FED'S US$200b LIQUIDITY BOOST

Published March 13, 2008

Regional markets get a fillip from Fed's liquidity offer

Plan welcomed but opinions differ over its long-term impact on US economy and markets

By R SIVANITHY


(SINGAPORE) Asian stock markets yesterday rebounded sharply in line with Wall Street's Tuesday reaction to the US Federal Reserve's latest credit market bailout plan, led by a 1.9 per cent jump in Hong Kong's Hang Seng Index to 23,422 and a 1.6 per cent gain for Tokyo's Nikkei at 12,861.

Most markets, however, were off their intra-day highs, suggesting that doubts remain over how effective the plan will prove to be and the length of the stockmarket rally, especially since previous Fed-inspired moves have failed to have a lasting effect.

In yesterday's session, the Straits Times Index first surged 100 points but ended with a net gain of 57.09 points at 2,917.94. It started the week at 2,836, a 15-month low.

The US central bank on Tuesday offered to let the biggest investment banks on Wall Street borrow up to US$200 billion in Treasury securities in exchange for hard-to-sell mortgage- backed securities as collateral.

In effect, the Fed has agreed to hold large volumes of mortgage-backed bonds that Wall Street firms are struggling to sell and is providing them with either cash or Treasury securities that they can immediately convert to cash - all in an effort to ease the acute strain in credit markets brought on by the sub- prime crisis.

The move came in tandem with liquidity injections from the Bank of Canada, Bank of England, European Central Bank and Swiss National bank.

The reaction so far from analysts is that it will lead to some short-term relief but the longer-term problems remain.

'They are essentially creating a US$300 billion bank out of nothing,' the New York Times quoted Lou Crandall, chief economist at financial research firm Wrightson ICAP, as saying.

But while the Fed's moves may relieve short- term cash problems, Mr Crandall said, 'it doesn't solve the fundamental issue - which is the decline of capital in the banking system'.

The US newspaper also quoted analysts warning that the central bank might make things worse in the long run by postponing the repricing of mortgage assets that financial institutions are holding, or by further weakening the value of the dollar and aggravating inflation.

AFP on Tuesday quoted Brian Wesbury, economist at First Trust Portfolios, as saying the action was better than a rate cut because it was targeted at the most troubled financial institutions.

'By narrowly targeting the problems in the credit markets rather than broadly influencing the economy through additional steep rate cuts, the Fed has greatly improved its approach,' Mr Wesbury said.

The news agency also quoted Simon Derrick at Bank of New York Mellon as saying the actions would at least buy the Fed some time and ease pressure to cut rates, which some say could be damaging in the long run by fuelling inflation.

'The jury remains out as to whether this will prove sufficient to free up the liquidity freeze in the credit markets,' Mr Derrick said.

Reuters meanwhile reported that, in an interview, International Monetary Fund (IMF) first deputy managing director John Lipsky said the coordinated move showed that central banks were aware of what's going on and are willing to take innovative actions.

'Is this going to cure what ails the economy? I would guess everyone realises the answer to that is 'no'. Is this going to be helpful in addressing the strains in financial markets? For sure, the answer is 'yes',' Mr Lipsky said.

Independent research outfit Ideaglobal said the impact of the announcement may last for 1-2 weeks but may not have the 2-4 week effect enjoyed after Dec 12, which was when the Fed and other central banks last pumped liquidity into the market.

'The central bank liquidity action can slow the liquidation in mortgage-backed securities and slow the increase in margin calls but the sharp fall in the US housing market/US recession will see a return to the credit bear market in the US,' said Ideaglobal's director of research Mike Gallagher.

Published March 13, 2008

COMMENTARY

Faced with crisis, the Fed innovates

Latest move different in scale and ambition from what it has attempted so far

By VIKRAM KHANNA


THE US Federal Reserve's new Term Securities Lending Facility is arguably the boldest and most innovative step taken so far to clear the logjam in the credit markets since the US sub-prime crisis blew up last August.

Let's look closely at what the Fed has essentially done. It has agreed to lend US$200 billion in the form of Treasury securities to primary dealers (and through them, to other financial institutions) for 28 days against collateral that includes not only US federal government agency debt (including mortgage-backed securities, or MBS), but also private AAA-rated MBS.

There are three key points to note here about how the Fed's actions are different from what it has done before.

First, the amount the Fed is willing to lend has increased significantly. When it first announced its Term Auction Facility in December (aimed at easing liquidity in the credit markets), it capped its lending at only US$20 billion - although this was progressively increased to US$100 billion last week. That has now been doubled, and the Fed has indicated that it could be increased even further.

