The Fed is Getting Desperate

http://www.rgemonitor.com/blog/roubini/252573/

Financial markets – especially the equity markets – have somewhat recovered since the financial markets reached a point of near meltdown around the time of Bear Stearns collapse. But the strains in money markets and credit markets remain severe and show little sign of improvement.

In mid-March – at the peak of the crisis - the Fed did not just partially bail out the Bear Stearns shareholders who would have been totally wiped out in the case of a disorderly collapse of Bear Stearns; more importantly the Fed bailed out JP Morgan that had – like Bear – and still has a massive exposure to the CDS market; it bailed out the creditors of Bear Stearns who would have suffered massive losses if the Fed had not outright bought $29 billion of toxic securities held by Bear; and it bailed out Lehman, Merrill and a good chunk of the shadow financial system as the Bear Stearns bailout – together more importantly with the new TSLF and the PDCF – ensured – for the first time since the Great Depression - that systemically important broker dealers would have access to the lender of last resort support of the Fed.

While the extreme tail risk of a systemic financial meltdown – and we were in mid-March one epsilon away from such a generalized run on most of the shadow banking system – was avoided by the trifecta of the Bear Stearns bailout, the TSLF and the PDCF the stresses in the financial markets – liquidity and credit crunch - remain severe as even the FOMC had to admit in its latest statement.

The severity and persistence of the liquidity crunch is evident from the fact that in the interbank markets spreads relative to Libor remain extremely high and still close to their peaks since this crisis started last summer in spite of 325bps Fed Fund ease by the Fed, in spite of the creation and vast expansion of the TAF auctions (now up to $150 billion over a month), in spite of the creation and extension of the TSLF, in spite of the creation of the PDCF. So now after the Fed has already allowed banks and non banks primary dealers to swap hundreds of billions of dollars of illiquid MBS (and now even any “good quality” ABS), after it has allowed the non bank primary dealers to have access to the Fed discount window on same terms as the banks, it has now decided to allow even non-US banks outside of the US to have access to the liquidity support of the Fed: indeed given the stubborn recalcitrance of term Libor spreads to fall in the US, UK , Europe and around the wor!
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Fed now claims that this stress in money markets is due to the fact that non-US banks are short of dollar liquidity and are thus putting pressure even on the borrowing rates of US banks.

So while foreign banks and foreign primary dealers already present in the US can have access to the Fed liquidity and Treasuries-swap-for-illiquid-assets facilities foreign banks without US operations now also need to be provided with the lender of last resort support of the Fed. How to do that? The Fed just announced a significant increase of its swap facilities with European central banks: the latter will be able to swap their euros, swiss francs, etc. for US dollars and then relend these dollars to their own banks that are structurally short of dollar liquidity. So, via foreign central banks now the Fed will also try to provide its safety net to non-US banks.

So as the stress in interbank markets is showing no sign of relenting the Fed has increasingly resorted to new operations that incrementally increase the number of institutions that have access to its safety net and the nature of its safety net: direct Fed Funds easing of 325bps and parallel sharp reduction of the discount rate; creation and now massive extension of the TAF that provided term liquidity to US banks; creation of the term facility (TSLF) that allowed both banks and non-bank primary dealers to swap illiquid MBS and now ABS for safe and liquid Treasuries; creation of the primary dealers credit facility (PDCF) that vastly extended the lender of last resort support to systemically important non banks (primary dealers); creation and now further extension of swap facilities with foreign central banks that will allow even non-US banks operating abroad to have access to the Fed’s dollar liquidity.

The Fed is getting most creative and desperate as all these facilities have done very little to reduce the liquidity crunch in spite of the fact that now $500 billion out of the $700 billion of safe Treasuries held by the Fed are now committed to be swapped for illiquid assets on the balance sheets of US and non-US banks and non-banks. That is why the Fed recently leaked even more non-orthodox ideas that are being discussed on how to buy even more illiquid assets once it runs out of safe Treasuries to swap: borrowing from the Treasury bonds to be swapped for illiquid MBS/ABS, issuing Fed debt notes (like the sterilization bonds used by some central banks to perform sterilized intervention, paying interest on reserves to potentially massively increase the liquidity available to banks without blowing the monetary base, etc.).

But in spite of all of these interbank spreads – both the Libor-OIS spread and the TED spread – remain stubbornly high and only modestly lower than their recent extreme peaks. Why? Banks and non bank primary having access to the Fed liquidity are hoarding such liquidity and not relending it to the other members of the shadow banking system for two reasons. First, they need that liquidity for themselves as the roll-off of SIV and conduits and concerns about future liquidity needs have led to a massive need for liquidity insurance; second, given the counterparty risk – who is holding the toxic waste and how much of it – that an opaque and non-transparent financial system has created no one trust its counterparties and is willing to lend them money on a term basis. Given this fundamental lack of confidence and trust in counterparties the money markets remain totally clogged and the massive orthodox and non-orthodox actions of the Fed have very little effects. Yes, now in
addition to banks, a dozen non bank primary dealers have access to the Fed liquidity. But thousands of other members of the shadow banking system – SIVs, conduits, money market funds, hedge funds, private equity funds, smaller broker dealers and investment banks – don’t have access to such liquidity. And most of these members of the shadow banking system borrow short and in liquid ways, are highly leveraged and lend or invest in longer terms and more illiquid ways. So they are all subject to liquidity or rollover risk.

So the liquidity crunch remains severe in spite of all of the extreme policy actions by the Fed and other central banks. In forthcoming note we will show why the recent stock market rally is just a bear market sucker’s rally; and why the credit crunch is getting worse rather than getting better. The worst is still ahead of us both for the real economy that is spinning into a more severe recession and for financial markets where unrecognized losses are much larger ahead than the losses that have been already recognized.





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