A professional investor alerted me to a not-widely-noted element of the Fed’s new discount window clone for primary dealers, the so-called Primary Dealers’ Credit Facility (I am going to lose track of the acronyms given the speed with which the Fed is coming up with new ways to socialize losses).
This overview is from the Fed’s press release:
The PDCF will provide overnight funding to primary dealers in exchange for a specified range of collateral, including all collateral eligible for tri-party repurchase agreements arranged by the Federal Reserve Bank of New York, as well as all investment-grade corporate securities, municipal securities, mortgage-backed securities and asset-backed securities for which a price is available.
The PDCF will remain in operation for a minimum period of six months and may be extended as conditions warrant to foster the functioning of financial markets.
Ah, but how will the Fed assign values to the collateral? From the Fed’s FAQ:
What collateral is eligible for pledging?
Eligible collateral will include all collateral eligible for tri-party repurchase agreements arranged by the Federal Reserve Open Market Trading Desk, as well as all investment-grade corporate securities, municipal securities, mortgage-backed securities, and asset-backed securities for which a price is available.
How will collateral be valued?
The collateral will be valued by the clearing banks based on a range of pricing services.
That sounds objective and innocuous, right? Guess again. As the investor commented:
Note also that the Fed’s accepting the clearing banks’ valuations on the assets that the brokers present as collateral. That is so very understanding of them. Given that the clearing banks hold similar assets themselves, they are probably grading on a curve here, so as not to mark down their own assets simultaneously, I’m guessing. We’ll give the best student here an A—make that a triple A!—and hey, look, we’re all triple A on this bus. Yikes.
Update 11:30 AM: We had missed these comments from Willem Buiter on the same issue, which reader Jay pointed out:
“…the pledged collateral will be valued by the clearing banks used by the primary dealers to access the new facility, based on a range of pricing services.” This suggests that the Fed will accept whatever valuations the clearing banks may come up with. The only qualification is that collateral that is not priced by the clearing banks will not be eligible for pledge under the PDCF.
Collateral eligible for pledge under the PDCF includes all collateral eligible for pledge in open market operations, plus investment grade corporate securities, municipal securities, mortgage-backed securities, and asset-backed securities.
This arrangement is an invitation to the primary dealers and their clearers to collude to rip off the Fed by overvaluing the collateral, including using false markets and/or arbitrary internal pricing models as part of their ‘..range of pricing services’ (what are pricing services anyway?). They can then split the difference. If the Fed wants to be mugged, why not let the primary dealers themselves price the collateral they offer the Fed?
For all collateral that is not priced in verifiable, liquid markets, the Fed should arrange its own auctions to discover the reservation prices of those offering the collateral. Leaving it to the clearers is a written invitation to be offered dross at gold valuations. The tax payer will be the loser. A bad and incomprehensible miss. This can be gamed by a bunch of reasonably smart high school kids.
The problem is I’m not sure Buiter’s idea of an auction works either, since sales in small lots do not represent the prices that would apply to larger transaction sizes….but at least it’s an idea. It would at least be better if the Fed checked prices (including those that can be derived from liquid markets) against those from the various services itself.