Notes on Fed Policy and Short-term Credit

  1. I just did my usual review of my FOMC indicators.  The FOMC should cut 25 basis points at the December 11th meeting.  Whatever the formal “bias” is, the verbiage will be a little of this and the a little of that, something like:  “Yes, we are worried about the solvency of some financial institutions.  That’s why we cut.  But this cut very likely should be enough, so don’t expect anymore.  Now leave us alone.”
  2. So Goldman sees a 3% Fed funds rate in mid-2008So do I.  Small moves in FOMC policy don’t achieve the desired ends, either when policy is rising or falling.  Large cumulative moves are needed to affect the behavior of market participants.
  3. The TED [Treasury – Eurodollar] spread is at its largest one-year moving average since 1990.  That’s significant short-term credit stress to the large banks, and it is worth watching.  It’s not just a US phenomenon either; in the UK the banks are under stress as well.
  4. Residential housing is driving the decisions of the FOMC.  As prices fall, more houses become non-refinancable, and non-salable (except at a loss).  All it takes then is for a problem to happen… death, disability, divorce, unemployment, or casualty, and another house goes on the market because of insolvency.
  5. So, I agree with Accrued Interest (great blog, doesn’t everyone want to read about bonds?).  Many Fed governors talk between meetings, and they trot out their baseline scenario, but often it is the worry of avoiding a somewhat likely negative scenario that can drive policy.
  6. At some level though, if the dollar falls far enough, the FOMC will have to reverse course, as Caroline Baum has pointed out.  Remember, that’s what drove the FOMC to tighten in 1986-87.
  7. Of course, the credit stress in the short end of the market has led some money market fund sponsors to bail out their funds (Legg Mason, Wachovia and B of A, while GE lets a pseudo-money market fund take a hit.  Remember, with money market funds, it’s not wise to stretch for yield, particularly not in bear markets for credit.
  8. One more weak Commercial Paper [CP] funding structure: using it as part of a “super senior” tranche in CDOs.  Now in this case, the collateral is weak — subprime mortgage loans, but this could be true of any CDO where the collateral comes under stress in the future, including high yield corporate bonds.  I wrote about this three months ago, but this one is still unraveling.
  9. I haven’t talked about it, because I wasn’t sure I had anything to add to the discussion, but the M-LEC, or super-SIV, proposed by the major banks seems like hooey to me.  After all, if this shifting of assets from one pocket to another created value, why wasn’t it done before?  It doesn’t change the underlying asset prices, and for the banks as a whole, it is just a zero sum game, unless new parties enter, at which point, they will have to offer a discount to move the paper, which eliminates one of the reasons for doing the deal.
  10. Putting another nail in the coffin, HSBC takes their SIVs onto their own balance sheet, cleaning up their own financing, and making it more difficult for the other banks who want to do the Super-SIV.

What an interesting time in the short-term debt markets.  For now, prudence dictates staying high quality in what financial institutions you lend to short term.