March 12, 2008
The Fed as Market Maker of Last Resort: better late than never
According to today’s FT: “… the US central bank announced that it would lend primary dealers in the bond market $200bn in Treasury securities for a month at a time and accept ordinary triple-A rated mortgage-backed securities as collateral in return.” … “The latest Fed gambit, announced as a co-ordinated move with other central banks, is designed to improve liquidity by allowing dealers to swap their mortgage-backed securities for Treasuries, which they can in turn use to raise cash.” … “The initiative takes the US central bank a step closer to the nuclear option of buying mortgage-backed securities in its own right, although it stopped well short of such an extreme action.”
The last sentence, of course, is rubbish. The Fed is now accepting non-agency-guaranteed mortgage-backed securities as collateral in exchange for loans of central bank cash. What it is doing is, from an economic perspective, equivalent to doing repos - sale and repurchase operations - (with primary dealers as counterparties) accepting any triple A-rate mortgage-backed securities as collateral. There can be little doubt that the logical next step - the outright purchase by the Fed of non-agency-guaranteed mortgage-backed securities (possibly from a wider range of counterparties than the primary dealers) - won’t be long in coming.
The Fed appears to be trying to obscure this simple reality by splitting the repo into two legs. In the first leg, the Fed lends US Treasuries to the primary dealers, accepting triple A-rated mortgage-backed securities as collateral. There are two key new features to this first leg, the new Term Securities Lending Facility (TSLF). First, 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). Second, it will accept as collateral not just federal agency debt and federal agency residential-mortgage-backed securities (MBS), but also non-agency AAA/Aaa-rated private-label RMBS.
In the second leg, the Fed will accept the Treasuries it just lent to the primary dealers as collateral for loans of central bank cash to the primary dealers.
Why make things simple when they can be made complicated? The Fed appears to be embarrassed about doing the right thing - acting as Market Maker of Last Resort (MMLR) by accepting illiquid securities as collateral in repos. By extending both the list of securities eligible as collateral in repos and the maturity of its operations, the Fed is doing what Anne Sibert and I have urged central banks to do since this crisis began ( see (1) (2) (3) and (4) ). All that remains to be done are (1) the extension of the set of eligible counterparties and (2) the conduct of outright purchases of asset-backed securities rather than just their acceptance as collateral in repos.
The old Lender of Last Resort (LoLR) model of providing funding liquidity to solvent but illiquid banks, at a penalty rate and against collateral that would be good in normal times but may have become impaired in disorderly market conditions, may be appropriate in a relationships-based financial system or traditional banking system. It is not capable of dealing with market illiquidity - the kind of liquidity problem likely to arise in a transactions-based model of financial capitalism, that is, a system in which a large share of intermediation occurs through the capital markets rather than through conventional ‘originate and hold’ banks.
In a transactions-based financial system, the Market Maker of Last Resort function complements or even substitutes for the Lender of Last Resort function as the instrument of choice for pursuing financial stability. Rather than disguising the fact that the Fed has woken up to the fact that the world has changed and that central banks have to accept an expanded range of eligible collateral from an expanded range of counterparties when key financial market seize up, the Fed should advertise the fact. They are doing the right thing.
It is key, of course, that the illiquid securities accepted as collateral be valued aggressively and subject to appropriate haircuts to minimize moral hazard. The Bank of England has recruited the services of Paul Klemperer to help it design auctions that will serve as (reservation) price discovery mechanisms, to ensure that the Bank (and behind the Bank the tax payer) do not end up with inadequately collateralised loans. I am sure the Fed must be doing the same with Paul Milgrom and other auction theory geniuses.
The Fed could force some of the effectively unregulated shadow banking sector players into a framework of supervision and regulation, by stipulating that it will deal with a wider range of counterparties than the usual suspects, but only if they are subject to a Fed-approved regulatory and supervisory regime.
In future weeks and months, it is possible that the central banks, including the Fed, will have to move from (multi-stage) repos accepting mortgage-backed securities as collateral to outright open market purchases of mortgage-backed securities and other illiquid private assets, and from an wider range of counterparties.
