Tick… Tick… Tick….
Tim Geithner has stated that the Federal Reserve’s low interest rates starting in 2003 (Geithner joined the NY Fed in 2003 – coincidence?) is the root cause of the current problem.
Having spent the last week devouring 10-K statement for all of the major radio companies (and it’s probably the case for most Amerian businesses), that definitely looks correct.
It goes something like this – back in the “good old days”, if you were a business and wanted to raise money to build a new factory, you had basically two options – sell more stock in your company, or borrow money by selling long term bonds.
Selling bonds meant a long term obligation to make cash profits from your new factory to pay back the loan. Raising money by selling stock didn’t commit you as strongly to paying cash for the money on a regular basis, but if your earnings didn’t increase over time, the value of your stock would be diluted and the stock would perform worse than your competitors.
Enter the Federal Reserve flooding the credit markets with very low cost money. This was George Bush’s doing in cooperation with Alan Greenspan. Following 9/11, the Bush administration felt a need to use government money to prop up the economy. (outside of New York City, 9/11 did not cause a big “hit” on the economy).
The consequence of this unneeded intervention in the economy was that given the choice of continuing to pay 13% on junk bonds or pay 2% to an investment bank (which was getting its money from the Fed), that’s a “no brainer”. Companies could drastically reduce their interest expense by swapping out their long term fixed rate debt with floating rate cheap money. Unforunately, people who don’t use their brain do stupid things.
The quick fix has a huge down side however (the same one hitting the residential mortgage market). Even if you had to borrow expensive long term money, you could budget cash flow out 10 years (or whatever the term of the bond is) and make rational investment decisions. Funding capital assets with short term variable rate money is very short term smart and long term stupid.
To try to mitigate that risk, companies (sometimes as a condition of the LIBOR credit facilities) purchased LIBOR/Fixed interest rate swaps. The swaps protect the company from the probability that sometime in the next “x” years, that very cheap LIBOR money is going to get more expensive.
That’s exactly what happened in September 2008 – With the failure of Lehman Brothers, reality set in. An Interest Rate swap carries the risk that the party that sold it to you could go out of business (as Lehman did) and leave you holding the bag. Who insures the insurer? There is no such thing in life as “no risk”.
Overnight, LIBOR shot up from like 1.2% to 4.5% in a single day. Had that not been stopped in its tracks, everything based on LIBOR would suddenly become very expensive and anyone who had sold hedges (interest rate swaps) was going to quickly become insolvent causing other sellers of swaps and lenders with LIBOR based loans to fail.
So the central banks of the world all turned on their fire hoses to flood the global economy with even more cheap money. They’re trying to put out the fire by flooding it with gasoline.
This can’t last. At some point, LIBOR is going to zoom back up to the real cost of money reflecting the actual risks of the borrowers. When it does, companies that borrowed long term money from the short term market will fail. Companies (or government agencies who didn’t know what they were doing) that have sold interest rate swaps will fail.