One of the upsides of blogging is sometimes other inquiring minds get to the bottom of matters that have been nagging at you.
We had warned a couple of months ago that a colleague with serious connections into the Treasury and Fed told us they were working on plans for a quasi-nationalization of the banking system. Their view was that while banks would technically be solvent, they’d have enough bad credits that they would be unable to extend new loans.
Steve Waldman, in a terrific post at Interfluidity, concludes that nationalization is underway, via the expansion of the Term Auction Facility and Fed’s new 28 day repo program.
Readers may know that there has been a lot of disquiet regarding the negative non-borrowed banking reserves that resulted form the TAF. Bond market mavens, such as commentator Caroline Baum at Bloomberg, dismissed those worries as reflecting a lack of understanding of Fed operations.
I remained troubled, not by the negative non-borrowed reserves figures per se, but by the fact that the Fed was downplaying an operation which was extraordinary. The TAF is a discount window of sorts, but with somewhat longer-term loans and no stigma. Note the TAF accepts the same types of collateral at the same haircuts as the discount windows.
But the discount window is a “break glass in case of emergency” facility. It’s when liquidity is so scarce that banks can’t borrow on normal terms, so they go to the Fed, post collateral, and get dough. The fact that a supposedly temporary operation has become semi-permanent and was increased (it was initially $40 billion, then it was quietly increased to $60 billion) was a troubling sign, yet the Fed acted as if this was business as normal.
Waldman does a thorough job of parsing the two initiatives announced Friday, the further expansion of the TAF, plus the establishment of the new repo facility.
Differences in degree can be differences in kind, and that’s what Waldman argues has happened. The US banking system is on life support. The Fed has now become a very big prop, far more significant than the highly publicized sovereign wealth fund investors.
From Interfluidity:
The Fed announced that it would auction off $100B in loans this month rather than the previously announced $60B via its TAF facility. In the same press release, the FRB announced plans to offer $100B worth of 28 day loans via repurchase agreements against “any of the types of securities — Treasury, agency debt, or agency mortgage-backed securities — that are eligible as collateral in conventional open market operations”.
The second announcement puzzled me. After all, the Fed conducts uses repos routinely in the open market operations by which they try to hold the interbank lending rate to the Federal Funds target. In aggregate, the quantity of funds that the Fed makes available is constrained by the Fed Funds target. So, what do we learn from this? Fortunately, the New York Fed provides more details:
The Federal Reserve has announced that the Open Market Trading Desk will conduct a series of term repurchase (RP) transactions that are expected to cumulate to $100 billion outstanding… These transactions will be conducted as 28-day term RP agreements.. When the Desk arranges its conventional RPs, it accepts propositions from dealers in three collateral “tranches.” In the first tranche, dealers may pledge only Treasury securities. In the second tranche, dealers have the option to pledge federal agency debt in addition to Treasury securities. In the third tranche, dealers have the option to pledge mortgage-backed securities issued or fully guaranteed by federal agencies in addition to federal agency debt or Treasury securities. With the special “single-tranche” RPs announced today, dealers have the option to pledge either mortgage-backed securities issued or fully guaranteed by federal agencies, federal agency debt, or Treasury securities. The Desk has arranged single-tranche transactions from time to time in the past.
There are a couple of differences, then, between this new program and typical repo operations:
1. The loans are of a longer-term than usual. Ordinarily, the Fed lends on terms ranging from overnight to two weeks in its “temporary open market operations”. The Fed will now offer substantial funding on a 28 day term.
2, The Fed is effectively broadening its collateral requirements by collapsing what are usually 3 distinct levels of collateral which are lent against at different rates to a single category within which no distinctions are made.
The Fed offered the first $15B of repo loans under the program today, so we can see how things are going to work. First, how did the Fed square the circle of ramping up its repos without pushing down the Federal Funds rate? Just as it had done with TAF, the Fed offset the “temporary” injection of funds with a “permanent open market operation”. The Fed purchased outright $10B of Treasury securities today at the same time as it offered $15B in exchange for mortgage-backed securities under the new program (at a low interest rate than in traditional repos against MBS collateral). The net cash injection was small, but the composition of securities on bank balance sheets changed markedly, as illiquid securities were exchanged for liquid Treasuries.
In James Hamilton’s wonderful coinage, the Fed is conducting monetary policy on the asset side of the balance sheet. This is an innovation of the Bernanke Fed. Conventionally, monetary policy is about managing the quantity of the central bank’s core liability, currency outstanding. When the Fed wants to loosen, it expands its liabilities by issuing cash in exchange for securities. When it wants to tighten, it redeems cash for securities, reducing Fed liabilities. The asset side is conventionally an afterthought, “government securities”. But the Bernanke Fed has branched out. It has sought to lend against a wide-range of assets, actively seeking to replace securities about which the market seems spooked with safe-haven Treasuries on bank balance sheets without creating new cash. By doing this, the Fed hopes to square the circle of helping banks through their “liquidity crisis” without provoking a broad inflation.
