Ideas:

- Libor up at new high
- Peaks in spreads lagged the ending of past crises
- Investors with steadier nerves than the consensus will win

Substantial strains continue to exist in the money market, as evidenced by Libor and Treasury bill rates . Today (Wednesday), 3-month Libor was set at 3.476 percent, up a whopping 26.5 basis points on the day -- and the widest spread to the fed funds target since 1987.

The yield spread had been around 80 basis points for months before this latest hiccup (a "normal" spread would be closer to 12.5-25.0 basis points). Three-month T-bills are trading at 0.42 percent, down 28 basis points on the day.

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Some of the strain in the money market undoubtedly reflects the forthcoming quarter-end, which is boosting demand for the most liquid assets, from Treasury bills to cash.

There are also pressures from Japan, which faces its fiscal half-year end, an event that even in normal times results in a repatriation of capital into Japan. Uncertainties over the U.S. plan to purchase distressed assets are of course contributing to the money market problem, not only on an institutional level, but on a retail level, as the proliferation of news on the plan is affecting the mood on Main Street.

• Busch's Blog: Fix The Money Market Freeze

I mentioned yesterday a pattern that deserves repeating: Libor, the TED spread, and other fear gauges have historically taken time -- at least 2-3 months -- before settling down following previous financial shocks. Such was the case following the demise of Long-Term Capital Management and Russia's default in 1998, and after the 1987 stock market crash.

It is only human nature for frayed nerves to take time to settle down. The key to whether it does is foreign involvement in U.S. markets, which is vital toward financing both the government's initial outlay (the $700 billion price tag massively overstates the actual price tag because the government is buying distressed assets at equally distressed prices; the U.S. could turn a profit), and its annual deficits.

No new ground has been broken in the dollar and I do not expect that it will for many reasons -- although confidence is an unpredictable variable, as many financial companies have found out this year.

More: Click for Latest Economic coverage ...

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As we await the latest performance by the dynamic duo of BenBernanke and Hank Paulson, I would hope they are spending sometime investigating something of their own: Namely, why themoney markets have frozen in the United States.

I would recommend they start with what is happening in thefallout from the Primary Reserve fund breaking of the buck forits money market fund.

This was due to the fund holding Lehman securities -- whichtriggered a mass exodus of shareholders from the fund.According to Reuters, the fund said it had about $23 billion inassets last Tuesday, down from about $65 billion as of Aug. 31.It's now down to $1.637 billion. The fund halted redemption ofshares last week. This has triggered redemptions from theentire fund complex, not just the money market.

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This is where the story gets interesting. On Monday, the SECissued an order that provides for "an orderly plan ofliquidation of fund assets to meet outstanding redemptionrequests and for making appropriate payment to the fund'sshareholders."

Dow Jones reported that the regulator also granted thepostponement of payment for shares which have been submittedfor redemption, also requested by the Reserve, saying it isnecessary for the protection of shareholders: "The Reserve hadasked the regulator to postpone the date of payment ofredemption proceeds for a period longer than seven days afterthe tender of shares for redemption."

Seems reasonable, doesn't it?

Unfortunately, it has massive implications for the rest ofthe money market and mutual fund business.

Shareholders are concerned about this occurring elsewhere,even with the new $50 billion money market plan. This meansmoney market managers don't want to invest in anything thatisn't the safest, most liquid asset, which they know they canretrieve in the shortest period of time. It's return OFcapital, not ON capital. This is why 3 month Treasury billsyield 0.7 percent and why the 3-month OIS (Overnight IndexSwap)-U.S. Libor spread has exploded to the upside. All billsbelow 3 months are yielding 0.3 percent to 0 percent, withsecurity fails being a constant threat.

The implications are not for an immediate buyout of $700billion in distressed mortgages, but for the SEC to make astatement that they are not going to freeze future redemptionsfrom mutual funds or money markets.

Then, it would be a good idea for Mr. Paulson and Mr.Bernanke to provide a larger, detailed program for assistingthe money market funds. Outside of finance, people don'tunderstand that the money markets are the engine of liquidityfor our financial industry and our economy. We need action onthis immediately.

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I just got off the phone with Ed Lazear (Chairman of the President's Council of Economic Advisors), and he made a good case for the severity of the crisis, esp. negative interest rate on t bills. It got bad last week. The sun turned to sackcloth, moon ran blood red, burning hailstone, etc....crazy stuff. Something had to be done.

