07 March 2008

Is the Fed Monetizing Bad Debt?

There is a funny situation going on with the Fed this morning.

As you know the Fed conducts two types of open market operations, permanent and temporary, through their NY office. This is how they manage their monetary policy.

There is a third type of hybrid repo recently created called the Treasury Auction Facility (TAF). Its similar to the Temporary Open Market Operation except its opaque and the terms are lengthier, and the types of collateral they accept appear to be looser than the Treasuries and agencies which are customary. Its a kinder, gentler, more discreet Discount Window. They kicked the amount up to 100+ Billion this morning. We like to think of it as "free money (below the inflation rate) for the banks" in return for shakey collateral.

Here's what we find confusing. The Fed has not conducted a 'Permanent Open Market Operation" since May 2, 2007. That's right, almost a year ago. At least, that is, before this morning when they conducted a 10 billion dollar permanent operation.

NY Federal Reserve Permanent Open Market Operations

What surprised us was that this is not an ADD, which is a purchase on their part and an addition to the money supply, but a sale of Treasuries to the banks by the Fed out of their own account in return for 'cash' which is considered a DRAIN.

Huh? The big tickle has been the liquidity crunch, so the Fed does a DRAIN?

Here's our take. The Fed has been taking all sorts of collateral from the banks at the TAF window. The banks are going to have to mark this debt to market at some point. We don't know how the Fed is actually valuing it for their repo purchases, since it has no liquid market.

In turn, the banks have plenty of short term liquidity. but they need to recapitalize and use that to build their cash flows with a 'multipler effect' which is tough to do with short term monies. The multiplier of a permanent add is 9x based on a 10% reserve requirement.

So the Fed, having just lent the banks 'cash for whatever' turns around and sells US Treasuries to the banks in return for the amount of 10 Billion which the Fed has recently lent to them short term with God knows what for collateral. How was that collateral valued? Who takes the loss?

See the gimmick? The Fed is letting the banks borrow short from the TAF on questionable collateral and get some nice solid long term Treasuries that can be loaned to the Public at 9x the amount or 90 billion. Looks better on the books, gives them some breathing room, and is nice and quiet.

If that was too complex an explanation, we'll offer the one from our friend Sean in Zurich:

They [the Fed] said they were going to neutralize the new TAF/term RP stuff... so banks end up funding their dodgy mtges with Tim at NYFRB and holding bills to compensate.

And there you have it. Selectively placed helicopter money. Our only curiousity is what exactly the Banks will be showing on their books when they start honoring FASB 157 and start marking to market. Are we going to be going through this at the end of each fiscal quarter for the forseeable future with the Fed playing Mr. Market?

Statement Regarding Sale of Treasury Bills from System Open Market Account

March 7, 2008

On Friday, March 7, 2008, the Federal Reserve’s System Open Market Account will sell $10 billion of Treasury bill holdings for settlement on Monday, March 10. This action is being conducted by the Federal Reserve Open Market Trading Desk (the “Desk”) in conjunction with the series of term RP transactions announced earlier today in order to maintain a level of reserves consistent with trading at rates around the operating objective for the overnight federal funds rate.

The Desk will continue to evaluate the need for the use of other tools to add flexibility to its open market operations. These may include further Treasury bill sales, reverse repurchase agreements, Treasury bill redemptions and changes in the sizes of conventional RP transactions.