Year: 2008

Last Thoughts on the FOMC Meeting

Last Thoughts on the FOMC Meeting

Posted on by David Merkel

FOMC cycles usually have some sort of underlying consistency to them. In this cycle, the underlying consistency has been:

  • Unorthodox measures, attempting to use the asset side of the Fed’s balance sheet to solve lending problems among banks and broker-dealers.
  • They have effectively “sterilized” their unorthodox measures by withdrawing other liquidity from the system, leading to…
  • Lack of growth of the monetary base, which has only risen 2% in the last year, and the last permanent injection of liquidity was 5/7/07. (After reviewing the Annual Reports of the Open Markets desk of the NY Fed 1996-2007, I think that’s a record… it is certainly a record for a loosening cycle. How can you have a loosening cycle without growing the monetary base significantly? Unless they are planning on reversing their policy easing rapidly once the financial crisis is past.)
  • They have never cut rates less than expected.

So, that leaves me at a 1% cut in Fed funds tomorrow, with a parallel cut in the now-meaningful discount rate. Now that primary dealers can borrow there, that will be an active window. That said, the Fed will probably try to sterilize any borrowings there, withdrawing liquidity elsewhere.

Come to think of it, that was one of the problems with the Bank of Japan as they slid into their crisis in the 1990s. They always sterilized their monetary policy so that it had little effect, thus restraining inflation, but not doing much for their overleverage situation.

In this case, that’s a mistake. We can live with price inflation. Dealing with the collapse of leverage is a lot tougher. The Fed can use unorthodox measures until their supply of lendable/saleable Treasuries runs out. Then they will have no choice but to begin monetizing the debts of the US Government or its agencies, if they want to attempt further stimulus. Then we will get price inflation. As for me, I would own TIPS here. CPI inflation will likely rise if the bailouts needed exceed the size of the Fed’s balance sheet. I also like agency residential mortgage bonds here. Implied volatilities can’t get that much higher, so we should get some sort of rally.

Let see what happens tomorrow.

Update

So what happens after I hit the publish button, but I receive a great article from Calculated Risk talking about the same issues.

National Atlantic Notes

National Atlantic Notes

Posted on by David Merkel

Given the furor of the day, I thought I might have to abandon the National Atlantic Teleconference call.? I didn’t miss the call.? The transcript is here (thanks, Seeking Alpha).? Let me quote my portion of the call.

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Operator

Thank you, sir. Today?s question-and-answer session will be conducted electronically. (Operator Instructions). We?ll go first to David Merkel of Finacorp Securities.

David Merkel – Finacorp Securities

Hi, Hello.

James V. Gorman

Good morning, David.

David Merkel – Finacorp Securities

Very good. I wanted to ask a little bit about the, you had a number of parties go over your reserves, three and all I believe and how, I would assume at this point you are rather certain that you have been able to clean up most of reserving problems particularly given what was happening in your claim department prior to, I guess September 2007? Can you walk us through that one more time?

James V. Gorman

Yes, we have taken a very hard look at the claim review process, within the claim department. We have modified the procedures, we have updated our diaries. And when you go through a change like this, your historical information and your typical loss development patterns are no longer appropriate to use.

David Merkel – Finacorp Securities

Right.

James V. Gorman

In estimating alternates. So, we had to rely heavily on projecting the open, ultimate number of claims that will be paid and the severity associated with those clients. And I think our review that was done as well as that done by our external auditors have focused on looking at average claim cost as opposed to looking at normal loss development methods.

We continue to look very closely, as part of our quality control process to make sure that the adjusters are in fact keeping claims up to date that we are managing them affectively and that we are in fact putting in place an aggressive settlement policy to move these claims off of our balance sheet. So, we are cautiously optimistic that we have our arms around, our ultimate liabilities. But, obviously there is no guarantee but we have scrubbed this thing it from many different angles.

