Fed Auction Futility

LIBOR, the interest rates banks charge each other for short term lending has been rising lately. Curve Watchers Anonymous notes that 1-month LIBOR was 2.61% a month ago while today it is 2.90%.

LIBOR is normally close to the Fed Fund Rates which is sitting at 2.25%. Typically the spread would be something like 15 basis points not the 64 that you see. And with expectations of rate cuts coming, it should be dropping or steady, not rising.

Interest Rate Derivatives Suggest LIBOR To Rise Further

Eurodollar futures signal LIBOR to Rise Further and banks remain wary of lending.

Interest-rate derivatives are signaling that the rate banks charge for loans in dollars in London may rise further as financial institutions remain reluctant to lend.

The persistence of banks' need for cash and increase in Libor rates has triggered speculation that the Federal Reserve will increase, for the third time, the amount it loans through its Term Auction Facility, which is known as TAF. The Fed has auctioned a total of $360 billion in temporary funds through TAF since its debut in December. This month, both TAF auctions were for $50 billion each in 28-day loans.

The rate at this week's TAF was 2.87 percent, or 82 basis points above the minimum bid set by the Fed, the highest spread to date. An increase in the spread signals a rise in demand for funds in the banking system.

Fed Announces Another Auction

Speculation the Fed would act again was right on the money. Hoping to ease credit woes, Fed to auction another $75 billion in Treasuries.

The Federal Reserve announced Wednesday it will auction an additional $75 billion in super-safe Treasury securities to big investment firms, part of an ongoing effort to help strained credit markets. The auction — the fifth of its kind — will be held Thursday.

In exchange for the 28-day loan of Treasury securities, bidding firms can put up more risky investments, including certain shunned mortgage-backed securities, as collateral. In the four auctions held so far, the Fed has provided close to $158.95 billion worth of the Treasury securities to investment firms.

The goal is to make investment houses more inclined to lend to each other. It also is aimed at providing relief to the distressed market for mortgage-linked securities. Questions about their value and dumping of these securities had driven up mortgage rates, aggravating the housing slump.

Goal Fails Miserably

Interestingly enough, analysis posted on the Fed's own website shows why the program is doomed to fail. The conclusion of a Fed sponsored study was that banks and broker dealers will not make short term unsecured loans to each other when instead they can swap increasingly lousy paper with the Fed.

The above logic was presented in Failures of the Term Auction Facility and Fed's Swap-O-Rama Gets Crazier.

Regardless of what the Fed is thinking, a rational person would conclude that banks and broker dealers will pawn off as much garbage on the Fed as the Fed is willing to take. And so the Fed's own balance sheet is ballooning with garbage.

The latest H.4.1 Report, Factors Affecting Reserve Balances shows that of the $867 billion in reserve bank credit that is normally treasury bills and notes, approximately $319 billion has been swapped out.

Today, another $75 billion will be added to the swap-o-rama total. That will make the Fed's balance sheet look something like this: $394 Billion Garbage to $473 Billion Treasuries. One additional swap will make the Fed's balance sheet more than 50% garbage.

Is this supposed to restore confidence in the Fed? In the banking system? In the US dollar? Is this supposed to make institutions want to lend? Is the fact that the Fed is holding garbage instead of the banks supposed to make the securities more valuable?

Whatever the Fed thinks its pawn shop is supposed to accomplish, it clearly isn't doing it. After all, the Fed Is Not King Midas.

Besides, this pawn shop arrangement with non-banks is not even legal. Nonetheless, the Fed seems willing to pursue swap-o-rama till its balance sheet fills up. At the current rate that will be 3-4 more months. Swap till you flop? Is ZIRP next? Printing? Whatever it is, it won't matter. Banks and brokers are becoming increasingly zombified with each passing day.

Comments

[Robohogs]

I have gotten to where I can tell when you have written a new article simply by the title. Get a life!

[nickgogerty]

just curious what happens when the colatoral gets downgraded below AAA. Does the FED/BOE ask for replacement from the pledger? I am interested in understanding the mechanics.

[Pangaea]

What's wrong with having written a new article?

Yeah, he's been consistent - consistently bearish - but don't you think it's important to read all sides of the coin?

[Pangaea]

"City's mother" - in response to your question, this might help:

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The distinction between liquidity and solvency is badly reported and widely misunderstood. A few economists, particularly Nouriel Roubini, have emphasized the difference, but by and large, the phrase "Fed intervention" is heard by investors as "Fed bailout." The essential fact is that the Fed's provision of short-term (generally 28-day) liquidity does not represent a “bailout,” and the Fed is emphatically not taking the default risk of the mortgage market onto itself.

To see this, keep in mind that the Fed works through “primary dealers” – generally large U.S. banks that are members of the Federal Reserve system. When the Fed enters a repurchase agreement, or other type of “lending facility,” it provides a certain amount of short-term funds to those dealers, in return for collateral in the form of Treasury securities, and more recently, investment-grade (cough) mortgage securities. But this is the important part – the dealers agree to “repurchase” those securities back from the Fed at the original price, plus interest.

As a result, even if the mortgage securities used as collateral go into default while they are in the hands of the Fed, the primary dealer still has to repurchase them from the Fed after 28 days, at the original price plus interest. The Fed does not take on the risk of default for the collateral, since it will get paid back as long as the member bank makes good. Instead, the only risk that the Fed takes on is the possibility that the primary dealer itself – a major U.S. bank – will go bankrupt during the 28-day period that the Fed holds the collateral. While the risk of a major bank failure has increased in recent months, the vast majority of the securities briefly held by the Fed will remain the problem of the institutions that owned them in the first place.
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hussmanfunds.com/wmc/w...

[flow5]

Borrowings from the FED for extended periods has been a reliable indicator of bank failures. Most of the time these banks can obtain another loan or roll over previous borrowings. Banks can be liquid and not solvent. And Banks can be solvent and not liquid. It's a mess that I can't sort out.