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5 THE SHAPE OF
US POPULISM, Part 4 A panic-stricken Federal
Reserve By Henry C K Liu
Because the Fed knows that primary dealers
are holding $139.7 billion agency securities and
$60.2 billion private label securities.
In
The Wall Street Examiner, Lee Adler wrote in his
article: Bandaid on a Ruptured Jugular:
Why do prime dealers (PDs) borrow
securities from the Fed? To sell them short. The
PDs are heavily short Treasuries at all times.
They are heavily long all other debt securities
simultaneously. The level of securities lending
in recent months is unprecedented in all of
human history, by an order of magnitude of 10.
The Fed is now responding to the
pressure of the
imminent collapse of the PDs
and major banks worldwide, because not only are
the PDs heavily short the stuff that is going up,
Treasuries, they are heavily long the stuff that
is going down, which is all other debt securities.
This is the worst of all possible worlds and the
Fed’s action is like putting a bandaid on a
ruptured jugular vein.
Stealth nationalization of the financial
sector Adler quotes Steve Randy Waldman
of Interfluidity (What Happens 28 Days later?):
"Since the Fed cannot retire loans made via TAF
and its repo program without adding to those
'elevated pressures', the loans should be
considered an equity infusion, because they’ll
be repaid at the convenience of the borrower
rather than on a schedule agreed with the
lender." What Waldman did not say was that the
Fed had ventured into a broad nationalization of
the prime dealers on Wall Street by being an
equity investor.
Does the same argument
apply to the new Term Securities Lending
Facility (TSLF)? On the face of it, it's harder
to view TSLF as an equity infusion, since the
Fed is not handing out cash. But to firms
holding illiquid securities that the Fed will
accept as collateral, the program is equivalent
to a not-so-efficient cash infusion, because the
Treasuries the Fed lends are liquid and can be
converted to cash easily in private markets,
according to Waldman.
So, this new
facility might well be a form of equity, if the
Fed is willing to roll it over indefinitely and
require payment only at the convenience of
borrowers or when a normal market for them
reappears. Waldman thinks what happens after 28
days is pretty clear. The swap will be rolled
over and over and over until the mortgage-backed
security market stabilizes. This could be a year
from now, or perhaps 10. That may sound
ridiculous but it is essentially what happened
in Japan.
Waldman suggests that
inquiring minds might ask what happens if the
value of the MBS drops. Will the Fed issue a
margin call or just look the other way? … One
thing is for sure: The more liberal the Fed is
in valuing the MBS the more likely a margin call
situation arises. However Waldman strongly
suspects the Fed will not disclose who is doing
the swapping, in what size, or whether the swap
ratio is 1:1 or not. So much for transparency.
"This may temporarily stop a further
squeeze against dealers who are short treasuries
and long MBS, but it is will not do much of
anything to restore a bid in the MBS market. Nor
will it cure the massive leverage problems at
many of the primary dealers and banks," writes
Waldman.
Adler cites an interesting
paragraph from a MarketWatch article: "Counting
the currency swaps with the foreign central
banks, the Fed has now committed more than half
of its combined securities and loan portfolio of
$832 billion," Lou Crandall, chief economist for
Wrightson ICAP noted. "The Fed won’t have run
completely out of ammunition after these
operations, but it is reaching deeper into its
balance sheet than before."
"Bernanke's
intent is to buy the primary dealers time, but
it really can't work. Those securities will not
be worth more tomorrow than they are today. For
now, a MBS fire sale was averted, but it can't
be put off forever," writes Adler.
On
March 16, 2008, the Fed announced that the New
York Fed has been granted the authority to
establish a Primary Dealer Credit Facility
(PDCF), intended to improve the ability of
primary dealers to provide financing to
participants in securitization markets and
promote the orderly functioning of financial
markets more generally.
The PDCF will
provide overnight funding to primary dealers in
exchange for a specified range of collateral,
including all collateral eligible for tri-party
repurchase agreements arranged by the Federal
Reserve Bank of New York, as well as all
investment-grade corporate securities, municipal
securities, mortgage-backed securities and
asset-backed securities for which a price is
available. The PDCF will remain in operation for
a minimum period of six months and may be
extended as conditions warrant to foster the
functioning of financial markets.
The
TAF program offers term funding to depository
institutions via a bi-weekly auction, for fixed
amounts of credit. The TSLF program is an
auction for a fixed amount of lending of
Treasury general collateral in exchange for
Open-Market-Operation-eligible and AAA/Aaa rated
private-label residential mortgage-backed
securities. The PDCF program now allows eligible
primary dealers to borrow at the existing
Discount Rate for up to 120 days.
Down the slippery slope The
moves into new province suggest that the Fed has
changed its traditional role in the economy with
the support of the White House and the Treasury.
