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Tuesday, March 11, 2008


fed announces new lending tool

a massive futures bounce on a federal reserve announcement of $200bn in treasuries to be lent in exchange for even private-label triple-a-rated mortgage-backed securities, and do so for extended terms of 28 days. the facility will be called the term securities lending facility, or TSLF (if TAF is precedent). as noted, the market is deeply sold and ripe for a bounce.

this move will liquify many mortgage-backed securities which cannot be sold at the moment but whose ratings have not yet been cut but perhaps should have been cut. note too that this will include -- for the first time -- broker-dealers who are not deposit-taking institutions such as merrill lynch or goldman sachs. as such, it is likely to go a long way toward solidifying (at least temporarily) the foundation of the big wall street trading houses -- which may put a floor under both credit and equity, both of which have been in forced liquidation mode. indeed, fil zucchi notes that the size of the facility is enough to soak up all the agency and mortgage-backed securities on the balance sheets of all the primary dealers!

this is a significant risk for the fed, which will now be taking on nominal credit risk -- something well outside its normal operating procedure. faced with what is shaping up as the most massive credit bust since the 1930s, ben bernanke is pushing the fed into strange territory. sooner or later, a great many MBS are likely not to merit triple-a. and there's the good possibility that one or more of the fed's broker-dealers will not survive the crunch.

you can't blame bernanke for innovating, in my opinion -- this isn't a mess of his making, after all. but in the end, while this may ease stress for a time -- perhaps a critical time, perhaps particularly for bear stearns -- the problem here is finally one of solvency. the fed cannot leverage these banks into better capital positions. ultimately, as real estate heads inexorably lower, recapitalization of money center banks will be required on a scale nouriel roubini envisions at 12-19% of gdp -- and many regional and smaller bank failures as well.

and indeed maybe these are in fact the first steps of a widespread nationalization of an insolvent american banking system.

the idea has been floated to have the fed start lending beyond primary dealers as well. if this were not a solvency issue, i might agree -- but what is protecting the fed from grave credit risk in the TSLF is the limitation of lending to the primary dealers, each of whom can be rescued under all but the most horrifying circumstances. the fed cannot be seen to be taking on the book of failing hedge funds, for example.

as it is, balance sheet constraints are starting to come into play for the fed. per steve waldman at interfluidity, it will have approximately $300-400bn more in sterilized capacity before it has to start issuing liabilities (ie, bills or bonds) to sterilize expanded lending and increasing its leverage. the fed's never done that, although third world central banks sometimes do in financial crisis. yves smith notes that that's really one more shot at what paul krugman thinks of as slapping the face of the market in the hope that this is all a panic that will pass.

update: per bca.

The Fed's latest move to introduce the Term Securities Lending Facility (TSLF) is an important step in relieving forced selling of high-quality MBS and Agencies, and in reducing the shortage of bank liquidity evident in wide libor spreads. However, we do not see it as a single-handed cure for current credit market woes, because the underlying problem is still in place: falling house prices and soaring foreclosures that have undermined collateral values and confidence in the banking system. The Treasury swap appears designed to alleviate pressures some dealers were experiencing over the decline in value of their holdings of agency bonds and MBS. Allowing dealers to swap these securities for Treasurys should stop these spreads from widening further, since dealers can sell Treasurys into the market instead of selling agencies and MBS. Thus, the TSLF will encourage some spread tightening in high-grade securities, but the announcement is unlikely to mark the end of the credit crisis or a peak in lower-quality spreads (especially subprime and Alt-A mortgage debt). For that, we need to see action directed at the bad bank debts or the struggling subprime homeowners. Bottom line: The TSLF is clearly a positive step but, in the absence of aggressive fiscal action, the pain in credit markets is likely to persist while home prices continue to fall and default/foreclosure rates rise.

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