Affordable Housing Institute : US

Ten days ago, the Federal Reserve made a bet that economic students will be studying for decades.  Under Ben Bernanke, the Fed pushed $200 billion – that’s your money and my money – into the global capital markets pot, in effect making a bet that assets the market won’t buy have the value their originators say they do.  

These tickets are valuable

 

As reported in The New York Times:

 

March 11, 2008

Fed to Lend $200 Billion More to Ease Market Strain

 

Scrambling to ease the strain on the credit market, the Federal Reserve announced a $200 billion program on Tuesday that would allow financial institutions, including the nation’s major investment banks, to borrow ultra-safe Treasury money by using some of their riskiest investments as collateral.

 

Set aside the pushbutton phrase ’some of their riskiest investments’ and focus on what has happened here. 

 

Normally the capital markets of the money store work fine – for every seller, there’s a buyer … at a price, sliding up and down the risk curve.  Back in December 2006, when these events were first breaking, Mycroft Holmes gave long-suffering Watson a tour of his money store, otherwise known as the Diogenes Bank:

 

 

“Why all these floors,” asked Watson, “each higher than the other?”

 

“Each,” said Mycroft with a rumbling chuckle, is a bit more sophisticated, a bit more able to assess risk.  A bit better paid.  And whom do you think ascends to these upper floors?”

 

“Those who cannot be accommodated below.”

 

“Precisely so,” replied Mycroft.  “If our commercial lenders believe a venture has some value, but is too risky for a standard loan, they may discreetly press a buzzer and summon one of our investment bankers.  Like Colonel Smithers here, temporarily on leave from another author’s works.”

 

From Goldfinger, to be precise

 

“An investment banker like Smithers has both authority and ability to structure customized debt and equity investments.  Only in large sums.  Only to clients who pass our more extensive screening and proper due diligence.  Smithers seldom descends to the ground floor.”

 

“How does he then secure customers?”

 

“They come to the money markets — banks such as ours — and are referred upward.  Higher floors, higher risk.  Higher risk, higher yields.”

Before Watson got to see the upper floors, he visited the basement, where the Treasury issued its gilts:
 

Down to the Treasury, where they print the money

The lowest floor of any country’s money store is its treasury, because that is the lowest risk investment.  All other investments face currency risk plus their own investment risks; so Treasuries always carry the lowest yields.
 

The origin — the theoretically risk-less investment — is sovereign debt.  (It’s not really risk-less, but every other financial instrument is denominated in the currency, and if the currency collapses, everybody else does too.)  In the US, that’s the Treasury bill.  Then, moving left to right, we introduce default risk bit by bit, and as we do, spread relative to the safe investment rises.

 

We can even populate this a bit.  If we believe that the rating agencies know what they are doing, then the distinctions among ratings ought to lie neatly along the risk curve line, with all AAA-rated instruments of similar maturity clustering tightly around a particular spread.  In reality, spreads do cluster, but this may be reverse-engineering — spreads concentrate toward ratings, rather than ratings to spreads. 

The securities in question are somewhere along the risk curve’s right side, so under normal circumstances they would command high spreads (interest rates above the safe rate).  These times are far from normal, they’re very conservatively abnormal, with the result that spreads are grotesquely wide, as shown in this slide from Doug Duncan, at the time chief economist for the Mortgage Bankers and now working for Fannie Mae:

That dramatic widening of spreads is very, very costly, and as I posted a little more than a month ago:
 

With risk spreads this wide, the music has suddenly stopped, and everybody’s holding large amounts of paper they don’t want, as described in this recent article from The Wall Street Journal:

 

A new problem is rippling through credit markets: Many of the corporate loans used to finance giant buyouts in the past few years are reeling in secondary market trading, making it virtually impossible for banks to unload other commitments they have made.

 

The holders of this debt are now facing a risk they never imagined would arise — the risk of execution.

 

I never thought I’d get into this position!

Holding unwanted paper was creating credit gridlock:

Everybody wants to get out, and everybody’s blocking everybody else
 

Not only could they not sell these assets – because everybody else had similar assets which they wanted to sell — the banks were also being forced to mark them down (‘mark to bottom,’ as some wags called it).  They were running short of liquidity (no ‘ready money,’ as Oscar Wilde’s Algernon described it).  So the Fed, fount of all liquidity, gave them a thirst-quenching drink:

Need some liquidity?
 

The Fed normally lends Treasury securities to banks for just a few hours. Under the new program, money will be lent for 28 days and the central bank will accept nongovernment mortgage-backed securities — the source of the current crisis in the credit markets — as collateral. The Fed will require that the assets, which are linked to soured home loans, have a premium credit rating.
 

Contrary to the Times’s description, the assets have to be good quality.  They just can’t be sold right now.
 

No hints where the market is going
 

The new program, dubbed the Term Securities Lending Facility, will effectively allow strapped financial institutions to hand over potentially damaged securities to the government in exchange for either cash or easily traded Treasury securities, some of the safest in the market. 
 

Once again, the Times is incorrect; the banks are not selling the securities, they’re pledging them as collateral for short-term Treasury loans.  [Hey, New York Times, that's why it's called a Lending Facility! – Ed.]
 

Liquidity matters:
 

Wall Street responded with a rally, with the Dow Jones industrials surging 150 points.

This was the central bank’s second effort in a week to unfreeze the nation’s panicky credit markets, where investors have become too frightened to finance even conservative debt offerings.
 

Herein lies the real meaning of Bernanke’s big bet — it’s not that the financial world has suddenly gone broke, but rather because the financial world has suddenly become scared.  Everybody’s slammed on the brakes at once, leading to both financial gridlock and financial pileups.
 

The markets were running smoothly just moments ago!
 

Stock markets soared after the announcement, with the Dow Jones industrials gaining 260 points before falling back to 11,925.85, a 185-point gain, at 12:30 p.m. as brightened investors snapped a three-day losing streak.
 

The Feds aren’t just opening the bank petcocks, they’re turning on all the liquidity taps:
 

More liquidity where that came from
 

The government will also accept mortgage-backed securities issued by government-sponsored companies like Fannie Mae and Freddie Mac.
 

We’ve previously seen that the GSEs enjoy awfully big advantages, which lets them rapidly grow or even turbocharge their balance sheets.  That brings a lot of risk, but it also brings benefits, one of which is on display here: the GSEs can be open 24/7 if the Fed lets them.
 

The Fed will lend the Treasuries through weekly auctions that begin March 27. 
 

Stepping up and buying with hard cash while everyone around you is selling is the mark of folly, wisdom, courage, or self-delusion.
 

Better be convinced you’re right
 

If Ben Bernanke and the Fed are right, their moves will unjam the gridlock and get capital moving again. 
 

If they’re wrong, the consequences could be disastrous for all of us.
 

I hope they’re right.  Fortunately, I think they’re right.

Time to choose

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