Category: Fed Policy

Sternly Bashing the Bear Stearns Bailout

Sternly Bashing the Bear Stearns Bailout

I find it interesting that some former senior people at the Fed are breaking the “code of silence.”? I don’t mean that those that leave the Fed go totally silent, but they are usually supportive of the current Fed if they speak.? Even Greenspan, who pushes his own legacy, is largely supportive of Bernanke.? But with Volcker speaking out, others are emboldened, like Vincent Reinhart.? I don’t know exactly what Reinhart said in his speech yesterday, but I would bet that it is similar to what he wrote here.

Some of his comments are similar to what I wrote in point 1 of this blog post of mine:

1) How to do a bank/financial bailout: a) wipe out common and preferred equity and the subordinated debt (and offer some warrants to the debtholders).? Make the senior debt take a haircut of 50% (and offer warrants), and the bank debt a haircut of 20% (and offer warrants). Capital is offered in exchange for the equity interest, together with some senior financing pari passu with the banks.? If the management and other stakeholders do not like those terms (or something like them), then don?t bail them out.

Now, realize I?m not crazy about ?lender of last resort? powers being in the hands of the government, but if we?re going to do that, you may as well do it right, and bail out depositors in full, while having others take modest to large haircuts.? There is no reason why the government/Federal Reserve should bail out common or preferred equityholders, and those that bought risky debt should pay part of the price as well.? This should only be done for institutions where significant contagion effects could affect other financial institutions.? The objective is to create a firewall for depositors, and the rest of the financial system.

There were better ways to achieve the protection of the derivatives market the the Fed wanted to achieve.? Take a page out of the playbook of the insurance regulators that are sweating over the financial guarantors.? Are they worried about the holding companies that own the operating insurers?? No, they are only worried about the operating insurers.? In the same way, the Fed didn’t need to sell off Bear Stearns, and (in a way) backstop the sale.? All they needed to do was say that they would provide credit to the derivatives arm if Bear failed.

Hindsight may be 20/20, but the Fed neglects Bagehot’s rule to lend infinitely at a penalty rate in a crisis.? The penalty has not been there.? Beyond that, Reinhart points to the ways that the Fed is taking credit risk onto its balance sheet, which limits its flexibility.

Can that credit risk have negative impacts on the Fed?? Yes, but maybe those effects aren’t big.? The Fed is a profitable institution.? How profitable?? Who gets the profits?? Well, the US Treasury gets the profits, essentially unifying the Fed with the US government in an economic sense.? From fiscal 2005-2007, the Fed earned $18.1, 21.5, and 28.5 billion respectively.? Any losses from credit risk will diminish what the Fed dividends back to the US Treasury, which will raise borrowing and taxes.? So the impact is minor, in one sense — you can destroy the value of the US Dollar, but the Fed is an arm of the US Government in an economic sense.? It dies only when the US Government dies, or when the US Government eliminates it (hey, it’s happened before in US history).

Still Too Early For Banks

Still Too Early For Banks

One thing about Jim Cramer, he is quotable.? Take this short bit from his piece, Graybeards Get It Wrong on Financials.

One of the loudest and most pervasive themes by a lot of the graybeards is that there is still much more pain ahead in the financials.Let me explain why that is wrong. First, the group is down from a year ago. It’s been hammered mercilessly.

More important, every time the stock market rallies is another chance for these companies to refinance.

Remember, as they go up, the companies are in shape to tap the equity market again because those who bought lower are being rewarded, psyching others to take a chance. In fact, other than the monoline insurance faux bailouts, people who pony up are doing pretty well.

Now, he might be right, and me wrong on this point (with my gray beard, though I am younger than he is).? But let me point out what has to go right for his forecast to be correct.

1) The inventory of vacant homes has to start declining.? Still rising for now, another new record.? Beyond that, you have a lot of what I call lurking sellers around, waiting to put more inventory out onto the market, if prices rise a little.? They will have to wait a while, and many will lose patience and sell anyway.? There is still to much debt financing our housing stock, and though most of the subprime shock is gone, much of the shock from other non-subprime ARMs that will reset remains.? Will prices drop from here by 20%?? I think it will be more like 12%, but if it is 20% there will be many more foreclosures, absent some change in foreclosure laws.? Foreclosures happen when a sale would result in a loss, and a negative life event hits — death, divorce, disaster, disability, and unemployment.

