Remarkably, this very timely essay is an example of “document reuse” . A June, 2001 version of this, apparently posted by Henry C. K. Liu himself, is still available in Sept 2007 within the Post Keynesian Thought 1993-2004 mailing list, here. This list apparently used to be at the University of Colorado.
Central Bank Impotence and Market Liquidity
By
Henry C.K. Liu
http://henryckliu.com/page137.html
This article appeared in AToL on August 24, 2007
[ Bear Stearns says its own two troubled funds have "very little value" Tue Jul 17, 2007 7:15PM EDT http://www.reuters.com/article/ousiv/idUSN1726029320070718 ]
After months of adamant official denial of any potential threat of the subprime mortgage meltdown spreading to the global financial system, the US Federal Reserve (Fed) on Friday, August 17, a mere 10 days after declaring market fundamentals as strong and inflation as its main concern, took radical steps to try to halt financial market contagion worldwide that had become undeniable. The Wall Street Journal reports that the emergency measures were hastily taken to promote what the Fed publicly referred to as “the restoration of orderly conditions in financial markets.” The telling words were “restoration of orderly conditions” in a market that had failed to function orderly. The Fed let the market know that it has shifted to panic mode.
Restoring Disorderly Market Conditions
The WSJ reports that the crisis of disorderly conditions began two days earlier on August 16 in London where $45.5 billion of short-term commercial paper issued by US corporations overseas was maturing but traders had difficulty selling new paper to roll them over as they normally would have by noon time in London, or 7 a.m. in New York. Demand for commercial paper had dried up suddenly in a tsunami of risk aversion. Less than half of the paper was eventually sold at distressingly high interest rates by the end of the trading day. At 7:30 a.m. in New York, Countrywide Financial Corp., the largest home mortgage lender, announced that it was drawing all of its $11.5 billion of bank credit lines because it had difficulty rolling over its commercial paper IOU.
By noontime in New York, near the end of the trading day in London, the dollar fell against the yen by 2% within minutes to cause [causing] traders to rush to unwind their yen carry trade positions. Money rushed into 3-month US Treasury bills, pushing the yield down from 4% to 3.4%, sharply widening the spread with corporate commercial paper, with some GE paper moving as high as 9.5%, which in normal times would be close to the Fed Funds rate which now stands at 5.25%. By evening, Chairman Bernanke of the Fed convened a conference call of board members. The next morning, Friday, August 17, the Fed capitulated.
To
ward off a market seizure, the Fed cut the discount rate at which
cash-short US banks and thrift institutions can borrow directly from
the central bank as a lender of last resort. The Fed announced that
it would grant banks and thrifts such loans from its discount window
against a liberal range of collateral, including technically
unimpaired triple-A rated subprime mortgage securities of uncertain
market value and liquidity. The discount rate was cut from 6.25% to
5.75%, making it merely 50 basis points above the Fed Funds rate
target, half of the normal spread for a neutral monetary policy. The
Fed also extended the period for loans at the discount window from
one day to up to 30 days, renewable by the borrower. These changes
“will remain in place until the Federal Reserve determines that
market liquidity has improved materially” and “are
designed to provide depositories with greater assurance about the
cost and availability of funding.”
The New York Fed,
which has the responsibility of operating the
Open Market Committee to keep inter-bank rates close to the Fed Funds
rate target by buying or selling securities and by making
overnight loans in the repo market (see: The Repo Time Bomb -
http://www.atimes.com/atimes/Global_Economy/GI29Dj01.html), had
injected substantial amounts of liquidity, $62 billion up to the time
of the discount rate cut, by such means into the banking system in
previous days. Earlier, the effective Fed Funds rate had traded
at 6%, 75 basis points above Fed target, as banks demanded higher
rates to lend to each other.
The Fed then convened an
extraordinary conference call for major money center banks to explain
its latest moves. It tried to encourage banks to use the discount
window, saying to do so would be a “sign of strength”
under current circumstances, not a sign of distress as in normal
times where banks are conventionally reluctant to use the discount
window, fearing that going to the Fed for cash might be interpreted
by the market as a sign a distress.
The Fed said in a policy
statement on the same day of the unusual discount window moves that
financial market conditions had deteriorated to the point where “the
downside risks to growth have increased appreciably”. The Fed
said it is monitoring closely market situations and is “prepared
to act as needed to mitigate the adverse effects on the economy
arising from the disruptions in financial markets”.
The
language of the 2007 Fed statement is an echo of Greenspan-speak.
Notwithstanding his denial of responsibility in helping through the
1990s to unleash the equity bubble, Alan Greenspan, the then Chairman
of the Fed, had this to say in 2004 in hindsight after the bubble
burst in 2000: “Instead of trying to
contain a putative bubble by
drastic actions with largely unpredictable consequences, we
chose, as we noted in our mid-1999 congressional testimony, to
focus on policies to mitigate the fallout when it occurs and,
hopefully, ease the transition to the next expansion.”
I
wrote in AToL on September 14, 2005: “Greenspan's formula of
reducing market regulation by substituting it with post-crisis
intervention is merely buying borrowed
extensions of the boom with amplified severity of the inevitable bust
down the road. The Fed is increasingly reduced by this formula to an
irrelevant role of explaining an anarchic economy rather than
directing it towards a rational paradigm. It has adopted the
role of a cleanup crew of otherwise avoidable financial debris rather
than that of a preventive guardian of public financial health.
Greenspan's monetary approach has been "when in doubt, ease".
This means injecting more money into the banking system whenever the
US economy shows signs of faltering, even if caused by structural
imbalances rather than monetary tightness. For almost two decades,
Greenspan has justifiably been in near-constant doubt about
structural balances in the economy, yet his response to mounting
imbalances has invariably been the administration of off-the-shelf
monetary laxative, leading to a serious case of lingering monetary
diarrhea that manifests itself in runaway asset price inflation
mistaken for
growth.”
(http://atimes01.atimes.com/atimes/Global_Economy/GI14Dj01.html)
Chairman Bernanke has now summoned his own clean-up team into
action. The Fed hopes that by assuring banks that they can now access
cash on less punitive terms from the Fed discount window,
collateralized by the full “marked to
model” face value of mortgage-backed securities, rather
than the true distressed value as “marked to market”,
for which they could find no buyers at any price in recent weeks as
the market for such securities has seized up, it can jumpstart market
seizure for mortgage-backed commercial paper and securities.
The
Fed announced the discount rate and maturity changes a day after a
video conference of its Open Market Committee in which the emergency
action was “unanimously” endorsed by all voting committee
members, except William Poole, president of the St Louis Fed, who had
argued publicly a few days earlier against an emergency rate cut
short of a “calamity” and who did not take part in the
vote.
By its emergency actions, the Fed conceded the existence
of a market “calamity”. Equity markets around the world
interrupted their week-long losing streak and rose reflexively on the
news on the last trading day of the week, albeit doubt remains on the
prospect that such market adrenaline is sustainable. The Dow Jones
Industrial Average (DJIA) gained 233.30 points, or 1.8%, edging back
to 13,079 on hope that the Fed has now finally come to the rescue of
a collapsing market.
Still, the yield on the two-year US
Treasury note fell 4 basis points to 4.18%, signaling continuing risk
aversion in the credit markets and investor flight to safety, not
even just to quality. Fed Funds futures indicate that the market
expects several quarter-point cuts from the current 5.25 per cent by
the end of the year to keep the troubled economy
afloat.
