So, in the end the Fed decided to copy Enron and become a Special Purpose Vehicle, more commonly known these days as a Structured Investment Vehicle. (SIV) The Fed has granted itself the ability to morph by expanding its short term lending and borrowing facilities to such an extent it is now the market.
The following is my take on what a research note would look like, if the Fed (FED) was a quoted, publicly traded company.
Lets recap how the Fed managed this amazing transformation from so-called Central Bank to an off balance sheet, Distressed Loan Hedge Fund.
It seems the transformation began with the appointment of a new CEO, a Mr Ben Bernanke who specialised in the history of distressed credit and loan periods, specifically the Great Depression and Japan. In hindsight the appointment by the Chairman, GW Bush, looks inspired, an astute move that showed a deep understanding of the problems that were to unfold. Indeed, it would not surprise me that after the Chairman leaves his current board position he becomes a target for the more discerning Hedge Funds.
The Chairman also appointed an old friend and ex-head of Goldman Sachs to the supporting role in PR and head of the Company's Debt Division, one Mr Hank Paulson. Hank had useful contacts throughout the Financial Sphere and acted as a conduit to Mr Bernanke. The chairman also slimmed down the Board of the Investment Vehicle, allowing decisions to be made in a more timely manner when problems occurred.
On appointment Mr Bernanke immediately set to work, using the premise of cost savings to cut back on the information the SIV gave to the public. With the loss of the M3 figures, off balance capital could be raised without alarming shareholders. He also began, in conjunction with Mr Paulson, a publicity campaign to make the under capitalised and debt burdened GSE's more attractive as investment conduits. This was no easy task, especially with the books being closely examined but as we shall see it was a necessary move to help shape the financial structure of the SIV.
Preparations continued to ferment a suitable environment that would allow FED SIV LLC to really ramp up its business strategy. Pressure had to be applied to raise interest rates that would allow stress to appear in the financial and economic systems. Firstly a sustained publicity campaign against inflation was launched with the hope that inflation expectations would grow, allowing acquiescence to the need to raise rates. This though was a smokescreen, designed to lead the crowd into the wrong trade. The second prong of this attack was already in play as FED compliance officials had, for some time, been pressurising Banks on lax loan standards, forcing a tightening of credit availability.
As the markets, the public, banks, dealers and hedge funds accepted the new conditions and set trades accordingly, the time was ripe for FED SIV LLC to take advantage of stresses in the system. What was important though was that FED ( Quote, Chart, News ) was not seen as the catalyst for the rapid changes that were to take place. It was a matter of waiting for a problem to arise and then, under the guise of assisting, make conditions such that lending dried up and debt became either unserviceable or untradeable. Thanks to the previous CEO, Mr Greenspan, the ability to mark debt derivatives to market had grown exponentially over the last few years. It would be difficult indeed to hide losses.
Then one summers day in 2007 the chance to profit came along. As credit had dried up and rumblings of difficulties at smaller bit part SIVs to roll Asset Backed Commercial Paper loans began to surface, interest rates broke away from FED fixed rate, reflecting an increased risk premium. As LIBOR rates rose, interbank lending slowed as capital was hoarded, causing credit lines and leverage facilities to be withdrawn. With markets betting on higher inflation and rates remaining high, FED stepped in and lowered rates at the discount window, hoping to pick up the demand not being serviced in traditional markets.
Although some business came their way, it seemed the financial system was trying to cope without the use of the new, innovative FED SIV. Then, as luck would have it, an investment house of some repute had to close down 2 hedge funds and recapitalise a third. Markets reacted by refusing to buy debt derivatives and banks demanded higher premiums on loans.
This was the opportunity FED had been looking for. It slashed the FED Fund Rates and expanded its lending facilities, using the System Temporary Open Market Operations (TOMO) in an aggressive move to replace funding, introducing longer term facilities on a rolling basis.
A new publicity campaign was started, playing down the stigma of borrowing from the FED SIV and encouraging its use. Hank Paulson began to talk up the dollar, in an attempt to forestall and foreign selling of dollar assets. Increasingly FED SIV began to talk down the risk of inflation and preferred to talk of a possible slowing economy. This subtle move balanced the bond vigilantes, who accepted that inflation was not the primary concern and bonds should start to price in an economic slowdown.
Although markets had become volatile and the failure of Mortgage Lenders and Hedge Funds continued, it appeared that FED had established a floor under the problems. The profits from increased lending began to grow.
The Stock Market took the situation in its stride, indeed in October '07 it made a new high. By now though talk of losses and discovery of toxic debt began to overwhelm bullish sentiment and stocks began to fall. It soon became apparent that problems had surfaced in Europe, where 2 FED subsidiaries, BOE Inc. ( Quote, Chart, News) and ECB Intl Ag, ( Quote, Chart, News ) started to make funds available to distressed traditional banks, indeed BOE Inc took one bank, Northern Rock, into its Distressed Business portfolio. With the dollar falling FED saw the new business in Europe as an excellent move and continued to push for overseas expansion.