“Monetary policy on the asset side of the balance sheet” is a bit too anodyne a description of what’s going on here though. The Fed has gotten into an entirely new line of business, and on a massive scale. Prior to the introduction of TAF, direct loans from the Fed to banks, including the discount window lending and repos, amounted to less than $40B, the majority of which were repos collateralized by Treasury securities. By the end of this month, the Federal Reserve will have more than $200B of exposure in its new role as Wall Street’s genial pawnbroker. Assuming the liability side of the Fed’s balance sheet is held roughly constant, more than a fifth of the Fed’s balance sheet will be direct loans to banks, almost certainly against collateral not backed by the full faith and credit of the US government (and beyond that we just don’t know). This raises a whole host of issues.
Caroline Baum wrote a column last week poopooing concerns about the Fed taking on credit risk via TAF lending. (Hat tip Mark Thoma.) I usually enjoy Baum’s work, but this column was poorly argued. In it, she points out that the Fed has all the tools it needs to manage credit risk. The Fed offers loans only against collateral, and requires that loans be overcollateralized. If the collateral has no clear market value or if there are questions about an asset’s quality, the Fed has complete discretion to force a “haircut”, writing down the asset (for the purpose of the loan) to whatever value it sees fit. And the Fed can always just say no to any collateral it deems sketchy.
All of that is quite true, and (as Baum snarkily points out) not hard to find on FRB websites. But it fails to address the core issue. Sure the Fed has all the tools it needs to manage credit risk. But does it have the will to use those tools? In word and deed, the Fed’s primary concern since August has been to “restore normal functioning” to financial markets. The Fed has chosen to accept some inflation risk in its fight against macroeconomic meltdown. Why wouldn’t it knowingly accept some credit risk as well? No one has suggested that the Fed is being “snookered”. Skeptics think the Fed is intentionally taking on bank credit risk while still lending at very low rates. Some of us find that troubling.
Which brings us to the more postmodern issue of what credit risk even means to a lender with unlimited cash and an overt unwillingness to let those it lends to default. In a way, I agree with Baum. Until the current crisis is long past, I think it unlikely that any large bank will default and stiff the Fed with toxic collateral. Why not? Because for that to happen, the Fed would have to pull the trigger itself, by demanding payment on loans rather than offering to roll them over. Since TAF started last fall, on net, the Fed has not only rolled over its loans to the banking system, but has periodically increased banks’ line of credit as well. In an echo of the housing bubble, there’s no such thing as a bad loan as long as borrowers can always refinance to cover the last one.
The distinction between debt and equity is much murkier than many people like to believe. Arguably, debt whose timely repayment cannot be enforced should be viewed as equity. (Financial statement analysts perform this sort of reclassification all the time in order to try to tease the true condition of firms out of accounting statements.) If you think, as I do, that the Fed would not force repayment as long as doing so would create hardship for important borrowers, then perhaps these “term loans” are best viewed not as debt, but as very cheap preferred equity.
Let’s go with that for a minute, and think about the implications. One much discussed story of the current crisis is the role of sovereign wealth funds in helping to capitalize struggling banks. Will they, won’t they, should we worry? Sovereign wealth funds have invested about $24B in struggling US financials. Meanwhile, the Fed is quietly providing eight times that on much easier terms.
If we view TAF and the new 28-day, broad-collateral repos as equity, what fraction of bank capitalization would they represent? I haven’t been able to find current numbers on aggregate bank capitalization in the US. In June of 2006, the accounting net worth of U.S. Commercial Banks, Thrift Institutions and Credit Unions was 1.25 trillion dollars. Putting together remarks by Fed Vice Chairman Donald Kohn and data on bank equity to total assets from the St. Louis Fed yields a more recent estimate of about 1.6 trillion. The average price to book among the top ten US banks is about 1.3. So, a reasonable estimate for the current market value of bank equity is 2 trillion dollars. The $200B in “equity” the Fed will have supplied by the end of March will leave the Federal Reserve owning roughly 9.1% of the total bank equity. Obviously, the Fed isn’t investing in the entire bank sector uniformly. Some banks will be very substantially “owned” by the central bank, whereas others will remain entirely private sector entities. As Dean Baker points out, the Fed is giving us no information by which to tell which is which.
What we are witnessing is an incremental, partial nationalization of the US banking system. Northern Rock in the UK is peanuts compared to what the New York Fed is up to.
You may object, and I’m sure many of you will, that our little thought experiment is bunk, debt is debt and equity is equity, these are 28-day loans, and that’s that. But notionally collateralized “term” loans that won’t ever be redeemed unless and until it is convenient for borrowers are an odd sort of liability. Central banks are very familiar with the ruse of disguising equity as liability. Currency itself is formally a liability of the central bank, but in every meaningful sense fiat money is closer to equity.
I do not, by the way, object to nationalizing failing banks. There are (unfortunately) banks that are “too big to fail”, whose abrupt disappearance could cause widespread disruption and harm. These should be nationalized when they fall to the brink. But they should be nationalized overtly, their equity written to zero, and their executives shamed. That sounds harsh. It is harsh. One hates to see bad things happen to nice people, and these are mostly nice people. But running institutions with trillions dollar balance sheets is a serious business. Accountability matters. These people were not stupid. They knew, in Chuck Prince’s now infamous words, that “when the music stops… things will be complicated.”, and they kept dancing anyway.
