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

Lee Adler on March 11, 2008 at 12:58 pm

I see this as having the potential to reverse the rally in the Treasury market, but not reverse the deterioration of the corporate, GSE, and MBS markets. Keep an eye on the spreads in the days ahead. If they continue to widen, it spells disaster.
Rogue Poster on March 11, 2008 at 1:01 pm

Does AAA include securites that only achieve that status because they are insured? What is “highest quality?”
Lee Adler on March 11, 2008 at 1:06 pm

They are still relying on the ratings agencies. With so many AAA issues that really aren’t AAA, I think that the issue is whether they are on watch or not. If they are on credit watch, they are automatically disqualified. They don’t say anything about taking CDOs. Just AAA rated private label MBS.
karen on March 11, 2008 at 1:08 pm

From Miller Tabak’s Tony Crescenzi:

As of Feb 27, primary dealers held $139.7 billion agency securities and $60.2 billion mortgage-backed securities. (Add those numbers up and you get $200 Billion! So the Fed’s facility is literally able to handle ALL the agency and mortgage-backed securities that dealers hold.

I hope this adds to the discussion which I sincerely appreciate.
LawyerL on March 11, 2008 at 1:26 pm

Here is the chart of Haircuts that the Fed is using for the TAF and likely the securities lending program

http://www.frbdiscountwindow.org/discountmargins.pdf

Here is the working paper that questions the authority

http://www.federalreserve.gov/ Pubs/FEDS/2000/200051/200051abs.html

Page 58
There is No Express Authority for the Federal Reserve to Purchase:
Corporate Bonds
Commercial Paper
Mortgages
Equity
Land (Other that Federal Reserve premises)
Stuart on March 11, 2008 at 1:27 pm

So here’s the question then. What happens in 28 days after each respective auction? They can only do one of two actions. Extend the term or call in the loan. If they extend, it will be clear for all this a covert bailout. If they call in the loans, we have even a bigger implosion a month from now.
MLK on March 11, 2008 at 1:35 pm

Lee, this was an impressive, rapid posting.

The further postings here from others, along with your responses, again beg the continuing question (since last fall) of how far the Fed will go to save the PDs. Back and forth this discussion goes with much talk this weekend (and here this morning) that the Fed through TAF was, in effect, “nationalizing” the PDs’ losses.

The fatal problem with this theory in my view is that the Fed is a separate entity. Its interests are not a mere mirror of either the “public interest” (whoever that is defined) or the PDs.

I just simply don’t see serious evidence that the Fed has decided to sacrifice, or even place in serious jeopardy by its own immediate actions) — let alone risk — its institutional interest to save some PDs.

The Fed may be accepting a broader range of securities but I throughly agree with your comment in #19. It is accepting high quality (such as it is) and over-collaterlizing.

I don’t think it’s coincidental that dead-duck Countrywide had to get their ($50 billions from FHLB, NOT the Fed.
LawyerL on March 11, 2008 at 1:41 pm

The FHLB is the mortgage dumping ground for the industry in my perception. The difference is that they only lend about 75% of value.

Stuart: I believe they will absolutely roll over in 28 days unless the market clears in a really substantial way. Unlikely IMHO.
MLK on March 11, 2008 at 1:49 pm

Re LawyerL in #27:

I agree they’re the dumping ground. FHLB debt carries an EXPLICIT USG guarantee.

I don’t know whether the Fed rolls some or all in 28 days. But my point is that the Fed is not going to bailout PDs (or anyone else) to its own detriment. Since this all started the Fed, over and over again, has made it clear it’ll provide liquidity but not capital. Any bailout will have to come from Congressal/Presidential/Administrative agency action (and check-writing).
karen on March 11, 2008 at 1:54 pm

“28 Days Later”

and excellent post at interfluidity

http://www.interfluidity.com/posts/1205254205.shtml