Friday, December 14, 2007

Well, what would you like?

I've said it before. We've moved beyond "good" solutions to the mortgage crisis. There is no reasonable step which would prevent large scale mortgage foreclosures, or continued pressure on credit spreads and other risk prices.

However, we can prevent the problems in housing from spiraling out of control. We can do this by providing liquidity to the system, in whatever form is most effective. Ideally, the Fed would find a way to provide liquidity where its needed, but not where its not. In other words, find a way to throw cash into the problem areas of the financial system without creating any more inflation pressure than necessary.

That's exactly what the Fed is trying to do with this new Term Auction Facility. I think James Hamilton has it right, in that its nothing more than the discount window with another name and an uncertain interest rate. The idea is to give banks a temporary avenue for raising liquidity at a time when liquidity is dear. Its nothing that banks couldn't do through the discount window anyway, but without the stigma.

Is there something special about year-end? Take a look at this graph of 1-month LIBOR...

Notice what happens when the 30 day window ticks over year end?

Nouriel Roubini whose writing is always eloquent and bearish, makes the point that "you cannot use monetary policy to resolve credit and insolvency problems in the economy." Absolutely right. But you can use monetary policy to prevent fear from creating illiquidity, and the illiquidity creating bank failures. So perhaps Roubini and I would agree that the TAF won't help make subprime borrowers current on their loans. But it can help make sure that banks can deal with elevated levels of delinquency and foreclosure.

Steve Waldman calls this a bailout. And the way he's defined "bailout" I guess he's right. But to me that term is sensationalist and not meaningful in this context. All the Fed is doing is creating an alternate discount window with mostly the same terms as the original. The shock and horror that the Fed could take AAA-rated CDOs as collateral is misplaced. They could take the same collateral at the discount window. Those who are complaining about the collateral rules are suggesting that the new vehicle should have more stringent terms than the exiting vehicle.

Anyway, Waldman says it's a bailout because the Fed is offering loans that other banks wouldn't be willing to offer. Here again, any bank who went to the discount window would borrow under the same terms. Does the continued existence of the discount window constitute a bailout? Put another way, banks would never use the discount window if financing was available elsewhere at similar costs elsewhere. So any time a bank uses the discount window, it's a bailout by Waldman's definition. This is why I am loathe to use that term.

Now let's consider how a loan of this kind would work.

  • Bank gives collateral to the Fed.
  • Fed gives cash to the bank.
  • 28 days pass.
  • If the bank is still in business... Fed gives collateral back and bank pays cash back plus interest.
  • If bank is out of business, Fed keeps the collateral and prints money to make up the loss.

As Yves Smith puts it, it really doesn't matter if the collateral is an old couch so long as the bank remains in business. That's how repo works. The guy who pledged the collateral remains the one on the hook for any market value differential during the repo term. So while the Fed may be willing to take less-than-stellar collateral, the real risk to the Fed is that the borrower bank is out of business in 28 days.

Anyway, I'll leave you with one final thought. We know that there are many banks under stress. Some may wind up belly up. Some may just need a capital infusion. Some may have losses, but have plenty of capital. The problem is that its difficult for banks to know who falls into what category. So they are hesitant to lend to other banks period. Any bank with excess capital understandably doesn't want to risk it on banks strapped for cash. And in fact, banks who have taken on some losses but are fundamentally sound are finding it difficult to get short-term funding. What the Fed wants to avoid is fundamentally sound banks suffering from a lack of liquidity. I believe that's all the TAF is designed to address. Is it possible some bad banks will use the TAF and stick the Fed with bad bonds. Maybe, but the odds are low that a bank would go from apparently sound to bankrupt in 28 days. Could happen, but the odds are low.

And if the Fed has to take on losses on one bank to save 20 more, that's a trade Bernanke will do every time.


Deborah said...

When you have some of these CDO's priced as low as 11c on the dollar and the fed is giving 85c on the dollar, it is a bailout.

Anonymous said...

Bailout? A pejorative term to assuage the anger of the citizen who sees his/her irresponsibility in permitting this system to flourish exposed.

While things were good, and CEO's were getting hundreds of millions for just doing their job, I didn't hear talk of bailouts.

The banking system, which has been fundamentally corrupted, is in danger of collapsing. LIBOR is the thermometer in the banks' rectum. They have quite a fever now.

Too late to talk about bailouts.

Accrued Interest said...


My understanding is that banks can only pledge AAA-rated CDOs, most of which are still trading with 90 handles. I believe if a bank had a CDO currently rated AAA and was trading at 10c on the dollar then they could pledge it to the Fed.

Even the AAA ABX is trading in the 80's in most vintages.

flow5 said...

