What's A Fed To Do!

A: The fed came out on Friday, right before the scheduled release of the employment data, and announced up to $200 Billion in additional loans via the use of term auction facilities (TAF) and repurchase agreements. The interesting thing here is the changes to the repurchase agreements; extension of loans to 28 days + widening of allowed collateral requirements. Steve Waldman at Interfluidity, has an excellent piece (found via Naked Capitalism) that discusses what the fed may be quietly up to! Since 2.25% fed funds rate cuts thus far has done little to help normalize the credit markets, confidence, LIBOR, or liquidity in secondary mortgage markets, whats a fed to do?

First, some key elements of Steve Waldman's piece regarding the fed's announced stimulus actions on Friday:

The Fed announced that it would auction off $100B in loans this month rather than the previously announced $60B via its TAF facility. In the same press release, the FRB announced plans to offer $100B worth of 28 day loans via repurchase agreements against "any of the types of securities — Treasury, agency debt, or agency mortgage-backed securities — that are eligible as collateral in conventional open market operations".

The second announcement puzzled me. There are a couple of differences, then, between this new program and typical repo operations:

1. The loans are of a longer-term than usual. Ordinarily, the Fed lends on terms ranging from overnight to two weeks in its "temporary open market operations". The Fed will now offer substantial funding on a 28 day term.
2. The Fed is effectively broadening its collateral requirements by collapsing what are usually 3 distinct levels of collateral which are lent against at different rates to a single category within which no distinctions are made.

Until the current crisis is long past, I think it unlikely that any large bank will default and stiff the Fed with toxic collateral. Why not? Because for that to happen, the Fed would have to pull the trigger itself, by demanding payment on loans rather than offering to roll them over. Since TAF started last fall, on net, the Fed has not only rolled over its loans to the banking system, but has periodically increased banks' line of credit as well. In an echo of the housing bubble, there's no such thing as a bad loan as long as borrowers can always refinance to cover the last one.

The distinction between debt and equity is much murkier than many people like to believe. Arguably, debt whose timely repayment cannot be enforced should be viewed as equity. (Financial statement analysts perform this sort of reclassification all the time in order to try to tease the true condition of firms out of accounting statements.) If you think, as I do, that the Fed would not force repayment as long as doing so would create hardship for important borrowers, then perhaps these "term loans" are best viewed not as debt, but as very cheap preferred equity.

What we are witnessing is an incremental, partial nationalization of the US banking system. Northern Rock in the UK is peanuts compared to what the New York Fed is up to.

You may object, and I'm sure many of you will, that our little thought experiment is bunk, debt is debt and equity is equity, these are 28-day loans, and that's that. But notionally collateralized "term" loans that won't ever be redeemed unless and until it is convenient for borrowers are an odd sort of liability. Central banks are very familiar with the ruse of disguising equity as liability. Currency itself is formally a liability of the central bank, but in every meaningful sense fiat money is closer to equity.

The entire piece is a great read, but it's interesting to see the collateral requirements widened to include agency debt & agency MBS. It seems we will be seeing more of these types of moves for the next few quarters as commodity inflation pressures the aggressiveness of future rate cuts. That doesn't mean we have no room left for rate cuts, but lets be honest here: RATE CUTS THUS FAR HAVE HAD NO EFFECT ON CONFIDENCE OR EASING DISTRESS TO THE SECONDARY MORTGAGE MARKETS AND RATES! The bankrate.com chart to the right shows you how lending rates have risen as the fed cuts FFR.

So whats needed? You may not want to know what Paul Miller over at Friedman, Billings, Ramsey estimated ---> $1,000,000,000,000. According to Marketwatch.com:

Why are interest rates on 30-year fixed-rate mortgages rising even as the Federal Reserve slashes interest rates and yields on Treasury bonds fall? The answer is that the mortgage market is short of roughly $1 trillion in capital, according to Paul Miller, an analyst at Friedman, Billings, Ramsey.

The modern mortgage market works with lots of leverage, or borrowed money. Investors, including hedge funds and mortgage real estate investment trusts, buy mortgage securities, but finance a lot of their purchases with this leverage. FBR's Miller estimates that $11 trillion of outstanding U.S. mortgage debt is supported with roughly $587 billion of equity. That's a leverage ratio of 19 to one. This has sparked a de-leveraging cycle in which some highly leveraged mortgage investors have to sell assets to meet margin calls. Forced selling pushes prices lower, sparking more margin calls, which in turn produces more selling and even lower prices.

Since every rate cut is in essence a wasted bullet in a limited capacity gun, the fed knows it needs to pick & choose its next shots wisely. Personally, I think another rate cut will come soon and there is now a Goldman Sachs rumor floating around the markets that one may come today. I doubt that rumor as it is consistent behavior when stocks have had an ugly downturn and are now seeking a quick short-covering rally. The next scheduled fed meeting is May 18th, and I think the move will come then.

The credit markets (auction rate markets, secondary mortgage markets, corporate credit spreads, CMBX's, CDX's, ABX's, etc.) continue to LEAD the stock markets and the world for that matter; these are the markets to watch for signs of confidence and right now the credit markets are not reacting to rate cuts. So, any future rate cuts we get will be targeted as 'setting a floor' and easing the downturn that we are clearly in right now at the expense of commodity inflation. The actions that seem more effective right now are the TAF & repos. Your thoughts?