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

Rogue Poster on March 11, 2008 at 12:06 pm

Looks more like three fingers of Jack in the morning coffee than a vote of confidence. Got the market out of bed, yes, but now the flu and cold symptoms are returning.
Lemur on March 11, 2008 at 12:23 pm

Who knows whats going to happen short term or indeed how high they can goose things today. But faced with days like this when I am giving back lots on my shorts I remind myself that just like Enron (whose financial gimmicks were no substitute for a sustainable business) that sooner or later ‘the king with no clothes’ will be exposed.

The fed is just stalling.
LawyerL on March 11, 2008 at 12:25 pm

The fed has published a list of haircuts (percentage of par or mktvaule)they would lend against. MBS with a maturity of 5 years or less is about a 2% haircut. Or put another way, they will lend 98% of the value of the MBS or agency paper.

Ofcourse the qustion is– what is the value of the MBS. It will be assigned by the FRBNY. If they use the ABX from markit,they will only be able to lend based on 55% of par for AAA subprime mortgage backed securities. BUT if they mark to model like the Investment banks do, the Fed can get the value up quite high I suspect.

The fed wants to do this–i.e get value up high, I suspect.

For other reasons, this program saves (or at least postpones the pain)for companies like Thornberg and other hedge funds
because this should slow down the margin calls by the investment banks on those types of Levered entities.
Lee Adler on March 11, 2008 at 12:28 pm

One thing I feel sure of is that this confirms just how badly the broker-dealer community has been wounded in this mess. I have repeatedly stated in my reports to subscribers and in posts over on the Stool Pigeons Wire at Capitalstool.com that they are the ones on the floor bleeding out. This is just more evidence of that. The pigmen no longer have the capacity to support the market. They are the walking dead.
Stuart on March 11, 2008 at 12:28 pm

“it will be extended indefinitely.” That reference to the 28 day loan period is the key assumption supporting any conclusion the fed is buying MBS.
Peter Duray-Bito on March 11, 2008 at 12:36 pm

$110B TAF
$100B 28-day repos
$200B Securities Lending
$80B TOMO

If fully deployed, the Fed will be pushing $500B secured by $700B in their own account(SOMA).

Folks, this is dangerous…
Jim S. on March 11, 2008 at 12:44 pm

OK, let’s say the Fed takes some MBS in exchange for a loan and lets say the PD goes BK.

So the Fed has to eat that loss. But what does that mean? Does it just mean that the Fed pumped money out of thin air into the system and (assuming the MBS isn’t worth much) now that money is gone?

Is it purely an inflationary event?

Thanks,

-jim
Lee Adler on March 11, 2008 at 12:47 pm

According to an official at the Fed, the mode of determining the value of the securities will be decided in the coming days before the first auction. This official, who was speaking off the record, also indicated that the collateral has to be of the highest quality, rated AAA, and here’s the more important factor in my view, not on credit watch for downgrade. If it is, it will not be accepted, and if it the collateral is downgraded during the term of the operation it would be put back to the borrower who would be required to replace the collateral.
LawyerL on March 11, 2008 at 12:49 pm

Oh another thing. There are other questions that arise.

In working papers of the Federal Reserve, the authors have questioned whether the Fed has the authoity to lend against MBS. Those authors concluded NO. The Fed is not authorised by congress to do this type of lending.

Another question. When you lend 98% are you really a lender or an equity investor.

an observation– if the Fed values the MBS high–the taxpayers can take a big hit. The collateral is still bad and not worth the loan amount no matter what the the rating agencies say.
Lee Adler on March 11, 2008 at 12:52 pm

He said that the purpose of the operation was to provide liquidity to good quality securities which cannot be moved due to market conditions. He also said that it was important that the effect of the operations were reserve neutral, that they would not affect the level of reserves in the system because they involved the swap of securities of equivalent value. This would enable the Fed to scale up the operation as necessary to accommodate the need.