I don't know. How about: Discount Window (no one likes to lose money)

Discount rates are penalty rates:
Primary credit 4.75%
Secondary credit 5.25%

TAF auction rates circumvent (are lower) discount window rates? Would correspond to repo rates? Collateral is acceptable that wouldn't ordinarily be traded in the repo market.
The FOMC targets the federal funds rate, nominally the rate banks charge each other on overnight loans of deposits at the Fed. What in fact the NY Open market Desk sets each day is the one-day repo rate on Treasuries, that is, the one-day cost-of-carry on government bonds. This is the true policy instrument -- and it affects huge amounts of money (essentially, the one-day return on all government securities), while fed funds transactions daily, in comparison, are a trivial amount.

12/13/07 Repo stop-out rate = 4% (in effect, the Fed cut an additional .25%?)

TAF rate = auction rate? Foreign spillover/outlet will cut the Libor rate to lower mortgage arm adjustments? Conflicts with bank's margins/cost of funding?

Reduce Foreigner's risk aversion? Increase Foreigner's appetite for U.S. securities?

Decreases international interest rate pressure, but what about U.S. banks?

One of the weaknesses of the U.S. banking system is that it consists of too many banks instead of a few large banks.

Disintermediation for the CBs can only exist in a situation in which there is both a massive loss of faith in the credit of the banks and an inability on the part of the Federal Reserve to prevent bank credit contraction, as a consequence of it's depositor's withdrawals.

The Fed can rescue individual banks but it cannot rescue the system. Let's see bank mergers where possible intead of direct bailouts.

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

Is it at all conceivable that the auction rate turns out to be higher then the discount rate? In essence, it would mean that the price of anonymity becomes higher than the price of public stigma attached to the discount window right?

calvert said...

I don't understand why the only two possibilities at the end of 28 days are
1. Bank returns cash and gets collateral.
2. Bank is out of business and Fed keeps collateral.
What about
3. Bank is still in business but doesn't have the cash and in fact needs more.
Why is this not possible? Thanks.

Accrued Interest said...

Richie: I haven't read anything that would indicate what the rate will be. So I say there is no reason why the rate wouldn't be higher than the DR. That beind said, most of the blogosphere seems to be assuming the rate will be lower. Haven't seen a GOOD reason why they think this.

Calvert: They just roll over. Your 3rd scenario is no different than a company doing overnight fed funds and rolling it over day after day. That happens all the time.

Brian said...


You said, "Is it possible some bad banks will use the TAF and stick the Fed with bad bonds. Maybe, but the odds are low that a bank would go from apparently sound to bankrupt in 28 days. Could happen, but the odds are low."

Why do you think the odds are low? Not to pick on you, but a smart, savvy guy like you thought WaMu was OK a couple of months ago. Do you think a career bureaucrat at a regulator is going to see through the fog here and identify the next basket case before next weeks auction? I sure don't. If you were running a bank about to go under and this life raft were thrown in the water, wouldn't you swim like mad for it? Isn't this what Mozillo is doing with the FHLB?

Moreover, once the Fed gets involved, they are in effect an equity investor if things go south at the bank during the term of the repo as Calvert suggested in scenario 3. If the bank is tapped out at the repo maturity date, they are going to go to the Fed and say, "you can't call the loan now, you will put us under". By this point, all the other lenders to the bank will have headed for the hills and the Fed will be holding the bag. They will only call the loan if they think things are now "normal" and the system can take the hit of a failure with creating a panic.

The adverse selection of risk to the Fed in these auctions, given the state of the interbank market, will be enormous. This increment of liquidity, given the risks inherent, is clearly not being priced at a market rate. If you think the risks in these loans isn't high, ask yourself why the Fed is going through all this effort only to create a liquidity facility that will be opaque with respect to who the borrowers are.

Accrued Interest said...

Brian: Touche (a little) on WaMu. But even there, its been more than 28 days since I gave up on WaMu and they are still in business. In fact, they just convinced investors to part with $2.9 billion in exchange for a convertable preferred.

I'm not saying you can know for absolute certain which banks might be within 28 days of insolvency. I think that the Fed will trade funding a couple bad banks in exchange for making sure that all good banks get funded.

For example, I know of a medium sized bank which had a small SIV program. The SIV did nothing but fund accounts receivables for commercial customers, so in essense these were normal business loans. Of course, no one wants SIV CP no matter what the collateral so this bank is trying to figure some other way to fund their SIV. Currently they are using a combination of a back up line of credit and buying the CP themselves. They may take the whole thing on balance sheet, which they have room to do, but it would put their capital too close to their mins for comfort.

