Sunday, June 29, 2008

Why Bennie Can't Lend

Those of us from a certain age will recall a book about the failings of the education system called Why Johnnie Can't Read. Well, we're about to see the failings of the financial system exposed in similar fashion. The Fed has gone from "savior" that will "bail out the market" to talking tough on inflation and pointedly refusing to promise further rate cuts.

So when did this happen and why? The first thing to note about the Fed is they don't actually determine interest rates. They have the ability to set the Fed Funds target rate but then they have to go out and defend it in the marketplace - just like any other private entity seeking to set an arbitrary price. The strongest tool they have in this price-fixing scheme is the aura of omnipotence that they have acquired over the years so few other players are willing to take them on. A wise Fed chairman knows this and sets the target close to the market rate to avoid a test of wills that he might lose - along with his credibility in the process.

So let's look at the resources they have available to defend their chosen target rate. The Fed began 2007 with $277 billion in Treasury bills. As of the August 23 report, that number was unchanged but things began to move quickly thereafter. From the late summer of last year the Fed reduced its T-bill holdings by $76.7 billion by the March 6, 2008 report, which works out to about $12 billion per month. This was accomplished by bills maturing and not being rolled over as they usually would, which was sufficient to fund the TAF and discount window lending. Then things changed.

Storm Warning
In March, something really bad was brewing. We would later find out that Bear Stearns, a major investment bank was in the process of going under. Demand for Fed loans picked up dramatically and maturing T-bills no longer provided enough cash to fund the demand. So, for the first time since the crisis began, the Fed began to sell outstanding Treasury debt from their own inventory in order to supply the funds for the Primary Dealer Credit Facility (PDCF) which was introduced in early March:

3/7 - $10 billion sold
3/12 - $15 billion
3/17 - $18 billon
3/19 - $15 billion
3/25 - $12 billion
3/26 - $9 billion
total - $79 billion sold in 3 weeks

Of course, that is in addition to the normal process of runoff as bills mature. The numbers can be easily confirmed with a search of the NY Fed's permanent market operations. These actions pushed the 3-month bill's yield from under 1.0% to 1.4% in a short period. In addition, the Fed also began to sell off its longer-term Treasury obligations - $35 billion worth in 7 auctions through April 3rd. This pushed the yield on the 10-year (TNX) from 3.3% to 3.6% over that time. They sold another $30 billion in May, helping to push the yield on the TNX north of 4.0%. These actions account for the entire 12-month decline in longer-term treasuries. I'm virtually certain that the initial upward push in Treasury rates was welcomed as an "end to fear" and "return to normalcy" - also helping to push down risk spread by the simple expedient of increasing the base rate. I doubt that the second surge above 4% was quite so welcome and a repeat of that right now would be quite a major problem for the Fed.

The Box
We have now seen that the Fed can move longer-term interest rates if it has the resources and is willing to suffer the consequences of those actions - just like any other private bank or bond market player. We also note that there have been no open market sales of Treasuries since late May and the accompanying spike in the 10-year rate - critical since standard fixed rate mortgages are priced off of that rate. Even without selling pressure from the Fed, the TNX is still hanging out right around 4.0%. The rise above 4.3% must have scared the Fed to death since they reversed their rhetoric and even obliquely threatened to raise the Fed Funds target. Another half-point rise in mortgage rates would be likely to finish off a housing market already on life support and Bernanke doesn't want that on his record.

The state of the bond market leaves the Fed unable to sell any of its longer-dated Treasuries without severely damaging consequences. Yet long-dated securities are essentially all they have left - Treasury notes (2-10 years) and bonds (30 years) equal $412.4 billion. That compares to only $21.7 billion of the original $277 billion worth of T-bills. This is all that the Fed can really use without inflicting damage on the bond market that will be somewhere between severe and completely counter-productive.

June 19 H.4.1 report


This is the box that Bernanke is in. He can declare a cut in the target rate but he has no ammo to defend it. $21 billion is nothing and trying to defend a lower target and failing would be the worst possible outcome. The market may eventually give the Fed room to cut another quarter point but economic conditions will have to deteriorate further before that happens. Worse yet, the market appears to know that. The one tool that can still be used is the Term Securities Lending Facility (TSLF) but the Fed is growing more reluctant to lend out its remaining hoard of high-quality Treasuries in return for toxic waste from the banks and brokers.

As we have pointed out before, the Fed has always had the ability to hide problems temporarily by papering over the cracks. In this case, they lent a lot of money to the commercial and investment banks so they would be able to hold assets instead of selling and recognizing the losses. If confidence and credit growth return quickly, this can reduce the pain. However, they do not have the ability to actually solve problems in the credit market and papering things over only makes things worse if the problem does not go away on its own. That is happening now as banks that should have sold before are now going to be forced to sell at lower prices and bigger losses. By trying to avoid a "fire sale" the Fed merely created a bigger one with a bit of a delay.

That is where we are now. The Fed has failed. The Great Oz has been exposed a just a man behind the curtain. Prepare for severe credit deflation and falling asset prices in markets that traditionally use leverage to purchase or hold positions.