The emergence of the Fed as a more forceful Market Maker of Last Resort also means that it can go easy on interest rate cuts. As I hold the view that the Federal Funds target rate has already been cut too far, I consider this to be good news indeed. It caps the loss of inflation-fighting credibility the Fed will inevitably suffer as a result of its panicky interest rate escapades since September, without reducing the effectiveness of its market liquidity-oriented financial stability policy.
All that remains is for the private financial institutions, banks and shadow banks, to recognise the losses they have incurred and to scale back their operations or go out of business in a reasonably orderly fashion. The Fed’s readiness to act as Market Maker of Last Resort means that the necessary writing down and writing off of impaired assets and the necessary liquidation of non-viable financial institutions is more likely to take place within a framework of reasonably well-functioning financial and credit markets.
[…] Financial Times […]
Posted by: politicalOBSERVER » Blog Archive » The Fed as Market Maker of Last Resort: better late than never | March 12th, 2008 at 2:45 am | Report this commentI crap in a bucket and try to sell it. Amazingly nobody wants to buy it. I need some money fast and somebody is willing to lend me boatloads of money using the bucket of crap as collateral (it *is* worth something after all I guess). The interest rate of the loan is lower than the going rate. The lender is willing to do this over and over again. Is the lender here losing out?
Who is losing out when the Fed does what it did today? Nobody? Tax payers?
Ponzi Q. Globalization
Posted by: communism strikes back | March 12th, 2008 at 4:09 am | Report this commentSurely the main question here is at what rate and on what terms the Fed is going to lend against private label RMBS? Some of the issues concerned - still farcically rated “AAA” - have fallen 50% in price. By playing along with the ratings game the Fed is implicitly condoning the behaviour of Moody’s, S&P, and Fitch, whose incompetence and corruption ought to have put them out of business a long time ago. The Fed’s intervention may boost liquidity temporarily in an area of the market which has completely dried up, but it’s nore likely that the additional funds will simply be sucked out of the system before we embark on another leg downwards in the credit crunch.
Posted by: Paul Amery | March 12th, 2008 at 9:08 am | Report this commentWhile on the surface the latest Fed action would appear to make sense, the fact is that the triple-A mortgage backed securities it is accepting as collateral are in fact nothing of the sort. In an interesting article on Bloomberg.com today the authors report that 74 out of 80 securities making up the AAA ABX index meet the AAA criteria. And to add insult to injury, both S&P and Moody’s, whose inability to rate securities timely and correctly is in large part responsible for the current mess, are now both deferring downgrades of AAA mortgage backed securities so as to avoid inflicting more pain, breaking their own rules for rating securities. What they hope to achieve by keeping up this charade for a little while longer is anyone’s guess.
Posted by: Stephan Bisse | March 12th, 2008 at 10:40 am | Report this commentThe striking inpact of the Fed’s action is enhancing mortgage market depth without adding to the monetary base. In this respect, it has filled the role of lender of last resort while minimizing the inflationary bias of this role.
Posted by: alfred smith | March 12th, 2008 at 12:25 pm | Report this comment“Even after downgrading almost 10,000 subprime-mortgage bonds, Standard & Poor’s and Moody’s Investors Service haven’t cut the ones that matter most: AAA securities that are the mainstays of bank and insurance company investments.
None of the 80 AAA securities in ABX indexes that track subprime bonds meet the criteria S&P had even before it toughened ratings standards in February, according to data compiled by Bloomberg. A bond sold by Deutsche Bank AG in May 2006 is AAA at both companies even though 43 percent of the underlying mortgages are delinquent.
Sticking to the rules would strip at least $120 billion in bonds of their AAA status, extending the pain of a mortgage crisis that’s triggered $188 billion in writedowns for the world’s largest financial firms. AAA debt fell as low as 61 cents on the dollar after record home foreclosures and a decline to AA may push the value of the debt to 26 cents, according to Credit Suisse Group.”
