Maybe the Real Reason for the Central Bank (Especially the Fed’s) Actions Wednesday

One of the perils of being an evening/overnight blogger is that one is either early or late to news items. But a positive aspect of being on the late side is that one can (hopefully) be thoughtful rather than reactive.

Wednesday we had the spectacle of five central banks taking coordinated action to deal with the worrisome and widening spread between interbank rates, such as Libor, and risk-free rates, signaling that banks no longer trust their peers. And the crunch would most certainly get nastier as the end of the year approaches, since even in normal times, banks pull back on their short-term lending then so they can square their own books.

The problem with this combined operation is that, as one spectator perhaps too correctly depicted the move, it was shock and awe, more PR than punch. However, as the Financial Times’ Martin Wolf pointed out, the PR may count, because (as he reads it), these measures are a sign that the helicopters will keep dropping cash as long as necessary, and thus may well shore up flagging confidence. More from Wolf later. Nouriel Roubini is (if possible) even more dubious, as we’ll discuss in due course.

Aside: why is it that when people talk of helicopters and cash, I see that “I love the smell of napalm in the morning” scene from Apocalypse Now? And remember, we did lose that war.

As Bloomberg depicts the recent actions, the Fed and other central bankers are trying to pursue joint but distinct courses of action, one to alleviate stressed conditions in the money markets, the other to provide appropriate monetary policy given the economic fundamentals. But can this work? The Fed funds market has been demanding lower rates, likely out of a belief that they are needed to shore up declining asset values.

James Hamilton at Econbrowser pens his usual thorough analysis. He focused on the novel aspect of the Fed’s action, which was the creation of a term auction facility. It sits somewhere between the discount window and Fed funds.

Some had complained at the Fed’s failure to cut its rate at the discount window, but frankly, I don’t see the point. We learned in August when things were rocky that banks simply don’t access it (yes, a few banks stepped up and took $500 million each to be sports, but that isn’t the usage intended). Too much stigma, no easy way to solve that problem. So the term facility is both a way to address the year-end crunch and could be a precursor to similar facilities as a adjunct to the not-well-loved discount window.

Hamilton’s synopsis:

The basic idea is that the Fed will specify a certain maximum amount that it would like banks to borrow. It intends to lend up to $20 billion for a 28-day term on Monday, and lend up to an additional $20 billion for a 35-day period on December 20. Potential borrowers will bid an interest rate to receive this loan, with I presume each $20 billion going to the highest bidders. Banks must also provide collateral for these loans.

The objective is clearly not just to get $40 billion more in reserves into the banking system next week– an open market operation could accomplish that just fine. The objective must be to get the reserves into the hands of those particular banks that want them most. Of course, those same banks could be getting them right now through the discount window, but choose not to, perhaps because of the stigma, or perhaps because of the financial penalty charged for discount borrowing relative to borrowing on the fed funds market from other banks. In effect, the term auction facility would reduce the spread between the discount rate and the fed funds rate to however low it needs to be in order to motivate $40 billion worth of borrowing next week.

The other thing the facility accomplishes is allow the Fed to accept lower-quality collateral from borrowers than its rules require for open market operations conducted through repurchase agreements. If there is an effect of the facility, I would think that this would be the mechanism. What may matter is not the reserves put in the system, nor who gets those reserves, but the troublesome assets temporarily taken off some institutions’ balance sheets.

I’m largely on the same page as Hamilton but see things a wee bit differently. First, I’m skeptical that $40 billion of repos, which is what these are, over the year-end period, really does much of anything, liquidity-wise (technically, this doesn’t create liquidity precisely because it’s a temporary infusion). Felix Salmon calls this a “bailout” but I don’t buy that. A one month pawn operation, even if you can hock your beaten-up couch, is still a loan, not a gift, unless you go bankrupt in that month and leave the pawnshop holding overvalued furniture.

And $40 billion doesn’t seem large enough to have much, if any, effect, unless the psychological impact is disproportionate. By comparison, commercial paper outstandings fell by $23 billion the week ended December 5.

