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Friday, September 25, 2009


all rests on liquidity

i caught this bit in ft alphaville yesterday, but pragmatic capitalist expanded on it marvelously.

Banks are in the business of lending, but an odd thing has occurred while bank earnings soared – they were doing no lending! Banks have been hoarding record amounts of cash as the government floods their balance sheets via various programs and bailouts. Many assume that the banks are either attempting to loan the money or simply letting it sit on their balance sheets earning nothing. But Moonraker’s analysis raises a more nefarious possibility – the banks are effectively creating a ponzi run stock market in which they use the bailout money to drive various market prices higher and thereby juice their own earnings. It’s quite brilliant when you think about it – until the music stops.

this is more or less exactly what is going on in not only the equity market but credit markets as well. and that makes it absolutely paramount for the individual stock market player to study the liquidity picture for the banks closely. as the spigot shuts, equity will likely be quick to suffer.

there's been a palpable change in the news flow around liquidity provisioning in the last week or two. as examples, bloomberg and the financial times among others have started reporting on federal reserve discussions with primary dealers and money market mutual funds on the use of reverse repos to mop up balance sheet cash.

The Federal Reserve has started talks with bond dealers about withdrawing the unprecedented amount of cash injected into the financial system the last two years, according to people with knowledge of the discussions.

Central bank officials are discussing plans to use so- called reverse repurchase agreements to drain some of the $1 trillion they pumped into the economy, said the people, who declined to be identified because the talks are private. ...

“To be effective, the Fed would have to drain several hundred billion dollars worth of funds through these reverse repos, between about $400 and $600 billion,” said Joseph Abate, a money market strategist in New York at Barclays Plc, a primary dealer. “You may have a dislocation in the repo markets due to the supply effect of the Fed injecting such a large amount of extra collateral into the marketplace.”

Bernanke [has written] that reverse repos could be done with counterparties beyond the Fed’s primary dealers, which serve as counterparties in open market operations and are required to bid on Treasury auctions.

More trading partners may be needed since primary dealers have been shrinking their balance sheets the past two years, and likely can’t absorb an additional $500 billion of securities, according to Abate at Barclays.

those additional counterparties are the money market mutual funds.

The central bank wants to use the deep-pocketed sector to refinance part of the giant portfolio of mortgage-backed securities and Treasuries acquired during the crisis, using a technique called "reverse repos".

This would involve the US central bank borrowing from money funds using some of its assets as collateral, thus draining liquidity from the financial system.

Such actions would neutralise the monetary consequences of the assets re-financed in this way, although the Fed would still hold the credit risk and mark-to-market risk on the portfolio.

The Fed has already talked of conducting reverse repos with primary dealers including the former Wall Street investment banks. But it does not believe that they have the balance sheet capacity to provide more than about $100bn (€68bn, £61bn) of finance.

This is not enough, given how much its balance sheet has swollen. The Fed is buying $1,450bn of MBS alone and has created roughly $800bn in additional bank reserves since the crisis began.

this hasn't happened yet, but other examples of liquidity provisioning are already being retracted. under the rubric of quantitative easing, the fed has gone into the market to buy outright hundreds of billions in treasuries and mortgage-backed securities. chairman bernanke has tried to differentiate what he's doing as "credit easing", but the net effect is to flush primary dealers with newly-minted cash. these programs have virtually reached their planned dollar targets and have not as yet been extended.

banks have also been funding extremely cheaply for nearly a year on the back of FDIC-based guarantees of their newly issued debt. banks utilized the program to issue more than $300bn in refinancing bonds that would otherwise have been extremely expensive if not impossible to float. the program is being allowed to expire, with the already-depleted FDIC on the hook for a pile of credit risk, and banks going forward are likely to be faced with continued significant regulatory pressure to shift their funding profiles away from constantly rolling short-term paper (which fostered so much trouble in 2008) into more stable (and more expensive) bonds. but the situation is far more complex than rolling out a new regulation. from the economist:

Unsurprisingly, regulators think that forcing banks to find more secure funding, along with more capital, will make the system safer. The Basel club of bank supervisors is considering new liquidity rules, as are many national regulators. New Zealand has already drawn up concrete rules. It is not clear how far this can go. There can be no return to an idealised past where only a dollar deposited in a bank would be loaned out. To force banks to rely only on deposits would require a big shrinkage of their balance-sheets, with devastating economic implications. Besides, not all deposits are sticky. The Bank of England reckons that $100 billion of Russian deposits were shipped out of Britain in the last quarter of 2008.

