Category Archives: Fed

Re: Bear Stearns Cont’d

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(some email q&a’s)

UPDATED as more questions come in!!

Why would shareholders approve this sale?

Answer, they may not. They may take their chances with getting more $ in bankruptcy.

Or a higher bid might surface.

The Fed has turned Bear Stearns into a ‘free call’ with their non recourse financing,

And the Fed has moved spreads of agency and AAA paper back towards ‘fair value’ with their openended funding lines. This removes ‘liquidity risk’ and allows the securities to return to being priced on ‘default risk.’

This has dramatically increased the business value of Bear Stearns.

The large shareholders can now say no to the sale, maybe add a bit of capital or take on a ‘business partner,’ and outbid JPM for the remaining shares (if needed).
Might even start a bidding war.

There could still be well over $60 per share of value for the winner.

And there’s a reasonable amount of time for them to put something together.

And maybe this was Bear’s plan all along.

They knew they needed Fed funding to maximize shareholder value, and the JPM involvement to stabilize their client base and buy the time to find a real bid.

(CNBC now showing a chart showing $7.7 billion in breakup value.)

Seth writes:

For 2 a share is Chase getting a boat load of non prime paper that over time is worth a lot more than 2?

From what I’m hearing it’s already worth maybe 75 or more.

And the Fed gave jpm a free call.

The $2 is the least that it’s worth, as the fed is providing non recourse funding for the assets at prices that support the $2 price.

And at the same time the Fed took action to restore pricing of agency and aaa assets to more accurately reflect their actual default risk, which is near 0.

This is different.In this case the moral hazard is in not funding the primary dealers.It’s too easy for the predators (other dealers, hedge funds, etc.) to first get short the stock and then start a run on any broker that has to have any non tsy inventory financed and drive them out of business.

By funding the primary dealers who are in good standing (they report their finances to the fed) and regulating capital requirements and haircuts predators are kept at bay and shareholders continue to assume the business risk of the primary dealers.

Steve writes:

And the Fed has said in times of crisis they will not punish the many for the few.

Moral hazard is not a fixed doctrine. It requires flexibility and in times of crisis they accept that their action (the Fed’s) will not address the doctrine. On balance it is a price (overlooking moral hazard) they must pay for the greater good.

They have done it in the past so doing it again reflects a degree of consistency not a change in policy.

Paul writes:

How do you respond to the moral hazard argument of the Fed bailing out Bear Stearns?

I’ll let the word ‘bailout’ go for now, and begin by saying the liability side of banking is not the place for market discipline, and it’s also probably not the place for market discipline for the Fed’s appointed (anointed?) ‘primary dealers.’

(I will also not here question the idea of having primary dealers in the first place, but don’t take that mean i approve of that setup, thanks!)

So given the Fed wants primary dealers, it then follows there are specific securities they go along with this assigned role.

Presumably those would include the likes of tsy secs, maybe agency paper, maybe AAA rated mtg backed securities, etc.

Presumably also are functions the Fed wants its primary dealers to perform, like being market makers, providing some notion of liquidity, etc. etc.

And, presumably, the Fed has some notion of public purpose behind this entire creation.

So, given all that, to support this ‘institution of public purpose,’ it behooves the Fed to ensure the primary dealers themselves have the available lines of credit to perform this vital public function (almost hurts to write that…).

The bank primary dealers do have ‘guaranteed liquidity’ and so are safely able to function as primary dealers, knowing they can always finance their inventory positions. This can be done via raising fed ensured bank deposits, and borrowing from the fed by using their inventory as collateral, etc.

The non banks were at a disadvantage to the banks in that they relied on the banks to fund their inventories.

Bear Stearns got shut down when the banks said ‘no’ for non credit related reasons. Bear had perfectly good collateral that they held as part of their primary dealer function (as defined by the govt regulations), and the banks said no, perhaps because they had their own internal issues.

The same would happen to the banks, and the entire economy, if the Fed simply said no to the banking system and one morning and didn’t open the payments system.

It’s just one of countless flaws in the institutional structure that doesn’t get noticed until it’s a problem, no matter how many times I’ve pointed it out to ‘authorities.’

So to your question, while I do see a lot of other moral hazard issues, I don’t see this as one of them.

