Rate Watch #752 A Serious Look at the Fed's Handling of the Liquidity Crisis
Rate Watch #752 A Serious Look at the Fed's Handling of the Liquidity Crisis
December 10, 2010
by Dick Lepre
dicklepre@rpm-mtg.com
www.loanmine.com
Fundamentals
October Trade Gap (Exports-Imports) was $38.71 billion. A lower trade gap means
a higher GDP at a given level of consumer spending. University of Michigan Consumer
Sentiment was 74.2, consensus was 72.5, previous was 71.6.
Initial Jobless Claims were 421,000 last week. It may not be a fundamental but the elephant in the room is the passage of the continuance of tax rates where they are. I find the language which politicians use regarding this to be disturbing. We should have a way to set the tax side of fiscal policy with more concern for the long-term health of the economy and less concern for things political. But I guess that politics is what politicians do best.
According to Zillow the total lost value of American homes since the market peaked in 2006 is $9 trillion. The sad fact is that the present value of homes makes more sense that that of 2006. What I mean by "makes more sense" is that the current prices are closer to that which people can afford with their real incomes and actually make the payments. In fact, it may be the case that in a macroeconomic sense prices should even be a bit lower. Also, I am by no means implying that Zillow provides the best estimates of value.
The Technicals
The daily is bearish (lower prices, higher yields), the weekly is bearish and the monthly while not actually bearish is about to fall into Yogi's crib. Am I the only one who wonders if there is a causal connection between next week's release of the Yogi Bear movie and the fact that the monthly is turning bearish?
I must point out that Jim Grauer (StoMaster) has started updating his comments about the bond tech almost every day. Check it out at StoMaster. This is complex stuff. You need to keep in mind that this is a technical analysis which deliberately blinds itself to economic fundamentals and looks only at the data (30 year Treasury bond futures). This technical analysis is presented here because I believe that it supplements analysis of fundamentals.
Analysis
The news has been that jobs are not being lost lately to the extent that they were being lost the past few years. While there is still little sign of economic expansion markets seems to have already presumed that there will be no tax increases. The underlying problem that the political process seems to be incompatible with economically sound decisions regarding the tax side of fiscal policy is hardly new but becomes more apparent at times such as these.
As to the question "why the gigantic spike in Treasury yields?" the answer is that at times like these trading thins and the market is moved by the people on the edges. Their reasoning seems to be that all we are likely to get is larger deficits and by selling bonds and increasing the cost of Treasury borrowing they are self-actualizing their beliefs.
Low Treasury rates have made debt service relatively painless in recent years but that could be about to change. Harsh fiscal realities on local, state and the national level are barely being addressed. The long-term price of this neglect may well be enormous.
FNMA will keep the current conforming and high-balance conforming loan limits in place for loans funded before September 30, 2011. After that, the high-balance conforming will be cut back (as word fail me here) to the permanent temporary limit of $625,500.
A list of the high-balance limits by county may be found here by selecting the state from the pull-down and typing the county.
The Fed and the Liquidity Crisis
The Federal Reserve last week released the details of the various programs which it instituted in response to the liquidity crisis which started in 2007. Between February 2007 when HSBC was the first large bank to make a large write-off ($10.5 billion) and August 2008 banks world wide had written off $500 billion. Banks had a dual problem. One was a capital problem but the persistent one was a liquidity problem. The capital problem was partially fixed by raising more capital and diluting the value of equity position of banks. The liquidity problem was more nefarious. Banks became suspicious of one another and their normal flow of interbank lending stopped.
Liquidity implies that an asset can be sold quickly without affecting the price. The underlying reality was that if banks started to sell their stakes in mortgages the prices would be driven constantly down creating cascading losses as the value of their stakes deteriorated and their new worth decreased.
The salient point was this: banks needed an extended period of time to get rid of their lousy assets of pools of bad mortgages. This required two things: 1) relaxation of accounting rules to not force banks to genuinely mark these assets to market 2) a massive injection of liquidity on a scale never before seen.
