27 September 2008

Speculation re Federal Reserve illiquidity

In the last two weeks — if I am reading the Federal Reserves’ balance sheet data correctly — the Fed has:

  • Increased “other loans” to the financial system by around $230 billion (from $23.56b to $262.34b);
  • Increased its “other assets” by about $80b (from $98.67b to $183.89b);
  • Increased the securities it lends out to dealers by $60b (from $117.3b to $190.5b);

That works out to the provision of something like $370b of credit to the financial system in a two week period. That may be a bit too high: the outstanding stock of repos felll by $40b (from $126b to $ 86b), leaving a $330b net change in these line items. But that is still enormous.

The most that the IMF ever lent out to cash strapped emerging economies in a year? $30b, in the four quarters through September 1998 (i.e. the peak of the 97-98 crisis)...

This is a very real crisis. The Fed’s balance tells a story of extraordinary stress. I never would have expected to see the Fed lend out these kinds of sums over such a short-period...

(in the comments section):

I’ve been speculating all week that the pressure being used on the Congress to pass the Paulson Plan is the threat of Fed illiquidity. As of two weeks ago, the Fed had lent out more than $600 billion of its $800 billion balance sheet Treasuries against crap MBS collateral.

The Paulson Plan would have allowed the banks to unwind the repos putting the Treasuries back in the Fed, get cash for the crap MBS, and get more Treasuries from the issues financing the $700+ billion funding of the Plan. As a bonus, the Paulson mark-to-maturity price becomes the implicit Level 3 price for capitalisation of all the firms and banks in the system, giving them some breathing room to stay in business. Everyone wins except the poor American taxpayer.

The Fed is very close to being illiquid. That is the fear factor we are seeing at work, and the reason no one will discuss why the bailout is needed - only emphasise the urgency...

Treasury “is totally dominated by Wall Street investment bankers” and “cannot be relied on to objectively assess” the impact of government policy on the financial industry, Allison wrote in a Sept. 23 letter to Congress. The letter was verified by Bob Denham, a spokesman for BB&T, North Carolina’s third- largest bank...

“The theory here is that the Fed has destroyed its balance sheet by taking on increasingly large chunks of non performing assets (the “toxic waste” made from mortgage-backed securities and the like) in exchange for loans of “real” cash to banks that may still end up not repaying them.

It is effectively “broke.” This is not what is supposed to happen to a central bank, which can print money without restriction, so let me explain what this means: it can no longer help the banks in a non-inflationary way. In order to take on more toxic collateral from the banks, it would need to actually print money, which would immediately be visible and would be seen as very inflationary.”

“So this is a desperate gamble by Paulson and Bernanke to avoid the run on the dollar that would be triggered by direct cash creation.”

Every year thousands of firms fail. 4/5’s of all restaurants fail within 5 years, yet we aren’t bailing out the restaurant industry. The individuals working in the finance industry are some of the nations best and brightest. If they aren’t working in finance, they will find other well paying positions.

700 billion dollars is a tremendous amount of capital. If we add that to the existing national debt, aren’t we just increasing the risk that foreign lenders are going to stop lending to the US and cause a run on the dollar? How much debt to GDP can a country have before foriegn lenders figure that lending to the US is just too big of a risk of not getting paid back either because of default or because they will get paid back by dollars devalued substanially by inflation?

1 comment:

  1. The Fed has 1 trillion dollars in US securities from their bank members on hand earning 6%. As you know the share holders get 6% as a dividend from the US although we pay 0.13% for a 30 day note holder.



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