The pawnbroker of last resort

Today was a big day in the markets with the FED announcing the creation of a new facility called the Term Securities Lending Facility. That is a mouthful that I can't remember. The dow surged 400points. Euphoria and relief. Some see it as the decisive FED intervention to resolve the credit crisis, others are already deriding it as a bailout that will ultimately cost the taxpayers. Me, I am just trying to make sense of it all, not exactly in real time but almost. This blog by Steve Waldman has greatly helped me get up to speed. I love the way this guy writes, very clear.

A refresh: the credit markets have been paralyzed since June 07 when the subprime losses started appearing. Housing collapses, prices go down, defaults spike, collateral damage is estimated at $300Bn. Damage is everywhere, no one know where. Interbank rates spike on 3 occasions reflecting the facts that the banks themselves don't know. Bank balance sheet take hits, leverage goes in reverse, credit markets freeze. The hit is compounded by illiquid assets that are accounted on "mark to market". Bigger writedowns driven by accounting. The banks in turn deleverage the hedges (aug 07). Markets have repeated barfs. Large portions of the banking system are suspected to be insolvent. Loop around one more time, actually two more times adn you reach now in the timeline. Are you scared yet?

The role of the FED is to safeguard the banking system by providing liquidity. They do so by lending cash. The FED is usually known as the lender of last resort.

The problem with the monetary policy of 'lender' is that it puts inflationary pressure on the economy. So Ben Bernanke has created a new facility that instead of injecting cash, essentially swaps assets. It is called "sterilized intervention". The FED is being dubbed the pawnbroker of last resort (via naked capitalism). By swapping illiquid assets, the mortgage based agency originated paper, for highly liquid T-Bills, the Fed are providing ample LIQUIDITY to the system.

The technicality is a tad more advanced: they give t-bonds, the t-bonds need to be repaid in 28 days. The collateral is WHATEVER (AAA subprime included). So the banks can now have some cash, they don't pay much for that honor and they have replaced even if temporarily, their illiquid subprime by cash. Of course, what happens with these short term debts is that they are rolled over and so the terms are extended as long as necessary.

But the net result is the same and the beauty of it? It creates liquidity but it doesn't add to inflation (hence the sterilized moniker). In fact it actually takes some money out of circulation in the form of interest payments. Some call the Bernanke tactic "monetary policy on the asset side of the balance sheet" (great blog: Paul Krugman of NYT). See Krugman, who seems to be a professor of econ at MIT? for wonkish explanations of Tobin equilibriums that explains all of this. I still have to understand ONE of those position diagrams and what they mean, so if a kind soul would be as good as to explain to me what tobin diagram mean, I would be for ever grateful. Last friday he criticized the FED by doing "too little" arguing that "sterilized intervention" while dramatic was usually unable to move the markets because they were too small. They really only served as a psychological slap to get markets back to reality. He was dubious as he said "this is the third slap in the face and it is scary". This time all he says is "half the FED reserve is committed (400bn), wow" (sic).

In other words, I read this as the most serious attempt to control this mess, the bet the bank intervention. If all goes according to plan: banks post collateral, get the tbonds, get the cash, shore up their sheets, start lending to each other, to others, stop clobbering baby hedge-funds, which in turn stop barfing in the stock market, the banks are saved, the markets stabilize, confidence is restored and there is a happy finish to this crisis. And if that $400Bn is not enough then there is more from where that came from according to the FED.

Nightmare scenario is subprime continues to wipe out money, the additional 400 isn't enough to cover the banks losses so they continue deleveraging, hedgies dies, markets tank, banks over-run the capacity of the FED to absorb the mess (1Tr) and print money on top. Of course that later scenario seems unrealistic as it will continue to swap illiquid assets for liquid ones until it runs out. So far a 20% decline in housing is 400Bn of losses so we would have to do 50% decline for the FED to really start sweating.

The banking industry has a market value of 2T so 400Bn represents... 20%. Interfluidity makes the point that since the debt roll over, the debt is factually equivalent to equity (where the repayment is the decision of the debtor: the FED are not going to redeem the money in 28 days, that is the whole point) and so the banks are being nationalized... 28 days later...

In the meantime, I feel like I am watching Star-wars, O-Benwan Bernbanker is our only hope and so far, despite the criticism, he is rising to the challenge and impressing a bunch of people who actually know what they are talking about. Me I am just in awe!