So the real effect may be, as Hamilton and others suggest, in the expansion of types of collateral that are considered acceptable. Hamilton’s notion that the assets are “taken off the balance sheet” is somewhat misleading. If this were indeed a repo, the assets go to the central bank temporarily; the borrower gets cash back (at a discount to the face value of the collateral) and shows a liability, an “agreement to repurchase.” However, repos are generally used only for highly liquid instruments, such as Tresuries. My impression that that is not the procedure envisaged herel. While the economics may be the same as for a repo, the form of the transaction may be somewhat different. The language in the press release is “term loans secured at the discount window.” That suggests that the assets remain on the borrowers’ balance sheets and the Fed simply has a secured interest.

Now how can the acceptance of relatively crappy (yes, crappy, it will accept even CDOs if they are rated AAA) collateral matter? First, there is a belief, not confirmed anywhere in neat tables with haircuts, that the Fed will accept even broader types of collateral than permitted at its discount window, but I don’t see language to that effect in its press release announcing the program. In fact, the reverse:

Under the Term Auction Facility (TAF) program, the Federal Reserve will auction term funds to depository institutions against the wide variety of collateral that can be used to secure loans at the discount window.

So this is basically a discount window under another name, with a different price setting mechanism. The Fed plans at least two more auctions in January, and will seek comments. So this is an experiment that may become a permanent feature, or may be tweaked further.

So what is the real significance of this move? See below:

Most of the CDO and subprime paper held by banks is AAA. Now I have no idea where this stuff is trading, and the fact is that a lot of it is not trading. However, lot of people are using the ABX as a proxy for subprime and other risky mortgage credit risk. So it may not be a price, but it’s a reference point for pricing. And it has AAA credits at 70 cents on the dollar.

So the Fed’s temporary facility could be used, quite legitimately, to mark anything that the Fed would accept as a repo at its collateral value for accounting purposes (you could theoretically have made the same argument for the discount window, but that’s an emergency facility, while this is intended for all comers). That places a very big floor under a lot of now-questionable credit. That move would reduce writedowns, the accompanying loss of confidence, and the need for additional equity well out of proportion to the paltry $40 billion the Fed is throwing into the mix. Of course, one could argue this is Japan circa 1992, but we are well down that path already.

Now to other skeptical comments First, the Financial Times’ Martin Wolf, who in “The helicopters start to drop money,” frets that the powers that be have now committed themselves to open-ended salvage operation, which will embolden too many miscreants to sin again:

The central bank helicopters are planning a co-ordinated drop of liquidity on troubled market waters. The money to be dropped now is not that large. But if this does not work, more will surely follow. The helicopters will fly again and again and again.

One point is clear: central banks must be pretty worried to take such a joint action. For what is remarkable about Wednesday’s statement is that five central banks – the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve and the Swiss National Bank – are co-ordinating their (different) interventions. Their hope must be that this action will trigger not panic (”what do the central banks know that I do not?”) but confidence (”now that the central banks are prepared to intervene in this way, I can at last stop worrying”)…

So why might Wednesday’s co-ordinated interventions succeed where previous actions have not? In a word, the answer is: stigma

Central banks have become increasingly worried about the unwillingness of banks to borrow from them. These banks reasonably fear that exceptional borrowing is a signal mainly of distress. The hope of the central bankers is that by auctioning funds to a wide group of institutions such anxiety would diminish, if not disappear. That hope is strengthened by the fact that these actions are joint: they are evidently aimed at lifting sentiment rather than saving specific institutions.

Will this work? The answer is that if the fundamental problem in the markets is lack of liquidity (that is, panic), rather than insolvency, and if central banks are believed willing to offer liquidity to solvent institutions without limit at what the latter consider a “reasonable” discount, then symptoms of stress should indeed disappear.

Yet these are both important provisos. In particular, there is good reason to believe that a good part of the stress is caused by worries over solvency, indeed by the reality of threatened insolvency in at least some cases. True, central banks or, more precisely, the treasuries that stand behind them, could eliminate that concern, too, by buying up every piece of paper, good, bad and indifferent. But that would also be an open-ended, possibly very expensive and certainly unpopular bail out.

