While you were sleeping: A financial coup d'état

Middle class family, US 2012

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Please don't miss today's Debt Rattle, April 9 2008

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Ilargi: Much of what I have said and feared lately is now coming to fruition. And then some. Nationalization is the key.

The entire mass of bad debt and worthless paper that the Fed has bought is about to be moved to your bank account. I'm sorry, but I don't feel like saying too much about it right now. Basically, it's very simple: the Treasury will -massively- increase its borrowing from the Fed (yeah, as if it's not high enough yet) - at 6% interest, as per the law -, and the Fed will slush all those extra funds right through to its member banks.

All in the name of saving "The System", without which all the world would allegedly sink into deplorable anarchy. Bear Stearns was burned at the altar for dubious reasons, and more will follow, until no banks are left except for those that play the game the way the banks behind the Fed want it to be played.

Actually, "game" is not the right word: the time for games is over. We are fast moving towards Benito Mussolini's ideal of corporate fascism: the state run by corporations and, ultimately, their bankers. Ironically, another one of Benito's favorite principles was "Government by Propaganda".

It's quickly coming down to this: Speak now or forever hold your peace.Here are three articles from today's Wall Street Journal. I suggest you forget what I said, and you make up your own mind.

PS: The title "WHILE YOU WERE SLEEPING" comes from one of the best pieces of journalism, and one of the most heart-wrenching stories I know, from Charles Bowden, Harper's Magazine 1996, available at Jay Hanson's incredible DIE OFF site, the most valuable collection of material that exists on the web. Don't even try to read that story if you're not sure you are prepared.


Fed Weighs Its Options in Easing Crunch

The Federal Reserve is considering contingency plans for expanding its lending power in the event its recent steps to unfreeze credit markets fail.

Among the options: Having the Treasury borrow more money than it needs to fund the government and leave the proceeds on deposit at the Fed; issuing debt under the Fed's name rather than the Treasury's; and asking Congress for immediate authority for the Fed to pay interest on commercial-bank reserves instead of waiting until a previously enacted law permits it in 2011.

No moves are imminent because the Fed still has plenty of balance sheet room for additional lending now. The internal discussions are part of a continuing effort at the Fed, similar to what is under way at foreign central banks, to determine its options if the credit crunch becomes even more severe. Fed officials believe the availability of such options largely eliminates the risk of exhausting its stockpile of Treasury bonds and thus losing its ability to backstop the financial system, as some on Wall Street fear.

British and Swiss central banks also are contemplating contingency plans. For now, the European Central Bank is reluctant to consider options that require substantial modifications of its standard tools. The Fed, like any central bank, could print unlimited amounts of money, but that would push short-term interest rates lower than it believes would be wise. The contingency planning seeks ways to relieve strains in credit markets and restore liquidity without pushing down rates.

The Fed is reluctant to heed calls from some Wall Street participants and foreign officials for the Fed to directly purchase mortgage-backed securities to help a market that still is not functioning normally. Before the credit crunch began in August, the Fed had $790 billion in Treasury securities on its balance sheet, about 87% of its total assets. Since then, it has sold or lent about $300 billion.

In their place, the Fed has made loans to banks and securities firms to assist them in financing holdings of mortgage-backed and other securities. Some on Wall Street say the potential for further declines in Fed treasury holdings could leave it out of ammunition.

The Fed holds assets to manage the nation's money supply and influence the federal-funds rate, which banks charge each other on overnight loans. When the Fed buys Treasurys or makes loans directly to banks, it supplies financial institutions with cash; in effect, it prints money. The cash ends up as currency in circulation or in banks' reserve accounts at the Fed.

Since reserves earn no interest, banks lend cash that exceeds their required minimum. That puts downward pressure on the federal funds rate, currently targeted by the Fed at 2.25%. The Fed could purchase securities and make loans almost without limit, expanding its balance sheet.

That would cause excess reserves to skyrocket and the federal funds rate to fall to zero. The Fed would contemplate such "quantitative easing" only in dire circumstances. The Bank of Japan took this step this decade after years of economic stagnation.

So the Fed is seeking ways to expand its balance sheet without causing the federal funds rate to drop. The likeliest option, one the Fed and Treasury have discussed, is for the Treasury to issue more debt than it needs to fund government operations.

The extra cash would be left on deposit at the Fed, where it would be separate from bank reserves on deposit and thus would have no impact on interest rates. The Fed would use the cash to purchase an offsetting amount of Treasurys in the open market; for legal reasons, it generally cannot buy them directly from Treasury.

Treasury's principal constraint is the statutory limit debt. Treasury debt was $453 billion below the limit Monday. In the past, Congress always has responded to administration requests to raise the limit, sometimes only after political theatrics.

