Money Market still Frozen

The $700 billion mortgage-rescue plan was unexpected rejected by the House on Monday. The stockmarket then was immediately in panic. The Dow Jones industrial average slumped by more than 400 points in 10 minutes after the result of the vote was shown on TV screens, and eventually plunged by 778 points, its largest point drop ever.

The shock from the House prompted Henry Paulson, the treasury secretary, and Ben Bernanke, the chairman of the Fed, to make more concessions on the bail-out. These include capping executives' pay in rescued institutions and increasing the limit of the Federal Deposit Insurance from $100,000 to $250,000. With these changes and more effortful lobbying, the Senate passed the bill in the middle of the week and the House finally passed it on Friday. However, confidence did not seem to be restored. After the bail-out plan was approved, the DJIA first gave up its 200+ gains and finally ended down more than 150 points.

One big problem to worry about is the money market. In the wake of the collapse of so many financial institutions in such a short period of time, banks are now extremely reluctant to lend money to each other for more than an overnight in fear of counter-party risk. This pushes the spread of LIBOR over the Treasury rates to more than 4 percentage points. Even credityworthy institutions are now paying punitive rates to get their necessary funding.

After seeing collapses of financial institutions all over the continent, the European money market has become even more clogged than the American one. In usual times, banks and investors arrange foreign-exchange swaps to get their needed funds in dollars or euros. But the market is now completely dried up. To help dealing with the problem, the Federal Reserve provided a credit line of $620 billion to its counterpart, the European Central Bank, for lending dollars to European banks. At first glance, it may look like a back-door bailout. However, there is a big difference with respect to the collateral the banks need to put at the central bank. In the American bail-out plan, or the TARP, troubled mortgage-related assets would be accepted as colleteral. In contrast, the European Central Bank would only accept colleteral of much higher quality. Moreover, the Fed in fact is lending directly to the ECB and so there is no real credit risk.