Repurchase Agreements and Covert Nationalization

The Fed announced that it would auction off $100B in loans this month rather than the previously announced $60B via its TAF facility. In the same press release, the FRB announced plans to offer $100B worth of 28 day loans via repurchase agreements against "any of the types of securities — Treasury, agency debt, or agency mortgage-backed securities — that are eligible as collateral in conventional open market operations".

The second announcement puzzled me. After all, the Fed conducts uses repos routinely in the open market operations by which they try to hold the interbank lending rate to the Federal Funds target. In aggregate, the quantity of funds that the Fed makes available is constrained by the Fed Funds target. So, what do we learn from this? Fortunately, the New York Fed provides more details:

The Federal Reserve has announced that the Open Market Trading Desk will conduct a series of term repurchase (RP) transactions that are expected to cumulate to $100 billion outstanding... These transactions will be conducted as 28-day term RP agreements.. When the Desk arranges its conventional RPs, it accepts propositions from dealers in three collateral “tranches.” In the first tranche, dealers may pledge only Treasury securities. In the second tranche, dealers have the option to pledge federal agency debt in addition to Treasury securities. In the third tranche, dealers have the option to pledge mortgage-backed securities issued or fully guaranteed by federal agencies in addition to federal agency debt or Treasury securities. With the special “single-tranche” RPs announced today, dealers have the option to pledge either mortgage-backed securities issued or fully guaranteed by federal agencies, federal agency debt, or Treasury securities. The Desk has arranged single-tranche transactions from time to time in the past.

There are a couple of differences, then, between this new program and typical repo operations:

1. The loans are of a longer-term than usual. Ordinarily, the Fed lends on terms ranging from overnight to two weeks in its "temporary open market operations". The Fed will now offer substantial funding on a 28 day term.
2. The Fed is effectively broadening its collateral requirements by collapsing what are usually 3 distinct levels of collateral which are lent against at different rates to a single category within which no distinctions are made.

The Fed offered the first $15B of repo loans under the program today, so we can see how things are going to work. First, how did the Fed square the circle of ramping up its repos without pushing down the Federal Funds rate? Just as it had done with TAF, the Fed offset the "temporary" injection of funds with a "permanent open market operation". The Fed sold outright $10B of Treasury securities today at the same time as it offered $15B in exchange for mortgage-backed securities under the new program (at a low interest rate than in traditional repos against MBS collateral). The net cash injection was small, but the composition of securities on bank balance sheets changed markedly, as illiquid securities were exchanged for liquid Treasuries.

In James Hamilton's wonderful coinage, the Fed is conducting monetary policy on the asset side of the balance sheet. This is an innovation of the Bernanke Fed. Conventionally, monetary policy is about managing the quantity of the central bank's core liability, currency outstanding. When the Fed wants to loosen, it expands its liabilities by issuing cash in exchange for securities. When it wants to tighten, it redeems cash for securities, reducing Fed liabilities. The asset side is conventionally an afterthought, "government securities". But the Bernanke Fed has branched out. It has sought to lend against a wide-range of assets, actively seeking to replace securities about which the market seems spooked with safe-haven Treasuries on bank balance sheets without creating new cash. By doing this, the Fed hopes to square the circle of helping banks through their "liquidity crisis" without provoking a broad inflation.

"Monetary policy on the asset side of the balance sheet" is a bit too anodyne a description of what's going on here though. The Fed has gotten into an entirely new line of business, and on a massive scale. Prior to the introduction of TAF, direct loans from the Fed to banks, including the discount window lending and repos, amounted to less than $40B, the majority of which were repos collateralized by Treasury securities. By the end of this month, the Federal Reserve will have more than $200B of exposure in its new role as Wall Street's genial pawnbroker. Assuming the liability side of the Fed's balance sheet is held roughly constant, more than a fifth of the Fed's balance sheet will be direct loans to banks, almost certainly against collateral not backed by the full faith and credit of the US government (and beyond that we just don't know). This raises a whole host of issues.