Second, the loans the Fed makes will now will be for 28 days rather than overnight, as before. This gives banks more time, and flexibility, to act.

Third, and perhaps most significantly, the Fed is now willing to accept as collateral not just US government-backed mortgage securities, but even private sub-prime-mortgage securities (some of which are rated AAA even if they don't deserve that rating). Or as some commentators bluntly put it, the Fed is willing to swap Treasuries for junk.

Whether this proves wise in the long run, we shall see. But in the short run, what the Fed has effectively done is to create a market for a vast pool of illiquid and unwanted securities. The banks which have been stuck with these securities, have been forced to mark them to market - meaning mark them lower and lower as US housing prices have kept falling.

As a result, banks' recapitalisation requirements have kept rising. This, in turn, has not only badly dented confidence in financial markets generally, but has also made banks afraid to lend - which has accelerated the housing downturn (thus jeopardising even non-sub-prime mortgages) and weakened the corporate sector (even healthy companies) and the economy as a whole.

The Fed's latest move will, of course, not solve all these problems at a stroke, and the Fed itself is modest about what it hopes to achieve, saying merely that the new facility 'is intended to promote liquidity in the financing markets for Treasury and other collateral and thus to foster the functioning of financial markets more generally'.

But with the new facililty, banks will be able to get at least some dubious mortgage assets off their books. In return, they will get high-quality liquid assets in the form of Treasury securities, which can easily be converted into cash. This will help unfreeze credit markets and, to some extent, also insulate banks from falling housing prices.

No surprise, therefore, that at least the initial reaction from Wall Street to the Fed's new facility was positive: the Dow Jones index jumped 3.55 per cent on Tuesday and banking stocks recovered sharply.

However, whether this bounce will turn into a rally remains to be seen. There are reasons to be cautious; a lot of unanswered questions remain. First, just how big can the new facility become? While the Fed has indicated that it will consider increasing it from US$200 billion, mortgage assets on the books of US banks run into the trillions - not to mention other potentially bad loans, notably those provided to leveraged institutions such as hedge funds and private equity funds.

Second, will the Fed roll over the loans after 28 days? How long will it keep doing this? And how, and when, will it dispose of the dubious mortgage assets - the 'junk' - it collects as collateral?

Bargaining chip

Perhaps most importantly, will the Fed (which now has enormous leverage vis-a-vis the banks) require banks using this facility to change their practices? Fed chairman Ben Bernanke has recently been exhorting these institutions to forgive some of the principal (not just interest) on some of their outstanding loans. The harder the bargain the Fed is able to drive on this critical issue - and it would have a lot of popular support - the more likely that it would succeed in staving off the much-dreaded wave of housing foreclosures (which could send the US housing market into free-fall), as with lower principal payments, homeowners would be less 'underwater' on their mortgages.

How this latest Fed move goes down politically in the US in this election year cannot be ignored either. If the move is viewed as a bailout of bankers at taxpayers' expense - and there are already rumblings to that effect - the Fed would be pressured to think again. But for now, Bernanke & Co deserve credit - and the benefit of the doubt - for daring to innovate in the face of a crisis.

Published March 13, 2008

FED'S US$200b LIQUIDITY BOOST

Move will help ease strains in financial markets: IMF

But it won't cure what ails the economy, says the bank's first deputy MD


(WASHINGTON) The US Federal Reserve's decision to pump more cash into a stressed banking system will not solve US economic problems, a senior International Monetary Fund (IMF) official said on Tuesday. But the move will help ease strains in financial and credit markets.

John Lipsky, the IMF's first deputy managing director, told Reuters that coordinated moves by the Fed and four other central banks to prop up global credit markets showed they were aware of what's going on and willing to take innovative actions.

'Is this going to cure what ails the economy? I would guess everyone realises the answer to that is 'no'. Is this going to be helpful in addressing the strains in financial markets? For sure, the answer is 'yes',' Mr Lipsky said.

In the past few days the Fed has pumped a total of US$400 billion into the US banking system. Separately, the European Central Bank, Bank of Canada, Bank of England and Swiss National Bank announced measures to boost liquidity.

On Tuesday alone, the Fed expanded its lending plan offering up to US$200 billion of highly liquid US Treasuries to primary dealers. The move won applause on Wall Street, calming US markets as US stocks rallied more than 3 per cent giving the Dow and Nasdaq its biggest daily percentage gains since March 2003.

