Jim Hamilton: What is a Liquidity Event?

Jim Hamilton takes a look at recent "troubling" events in financial markets:

What is a liquidity event?, by Jim Hamilton: It was an exciting week in financial markets, including some dramatic central bank interventions in short-term money markets. ...

First, a little background... The banking system as a whole usually holds only a small amount of reserves in excess of what is required. A bank that ends up with extra reserves would find it advantageous to loan Federal Reserve deposits overnight to a bank with a deficit in what is called the federal funds market. The interest rate on these overnight loans is usually very sensitive to the quantity of excess reserves in the system, so the Fed could change this rate by adding or subtracting deposits through open market operations. The Fed simply announces the rate it intends to maintain, with the current target being 5.25%, and the announcement is credible because all participants know that the Fed will be adding or draining reserves as necessary to keep the rate near the target.

Not all loans will take place exactly at the target rate, however. These loans are unsecured, and though their very short-term nature makes the risk small, it is not zero. Small banks will often pay a slightly higher rate to borrow fed funds than will big banks, and an individual bank will have a maximum amount it is willing to lend to any given other bank. If a bank has a really big outflow of reserves, or its usual sources for borrowing short-term funds dry up, it may need to offer a rate well in excess of 5.25% in order to maintain a positive level of reserves.

This was the case on Friday, on which the fed funds market opened with some trades at 6%, some 75 basis points above the rate that the Fed has declared it will defend. So, the Fed used open market operations in the form of repurchase agreements to create new reserves, evidently in the amount of $38 billion. One can put this number in perspective with the following graph of what Federal Reserve deposits usually turn out to be over a two-week period. This was a huge intervention, on a par with the remarkable measures taken September 11, 2001, when the interbank loan market faced severe disruption from the physical destruction of a large number of the key institutions that make these markets. Again this week it seems that banks suddenly desired a huge volume of reserves in excess of the amounts they are required to maintain.

Federal Reserve deposits (in billions of dollars) and size of this week's reported liquidity injection. Original weekly data have been converted to biweekly. Data source: FRED

...Some analysts have interpreted the Fed's action as "bailing out the banks", and are particularly troubled by the fact that the assets purchased by the Fed through the open market operations apparently involved mortgage-backed securities. I too was a little surprised that the Fed would consider buying anything other than Treasury bills, though I agree with Calculated Risk that since the reserves were injected in the form of a 3-day repurchase agreement,

unless the banks go under in 3 calendar days, they will pay the loan back with 3 days of 5.25% interest. No big deal.

More sound analysis was provided by Felix Salmon, King Banian, Paul Krugman, and Mark Thoma. And here's William Polley:

A lot of entities holding mortgage backed securities needed liquidity. They were willing to borrow at a higher overnight rate to get that liquidity as evidenced by the spike in the funds rate early in the morning. The Fed, quite understandably, did not want the funds rate to spike, and so they loaned these banks reserves accepting mortgage backed securities of the highest quality as collateral (the Fed was NOT bailing them out by buying distressed subprime loans). This kept anyone from unloading good quality assets at fire sale prices just to get liquidity. That would have been disastrous. The agreement is that on Monday the banks get their securities back and the Fed takes back the reserves.

The bottom line is that the Fed was doing exactly what it needed to do. But the fact that this was needed is a very troubling development.

Comments

[groucho]

"This kept anyone from unloading good quality assets at fire sale prices just to get liquidity. That would have been disastrous."

Since agency MBS pricing has been based on the same faulty mark to model and fraudelent appraisal process as private MBS, how could the MBS the FED purchased be considered "good quality"?

This is the same MORAL HAZARD policy that has been creating the ponzi asset boom/bust episodes we repeatedly see around the world. The latest being the huge mortgage fiasco.

Let the MARKET determine the value of these assets. Long term, todays fire-sale prices will prove to be too high anyway. Does the gov't really want to experience another Japanese style drawn out malaise?

[guest]

This is confusing the hell out of me.

I crap in a bucket and try to sell it. Amazingly nobody wants to buy it. I need some money fast and somebody is willing to lend me boatloads of money using the bucket of crap as collateral (it *is* worth something after all I guess). The interest rate of the loan is lower than the going rate. The lender is willing to do this over and over again. Is the lender here losing out?

Who is losing out when the Fed does what it did today? Nobody? Tax payers?

Ponzi Q. Globalization

[Richard A.]

"unless the banks go under in 3 calendar days, they will pay the loan back with 3 days of 5.25% interest. No big deal."

But if they don't pay it back -- the Fed gets stuck with overvalued mortgage-backed securities. Then the Fed sells these securities at a loss -- less money for the treasury -- more taxes for the little guy.