Far from improving, the funding profile of the Western banking system has been getting even sicker this year. Banks have been raising equity and long-term debt and gathering deposits, but in the grand scheme of things their efforts have made little difference. For America’s top eight commercial banks such higher-quality forms of funding have risen only slightly, from 78% to 80% of the total in the past six months. America’s two surviving investment banks, Goldman Sachs and Morgan Stanley, still depend on shorter-term borrowing, usually secured with collateral. This is fairly reliable but, as Bear Stearns showed, in a market meltdown it can dry up without central-bank support. In Britain, Lloyds Banking Group, a leading wholesale-funds junkie, still has half of its total funding maturing in under a year.

If the duration of funding has not changed much, its source has. In America, the euro zone and Britain, central-bank lending and public guarantees of bank bonds have reached about $2.7 trillion. That equates to about 9% of banks’ wholesale funding, using IMF estimates. Support is concentrated on the banks with the worst funding profiles. So Dexia in Belgium has €82 billion ($117 billion) of state funding, and Lloyds could have up to £100 billion ($162 billion).

The original idea was that state support could be withdrawn swiftly as the panic subsided. America’s main debt-guarantee scheme will close to new issuance next month (with those guarantees already issued expiring in 2012). Europe’s schemes are typically due to close by the end of the year, with guarantees expiring between 2012-14. The hope is that banks will not only be able to refinance debt on their own but also extend its maturity, cutting their dependence on fickle short-term funding.

Funding strains have eased. So far this year, Western banks have issued $645 billion of bonds without government guarantees, according to Dealogic, a research firm. But the idea that the banking system can improve its funding profile at the same time as it weans itself off explicit state guarantees looks wildly unrealistic. This partly reflects the sheer volumes of debt involved. As well as turning over existing short-term borrowings of some $18 trillion, Western banks have to refinance longer-term debts that are maturing at the rate of about $1.5 trillion a year. With securitisation markets damaged and confidence in banks battered, that will not be easy.

It is also unclear that the most needy banks can borrow freely yet. Lloyds issued an unguaranteed and unsecured ten-year bond on September 3rd at 193 basis points above government yields, about double what the safest British bank, HSBC, might pay. Not only is this rate “uneconomic”, according to one banker, but Lloyds only raised €1.5 billion, a drop in the ocean. In July Dexia sold a similar five-year bond at 160 basis points above government yields, but the issue size, at €1 billion, is also tiny relative to its needs.

central bankers have really provided two kinds of liquidity support for banks in these difficult times. the use of the federal reserve's balance sheet through repos pushed treasury bonds into the banks and less marketable debt into the fed. these t-bonds could then be used to raise cash on the asset side of the banks' balance sheets. the second form -- and the more important, in my eyes -- was the earnest support of commercial bank (and select other) liabilities through both the fed and the treasury by way of TARP. the alphabet soup of fed special programs in support of money markets, commercial paper, et al were all essentially aspects of this aim, as were FDIC bank debt guarantees. without them, a fast-motion replay of the banking system collapse of the 1930s was a mortal lock. the question, though, is really whether they can even yet be removed.

the economist points out the incredible scale of the funding profile problem that have accrued in the western banking system as a direct result of decades of current account deficits -- "As the Western banking system has expanded over the past two decades its assets have grown to about 2.5 times its deposits" -- "As well as turning over existing short-term borrowings of some $18 trillion, Western banks have to refinance longer-term debts that are maturing at the rate of about $1.5 trillion a year". these are absolutely boggling figures, and put into stark relief the practical limitations of the federal reserve in dealing with systemic funding difficulties in the intermediate term, though that the fed stemmed the tide last year is without question.

stability aside, the difficulty going forward is that wholesale funding, particularly if it is of longer duration, is relatively expensive. many deposit-poor banks may find themselves, without the help of the fed in procuring funding, in a position where the sensible thing will be to divest of assets and contract the balance sheet into something more in line with their deposit base. this means pressure on asset prices -- the opposite of what has been enabled over the last six months.

in summary, it looks very much like the government support of liquidity provisioning for the banking sector is waning in the aftermath of an inventory cycle in the economy and a massive liquidity-fueled rally in the tail end of the systemic capital structure. withdrawal of both liqudity-enhancing asset swaps and direct support of liabilities could have important ramifications for this rally.

UPDATE/ADDENDUM: it's also important to note that this is not exclusively a US story. as alphaville cites today, europe ex-germany is largely in the same position if not worse. the european central bank is there playing exactly the same role as the fed here, and are at a similar juncture.

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