Hardly a Bailout / Hussman

Excellent sober analysis what the Fed and other Central Banks have done as you would expect from Hussman. There has been lots of confusion and misreporting what really happened last week. Click on the headline to read the entire piece. In combination with Mish´s take you should get a 360 degree view of the implications from this massive injection.

Wie man das von Hussman erwarten kann einer erstklassige nüchterne Analyse was genau von Seiten der Notenbanken in der letzten Woche veranstaltet worden ist. Klickt bitte auf die Überschrift um den kompletten Report zu lesen. Um das Bild abzurunden empfiehlt sich Obendrein Mish´s Post
The Federal Reserve did exactly what it was supposed to do on Friday.

As I've noted before, under most conditions, the Federal Reserve is irrelevant in the sense that (since the early 1990's when reserve requirements were removed on all but demand deposits) there is no longer a link between bank reserves and the volume of lending in the banking system. However, the Fed certainly has a role to play during bank runs and other crises where the demand for the monetary base soars.

That's exactly what the Fed did on Friday. Contrary to the apparent belief of investors, the Fed did not shift its policy, nor did it “bail out” the mortgage-backed securities market by “buying” them from banks.

What actually happened is that the Federal Funds rate shot to about 6% on Friday morning, and the FOMC brought it down to its target rate by entering into 3-day repurchase agreements . The banks sold securities to the Fed on Friday, and are obligated to buy them back from the Fed on Monday at the sale price, plus interest. Such open market operations are designed to ease the immediate demand for liquidity, and to give the banks and dealers more time to find buyers in the open market for the securities they are trying to liquidate.

This was not a major policy shift. Again, it was an effort to keep the Federal Funds rate at the current target of 5.25%, in the face of demand for base money that was pushing the Fed Funds rate to 6%.

These repurchase (RP) agreements fall into three increasingly broad “tranches:” 1) Treasury securities, then 2) federal agency debt, and finally 3) mortgage backed securities issued or fully guaranteed by federal agencies. “Today's RPs were of this type,” noted The Federal Reserve Bank of New York , which conducts the Fed's open market operations. So the Fed was not taking in the toxic, leveraged, exotic stuff.

Economist Steven Cecchetti concurs, “A quick look at the history of these temporary open market operations shows that they have been taking mortgage-backed securities as collateral for repo for some time. The quantities have normally been small (between $100 mil and $2 bil) but they have been doing it. So this is not what I would call an ‘intervention in the mortgage-backed securities market.' And it is not unusual.”

> SCHADENFREUDE that Greenspan new book is hitting the shelves just at the time his legacy is almost gone to zero.......

> Kann mit meiner SCHADENFREUDE nicht wirklich hinterm Berg halten das just zu Zeiten wenn von seinem Glanz der Lack komplett abgesplittert ist sein Buch die Regale entern wird.....

Now, the size of the operation ($38 billion) was unusual, as was the scale with which the Fed allowed dealers to submit mortgage-backed securities as collateral, rather than simply Treasury and agency securities. My impression is that in doing so, the Fed had no intent of “bailing out” the mortgage backed market, or of creating a huge “moral hazard” by absorbing losses for the irresponsible behavior of lenders. Rather, the Fed had to allow submission of mortgage-backed securities because that's what the banks actually own, and it's precisely the collateral for which the banks can't find a buyer.

Look at Treasury bill yields – they're dropping sharply again because investors are scrambling for default-free securities as a safe haven. Banks and dealers have no problem selling those puppies on the open market, so there's no reason to enter a Fed repo to do it. But banks have drawers full of the mortgage-backed stuff that they can't get rid of, so the Fed bought them more time by allowing them to post those securities as collateral for 3 days. Most likely, the Fed will have to do it again on Monday, but in any event, these are not securities that are going into the “investments” column of the Fed's balance sheet. They are simply collateral taken for short-term credit extended. The Fed does not assume a risk of loss unless the bank defaults on the repurchase agreement with the Fed

A few interesting details – in the midst of Friday morning's panic, banks would have liked to have done more. At the 8:25 AM operation, $31 billion of securities were submitted by the banks for repo, and $19 billion were accepted by the Fed. At 10:55 AM, $41 billion were submitted, and just $16 billion were accepted. But by 1:50 PM, the scramble for funds had eased somewhat - $11 billion were submitted, and $3 billion were accepted.

Given that about $1.4 trillion of interest-only adjustable-rate mortgages were issued in 2005 and 2006, and hundreds of billions in sub-prime mortgages are already delinquent, a $38 billion repurchase operation by the Fed, where the securities posted as collateral have to be bought back by the banks unless the banks default, is hardly a “rescue operation.”

The Fed has an interest in stabilizing the banking system and the real economy. It has no interest in taking the private sector's loss for the irresponsible lending practices of recent years, nor in saving overly aggressive hedge funds from the losses on their leveraged bets. Again, the Fed did exactly what it was supposed to do on Friday. There will inevitably be enormous losses taken as a result of mortgage defaults – but don't assume it will be the Fed that takes them.