Unsustainable Adrenaline
By Monday,
August 20, the adrenaline already wore off and the DJIA turned
negative by noon on the first trading day after the Fed emergency
actions. The flight to safety pushed the 3-month treasury yield to
2.5% at one point. It can be expected that sharp volatility in the
equity markets will continue as announcements of assurance are issued
by the Fed, the Treasury and key Congressional Committee chairmen to
temporarily boost the market on false hopes only to be brought back
down later to reality. The market is casting a vote of no confidence
in the Fed’s ability to save the market. At best, the Fed can
slow down the credit meltdown by extending it out into years rather
letting the market execute a needed catharsis. It is not a scenario
preferred by true free marketers.
No doubt the Fed has an
arsenal of offensive monetary tools at its disposal. But just like
the war on terrorism in which all the guns of the Pentagon can have
no effect unless the military can find real terrorist targets, the
Fed’s monetary tools remain useless unless the Fed knows where
to intervene effectively. Just as terrorists morph into the general
population to make themselves difficult to identify, the problem with
structured finance is that by transferring unit
risk to systemic risk, it deprives the Fed of effective targets to
intervene on a systemic re-pricing of risk. When contagion has
already spread risk aversion to all vital components of the credit
market, containment is no longer an effective cure. Financial health
will continue to decline in the entire system until the risk appetite
virus works its natural cycle. Excess liquidity
is like a drug addiction. It cannot be cured
with another stronger addictive drug by adding
more liquidity. What the Fed is trying to do is not merely to
restore market liquidity, but to preserve excess liquidity in the
market. It is trying to avoid a crisis by setting the stage for a
bigger future crisis.
Low Interest Rates Hurts the Dollar
The problem with the single-dimensional prognosis on the
curative power of policy-induced falling interest rates on the ailing
economy is that it ignores the adverse impact such interest rate cuts
will have on the exchange value of the dollar which has already been
falling in recent years beyond levels that are good for the economy.
How the Discount Window Works
Eligible
depository institutions are allowed to borrow against high-grade
collaterals directly from the Fed’s discount window to meet
short-term unanticipated liquidity needs. One category of these
collateralized loans, termed “adjustment credit,”
comprises loans that are usually overnight in maturity and are made
at an administered discount rate. However, banks traditionally only
make sparing use of the discount window for adjustment credit
borrowing. The discount window is also used for seasonal borrowings,
mostly associated with agricultural production loans, and for
“extended credit” for banks with longer-maturity
liquidity needs resulting from exceptional circumstances.
The
most potent power bestowed by Congress on the Federal Reserve System
is the setting of the discount rate. Raising the discount rate
generally increases the cost of bank borrowing and slows the economy,
while lowering it stimulates economic activity, since banks set their
loan rates above the discount rate, and not by market forces. In
contrast, while the Fed Funds rate is also set by the Fed, it is
implemented by the Fed Open Market Committee participating in the
repo market to keep the short-term rate close to the Fed’s
target. The discount rate affects cost of funds without affecting
money supply while the Fed Funds rate changes the level of the money
supply. Both rates are set by fiat by the Fed based on the Fed’s
best judgment within its theoretical preference. The difference
between the two rates is that the discount rate is set independently
of market forces while the Fed Funds rate acts through market forces.
With the discount rate, the Fed sets the rules of the money market
game while with the Fed Funds rate, the Fed acts as a key money
market participant.
In response to the October 19, 1987 crash,
Alan Greenspan, as the newly appointed Fed chairman, lowered the Fed
Funds rate from 7.25% set on September 4, 1987, 45 days before the
crash, to 6.5% by early February, 1988, while keeping the discount
rate at 6%. On February 23, the Fed increased the spread to 3-1/8
percentage points with the Fed Fund rate at 9-5/8% and the discount
rate at 6-1/2%. The Fed then lowered both rates gradually to 3%
with zero spread by September 4, 1992 below the inflation rate for
August which was 3.15%. The negative interest rate launched the debt
bubble that first fueled the tech bubble which peaked on March 10,
2000 and burst in subsequent months when Greenspan raised the Fed
Funds rate to 6.5% on May 16 and the discount rate to 6% before
lowering rates starting January 3, 2001 to save the market. By
November 6, 2002, the Fed Funds rate was 1.25% and the discount rate
was 0.75% to fuel the housing bubble which was also turbocharged by
subprime mortgage securitization. That housing bubble is now
bursting.
Until January 3, 2003, the discount rate normally
was set at 25 to 50 basis points below the Fed Funds rate. On
that historic day, the discount rate was reset by policy to be 100
basis points above the Fed funds rate. On June 25, 2003, when the Fed
Funds rate was at a historical low of 1%, the discount rate was set
at 2% when the inflation rate was 2.11%. Negative interest rate
expanded the housing bubble in a frenzy rate.
Before 2003, to
prevent banks from exploiting the spread between the Fed Funds rate
and the then lower discount rate, the Fed required banks to document
any need for funds as appropriate to the discount facilities’
policy intent. Discount window loans would not be granted as bridge
loans to enable banks to wrap up planned investment or to exploit
loan opportunities beyond the bank’s normal liquidity range. In
addition, banks were expected to have first exhausted all other
reasonable sources of credit before borrowing from the discount
window and should expect to face greater regulatory scrutiny if they
borrow at the window too frequently. These non-pecuniary penalties
made many banks reluctant to borrow at the discount window for
adjustment credit, concerned over a perceived “negative signal”
that such action would send. The volume of borrowed reserves was
generally less than 1% of total reserves.
Setting the discount
rate above the federal funds rate target was an important change in
the administration of the discount window to allow for more reliance
on explicit market pricing to determine the volume of discount window
borrowing and to remove the perceived stigma to discount borrowing.
Eligibility requirements would be streamlined and rendered consistent
with reliance on the discount window as a relatively unfettered
source of liquidity for financially sound banks during tight money
market conditions that would otherwise result in a spike in the Fed
Funds rate.
The initial proposal set a cap for the discount
rate at 100 basis points above the federal funds rate target.
Historically, this cap would have been breached by the average daily
federal funds rate only about 1% of the time, with roughly half of
those days coming on bank settlement days. However, the frequency
with which individual trades throughout the day would have exceeded
the cap was significantly higher. The closing Fed Funds rate would
have exceeded this cap approximately 4% of the time. As banks
adjusted their reserve management practices under the new operating
procedures, this cap became binding more frequently than history
would suggest. In any case, the average daily cost of federal funds
to banks should be reduced and the Federal Funds rate should remain
closer to the Fed’s target.
This rule change on the
discount rate was expected to have several benefits. First, providing
a cap on the federal funds rate by endogenously supplying reserves to
meet high periods of demand should reduce interest rate volatility.
This might become more significant as continual financial innovation
would otherwise further reduce banks’ required reserves and
render the demand for reserves more interest inelastic, as required
clearing balances assume a larger share of the total demand for
reserves. Second, the simplification of discount window borrowing
procedures should lead to reduced administrative costs and streamline
operations. Third, these simplifications also will help clarify the
intent of individual discount window regulatory decisions, since less
subjective assessment is required. Finally, monetary policy could be
rendered more effective, to the extent that the discount rate could
become a tool for capping the federal funds rate. This cap could be
adjusted to keep the Fed Funds rate close to the target value, where
“close” is determined as a matter of monetary policy
decisions that reflect current market conditions. In Fed newspeak,
the “discount” rate then becomes more expensive than full
price inter-bank borrowing.
Primary and Secondary
Credit
On January 9, 2003, the Fed adopted this procedure
and introduced two levels of discount rate: primary and secondary.
