Friday, April 4, 2008

these past few weeks have been extraordinary in that the fed has had to take actions that have not been used since the depression and a few that heretofore have never been used. the culmination of increasing risks in our financial system forced the fed to take the recent extraordinary actions of creating two new lending facilities for primary dealers and facilitating a merger of bsc with jpm to prevent a liquidity and solvency crisis from potentially toppling the us capital markets.

as the fed lowered its fed funds rate, a growing flight to quality, as reflected by the rush into treasury securities and away from any security that might have credit risk, began to take hold. despite the decline in treasury interest rates, these declines did not spread to other areas of the capital markets, as exemplified by the 30-year agency mortgage-backed securities market, where yields rose while treasury yields declined. at one point, fnm and fre yield spreads increased to over 300 basis points above the treasury curve versus a more normal 150 basis point spread. our capital markets were shutting down since participants did not trust the counter parties with whom they were trading.

from the beginning of this credit crisis, it was apparent that deflation in the value of assets would create widespread balance sheet impairments within corporations, consumers and other involved parties; therefore, counter party solvency risk was likely to become an important issue. it appeared that the fed might be starting to realize this when they announced their first move on 12/12/07, with the establishment of the Term Auction Facility (TAF) to provide greater liquidity to the system by accepting a wider array of qualifying securities for term funding to depository institutions. this facility was increased in size on 1/4/08 and again on 3/7/08. subsequently, on 3/11/08, the Term Securities Lending Facility (TSLF) was created to provide treasury securities to primary dealers in exchange for a wide array of qualifying securities for a 28-day term. on 3/16/08, the primary dealer credit facility was created to provide overnight funding to primary dealers in exchange for qualifying securities that include corporate bonds, municipal securities, mortgage-backed securities and asset-backed securities. these last two programs provide liquidity assistance to primary broker/dealers and are the first of their type since the depression in the '30s. this is a fundamental change in the policies of the fed and may place its balance sheet at risk because of the potentially risky nature of the securities pledged. the fed did not regulate broker/dealers since this was the responsibility of the sec. now it appears the fed has become the lender of last resort to a borrower that had not been regulated or subject to review by the fed. in essence, the balance sheet of the fed, and potentially us taxpayers, is being placed at risk for institutions that increased their balance sheet leverage and risk, during good times, so as to enhance their firm’s profitability but now, during a time of difficulty, they are looking to the fed to be the savior, despite their previous business mismanagement practices. is this is a strategy of heads they win, tails the us taxpayer loses? these recent fed policy changes have taken place without a full public discussion with congress. it appears the fed saw fit to do this since there was a vacuum in the capital markets and the risks were beginning to spiral out of control.

the fed also resorted to a depression-era clause, Article 13 (3) of the Federal Reserve Act that is to be used only in “unusual and exigent circumstances,” to deal with the bsc crisis. the fed initially guaranteed $30 billion of bsc assets so that jpm could acquire the company for $2 per share. this is the first time since the depression that the fed will be taking brokerage firm collateral onto its balance sheet and placing itself at risk because of the excesses and unsound business practices of a brokerage firm. in an earlier era, bsc would have been left to fail. this is not the case today since there was apparently a deep fear on the part of the fed that a failure of bsc could create a domino-like crisis infecting a wide array of financial institutions, thereby accelerating and deepening the current credit contagion. one interesting question yet to be answered is how much counter party exposure did jpm have to bsc. some are calling the entire bsc/jpm transaction suspicious. they are saying that if the situation were so precarious, why shouldn’t shareholder ownership have been entirely wiped out because of the excesses and mismanagement by their firm? they want to know why the fed's balance sheet should be placed at risk while shareholders are receiving some type of compensation. of course, a week later, the bid was raised from $2 to $10 per share, increasing the value conveyed by approximately $1 billion.

