Covert Nationalization of the Banking System

One of the upsides of blogging is sometimes other inquiring minds get to the bottom of matters that have been nagging at you.

We had warned a couple of months ago that a colleague with serious connections into the Treasury and Fed told us they were working on plans for a quasi-nationalization of the banking system. Their view was that while banks would technically be solvent, they'd have enough bad credits that they would be unable to extend new loans.

Steve Waldman, in a terrific post at Interfluidity, concludes that nationalization is underway, via the expansion of the Term Auction Facility and Fed's new 28 day repo program.

Readers may know that there has been a lot of disquiet regarding the negative non-borrowed banking reserves that resulted form the TAF. Bond market mavens, such as commentator Caroline Baum at Bloomberg, dismissed those worries as reflecting a lack of understanding of Fed operations.

I remained troubled, not by the negative non-borrowed reserves figures per se, but by the fact that the Fed was downplaying an operation which was extraordinary. The TAF is a discount window of sorts, but with somewhat longer-term loans and no stigma. Note the TAF accepts the same types of collateral at the same haircuts as the discount windows.

But the discount window is a "break glass in case of emergency" facility. It's when liquidity is so scarce that banks can't borrow on normal terms, so they go to the Fed, post collateral, and get dough. The fact that a supposedly temporary operation has become semi-permanent and was increased (it was initially $40 billion, then it was quietly increased to $60 billion) was a troubling sign, yet the Fed acted as if this was business as normal.

Waldman does a thorough job of parsing the two initiatives announced Friday, the further expansion of the TAF, plus the establishment of the new repo facility.

Differences in degree can be differences in kind, and that's what Waldman argues has happened. The US banking system is on life support. The Fed has now become a very big prop, far more significant than the highly publicized sovereign wealth fund investors.

From Interfluidity:

The Fed announced that it would auction off $100B in loans this month rather than the previously announced $60B via its TAF facility. In the same press release, the FRB announced plans to offer $100B worth of 28 day loans via repurchase agreements against "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 second announcement puzzled me. After all, the Fed conducts uses repos routinely in the open market operations by which they try to hold the interbank lending rate to the Federal Funds target. In aggregate, the quantity of funds that the Fed makes available is constrained by the Fed Funds target. So, what do we learn from this? Fortunately, the New York Fed provides more details:

The Federal Reserve has announced that the Open Market Trading Desk will conduct a series of term repurchase (RP) transactions that are expected to cumulate to $100 billion outstanding... These transactions will be conducted as 28-day term RP agreements.. When the Desk arranges its conventional RPs, it accepts propositions from dealers in three collateral “tranches.” In the first tranche, dealers may pledge only Treasury securities. In the second tranche, dealers have the option to pledge federal agency debt in addition to Treasury securities. In the third tranche, dealers have the option to pledge mortgage-backed securities issued or fully guaranteed by federal agencies in addition to federal agency debt or Treasury securities. With the special “single-tranche” RPs announced today, dealers have the option to pledge either mortgage-backed securities issued or fully guaranteed by federal agencies, federal agency debt, or Treasury securities. The Desk has arranged single-tranche transactions from time to time in the past.

There are a couple of differences, then, between this new program and typical repo operations:

1. The loans are of a longer-term than usual. Ordinarily, the Fed lends on terms ranging from overnight to two weeks in its "temporary open market operations". The Fed will now offer substantial funding on a 28 day term.

2, The Fed is effectively broadening its collateral requirements by collapsing what are usually 3 distinct levels of collateral which are lent against at different rates to a single category within which no distinctions are made.

The Fed offered the first $15B of repo loans under the program today, so we can see how things are going to work. First, how did the Fed square the circle of ramping up its repos without pushing down the Federal Funds rate? Just as it had done with TAF, the Fed offset the "temporary" injection of funds with a "permanent open market operation". The Fed purchased 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. Conventionally, monetary policy is about managing the quantity of the central bank's core liability, currency outstanding. When the Fed wants to loosen, it expands its liabilities by issuing cash in exchange for securities. When it wants to tighten, it redeems cash for securities, reducing Fed liabilities. The asset side is conventionally an afterthought, "government securities". But the Bernanke Fed has branched out. It has sought to lend against a wide-range of assets, actively seeking to replace securities about which the market seems spooked with safe-haven Treasuries on bank balance sheets without creating new cash. By doing this, the Fed hopes to square the circle of helping banks through their "liquidity crisis" without provoking a broad inflation.

"Monetary policy on the asset side of the balance sheet" is a bit too anodyne a description of what's going on here though. The Fed has gotten into an entirely new line of business, and on a massive scale. 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.

Caroline Baum wrote a column last week poopooing concerns about the Fed taking on credit risk via TAF lending. (Hat tip Mark Thoma.) I usually enjoy Baum's work, but this column was poorly argued. In it, she points out that the Fed has all the tools it needs to manage credit risk. The Fed offers loans only against collateral, and requires that loans be overcollateralized. If the collateral has no clear market value or if there are questions about an asset's quality, the Fed has complete discretion to force a "haircut", writing down the asset (for the purpose of the loan) to whatever value it sees fit. And the Fed can always just say no to any collateral it deems sketchy.

All of that is quite true, and (as Baum snarkily points out) not hard to find on FRB websites. But it fails to address the core issue. Sure the Fed has all the tools it needs to manage credit risk. But does it have the will to use those tools? In word and deed, the Fed's primary concern since August has been to "restore normal functioning" to financial markets. The Fed has chosen to accept some inflation risk in its fight against macroeconomic meltdown. Why wouldn't it knowingly accept some credit risk as well? No one has suggested that the Fed is being "snookered". Skeptics think the Fed is intentionally taking on bank credit risk while still lending at very low rates. Some of us find that troubling.

Which brings us to the more postmodern issue of what credit risk even means to a lender with unlimited cash and an overt unwillingness to let those it lends to default. In a way, I agree with Baum. Until the current crisis is long past, I think it unlikely that any large bank will default and stiff the Fed with toxic collateral. Why not? Because for that to happen, the Fed would have to pull the trigger itself, by demanding payment on loans rather than offering to roll them over. Since TAF started last fall, on net, the Fed has not only rolled over its loans to the banking system, but has periodically increased banks' line of credit as well. In an echo of the housing bubble, there's no such thing as a bad loan as long as borrowers can always refinance to cover the last one.

