Fed Rally on Garbage Paper!

5 Day Dow Jones Industrials, 3 minute chart

Perfect timing by the Fed in their surprise, $200B lending:

As we have noted recently, markets have been moderately oversold, with negative sentiment high, and disbelief in the economic recession still surprisingly widespread (Some are even claiming that the credit crunch is a myth).

The Fed action came at a time when the markets were ripe for an oversold bounce.

Before we continue, let's understand what the Fed actually did: Rather than merely expanding the existing Term Auction Facility [TAF], they went several steps further. They created a new credit facility, the Term Securities Lending Facility [TSLF].

Then, they empowered the TSLF to accept a broad range of private collateral -- "AAA" private mortgages in addition to those that are agency paper.

Note the quality of the paper the Fed is accepting, via a recent Bloomberg report:

"Even after downgrading almost 10,000 subprime-mortgage bonds, Standard & Poor's and Moody's Investors Service haven't cut the ones that matter most: AAA securities that are the mainstays of bank and insurance company investments.

None of the 80 AAA securities in ABX indexes that track subprime bonds meet the criteria S&P had even before it toughened ratings standards in February, according to data compiled by Bloomberg. A bond sold by Deutsche Bank AG in May 2006 is AAA at both companies even though 43 percent of the underlying mortgages are delinquent.

Sticking to the rules would strip at least $120 billion in bonds of their AAA status, extending the pain of a mortgage crisis that's triggered $188 billion in writedowns for the world's largest financial firms. AAA debt fell as low as 61 cents on the dollar after record home foreclosures and a decline to AA may push the value of the debt to 26 cents, according to Credit Suisse Group." (emphasis added)

If I read the Fed release correctly, this is the junky paper the Fed will be accepting as collateral.

Why did they do this?

-New pressures on ALL agency spreads;
-Rising mortgage rates despite FOMC rate cuts;
-Ongoing limited credit availablility;
-Dramatic widening spreads between mortgage-backed paper and US Treasuries

The good news is this will help brokers and banks; the bad news is it will do nothing to help the Housing market, or stop the decline in House prices. Nor will it help resolve the inverted pyramid of derivatives that sits atop Housing. And, one has to believe it will only add to inflationary pressures.

"No recession at any cost" seems to be the Fed's philosophy in light of the latest massive cash infusion to Banks...

~~~

Watch this rally towards the end of Tuesday. If it fades, it will be time to get crazy short . . .

20 Day Dow Jones Industrials, 3 minute chart

So what is the quality of the collateral willing to be accepted by the TSLF? As we noted above, much of this paper is junk.

Consider this recent survey of triple A [AAA] paper, at risk of losing their AAA rating in the ABX Indexes, via Bloomberg:

Click here for interactive chart

Source: Bloomberg

Sources:
Fed to Lend $200 Billion, Take on Mortgage Securities
Scott Lanman
Bloomberg, March 11 2008

Moody's, S&P Defer Cuts on AAA Subprime, Hiding Loss
Mark Pittman
Bloomberg, March 11 2008

Portfolio Strategy | Crunch Mythology
Ken Fisher
Forbes 03.24.08, 12:00 AM ET

Comments

[Balsamo:]

Well, finally we're having one of those pup-up bear market rallies that were so common in the 2000-2002 period. Let's enjoy it for a couple of days or weeks...

What scares me is that the fed keep fighting on such short term issues disregarding the real threats.
It's becoming more and more confusing to figure what the fed realy want to save anyway...the economy, the markets, bear stern ?????

A couple of days ago, Jeff Miller in one if his article on this site quoted David Malpass from Bear Stern:

“We think there’s a general underestimate of the power of central banks to stimulate their economies in the short term.
• U.S. recessions have occurred when the Fed tried to stop inflation with high interest rates (1974, 1980, 1982, 1990), a situation the Fed may put off until 2009 or 2010. In contrast, when the Fed has held interest rates down to the inflation rate or below, the result has been strong growth, as in 1977 and 2003.”

I found it amazing.
It just illustrates the common confusion that exists when considering stock markets and the economy. Just take a look at a historical chart of the SP 500.
According to Malpass, recessions occur when the fed tries to stop inflation. Ok.
But what tells the market. First quarter 1974 : Nice Bear market rally push the SP from around 60 to more than 100; meanwhile fed action made CPI plunge from 12.2% to around 6%....untill...1977

And Malpass to continue “strong growth resulted from the fed holding rates down as in 1977”
What tells the market? :The SP just plunged in response to around 80…oh and the CPI jumped to 15% by 1980
1982 : Thanks to Volker, we all entered the longest bull market in history.

By the way, the year 2003 quoted by Malpass is misleading as the fed started to lower rates in march 2001…And started to raise rates in July 04… Remember how the markets reacted to both dates?

Now we can consider what Uncle Bernanke is doing now with more background.

My conclusion is that the fed is fighting the wrong threat with the wrong tools.

2008 Mar 12 06:41 AM

[sammyg123:]

Great comment Balsamo. Just wait - watch the liberal operatives come in with some anti-Bush quotes and suggesting an Iraq pullout. Wait for it....wait for it....

2008 Mar 12 10:45 AM

[Tony Soprano:]

You said:
"The good news is this will help brokers and banks; the bad news is it will do nothing to help the Housing market, or stop the decline in House prices. Nor will it help resolve the inverted pyramid of derivatives that sits atop Housing. And, one has to believe it will only add to inflationary pressures."

Please tell me something I don't know. The Fed swap was not intended to cure the housing crises. Also, why were you so quick to go negative? Are short the market? Finally, I don't, and others as well, believe that this swap will add to inflation. A fed cut on May 18th will add to inflation but not the new swap. Why didn't you point out this difference?

2008 Mar 12 12:50 PM

[Jason Rines...:]

In the end, this is a bailout of the least responsible players in the U.S. economy. On top of that the true bailout comes from an already overstretched Middle Class with no say or choice in the matter. But some of the market is still free and consumers have stopped spending as small businesses have (80% of U.S. economy). In the end, some of these people will drink their own poison coolaid as Warren Buffett likes to say.

Me myself, I am very, very negative and would feel positive if overpaid, worthless CEO's stepped down or were fired for their malfeasance. Has that happened? Nope.

2008 Mar 12 10:51 PM

[elwind45:]

I think some big player dumped 231b in treasuries on the treasury. (china?) The story of bailout was a fabrication. The ability of treasury to absorb paper is providing floor. The story of coordination between central banks has been de-bunked by currency trading since tuesday! The fed should cut rates in half and defend dollar. Heck dollar carry trade is alive and very well! This scheme was hatched out of some real event.

2008 Mar 14 04:53 AM