Fed officials also are investigating the feasibility of the Fed issuing its own debt and using the proceeds to purchase other assets or make loans. It has never done so; the legality is unclear. Some foreign central banks, such as the Bank of Japan, do so.

Another possibility is seeking congressional approval to pay interest on banks' reserves immediately instead of waiting until a 2006 law permits that in 2011. If the Fed paid, say, 2% interest on reserves, banks would have no incentive to lend out excess reserves once the federal funds rate fell to that level.

Congress put off the effective date because paying interest on reserves reduces the Fed profits that are turned over to the Treasury each year, widening the budget deficit. Although preliminary explorations suggest Congress would be open to accelerating the date, the Fed is leery of depending on action by Congress.

The Fed is inclined to use any additional maneuvering room to lend through its existing and recently expanded avenues. Officials are reluctant to buy mortgage-backed securities directly. They worry that such purchases would hurt the market for MBS that the Fed is not permitted to buy: those backed by jumbo and subprime and alt-A mortgages, which are under the greatest strain.

Moreover, the Fed is not operationally equipped to hold MBS and would probably have to outsource their management. Such holdings wouldn't help avert foreclosures much, since the Fed would have little control over the mortgages that comprise MBS.

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What Could the Fed Do?

Since the Federal Reserve began rolling out ever more creative steps to unfreeze credit markets, it has sold or pledged a growing portion of its portfolio of Treasurys in order to put loans on its balance sheet to banks and securities dealers backed by mortgage-backed securities and other shunned collateral. This has led some observers to worry that if the Fed continues at such a pace, it could run out of ammunition, forcing it to move to quantitative easing

But Fed officials believe those fears are misplaced.

First, here’s what the Fed has done (as of April 3):

1. Lent banks $10.3 billion through the discount window.


2. Lent banks $100 billion in term auction credit.


3. Lent securities dealers $76 billion through standard repurchase agreements.


4. Lent securities dealers $34.4 billion through the discount window.


5. Lent securities dealers $75 billion of its Treasurys in return for other collateral through its new Term Securities Lending Facility.


6. Lent up to $36 billion to the European and Swiss central banks.

This still leaves the Fed with about $500 billion in unencumbered Treasury bonds. Some of that is spoken for — the Fed has promised to lend $29 billion to a new entity to take over assets now on the books of Bear Stearns, and up to $125 billion more in its Term Securities Lending Facility. However, anything more such commitments would likely be at least partly offset by reduced borrowing in its other facilities.

All the same, the Fed likes to think of worst-case scenarios and thus has been thinking about ways to expand its ability to lend. In an extreme case it could resort to quantitative easing as the Bank of Japan did from 2001 to 2006, that is buying up large amounts of assets, and letting the fed funds rate fall to zero. But it would rather avoid that. Here are some ways it could expand its lending capacity while maintaining control of the fed funds rate.

1. The easiest would be to ask Treasury to issue more debt than it needs to fund government operations. As investors pay for the bonds, their cash moves from bank reserve accounts at the Fed to Treasury accounts at the Fed. The Treasury would allow the money to remain there, rather than disbursing it or shifting it to commercial banks who, unlike the Fed, pay interest. Because the shift of cash out of reserve accounts leads to a shortage of reserves, it puts upward pressure on the federal funds rate.
   
   To offset that, the Fed would enter the open market and purchase Treasurys (or some other asset), replenishing banks’ reserve accounts. The net result is that the Fed’s assets and liabilities have both grown but reserves and the federal funds rate are unaffected. This wouldn’t cost Treasury anything so long as it doesn’t bump up against the statutory debt limit. The loss of interest on its cash deposits at the Fed would be roughly offset by the additional income the Fed pays Treasury each year from the interest on its bond holdings.


2. The Fed could issue its own debt or short-term paper. The debt would be an increase in liabilities and it could presumably buy whatever it wanted with the proceeds. Whether the Fed can do so legally is less clear. It previously used the “incidental powers” given it under the Federal Reserve Act to issue options on federal funds around the turn-of-the century date change, and issuing its own debt would likely require invoking the same thing. As one Fed study has noted, use of such power must be “necessary to carry on the business of banking within the limitations prescribed by [the Federal Reserve] Act.”


3. The Fed could seek to pay interest on reserves. Banks lend out excess reserves at whatever rate they can get because the Fed doesn’t pay interest. That’s one reason the federal funds rate often crashes late in the day, when banks realize they have more reserves than they need. Paying interest on reserves would put a floor under the federal funds rate. The Fed could then make loans and purchase assets with little concern for the impact on the federal funds rate.
   The Federal Services Regulatory Relief Act of 2006 empowers the Fed to start paying interest at a rate or rates not to exceed the general level of short-term interest rate effective Oct. 1, 2011. The distant date was a result of Congress’ effort to hold down the cost, since payment of interest will cut into how much money the Fed remits to Treasury each year. The Fed could ask Congress to bring that date up to the present. As a general rule the Fed hates to ask Congress for anything for fear of what else Congress might ask for in return. But if the crisis got to the point the Fed felt it really needed this, it’s hard to imagine Congress refusing.


