When asked what represented the greatest challenge for a statesman, British Prime Minister Harold Macmillan responded in his typically languid fashion, "Events, my dear boy, events."
I wonder if any of the Fed Committee members recalled that quote during the video-conference held the day before the announcement of the "new" Term Securities Lending Facility (TSLF). It seems events are occurring at a faster pace than the Fed anticipated, causing more emergency plans to be put into operation.
One of the quirks of investing and trading is that news becomes old hat or familiar in a short space of time and actions that were seen as emergency responses become accepted after a few days or weeks. Not that surprising I suppose when the emergency is among the Banks and Institutions required to make the monetary system work.
After an increase in the size and frequency of repos, including the introduction of two 14 day rolling repos and discount rate cuts; the next crisis was met with the introduction of large cuts to the Fed Funds Rate and the introduction of Term Auction Facilities (TAF) and dollar lending facilities to other Central Banks. Then this week, after further rate cuts, the Fed enlarges the TAF, increases the dollar lending and introduces TSLF.
So here we are, 8 months since the sub-prime implosion morphed into a credit market crunch that ate Bank capital reserves at a phenomenal rate and the Fed launches another lifeboat from stricken USS Irresponsible Lender. Only this time there is no pretence of rescuing the passengers on the stricken liner, this lifeboat is exclusively for the Bankers, the crew of the USS Irresponsible Lender.
Let us first look at the new lifeboat, the TSLF. Here is the Fed statement on the matter:
"The Federal Reserve has announced that the Open Market Trading Desk ("Desk") will expand its securities lending program and initiate a Term Securities Lending Facility ("TSLF"). Under the TSLF, the Desk will lend up to $200 billion of Treasury securities held by the System Open Market Account to primary dealers secured for a term of 28 days by a pledge of other collateral. The Desk's current overnight Securities Lending operation will continue with no changes to program terms.
Weekly TSLF auctions will alternate collateral schedules resulting in a bi-weekly cycle for each pool of eligible collateral. In the first auction, the Desk will arrange an auction for a loan of Treasury securities against a pledge of all collateral currently eligible for repurchase transactions currently arranged by the Desk. In the second auction, the Desk will auction Treasury collateral for loan against a pledge of AAA/Aaa-rated private-label residential MBS not on review for downgrade, as well as collateral currently eligible for Desk repurchase transactions. Loans and collateral will be exchanged free of payment between securities accounts at the dealer's designated clearing bank. Loans will settle on a T+1 basis.
Each TSLF auction will be for a fixed amount announced ahead of the auctions. The first auction is scheduled for March 27, 2008, at 2:00 p.m. Eastern Time and results will be posted to the Federal Reserve Bank of New York shortly after the auction close.
The TSLF will be a single-price auction, where accepted dealer bids will be awarded at the same fee rate, which shall be the lowest fee rate at which bids were accepted. Dealers may submit two bids for the basket of eligible Treasury general collateral announced at each auction. At the TSLF auction, each dealer aggregate award and each individual bid will be limited to no more than 20 percent of the offering amount.
The Desk will consult with the primary dealers on technical design features of the TSLF in the coming days and specific auction details may be adjusted based on these conversations, experience in the initial auctions and market conditions." (My emphasis).
Primary dealers (PD) get treasuries in exchange for other types of bonds they cannot use due to current credit market conditions.
There is however another factor that was pretty much ignored in the most recent developments. The Fed introduced a series of Permanent Open Market Operations, selling treasuries to PDs. So far there have been 2 POMO's (double the number for the whole of 2007), the first for $10bn and the latest for $15Bn. These are cash transactions; the Fed received $25Bn in cash and gave out Treasuries from the System Open Market Account (SOMA).
There can be little doubt that the current crisis is centered on the PDs and is directly related to a lack of usable collateral to enable PD borrowing to take place. That is, no one is willing to lend if the collateral is not AAA government debt. The Fed is attempting to relight lending by swapping usable collateral (treasuries) for other AAA/Aaa debt that is not at risk of downgrade.
If the Fed allowed free market forces to operate then the PDs would have to buy treasuries from the market to possess the collateral required to borrow. This is clearly beyond their ability as the losses realized from selling low and buying high would obliterate their balance sheets. The Fed has decided to meet the Bankers margin call.
You may ask "why didn't the PDs just buy the treasuries from the Fed?" A fine question that deserves a simple, observational answer.
The Fed has conducted two 1 month TOMOs in recent days, lending out cash and taking mortgage backed collateral in exchange. The amount lent out is $30Bn. So to raise the cash to buy the treasuries from the POMO, the PDs borrowed from the TOMO. What does that tell us?
Quite simply the PDs have no cash reserves. They are bankrupt. When I mentioned in the recent Weekly Reports that the Fed had temporarily nationalized the Banks/Brokers, this is what I meant. The Fed is allowing PD assets to be moved off the balance sheet and into a new investment vehicle. The only difficulty is how do you make the make the words "Federal Reserve" and "Structured Investment Vehicles" into a new acronym?
