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Friday, May 02, 2008 3:22 AM


Bernanke Gets S.O.S. Call


Bloomberg is reporting Bernanke Urged to Do More to Ease Bank Funding Costs.

Federal Reserve Chairman Ben S. Bernanke may need to step up his effort to unfreeze bank funding markets as a surge in borrowing costs blunts the impact of the cash auctions the central bank introduced in December.

"There's clearly a need for the Fed to do more," said Charles Lieberman, a former New York Fed economist who's now chief investment officer of Advisors Capital Management LLC in Paramus, New Jersey. "The underlying problem" is that banks and other investors are "still nervous" about lending to each other, he said.

Increases in Libor and other rates are "a pretty clear indication that liquidity remains an issue or that term liquidity remains scarce," said Dean Maki, chief U.S. economist at Barclays in New York and a former Fed researcher. "The Fed's made pretty clear they're going to continue to attack those problems as needed."

The Fed auctions 28-day loans through the TAF, helping banks borrow funds that they might not obtain from counterparts. The Fed created the tool because of rising rates on one- to three-month loans among banks, Fed Governor Frederic Mishkin said in a February speech. The auctions may have had "significant beneficial effects on financial markets," he said at the time.

Another gauge of bank funding costs, the premium on Libor over the overnight indexed swap rate, a measure of what traders expect for the Fed's benchmark rate, reached 87 basis points on April 21. That was the highest since the Fed announced the TAF on Dec. 12.

Bigger TAF operations would probably slow or reverse the increase in borrowing costs, said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. Originally $40 billion a month, the Fed raised the amount of the auctions to $60 billion in January and to $100 billion in March.

"Any substantial further increase would start moving the program to a level where" it is more than "just psychologically relevant," Crandall said.
TAF Not Working As Expected

The TAF has not increased bank to bank lending, nor should it. I have discussed this on several occasions, most recently in Failures of the Term Auction Facility and Fed's Swap-O-Rama Gets Crazier.

Inquiring minds may want to see what the LIBOR situation looks like after the latest 25 basis point rate cut. Curve watchers analysis offers this chart to consider.



click on chart for sharper image

So much for the Fed's plan to spur bank to bank lending via various swap-o-ramas. The spread has gone from 14 basis points to 72 basis points in the last three months. In addition, 1-year ARMs are higher than a year ago by 33 basis points even though both LIBOR and Treasury yields are substantially lower than a year ago. 30 year fixed mortgages are about what they were a year ago, while 15 year mortgages are a mere 20 basis points better.

Factor in increased down payments, increased fees, etc and mortgage rates have actually gone up substantially. Credit risk is rising.

The rate cuts have substantially helped those in existing ARMs with those in ARMs tied to treasuries rather than LIBOR faring far better. Those seeking a mortgage for the first time are not benefiting at all.

Congress Sends Out S.O.S. Call

Bloomberg is reporting 'Rogue Operation' Spurs Further Bailout Calls.
A month after the Federal Reserve rescued Bear Stearns Cos. from bankruptcy, Chairman Ben S. Bernanke got an S.O.S. from Congress.

There is "a potential crisis in the student-loan market" requiring "similar bold action," Chairman Christopher Dodd of Connecticut and six other Democrats wrote Bernanke. They want the Fed to swap Treasury notes for bonds backed by student loans.
My Comment: The TAF has worked so well at spurring bank to bank lending, I am sure "similar bold action" would work equally well for student loans.
Student loans are just the start. Former Fed officials and other Fed-watchers say that Bernanke's actions in saving Bear Stearns will expose the central bank to continuing pressure to use its $889 billion balance sheet to prop up companies or entire industries deemed important by politicians.

"It is appalling where we are right now," former St. Louis Fed President William Poole, who retired in March, said in an interview. The Fed has introduced "a backstop for the entire financial system."
My Comment: Appalling is right, but illegal is closer to what's happening.
The Fed's loans to Bear Stearns were "a rogue operation,'' said Anna Schwartz, who co-wrote "A Monetary History of the United States'' with the late Nobel laureate Milton Friedman.

"To me, it is an open and shut case," she said in an interview from her office in New York. "The Fed had no business intervening there."

"There is no way to put the genie back in the bottle," Minneapolis Fed President Gary Stern said in an interview with Fox Business Network on April 18. "What worries me most about where we wind up is that we will have an expansion of the safety net without adequate incentives to contain it."

Stern noted that he supported the Fed's moves to restore financial stability.
My Comment: This is interesting. We have a Fed governor admitting the Fed has unleashed a genie that cannot be contained, but he supports the action anyway.
Richmond Fed chief Jeffrey Lacker and policy adviser Marvin Goodfriend wrote in a 1999 paper that central bank lending creates ever-expanding expectations. "The rate of incidence of financial distress that calls for central bank lending should tend to increase over time," they wrote. That "creates a potentially severe moral-hazard problem."
My Comment: There is nothing "potential" about this. The Fed is a moral hazard.
Bernanke rejected Dodd's request in an April 25 letter, saying it's up to Congress and the Bush administration to address diminishing profits on the loans.
This S.O.S. was unanswered. Nonetheless, the expectations genie has been unleashed and it will not be long before more S.O.S. alarms are sounded.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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