Wednesday, 12 March 2008

The Fed has a cunning plan

I spent this morning trying to make sense of the Federal Reserve's announcement that it would introduce a new lending operation - the Term Securities Lending Facility (TSLF).

For what it is worth, here is my attempt to clarify what is going on. If I am wrong, please do not hesitate to let me know. In recent days, I have found some of the comments on this blog enormously useful. So please keep them coming.

First, we start with two balance sheets; the first belongs to the Federal Reserve; the second belongs to a typical regional US bank, which we shall call the First Bank of Crapville.

The Fed's balance sheet is straightforward. It has one asset - treasury bills; and one liability - cash. When it wants to increase its assets, the Fed prints more money and goes out and buys more US treasury bills. This type of exchange is called open market operations.

The First Bank of Crapville has a slightly more complicated balance sheet. Starting with liabilities, it has the owners capital, deposits and loans from other banks. On its assets side, it has some safe T-bills, some loans, which are both good corporate loans as well as some mortgages. Finally, it holds some mortgage backed securities.

Here is an image representing the two balance sheets:

(Click on the image for a larger version)

During the bubble years, the bank got a little carried away. It lent heavily to households wishing to buy overpriced houses in Crapville. The First Bank of Crapville used an extensive network of mortgage broker to drum up business. Unfortunately, many of those brokers issued mortgages to borrowers who lied about their income. In some cases, borrowers speculated on the condo boom in downtown Crapville. Some of these borrowers are now walking away from their recently purchased houses and condos.

However, the problems do not stop there. The Bank also bought some of mortgage backed securities. These assets seemed like a great idea at the time, since they were all rated AAA by the ratings agencies.

While the bubble continued, the bank did well, and other banks were happy to extend it loans, which allowed the bank to build up a large portfolio of MBS securities and direct mortgages.

However, along comes the housing crash and the bank's assets are now starting to go bad. The default rate on their loans is rising and their MBS securities, if they were marked to market, threaten to wipe out a large part of the bank's capital.

Furthermore, other banks have become rather nervous about the First Bank of Crapville and are threatening to pull out their loans. If this happened, the bank would not have the cash to repay these loans and if it liquidated its assets, it would be forced to sell them at a deep discount. However, the bank has one advantage. All its depositors have federally guaranteed deposits, so a conventional run is unlikely, at least in the short run.

In normal times, the relationship between the First Bank of Crapville and the Fed is relatively straightforward. When the bank is short of cash, it sells some of its T-bills to the Fed, and in return, the Fed supplies the dollars. Naturally, this kind of open market operation increases the money supply. This exchange is illustrated in the image below.

(Click on the image for a larger version)

Today, things are different; the relationship between the Fed and Crapville's formally finest financial institution is a little strained. The CEO of the bank has telephoned Mr. Bernanke and warned him that the bank's assets are deteriorating, it is making losses and its financing is drying up. The CEO has a particular problem with other banks, who are unwilling to extend any further loans because there is a rumour that the First Bank of Crapville is heavily exposed to the collapsing US housing market.

(click on the image for a larger version)

Rather than let the First Bank of Crapville face the consequences of its disastrous lending policies, Bernanke reassures our beleaguered CEO. "Don't worry" Benanke says "Come to the Fed tomorrow, with your toxic MBS securities and I will replace them with good old US treasury bills".

Early next morning, the CEO is knocking down the door of the Fed with a briefcase of MBS certificates. Other banks hear that the First Bank of Crapville has off-loaded those toxic MBS securities and are now ready to extend loans.

However, Bernanke also tells the CEO "you can only have these T-bills as a temporary loan. In the meantime, I want you to go and get some more capital". The CEO nods in agreement and the next morning he is on the red-eye flight to Abu Dubai looking for a Sovereign Wealth Fund to recapitalize this bank.

To be fair to Bernanke, this scheme has some good points and some dangers. On the positive side, if the bank CEO successfully finds some new capital, then shareholder equity will be diluted. In other words, it will be the shareholders that will take the hit for the losses.

Moreover, this temporary measure doesn't involve a significant increase in the money supply. At least in the short run, the inflationary implications are minimized. Finally, the Fed are using 28 day repos, which means that if the First Bank of Crapville finally becomes totally insolvent, then the Fed has a fair chance of getting its T-bills back.

