A professional investor alerted me to a not-widely-noted element of the Fed’s new discount window clone for primary dealers, the so-called Primary Dealers’ Credit Facility (I am going to lose track of the acronyms given the speed with which the Fed is coming up with new ways to socialize losses).
This overview is from the Fed’s press release:
The PDCF will provide overnight funding to primary dealers in exchange for a specified range of collateral, including all collateral eligible for tri-party repurchase agreements arranged by the Federal Reserve Bank of New York, as well as all investment-grade corporate securities, municipal securities, mortgage-backed securities and asset-backed securities for which a price is available.
The PDCF will remain in operation for a minimum period of six months and may be extended as conditions warrant to foster the functioning of financial markets.
Ah, but how will the Fed assign values to the collateral? From the Fed’s FAQ:
What collateral is eligible for pledging?
Eligible collateral will include all collateral eligible for tri-party repurchase agreements arranged by the Federal Reserve Open Market Trading Desk, as well as all investment-grade corporate securities, municipal securities, mortgage-backed securities, and asset-backed securities for which a price is available.
How will collateral be valued?
The collateral will be valued by the clearing banks based on a range of pricing services.
That sounds objective and innocuous, right? Guess again. As the investor commented:
Note also that the Fed’s accepting the clearing banks’ valuations on the assets that the brokers present as collateral. That is so very understanding of them. Given that the clearing banks hold similar assets themselves, they are probably grading on a curve here, so as not to mark down their own assets simultaneously, I’m guessing. We’ll give the best student here an A—make that a triple A!—and hey, look, we’re all triple A on this bus. Yikes.
Update 11:30 AM: We had missed these comments from Willem Buiter on the same issue, which reader Jay pointed out:
“…the pledged collateral will be valued by the clearing banks used by the primary dealers to access the new facility, based on a range of pricing services.” This suggests that the Fed will accept whatever valuations the clearing banks may come up with. The only qualification is that collateral that is not priced by the clearing banks will not be eligible for pledge under the PDCF.
Collateral eligible for pledge under the PDCF includes all collateral eligible for pledge in open market operations, plus investment grade corporate securities, municipal securities, mortgage-backed securities, and asset-backed securities.
This arrangement is an invitation to the primary dealers and their clearers to collude to rip off the Fed by overvaluing the collateral, including using false markets and/or arbitrary internal pricing models as part of their ‘..range of pricing services’ (what are pricing services anyway?). They can then split the difference. If the Fed wants to be mugged, why not let the primary dealers themselves price the collateral they offer the Fed?
For all collateral that is not priced in verifiable, liquid markets, the Fed should arrange its own auctions to discover the reservation prices of those offering the collateral. Leaving it to the clearers is a written invitation to be offered dross at gold valuations. The tax payer will be the loser. A bad and incomprehensible miss. This can be gamed by a bunch of reasonably smart high school kids.
The problem is I’m not sure Buiter’s idea of an auction works either, since sales in small lots do not represent the prices that would apply to larger transaction sizes….but at least it’s an idea. It would at least be better if the Fed checked prices (including those that can be derived from liquid markets) against those from the various services itself.
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Oh, the marks are available – and the banks avoid them at all costs. They want no knowledge of bond prices, and as long as the government (or their customers) does not force them to find ‘real’ prices, they are technically solvent.
But in reality, they are all bankrupt; merrill, lehman, ubs, countrywide (and therefore BofA; yes it’s that bad), wamu, national city… the gamut.
And we haven’t even started with the option-ARM recastings yet!!!
Are we surprised? Ask a homeowner what his/her house is worth, and they will always price it significantly higher than market. In the long term, the nominal value of everything goes up and that is what the Fed is counting on to bail out the system. Forget protecting the US dollar, save the banks is the mantra.
Willem Buiter:
“Third, “…the pledged collateral will be valued by the clearing banks used by the primary dealers to access the new facility, based on a range of pricing services.” This suggests that the Fed will accept whatever valuations the clearing banks may come up with. The only qualification is that collateral that is not priced by the clearing banks will not be eligible for pledge under the PDCF.
Collateral eligible for pledge under the PDCF includes all collateral eligible for pledge in open market operations, plus investment grade corporate securities, municipal securities, mortgage-backed securities, and asset-backed securities.
This arrangement is an invitation to the primary dealers and their clearers to collude to rip off the Fed by overvaluing the collateral, including using false markets and/or arbitrary internal pricing models as part of their ‘..range of pricing services’ (what are pricing services anyway?). They can then split the difference. If the Fed wants to be mugged, why not let the primary dealers themselves price the collateral they offer the Fed?”
“Three hits and three misses for the Fed”
http://blogs.ft.com/maverecon/2008/03/three-hits-and-three-misses-for-the-fed/
Does anyone have any word on when the FED will allow homeowners to access the the Fed Homeowners Credit Facility FHCF using their homes as collateral?