The problem is that they are just beginning to understand what a few of us (including Larry Kudlow and Steve Forbes) have seen all along:

Over-regulation brought us to this crisis, not under-regulation. If we get the diagnosis wrong, then the prescription will be wrong too.

Think of the analogy of a 'bail out': someone knocks a hole in a boat and the water rushes in. The crew bails water out of the boat to keep it from sinking. If things are really bad, another boat comes and helps. This analogy points to the real problem: the hole! If you patch the hole early, no bailing is needed. If you patch it very late, the whole ship needs to go into dry dock. But the bailing out only makes sense in the context of patching the original problem. The worst thing to do would be to allow the ship to sink to make some kind of populist political point. No, revise that:

The worst thing to do would be to take the left's view and say "too much water in the boat, let's knock more holes into it so the water can get out."

That's what more regs would mean. Place salary ceilings on "every company that benefits in any way whatsoever from the bailout" as Barney Frank said today on CNBC, and you'll get a talent exodus. Give judges the power to obviate existing mortgage contracts with investors around the world - the dollar will plunge. Every one of those proposals is another hole in the boat.

The best thing to do is to patch the holes. Here they are:

Some are talking about putting a hold on the mark to market regulations. That's a start but not enough. Don't suspend mark to market, abolish it. It's part of the whole Sarbox, Spitzer, FAS 157 wave of punitive regulation after Enron. It makes no sense to impose and universalize temporary downturns, especially during panics.

Abolish the Bank Holding Company Act. It's a remnant of the 1920s before branch banking. Its only current effect is to keep private equity from buying majority stakes in troubled banks. Goldman's decision yesterday just illustrates the problem. They had to change structure in order to buy up other banks. This is nuts. Get rid of this dinosaur and private equity will start the capital infusions.

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Abolish the Community Reinvestment Act. Forcing banks to make minority loans is the original sin out of which came the Subprime mortgage industry. Let banks decide where to loan; that's their job. Leave identity politics out of our credit system.

Do all of the above and I'm not at all sure that any bailout would still be needed. Before we subsidize these institutions, let's stop the things we are already doing to collapse them. Back to Hippocrates: First of all, do no harm.

What are other CNBC.com guest commentators saying?

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The yield spread between 3-month LIBOR and the fed funds rate is at its widest since 1987, reflecting continued funding strains in the inter-bank market and anxieties over the U.S. financial system in general. It is not surprising to see anxieties as high as they are given the magnitude of the current crisis, the history of reactions to previous crises, and plain old human behavior.

Concerns over whether Washington will pass the Treasury Department's proposal for purchasing up to $700 billion of distressed assets is the excuse given by most for the renewed strains in the financial markets, although it is difficult to fathom that investors truly believe Congress will fail to pass a bill this week. This means that the true driver of the continued strain in the money markets was last week's harrowing events and the impact it had on the psyche in the U.S. and around the world. Frayed nerves will eventually calm, as with past crises. (See more spread discussion in the video)

There is a long trail to the current financial crisis. Listening to our Government leaders blaming Wall Street greed for the entire debacle begs a response. The Government itself is an accessory before the fact to the state of affairs we find ourselves in today. Let’s review:

In the beginning – there were bad lending practices. And they are at the core of this extraordinary mess.

What was at the heart of the bad lending practices? The Federal Government!! Under both the Clinton and Bush administrations, it was government policy to encourage the private sector to ease underwriting standards in order to expand housing ownership in the U.S. The Federal Reserve under Alan Greenspan was an enabler in that development, by employing a monetary policy that kept interest rates exceedingly low, to the benefit of mortgage seekers. So lay blame on the US Government for bad policy.

The mortgage industry jumped on that bandwagon creating millions of new homeowners by advertising ‘no income verification’ mortgages and luring unsophisticated and sometimes barely literate would-be homeowners into debt obligations they did not understand. So lay blame on the mortgage industry for duplicity and greed.

Wall Street found a way to ‘create a silk purse out of a sow’s ear”. They employed their best and brightest - sophisticated software programmers and brilliant mathematicians - to package all that junky mortgage paper and create investment vehicles that suited many sophisticated investors’ risk appetites. They convinced the credit agencies that a million pieces of junk all bundled together really are riskless. So lay blame on the credit rating agencies for stupidity.

Wall Street then leveraged their shareholders’ balance sheets to the hilt to capitalize on the spread between low short term interest rates and the higher rates available from these new investment vehicles they created from all the junk mortgage paper. So lay blame on Wall Street for [w]recklessness.

