Is the liquidity crunch over?

Here is my thinking:

Let’s review treasury rates (aka, the “riskless” rates) for the US and UK over the next six months. According to the Financial Times data on November 14^th, 2008:

• US treasuries set to expire in six months yield 87 basis points (Deflation).
• UK treasuries set to expire in six months yield 199 basis points (who knows)
• One British Pound today is worth 1.4827 US Dollars
• One British Pound’s worth in six months as of today’s spot forward is 1.4807 US Dollars

The rates for sovereign taxpayer debt and the interlinking value in currency should display the differences in risk of each country.

• $100 invested in US treasuries vs. $100 invested in UK treasuries and converted at the corresponding spot and forward rates should yield the same rate of return.
• Converting $100 to pound equivalents, investing in UK treasuries, and returning those pounds to US Dollars six months from now returns a dollar more (.98 US cents) in value.

In normal times, no way. Someone in any trading house would be looking for the “blips” to quote Michael Lewis from Liar’s Poker. Here are a two observations why this opportunity exists today:

• As discussed in previous posts, we’ve witnessed massive flight to quality recently, as capital has left emerging markets and safe harbored itself in US Treasuries
• The REPO market continues to be stressful. Again, as discussed in previous posts, the lack of shorting treasury opportunities has caused massive spreads differences in otherwise equally risky cash flows.

What is interesting though is that the link between currency and risk still exists for the most part. For the UK though, that means its current treasury yields are tied far more to the US and the Dollar than they are to their own interest rate policy (currently at 3.00%). While the Bank of England has been aggressive in rate reductions, its own government bonds in no way reflect this.

Since the bailout was enacted, three-month LIBOR declined from highs of 4.75% to 3.52%. Further, three-month LIBOR dropped 90 basis points in this last week.

Room to drop?

The market votes yes. Three-month Eurodollar contracts closing in December (the three-month LIBOR futures rate) is pricing at 2.63%. By June, three-month LIBOR is expected to decline to 2.48%.

Context on the market prediction is critical. We must understand how much risk is priced into spreads.

TED Spreads, the base spread of risk between private capital and riskless funds, remain large.

• Today, three month treasuries yield .93%.
• Investing in treasuries today for returns in March 31st, 2009 yields 1.2125%.
• The implied treasury yield matching the Dec EuroDollar Contract is therefore .72%.
• Further, for three month March LIBOR, projected at 2.50%, equivalent three month Treasuries yield .22%.

So, good news and bad news. LIBOR is declining, but the TED spread remains wide.

As a side note, it is now obvious that Treasury Yields have priced a massive rate cut over the coming months.

Since last we spoke, the government invested $125 billion into the nine biggest banks and will invest $125 billion into an additional number of banks, potentially other financial companies. The investments, up to $25 billion or 3% of risk weighted assets into any specific company, are supposed to ease liquidity issues, and reduce cost of funds between banks.

For Taxpayers, the returns depend on your view.

• The terms of the treasury (on behalf of the tax-payer) investment are a dividend of 5% of invested capital.
• The preferred share investment is callable anytime after three years.
• Should the banks issue new equity prior to three years, they can buy out the tax-payer at par with that funding. In essence, any current equity owner is diluted regardless.

The taxpayer does not have any savings (found in lack in government surplus), so it must raise debt to fund the bank bailout.

Examining two and five year treasury yields, they are priced at 1.555% and 2.609%. respectively.  Assuming the Treasury Department does the right thing (See Note Four A), it will sell five year debt to finance the bailout.

Doing the math, paying 2.609% to receive 5% seems like a good deal. It does make a lot of arguments against it seem not as compelling.

Here’s another way to look at the deal though.

Assume the treasury invests up to $250 Billion, the returns over three years are $6 Billion a year. Enough to pay for approximately one year of pork projects John McCain rails against continuously.

Is this then a good investment? You decide.

Hank Paulson is a graduate of Harvard Business School, my cross town rival. (I went to MIT Sloan).

As 60 minutes shadowed him prior to the Congressional Approval of his bill, he was a leader handling a crisis:

1. Keep calm
2. Keep the solution simple
3. Execute the simple solution

So he must have known using the Treasury Department to buy asset back securities would be challenging, painful, and timely.

Today, the Financial Times, the New York Times, and the Wall Street Journal are all reporting the Treasury Department is considering equity stakes in banks, rather than purchasing asset backed purchases.

This solution, proposed and scoped early last week in our Third Note, is simpler and more effective.

1. Take equity ownership,
2. Ease capital constraints,
3. Start working through this mess.

On Timing, Hank has no choice.

If a bank asked you for a debt investment of 10 years, would you say yes? At what rate? Most banks are having real problems rolling over their long term debt. Sans long term debt, banks must use short term LIBOR, crippling our working capital system.

Yesterday, US Overnight LIBOR closed at 5.375%, up 1.48% for the day.

Hank, it is time to hit the reset button.

Secretary of the Treasury Henry Paulson aka Hank, AKA King Henry, the former chairman of Goldman Sachs appeared on Meet the Press this Sunday. He said “Last week there were times when the capital markets or credit markets were frozen.”

Was he lying?

No. Hank was telling the truth.

Let’s look at markets for short term money. Why? When prices for short term money move, prices for other money must concurrently move. Starting on Monday, September 15^th, when Lehman Brothers, an investment bank, declared bankruptcy, one month LIBOR rates for money were 2.49%. Essentially, the base opportunity cost of private investing for one month was 2.49% on an annualized basis. While the S&P 500 and Dow Jones Industrial Index swooned wildly, one month LIBOR ticked up every day, closing on Friday at 3.19%. In other words, the private sector opportunity cost of efficient investment swooned by 33% in five business days.

Why? Did inflation increase? Did oil prices increase? No. None of this occurred. What did occur was the increased need for cash on banks’ balance sheets. Faced with dramatic uncertainty answering questions such as :

• what do we own? and
• what do our competitors own?

The best answer every bank came to was “don’t loan and keep cash for our own security”.

But it wasn’t just LIBOR that increased ….

Short term 30-Day Commercial Paper, the basic note that keeps corporation engines oiled increased from 2.2 to 2.5%. And to show how much the average American did not trust the solvency of the banks (rightly so if all their business model is now preserving cash and not efficiently loaning cash), One Month Certificate of Deposits increased from 2.51% to 5.0% in the same span of days this week. In other words, if you – dear reader - had a goal of opening a CD last Monday, got sick, and went to the bank on Friday, your rate of return would have doubled.

Is this unheard of?

I think so. If we examine the changes in the same rates from randomly June 4 to June 8, 2007 there was no change in LIBOR rates. If we examine the same rates randomly from July 16 to July 20, 2007 again, no change again. LIBOR held steady at 5.32%. What was the Fed Funds discount rate then? 5.25%. Historically, this has been the case: a strong convergence of the two rates.

What was the Fed Funds rate this week? 2.00%.

Let’s take a deep breath: 3.19% one month LIBOR vs. 2.00% Fed Funds Target Rate means private sector’s unease forced efficient private sector rates north of 50% above the “discount rate”. Given this over 100 basis point difference in discount rate money vs. private credit, Hank was most certainly telling the truth.

What could be next?

This week will be as wild as last week.