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Sunday, January 06, 2008 10:48 PM

No Helicopter Drop For Failed Banks

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The question at hand is: Can the Fed provide capital to GSEs or failed banks? Anyone who thinks so is wrong.

The Fed can only provide liquidity, not capital, to failing institutions. That is not only my opinion, that is the opinion of the Fed as well. Let's start by taking a look at Fannie Mae (FNM) and Freddie Mac (FRE) and continuing further with a close look at liquidity itself.

Can the Fed Provide Capital to the GSEs?

On January 17th 2007, William Poole, President of the Federal Reserve Bank of St. Louis gave a speech on the topic GSEs: Where Do We Stand?

Financial firms throughout the economy ought to have an intense interest in reforming the GSEs. One reason is simply that banks and other financial firms, and many nonfinancial firms, hold large amounts of GSE obligations and GSE-guaranteed mortgage-backed securities.

I believe that many risk managers simply accept that GSEs are effectively backstopped by the Federal Reserve and the federal government without ever thinking through how such implicit guarantees would actually work in a crisis. The view seems to be that someone, somehow, would do what is necessary in a crisis. Good risk management requires that the “someone” be identified and the “somehow” be specified.

I have emphasized before that if you are thinking about the Federal Reserve as the “someone,” you should understand that the Fed can provide liquidity support but not capital.

As for the “somehow,” I urge you to be sure you understand the extent of the president’s powers to provide emergency aid, the likely speed of congressional action and the possibility that political disputes would slow resolution of the situation.

At present, there is no process and no one knows what would happen if a GSE is unable to meet its obligations. .....

Sound risk management practices require that GSE managements base decisions on market values, or estimates as close to market as financial theory and practice permit. The reason is simple: Fannie Mae and Freddie Mac pursue policies that inherently expose the firms to an extreme asset/liability duration mismatch. They hold long-term mortgages and mortgage-backed securities financed by short-term liabilities. Given this strategy, they must engage in extensive operations in derivatives markets to create synthetically a duration match on the two sides of the balance sheet. These operations expose the firm to a huge amount of risk unless the positions are measured at market value. ....

For those who believe that a GSE crisis is unthinkable in the future, I suggest a course in economic history.
Key GSE Points
  • Size and leverage of Fannie Mae and Freddie Mac is enormous.
  • The Fed does not want to be responsible for a blowup at either company.
  • Both pursue policies that inherently expose the firms to an extreme asset/liability duration mismatch.
  • Both hold long-term mortgages and mortgage-backed securities financed by short-term liabilities forcing them to synthetically create a duration match via massive amounts of derivatives.
  • The stocks act as if there is implicit government guarantees. There are no such guarantees.
  • The lack of market discipline is striking.
  • The Fed can provide liquidity not capital.
  • A crisis is not unthinkable. Those that think so need a course in economic history.
Federal Reserve Emergency Powers

In the Panel on Government Sponsored Enterprises, Poole spoke on the Emergency Powers of the Fed.
I am acutely aware that should there be a market crisis, the Federal Reserve will have the responsibility to manage the problem. Just as many market participants apparently believe that GSE obligations have the implicit backing of the federal government, they may also believe that the Federal Reserve has all the powers necessary to manage a crisis. The Fed’s successful efforts to handle the stock market crash in 1987, the near-insolvency of Long Term Capital Management in 1998, and the financial effects of the 9/11 tragedy all justifiably increase market confidence in the Federal Reserve. In the interest of a full understanding of the Federal Reserve’s powers in the event of a crisis in the market for GSE obligations, I’ll outline the Fed’s powers as provided by the Federal Reserve Act.
The Federal Reserve has ample power to deal with a liquidity problem, by making collateralized loans as authorized by the Federal Reserve Act.

The Fed does not have power to deal with a solvency problem. Should a solvency problem arise with any of the GSEs, the solution will have to be found elsewhere than through the Federal Reserve.
The Fed Can Provide Liquidity NOT Capital

Three Key Sentences made by a Fed Governor
  • The Fed can provide liquidity support but not capital
  • The Fed does not have power to deal with a solvency problem.
  • Should a solvency problem arise with any of the GSEs, the solution will have to be found elsewhere than through the Federal Reserve.
The Fed cannot provide capital to Fannie Mae (FNM), Freddie Mac (FRE), Citigroup (C), Washington Mutual (WM), JPMorgan (JPM) or anyone else. For all this talk of "helicopter drops", Poole seems to be calling Bernanke's Bluff.