Caroline Baum wrote a column last week poopooing concerns about the Fed taking on credit risk via TAF lending. (Hat tip Mark Thoma.) I usually enjoy Baum's work, but this column was poorly argued. In it, she points out that the Fed has all the tools it needs to manage credit risk. The Fed offers loans only against collateral, and requires that loans be overcollateralized. If the collateral has no clear market value or if there are questions about an asset's quality, the Fed has complete discretion to force a "haircut", writing down the asset (for the purpose of the loan) to whatever value it sees fit. And the Fed can always just say no to any collateral it deems sketchy.

All of that is quite true, and (as Baum snarkily points out) not hard to find on FRB websites. But it fails to address the core issue. Sure the Fed has all the tools it needs to manage credit risk. But does it have the will to use those tools? In word and deed, the Fed's primary concern since August has been to "restore normal functioning" to financial markets. The Fed has chosen to accept some inflation risk in its fight against macroeconomic meltdown. Why wouldn't it knowingly accept some credit risk as well? No one has suggested that the Fed is being "snookered". Skeptics think the Fed is intentionally taking on bank credit risk while still lending at very low rates. Some of us find that troubling.

Which brings us to the more postmodern issue of what credit risk even means to a lender with unlimited cash and an overt unwillingness to let those it lends to default. In a way, I agree with Baum. Until the current crisis is long past, I think it unlikely that any large bank will default and stiff the Fed with toxic collateral. Why not? Because for that to happen, the Fed would have to pull the trigger itself, by demanding payment on loans rather than offering to roll them over. Since TAF started last fall, on net, the Fed has not only rolled over its loans to the banking system, but has periodically increased banks' line of credit as well. In an echo of the housing bubble, there's no such thing as a bad loan as long as borrowers can always refinance to cover the last one.

The distinction between debt and equity is much murkier than many people like to believe. Arguably, debt whose timely repayment cannot be enforced should be viewed as equity. (Financial statement analysts perform this sort of reclassification all the time in order to try to tease the true condition of firms out of accounting statements.) If you think, as I do, that the Fed would not force repayment as long as doing so would create hardship for important borrowers, then perhaps these "term loans" are best viewed not as debt, but as very cheap preferred equity.

Let's go with that for a minute, and think about the implications. One much discussed story of the current crisis is the role of sovereign wealth funds in helping to capitalize struggling banks. Will they, won't they, should we worry? Sovereign wealth funds have invested about $24B in struggling US financials. Meanwhile, the Fed is quietly providing eight times that on much easier terms.

If we view TAF and the new 28-day, broad-collateral repos as equity, what fraction of bank capitalization would they represent? I haven't been able to find current numbers on aggregate bank capitalization in the US. In June of 2006, the accounting net worth of U.S. Commercial Banks, Thrift Institutions and Credit Unions was 1.25 trillion dollars. Putting together remarks by Fed Vice Chairman Donald Kohn and data on bank equity to total assets from the St. Louis Fed yields a more recent estimate of about 1.6 trillion. The average price to book among the top ten US banks is about 1.3. So, a reasonable estimate for the current market value of bank equity is 2 trillion dollars. The $200B in "equity" the Fed will have supplied by the end of March will leave the Federal Reserve owning roughly 9.1% of the total bank equity. Obviously, the Fed isn't investing in the entire bank sector uniformly. Some banks will be very substantially "owned" by the central bank, whereas others will remain entirely private sector entities. As Dean Baker points out, the Fed is giving us no information by which to tell which is which.

What we are witnessing is an incremental, partial nationalization of the US banking system. Northern Rock in the UK is peanuts compared to what the New York Fed is up to.

You may object, and I'm sure many of you will, that our little thought experiment is bunk, debt is debt and equity is equity, these are 28-day loans, and that's that. But notionally collateralized "term" loans that won't ever be redeemed unless and until it is convenient for borrowers are an odd sort of liability. Central banks are very familiar with the ruse of disguising equity as liability. Currency itself is formally a liability of the central bank, but in every meaningful sense fiat money is closer to equity.