'Is this the definitive solution? Who knows? It's certainly not clear,' Mr Lipsky said, 'but the bigger message is that the Fed, like other central banks, has recognised the seriousness of the situation . . . and have been willing to react in a forthright way and have been willing to be innovative in that reaction'.

'If this action is insufficient you would expect that there will be a willingness to take new action when appropriate,' he added.

Mr Lipsky said central banks had worked closely for some time to deal with the credit turmoil, which began with an increase in defaults in the US sub-prime housing mortgage market and spilled into European markets.

He said their actions were 'clearly intended to be seen as coordinated'.

'It reflects their recognition that issues, especially financial issues today, are inevitably global issues . . . and can't be viewed effectively as a piecemeal issue facing one or another economy or market, and that is a clear message and not a coincidence,' he added.

Mr Lipsky said the Fed was 'appropriately' paying close attention to links between financial market strains and the broader US economy.

Asked whether there was a risk that central banks were not getting traction with efforts to bolster credit markets, Mr Lipsky replied: 'Of course, but remember they are responding to some fundamental signals in the economy and mostly acutely to the weakness in the housing sector.'

'It is not going to be solved until there is, on the one hand, greater certainty about the economic outlook and, secondly, that the economy seems healthier,' he said. -- Reuters

Published March 13, 2008

Fed trying to buy time, say economists

Debenture spreads narrow in positive market response


(NEW YORK) A central bank plan to infuse the financial system with new cash is a temporary fix for the debilitated US mortgage bond and housing markets, but not a cure.

The programme announced by the Federal Reserve on Tuesday frees up money for mortgage loans and dealer bond buying in the two markets paralysed by limited funding and fears of bank failures, economists and analysts say.

'This is a tourniquet, it will staunch the bleeding, but it may not turn us around and bring the patient to health,' said Susan Wachter, real estate and finance professor at The Wharton School, University of Pennsylvania.

'This is designed to stop in its tracks what might otherwise be an old fashioned credit crunch where the banks simply themselves seize up,' Ms Wachter said. 'It's not a sure fire end of the crisis by any means.'

The Fed will let dealers use US agency debentures and agency mortgage bonds, as well as top-rated private label mortgage securities as collateral in the new lending facility.

This will be the first time the Fed takes non-agency residential mortgage bonds as auction collateral in its latest effort to add market liquidity. It already accepts this kind of paper as collateral from banks that borrow directly from the US central bank at the discount window.

The initial US$200 billion funding for the plan might be raised, according to the Fed. The size of the plan pales in comparison with the mortgage bond markets totalling more than US$7 trillion.

Historically high defaults and foreclosures froze mortgage lending to all but the highest quality borrowers, and closed many companies who relied on higher risk home loans. Trouble that shut down the sub-prime mortgage sector has now started cascading to higher quality loans, leading to a growing number of private and federal plans to restore order in the mortgage bond and housing markets.

The Fed said that the private-label MBS (mortgage backed securities) it would accept must be AAA-rated and could not be on watch-list for rating cuts. Possibly US$1 trillion of those securities were eligible, according to senior Fed staff members.

The market for private label bonds, or those backed by mortgages too large for Fannie Mae and Freddie Mac to buy, was stung too as lenders and investors grew more risk averse. A recent government plan to sharply, but temporarily, raise the size of loans those top two US home funding companies purchase should also provide short-term relief.

The Fed is 'buying time' by unfreezing markets for some highly illiquid assets, said Robert Eisenbeis, chief monetary economist at Cumberland Advisors and former Atlanta Fed executive vice-president. 'But liquifying those assets does not mean the funds will flow back into mortgage markets.'

There was an immediate and positive initial response in the MBS and agency debenture markets on Tuesday. Debenture spreads narrowed as much as 12 basis points versus Treasuries from some of the widest spreads in the decade-long history of Fannie Mae's benchmark and Freddie Mac's reference note programmes.

Agency mortgage bonds also outperformed Treasuries by a far margin after hitting the widest spreads in over 20 years before the Fed plan. Prices of 30-year bonds rose slightly while 10-year Treasury notes sank 1 1/4 point. An index of AAA-rate non-agency MBS that lost 43 per cent since September also gained slightly.

'Liquidity constrained financial institutions have been unable as well as unwilling to lend, so if you can free up that capability it's going to help,' said Margaret Kerins at RBS Greenwich Capital in Chicago. -- Reuters