But accountability has gone out of style. The Federal Reserve is injecting equity into failing banks while calling it debt. Citibank is paying 11% to Abu Dhabi for ADIA’s small preferred equity stake, while the US Fed gets under 3% now for the “collateralized 28-day loans” it makes to Citi. Pace Accrued Interest (whom I much admire), I still think this all amounts to a gigantic bail-out. And that it is a brilliantly bad idea from which financial capitalism may have a hard time recovering. Like a well-meaning surgeon slicing up arteries to salvage the appendix, the Federal Reserve is only trying to help.
From a corporate finance perspective, Waldmans’ argument about the Fed effectively being an equity provider isn’t as off base as it sounds. If you as a creditor are unable to call in your loans or otherwise exercise your contractual rights, your position is so badly subordinated that you are effectively equity. And there is no indication that the Fed will take any more action relative to the banks that become dependent on it beyond its normal supervisory role. To behave otherwise, after all, would make it even more difficult for those organizations to function in the marketplace, which risks damaging their ability to function even further.
38 comments
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Yves: If the fed is to become the “pawnbroker of last resort” in addition to the lender of last resort, and if in addition it accepts both diamonds and cubic zirconium without checking which is which at
the time they are exchanged, would it not be reasonable to add to the “pawn contact” a little clause to the effect that,
in case D is actually CZ, we get your first born, can
garnish your salary and will put you into debtors
prison? Could the Fed not make it a requirement to
the banks borrowing under such a facility that they
can require the elimination of all dividends on common (and?) preferred shares, force staff cuts and sales of non core facilities, if collateral proves
unsound, until banks profits make up the shortfall?
OOps! I just figured it out – that would be nationalization, wouldn’t it?
I’ve been watching this as well. Free market indeed.
What I want to puzzle out is the duration and volume of bailout required. It would seem to be in the multi-trillions if not resolved in less than a year. How sustainable would that be?
All of this is about the securitization crisis. Unless and until that description is used 99 times out of 100, there will never be the political know how and will to avoid serial disaster remedies. Yet, look at the description that rules our media and our governmental discourse: Subprime crisis.
This is not a subprime crisis. It is a securitization crisis. It is a crisis in the capital markets. It is not a crisis in one section of the housing markets.
For all of you with small to large influence: please start using language with meaning.
Securitization crisis.
Brilliant analysis by Steve Waldman. Thanks for posting that Yves.
This nationalization is very “covert” in the sense that we don’t know how much credit (or equity rather) that the Fed has placed into any individual financial institution.
Which banks are being nationalized right now by the Fed?
WE DON’T KNOW.
It looks like the expansion of the TAF and the RPs are very much for the purpose of trying to hold up the Agency and MBS markets (and prevent spreads from widening any further). The Fed is reallocating their balance sheet from Treasuries to MBS/Agencies.
Fannie and Freddie are the last pillar of the US real estate market. The downward spiral of hedge fund forced liquidation is threatening to blow out the spreads on their securities and collapse the real estate market.
I agree with the last comment that this is a “securitization crisis” (not a “subprime crisis”).
I am not sure what people want the FED to do. Everybody wants treasury collateral right now. There is a huge shortage in the REPO market with General Collateral trading 50-75bps below the funds rate. This asset swap is a way of easing the squeeze.
Why would anyone “swap” “assets” of unequal value?
Here’s a news flash: If you paid too much for a commodity, or if the value of a commodity has fallen subsequent to your acquisition (acquisition – not “purchase”) of that asset, it is either,
a) no longer an asset, or;
b) a devalued asset -making the holder take a haircut on the basis.
The trading of unequal “assets” – as if they were fungible – is why no one knows the true value of anything, anymore.
This tinkering by the Fed – under cover of secrecy and non-disclosure – will tie the vast majority of Americans to a millstone (as opposed to having a pocket full of rocks) and throw them overboard.
How long can we hold our collective breath?
The assets aren’t of unequal value. All the collateral that the FED takes gets marked to market on a daily basis even for term RPs.
The secret, shadowy character of the current FED operations is a pretty strong argument for shutting it down and transitioning its functions to the Dept of Treasury. It might have been a tenet of the Friedman era that central banks should be independent but that era is over. Increasingly people are going to look at the cult of personality surrounding Greenspan as the root cause of this crisis. The solution is to make unaccountable government power accountable. People might wail that politicized central banks will be even worse, but it is difficult to make that argument now. The guarantee against politicized money are constitutional rights to own and trade of gold and other currencies. By the way, is it really true that Citi is too big to fail? It is already impaired. What functions is it providing now that cannot be replaced. Would Citi collapsing really be any bigger than the World Trade Center towers collapsing. I doubt it.
anonymous @ March 8, 2008 9:53 AM
Really? So why did the Fed lift a finger in the first place? Why not have the banks obtain the loan commercially and/or in the open market? Why not have them sell the “asset” directly to the open market to square their accounts? If the asset(s) are honestly valued, a private buyer would certainly come forward.