Moreover, even if today’s stress is indeed a liquidity problem (something that we do not now know), there remains the question of the scale of the intervention required. Assume, for example, that central banks end up buying a vast amount of paper and so providing liquidity to institutions that have deliberately taken on big risks, by lending long and borrowing short. They have then validated those strategies, after the event.

So does the action by the central banks give us good reason to stop worrying? Only if you like huge rescue operations of incompetent bankers, would be my answer. They may well get the markets back into order. They may, in this way, rescue economies from the threat of recessions. But that is not the end of the story. The bigger the rescue has to be today, the more stringent regulation of financial institutons will have to be in future.

Nouriel Roubini elaborates on the theme mentioned by Wolf, that the central banks’ measure are aimed at a liquidity problem rather than a solvency problem (Wolf did suggest the central banks could address that too if they stood ready to take on massive amount of paper; we aren’t there yet).

This observation, that solvency and lack of transparency present a very different set of problems than liquidity, has been a theme of Roubini’s for some time. Even though it has gotten favorable mention in the financial media, it does not seem to have penetrated policymakers’ thinking.

From the RGE Monitor:

The announcement today of coordinated liquidity injections by FED, ECB, BoE, BoC, SNB is however too little too late and it will fail to resolve the liquidity and credit crunch….

There has some heated debate in recent weeks on whether the liquidity crunch is due to:

a) short-term year end liquidity needs (the “Turn”);

b) a more persistent liquidity risk premium;

c) a rise on counterparty risk and broader perceived credit problems of counterparties; i.e. serious problems of insolvency rather than illiquidity alone.

d) a more general increase in risk aversion due to severe credit problems and information asymmetries (risk aversion due to uncertainty about the size of the financial losses and uncertainty on who is holding the toxic waste of RMBS, CDOs and other ABS products);

e) the failure of the monetary transmission mechanism in a financial system where most financial institutions are now non-bank and thus do not have direct access to the central banks’ liquidity or lender of last resort support.

The severe financial crunch is likely due to all of the factors above; but the measures announced today can only partly deal with the first of the two explanations above of the crunch and will do nothing to address the other causes of the crunch. These measures will not be successful for a variety of reasons.

First, you cannot use monetary policy to resolve credit and insolvency problems in the economy; and most of the crunch is due not just to illiquidity but rather to serious credit and solvency problems of many economic agents (households, mortgage borrowers, subprime, near prime and prime mortgage lenders, homebuilders, highly leveraged and distressed financial institutions, weak corporate sector firms).

Second, monetary injections cannot resolve the information asymmetries and generalized uncertainty of a financial system where financial globalization and securitization have led to lack of transparency and greater opacity of financial markets; these asymmetric information problems that generate lack of trust and confidence and significant counterparty risk cannot be resolved with monetary policy.

Third, the US is at this point headed towards a recession regardless of what the Fed does as the build-up of real and financial problems (worst housing recession ever, oil at $90, a severe credit crunch, falling capex spending by the corporate sector, a saving-less and debt burdened consumer buffeted by ten separate negative shocks)….

Fourth, the actions by the Fed today provide more liquidity to a greater variety of institutions but, as the Fed announced, these institutions are only “depository” institutions, i.e. only banks. The severe liquidity and credit problems affect today a financial market dominated by non-banks that do not have direct access to the liquidity support of the Fed; these include: broker dealers and investment banks that do not have a commercial bank arm; money market funds; hedge funds; mortgage lenders that do not take deposit; SIVs, conduits and other off-balance sheet special purpose vehicles; states and local governments funds (Florida, Orange County, etc.).

All these non-bank institutions do not have direct access to the Fed and other central banks liquidity support and they are now at risk of a liquidity run as their liabilities are short term while many of their assets are longer term and illiquid; so the risk of something equivalent to a bank run for non-bank financial institutions is now rising. And there is no chance that depository institutions will re-lend to these to these non-banks the funds borrowed by central banks as these banks have severe liquidity problems themselves and they do not trust their non-bank counterparties. So now monetary policy is totally impotent with dealing with the liquidity problems and the risks of runs on liquid liabilities of a large fraction of the financial system (in a world where these non-bank financial institutions play a larger role in financial markets than non-banks).