2) We still have to reconcile a lot of junk corporate debt issued from 2004-2007, much of which is quite weak.? Credit bear markets don’t end before you take a lot of junk defaults, and we have barely been nicked.? Yes, we have had a sharp rally in credit spreads over the last five weeks, but bear market rallies in credit are typically short, sharp, and common, keeping the shorts/underweighters on their toes.? You typically get several of them before the real turn comes.

3) We have not rationalized a significant amount of the excess synthetic leverage in the derivatives market.? With derivatives for every loser, there is a winner, but the question is how good the confidence in creditworthiness between the major investment banks remains.? Away from that, Wall Street will be less profitable for some time as securitization, and other leveraged businesses will recover slowly.

4) Credit statistics for the US consumer continue to deteriorate — if not the first lien mortgages, look at the stats on home equity loans, auto loans, and credit cards.? All are doing worse.

5) Weakness in the real economy is increasing as a result of consumer stress.? Will real GDP growth remain positive?? I have tended to be more bullish than most here, but the economy is looking weaker.? Let’s watch the next few months of data, and see what wanders in… I don’t see a sharp move down, but measured move into very low growth in 2008.

6) What does the Fed do?? Perhaps they can take a page from Cramer, and look at the progress from private repair of the financial system through equity and debt issuance.? It’s a start, at least.? But the Fed has increasingly encumbered is balance sheet with lower quality paper.? Two issues: a) if there are more lending market crises, the Fed can’t do a lot more — maybe an amount equal to what they have currently done.? b) What happens when they begin to collapse the added leverage?? Okay, so they won’t do it, unless demand goes slack… that still leaves the first issue.? There are limits to the balance sheet of the Fed.

Beyond that, the Fed faces a weak economy, and rising inflation.? Again, what does the Fed do?

7) Much of the inflation pressures are global in nature, and there is increasing unwillingness to buy dollar denominated fixed income assets.? The books have to balance — our current account deficit must be balanced by a capital account surplus; the question is at what level of the dollar do they start buying US goods and services, rather than bonds?

8 ) Oh, almost forgot — more weakness is coming in commercial real estate, and little of that effect has been felt by the investment banks yet.

As a result, I see a need for more capital raising at the investment banks, and more true equity in the capital raised.? Debt can help in the short run, but can leave the bank more vulnerable when losses come.? The investment banks need to delever more, and prepare for more losses arising from junk corporates and loans, housing related securities, and the weak consumer.

Eight Fed Notes

Eight Fed Notes

1)? Let’s start out with my forecast.? I’ve given it before, but it has become the conventional wisdom — at the next FOMC meeting at the end of April, the Fed will cut by 25 basis points.? They will make the usual noises about both inflation and economic weakness, as well as difficulties in the financial system, and comment that they have done a lot already — it is time to wait to see the power flow.? The only difficulty is whether we get another blowup in the lending markets that affects the banks.? We could see Fed funds below 2% in that case, but absent another crisis, 2% looks like the low point for this cycle.? Now all that said, I think the odds of another crisis popping up is 50/50.? We aren’t through with the decline in housing prices, and there are a lot of mortgages and home equity loans that will receive their due pain.

2) One interesting sideshow will be how loud the hawks will be opposing a 25 basis point cut.? We have comments from voting members Plosser and Fisher already. Price inflation is a real threat to them, and one that is closer to the Fed’s core mission than protecting the financial system.

3)? Okay, give the Fed some credit regarding the TSLF, which is now almost not needed.? The TAF is another matter — there is continuing demand for credit there.? It will be interesting to see when the Fed will stop the the TSLF, and what happens when they try to unwind the TAF.? As it seems, some banks still need significant liquidity from the TAF.

4) Indeed, if the Fed is lending to investment banks, it should regulate them.? I would prefer they didn’t lend to investment banks, though.? Better they should lend to commercial banks that are negatively affected by investment bank failures, and let the investment banks fail.? After all, there is public interest in the safety of depositary institutions, but I’m not sure that if the investment banks disappeared, and the commercial banks were fine, that the public would care much.? It certainly would teach the investment banks and the investing public a real lesson on overdoing leverage.

5)? Okay, so LIBOR rises after it seems that some bankers have been lowballing the rate in an effort to show that they are not desperate for funds.? Significant?? Yes, the TED spread has widened 12 basis points since then. ? I’m sure that borrowers with mortgages that float off LIBOR will be grateful for the scrutiny.

