Walter Kurtz's  Instablog

 

One of the most successful government programs to stabilize the financial system has been the FDIC's Temporary Liquidity Guarantee Program (TLGP). It allowed banks to issue short-term notes that are backed by the FDIC. The media generally focuses on the fact that the guaranteed paper was significantly cheaper for banks than issuing notes on their own. This is correct - once investors realized that this is truly a government program, it started trading much closer to treasuries (although people felt that there was some political risk associated with the guarantee).

But many forget that at the end of 08, banks couldn't issue paper at all, even at historically high yields. TLGP effectively unclogged the frozen credit markets, allowing first banks, but shortly after other types of corporations to issue paper, leading to an incredibly robust primary debt markets today.

A total of $329.5 billion of notes have been guaranteed by the FDIC. The question of course is who has been most active in utilizing this program. The usual suspects are there: C, BAC, JPM, etc. But the largest user (and the entity to which the FDIC has the most risk) has been GE Capital (close to $90 billion). "We bring good things to life" means we bring lots of FDIC guaranteed paper to the market. Next time you screw in a light bulb, just remember your tax dollars have kept the lights on, literaly.


source: Bloomberg

Other "non-bank" users have been GMAC, American Express, MetLife. We also had some non-US banks participate such as HSBC. The program is about to end however, with the last date of October 30th to issue an FDIC note. This is one of those tools that the government will have available in case of another crisis in the future. Just dust off the old TLGP docs and you are ready to restart the debt markets.

TLGP

 

The unsecured bondholders have recently sued the lenders of the so-called "the Godfather Loan" (rescue package) lead by Barclays. They claim that the Godfather Loan was done with the knowledge that the company will default as a result of that "rescue package" (amounting to a fraudulent conveyance). The "Godfather" lenders have practically all of the unencumbered assets as the collateral package for their loan (5 x the loan amount). The unsecured lenders (the bond holders) filed a complaint that the $3 billion rescue loan subordinated their claims, making CIT unable to pay the bond holders next summer. This is going to be a long fight.

This chart shows (roughly) the CIT debt maturities going forward. It's not pretty.



To avoid default CIT has to bring down leverage. To accomplish this, they are trying to reduce the debt outstanding by at least $5.7 billion of face value (much of it at nearby maturities). They are offering to exchange existing bonds for new notes and preferred equity. According to JPMorgan, they will need 79% of the bond holders to participate. Not only do they need large numbers of participants to get to the $5.7 billion of reduction, but a number of debt holders have CDS protection against their CIT bonds (basis trade) and would prefer for CIT to default. A default would force convergence of the basis (the CDS would settle at the auction-priced defaulted bond level) and make these guys some money instantly. They are mostly indifferent to the recovery rate on their bonds (the lower the recovery, the more their CDS will pay them). The basis position holders would therefore vote for a for a prepackaged bankruptcy instead of the proposed exchange. The fact that they can't count on the basis holders means that CIT needs an even larger fraction (79%) of the debt holders to agree to the exchange.

But to get 79% of the non-basis holders to agree to the exchange (tender) is going to be rough. It looks increasingly likely that CIT is headed for bankruptcy, which is what the "Godfather Loan" guys (who want to grab the collateral) as well as the basis trade holders ultimately want. Welcome to the world of distressed debt investing.

 

Let's take a quick look at options currently available to the Fed and their potential next steps. With the dollar under pressure and bank reserves at historical highs, one would think the Fed is getting uneasy with all the liquidity in the system. Now that the short-term liquidity facilities are winding down, much of the new securities purchases will increase the balance sheet and grow the money supply. Many beleive this will surely lead to inflation.

To address this, the Fed has the following two tools (outside of outright securities sales):

1. Purchase new securities (RMBS, Agency paper, etc.) on repo (sterilized purchases). The Fed would effectively buy the securities and immediately lend them out for some period, taking in cash collateral. This takes these securities out of the market, but does not increase the money supply because the proceeds from these sales would not be available to the dealers (the proceeds become the cash collateral). This could be done not only with new purchases, but with securities already on Fed's balance sheet (about $1.5 trillion worth). To accomplish this on a scale that makes a difference, the Fed needs to set up repo lines with banks and dealers outside of the Primary Dealer group. The primary dealers may not have the capital to absorb such massive amounts of repo transactions on their own.

2. The Fed could also raise rates. But this wouldn't be simply raising the Fed Funds Target Rate. Instead the Fed now has the ability to raise interest rate on the reserves that banks keep with the Fed. That immediately creates a floor on rates because banks have no incentive of lending at levels at or below the reserve rate. Instead they can simply deposit the funds with the Fed on a riskless basis. This tool has been used by other central banks for decades.

The first tool may be set up relatively soon, particularly for new purchases, but it's usage should be fairly modest in the near-term. The rate increases however are months away. Here are two reasons for the Fed's dovish approach:

1. The Fed will not take any rate action until they see improvement in employment. And as we discussed earlier, this may take a while. This is particularly true because many recent jobs (the "bubble jobs") were created on the back of construction spending.

2. The Fed (among numerous measures available to them) watches one key indicator quite closely: the rate of change in "broad" money supply relative to the "narrow" money supply. It's a measure of how effective the liquidity injections have been in stimulating lending. Banks can be loaded with cash, but if they don't lend, the cash is not making it's way into the broader money supply (the banks effectively stay overcapitalized). And that means the broader economy is not benefiting from the liquidity the Fed had provided, which limits it's growth. The chart below shows the relative growth of M1 (narrow measure) and M2 (broader measure). Until M2 picks up significantly, the Fed will do very little in terms of tightening.


source: St. Louis Fed


Inflation is unlikely to pick up until credit is available in the broader economy to allow corporations and individuals to pay higher prices. With broader money supply responding this slowly, significant price and wage increases are unlikely in the near-term.

The possibility of the Fed actually selling securities from it's balance sheet outright is even less likely. Such sales may impact long-term rates, which may have a negative effect on housing and the consumer, and the Fed will categorically not go there. The RMBS securities, the agency paper, and even treasuries they have bought, will stay on Fed's balance sheet for years to come, possibly to maturity.