Tuesday, March 25, 2008

The credit market's Bacta Tank

The market's reaction to Bear Stearn's demise has been impressive. The stock market story has been well-covered, but the credit market story is really the one to watch.

Right now we have two major themes in the credit markets. The first is a real economy recession, with a very weak housing market at its epicenter. The second is a battered financial sector, where strained capital and fear of spiraling contagion has caused a dearth of liquidity.

A real economy recession should legitimately cause the price of taking risk to rise. In the case of mortgage-related credit risk, for instance the ABX index, prices should obviously be drastically lower. This is the kind of risk pricing that capital markets can handle. In fact, that kind of risk pricing is exactly why capital markets are an important part of our free-market system. We need a market where various risks are correctly priced, as this helps to channel capital to areas where it is most needed.

But the second major theme is interfering with the market's ability to properly price risks. Potential buyers of risk, from hedge funds to banks to broker/dealers, became overextended during the credit bull market and now need to repair their their own balance sheets. No matter how attractive various pricing levels are, these buyers are are not a position to take advantage. Some of those that became overextended have been forced to unwind some or all of their positions. In many cases, such as the liquidation of municipal bond arbitrage programs, the problem had nothing to do with actual credit losses. But given the weak liquidity, any large scale selling caused prices to plunge.

As a result, classic investment analysis, pouring over 10K's and analyzing cash flows, has not been a winning strategy. Until very recently, investors who dabbled in anything that looked fundamentally "cheap" got burned. Sector after sector suffered historic spread widening amidst persistent forced selling. This created a negative feedback loop, as real money investors sit on the sidelines waiting for some semblance of calm before putting their cash to work.

The never few weeks will test whether that negative feedback loop has broken. Municipal yields have been falling. 10-year Fannie Mae debt spreads have dropped about 35bps since Friday, and are now as tight as they've been since early February. Agency MBS spreads are about where they were at the beginning of March. Brokerage CDS are actually tighter month-to-date.

This is important because it means that there are investors who bought good bonds on recent dips and enjoyed good results. This is what it will take to break the negative feedback loop in the bond market.

Whatever you think of where the economy is heading, the system needs efficient pricing of risk. Persistently bad technicals have been getting in the way of this healthy process. Watch interest rate swaps spreads, GSE debt spreads, and agency-backed MBS spreads to see if this follows through.

28 comments:

the muni investor said...

Municipal yields have been falling.

Surprising you say that, I've seen them rise over the last week. 20 yr Cal munis have seen a rise of about 20 bps since the rate cut. The rates I see are only slightly shy of the previous highs they hit a while back.

James I. Hymas said...

The never few weeks will test whether that negative feedback loop has broken

Freudian slip?!

Anonymous said...

"But the second major theme is interfering with the market's ability to properly price risks."

What was interfering with the market's ability to price risk before everything blew up?

I would suggest that the opacity in structured finance products prevented realistic pricing. This hasn't gone away and realistic price discovery will have to wait until the products age and actual cash flows replace expected cash flows.

This is a little off topic, but I was just reading an op ed page in the WSJ . http://online.wsj.com/article/SB120640802947261173.html?mod=todays_us_opinion

The money quote in this was: "The desire to abandon or deemphasize the mark-to-market model is based upon the logic that, if the public didn't know how bad things were, then the all-important confidence in the system would not be at risk and we would be safer. The price to be paid -- the complete obfuscation of the truth -- is simply way too large."

The audacity of blaming traditional accounting (which frequently uses estimates for loan impairment) for 'complete obfuscation of the truth" is a little hard to take given the role that securitization has had in obfuscating valuation. For example, CDO^2 of subprime mortgages. There was and is really no justification for creation of these things other then to hide risk.

Unfortunately, in order to restore some confidence in markets it was necessary to have the Fed intervene in i banking. What kind of price discovery do you have in a panic? Markets are great until they aren't. Then we need the Fed to come in and make price discovery irrelevant in order to maintain some degree of liquidity to at least allow an orderly unwind.

