Thursday, August 16, 2007

Fear leads to suffering

I have argued strongly in this space for a Fed cut the last few days. Looking at trading activity the last several days, the Fed had in fact moved their target rate to 5.00%. So, at least temporarily, the Fed has in fact cut rates. Today it seems that trading has resumed at 5.25%.

I've received a fair number of comments arguing against the Fed cut. They have almost all been quality comments with what seem like reasoned positions. Some of the comments, however, seem to misunderstand either the case I'm making for Fed intervention or what the effects of a Fed easing might be for financial markets. So I thought I'd take a little time to clarify my view in the form of a Q&A.

1) When you say the market is highly illiquid, what does that mean exactly?

Right now its impossible to trade large numbers of bonds. I'm not talking about housing related stuff. I mean its impossible to trade many plain vanilla bonds. Those you can trade have become much more expensive to trade, because the bid/ask is wider.

For anything housing related, forget it. There are no bids.

2) Why should I care about illiquidity?

The problem comes in where good bonds cannot be sold at any price. Read that last sentence carefully. It isn't the Fed's problem if risk spreads widen. It isn't the Fed's problem if bonds default. It isn't the Fed's problem if banks make bad loans. It is a problem if good bonds cannot be sold at any price.

If a bank has underwritten a series of fixed-rate, fully documented, first lien, prime jumbo mortgages but cannot sell them into the bond market, then they have to keep the loans on their balance sheet. That takes up capital that would otherwise be used for other loans. Basically the jumbo mortgage market grinds to a complete standstill.

3) But the conforming limit is $417,000! Why should we care about bailing out these fat cat home owners? They were stupid enough to buy into a bubble market! Why not just let the price of homes fall and solve the problem that way?

First of all, middle-class homes in many large metropolitan areas, particularly on the East Coast and California, are north of $500,000. So jumbo loans are not just for the rich.

Second, the "let the price fall" idea is fine and good, but there still needs to be a functioning market in order for that solution to work. For example, let's say I bought my house for $700,000 last year. Let's assume that price was too high, merely the result of a housing bubble in my area. But what should the house really be worth? We can't know unless the market is allowed to function. Maybe $650,000. Maybe $600,000. Maybe $400,000. If no one can get a mortgage against the property, then I can't sell the house at all.

The corollary to the tech bubble would be to conclude that everyone who bought Yahoo stock in 1999 were idiots. We should therefore shut down the NASDAQ entirely. Don't allow those greedy tech stock buyers to sell their stock at a loss. Don't allow them to trade it at all. Does that make any sense?

4) (Actual comment from Darth Toll who wins the "Best Screen name" award for 2007, in response to me comparing the market to an irrational bank run)

Are you trying to say that there is no logical basis for this fear, kind of like a "the only thing we have to fear is fear itself" thing?

The fear surrounding sub-prime securities is well founded, obviously. The fear surrounding homebuilders is well founded. The fear surrounding prime mortgages with full income documentation and 20% cash down payments is unfounded. Well, maybe not completely unfounded. Maybe those bonds should trade wider than they have in the past because the likely recovery rate is a bit lower (due to weak HPA) than history. But for there to be absolutely no liquidity? Untradable at any price? The housing market just isn't that bad people. Not every mortgage underwritten in 2007 is going to default. It really is time to separate legitimate fears from pure paranoia.

5) Why should the Fed cut rates to bail out sub-prime lenders/homebuilders/hedge funds? If they made bad loans, why shouldn't they just go bankrupt? Banks should learn a lesson about making bad loans.

The Fed injecting liquidity won't do a damn thing to help hedge funds and/or financial institutions suffering real losses from bad loans. New Century is bankrupt and they are staying bankrupt. BSAM's funds are worthless and they are staying worthless.

Nothing the Fed is going to do will make delinquent borrowers current again. Maybe lowering interest rates will prevent a small number of defaults because resets will be lower, but all of these NINA and liar loans are going to go bad no matter what. I mean, there are loans that go bad and there are just bad loans. No one is going to save banks that made too many bad loans.