David Merkel – Finacorp Securities

Great, well that?s good. The re-insurance recoverable change, it was $3.1 million or something like that? What was that about?

James V. Gorman

While we project our direct loses, we also project how much is going to commend in ceded loses and you know based upon our current retention as a company we?ve retained the first 500,000 of loss the emergence of ceded losses is very slow to develop.

David Merkel – Finacorp Securities

Right.

James V. Gorman

And we have looked more carefully at our projected reinsurance recoverables and determined that we are not going to be in a position to collect as much as we had previously thought. This is not connected at all to any reinsurance recoverable on paid clients.

David Merkel – Finacorp Securities

Yes got it.

James V. Gorman

This is based on projected losses.

David Merkel – Finacorp Securities

Okay. Last question, do you have side of your balance sheet, you know, there is a decent amount of turmoil out there now, with respect to various types of AAA structured product and I know you didn?t do that much with subprime or anything like that. But, what are you experiencing if anything on the asset side of your portfolio at present, I assume that it?s just ordinary payments of cash flows from your mortgage bonds and other assets, because you have a fairly high quality portfolio we use the way the rating agencies rate them. Are you experiencing any difficulties there at all?

James V. Gorman

Well, I?ll start that answering your question David and then I?ll turn it to Frank, but from the investments, I would like to just further assure our investors that we have absolutely no subprime exposure. In addition, any bond that we have is A or better on its own merits without the effective any MBIA or AM backed insurance less to the rating, further we have no equities in our portfolio. So, on the investment side, I think that we are pretty planned and pretty solid and we had a great yield in ?07 given all of the decrease in interest, average interest rates. Frank can you add anything to that on the balance sheet.

Frank Prudente

I think you well covered it I may I think we felt for a long time, we have a conservative portfolio and with a disruption we?ve seen in the market it?s evident it?s conservatism by us not having any issues.

David Merkel – Finacorp Securities

Well, thank you gentlemen. I appreciate it and I will be looking forward to any releases that describe the logic for the $6.25 purchase price. So, I thank you both.

James V. Gorman

Thank you, David.

David Merkel – Finacorp Securities

Take care.

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Okay, why did I ask those questions?? Why not bluster about the huge discount to book that they are selling the company at?

Rather than do it that way, I asked about the two least certain items on their balance sheet — their loss reserves, and the value of their assets.? If they express confidence in those two numbers, then it will be hard to back away from an adjusted book value north of $10.? Why does this have value?? Well, there are many other investors bigger than me in the company, and this gives them a reason to vote down the deal.? NAHC has no debt; there is no solvency crisis here, so a large discount to book is not warranted.? With a short-tail P&C company you could hire a specialist to inexpensively run the book off, and after a year or so, sell of the tail of the company.? We would definitely realize a price north of $6.25.

But what if the deal goes through?? In that case, I might not tender my shares, but file for appraisal rights.? I would show the judge the management’s answers to my questions, demonstrating the confidence that they had in the asset values and reserving, immediately after the deal announcement.? It is rare that the judges allow deals to go out at less than tangible book value, particularly on short-tailed P&C companies with little insolvency risk.

So, that’s why I asked those questions.? Now to see what happens.

Full disclosure: long NAHC

Another Dozen Notes on Our Manic-Depressive Credit Markets

Another Dozen Notes on Our Manic-Depressive Credit Markets

Posted on by David Merkel

This is what I sometimes call a “Great Garbage Post.”? I’ll cover a lot of ground, so bear with me.

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.

2)? Bear Stearns.? Ugh, a bank run.? A testimony to leverage.? Book value is only fair if one can realize the value over time.? High leverage implies a haircut to book value in bad times, because the value of the assets can go down dramatically.? Will they get a buyer?? I don’t know, and I wouldn’t trust JC Flowers.? If what Jamie Dimon might be thinking is what the Bloomberg article states, then I think he has the right idea: keep the best businesses, dissolve the rest.