Primary credit is available to generally sound depository
institutions on a very short-term basis, typically overnight, at a
rate above the Federal Open Market Committee’s target rate for
federal funds. Depository institutions are not required to seek
alternative sources of funds before requesting occasional short-term
advances of primary credit. The Fed expects that, given the
above-market pricing of primary credit, institutions will use the
discount window as a backup rather than a regular source of funding.
In reality, as the debt economy developed, banks were able to use the
discount widow without regulatory scrutiny to fund planned investment
or loan opportunities that yielded returns higher than the punitive
discount rate. The Fed in effect became a funding agency of last
resort for the debt bubble.
Primary credit may be used by
banks for any purpose, including financing the sale of federal funds.
By making funds readily available at the primary credit rate when
there is a temporary shortage of liquidity in the banking system,
thus capping the actual federal funds rate at or close to the primary
credit rate, the primary credit program complements open market
operations in the implementation of monetary policy.
Primary
credit may be extended for up to a few weeks to depository
institutions in sound financial condition that cannot obtain
temporary funds in the market at reasonable terms; normally, these
are small institutions. Longer-term extensions are supposedly subject
to increased administration. It is not clear if the Fed’s new
term of up to 30 days involves increase administration to subject
borrowing banks to face greater regulatory scrutiny.
Secondary
credit is available to depository institutions not eligible for
primary credit. It is extended on a very short-term basis, typically
overnight, at a rate that is above the primary credit rate. Secondary
credit is available to meet backup liquidity needs when its use is
consistent with a timely return to a reliance on market sources of
funding or the orderly resolution of a troubled institution.
Secondary credit may not be used to fund an expansion of the
borrower’s assets. The secondary credit program entails a
higher level of Reserve Bank administration and oversight than the
primary credit program. The Fed will require sufficient information
about a borrower’s financial condition and reasons for
borrowing to ensure that an extension of secondary credit is
consistent with the purpose of the facility.
Effect of
Discount Borrowing Controversial
Discount window borrowing
is sensitive to the spread between the Fed Funds rate and the
discount rate. As the spread narrows, discount window borrowing can
be expected to increase. Hence, discount window borrowing would
offset, at least in part, the effect of open market operations on
reserve supply. The effect of this feature of discount window
borrowing remains controversial even after an indeterminate debate in
1960 among economists on whether the discount mechanism offsets, as
argued by Milton Friedman, or reinforces, as counter-argued by Paul
Samuelson, the monetary policy objectives of the Fed.
Discount
Borrowing Stigma
During the early 1990s, borrowing from
the discount window fell significantly, averaging only $233 million,
even though this was a period of banking system stress. Stavros
Peristiani, Assistant Vice President in the Banking Studies Function
at the Federal Reserve Bank of New York, whose primary areas of
research include housing finance, mortgage-backed securities, bank
mergers and acquisitions, discount window borrowing, and initial
public offerings, argues that this decline may have been due to banks
refraining from requesting discount loans because of the perception
that it would send a negative signal to the Federal Reserve, bank
supervisors, and eventually the market at large. Even when banks’
financial conditions improved in the mid-1990s, banks remained
reluctant to borrow from the Fed.
Partly to address this
reluctance, the Fed replaced its adjustment and extended credit
programs with the new primary and secondary credit facilities. Now,
banks in good financial condition could borrow from the Federal
Reserve capped at 100 basis points above the Fed Funds rate target.
The above-market price of funds serves as a rationing mechanism that
dramatically reduces the need for supervisory review of the potential
borrower. Because use of the new primary credit facility would not
necessarily imply anything negative about a borrower, banks should be
more willing to use the facility if market or bank-specific
conditions warrant. In fact, since the implementation of this new
facility, banking supervisors have specifically announced that
“occasional use of primary credit for short-term contingency
funding should be viewed as appropriate and unexceptional by both
[bank] management and supervisors.” Still, banking being
a traditionally conservative industry, such stigma persists about
discount window borrowing. The above-market price of the discount
rate has been cut on August 17, 2007 by the Fed by half from its100
basis points cap to 50 basis points over the Fed Funds rate target to
facilitate discount borrowing had to be qualified with a public
repeat of Fed policy that such borrowing does not reflect weakness in
the borrowing banks. Yet the cut in the discount rate reflect
weakness in the entire banking system, a message not missed by astute
market participants.
When a bank borrows from the Fed’s
discount window, it increases the funds it has in its reserve account
held at the Fed, which the bank can apply towards meeting its reserve
requirement. Thus, ceteris paribus, one would expect that when
required reserves are higher, discount window borrowing would be
higher.
Reserve requirements are the amount of funds that a
depository institution must hold in reserve against specified deposit
liabilities. Within limits specified by law, the Federal Reserve
Board of Governors has sole authority over changes in reserve
requirements. Depository institutions must hold reserves in the form
of vault cash or deposits with Federal Reserve Banks. The dollar
amount of a depository institution’s reserve requirement is
determined by applying the reserve ratios specified in the Federal
Reserve Board’s Regulation D to an institution’s
reservable liabilities which consist of net transaction accounts,
non-personal time
deposits, and euro-currency liabilities.
Since December
27, 1990, non-personal time deposits and euro-currency liabilities
have had a reserve ratio of zero. The reserve ratio on net
transactions accounts depends on the amount of net transactions
accounts at the depository institution. The Garn-St Germain Act of
1982 exempted the first $2 million of reservable liabilities from
reserve requirements. This “exemption amount” is adjusted
each year according to a formula specified by the act. The amount of
net transaction accounts subject to a reserve requirement ratio of 3%
was set under the Monetary Control Act of 1980 at $25 million. This
“low-reserve tranche” is also adjusted each year. Net
transaction accounts in excess of the low-reserve tranche are
currently reservable at 10%.
Reserve
Balance Driven by Interbank Payments
The demand for
reserve balances is increasingly being driven by growth in interbank
payment activity rather than by minimum reserve requirements.
Interbank payments are processed over Fedwire,
the large-value payment system owned and operated by the Fed. The
value of aggregate Fedwire payments increased from roughly $1.3
trillion a day in 1992 to roughly $3 trillion a day in early 2004.
These payments are funded from an aggregate reserve balance that, as
of the first quarter of 2004, averaged only $11.5 billion.
To
facilitate an efficient payment system, the Fed allows banks to
maintain limited negative reserve balances during the business day at
a low cost, currently 27 basis points at an annual rate, but imposes
a stiff 400-basis-point penalty on negative balances held overnight.
Before 2003, hanks [banks] faced with an
unexpected negative balance late in the day might have gone to the
discount window, but they might have remained reluctant. The new
primary credit facility reduces the perceived stigma of borrowing
from the Fed, and banks in this situation would borrow from the
central bank and pay a penalty capped at 100 basis points over Fed
Funds rate.
The Clearing House Interbank
Payments System (CHIPS) is a privately operated,
real-time, multilateral, payments system typically used for large
dollar payments, owned by financial institutions, and any banking
organization with a regulated US presence may become an owner and
participate in the network. The payments transferred over CHIPS are
often related to international interbank transactions, including the
dollar payments resulting from foreign currency transactions, such as
spot and currency swap contracts, and Euro placements and returns.
Payment orders are also sent over CHIPS for the purpose of adjusting
correspondent balances and making payments associated with commercial
transactions, bank loans, and securities transactions.
Since January 2001, CHIPS has been a real-time final
settlement system that continuously matches, nets and settles payment
orders. In June 2007, CHIPS processed $2.645 trillion of payments.
CHIPS typically handles about 300 payments ($90 billion in gross, $36
billion net) in its queue at the end of the day.
