Wednesday we had the spectacle of five central banks taking coordinated action to deal with the worrisome and widening spread between interbank rates, such as Libor, and risk-free rates, signaling that banks no longer trust their peers.
And the crunch would most certainly get nastier as the end of the year approaches, since even in normal times, banks pull back on their short-term lending then so they can square their own books.
The problem with this combined operation is that, as one spectator perhaps too correctly depicted the move, it was shock and awe, more PR than punch.
However, as the Financial Times’ Martin Wolf pointed out, the PR may count, because (as he reads it), these measures are a sign that the helicopters will keep dropping cash as long as necessary, and thus may well shore up flagging confidence. More from Wolf later. Nouriel Roubini is (if possible) even more dubious, as we’ll discuss in due course.
Aside: why is it that when people talk of helicopters and cash, I see that ‘I love the smell of napalm in the morning’ scene from Apocalypse Now? And remember, we did lose that war.
As Bloomberg depicts the recent actions, the Fed and other central bankers are trying to pursue joint but distinct courses of action, one to alleviate stressed conditions in the money markets, the other to provide appropriate monetary policy given the economic fundamentals. But can this work? The Fed funds market has been demanding lower rates, likely out of a belief that they are needed to shore up declining asset values.
James Hamilton at Econbrowser pens his usual thorough analysis. He focused on the novel aspect of the Fed’s action, which was the creation of a term auction facility. It sits somewhere between the discount window and Fed funds.
Some had complained at the Fed’s failure to cut its rate at the discount window, but frankly, I don’t see the point. We learned in August when things were rocky that banks simply don’t access it (yes, a few banks stepped up and took $500 million each to be sports, but that isn’t the usage intended).
Too much stigma, no easy way to solve that problem. So the term facility is both a way to address the year-end crunch and could be a precursor to similar facilities as a adjunct to the not-well-loved discount window.
(You can read Hamilton’s synopsis pens his usual thorough analysis.)
I’m largely on the same page as Hamilton but see things a wee bit differently. First, I’m skeptical that $40 billion of repos, which is what these are, over the year-end period, really does much of anything, liquidity-wise (technically, this doesn’t create liquidity precisely because it’s a temporary infusion).
Felix Salmon calls this a ‘bailout’ but I don’t buy that. A one month pawn operation, even if you can hock your beaten-up couch, is still a loan, not a gift, unless you go bankrupt in that month and leave the pawnshop holding overvalued furniture.
And $40 billion doesn’t seem large enough to have much, if any, effect, unless the psychological impact is disproportionate. By comparison, commercial paper outstandings fell by $23 billion the week ended December 5.
So the real effect may be, as Hamilton and others suggest, in the expansion of types of collateral that are considered acceptable. Hamilton’s notion that the assets are ‘taken off the balance sheet’ is somewhat misleading. If this were indeed a repo, the assets go to the central bank temporarily; the borrower gets cash back (at a discount to the face value of the collateral) and shows a liability, an ‘agreement to repurchase.’
However, repos are generally used only for highly liquid instruments, such as Treasuries. My impression that that is not the procedure envisaged herel. While the economics may be the same as for a repo, the form of the transaction may be somewhat different.
The language in the press release is ‘term loans secured at the discount window.’ That suggests that the assets remain on the borrowers’ balance sheets and the Fed simply has a secured interest.
Now how can the acceptance of relatively crappy (yes, crappy, it will accept even CDOs if they are rated AAA) collateral matter? First, there is a belief, not confirmed anywhere in neat tables with haircuts, that the Fed will accept even broader types of collateral than permitted at its discount window, but I don’t see language to that effect in its press release announcing the program. In fact, the reverse:
Under the Term Auction Facility (TAF) program, the Federal Reserve will auction term funds to depository institutions against the wide variety of collateral that can be used to secure loans at the discount window.
So this is basically a discount window under another name, with a different price setting mechanism. The Fed plans at least two more auctions in January, and will seek comments. So this is an experiment that may become a permanent feature, or may be tweaked further.
So what is the real significance of this move? See below:
Most of the CDO and subprime paper held by banks is AAA. Now I have no idea where this stuff is trading, and the fact is that a lot of it is not trading. However, lot of people are using the ABX as a proxy for subprime and other risky mortgage credit risk. So it may not be a price, but it’s a reference point for pricing. And it has AAA credits at 70 cents on the dollar.
So the Fed’s temporary facility could be used, quite legitimately, to mark anything that the Fed would accept as a repo at its collateral value for accounting purposes (you could theoretically have made the same argument for the discount window, but that’s an emergency facility, while this is intended for all comers). That places a very big floor under a lot of now-questionable credit.
That move would reduce writedowns, the accompanying loss of confidence, and the need for additional equity well out of proportion to the paltry $40 billion the Fed is throwing into the mix. Of course, one could argue this is Japan circa 1992, but we are well down that path already.
Now to other skeptical comments First, the Financial Times’ Martin Wolf, who in ‘The helicopters start to drop money,’ frets that the powers that be have now committed themselves to open-ended salvage operation, which will embolden too many miscreants to sin again.
Nouriel Roubini elaborates on the theme mentioned by Wolf, that the central banks’ measure are aimed at a liquidity problem rather than a solvency problem (Wolf did suggest the central banks could address that too if they stood ready to take on massive amount of paper; we aren’t there yet).
This observation, that solvency and lack of transparency present a very different set of problems than liquidity, has been a theme of Roubini’s for some time. Even though it has gotten favorable mention in the financial media, it does not seem to have penetrated policymakers’ thinking.
Posted by Yves Smith on Naked Capitalism, Thursday December 13th