And let us be clear: the Federal Reserve Act striclty forbids the Fed from lending to non-depository institutions apart from very emergency situations that would require a complex and cumbersome approval process and the provision of high quality collateral. And the Fed has never – in its history – used this procedure and lent money to non-depository institutions.

Fifth, as discussed before on this blog, this is the first real crisis of financial globalization and securitization; it will take years of major policy, regulatory and supervisors reform to clean up this disaster and create a sounder global financial system; monetary policy cannot resolve years of reckless behavior by regulators and supervisors that were asleep at the wheel while the credit excesses of the last few years were taking place.

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10 comments

  1. vlade

    Repo leaves repo-ed security on the loan’s recipient balance sheet – so whatever gets repoed doesn’t help the balance sheet much (that’s despite the fact that the legal ownership changes).
    At least in the UK.

    I also doubt very stronly about the flooring – you cannot really argue that the value (on the market of something) is x because fed is happy to take it for x (and get you to pay x+y at the end of the term) – mostly becasue no-one in the market would buy it from you for x, as the only thing they could do with it is to repo it to Fed, but ultimately they would get it back (and have to repay the pile of cash, so all that would happen is that they would get a very shorttime infusion of cash, which they would have to repay rather quickly).

    Note also that if the asset collapses while Fed holds it (and, if it indeed is a repo), two things happen: cpty will have to supply a new collateral (for which they don’t get anything), and they still have to pay x+y as agreed before. So, Fed carries no loss unless cpty goes bust, and all loses are still carried by the cpties. This is one of the reasons why the price doesn’t get necessarily floored. If you have an asset and expect to receive 20p in a pound, repoing it doesn’t help, it’s still worth 20p to a pound even if Fed’s willing to (technically) pretend it’s worth more. I think that CBs are using this as a technicality to allow them effectively unsecured lending (which they can’t do otherwise).

    Above of course assumes that the repo facility will not keep rolling – if it would, then Fed indeed effectively “buys” the asset, and the flooring will come. So, I will wait and see whether Fed will do only the four auctions it promised, and what it will do when the maturity comes.

  2. Anonymous

    This facility is an extension of the discount window. It may be useful for year end precautionary reserve management by banks who want to avoid the ‘stigma’ of window borrowing. But its only a band-aid, and a weak one at that. The Fed is doing everything it can to avoid lowering the funds rate as a response to the credit problem. But using non-funds rate tools assumes implicitly that libor and commerical paper spreads are independent of the funds rate. This is questionable. Credit spreads are disproportionately high relative to the current level of the funds rate. They have a disproportionate monetary tightening effect relative to that rate. So monetary policy overall is too tight. The Fed will have to respond to credit spreads that have reversed much of the effect of funds easing to date – by easing the funds rate further. They made a mistake by not dropping 50 bp this time. The yield curve has been inverted too long at this stage and the inversion is also telegraphing that debt deflation rather than inflation is the greater threat.

  3. vlade

    Anynymous: correct me if I’m wrong, but you can only borrow at fed-funds (definitely BoE) if you are collateralized. If you can give collateral, you just can’t get the money, full stop. If you have already used up all your treasuries and similar stuff (and who, apart from Japanese/China/GCC etc. central banks was buying treasuries in any extent for last years when you could have bought commercial paper which gave you better returns and was AAA rated?), you can’t borrow. Be it at fed fund, be it at discount, at whatever rate. In fact, the top price (=low yield) you have to pay for treasuries might be also an effect of the scramble for repoeable securities.

    LIBOR, on the other hand, is unsecured loan, so you don’t need any collateral to get that – and that’s where you turn to if you don’t have any collateral to repo with your friendly (or not) CB.

    That’s the reason why I think that CBs are just trying to figure ways of doing effectively unsecured loans.