Ideally a bank like this would like to run off the SIV and make new loans of this type on balance sheet. Basically let the SIV slowly drift away.

But in order to do that, they need some time. I think the Fed would like to give them some time. And I think its banks like this which the TAF is aimed at.

x-man said...

Accrued Sir,

BB definately eats one bank loss to save 20 banks.

But what if its not just one bank? Is bad mortgage paper contained to one bank? What if a BUNCH of banks go down at once? Like saying that a bunch of foreclosures could simultaneously happen all over the country at once. But that could never happen

And what about Greenspans allowed 'sweeps', so the bank can move money between consumer accounts overnight, effectively keeping their fractional reserves around 1%, instead of 10%? Lots of literature out there on this. that's scary man! What if there's 1000 point drop in the dow in feb? what if mm funds break the buck? But that can't happen. It hasn't happened in almost 80 years. But wait, wasn't northern rock the first bank run in england in like eighty yrs

It is WHOLLY possible we see U.S. bank runs in 2008. I'm not saying its a fait accompli, but you have to admit, if it did go, it might get UGLY very fast. They only have ONE PERCENT of the dough on hand. Imagine going to Citi bank for that $$$ in savings and they say SORRY. crraaazy to think about. It happened IN ENGLAND!

Big picture thoughts:

This whole mess is leverage derived from bad real estate loans. When housing bottoms, then all the derivatives can find pricing. Till then, we're in the shit.

I defy anyone to show big picture charts on inventory, price to rent, mean ratios on housing that show ANYTHING but a 20% drop nationally in housing prices. I'm being conservative about that 20%.

None of that pile of derivatives can withstand that. None of the models modelled for that. Because it was deemed a 10 sigma event.

But it happened. The models are mmmm toasty. Now WAY Too much is owed. Counterparty failure EXPLOSION coming soon to an RSS feed near you. If MBIA is in this bad shape at the end of the first quarter of the game...they are going out on a stretcher in the fourth quarter. Maybe the third. Maybe before halftime.

Come on everybody! Step back! The mind reels! Holy shit! The next five years WILL WITNESS HISTORIC CHANGE in the markets.


Brian said...


I agree that is the example you cite is the kind of bank that SHOULD get the money, but I think the auction is open to all comers (provided they are depository institutions) regardless of their inherent credit risk. To the extend the taxpayer is ultimately at risk here, some of these banks are getting a free lunch.

And to your point about WaMu, yes they are still in business, but what if the Fed had lent them money as of the analyst's day. Do you think there is ANY chance they wouldn't roll it after this week's news at some subsidized rate despite the markedly higher risks?

I agree the Fed is willing to pay some price in order to enhance liquidity to those that deserve it. I just don't see any differentiation between sound and unsound institutions here. Maybe there are some fine grained aspects of how they run this that filters out the basket cases, but I haven't heard it.

Accrued Interest said...

Brian: I think that's what I mean when I say there are no good solutions left. In other words, the only options we have involve distasteful elements. Like bad banks getting cash.

Now I believe banks can only get this money if they are approved by their local FRB. That's supposed to help prevent bad banks from getting involved, but I don't know how confident I am that the local FRB can route out all bad banks given how quickly the situation is changing.

James I. Hymas said...

The fears expressed regarding a bad bank providing bad collateral are one reason to support a combination of bank supervision & central bank authority.

I discussed this point in my own blog on December 5 (down a bit, search for "Cecchetti".

X-Man: The UK has crappy, grossly underfunded deposit insurance, which contributed to the panic. More refs on my post of November 28, again search for "Cecchetti".

oldervirginian said...

As an old fuddy who has lived thru, suffered from and profited by, past housing crunches and euphorias...(I was a builder in Jimmy Carter's years when mortgage rates were 15%+..and we survived)...this too shall pass, and I am enjoying all the doomsday/chickenlittle rhetoric, for as a bottom feeder it does make for bargains, which I will ride to the next real estate boom before I cash out and retire.

This too shall pass, life does go on, and this is a mild cold, not the flu.

Anonymous said...

Richie makes a good point about a possible stigma premium.

Couldn't the Fed have tried destigmatizing the discount window first? If depository institutions can use the TAF anonymously, then why wasn't the discount window anonymized a couple of months ago? Was there some regulatory obstacle to doing so? Or am I missing something obvious?

Anonymous said...

the original post gets it just about right. the front end of the curve is tremendously dislocated and there is a real fear of a year-end funding crunch. The CP market is FUBAR. A bank failure (or failures, as history shows these things can rapidly take on a life of their own) is clearly the worst outcome.