Having been in similar situations in the insurance industry regarding GIC contracts, I’m a little surprised that the BBA doesn’t have some requirement regarding honoring the rate quote up to some number of dollars.? On the other hand, can’t they track actual eurodollar trading the way Fed funds gets done, and then just publish an average rate?

6) Onto the last three points, which are the most controversial.? You know that I think the core rate of inflation is a bogus concept.? If you are trying to smooth the result, better to use a median or a trimmed mean, rather than throwing out classes of data, particularly ones that have had the highest rates of inflation.? Given the inflation that is happening in the rest of the world, I find it difficult to believe that we are the only ones with low inflation, unless it is an artifact of being the global reserve currency.

7) I was quoted at TheStreet.com’s main site regarding the Fed. I think that the Fed is caught between a rock and a hard place, but I am not as pessimistic as this piece.

8 ) Finally, how do the actions of the Fed get viewed abroad?? Given the fall in the US Dollar, not nearly as favorably as the press coverage goes in the US.? Do I blame them? No.? They sense that they are losing economic value to the US, and that they are implicitly subsidizing us.? No wonder they complain.

Ten Things To Be Concerned About

Ten Things To Be Concerned About

1)? Picking up on some comments from last night’s post, why I am I not concerned about counterparty exposure?? Because Wall Street has always been very good at cutting off overleveraged clients in the past.? LTCM was an exception there, and only because Wall Street gave in to their request for secrecy.? Wall Street grabs collateral first, and then lets the client argue to get it back.? The investment banks require a significant margin, and when there is significant concern about getting paid, the lines get pulled.

The real worry here is that the investment banks don’t have good enough risk controls for each other.? Note that Bear’s crisis started when other banks stopped extending credit to Bear, and the fear fed on itself.

I liken the investment banks to long-tail commercial casualty insurers.? No one knows whether the reserves are right.? No one can.? Confidence is a necessary part of the game, which is made easier at lower levels of leverage.? But high leverage and opaqueness are a recipe for disaster when volatility rises.

2) Should you worry about Fed policy?? Yes.? The Fed is steering away from the Scylla of a compromised financial sector, and into the Charybdis of inflation.? As I will point out later, that is already having impacts on the rest of the world.? As for now, there are a few ill-informed writers who say that a negative TIPS yield on the short end is a reason not to buy TIPS.? That might be correct if inflation mean-reverts.? Given the short-term resource scarcity building in our world, I don’t think that is likely.

3) Should you worry about the US Government budget deficit?? A little — oh, and worry about the real deficit, one that puts the wars and other emergency appropriations on-budget, and takes out the excess cash flow from Social Security.? In a macro sense, for the nation as a whole, the impact isn’t that great… but it sends a message to foreign creditors who wonder what the value of the dollars will be when they get paid back.? When they see the Fed running an aggressive monetary policy in the face of rising inflation and a weak dollar, it makes their heads spin, as they contemplate the hard choices the weak dollar forces on them.

4) Could the falling dollar cause a crisis in China?? Maybe.? China is levered to US growth, which is slowing, and their export competitiveness versus the US declines as the dollar declines.? And what will they do with all of those dollar reserves?? Beats me.? After a certain point, additional reserves are useless — it is akin to lending more to an entity that you know is insolvent.? My guess is that the yuan will get revalued after the Olympics, and then the real slowdown will hit China.

5)? What of foreign food riots; are they a worry?? (More, and more.)? A little.? They are a canary in the coal mine.? They point to the short-term scarcity of total resources in our world, which only becomes obvious as a large part of the world tries to develop.? But, one practical thing that it implies is that energy and food prices will remain high for some time.? We are one global market at present, and energy and food prices are interlinked through the energy and fertilizer costs of farmers, and through stupid ideas like corn-based ethanol.

6) What of flat crude oil? production?? Yes, worry.? As I have said before, the government oil companies of OPEC countries control most of the supply, but they don’t always manage their resources as well as a capitalistic oil company.? Mexico, Venezuela, and Russia have declining production, to name a few.? The Saudis may not want to produce more, because they don’t know what to do with all the US dollar reserves that they have today.? Or maybe they can’t…

7) Worry about falling housing prices?? Yes.? The problems in the housing market stem from overbuilding.? There are too many houses chasing too few solvent borrowers.? This will eventually affect prime mortgages, because declines of 15-20% in housing prices mean that many prime loans would be underwater in a sale.? Remember, an underwater loan becomes a default after a negative life event — unemployment, death, disability, divorce, and uninsured disaster.