And then SOME Wall Street firms paid their employees with illiquid stock and made it difficult if not impossible for them to diversify their assets. Their employees were enslaved – trapped by a system that penalized them for doing what they advised all their clients to do: make sure to diversify your assets and do not have all your eggs in one basket. So lay criminal blame on SOME (not all) Wall Street firms for destroying the livelihoods and the assets of their own employees.

AND THERE IS MORE THAT WE CANNOT FORGET:

Back in 2002, the US Government added a deadly long tailed fuse to the fire which has now exploded. By responding to abuses then in existence, it found an expedient solution that sowed the seeds of today’s crisis. That ‘solution’ was Sarbanes Oxley. By forcing companies to mark-to-market investments – something that was decried by many sound economists and academicians – the Federal Government ignored all the logical accounting rules that support pricing models that utilize different pricing rules for different types of assets. Be it naïveté, ignorance or the need to provide their constituencies with a politically aggrandizing ‘solution’ to the ‘evils of corporate America’, it was BAD POLICY and it is wreaking havoc today. So lay blame again on the Federal Government for creating bad policy and bad law.

One can already envision the new wave of regulation that the Government will emerge from this current crisis. Don’t for a moment think it won’t come. And because this financial crisis is bigger than those others we have experienced in our lifetimes – Long Term Capital in 1998, Savings & Loans in the late 1980s and early 1990s, portfolio insurance in the late 1980s, Penn Central in the mid- 1970s – the regulatory response will be far greater than Sarbanes Oxley. Well be warned – the seeds of a future crisis are just now being sown in the halls of Washington. The Government needs to learn from its own mistakes that cinching capitalism too tightly will only create a balloon-like response, causing another bubble which too will be burst.

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Patricia W. Chadwick is an asset manager and financial consultant with more than 25 years of investment experience. She is founder and president of Ravengate Partners LLC, a consulting firm that provides advice on financial markets and global economics.

By now, either you’ve heard US Treasury Secretary HankPaulson on the Sunday morning talk shows or you’ve readabout what he has said on the US government’s bailoutplan. There are tremendous issues with the plan as it charts acourse distinctly different from what has been used in thepast.

Let’s start with the bill itself: it’s 3 pageslong. Only 3 pages long….And it asks for a staggering sumof money with wide ranging powers to buy the broadest amount ofmortgage related securities with a minimal of oversight. Otherthan that, it’s great.

It asks for $700, 000,000,000 and needs to amend thestatutory limit on the public debt to borrow it. Then it askslawmakers in Congress to pass the bill in a very speedy mannerto stave off the collapse of the US financial system. Last timeI checked, there’s no provision in the US constitution toturnover the country’s check book to one plan, onedepartment, and one man.

This is a huge leap of faith and I suspect that leaders ofCongress and the presidential candidates will urge caution oract cautiously. Yes, this is the time for action. No, this isnot the time to essentially restructure the entire financialsystem of the country that has worked well up until we had 1%interest rates. There are other solutions and ideas that needto be considered. Remember, this is not an RTC type situationwhere the government already had the bad assets put to them viathe FDIC and then had to figure out what to do. This is atakeover of choice

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I've been arguing that in order to facilitate the stabilization of financial firms and shore up the value of financial assets the Federal Reserve would have to expand its balance sheet. The Fed did so with a vengeance this week, according the new date released by Fed late yesterday.

The Fed's H.4.1 release indicates that total Federal Reserve credit expanded by an average of $43.06 billion to $931.34 billion in the week ended Wednesday, an increase on par with the massive liquidity injections posted in September 2001 and for Y2K.

In both cases, the value of financial assets increased very sharply, with U.S. equities posting advances of over 20%. It is hard to imagine an outcome any different than what has transpired, as increases in money supply always lead to increases in asset prices, beginning with financial assets (this is the first and only trade to consider when central bank liquidity increases) and then real assets (this is the second trade, which is some time away, as the economy will take time to recover and boost inflation pressures).

I argued this week that the dollar's value need not fall on the enlargement of the Fed's balance sheet, both because the enlargement is helping to stabilize the U.S. financial system and because market participants are likely to view the enlargement as temporary rather than as a signal of excessive money supply growth that would debase the dollar's value. The rebound that has occurred in the dollar helps validate this view. Nevertheless, if perceptions shift and foreign investors begin to believe that the de-leveraging of the U.S. financial system will require sustained increases in Fed credit, the dollar's value will decline.