But say there is a prime mortgage originator who borrows short-term to underwrite their loans? Now they cannot securitize their prime jumbo loans, and therefore cannot repay their short-term facility. Do we want to drive institutions like this bankrupt merely because the market fears all mortgages? What "lesson" is that teaching and to whom?

6) Easing policy now is too risky. The Fed will just create another bubble, basically delaying the ultimate pain. Why not just take our lumps now and get on with it?

This is a very fair question, and a tough one to counter. I keep thinking back to 1998, which as I've written has a lot of parallels to today. In July 1998, the Fed had a tightening bias. In September they cut 25 bps. In October they cut another 25bps intra meeting, then cut again at the November meeting. By spring the LTCM crisis had largely passed, and credit spreads
had mostly recovered. In June 1999 they were hiking again.

Some say the Fed exacerbated the tech bubble by cutting in 1998. I disagree. As evidence I look at credit spreads, which widened substantially in the Fall of 1998 and never got close to pre-LTCM levels until 2004. It wasn't easy money in the debt markets that allowed the tech bubble to continue. Now we will never know whether they Fed could have engineered a better outcome during the tech bubble had they taking an alternative approach. So it might be fun to debate, but I think we can agree there will never be a real "answer."

While we're on the subject of Long-Term Capital Management, that "bail out" that the Fed engineered was only a real bail out of the financial system, not a bail out of the fund. The fund shareholders were wiped out. The bail out really only prevented contagion as well as protecting the creditors from suffering through a liquidity crunch as they all tried to beat each other to the door.

Please feel free to comment.

48 comments:

hans said...

Surely quality housing-related bonds are worth something. Why not bid a very low price to counter the increased risk? No matter how fearful everyone is, it's not like all mortgages (and mortgage-backed securities) in the US are going to fail. Hold them until they mature, and you don't need to care that much about liquidity before maturity, right?

(then again, I'm just a retail investor, so what do I know)

Flow5 said...
This comment has been removed by the author.
Flow5 said...

Percent change at seasonally adjusted annual rates:

M1 M2
3 Months from Apr. 2007 TO July 2007: -3.00 3.5

6 Months from Jan. 2007 TO July 2007: -0.5 5.5

12 Months from July 2006 TO July 2007: -0.3 6.1

An average of 3.5% annual rate of change is required for stable growth.

Flow5 said...

The importance of Vt in formulating – or appraising monetary policy derives from the obvious fact that it is not the volume of money which determines prices and inflation rates, but rather the volume of monetary flows (MVt) relative to the volume of goods and services offered in exchange.

The most important single factor contributing to the increased rate of money turnover probably was those structural changes which made virtually all time deposits the equivalent of low velocity demand deposits.

High interest rates and expectations of higher prices have been both cause and effect of rising rates of Vt.

Illiquidity is recessionary. It is evidence of a fall in the velocity of our means-of-payment money.

psychodave said...

Today it seems that trading has resumed at 5.25%. [tddg]

1) Huh?

http://www.newyorkfed.org/markets/.
./omo/dmm/temp.cfm

shows a $12bln 1-day Repo at 9:40am with majority of securities at Stop Out of 5.07% and Weighted Avg at 5.104%

Please help by explaining to an innocent bystander.

2) When this position closes (matures in 1 day) doesn't the money (today's fully collateralized loan plus repo rate) get "drained" from reserves? I.e., isn't this net contractive, not expansive, to the reserves?

With your help a civilian could come to understand Open Market Desk operations.

Anonymous said...

The problem comes in where good bonds cannot be sold at any price. Read that last sentence carefully. It isn't the Fed's problem if risk spreads widen. It isn't the Fed's problem if bonds default. It isn't the Fed's problem if banks make bad loans. It is a problem if good bonds cannot be sold at any price.

So it is a problem, but is it the Fed's problem? What is lowering rates going to do if the problem is in the spread? I don't know much about fixed-income trading (hence my reading this blog) but it seems to me that the Fed can't lower the rate of fear.