Posted by: bloomberg | March 12th, 2008 at 12:42 pm | Report this commentI’ve been trying to put this injection of a lot of Billions within the context of a medical situation and have come up with this:
Posted by: Johan van Waveren | March 12th, 2008 at 1:53 pm | Report this commentThere’s a patient with clogged arteries who is having a heart attack, instead of opening up the patient and making an emergency bypass operation the doctor has injected a wallop of pure adrenaline straight into the heart to crank it up so as “to flush the arteries”. What the doctor forgot is that the arteries themselves are clogged, so something is going to go bust or “pop”, if that’s a better term.
A bypass operation would have constituted a semi-nationalization of the credit-insurers, an open government guarantee for Fanny Mae and Freddy Mac, a holding steady on the interest rate, criminal investigations into the lending practices of the “subprime-generators” and some staunch backbone by the administration.
Instead, the patient is up and out of bed, although pale and shaken and is asked “to pull the world’s economic train”. Guess what happens when the adrenaline works off and the train gets loaded with adrenaline-stoked inflation? It is going to get awfully heavy and those arteries will simply close or burst; needless to say “there will not be an upturn in the second half of 2008”.
Welcome to the United States of Debtors. Already a weird combo of the old Prussian military complex overlaid on a banana republic financial/monetary system, the United States is headed down the path towards the world moving away from the USD as a reserve currency. Just as the pound shriveled from $4USD to one, the USD is headed for an equivalent devaluation. Only then will there be a groundswell of opposition and the removal of the power brokers who destroyed the middle class.
Posted by: Boat 52 | March 12th, 2008 at 2:17 pm | Report this commentSadly written by a life long republican who earned his wealth in the investment business.
This entire mess remiinds of another mess-Iraq. We ignore the crimes that put us in the situation in the first place. Then we must contend with the unsavory consequences of dealing with the problem. “Stay the course” mentality is apparent in both situations. We can’t abandon the strategy that got us where we are because the consequences of reversing course are so potentially damaging. This line of thinking in the financial markets breathes additional life into the moral hazard of rewarding reckless behavior with continued and unlimited financial support.The most telling news of the day was that the dollar reached new lows on the heels of this latest bailout even while the equity markets threw a party. A long measured contraction is necessary to unwind the levered madness that has infected the global economy. What sense does it make to have derivatives positions that exceed the real value of the global economy?The ethereal wealth created in these voyuer markets is illusory and ultimately disasterous as the players have no financial interest in the underlying assets other than levered speculation. And for this the financial system has been put at risk? The real question isn’t can we withstand the financial hit of a cold turkey reckoning but instead can we affort to “stay the course”?
Posted by: gym-bob | March 12th, 2008 at 5:50 pm | Report this commentThis liquidity boost is the equivalent to giving an ebola patient a blood transfusion. Yes, it helps, but it does not stem the disease. The financial institutions will continue to play “beggar thy neighbor” hoping to survive the contagion of margin calls driven by the lack of transparency - who do you trust? Who really understands in detail what is going on in their own institution never mind the global market place? Some of those who may know are most likely not talking since, as good capitalists, they are looking for opportunities to capitalize on this fiasco. And even if they are, how does one recognize the right path?
It is suggested that the US Government, as a lender of last resort, giving the proper haircut on impaired financial assets that would be good in “normal times” is a good strategy. Just some thoughts. Whose models do we use for this haircut valuation, the rating agencies’ or the investment institutions’? And how do we value, for “normal times”, (whatever those are, as I think the real estate bubble that led to the pre-collapse values is hardly a measure of normal times)?
The mess can be cleaned up but the solution needs to be visionary beyond discussions of haircuts and normal times. Growth is capitalism mantra. The global economy needs a new source of real growth to push up consumer incomes and spending again and give consumers and industry a real and compelling focus while the financial industry is completely restructured so as to keep finance tied to the real economy and stop creating financially engineered derivative vaporware. I suggest wall street engineers and phd’s refocus on real socially beneficial products such as replacements for the US’s collapsing physical infrastructure or new carbon foot print reducing technologies. (I understand FEMA is looking for a few good men). Rather than continuing to stare at the on-coming headlights while giving more cash to the folks that have amply proven again that they are the least capable of handling it responsibly, maybe the US Government should provide some liquidity to real entrepreneurs who can create real products to generate revenue growth and jobs to generate income with which to buy those products. Wouldn’t that be novel as compared to constantly bailing out these myoptic overpriced and over-educated type A’s.