The Fed has, in effect, tranched the debt – giving the false impression that all asset classes are equally valuable and equally low-risk.
Your response sounds like you’ve been drinking Kool-aid. Are your lips and tongue purple?
The nationalization combined with internationalization of accounting rules should make everything fine. Troubled US banks ought do a Societe Generale and just move the losses to 2007 and start 2008 with a cleans slate. See
Loophole Lets Bank Rewrite the Calendar
http://www.nytimes.com/2008/03/07/business/07norris.html?_r=1&ref=business&oref=slogin
anonymous @ March 8, 2008 9:53 AM
They are trying reduce the spread between MBS collateral and government collateral. Its a way of helping the banking system cope with a flight to quality during a period of extreme deleveraging by the market.
I don’t see the joy in wanting the market to seize up and not function. The FED is stepping in as a lender of last resort and it should.
Speaking of deleveraging….
It seems like the recent acceleration in hedge fund forced liquidation has the potential to bring down the whole financial system. The hedge fund “deleveraging” seems destined to become a self-reinforcing downward spiral. From the information that I’ve been able to gather, the hedge fund complex has accumulated perhaps $3 trillion in total borrowing.
I found the chart on this Web page provides excellent insight into what has happened in the hedge fund complex in the past 5 years:
http://www.allaboutalpha.com/blog/2007/04/19/bridgewater-hedge-fund-leverage-now-at-levels-not-seen-since-ltcm/
It shows that most of the massive borrowing currently amassed by the hedge funds has taken place since 2003. My “assumption” is that we will return to pre-2003 levels of borrowing. That implies an unwind of $3 trillion in borrowing.
The investment banks have massive exposure to hedge fund assets as a result of being their PRIME BROKERS. The exposure shows up on their balance sheet as repurchase agreements (lending). This serves to disguise their exposure to the underlying hedge fund assets that collateralize the repos. This has barely been mentioned in the media so far.
The investment banks effectively own the majority of the hedge fund assets. When the hedge fund assets get liquidated en masse, the investment banks will take huge losses when the proceeds from the asset firesales are insufficient to repay the borrowing.
The investment banks are really a Ponzi scheme. Increasing leverage elevates asset values, which creates equity for the banks to enable further leverage. They look like a house of cards destined to collapse.
All of this is eerily similar to 1929. The leverage in the markets has been amassed at the institutional level this time (instead of the retail level).
Re: it accepts propositions from dealers in three collateral “tranches.”
One would hope The Fed is able to come to terms with accounting in regard to FASB 157 and 158, both of which were delayed last year. These FASB accounting issues are related to mark-to-market disclosure and valuation.
The collateral transfers in question here are simile-like, i.e, we have corporations dumping toxic waste into our drinking water, while The Fed lowers the parts per billion accountability levels.
The Level 3 mark-to-market accounting is to help us plain farm folks understand more about the derivatives and behind the scenes illusions, e.g, Level 3 speaks of unobservable assets, which need to be valued at current market rates. Why then, as citizens of America are we being placed in a position where accounting rules are not being used, not being implemented or used to help strengthen our economy. It seems to me, this is a matter of National Security, and if we allow a bunch of crooks to keep dumping toxic junk into our system, we will all be impacted by the insidious nature of this cancer!! Get real, these crooks need to go to jail and we need to see people in this government resign for contributing to false and misleading information and fraudulent accounting practices!!
Outstanding analysis & right on. A debt isn’t a debt if the lender never calls it… but that doesn’t mean it isn’t a ‘liability’. Sword Of Damocles Financial would be an appropriate name for some of these ‘new’ firms.
Um…
I have an imperfect understanding of finance at this level.
If I understand correctly, you’re saying the FED is willing to act as a bottomless lender that is unlikely to ever call in loans.
Won’t that result in even more inflation and foreign countries dumping their dollar holdings?
If we actually built anything in america, this might not be so bad, but with 65% of our oil being imported (to say nothing of the endless stream of consumer goods), is this just a new, bigger bubble to absorb the other bubbles?
Just think of TAF as price supports for the family farmers of Wall St.
Note that this operation is not resulting in an increase in the “liquidity” in the banking system. What the Fed is offering via the TAF will be matched with draining reserves via open market operations (which are done with Treasuries).
So what it is trying to do is a surgical operation, directing liquidity to the sector of the market (agency securities and mortgages) that is most in distress.
Yves,
The Fed is not offering liquidity on agencies–it doesn’t like the market direction and is offering price supports. The problem is not that banks need liquidity and now can pledge agencies to obtain it. The problem is that the value of the bank’s agencies is dropping, and the banks keep acquiring agencies as their prime brokerage clients get squeezed and can’t meet margin calls. The Fed is looking to prevent fire sales of portfolios and the attendant hits to bank capital. They can’t accomplish that long term, unfortunately, any more than they can move the FX markets. Once again, handyman Bernanke sees a few days of things he doesn’t like in the market, and rashly steps in to fix it. Good luck to him in trying to maintain the price of 32x leveraged agency portfolios.
for this TAF operation of FED absorbing toxic waste onto its system, does fed rate need to go lower? 0.75% or 1% cut??