What follows are brief synopses of the various Fed created programs to provide liquidity.
TAF
One solution was the Term Auction Facility. The TAF was not merely a Federal Reserve thing. It was the coordinated effort of the Federal Reserve, the European Central Bank, the Bank of England, Bank of Canada, and the Swiss National Bank.
Under the Term Auction Facility program, the Federal Reserve auctioned term funds to depository institutions by taking of a larger set of assets as collateral that the Fed would normally take at its discount window. Cash was provided with a broader set of assets as collateral.
I am going to sidetrack here with comments on some of what I have read about this. The Fed was not giving money to anyone. It was lending money. All of these loans were secured. The Fed lost zero. In fact it made money. It most certainly took risks because it lowered the standard of the collateral it took.
The details of who got TAF money are in this spreadsheet.
Primary Dealer Credit Facility (PDCF)
Some of the entities damages by the liquidity crisis were primary dealers. There are currently 18 primary dealers. These are the entities which the Treasury department uses to wholesale Treasury auctions. One of the most important elements of this is what is called a "Triparty Repurchase Agreement." A repurchase agreement (repo) is the sale of securities and the agreement by the seller to repurchase those securities for a given price on a given date. These are Wall Street versions of a pawn shop. A Triparty Repurchase Agreement is a repo where there is a third part which acts as custodian for the securities. With these entities damaged and lacking the trust of counterparties, the Fed established PDCF as an overnight loan facility for primary dealers. It was to primary dealers what the Fed window is to member banks. The dealers of immediate concern were Goldman Sachs, Morgan Stanley, and Merrill Lynch. Details of all of the PDCF transactions are in this spreadsheet.
The facility was announced on March 16, 2008, and was closed on February 1, 2010. All loan were repaid with interest.
It should also be noted that the big Wall Street investments banks were subsequently either acquired by commercial banks or redefined themselves to become bank holding companies and can now borrow from the Fed window.
Term Securities Lending Facility (TSLF)
This was another type of support for primary dealers and loaned liquid Treasury securities with less than totally liquid securities as collateral. These "less than totally liquid securities" were agency MBS, CMO and bonds with ratings from AAA to Baa/BBB. The TSLF was announced on March 11, 2008 and closed on February 1, 2010. All securities loans made under the facility were repaid in full, with interest.
Agency Mortgage-Backed Securities (MBS) Purchase Program
This was the facility for purchasing residential mortgages. This helped Main Street not Wall Street. These was FNMA, FHLMC and GNMA (FHA and VA) mortgages. The Fed purchased these mortgages in bulk from primary dealers. Most of these remain owned by the Fed and each transaction has its own CUSIP number. In addition to the interest received there has been much principal repayment as homes are sold and as those Fed owned mortgages were refinanced at lower rates this year. Understand that the Fed paid zero for the money. It created these fund out of thin air. All of the interest received (less what is paid to the servicer) is profit. The notion that this was a dramatic increase in money supply which could create asset bubbles especially with low interest rates is valid. Asset bubbles are a collateral effect.
Commercial Paper Funding Facility (CPFF)
Commercial paper is short-term (<270 days) borrowing usually by businesses and governments to fund short-term operating expenses. Some commercial paper is backed with assets and some is unsecuritized. This is a critical source of funding for many businesses. While a business can issue commercial paper itself, most commercial paper is sold to broker-dealers (investment banks and bank holding companies) and those entities find retail buyers for this paper. To a large extent is was money market mutual funds which provided the cash for commercial paper. On September 16, 2008, consequent to the Lehman BK investors started moving money out of money market mutual funds and these funds had to liquidate assets at a bad time. On that day the Reserve Primary Fund, the oldest money fund in existence, and a holder of $785 million in Lehman Brothers commercial paper "broke the buck" meaning that every dollar invested there was worth less than $1.00. Before that day, in the entire 37 year history of money market funds this had only happened twice. The notion that other than cash and bank deposits money market funds were the safest investments had gotten a serious jolt.