I have pointed out many times before that the Fed has no authority to do "a drop" and would not do so even if they could. It is obvious the Fed is going to slash interest rates, but that action addresses liquidity and confidence. It does not do a thing for solvency issues.

The crisis we are in now is a solvency crisis, not a liquidity crisis. There are no bigger bubble to be blown that will provide jobs and allow consumers to pay debts.

Is 1929 a walk in the park compared to today?

Several people have asked me to comment on Crisis may make 1929 look a 'walk in the park'.
As central banks continue to splash their cash over the system, so far to little effect, Ambrose Evans-Pritchard argues that things risk spiralling out of their control

Twenty billion dollars here, $20bn there, and a lush half-trillion from the European Central Bank at give-away rates for Christmas. Buckets of liquidity are being splashed over the North Atlantic banking system, so far with meagre or fleeting effects.

Quietly, insiders are perusing an obscure paper by Fed staffers David Small and Jim Clouse. It explores what can be done under the Federal Reserve Act when all else fails.

Section 13 (3) allows the Fed to take emergency action when banks become "unwilling or very reluctant to provide credit". A vote by five governors can - in "exigent circumstances" - authorise the bank to lend money to anybody, and take upon itself the credit risk. This clause has not been evoked since the Slump.
A Little Acid Test for Fed "Liquidity"

There are several errors in that story that warrant further discussion. Let's start with the idea that $20 billion here $20 billion there amounts to some mammoth increase in liquidity.

Proof that these liquidity ideas are way overdone can be found in John Hussman's article A Little Acid Test for Fed "Liquidity".
If you track all those daily and weekly rollovers and figure out the total quantity of Fed repos outstanding at any given time, you'll find that the Fed has only injected $18 billion in “liquidity” since March.

If investors think the Fed buying up a few billion of Treasury and agency debt means a hill of beans, they might do well to remember that the U.S. government is running up annual deficits in the hundreds of billions. In fact, the U.S. Treasury will float tens of billions of new debt in December alone (most of which will be sopped up by foreigners, who have increased their holdings of Treasuries by well over $200 billion in the past year). This will be mixed in with refinancings.

So it's difficult to understand why investors would get all excited about the Fed temporarily buying up a few billion in government securities, when we've got a Federal government that's simultaneously and permanently issuing and then constantly rolling over many, many times that amount. It‘s an escape into dreamland to believe that Fed actions have any chance at all of providing more “liquidity” when the Federal government's deficits suck up in a matter of weeks every bit of liquidity that the Fed has provided in a year. These Fed actions are nothing but marginal tinkering around the edges of the global financial system.
The above chart is strike one for anyone that thinks the Fed is providing massive amounts of liquidity to the system.

ECB Christmas Give Away?

Was the "lush half-trillion from the European Central Bank at give-away rates" that much of a Christmas gift?

I confess. This number was so huge that at first I thought it meant something. Subsequent digging has changed my mind. Please consider Vanishing Act - Are the Fed and the ECB Misleading Investors about "Liquidity"?
Contrary to the impressions they attempt to create, neither the Fed nor the ECB have "injected" material amounts of "liquidity" into the international banking system in recent months.

ECB Liquidity – “Now you see it, now you don't!”

Last week, the market shot higher on reports that the European Central Bank was injecting 348.6 billion euro (the equivalent of US$500 billion) of liquidity into the European banking system. The truth is that the ECB actually drained liquidity last week. The ECB data is a little less transparent than the Fed's but they also do their rollovers less frequently (typically one “main refinancing” each week and a few other fine-tuning transactions).

Again, if you want to track these, here's a link to the source data. About half-way down the page is a link to a data file of historical ECB operations (note that the amounts reported are in thousands of euro).

Let me start by thanking Bill Hester, who did the careful (and I'm sure unpleasant) job of sorting through all of the transactions and tying out one refinancing with the next. The following chart summarizes how the ECB has operated in recent months:

Despite the apparently enormous amount of last week's 348.6 billion euro “main refinancing,” the fact is that it was a rollover of existing repos, not a “new injection” of funds. What's more interesting is what didn't get reported.

At the beginning of the week, the ECB had 488.5 billion euro in net liquidity outstanding. By the end of the week, the ECB had 485.5 billion euro outstanding.

So here's the blunt truth: the ECB drained 3 billion euro of liquidity last week!