Before all of this is done, one of the major mortgage insurers should fail.? We aren’t there yet.

8 ) What of falling residential real estate prices in foreign countries? Yes, worry.? For Europe, it could lead to the end of the Euro, as countries needing looser monetary policies get tempted to abandon the Euro.? If the Euro’s existence becomes questioned, it will be a systemic risk to the world.

9) What of credit card delinquencies?? Yes, worry.? It shows that total financial stress on the consumer is high, particularly when added to the problems in mortgage and home equity loans.

10) Should you worry about bank solvency?? A little.? All of these previously described stresses have some bearing on the ability of the banking system to make good on their obligations.? Be aware that the FDIC was designed to handle sporadic losses, not systemic crises.? The odds of these problems affecting the depositary financials is still low, but the protective measures will not be capable of dealing with the worst case scenario, should it arise.

Perhaps I have more to worry about.? As I close up here, I haven’t mentioned the PBGC, Medicare, and a variety of other problems.? But, I have to call it a night, and symmetry with last night’s piece is worth a little to me.

Five Notes: What Can the Fed Do?

Five Notes: What Can the Fed Do?

1) There have been a number of recent articles questioning/explaining what the Fed can do in this present environment. Here are some examples:

My own view is that the Fed has used up a lot of firepower on the asset side, but still has a lot to work with. That said, the Fed should be careful not to complicate its balance sheet with a lot of off-balance-sheet agreements. Policy flexibility for a central bank is a real plus, so complicated agreements that make formerly liquid assets illiquid are to be avoided, particularly in a crisis.

Regarding Fed funds, it looks like they will cut 25 basis points on 4/30, but make noises that they are getting close to being done. Perhaps 1.75% will be the low for the cycle.

2) I already miss Alea. Before jck went on hiatus, he commented that the TAF was not effective at lowering rates, and that the TSLF was a success, though by success, he means that it’s not in hot demand. Tony Crescenzi speaks similarly. Perhaps the existence of the PDCF reduces the need.

3) Perhaps Lehman is an example of that, moving buyout loans off of their books, and getting financing for the AAA portion from the PDCF. Given the imitative culture of Wall Street, I would expect to see this repeated by other investment banks.

4) Volcker-mania. In one sense, it’s weird to see him speaking out now, given that he was silent for Greenspan, save for a little at the end. I agree with almost all of what he has been saying; it reads like my writings over the past five years. For a sampling of opinion:

Greenspan ate sour grapes, and Bernanke’s teeth have been set on edge. Bernanke inherited Greenspan’s ignored problems. At this point he and the Fed are puzzled — seeing rising inflation, but fearing what higher rates could do to the banking system. With a similar view that the Fed has few good options, consult Tim Duy.

5)? Finally, if we turn off the microphones, and shut down the cameras, will Alan Greenspan cease to exist?? His defensiveness toward his record undermines his record.? Better he should stop talking publicly, particularly if he follish enough to suggest that the housing market will bottom in 2008.

Fourteen Notes on Monetary Policy

Fourteen Notes on Monetary Policy

This post is on current monetary policy. The review piece on how monetary policy works is yet to come.

1) Let’s start out with the regulatory issues to get them out of the way, beginning with Bear Stearns. To me, the most significant thing to come out of the “rescue” was the Federalizing of losses from the loans that were guaranteed by the Fed (something which I noted before had to be true, since the Fed turns over its profits to the Treasury), and the waiving of many leverage rules for the combined entity (also here and here). These in turn led to an attitude that if the Fed was going to lend to Bear (however indirectly), then they should be regulated by the Fed.

Now, I don’t blame the Fed for bailing out Bear, because they were “too interlinked to fail.” You could say, “Too big to fail,” but only if you measure big by the size of the derivatives book. The last thing that the investment banks needed was a worry on concentrated counterparty risk affecting the value of their derivative books.

That said, given that Jamie Dimon was very reluctant to help unless the Fed provided guarantees, and the low price paid, it indicates to me that Bear and the Fed were desperate to get a deal done. What was in it for Bear? I’m not sure, but the deal avoided greater ignominy for the board, and might preserve jobs at Bear for a longer period of time.