When the liquidity crisis happened the money market funds were reluctant to purchase commercial paper. We were facing a serious recession and the sources of credit to many businesses disappeared almost overnight.
The Federal Reserve created the CPFF and the Federal Reserve Bank of New York provided three-month loans to the CPFF LLC, a specially created limited liability company (LLC) that used the funds to purchase commercial paper directly from eligible issuers.
The facility was announced on October 7, 2008, began purchases of commercial paper on October 27, 2008, and was closed on February 1, 2010. Net portfolio holdings of the CPFF LLC peaked at $351.4 billion on 1/23/2009. The CPFF LLC was dissolved on August 30, 2010. All loans that were made to the CPFF LLC were repaid in full.
This is a link to the CPFF page at the site of the Federal Reserve Bank of New York. This is a spreadsheet of all CPFF purchase transactions. This is a spreadsheet loans that FRBNY made to the CPFF.
Term Asset-Backed Securities Loan Facility (TALF)
This addressed asset based securities (ABS). Asset based securities are what banks, for example, use to finance auto loans, credit card debt and student loans. When the liquidity crisis happened investors were reluctant to purchase ABS. While TALF lending was done through intermediaries the people who benefited were everyone who wanted an auto loan, a credit card, a student loan or a small business loan. TALF loans were collateralized by assets. The value of the assets always exceeded the value of the loan. This helped Main Street not Wall Street.
The facility was announced on November 25, 2008, and began lending operations in March 2009. TALF lending was authorized through June 30, 2010. The only info I can find says that 60% of the loans were paid off this September and that "All loans that have not been repaid in full early are current in their payments of principal and interest and no collateral has been surrendered in lieu of repayment."
Central Bank Liquidity Swap Lines
These are foreign exchange swaps. Two types were enabled one for foreign banks wanting to temporarily exchange their currency for U.S. dollars and one for providing liquidity for foreign currency assets of U.S. banks. The later were never activated. Since I am bad at explaining FOREX in my down-to-earth fashion I will merely plagiarize the Fed.
"To address severe strains in global short-term dollar funding markets, the Federal Reserve established temporary central bank liquidity swap lines (also referred to as reciprocal currency arrangements) with a number of foreign central banks. Foreign central banks then could draw on those lines to provide dollar liquidity to institutions in their jurisdictions. In the swap transactions, the Federal Reserve deals only with the foreign central bank. The transaction is structured so that the Federal Reserve does not bear any foreign exchange risk. In May 2010, dollar swap lines were reestablished with certain foreign central banks because of the reemergence of strains in dollar funding markets.
The FOMC authorized temporary dollar liquidity swap arrangements with 14 foreign central banks between December 12, 2007, and October 29, 2008. The arrangements expired on February 1, 2010. All transactions were executed in full, in accordance with the terms of the swap arrangements.
In May 2010, in response to the reemergence of strains in short-term dollar funding markets abroad, the FOMC re-authorized dollar liquidity swap lines with five foreign central banks through January 2011."
The Special Case
The Fed thought that there were some special cases which needed their own facilities. (The Fed, Treasury and FDIC put together special liquidity facilities for BofA and Citigroup but these were never used.) The notable special case was AIG. AIG was (in theory) an insurance company with headquarters in New York City. To oversimplify things the London unit of AIG became heavily invested in Credit Default Swaps on collateralized debt obligations (CDOs) and the large decrease in the value of these created a liquidity crisis for AIG. AIG was starting to look like Lehman Brothers 2.0 (Lehman had declared bankruptcy and AIG had a similar portfolio.) AIG had large positions in subprime and Alt-A mortgages. On September 16, 2008, AIG's stock dropped 60 percent. The Federal Reserve tried to broker a massive non-government line of credit for AIG but there were no takers. AIG's potential losses were diverse and the opinion of the Fed was that it was easier to bail out AIG that to let it fail and bail out wherever counterparties would be destroyed by an AIG bankruptcy. See this New York Times post of that day.
