Tuesday, October 07, 2008
purchasing commercial paper
The U.S. Federal Reserve is reportedly looking at getting into unsecured lending, an extreme step that could allow it to directly purchase commercial paper, according to a report in the Financial Times. The report said the Fed had never done so in its history, but doing so could allow it to participate in the frozen inter-bank money market and the contracting commercial paper market. The Fed doesn't believe it has the legal mandate to make unsecured loans, so it would need the Treasury to guarantee any losses.
this most recent slide is, to my way of thinking, the market starting to price the worst case scenario -- the collapse of deposit intermediation, the inability of banks to funnel deposits to commercial use.
the death of interbank lending is very serious, but it represents a migration from peer-to-peer to a server-client model (with the federal reserve as server). that could continue for some time, provided that the server remains healthy and that most banks are able to present useable collateral.
but the retraction of deposits from non-financial commercial paper represents illiquidity for non-financial corporates. as their short-term debt rolls off, if it cannot be refunded, it must be paid out of cash or the company default. ford recently paid $1.2bn in roll-off CP in cash. that cannot last long, as cash balances are limited in many cases. the economist suggested that CP could remain in such a condition for a week or so before defaults begin in earnest. and that is how a severe depression could kick off.
moreover, banks have been hitting up the financial CP market for funding as well, presumably for funds they cannot get through the fed. this, in combination with the flight to treasuries, is forcing CP raes much higher where it is possible to sell at all.
the fed has heretofore restricted itself to lending against discounted collateral. it has widened what it will accept, surely, but it is secured lending. CP is unsecured -- meaning the program could get as large as needed (regardless of how little collateral could be offered) to prevent a wave of sudden bankruptcies.
a sufficiently large program could mean the end of this most brutal phase of the credit crunch.
as suggested above, the fed would be taking massive credit risk -- these loans are unsecured, even if CP has historically been very safe. treasury would have to assent in case the need arose to recapitalize the fed.
UPDATE: the fed has announced a plan to do it -- futures are skyrocketing.
UPDATE: more from FT -- CP will be purchased and dumped into a special-purpose vehicle (a government super-SIV, in essence) -- acronym CPFF (commercial paper funding facility) -- will buy 3-month (longest duration) both non-financial and asset-backed. that last is particularly risky, as ABCP is very questionable. in some respects, this is a widened version of the super-SIV, which failed to get off the ground in large part because private parties were to fund it.
By eliminating much of the risk that eligible issuers will not be able to repay investors by rolling over their maturing commercial paper obligations, this facility should encourage investors to once again engage in term lending in the commercial paper market. Added investor demand should lower commercial paper rates from their current elevated levels and foster issuance of longer-term commercial paper. An improved commercial paper market will enhance the ability of financial intermediaries to accommodate the credit needs of businesses and households.
UPDATE: alea -- and last night on the rumors:
Now that they have comprehensively destroyed unsecured lending, the Fed is said to be scheming to revive it. Sorry, won’t work, banks need to raise capital and they have no incentive to raise it as long as they can feast on subsidized lunches, courtesy of the Fed.
UPDATE: above caveat is very important -- "a sufficiently large program". the non-financial CP market is $1.6tn deep, and has contracted at a rate of $60bn a week recently.
UPDATE: immediate effects, via john jansen:
The IG 11 closed last night at 177 1/2. Following the Federal Reserve bail out of the CP market the index is around 161 1/2.
UPDATE: sorry for the stream of consciousness -- i commented at dash of insight:
i agree that incrementalism is most often good, prof -- but i do think there is room for measured criticism of policy responses so far. particularly in the interbank lending market, where the fed's facilities have effectively crowded out private lending because the fed isn't lending "freely at a punitive rate". in offering secure financing too cheaply, now they've got a huge slice of the interbank market with no good plan to wean banks off -- creating significant credit risk for the fed.
it seems to me that they've (accidentally?) created the need to either bail out the fed with the paulson plan -- directing treasury asset purchases to banks who have participated in the TAF in order to relieve the fed of their exposure -- or create a new capital-injection facility to protect the fed from TAF failures that would stick the fed with shoddy collateral.
and now this CPFF, which looks totally necessary to me to prevent cascading non-financial failures -- but also represents an acknowledgement that letting lehman and wamu fail exposed the reality of large capital shortfalls on mismarked portfolios that can wipe out most of the capital structure in liquidation. fear of that won't abate with the CPFF, i suspect, leaving the fed with a huge pile of CP to buy -- and risk that expands into non-financial failures associated with consumer retrenchment.
would you agree that financials need capital to restore confidence and can't raise it except on the most uneconomic of terms? if so, isn't an explicit RFC the destination -- even if it can't restore the good old days of irresponsible lending? and so why dither with the increments, allowing time to foment panic and worsen the damage that will need to be repaired?
there's a looming terrible reality here highlighted by willem buiter (via yves smith), perhaps first glimpsed by many when lehman defaulted.