2) At a time like this, many cry for tighter regulation in the the intermediate-term and more aggressive actions in the short-term to restore liquidity. Forget that the two of these fight each other. Personally, I find the comments from the IMF amusing because they are an institution in search of a mission; the IMF was designed to help developing nations, not developed ones. The comments from the FDIC Chairwoman are good, but really, where were the banking regulators in 2005-2006, when something useful could have been done?

3) Does the Fed want to be a broader financial regulator? My initial guess would be “no,” but I could be wrong here. Part of my reasoning is that they have not used the powers effectively that they already have. Another part is that monetary policy has often been misused, and been pro-cyclical. With their new powers, they will still face significant noise and data lags. Why should they be more successful at a more complex task than they have been with the less complex task of monetary policy? Schiller is way too optimistic here. The central bankers are part of the problem here, not part of the solution. For years they provided too much liquidity in an effort to keep severe recessions from occurring, and in the process they removed fear from the financial system, and too much leverage and bad underwriting built up. Now the piper has to be paid.

4) Eric Rosengren, president of the Federal Reserve Bank of Boston, comments on the difficulties involved in effective regulation of financial institutions as a lender of last resort.? The Fed will have to build new models, and think in new paradigms.

5)? Charles Plosser, President of the Philadelphia Fed, tells us not to overestimate monetary policy.? Sage words, and rarely heard from the Fed (though in my experience, more often heard toward the end of a loosening cycle).? Plosser moves up a couple of notches in my view… monetary policy can deal with price inflation, and that’s about it.? Once we try to do more than that, the odds of making a mistake are significant.

6)? Who loses when the Fed loosens?? Savers.? They earn less; there is a net transfer of wealth from savers to borrowers.? Holders of US-dollar based fixed income assets also bear the brunt, if thy have to convert it back to their harder currency.

7)? Perhaps the TSLF is succeeding.

8 ) But perhaps all of the Fed’s efforts on the asset side are making it more difficult for Fed to keep the fed funds market stable.? I have one more graph that stems from my recent piece on the Fed:

Note that during the past six months, the low transaction on Fed funds was significantly below the effective rate.

9) VIX and More has latched onto this calculation of M3.? Given the changes and the adjustments that they have made, and the 20% or so rate of growth for M3, I would want to see a “spill” of the calculation to see what’s going on.? Perhaps there has been some double-counting.

Now, if we are talking about MZM (all monetary liabilities immediately redeemable at par) , we are facing high rates of growth — around 17% YOY.

My M3 proxy, total bank liabilities, is running ahead at a 13%+ rate.? Only the monetary base stays in the mud with barely 2% growth.? I still think that the Fed is trying to restrain inflation through no monetary base growth, while allowing the healthy banks to grow aggressively.? So much for supervision.

10)? Reading the H.4.1 report the past weeks have had the Fed lending more directly through their new programs, and selling Treasuries to keep the Fed’s balance sheet from growing.

11) I expect the minutes tomorrow to reveal little that is new; if anything, it will highlight the competing pressures that the Fed is trying to deal with.

12) For a view compatible with mine, read Bob Rodriguez of First Pacific Advisors.? One of my favorite equity managers, and he is doing well in the present environment.

13) The yield curve and Fed funds futures indicate another 25-50 basis points of easing in this cycle, at least, until the next institution blows up.

14) Finally, and just for fun — two guys I would nominate for the Federal Reserve Board — Ron Paul and James Grant.? Toss in Steven Hanke, and it starts to get interesting.

Shelter Fallout

Shelter Fallout

Though sometimes I do posts that are a melange of different items that have caught my attention, I do try when possible to gang them up under a common theme.I try not to do “linkfests” because I want my readers to get a little bit of interpretation from me, which they can then consider whether I know what I’m talking about or not. Anyway, tonight’s topic is housing. I didn’t get to my monetary policy 101 post this week — maybe next week. I do have three posts coming on Fed policy, credit markets, and international politics/economics. (As time permits, and ugh, I have to get my taxes done…. 🙁 )

