Living in Clip

Imagine credit is the world's largest, loudest, most awesome guitar amplifier and we've just blown almost all of the speakers. When you overdrive an amplifier it heats up and this heat makes it more difficult for the amplifier to handle a large burst of energy (Think of the bankrupcy of Lehman Brothers.) When this happens, the amplifier cannot reproduce the signal and clips, sending the burst of energy to the speaker which blows up the speaker coil.

The repo market is living in clip right now. In this tightly coupled market of lending between institutions, one failed trade can cascade through the system causing massive counterparty failures. On Tuesday a record 2.290 trillion dollars worth of trades failed. Borrowing rates on loans backed by U.S. Treasuries are stuck near zero percent, suggesting that despite the offer of free money, no bank is willing to part with their holdings of government debt which is crucially necessary for them to hold as collateral to ensure their solvency. The Ted spread, a measure of the difference in borrowing costs between interbank loans and loans directly from the government is stuck at historic highs, as banks hoard capital and refuse to lend for more than an extremely short duration.

As this clip ripples through the system it is rapidly destroying crucial cogs in the machine. This more than any other factor is what has contributed to the massive collapse in paper and tangible assets as fears of deflation lead to widespread discounting in the prices of all assets. Despite an easing in the credit default swap market on the risk premium for financial companies, we can not even hope for a bear market rally until some semblance of trust is restored.