What’s the big commotion? I’ve said for months when push comes to shove the Fed will discount anything the major banks offer it, even horse manure. TAF, 28 days, repos, what are you talking about? IT DOESN’T MATTER! The Fed will buy whatever paper the banks tell it to. Stop immersing yourself in insignificant details.
I’m hearing that horse manure will now be traded as a fungible commodity, in addition to:
Urea
A combination of carbon, nitrogen, oxygen, and hydrogen (the building blocks of all life), urea is a potent fertilizer. Originally isolated from urine in 1773, it was the first organic compound to be synthesized in the lab from inorganic materials. Today, urea is a major industrial chemical (it adds flavor to cigarettes – yum).
Also See: Commingling of Commodities: All Commodities stored hereunder may be commingled and warehoused as one general lot of fungible goods and the Bank shall be entitled to such portion of such general lot as the amount of the Commodity represented by the Warehouse Receipt bears to the whole of such general lot of such Commodities.
Also, in regard to The Fed accepting manure as collateral: Release of Commodities: For greater certainty it is hereby stated and agreed that the Collateral Manager shall not allow the release of any Commodities unless it has received written instructions from The Fed stating the person to whom the Commodities shall be released and the date and manner of such release, notwithstanding alternative or contradictory instructions from the Depositor.
Anon of 4:35 PM,
I don’t see how you can say the Fed isn’t offering liquidity support on agencies. Look at its new $100 billion repo facility. Two of the three tranches are for agency or agency guaranteed debt.
Folks,
The issue is NOT so much the quality of the collateral the Fed is taking, the issue is the amount and the fact that it needs to offer this much. $100 billion is in Treasuries or agency-backed debt. The TAF, if you bothered checking the collateral table (for which I’ve provided links in previous posts) is stuff that is at least good in quality, and the Fed applies haircuts to market prices. This is far from “toxic waste.” The Fed also claims to be conservative in what they are accepting, and can reject collateral
But back to the pawnbroker analogy…..they only take stuff that is salable, like jewelry, not your beat up couch.
Yves,
By definition, if the stuff is salable, then it can be sold. If it can be sold, then why aren’t they selling it?
The answer is that they don’t like the bid.
So the TAF auction and term repo are intended to save banks from having to sell agencies at bids that they don’t like. This is different from subprime, where presumably there was no bid.
The reason the Fed wants to prop up agency bids is obvious: they want to stop a chain reaction of margin calls caused by deteriorating agency values.
Re: back to the pawnbroker analogy…..they only take stuff that is salable, like jewelry, not your beat up couch.
I like the garage sale analogy better, because at the end of the day, after you mark-to-market and no one wants your sofa or underwear, you load that up and give it away to Goodwill, who then marks-to-market anything that has any potential value, and the “rest” is placed in the trash bin, where it goes to a dump, where people can still pick over that waste and recycle that back to other garage sales…gheeesh, dont you get it?
In the case of manure, you simply match the demand for unit output to the yield and sell futures and have SIFMA pump velocity!
Yves,
The trends in the TAF were clear, there was a sequentially increasing number of bidders and higher bid to cover ratios if you check the series of press releases. Thhe article is right on about debt versus equity and it goes to the question of if a repo is permanently rolled is it a repo of a print? On the flip side the banks will not ramp their lending so the “liquidity” to he market concerns are misplaced. The Fed can shower money on everyone they want but that doesn;t mean you get a multiplier effect. Therein lies the problem. The ultimate end user is overburdened and incapable of taking on more. That is unless BIll gross gets his way and we all get 2% 30 year paper backed by the FHA. Joke.
I for one am willing to trust that the Fed understands that it can’t role this bank debt forever and has an exit plan in mind. I am also willing to accept the possibility that, what with the new mark to market rules, some banks may end up operating for several years on a technically undercapitalized basis (e.g. 3% leverage ratio).
The CDS collapse is likely to lead to a major shuffling of the capital deck. Do you really want the Fed to nationalize some “too big to fail” banks, only to find out that it closed down the stronger banks? I think the Fed needs to wait for CDS to sort itself out before developing a policy for putting an end to the crisis.
yves,
You know what this boils down … huh, huh, do yah?
As a society — perhaps as a globalized tribe, we have lost the ability to define what money is, or what it represents. That could explain the problem with ratings models, valuation models and bubbles and this systemic meltdown/implosion, this Great Depression-like deja vu (all over again).
The journey of this information highway is perhaps resulting in information impact which in some way has warped or distorted our collective understanding of many dynamics — as we are all brought together into a new world paradigm, with too many dynamics to understand. The speed of change and the hyper efficiency of expansion may have pushed this envelope too far too fast, and now dis-connected, we have fragmented blogs where people are hoping to explain change and discover why the government seems so …. retarded. We wonder why money is not making sense!