1) The big question is how much further will housing prices fall, and when will the turn come. My guess is 2010 for the bottom, and a further compression of prices of 15% on average. Now there are views more pessimistic than that, but I can’t imagine that a 50% decline from the peak would not result in a depression-type scenario. (In that article, the UCLA projections are largely consistent with my views.) It is possible that we could overshoot to the downside. Markets do overshoot. At some level though, foreigners will find US housing attractive as vacation/flight homes. After all, with the declining dollar, it is even cheaper to them. Businesses will buy up homes as rentals, only to sell them late, during the next boom.
2) But, the reconciliation process goes on, and with it, losses have to go somewhere. In some cases, the banks in foreclosure refuse to take the title. Wow, I guess the municipality auctions it off in that case, but I could be wrong. Or, they let the non-paying borrowers stay. I guess the banks do triage, and decide what offers the most value to act on first, given constraints in the courts, and constraints in their own resources. Then again, developers can reconcile the prices of the land that they speculated on to acquire. In this case, cash is king, and the servant is the one that needs cash. I just wonder what it implies for the major homebuilders, with their incredible shrinking book values. Forget the minor homebuilders… Can one be worse off? Supposedly my father-in-law’s father lost it all in the great depression because he was doing home equity lending. There are wipeouts happening there today as well. Add in the articles about unused HELOC capacity getting terminated (happened to two friends of mine recently), and you can see how second-lien lending is shrinking at just the point that many would want it.

3) The reconciliation process goes on in other ways also. Consider PennyMac, as they look to acquire mortgage loans cheaply, restructure, and service them. Or, consider Fannie and Freddie, who are likely to raise more capital, and expand their market share (assuming guarantees don’t get the better of them). Or, consider the Fed, which has tilted the playing field against savers, and in favor of borrowers, particularly those with adjustable rate loans. No guarantee that the Fed can control LIBOR, though…

4) The reconciliation process steamrollers on. We’ve seen Bear Stearns get flattened trying to pick up one more nickel, and maybe Countrywide will get bought by Bank of America, but you also have banks with relatively large mortgage-lending platforms up for sale as well, like National City. Keycorp might bite, but I’ve seen Fifth Third rumors as well. Then there is UBS writing down their Alt-A book, along with a lot of other things.

5) A moment of silence for Triad Guaranty. A friend of mine said that they were the worst underwriter of the mortgage insurers. Seems that way now. Another friend of mine suggested that MGIC would survive off of their current capital raise. They stand a better chance than the others, but who can really tell, particularly if housing prices drop another 15%.

6) Beyond that, the financial guarantors have their problems. FGIC goes to junk at S&P. MBIA goes to AA at the operating companies, and single-A at the holding company at Fitch. I personally think that both MBIA and Ambac will get downgraded to AA by S&P and Moody’s. I also think that the market will live with it and not panic over it. That said, BHAC (Berky), Assured Guaranty, and FSA (Dexia) will get to write the new business, while the others are in semi-runoff.

7) Now for the cheap stuff. Amazing to see vacancy rates on office space in San Diego rising. I think it is a harbinger for the rest of the US.

8 ) Buy the home, take the copper, abandon the home, make a profit. Or, just steal the copper.

9) Bill Gross. A great bond manager, but overrated as a policy wonk. Many would like to see home prices rise, but others would like to buy a home at the right price. How do we justify discriminating against those who would like to buy a cheap house?

10) “The prudent will have to pay for the profligate.”? Well, yeah, that is much of life, in the short run.? In the long run, the prudent do better, absent aggressive socialism.? The habits of each lead to their rewards, and the ants eventually triumph over the grasshoppers.

Feeding on Fed Funds

Feeding on Fed Funds

One of my Finacorp colleagues pointed me to some Fed funds data yesterday, and it made me want to write an article. He pointed out something that looked anomalous about the way Fed funds is trading, namely, that on many days in the last month, that some trades are going on where some banks out there are accepting almost zero for the rate on investing excess reserves.

Let me back up. We talk about Fed funds all the time, but we don’t often stop to talk about what it means. Banks and thrifts have to keep non-interest bearing reserve funds at the Fed. Those funds can be deposited by the depositary institution at the Fed, or, they can borrow the funds from another institution that has excess funds deposited at the Fed. Thus there is an active lending market between banks for reserves deposited at the Fed. The weighted average rate at which these overnight loans get done is called the effective federal funds rate.

The Fed influences where Fed funds trades through open market operations, where they lower the Fed funds rate by increasing the supply of reserves to the system through temporary repurchase transactions, and outright purchases of securities through the creation of new credit, thus expanding its balance sheet (a permanent injection of liquidity). The Fed raises the Fed funds rate by decreasing the supply of reserves to the system through temporary reverse repurchase transactions, and outright purchases of securities which reduces credit, and shrinks the balance sheet of the Fed (a permanent reduction of liquidity — rare).