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Now for a pollyannaish view of the secular upturn in the global economy: the bursting of the credit bubble, in combination with the removal of excesses in the commodities and emerging markets has set a foundation for a more stable and lasting secular upturn in the global economy than could have otherwise been possible. Therefore, when the global economy emerges from the current cyclical downturn, it will lifnmgvn10 index gpkely enter a prolonged period of solid economic expansion.

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The emerging markets look particularly attractive in this respect. Free market capitalism and economic prosperity will continue to spread throughout the world. This is the secular bet to make. Because of the de-leveraging imperative, the U.S. won't necessarily be part of this picture, at least on a relative basis; de-coupling will return at the first sign the U.S. economic and financial situation has stabilized. This is the kind of thing I am talking about when I stress the value of macro-style investing in my new book, Investing from the Top Down.

More: Click for Latest Economic coverage ...

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#1

SEC + FSA=No Shorts Today!:After bankexecutives and politicians have blamed hedge funds (and othernefarious market participants) for the extreme volatility infinancial sector equities, both the U.K. and the U.S. marketregulators imposed bans on short selling in these stocks. Alsostarting Tuesday, the FSA will require investors to discloseeach day any short positions in excess of 0.25% of the ordinaryshare capital of financial companies at the end of trading theprevious day. These new regulations will stay in place untiluntil Jan. 16, although they will be reviewed after 30days.

After coming under heavy criticism from Republicanpresidential candidate John McCain, SEC has issued an emergencyorder on Friday temporarily halting short selling of 799financial stock. SEC head Christopher Cox said "The emergencyorder temporarily banning short selling of financial stockswill restore equilibrium to markets. This action, which wouldnot be necessary in a well-functioning market, is temporary innature and part of the comprehensive set of steps being takenby the Federal Reserve, the Treasury, and the Congress."

#2

There has been no issuance of corporate bonds this week, a rare event. Typical issuance is over $20 billion per week.

In addition, the total amount of commercial paper outstanding fell by $52.1 billion in the week ended September 17th to $1.763 billion, the largest weekly decline since last December. The drop reflects the seizing up of the credit market that has occurred this week and withdrawals of monies from money market funds. The commercial paper market has been relatively stable since contracting sharply a year ago and in recent weeks had seen strong increases in the total amounts outstanding, so this latest decline marks an abrupt shift.

The Lehman bankruptcy sent waves of asset sales and capitalraises throughout the system. One of the early casualtieswas the "Breaking-Of-The-Buck" at the Primary Reserve moneymarket fund. However, there are numerous otherripples.

The Straits Times reports that some Singaporeinvestors of a product linked to Lehman Brothers have receivedlate-night phone calls from DBS Bank warning them that theirentire stake may be wiped out. "The investors havetheir cash in a product called DBS High Notes 5 that the bankoffered wealthier clients last year." Even muni bondswere hit hard yesterday (check out ETF MUB) which underscoresthe extent of the panic.

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CNBC Stock Blog:

-VIX at 50!?Options Boil on Volatility

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The point isn't to single out one bank or product, but thatthis is a microcosm of what is occurring as the bankruptcyreverberates throughout the system. Then we had thecollapse in the Russian stock market and then we hadAIG.....And the mad rush to "safe" collateral was on yesterdayculminating with US cash management bills being bought at 0.1basis point. Yes, that's 0.1.

After Fed Funds traded as high as 9% last night, we had acoordinated liquidity add by the major central banks that isassisting in easing this panic into cash. The U.S.Federal Reserve made an extra $180 billion available to centralbanks around the world to lend on to their local commercialbanks in a bid to get dollars circulating in overnight and termmoney markets according to Reuters. The Fed wire is nowopen late into the night to add the liquidity necessary to keepthe gears of capitalism going.

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We've seen a big shift overnight in the direction of Yen/Chfcarry positions as these trades have rallied signaling a returnback into "risky" assets. Oil has rallied strongly, bondshave sold off, and equities have rallied....for now. I'mlooking for more of this today as the markets try to catchtheir breath and assess the damage. GS and MS haverallied as well as they appear to be surviving the crisis.

Wachovia and MS are in merger talks according toCNBC. Wamuhas put itself up for auction with itsextensive California branch network a major attraction forbuyers. SEC's Cox has changed the rules for short sellingand is now requiring hedge funds to report their shorts. Lloyds Bank buys troubled HBOS mortgage lender. There'stalk in Congress of putting together an RTC like entity to buydistressed debt from the entire financial sectorcommunity. Even Russia has come out with a package toassist their stock markets.