Of course, another bit of Street color is that this scheme is aimed most pointedly at Countrywide.

It is interesting that folks throw around the "bailout" pejorative as if there were some halcyon day when banking systems never experienced instability. This ahistorical view, often coupled with some hackneyed populism, is unhelpful.

We're dealing with a market challenge, there will be some pain for all to experience, we'll get through. Markets are cyclical, it's important to take the long view.

Greg said...

As quite a few bloggers have already pointed out, the United States has looked down its nose and belittled Asian countries for propping up un-economic businesses with below market rates.

Evidently, the US doesn't think very much of its own advice.

There is NO credit crunch. Billionaires like Ichan and Richard Branson have raised money. So has Citadel. Of course, they aren't foolish enough to pay as much as the Fed.

Banks can get credit-- just not at positive carry. The Fed keeps (irresponsibly) lowering rates, but LIBOR barely moves -- banks don't want to lend to each other at low rates. This is a fancy way of saying the Fed is offering to lend money at rates lower than what the free market would charge.

Never trust someone who doesnt take their own medicine. In other words: Don't trust the Fed.

AI may be right that there is no good solution -- but that doesn't mean we should do something that causes even more harm than the status quo.

We have too much housing supply, financed by too much debt. We have more banks than any other country on Earth. What we have a shortage of is savers.

When the Fed lowers rates, it is NOT free. I really wish AI and others would acknowledge that.

The Fed is TAKING from savers (which we have a shortage of), and giving to banks (which we have a surplus of). Banks are supposedly sophisticated institutional investors; but there is no penalty being paid by any banking executive for the unprofessional "risk management" that they were not doing for years.

Please do not insult everyone by suggesting a CEO got "fired" with a $160 million severance package. Thousands of Joe Averages were laid off with barely a few weeks severance when they did their jobs. These CEOs were absolutely incompetent and still walked away with about 2,900 *years* of severance (take $160MM and divide by the average annual pay of 55K).

We are all smart enough to recognize the Fed and Treasury will never restore faith in a such a good ol' boy system.

There may not be a "good" solution, but there certainly are better solutions that would restore responsible risk taking. The Fed/FDIC can easily step in, protect depositors (up to $100K only) and/or transfer payments processing to solvent institutions.

Let Citibank FAIL (or Countrywide or whatever bank, Citi just happens to be in the headlines at the moment).

When shareholders see they will not be bailed out for management stupidity, they will discipline their employees -- ie management.

I take great issue with AI's suggestion that the least bad solution is to penalize savers.

The best solution is to let the foolish suffer the consequences of their actions, while protecting depositors and the payment system ONLY. Let the creditors and shareholders take the loss that is the result of their bad decisions.

This solution would not require any legal "cover" from the Treasury or Congress-- its already the law.

It is in the long term interest of the country and the banking system to make an example out of big bank or two.

Otherwise, all that nonsense about risk and reward they teach in business school is just hot air.

Flow5 said...

Nouriel Roubini: "you cannot use monetary policy to resolve credit and insolvency problems in the economy".

Dr. Roubini never studied 1966.

We've always caved into, and vigorously supported, all of the banking innovations, proposed by all of the bankers. So we can only well expect, more of the same, only worse (Financial Services Regulatory Relief Act of 2006).

Anonymous said...


I think we have an answer to your question. See Steve Cecchetti (via Naked Capitalism):

the Federal Reserve Bank of New York reports that in 3 out of every 10 days since the crisis started, the maximum trade in the federal funds market exceeded the discount lending rate

Remember the Fed funds rate that makes the headlines (currently 4.25%) is in fact just a target rate. The Fed tries to target this rate through open market operations (repurchase agreements, etc), but the actual rate for any particular transaction is determined by overnight lending of reserves from one bank to another. That is, the precise rate of any such individual transaction is negotiated between the two banks involved, and can differ from the fed funds target rate set by the FOMC in its regular meetings.

In other words, we can be quite sure that the highest TAF auction rate will exceed the discount rate... because some individual fed funds overnight loans have already been exceeding the discount rate!

flow5 said...

"Prior to January 2003, the discount window lending consisted of adjustment credit, extended credit and seasonal credit programs. Customarily, the interest rate on adjustment credit was less than the federal funds rate, usually 25-50 basis points during the 1990s. The below-market rate for adjustment credit created incentives for an institution to borrow at the discount window. However, regulation required institutions to first exhaust other available sources of funds and explain their need for adjustment credit."

The Discount rate or adjustment credit was formally a true discount to the federal funds rate. This encouraged banks to borrow at the discount rate and re-loan their advances at the higher interest rates prevailing in the federal funds market. That is the banks flaunted the rule that borrowing from the discount window shouldn't be used for arbitrage or profit.