The distinction between debt and equity is much murkier than many people like to believe. Arguably, debt whose timely repayment cannot be enforced should be viewed as equity. (Financial statement analysts perform this sort of reclassification all the time in order to try to tease the true condition of firms out of accounting statements.) If you think, as I do, that the Fed would not force repayment as long as doing so would create hardship for important borrowers, then perhaps these "term loans" are best viewed not as debt, but as very cheap preferred equity.

Let's go with that for a minute, and think about the implications. One much discussed story of the current crisis is the role of sovereign wealth funds in helping to capitalize struggling banks. Will they, won't they, should we worry? Sovereign wealth funds have invested about $24B in struggling US financials. Meanwhile, the Fed is quietly providing eight times that on much easier terms.

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.

You may object, and I'm sure many of you will, that our little thought experiment is bunk, debt is debt and equity is equity, these are 28-day loans, and that's that. But notionally collateralized "term" loans that won't ever be redeemed unless and until it is convenient for borrowers are an odd sort of liability. Central banks are very familiar with the ruse of disguising equity as liability. Currency itself is formally a liability of the central bank, but in every meaningful sense fiat money is closer to equity.

I do not, by the way, object to nationalizing failing banks. There are (unfortunately) banks that are "too big to fail", whose abrupt disappearance could cause widespread disruption and harm. These should be nationalized when they fall to the brink. But they should be nationalized overtly, their equity written to zero, and their executives shamed. That sounds harsh. It is harsh. One hates to see bad things happen to nice people, and these are mostly nice people. But running institutions with trillions dollar balance sheets is a serious business. Accountability matters. These people were not stupid. They knew, in Chuck Prince's now infamous words, that "when the music stops... things will be complicated.", and they kept dancing anyway.

But accountability has gone out of style. The Federal Reserve is injecting equity into failing banks while calling it debt. Citibank is paying 11% to Abu Dhabi for ADIA's small preferred equity stake, while the US Fed gets under 3% now for the "collateralized 28-day loans" it makes to Citi. Pace Accrued Interest (whom I much admire), I still think this all amounts to a gigantic bail-out. And that it is a brilliantly bad idea from which financial capitalism may have a hard time recovering. Like a well-meaning surgeon slicing up arteries to salvage the appendix, the Federal Reserve is only trying to help.

From a corporate finance perspective, Waldmans' argument about the Fed effectively being an equity provider isn't as off base as it sounds. If you as a creditor are unable to call in your loans or otherwise exercise your contractual rights, your position is so badly subordinated that you are effectively equity. And there is no indication that the Fed will take any more action relative to the banks that become dependent on it beyond its normal supervisory role. To behave otherwise, after all, would make it even more difficult for those organizations to function in the marketplace, which risks damaging their ability to function even further.

Hamilton: Negative Real Interest Rates Feeding Commodities Bubble

Jim Hamilton must feel like a Cassandra. At the Fed's Jackson Hole conference last August, Hamilton gave a presentation that warned that the pricing of Fannie's and Freddie's debt was unwarranted given their highly leveraged balance sheets unless you believed that they really were full faith and credit obligations. He warned that assumption would be tested by the market and that the Fed would be the party that would have to come to the rescue.

Over the last three weeks, agency spreads have increased to levels not seen in a generation. Friday the Fed announced some new measures to shore up the market, including a one-month repo facility that seems a tad generous in how it treats agency-guaranteed collateral.

Now Hamilton is telling us what many suspect, namely, that the Fed's interest rate policies are stoking the commodities boom to dangerously overheated levels. But Hamilton marshals data and arguments.

As we have said before, negative interest rates are a seriously bad idea, except (perhaps) on a short-term basis, say, six months. But the problem is that the monetary authorities, having painted themselves in a corner a bit by going so low, are then reluctant to increase rates until they have solid signs of economic recovery. Given the lag time for rate changes to have effect, this results in an overly long period of excessively low rates.

And negative rates fuel speculation. With money effectively free, anyone who can borrow on good terms has every incentive to find something to do with it. We had dot coms, housing, and now commodities, And debt-fueled expansions produce poor quality growth. Our latest growth period is the first in which household earnings failed to reach the high of the previous expansion. But the Fed seems incapable from learning from its experience.

From Econbrowser:

f the Fed thinks that recent commodity price moves have nothing to do with their own actions, perhaps they should think again.

The yield on the 2-year Treasury fell yesterday to 1.5%. It's impossible to imagine that the average inflation rate over the next two years could be less than 2%, meaning that the real interest rate-- the nominal rate minus expected inflation-- has become unambiguously negative. Greg Mankiw is impressed that when you plot the implied real yield on the Treasury inflation indexed security maturing in 2010, you indeed get a graph of the real interest rate that has recently become quite negative. If there is no inflation over the next two years, you'd actually pay more in dollars to buy this security than you will receive back in coupons and principal. With inflation, you may make a nominal gain, but you're guaranteed to end up with less than you started in real terms.


Apart from the evidence of your lying eyes, does economic theory allow the possibility of a negative real interest rate? The answer, in an economy in which there is only a single consumption good that can be costlessly stored, is no. In such a world, you would never park your capital in the form of a Treasury asset that cost you one potato today and repaid you 0.99 potato next year, when you had available an opportunity instead to put a potato in your cupboard today and still have a perfectly good potato next year.

Percent change in commodity prices since Jan (click to enlarge)

As Greg points out, in the actual U.S. economy we of course have thousands of goods and services, many of which cannot be stored at all, and most potatoes don't actually fare that well if you leave them in your cupboard for a year. But some items certainly can be stored pretty easily, and it is quite striking that the list of goods that are most readily stored is precisely the list of items whose price has been bid up most spectacularly since the real interest rate turned negative. The accompanying table displays the nominal price change over the last two months in the prices of the main commodities I could get my hands on through Webstract. Note these are the actual changes since January 1-- to quote these at an annual rate you'd multiply by about 6.

Can the real interest rate be negative in a world where some but not all goods can be stored costlessly? Consider for illustration an economy with two goods, immortal potatoes and transient haircuts, with both items currently selling for $1 and both given equal weights in the CPI. If you put $2 into a 1-year TIPS with a real interest rate of -1% in that world, next year you'd have the ability to purchase 0.99 potatoes and 0.99 haircuts.