Obviously this is not really directed at your post, and I am venting at the WSJ.

Anonymous said...

At the risk of being accused of splitting hairs, it's a positive feedback loop not a negative feedback loop.

Positive feedback loops are inherently unstable. They feed on themselves until they explode. Negative feedback (corresponding to correct pricing of risk) is what we need to return to.

eh said...

Persistently bad technicals have been getting in the way of this healthy process.

Huh?

At the risk of being accused of splitting hairs, it's a positive feedback loop not a negative feedback loop.

Exactly correct, and it's not hairsplitting. It may have had negative economic and market consequences, but this was because the problem got worse, and hence it was a positive feedback loop.

Anonymous said...

AI,

Could you explain the significance of swap spreads? Are they a way to measure counterparty risk? It is my understanding CDS are discounted using swap spreads.

Thanks,
cb

Accrued Interest said...

Muni Investor: I'm seeing rates about 20bps below the high in the 10-year area and about 10bps lower in the 20-year area.

James: Perhaps!

Anon: I don't think its smart to ever just ignore M2M. I think there are firms who believe they've been unfairly punished by M2M in this market. And maybe some of them are right. But what's the alternative? Have firms invent whatever market value they want? Yes, the market sometimes overshoots, but I think you have to set up your balance sheet to deal the possibility of such an overshoot.

Eh: Not sure I follow. I was trying to refer to the market giving negative feedback, which impacts investor behavior.

Anon: Swap spreads (refering to interest rate swaps) are a broad measure of counterparty risk. CDS are a type of swap. But other than that, I'm not sure what you mean. I think CDS are discounted by the CDS spread when you close them out.

Electrical Engineer said...

Regarding feedback loops, the positive and negative refer to the amplification of the error on each loop cycle, not the consequences of the loop itself.

Portfolio insurance circa 1987 is the most notorious example of a positive feedback loop, even though its consequences were decidedly negative.

You can file this under the learn something everyday. :-)

Accrued Interest said...

Well hot damn. Did not know that. Thanks.

PNL4LYFE said...

LOL, I was just about to say something along the lines of "that's what happens when you have engineers reading finance blogs." But electrical engineer beat me to the punch.

I would add one thing about buyers that have stepped in recently and done well since the most recent bottom: there are a lot of non-traditional players entering various markets. The two best examples I can think of are hedge funds entering the ARS market and real money players buying bank loans. In both cases, these buyers put a floor under a market where the traditional buyers were unable or unwilling to participate. But in both cases, the equilibium price is far below the levels of a year ago.

In ARS, hedge funds were willing to collect fat coupons on nearly-failed auctions, but are not willing to pay enough to make ARS an attractive market for issuers.

Similarly, none of the current buyers of bank loans will pay the prices that CLOs were willing to pay. Between higher risk, lower Libor, and demand for absolute yield (rather than spread to libor), these loans are probably not going to trade out of the 80s anytime soon.

That said, it's clearly a positive if an orderly clearing price is established for all these assets. I'm just pointing out that the price will be considerably lower than par.

Anonymous said...

AI: Whatever you think of where the economy is heading, the system needs efficient pricing of risk.

Agree 100%, but perhaps with different reasoning.

Wall Street has been doing a disastrous job of pricing risk for about a decade now. Many "financial professionals" have marketed over-leveraged beta as though it was something other than foolish.

It was Wall Street's job to assign a low price to this risk -- but instead we bid everything through the roof. We had a lot of help from unqualified people at the Fed (Greenspan and Bernanke) who constantly mis-diagnosed the economy but regardless of circumstance- easing credit was invariably the best (and only) response.

After a long "positive feedback loop", the market is finally trying to eliminate the snake oil salesmen pretending to be financial experts. They are being ruthlessly eliminated, as you would expect.

