Huge Mushrooming in Central Banks' Liquidity Pumping

September 6, 2007 (LPAC)--Throwing more gasoline on the fire, central bankers in the U.S. and Europe chose to infuse nearly $100 billion into the imploding banking system. And this, just after having thrown $200 billion into the system since Aug. 9. Today, the U.S. Federal Reserve threw in $31.25 billion, the largest single-day infusion since Aug. 10. Earlier in the day, the European Central bank tossed in $57.4 billion in temporary funds to the money markets hoping, beyond hope, to "ease tensions" as Reuters coyly put it. Now joining the fire-brigade, the Bank of England announced today it would pump cash into the financial system by next week.

The Fed's move came as it released data today showing that the U.S. commercial paper market shrank for a fourth week, "extending the biggest slump in at least seven years," Bloomberg noted. Commercial paper fell $54.1 billion in the week ended Sept. 5 to a seasonally adjusted $1.93 trillion. The fall included a $31.3 billion decline in asset-backed commercial paper.

The Bank of England said it will, generously, hold its base bank borrowing rate to 5.75% in a gesture to reduce overnight borrowing costs. The BoE, according to AFP wires, said it would raise $35.6 billion for commercial banks to borrow.

Income and wealth are too concentrated in the US for aggregate numbers to tell us much. It's too coarse a view. Instead one must use segment analysis, looking at the situation of average households in the 2nd and 3rd quintiles of income or wealth. The census has the numbers.

From the U.S. Census report Net Worth and Asset Ownership of Households:

Look at Table F: Net worth excluding home equity:
2nd quintile has $6,349
3rd quintile has $12,333
Much of that is in retirement accounts. Both have almost no net cash (cash minus credit cards).

Consider an average American household now vs. 1980 (3rd income quintile):

Then:
* one spouse working.
* little debt other than the 30 year fixed mortgage and car loan (both with large down payments, hence equity) (if they had plastic, it was for gasoline, like Texaco)
* reasonable savings, both in the bank and a perhaps a defined-benefit pension plan

If he lost his job they could survive for quite a while by cutting expenses, relying on savings, unemployment insurance, and part-time work for one or both spouses.

Now:
* both spouses working
* big debts: big mortgage, 5 year car loan (little or no equity), revolving credit debt
* little or no savings outside of their retirement accounts

If one spouse loses his or her job they are in immediate risk of bankruptcy in the next 90 days. If one or both is an independent contractor, there might not even be unemployment insurance.

Second income quintile households are in an even more precarious condition. Since this transformation of American finances we've never had a serious recession. Imagine if we have a downturn like 1980-82. We might see bankruptcies on a scale like nothing since the 1930's.

For more on this see research by the Levy Institute of Bard College. They have a wide range of studies on this topic.

But critics say the Fed's rate cuts can't produce a miracle. The credit crunch on Wall Street reflects an unwillingness to lend because of a lack of trust, not a lack of funds. Until the markets get rid of the chaff, the price of credit isn't going to be that important.

So far, the Panic of 2007 isn't like your grandfather's recession. Credit Suisse economist Neal Soss calls it "new allergy to structured finance." "You're not going to cure that with a cut in the federal funds rate," Soss said.

The most prominent exponent of the "recession is coming" view is Martin Feldstein, one of the grand old lions of macroeconomics, who spoke to all the Federal Reserve policy-makers at the Jackson Hole retreat last weekend.

Feldstein says that the housing sector is at the root of three major concerns, any one of which could significantly slow economic growth.

First, he said, the drop in home prices has devastated the home-building sector, costing thousands of jobs and slicing output. The decline in residential investment has shaved about 1 percentage point off growth in each of the past two years.

Second, the collapse of the subprime-mortgage industry has spiraled into a wider credit squeeze, hurting the ability for companies outside of mortgage and housing businesses to obtain the credits they need to operate.

Third, consumer spending could be reduced significantly by the inability of homeowners to borrow against their home equity, closing off what has been a big source of disposable income for consumers.

There's a big disagreement among economists about the role of mortgage-equity withdrawal in consumer spending over the past five years. Contrary to Feldstein's position, some don't believe it's had any impact at all. (CHS: you mean $1.5 trillion had no impact at all??)

Investors will find out soon enough, because equity-takeout mortgages are now "officially dead," according to Alec Crawford, a market strategist in mortgage-backed securities for RBS Greenwich Capital.

Prada called for global regulators, banks and investors to develop an information warehouse where all CDOs, bonds based on pools of debt and other assets, would be recorded so that the risk of losses can be quantified. The CDO market should replicate the Depository Trust & Clearing Corp., which has monitored credit-default swap trades since last year, Prada said.

Concerns that banks may be damaged by losses on CDOs backed by mortgages to U.S. borrowers with poor or limited credit history caused investors to withdraw lending, driving commercial paper yields to a six-year high and forcing central banks to provide more than $350 billion of emergency cash.