4. The Fed could try to do the mirror image of the Term Securities Lending Facility. In other words, take the mortgage backed securities pledged to it by dealers in return for Treasurys, and re-pledge them to other dealers, taking Treasurys back. Since the Fed is highly unlikely to fail, dealers might be more comfortable accepting MBS as collateral from the Fed than from other parties. But this might be complicated to do if the MBS are held by a custodial bank as is typical in a triparty repo.

It should be noted that these steps only address the magnitude of the Fed’s lending capacity, not what it does with that capacity. In theory it could simply conduct more of the types of operations it is doing now, or it could get more aggressive, including buying MBS outright, as some on Wall Street have urged it to do. The Fed isn’t closing the door on that but for now doesn’t want to go that route. An alternative would be to sell credit default swaps on MBS or other assets. This would take some of the credit risk of MBS onto its balance sheet — and thus encourage private investors to hold them — while not directly expanding its balance sheet. But doing so presents some of the same thorny issues that buying MBS outright does.

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Benefits of the Fed Doing Reverse MBS Swaps

As reported by The Wall Street Journal, one of the more remote contingencies the Federal Reserve has considered is a mirror image of the Term Securities Lending Facility: it would take the mortgage backed securities pledged to it by dealers in return for Treasurys; then repledge them to other dealers, taking Treasurys back.

Since the Fed is highly unlikely to fail, dealers might be more comfortable accepting MBS as collateral from the Fed than from other parties. But this might be complicated to do if the MBS are held by a custodial bank as is typical in a triparty repo.
Lou Crandall of Wrightson Associates thinks it’s cool idea. His thoughts:
I’ve been discounting the inflated Treasury borrowing option a little bit because the traditional legal view at Treasury has been that the Secretary’s borrowing authority only extends to financing Congressional appropriations. (They cited legal objections last summer when they were urged to pump up their borrowing and put the money back into the [Treasury Tax and Loan] system last summer as a way of providing support.)

Running a banking business is frowned upon. I don’t doubt that [Treasury Secretary Henry] Paulson could persuade the Treasury’s lawyers to rethink their position if absolutely necessary, but it would be a lot cleaner to go to Congress for authority to create a larger warehouse for financial instruments. The reverse swap is intriguing because it is sufficiently exotic that it might sidestep some of the traditional legal issues. My hat is off to whoever thought of it. That is one option that hadn’t occurred to me.

After a quick first reading, it sounds to me as if the idea would be to take the triparty collateral and put it back into the market with a Fed seal of approval. The curious thing about recent repo market disruptions is that counterparties have started caring more about the counterparty than the collateral because nobody wants to be caught up in the uncertainty of a bankruptcy. If the Fed were on the other side, the counterparty risk component would fade away in an MBS repo. That’s so creative/outside-the-box that I hesitate to simply assume that’s what the Fed is talking about.

The Fed could provide guarantees in the financing market that would substantially expand its balance sheet resources through the equivalent of a matched-book operation. With sufficient leverage, they could revalidate a huge range of privately-financed mortgage debt. I’m not sure they should or could legally, but it is really interesting and worth chewing over.

For what it’s worth, I really do think this is an idea that would be worth pursuing if the Fed were faced with an emergency need to provide funding through the discount window. The key would be to set up arrangements to bypass the dealers — to do reverses directly with money funds and other money market funds providers. One of the distinctive features of the Bear collapse, as [New York Fed President Timothy] Geithner and others have said, is that investment banks had trouble accessing the secured lending market. Counterparties asked themselves if it was worth taking the risk of getting tied up in bankruptcy court even if they were comfortable that their principal was secured.

If the Fed did MBS-backed reverses with dealers, it would effectively be undoing part of its current liquidity provision. If it did reverses with money funds, it would expanding its support for the market. In effect, it would be taking on the role of a central counterparty for the repo market. I’m sure the operational challenges would be significant, and I don’t know enough to have a view about the legal issues, but it strikes me as being even cleaner in theory than the Treasury cash balance gambit.

On a technical detail: It may be that the logistical hurdles for MBS are challenging, but I have zero sympathy for the claim that it is a significant hurdle. The New York Fed has no trouble serving as custodian for foreign central banks that hold wirable MBS securities; why should it have a problem doing so for the FOMC? That either sounds like a smokescreen or like civil servants deciding that they are being put upon.

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