Why buy the TIPS when you could simply save the $2 in the form of 2 potatoes and still have those same 2 potatoes a year from now? If nothing else changes, and 2 potatoes were still worth 2 haircuts a year from now, everybody would want to do just that. If we were in long-run equilibrium before the real rate went negative, in response to a negative real interest rate, everybody would want to buy potatoes today as an investment vehicle. The price of potatoes today would have to be bid up to a point above the long-run equilibrium so that from here, potato prices are expected to rise less quickly than the price of hair cuts. Your 2 potatoes might be worth 2 haircuts today, but if they're only worth 1.96 haircuts next year, you might be just indifferent between an investment in TIPS or physically storing the commodity.

Now the real world is admittedly more complicated. Playing commodities is the farthest thing from a risk-free investment, and the calculation is more along the following lines. There is a downside risk from investing in commodities, and that downside risk grows the farther relative commodity prices move above their long-run equilibrium values. But the lower the real return available on assets such as Treasuries, the more investors are willing to face those risks, with negative real rates just producing an extreme version of that calculation. This of course is just a variant of Jeff Frankel's claim that interest rates are a prime driver of commodity prices.

I'm also willing to believe that there are a number of investors plunging into commodities today who don't know what they're doing. The economic fundamentals warrant a temporary increase in the relative price of commodities, for the reasons just given. Some less sophisticated investors see the surging commodity prices and jump on the bandwagon, thinking they're going to continue to go only up. To the extent that this is part of what's going on in the current market, it is just one more reason why commodity prices have responded as sharply as they did to negative real interest rates.

But wouldn't it be nice if instead of reasoning by "suppose that" and "what if", economists could resolve our disagreements like real scientists with controlled experiments? I have a modest suggestion along these lines.

With the Fed's target interest rate currently at 3.0%, a 1.5% two-year nominal Treasury yield implies that the market is expecting the Fed to cut rates a whole lot more and in a big hurry. Is 75 the new 25? asks Greg Ip-- we used to expect 25 basis points each meeting, now it seems to be 75.

So the Fed would clearly shock the markets by only bringing the rate down 25 basis points this month, to a new target of 2.75%. If Frankel is correct, we'd see an immediate plunge in commodity prices across the board. If we didn't see that price response, then the outcome of the experiment would have proved that the Fed is right in claiming that the recent commodity price moves have nothing to do with the FOMC.

So how about it, Ben? Wouldn't it be fun to collect a little high-quality data here? In the name of science?

Of course, Bernakne lacks the nerve; that's precisely why commodities are acting the way they are.

And even if they give up half their gains since January, I bet most investors won't be deterred (all the gains, conversely, would have a deterrent effect). As Hamilton points out, commodities are the best inflation hedge. There are good odds for US investors that the dollar will continue to depreciate, independent of the inflation outlook. Yes, you might get nailed and take a bad hit, and it could easily take a year to recover losses. But absent an economic collapse, the odds of continued tight supply and inexorable (over time) demand increases over the next few years appears to be sounder than any other bets on offer right now.

"Sense of crisis haunts trading floors"

An article in today's Financial Times is useful, albeit sobering, for attempting to give more of a calibration of the negative sentiment sweeping credit markets. Pretty it isn't.

Note also that the FT isn't big on stories with emotional content.

From the Financial Times:

A palpable sense of crisis pervades global trading floors. Not since the meltdown of the Long-Term Capital Management hedge fund in 1998 have interest rate and derivative markets suffered such a breakdown in confidence.

In the past decade the scale of bond and derivative trading has expanded enormously, as global banks have provided easy access to trading for hedge funds and other investors.

That source of cash has dried up as banks seek to protect their deteriorating balance sheets amid writedowns of impaired assets. Big banks have pulled back from lending to clients for trading, starting a vicious downward spiral across the mortgage, interest rate swap, municipal bond, corporate debt and global credit derivative markets.

As investors have purged mortgages from portfolios, interest rate swap spreads – a barometer of bank credit risk – have surged more than a percentage point above Treasury bond yields.

In the credit derivatives market, the cost of buying insurance against corporate default has hit highs in the US, Europe and Japan.

The Federal Reserve’s response on Friday – a boost in short-term lending for banks this month to $100bn (€65bn, £50bn) from $60bn – provides more cash for banks in return for posting mortgages and other assets as collateral. But there are fears the benefit will not percolate beyond a small circle of banks.

“As the nation’s financial risk and lending has become concentrated in ever fewer money centre banks, the Fed finds itself more powerless than ever to control the spreading conflagration in the credit markets,” said Bill O’Donnell, strategist at UBS.

Banks have tightened lending standards in the repurchase market, where cash is borrowed against assets by hedge funds and others. This has forced some funds, such as Peloton and Carlyle Capital, to sell assets bought using borrowed funds. As assets are sold, prices fall further, prompting banks to keep tightening lending standards.

Many expect the turmoil to go on for much longer than the 1998 crisis.

“LTCM was such a transitory event compared with today,’ Mr O’Donnell said. “This is not just about the collapse of one entity, this is about millions of homeowners who are underwater.”

Until home prices stop falling and foreclosure rates cease rising, investors will keep shying away from holding mortgages. On Thursday, Citigroup said it planned to reduce its US mortgage assets by $45bn during 2008.

Unlike past housing crises, the banking sector is far less well equipped to cope with the fallout because of the wave of banking consolidation in the last decade, said Mr O’Donnell. This means the pain has become concentrated among a small handful of institutions, all of whom play a crucial role in keeping all markets liquid.

“As each of the mega-banks begins to suffer from housing-driven balance sheet stress, they simultaneously pull credit lines from other fully-functioning markets,” he said.

Note that in the wake of the LTCM crisis, it took swap spreads, a measure of market perceptions of risk, a full year to return to their former levels.

MBIA Tells Nasty Fitch to Go Away; Ambac's Friends Manipulate Market

Further confirmation of the lack of integrity in the markets comes via the desperate and pathetic measures of the monoline insurers.

First, a Bloomberg story tells us that MBIA has asked Fitch to quit rating some of its insurance units because it thinks its grading scale is too harsh.