Former Fed chairman Paul Volcker said in a
public television interview the same evening
that the Fed’s decision to lend money to Bear
Stearns Cos. [via commercial bank JP Morgan
Chase] to keep the investment house from
collapsing is unprecedented and "raises some
real questions" about whether that was the
appropriate role for the Fed. The wisdom of the
decision depends on "how severe this crisis was
and the Fed’s judgment about the threat of
demise of Bear Stearns," Volcker said. "That’s a
judgment they had to make and an understandable
judgment. It is absolutely not what you want for
the longstanding regulatory support system."
The Fed's action then was an open
admission that an ominous systemic crisis of
total meltdown was a clear and present danger.
Unlike the TAF, which swaps cash for MBS
and therefore requires sterilization so as not
to push the Fed Funds Rate below target, the
TSLF is simply a swap of one instrument for
another, albeit an inferior one. It is not
printing, and it injects no cash into the
system. To avoid the need to sterilize the
liquidity injection, the Fed exchanged
Treasuries in its procession for securities of
dubious market value held by Bear Stearns.
Since Bear Stearns is not a banking
holding company and does not own a bank, the Fed
could only rescue it by providing the funds to
JP Morgan Chase, a commercial bank that can
access the Fed discount window for funds, to
acquire Bear Stearns at a fire sale price of $2
a share, a ceiling dictated by the Fed to avoid
the appearance of bailing out Bear Stearns
shareholders, while other investors were bidding
at $5.98. The shares had traded at $170 at its
peak in January 2007 and at $67 two weeks before
the rescue. The Fed will guarantee up to $30
billion of potential losses on Bear assets,
later reduced to $29 billion with JP Morgan
assuming the first $1 billion losses. It was the
Fed’s first rescue of a prime dealer broker
since the Great Depression and its latest effort
to soothe financial markets roiled by fallout
from rising mortgage defaults. Latest reports
have JP Morgan renegotiating the sale price at
$10 per share to ward off shareholder attempts
to block the Fed-sponsored deal.
So far,
the three special facilities introduced by the
Fed in quick succession have failed to stabilize
the credit market: The TAF (Term Auction
Facility) failed to restore liquidity. The
TSLF (Term Securities Lending Facility) failed
to restore liquidity. The PDCF (Primary
Dealer Credit Facility) can be expected to fail
to save a rising number of distressed primary
dealers.
Clearly the bond market does
not believe the TAF, the TSLF, or the PDCF, all
liquidity actions, are going to solve the
insolvency problem facing over-leveraged
institutions.
Fed chairman Ben Bernanke
is increasingly perceived by the market as
running out of room to pump money into the
financial markets and to cut interest rates to
rescue the faltering economy. To providing
liquidity to the market, the Fed has already
committed as much as 60% of the $709 billion in
Treasury securities on its balance sheet. It has
opened the door of moral hazard to more bailouts
with the decision to become a lender of last
resort for Bear Stearns, one of the biggest Wall
Street dealers.
The Fed is now forced to
respond to the pressure of the imminent collapse
of distressed primary dealers and major banks
worldwide. Primary dealers have routinely
heavily shorted Treasuries that are now going up
in price, and heavily longed all sort of other
debt instruments that are now going down in
price. The normal formula for easy profit has
become the worst of all possible worlds for
primary dealers in times of market distress.
Moreover, the high leverage will magnify the
losses as it did profits during good times. Also
structured finance has generated derivatives
that are based on hundreds of trillions of
dollars in notional value, causing every slight
move in interest rate to produce payment
obligations in hundred of billion of dollars
among institutions whose capital structures are
woefully inadequate.
Legal
challenges Inner City Press/Community on
the Move, a housing and fair lending activist
group, has challenged the legality of the Fed's
quick approval of refinancing for Bear Stearns
via JP Morgan Chase, questioning the Fed's
authority to approve the deal involving a
non-bank institution.
In a complaint
filed with the Fed a day after the Fed action,
Inner City Press labeled the central bank's
brokering of the Bear Stearns deal as "entirely
illegal" and anticompetitive, and questioned
whether the required number of Fed Board
governors had voted for it.
Bernanke
took advantage of little-used parts of Fed law,
added in the 1930s and last utilized in the
1960s, that allow it to lend to corporations and
private partnerships with a special board vote.
Such votes require approval from five Fed
governors. The seven-member Fed board currently
has two vacancies, and one governor, Randall
Kroszner, is serving past the January 31
expiration of his term.
Inner City Press
questioned the legality of the Fed approving the
Bear Stearns deal without public notice, on the
grounds Bear Stearns "is not a banking holding
company and it does not own a bank."
The Federal Reserve bypassed
its own normal emergency-lending policies to let
securities firms borrow at the same interest rate
at the discount window as commercial banks as the
central bank sought to stave off a
financial-market meltdown. Guidelines revised in
2002 say the Fed should charge non-banks more than
the highest rate that
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