Saturday, March 8, 2008

The Fed nationalizes the banks



NOTE: Please also read today's Debt Rattle, March 8 2008



Ilargi: In the article below, Steve Waldman at Interfluidity shines his light on how he thinks the Fed, behind the scenes, props up the US banking system.



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. 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.


18 comments:

Iowa Boy said...

The losses get socialized bit by bit, they try their "everything is a nail" bit with the rate cut hammer because they've got no other tool and it wouldn't matter if they did, because more liquidity doesn't fix a solvency problem.

The taxpayers get to hold the bag on this one after the wealthy skate away, but for a few sacrificial goats like those mortgage company CEOs who get hung out to dry so the media can be used to adjust the victims, er, citizens' perception of the situation.

At least its coming to pass while Bush is in office - no convenient "Oh, a Democrat got elected and look what happened!"

Peak oil and climate change are bad enough problems; we're going to miss the trillion pissed away in Iraq when we finally start on remediation here.

God, what a disaster.

FB said...

Hello,

Just read the article and one section raised a question.

The author writes:
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.

My question is this. Are there not other triggers? Can a bank not simply fold, in spite of Fed help? It strikes me that if the Fed is doing all this, it is precisely because that risk exists.

Can someone shed some light on this question?

Thank you,
FB

Ilargi said...

François,

Steve Waldman suggests that the Fed will prop up the banks to such an extent, that is to say, almost limitless, that banks can indeed not fail.

If he is right, the Fed would wind up with limitless amounts of worthless paper. Or would they? Another way to look at this is that the Fed would de facto end up owning the banks outright.

And if that were their intention, accepting bad paper becomes a means to an end.

Note that Waldman implies that the Fed is the government. I would personally never make that claim.

Anonymous said...

Brilliant piece of speculation here! I never thought of the connection between debt and equity you propose. Did Japan's equivalent of the Fed pull shenanigans like this in the nineties? I remember that the banks were very obstinate about marking down their bad loans. Did the Japanese Fed take these loans as collateral?

Greyzone said...

So there is the play. Will it work? It might. Markets are more psychology than anything else. Could the Fed stop the deflationary crash now? Very possibly, at least for a long while.

The one unknown is how foreigners are going to view the dollar in light of this Fed play. If the dollar keeps falling like a stone, nationalizing the banks won't help because the result will show up as massive price increases for US consumers and that still kills their market. In order for this to work, the US has to persuade large dollar holders, from Japan to China to Saudi Arabia, that the dollar is going to at least be "ok" if not strengthening. If this bit of legerdermain can be successfully pulled off, then we have a possibility that the default of the United States may have to wait for another day.

I call this attention because, at the time, none of us believed the US could avoid default in the late 1970s. Yet it did. Part of that was the US convincing Japan and Saudi Arabia to hold on to their dollars. Part of that was tightening the belt by raising rates to combat inflation. This is an entirely different situation but it remains at least theoretically possible that Bernanke and company may yet convince the market that all is going to be ok.

We may not believe that and to us the fundamentals look irreversible. But we may yet turn out to be wrong purely because of human desire to believe the best rather than accept reality.

Personally, I still don't believe they can pull this off but after my experience in the late 1970s I learned that you never say never on economic matters. Psychology matters and it matters far more than people think it should. If everyone agrees that the emperor is still dressed in fine clothes, then he is, so far as the market is concerned.

On the upside, if this occurs, it means that those of us looking to invest more heavily in self-sufficiency have more time to do so. I'm still not counting on that but it may yet come to pass. It also means that commodity pressures should remain alive and well so those of us speculating based on peak oil may continue to do reasonably well.

ric said...

So this is what it looks like to pump and dump a country.

Who are the main stakeholders of the Fed? Is it known?

Ilargi said...

ric,

For Fed ownership, I recommend you start reading this interview, and take it from there:

Interview with G. Edward Griffin, Author of 'The Creature from Jekyll Island'

Whatever you conclude, it certainly isn't a boring story.

Iowa Boy said...

re: maintaining the dollar value.


We're off the gold standard as of 1971, one can argue the dollar's value was predicated on maintaining global security for oil flows from 1971 - 2008. What do we have left?

Eleven aircraft carriers. Twenty two cruisers. Fifty one destroyers. Ten assault carriers. Thirty frigates.

We've already proven we'll use armed robbery as a guiding principle behind foreign policy. Even a shiny new Democratic administration is going to face a worn out military, troubles at home, and the temptation to redirect ... or am I too skeptical re: human nature?