By late November '07 it became apparent that some analysts had seen that the continuing FED rate cuts could have a damaging effect on the economy:
"Stephen Stanley, Chief Economist at RBS Greenwich Capital, says consumer conf might rebound like it did in 2005 but "the downside risks are very real. We continue to believe that the Fed would be well-served by holding off on any rate cuts in December and addressing market illiquidity head on by flooding the system with reserves."
Even some of the FED board had misgivings, at least in public:
Federal Reserve Bank of Philadelphia President and CEO Charles Plosser said today that because weaker economic growth is already expected in early 2008 and was considered when the Fed cut interest rates in October, he is not inclined to seek another cut unless growth is much weaker than expected.
"Arbitrarily lowering interest rates or providing liquidity to the market does not provide the answers the market seeks," he said. "Indeed, in some circumstances, lowering interest rates may prolong the painful process of price discovery."
It was clearly time for events to take another turn, so as not to undermine FED business strategy. LIBOR had reached new 6 ½ year highs showing the well prepared public, through a well rehearsed media that credit problems were resurfacing.
Indeed Commercial Paper rates began to rise again, even though FED rates were lower, as was the 3 Month T-Bill yield:
The inability to issue acceptable CP was threatening the ability of all borrowers to roll over their short term debt. Banks had become averse to lending:
(Charts by Colin Twiggs at Incredible Charts)
It was becoming clear that a second and more dangerous wave of credit destruction was approaching.
Fortunately CEO Bernanke had been waiting for such a crisis to unfold and had ensured that staff had drawn up a contingency plan. With the fortuitous failure of the Citi led attempt at setting up the "Super SIV" or M-LEC, FED were now in the driving seat.
By early December, Chairman Bush and PR guru Paulson began to outline a possible plan that involved renegotiating failing mortgages and made noises about mortgage forebearance. This helped to heighten the sense of fear in the market place, making the next move by FED to be seemingly natural. A new systemic threat had appeared, smaller SIV's began to fold and default in large numbers. As Moodys mentioned, the costs were climbing higher everyday:
"Moody's completed partial review of the SIV sector prompted by the continued market value declines of asset portfolios. Moody's confirmed, downgraded, or placed on review for possible downgrade, the ratings of 79 debt programmes (with a total nominal amount of approximately US$130 billion). This action affects 20 SIVs."
Then it happened, the Insurers or Monoliners as they became known, began to show serious signs of stress, as liabilities far outstripped capital reserves. Banks and Investment houses had no choice, either the SIV and Hedge fund liabilities were defaulted upon or they had to come back onto the balance sheet. This was the opportunity FED had been looking for, with a clear field it was time to roll out the new derivative innovation that had been carefully put together in the summer. With much fanfare FED announced the new strategy, involving its worldwide subsidiary companys.
Release Date: December 12, 2007
For immediate release
Today, the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank are announcing measures designed to address elevated pressures in short-term funding markets.
Federal Reserve Actions
Actions taken by the Federal Reserve include the establishment of a temporary Term Auction Facility (approved by the Board of Governors of the Federal Reserve System) and the establishment of foreign exchange swap lines with the European Central Bank and the Swiss National Bank (approved by the Federal Open Market Committee).
Under the Term Auction Facility (TAF) program, the Federal Reserve will auction term funds to depository institutions against the wide variety of collateral that can be used to secure loans at the discount window. All depository institutions that are judged to be in generally sound financial condition by their local Reserve Bank and that are eligible to borrow under the primary credit discount window program will be eligible to participate in TAF auctions. All advances must be fully collateralized. By allowing the Federal Reserve to inject term funds through a broader range of counterparties and against a broader range of collateral than open market operations, this facility could help promote the efficient dissemination of liquidity when the unsecured interbank markets are under stress.
TAF was a great success, with demand outstripping supply. Profits from this venture should easily outstrip those from the more cumbersome and shorter term Repos under the TOMO System. TAF started out at $40Bn and was set to climb up to $100Bn as long as demand remained high. With Banks refusing to lend except on AA and above collateral, credit markets were still frozen. TAF allowed FED to fund short term loans on easier collateral terms, replacing the shortfall in Commercial Paper. FED had cornered the market.
FED SIV LLC was not about to sit back in the current climate. Opportunities in other areas were beginning to become apparent. CEO Bernanke's historical research had led him to believe that once problems of this nature became public knowledge the FED could be expected to continue its move to dominate US banking, with little or no opposition.
In January '08 FED moved quickly to offset the fallout from the SocGen failure in Europe, where lax French regulation had allowed a lone trader (not so alone as we subsequently discovered) to run up huge losses as he had bet against the FED business model. FED was delighted to put further pressure on Treasury Bond short players by cutting FED rate savagely. Stocks bounced and began to move upwards, soothing the nerves of the masses.