I do not, by the way, object to nationalizing failing banks. There are (unfortunately) banks that are "too big to fail", whose abrupt disappearance could cause widespread disruption and harm. These should be nationalized when they fall to the brink. But they should be nationalized overtly, their equity written to zero, and their executives shamed. That sounds harsh. It is harsh. One hates to see bad things happen to nice people, and these are mostly nice people. But running institutions with trillion-dollar balance sheets is a serious business. Accountability matters. These people were not stupid. They knew, in Chuck Prince's now infamous words, that "when the music stops... things will be complicated.", and they kept dancing anyway.

But accountability has gone out of style. The Federal Reserve is injecting equity into failing banks while calling it debt. Citibank is paying 11% to Abu Dhabi for ADIA's small preferred equity stake, while the US Fed gets under 3% now for the "collateralized 28-day loans" it makes to Citi. Pace Accrued Interest (whom I much admire), I still think this all amounts to a gigantic bail-out. And that it is a brilliantly bad idea from which financial capitalism may have a hard time recovering. Like a well-meaning surgeon slicing up arteries to salvage the appendix, the Federal Reserve is only trying to help.

Comments

[Britishsteel]

Does nationalization promote a free market? Does that not open the door to cronyism via { not saving all the banks but only the ones to big to fall?} Does that open the door to creeping socialism? You be the judge, I know where I stand on the issue, central anything to me is socialism. Government should only regulate to the point of helping to instill trust not to make it easier to abuse the trust . A free market demands a value based on what the market will bear at any given point and by the Fed issuing 23A exemptions at will and extending the loan periods of TMO's they are engineering a free market into a controlled market and that is not the basis of capitalism.

[warrenmosler]

First, you need to get out of the gold standard (fixed fx/convertible currency) and into the current non convertible currency/floating fx $US regime.

"In James Hamilton's wonderful coinage, the Fed is conducting monetary policy on the asset side of the balance sheet. This is an innovation of the Bernanke Fed. Conventionally, monetary policy is about managing the quantity of the central bank's core liability, currency outstanding.

THAT'S FROM THE GOLD STANDARD DAYS, OR, IN TODAY'S WORLD, THE FEW CURRENCIES THAT STILL HAVE VARIOUS FIXED FX POLICIES FOR CB CONVERTIBILITY.

When the Fed wants to loosen, it expands its liabilities by issuing cash in exchange for securities. When it wants to tighten, it redeems cash for securities, reducing Fed liabilities.

THIS ISN'T HOW IT WORKS WITH TODAY'S NON CONVERTIBLE CURRENCY/FLOATING EXCHANGE RATE REGIME.

OPEN MARKET OPERATIONS ONLY 'OFFSET OPERATING FACTORS' AND FED ACTIONS ONLY SERVE TO ALTER THE MIX OF PRIVATE SECTOR HOLDINGS OF CURRENCY, SECURITIES, AND FED BALANCES (RESERVES). THE ONLY FURTHER PURPOSE OF ALTERING THIS MIX IS SETTING AN INTEREST RATE.

IT IS ALL ABOUT PRICE, AND NOT QUANTITY, WITH TODAY'S FLOATING FX REGIME. THERE IS NO OTHER CHOICE AS A POINT OF LOGIC.

The asset side is conventionally an afterthought, "government securities". "

THE NEXT POINT IS THAT THE LIABILITY SIDE OF BANKING IS NOT THE PLACE FOR 'MARKET DISCIPLINE' AS A PRACTICAL MATTER, HENCE GOVT. INSURED DEPOSITS. INSTEAD, REGULATION IS ON THE ASSET SIDE- BANKS ARE HIGHLY REGULATED VIA CAPITAL REQUIREMENTS (HOW MUCH LEVERAGE SHAREHOLDERS ARE ALLOWED TO HAVE) ALONG WITH A RESTRICTED LIST OF 'LEGAL ASSETS' AND DEFINED RISKS FOR 'GAP', DIVERSITY, AND THE LIKE.