Anonymous said...

Unless I misunderstand, this Fed bailout structure can only last as long as there is no mark-to-market on the underlying pledged assets, because as soon as market value for said assets is determined, the Fed is forced to recognize that value (as opposed to the face value which it may be recognizing now). In short, this still only constitutes a temporary liquidity solution (although with rollovers, it may not be so temporary). The key issue is that as long as the pledged assets continue to devalue based on higher default/foreclosure rates, the capital bases of the financials/banks will still continue to decline, and as entities this program really doesn't do anything to save them. It is merely a cheap source of temporary liquidity to avoid a series of domino'ing margin calls which would create a fire sale on almost all non-treasury assets (which was probably recognized as a threat as a couple of the Muni Hedge Funds unwound the other day).

Matthew.

Anonymous said...

Ilargi,

Does this mean the FRB is taking over the commercial banks?

ric said...

Greyzone,

I may be reading it wrong, but I liked the equivocation of your post. Reminds me of the Tao Te Ching:

"The enlightened possess understanding
So profound they can not be understood.
Because they cannot be understood
I can only describe their appearance:

Cautious as one crossing thin ice,
Undecided as one surrounded by danger,
Modest as one who is a guest,
Unbounded as melting ice,
Genuine as unshaped wood,
Broad as a valley,
Seamless as muddy water."

Ilargi said...

Matthew, Anon

Hypothetically, the Fed could take over the banks, and in that case, the more assets are marked to market, the cheaper it gets for the Fed.

I updated today's Debt Rattle a while back with the article that proves my statement yesterday that the wheels have come off. It also fits the scenario that this hypothesis suggests.

The mother of all margin calls.

Anonymous said...

Ilargi,

Would the FRB like to own the banks they are trying to bail out? What would be the consequences?

Greyzone said...

Then the Fed's desperation move (and de facto nationalization of the banks is sheer desperation) may be too late already.

Those of you trying to gauge how much time is left, you can't. Everything is guesswork on how fast the system can devolve from here. Days, weeks, months? No one here can authoritatively say.

I'd be very leery of any supposed "terrorist" incident this year though. It would be much too convenient.

Anonymous said...

In the 70s USA was the one and only big economy. Nowadays it is not, China, India are roaring.

In the 70s there was no food shortage, the green revolution was bearing its fruits. Nowadays we are 6 billion human beings and arable land has not expanded on this planet.

I agree that economy is not science, things can happen beyond rationals.

What I see is that the US thinks that as long cheap and abundant money keeps flowing down the financial system, average citizen can keep on buying and the system will go on for ever... Meanwhile in Europe inflation is taken more seriously and rates are kept "high" to prevent it... therefore we have two opposite courses of action. We'll see which is better.

Stoneleigh said...

GreyZone,

I think it's too late. The flood of margin calls has already begun, and those assets will be marked to market as defaults occur and collateral is sold into illiquid markets. There's no way any institution, or group of institutions, could stop this, because once confidence is gone, the market can withdraw liquidity faster than anyone can create it.

Iowa Boy said...

Several responders have posted with the implicit assumption that as long as the market doesn't go down (ie DOW on TV is "OK") that the market doesn't go down. I think this is wrong on two accounts.

The loss has already occurred. If you bought a really great tulip bulb that is certain to produce a variegated bloom six weeks before tulip mania ends all you're holding is a tulip bulb infected with an interesting virus. If banks, hedge funds, etc are all leveraged 32:1 and the mark to make believe is already unwinding this is already past the control of any personality, no matter how many helicopters full of cash might be available. Currency at a minimalist level is a symbol for stored productivity and these overinflated entities have little or no real value.

The whole concept of GDP is a bit synthetic - the make believe world of economists is about to get penetrated by peak oil and climate change as well as the foolishness in the markets this last decade which we focus on here. The underpinnings of productivity are energy and the underpinnings of consumers are food. Both of those "real" commodities are going to go up, up, up.

What matters now is usable calories and consumable BTUs. Yes, really, the 'unwinding' must proceed to this point. This might take a generation ... or two ... but its inevitable. If you want a civil society at your current location you'd better have hydro, wind, solar, or a nuclear plant handy, and if its the latter you'd better have one of the three former you can develop because those things don't last forever.

Anonymous said...

"Anyone with leveraged investments in non-100% liquid assets will be caught under the wheels of the oncoming steamroller"

I assume this excludes commodities futures?