Liquidity
Risk in the Interbank Payment System
Liquidity
risk is the risk that the financial institution
cannot settle an obligation for full value when
it is due even if it may be able to settle at some unspecified
time in the future. Liquidity problems can result in opportunity
costs, defaults in other obligations, or costs associated with
obtaining the funds from some other source for some period of time.
In addition, operational failures may also negatively affect
liquidity if payments do not settle within an expected time period.
Until settlement is completed for the day, a financial institution
may not be certain what funds it will receive and thus it may not
know if its liquidity position is adequate. If an institution
overestimates the funds it will receive, even in a system with
real-time finality, then it may face a liquidity shortfall. If a
shortfall occurs close to the end of the day, an institution could
have significant difficulty in raising the liquidity it needs from an
alternative source.
Systems that postpone a significant
portion of their settlement activity in dollars toward the end of the
day, such as CHIPS, may be particularly exposed to liquidity risk.
These risks can also exist in Real Time Gross Settlement (RTGS)
systems such as Fedwire. Systems or markets that pose various forms
of settlement risk also pose forms of liquidity risk.
With the
average daily turnover in global FX transactions at over US$2
trillion, the FX market needs an effective cross-currency settlement
process. Continuous Linked Settlement (CLS) is a means of
settling foreign exchange transactions finally and irrevocably. CLS
eliminates settlement risk, improves liquidity management, reduces
operational banking costs and improves operational efficiency and
effectiveness.
CLS Bank based in New York is an Edge
Corporation bank supervised by the Federal Reserve. CLS Bank is a
multi-currency bank, holding an account for each Settlement Member
and an account at each eligible currency’s Central Bank,
through which funds are received and paid. Technical and operational
support is provided by CLS Services, an affiliate of CLS Bank.
CLS
Bank, while eliminating the bulk of principle risk through its
payment-versus-payment design, retains significant liquidity risk, as
funding is made on a net basis, and pay-in obligations may need to be
adjusted in the event that a counterparty is unable to fund its
obligations. Other systems, including securities settlement systems,
may also be subject to liquidity risks.
To manage and control
liquidity risk, it is important for financial institutions to
understand the intraday flows associated with their customers’
activity to gain an understanding of peak funding needs and typical
variations. To smooth a customer’s peak credit demands, a
depository institution might consider imposing overdraft limits on
all or some of its customers. Moreover, institutions must have a
clear understanding of all of their proprietary payment and
settlement activity in each of the payment and securities settlement
systems in which they participate.
Clearing balance
requirements represent obligations to hold reserves that are set at
the discretion of a bank before each reserve maintenance period. Only
balances held at the Federal Reserve during the two-week reserve
maintenance period are eligible to satisfy clearing balance
requirements. A bank is penalized for ending any day overdrawn on its
account at the Fed, as well as for failing to meet its requirements
by the end of the maintenance period. To obtain the necessary
reserves to avoid these fees if unable to borrow the necessary amount
of reserves from another bank, a qualifying bank may borrow reserves
directly from the Federal Reserve at its discount window facility
under the primary credit program, at a rate typically set not more
than 100 basis points above the target Fed Funds rate. This spread
between the primary credit rate and the Fed Funds rate target is
generally viewed as representing a de facto penalty associated with
being deficient. This penalty has been cut in half on August 18.
[6.25 -> 5.75 / 5.25] The Federal Reserve does not pay
interest on reserves held in excess of requirements. Thus, the
opportunity cost of holding excess reserves is a bank’s
marginal funding cost, which is represented by the Fed Funds
rate.
To provide banks with some flexibility in meeting their
requirements for avoiding these penalties and costs, the Fed allows
banks to apply excess reserve balances held in one maintenance period
to meet reserve requirements in the following period, in an amount up
to 4% of reserve requirements in the second period. Similarly, a bank
may end a period up to 4% short of its reserve requirements and pay
no penalty, so long as it holds sufficient excess reserves in the
following period to offset this deficiency.
Fed Actions aim
at Mutually Contradicting Objectives
The Federal Reserve
action on the discount rate tries to meet its short-term
responsibility to keep financial markets functioning by injecting
funds into the banking system. At the same time, the Fed tries also
to macro manage the economy in containing inflation by tightening the
money supply through interest rates increases. For almost a century
since its establishment in 1913, the Fed has been engaged in a
continuous battle between inflation and economic growth by standing
on both sides of the conflict to keep a balance. This conflict is a
structural malady of market capitalism. Recurring economic recessions
or depressions lead to asset depreciation or disinflation or
deflation which can only be cured by currency devaluation which
translates into inflation. Some economists, including Ben Bernanke,
the new Fed Chairman, support inflation targeting as a viable
monetary policy option.
Fixing the Market Liquidity
Drought
The cut of the discount rate is designed to tackle
the liquidity drought in the banking system and to keep banks liquid
to prevent financial markets from seizure. The new policy
statement signals that the Fed stands ready to cut interest rates if
necessary to deal with the contagion effects of the subprime mortgage
generated liquidity crisis on the real economy. The objective is to
restore the flow of funds through the banks into the financial system
to limit the damage to the real economy. Whether intended or not, the
Fed’s new policy stance sparked speculation that the European
Central Bank, which injected over 150 million euros into its banking
system in previous days, might be forced to back off raising euro
interest rates in September to prevent the euro from rising
further.
Up to the time of the discount rate cut on August 18,
the Fed had to repeatedly pumped liquidity ($52 billion) into the
financial system through the repo market to keep the overnight Fed
Funds rate from rising above its target of 5.25%. This Fed monetary
market tactic has been described by market participants as the Fed
practicing “stealth easing” or “synthetic easing”;
that is, to inject funds without lowering the Fed Funds rate. But
while the Fed hoped to restore liquidity to financial system with an
injection of some $52 billion to the overnight money market, this
injection failed to impress the market. Three-month lending rates
remained high and the asset-backed commercial paper and jumbo
mortgage market remained dysfunctional. The stock market continues to
fall after a brief reprieve.
Ready investors for debt
instruments of all sorts have become endangered species in this
market seizure. The Fed is determined to restore liquidity in these
seized markets to fulfill its mission of keeping markets
functioning. It also believes that the longer credit markets
stay seized, the bigger the risk of disrupting the flow of credit to
households and businesses in the economy to induce a recession or
worse. Yet moving aggressively on the discount window front will
ensure availability of funds to the banking system to keep banks
solvent but it may not help to get markets working unless the Fed is
prepared to drop massive amounts of dollars from helicopters on main
street as Fed Chairman Bernanke once quipped before becoming
chairman.
The Fed has not changed the nominal rating level of
securities eligible for these operations even though the ratings have
been decoupled from real market price of the securities. By reducing
the penalty rate on discount window lending from 100 basis points
over the federal funds rate to 50 basis points, and allowing
banks to obtain 30-day loans rather than overnight money, the
Fed ensures that banks encountering difficulties securing finance
against mortgage-backed and other collateral have assured access to
liquidity at reasonable rates. And many banks are encountering such
difficulties as they fail to find buyers in the debt market for the
asset-back securities they hold as collateral for bank loans made to
hedge funds and private equity groups.
Central Bank
Impotence
But the time has long
passed when central banks adding liquidity to the financial system
can help a liquidity crisis in the market. When the Fed
injects funds directly into the money market through the repo window,
banks and thrifts and other non-bank financial institutions that need
funds can participate. With the daily volume of transaction in the
hundreds of trillions of dollar in notional value of over-the-counter
derivatives, the Fed would have to inject fund
at a much more massive scale to affect the market. Such massive
injection will mean immediate and sharp inflation.
Worse yet, it will cause a collapse of the
dollar.