The Fed simply told JPM to deal with Bear in the normal course of business and lend vs qualifying collateral as has always been the case, and as is the case when the Fed lends to JPM.

Let me know if I’m missing something, thanks!

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Mar 15 update

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The question for the Fed: Will further rate cuts help or hurt the credit crisis?

The Fed has been cutting to support the financial sector, and address risks (as they see them) of financial sector issues spilling over to the real sector.

How does the Fed see rate cuts helping the financial sector?

Lower payments for borrowers assist in servicing/refinancing outstanding debt and facilitate continued ‘borrowing to spend.’

However, in this cycle, it seems that rate cuts have been instrumental in the USD decline that correlates with rising gasoline/food/import prices.

‘Well anchored’ wages mean consumers are spending more on food/energy and have less for other goods and services.

And less for debt service, as evidenced by rising delinquencies and the (still mainly subprime, but starting to spread) deteriorating credit quality of consumer loan portfolios.

Yes, exports are increasing dramatically, supporting GDP, keeping the output gap reasonably low, but not increasing income for debt service where that is needed.

So the question for the Fed is, on balance, will further rate cuts help or hurt the credit crisis?

Will further cuts ‘ease financial conditions’ via interest rate channels?

Or will further cuts ‘tighten financial conditions’ via the current fx/inflation/debt service income channel?

And, even if those potential outcomes for the credit crisis are approximately equal, does the nod go to not cutting for reasons of residual inflation issues?

So far, not a single ‘real economy’ company has had problems beyond a slowdown in earnings and concern over future earnings. And slowdowns in sales have all been related to consumers being hurt by higher food and energy prices.

This implies the falling dollar/higher import prices is what has hurt the companies that have been subject to consumer weakness.

This implies Fed policy designed to protect the real economy from from potential spillover from the financial sector crisis has, as a side effect, done direct damage to the real economy.

And, of course, this is only relevant for the Fed if it comes up for discussion at the meeting on Tuesday.

Close friends tell me it probably won’t.

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Re: fed’s action

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>
>     On Wed, Mar 12, 2008 at 8:40 PM, Davidson, Paul wrote
>
>     Warren:
>
>     Don’t you think it was a strange open market operation —
>     where the Fed was moving Treasuries from their balance
>     sheets to private balance sheets (even temporarily) —
>     while accepting as collateral the highest grade mortgage
>     backed securities? Usually open market operations involve
>     Treasuries going one way and bank deposits (not
>     collateral) going the other way.
>
>

Hi Paul,

It was a ‘securities lending operation’ and was probably done that way to be in compliance with existing Fed regulations regarding interaction with the dealer community.

The Fed probably already had authority to lend securities to the primary dealers from their portfolio, and either get cash in return or other securities rated AAA or better (govt, agency, etc). So they offered to loan their tsy secs and accepted the dealer’s securities as collateral for the transaction.

Note that the dealers remain as beneficial owner of the securities pledged to the Fed in return for the tsy secs, and so the Fed is not assuming that risk. The dealers do get tsy secs which they can then in turn use as collateral for loans in the market place at much lower rates than loans vs the collateral they gave the Fed.

So the end result is the dealers get to borrow at the lower rates.

No ‘money’ is added to the system by the Fed. The Fed just sets rates as is always the case.

However, this is not to say they didn’t have other reasons for doing it this way. They continue to display a very limited knowledge of monetary operations and it’s not always clear why they do what they do.

Best to Louise!

Warren

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Monetary ops

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The larger point is that ANY assets banks are allowed to hold already have to be on the regulators approved list, and banks in any case can fund all their (legal) assets with with govt insured deposits.

So why should another arm of government, the Fed, not always provide funding for the same govt approved assets that the govt already provides funding for? Why did it take them so long to come up with the TAF and now with the security lending facility?

And even now only with partial measures?

Clearly they are still in the dark on the workings of monetary ops and reserve accounting?

You may recall my proposal back in August (long before that, actually):

Drop the discount rate to the FF rate and open it up to any bank legal assets.

This should have always been the case.

The Fed’s ‘job’ is to administer interest rates, and that’s how you do it.

