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Sunday, March 09, 2008 4:08 PM

Fed's New Role as Pawnbroker

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Lots of people have been asking me about the increase in the TAF and what it means and whether or not the Fed is hyperinflating. Let's start from the beginning.

Fed to Increase TAF and Emergency Repos

Here is a summary of the announcement: Fed To Increase TAF, Announces Up To $100 Billion In Term Repo Operations.

In an effort to inject liquidity into the market, the Federal Reserve announce Friday that it is upping the amount of credit offered through the Term Auction Facility (TAF) as well as kicking off a series of term repurchase transactions. The announcement came on the heels of a February employment report that revealed the biggest monthly job loss, a decline of 63,000, in over 5 years.

"The Federal Reserve will increase these auction sizes further if conditions warrant," the policymaking arm of the U.S. central bank said in a statement. "To provide increased certainty to market participants, the Federal Reserve will continue to conduct TAF auctions for at least the next six months unless evolving market conditions clearly indicate that such auctions are no longer necessary."

The Fed also announced a series of term repurchase transactions that will reach $100 billion. The agreements will allow "primary dealers may elect to deliver as collateral any of the types of securities--Treasury, agency debt, or agency mortgage-backed securities--that are eligible as collateral in conventional open market operations." The Fed added that they will increase the size of the repurchase operations "if conditions warrant."
Is This Hyperinflating?

No, it's not. So far all the Fed has done is supply $15 billion in temporary repos while offsetting that with a drain of $10 billion in permanent money supply. In the grand scheme of things the net amount is peanuts, but other factors are worth considering such as...

Fed's New Role as Pawnbroker

There is an excellent writeup of the current situation by Steve Waldman's on his Interfluidity site. The post is called Repurchase agreements and covert nationalization.
The Fed sold outright $10B of Treasury securities today at the same time as it offered $15B in exchange for mortgage-backed securities under the new program (at a low interest rate than in traditional repos against MBS collateral). The net cash injection was small, but the composition of securities on bank balance sheets changed markedly, as illiquid securities were exchanged for liquid Treasuries. In James Hamilton's wonderful coinage, the Fed is conducting monetary policy on the asset side of the balance sheet. This is an innovation of the Bernanke Fed.

Prior to the introduction of TAF, direct loans from the Fed to banks, including the discount window lending and repos, amounted to less than $40B, the majority of which were repos collateralized by Treasury securities. By the end of this month, the Federal Reserve will have more than $200B of exposure in its new role as Wall Street's genial pawnbroker. Assuming the liability side of the Fed's balance sheet is held roughly constant, more than a fifth of the Fed's balance sheet will be direct loans to banks, almost certainly against collateral not backed by the full faith and credit of the US government (and beyond that we just don't know). This raises a whole host of issues.

If we view TAF and the new 28-day, broad-collateral repos as equity, what fraction of bank capitalization would they represent? I haven't been able to find current numbers on aggregate bank capitalization in the US. In June of 2006, the accounting net worth of U.S. Commercial Banks, Thrift Institutions and Credit Unions was 1.25 trillion dollars. Putting together remarks by Fed Vice Chairman Donald Kohn and data on bank equity to total assets from the St. Louis Fed yields a more recent estimate of about 1.6 trillion. The average price to book among the top ten US banks is about 1.3. So, a reasonable estimate for the current market value of bank equity is 2 trillion dollars. The $200B in "equity" the Fed will have supplied by the end of March will leave the Federal Reserve owning roughly 9.1% of the total bank equity. Obviously, the Fed isn't investing in the entire bank sector uniformly. Some banks will be very substantially "owned" by the central bank, whereas others will remain entirely private sector entities. As Dean Baker points out, the Fed is giving us no information by which to tell which is which.

What we are witnessing is an incremental, partial nationalization of the US banking system. Northern Rock in the UK is peanuts compared to what the New York Fed is up to.
For Wonks Only

Paul Krugman has an analysis of Waldman's post in What’s Ben doing? (Very wonkish) It's an interesting read with lots of graphs, some of which only "wonks" can understand. Nonetheless it's a good read and I highly recommend it. Here is one chart and some commentary from Krugman that is understandable even by non-wonks.
The financial crisis seems to have entered its third wave. Panic in August, then partial recovery thanks to lots of money thrown at the system by the Fed. Renewed panic late fall, then partial recovery thanks to even more money thrown in, especially the Temporary Auction Facility. And panic has set in yet again:

This is now the third time Ben & co. have tried slapping the market in the face — and panic keeps coming back. So maybe the markets aren’t hysterical — maybe they’re just facing reality. And in that case the markets don’t need a slap in the face, they need more fundamental treatment — and maybe triage.
Libor Spreads On A Percentage Basis

Instead of looking at the chart of LIBOR vs. Treasuries on an absolute basis, let's look at things on a percentage basis. After all, 100 basis points difference means a lot more when treasuries are at 1.5% then when they are at 12%.

The following charts are from my friend Jay Matthews at Velocity Capital who has been tracking spreads ever since I mentioned the idea in a column back in December. He was kind enough to send me an update yesterday.

Percentage 1 Month LIBOR Minus 3 Month T-Bill
(since 1989)

click on chart for sharper image

Percentage 1 Month LIBOR Minus 3 Month T-Bill
(closeup since 2000)

click on chart for sharper image

Bold New Frontier

Note: the spread comparison probably should be 3 month LIBOR to 3 month T-Bills but the difference between 1 month LIBOR and 3 month LIBOR is not that significant (6 basis points).

Look how clear those "three waves of panic" can be seen on a percentage basis. This third wave up looks far worse than the others. And while LIBOR seems to be acting normal vs. the Fed Funds Rate, it most assuredly is showing signs of stress vs. treasuries. The latest wave up is a bold new frontier.

Disconnect In Treasuries vs. Mortgages

LIBOR vs. Treasuries is not the only sign of stress. There is a huge disconnect between treasuries and fixed rate mortgages.

15 Year Fixed Mortgages vs. 10 Year Treasuries

click on chart for sharper image.

The above chart is from Disconnect In Treasuries, which was itself was a followup post to Financial System Broken - Markets 'Utterly Unhinged'. Inquiring minds may wish to take a look.


Yes, the Fed is taking increasingly suspect collateral, but it is only giving discounted value for it. For now anyway, the Fed appears to be acting more like a responsible pawnbroker than someone giving away the candy store (at least in terms of collateral).

Calculated Risk offered this opinion about nationalization to consider:

As Waldman notes, the Fed offers loans only against certain collateral, and requires that loans be overcollateralized. I've seen the lendable amount sheet, and I think the Fed is pretty well protected - so I think the author takes it one step too far to call this "covert nationalization".

The next step is not hard to imagine, however. When does the TAF (Term Auction Facility) become the PAF (Permanent Auction Facility)? Or has it already?

Zombification of Banks

Bernanke clearly has some new innovations, but the name of the game itself has not changed much: Banks are so capital impaired they cannot lend. They refuse to write down assets to reasonable levels because to do so would bankrupt them.

Thus with each passing day, the more asset values plunge, the more zombified our banking system becomes. Zombification of banks is exactly what happened in Japan. Bernanke could cut interest rates to zero tomorrow and it would not change matters much if at all. Academia is meeting a real world test, and Bernanke has met his match.

Mike "Mish" Shedlock
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