A Dark Day

FIRST A PUBLIC SERVICE ANNOUNCEMENT: COLBY WHERE ARE YOU???

I'm sure everyone will soon hear of how the Fed is saving the economy by reducing interest rates by 3/4%. The news will go on and on about how this is a good thing and the ship will soon right itself. To use one of my more recently blogged expressions "Um, no". When the Fed lowers SHORT TERM INTERBANK interest rates eight days before its next meeting, it's NOT good. This is a sign of a drastic action for a desperate situation.

The public rarely knows what is the new, in vogue fear of Wall Street until after its happened. From what I have read (you never know the new fear unless you shift through the latest public fear to find the next one. You do this by reading several articles and picking up on the two or three sentences which coincide with the other articles. Now if I was any good with this I would be blogging from my beach house on Maui/Bali/Perth/Newport Beach/my own island etc. so take this with the knowledge that I can only guess as I'm an interested student and spectator) the latest fear is counter-party risk.

This type of risk is associated with the different parties subscribing to a financial instrument. Take a vanilla swap for instance. Two "people" Mike and Fred agree to pay each other a cash flow based on the USA short term interest rate (there are many good and valid reasons for doing this, but I won't bore you with the details). Mike has lost A LOT of money betting (yes, gambling) on Ma and Pa Kettles mortgage and can not pay Fred his cash flow. This is counter party risk. Usually the counter party risk in nominal if you contract with solid individuals with solid track records, credit, reserves, etc., but now with even the largest, supposedly secure financial institutions having difficulties and being "forced" (BofA) (quotation mark alert ;) ) to merge with severely troubled (Countrywide) mortgage companies, the balance sheets of these companies are increasingly under threat.

This is where counter party risk comes in. The vanilla swap contract that Mike and Fred entered into has a monetary value (asset) based upon the cash flows. If Mike or Fred (counter parties, Mike in this case) can not pay their part, the swap no longer has any significant value and is no longer an asset to the solvent(?) holder of the other side of the swap. Fred now takes a hit to his revenue (lack of cash flow payments from Mike) and to his balance sheet (the swap is no longer an asset and has to be removed from the asset side of the balance sheet). The problem now is whether Fred used this asset (the swap contract) to back (as collateral) a loan on his helicopter. If Fred did and Helicopter Lending Inc. finds out that this collateral is no longer worth anything then it will ask/demand/threaten Fred to back the loan with CASH. If Fred doesn't have the cash, he then defaults along with Mike. This scenario then dominoes throughout the financial industry and now the Fred's and Mike's of the world sell off contracts for pennies on the dollar (if they can find someone to buy them) to raise cash to back their other obligations. This further degrades the balance sheet as once lofty value assets are replaced with lower value cash or other financial instruments. If the balance sheet becomes unbalanced and companies run afoul of financial regulations and loan covenants, panic ensues. This is bad for everyone as institutions hoard cash to meet obligations or regulations, stop lending and consumers stop buying. This is the new fear on Wall Street.

To tie these two things together (yes I think they are related) the Fed may have lowered rates to help the financial institutions re balance their capital needs without resorting to a massive sell off of financial instrument assets. Whether this works or not is dependent upon the suckers that are in the barrel. If you think this rate reduction was to help you or me directly (we may be helped by not having our economy melt down), sorry, think again.

To tie this to a previous post about the value of the dollar, as interest rates decrease, the value of the dollar compared to other currencies decreases. This makes it more expensive to travel and increases the price of commodities like oil. Reducing interest rates also makes inflation likely higher.

Well till next time.