The problem for the last 6 months or so is that the federal govt won't allow the markets to do their job. Whether its gaming the balance sheets of insolvent banks and monoline insurers, or the defense of mark to pretend over mark to market, or providing financing to those who cannot get it from an economically motivated player -- the govt (especially the Fed) has refused to allow the markets to properly price risk.

And the longer we pretend that this is a "liquidity" problem, not an insolvency problem -- the longer it will take for the financial sector to rebuild itself.

In spite of all the apocalyptic hysteria in the media, most of Main Street is doing OK. Depending who you ask, its a slowdown or a recession -- but it is not the end of the world by a long shot. After years of expansion, a recession (assuming we are in one) isn't really a bad thing or unexpected.

Wall Street, by contrast, is seeing the end of its world. Over-levered portfolios (which are a textbook definition of BAD RISK) are being destroyed. Sorry folks, that is part of the healing process. Bernanke cannot prevent it without causing even more harm to the rest of Wall Street and to Main Street.

In short, the federal government, and Bernanke in particular, is preventing the efficient pricing of risk. Just like the actual Depression in the 1930s, the Fed is taking a bad situation and turning it into a disaster of epic proportions. We would be a lot better off if the Fed stopped "helping".

Now, the Fed is engaging in economic central planning -- you know Wall Street is intellectually bankrupt when they start cheering that. Why did the Fed choose Bear Stearns for termination? Why did it effectively pick JPM to "win" the corpse? Why did the Fed pick Blackrock to manage the mortgage portfolio? Maybe these guys are the best qualified -- but shouldn't it have been put out to bid? Was JPM not qualified to take on the mtge portfolio? If so, why were they given the rest of Bear? The whole thing just stinks of the gold ol' boy network looking out for themselves at the expense of everyone else -- and that is not going to restore confidence in the system

PNL4LYFE said...

At most recent anon:

I agree with much of what you said. Clearly, many people at every level made terrible decisions regarding risk; CDO buyers and ratings agencies in particular. I place mortgage originators and unqualified home buyers on the second tier of stupidity because the incentives were there for them to do exactly what they did. Mortgage orginators were well paid to write mortgages that couldn't be repaid. Home buyers were given free options on real estate prices.

At the end of the day, several trillion dollars of real estate "wealth" has to be destroyed to rebalance the system. This can happen either by inflation or price depreciation (or both), but I don't see how allowing bank failures and complete seizure of the capital markets will make this more efficient or less painful for main street. If the Fed and Treasury step aside and let the train wreck happen, main street will suffer because they are just as addicted to easy credit as Wall Street.

Accrued Interest said...

I have been trying to argue that its both a solvency AND liquidity problem. But see, the liquidity problem threatens to spiral out of control, completely wrecking the system. Look at what happened to municipals. Why the hell should municipal bonds be trading so freaking wide? Or govt. gtd student loan paper? Its because there is a liquidity problem. See, the Fed has to keep pumping in liquidity to keep the contagion under control while we deal with the real credit problems.

I think people need to realize that it isn't an either/or situation. We have both a legitimate credit problem AND a serious liquidity problem.

I personally think we are on the road to improving liquidity. The credit problems will be with us for a while yet.

Anonymous said...

Liquidity in the sense that the price of risk has risen so high that there is no trade. The Fed is forced to forcibly lower the price of risk by using tax money to buy risk at a cheaper price than the market wishes to mark it to. Call it the "Government Model" that risk is being marked to.

But I don't really think it matters. What matters is jobs. And that's where the positive feedback loop is going to crush us.

No jobs. No consumer economy. No more American Capitalism.

Yes, a bleak outlook, but I think accurate.

And it will be a very slow, painful death.

Think of Bushie. Every morning he looks at the Dow. That's it. And it just won't stay up. He scrambles around for some more Cialis, but the damn thing just won't stay up. He's on the verge of calling Spitzer he's so nuts.

Anonymous said...