But remember, during crises, highly levered financial institutions are vulnerable, unless most of their financing is locked in long-term.? Most investment banks don’t fit that description, particularly with all of the synthetic leverage in their derivative books.

3) The downgrades on commercial bank credit ratings will continue to come, particularly for those that were too aggressive in lending to overlevered situations, e.g., home equity lending.? Home equity lending is very profitable in good times, but then it gets overcompetititive, and underwriting standards deteriorate.? Then a lot of money gets lost, as in 1998, where most of the main lenders went under.? In this case, most of the lenders are banks, and they aren’t concentrated in that line alone.

4)? Home builders are taking it on the chin.? Consider this article about joint venture failures of homebuilders.? It is my guess that we will see a few of the major homebuilders fail.? It will take us to 2010 to reconcile all of the excess inventory.? Personally, I would guess that the stable home ownership rate is still below the current level by maybe 2% of the households.? We tried to force homeownership on people that were not ready for it, people who didn’t have enough financial slack to make it through even a slight recession.

5) I find it amusing that Bob Rubin, the only guy in the Clinton Administration that I liked, says that few people anticipated this bubble. (Sounds like Greenspan, huh?)? Well, in a sense he’s right.? Probably fewer than 1% of Americans anticipated these results, but there were enough writers in the blogosphere that were saying that something like this would come (including me), that some could take warning.? As in the tech bubble, there were a number of notable commentators warning, but no one listens during the self-reinforcing cycle of the boom.

6) I am sticking with a 50-75 basis point move from the Fed in the coming week.? They want to move aggressively, but they don’t want to use up all of their conventional ammo, when they are so close to the “zero bound.”? They might disappoint the markets, but not on purpose.? They will tend to follow what the markets suggest.

7) This Fed is more willing to try novel solutions than in the Greenspan era.? Even so, I expect them to run into constraints on their ability to deal with the crisis, which will force the Treasury Department (yes, even in the Bush Administration) to act.

8)? The glory of “core inflation” is not that it excludes the most volatile classes of goods, but the ones for which there is the most excess demand.? Food price inflation is running.? Farmers can’t keep up with the demand.? Poetic justice for the hard-working farmers of our country, who have had more than their share of hard years.? Agriculture is one of the industries that makes America great.? Let the rest of the world benefit from our productivity there.

9)? This is one of those times where one can get a “pit in the stomach” from considering the possibilities from a financial crisis.? As leverage dries up, those with the most leverage on overvalued asset classes get margin calls, leading to forced liquidations.? As it stands now, many credit hedge funds are finding it difficult to maintain their leverage levels, and other hedge funds are finding their lending lines reduced.? This forces a reduction in speculation, and the prices of speculative assets.

10)? Be careful using the ABX indices.? They are too easy to short, and do not represent the values that are likely to be realized in the cash markets.? The same is true of the CMBX indices.? This would lead me to be a bull, selectively, in AAA CMBS, after careful analysis of the underlying collateral.? (CMBS was a specialty of minewhen I was a mortgage bond manager.)

11)? Two interesting articles on character and capitalism.? This is a topic that I havea lot to say about, but every time I sit down to write about it, I am not satisfied with the results.? Let me make a down payment on an article here.? Capitalism is good, but Capitalists often abuse it.? Short-sighted capitalists play for short-term advantage, and end up burning up relationships.? Longer-term capitalists play fair, because they not only want deal one, but deals two, three, four, etc.? They play fair because they will do better in the long run, even if they are intelligent pagans.? (Christians should play fair anyway, because their Father in heaven looks at their deeds.? If we love Him, we will please Him.)

Economics isn’t everything.? Smart businessmen know that a good reputation is golden.? They also know that happy employees are more productive.? Suppliers that get paid on time are more loyal.? These are the benefits of ethical, long-run thinking.