However, the scheme also has some dangers. The most obvious problem concerns the length of this operation. Bernanke will find it easy to start lending out his T-bills to illiquid banks, but he may find it difficult to stop. He may find that US banks may become increasingly dependent on these repo operations to maintain profitability. Starting a massive T-bill injection is easy, finding an exit strategy may be more difficult. (At this point, one is tempted to make comparisons with US foreign policy, but let us forego that cheap point).

Second, these repo operations transfer the income streams. So while the Bank is receiving the interest payments from the T-bills, the Fed will receive interest payments on the MBS securities. If the default rate on those assets increases significantly, the Fed could find itself making losses on this deal. Of course, central bank losses are not like losses anywhere else. The Fed controls its own liabilities, which are cash. To cover these losses, the Fed will just print more money, but that is inflationary.

Finally, the Fed could be overwhelmed by the demand from banks for these operations. In fact, this must already be the case. Otherwise, why has the Fed increased the volume of these operations so dramatically.

Although the TSLF and the TAF might offer some temporary relief to bank balance sheets, the full extent of housing-related banking losses are not yet known. However, we do know two things. First, there is a tidal wave of variable mortgage interest rate resets this year. Second, the US economy is just about ready to slip into a recession. Therefore, the foreclosure rate is probably going to increase, pushing the banking system closer to a systematic meltdown.

Will Bernanke's plan work? Let us hope that it does, because if it does not, we are collectively looking at the financial equivalent of a nuclear winter. The world will become a very harsh place if the US financial system collapses.


Anonymous said...

Great 101 analysis Alice. I wouldn't dispute anything you wrote but would add the following:

1. You nailed the main point that's currently being misrepresented - this is not inflationary because the fed is not printing... BUT

2. The Fed doesn't create TBills, that's the Treasury's job. To create them you need a buyer who has money. Therefore at some point the Fed cannot increase this facility because they will run out of TBills.

3. So how many Tbills do they have? I read they've already hit the halfway mark.

4. So with a limit on this facility there's a limit to how much MBS they can take on. What % of total MBS value are the Fed's holding of Tbills? I read (but can't confirm) it's only about 5%.

All of which seems to say that this is a temporary fix that is doomed to failure. There's no way around the cold hard fact that when people stop paying mortgages somebody takes the losses on the MBS.


Anonymous said...

Oh, one more thing - why would anybody lend money to the bank of Crapsville when they know that in 28 days they'll have all that MBS sludge back on their books?

They won't UNLESS market sentiment is the Fed intends to roll over the facility perpetually.

Therefore this facility can only fix a liquidity problem, not solvency. Bad debt is a solvency problem.

Therefore it seems the primary motivation for this move was to delay margin calls on banks in the hope a miracle happens in the next month or two.


Alice Cook said...


We can answer your question re: the number of T-bills that the Fed holds. However, the number is finite and if things get really bad, probably insufficient.

On the 28 day roll over; I agree. As I said in the post, I suspect this operation could be around for a long time.

Here is the thing, the more you find out about banking difficulties, the scarier it becomes. I, for one, have stopped laughing at problems over there, and sincerely hope that the Fed can sort things out.


Anonymous said...

With worsening strains in credit market threatening to deepen and prolong an incipient recession, analysts are speculating that the Federal Reserve may be forced to consider more innovative responses -– perhaps buying mortgage-backed securities directly.

“As credit stresses intensify, the possibility of unconventional policy options by the Fed has gained considerable interest, said Michael Feroli of J.P. Morgan Chase. He said two options are garnering particular attention on Wall Street: Direct Fed lending to financial institutions other than banks and direct Fed purchases of debt of Fannie Mae and Freddie Mac or mortgage-backed securities guaranteed by the two shareholder-owned, government-sponsored mortgage companies.

Julie said...

Nice post, very informative.

Josh said...

How long before the BoE are exchangng gilts for mortgage debt. Oh, I forget, the BoE was at that game back in August when Northern Rock went down.

The Real Lizzy said...


When are you going to do a post on the Irish housing market?

Anonymous said...

Its funny how many people blame the current situation upon 'evil' moneylenders when it seems they're the ones in most trouble. The more I read on the subject the more it seems to me that its actually the land speculators that have caused the trouble.

As my granny used to say; 'There's no such thing as a free lunch' and land investors have just had the largest free lunch in history.

Anonymous said...

I wonder whether the new non-dom tax will have any effect on the London housing market? I'm amazed that Darling had the stomach to force it through.