I think we should all be a lot more careful about what we wish for, otherwise we might get it.

The Fed is supposed to be lender of last resort to federally chartered banks-- which they regulate. At present, the Fed is has no statutory authority to lend to Wall Street (like Bear), which is regulated by the SEC. The Fed does not allow its banks to take on anywhere near the same leverage as the SEC allows sell side houses to take on -- and arguably the banks are not allowed to take on the same levels of risk.

So if the Fed is now going to be lender of last resort to Wall Street, they are going to ask for (and get) more regulatory authority.

Big, bloated, bureaucratic and heavily regulated banks like JPM and B of A become the future of finance-- Goldman Sachs and Blackstone and most hedge funds become "too risky" and must severely curtail trading and risk taking activities... "market prices" are set by the financial equivalent of electric utilities.

A political committee in Washington decides what firms should exist and which should not.

Any pricing / risk mistakes are born by the taxpayers -- with absolutely no recourse to the bureaucrats (govt or JPM) who made the mistakes.

Comrades, the evil capitalists have defeated themselves

Darth Toll said...

"I have been trying to argue that its both a solvency AND liquidity problem."

Thanks AI, I finally see where you are coming from and agree wholeheartedly. Where we may differ somewhat is that you seem to believe that the insolvency issues, while serious, are not systemic.

My point is that the Fed can and should address liquidity concerns and they seem to be doing a reasonably good job at that. However, they are making hints and baby-steps towards monetizing, which crosses the line over to insolvency, which they have no legal authority to address and Poole has talked about this repeatedly. Poole has said that the Fed can provide liquidity but not capital, and he has been adamant on this point.

Of course, actions and words often conflict and we must observe if the Fed is simply jawboning about not taking dicey securities in exchange for treasuries, or if they roll this over again and again ad nauseum and are in effect monetizing.

If or when they commit to go down this road, they will have wrecked the currency and the economy for possibly generations in order to bail out insolvent banks which they have no responsibility to do. What is needed here is total transparency as to which banks are insolvent and which aren't. Get out all of the dirty laundry, allow Wall St. pigmen bankers to take appropriate hits and move on stronger and wiser in the future. The Fed doesn't seem interested in this and seems to be opting for obfuscation and opaqueness. Now, thanks to the new programs, we only know on Thursday what the Fed has been up to with their operations all week.

The question is: Is the Fed leaning towards monetization because they KNOW that the WHOLE SYSTEM is insolvent and cannot be repaired without direct capital infusions?!? The answer to this question will tell us what the future for our economy and nation may hold.

Sivaram Velauthapillai said...

ANON: "No jobs. No consumer economy. No more American Capitalism."



How can you be sure the job picture is bad? I'm not saying it's great but it doesn't look bad.

Remember, the real estate bubble burst in 2005. That's three years ago!!! The US economy has been decelerating ever since, without the job count falling completely apart.

The financials started falling apart last year so we have had almost 6 months of job declines in the financial industry. (Unfortunately for many reading this, financial jobs are going to decline. The Economist had a good article this week about the possbility of the end of the financial boom.)

Retailers, recreation, and so forth are showing weakness but that's normal during an economic slowdown. They generally bounce back up. People are still going to shop and buy things--but not at the prior rates.

Manufacturing-related industries have already been in a depressed state for almost the whole decade. If anything, manufacturing jobs are more likely to surprise on the upside than the downside. With the US$ decline, it should make USA more competitive.

People who have been calling for the end of consumption have said similar stuff for several decades now. The fact of the matter is that it is extremely rare for US consumption to decline year over year. That's actually the case with most developed countries that are not facing demographic issues or other political issues.

The reason I'm saying all that is because, of all the factors out there, the job situation is one of the few positives right now. Jobs will decline no doubt. But that's the case with slowing economies. I don't see unemployment getting out of hand.

I don't don't see the end of "capitalism" (whatever that means). The only way we will have some dire results is if there is a war or some government intervention (eg. tariffs, banning foreign goods, etc).

