The Fed opened the window to broker dealers. This is a shocker, a sign of the Fed’s desperation.
Recall that one of the reasons the Fed was able to assure us it wasn’t taking too much risk in its Term Auction Facility was that it said the institutions involved were sound. It doesn’t supervise broker-dealer and cannot make any such assurances. This is simply extraordinary.
This move is intended to last only for six months, but if the financial markets continue to be rocky (likely) and broker dealers use the facility, it’s hard to know how long it will take to wean them off it. However, use of the discount window has been seen as a sign of weakness, and use has therefore been minimal. That may mean this move proves to be largely symbolic, since the broker-dealers may not avail themselves of it either. The next measure would then be to allow them to use the TAF. Expect that to come soon.
In addition, keep in mind that the JP Morgan deal for Bear does not necessarily mean that customer will not continue to flee. If the exodus continues, the firm might still have to declare bankruptcy, which could well be a systemic event. So the Fed is using whatever firepower it can marshal.
From Greg Ip at the Wall Street Journal:
In an extraordinary weekend move, the Federal Reserve announced the most dramatic expansion yet of its lending, promising to lend for up to six months to securities dealers under terms normally reserved only for tightly regulated banks.
The Fed also cut the rate on such direct loans by a quarter of a percentage point, just two days before it is likely to slash interest rates more broadly. It cut the discount rate — ordinarily charged on direct loans to banks, and now also to securities dealers — to 3.25% from 3.5%.
That narrows the spread with the more economically important federal-funds rate, now 3%, to a quarter of a point. The Fed is also expected to cut the fed-funds rate target by at least half a point at its meeting tomorrow….
Since the current credit crisis began in August, the Fed has taken ever more innovative steps to push its remedies beyond the banking system.
The Fed can lend with few constraints to banks through its “discount window” to prevent a shortage of cash caused by a temporary interruption or a generalized loss of confidence. But it has rarely lent to nonbanks, although it has had the authority to do so since 1932, if five of its seven governors approve. It last lent under this authority in the 1930s.
Even as it innovated in the current crisis, the Fed had avoided favoring a particular firm or class of securities. On Friday it crossed that line, stepping in to provide emergency funding to keep Bear Stearns afloat amid a severe cash crunch at the Wall Street firm.
Adam Posen, a central-banking expert at the Peterson Institute for International Economics in Washington, said other troubled firms claiming an equally critical position at the nexus of the financial system now “have political and legal precedent to ask for” help. He said the expectation of such help could also harden the negotiating position of a troubled firm, potentially complicating private-sector solutions.
Fed officials say they didn’t act to prevent a big firm from failing, but to prevent a firm enmeshed in critical markets from failing in a single day, causing a potentially huge disruption in the financial system.
Fed officials don’t dispute that their decision carries “moral hazard” — the risk that any sort of bailout encourages more of the same risky behavior later. But they believe that compared with the alternative scenario, that cost is small. The funding is structured so that the greater benefit is to those who lent money to Bear Stearns in the “repo” market for secured, overnight loans, not to Bear Stearns itself. Moreover, they note it’s unlikely any firm will consider the loss Bear Stearns’s shareholders are likely to sustain as an acceptable price for taking the same risks in hopes of a bailout.
Still, with the credit crisis showing no sign of ending, “Thinking about the appropriate terms of bailouts is especially important if, as seems likely, other firms require similar help down the road,” said Doug Elmendorf, a scholar at the Brookings Institution and former Fed economist.
The Fed has intervened from time to time in specific situations, from Treasury loans to Mexico in 1994 to brokering the rescue of the hedge-fund Long Term Capital Management in 1998. But it has been rare for the Fed to put its own money at risk. The most important example of this was in 1984 when it and the Federal Deposit Insurance Corp. lent billions to Continental Illinois. Efforts to find a buyer were fruitless and the federal government ultimately ended up owning most of the failed bank.
“The financial system is much more interconnected and opaque than in 1984,” says Kenneth Kuttner, a monetary economist at Oberlin College and former Fed staff economist. That has made “the lender of last resort role much more complicated.” The crisis, he said, is exposing “the limitations and constraints” of the rules laid out for the Fed in the Federal Reserve Act.
Since the 1980s, Congress has limited the ability of regulators to prop up weak banks. At the same time, the financial system has moved away from insured deposits to other sources of funding. Securities dealers’ “repo” borrowings — short-term collateralized loans that grease the market for a wide variety of securities — have more than doubled to $4.5 trillion and now exceed banks’ federally insured deposits.
