Global liquidity

As for a crisis of confidence in the U.S. (and thus the capital outflow in August), there is a reassuring reason for it: In August there was a contraction of global liquidity as certain credit markets, especially the commercial paper market, froze. The horrendous Treasury numbers reflect the selling of what was liquid to keep from having to sell potentially bad investments into a market where there were no offers, meaning a 100-percent write-off would have been necessary. The August capital flow report was almost certainly an aberration, and we can expect normal levels in the November report (for September) or the December report (for October). It was a true crisis and it was U.S. assets that saved the day. Global investors will remember that next time.

But there is a very dark cloud in that silver lining: the effort by the big three banks — Citigroup, Bank of America, and JPMorgan Chase — to establish a “Superconduit” fund that will be the lender of last resort for financial institutions that own potentially toxic paper. The fund will be on the order of $80-$100 billion and will buy only the top-rated paper if the holders find it difficult to get pricing or a buyer.

But wait a minute — who is to say the high rated paper deserves the high ratings? The ratings agencies were part of the problem in the first place, going along with the packaging of bundles of sub-prime paper into what was supposed to be a triple A rated package. This packaging idea is based on modern portfolio theory, which works when the prices of the various components do not move in sync with one another. It would have worked except that in the real-life credit squeeze we had in August, the individual bits and pieces of the bundle were correlated. In a nutshell, correlation is what you get in a panic.

Banks created “structured investment vehicles” to keep this paper off their balance sheets, and they funded these SIVs with commercial paper backed by the very paper they didn’t want to hold on their balance sheets. The purpose of the Super conduit is to restore liquidity to the commercial paper market, which also contains non-financial corporate issues (including blue-chip names) and financial institutions themselves, including the very banks creating a lender of last resort for their own off-balance sheet entities.

What’s wrong with this picture? First, the Super conduit doesn’t solve the issue of toxic sub-prime debt. It still has to be taken out back and shot — meaning somebody has to take the loss. It’s exactly like the Latin American debt problem of the early 1980s — the banks don’t want to admit they were bad at their core business credit evaluation).

The Super conduit buys them some time to get each asset in each bundle priced correctly. So far it’s a strictly private initiative and thus not technically a bailout of banks “too big to fail,” but many commentators are suspicious the initiative will fail — i.e., other banks will not join the fund, which will mean taxpayer dollars might have to come into the picture. That’s doubtful, since the U.S. is against such interventions as a matter of principle, but the fact that people are raising the issue indicates how deep the lack of trust is in banks and government. If you can’t find a sucker to buy bad paper, sell it to the taxpayer.