12) In closing, a poke at quantitative analysis done badly.? Consider Paul Wilmott, or William Shadwick.? With bosses over the years, often they would ask me a seemingly simple quantitative question, and I would reply, “Here’s the standard answer: XXXXX.? But there are many reasons why that answer could be wrong, because the math makes too many assumptions about market liquidity, investor rationality, soundness of funding sources, etc.”? Most quants don’t know what they are assuming.? They are too good with the math, and not good enough at the human systems that inadequately lie behind the math.

As a quantitative analyst, I have generally been a skeptic.? At times like this, when the assumptions are breaking down, it gives me a bit of validation to see the shortfall.? That said, it’s no fun to be right when you are losing money, even if it is less than others are losing.

Thinking About the Bear Stearns Bailout

Thinking About the Bear Stearns Bailout

Posted on by David Merkel

When I go to prayer meeting on Thursday evenings, I have recently begun requesting prayer for the economy and policymakers.? Ordinarily, I resist doing that, because it usually doesn’t sound right.? I remember one time two years ago explaining why we should pray about a given economic issue, and my dear wife said, “Let me get this straight.? We’re praying for the World Economy, that we don’t have a disaster?”? But when I was asked to explain my concern recently, I said, “Things are breaking in the financial system that no one a year ago would expect to break, and the costs could be high.? A second Great Depression is not impossible, and a repeat of something similar to the 70’s is more likely, minus the ugly clothes.”? That said, I am satisfied with praying for my daily bread, and the daily bread of others.

I didn’t expect to start the post this way, but that’s what’s on my heart.? Things are breaking that should not break, but what is happening is consistent with what I have been writing about here and at RealMoney for the past four years.? I am not a bear by nature, nor a bull.? I just try to analyze economic situations from a holistic perspective, and what I have seen over the past four years, was a massive increase in leverage that was not sustainable.? This affected the investment banks as well, and in this case, Bear Stearns in particular.

Confidence is tricky.? The investment banks are more highly levered than mortgage REITs, and we have seen the fallout there, even though real estate is more stable than the assets financed by most investment banks.

This is why in investing, I write about having a provision for adverse deviation, or in Ben Graham’s terms, “A margin of safety.”? With leverage, one should always calculate the maximum amount of? leverage consistent with prudence, and then take several steps back from there.? What is permissible in the boom phase has little relevance to the bust phase.

Now, I tell my children, “Don’t blame the Ump.”? In sports, if it is call of an umpire or referee that is the difference between victory and defeat, then you did not deserve to win.? You did not gain a commanding lead in the contest.? In this situation, Bear Stearns played close enough to the edge that rumors could begin to push at their short-term financing base, creating a crisis.? Investment banks must be like Caesar’s wife — there can’t be a hint of impropriety (with respect to financing).

Now, with a downgrade in credit ratings, Bear Stearns will have to find a buyer.? Why?? Major financial companies that lend have to have A-1/P-1 commercial paper ratings in order to make money.? The ability to borrow at cheap rates in the short run is important to profitability.

Naked Capitalism has some good points on this topic.? I would echo on the mortgage exposure.? More important is not being liked.? According to friends of mine, Lehman got rescued privately during the LTCM crisis because they convinced creditors to support them.? Bear walked out on the LTCM bailout, and it still leaves a bad taste in the mouth of Wall Street.? Wall Street does have honor, in a twisted way.? They remember who were their friends during tough times.? Bear was not one of them.

When there is a lot of worry around, it doesn’t take much to kick a marginal firm over the edge.? Bear had ample opportunity to move to lower level of leverage, and did not do it.? Now let’s talk about the rescuer.

The Omnipotent Federal Reserve

The Fed can’t run out of bullets, because it can always print money.? That comes with an inflation price tag attached, though.? In this case, they are providing funds freely to J. P. Morgan to the extent that they lend to Bear Stearns.? Now, I know why the Fed did this.? Bear Stearns my be small in a market capitalization sense, but is large when one considers all of the debts that they have, both in the cash and synthetic markets.? (As an aside, I was analyzing some muni bonds of a major issuer today, and it amazed me that Bear Stearns was their #2 counterparty.)