Anonymous said...

A fed related question: When the fed pumped cash into the market through repos, I understand that they were lending overnight with the fed taking mortgage-related ABS as collateral. My question is what value did the fed give to that bond collateral? 50 cents on the dollar? I guess what I'm asking is if the fed did any price discovery for the market with its repos.

Anonymous said...

"Let's just say we'd like to avoid any moral hazard entanglements."

Three points:

1. I'm surprised that a mortgage expert like you forgot about a basic "retail" financial engineering solution! Almost any prime jumbo mortgage borrower can do a first mortgage of $417,000 at 6.23% for a 30-yr, then a second jumbo (say, at 7.5%) for the remainder of the mortgage. The blended rate is higher than if the whole thing were a conforming one, but so what? The borrower is prime, but not exactly in need to GSE support for "affordable housing." There are already higher limits than $417K in places like Hawaii where a higher limit is needed.

2. Firms that can't securitize their mortgages can go back to being *real bankers*, where the 4 C's (character, collateral, capital and capacity) actually matter. There *are* still banks that do hold loans on their balance sheet. My portfolio has a large position in such a publicly traded regional bank, and it has held up very well during this downturn.

3. Credit dislocations are disorderly. In the coming weeks, plenty of money managers will be picking through the wreckage, buying your bonds that are "impossible to sell" at prices that *they* think are bargains.

psychodave said...

@anon 7:33 PM
Yes, they always do price discovery. In just the transaction I cited they received over $65bln in bids from their primary dealers, and accepted only $12bln.

[Federal Reserve Bulletin Nov. 1997 "Open Market Operations in the 1990s"]
"The offers set forth a rate and an amount of repurchase agreements hat the dealer ... is prepared to transact."
and, footnote 4:
"The price at which the Federal Reserve temporarily purchases the securities is that day's market price. This price and the rate quoted by the dealer determine the price at which the Federal Reserve resells the securities."

psychodave said...

@anon 7:33 PM
I left out that, in the transaction I cited, the majority of the securities accepted were MBS (mortgage-backed securities) from GSEs (gummint-sponsored enterprises).

The Open Market Desk received more offers with Treasuries as collateral than the total $12bln they accepted.

My indirect inference is that the Fed successfully communicated its willingness to make a short term loan at reasonable rate on the highest quality issues of a beleaguered sector of the Fixed Income Market.

Anonymous said...

"5) Easing policy now is too risky. The Fed will just create another bubble, basically delaying the ultimate pain. Why not just take our lumps now and get on with it?"

Pretty answer to this, I think - a cut in the fed rate will not help the real economy in that the consumer and/or firms won't necessarily benefit. If we believe that lenders have re-priced risk, and the spreads on all kinds of asset classes seem to suggest that they have, a rate cut may not make any difference. Whereas before a 25 basis point cut in rates would have more or less resulted in a 25 basis point reduction in mortgage rates, corporate bond rates, etc. increasing demand for debt of all types, now a 25 basis point reduction in the fed rate still has consumers and businesses screwed relative to what they could have borrowed at as little as several weeks ago (and maybe worse if spreads continue their upward climb).

If that's the case, then all this fed lubrication (and/or an eventual rate cut) may do is shift the effect from a bank-led credit crisis/recession to a consumer-led consumption recession. To me it seems that that is probably what the fed wants anyway since bank-led credit crunches can immediately make an economy seize-up, whereas consumer-led recessions take time to play out and don't cause as much near-term pain.

Anonymous said...

How does a rate-cut lead to credit markets "un-siezing" (by way of causation not amorphous sentiment-lifting etc) is the part I don't get. Do debt buyers suddenly become risk-averse because of the cut?

Flow5 said...