derivatives are an interesting subject. within the greater derivatives market, there is a segment, referred to as credit default swaps (CDS), which has grown from $900 billion in 2001, to $45.5 trillion in 2007. these swaps offer bankruptcy protection to a corporate lender or a chip on the gaming table to a speculator. an earlier derivatives market meltdown occurred with the collapse of Long Term Capital in 1998. despite its collapse and the emergency creation of a rescue group of companies (tellingly, bsc declined to participate), the derivatives market was allowed to explode in size, while various regulatory agencies did little to control or moderate the potential risk that was developing. apparently market participants and regulators learned very little from this near cataclysmic event. in the case of bsc, it held $2.5 trillion of swap contracts, according to the 3/23/08 new york times article, “What Created this Monster?” apparently, the risk of a CDS contagion helped to force the fed’s hand to create a bailout of bsc.

in my opinion, a new financial system is in the process of being created, a beginning of a new era. call it the pre-bsc and post-bsc. obviously the fed will not place its balance sheet at greater risk without having some type of regulatory authority over those financial institutions that now have access to its liquidity services. in essence, new and increased levels of regulations are a likely outcome from this series of events. i think primary dealers and the rest of the brokerage industry will be subject to greater regulatory oversight, with a concomitant reduction in firm flexibility and financial leverage. these new regulations will also likely limit customer financial flexibility and, thus, they may potentially lessen the availability of credit. furthermore, the consolidation of regulatory authority into a central regulator does not, in and of itself, ensure that systematic risk to the us financial system will be reduced. unless the fed or the new central agency that is established have the regulatory authority and courage to act, nothing will have changed. as an example, the fed had the authority to influence or control the excesses that developed in mortgage loan originations by its regulated depository institutions. the fed did not act, despite federal reserve data showing that mortgage lending was getting out of control. have the fed's recent actions increased the likelihood of an increase in moral hazard risk or the socialization of risk? by this i mean that there is a movement at various levels of government to stem the tide of mortgage foreclosures while trying to increase the level of liquidity available in the mortgage market. fnm and fre recently had their special capital requirement reduced from 30% to 20%. that previously higher capital requirement had been put in place because these two agencies had engaged in reckless and questionable accounting and management practices. they were not in a position to address this mortgage crisis, for which they had originally been created, because their balance sheets had become impaired by unsound profit motivated activities. they were just too financially leveraged. with this new lower level of required capital, subject to raising a non-disclosed amount of new capital, they are now being placed in a position that would allow them to acquire $200 billion of additional mortgage securities. should this new flexibility lead to their balance sheets becoming overextended again, there is the potential risk that taxpayers may be forced to ride to their financial rescue. in addition to these actions, the fhlb is being asked to increase its purchases of mortgage-backed securities by $160 billion. finally, senator dodd and congressman frank are in the process of crafting legislation that would possibly create a new entity to help deal with a prospective flood of potential foreclosures. this new entity could buy as much as $300 or $400 billion of mortgages under various types of aid packages. they are not referring to this as a bailout but rather as a “rescue” package. because of the recent fed action that bailed out bsc and their counter parties, we can expect to hear the argument that, if wall street can be bailed out, why should there not be some help given to main street?

will the fed become even more politicized? with the taxpayer’s purse being placed at greater risk by these governmental entities’ increased financial risk, the process by which the fed conducts monetary policy may be placed in jeopardy. will the fed be as willing to raise interest rates to fight economic excesses or inflation if it means it could cause losses for these governmental entities or place the american mortgage borrower at increased financial risk? should individuals and financial institutions conduct themselves in a financially prudent manner, knowing that the government will likely ride to their rescue? why shouldn’t they take increased risk with the expectation of short-term gain, while laying off long-term risk to the government?

ever since the government bailout of chrysler in 1979-80, this country has been on a course of raising the safety net so that the market’s discipline, in a capitalistic economic system, has been truncated (although chrysler paid the loans back early and the government actually made money on that deal). the market’s discipline has not been allowed to work for fear of the potential economic fallout. has this been the correct or incorrect choice?

for better or worse, a new financial era is upon us.

disclosure: long jpm

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