All the guessing games that go on around FOMC meetings today, revolve around the Fed funds target rate. That’s the rate the the Fed in the short run says that it will try to keep the effective Fed funds rate at, primarily through temporary measures using repurchase and reverse repurchase transactions.

Back to the Present

Since August 1993, the high and low transaction yields for Fed funds each day have been recorded. The following graph shows the high, low, and effective Fed funds rate from then until the present.

As you can see, the difference between the high and low for Fed funds on a given day can be substantial.? Most commonly the big ranges happen near the end of accounting periods, or at minor financial panics, whether for legitimate reasons (LTCM, 9/11), or dubious reasons (Y2K).? In any case, there can be a scramble for overnight fed funds, leading to a very large high rate for the day.? Conversely, there can be a very small low rate for the day when enough institutions have significant excess funds to lend at Fed funds, and few takers at some point during the day.

That range between high and low Fed funds can be quite large, as you can see in the following graph.? In order to show the persistence of the range, to flatten out the influence of disasters, and quarter- and year-ends, I threw in a 22-day moving average, which is meant to approximate the rolling monthly average.

In this present environment, I am most concerned with how low Fed funds trades on a daily basis.? Since that is a noisy figure as well, I applied a 22-day moving average there.

The range for Fed funds trading is high on a monthly average basis, butnot as high as it was at points back in the mid-90s. Short-term interest rates were higher then, so there was more room on the downside for the range to expand, which is not possible today.? What is unusual now is that the low trade for Fed funds is averaging near the levels achieved during the wondrous 1%-1.25% Fed funds rate policy that the Greenspan Fed instituted from late 2002 to mid-2004.

In the midst of a period where liquidity is so scarce, we have a situation where some banks are having a hard time getting a good yield from Fed funds.? To summarize the situation, look at my final graph:

This is a scatterplot to show how the moving averages for low Fed funds varies against the range for Fed funds.? The diagonal line is there for convenience to show where the moving averages for the range and the low would be equal.? Back during the 2002-2004 era, though rates were low, Fed funds traded in a tight band.? In the mid-90s, rates were higher, but we had occasional periods where the range would explode for accounting or crisis reasons.

Now we are in a period where we have a volatile range for Fed funds amid low rates.? This is unusual.? I’m open to new ideas here, but it seems that the liquidity situation in Fed funds is volatile enough that some banks end up snapping at low yields at some point each day.? Just another piece in a difficult policy period for the banks and the Fed.? If I have to speculate, it indicates that some banks are already awash in liquidity, and aren’t sure what to do with it.

Federal Office for Oversight of Leverage [FOOL]

Federal Office for Oversight of Leverage [FOOL]

I want to go back to an article that I wrote early in the history of this blog, when nobody read me except a few RealMoney diehard fans — Regulating Systemic Risk From Hedge Funds.? It was a critique of the ?Agreement Among PWG And U.S. Agency Principals On Principles And Guidelines Regarding Private Pools Of Capital.?? Yes, the “shadowy” President?s Working Group on Financial Markets.? Some will call it the “Plunge Protection Team.”? Well, if they are that, they are certainly not playing up to their billing.? As an aside, I tend not to believe in conspiracy theories, because most bad plans of our government don’t require them.? As Chuck Colson pointed out regarding the Nixon Administration and Watergate leaks — he felt that information tightness in the Nixon White House was so effective, that if a conspiracy could work, it would have worked there.? (Since it didn’t work, and the information leaked out, it had a surprising effect on Colson’s life, as he concluded that the disciples of Jesus (Y’Shua) could not have conspired to steal the dead body, hide it, and fake a resurrection.? But that’s another story.)?? Suffice it to say that I don’t think the government intervenes in the major financial markets of our country — there would be too many accounting entries to hide, and someone would have a real incentive to leak the information, or write a book about it.

Going back to my article, I tried to point out the difficulty of gathering data and analyzing it.? It was also somewhat prescient as I said, “Let me put it another way: if the government wants to reduce systemic risk, let them create risk-based capital regulations for investment banks, and let them increase the capital requirements on loans to hedge funds and investment banks. Or, let the Fed change the margin requirements on stocks. These are simple things that are within their power to do now. In my opinion, they won?t do them; they are friends with too many people who benefit from the current setup. If they won?t use their existing powers, why would they ask for new ones?