Just while William Poole President of the "maverick" Federal Reserve Bank of St. Louis announced that inflation is still the overriding consideration, commercial paper fell 91b as of the week 8/15. This volume is lower than the figure reported previously on 6/20. (2 years ago that figure was 158b) The commercial paper segment of the money supply is all of the sudden headed south.
http://www.federalreserve.gov/releases/cp/outstandings.htm

Flow5 said...

bjihuCommercial paper (CP) is a unsecured promissory note. CP has a fixed maturity (typically 30 days). CP can be discounted from face value or interest-bearing. Ordinarily CP is issued by large companies, having back-up lines of credit, supported by high credit ratings.

Its dollar volume is the 2nd largest of any money market instrument (second to U.S. government securities). It is used for short term working capital. It is similar to a line of credit but less expensive to float/issue. Due to CPs short maturities, issuers must continually refinance (roll-over) a significant amount of maturing paper.

The liquidity crisis is making it expensive and hard to roll-over maturing obligations (unavailable, inaccessible, inconvertibility). Some firms are using credit-enhancements, (1) letters of credit (LOC), (2) asset-backed pledges, and (3) revolving credit (variable payments) etc., as defenses.

Commercial paper is a barometer for the immediate economic outlook. Because of its short maturity, commercial paper is exempt from SEC regulations, i.e., their 270 days guideline...

The volume of commercial paper outstanding was previously included in the definition of the M3 money supply figure. However only commercial bank financed paper was correctly reported/included in M3.

The current fall in the volume of commercial paper reflects both illiquidity and an upcoming contraction in gdp. It represents a decline in the supply of money as well as a decline in the velocity of money – a doppelganger.

Series: WCPF1M, 1-Month AA Financial Commercial Paper Rate

http://research.stlouisfed.org/fred2/

use custom range 2007-01-01 - present

Anonymous said...

1) I have always felt the Fed's big mistake was not raising rates much more quickly post 2002---those endless 25 bp raises just took too long from too low a level. I remember saying they should just move to 4% from 1% and get it over with.

2)Flow5's discussion of CP is critical and the issue will be receiving more attention. There are significant numbers of managers who are switching cash holding from CP backed MM funds to treasury/agency funds. I am not sure if that cascades out of control too or not....

Anonymous said...

I-N-D-E-P-E-N-D-E-N-T

S-A-V-I-N-G-S

Anonymous said...

Accrued Interest,

I really appreciate your blog, but I really disagree with this post.

You, like many others, say, "let's help assets that are fine regain liquidity."

By saying jumbo prime MBS is "fine", you are making assumptions about default rates, severities, CA unemployment rates, etc. Who's supposed to make these assumptions? The market. And the market says they are not fine.

The market is a discounting mechanism. Sometimes you disagree with its message. I disagreed strongly when the market said you can pile on leverage and sell volatility with abandon. Now you disagree with its message that there are consequences to this leverage.

The difference is when the market disagreed with me, the Fed did nothing about it. When the market disagrees with you, the Fed is repo'ing ABCP. This puts the Fed squarely on one side of the trade.

When the government is always on one side of the trade, we call that manipulation.

David Pearson

TDDG said...

I want to try to reply to every point here if I can.

Hans: "Why not bid a very low price to counter the increased risk?"

Great idea, but no one is doing it. What we need is some liquidity while we're waiting for the market to develop a bid for this paper.

Psychodave: Fed Funds is currently trading at 5.25% which is equal to their target. There were trades Wednesday and even Thursday at 5.00% but it isn't as consistent as it was on Tuesday.

In theory "temporary" open market activity only add to reserves for the repo term, so perhaps as short as 1 day. But in practice, the Fed adds reserves through "temporary" injections almost every day.

Anonymous said...

This point has been made by others, but I'm sorry, I refuse to believe that housing-related bonds cannot be sold *for any price*.

I am happy to believe that they cannot be sold *for a price the vendor wants*.

You may not like a price of ten cents on the dollar for mortgage-backed securities , but I'm sure you can find buyers at that price ... if you can convince buyers they are not buying toxic waste.

TDDG said...