When the Fed adds liquidity directly into
the banking system through the discount window, it injects high-power
money into banks by making interest rate for overnight interbank
banks loans within its set target. The theory is that banks will in
turn be able to make loans at interest rates deemed appropriate by
the Fed, thus relaying the added liquidity to the market in
multiple amounts because of the mathematics of partial reserve.
But
just because banks are able to make loans at low interest rate does
not mean banks can find borrowers with
credit ratings to justify the low rates. John Maynard
Keynes' concept of a liquidity
trap is that market preference for cash positions
can outweigh interest rate considerations. In a financial crisis,
there may simple [simply] not be enough
credit-worthy borrowers at any interest rate level and the
[resulting] number of sellers
[(would-be borrowers) may] stay stubbornly larger than the
number of buyers [(erstwhile lenders)] because
sellers need to sell precisely because they do
not have credit worthiness to borrow even at low
interest rates and buyers stay on the sideline waiting for even lower
prices.
Even when the Fed lowers the discount rate, banks will
only see their threat of insolvency reduced. Banks will still be
sitting on piles of idle cash that they cannot
lend. This is known as banks pushing on
a credit string. Keynes
insightfully observed that the market can stay irrational longer than
most participants can stay liquid. Since central
banks are now mere market participants because of the
enormous size of the debt market due to the wide-spread use of
structured finance with derivatives whose notional value adds up to
hundreds of trillion of dollars,
the market can stay irrational longer than even central banks can
stay liquid, if central banks do not want to drive their currencies
to the ground. With deregulated global financial markets, central
bank capacity for adding liquidity to the banking system is
constrained by its need to protect the exchange value of its
currency. For the US, which depends on foreign central banks to fund
its twin deficits, any drastic fall of the dollar will itself
create a liquidity crisis from foreign central banks shifting out of
dollar in their foreign exchange reserves.
Federal Reserve
flow of funds data shows outstanding home mortgages in Q1 2007 to be
at $10.4 trillion. About $1 trillion in mortgages are due for a reset
by the end of 2007 alone. A 4% reset of interest rates on $1 trillion
of mortgages would require addition payments of $40 billion.
Agency-and GSE-backed mortgage asset amounts to $3.9 trillion.
Issuers of asset-backed securities home mortgages asset amounts to
$1.9 trillion. The numbers are further magnified hundred of folds by
structured finance with high leverage which magnifies the cash flow
caused by even the slightest interest rate volatility. Liquidity
problem associated with counterparty default could quickly run up to
trillions of dollars. What does
the Fed hope to accomplish with injecting a mere $50 or 100 billion
in the banking system, except to show its impotence?
The Fed can keep the banks from failing, but it cannot prevent the
harsh reckoning of the debt bubble economy.
What is Market
Liquidity?
After all, what is market liquidity? Economists
refer frequently to liquidity in the abstract, yet in reality,
liquidity is difficult to define and even more difficult to measure
and almost impossible to restore because it is hard to know where the
weak links are. On Wall Street, liquidity
refers to the ability to buy or sell an asset quickly and in large
volume without substantially affecting the asset’s price.
Shares in large blue-chip stocks like General Electric used to be
considered liquid, a description long since rendered invalid because
of market volatility.
Of the several
dimensions of market liquidity, two of the most important are
tightness and depth. Tightness is
a market’s ability to match supply and demand at low cost
(measured by bid-ask spreads) quickly, while market depth
relates to the ability of a market to absorb large trade flows
without a significant impact on prices (approximated by volumes,
quote sizes, on-the-run/off-the-run spreads and volatilities). When
market participants raise concerns about the decline in market
liquidity, they typically refer to a reduced ability to deal without
having prices move against them, that is, about reduced market
depth.
Cycles of liquidity crises have been a recurring
feature of financial markets. Commonly used indicators of market
liquidity are notoriously imperfect as reliable measures of liquidity
conditions. While conditions in the autumn of 1998 were indeed
identified as reflecting the adverse shock of the 1997 Asian
Financial Crisis to liquidity in financial markets, liquidity
indicators seemed to suggest that, with the notable exception of the
US government bond market, liquidity conditions were broadly restored
to pre-crisis levels within a short period in the US. However, the
usual indicators typically capture only a single dimension
of market liquidity and none of them were forward looking in
nature, making it difficult to draw any conclusions as to how
long-term future liquidity conditions were being shaped by responses
to current liquidity stress. Bubbles are the bastard children
of liquidity overshoots.
While idiosyncratic factors
might be cited as being responsible for the perception of low
liquidity in specific markets, reduced market liquidity is unlikely
to be a purely conjuncture phenomenon. From a financial stability
perspective, some of the structural factors at work can be
highlighted, focusing on developments bearing on liquidity conditions
in the integrated global financial system at three different levels,
namely:
(i) Firms: developments at the level of major financial
firms participating in the core financial markets;
(ii) Markets:
developments in the structure and functioning of markets themselves;
and
(iii) System: developments across the global financial system
as a whole, such as the systemic effects of credit derivatives.
Liquidity and Credit Risks
Such structural
developments may have served to reinforce the links between liquidity
and credit risks, but also the distinction between normal conditions
and abnormal conditions and between normal times and times of stress
when confidence declines. The current challenge is one of
returning an abnormal economy of excess liquidity to an economy of
normal liquidity without extinguishing the flame of liquidity
entirely. The period of stress will be the time it will take to work
off the excess liquidity, to turn the liquidity boom back
[but doesn't von Mises say you can't do this?! "There is no
means of avoiding the final collapse of a boom brought about by
credit expansion."] to a fundamental boom. It
is not possible to preserve abnormal market prices of assets driven
up by a liquidity boom if normal liquidity is to be restored.
All the soothing talk about the fundamentals of the economy
being strong notwithstanding the debt bubble is insulting to the
thinking mind. This is a debt economy fed by a
liquidity boom. When the liquidity boom turns to bust, all the
strong fundamental indicators such as corporate earnings will wilt
from a debt crisis. Asset value cannot be held up by simply adding
excess liquidity forever without creating hyper
inflation. Also, some liquidity problems, such as those caused
by a loss of market confidence, cannot be solved by merely injecting
money into the financial system which in fact will only add to the
problem. Restoring market confidence requires a rational
restructuring of the economy to absorb excess liquidity.
Liquidity
Risks Under-priced
Many market participants had felt that
pre-LTCM (a major hedge fund that
collapsed in Sept 1998 from wrong bets on Russia sovereign bonds
rising in value above US sovereign bonds) liquidity risk in
many credit markets had been under-priced, and that the under-pricing
led financial institutions to underestimate liquidity risks with a
“liquidity illusion” mentality. Such under-pricing
inhibited developments that would enhance the market’s ability
to retain liquidity in times of sudden stress. There were indeed
several occasions since the LTCM crisis, such as the September 2006
collapse of Amaranth Advisors, which lost nearly $6 billion in a
single week after a highly leveraged bet on the future price of
natural gas prices blew up, when conditions in some markets turned
adverse but liquidity, which typically declined sharply in the midst
of the crisis, proved to be rather resilient.
The trading strategies employed by LTCM's highly leveraged portfolio were generally uncorrelated with each other in order to benefited from diversification. However, a sudden rise in liquidity preference in the market in late summer of 1998 led to a sharp marketwide repricing of all risk leading these positions to all move in the same direction. As the correlation of LTCM's positions increased, the diversified aspect of LTCM's portfolio vanished and large losses to its equity value occurred. Thus the primary lesson of 1998 is more than one of liquidity which the [is] the effect rather thn the cause of the crisis. Fundamentally, it was a problem of paradign shift that changed the underlying Covariance Matrix used in Value at Riak (VaR) analysis from stattic to dynamic.