Now the Fed has Fed funds, the discount window, TAF, TSLF, and more.? I am not here to fault them for lack of creativity.? I am here to fault them for (like Bear Stearns) overtaxing their balance sheet.? There is only so much that the Fed can rescue before it chokes, because they (at that point) have no more safe assets to pledge.

I sold my capital markets exposure earlier this week, and I am glad that I did, late as that was.? The Fed is not big enough to rescue all of the investment banks, nor could they rescue the GSEs, without creating significant price inflation.? What a mess.? Avoid the depositary financials, and those that lend and intermediate aggressively.? This is not a time to be a hero in financials.

Book Review: Easy Money

Book Review: Easy Money

Posted on by David Merkel

Easy MoneyFor most of my readers, this book may prove to be too basic, but we all have friends that are not “money people.” They don’t know how to take care of their finances, and they constantly get into money troubles. This book could be of help to them.

Now, as you can see from the picture, you can see that she refers to herself as, “The Internet’s #1 Personal Finance Expert.” I can’t vouch for that. I like to think that I am aware of a wide number of trends in investing and money management, and this was the first time I heard of her.

There were five main things that appealed to me about this book. First, it’s not a long book (173 pages in the main body of text), and it is simply written, so an average person not good with finances could make his way through it. Second, even though small, it is pretty comprehensive for the finances of an average person or family. Third, I think she gets most issues right for average people who have relatively simple financial problems. Fourth, it provides advice on where to get more data, without marketing herself directly. Fifth, it summarizes action points for each area of personal finance.

I do write about personal finance a little, but you will never get the detailed advice on cash management, budgeting, personal credit, hiring advisors, and shopping smart from me that you will get from this book. My contribution is a more savvy view of investing and insurance. On the latter topic, insurance, I thought she covered the bases well. (As an aside, she shares my bias against variable annuities.)


Now, was there anything that I wasn’t crazy about? I know she wrote a book on the topic, but I think it would have been worthwhile to briefly explain why keeping a high credit rating in this age is so important, because of the effect that it has on insurance premiums, and even employment, leaving aside how much you will pay in interest, and how onerous lenders and creditors will be with you if you ever make a mistake.

Now on investing topics, the book is good but not great. For the average person that doesn’t matter. For those wanting to take a step up, I would recommend The Dick Davis Dividend. She focuses on saving enough (most people don’t save enough), and asset allocation through passive investments. She is a little too bullish on real estate for my tastes. Someone following her advice in these areas will do better than most, if they have the discipline to avoid panic and greed.

But, leaving those quibbles aside, this is a solid book, and those following its advice will benefit.

Full disclosure: If you buy through Amazon.com on any of the books that I review through links on my site, I get a very modest commission.

Personal Finance, Part 15 — How I Buy Cars

Personal Finance, Part 15 — How I Buy Cars

Posted on by David Merkel

When I buy a car, I analyze what car I would like to buy.? I look at reliability, repair costs, overall costs, and style.? I use Consumer Reports to help me analyze this.? Then I go to the website(s) of the manufacturer in question, and copy the data on all of the used models on offer at the dealerships within 30 miles of me.? With price as the dependent variable, I then run a regression with model year as dummy independent variables, and total miles as an independent variable.? After I run my regression, I look at the cars with the biggest price deviations, the predicted price is a lot higher than actual.? I then look at the features of the underpriced cars, and choose one where there are good features with a discounted price.

I go to that dealer, review the car, test drive it, and if it passes my tests, I haggle over the price, and buy it. ? In my experience, this cuts thousands off the price of the car.? What a great reason to have studied econometrics.

$6.25?!

$6.25?!

