Tuesday, March 11, 2008

Rabbits & Hats


Today (http://www.federalreserve.gov/newsevents/press/monetary/20080311a.htm) the Federal Reserve announced its willingness to swap $200 billion of U.S. Treasury securities in its portfolio for a variety of securities (including mortgage backed) in primary dealers’ portfolios for 28 days at a time. This bolsters the dealers because they get to exchange suspect securities in their portfolios for the gilt-edged U.S. Treasury securities in the Fed’s portfolio. That enhances the dealers’ balance sheets and the willingness of others to conduct business with them. Credit markets should ease. (Primary dealers are large financial institutions – including banks – that make markets in securities.)

Here is the key paragraph from the Fed’s announcement:

“The Federal Reserve announced today an expansion of its securities lending program. Under this new Term Securities Lending Facility (TSLF), the Federal Reserve will lend up to $200 billion of Treasury securities to primary dealers secured for a term of 28 days (rather than overnight, as in the existing program) by a pledge of other securities, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS. The TSLF is intended to promote liquidity in the financing markets for Treasury and other collateral and thus to foster the functioning of financial markets more generally. As is the case with the current securities lending program, securities will be made available through an auction process. Auctions will be held on a weekly basis, beginning on March 27, 2008. The Federal Reserve will consult with primary dealers on technical design features of the TSLF.”

The Fed has pulled another rabbit from its hat and the stock market jumped. But will this action be sufficient to thaw the chill that has befallen the credit markets?

Prof. Paul Krugman has his doubts. In an article in yesterday’s New York Times (http://www.nytimes.com/2008/03/10/opinion/10krugman.html?_r=1&oref=slogin), that anticipated today’s Fed’s action, he put it this way:

“What’s going on? Mr. Geithner described a vicious circle in which banks and other market players who took on too much risk are all trying to get out of unsafe investments at the same time, causing ‘significant collateral damage to market functioning.’

“A report released last Friday by JPMorgan Chase was even blunter. It described what’s happening as a 'systemic margin call,' in which the whole financial system is facing demands to come up with cash it doesn’t have……….

“The Fed’s latest plan to break this vicious circle is — as the financial Web site interfluidity.com cruelly but accurately describes it — to turn itself into Wall Street’s pawnbroker. Banks that might have raised cash by selling assets will be encouraged, instead, to borrow money from the Fed, using the assets as collateral. In a worst-case scenario, the Federal Reserve would find itself owning around $200 billion worth of mortgage-backed securities.

“Some observers worry that the Fed is taking over the banks’ financial risk. But what worries me more is that the move seems trivial compared with the size of the problem: $200 billion may sound like a lot of money, but when you compare it with the size of the markets that are melting down — there are $11 trillion in U.S. mortgages outstanding — it’s a drop in the bucket.

“The only way the Fed’s action could work is through the slap-in-the-face effect: by creating a pause in the selling frenzy, the Fed could give hysterical markets a chance to regain their sense of perspective. And to be fair, that has worked in the past.

“But slap-in-the-face only works if the market’s problems are mainly a matter of psychology. And given that the Fed has already slapped the market in the face twice, only to see the financial crisis come roaring back, that’s hard to believe.”

Will the Fed’s action today be sufficient to restore confidence in the credit markets? It seems unlikely because of the underlying fundamental problem: The credit crisis stems from the mortgage crisis which stems from the glut of homes on the market. The residential-real-estate glut is not a financial mirage, but the obvious consequence of an asset inflation that has become an asset deflation. Mortgage-backed securities have become toxic waste because the value of their underlying assets has melted away. Until the deflation has run its course and home prices have stabilized, it’s difficult to see how the financial markets can fully recover.

© 2008 Michael B. Lehmann

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