The high leverage
employed by the LTCM in order to maximize gain made it highly
vulnerable to volatility and credit risk even though the
logic of LTCM's directional bets was valid in thinking that the
values of government bonds should converge. But the high
leverage deprived an undercapitalized
LTCM the luxuary [luxury] of needed
staying power to benefit from the eventual convergence.
Hidden
Relays of Counter-party Risk
However, some elements
of recent developments, such as widespread financial consolidation,
the increasing use of non-government and synthetic securities,
particularly collateralized debt obligation (CDO) instruments, as
hedging and valuation benchmarks, might influence the behavior of
market participants in a way suggesting that market
dynamics in times of extreme stress can change significantly and
abruptly. This has heightened concerns about credit risk,
particularly the hidden relay of counter-party risk, which can
undermine market participant willingness to enter into transactions
and thus weaken market liquidity in market environments of heightened
uncertainty. Other elements, such as aggressive collateralization
practices and overdevelopment in risk management policies, which
generally enhance market stability in normal times, could add
pressure in times of extreme stress.
Price as a
Function of Liquidity
Price is a function of liquidity
which [price] can be quite detached from
normal value. Liquidity conditions offer a new paradigm as the key to
understanding why and how the markets move. Liquidity
is consistently a reliable indicator on which to base the timing of
trading and investment decisions. Liquidity is the key
determinant of the direction of the stock market, but it does not
inform on fundamental value. The aggregate
capitalization of any market or market sector, whether stocks,
real estate, precious metals, commodities, debt instruments etc., is
a function primarily of liquidity, with the economic value
having only secondary impacts except when liquidity is neither
excessive nor scarce. The total value of any market is impacted by
its current liquidity trend as technical analysts know.
Changes in The Trading Float
Liquidity
can also been measured by the relationship between changes in the
total trading float of shares or debt instruments in the entire stock
and credit markets and the change in cash available for investment.
Market liquidity has two components: the change in the trading float
and the change in the cash available to buy. Liquidity analysis, in
essence, is measuring change in the trading float of assets and
tracking the movement of cash. [References:
TrimTabs
Liquidity Theory,
.http://www.winninginvesting.com/liquidit.htm
, (www.trimtabs.com)
gives you free access to the same reports they send to paying
customers, except they’re posted a couple of days later. You
can download three different reports from the site: Daily
Liquidity Trim Tabs, Liquidity Trim Tabs
(weekly), and Mutual Fund Trim
Tabs (weekly) (at least in
998!). ... ]
For
the equity market, some analysts offer a daily liquidity number
(Daily Liquidity Trim Tabs) that is determined by adding
US equity fund inflows,
2/3 of newly announced cash takeovers,
1/3 of completed cash takeovers and subtracting
new offerings.
Their longer term analysis of the underlying trends in liquidity takes in account
stock buybacks,
insider selling and margin debt.
Mutual Fund Trim Tabs
survey over eight hundred and fifty equity and bond funds daily. US
stock market liquidity looks at flows into equity mutual fund that
are not international specific. International equity and bond funds
flow are determined separately. Trim Tabs Market Capitalization Index
measures the market value for all NYSE, NASDAQ and AMEX stocks. The
AMEX is included but not listed. Trim Tabs Market Cap Index does not
include ADR’s.
Liquidity and Income
Distribution
Liquidity analysis starts with the overall
economy’s cash flow. The best way of watching US cash flow is
daily and month income tax collections. Higher income tax collections
suggest higher incomes. The Internal Revenue Service reports that
while incomes have been rising since 2002, the average income in 2005
was $55,238, nearly 1% less than in 2000 after adjusting for
inflation. The number of tax payers reporting income of over $1
million grew by 26% to 303,817 in 2005 from 2000. This group,
representing less than 0.25% of the population, reaped 47% of total
income gain in 2005 compared with 2000. This group also received
62%of the tax savings on long-term capital gain and dividends of the
2003 Bush tax cut. Those making over $10 million received tax savings
of nearly $2 million each. This group enjoyed a tax saving of $21.7
billion on their aggregate investment income. Some 90% of the working
population made less than $100,000 in 2005. They received $318 each
on average in tax savings from investment. Nearly 50% of the working
population reported income of less than $30,000. Liquidity in
US markets is driven by debt, not income, and most of the debt is
sourced from foreign central banks. [This
debt sourcing would include your Japanese carry trade, I guess.] [Not
sure I get the drift of this paragraph.]
Liquidity
and Market Capitalization
The conventional "value"
paradigm says that the overall market capitalization is a function of
the growth of aggregate cash flow of all stocks, and that the stock
market discounts future earnings. This has never worked in reality.
Market capitalization derived from price levels is
always a function of liquidity as it is almost impossible for
any central bank to match money supply growth with economic growth
perfectly in the short term.
The conventional value paradigm
is unable to explain why the market capitalization of all US stocks
grew from $5.3 trillion at the end of 1994 to $17.7 trillion at the
end of 1999 to $35 trillion at the end of 2006, generating a
geometric increase in price earnings ratios and the like. Liquidity
analysis provides a ready answer. Between the end of 1994 and
the end of 1997 the trading float of shares shrank, and from early
1998 through the end of 1999 the trading float was unchanged. Over
those same five years the amount of money looking to buy that
shrinking or stagnant pool of shares kept growing. The result was
that market cap kept rising regardless of economic value, with a
stock market up more than over three times in five years. It is
a clear evidence of the Quantity Theory of Money at work. It is
called a liquidity boom, which also fed the housing bubble in the
recent years.
Money Flow and Liquidity
Money
flows from buyers to sellers. If the buyers retired the shares or
debt instruments purchased and the sellers, mostly portfolio
managers, had to replace their holdings from a smaller market float
(the number of shares outstanding in the market); that adds
liquidity. If the sellers vend newly printed shares and used the cash
for anything other than buying other shares; that reduces liquidity.
If sellers suffer losses, liquidity is reduced by the transaction. A
Federal fiscal deficit reduces liquidity, particularly if the
spending is overseas, such as foreign war.
Liquidity and
the Impact of News
Liquidity determines how strongly news
will affect stock prices. Positive liquidity can spur the market
significantly higher when other indicators are positive and cushion
the fall when those indicators are negative. Conversely, negative
liquidity can dampen the effect of good news. When liquidity
contracts on hopeful news, as the current market indicates, risk
aversion is the driving force. Liquidity
almost always stays in step with the market and visa versa.
Keynes'
Concept of Liquidity Trap
For an economy subject to
business cycles, the lower the present rate of interest, the larger,
ceteris paribus, would be a future rise, the larger the expected
capital loss on securities, and the higher, therefore, the preference
for liquid cash balances. As an extreme possibility, Keynes envisaged
the case in which even the smallest decline in interest rates would
produce a sizable switch into cash balances, which would make the
demand curve for cash balances virtually horizontal. This limiting
case became known as a liquidity
trap.
In his two-asset world
of cash and government bonds, Keynes argues that a
liquidity trap would arise if market participants believed that
interest rates had bottomed out at a “critical” interest
rate level, and that rates should subsequently rise, leading to
capital losses on bond holdings. The inelasticity of
interest rate expectations at a critical rate would imply that the
demand for money would become highly or perfectly elastic at this
point, implying both a horizontal money-demand function and LM
(liquidity preference/money supply) curve. The monetary
authority, then, would not be able to reduce interest rates below the
critical rate, as any subsequent monetary expansion would lead
investors to increase their demand for liquidity and become net
sellers of government bonds. Money-demand growth, then, should
accelerate when interest rates reach the critical level.
