Credit Markets Threaten Retail Banking, Bank Runs Next?
Dan Denning

The share market is not the most important story today. That may be tough for you to believe. After all, the 777 point figure decline on the Dow is the most visible symptom of what's killing the market.

But in terms of percentages, Monday's 6.9% decline in the U.S. doesn't even rate as one of the top ten worst one day percentage declines in history. Maybe that will come later this week. It might come in emerging markets.

The big story, though, is in the credit markets, which are in as bad a shape as they've been since the credit crisis began. The credit markets are vital to the banking system and the banking system is vital to anyone with deposits in the bank. This is how the credit crisis intersects with the real economy.

Remember, the whole target of the Paulson plan was to relieve pressure on banks. That pressure is right back on, following the failure of the U.S. House to sign on to the deal. That pressure threatens to spill over into the commercial banking sector, where we wonder what it will do the confidence of people who have money in the bank and not a lot of a confidence in the financial system at the moment.

Let's be clear about what we think the last two days mean: the Fed and Treasury are worried about the viability of the banking system. Why? Well, another bank was taken over in the U.S. (Wachovia by Citibank) and four European banks were effectively nationalised.

The trouble is as simple as it is intractable. The banks have heaps of assets on the balance sheet they can neither sell nor price. That alone is bad news. Write downs on those assets threaten to wipe out equity capital.

But if it were just a case of allowing a few institutions to fail, you'd have a run of the mill crisis. Not an epic one. After all, three out of Wall Street's five investment banks were allowed to collapse or forced to reorganise.

Officials and regulators might have been worried about the investment banks in terms of their counter-party risk in the credit-default-swap market. But Paulson and Bernanke let Lehman fail, arranged a marriage of Bank of America and Merrill Lynch, and threw Goldman Sachs and Morgan Stanley a lifeline by allowing them to become commercial banks.

Now, they must fear that the credit markets are threatening the retail banking sector. But how? Banks fund their operations by either deposits or loaning to one another. Those loans are sometimes overnight, sometimes longer. But the inter-bank lending market only works if banks believe that one another's collateral is good and loan to one another.

Much of the financial sector's collateral, though, is precisely the stuff that's falling value, namely securities backed by residential American real estate. Banks need each other to meet their funding obligations. But with the collapse in value of their main collateral, no one wants to lend. They all doubt each other.

The Paulson plan aims to cut the bad collateral out of the system like a cancer and replace it with Treasury bonds. But with the plan in tatters, the market is already anticipating more trouble and taking action. This action is removing another key source of bank funding: the money market. It's being taken because investors are beginning to wonder which retail banks might go under if the credit markets don't thaw.

With more and more investors doubtful about the bank's ability to survive write downs in their assets, or to secure funding, money is fleeing the money market for the short-term Treasury market (yields on 30-day Treasuries are just 0.066%).

This flight from the money market removes another key source of short-term bank funding, and puts the banks under even more pressure. This is why the Treasury moved to back-up money market funds last week. It was effectively asking investors not to remove money from the money- market by giving that money a Federal guarantee.

We're not certain the guarantee is going to ease anyone's mind in the current situation. We'd expect more money market outflows, further putting the screws to the banks. And though the Fed unleashed a torrent of overnight money to prevent a total drought of liquidity (nearly US$600 billion), the market is slowly coming to the realistation that more banks are going to fail as their assets reflect the market price.

There is a certain symmetry between Wall Street's behaviour and Main Street's behaviour. At the household level, some sellers refuse to lower prices on their homes because they do not want to take a loss. They believe the market will recover. But in the meantime, banks are selling foreclosed homes as quickly as they can. Prices continue to fall (affecting all those bank assets/collateral).

Meanwhile, financial institutions could probably unload a lot of their housing-backed debt on private equity and hedge funds-but only if they were willing to take a big haircut. That haircut would wipe out equity capital.

The banks want a deal that keeps them in business. They want the Paulson deal. But the U.S. taxpayers don't want the Paulson deal. They've said so all week. So where does that leave us?

It leaves us exactly where we've always had to be: the continued de- leveraging of the global financial system. That means more asset-write downs, more bank failures, and sooner or later, a run on a few banks as depositors begin to realise that the frozen credit markets are going to lead to the death of some over-leveraged banks unable to fund their operations or roll over their debts.

We may get Paulson Two, of course. Congress will cook up some other version of the plan that addresses things like equity warrants or taxpayer protection. But none of that solves the problem at the heart of the financial system: a tremendous amount of borrowed money has been invested in assets that are falling in value. The inevitable result is a credit deflation. There is no way of improving the quality of the assets.

The Fed is not waiting to see what Congress does to respond. It's about to grow its balance sheet in a monstrous way. It will take on new liabilities and create new money to do so if it must. That's why the only exception to yesterday's commodity sell-off was gold. We'll have more on this latest phase of the crisis in a special mid-week edition. Until then...

Dan Denning
The Daily Reckoning Australia

P.S. to get The Daily Reckoning direct to your inbox sign up to our free e-mail newsletter or if you prefer to use RSS, subscribe to the Daily Reckoning RSS feed.