Posted on by David Merkel

I will have a fuller post after I talk with Jim Gorman, CEO of National Atlantic.? If he thinks his company, which he owns around 13% of is only worth $6.25/share, that is a real surprise to me, and inconsistent with all of the other discussions that I have had with him over the last four years.? A few of you have asked me about appraisal rights.? Really, we should talk about this later if the deal gets approved; it’s too early to speculate there.? For those that remember my early posts at RealMoney on the Mony Group acquisition, remember that book value is sometimes illusory.? I don’t think that is the case here, but let me talk with Jim Gorman, and listen to the earnings call on Monday.? If they deliver another bomb, like last quarter, maybe $6.25 is generous.

Full disclosure: long NAHC

One Dozen Notes on Our Crazy Credit Markets

One Dozen Notes on Our Crazy Credit Markets

Posted on by David Merkel

1) I typically don’t comment on whether we are in a recession or not, because I don’t think that it is relevant. I would rather look at industry performance separate from the performance of the US economy, because the world is more integrated than it used to be. Energy, Basic Materials, and Industrials are hot. Financials are in trouble, excluding life and P&C insurers. Retail and Consumer Discretionary are soft. What is levered to US demand is not doing so well, but what is demanded globally is doing well. Much of the developed world has over-leverage problems. Isn’t that a richer view than trying to analyze whether the US will have two consecutive quarters of negative real GDP growth?

2) So Moody’s is moving Munis to the same scale as corporates? Well, good, but don’t expect yields to change much. The muni market is dominated by buyers that knew that the muni ratings were overly tough, and they priced for it accordingly. The same is true of the structured product markets, where the ratings were too liberal… sophisticated investors knew about the liberality, which is why spreads were wider there than for corporates.

3) Back to the voting machine versus the weighing machine a la Ben Graham. It is much easier to short credit via CDS, than to borrow bonds and sell them. There is a cost, though. The CDS often trade at considerably wider spreads than the cash bonds. It’s not as if the cash bond owners are dumb; they are probably a better reflection of the true expectation of default losses, because they cannot be traded as easily. Once the notional amount of CDS trading versus cash bonds gets up to a certain multiple, the technicals of the CDS trading decouple from the underlying economics of the bond, whether the bond stays current or defaults. In a default, often the need to buy a bond to deliver pushes the price of a defaulted bond above its intrinsic value. Since so many purchased insurance versus the true need for insurance, this is no surprise.. it’s not much different than overcapacity in the insurance industry.

4) If you want a quick summary of the troubles in the residential mortgage market, look no further than the The Lehman Brothers Short Swaption Volatility Index. The panic level for short term options on swaps is above where it was for LTCM, and the credit troubles of 2002. What a take-off in seven months, huh?

LBSOX

5) Found a bunch of neat charts on the mortgage mess over at the WSJ website.

6) I have always disliked the concept of core inflation. Now that food and fuel are the main drivers of inflation, can we quietly bury the concept? As I have pointed out before, it doesn’t do well at predicting the unadjusted CPI. Oh, and here’s a fresh post from Naked Capitalism on the topic of understating inflation. Makes my article at RealMoney on understating inflation look positively tame.

7) The rating agencies play games, but so do the companies that are rated. MBIA doesn’t want to be downgraded by Fitch, so they ask that their rating be withdrawn. Well, tough. Fitch won’t give up that easily. Personally, I like it when the rating agencies fight back.

8 ) Jim Cramer asks if Bank of America will abandon Countrywide, and concludes that they will abandon the bid. Personally, I think it would be wise to abandon the bid, but large companies like Bank of America sometimes don’t move rapidly enough. At this point, it would be cheaper to buy another smaller mortgage company, and then grow it rapidly when the housing market bounces back in 2010.

9) Writing for RealMoney 2004-2006, I wasted a certain amount of space talking about home equity loans, and how they would be another big problem for the banking system. Well, we are there now. No surprise; shouldn’t we have expected second liens to have come under stress, when first liens are so stressed?