Keynes
argued that there were three reasons why market participants hold
money.
They hold cash for pending transactions purposes, which is what the quantity theory had always said.
They also hold money for precautionary reasons, so that in an emergency they would have a ready source of funds.
Finally, they hold money for speculative purposes. The speculative motive arose from the effects of interest rates on the price of bonds. When interest rates rise, the price of bonds falls. Thus when people think interest rates are unusually low, they would prefer to hold their assets in the form of money. If they invested in bonds and the interest rate rose, they would suffer a loss. Hence the amount of money market participants would want to hold should be inversely related to the rate of interest. Market participants will want to hold more money (liquidity) when interest rates are low than when they are higher, despite a loss of interest income.
Keynes’
introduction of the interest rate into the demand for money has
survived in modern finance, but not for the reasons he gave. Keynes
was thinking in terms of a two-asset world: money, which earned
no interest but which was liquid and had no danger of a capital loss,
and bonds, which earned interest but which were not as liquid and
which has a risk of capital loss. If one thinks not in terms of a
two-asset world, but in terms of the range of assets which actually
exist in the current financial world, there is no reason to hold cash
balances for either precautionary or speculative purposes. These are
assets that are both very liquid and interest bearing, such as money
market accounts and Treasury bills, plus all forms of options in
structured finance.
Though Keynes' two-asset-class
explanation of why interest rates influence the demand for money is
outdated by developments, his other explanations are still sound.
Money held for transactions purposes is much like inventory which
businesses hold. A rise in interest rates will decrease the optimal
amount of money as inventory, and a rise in the cost of re-monetizing
will increase the optimal amount. Modern management has introduced
just-in-time inventory which renders this argument mute. [er,
moot] Most chief financial officers have also perfected
just-in-time cash management schemes. The exception is that holders
of money can live on it, which is not true for holders of most other
inventories.
Liquidity and Money Velocity
When
market participants hold cash balances, they may no longer hold their
assets in a form that earns no interest, yet interest rates does
generally tend to increase with less liquidity. If interest rates
rise on non-money assets relative to money, the cost of holding money
in terms of interest foregone rises, and one would expect market
participants to try to economize on cash. A business, for example,
could shift money from checking accounts into treasury-bills, or
resort to loans instead of selling assets with high future value. It
would be worthwhile to make more transactions into and out of
interest-bearing assets to take advantage of the higher interest
rates. When interest rates are very low, these transactions may not
be worthwhile, and the business may be willing to let money lie idle
for short periods in checking accounts. High interest rates
thus increase the velocity of money. Interest payments do not
disappear from the system; they go into the lenders’ pocket
thus increasing liquidity. A liquidity trap tends to develop in a
price deflation environment.
Liquidity and Monetization of
Assets
Liquidity
is the ability to monetized assets without causing prices to fall.
Liquidity thus depends on more than just the availability of cash. It
depends also on the availability of demand for
assets, i.e. willing buyers. A liquidity crunch can develop
even if there is plenty of zero-interest rate cash in buyers’
pockets but every buyer is waiting for lower prices, causing assets
to be illiquid, i.e. unable to be monetized without lowering prices.
It can also develop if buyers lose confidence in the future of the
economy. Distressed assets cannot exit to cut losses at any price and
they bring down prices of even otherwise good assets. This is what
causes contagion which can start a downward spiral of
self-fulfilling fear.
Liquidity and Money Depreciation
The ultimate effect of central banks injecting money into the
banking system is the depreciation of money which now is fiat
currency in all countries. When the European Central Bank (ECB)
injects euros into its banking system, the euro will fall against
other fiat currencies, including the dollar, forcing the Fed to also
inject money into the US banking system. This can quickly turn
into a competitive currency depreciation game. For all central
banks facing a liquidity crisis, the option is a market crash or a
currency crash, or if central bankers are not careful, it can easily
become a crash of both equities and
currencies.
Unpaid Debt Destroys Economic Value
When
debts are not repaid, financial value is destroyed which will be
expressed in falling asset prices. This loss of value will need
to be reckoned in the economy. When individual market participants
lose in a normal transaction, other participants normally gain from
their losses. But when value is lost by debts unpaid, the creditor
loses while the debtor gains by reducing his liability. And if
default debtors are bailed out as a class by the central bank,
the issuer of money, creditors as a class lose relative to their
position to debtors before debtor default, albeit the face value of
the loss is reduced by the amount of the bailout. The cost of the
debtor’s virtual gain and the reduced loss suffered by the
creditor is passed onto the financial system by the central bank
bailout. It is more than a moral hazard problem of encouraging
debtor future adventurism. The economy actually pays by accepting
excess liquidity and financial friction against real growth.
Falling
prices can be slowed down somewhat by the depreciation of money
but only up to a point, after which worthless money can add to the
fall of real asset prices after inflation. That point is dangerously
near at this very moment in the global economy to usher in a period
of sustained deflation. The Federal Reserve added $52 billion in
temporary funds to the money market through the repurchase agreement
of securities including mortgage-backed debt to meet demand for cash
amid a rout in bonds backed by home loans to risky borrowers. The
Fed’s additions were the biggest since the September 11, 2001
terrorist attacks. The additions came in three repo transactions of
$19 billion, $16 billion and $3 billion. Losses in U.S. subprime
mortgages have been rippling through credit markets, driving interest
rates higher and sinking stocks and seizing credit markets.
The
Fed accepted mortgage-backed debt issued or guaranteed by federal
agencies, so-called agency debt and Treasuries as collateral for the
repos. Normally, the Fed does not accept
mortgages as collateral for repo transactions but the move
signals an attempt by the central bank to alleviate financing fears.
Wall Street dealers are seeking the sanctuary of government bonds and
are trying to sell their holdings of riskier assets such as mortgages
if buyers can be found. Until then, they may keep going to the repo
market for overnight funds.
Hedge Fund Woes
In
the past three weeks, the computer models that some hedge funds use
to make trades to implement their strategies have been victimized by
paradigm shifts. These models typically scan markets to spot tiny
price discrepancies under normal conditions, and then place highly
leveraged large orders to capture gains that add up to outstanding
returns on capital. With unusual market volatility and disorderly
markets, highly leveraged hedge funds can face margin calls from
brokers that develop into fire sales of good assets in their
portfolios.
Hedge funds with market-neutral strategies have
been wagering on high-quality stocks, or stocks that trade at low
valuations based on various metrics, and betting against stocks that
appear overpriced. The relatively conservative approach enables
traders to feel comfortable in using leverage to boost returns. With
unexpected margin calls from banks, [hedge
funds] were forced to sell their holdings of high-quality
stocks to raise cash, and closed out short trades by buying back
shares of companies identified by models as overpriced. Others sold
positions simply to become more conservative, in a volatile market.
Since market-neutral funds often are guided by similar
computer models and share similar holdings, the actions magnified
moves in asset prices. Funds that are normally pillars of stability
in normal markets become detonator of instability in disorderly
markets.
Concern Shifted from Hedge Funds to
Banks
However, the Fed’s actions reflected a shift
of the focus of concern from hedge funds towards banks who loaned the
hedge funds money to trade with leverage. Banks are also exposed to
the problem of having committed credit lines to financial
institutions with subprime exposure, such as mortgage lenders or
specialist investment vehicles. Banks have also arranged loans to
risky firms such as buy-out groups, which they
had planned to sell into a debt market that had evaporated
overnight. An estimated $300 billion of
unsold loans are sitting on bank balance sheets, gobbling up
funds [and] pushing up reserve
requirements. Banks themselves are facing problems raising funding in
the money markets where investors are very nervous about lending
money to anybody who might be potentially exposed to subprime losses.