We will have to wait for the next blowup for the Federal Government to get serious about systemic risk. They might not do it even then. Upshot: be aware of the companies that you own, and their exposure to systemic risk. You are your own best defender against systemic risk.”

There is another reason why they would not act then, as I had pointed out at RealMoney over the years.? Bureaucrats are resistant to offering changes where if thy would get harmed if the changes led to a market panic.? Once the market panic starts, they can move with greater freedom, because no one will be able to tell whether changes imposed during the panic intensified the panic or not.

So, color me skeptical on efforts to monitor and control systemic risk.? It would be very hard to do effectively, and there are too many powerful interests against it.? Also, it would be difficult to get the gross exposure data necessary for inhibiting crisis, because many financial instruments would have to be split in two or more pieces.

As to the articles I have read on Treasury Secretary Paulson’s plan, they divide into credulous (one, two), mixed, and skeptical/hostile (one, two).? Let me simply observe that any plan for the control of systemic risk has to overcome:

  • Political opposition
  • Lack of effective data
  • Lack of an effective model
  • Lack of willingness to implement the conclusions generated by the staff/modeling
  • Inter- and Intra-agency disagreements
  • Data and action lags

If it is already difficult for the Fed to implement contracyclical monetary policy, just imagine how difficult it will be for them to deal with a problem that is far more tricky because of its multivariate nature.? Imagine them trying to analyze the effects from currencies, commodities, operating businesses, credit, ABS, RMBS, CMBS, equity-related businesses, counterparty risk, etc.? This is not trivial, and Paulson I suspect knows it all too well, which has led him to make a modest proposal that will likely not be effective, but will likely run out the shot clock for the Bush administration, leaving the issue for the next President to deal with.

The Fed is not by nature an activist institution, and it would have to become far more activist in order to effectively regulate the bulk of all financial institutions in the US.? I don’t see it happening.

As an aside, I am ambivalent about Federal regulation of insurance, and this RealMoney article of mine still expresses my views adequately.? Still, it would make sense to hand over oversight of financially sensitive insurers, such as the financial guarantee insurers and the mortgage insurers to the Feds, together with whoever oversees the ratings agencies.? An integrated solution is preferable.? (I still like my proposed name for the new regulator, “Federal Insurance Bureau” [FIB… well, it can’t be the FBI].

As for some of the fog that a regulator of investment banks would exist in, consider these two articles on hedge fund distress.? What affects the hedge funds, affects the investment banks.? They are symbiotic.

As a joke, given that it is the first of April, if we do get a regulator for overall financial solvency and systemic risk, I believe it should be called the Federal Office for Oversight of Leverage [FOOL].? After all, I think it is taking on a fool’s bargain.

Two Monetary Policy Graphs for the Evening

Two Monetary Policy Graphs for the Evening

A few notes before I begin this evening. I tried posting twice, but my system failed twice, and the auto-save did not do its job faithfully. So, one reduced post, if I can get it out. Next week, I should publish a small primer on how monetary policy works. Also coming up is my next portfolio reshaping.

Well, there is certainly no more stigma in borrowing directly from the Fed. Just look at the discount window:

That’s a new record since the beginning of my data (1980), and more than doubles the last peak in 2001.

The following graph (look at the lower green graph) is the ratio of my M3 proxy (Total Bank Liabilities) to high-powered money (Total Fed Credit, the Monetary Base).

This ratio measures the willingness of the Fed to allow the banking system to lever up their deposit base relative to the size of the Fed’s own balance sheet. The data only goes back to 1980, but we are knocking at the door of a new high. The recent move up began in earnest at the beginning of the last tightening cycle, but has persisted into the loosening cycle, as the FOMC has not let the monetary base grow, but has permitted the banks to continue to gather deposits (banking, savings, CDs, money market funds). Some capital requirements have been loosened, and I suspect the bank examiners are not playing hardball at present, at least compared to the attitude 18 months ago.

After all, the banks don’t have to pay much interest to those who deposit money with them with a curve this low and steep, and many people are afraid of the equity markets, and are letting balances at the banks grow. The banks get cheap funding, and they use it to buy short-duration agency RMBS yielding 3-4%, which is a winner, at least for now.

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