Gee, the whole point of a rating is that it is supposed to be objective. But no, MBIA wants to limit itself to craven ratings agencies (let's face it, they were all under tremendous pressure not to downgrade the monolines. Fitch stuck to its guns; S&P and Moody's used the fig leaf of likely-to-be-inadequate capital-raisings to capitulate while in their fantasy, maintaining their honor).

Fitch doesn't have to comply, and if I were them, I wouldn't. The more they stand apart from Moody's and S&P, the better they look.

From Bloomberg:

The bond insurer MBIA Inc., which is facing a downgrade, asked Fitch Ratings on Friday to stop issuing credit ratings on its insurance units.

MBIA said that it had requested that Fitch withdraw its ratings on units including the AAA-rated MBIA Insurance Corporation.

Fitch is the only top credit rating company that continues to consider a downgrade of MBIA’s rating. Moody’s Investors Service and Standard & Poor’s both affirmed the company last week....

A spokesman, Willard Hill, said that MBIA disagreed with Fitch’s model for capital allocation. He did not know whether Fitch planned to comply with its request. “This is something we have been evaluating for a long time,” Mr. Hill said.

Fitch says that MBIA should have more capital than required by S.& P. and Moody’s to support the asset-backed securities it guarantees, Mr. Hill said. That is “incompatible” with MBIA’s plans to separate the company’s businesses in the next five years, he said.

Second, Ambac continues in what looks an awful lot like manipulation. Recall that we had the specter, twice, of CNBC announcing rumors of Ambac's progress with bailout talks within a half an hour of the close of trading.

These rumors turned out to be inaccurate, but they served to lead to a big rally in the shares (with a large short interest, any move upwards will lead to a lot of covering).

Note that this is already highly suspicious. When NYSE companies have announcements during the trading day, they are supposed to call a trading halt. But the leak was done in a manner that seems designed to inflict maximum pain on the shorts.

Why is it probable that Ambac was behind the leaks? Because, unlike the Treasury's failed SIV rescue effort, the monoline bailout negotiation have had very few unauthorized comments. Remember, you have an M&A shop running the process, Perella Weinberg, and people from that discipline take confidentiality very seriously. At a minimum, after the initial leak, there should have been a search for the guilty and sufficiently stern warnings so as to prevent a second leak.

Today, it appears that Ambac painted the tape. Investors placed trades in the minute before the close to goose the stock price reported for the day (Thornberg did so as well):

Shares in Ambac and the mortgage lender Thornburg Mortgage surged Friday after investors traded blocks of at least 10 million shares in the week’s final minute, according to Bloomberg data.

The transactions multiplied Ambac’s 4-cent gain for the day into a $2.08 increase, closing at $9.50, and turned a 24 percent drop for Thornburg into an 8.5 percent rally. The stocks rose on orders submitted by investors instructing brokerage firms to trade at least 10 million shares as near to the end of the day as possible, according to exchange data compiled by Bloomberg.

While there did not appear to be any news to send Ambac higher, “people think something’s going on because the print went up so high,” said Joseph Saluzzi, the co-head of equity trading at Themis Trading in Chatham, N.J. “It doesn’t look like it’s a keypunch error since it was such a large block.”

Further indication that these trades were designed to goose the stock price? Ambac's price fell sharply in after-market trading. From MarketWatch:

Shares of Ambac Financial slumped more than 13% in after-hours trading Friday, after the struggling bond insurer raised $1.5 billion in a share offering to help it protect its crucial triple-A credit rating. Shares of Ambac fell to $8.25 in late trading

Links 3/8/08

Jail for Australian kiss killers BBC

After the Ratings Agencies John Quiggin

What is to be done? Paul Krugman

Fedspeak Highlights: Mishkin on Dollar Depreciation Economics Blog, Wall Street Journal. "Frederic Mishkin says dollar depreciation has had “modest” impact on inflation." Mishkin is not one of my favorites.

Judge: Flat-Fee Arrangements in Foreclosures, Bankruptcies “Corrosive” to Practice of Law Housing Wire

Fitch cuts WaMu rating, says may cut other banks Reuters

The John McCain Market Selloff The Big Picture

Antidote du jour. Reader Joe said I needed some less cute photos, and then sent me pix that for the most part were endearing. But this honors the spirit of his request:



Rex cats do indeed look ratlike (they've been bred to be hairless for people who are allergic to cats). Let's pretend the ornamentation was done with Photoshop.

Fed Fund Rate Predictions

Courtesy the Cleveland Fed. Note that this is as of time, the Fed fund futures market says there is zero probability of a 25 basis point reduction. A 50 basis point cut has 50% odds.

Note this chart is dated March 6. and therefore does not reflect the impact of the announcement of the increase in the Term Auction Facility.



David Leonhardt of the New York Times reports that later trading showed expectations shifted to a deeper cut:

Traders became even more confident, based on the price of futures contracts, that the Fed would cut its benchmark interest rate three-quarters of a point, to 2.25 percent, when policy makers meet on March 18.

Another Times article by Edmund Andrews points out the Fed lacks effective remedies:

The Fed’s problem is that its main weapons against a downturn — lower interest rates and easier money — are ill suited to a crisis that stems from collapsing confidence about credit quality.

Even though the central bank sharply cut short-term interest rates twice in January and clearly signaled that it would cut them again on March 18, rates for home mortgages have risen and rates for many forms of commercial loans have jumped sharply.

Fed Increases the Term Auction Facility

The Fed raises the amount on offer for the TAF from $30 billion to $50 billion, bringing the size of the facility to $100 billion.

The stock market took cheer briefly, but as of this writing, the Dow has retreated back into negative territory.

From Bloomberg:

The Federal Reserve plans to increase its loans to banks this month to offset a deepening credit crisis threatening to tip the U.S. economy into a recession.

The central bank increased to $50 billion each from $30 billion the amount intended for auctions of funds planned for March 10 and March 24. The Fed also said in a statement in Washington today that it will make $100 billion available through weekly 28-day repurchase agreements, where the central bank lends cash in return for assets such as Treasuries.

The decision is the central bank's latest attempt to reduce the threat to the economy from banks curtailing loans to companies and households. Banks and securities firms have posted losses exceeding $181 billion since the start of last year as the impact of surging defaults on subprime mortgages rippled through world financial markets.