  4. Anonymous

    Vlade – they’re not doing unsecured loans. As Yves says in the post:

    ” Under the Term Auction Facility (TAF) program, the Federal Reserve will auction term funds to depository institutions against the wide variety of collateral that can be used to secure loans at the discount window.

    So this is basically a discount window under another name, with a different price setting mechanism. The Fed plans at least two more auctions in January, and will seek comments. So this is an experiment that may become a permanent feature, or may be tweaked further “

    The acceptable forms of collateral will be the same as for the discount window (which in fact are remarkably expansive).

    This is a key point in terms of why either facility should not be considered as a credit ‘bail-out’.

    This term facility really allows banks to meet their reserve requirements in a planning mode rather than an emergency response mode over year end.

    Other than that, it won’t accomplish broader pricing normalization in libor and CP spreads in my view because the Fed is underestimating the full extent that those spreads are having on monetary tightening over and above the funds rate.

  5. Mike

    Excellent post and comments.

    News reports state that Temporary Auction Funds winners will remain anonymous. Will they disclose how many banks were bidding, or the portion of the funds sold?

    There has been a realization that real estate isn’t as valuable as was thought; mortgages aren’t as secure as was thought; ratings of securitised debt isn’t as high as was thought; financing long term debt with short-term money isn’t as sophisticated as was thought.

    What should a holder of overvalued stuff do (assuming they are solvent)? Borrow against it? Then invest the proceeds? In what?

  6. vlade

    Anonymous:
    What I meant by “unsecured loans” was that if the value of collateral is significantly below of what you Fed says it is, a part of the loan is unsecured (could be a large part).
    I wasn’t aware that all of the term facility collateral would be applicable to the discount window though. It still doesn’t change the argument – if anyone was brave enough to use discount window, due to the nature of the collateral the loan would be (effectively) unsecured. So it could just be that Fed was trying the trick earlier, but had no bites (because of the stigma associated with discount window – although I believe people will be watching closely who will take up the auctoion and what they will bid).

  7. doc holiday

    Re: So the real effect may be, as Hamilton and others suggest, in the expansion of types of collateral that are considered acceptable. Hamilton’s notion that the assets are “taken off the balance sheet” is somewhat misleading

    >> By allowing CDOs with higher risk to be used as Fed Window colateral adds risk to this mess and if Im not mistaken, these CDOs and SIVs, ets are taken off the balance sheet, which adds further distortions to this bail out attempt!

  8. foesskewered

    The crux of the problem is not just persuading the banks to take up the loans but how to pass it on (as they so cheerfully did with the toxins) and somehow start a chain of credit to non-banks or those without recourse to fed funds.

    mike: if you have overvalued stuff, obviously you’d try to sell it on or hock it to the person who offers you the best price, the problem is, as yves has pointed out , is the term, 28 and 35 days are way too short. Can’t blame the investing community for thinking that these are merely measures postponing the crisis, not solving it. Guess is, some bankers are gonna have a headache regardless of whether they’re teetotalling this holiday season or not.

    vlade:
    Just wondering but what happens when those AAA rated collateral turns non – AAA, maybe AA or worse during these period whether it’s due to the rating agencies or the insuring agency? Would the net effect then be the fed making money from these loans, thereby further punishing the banks ?

  9. Walt French

    Methinks you underrate the importance of the year-end turn, where US banks repo stuff they don’t want on their year-end statements to brokers.

    No doubt, the brokers couldn’t predict being able to line up enough high-risk capital, despite the high profitability of the deal in past years. The TAF takes some of the pressure off these deals, allowing the banks to report less junk than otherwise.

  10. Mr. Naybob

    Yves,

    Great minds think alike, as I said on the 12th, its the worlds largest pawn shop.

    http://naybob.blogspot.com/2007/12/fed-worlds-largest-pawn-shop.html

    Roubini has it nailed “only depository institutions, i.e. only banks.

    Does anyone think Tony Soprano would set up a pawn shop for anyone other than his shylocks? (The banks)

    This way the Feds masters (the banks legally own the Fed) can take the money and lend it to the other institutions, at a nice vig, like 9%.

    The Nattering Naybob

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