A Sensible and Refreshing Move from the Fed

by: Promod Radhakrishnan

How can I not blog today?

We had the best day of the year by far Tuesday, with the Dow up more than 400 points! In a refreshing move at unleashing much-needed liquidity into the system, the Fed announced a Term Securities Lending Facility [TLFS], which provides for a line of up to $200 billion in treasury securities against collateral from its 20 prime dealers (banks, agencies etc.) in the form of MBS and other AAA paper. What does this mean?

1) For starters, this is literally a stamp of assurance from the Fed that it will not let the MBS/ABS securities go to zilch in value (which is what the market seemed to think apparently, given the run on Financial sector shares).

2) This also means big players like Citigroup (NYSE:C), Goldman Sachs (NYSE:GS), Merrill Lynch (MER) and even smaller players (including troubled ones like Thornburg (TMA) and Caryle) can borrow treasury securities by providing AAA MBS paper (this includes paper sold by banks, Freddie Mae (FRE), Fannie Mac (FNM)) as collateral. They in turn can loan these treasuries to investors in return for cash... thus providing much needed liquidity to these players.

This has been by far the best move by a central agency to address the situation in a sane manner. Rate cuts won't take us far and would in turn put us in danger of stagflation. Subsidies to troubled borrowers would address part of the issue, but in a non-meritocratic way.

This brilliant move by the Fed was even more powerful since it was coordinated with the ECB, Bank of England etc., each of them providing additional liquidity building measures totaling over $45 billion. There might be some feeling this Fed move is again reactive, but no one has been successful at predicting the depths to which the MBS and ABS markets have fallen, and even the larger debt market in general. Who would have imagined economic confidence in US waning to such an extent that default swaps on German bonds start getting priced lower than that on US treasuries?? We are in an abnormal economic situation and any balanced moves by the Fed to address the liquidity crunch will help stabilize the market and bring credit and lending back on track. This would not remove credit issues but would at least provide more breathing room for the large players.

Financials were up big time, with Citi leading with a 9%+ gain. Troubled players like Thornburg also saw big upside moves. I feel most of the financials have enough momentum now to erase the near-term decline they had over the past 2-3 weeks. However, the FOMC announcement of rate cut next week might provide a damper - I don't think a sane Fed would try to appease the market with a 50 bps+ cut. This might cause short term negative momentum. I just hope the Fed plays the move along with good forward-looking commentary to ease market jitters.

In addition to the good news from the Fed, consumer confidence index measures from Germany and supply/manufacturing indices from Germany and Japan provided enough of a hint that all's not bad. Europe and Japan still seem to keep enough momentum - meaning well for most of the large global US corporations and money center banks. Bad for the dollar perhaps, since strength in Europe means the ECB or Bank of England would not be forced to come down from their hawkish rate stances. However, once the Fed controls unbridled rate cut expectations next week, the dollar should rally back to $1.45-$1.48 levels against the Euro again.

On the micro-side, if you had locked in January calls at a strike price of 25 for C early Tuesday, it's difficult to imagine you would lose money by year's end.

Disclosure: None