Marcy Kaptur for President

The real reason behind the mad rush

Extraordinary times

Posted on Friday, September 26th, 2008 by bsetser

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).

The most the IMF ever lend out over two years?

$40b, in the eight quarters through June 2003 (this covered crises in Argentina, Brazil, Uruguay and Turkey)

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.

And what have the rest of the world’s central banks done over this period?

There has been a lot of talk that central banks would abandon US assets because the perceived risk of holding dollars (and Treasuries) has gone up.

The custodial data though don’t provide much evidence to support this theory.

Over the last two weeks, the Fed’s custodial holdings have increased by over $40b, rising from $2394.7b to $2435.9b. Treasuries account for over $30b of the increase, but Agency holdings are rising as well. Chalk up one (minor) success for Paulson.

Right now, it seems like central banks are running into the safest US assets, not running away from the dollar. That of course could change. But it is hard to square a $20b weekly increase in the New York Fed’s custodial holdings with a story based on a fall in central bank demand for dollars. For that matter, it is hard to square the $425b increase in the New York Fed’s custodial holdings since last September with all the of the angst about the dollar’s status as a reserve currency.

If anything, the pace of growth in the Fed’s custodial holdings over the past two weeks strikes me as stronger than the likely pace of global reserve growth. That suggests to me that central banks are shifting funds out of the commercial banks (and money market funds) into Treasuries that can be held at the Fed’s custodial accounts. I would bet that central banks are shifting money to the BIS as well.

Remember, most central banks do not have a mandate to take credit losses. They can take currency losses — as currency risk is implicit in the notion of foreign exchange reserves. But having money in a bank that fails would be very hard for most to explain.

Note that all my data compares the data for the end of the reporting week, i.e the data for September 24 to the data for September 10.

UPDATE: I should have noted a fall in the Fed’s repos with the banks in my initial post. The changes in the Fed’s balance sheet are so large that I am not sure that I still know how to read the report, so please attach an error bar to the numbers above (apart from the numbers on the custodial holdings). I may have missed some additional credit extension, or some offsetting items. The basic story though is clearly true: the changes in the Fed’s “other loans” alone are enormous.

From http://blogs.cfr.org/setser/

Also a great follow up post to this written by a guy who blogs by the alias of London Banker...

1. September 26th, 2008 at 4:20 am
   London Banker Says:
   

   Excellent and timely, Brad. 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.

P.S. I also like london bankers latest post...
http://londonbanker.blogspot.com/2008/09/learning-from-rudi-bogni-thin-space-of.html

Huh?

" (c) DIRECT PURCHASES.—If the Secretary deter
mines that use of a market mechanism under subsection
(b) is not feasible or appropriate, and the purposes of the
Act are best met through direct purchases from an individual
financial institution, the Secretary shall pursue additional
measures to ensure that prices paid for assets are
reasonable and reflect the underlying value of the asset. "

Isn't the use of these extreme measures indicative of the fact that the very opposite is the case! That by acting as the purchaser-of-crap-of-the-last-resort it is guaranteed that prices being paid for these assets are not reasonable and can't possibly reflect the intrinsic value of the assets (because if they did reflect the underlying value wouldn't someone else be interested in buying them too?) Or more importantly shouldn't it be determined that they are being purchased at a discount!

A Look at the Bailout

As Tony predicted here:

...Leonhardt addresses briefly, near the end of the article, the notion of limiting the pay of Wall Street executives who waddle up to the public trough. Good Luck: I bet the tax lawyers and accountants are salivating at the prospect (hell, having previously been one such tax accountant, I know they are)...

Sure enough, in conducting a first review of the proposed bailout, Clusterstock (all emphasis, both color and bold, is Clusterstock's) notes:

Executive compensation at bailed-out companies. Toothless: The plan ostensibly prohibits golden parachute payments to CEOs and other "C-level" execs at bailed-out companies. However, it really only prevents payments on severance deals that are struck AFTER the bailout (specifically, it prohibits these deals completely). There is nothing about cancelling (sic) the severance payments that the executives are ALREADY contractually entitled to. What this means in practice is that bailed-out companies will have trouble hiring the best talent...because why would you work at Bailed Out Company A when you could go across the street and get a fat severance deal? It also doesn't mean the companies can't pay their CEOs $500 million a year. IN ADDITION: There's another absurd section that makes all compensation above $500,000 for the three highest paid employees at the company not tax-deductible for the company. This is LUDICROUS. It means the company can pay the executives anything it wants and that the penalty for this will be exacted on the company and its shareholders. (Unless we're mistaken, Americans are furious that CEOs make $50 million a year for running companies into the ground, not that the $50 million is tax deductible).

