Tightening bank credit will bring recession

Dec.21, 2007

Last night I renegotiated the fixed portion of my line of credit that is based on my house. The menu of interest rate options presented to me was far from pleasing.

Despite the recent rate cuts announced by both the Fed and the Bank of Canada my bank has raised mortgage and line of credit interest rates as recently as yesterday by 25 basis points.The prime rate in Canada is still far too high to prevent an economic slow down and the banking system's practices and the general seizing up of liquidity because of the asset backed commercial paper crisis with inter bank lending having become very restricted is evidence of how serious the risk of recession is.
The growing gap between the bank rate and the inter-bank lending rate or LIBOR rate that is, the London inter-bank offer rate whereby banks can borrow euro-dollars on the London market to ease their liquidity problems is a growing problem. In early December the gap between the US Federal funds rate and the US libor rate was on a three month term 93 basis points higher. Even when the central bank cut rates the LIBOR rate initially went higher.

One of the leading US fixed income fund managers, Bill Gross who is in charge of 3/4 of a trillion dollars through his Pacific Investment management company is already convinced that the US economy is in recession and is calling for a 5 % deficit to GDP -an increase over the
current 2 % deficit to GDP ratio- in order to rescue the economy from a recession and financial implosion driven by the commercial paper crisis.

One has to go a long way back to find a comparable high ranking financial busiessman calling for Keynesian solutions to the emerging slow-down.   ( see View from the top Bill Gross, managing director of Pimco p. 10 the Financial Times, p.10 ¸,Dec.21, 2007; see also Pimco boss says US in recession, p.3, FT Dec.21,2007

In another related column in today's FT there is a call for the creation of a special fund to guarantee the purchase of long term sub prime and other higher risk debt   debt at a discounted rate off the face value in order to create puts for the future possible sale of these debt instruments in order to create an orderly market for them and greatly reduce the possibility off total collapse.(   see Mark Fish and Bebb Stall, " Root out bad debt or more pain will follow." p.9)

If the world pursued this option according to the authors the total debt impact might shrink to as low as 75 billion from the current 300 plus billion.This sounds like a very good idea although critics of moral hazard will not be supportive of the proposed move. But in the absence of such a move serious trouble lies ahead.

Here in Canada, Coventree Inc the firm at the centre of ABCP mess has announced that it may go out of business because of the losses it has encountered over bad ABCP. Coventree was the sponsor of 16 billion dollars of the ABCP that has got into trouble. Their shares which sold for over 16 $ in July are now trading at 64 cents.

As well Stephen Harper the current Canadian Conservative Prime Minister has announced that his government will not bail out the commercial banks who are affected by the crisis on the grounds that this would violate his party's pro market Conservative principles.

This tough attitude may not hold up for long if the crisis develops into a fully fledged financial collapse. It is also unlikely to make him very popular with Canadian bankers and business leaders(though it might with the general public who tend to be very unsympathetic to the banks but who also misunderstand the seriousness of the current problem) who at this point probably would welcome some sensible intervention to help resolve the crisis.

In any case the Federal Deposit Insurance corporation backs up individual depositers at the commercial banks in the case of bank failure, so to some extent Harpers' tough talk makes little sense. If one of the major Canadian banks showed any sign of insolvency because of the crisis that would be very serious news for any Prime Minister regardless of political stripe.For it would not just be the bank's shareholders and customers who would suffer in such circumstances but the entire Canadian economy.

For the moment the Canadian commercial banks are balking at accepting the Bank of Canada's attempt to broker a multi party approach to solving the problem.

In the US the Fed successfully auctioned off 20 billion dollars in loans at 4.67 % interest in an effort to inject liquidity. The demand for these loans far outstripped supply indicating the depth of the crisis.