Anon #1: "So it is a problem, but is it the Fed's problem? What is lowering rates going to do if the problem is in the spread?"

The problem isn't the spread, because there is no trading at all. If there were merely a higher risk premium applied to MBS, the system could deal with that.

Anon #2: "I understand that they were lending overnight with the fed taking mortgage-related ABS as collateral. My question is what value did the fed give to that bond collateral? 50 cents on the dollar?"

My understanding is that they accepted agency-backed MBS as collateral. So there is no default risk. Generally in a repo transaction (not with the Fed but with a broker) you don't need to value the underlying. If the underlying is risky, they either just won't accept it or they alter the haircut.

The media is misreporting what a repo transaction really is. Although technically, a Fed repo involves the Fed "buying" a bond from a bank, the Fed has also agreed to sell it back at a pre-determined price on a pre-determined day (usually the next day). The pre-determined price is, in effect, an interest rate charged. So its really a very short-term securitized loan.

TDDG said...

Anon:

"Let's just say we'd like to avoid any moral hazard entanglements."

Well, that's the real trick isn't it?

On the jumbo thing, that's fine if there is a market for the second. Which there isn't.

On the "go back to being real banks" idea, that's fine too, but banks aren't currently capitalized to act this way.

As far as PM's picking through the wreckage, I totally agree.

All we need is the Fed to provide a little liquidity, giving the free market just a bit of time to work this out.

TDDG said...

Anon: "If that's the case, then all this fed lubrication (and/or an eventual rate cut) may do is shift the effect from a bank-led credit crisis/recession to a consumer-led consumption recession."

I think this is a great reponse and I wish I had written it myself. Fed easing now isn't going to prevent serious economic pain. But it may shift the pain from something very dangerous (banks collapsing) to something more easily digested (weak consumer spending).

TDDG said...

Anon #18 (or whatever... why don't you people post your damn names?)

"How does a rate-cut lead to credit markets "un-siezing" (by way of causation not amorphous sentiment-lifting etc) is the part I don't get. Do debt buyers suddenly become risk-averse because of the cut?"

If the Fed keeps allowing agency MBS to be posted as collateral for repos, then any mortgage originator who has agency MBS in their portfolio can get cash to maintain their balance sheet. If the market knows this avenue is available, traders are forced to put a lower probability of bankruptcy on someone like Countrywide. In turn, this should eventually allow CFC to access more normal channels of capital, like CP, which is currently unavailable to them.

TDDG said...

Flow5:

The Fed just cut the Discount Rate and sounds wide open to proving more liquidity if needed. So I think their actions are speaking louder than their words.

On the CP issue, this is exactly what I'm getting at. We can't have it where solid financial institutions can't access the CP market "just because." I mean, we need some outlet, and I think the Fed's repo activities are potentially that outlet. Consider that if an industrial company has a CP program which gets shut down, they invariably take down a bank credit line. But that means the banks need to fund the credit line. Someone someplace has to step up and provide the liquidity, even if only for a short while.

TDDG said...

Anon #456:

"I have always felt the Fed's big mistake was not raising rates much more quickly post 2002---those endless 25 bp raises just took too long from too low a level. I remember saying they should just move to 4% from 1% and get it over with."

I think the Fed was worried about tripping up all the cash and carry programs (which they created with 1% FF anyway). I think in hindsight it was the 1% FF that was the mistake. But given that, I think they could have gotten away with some 50bps hikes in there and cut the time to move from 1% to 5.25% by 1/3.

TDDG said...

David:

"By saying jumbo prime MBS is "fine", you are making assumptions about default rates, severities, CA unemployment rates, etc. Who's supposed to make these assumptions? The market. And the market says they are not fine. "

If these bonds aren't fine, then give me the right price. Right now there is no price. That's the problem. The market could work with ANY price, but it can't work with no price at all.

"The market is a discounting mechanism."

OK, but right now its discounting zero cash flow on a security that will obviously have cash flows. You can't reconcile that.