Buiter suspects that the banks as a whole are insolvent even if they hold assets to maturity. In other words, the argument that bank distress is due in large degree to mark-to-market pricing meeting a panicked flight to quality is wishful thinking. While many readers of this blog would agree with that view, it's quite another for an economist with considerable central bank/regulatory experience to voice that opinion.
and as the BCA said yesterday:
In a recent Special Report, we highlight that it took a massive policy response in prior real estate/financial sector crises (e.g. Norway, Sweden, Finland, Japan and the U.S.) before markets stabilized. In fact, in each episode conditions did not stabilize until the vast majority of struggling institutions were supported or dissolved. In three instances the government needed to extend a blanket guarantee for the entire banking system. Moreover, the longer policymakers delayed a sizable bailout package, the greater were the economic and banking sector losses. Bottom line: History suggests that a rapid and sizable policy response (that deals with the majority of problem loans) is needed when faced with a banking crisis. Hesitation allows a negative economic feedback loop to develop, ultimately leading to greater cleanup costs. This is already evident in the U.S. and Europe, where recessionary pressures are intensifying.
buying CP (and lots of it) can prevent immediate cascading collapses, financial and non-financial, that would echo around the world -- but it won't fix that core issue, and so won't unjam credit markets. bank recapitalization is what is needed, and much more than the paulson TARP seems to provide for. though indeed no one knows how much capital is needed until some floor can be established for house prices -- one that might be very far away indeed as recession picks up steam.
and, truthfully, there's another roadblock after that -- as highlighted earlier in examining the case of japan, recapitalized banks are extremely unlikely to support overleveraged shadow banking components, overleveraged housing and overleveraged consumers. japan's banks abandoned japan's former bubble economy and made their new loans overseas. i'd expect as much of recapitalized american banks.
UPDATE: yves smith on the CPFF.
UPDATE: minyan peter:
I would offer that this is a net negative and represents yet another focus, by the regulators, on the effect and not the cause of the problem. Clearly the Fed is trying to use its balance sheet, rather than bank balance sheets, to solve the problem. (For background, when corporations can't rollover maturing commercial paper and don't have liquidity on hand, they borrow from banks under standby credit lines.)
The Fed is clearly trying to forestall this, as commercial banks have neither the liquidity nor the capital to move another $1.0+ trillion of maturing commercial paper onto their balance sheets in the form of loans.
To me a much better solution on the part of the Fed/Treasury would be to take the $700 billion approved under the bailout bill and put it into the banks as equity. Now, assuming half of the amount is used to writedown toxic assets, the remaining amount could support $3.5 trillion in potential credit capacity.
UPDATE: nouriel roubini, via a contrite felix salmon.
We are near total financial and corporate meltdown dude.
At this point the ony institution able and willing to lend is the Fed. That is why I suggested last week the CPFF to avoid this meltdown.
First you avoid a systemic collapse that was literally a couple of days from occurring. Once things have calmed in a few weeks you can start thinking about ways to restore lending among private institutions.
Yep we have reached the point where the Fed is the only bank in the land or, better, in the globe as the huge swap lines now allow the Fed to lend dollars to non-US banks outside the US.
That means that the Fed will now lend to banks, to non-banks in the shadow banking system, to corporations and to state and local governments. There is no one else lending now as counterparty fear is extreme.
Read my February 12 steps to a financial disaster paper. We are now as I predicted at step 12
Sorry if I now say I told you so...
UPDATE: more from john jansen:
The Yankee banks are significant users of the commercial paper market and issue for size. In the glory days of the 1980s and 1990s when the system was awash in a sea of liquidity, many of these Yankee banks chose not to endure the legal and regulatory morass that issuance in the States required.
Therefore, many chose to repatriate there commercial paper issuance to the home country and fold it into to a global issuing network. That was a great idea at the time but does not work as well now as the Federal Reserve program requires that the issuer be domiciled here in the USA.
So that will shut out of the market about 50 percent of the issuers of CP. My trader friend suggested that possible European governments might consider a similar program.
The second problem is that the Federal Reserve facility only applies to the pristine A/1 P/1 borrower. It does not aid the lower quality A2/P2 borrower. These borrowers represent another 10 percent of issuers.
So the Federal Reserve is in the game but it will take the market some time to decipher the ultimate meanings of today’s radical actions.
UPDATE: and yet more from the indispensible john jansen:
The corporate bond market is mired in a melancholy malaise. Sentiment is glum and no amount of good news can shift sentiment. The Federal Reserve announcement this morning of the CP rescue package should have sparked some buying. One veteran corporate bond salesman noted that he saw not even a nibble.The Bernanke speech today was essentially a notice that the FOMC would lower rates at the next regularly scheduled meeting. That should have brought some cheer to investors but if it did, they chose to do something other than opening their wallet to procure corporates.
The IG 11 which traded as tightly as 161 ½ after the Federal Reserve CP announcement is back to 170.
The salesman with whom I spoke offered the saga of the GE 10 year note. It began the day 425/405 and moved to 395/375. The issue has surrendered those early gains and is now 415/295.
this looks like a vote of no-confidence, but frankly i suspect roubini is right -- a major disaster is probably going to be avoided by this action, PROVIDED that it is put in place with all alacrity (ie, today or tomorrow). perhaps when the fed starts purchasing things will lighten... and perhaps not. as above, this staves off one avenue of collapse but does not solve any fundamental problem.