``Given what we have seen in terms of illiquidity in the financial markets in the last four or five days, this came right in time,'' Ajay Rajadhyaksha, head of fixed income strategy at Barclays Capital in New York, said in an interview with Bloomberg Television.....

Fed officials said today's announcement wasn't related to the Labor Department's jobs report, and was aimed at addressing the deterioration in credit markets. The officials, speaking on condition of anonymity in a conference call with reporters, also said the measures won't expand the Fed's balance sheet.....

Officials said they will keep the benchmark federal funds rate target around the level set by the FOMC, indicating they don't plan for the liquidity measures to drive the rate lower

Fisher: Don't Expect the Fed to Bail You Out

Let's see if the credit markets take this warning seriously. From Bloomberg:

Federal Reserve Bank of Dallas President Richard W. Fisher said investors shouldn't assume the Fed will keep up the recent pace of interest-rate cuts.

``We reacted with very deliberate actions'' in January, said Fisher in an interview with Bloomberg Television in Paris. ``That shouldn't lead markets to expectations that we will continue to react in that manner.''

Fed officials have cut their benchmark rate by 2.25 percentage points since August, taking it to 3 percent. The 1.25 percentage point of reductions in January was the fastest easing of policy in two decades.

Fisher also downplayed speculation that the Fed is set to hold an emergency meeting after a recent rise in credit costs.

``I would discourage you from thinking that simply because of a significant action in the credit markets, like we had yesterday, that suddenly we're going to have an Open Market Committee meeting, and that suddenly we're going to move Fed funds rates in response,'' said Fisher. ``It doesn't work that way.''

"Vicious spiral haunts debt markets"

Gillian Tett in the Financial Times points out a nasty conundrum. For the credit markets to get back to some semblance of normalcy, prices of instruments have to fall their clearing price. Only a very few will buy before a bottom has clearly been reached. But reaching liquidation prices will entice the capital that has been sitting on the sidelines (or piled into commodities) to start buying.

However, under a mark-to-market regime, realizing those prices will render a lot of firm technically bankrupt. It isn't just that this is politically unacceptable. Some of these firms are too big to fail in a practical sense; the damage to the confidence in the financial system would offset the salutary effects of reaching the market clearing price level. In addition, they are an essential part of the modern financial infrastructure. Lose, say, a Citi and a UBS, and you have impaired global intermediation capacity, much like losing part of a road system or electrical grid. You can probably still get from A to B, but with more cost and less speed (of course, with firms sitting on the sidelines in the agency market maybe the difference won't be as evident as the policymakers believe, but fewer big entities intermediating means less intermediation under most circumstances).

From the Financial Times:

This weekend the Group of Ten central bankers will convene in Basel for one of their regular pow-wows. The discussions will be fraught.

Almost three months ago, a similar gathering paved the way for an unprecedented bout of collective action in the money markets that was supposed to halt the sense of financial panic.

But three months later, the grisly truth is that market anxiety is seeping back with a vengeance. Thus the crucial question confronting the central bankers this weekend, as they fly in to snowy Switzerland is twofold: first, are we on the verge of a new downward lurch? And second, is there anything the G10 bankers can actually do to stop this?

A downward lurch does look a real danger now, not least because the central bankers themselves are looking increasingly impotent when it comes to tackling the fundamental reasons why sentiment is so fragile.

The western financial system is caught in a trap. On the one hand, there is an urgent need for clearing prices to be established for impaired assets to restore confidence; on the other hand, if this is done in a mark-to-market world, there is a risk that some banks will run out of capital. Policymakers are in the unenviable position of knowing almost any step they take risks denting sentiment further.

First, a bit of background. History suggests a crucial component for ending a financial crisis is to establish some sense of clearing prices. Once goods look cheap – and it does not seem they will soon become cheaper still – buyers tend to rush back in. This, after all, is Economics 101, and it applies as much to houses and cars as collateralised debt obligations.

Now, in theory, there are plenty of reasons to expect investors to start rushing into the credit markets soon, in a manner that could stabilise sentiment. After all, many credit prices have slumped dramatically. And while banks may be capital constrained, plenty of investors are sitting on pots of free cash, such as sovereign wealth funds and even mainstream asset managers and pension groups.

But these groups are notably not buying credit yet, either because they are still paralysed with shock or, more realistically, because they have a nasty feeling that while a leveraged loan, say, looks cheap, it could be cheaper in the future.

How can you combat this? Fifteen years ago, the US government devised a clever trick in the aftermath of the savings and loans crisis, by conducting firesale auctions of S&L assets. This was brilliantly effective in establishing clearing prices and turning sentiment around, because as soon as investors saw some assets being sold at knockdown prices they starting jumping in, meaning that within a few months, prices were rising again.

But these days the US government faces a crucial impediment to repeating this trick. Back in the days of the S&L crisis, US banks were not forced to mark their books to the firesale prices. But now the mark-to-market creed has taken hold. And it is a fair bet that if US banks were forced to mark their books to the initial clearance price for a CDO squared, say, some would run out of capital. Hence the trap: in the modern financial system, you can have mark-to-market accounting systems, or quick action to establish clearing prices, but probably not both, without blowing up some banks.

Of course one way to exit this trap would be to abandon the mark-to-market rules for a while, or loosen capital adequacy standards. Some furtive discussions between policymakers along these lines are already occurring.

But I would be surprised if any action occurs soon. So the risk now is that we will remain trapped in this climate of grinding fear for months – at best. Few institutions have much incentive to voluntarily create clearing prices. However, hedge funds are now being forced to make asset sales in an ad hoc, opaque manner that is adding to the sense of fear. This is forcing the banks to mark books lower and pull in their horns, sparking even more hedge fund sales and fuelling concern about banks. It is a viciously unpleasant spiral.

Let us all hope the G10 have some amazing new tricks up their sleeves; if not, we are moving into dangerous waters.

Honey, I Blew Up the Bank

No, this isn't a confessional by Jerome Kerviel. Instead, it's a few excerpts of a very good paper by the Senior Supervisors Group (regulators from France, Germany, Switzerland, Britain and the United States) who went poking around 11 major financial institutions to find out how they botched their risk management so badly last year. The report was presented privately in February and released today by the New York Fed (hat tip Mark Thoma).

