Saturday, April 12, 2008

What are the Fed's facilities facilitating?

Guambat, in his usual Guambatian way, is again wading in way over his head in things economic in order to try as he might to begin to understand in the most simplistic of ways another of the big events of the day.

Being mathematically and philosophically challenged, Guambat tends to trust, and thrust, his nose in these things. Some things, such as the alphabet soup of financial derivatives, did not just quite smell right to him, so growing unsatisfied in trying to follow their inception and purpose, he turned up his nose at them, for instance.

Surely the big event of these days is the Fed's attempt at reverse alchemy: its attempt to "rescue" the big financial institutions from their very own folly and thereby paint a rainbow over every homeowner, and put a chicken in every pot for the rest of us whilst they are at it.

These are some of the pieces that Guambat is trying to synthesize and sense-thesize; they smell like they ought to lead to some understanding of the topic but Guambat confesses to not at all yet realise how.

Let's start with Mike Mish Shedlock's piece in Minyanville, "Risky business for Fed", though we could as easily start anywhere; once you tug on any of these threads the whole thing seems to wind up on the floor in a spaghetti of loose wool.

In an attempt to increase market liquidity, and promote bank to bank lending, the Fed has created three new lending facilities. Let's do a quick recap:

* In the Term Auction Facility (TAF), the Fed (via auction) swaps cash for questionable securities. This facility is for banks.
* In the Term Securities Lending Facility (TSLF), the Fed swaps treasuries for questionable securities. This facility is for banks.
* In the Primary Dealer Credit Facility (PDCF), the Fed swaps treasuries for questionable securities. This facility is for broker dealers.

In Failures of the Term Auction Facility, I showed how and why the facilities were failing to accomplish their mission. Simply put, banks don't trust each other, so they're unwilling to lend to each other except at an unusually wide premium. Instead of encouraging more bank to bank lending, the Fed has simply become a dumping ground for all the garbage mortgage backed securities no one wants to hold.

A paper from the Federal Reserve Bank of San Francisco, "A Black Swan in the Money Market", by John B. Taylor and John C. Williams also took issue with the Term Auction Facility. Their conclusion is:
We show that increased counterparty risk between banks contributed to the rise in spreads and find no empirical evidence that the TAF has reduced spreads. The results have implications for monetary policy and financial economics.

In his usually helpful way, Sam Jones, writing in FT Alphaville, tries to put that paper's thesis in a form that, if not digestible, is at least of a fragrance that Guambat can experience. He says,
the most interesting thing is a corollary of the research, rather incidental to its main findings about the TAF.

Statistically speaking, a six-sigma event should occur every 2,500,000 days - or once every 6849 years. Notwithstanding the fact that markets have experienced six six-sigma events in the past 20 years (what’s the probability of that?) they note that the OIS-Libor spread puts the current financial crisis as a sixteen sigma event.

Such perhaps, is the folly of stochastics. Even so, it’s the accepted line: statistically the credit crisis was shocking, sudden, and unexpected. Viz. there was a massive jump in market risk in August 2007.

Which is why taking a longer view is so arresting. Taylor and Williams also provide a graph going back to 1991 of 3 month Libor (unsecured) against 3 month treasury-backed interbank repos (secured). Although it’s more “fuzzy”, the authors do say it’s probably an even better measure of “pure risk” than the OIS-Libor proxy.

Over the full sixteen year period, there are several spikes corresponding to past financial blips, of which the current is far and away the largest. What’s clear though, is that by any standard-deviation or measure of volatility over the longer period, the current crisis is nowhere near a six-sigma event.

So - extrapolating in lay terms here - while the current crisis was unlikely, it was historically predictable.

Which, to some extent, seems to validate the oldest risk rule of them all: it wasn’t different this time.

Greg Ip, in his WSJ Economics Blog, adds more pieces to the puzzle in his post "What could the Fed do?".
Since the Federal Reserve began rolling out ever more creative steps to unfreeze credit markets, it has sold or pledged a growing portion of its portfolio of Treasurys in order to put loans on its balance sheet to banks and securities dealers backed by mortgage-backed securities and other shunned collateral.

First, here’s what the Fed has done (as of April 3):
1. Lent banks $10.3 billion through the discount window.
2. Lent banks $100 billion in term auction credit.
3. Lent securities dealers $76 billion through standard repurchase agreements.
4. Lent securities dealers $34.4 billion through the discount window.
5. Lent securities dealers $75 billion of its Treasurys in return for other collateral through its new Term Securities Lending Facility.
6. Lent up to $36 billion to the European and Swiss central banks.
Ip then discusses the how all this lending is beginning to dip deeply into the Fed's nest egg of Treasury securities, and offers "some ways it could expand its lending capacity while maintaining control of the fed funds rate" even though "these steps only address the magnitude of the Fed’s lending capacity, not what it does with that capacity".

One of his suggestions is
"The Fed could try to do the mirror image of the Term Securities Lending Facility. In other words, take the mortgage backed securities pledged to it by dealers in return for Treasurys, and re-pledge them to other dealers, taking Treasurys back."
In ways legal that Guambat has not the time or inclination to explore, this option evidently skirts some legal issues and obstacles, as explained by Lou Crandall, who evidently thinks its a "cool" idea, in a post in the Real Time Economics WSJ blog.

But, for Guambat it comes back to the smell test, and fails. Steve Waldman extracts the aroma better than the best sommelier:
These so called "reverse MBS swaps", under which the Fed would refill their stock of Treasuries by swapping back iffy securities wrapped with a Fed guarantee, would have no direct balance-sheet impact whatsoever, and if repeated would provide the Fed with a potentially infinite supply of Treasury securities to swap! Of course, the proposal is simply a scheme to create off-balance-sheet liabilities in order to evade what might be on-balance-sheet limits. Wow.

I frequently marvel about how, in order to respond to the credit crisis, the Fed as well FHLB, Fannie, and Freddie, are doing precisely what got private actors into their messes in the first place. Off-balance-sheet liabilities are a logical next step.

Back to Mike Shedlock, where we started, and he is not smelling roses, either.
This is not cool, it's absurd. It's scary that anyone could think this could possibly work. Let's chart this out mathematically.

Case #1

* Citigroup swaps garbage with the Fed for treasuries.
* The Fed swaps the same garbage with Citigroup for its treasuries back.
* This is supposed to accomplish something?

Case #2

* Citigroup swaps garbage with the Fed for treasuries.
* Lehman swaps garbage with the Fed for treasuries.
* The Fed swaps Lehman's garbage with Citigroup to get treasuries back.
* The Fed swaps Citigroup's garbage with Lehman to get treasuries back.
* Lehman holds Citigroup's garbage.
* Citigroup holds Lehman's garbage.
* This is supposed to accomplish something?

Wouldn't it be much simpler to have the Fed guarantee the debt and forget all this swapping madness? No I don't want that to happen, I am just stating the insanity of all this swapping if the only purpose is to get the "Midas Touch" from the Fed.

Logically speaking, this proposal would have the Fed guarantee all bank and broker dealer debt simply by touching it. However, the Fed is not Midas. And this is not a "cool idea", it's insanity.


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