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Saturday, August 11, 2007

Financial Markets Running On Empty

Glen Hubbard, former Chair of the Council of Economic Advisors, and Laurence Meyer, former Federal Reserve Bank Governor and current principal of noted economic consulting firm Macroeconomic Advisors, both appeared on a segment of The NewsHour on PBS on August 10, 2007. They addressed questions about the past two weeks of wildly fluctuation stock prices and the financial linkages between the hedge fund world, the sub-prime lending sector, the general banking industry and the overall economy.

Hubbard and Meyer are two of the highest profile "professional" experts on the economy and the financial sector. So how did the "pros" do at explaining the crunch? Not well. Their explanations both framed the wild fluctuations as a perfectly logical result from a sudden shift in the "risk spread" between the cost of "safe" money versus the cost of achieving higher returns as markets realized the risks taken to earn those higher returns were in fact much larger than previously understood.

Oh. Of course! Makes perfect sense. A little temporary confusion over the amount of risk I took on getting that 7% return instead of the safer 5% return. The Fed steps in, puts a little cash into the pockets of the big banks to calm the fears of the little guys driving the banks' temporary need for additional cash and presto! Everything will be smoothed out in a few days. Nothing to see here, move along…

Both Hubbard and Meyer indirectly commented on the staggering $38 billion dollars injected by the Fed during the August 10 trading day to calm the market but glossed over details about the very short term benefit of the intervention, the sheer size of the intervention and the quality of the assets swapped to free up the cash. For that, the mechanisms have to be looked at from other angles.

An Amateur Explains Borrowing from the Federal Reserve

How does the Fed actually "inject" the cash? Member banks needing extra cash to meet reserve rules or pay out cash for withdrawals can borrow money from the Fed at the Federal Funds rate, currently targeted at about 5.25%. Borrowing banks typically provide collateral for these loans in the form of Treasury Bills, which don't eat into the borrowing bank's cash reserve but are almost as "liquid" as cash in terms of their safety. These loans are typically termed repurchase or "repo" loans and typically have very short terms -- usually two weeks.

If the Fed decides the market for this money only requires X billion to be made available, that's all they loan out. If member banks become more nervous about cash needs and want to borrow more, they can borrow from each other or any other source but, like any other market, if demand exceeds supply, the price (the interest rate) goes up. The Fed "injects" additional cash by deciding to loan out more of its cash. As the supply gets closer to demand, the "price" of the money falls, reducing the interest rate.

If the Fed wants to reduce cash on hand in member banks to shrink the money supply, it can reverse the direction of a "repo" and act as the net borrower of the cash rather than the source. This bids up the interest rate but attracts cash in from member banks, thus reducing the money supply. Since the market for these short term funds varies daily and terms usually extend 14 days, at any given time, the Fed's books will show outstanding "repos" and "reverse repos".

In a balanced market where the Fed and all of its member banks agree upon the degree of risk in the world and their short term needs for cash, the rate on inter-bank loans matches the rate target publicly advertised by the Fed. Before the opening of trading on August 10, the rate on inter-bank loans between member banks had reached 6.0% in contrast to the 5.25% target rate of the Fed. In short, the member banks had become extremely nervous about demands for cash and the price of borrowing to get that cash was spiking up.

Do You Smell Smoke?

If the Fed loans money every day to member banks, what's the big deal about the $38 billion lent on August 10? The best way to answer that question is to pose another one: Did August 10, 2007 feel like September 11, 2001?

The first bit of perspective comes from examining normal values of outstanding repo and reverse repo agreements on the Fed's books. Each Thursday, the Fed publishes a summary reflecting the averages of that week's daily figures:

Report Date    Repos    Reverse Repos
August 9 $18.6B $31.6B
August 2 $25.8B $33.3B
July 26 $18.9B $31.5B
July 19 $22.5B $31.6B


As an example for clarity, the $18.6 billion shown for the report issued August 9 means that over the seven day period from August 3 to August 9, the value of outstanding repurchase agreements averaged $18.6 billion each day.

