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This Patient Still in ICU

BlackRock's Peter Fisher--reported as possible choice for NY Fed--says the banking system is still ailing.

Eric Jacobson: Hi, I'm Eric Jacobson. I'm a fixed-income specialist with Morningstar, and we're fortunate enough today to have a guest from BlackRock. Peter Fisher is the co-head of fixed income at BlackRock, and also a member of their executive committee.

Prior to joining BlackRock, Mr. Fisher was the Undersecretary for Domestic Finance of the United States Treasury Department. Peter, thank you very much for joining us today.

Peter Fisher: My pleasure, nice to be here.

Eric Jacobson: So, as you know Peter, this has been another tumultuous week in a string of them. We've had some pretty big marquee events from announcements made by Citigroup through to the meetings on the Hill with the automakers, and the market hasn't been all too happy with a lot of these developments.

So, I was hoping you could sort of give us your sense of what's been happening this week, and kind of an overall sense of where do you think things stand and how those events play in or aren't as important as they may look?

Peter Fisher: Well, there are a couple of different things that have all been coming together at once. First, we knew the fourth quarter was going to be very choppy in fixed income and all our capital markets.

The whole banking system has been on a race to try to slim down their balance sheets. So, on the other side of their annual statement dates, they won't have dubious assets on their books, and their balance sheets will look as clean as they can get them.


Now, a lot of the major firms have November 30 year ends, and those that have December 31 year ends, realize they want to try to get clean and clean themselves long before they get into the thinner markets in December.

So, we knew we were going to have very choppy markets to begin with. We've certainly seen this week a lot of risk assets, commercial mortgage-backed securities and others being dumped on the market.

It's a lot of forced liquidations as prime brokers cut back on credit to investors, as well as a lot of major firms themselves cleaning out positions. This has been the first impulse that's created a lot of choppiness and volatility in the market.

Now, the second impulse that is coming to bear here is, this has been the first month in which we've really gotten to look at how weak the real economy is. How weak retail sales are. How weak auto sales have been.

That's showing through now, and that's another source of volatility that's coming to bear in you see how the auto companies are trading and others. So, that's the second source.

The third source is, while it's nice to get the presidential election behind us, every presidential transition is a source of volatility, as we wonder who is going to be in the cabinet and who's going to do what and what new policies will there be?

Then on top of that, lame duck sessions of Congress are themselves a source of volatility, because we're never quite sure whether Congress is or isn't going to actually accomplish something in a lame duck session.

They go back and forth on whether there will be a package for the auto companies, is another example of that. So, there is a lot coming together this week in particular that's given us this extraordinary volatility and further sell-off in both the equity and the fixed-income markets.

Eric Jacobson: Well, that's interesting, and I think that mention kind of segways nicely into a broader question that I have, which is, what is your assessment in terms of where we stand today with regard to the lending markets?

Not just for example the long-term bond markets, where we know that yield premia are very high, but also the short-term and inter-bank lending markets where there is a sense apparently among people who are talking about it publicly that things have improved quite a bit.

But if you look at the historical data, it still seems that maybe the health isn't really quite there yet, and it's not entirely clear how much lending is available and going on. Give us your thoughts on sort of a bigger basis there if you will, and how would you look at the health of the system?

Peter Fisher: Well, let's break it down on the short-term funding markets and longer-term. Help me remember to come back to the longer term. For the short-term funding markets, of course it's good that some of the spreads, the TED spread, LIBOR spread, swap spreads have come in a bit from their absurd and extreme historical highs.

So, that's good that those have come down. We do need to remember that the central banks are doing some extraordinary things with their balance sheets, pumping extraordinary amounts of money into the system.

So, they're sort of bypassing the money markets, the banking system can go directly to central banks here and elsewhere and get a huge liquidity injection and lending. Some of that is going straight to commercial enterprises in the form of the Fed's commercial paper programs.

So, I liken this to asking, has the patient's temperature come down, and the answer is yes, and that's very nice. But the patient is still in the ICU, and is getting a massive intravenous injection of both new blood and all kinds of treatments, antibiotic treatments.

So, we sure hope his temperature is coming down, but we got to recognize, the banking system is still in the ICU with all these special provisions from the central bank. So, of course, some of these short-term inter-bank spreads are coming down, because those markets aren't being used or relied upon to the same extent.

But it's good that the central banks are doing this, because without it, we might have really frozen up our short-term lending markets and the commercial sector and industrial sector wouldn't have been in a position to rollover their short term commercial paper and keep their payrolls and routine activities going.

So, that's sort of good news and bad news there in the short term. In the longer-term out duration, this is pretty stressed conditions. That's where the liquidations are coming in, risk assets are falling off of balance sheets left and right.

It's a challenge. There are not a lot of people who want to grow their balance sheet in the form of new lending here. There's probably not a lot of demand for new lending outside the financial sector and people who are trying to hang on to levered balance sheets and the assets they are holding onto.

So, we're not there yet either on that. Now, I think what the Treasury has been doing directionally since mid-September has been in the right direction. There has been a lot of noise and disturbance and a loss of confidence around their execution and their explanation of it.

But I think they've gotten a sense of the scale of the problem that this is going to require a massive recapitalization of the banking system from the government. It's not pretty. The alternative is to see asset prices just keep falling, and some of that is going to take place anyway.

I think that we really only should be looking for signs of health in the banking system by the end of the first quarter next year and into the second quarter. That's how long it's going to take for enough of the big intermediaries to have cleaned themselves up and gotten in a position where they are confident they can start growing their balance sheets and lending again.

Eric Jacobson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.