Bandaid on a Ruptured Jugular

March 11, 2008

Let’s talk about the Fed’s expansion of its securities lending program that the market is so excited about this morning. It seems to me that the market does not understand the implications of this action.

We’ll take this one step at a time.

What is the purpose of borrowing securities from your broker? It’s the same for Primary Dealers borrowing Treasuries from the Fed. Why do PDs borrow securities from the Fed? To sell them short.

The Primary Dealers are heavily short Treasuries at all times. They are heavily long all other debt securities simultaneously.The level of securities lending in recent months is unprecedented in all of human history, by an order of magnitude of 10.

Securities lent by Fed to Primary Dealers

Why is that? Because they were heavily short Treasuries and are being subject to the greatest Treasury short squeeze in history. Their only out was to borrow more securities from the Fed and short more into the market as the public clamor and panic for “safe” Treasury securities rose to a mad crescendo.

The Fed is now responding to the pressure of the imminent collapse of the Primary Dealers and major banks worldwide, because not only are the PDs heavily short the stuff that is going up, Treasuries, they are heavily long the stuff that is going down, which is all other debt securities.

This is the worst of all possible worlds and the Fed’s action is like putting a bandaid on a ruptured jugular vein.

Accordingly, I predict that this morning’s massive short squeeze will be reversed in due course, perhaps no more than a few hours.

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This entry was posted on March 11, 2008 at 9:02 am and is filed under Today's Markets. You can follow any responses to this entry through the RSS 2.0 feed.

68 Responses to Bandaid on a Ruptured Jugular

OOUA on March 11, 2008 at 9:48 am

I noticed the NOB spread had a peculiar twist to it recently, it appears that the 10/yr/note short hedges against mortgage portfolios weren’t working as intended and in fact caused more damage as the mortgage portfolios found lower or no bids and the flight to quality caused the treasuries to move higher … a double whammy, getting caught wrong doing what is supposed to be the right thing … sooner or later this fiat interest rate enviornment will align itself with the real world, either as a result of the dollar sliding even further or foreign investment out and out drying up, or both
bear cave on March 11, 2008 at 10:22 am

I’ll tell you what, even though at this point I have transitioned over from breakout/breakdowns to a “Short & Hold” attitude–at least, it feels like that what with the risk tolerance you have to have–this risk is ridiculous, what with these short squeezes… “Road Warrior Market” indeed.

Here’s to the Little Sctick Save That Couldn’t.
Lee Adler on March 11, 2008 at 10:36 am

If the Fed has broken the back of the panic flight to safety into Treasuries with this action of providing unlimited inventory to the dealers with which to meet the demand, they are going to rue the day. The panic could easily go in reverse to reach levels that would have been unimaginable. Yields are already up 17 basis points. If they get above 3.70 in the next couple of days, it would only take a couple more days to get to 4.70 as the market collapses.

This really sets off all kinds of interesting possibilities. We have to wait for the end of the day to see where things stand. I’d hate to see all our shorts get stopped out, but if it happens, so be it. The Fed has declared itself the seller of last resort for Treasuries here, and the market has responded by saying, “Here, take mine, take mine!”

So let’s see how this little gambit works.
Jason Seese on March 11, 2008 at 10:38 am

Great article. Thank you for giving us insight into the Fed’s action today. I did not really understand what the Fed was doing; but you explained it very nicely.
Stuart on March 11, 2008 at 10:58 am

What an orchestrated dog and pony show this is turning into. Unbelievable. Yen gets pummeled, Euro turns around on a dime… unbelievable pulling of the levers
Jesse on March 11, 2008 at 11:15 am

Lee, that was a very poor analysis of today’s action. Here’s a more complete description:

1. The Fed is lending treasuries and taking back mortgage securities that currently have a very poor market value. Think about it. Let’s say you’re Bear Stearns and are sitting on billions of crap mortgage securities. You’ll now be able to trade those at FACE VALUE for treasury securities. Instant liquidity. The Fed just bought those crap mortgages at full face. Sure, it’s considered at 28 day loan, but it will be extended indefinitely. This is true helicopter money to the tune of $700 for every person in the United States except that only banks and Wall Street are getting the money.

2. What does this do? It frees up $200 billion for lending and speculating. You think that makes no difference? You’re wrong. It makes a big difference.

3. The write-downs will now stop on mortgage paper. The Fed has now backstopped market values on mortgage paper. No more write-downs means more capital available to lend and speculate.

This is a very big deal. That $200 billion will have a multiplier of at least 10 and account for $2 trillion of buying power just unleashed into the markets.

This won’t begin until March 27. Add in another 50 basis point rate cut on March 18 and we are off the races.

Cover your shorts now or get burned badly.
Lee Adler on March 11, 2008 at 11:39 am

Jesse- Russ and I are currently having the same conversation of the points you raised. You’ll have to forgive me for the “poor analysis” which I wrote in the first few moments after the release.

At this point I would agree in part with what you’re saying, however, based on what I read on the Fed’s discussions of what collateral they accept, they never accept face value of a security as collateral for anything, so I would assume that this applies to the securities swap. The Fed performs an analysis of some kind to establish the value of the collateral, and they lend on some portion of that. There was no information in the documentation of this announcement that the Fed will accept collateral at face value rather than market value. So is this a means of swapping bad collateral for good? I highly doubt it, but we’ll see.
If information becomes available that says the Fed will accept the securities at face value I would have to change my current thinking accordingly.

I don’t think that this frees up $200 billion for lending and speculating. The PDs are currently short about $95 billion in Treasuries. Last August, they were short about $180 billion. They have gotten absolutely killed. At the same time their long positions in the stuff that has been going down in value have ballooned from around $400 billion to around $590 billion. So they have been on the wrong side of both trades to the tune of hundreds of billions and their positions have been constantly deteriorating and getting bigger at the same time, for 6 months.

The $200 billion in securities lending is like giving a transfusion to a corpse.
I don’t see the connection between this action and stopping the deterioration of mortgage paper. If you can provide some evidence of how you think that would work, I will certainly consider it.

Until then I will stick with my poor analysis. I think it’s the correct poor analysis, but it was hasty, and I may have to think it through some more.

Of course, the proof is in the pudding.I suspect that the outcome of this clearly desperate action will be the same as to the other Fed actions.
CE on March 11, 2008 at 11:45 am

Jesse,

I think the Fed is not really buying the crap mortgage securities. It’s more of a loan with MBS as collateral. If the value of these collateral drops, then I would believe that Fed will ask for top up.

What I think today’s Fed action does is to allow PD that are short on cash to get some liquidity without selling their MBS into a very weak market. This prevents further collapse of MBS market.

What you describe is more of Fed BUYING over the MBS, which I don’t think is the case, yet.
Lee Adler on March 11, 2008 at 11:49 am

CE. That sounds right to me.

It’s fascinating. Lots more questions than answers right now.
Lee Adler on March 11, 2008 at 12:04 pm

The gambit does not appear to be working. The 10 year Government Agency spread has widened out to 95 on Fannie-103 on Freddie. New record for this crisis.

The first Primary Dealer to go bk should be BSC. But there may be others less well known who beat it to the punch.

Our short covering triggers become effective at 3PM. I’m anxious to see how things stand at that time.