Sanity Makes a Comeback

The stock market went down today, despite a rate cut from the Fed coordinated with a global loosening of monetary policy. Good. Why good?

Monetary policy is, in some respects, a synthetic indicator of interbank lending policies. In the past, they were a powerful bellwether for the domestic interbank lending market at large, which felt that it had to adopt the Fed's stance on interbank lending. In an efficient market, that's theoretically the logical reaction; this AAA institution will lend to you at X! We should too!

Actual lending rates have almost no correlation to the Fed funds rate right now, because banks are focusing on huge, strange changes in the LIBOR rate. And they should! This means that banks are making independent risk decisions about each other - and they SHOULD!

Does this create efficiently-operating credit markets? Absolutely not. In fact, it's a disaster! But it SHOULD be a disaster in a world where Bank A has no idea what the assets of Bank B are worth, and Lehman and Bear Stearns can simply wink out of existence. Central banks are not the only policymakers - individual, private institutions can and should make independent judgments of counterparty risk in interbank lending decisions. And individual, private institutions now realize that a lack of balance sheet transparency makes it impossible to judge the risk of a counterparty in a transaction. Look at Merrill! They theoretically were sold because a paranoid Chase demanded 5 billion in collateral out of nothing more than simple fear.

Why is that a good thing? That kind of shit is why the Great Depression happened! It's a good thing because banks will now be forced to figure out some agreed-upon method for valuing L3 and illiquid assets. A standard will emerge from this, hopefully with the assistance of regulators and politicians who remain about a year behind this crisis, to restore some semblance of order to interbank markets. It will have to. Interbank lending is a vital, required function for efficient market operation. After everyone's done being terrified, the logical response will be to develop a disclosure standard that is both more granular and more fair than the ratings agencies.

Right now, the rational reaction is to be scared like crazy that the bank you're lending to has an evil asset that will swallow them - and the money you lent them - whole. That's sanity given the events of the last 6 months. The next sane step will be to come clean so markets can function and you yourself can borrow in response to your own fear. Once this moment of clarity strikes, the recovery can begin.