That day the Fed decided to act on its own and provided AIG with a credit line of up to $85 billion, AIG was aided both by the Fed's line and Treasury's TARP program. The Fed created 2 LLCs to lend money to AIG. These were called Maiden Lane II and Maiden Lane III. (The Federal Reserve bank in Manhattan is at the corner of Liberty Street and Maiden Lane. For you movie trivia freaks, Maiden Lane is also the street in San Francisco where the scene in the pet shop at the opening of Hitchcock's "The Birds" was filmed.)
AIG went from being a Dow company to a company 79.9% owned by the US government. (Note that the 79.9% ownership thing is designed to keep this off the books of the Fed or Treasury. If the government owned 80% or more these would appear on the government's balance sheet.) The ongoing plan has been to recapitalize AIG and sell off pieces and repay Treasury and the Fed.
It looks as if money will be lost on the AIG deal. In October the Special Inspector General for TARP estimated that Treasury would lose $5 billion. This was down from the April 2010 estimate of a $45 billion loss. This has devolved into media dissing of Treasury as covering up the AIG loss. The fact is that we do not know what the AIG loss will be because much of the position held by Treasury is in AIG preferred stock.
So What?
Since this was announced I have read countless criticisms of the Fed's actions as detailed in this report. The fact is this: the Fed acted independently in most of these cases. It acted under authority granted to it by of Section 13(3) of the Federal Reserve Act, which permitted the Board, in unusual and exigent circumstances, to authorize Reserve Banks to extend credit to individuals, partnerships, and corporations. If these were not unusual and exigent circumstances then I am not sure what constitutes such.
The Fed did not give money away to any entity. It reacted in a most dramatic way to a massive liquidity crisis which, if not immediately addressed, could have created a worldwide depression. The Fed provided liquidity for funding mortgages, credit card debt, student loans and auto loans. As far as I can tell the only long term loans are the mortgages purchased by the Fed from FHLMC, FNMA and GNMA. There are still positions in TALF loans which are also consumer oriented. The Fed helped Main Street as well as Wall Street. All of the loans made to increase liquidity to commercial banks and investment banks are repaid.
The Fed acted boldly and may someday be judged to have averted a worldwide economic catastrophe and the end of 2009 transferred more than $45+ billion in profit to Treasury. The discussion about whether the Fed should have the dual mandate of controlling inflation and keeping unemployment low misses the fact that real mandate of the Fed is preservation of the banking system. The elements of the dual mandate are secondary and we do not normally think about the Fed's first purpose because things such as this liquidity crisis do not occur often.
As I said last week: The Fed gets criticized by folks of all political beliefs. To me criticizing the Fed is like criticizing the fire department. Building owners complain that they do water damage and the arson squad complains that they destroy evidence. Like the fire department, as the Fed puts out economic fires it does create collateral damage. That collateral damage takes the form of asset bubbles created by low interest rates and large increases in money supply. The Fed quite possibly averted a major worldwide depression and it so doing made enough money that is gave Treasury $45 billion in 2009. So before anyone bitches about the Fed they should perhaps think about that.
The liquidity crisis unfolded with such speed that there was no time for any entity other than the Fed and other central banks to act. The Fed needed to act without proximate input from politicians. Congress gave the Fed its agenda. Listening to people in Congress and comedians on TV question Bernanke is, to me, laughable. With these programs the Fed helped Main Street and Wall Street. When it helped Main Street it also helped Wall Street. When it helped Wall Street it also helped Main Street. The notion that Wall Street and Main Street have opposing interests is one of the dumbest fallacies to come from all the discussion about what the Fed did.
If you have something to add to this discussion please post a comment below.
Dick Lepre
RPM - SF
1400 Van Ness Avenue
San Francisco, CA 94109
DRE License # 01143973
dicklepre@rpm-mtg.com
Web site: www.loanmine.com
Blog: economy.typepad.com
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