Amen
Wow. Fantastic find, Yves. I think the analysis of what is happening (the conversion of suspect agency debt into liquid and secure treasuries) is spot-on, but I don’t think the target of this largesse is the banks per se (although that’s definitely a fringe benefit).
Could this instead be the govt finally caving on the implied guarantee of agency debt? While every govt official has officially stated that Fannie/Freddie do not have a govt guarantee, no one believes the govt would allow those markets to fail. This would be a way of nationalizing that debt pool without “officially” doing so. Think of the Fed as the govt’s SIV, carrying agency liabilities in an off-balance sheet vehicle: technically, the debt is not on the govt’s ledger but if any of the debt on the Fed’s ledger were to default, it has already been replaced with treasuries which do carry an explicit guarantee.
In this scenario, the Fed must prepare for a not-insignificant amount of its repo assets to fail. While I agree the default risk on overnight treasure securities is virtually nil, the risk of default in 28-day repos of agencies is distinctly nonzero, especially as these repos will likely be rolled over every 28 days for the next couple of years until bank balances are repaired and agency spreads come back down to historical norms.
But perhaps that’s the point: allow banks to exchange their agency debt into treasuries on a semi-permanent basis, have the govt. assume the risk of default on that debt during these dark days, then return the debt at par to the banks when the markets have stabilized again. (sounds like socialize the losses, privatize the gains, no…?)
Hey Lune,
That sounds great for the banks and all, but what happens when the average (and by average, I mean me) person notices that these arbitrary business entities can be endlessly bailed out by the government (ie. taxpayer)?
I mean, now that everything is digital, what’s the real difference between a bankrupt bank with a pile of devaluing assets, and the average bankrupt person with a pile of devaluing assets?
…
I’m with you on thinking the “value of money” has been lost- but I suspect that it has more to do with the petro-dollar becoming the petro-ruble and petro-euro. I probably read too many “peak insert-commodity-here” blogs, but I seems like fiat currency only really works in expanding economies.
One thing notably absent from this analysis, and from any speculation by any commenters, is this: How long can this game go on? Does the Fed have a bottomless pit of money? How long before the world wide dollar revolt?
Is the Fed merely rearranging the deck chairs? Personally, I think so. At some point, the child at the amusement park will ask for another ticket to ride, and mommy will have to say: “Sorry, son, there are no more tickets.”
ctmm-
I didn’t mean to imply that I support such a policy. IMHO, I think Fannie/Freddie should be allowed to default if it comes to that, and for that matter, so should Citi and all the other “too big to fail” institutions out there (if they really are providing such an invaluable service, then someone is willing to pay good money for such service, which means someone else will come up to provide that service. The invisible hand and all, right?).
As for your question about the difference between the bankrupt bank and the bankrupt person, it comes down to Trump’s famous dictum “If I owe the bank a million dollars, it’s my problem; if I owe the bank a billion dollars, it’s the bank’s problem”. Especially when Wall St. has purchased the sympathies of our public officials and Main St. is viewed as nothing but outsourcing fodder.
NotNOW,
Yes, there are no doubt limits to risk internalization. Perhaps it is part of the modern psyche to avoid nonlinearity and countervailing pressures, so I wonder to what extent the expand(ing) operations will impact interest rate differentials and whether they speed or retard the fed’s move towards a zero bound funds rate?
In a larger sense I’m inclined to see these attempts to control and mitigate as no more than responses to growing financial uncontrollability, and responses which, last instance, must compound exactly that which they attempt to control. I doubt that permanent crisis management can ever be permanent while, same time, am sure there are systemic limits to accumulation of fictitious capital.
March 9, 2008
To: naked capitalism.com
From: Earl L. Crockett
Re: Sat. March 8, 2008 article, “Covert Nationalization of the Banking System”
Through the Looking Glass, and Down the Rabbit Hole.
It seems that we’ve all been forced into having to think macro-economics to a new level. At least that is the case for me. And it has seemed in the last ten days as if I’ve gone through the “looking glass” and down the “rabbit hole” day by day with announcements like Bernanke’s suggestion to member banks that they consider a “reduction of capital” on mortgage loans in their portfolios, etc. In a way, and these matters are still trying to sink into my head, Bernanke is passing on his “28 day loan if you’re able to pay” “equity” infusion practices to member banks who would then would be making after the fact, voluntary, equity contributions to their mortgage loan holders by reducing a percentage of the mortgage loan rather than having to dump the whole loan amount into a “non-performing’ loan status. Not really a bad idea as bizarre as the idea first seems.
On the macro side I’ve wound up with note pad sheets with 10 and 11 zeros spread across my desk having to think in “Trillions” for the first time in my life, and I am 70 years old. Here are some of the numbers that I’ve come up with:
It is reported in the last few days that there are 900,000 homes presently in foreclosure. Taking a “what if” and/or “bigger than a bread basket” business approach, lacking any “for certain” data, I’ve assumed a $200,000 to $400,000 per home amount for those homes in foreclosure. So…current non-performing mortgages industry wide could be in the range of $180 billion to $360 billion. If the current estimated national bank equity is “2.0 Trillion”, as given in the above referenced article, then this would be a 9.0% to 18% industry wide reduction in total bank equities/assets, and as suspected in the above article these amounts are probably tilted in the direction of a few “big time” lenders rather than being industry wide. Now this is a big impact for sure, but then one could ask why has Bernanke seen fit to lay out $140 billion in Jan. and Feb. 2008 (I think), $200 billion in March, with the further advice that this could go on “for another six months”? If you add these potential Fed “loan” numbers through the “another six months’ the number comes out to be $1.540 trillion which is approaching 75% of the “bank industry-wide equity”.