Look, I'm as big a free market guy as anyone, but I believe the Fed has a role as lender of last resort. I think those arguing that the Fed shouldn't perform this role should consider the U.S. economy in the 1930's and the Japanese economy of the 1990's.

I don't believe the Fed is accepting ABCP. If I'm wrong, I'm wrong, but I can't find any reference to this.

Anonymous said...

Fed funds still trading below 5.25%:

http://www.newyorkfed.org/markets/omo/dmm/fedfundsdata.cfm

4.97% as of August 16.

The systematic risk right now is in investor losses which, quite frankly, doesn't bother me at all. If there is a guy making $300,000 a year fresh out of school and "hooked" into the firm and he is not catching bids on the bond desk, then fire his ass and send him home. Maybe we will see "financial" day laborers being scooped up on Wall Street whenevr there is work.
If the problem is caused by a temporary lack of liquidity then a easing of rates will help. But that is not the case. It is being caused by a "de-rating" of asset quality and no amount of Fed easing will help.

TDDG said...

Anon #1MM:

You can refuse to believe it if you want. I don't know what to tell you.

Flow5 said...

If the 12 discount windows are properly administered, advances would only be made to meet emergency outflows of funds from the applicant banks. Advances by the reserve banks would be closely monitored to prevent the use of these funds for profit, that is, to finance an expansion of thee applicant bank’s earning assets. If legal reserves acquired through advances are used to finance bank credit expansion, then the fed is allowing the depository institutions to usurp a power that should be the exclusive province of the central bank.

For many years (before George Mitchell & some others) it was understood that discounting was a privilege, not a right. Banks should not borrow from the central bank except in an emergency. And an emergency does not extend to helping a banker meet obligations under lines of credit. Under this system bankers know they have to hold sufficient liquid assets to meet such contingencies, or meet their obligations through their “managed liabilities.” As it is, bankers can borrow to meet “seasonal needs.” Today, discount rules and administration are so lax, that borrowed funds can be resold in the federal fund’s market. By providing virtually free access to the discount window, the Fed relinquishes its power to control money creation.

It should be emphasized that one dollar of borrowed reserves provides the same legal-economic base for the expansion of money as one dollar of non-borrowed reserves. The fact that advances have to be repaid in one month or less is immaterial. A new advance can be obtained, or an old advance extended, or the borrowing bank replaced by other borrowing banks. The importance of controlling borrowed reserves is indicated by an excessive volume of free legal reserves/discounting.

Under proper conditions and surveillance, the increased volume of discounting can be easily offset by concurrent open market sales or through a smaller volume of purchases than would otherwise have been made. Discount window administration is necessarily concerned with the emergency needs of specific banks. Applications for secondary credit to meet short-term liquidity needs or to resolve challenging financial circumstances should be given priority. In this way the illiquidity needs of the problem banks can be addressed before they balloon.

In contrast, the FRBNY’s “trading desk” deals with a network of 21 established primary dealers which participate in the Fed’s open market operations and submit bids or offers as well as trade using the automated U.S.Treasury securities auction system when bonds, bills, & notes are originally sold. It follows that “primary dealers must be in compliance with Tier I and Tier II capital standards under the Basel Capital Accord, with at least $100 million of Tier I capital” and thus by observance are not encountering the same kind liquidity problems experienced . Instead the primary security dealers are reaping a windfall. A responsible central banking policy will not permit the determination of the volume of legal reserves of depository institutions to be dictated, even in a small way, by the profit proclivities of commercial bankers.

Dave M. said...

tddg said..." It wasn't easy money in the debt markets that allowed the tech bubble to continue. Now we will never know whether they Fed could have engineered a better outcome during the tech bubble had they taking an alternative approach.""

I kept hoping that the Fed would increase margin requirements for investors. As it turned out the brokerages did their job for them when they made many dot-com stocks unmarginable. IMO, Greenspan should have done it for the entire stock market, as i think that would have killed a lot of the speculation.

Anonymous said...

As ugly as the markets are, the behind the scenes situation is even uglier.