Damage had been done though, as a tightening of availability of Treasuries caused by a flight to safety further restricted borrowing, as by this stage Banks would only accept the highest grade collateral on loans.
FED was quick to seize on this new business opportunity as it held Treasury reserves in excess of $750Bn. More could always be supplied by the Company Debt Division, it just took a call to Hank.
Sure enough by early March '08 conditions were ripe for FED to enter the Collateral Swaps market, accepting low graded debt in exchange for AAA rated treasury debt. To enable this, FED SIV LLC created a new conduit known as the Term Securities Lending Facility. Here is the company press release:
Release Date: March 11, 2008
For immediate release
Since the coordinated actions taken in December 2007, the G-10 central banks have continued to work together closely and to consult regularly on liquidity pressures in funding markets. Pressures in some of these markets have recently increased again. We all continue to work together and will take appropriate steps to address those liquidity pressures.
To that end, today the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank are announcing specific measures.
Federal Reserve Actions
The Federal Reserve announced today an expansion of its securities lending program. Under this new Term Securities Lending Facility (TSLF), the Federal Reserve will lend up to $200 billion of Treasury securities to primary dealers secured for a term of 28 days (rather than overnight, as in the existing program) by a pledge of other securities, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS. The TSLF is intended to promote liquidity in the financing markets for Treasury and other collateral and thus to foster the functioning of financial markets more generally. As is the case with the current securities lending program, securities will be made available through an auction process. Auctions will be held on a weekly basis, beginning on March 27, 2008. The Federal Reserve will consult with primary dealers on technical design features of the TSLF.
In addition, the Federal Open Market Committee has authorized increases in its existing temporary reciprocal currency arrangements (swap lines) with the European Central Bank (ECB) and the Swiss National Bank (SNB). These arrangements will now provide dollars in amounts of up to $30 billion and $6 billion to the ECB and the SNB, respectively, representing increases of $10 billion and $2 billion. The FOMC extended the term of these swap lines through September 30, 2008.
The actions announced today supplement the measures announced by the Federal Reserve on Friday to boost the size of the Term Auction Facility to $100 billion and to undertake a series of term repurchase transactions that will cumulate to $100 billion.
FED was becoming not only the dominant force in US Banking but was achieving massive profits as lucrative trades in Distressed Debt added to the bottom line. With the ability to dump non-performing Distressed Debt and re-claim Treasuries the risk of default by a borrower was minimal.
By now though the problem of collateral degradation had spread beyond the banks and entered the Broker arena. A loss in confidence in the assets held at Bear Stearns caused a run that saw Bear collapse inside 3 days.
FED instituted an emergency board meeting and using company procedures not seen since the 1930's moved swiftly to make an asset grab. Acting through an old associate firm, JP Morgan, FED promised a credit line of $29Bn to secure Bear assets. It then set up a subsidiary Fund to control ex-Bear assets with Blackstone running day to day activities, as seen in this hasty press release:
"This action is being taken by the Federal Reserve, with the support of the Treasury Department, to bolster market liquidity and promote orderly market financing," the NY Fed said in a statement.
It will take control of a portfolio of assets valued at 30 bln usd as of March 14 pledged as security for 29 bln usd in term financing from the NY Fed at the 2.50 pct discount rate.
JP Morgan will bear the first 1 bln usd of any losses in the portfolio and any gains will accrue to the NY Fed. The Fed has hired BlackRock Financial Management to run the portfolio under guidelines established by the NY Fed "designed to minimize disruption to financial markets and maximize recovery value."
It looks like someone in the Press Dept used the old name of the Company, pressure to get this deal out must have been intense.
To ensure that FED would not have to go through such an unseemly rush when the next Institution fails it released details of its latest SIV conduit, the Primary Dealer Credit Facility:
Federal Reserve Announces Establishment of Primary Dealer Credit Facility
March 16, 2008
The Federal Reserve has announced that the Federal Reserve Bank of New York has been granted the authority to establish a Primary Dealer Credit Facility (PDCF). This facility is intended to improve the ability of primary dealers to provide financing to participants in securitization markets and promote the orderly functioning of financial markets more generally.
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.
It is clear that with Chairman Bush, CEO Bernanke at the helm, excellently supported by Hank Paulson, head of the Debt Division, FED is well placed to take advantage of the Distressed Debt markets. Profitability seems assured and risk has been prudently cut.
With a business model designed to allow lending of assets and cash in exchange for illiquid and unwanted lower grade debt as collateral, FED has cornered short to medium term lending. Charging rates between 2-3%, coupled with guarantees of reverse swapation and income streams from various Managed Conduit Funds, FED dominates the market.
The Collection Agency rates FED as a Strong Buy.