Anonymous said...

OK, so Greenspan goes and says the market is experiencing "irrational exuberance" -- but also says he can't and shouldn't do anything to curtail the stupidity. He neglects to mention that his own easy money policies and Greenspan put are at least partly (if not mostly) to blame.

It blows up, and he can't throw enough money at it. He says this "fixes" the problem.

Then we get even more irrational exuberance, but this time its in housing instead of dot-coms. Once again, the Fed does nothing to curtail any of the upside. Once again, the Fed neglects to mention that their absurdly easy monetary policies mostly caused the problem (well, combined with a total lack of regulation of bank lending practices).

And once more, the "solution" is even easier money. But now, we replace the Greenspan put with a back room, behind closed doors deal to bail out Bear Stearns -- putting taxpayer money at risk.

We have a liquidity problem all right -- the Fed is making too many problems by providing too much liquidity. Everytime they add more liquidity, they make a larger and larger bubble

Christopher Wheeler said...

I think the stock market story and the credit market story are inextricably intertwined. Less than two weeks out form the announcement of the Morgan/Bear Stearns firesale deal, Morgan increases the price by 500%, and yet BSC stock is selling for more than the deal price.

At the same time, Bear Stearns is continuing to trade, using the implied backing of JP Morgan to ease the liquidity crunch. Please notice that no money has yet changed hands in this deal.

If I were Bear Stearns, I would be raising cash and deleveraging as fast as humanly possible. If the logjam in the credit markets is broken, it's not impossible to imagine the buyout deal getting unwound. Bear Stearns could end up surviving as an independent entity.

Anonymous said...

Trichet, the head of the European Central Bank, says that lowering interest rates produces inflation and, thus, passes the follies of the financial institutions on to the consumer who pays the price...literally.

For that reason, he keeps interest rates high in the hope of restraining inflation.

But what does he do about institutions like Bear Stearns and its boy-wonder hotshot "leader" Jimmy Cayne?

Simple. He takes them over. Locks 'em up. Makes them an offer they can't refuse. Oh, they look the same afterwards, but they're controlled by the ECB.

So, in that context, look at what Bernanke has done.

He has fucked it up on both counts:

1) He is lowering interest rates like there is no tomorrow. Result: massive inflation.

2) He is, get this, he is ponying up tax-payer dollars to JP Morgan to buy Bear Stearns.

You can't make this stuff up. You really can't.

And anyone who expects the US to be still standing in 5 years is nuts.

Look what's happening in England. It's being sold to India. Wow! Who'd a thought?

Anonymous said...

AI: I have been trying to argue that its both a solvency AND liquidity problem. But see, the liquidity problem threatens to spiral out of control, completely wrecking the system. Look at what happened to municipals. Why the hell should municipal bonds be trading so freaking wide? Or govt. gtd student loan paper? Its because there is a liquidity problem.

AI, you are the answer to your own question... you trade many different types of bonds (as do most fixed income traders). You have posted on everything from munis to CDOs to mortgages to Treasuries.

Muni spreads are so wide because the same INSOLVENT players are in both munis and mortgages. When the foolish and overleveraged lose their client's shirts in bad mtge trades, they have to raise money anyway they can -- selling munis or GNMA or more generally whatever isn't nailed down.

The sudden influx of panic sellers (aka THE INSOLVENT) overwhelms the normal number of buyers -- supply overwhelms demand leading prices to tank -- this isn't rocket science and its not a liquidity problem. Its a large number of insolvent players dumping anything they can in a desperate, but ultimately hopeless, effort to stay afloat.

And the people who have lots of cash? Why would they buy anymore than their normal lot? Why try to catch a falling knife? These people are acting very rationally by staying on the sidelines until the dust settles. There is a huge amount of liquidity -- if anything an excess -- but they aren't going to lend money to people they know are insolvent.