Fed officials believe that multiple sources of credit have made the economy more resilient and less exposed to problems in banks. Less than a year ago, Fed Vice Chairman Donald Kohn predicted that with a more market-based and less bank-based system, the Fed would rely more on interest rates to stem crises than direct loans to market participants.
But the Fed has already learned that interest-rate cuts alone aren’t enough to stem the current crisis, and has not only had to use the discount window, but in ways it never thought likely.
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the fed and treasury are scared sh**less
they are down this well aware of the unknown risks they are taking as they feel there is no other way to stabilize the situation.
given that they do not and have no authority to regulate broker dealers it will really be temporary or in the future legislation will be passed to bring broker dealers under the fed umbrella.
the fact that this action is for six months is scary as hell. they fed is thinking sh** will be hitting the fan for six months!!!!
i do not feel calmed whatsoever
The Fed, in its attempts to calm the panic, is acting so panicky that it’s having the opposite effect.
The ultimate example that one should never, ever depend on government in any form to solve anything.
FUBAR.
TomD
I was thinking of making a comparison between the crane collapse in New York and the state of our financial markets, but decided to leave that to other.
The bar at the base of the little townhouse that was completely crushed was called Fubar.
“The Fed, in its attempts to calm the panic, is acting so panicky that it’s having the opposite effect.”
Agreed. As an investor I have no idea what to do. Those negative yield TIPS are starting to look attractive after all.
Maybe I should sell everything and store my entire net worth in nickels. Then if we get inflation I can smuggle the nickels across the border and melt them down, and if we get deflation I can just cash them in at face value.
Obviously I’m joking since it’s now illegal to export nickels outside the US.
Fubar worked, so…………..
This could be the day of the Wahoo bird.
That’s the bird that flies in ever-decreasing concentric circles until if flies up its own asshole screaming WAHOOOOOOOOOOOOO!!!!!!
TomD
Tom D:
If government had done its job (curbing the excesses of the greed-driven among us) it would not now be trying to do the impossible. Does this crisis show the ineffectiveness of government? Or the utter unreliability of our financial institutions and the people who run them so recklessly? Or both? Is it just the latest chapter in the long, long book of human folly?
I can’t believe the Fed would do something like this without thinking through the consequences.
We’ve already seen the law of unintended consequences so far:
1) Congress raises conforming limits on Fannie/Freddie to help unfreeze the mortgage market. Result: agency spreads skyrocket, bringing down Bear and a host of hedge funds. Mortgage markets still remain frozen.
2) Fed opens TSLF to unfreeze mortgage market. Result: Carlyle goes bankrupt as people rapidly arbitrage the difference between holding MBS in firms that can and can’t access the new credit facility. Mortgage markets remain frozen.
Now we have 3) Fed opens TSLF to broker-dealers. Given the track record of our esteemed Fed so far, I shudder to think what the unintended consequences of this one will be, and I’m disturbed that it’s very likely that no one has thought about that while running around in a panic shooting from the hip at any shadow that comes up. Anyway, here’s my speculation…
The Fed is already close to tapping its full balance sheet. The trigger for the collapse of the past few weeks has been the rise of agency spreads, which is the cause not the effect of all the implosions we’ve seen so far. So to stop the panic, the Fed would have to intervene in the agency market. But it’s remaining reserves of ~$400bil is tiny compared to the amount of debt out there. Furthermore, even a full faith govt. guarantee is unlikely to stop the rise in premiums (witness Ginnie Mae debt, where spreads are increasing even with a govt. guarantee). This is partially because of panic, and partially because agency debt will have fundamentally different behavior when it includes all the extra debt Congress is talking about stuffing it with. So with that uncertainty and unpredictability, it’s no wonder spreads are increasing.
As the spreads continue to claim more casualties, more firms will line up for funding (when do hedge funds get to drink directly from the punch bowl? At this rate, probably in a week or two), and the Fed, unable to say no, will have to start issuing treasuries to expand its balance sheet. Within a matter of a month or two, the Fed will find itself with a trillion or so dollars of impaired debt in a “repo” that can’t ever be recalled (some because the counterparty’s balance sheet is still too weak, others because the counterparty has gone BK). The ultimate casualty? The Fed itself, unable to lower interest rates below 0%, facing default on collateral on its hands, and counterparties (central banks) unwilling to trust the Fed to manage the dollar any longer.
Oh yeah, and mortgage markets will still be frozen.