It’s about price, not quantity. Fed operations don’t materially change any of the monetary aggregates, as many who should have known all along have been ‘discovering.’

Yes, in good times the system did function reasonably well, but the risk was always there that in a crisis it would break down.

My other proposals remains equally valid:

Let government agencies fund via the Fed Financing Bank (at Treasury rates). They exist for public purpose, shareholders remain at risk for default losses, and lower interest rates would get passed through to the housing markets.

The Treasury should open it’s lending facility and lend Treasury securities in unlimited size to primary dealers.

Lastly, this is a good time to get the Treasury out of the capital markets and limit them to the issuance of 3 month bills. This would lower long-term rates, which is the investment part of the curve.

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Fed policy changes Cont’d

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(A response to a comment about Fed policy changes)

On Tue, Mar 11, 2008 at 9:46 AM, Mike wrote:

the dollar may be the buy of a lifetime here….

Right, especially if the Fed cuts less than expected next week, or not at all.

Vicious reversal of commodities, USD, short term rates, but bad day or two for stocks.

This expanded lending facility may also function to increase the supply of short Treasuries for money funds and narrow the Treasury/LIBOR spread and shut up the rocket scientists who say low rates on short term Treasuries are the market screaming for rate cuts.

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Fed policy changes

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The Fed continues to show a deficiency in understanding monetary operations with the latest moves. While steps in the right direction, a better understanding of monetary operations would have meant funding ANY member bank asset at the FF rate and establishing an unlimited term lending facility for Treasury securities.

Meanwhile they seem to be trying to minimize further rate cuts and instead trying to target areas of illiquidity as per Friday and today’s announcements. They may have reached their inflation tolerance with crude at $109, the dollar continuously falling, and inflation expectations elevating.

Somewhat more troubling is the eurozone seemingly wanting dollar lines from the Fed. Not sure why, but borrowing external currency isn’t ordinarily a good sign.

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MSNBC: dollar exit supports GDP

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This is all part of the effort of non-residents to no longer accumulate $70 billion per month of US financial assets.

The USD goes down as they try to sell USD to each other at lower and lower prices and doesn’t stop until levels are reached where it makes sense to spend the USD here. That’s the only way the net accumulation can be reduced.

Here is BMW is buying US labor content in parts and finished products.

The US has become a substantial and growing auto exporter.

Exports continue to pick up much of the slack from the housing market, as GDP muddles through.

And the Fed thinks this is a good thing. Bernanke stated in from of Congress that he’d like to see exports and investment (in export businesses) drive US GDP rather than consumption.

If the trade gap goes to zero, trade could be adding about another 2% to US demand/GDP.

BMW plans to increase US production while cutting workers in Germany

by Page Ivey

On one side of the Atlantic Ocean, BMW says it will cut 7.5 percent of its work force over two years. On this side of the water, the company says it plans to increase production by more than 50 percent by 2012.

“This is completely driven by the plunge in the dollar,” said Greg Gardner with Oliver Wyman, publisher of the Harbour Report on automotive manufacturing activity. “It is untenable to produce at a much higher cost in Germany.”

The euro climbed to record heights Friday, reaching $1.5463 before falling back to $1.5335 in late trading after the Federal Reserve announced it would provide more cash to banks that need it. That means European goods cost more for Americans to buy.

By building the cars in the U.S., BMW can save money on the lower dollar and on wages since its South Carolina workers make less than German workers, Gardner said.

The declining dollar also means BMW and other foreign automakers likely will start buying locally for more of the parts used by their U.S. plants, he said.

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Reuters: payrolls and the output gap

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U.S. Feb payrolls drop for second straight month

by Glenn Somerville

U.S. employers cut payrolls for a second straight month during February, slashing 63,000 jobs for the biggest monthly job decline in nearly five years as the labor market weakened steadily, a government report on Friday showed.

The Labor Department said last month’s cut in jobs followed an upwardly revised loss of 22,000 jobs in January instead of 17,000 reported a month ago. In addition, it said that only 41,000 jobs were created in December, half the 82,000 originally reported.

December was first reported as a ‘very weak’ 17,000 increase, revised to up 82,000 a month later (not ‘as originally reported’ as above) and now further revised to up 41,000.

These are substantial swings with current market sensitivities, and January and February will likely be further revised next month.