I think the answer might be in the following:
“Economy.com estimates 8.8 million homeowners, or about 10 percent of homes, will have zero or negative equity by the end of the month. Even more disturbing, about 13.8 million households will be “upside down” if prices fall 20 percent from their peak. The latest Standard & Poor’s/Case-Shiller index showed U.S. home prices plunging 8.9 percent in the final quarter of 2007 compared with a year earlier”.
If you apply the former hypothetical “$200k to $400k per house” numbers to the potential near term foreclosure homes the numbers become $1.76 Trillion to $3.52 trillion (8.8 million homes), on to $2.76 trillion to $5.52 trillion (13.8 million homes). My guess is that these are the numbers that Bernanke has written on his office blackboard.
While my natural proclivity is far from being a “nay-say-er” or “down-side-bottom feeder”, it does looks to me like our national banking system is approaching bankruptcy, another “through the looking glass and down the rabbit hole” distinction. And, and this is a very big AND, if that happens then what can be said about the Federal Reserve itself to say nothing about our whole economy? My advice to myself, and to all of you, is to pay close attention to what the “Standard & Poor’s/Case-Shiller index” says about home prices for the first quarter 2008 that will come out sometime in April. And yes I do understand that a lot of this mortgage debt has been “laid off” to International markets, but that number is presently “unseen” by me from my position at the bottom of the “rabbit hole”.
I applaud “naked capitalism”, and the many respondents for their “to the bone” knowledgeable assessments of “what the hell is going on?” with our economy. My only question of Bernanke is his same day announcement, a week or so ago, that followed and was seemingly in support of Bush’s “were not in a recession it’s only a slow down”, press release, causing none other than Warren Buffet to announce the next day “We’re in a recession”. Thanks Warren! A former Stanford Business School graduate (circa 1983) intern, and then associate of mine, Steve Garfink, had Bernanke as a Prof., and says “Bernanke is a really smart guy.” I certainly hope so! And I also hope that Bernanke has “This Could Happen” written boldly in the middle of his office black board under the above statistics. But as much as I try, I can’t see what he could do about it.
Earl L. Crockett
It’s an important observation on the structure of the Fed balance sheet, but the effect is a far cry from SWF capital injections.
This is debt. Equity isn’t collateralized.
TAF is an extension of the discount window in terms of the quality of acceptable collateral and its valuation. The Fed has the option of changing collateral valuation parameters as required by market conditions, on rollover dates.
These are horrendous markets, but it’s a gross exaggeration to say that the Fed is nationalizing banks via TAF. If that happens, it’s a later step.
The interesting point that no one has commented on is the existence of a Fed balance sheet constraint on limits to the outstanding TAF.
The Fed is limited by the size of the liability side. It doesn’t ‘force feed’ currency note into the system beyond the demand of the banks and the public for currency. And it has no room to expand bank reserve balances in aggregate of it wants to maintain control over the level of the funds rate. That’s why it’s ‘sterilizing’ now.
So the upper limit to TAF is essentially the size of the Fed balance sheet now, allowing for natural growth in currency demands of the banks and the public.
Beyond that, the Fed couldn’t ‘sterilize’ by selling other assets. It would have to start issuing its own liabilities, such as the sterilization bonds issued by the PBOC used to offset their foreign exchange purchases.
Interesting analysis…and it would be even more interesting if the “Fed” were a government institution. It is not. The Fed is a consortium of private banks, not an arm of the US government. How, then, does it “nationalize” anything?
I think we should take a step back & give a round of applause to Ben Bernanke. Whether you agree or disagree with everything he has done since August, I think you have to hand it to him for sheer inventiveness.
I largely view our situation as something which gathered itself over a long period of time – before Benanke inherited the reins.
If he can pull it off, I think we’ll be praising him in a few years. Of course, all of this innovative shuck & jive might go down like a led balloon…then Gd help us, Bernanke first in line.
(& I’d just like to add that sending a Memo to a blog rocks! Earl, please keep being you – I’m serious!).
March 10, 2008
To: naked capitalism.com
From: Earl L. Crockett
Re: Continuing conversation re: “Covert Nationalization of the Banking System”
A follow up to: “Through the Looking Glass and Down the Rabbit Hole.”
Calling a Spade a Spade.