10) In crises, hedge funds and mortgage REITs financed by short-term repo financing are unstable. No surprise that we are seeing an uptick in failures.

11) As I have stated before, I am not surprised that there is more talk of abandoning currency pegs to the US dollar. That said, it is a getting dragged kicking and screaming type of phenomenon. Countries get used to pegs, because it makes life easy for policymakers. But when inflation or deflation gets to be odious, eventually they make the move. Much of the world pegged to the US dollar is importing our inflationary monetary policy.

12) Finally, something that leaves me a little sad, people using their 401(k)s to stay current on their mortgages. You can see that they love their homes, as they are giving up an asset that is protected in bankruptcy, to fund an asset that is not protected (in most states). Personally, I would give up the home, and go rent, and save my pension money, but to each his own here.

Brief Note on the Fed Actions

Brief Note on the Fed Actions

Posted on by David Merkel

I’ve been puzzling about the recent Fed actions, and I think there is less there than meets the eye.? Don’t get me wrong, the Fed has acted.? It is changing the composition of its balance sheet in the short run, absorbing MBS, and pushing out Treasuries.? But it is not expanding its balance sheet.? After several novel policy initiatives, it should be painfully obvious to Fed-watchers that the lack of increase in the monetary base is intentional.

The Fed is trying to influence financing in the residential mortgage market versus Treasuries, in the short run.? It is not trying to stimulate the economy through expanding the monetary base.

The short-run aspect of the program hobbles it to some degree.? The Fed can say that they will continue to finance in the short term indefinitely, but nothing says that louder than expanding the terms from 28 days to two years.? If it’s in the agreement, the expanded length of financing will get a much bigger result than a rolling four week window.? Think of it this way: the Fed might want to continue the short-term financing indefinitely, but there have been times in the past where the Fed has felt forced to abandon a plan because of global macroeconomic events (think 1986-7, when the dollar fell, then the bond market fell, then the stock market fell…).? Promises are one thing, contractual terms are another.

I’m not a fan of central banking, but if we are going to have central banking, this is a time when the monetary base should be expanding, at least modestly.? I think the Fed in this case is being “too clever” and needs to do a permanent injection of liquidity.? If they don’t want to do that, well, let’s move back to the gold standard, and privatize monetary policy.

Redirection of Liquidity, Not Creation of Liquidity

Redirection of Liquidity, Not Creation of Liquidity

Posted on by David Merkel

These short-term financing arrangements (TAF & TSLF) are an attempt of the Fed to redirect liquidity from ordinary channels (fed funds and the like), to the short-term funding of banks and dealers with acceptable collateral. Acceptable collateral varies, with differing haircuts depending on the collateral and the financing program. At this point, Agency MBS and AAA whole loans (not on review for downgrade — presumably that means no negative outlooks from any ratings agency) are encouraged.What I find most interesting in all of this how little true liquidity the FOMC has injected in this cycle. The monetary base is flat. What this looks like is an attempt to selectively reflate the economy — help the banks and dealers, but keep total liquidity close to fixed.

And, in the face of this, total bank liabilities keep expanding at a 10%+ clip. It almost feels like any source of liquidity is good liquidity to the banks. Of course, they get a lot of it from the FHLB, which has been the big unconstrained lender in this cycle. Fannie and Freddie may now be able to make larger loans, which loosens up hosing finance a bit, but only the FHLB has the balance sheet to do so in this cycle, and they have done it. Call them the “shadow Fed.” But even their balance sheet is finite, and they are only implicitly backed by the US Government, like Fannie and Freddie.

So where does this leave us? Muddling along. Even the redirection of liquidity will not get the banks and dealers too jazzed, because they are only short term measures, with uncertain long-term funding availability and cost. More attractive than the “free” market for now, but that’s about it.

The Fed is trying some clever ideas. I have just two concerns — what happens when you unwind them, and are they perhaps too clever?? There may be unintended consequences…

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