And since it is hard to know who is holding subprime exposure,
because these securities have been scattered around, banks are being
blackballed in an indiscriminate fashion. The is a confidence problem
that the Fed cannot do much about, short of offering to buy worthless
securities that even a liquidity boost cannot restore fully.
Commercial Paper Crisis
In the US, asset-backed
commercial paper, which comprises about $1.15 trillion of the $2.16
trillion in commercial paper outstanding, is bought by money market
funds with conservative investors. The cash enables some selling
entities to buy mortgages, bonds, credit card and trade receivables
as well as car loans. The commercial-paper market, a critical
source of short-term funding for an array of companies, was becoming
inaccessible for a growing number of companies since the beginning of
August. There were also signs of trouble in parts of the currency
market. The asset-backed commercial paper market, a crucial arena
where financial institutions raise funds, has had no buyers in recent
days.
This has been a recurring
problem in this debt economy. On March 13, 2002, GE Capital launched
a multi-tranche dollar bond deal that was almost doubled in size from
$6 billion to $11 billion, making it the largest-ever
dollar-denominated corporate bond issue up to that time. Officially
the bond sale was explained as following the current trend of
companies with large borrowing needs, such as GE Capital, locking in
favorable funding costs while interest rates were low. On March 18,
Bloomberg reported that GE Capital was bowing to demands from Moody's
Investors Service that the biggest seller of commercial paper should
reduce its reliance on short-term debt securities. The financing arm
of General Electric, then the world’s largest company, sought
bigger lending commitments from banks and replacing some of its $100
billion in debt that would mature in less than nine months with
bonds. GE Capital asked its banks to raise its borrowing capacity to
$50 billion from $33 billion.
Moody's, one of two
credit-rating companies that have assigned GE Capital the highest
"AAA" grade, had been increasing pressure on even top-rated
firms to reduce short-term liabilities since Enron filed the biggest
US bankruptcy on December2, 2001. Moody's released reports analyzing
the ability of 300 companies to raise money should they be shut out
of the commercial paper market. GE Capital and H J Heinz Co said they
responded to inquiries by Moody’s by reducing their short-term
debt, unsecured obligations used for day-to-day financing. Concerns
about the availability of such funds have grown that year after Qwest
Communications International Inc, Sprint Corp and Tyco International
Ltd were suddenly unable to sell commercial paper.
Moody’s
lowered a record 93 commercial paper ratings in 2001 as the economy
slowed, causing corporate defaults to increase to their highest in a
decade. One area of concern for the analysts was the amount of bank
credit available to repay commercial paper. While many companies had
credit lines equivalent to the amount of commercial paper they sell,
some of the biggest issuers did not. GE Capital, for example, had
loan commitments backing only 33% of its short-term debt. American
Express had commitments that cover 56% of its commercial paper.
Coca-Cola supported about 85 percent of its debt with bank
agreements, according to Standard & Poor’s, the largest
credit-rating company, which said it was also focusing more attention
on risks posed by short-term liabilities.
In the first half of
2002, companies sold $107 billion of investment-grade bonds, up from
$88 billion during the same period in 2001. The amount of unsecured
commercial paper outstanding fell by a third to $672 billion during
the previous 12 months. PIMCO director Bill Gross disputed GE’s
contention that the company’s new bond sales were designed to
capture low rates, but because of troubles in its commercial paper
market. If the GE short-term rate rises because of a poor credit
rating, the engine that drives GE earnings will stall. Gross
dismissed GE earning growth as not being from brilliant management,
former GE chairman Jack Welch's self-aggrandizing books not
withstanding, but from financial manipulation: taking on debt at
cheap rates and using inflated GE stocks for acquisition.
GE
had $127 billion in commercial paper as of March 11, 2002. That
amounted to 49% of its total debt. Banks credit lines only covered
one-third of the short-term exposure. GE capital core
funds itself by borrowing commercial paper from investors in
the marketplace, and the interest payments that it pays on those
commercial paper instruments give it floating rate exposure, because
they turn over frequently, short duration.
In Q4 2006, GE
total commercial paper balance was a little over $90 billion, a
quarter of its financing. GE makes loans to customers, and a
significant part of its loans to customers include fixed rate
payments of interest. So to match fund
its assets, to have fixed rate interest costs to go with the fixed
rate interest income, GE enters into a basis interest rate swap. GE
offsets the floating interest rate exposure to the CP and pays a
fixed rate of interest to the swap counter-party to match funds its
asset.
As of June 30, 2007, the US Corporate Bond Market
totaled $3.7 trillion in outstanding par value split 82% investment
grade and 18% speculative grade. Across the pool of industrial bonds,
the par value share of issues rated speculative grade is
substantially higher at 31%. The par value of bonds maturing through
the end of 2007 totals $194.9 billion. The bulk (95%) of this volume
($186.0 billion) consists of investment grade bonds with the
remaining volume ($8.9 billion) residing at the speculative grade
level.
Commercial paper outstanding fell $91.1 billion in the
week ended Aug. 15 to a total of $2.13 trillion, a weekly plunge that
captured both bond and stock markets attention. The data,
released on the Federal Reserve Board Web site, validated the trend
that issuers were being forced to make orderly exits from the
commercial paper market to obtain financing elsewhere.
CDO
Illiquidity
Collateralised debt obligations (CDOs) are
designed to let some high-risk tranches take the first loss if any of
the underlying debt defaults, while other “senior”
securities only suffer losses after the riskier tranches are wiped
out. In a typical CDO, senior securities can achieve credit ratings
much higher than those of the underlying debt, sometimes triple-A,
the same rating as US government securities. The catch is that many
CDO securities are infrequently traded and some are tailored by
investment banks for specific clients, such as pension funds, and
have never traded. Without a market price, valuation involves complex
computer models and subjective assumptions. The credit crisis will
hit the pension funds; it is merely in a matter of time.
Bear
Sterns in July revealed large losses at two hedge funds that owned
subprime-related CDOs, but had trouble quantifying the losses.
Attempts to sell the instruments ran into trouble because few traders
offered anything except very low, fire-sale prices.
This
raised questions over whether hedge funds, investment banks and even
pension and insurance groups know
the market value of their structured credit holdings. As a result,
the CDO market is closed, and access to credit, especially for
leveraged buyout debt, has been severely curtailed. The news that BNP
Paribas was suspending three funds underlined the valuation problem
caused by a liquidity drought in the market.
Some senior US
finance officials calculate losses in the subprime-related sector to
be a containable $100 billion. The market seems to have a different
opinon. The impact from uncertainty is now spreading to affect other
debt markets, such as the corporate bonds and commercial paper
market. That is creating severe trading losses and destroying
confidence.
The Politics of Bailouts
Politicians
are talking about taking measures to help households suffering from
the subprime crisis to prevent as many as 3 million largely
low-income households from losing their homes. However, that will not
solve the crisis in the financial markets. In fact it may add to it.
But with the central banks pumping in money to help banks from
failing, while families are evicted from their homes is very bad
politics in a election year. The central banks are giving financial
institutions whose credit rating and cashflow are not much better
than family with subprime mortgages, free credit cards with a
subsidised interest rate and no spending limit for as long as needed,
while these very same institutions are foreclosing on the homes of
their customers. This crisis will likely build to a crescendo just
before the November presidential election. Its going to be a very
interesting election. Will the credit crisis of 2007 usher in an age
of popularism in US politics?
http://www.atimes.com/atimes/Global_Economy/IH24Dj02.html
Henry C K Liu is
chairman of a New York-based private investment group. His website is
at www.henryckliu.com .