Where will the market be eight days from now? Will it look back on Tuesday’s Fed action as the turning point in the great credit crisis of 2008? Or will yesterday’s action be just another failed attempt to halt the rampaging bear market in credit?
You have to give it to Ben Bernanke. For an academic, he sure has a great sense of theatre. It may not last long. But Tuesday’s 416 point rally on the Dow Jones was kind of refreshing, wasn’t it? It’s like coming up for air after you’ve been holding your breath under water… for two months.
Inhale. Did you know that by inhaling and exhaling three times-calmly and fully-you actually reduce the chance you will lose your temper? Fear and anger are physiological as well as psychological. Calm, deep breathing lowers your heart rate and prevents the chain reaction of neurochemical events in your brain that leads to bouts of anger and panic. Perhaps oxygen tanks should be made available in the trading pits.
Then again, traders were quite happy with their Fed-induced high on Tuesday. U.S. investors sent the indexes up by over three and half percent thanks to a new plan of attack by the supreme allied commander in the war against deflation, U.S. Fed governor Ben Bernanke.
General Bernanke-or perhaps we should call him Air Marshall, in honour of his arsenal of money-dropping helicopters-bombed the markets with an innovative new strategy. It’s called a Term Securities Lending Facility (TSFL).
Starting 27 March, the Fed will loan prime brokers (big banks) up to US$200 billion in U.S. Treasury bonds. In exchange for the Treasuries, the banks will deposit with the Fed collateral in the form of AAA rated residential mortgage backed securities (RMBs) and agency debt issued by Fannie Mae and Freddie Mac.
The prime brokers, you’ll recall from yesterday’s Markets and Money, are putting the screws to hedge funds. After years of virtually no-questions-asked lending, the prime brokers are now engaged in no-answers-accepted margin calls.
For example, the hedge fund run by Carlyle Capital is trying to prevent its creditors from selling US$16 billion in collateral. The fund pledged the assets as collateral for loans last year. The banks (prime brokers) want their money back, and are antsy to get it. The trouble is, in their rush to sell the collateral, the banks risk collapsing prices for all sorts of other assets that have been pledged as collateral. More selling leads to falling prices leads to more selling. You can see where all that goes. Down.
Into this no-trust zone between borrowers and lenders steps the Fed. The Fed hopes that by taking the illiquid collateral off the prime broker’s hands, it can prevent cascading asset sales. But will the prime brokers begin lending again? Hmmn.
The prime brokers could simply keep the Treasuries on the balance sheet for a month and boost their own capital. This would prevent them from having to borrow more capital from the Gulf States. Or they could lend against the Treasuries. In a fractional reserve banking system, $200 billion worth of new assets can quickly become $2 trillion worth of new lending (lending at 10x reserves).
If the banks expand lending on their comfy new Treasury capital base, well then the Fed will have achieved its goal of loosening up the credit markets. But here’s a question for you… if the new term securities lending facility leads to an expansion in bank lending, why hasn’t the gold price reacted? Hasn’t the Fed indirectly increased the money supply?
For starters, the Fed’s action today makes it less likely to cut rates by 50 or 75 basis points next week. That’s one reason gold didn’t move more today. But the bigger reason is that we have to wait and see if the Fed’s action has the intended reaction, namely restoring liquidity to the financial system.
Stocks sure liked what they saw. But stocks always behave impetuously. The stock market and the credit market are two different animals. It’s too early to tell if banks will actually change their lending behavior because of the new lending program. We walk past a magic shop on St. Kilda Road every day. But that doesn’t mean we have a closet full of wands and white rabbits.
Maybe banks will use the Term Securities Lending Facility. Maybe they won’t. The banks know a third new wave of mortgage debt is already facing higher delinquency rates. They may not be in any hurry to loan more money at all, knowing that a lot more collateral is about to go bad.
What do we know? Not much. But it does seem safe to say the Fed has solvency in mind as much as liquidity.
The Term Securities Lending Facility is supposed to allow prime brokers to exchange illiquid assets for liquid ones for 28 days. But that 28 days… could just as well be 56… or 84… or three years. That is, the Fed has shown us it’s willing to take de facto ownership of bad mortgage debt in order to restore order to the system and guarantee that banks don’t become insolvent due to inadequate capital.
Of course the Fed can’t come right out and say its willing to own bad debt. If it did, the U.S. dollar would tank even more. But the bond market isn’t stupid. “The risk of losses on U.S. Treasury notes exceeded German bunds for the first time ever amid investor concern the subprime mortgage crisis is sapping government reserves, credit-default swaps prices show,” reports Abigail Moss at Bloomberg.
The bond market realises that via the Term Securities Lending Facility the Fed has wandered down a path that may lead to the natonialsation of a huge amount of bad American mortgage debt. At the very least, this means inflation. And there may be bigger plans in the offing.
Here’s a thought: what does a thirty year U.S. Treasury bond have in common with a thirty year, fixed-interest rate mortgage?
They both, quite obviously, have the same duration (30 years). Is it inconceivable that the Fed would buy up (at some discount) a large portion of Fannie and Freddie’s mortgage portfolios, and then, as the new lender, allow Americans to refinance into 30-year fixed mortgages? The Fed could then either hold onto the new mortgage portfolio, or foist it off on some new government agency.
It’s not inconceivable, because we just conceived it. In any event, this drama isn’t over yet. Monetary intrigue aside, the world’s central banks are fighting debt deflation with all the tools of inflation. As a result, you’re getting inflation.
In China, inflation is growing at its fastest pace in 11 years. Chinese consumer prices were up 8.7% in February. Food costs were up a staggering twenty three per cent.
U.S Vice President Dick Cheney has been dispatched to the Middle East to try and talk down oil prices from $108. Good luck with that Mr. Cheney. Gulf States are importing inflation through their dollar pegs. Keeping oil prices high by refusing to increase supply may be the Saudi’s way of getting back at Bernanke for gutting the dollar.
An eventful day, all in all. The local market will probably follow New York’s lead. For the day, that means up. For the year? We reckon stocks better enjoy the fresh air while they can. Inflation sucks out all the oxygen in a room like a greedy fire.
Markets and Money