At the same time, the unemployment rate fell to 4.8%. The previous increases corresponded to an unexpected jump in the labor force participation rate, which has now fallen back some in line with Fed expectations.

The Fed has long been anticipating that demographic forces would reduce the labor force participation rate and thereby tighten the labor markets.

That is, we are running out of people to hire; so, new hires fall while the unemployment rate stays the same or goes down.

The last several months are consistent with this outlook, and it means the output gap isn’t all that large, as 4.75% unemployment is deemed by the Fed to be full employment with anything less further driving up inflation.

All this makes things more difficult for the Fed:

  • Stagnant GDP
  • Declining labor force
  • Very small output gap
  • Dangerously rising inflation

Without a major net supply response (a 5+ million bdp jump in crude or crude substitutes or drop in demand), crude prices will likely continue to rise. The drop in net demand for OPEC crude that cuased the price to break was about 15 million bdp in the 1980s, for example.

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Reuters: Yellen the Dove turing more hawkish

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Yellen: Fed faces unpleasant mix on prices, growth

by Ros Krasny

CHICAGO (Reuters) – San Francisco Federal Reserve Bank President Janet Yellen said on Friday that the U.S. central bank faces an “unpleasant combination” of risks to inflation and growth in setting interest rate policy.

“The U.S. economy is particularly exposed to downside risks from the unwinding of the housing bubble and disruptions in financial markets,” Yellen said in remarks prepared for Banque de France’s symposium on globalization and monetary policy in Paris.
“There is some slack now in the U.S. labor market and, if these downside economic risks materialize, quite a bit more slack could emerge,” she said, which would tend to dampen inflation.

The dove position: OK to cut now because inflation coming down later anyway.

Still, Yellen said inflation risks were “roughly balanced” and that the Fed “cannot afford to take for granted that inflation expectations will remain well-anchored.”

The hawk position: if you let inflation expectations elevate (and there are signs this is happening), it’s too late, and a much larger output gap is needed to bring it back down.

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Bernanke and the beast: beware the MNOG!

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4:20 pm Eastern time, March 6

2008-03-06 Tips 5y5y fwd

TIPS 5y5y fwd

Twin themes remain since Q2 2006: weakness and inflation.

Weakness:
The great repricing of risk continues driving credit spreads wider, bid/offer spreads wider, volumes lower, and market forces continue to drive a general, massive deleveraging in the financial sector.

Housing is very weak: sales and construction are down more than 50% from the highs.

Unemployment is up a few tenths, and domestic demand in general is subdued.

Overall, strong exports keep us out of recession, and the real economy muddles through with GDP near zero.

Inflation:
Crude back up through $105, and the $ index down big to all time lows, driving up import prices and external demand (and rising export prices), and our own pension funds are driving up commodity prices by allocating funds to passive commodities.

CPI is up about 4.5% year over year, and core is moving up towards 2.5% as well.

The Fed
The Fed strategy has been to cut rates as an expression of doing what’s necessary to help the financial sector’s problems from spreading to the real economy.

The Fed sees a risk of a massive, 1930’s like, output gap and deflation. They see no reason to worry about the current 4.5% inflation when a potential 10%+ deflation/depression is looming, and with their models forecasting lower inflation.
And as they see inflation expectations remaining now ‘reasonably well anchored,’ and futures markets indicating lower prices for the out months vs the spot months, the Fed’s models continue to forecast lower inflation in the months and years ahead.

Policy is necessarily formed on forecasts, not rear view mirror observations, even if those forecasts have been continuously wrong for the last year. As a point of logic, there is no choice but to continue to forecast to the best of their ability and to continue to formulate policy around those forecasts.

Unfortunately, things have gone awry.

Rather than adding to demand and supporting GDP through the anticipated monetary and credit channels, the Fed’s rate initial rate cuts instead have seemingly driven the $US down and raised the price of imports, particularly energy.

With nominal wages ‘reasonably well anchored’ this has acted as a tax on the consumer and further reduced domestic demand. Falling real wages did coincide with increased exports, but not enough to keep GDP from falling ‘below trend’ and the output gap somewhat wider than it was previously.