I wish to acknowledge for myself, and hopefully without stretching the matter too far, and maybe for all of us, that we are on new, and never before seen, financial market territory. Yes “history” is important, but that “history” that is desperately being attempted to be applied to what’s happening now, I think, has to be acknowledged as being as old hat as monthly market village meetings in the Middle Ages. Why do I say this? Well let’s start out with a “$650 trillion derivative market”, and its “little cousin”, the “$45 trillion credit default swaps (CDS)”, and the fact that derivatives were only created in 1995 during the “every thing is now going up, and aren’t we the lucky ones” era of prosperity. I will be honest, and you’ve already probably figure this out, I had to go to Goggle re: Wikipedia re: “financial derivatives” last week, and left the page thinking that I had selected Portuguese rather than English as language. My only solace to this still not understood financial market, and I have no stomach to even try at the moment, has been statements like that reported by Ambrose Evans-Pritchard, International Business Editor for Telegraph.com as follows:
“We are becoming increasingly concerned that the authorities in the world do not get it,” said Bernard Connolly, global strategist at Banque AIG. “The extent of de-leveraging involves a wholesale destruction of credit. The risk is that the ‘shadow banking system’ completely collapses,” [read derivatives] he said”.
Well gee wiz, if the “authorities in the world do not get it,” who am I to complain? Except for the fact none of us probably “get it”, and someone, someday, very soon, should ring the class room bell, and give us a quick tutorial. And I sure don’t recall my (Circa 1962) business school “Money, Credit & Banking” class Prof., Admiral Challenger, ever mentioning a “shadow banking system”. (Talk about the “Middle Ages”?)
And then this morning Paul Krugmam, under the article title of “The Slap Face Theory”, a very good article about other matters at play in the “shadow bank system” (my appellation), says “Last month another market you’ve never heard of, the $300 billion market for auction-rate securities (don’t ask), suffered the equivalent of a bank run.”
I don’t want to add to much to this, and will let the “another market you’ve never heard of”, and the “(don’t ask)” speak for itself.
This has been a rather protracted introduction to what I really want to say to all of you, as well as to myself. Everyone that I’ve read in the last week, including my own stuff to some extent, has been very gentlemanly and ladylike, in not wanting to appear to be alarmists, extremists, the sky is falling, the wolf is at the door, and hedge fund appearing salesman, fear mongers. This is an admirable way of being, indeed. Fear will not solve this problem even though it might be a useful motivator to a next, and hopefully more positive, course of action. Ambrose Evans-Pritchard, International Business Editor, for Telegragh.com, and author of multiple books, published a well thought out article titled “The Federal Reserve’s Rescue has Failed” a few days ago, and got hammered, and I mean really hammered, for what he had to say. He was also courageous, honest, and gutsy enough to end his article with this statement, “For the first time since this Greek tragedy began, I am now really frightened.” Isn’t it interesting that a clearly stated personal opinion, by a very knowledgeable guy, at the end, and separate from, the factual data of his article should draw so much heat? Clearly only a handful of us are ready to hear that the “emperor has no clothes” much less actually say it loud enough that anyone else can hear it.
And we have another “problem”. We’ve been brought up, if not traumatized, by our educational system, to think that we have to “know” all of the facts on all things before we can speak on any given matter. Well we don’t, and I think it is fair to say at this point that nobody else does. So what are we waiting for? And to be squeaky clean this is not a decision that anyone should allow anyone else to talk them into. Sorry to say, you’ve got to reach the plateau all on your own. What I’m trying to say might be easily communicated by the old saying “If it looks like a duck, if walks like a duck, and it quacks like a duck, then it must be a duck.” Folks, I think we have a genuine, honest to god, no fooling “duck” on our hands. Think about it.
So you might ask, “So what are you going to do about it mister smarty pants?”
We’ll I’ll tell you what I’m going to do about it by saying the following:
“Our Nation, meaning our very way being and living, is in near term Peril, period.”
(Webster: Peril, 1: exposure to risk of being injured, destroyed, or lost.)
Earl L. Crockett, March 11, 2008
And what to do, you then ask? Bernanke is the one to call the “meeting”, a meeting declared to be an inquiry into, and about, real “outside of the box” thinking and solutions. My preference would be that the”meeting” be held in the dark of night, in the basement of the Fed, sans politicians, with no public notice, and having a well stocked bar, as they will surely need it. My first call would be to Milton Friedman, but he’s not around any more. I would also add such industry types as Buffet, Gates, and Jobs along with the “Friedman’s”. Buffet because he is the most honest, no nonsense, knowledgably, business nurturing, human being known to me with the possible exception of my now deceased business mentor George Quist. Gates because he and Buffet are the two richest men in the world, and therefore have the most at stake financially. And Jobs because he is the most creative “outside of the box” thinker, designer, and implementer of ideas, and technology, on the Planet. You probably have your own ideas about who should attend. I think it would be a very interesting conversation to pursue. So…is this an”outside of the box”, presumptuous, and even strange idea? Of course it is, but desperate measures for desperate times. And as much as I dislike the word desperate, my dad would have said its’ time to call “a spade a spade”. Warm up your G-5’s boys and girls your country needs you.
Earl L. Crockett
The problem is the FED can NOT nationalize anything. The FED is not a government entity . IT is a private institution.
If anything should be Nationalized it should be the FED itself.