06 August 2008

Reserves? We Don't Need No Stinking Reserves!


The credit crisis was caused by a long period of negative short term interest rates, excessive money supply growth, reckless credit expansion, insufficient reserves and over leverage. The regulatory process became hopelessly ineffective and co-opted. Key safeguards that had been in place since the 1930's were brought down through conscious and well-funded lobbying.

The banks think that they have established the principle that if they overborrow enough, if they are reckless enough, if they expand enough, they become "too big to fail" and their losses will be borne by the taxpayers and all holders of the currency, while they keep their personal profits and bonuses.

The Fed would like to introduce some 'turbo-charging' to that money-printing machine, cry 'Fiat!' and unleash the dogs of leveraged credit expansion and monetary inflation. The final link will be a directly funding capability between the Treasury and the Fed, which although not legal is not yet technically sanctioned by the US Uniform Code of Law. But if the Treasury can monetize debt directly such as in the Paulson plan for Fannie and Freddie purchases that point may be moot for quite some time. This is going to be interesting.


Divorcing Money from Monetary Policy
Authors: Todd Keister, Antoine Martin,and James McAndrews
New York Federal Reserve

Many central banks implement monetary policy in a way that maintains a tight link between the stock of money and the short-term interest rate. These procedures require the central bank to set the supply of reserve balances precisely in order to implement the target interest rate.

Because reserves play other important roles in the economy, the link can create tensions with other objectives of central banks. For example:

The imbalance between the intraday need for reserves for payment purposes and the overnight demand leads central banks to provide low-cost intraday loans of reserves to participants in their payments systems, exposing central banks to credit risk and potential moral hazard problems. (This is like worrying about having dirty dishes in the sink while hauling toxic sludge into the house by the truckload, if one considers the dodgy debt the Fed is bringing in from the investment banks through Special Facilities. As for their concerns about moral hazard, these financial swingers have the moral sensibilities of a billy goat. - Jesse)

The link between money and monetary policy prevents central banks from increasing the supply of reserves to promote market liquidity in times of financial stress without compromising their monetary policy objectives. (This is the issue, the punchline. The bank wants to be able to flood the market with liquidity at will without it showing up in the short term interest rates and money supply figures. Since they have eliminated M3 that takes care of the top end. They basically would like to free themselves from even nominal restraints on printing money. - Jesse)

The link also relies on banks facing an opportunity cost of holding excess reserves, which leads them to expend effort to avoid holding these reserves and thereby makes the monetary system less efficient. (Yes we have seen the high efficiency that has been gained recently by insufficiently low reserves and high gearing of leverage. Let's increase it now that we think the worst has past to see if we can get lucky again - Jesse)

Keister, Martin, and McAndrews consider an alternative approach to monetary policy implementation—a “floor system”—that can eliminate these tensions by “divorcing” the central bank’s quantity of reserves from its interest rate target.

By paying interest on reserve balances at its target interest rate, a central bank can increase the supply of reserves without driving market interest rates below the target.

The authors explain that a floor system allows a central bank to set the supply of reserve balances according to the payment or liquidity needs of financial markets. By removing the opportunity cost of holding reserves, the system also encourages the efficient allocation of resources in the economy.

A version of the floor system was recently adopted by the Reserve Bank of New Zealand; this option for monetary policy implementation will be available to the Federal Reserve beginning in 2011.

Divorcing Money from Monetary Policy - NY Fed - pdf download


The Next Shoe to Drop - Pay Option ARM Defaults


Pay Option ARMs - Up to 48% Default Rate! First Federal Featured
August 5th, 2008
Mr. Mortgage

I have been preaching that the ‘Pay Option Implosion’ will make the ‘Subprime Implosion’ look like a hiccup in states in which this loan program was widely used such as CA. This is because this loan program knows no socio-economic boundaries and was very heavy used in more affluent areas because of its ultimate affordability feature, negative amortization.

The Pay Option ARM (POA) is the most toxic of all loan programs with up to 80% of borrowers making the minimum monthly payment and acruing negative. Combine that with a house price crash of 32% in the past 13 months in CA and most of these borrowers owe more than their home is worth and are at an exponentially greater risk of loan default. Remember, these were once PRIME borrowers in many cases.

Part of my day job is analyzing banks and mortgage lenders using proprietary data and tracking mortgage loan defaults and REO by bank. I can see near real-time what is happening on a bank level and it is not pretty. About four months ago I noticed the subprime defaults waning, which I have been telling all of you about ever since. Over the past four months subprime defaults in CA are down about 25% but total Notice of Defaults have remained near historic highs of 43k per month. This is because Alt-A defaults have filled the gap.