Further rate cuts did the same – drove the $ down/prices up further, and reduced real wages and domestic demand. And further increased exports just enough to keep GDP near zero.

And the ‘credit crisis’ continues.

And inflation expectations have elevated. Note the attached chart of 5 year TIPS 5 years forward. The Fed has indicated this is one of their important indicators of inflation expectations and was taking comfort that it had been reasonably well anchored up to a few months ago. Now it’s just passed previous all time highs.

Even the Fed doves have recently said inflation is above their comfort zones, and they have been qualifying their support for rate cuts with statements like ‘if oil prices fall or remain at current levels’ when crude was around $100 or less.

Here’s the problem for the Fed:
They rely on output gaps to bring inflation down to their comfort zones. When they see even tail risk of major deflationary forces setting in they feel more than justified in addressing that risk of an excessive output gap that would not only slow inflation but bring on outright deflation.

But as inflation persists and expectations become less well anchored, the Fed believes the required output gap to bring inflation back down increases substantially, as their most recent studies show that it takes ever larger moves in interest rates to alter unemployment, and ever larger moves in unemployment to alter inflation.

Should housing simply stop contracting, and housing prices only level off, tail risk of an output gap large enough to cause a massive deflation fades.

Suddenly, the forecast output gap, while positive, is far too low to bring inflation and inflation expectations back into the Fed’s comfort zones.

The Fed is already out on the fringes of mainstream economics, including the text books Bernanke and Mishkin have written.

Mainstream economics says that if you are at full employment (believed by the Fed to be a 4.75% unemployment rate) when faced with rising energy costs that drive up prices and reduce consumer demand, leave it alone.

Don’t cut rates and add to demand, and turn a relative value story into an inflation story.

Instead, let demand weaken, let GDP fall, so that other prices will remain stable and and only relative value adjusts as markets allocate by price.

If you do support demand with rate cuts, you only drive inflation higher, real wages fall anyway, inflation expectations elevate, and the real cost of then stopping/reversing this process and bringing inflation back down is far higher than if you had left it alone.

In fact, that’s what all Fed members said continuously up to last August. In recent testimony, for example (see recent postings on this website), Bernanke said the Fed didn’t cut rates because there was an inflation problem.

If crude stays at current levels or continues higher (which I suggest it will as Saudis/Russians continue to act as swing producers, and demand remains far higher than needed for them to continue to support prices at current levels), all inflation measures will continue to march higher.

And with oil producers and other foreigners now spending their $ revenues rather than holding $US financial assets, exports keep rising and keep the current output gap from widening.

For the Fed, this means the MNOG (minimum non-inflationary output gap) needed to bring inflation down to comfort zones goes up substantially.

Their current MNOG could now very well be substantially higher than the current output gap (unemployment was last reported at 4.9%).

And this MNOG beast seems to be growing by the day.

So today’s news of initial claims coming down some, retail sales showing some Feb recovery vs Jan, pending home sales flattening, muni markets reorganizing and selling bonds again, and the ISM bouncing back yesterday, and mainstream companies in general reporting reasonably good to excellent current earnings, all indicate the MNOG is growing faster than the current output gap is growing.

And less than 60 days away are the $150 billion in tax rebate checks.

For the Fed, however, ‘deflationary spiral’ tail risk remains, particularly if you see the risks as those of the 1930’s gold standard days. Back then, the supply side of credit would abruptly shut down for both the private and the public sector, and financial sector issues were immediately transmitted to the real economy. (It doesn’t work that way with today’s non convertible currency and floating exchange rate regime, where public sector spending is not operationally constrained, but the Fed doesn’t yet seem to see it that way.)

Today’s equity markets contribute to the Fed’s tail risk fears- they see the stock market as a reliable leading indicator.

The equity markets are under pressure from both directions: a weak economy is bad for business and a rebound means higher interest rates from the Fed.

And with a Fed that believes the only tool it has to fight tail risk deflation is changing interest rates (see Bernanke testimony), it is rational for markets to expect the Fed to toss another big chunk of raw meat to the MNOG with another big fed fund rate cut after the March 18 meeting.

Data dependent, of course.

Payrolls tomorrow. Jan revision probably more relevant than the Feb number, as the pattern has been for substantial revisions a month after the initial announcement.

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