My daughter is a financial risk consultant with the consulting arm of one of the top accounting firms. Yesterday she received a call to get to GS as quickly as possible...it seem the derivatives settlement process is in danger of coming unglued.

Since most of these are poorly documented private contracts with counterparties, there are $billions at stake where they don't know the counterparty or if the CP is even still in business. This has made it impossible to ascertain their existing positions because so many of the "sells" in the last couple of months have not been settled, but are in limbo.

The NY Fed has been warning of this situation for the past several months...it seems like it is here in real life. My daughter has been told to expect to be at GS through the end of the year...the mess is HUGE.

Re the FOMC move, only depository institutions, thrifts, banks, etc. are allowed to borrow at the discount window; loans now good for 30 days.

David Pearson said...

The London Telegraph reported "sources" saying that the Fed "quietly" began accepting ABCP repo's.

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/08/17/cnfed117.xml

The spirit of the repo facility is to provide ready access to liquidity where counterparty risk is an issue. As such, the repo's are supposed to use liquid, safe, easy-to-value instruments. One can easily argue that the ABCP does not fit the bill. Obviously, the Fed's actions ooze with moral hazard.

DAB said...

"Anon #18 (or whatever... why don't you people post your damn names?)"

Advice taken (though I was not any of the anon's on this thread. For full disclosure, I am the electricity trader and have been a curmudgeon against rate cuts and the debt and for the dollar). :-)

Anyway, the recent anon post of the dude's daughter straightening out counterparty risk got me thinking. To what extent does this crisis result from operational risk concerns? For example, in Florida the creditor can not simply foreclose on a mortgagee in arrears, and in some cases it is impossible to even determine the legal standing of creditors when a mortgage has changed hands. Does that then tie up the liquidity of the MBS, separately from whether it can catch a bid in the market, in which that mortgage is packaged or can that one be hived out (assuming anyone can even figure out it is in there...)?

Basically, to what extent has Basel II failed to mitigate this crisis, or is this an issue for Basel III?

It was pretty obvious at GARP this year that nobody outside possibly the most robust and sophisticated five or so banks in the world really had a good handle on implementation of Basel II’s Operational Risk requirements. Maybe this is the crisis that gets that straightened out (stipulating that it is a crisis, which in general I am not prepared to do)?

Flow5 said...

By lowering the discount rate to 5 3/4% the Fed expanded the collateral accepted and provided more competitive rates with its discount window advances (as opposed to using open market operations to purchase Treasury, agency, & mortgage-backed securities):

DISCOUNT WINDOW COLLATERAL ACCEPTED
http://www.frbdiscountwindow.org/frscollateralguide.cfm?hdrID=21&dtlID=81

TDDG said...
This comment has been removed by the author.
TDDG said...

I talked to two banks and Fannie Mae, and they are saying you cannot use ABSCP as repo collateral with the Fed. You can use it as collateral at the discount window. But I understand that's been the case for a long time. You can use Baa-rated corps also.

I'm inclined to agree with Flow 5 that the discount window isn't really being used the way it once was. It used to be said that if a bank came to the discount window on Monday, expect the FDIC to be at their hedquarters on Tuesday.

TDDG said...

BTW, my bank sources are not people who deal directly with the Fed or anything, so I won't swear they know for a fact that the Fed isn't accepting CP repo.

Bear in mind that for someone to use CP as repo, they have to be the lender not the borrower. In otherwords, they aren't the issuer of CP, they are the one who bought the CP. That's an important distinction. Banks that used ABSCP to fund CDO programs or mortgage warehouses are not the ones who'd get to use them for repo, even if the rumor is correct.

TDDG said...

As to Anon's daughter going into Goldmand Sachs, its an interesting story. I'd suspect with several hedge funds and mortgage originators failing that the big dealers are going to have to do a lot of work to figure out their counterparty situation. Don't forget about REFCO failing, though. That kind of thing can be worked out.

TDDG said...