The story reported and repeated ad nauseum on the financial channels was that the ECB “injected” the equivalent of US$500 billion of “liquidity” into the international financial system last week.
That is strike two for anyone who thinks the Fed and the ECB have been injecting massive amounts of liquidity.

Section 13 (3) Is Much Ado About Nothing

Ambrose Evans-Pritchard writes: "Section 13 (3) allows the Fed to take emergency action when banks become "unwilling or very reluctant to provide credit". A vote by five governors can - in "exigent circumstances" - authorise the bank to lend money to anybody, and take upon itself the credit risk."

The document from which the above paragraph comes is called The Scope of Monetary Policy Actions Authorized under the Federal Reserve Act. Here are some additional details about those emergency lending statutes:
Reserve bank ... "Hackley (1973) has interpreted this provision as indicating: ... it seems clear that it was the intent of Congress that loans should be made only to creditworthy borrowers; in other words, the Reserve Bank should be satisfied that a loan under this authority would be repaid in due course, either by the borrower or by resort to security or the endorsement of a third party."

Under this interpretation, this restriction in section 13(3) could significantly curtail the potential effectiveness of using loans to IPCs to stimulate aggregate demand. In an environment of a sluggish economy and elevated credit risk premiums, lending only to only creditworthy IPCs or accepting only relatively high-quality collateral leaves may limit the scope to lower risk premiums. But, even if the Federal Reserve could take more credit risk onto its balance sheet, any social benefits from the Federal Reserve doing so would need to be balanced against the potentially substantial drawbacks associated with placing the Federal Reserve squarely in the process of allocating credit among private sector borrowers.
Once again, the Fed's ability to do something is dramatically overstated. For starters, it should be clear we are talking about liquidity not capital. Secondarily, it is clear that that liquidity is for credit worthy borrowers only.

Excitement over Section 13 (3) is much ado over nothing just as this excitement over liquidity drops by the Fed and ECB via repo actions is much ado over nothing.

Providing Stimulus When Rates are Zero

Most of the ideas bandied about how to combat deflation are purely academic. Furthermore, those ideas ignore consequences and have not been tested in real world applications. Right now however, I am more interested in what the Fed cannot do, simply because such discussion refutes widely held beliefs about what people think the Fed can do.

Here is a document from the Federal Reserve about Monetary Policy When the Nominal Short-Term Interest Rate is Zero.
The Federal Reserve could also provide stimulus to aggregate demand either by purchasing U.S. agency or private-sector debt (Section 6) or by extending loans in which such debt was used as collateral (Section 7). In both types of operations, the Federal Reserve Act limits the actions of the Federal Reserve.

For example, there is no express authority for the Federal Reserve to purchase corporate bonds or equities. And in making loans, the Federal Reserve seems to be restricted in taking onto its balance sheet the credit risk of private-sector nondepository entities.

Restrictions in the Federal Reserve Act all but rule out "money rains" by the Federal Reserve.
No Helicopter Drop By The Fed

The key point above is there is no grounds for a "helicopter drop" by the Fed. Furthermore, the Fed would not take such action even if they could. The Fed is a private business, it would not give away free money even if it could, just as Pizza Hut is not going to give away free pizzas to everyone for a year.

It is amazing the powers people attribute to the Fed. Close examination shows those powers are nothing but a smoke and mirrors Ponzi scheme that blows bigger bubble after bigger bubble, crisis after crisis.

The Fed has indeed wrecked the economy by its serial bubble blowing activity. However, the Fed is powerless to "fix" it, because the only "fix" the Fed has is the very same Ponzi scheme of repetitive bubble blowing that wrecked it. The only legitimate long term fix is to abolish the Fed and let the free market cure the problem over time. Further attempts by the Fed or Congress to "fix" things will only make matters worse.

All Ponzi schemes eventually implode, and this Ponzi scheme of repetitive bubble blowing is imploding now. History shows that once confidence is lost in the Ponzi scheme by either the lenders or borrowers, it is all over. Well guess what: It's all over. Those expecting a "helicopter drop" of capital from the Fed to fix this mess will be sadly mistaken.


Is the Fed a Private Institution?

I need to make a clarification to one thing I have said above in referring to the Fed as a private institution. My statement was incorrect.

See Who owns the Federal Reserve? for this clarification: "The Federal Reserve System is not "owned" by anyone and is not a private, profit-making institution. Instead, it is an independent entity within the government, having both public purposes and private aspects."

That statement does not materially change arguments presented above or elsewhere about the powers of the Fed.

Mike "Mish" Shedlock
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