"Under the administration of the discount window revised January 9, 2003, an eligible institution need not exhaust other sources of funds before coming to the discount window, nor are there restrictions on the purposes for which the borrower can use primary credit."

In 1980, Paul Volcker, Past chairman of the Board of Governors of the Federal Reserve System, appeared before the House Domestic Monetary Policy Subcommittee. In response to a question as to why the Fed had supplied an excessive volume of legal reserves to the member banks in the third quarter 1980 (annual rate of increase 13.2%), Volcker's defense was that there are two types of legal reserves: 1) borrowed (reserves obtained by the banks through the Federal Reserve Bank discount windows), and 2) non-borrowed (reserves supplied the banking system consequent to open market purchases).

He advised the congressmen to watch the non-borrowed reserves -- "Watch what we do on our own initiative." The Chairman further added --- "Relatively large borrowing (by the banks from the Fed) exerts a lot of restraint."

This is of course, economic nonsense. 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 had to be repaid in 15 days was immaterial. A new advance can be obtained, or the borrowing bank replaced by other borrowing banks. The importance of controlling borrowed reserves was indicated by the fact that at times nearly 10% of all legal reserves were borrowed.

This was the underlying rationale for changing the discount window policy in 2003. However appropriate it was formally, in the current enviornment it is conterproductive and I don't see why the discount window should be administered using a penalty rate.

That is there was no shortage of takers at the discounted rates.

Anonymous said...


A further clarification:

For the reasons mentioned in my previous comment, it seems almost certain that the highest TAF auction bid submitted on Monday will be higher than the discount rate (because, basically, that's the situation we're already in).

However, we'll probably never know about it if it happens, because all auction winners will pay the lowest possible winning rate (the "stop-out rate"). Only the stop-out rate will be announced, and no information about individual bids will be made public.

So we probably won't see the TAF rate turn out to be higher than the discount rate, unless things are really dire and $20 billion worth of high bids are submitted. Otherwise, the (near-certain) existence of bids higher than the discount rate will never be revealed.

Interestingly, the fact that all auction winners will pay the same "stop-out rate" means that the Fed will end up lending money for less than nearly all auction winners would actually be willing to pay. Take our money, please...

flow5 said...

9/1/2007 -0.19 -0.09
10/1/2007 -0.52 -0.24
11/1/2007 0.14 -0.18
12/1/2007 0.66 -0.14
1/1/2008 0.59 0.06
2/1/2008 0.25 0.01
3/1/2008 0.01 0.02
4/1/2008 0.00 0.01
5/1/2008 0.00 0.00
6/1/2008 0.10 0.01
7/1/2008 0.17 0.01
8/1/2008 0.05 0.01
9/1/2008 -0.42 0.04
10/1/2008 -0.30 0.06
11/1/2008 0.20 0.05
12/1/2008 0.35 0.02


Economic activity bottomed in Oct. Housing prices bottomed this Dec.
Stagflation's not yet in sight.

flow5 said...

Above forcast discounts the transactions velocity. It also assumes that the Fed continues to follow its' fallacious real bills doctrine.

The differnece between the former Discount Window policy's (pre 2003)stop-out rate is that it was lower than the FFR.

The TAF's policy stop-out rate will be above the FFR.

Anonymous said...

Investors stunned by ECB’s €350bn

Short-term market interest rates in the eurozone plunged at their fastest rate for more than a decade on Tuesday after the European Central Bank stunned investors by pumping a record €348.6bn worth of funds into the markets.

The ECB is not populated by impulsive dreamers gargling bong water and gorging on peyote buttons in front of their computer screens.

If they take emergency action, there must be an emergency.

Borrowing is going to get a lot tougher before it gets easier. I sincerely believe that we are facing the perfect storm.

mannfm11 said...

I don't think the Fed is going to lose anything. If you know what a margin call is, if the value of this collateral drops below 100%, they will get a margin call. This isn't a bailout, it is allowing banks to pay their liabilities inside the system. they took this stuff on their books, can't get rid of it and they owe the outside banks cash. They can't cash their own checks like they can imagine money into your account.

Auction Script said...

I think, it was happened due to the financial crises occurred in the world. Actually having loans was easy from the bank and the peoples invested all the money making properties, when they were not in the condition to pay out the bank, they wanted to sell that but no buyers was available in the market.

Bahamas Property said...

Actually it may be happened with that as it would mean that the price of anonymity becomes higher than the price of public stigma.

But how it is possible that all are ends in only twenty eight days and banks are making collateral in return of the cash, and they are doing business right now but have no cash to fed.