One more point on CP as collateral. In theory, if the repo collateral fails (e.g., the ABSCP defaults), that doesn't eliminate the repo borrower's obligations. So really if Bank of America pledges ABSCP for collateral, and the CP went into default, BofA would still owe the Fed when the term is up. Only if the CP becomes worthless AND BofA is insolvent is the Fed at risk of losing money.

David Pearson said...

TDDG:

You imply that depositories have downside risk from going to the discount window ("they'll be there on Tuesday").

True in normal circumstances, when one or another bank may be guilty of fraud or mismanagement, but not now. Imagine the news if the Fed sends out those examiners: it would put us back into a situation of illiquidity. It would create a run on that bank's deposits. It would in short create the situation that access to the discount window is supposed to avoid.

The Fed is hostage to the market's addiction to liquidity.

TDDG said...

I'm saying it USED to be viewed that way. Not no mo'.

http://blogs.wsj.com/economics/2007/08/17/using-discount-window-is-sign-of-strength-fed-says/

knzn said...

"It isn't the Fed's problem if risk spreads widen."

I think you understate the case. If the Fed is trying to run a "mildly tight" policy, and risk spreads widen, rendering credit "moderately tight", then the Fed needs to cut rates in order to continue its "mildly tight" policy.

Anonymous said...

TDDG said: "I talked to two banks and Fannie Mae, and they are saying you cannot use ABSCP as repo collateral with the Fed. You can use it as collateral at the discount window. But I understand that's been the case for a long time. You can use Baa-rated corps also."

A bank treasurer confirmed this for me, but noted that the amount of collateral that has to be pledged is variable: you may get $0.50 for each dollar collateral. While this is better than being in a "locked" market with no bids, it is hardly "opening the floodgates of liquidity."

Also, the L.A. Times reported an old-fashioned bank run at Countrywide Bank, which has $107 B in assets. Parent CFC does about $40 B a month in mortgages.

CFC execs declined to comment on the effects of CFC Bank's heavy withdrawals might have.

My take would be that CFC Bank is a small part of the overall operation. However, is it the only part that can borrow at the Fed discount window? Is there a mechanism to get money from CFC Bank to the parent to get all the loans in the pipeline funded?

TDDG said...

KNZN: I agree with you on credit spreads, that's a good point. BTW, I liked your piece on the Greenspan Put.

Would you say that the Fed was frustrated by continually tight credit spreads as they were tightening policy in 2004-2005?

On Countrywide Bank, the analyst at MER thought they would try to move the majority of their operations under the bank umbrella. They can indeed borrow from the window.

Mikey said...

Raising the conforming loan limit is just raising the subsidy.

I have trouble buying into the concept that a subsidy or an increase in the subsidy is for the benefit of the buyer. When has that ever been the case? It mainly benefits the seller. It's the sellers out there screaming for this.

If they said, "not enough people are going to Mets games," and said, "OK, so we'll give everyone who goes $20 to offset the cost," yeah, more people will go, but who benefits from that and who would think prices would remain unchanged?

I just thought of a real example. When the tax credits for the Prius started falling, it was Toyota Motor doing the whining to bring them back. The seller.

knzn said...

“Would you say that the Fed was frustrated by continually tight credit spreads as they were tightening policy in 2004-2005?”

Well, they were vocally frustrated by the maturity spreads, so I imagine they were taking the credit spreads into account too. Historically, flat and inverted yield curves tend to lead widening credit spreads (at least for the junk bond spreads that I looked at). This time the lead turned out to be longer than usual. Somehow these things always seem to go on just long enough to convince the last skeptic that it might be different this time, and then finally Lucy lets go of the football yet again.

Flow5 said...
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Flow5 said...

Will rigor mortis set in?

There have been only 42 Bank & Thrift failures in the last 10 years. In the 10 years prior to 1997, there were 2,179 Bank & Thrift failures.

http://www2.fdic.gov/hsob/HSOBSummaryRpt.asp? BegYear=2007&EndYear=1979&State=1