The paper, "Observations on Risk Management Practices During the Recent Market Turbulence," is remarkable in how damning it is. Oh, it's correctly anodyne, it simply sets forth the good and bad practices in a number of categories. The lapses speak for themselves. They are glaring and multi-dimensional.

If I were to put the findings in simple categories, the shortcomings would include:

A "see no evil" approach to risk models. There was a lack of critical thinking, particularly when better models might curtal business. There was often a naive (or perhaps more accurately, an unduly optmistic) use of VAR, and at many firms, a credulous attitude towards ratings.

Inmates in control. Far too much discretion was given to desk and business unit managers.

Insufficient attention to firm-wide risk. Risk was too often managed and measured in a disaggregated fashion, with inadequate concern given to stress events that could hit multiple markets.

Weak liquidity management. This is a shocker. Botching liquidity management will bring a firm down fast. But it appears treasury departments weren't well integrated into a lot of firms' risk practices.

Senior management putting profits before prudence. This has been widely suspected, with some sightings (for instance, Merrill forced out the head of its structured finance business because he recommended against expanding it further in 2006) and it indeed appears to have been a common pattern.

Some representative sections follow.

Why worry about evaluating credit risk when you have rating agencies:

At firms that performed better in late 2007, management had established, before the turmoil began, rigorous internal processes requiring critical judgment and discipline in the valuation of holdings of complex or potentially illiquid securities. These firms were skeptical of ratings agencies' assessments of complex structured credit securities and consequently had developed in-house expertise to conduct independent assessments of the credit quality of assets underlying the complex securities to help value their exposures appropriately.....Subsequent to the onset of the turmoil, these firms were also more likely to test their valuation estimates by selling a small percentage of relevant assets to observe a price or by looking for other clues, such as disputes over the value of collateral, to assess the accuracy of their valuations of the same or similar assets.

In contrast, firms that faced more significant challenges in late 2007 ... generally had not established or made rigorous use of internal processes to challenge valuations. They continued to price the super-senior tranches of CDOs at or close to par despite observable deterioration in the performance of the underlying RMBS collateral and declining market liquidity. Management did not exercise sufficient discipline over the valuation process: those firms generally lacked relevant internal valuation models and sometimes relied to passively on external views of credit risk from rating agencies and pricing services to determine values for their exposures. Given that the firms surveyed for this review are major participants in credit markets, some firms' dependence on external assessments such as rating agencies' views of the risk inherent in these securities contrasts with more sophisticated internal processes they already maintain to assess credit risk in other business lines. Furthermore, when considering how the value of their exposures would behave in the future, they often continued to rely on estimates of asset correlation that reflected more favorable market conditions.

"Don't bring me bad news":

Less successful firms had difficulty getting senior management and business-line management to
embrace the use of forward-looking scenarios with large underlying price movements and to participate in the
development and use of such tools. According to some risk managers, the larger the shock imposed, the less plausible the
stress tests or scenarios in the eyes of business area and senior management.

Ignore those icebergs, full steam ahead:

An overarching difference is apparent in the balance that senior management achieved between expanding the firms' exposures in what turned out to be high-risk activities and fostering an appropriate risk management culture to administer those activities. [...] For example, firms that experienced material unexpected losses in relevant business lines typically appeared to have been under pressure over the short term either to expand the business aggressively, to a point beyond the capacity of the relevant control infrastructure, or to defend a market leadership position. In some cases, concerns about the firms reputation in the marketplace may have motivated aggressive managerial decisions in the months prior to the turmoil. [...]

[S]enior management at ... firms that recorded relatively large unexpected losses tended to champion the expansion of risk without commensurate focus on controls across the organization or at the business-line level. At these firms, senior management's drive to generate earnings was not accompanied by clear guidance on the tolerance for expanding exposures to risk. For example, balance sheet limits may have been freely exceeded rather than serving as a constraint to business lines. The focus on growth without an appropriate focus on controls resulted in a substantial accumulation of assets and contingent liquidity risk that was not well recognized.

"AAA CDOs? Sure, those are safe":

For example, several firms misestimated basis risk in their approaches to managing the CDO warehousing and
packaging business and significantly underestimated the risk of the super-senior positions they retained as a result. The practice at some firms of valuing super-senior tranches of subprime CDOs at or close to par value and assuming that their risk profile could be approximated using the historical corporate Aaa spread volatility as a proxy failed to recognize these instruments’ asymmetric sensitivity to underlying risk (in contrast to an unstructured corporate bond of the same rating). The first loss protection built into the securitization structure created an asymmetric exposure to losses in the underlying assets, so that the senior tranche became more sensitive to default rates as credit quality deteriorated. As volatility spiked up and credit spreads widened, the increasing sensitivity of the instrument to underlying risk led to accelerating mark-to-market losses. In general, the construction of CDOs tends to make them more sensitive to systematic shocks. In contrast, highly rated corporate debt issuances tend to be more sensitive to “idiosyncratic” risk, or risks associated with characteristics specific to the corporation that issued the debt.

There's a lot more where this came from; do read the paper.

Credit Swaps Feedback Loops Raising Corporate Borrowing Costs

An article in Bloomberg, "Credit Swaps Thwart Fed's Ease as Debt Costs Surge ," focuses on a noteworthy phenomenon, but does a lousy job of explaining it. I'm posting it nevertheless in the hopes that a reader in the relevant markets might shed some light.

The story tells us that corporate borrowers, even AAA ones like General Electric, are facing borrowing costs that seem inappropriately high due to the impact of correlation models for credit default swaps, which are no longer working properly.

The article states that as CDO prices fell, banks that owned them attempted to hedge them. OK, I get that part. They then began use indices to hedge the exposures. I get that too. But apparently they were using indices on corporate bonds like the the Markit CDX North America Investment-Grade Index.

Huh? A corporate bond index to hedge exposures that are significantly if not primarily real estate related? Presumably the use of an index from a completely different asset type was used to hedge CDOs based on the famed correlation models mentioned in the article.

But guess what? Markit was founded in 2001. Any models based on its indices have so little history as to be the functional equivalent of garbage, which is what we are seeing now.

The article is also not clear how the CDS prices are distorting the price setting for new bond issues. I assume it is because price formation no longer takes place in the cash bond market but in the CDS market (that's been true for some time for secondary trading, since a lot of corporate bond issues don't trade very much, if at all).

