The types of instability

Money market funds were one of the more minor vectors of the crunch. Since they did not want to break the buck, and as they had rather limited loss absorption capability (thanks to the lack of anything akin to equity), they were sellers of the debt of any institution rumoured to be in trouble. In other words, they exacerbated funding liquidity risk but helping to turn a rumour into reality.

Belated the SEC has proposed revisions to the regulatory framework for funds: see here for a prospectus.

What these proposals will do is turn a nasty dynamic destabiliser into a static one. Since funds will be unable to invest in low quality instruments, they will not be able to fund lower quality firms at all. In effect the barrier to entry for the big boys club will get higher.

On the curve

Bloomberg says Geithner Bets U.S. Can Avoid Japan Trap Through Bank Earnings.

For that bet to come off, US banks have to earn lots of money.

What's the major determinant of bank earnings that Geithner can control? The shape of the curve. Banks make money if their short term cost of funds is lower than the longer term rates that the loans they make price from.

So... pay 1m USD Libor, receive constant maturity 3 year swaps. Trade of the month.

What money market?

The term 'money market' is pretty unhelpful in current conditions. There isn't one. There is a short term Libor market, which is decidedly interesting at the moment, and a short term govy market, which is awash with liquidity at least in some currencies. These two markets have decoupled.

The FT, reporting on a speech by Axel Weber, president of the Bundesbank, says:

[...] the tools that modern central banks possess to address liquidity problems can only directly address such runs inside the traditional banking sector, and do not directly touch the non-bank financial sector, which has been hardest hit by the current credit crisis.

Mr Weber’s analysis highlights the dilemma facing central banks, which cannot channel funds directly to the non-bank financial sector, and may therefore have to resort to easing monetary policy instead.

Once the Libor market disassociates from the govy market, there isn't much that a central bank can do. They control financial operations in the govy market, and they can inject extra liquidity there via accepting a broader range of collateral at the window, cutting rates, or whatever. But they have no power over the Libor market. They can hope that if the differential between the two markets becomes large enough banks will step in, borrow from the central bank, and lend into the Libor market, but they can't force that to happen.

Weber claims that the current situation is like a run on a bank, but one effecting conduits and SIVs rather than banks per se. In that these vehicles are suffering a liquidity squeeze that they are vulnerable to due to mismatched funding, I'd agree. But Weber says this "is a total over-reaction". I'm not so sure. If you can get Libor plus 100 for lending a AAA Libor-based funder cash (because cash is really scarce and you have it) why wouldn't you?