The Alt-A universe is much larger in unit count and dollar volume than subprime so even though we are just at the beginning of the ‘Alt-A Implosion’, they have already filled in the subprime default void. Scarier yet, roughly 65% of all Alt-A defaults are POA’s. (Pay Option ARMS) The ‘POA Implosion’ is upon us.

As a matter of fact, just last week S&P, Moody’s and Fitch all hit Alt-A hard with an emphasis on Pay Option ARMs....

Morgan Stanley Cuts Home Equity Lines of Credit


Morgan Stanley Said to Freeze Home-Equity Credit Withdrawals
By Christine Harper

Aug. 6 (Bloomberg) -- Morgan Stanley, the second-biggest U.S. securities firm, told thousands of clients this week that they won't be allowed to withdraw money on their home-equity credit lines, said a person familiar with the situation.

Most of the clients had properties that have lost value, according to the person, who declined to be identified because the information isn't public. The New York-based investment bank will review home-equity lines of credit, or HELOCs, monthly from now on, the person said yesterday.

Wall Street firms including Morgan Stanley are ratcheting back on risks after the collapse of the subprime mortgage market and ensuing credit contraction saddled banks and brokerages with almost $500 billion of writedowns and losses. Consumers fell behind on home-equity credit lines at the fastest pace in two decades in the first quarter, the American Bankers Association reported last month.

``Morgan Stanley periodically reassesses client property values and risk profiles,'' said Christine Pollak, a Morgan Stanley spokeswoman in Purchase, New York. ``A segment of clients was recently notified of a change in the status of their home- equity line of credit, or HELOC, due to a change in the value of their property and/or their credit profile.''

Pollak declined to specify the dollar amount of the frozen credit lines. The firm's global wealth management division, which doesn't disclose how many clients it serves, had 8,350 advisers managing $739 billion of customer assets at the end of May, according to its second-quarter earnings report.

No Recovery Seen

``It's evidence that they don't think the economy is going to recover quickly,'' said Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York who rates Morgan Stanley shares ``outperform'' and who owns some of the stock. ``The fact that they're trying to get ahead of the problem is very good.''

Morgan Stanley has already taken about $14.4 billion of losses related to leveraged loans and collateralized debt obligations. The clampdown on home-equity loans mirrors similar efforts by commercial banks, said David Hendler, an analyst at Credit Sights Inc. in New York.

``All consumer lenders and home-equity lenders are reassessing the environment given the pressure on housing and the economy,'' Hendler said....


Here Come the Waves of Credit Defaults, Deleveraging, and Recession


Its called an economic contraction. The US is in a serious recession, much more serious than the headlines will allow because of the significant understatement of inflation in the chain deflator, worse even than the CPI. The government and financial sector is acting with reckless disregard for the welfare of the country by silencing all the alarms one used to be able to rely upon to protect themselves and make sound personal and business decisions.

Credit Card ABS Locking Up: Report
By: PAUL JACKSON
August 5, 2008
HousingWire.com

Here it comes: the spillover from subprime mortgages that many secondary market participants had hoped not to see looks increasingly as if it may finally be coming home to roost. A published report Tuesday morning noted that the credit card ABS market is locking up, as investors pull back from the sector and more borrowers begin to default on their consumer credit debt.

The Wall Street Journal, citing data from JP Morgan Securities, said that issuance of credit card ABS fell to $4.4 billion during July, off from $5.26 billion in June and less than half of the $10.1 billion issued in March. A report by JP Morgan structured finance analysts said that deal flow has “slowed considerably” — and, adding insult to injury in the latest xBS market to falter, those deals that are coming to market are taking longer to do so.

Adding to investor fears in the credit card sector was an August 1 report by Citigroup Inc. with the Securities and Exchange Commission that saw the fourth-largest credit card issuer post a $176 million loss in credit card securitization activity during the second quarter.

Overall U.S. ABS issuance slowed to a crawl, totaling just $8.6 billion in July according to industry trade publication Asset Backed Alert; so far this year, ABS issuance has totaled just $123.5 billion.

Last year at this time, total U.S. ABS issuance was $465.8 billion. Forty-two percent of U.S. ABS issuance this year has been in the form of credit card debt, the largest percentage of ABS (which also includes auto financing, student loans, and the like).

July’s abysmal ABS issuance total was the worst since December 2007, and the second worst in more than 9 years; and it’s led more than a few market participants to wonder what’s next in a capital market that has been reeling from the effects of the mortgage crisis for more than a year now.

“One has to wonder if the subprime thing wasn’t just an underwater event out in the ocean and now the tsunami waves are rolling in, one after another,” said one of HW’s sources, an MBS/ABS analyst, via email on Tuesday morning.