From Bloomberg:

Credit trading models used by Wall Street have gone haywire, raising company borrowing costs even as Federal Reserve Chairman Ben S. Bernanke cuts interest rates.

General Electric Co. is one of five U.S. companies rated AAA by both Standard & Poor's and Moody's Investors Service, making its ability to repay debt unquestioned. Yet when the Fairfield, Connecticut-based firm sold 2.25 billion euros ($3.35 billion) of five-year bonds last week, its annual interest payment was $17 million higher than on a sale nine months ago.

Borrowers from investor Warren Buffett's Berkshire Hathaway Inc. to Germany's HeidelbergCement AG face the same predicament. Yields on $5.12 trillion of corporate bonds tracked by Merrill Lynch & Co. average 2.05 percentage points more than U.S. Treasuries, the most since at least 1997.

The higher costs are an unintended consequence of securities that allow investors to speculate on corporate creditworthiness. So-called correlation models used to value them have become unreliable in the fallout from the U.S. subprime mortgage crisis. Last month some showed the odds of a default by an investment- grade company spreading to others exceeded 100 percent -- a mathematical impossibility, according to UBS AG.

``The credit-default swap market is completely distorting reality,'' said Henner Boettcher, treasurer of HeidelbergCement in Heidelberg, Germany, the country's biggest cement maker. ``Given what these spreads imply about defaults, we should be in a deep depression, and we are not.''

The problem started in the second half of last year when subprime mortgage delinquencies started to rise, causing investors to retreat from complex instruments such as synthetic collateralized debt obligations, or packages of credit-default swaps that became hard to value. The swaps are contracts based on bonds and used to speculate on a company's ability to repay debt.

As values of CDOs began to fall, banks that had sold swaps underlying the securities started to buy indexes based on them instead, a method of hedging their losses on portions of the CDOs they owned. The purchases are driving the cost of the contracts higher, raising the perception that company bonds tied to the swaps are suddenly riskier and leading investors to demand higher yields throughout the corporate debt market.

The Markit CDX North America Investment-Grade Index, a gauge of credit-default swaps on 125 companies from Wal-Mart Stores Inc. to Walt Disney Co., has more than doubled since the start of the year. It jumped as much as 21.5 basis points today to a record 186 basis points, according to Deutsche Bank AG. The index dropped to a low of 29 in February last year...

Banks bought more contracts on indexes containing GE's swaps after CDO pricing models broke down, sending the so-called default correlation to more than 100 percent last month from 60 percent in July, according to research from Zurich-based UBS.

The programs, which computed the value of the highest-rated portions of CDOs, implied that all companies in the CDX index would default if just one did. Banks often hold these senior tranches after arranging the CDOs for investors.

``The banks that have been using correlation to calculate their risk will have to go back to scratch,'' said Janet Tavakoli, president of Chicago-based Tavakoli Structured Finance. ``By using correlation models as the main means of risk management, the engineers threw out sound banking practices.''....

The mathematical breakdown is compounding the decline by creating a vicious circle. As the cost of the swaps on the CDX index increases, the models signal a greater risk of defaults, and vice versa. A bank holding $100 million of the highest-rated portion of a swap-based CDO now has to buy $60 million of swaps to maintain its hedge against losses, JPMorgan said. A year ago, it would have had to buy $10 million.

``The recent unwind and activity in that market is also causing activity in our name,'' said GE spokesman Russell Wilkerson. Swaps linked to GE's financing unit are included in 67 percent of European CDOs, more than any other company, according to S&P.

Before the subprime collapse, the burgeoning CDO market had the opposite effect. Increasing demand for the underlying assets helped lower U.S. corporate bond yields to 1.28 percentage points over similar-maturity government notes in February 2007, the smallest spread since 2005, indexes from New York-based Merrill show. Synthetic CDOs pool swaps, while others package loans or bonds.

``It's the key factor that brought spreads to irresponsibly tight levels up to the end of the second quarter of last year,'' said Nigel Sillis, director of fixed-income and currency research at Baring Asset Management in London. ``Now we're seeing the reverse, except that the impact is far more negative than it was ever positive.''

One way to make the models useful again is to reduce the amount banks expect to recover from defaulted bonds to 30 percent of face value from 40 percent, according to analysts at UBS and New York-based Citigroup Inc. Banks would still have to buy more default protection though, keeping the pressure on borrowers.

``The unwinding of structured credit is eating away at the fabric of the corporate bond market,'' said Suki Mann, a credit strategist at Societe Generale SA in London. ``The increase in credit-default swaps is making it far too expensive to borrow.''

LInks 3/7/08

Emotion + “Radical Neuroscience” = Alpha All About Alpha Emotion allegedly plays a role in trading success.

1.54, 105, 1.45 -- deleveraging continues ... Brad Setser. Setser argues, among other things, that foreign central banks should shift out of Treasuries into agencies. Good idea, but it will never happen.

‘Dr. Doom’ Gloomy On U.S. Economy Boom2Bust. I always thought Dr. Doom was Henry Kaufman, but he has some competition for the sobriquet. This post summarizes an interview with Marc Faber.

How the French invented subprime in 1719 James Macdonald, Financial Times. Even if you have heard of John Law, this is worth reading.

Antidote du jour:

Citi To Shrink Mortgage Portfolio by $45 Billion

The retreat from the mortgage market continues. Not surprisingly, no one wants to lend to high-risk borrowers that are now having trouble paying.

Notice also that Citi plans to sell a high proportion of its new mortgages to Fannie and Freddie.

From the Financial Times:

Citigroup is to shrink its $200bn-plus mortgage portfolio by a fifth in an effort to reduce its reliance on low-growth assets and free up capital to bolster its finances.

The US financial services group is also planning to move the bulk of new loans off its balance sheet by securitising them or selling them to Fannie Mae and Freddie Mac, the government-sponsored mortgage financiers...

Bill Beckmann, the head of the enlarged mortgage business, told the Financial Times that the planned $45bn reduction in mortgage assets would help Citigroup to reduce risk and release capital for investments in faster-growing businesses.

Mr Beckmann added that most of the reduction would come from repayments of existing loans but said that Citigroup would also explore the sale of some loans.

