I've been harping about this one for a while now ...



The TED Spread ...

(snip)The price difference between three-month futures contracts for U.S. Treasuries and three-month contracts for Eurodollars having identical expiration months.

The Ted spread can be used as an indicator of credit risk. This is because U.S. T-bills are considered risk free while the rate associated with the Eurodollar futures is thought to reflect the credit ratings of corporate borrowers. As the Ted spread increases, default risk is considered to be increasing, and investors will have a preference for safe investments. As the spread decreases, the default risk is considered to be decreasing."(snip) from InvestoPedia

in more useful terms ...



(snip)"The backers of the bail out have come out with why we need to give them a blank check for economic dictatorship: it's a good bet on the markets.

No really, that's their best pitch. Their argument is this: Credit has seized up, and it is time to use the government's ability to act as borrower of last resort to buy up instruments now listed as "toxic waste" by Wall Street. Prof Brad DeLong just wrote in weak support of the plan. His estimate of how many jobs this could preserve over two years? 5 million.

Unfortunately for this argument, his math is fuzzy and way off. And maybe that's why earlier this year DeLong was one of those people saying that this was not a recession, that we needed only a minimum of stimulus. Up to a few weeks ago he thought that the whole period might escape being truly an unequivocal recession. In other words, if DeLong's back-of-the-envelope math were good, we wouldn't be having this conversation.

But I don't want to go after Prof. DeLong, who is not by any stretch of the imagination responsible for this mess nor a cheerleader for the policies that got us here, but merely someone offering an opinion. He's been on the side of right often enough when it was uncomfortable that no one should doubt his intentions or his sincerity.

However the same cannot be said for the plan itself, or any plan predicated on the idea that the problem is a lack of business confidence. The plan is premised on the idea that it is fear of contagion that is driving the crisis, when, as the collapse of Washington Mutual shows, the collapse is driven by underlying economic fundamentals.

What is going wrong, acutely, is that bankers around the world are not lending to each other. This can be seen by spikes in what is called the "London Interbank Offer Rate" or LIBOR. LIBOR is what banks are willing to charge each other, on average, for a loan. The idea being that this way the total banking system keeps the minimum amount of money on hand to meet runs on the bank, and there are built in incentives to keep a bit more money than a bank needs, but not too much.

Normally LIBOR for a given currency is fairly close to what the central bank of that currency calls it's target rate. Basically, if banks are charging each other more for interbank money than a central bank likes, the central bank can come in and undercut them. If banks are charging more for money, that means that banks will keep more money on hand, meaning credit is harder to get, and they will start to prefer to loan to each other, since lending to another bank is a fairly safe bet.

When LIBOR for a currency spikes above a central bank's target for significant periods of time, or spikes a lot above that rate, then it is a sign the central bank is losing control of the money supply. Something needs to be done. Last week isn't even the first time in the last year, it happened in August of 2007, and in February of 2008. These dates aren't coincidences, both times the spurred official Washington to "do something." Mostly what official Washington did was throw money in the wrong place, and then declare the crisis contained.

The reason for these spikes isn't perceived risk. After all, the banks that have gone under are few in number, and all of them sent signals of being in deep trouble long before they did. Bear Stearns was marked for death in July of 2007, and only finally failed in March of 2008. By March 2008, Lehman Brothers and Merrill were known to be next, even though they did not fail until September. In short, it is relatively easy to avoid a bank that is going to fail with slightly less due diligence than is required to fill out the office fantasy football league.

The reason it is not risk of a bank failure that is driving interbank lending problems can be seen by the decision in China not to engage in interbank lending to the United States. One can argue that it is risk premium in the case of one bank not lending to another, or even a country having a list of banks it does not approve of, but not for blanket bans. And China, while they have been formal about it, is not alone.

Thus what is going on is what Keynes called "Liquidity Preference." Not in the sense of worrying about a bank going bust, but in the difference in the magic property of US Treasuries to be treated as cash. That is, the difference between an even the soundest interbank loan or CD, and a Treasury, is that the holder of a Treasury is every so slightly more liquid than holding anything else. With the series of over the weekend announcements, such as Freddie and Fannie, such as AIG, such as Bear Stearns, such as Lehman Brothers, the penalty for not being liquid on "any give Sunday" has been rather high. Ask the person who went to bed on Friday looking at their Freddie Mac stock.

The road to beating this crisis then is not about "business confidence," that old Hooveristical fantasy that led to trying to balance the budget in the teeth of the Great Depression, but in reducing the banking systems liquidity preference. This is related, but it is not the same thing. One can reduce liquidity preference, because liquidity preference isn't just about fear, it's about greed too. No one wants to be caught short of cash when prices collapse and there is a buying opportunity.

Looked at this way, the Paulson-Frank Toxic Waste Hedge Fund doesn't do anything, in that there will still be the same belief, a correct one, that equities trading at 16 times trailing P/E are over priced going into the second dip of a double dip recession, and that there are huge volumes of paper out there ready to implode. In fact, that the Paulson-Frank Toxic Waste Hedge Fund is buying up toxic waste is making matters worse, since banks around the globe want to be sure they get a chance to line up and sell to the Dumbest. Money. Ever. What other fund would start out, according to one of its supporters, with the goal of losing 16%?"(snip)