Posted by: andrey | March 12th, 2008 at 6:25 pm | Report this commentThe core problem is the continuing decline in U.S residential real estate prices. As long as this rot in housing continues, mortgage-backed securities and other similar instruments will continue to be under-pressure and any meaningful recovery of the financial markets and the wider US economy seems unlikely.
Posted by: Omar | March 13th, 2008 at 1:27 am | Report this commentGood luck, Mr. Bernanke.
Is the author trying to be funny?
“All that remains is for the private financial institutions, banks and shadow banks, to recognise the losses they have incurred and to scale back their operations or go out of business in a reasonably orderly fashion”
The banks will do everything to avoid loses and the loses are being pushed onto tax payers through FHLB’s purhases
Posted by: herb karajan | March 13th, 2008 at 6:50 am | Report this commentWillem,
Always love to read your blogs. On to the topic at hand - I have been saying the same thing since the beginning of this mess as well in heavy debates with my day trader friends (but then no one cares what I say - I am just an MBA student 2 years out of school & a keen monetary policy enthusiast). But yes, Fed was created as a Banker to the Banks and a lender of last resort, a role JP Morgan played very well in the last big crisis in early 1900’s.
The point I made throughout was
a)There was not a lot of need for rate cuts because for home owners struggling to pay reset rates at Prime + 5-7% wouldnt be able to make payments even when you drop Prime by 1-2% points by lowering the short end of the curve! and
b) Banks are hoarding cash because they are marking to model a lot of their assets with no clear understanding of their liquidity positions & capital base - hence Fed should get all the large Bank heads into a room and assure them that it is ready to do everything it takes to ensure liquidity is available (increasing confidence like in LTCM case). This would have helped stave of the crisis of credit & Interbank markets freeze.
Now call me crazy but this is what the Fed is ultimately doing albeit a little late and with disastrous consequences for the USD and Commodities sector. Some of the pain would have been caused anyways, but a lot of pain in these two markets could have been avoided.
Additionally till Q42007, other than Financial sector, most other parts of the economy were doing fine - until credit markets started to freeze and there were no $’s to invest in CapEx for companies looking to take advantage of the low USD and boost manufacturing & exports of this country.
Well as you said, better late than never.
Keep up the good articles Willem, its always a pleasure to read your writing.
Posted by: Piyush | March 13th, 2008 at 2:15 pm | Report this commentHi Willem,
Posted by: Miranda Xafa | March 13th, 2008 at 3:39 pm | Report this commentIf the Fed moves from (multi-stage) repos accepting MBSs as collateral to outright open market purchases of MBSs, this would be tantamount to monetizing the credit losses. In view of their size (in the hundreds of billions), monetizing the losses will almost certainly push the dollar further down from already depressed levels. The difference between the current multi-stage repos and the monetization scenario is that the Fed’s counterparties can now repo out the Treasury paper and thus tap EXISTING liquidity sources, whereas the monetization scenario entails NEW liquidity creation by the Fed - surely an important factor for the fate of the dollar!
Keep up the good work,
Miranda Xafa
Thanks, Miranda. You are right, the Fed is engaged in what in the forex market would be sterilised foreign exchange market intervention rather than the non-sterlised forex market intervention that I prefer.
I want additional liquidity creation. The Fed can always mop up any additional monetisation that occurs by open market sales of Treasury debt to those few private agents that are not liquidity constrained. For a central bank that sets interest rates rather than targeting the quantity of some monetary aggregate, the monetisation issue should not matter in any case.
Posted by: Willem Buiter | March 13th, 2008 at 3:51 pm | Report this comment