THIS MEANS THAT ANYTHING THE BANK ALREADY OWNS HAS BEEN 'APPROVED' BY THE BANK REGULATORS, AND BANKS ARE ALLOWED TO FUND THESE ASSETS WITH GOVT INSURED DEPOSITS, WHICH HAPPEN TO BE APPROX EQUAL TO BANK LOANS AND OTHER ASSETS, AS 'LOANS CREATE DEPOSITS.' (THE GOLD STANDARD, FOR EXAMPLE AND IN CONTRAST, IS A LOANABLE FUNDS WORLD, ISLM, ALL THAT). YES, BANKS LENDING TO EACH OTHER PUTS A LAYER OR TWO BETWEEN THE DEPOSITS AND LOANS QUITE OFTEN, BUT THAT'S A DIFFERENT MATTER.

SO FOR ALL PRACTICAL PURPOSES THE RISK TO THE GOVT DOESN'T CHANGE WHEN THE FED FUNDS ANY LEGAL BANK ASSET VIA THE TAF OR ANY OTHER FORM OF FINANCE FROM THE FED. WHAT DOES CHANGE IS THE RATE BANKS PAY FOR FUNDS, IF/WHEN THAT RATE HAS CLIMBED ABOVE THE FED'S TARGET RATE DUE TO WILLINGNESS OF BANKS LENDING TO EACH OTHERE.

AGAIN, AS IT HAS BEEN NOTED, LOANS CREATED DEPOSITS, AND DEPOSITS FOR ALL PRACTICAL PURPOSES FUND ALL THE LOANS AND OTHER BANK ASSETS AS A MATTER OF ACCOUNTING. THE TAF AND OTHER FED OPERATIONS DOESN'T ADD ANY NET FINANCIAL ASSETS TO THE BANKING SYSTEM, AND IN FACT VERY LITTLE NET FUNDING IS EVER OBSERVED FROM A CB TO THE BANKING SYSTEM, AS EXPLAINED ABOVE.

MONETARY OPERATIONS ARE NOT COMPLEX- SIMPLE DEBITS AND CREDITS. CLEARLY THE FOMC HAS LESS THAN A WORKING KNOWLEDGE OF RESERVE ACCOUNTING AS DOES MUCH OF THE STEET AND ACADEMIA. A LITTLE EDUCATION FROM THOSE IN THE FED WHO HAVE A KEEN AWARENESS OF WHAT'S GOING ON WOULD GO A LONG WAY TOWARDS MOVING ON FROM NON ISSUES TO THE REAL ISSUES FACED BY THIS ECONOMY.

[sk8rX]

This seems like the perfect solution.

The Fed offers to give away cash to the banks (raised through the sale of Treasuries) in exchange for the toxic equity/mortgages sitting on their balance sheets, eliminating the credit crisis. The Fed may even be able to use Treasury sales to inject home equity into these mortgages before returning them to the banks to stem off the tide of foreclosures.

This offer appears to be holding the rest of the world hostage - If they don't buy the Treasuries then the Fed will be forced to print more money (devaluing the US dollar) to pay for their buying binge of toxic equity.

You can bet that countries that export heavily with the US will prefer to purchase the Treasuries instead of experiencing the pain of further devaluation of the US dollar (inflation, reduced demand for exports, etc).

These Treasuries are simply IOUs that were given to the Fed by the US treasury. Now the Fed is passing them out abroad, but as a result the US government hasn't gone any further into debt and the currency hasn't devalued.

Overall it appears to me that the Chinese & Japanese taxpayers will be left footing the bill for the housing crisis in the US.

[pharma]

"Overall it appears to me that the Chinese & Japanese taxpayers will be left footing the bill for the housing crisis in the US."

The writer is assuming that everybody is stupid. It is a very dangerous and near-sighted assumption. The most important reason is that the USA is a high net importer. Therefore, US economy needs them much more than they need the USA.

Finally, US$ is a reserve currency that allowed US parasitic way of life for so long. Looks like, this is coming to an end in the next few years. Just look at EU: their disconnect with Feds is quite striking.