The same article addresses, in part, the question asked here with the following (again, all emphasis remains theirs):

Equity/warrants: The Treasury MUST be granted warrants or debt instruments (senior debt) from public companies in exchange for more than $100 million of bailout money. No specific language on how significant this warrant or debt position must be, except that it must "provide for reasonable participation by the Secretary, for the benefit of taxpayers, in equity appreciation in the case of a warrant, or a reasonable interest rate premium, in the case of a debt instrument." AND...must provide additional protection against taxpayer losses. This is an important and just provision. The tension will be between the government wanting to take enough equity to offset the risk without scaring the bank away.

I am still not convinced that having an equity stake in an insolvent or nearly insolvent company is any form of assurance to taxpayers. I do, however, understand that it may be better than nothing. This whole plan is very clearly a start of things to come, and we'll be seeing more legislation coming through revising and expanding the government's role and authority to interact with corporations.

I hope someone here, maybe Percicles or Tony, can speak to the history of government's interaction with the corporation as individual relative to government's interaction with states as relative to the individual (specifically civil rights). There is clearly a role for regulation that has been fought for and well established, but this is no longer regulation, this is active participation. What can we expect from the future in judicial and legislative terms? Is the commerce clause sufficient Constitutional ammo for all of this, or will we see new arguments to protect these newfound and newly stated powers of government?

Also, mark-to-myth is placed under review and may be suspended. This can have enormous impact and we can all expect to hear more about it in the coming months:

VERY STRANGE AND POSSIBLY ALARMING: The SEC has the ability to suspend mark-to-market accounting for financial institutions when it thinks doing so is in the public interest. The SEC will also be launching a "study" of mark-to-market accounting. Mark-to-market has been fingered as one of the villains in this collapse. It isn't, but it sounds as though the SEC may have been persuaded that it is. Without mark-to-market, there's a lot more risk of a Japan-type scenario, where banks live in denial for years about how far up the creek they are.

Sickening

http://www.commondreams.org/headline/2008/09/25-6

Wiping Out Community Banks

The most shocking line in this WSJ article has to be:

"Our bank has excellent earnings and a very clean loan portfolio," Mr. Allen says. "The only mistake we made was in owning U.S. government agencies."

The article is about small community banks who are seriously threatened by the government's failure to recognize the role GSE preferred stock played in the portfolios of organizations of all types and sizes. This particular piece was presaged by this Barron's piece from early September:

While most of the money-center banks continued to enjoy the benefits of a short-covering rally, shares of several regional names have suffered sharp losses in the session....In many cases, regional banks use the proceeds of the preferred dividends to maintain their required capital levels, meaning that the loss of that income stream could put their balance sheets at risk.

There are other problems as well. The WSJ piece discusses how the government has recognized an unfortunate scenario adding pain to the misery:

Banks also are seeking tax relief. Because of a quirk in tax law, the banks won't be able to deduct most of the losses on their Fannie and Freddie holdings on their federal taxes. The financial damages are considered "capital losses" for tax purposes -- meaning they can be used as a deduction only against capital gains earned by banks. But few community banks have meaningful capital gains to report. So, in the tentative agreement reached over the weekend in the massive financial bailout, Congress plans to let banks deduct the losses from ordinary income, cushioning the blow.

Roughly one month ago, this Financial Week article explored the risks posed to regional banks by the government's GSE takeover. The reality of failed banks of many shapes and sizes is now upon us. In fact, RGE Monitor reports:

Chris Whalen (RGE FinanceMonitor/IRA): number of US banks likely to fail by the year ended July 2009 (110) and total assets of said failed banks ($800 billion). Based on our work, four buckets seem to be visible: 1) large banks, 2) large regional banks, 3) specialized institutions and 4) community banks.

Certainly, organizations such as Lehman Brothers and a wide array of hedge funds are feeling pain for reasons other than owning GSE preferred stock, but there are many organizations that are suffering as a result of only this financial sin. A financial sin as unthinkable a sin one year ago as polygamy prior to the excommunication of Hyram Brown. For all of the talk about big risk takers and unwise lending, the vast majority of these small banks had extraordinarily conservative loan books and solid understanding of their clients and their clients' businesses. Yet, many will fail, be severly damaged, or be forced into the hands of others.

McCain and monkeys

I thought this was an interesting post and was just experiencing the same thing with my new rotation (it's in a monkey behavior lab). However I think they are drawing the wrong conclusions and McCain's lack of eye contact seems to just be a technique to unnerve his opponent. McCain doesn't even look in Obama's direction, thus, to my mind, expressing a lack of interest rather than submission. What I experienced with the monkeys was a somewhat different lack of eye contact. With the monkeys, they would trace an "aura" around your face, never making direct eye contact, but would certainly orient themselves towards you when you spoke, expressing interest. It seems McCain is just trying to put Obama off balance and distract him rather than actually feeling submissive. I've definitely avoided eye contact in a debate for this precise reason. If the person starts wondering why you aren't looking at them or if they are being boring then they might lose their train of thought. Not terribly certain if it works but its worth a shot and it allows you to focus on their words and not their non-verbal communications as well.

Or maybe he had to go to the bathroom, he is old after all...