Refusing to lend money to insolvent people is not a liquidity issue -- its common sense.

Anonymous said...

AI: I would like to hear your thoughts on whether the Fed should be easing to "fix" the credit bubble unwind...

You have argued this is (at least partly) a liquidity crisis, while others have said it is an insolvency crisis.

But regardless of the above -- system wide we are looking at over $1 trillion in losses (Gramps predicted $1-1.5 trillion, while Goldman is saying $1.2 trillion). The Fed's TOTAL balance sheet assets average only about $900-950 billion.

If the Fed is going to remain an ongoing institution (Jim Rogers argues it shouldn't!) -- it will need to keep at least some of these assets, make up whatever percentage you like.

Even if they spent 100% of their assets (and ceased to exist) the Fed simply cannot absorb the mistakes made by Wall Street -- the problem is bigger than the Fed.

In short, the Fed's promise to fix the "liquidity" crisis is hollow and lacks credibility -- unless they run massive inflation.

Even if you want to argue it is a liquidity issue, the Fed's policy is to throw the baby out with the bath water. Destroy the entire economy with inflation in order to save Wall Street firms who failed to exercise good risk management.

As you yourself said, the economy NEEDS to have efficient pricing of risk. I don't see how you can say that, and at the same time say the Fed needs to provide Wall Street with a free put option.

Anonymous said...

Anon 2:30

The Fed's TOTAL balance sheet assets average only about $900-950 billion.

You are forgetting that the Fed has already pledged about $200 billion in the TAF and TSLF, as well as $29 billion toward the Bear Stearns bailout.

That leaves the Fed with only $700 billion to work with (minus whatever it needs for on going operations).

gramps said...

The results from the TSLF are in: the bid to cover ratio was a paltry 1.15 (compared to about 2.0 for recent Treasury auctions, which is a pretty low bid to cover ratio in itself).

Only seven banks submitted bids... sorry to beat a dead horse AI, but only 7 banks bidding doesnt lend any support to the notion of a liquidity crisis. The Fed is literally throwing money at the banks and they don't want it. This just is not a liquidity crisis in any way.

Going back to the 1.15 bid to cover ratio -- the number is a bit deceptive. If you look at the details, that number is $86 billion PAR of (ahem) "eligible collateral" being exchanged for $75 billion par of US Treasuries.

If the collateral was worth anything like par, the TSLF shouldn't be necessary.

The Fed is an active participant in accounting fraud -- the biggest problem is that they aren't fooling anyone.

It is mind boggling that Bernanke thinks the way to get the economy going again is to pretend housing prices have not declined -- does he think global investors are stupid? Does Bernanke not read any newspaper or talk to any realtors?

And if banks have a solvency problem (and at least in aggregate they do) -- does it make sense to put the solvency of the Fed in doubt as well?

The Fed won't be allowed to collapse of course -- but international investors have seen this movie before. The currency collapses instead of the hollow central bank. International investors will get back their USD, but those USD will be worth a LOT less -- meaning international investors are locking in a loss

Its a bit of a truism to say the US is dependent on capital from abroad.

One little caveat emptor for US investors thinking of buying US Treasuries: the 1yr carry on a 10yr Treasury is about 2% -- 3.5% yield minus about 1.5% repo cost (yes, I know I am taking some liberties with that, but the basic gist of what I am saying holds). So you clear 2%. The BPV on a 10yr is about 850 -- meaning if 10yr rates increase by a mere 24bp, you lose all your carry for the **year**.

With the Fed running inflation as fast as they can, and the tanking dollar encouraging international investors to look elsewhere -- the only thing standing between a 10yr "investor" and a loss is never ending panic in the market.

James Grant recently said US Treasuries have become "return free risk" -- a play on the academic nonsense of risk free return, as well as a new way of saying they are once again certificates of confiscation.

AnonX said...