He said that, by the third quarter of this year, 90 per cent of new mortgages originated by Citigroup would either be securitised or sold to Fannie and Freddie - a move that was expected to reduce the company’s capital and credit exposure.

Over the past year, as housing woes have deepened, Citigroup has been reducing its mortgage portfolio.

The company’s volume of outstanding mortgages, which stood at $286bn in the first quarter of 2007, fell to $232bn in the last three months of the year.

The annual rate of growth in mortgage origination has also declined from 19 per cent at the beginning of last year to 11 per cent in the last quarter.

However, Citigroup’s mortgage book remains 30 per cent higher than at the beginning of 2006.

Credit Markets "Utterly Unhinged"

The credit markets are casting a big vote of no confidence in the idea that the Federal government can rescue the housing market.

As we noted before, spreads on agency securities have widened to extreme levels. This renders the Fed's rate cuts largely ineffective, at least if the intent was to give relief to the housing market via lower rates (note some believe the Fed wants to steepen the yield curve. Since banks borrow short and lend long, a big gap between short and long term rates will allow them to rebuild their battered balance sheets faster).

Some of the sources in the Bloomberg story seem close to panicked, and investors contend that investment banks are backing away from making a market. This is in securities historically considered to be virtually as solid as Treasuries, and the market is nearly as big as the Treasury market. There's plenty of reason to be worried.

When will the Fed get the message that its plan of action is actually backfiring? It can't remedy a solvency crisis via monetary action. What is needed is considerably more transparency, so that counterparties become less reluctant to conduct business with each other. I don't have a clear idea as to how to achieve that (full transparency would any firm with trading positions at a disadvantage). However, the Fed has access to top experts and has know since last August that counterparty worries are a big part of the problem. Dealing with it indirectly is no longer effective.

Note there are also worries that hedge fund unwindings could lead to seize-ups in other sectors of the credit market.

From Bloomberg:

Yields on agency mortgage-backed securities rose to a new 22-year high relative to U.S. Treasuries as banks stepped up margin calls and concerns grew that the Federal Reserve may be unable to curb the credit slump.

The difference in yields, or spread, on the Bloomberg index for Fannie Mae's current-coupon, 30-year fixed-rate mortgage bonds and 10-year government notes widened about 11 basis points, to 227 basis points, the highest since 1986 and 93 basis points higher than Jan. 15. The spread helps determine the interest rate homeowners pay on new prime mortgages of $417,000 or less.

The markets have become ``utterly unhinged,'' William O'Donnell, a UBS AG government bond strategist in Stamford, Connecticut, wrote in a note to clients today. A lack of liquidity has ``led to stunning air-pockets in price levels.''

Investors are realizing that banks have little room to make new investments amid rising losses and a flood of unwanted assets, said Scott Simon, head of mortgage-backed bonds at Pacific Investment Management Co. The world's top banks have reported more than $181 billion in asset writedowns and losses, been stuck with $160 billion of leveraged buyout loans, and bailed out $159 billion of structured investment vehicles.

``Everything is telling you the financial system is broken,'' Simon, whose Newport Beach, California-based unit of Allianz SE manages the world's largest bond fund, said in a telephone interview today. ``Everybody's in de-levering mode.''....

The widening spreads prompted speculation the government may step in to support securities guaranteed by Fannie Mae and Freddie Mac, said Tom di Galoma, head of U.S. Treasury trading in New York at Jefferies & Co., a brokerage for institutional investors. The Treasury Department said the rumor isn't true.

``The Fed can't really save the mortgage market,'' di Galoma said. ``As they keep cutting, mortgage rates aren't going lower.''

The spread of current-coupon fixed-rated securities guaranteed by Ginnie Mae against 10-year Treasuries has climbed 39 basis points this month to 189 basis points, also the highest since the 1980s, according to Bloomberg data. Debt guaranteed by Ginnie Mae is explicitly backed by the U.S. government, and based on loans already insured or guaranteed by its agencies. A basis point is 0.01 percentage point.....

``The capital issues at commercial banks are making them, in general, reluctant to lend, so lending is either harder to find or when you do find it, it's more expensive or the other terms are more-limiting.'' Steven Abrahams, an analyst with Bear Stearns Cos., said in a telephone interview yesterday.

``If there's less money to finance positions and less balance-sheet available to warehouse positions, the markets are going to become more volatile,'' he said....

``The single biggest concern right now is who's the next hedge fund to blow up, and how big are they,'' Arthur Frank, the New York-based head of mortgage-backed-securities research at Deutsche Bank AG, said in an interview today. ``The more the market widens, the more likely it is that another leveraged player has to sell, so it does feed on itself.''....

``Traders are putting their phones down and backing slowly away from their desks,'' O'Donnell said today in a telephone interview. ``Relatively little'' agency mortgage-backed securities are being traded, Pimco's Simon said.

Blankfein Upbeat; Gross Distorts Data and Calls for Federal Rescue

We have the specter of two CEOs, each heading a firm that is a leader in its businesses and a debt powerhouse, making close to polar opposite statements about the prospects for the credit markets.

Lloyd Blankfein, Goldman's chief, said today that the credit crisis was half to two thirds through its course. While there may be more rocky episodes, he believes the worst is over.

Bill Gross, the co-head of Pimco, argued in the Financial Times that if Feds don't start throwing money at the housing market immediately, we'll have, um, a super bad contraction (as we discuss later, he goes to some length to avoid using the D word).

They've both oversold their case.

Now in fairness, while Blankfein was optimistic about the trajectory, he still sounded cautious notes. From Bloomberg:

Goldman Sachs Group Inc. Chief Executive Officer Lloyd Blankfein said the credit-market contraction that started with subprime mortgages is at least halfway over.

``We're not in the ninth inning by any means, we're maybe two-thirds through, a half to two-thirds,'' Blankfein, 53, said today in an interview. ``I think it will consume our attention for the rest of this year.''...

``It's going to be difficult, there's going to be stress and pain, not just for Wall Street but more importantly for citizens, but it is being worked through,'' Blankfein said. ``The signs of it are all the attention, the writedowns, the fact that assets are being disposed of'' and sold to ``more patient capital.''

Now of course, Goldman needs to be positive; it's almost certain to join its peers and show signs of bond market stress in its first quarter earnings announcement