Wednesday, March 12, 2008

The Fed's Swap Meet

In an attempt to restore liquidity the Fed came up with a new facility called the Term Securities Lending Facility (TSLF). This program allows primary dealers to exchange a total of $200 billion mortgage backed securities (MBS) for treasuries. The period is 28 days instead of the traditional overnight lending. Why $200 billion? Because primary dealers hold $139.7 billion agency securities and $60.2 billion mortgage-backed securities. Minyanville cited Tony Crescenzi at Miller Tabak for those numbers early Tuesday.

Unlike the Term Auction Facility (TAF), which swaps cash for MBS and therefore requires sterilization so as not to affect the target funds rate, the TSLF is simply a swap of one instrument for another. It is not printing, and it injects no cash into the system even though there are misleading headlines such as this one bandied about by MarketWatch: Fed turns on the spigot of money again.

Lee Adler in Bandaid on a Ruptured Jugular explains what the Fed is up to with the TSLF.

The Primary Dealers are heavily short Treasuries at all times. They are heavily long all other debt securities simultaneously. The level of securities lending in recent months is unprecedented in all of human history, by an order of magnitude of 10.

Securities lent by Fed to Primary Dealers

The Fed is now responding to the pressure of the imminent collapse of the Primary Dealers and major banks worldwide, because not only are the PDs heavily short the stuff that is going up, Treasuries, they are heavily long the stuff that is going down, which is all other debt securities.

This is the worst of all possible worlds and the Fed’s action is like putting a bandaid on a ruptured jugular vein.
Lord only knows why primary dealers were short treasuries when interest rates were falling and the Fed was cutting rates, but that is what was happening.

What happens after 28 day is pretty clear. The swap will be rolled over and over and over until the mortgage backed security market stabilizes. This could be a year from now, or perhaps 10. That may sound ridiculous but it's essentially what happened in Japan. It's also part of the Zombification process I described in The Great Pretender.

This may temporarily stop a further squeeze against dealers who are short treasuries and long MBS, but it is will not do much of anything to restore a bid in the MBS market. Nor will it cure the massive leverage problems at many of the primary dealers and banks.

Here's an interesting paragraph from the MarketWatch article reference earlier: "Counting the currency swaps with the foreign central banks, the Fed has now committed more than half of its combined securities and loan portfolio of $832 billion, Lou Crandall, chief economist for Wrightson ICAP noted. 'The Fed won't have run completely out of ammunition after these operations, but it is reaching deeper into its balance sheet than before."

The Fed is simply too small an actor, relative to the global banking system, to have enough impact. Consider: one analyst observed that with its new programs (the new $100 billion repo facility and the $200 billion Treasuries-for-MBS facility), the Fed had just creates a $300 billion bank overnight. True enough, but consider: Citigroup's balance sheet has $2.2 trillion in assets. Steve Waldman estimates that the Fed can take deploy another $300 to $400 billion to similar operations. It can take one more big shot at this problem (ex monetary moves, which Hamilton deems ineffective) before it has used up all its powder. Source

Bernanke's intent is to buy the dealers time, but it really can't work. Those securities will not be worth more tomorrow than they are today. For now, a MBS fire sale was averted, but it can't be put off forever.

The ongoing tsunami of housing related bankruptcies and foreclosures will seal the fate. Meanwhile the zombification of banks continues.