>I have been trying to argue that its both a solvency AND liquidity problem<

It's obviously both, and we won't know exactly the extent of both until things unwind a little and the exotic instruments from hell age to the extent that we have a better idea of the ultimate haircut.

It's interesting how quickly fear can both materialize and dissipate. A couple of weeks ago, there was measurable fear of a meltdown. Essentially a panic. Two days after the Fed intervened in Bear, all you could see is greed.

Part of the uncertainty was the extent to which the Fed would intervene. That has been cleared up. The Fed isn't going to let the system blow up because of a lack of liquidity. To the extent that there are solvency issues, they can't be covered up and will emerge in an orderly fashion,

If GM is to be believed, one of the drivers was CDS's on Bear and CW. The idea of letting hedge funds to start a stampede by rumor mongering and highly leveraged shorting is not something that the Fed should stand around and watch. Especially since they are on the hook for the non-shadow banking system.

I guess the only thing I find troubling is people emphasizing the 'moral hazard' in the Fed's action. If you are trying to increase confidence and prevent a run on the bank, by definition, you create a moral hazard. The entire idea is to increase confidence which reduces fear.

People are pointing at the success of the Fed action as evidence that it shouldn't have been done. In other words, the panic has lifted and the greed (which is always there) emerges.

It will be interesting to see which assets end up with the Fed. I expect that it will be those with the biggest difference between bookable price and market price. By bookable, I mean the price that can be booked in their financial statements. These may not be the worst assets. I expect that a decent amount of it is not the worst but rather some of the better stuff. JPM was talking about using some of the $30 billion - like $9 - for leveraged loans, which are currently selling for 80 cents on the dollar.

The Fed let Carlyle tank, which was agency debt and not a solvency problem as well as Thornberg, again not an asset problem. Both were leverage issues.

The Fed has also sent the message that credit derivatives won't be a reliable way to profit from the collapse of a regulated institution or (unfortunately) a major I-bank. I would like to know how much this cost speculators. It would be nice if some were severely damaged.

The real danger was for the Fed to go in and *not* be able to quell panic. That would have been a disaster, since it would have made panic much worse.

It looks like the stock market has already figured out that stopping a panic doesn't mean a bottom, and that to the extent that these are solvency issues, they will come out sooner rather than later.

There was a story today about a LBO buying its own debt for 80 cents on the dollar. For everyone that is obsessed with fair value accounting or mark to market, should any LBO be able to write down its debt to the current 'market price' and take a profit from the remarked liability? I think not, but will be interested in seeing how it is handled.

Accrued Interest said...

This is a really great conversation and I'm sorry if I don't respond to every one.

I don't think the right comparison is between the ~$1 trillion in losses vs. the Fed's balance sheet. First of all, if the Fed lends Treasuries to primary dealers in exchange for MBS, that isn't a loss of assets. Its an exchange of one asset for another. Not unlike when a bank lends cash to a borrower. Its an exchange of one asset (cash) for another (loan).

Second, the Fed isn't trying to absorb losses. That's "solvency" thinking. What its trying to do is keep liquidity flowing. In other words, to make sure that the system doesn't fail.

Right now we have a situation where prime, fixed rate, first lien, senior tranche MBS are very hard if not impossible to trade. And yet the realized losses on those securities will be small. There is no rational calculation of default rates that suggests these loans should be worth 80c. The Fed is merely saying that they will lend against that collateral. They aren't buying the collateral. As long as the bank/dealer remains in business, the P/L from the bond remains with the original holder. But the dealer does get some cash to deal with day-to-day needs. That keeps the system going while we're working through the solvency issues.

By the way, Goldman's estimate for $1.2 trillion in losses was world-wide. They only estimated $460 billion in the U.S.

Anonymous said...

AI: not true.

Goldman estimated $460 billion losses for Wall Street and hedge funds-- and $1.2 trillion for the US overall.

Accrued Interest said...

This article says world-wide...

http://news.yahoo.com/s/nm/20080325/bs_nm/usa_credit_goldman_dc