Happy St. Patrick’s day, Yves :-)
Lune,
That was a great comment.
The Fed is already at the end of its debase the currency strategy. The ten-year Treasury auction last week stank. A steeper yield curve means more costly mortgages, unless people do floaters as they did in the inflationary 1970s (they aren’t so awful if they have interest rate ceilings and floors, but from what I can tell, no one has dusted off that product. Plus with subprime ARMs having taken down so many borrowers, you might have a problem with customer receptivity to the product).
Yves-
That was the first unintended consequence, wasn’t it? Lower overnight rates to unfreeze the mortgage market and watch 10-year rates increase as people worry about inflation.
I’m wondering: if the demise of Carlyle and BSC was hastened because they were firms that couldn’t access Fed money and thus were foreclosed by firms that could, what will happen Monday? I’m thinking hedge funds, unable to access the Fed directly, will be eaten alive by the IBs.
Why? Because I’m figuring they’ll find it safer to shut down hedge funds, take their collateral and convert it into Treasuries, even at the usual Fed haircut, rather than deal with the prolonged uncertainty and volatility of working with their hedge fund clients for an orderly unwind of their positions.
When there was no choice but to choose option #2, plenty of IBs bent over backward to try to keep the hedgies afloat, lest the market collapse. But now, better to shut them down, stuff the Fed with the remaining crap, and sleep better at night knowing your collateral is now in Treasuries rather than illiquid and opaque hedge fund positions. Which IB out there wouldn’t be willing to convert their whole CDS position into treasuries even at a 50% discount (especially since with a repo, if the CDSes don’t default, you’ll get them back at par when the storm has settled)?
That’s an entirely plausible scenario. Eeek.
I don’t know if I have the energy for another long post tonight (all this drama is enervating), but I wanted to write one on the prisoner’s dilemma. We seem to be here now (Eugene Linden sent me one of his pieces which argued that vampire bats do a better job than we humans do).
If everyone sells each other out, like all the IBs shut down the levered hedgies (they’ve already started down that path), they might think they are improving their risk, but systemically you create a disaster and leave everyone worse off. If everyone showed a bit of forbearance right now, we’d all be better off, but the mindset is “devil take the hindmost.”
Your story on The fed is just awful in what it implies! They have lost control and at this point either they are retarded or have some hidden agenda.
Re: JP Morgan. My theory is, the reason that JPM & The Fed offered $2B, was because this was an arms length deal, and in the end, JPM only had $2B in the vault. This price of $2 is as meaningless as The Fed opening the door for any shoeshine boy that needs to trade a bike for cash. The Fed Pawn Shop is not a welcome turn of events and, as usual, it would be nice to see some fringe element from this government to come forward to take control, or to investigate or to do something other than look like limp puppets in a mafia casino. We don’t even seem to have the press asking questions, it’s like deer in the headlight syndrome, where thoughts are frozen. Where the hell is DOJ, FTC or even IMF, NATO, maybe Colin Powell. Maybe this is what happens when Rome falls, people sit around looking at each other, reading the news, as buildings burn down…..
This is getting weird yves!
Prisoner’s dilemma indeed. As a commentator in another blog said:
2 rules of financial investing:
1) Don’t panic.
2) If you have to, panic first.
As far as I can tell, the only reason banks didn’t shut down hedge funds earlier is because all that crap would end up on their own books. But now that they have a reliable way of disposing of that stuff, why not? It’s not like they have any fiduciary duty to the hedgies’ investors. The only reason hedge funds haven’t done this yet is because they can’t.
In essence, I’m afraid the Fed has created the mother of all arbitrage opportunities. If you have access to the Fed’s TSLF/TAF, then the Fed is acting as your market maker, able to convert your toxic bonds into liquid and safe treasuries for a price above what the private market will pay.
But only a privileged few have access to the Fed. Thus, the banks are able to arbitrage the enormous difference between the private market for toxic debt and the public (i.e. Fed) market for toxic debt, leaving the private market (i.e. hedge funds) wiped out.
Lune,
The prime brokerage market is highly concentrated. Goldman, Morgan Stanley, Deutsche and Bear have about 75% of the market, maybe 80%. I just read that BofA was trying to sell or had sold its PB.
Goldman is a pig and very clever about not looking like one (this is based on having worked there). They’d be my prime candidate for pursuing your strategy.
Lune,
Please start your own blog or become a regular commentator. A brilliant analysis of this fiasco.
Yves, your blog is one of my first reads every am.