Thursday, October 9, 2008

Crisis Handbook

VoxEU has produced an instant book of essays on the evolving crisis. I found Barry Eichengreen's piece particularly informative.

Waste Treatment and Toxic Assets

Le Monde has an interesting short note on a banal waste treatment consortium in Yvelines. Like many such public works projects, it floated two bond issues to finance its operations. Then, in order to meet its operating expenses in a changed financial regime, it enlisted the services of a financial consulting firm, which advised it to take a position in international currency swaps, a complicated financial instrument that the facility's board no doubt did not fully understand. But they had paid for what they thought was competent advice. For a while all went as planned, but then came the crisis, and now this waste treatment facility has on its hands what the financial world has come to call a "toxic asset," which it does not know how to incinerate.

One small example among millions, no doubt, but it has the illustrative value of showing that the problem cannot simply be reduced to "subprime mortgages" or "the US housing bubble." Things are crazier than that. Just how crazy we're only beginning to discover. Read today's excellent NY Times article on derivatives and the determined opposition to regulating them, led by Alan Greenspan, yesterday's unassailable gnome. Another excellent article on the crisis is this one by Martin Wolf.

French Nobel

J.-M. Le Clézio has won the Nobel Prize for literature.

The earlier award for medicine to Luc Montagnier and Françoise Barré-Sinoussi has already aroused some controversy.

On the ECB Rate Cuts

On the subject of the ECB rate cuts, I received two informative e-mails from a knowledgeable reader who must remain anonymous for professional reasons. Here is what he says (quoting from press releases):

"Last night, the ECB switched the way it conducts its weekly auctions from variable to fixed-rate tenders. The effect of this in practice, as discussed on the next page, is equivalent to cutting interest rates by almost a further 75bp on top of the 50bp cut announced earlier in the day.

"Having participated in the coordinated central bank action earlier yesterday and cut rates by 50bp to 3.75%, the ECB followed up with further policy moves later on in the day, which in practice has the effect of cutting rates by almost a further 75bp on top of that. This relates to the way monetary policy is implemented in practice.

"Until now, the ECB conducted so-called variable rate auctions, whereby each week, it decided and announced the total amount of liquidity it was going to provide to the banking system as a whole. To obtain a share of this liquidity, banks entered bids in an auction, whereby they stipulated the sum they wanted to borrow from the ECB and the interest rate they were prepared to pay for this. The minimum bid rate in this auction was the official rate. The ECB then filled the bids top-down, allocating funds to the bank that bid for the highest interest rate first and so on, until its total liquidity provision target was met. This meant that, in practice, the actual rates at which banks borrowed was generally higher than the ECB's official rate. In normal times, that gap was around 6 or 7 basis points. But the extraordinary surge in money demand by banks means that at the last auction, the gap between the official rate and the (average) actual rate was 74bp.
"Yesterday evening, the ECB announced it was switching to conducting fixed-rate tenders instead. This means that the ECB is prepared to provide however much liquidity banks want at exactly the minimum bid rate. In effect, this therefore makes borrowing for banks much cheaper, eliminating the gap between the official and the actual borrowing rate.

"On top of that, the ECB narrowed the window for lending and borrowing outside the auction process in the discount facilities from +50bp/-50bp relative to the official rate. In practice, this matters much less, although it will help banks' profitability a little."


From Citi:

Furthermore, from today onwards the ECB reduced the spread between the interest rate of the marginal lending facility, where banks can receive overnight credit from the ECB, and the ECB target rate from 100 bp to 50 bp. Hence, the rate of the marginal lending facility dropped from 5.25 yesterday to 4.25 today (50 bp rate cut plus 50 bp spread cut).

Yet another "stealth" cut. The question is: why did they not trumpet these two additional changes?