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Just a few days ago, I read a few headlines on various financial sites noting that “liquidity issues have eased” or that the current trouble in the markets was just “fear mongering” so speculators could take advantage. Various “officials” noted that problems were contained, would only affect a few, we’d have a soft landing, etc, etc. Well, this morning we got some news that basically says, “Hello McFly, we have a liquidity crisis.”

In response to rapidly increasing short-term funds rates, the Central Bank of Europe loaned $130 Billion to the European banks and followed that action by stating it would make “unlimited cash available to fight the liquidity crunch.” The Fed took similar actions making an additional $24B in temporary cash available.

(From Bloomberg)

The European Central Bank, in an unprecedented response to a sudden demand for cash from banks roiled by the subprime mortgage collapse in the U.S., loaned 94.8 billion Euros ($130 billion) to assuage a credit crunch…

…The overnight rates banks charge each other to lend in dollars soared to the highest in six years within hours of the biggest French bank halting withdrawals from funds linked to U.S. subprime mortgages. The London interbank offered rate rose to 5.86 percent today from 5.35 percent and in Euros jumped to 4.31 percent from 4.11 percent...

… The ECB said it would provide unlimited cash as the fastest increase in overnight Libor since June 2004 signaled banks are reducing the supply of money just as investors retreat because of losses from the U.S. real-estate slump. Paris-based BNP Paribas SA halted withdrawals from three investment funds today because the French bank couldn't value its holdings. …

… For Bank of America Corp., the No. 2 U.S. bank by assets, today's increase in overnight borrowing costs is the biggest since the Federal Open Markets Committee raised interest rates at the end of June 2004. For UBS AG in Zurich, Europe's No. 1 bank, it's the largest jump since August 2004…

…Both banks said their overnight borrowing costs rose 65 basis points to 6 percent. Royal Bank of Canada and Barclays Plc also said they would pay 6 percent…

Whilst I’m sure some will view these actions as “under cover rate cuts,” in truth, neither action really constitutes a rate cut per se (if we look at Wednesday’s rate as a baseline) rather it was an intervention designed to “equalize” or control the rapid rate increases due to the high demand for cash. These actions point to the fact that there are a couple of financial institutions out there that are in very serious trouble and that we’ll see more of these types of actions in the future.

However, let’s not forget that increasing the money supply is what got us into this situation in the first place, whether it was done via low interest rates or physically increasing the amount of cash available to the banks. Understanding that these types of actions are very necessary, it still begs the question ‘what negative side effects are we going to be facing in the future?’

Digging into the specifics of what precipitated the actions of the ECB, we find it was when a French bank (BNP Paribas SA), suspended investment withdrawals in a fund that had heavy subprime mortgage exposure. At present, the bank is unable to quantify its losses as it’s having trouble valuing the assets within the funds. Sound familiar? This situation, again, points to the danger of the mark to model valuation model, especially when an institutional investor can value assets via mark to model and then borrow money against them; the whole scenario reeks of the “fox in the chicken coop”.

Based on the rapidly mounting evidence around us, I suspect that we can anticipate the following to occur over the next 2-4 months:

1) The chances for a recession in the US and Europe are now quite high. Of course, we now live in a different world, so recession may not mean what it did in the 70s and 80s.
2) Rapidly mounting hedge fund carnage. I wouldn’t be surprised to see hedge funds start dropping like flies in a similar fashion to March’s subprime lender collapse.
3) Another brokerage firm to join Bear Stearns in the dog house
4) Banks begin to report serious problems. Expect the problem to begin with the small local banks and spread to the large retail banks. I don’t anticipate any of the big retail banks needing a bailout, but I wouldn’t be surprised if a couple of them go through some very rough times.
5) The banks to report rather dismal Q3 earnings
6) More and more mortgage lenders to go under, every week it seems that another mortgage lender is facing margin calls or having trouble meeting its debt obligations.

I know that there are a lot of analysts out there who are encouraging investors to pour money into the banks due to the high dividend yields, the fact that the companies are still profitable, and currently trade well under their analyst targets, etc. However, I think that we can expect to see the earnings (and stock prices) of the banks decline over the next 2-4 quarters. If you’re betting on a recovery, then the stock prices will obviously recover from where they are now. BUT, you’ll probably get better bargains if you wait until after the Q3 or Q4 earnings reports.

Over the next 3-6 months, the big questions will be as follows:

1) Which financial institutions are in the most trouble?
2) Will a full-fledged Fed bailout be necessary?
3) When will the bulls stop calling “the bottom” or say “fears are overblown” based on the slightest bit of good news?

The optimistic bulls worry me the most, as some are in some rather high positions of power -- how are we really going to address the problem if some people are insisting on saying that there isn’t one? Better yet, how do we prevent this situation from happening again if we don’t look at it as a systemic problem as opposed to a one-time aberration?

Disclosure: the author doesn’t positions in any of the companies mentioned in this article.

Source: No Liquidity Crisis? Then Why Are the ECB and the Fed Increasing the Money Supply?