Right now the PDs are purely a front, emperors without clothes. Ben Bernanke is literally behind the curtain, pulling the levers. The problem for the Bernanke is the lack of levers, the SOMA is a finite resource, which I estimate to have $600Bn (ish) of usable collateral available. After using that resource the Fed would either have to buy newly issued treasuries from the US Government or issue its own bonds. That would mean either the printing of new dollars to buy the treasuries or the invention of a new dollar derivative to use in the credit markets. Either choice has inherent risks to the dollars worth. Other new initiatives may well be viewed as panic moves, the goodwill of market participants may have been eroded to zero on this latest "boost" in the stock markets.
Why did stocks go up? Maybe the Hedge Funds stopped getting pressurized on their leverage and margin, allowing them to buy. If it is down to such a tenuous reason then the rally will last until the next squeeze on the lenders capital. Maybe I'm wrong, maybe it was just seen as a good buying opportunity by one and all.
None of these measures help Corporate America or the US public other than to allow the continuation of further debt accumulation, hence Bernanke floating ideas such as debt relief on mortgages. I await his solution for Corporate America with baited breath.
The yield curve tells a story that things are not different. Click on the image below to see what the yield curve did at the beginning of the decade through to the current day. Press animate on the lower menu to start.
With thanks to Stockcharts.com
Take a snapshot of the curve toward the '01'02 divide and compare it to current conditions. You can see how long it took after late'01 for stocks to eventually bottom. Remember, post 9/11 the Fed was extremely active, especially helping the Banking/Broker sector recover. Maybe it's NOT different this time, maybe the reality is that long end rates have gone as low as they will?
This is central to the future prosperity of the US. With the Fed pushing treasuries into the market place, prices are now more likely to fall, causing yields to rise. Fed rate cuts are only affecting the short (duration) end by steepening the curve, allowing a borrow short to lend long trade - just like the strategy used in the Commercial Paper markets prior to the credit crisis.
Whilst such a mechanism might help the Banks etc, it will force rates higher on loans, credit cards and mortgages. It will also require higher yields on corporate debt. Here is the rub, to recharge the reserves of the Banks; the money has to come from outside of the banking system. That means higher costs to the public and Corporate America. That means a domestic US deflation as the money supply is reduced.
For consumers that has already begun:
Even with rising CPI - including energy and food, the consumer is now spending less on a y-o-y basis.
For Corporate America you can see the problem:
Notice the beginnings of a move higher for both Aaa and Baa debt even after the new premium built in by the fall in treasury rates.
Thus we are left with 2 possibilities for events further ahead.
If the measures taken by the Fed are long term (and I cannot see how they can be viewed any other way for them to be effective) then rates will rise as treasuries flood into the market and the dollar suffers further devaluation. This will stifle new lending and causing an increase in default on current lending. It should not be forgotten that if paper, other than treasuries, is no longer acceptable collateral to facilitate lending then the credit markets will remain frozen for everyone other than those with treasury holdings.
The US (and World) financial system is reliant on credit to enable production, where borrowings are used to increase productivity returns beyond the capital borrowed and the cost of servicing the debt. It is when an expansion plan fails that debt has to be rolled over by Corporations.
Eventually the cost of the increasing burden of servicing debt coupled with a false measure of productivity meets an event, the inability to roll debt forward due to a lack of lenders. At this point the Corporation defaults. Corporations with strong cash reserves and low/no borrowing will survive, employing their savings (cash reserves) to expand productivity.
The consumer has already reached the event moment. The consumer's productivity is rewarded by wages. If however assets are bought using debt and the future payment of that debt is reliant on asset appreciation, then the risk of asset depreciation requires even higher productivity from the consumer or further lending to push out the timescale to allow the appreciation to occur.
If we discount the ability for many to borrow then the only recourse is to earn more and either service a higher percentage of the debt (increase payments) or save until the asset price is met. If consumers are in unproductive jobs then the expansion of wages is unlikely, indeed the risk will be a curtailment of employment. Both situations result in a deflation of the amount of money circulating an economy.
Both the consumer (public) and Corporations will survive albeit without some current participants. The debt will have been cleansed and true savings and investment will allow the purchase of assets and proper investment. The only downside is the loss of revenue for the Bank/Broker sector, whose survivors will return to more stringent and traditional methods of banking.
If the Fed plan fails and credit markets become even more chaotic then the disruption will spread to all sectors of the global economy.
How can the Fed plan fail? The risk is with the dollar. If the action taken by Bernanke is seen as a massive dilution of the strength of the dollar then it and its derivatives will all fall in price, regardless of any concerted cooperation by Central Banks.
If the markets believe the treasuries constantly introduced into the market are being used to shore up massive losing positions then the risk of default will increase. This will cause a fall in the price, placing the PDs with a further tranche of "sold low, buyback high" assets. With a lower pricing on dollar derivatives, the dollar will suffer the same fate as underlying loans have in MBS derivatives. The mechanism is the same.
With the Fed placing itself in a position were it holds lower worth assets than the treasuries it issued, the risk of a default by a PD becomes a risk to the Fed. In default the PD will have to hand over the treasuries used as collateral, leaving the Fed no better off than an SIV stuffed full of toxic debt that is unable to raise funds in commercial paper markets. The risk would be a loss of confidence with the Fed as an Institution.
The question posed is would the Fed allow treasuries lent out to PDs to be taken by creditors in the event of a default?
