the risk of lending to a bank and having that bank go belly up or not be able to repay the loans. The key words to the coordinated policy action today are simple, "liquidity freeze" and "EU Bank Borrowing Costs' and this is a big problem. If a mere 50 basis point reduction was so needed, there must be real problems within the EU Financial sector. As we have already talked about, Italian banks are not immediately allowing withdrawals by customers of over $2,000 Euros. Instead an order had to be placed by the customer and the bank would notify them when the money was available.  This was curious, but we uncovered the reason a few days later. Italian banks are so locked out of liquidity markets that they resorted to a VERY odd solution-they are borrowing directly from the London Stock Exchange, which is using traders funds to supply Italian banks with the money needed at a premium on 3 day loans. Thus the reason for the wait, as the London Stock Exchange is deriving something like 15% of their income from these transactions, obviously the Italian banks do not want to borrow any more money then they absolutely need, it's somewhat akin to "Just in time inventory management".

It should be understood that the F_E_D is not bailing out Europe through the new swap line agreements, but they are trying to reduce the stress on the highly leveraged EU banks ( as mentioned before, unlike the US, they are leveraged 26:1 making a 4% decline a total wipeout of equity-a major concern). It's also important to understand this is not sovereign lending, it's making borrowing for banks cheaper as they already face hurdles in raising their capital base as the EU has demanded-remember how many US dollar denominated assets the EU banks have liquidated which supported the Euro as dollars were sold and Euros were bought to repatriate the capital. The sales were obvious in the Primex market offered by Markit as well as USTs and most likely US equities and fund redemptions. 

Further evidence of this was released today by ICI (Investment Company Institute).  Domestic Equity Funds just saw another $3.8 billion dollars pulled from Funds and thus the market. This is the 14th consecutive weekly outflow (totaling $44 Billion) and the timing is about right as compared to the EU banks ordered to recapitalize, which means that they need to raise just about the same amount as their combined market cap. As we talked about, they refuse to issue shares to raise money as they are trading below book value, instead they have opted to sell everything not nailed down and it wouldn't surprise me at all if some of these outflows from domestic funds were being repatriated directly to EU financial institutions. The consecutive outflows would actually be 31 weeks if it weren't for 1 week of inflows of less then a billion dollars, the total for 31 weeks is $130 billion dollars.

While this tid-bit is slightly off topic, it does show the power of the F_E_D's QE program to levitate the market as well as inflation. Since 2010, the market has lost $214 billion from Equity Funds, yet the market climbed higher due to the arrangement between the F_E_D and the Primary dealers which were flipping bonds to the F_E_D (in some cases only holding them for a week) and in return earning billions of risk free money that was put to work in the market, mostly in the most heavily weighted stocks. Note what the market looked like (a top) at the end of QE 1 and note what the market looks like now (a top) after the expiration of QE2. Here's flow chart of funds incoming or outgoing vs market performance.

Note that while money was flowing out in 2010 during QE2, the market kept rising. Look at what happened after QE2 ended with outflows, the market dropped considerably. The October outflows were substantial compared to the median and this is around the time the EU banks were selling everything.

I digress...

While the break-up of the EU may seem far-fetched, Germany has certainly been making movements that could be construed in many different ways, almost all would either disband the EU or cause the EU to fail. In the F_E_D's new agreement, which is posted at the New York F_E_D website, there is no mention of who would be responsible to repay funds in the case of an EU breakup, something I'm sure Ron Paul would like to ask Bernakacide.

The statement by the F_E_D added the following:

U.S. financial institutions currently do not face difficulty obtaining liquidity" but if conditions deteriorate the Fed has tools which they "are prepared to use,"

Today it seems this has been widely interpreted as Too Big to Fail banks such as Bank of America, could be rescued if need be, but it is more appropriate to read the statement in the following manner, “ If US banks face a liquidity crunch, the discount rate could be lowered from 75 basis points. If financials saw any strength from the initial interpretation, they would most likely be very mistaken as the F_E_D would be very unlikely to address bank failures at this time and within the context of the policy action. Still it is strange that EU banks can borrow from the F_E_D cheaper then US banks. This must speak to the financial conditions in the EU being a lot worse then is currently thought.

It would also be important to consider that the F_E_D may be charging a slight premium as US banks can borrow directly from the F_E_D's discount window which carries some degree of risk, whereas EU borrowing is by the ECB, less risky then an individual bank.

One of the strangest features in the policy action is the framework set up, but not activated, that would allow US banks to borrow Euros, Yen, Loonies, Pounds and Swiss Francs directly from the F_E_D. Policy changes by the F_E_D are not arbitrary and this curious feature was put in place for a purpose in which they could be activated in the future, the question is why?

In the NY F_E_D's FAQS here is what they have to say:

Why is the Federal Reserve establishing lines for these five currencies and with these five central banks?

These five currencies are used globally and account for the bulk of the foreign currency funding of U.S. financial institutions.

This is curious and a bit alarming.

Today's reaction certainly seemed to be a knee jerk reaction and we saw many indications of that. Just as a reminder, here's a chart I posted earlier today which depicts the last time there was a globally coordinated central bank intervention...

More coming, I've uncovered some interesting charts sniffing around today.