The Paulson Plan ponzi scheme?

We’ve had nigh on twelve months of credit crisis.

But only truly now – after a year of violent structured finance deleveraging that has crippled banks – are we seeing the effects of a true, metastatic credit crisis. One which the Paulson Plan may actually exacerbate.

A hat tip here is deserving of Yves Smith and some of the commenters on Naked Capitalism – who have been discussing much of the below.

What do banks do? Ultimately, they perform a simple arbitrage: short term deposits, converted to long term lending. On the most basic level, that involves taking consumer deposits and turning them into mortgages. In the modern world, in means tapping the wholesale money markets, and turning the money raised there into longer term loans.
Commenter FairEconomist at Naked Capitalism notes:

Much of the working capital market, for decades has come via money market funds (MM). Joe public or Joe CFO deposits money into a MM. That MM loans it to a bank (usually by buying paper, and usually at a medium duration) and then that bank loans it out to business for inventory, payroll or whatever. The MM has converted Joe’s demand deposit into a fixed-duration loan. 

The behaviour of money market funds is thus critical to the behaviour of banks, and the relationship is affected through so-called commercial paper.

Yesterday, the Federal Reserve issued its weekly commercial paper market data. For the past week, the market has been in turmoil. Lending beyond all but the shortest of horizons had collapsed. The latest release shows some signs of improvement but everything is still under strain. Short term is the name of the game.

This chart, which we wrote about eariler this week, is part of the problem:

(The graph is from Jeffrey Rosenberg at Bank of America)

Prime money market funds – those which buy commercial paper – have seen assets under management decrease by $389bn in the past two weeks. Treasury and Government money market funds – which buy treasuries and sovereign debt – have seen assets under management increase by $244bn.

The Tarp, of course, will be funded by issuing Treasuries. Under the most likely modelled scenario, the Tarp will leave the US government with a financing need of $931bn in 2009.

The Treasury market is large and liquid. But it has already had to deal with a 135 per cent increase in supply since June last year. The Tarp would push it massively higher. There isn’t a worry about finding buyers though, because in the current febrile market, there are many many private buyers of Treasury debt. Foreign central banks might not have much appetite for Tbills, but others do.

Among those others: money market funds.

A glut of Treasuries then, might further skew the money market fund universe away from commercial paper. And doing so would exacerbate the funding crisis banks and corporates are facing.

It’s not just the Tarp doing this either. Hugely increased central bank liquidity support as well as a host of other government interventions will need to be financed through Treasuries.

Related links:
The Fed’s liquidity crisis – FT Alphaville