[BriceTimmons]

Here, here! Nationalization of banks in cases like this is virtually a necessity, but nationalization of the banks' finances without taking the reins is much akin to paying off a wayward friend's drug debt without putting him in rehab. As James Spader said of just such a situation in Less Than Zero, "Everybody's Accountable!"

[BriceTimmons]

@sk8rX: "Now the Fed is passing them out abroad, but as a result the US government hasn't gone any further into debt and the currency hasn't devalued."

It's incongruous to define a T-bill as an "IOU" from the government and subsequently state that the government "hasn't gone any further into debt." Further, at the rate this government spending without generating revenues, it's going to have to get a Providian card.

Further, what if the "Chinese and Japanese taxpayers" balk? China's domestic market has been on such an uptick over the past few years that it has already begun to make up the shortfall in U.S. consumption. What happens when that natural process prompts a rise in the price of finished goods while the U.S. simultaneously deals with double-digit inflation rates? What if they decide to start diversifying their reserves away from dollar-based assets? Not an unreasonable move as the generation of bankers from the Bretton-Woods era retire to be replaced by people who don't obsess over dollars and the Euro forges ahead.

Managing from the asset side of the sheet can still produce inflation, especially in a world with virtually nothing blocking capital mobility. If banks swap T-bills for currency from abroad and then employ that currency domestically, the money supply has still increased domestically, if not internationally. I can't think of any particular reason that inflation has to be limited to a specific currency rather than a geographic region, just as commodities can fluctuate in value against multiple currencies or just against one and can vary region to region.

[sk8rX]

Anyway, good point about inflation - I agree that domestically the money supply has increased even though no new money was printed.

To explain my point about the T-Bills (correct me if I'm wrong) is that they are created by the US government and are given to the Fed as collateral when the government needs a loan to finance regular government operations.

While the Fed holds on to collateral T-BIlls from the US government, it could then turn around and use the T-Bills as collateral for loans for itself from foreign central banks (such as BOC, ECB, BOJ, PBoC, etc). Since no further Treasuries were created to generate the cash the US has not gone any further into debt.

The extra cash would be used to buy up toxic equity in ever increasing, revolving loans to the banks.

Now here is a thought - is this a plausible scenario?:
1) The Federal reserve continues to increase the size of the revolving toxic repos (currently at 200 billion) to 'extreme' proportions, so that the Fed is in a position where they hold the majority of the bad mortgages as collateral in these revolving loans.
2) All at once the Fed discontinues the loans (doesn't roll over into the next month) causing the banks to default. If I'm not mistaken this means that the Fed would then own the mortgages and could then act on their own recommendation - to forgive negative home equity - under conditions of their choice. Once again they could finance the 'forgiveness' event with Treasuries sold to other central banks. This could reignite the economy. Is the possibility really that far off? It was the Feds own idea to forgive negative equity!

Not many central banks would like the idea of buying Treasuries to support this if the US outlook would remain grim however they may buy into the idea when the alternative is further US inflation to finance the purchase. On the more positiive side they may buy into the idea because if it does reignite the economy then the US would be importing again, the US could raise interest rates again to add value to the currency (making it profitable again for exporting nations to export to the US), and it would probably give the Treasuries a positive real return.

If the US continues to inflate on the other hand, other countries may take this grievously for the negative effects on their countries, and also, the big lenders will recognize that the ~9 trillion US dollars owed to them by the US governement is becoming less valuable under inflation (e.g. if the US devalues its currency by approx 10% then they have effectively eliminated almost 1 trillion of that debt in real terms without paying back a penny) - leading to conflict.

[CharcotEpigone]

Umm -- could it just be simpler to say that the Fed is giving 11% - 3% times 200 billion ($14 billion a year) to prop up a leaking vessel (i.e. the Bush War and the US car economy). Doesn't seem so expensive, particularly by War Economy standards. Will it work? Maybe.

[deefree]

giving an investment banker access to the Fed window is like giving a crackhead access to a cocaine mine.