The $38 billion dollars of repo agreements issued August 10 represented a huge spike in "smoothing" from the norm. The $38 billion total is certainly an attention getter but were the events of August 10 nearly equal to the threats to market stability after September 11? Keep reading…

In the week after September 11, 2001, the markets faced all of the following unprecedented risks:

* stale, uncertain pricing for stocks and bonds from days of halted trading
* major social and political uncertainty after a critical financial and military attack
* major damage to the physical and electronic trading engines used in the markets
* billions in risk from uncertain claim amounts on major insurance carriers

To address the post September 11 crisis, the Federal Reserve used the repo mechanism to inject huge amounts of cash, including one infusion totaling $50.4 billion on September 19, the third trading day after markets re-opened. (#3) By September 20, total outstanding repos were valued at $75.3 billion. (#4)

The sequence and timing of the injections on August 10 are noteworthy as well. One day prior, the Fed injected $24 billion dollars yet the market plunged 387 points. (#5) Prior to the markets opening on August 10, an additional $19 billion was injected, yet the Dow dropped another 93 points immediately after opening. The Fed then had to publicly state to the market it would intervene throughout the day as necessary and, sure enough, it felt the need. The Dow dropped a net of 212 points before recovering to close only 31 points down.

A second key concern about the market picture is that central bank intervention was not limited to the United States. The European Central Bank announced its own weekend injection plan to the tune of $83.6 billion (US) beginning August 10 following a $130.6 injection completed on August 9. (#6) The Bank of Japan performed an equivalent operation worth approximately $8.4 billion (US) as its stock market plunged on fears over US mortgage problems. (#7). The need for simultaneous emergency interventions across multiple continents means the theories underlying a huge variety of derivative investments used to hedge against currency fluctuations and regional economic problems may all be at risk. Leveraged bets on those derivative instruments has wound up coupling the performance of investments thought to be independent or inversely correlated with one another, completely defeating the purpose of many of these investments.

Perhaps most disconcerting about the one-day $38 billion dollar injection is a change in practice announced by the Fed with the intervention. Each weekly report on the Fed's positions includes a footnote to the repurchase figures which states (emphasis added)

4 Cash value of agreements, which are collateralized by U.S. Treasury and federal agency securities.

In English, this means the Fed provides these repurchase arrangements and frees up cash for use by borrowing banks in exchange for very low-risk, "near-cash" securities. As very short term instruments, this improves liquidity throughout the system by narrowing the risk spread between the two classes of assets being swapped (cash to the banks, near-cash securities to the Fed) as much as possible.

In announcing its operations on August 10, the Fed actually stated it would accept mortgage backed securities (MBSs) as collateral. Of course, mortgage backed securities are the very instruments which have changed hands from sub-prime retail lenders to MBS intermediaries and now to top-line banks who have been purchasing the higher interest debt hoping to collect interest payments to help them pay higher competitive rates to their own retail money market customers.

Just stop and think about that for a moment. Some of the most risky debt floating around the financial industry that is CAUSING the financial instability is now being accepted by the Federal Reserve central bank as collateral for daily "liquidity lending" at the core of our banking system. This makes about as much sense as regular banks lending additional cash to pay-day loan stores experiencing a spike in demand for emergency cash and accepting held pay stubs from their end customers as collateral even though half of the pay stubs are from companies already on the brink of bankruptcy. The need by member banks to offer mortgage backed securities as some of their collateral on daily inter-bank borrowing means even top-line banks have virtually NOTHING left in the tank as a cushion to protect them from any surprises in their loan portfolios or the investments they've made trying to collect higher returns to turn around and offer higher returns to compete in a bubble financial climate.

Were the financial risks averted on August 10 nearly as dangerous as those in the days after September 11, 2001? The Fed certainly seemed to think so. In the absence of any other social, political or military input to cause a panic, the Fed's decision to intervene on a scale not seen since that obviously crucial period should make every American ponder how our economy is being operated and for whom. None of us have seen this exact movie before. It's still being filmed on the lot. However, I'm guessing the screenplay doesn't end with the words "soft landing."


#1) http://www.ft.com/cms/s/0b908a2a-4767-11dc-9096-0000779fd2ac.html

#2) http://findarticles.com/p/articles/mi_qa3678/is_200201/ai_n9039172

#3) http://www.cnbc.com/id/20211772

#4) http://www.federalreserve.gov/releases/h41/20010920/

#5) http://www.bloomberg.com/apps/news?pid=20601103&sid=aKF5hoe_fU2Y&refer=news

#6) http://money.cnn.com/2007/08/10/news/international/bc.centralbanks.reut/

#7) http://www.komotv.com/news/business/9086551.html