Why is this considered a surprise? This was the Fed’s point, wasn’t it? After all, if the banks had a true mark-to-market price, they could sell it on the market and not have to use the Fed. As previous posts and comments have noted, there is actually a lot of money waiting in the sidelines (witness the drop in short term treasury rates). The only problem is the banks don’t want to offer their securities at what the investors are bidding. Hence the “lack” of liquidity.
It’s somewhat ironic that the same people who say liquidity has disappeared can in the same sentence say that oil prices will come down because all the recent runup is due to speculators creating another bubble. Either there’s enough money available for investing / speculating, or there isn’t. If people are dropping billions into the commodity market and taking it out of the mortgage market, that’s because they feel they can get a better return in commodities. Price mortgage debt competitively and you’ll get plenty of liquidity flooding back.
But of course, that wouldn’t achieve the larger goal of socializing the losses of our dear banks, now would it?
Let’s face the facts: The Fed, the Federal Home Loan Banks and the Treasury (aka U.S. Government) have and will continue to do everything possible to support the U.S. financial system and even attempt to hold house prices at least 20 percent above realistically sustainable and economically viable levels.
AND, OF COURSE, THIS IS ALL BEING DONE WITH U.S. TAXPAYER MONEY, now and for future claims.
I am a professional investor, trying to do my best in uncharted waters for my clients. And what do I see?: First, the monoline insurance companies should be downgraded big-time, but S&P and Moody’s NEVER get around to it, because THEY DO NOT WANT TO BE THE CATALYST FOR THE END OF “MODERN” FINANCE… Yves has done a great job of spotlighting the monoline’s situation, and I have spent many hours analyzing the situation — which rationally suggested big-time trouble for the financial markets — but NO, the big monolines were never downgraded (clearly, the rating agencies didn’t want to take the heat).
And now we have not only the Federal Home Loan Banks giving huge amounts of money to their member banks in return for lousy collateral, but the Fed has rapidly progressed through a series of moves to the point where it accepts collateral that NOBODY ELSE WILL TOUCH, AND AT THE VALUATION OF THE SWAPPER! According to the Fed’s latest statements, this includes “third-party” stuff that will be shifted to the Fed from hedge funds via the prime brokers that now have straight-line access to the Fed’s coffers.
Consequently, the Fed is now the willing recipient of all the toxic waste held in the private sector, one way or another.
AND THIS IS EVEN BEFORE CONSIDERING THE REALITY THAT THE TREASURY, UNDER EITHER A REPUBLICAN OR A DEMOCRAT, WILL BE EAGERLY DEVISING PROGRAMS TO BUY UNDERWATER MORTGAGES, ETC, ETC, IN ORDER TO PROP UP THE HOUSING SECTOR AT PRICES THAT ARE AT LEAST 20 PERCENT ABOVE CLEARING PRICES, BASED UPON THE CUSTOMARY METRICS OF PRICE-TO-HOUSEHOLD EARNINGS, ETC.
AND MOST IMPORTANTLY, THE FINANCIAL MEDIA DOESN’T HAVE A CLUE — THEY TRULY HAVE NO UNDERSTANDING OF WHAT’S GOING ON. AS ONE EXAMPLE, LOOK TO TODAY’S NEW YORK TIMES ARTICLES ON HOUSING, ETC.
So where am I now? — totally frustrated. It is hard to accept the course that is clearly inevitable – the BIG BAILOUT FOR ALL THOSE WHO SHOULD BE GETTING THEIR JUST HARD DUES. But that’s clearly the trajectory, and we all are going to pay taxpayer money for it — BIG TIME.
MF
It may be possible to design a suitable auction to insure accurate (or at least not excessive) prices. Perhaps something along these lines:
Primary dealer submits collateral and its value (separate submissions for each type of collateral).
An auction for the collateral is conducted; the submitting dealer is excluded.
The submitting dealer obtains a put option at the winning price. This prevents bidders from propping up the price – they just might be stuck with the collateral.
If the winning bid is less than the submitted value, the winner receives a call option for the collateral at the winning price. This prevents submitters from overvaluing the collateral – they just may be required to sell at actual value (and mark the remainder of this asset type to market since it has just been established).
The submitter is delivered the lesser of its submitted value and the winning bid (if one of the options is exercised, that amount is delivered and the collateral goes to the winner).
I don’t disagree that an auction process could be designed; my concern is disparity in lot sizes.
If a dealer submitted a very large amount of a certain kind of paper, he might not want that exposed (for instance, most of the AAA CDOs held by Merrill and Citi is paper they issued; if the Fed put up a big amount to test the price for a comparable lot size, the market would be able to guess who was posting the collateral and that might have repercussions. Plus there might not be any bids on a large amount.
Smaller lots (in the single digit millions) probably would attract bids but would have limited use in evaluating the prices of much larger trades (hundreds of millions). But prices of small lots would certainly be higher than those for large amounts, so if they resulted in lower prices than the clearing banks’ marks, it would force the banks into more, ahem, candor.
That’s a long winded way of saying it could be useful but you need to recognize the limitations.