[Ivan Kitov]

Richard,

if you get it right and have some stocks it's time to get rid of them.
Buy 10-year notes.

Lucky Chinese, got $1,000,000,000,000 in T-bonds. Will enjoy high demand soon.

[anne]

There is simply no concern about a failure to repay eoityh interest a Federal Reserve liquidity extension, nor is there danger of the Fed holding overvalued mortgages. The debt is amply valued.

Ponzi, enough with the crude imagery.

[Michael Cain]

Anne: "The debt is amply valued."

Anne, can you offer any evidence of that? The root of the situation appears to be that no one is willing to pay the current MBS holders' asking price for the securities, due to "the market" suddenly realizing that they have no clue about the actual value. What secret information does the Fed have that, if stuck with the securities, the loaned amount was "correct"?

[anne]

The value of a mortgage package offered as collateral for liquidity is easily understood because the package will be short term in duration and the mortgages involved of minimal default risk and further secured again real property. Notice how easily Vanguard values bond funds nightly, with bond packages of varying duration in a given portfolio and the most limited duration packages essentially available as immediate collateral or even cash. There is simply no threat to the Federal Reserve in holding mortgages as overnight collateral.

[anne]

The question that should be asked is why Vanguard bond portfolios as so long expected have held no difficult mortgage debt but not so for Goldman Sachs portfolios?

[Sarah]

I asked the guy who did the Fed tour yesterday why the Federal Reserve hadn't been requiring stricter underwriting on bank originated mortgages and maybe something akin to reserve requirements on them. (Like, I suggested, requiring them to hold a certain percentage of them themselves.)

His answer on the stricter underwriting part of the question didn't entirely cut it with me (the Fed did tighten 'guidelines' last year-- very much a case of 'too little, too late' in my opinion) but his reason for not requiring banks to hold mortgages made a lot of sense, I thought. He said that in the past the Fed had had a lot of problems with regional banks failing due to local housing slumps -- he cited Texas as a particularly bad example-- and MBS was actually a pretty good way of spreading that risk around.

Hamilton's chart gives a good idea of why this caused such a furor-- it wasn't what happened, but the size of it that was unusual. Also, since MBS are relatively new and the Fed's acceptance of them in repos even newer, lots of people were caught by surprise and many at first thought that something really unprecedented had happened.

I must say to be taking macroeconomics and have a trip to the Fed scheduled at this particular moment was a huge piece of luck! I can't imagine a more exciting introduction to what can be a pretty dry subject.

says...

"There is simply no threat to the Federal Reserve in holding mortgages as overnight collateral."

Anne, yes and no....in the short term the FED isn't threatened because they are legally allowed to monetize a variety of assets that congress has spelled out in their charter. And if they have their way they will try to monetize anything and everything not nailed down, including that "bucket of crap" that ponzi is trying to sell (with little luck).
In the long term, this nonsense will come to an end. Why? Because it IS nonsense.
The FED tried (and failed) to reflate the productive parts of the US economy. The hole they thought the US was entering is now much, much deeper.
Will the FED move to outright purchases of MBS going forward? While it's still too early to know what Bernanke will do, we do get some clues from Bush's strategy in Iraq.

THE SURGE........Will Bernanke copy Bush's playbook and hope for a miracle with a quick surge in outright MBS purchase in hope of putting a floor under their price?

We shall soon find out...................................

[anne]

Sarah:

"Also, since MBS are relatively new and the Fed's acceptance of them in repos even newer, lots of people were caught by surprise and many at first thought that something really unprecedented had happened."

Interesting comment, but though the Federal Reserve acceptance of mortgages as collateral dates to 2001 why do you write mortgage backed securities are relatively new? I date them about 25 years old.

The Fed however was far too late in calling for tighter standards for mortgages, which could well have begun when the Fed began to tighten.

[anne]

The Federal Reserve acceptance of mortgages as collateral dates to "2000 and possibly earlier."

[Bruce Wilder]

Michael Cain: "The root of the situation appears to be that no one is willing to pay the current MBS holders' asking price for the securities, due to "the market" suddenly realizing that they have no clue about the actual value."

I think you don't understand why "liquidity" matters, and its management is distinct from the management of market prices.

Continuous auction markets -- the various financial, stock, bond, forex and commodity markets among them -- depend for their functioning on professional arbitragers or "speculators" in common parlance, who buy and sell constantly and often in a volume many times the actual throughput of the market. It is, in many ways, a continuous and furious game of musical chairs, but it enables the markets to provide well-informed prices and open "liquid" markets, where transactions can usually be made without much notice or preparation, or risk.

A "liquidity event" is simply a moment when the music for that game of musical chairs stops. Without the continuous, furious arbitrage of the professionals, there suddenly is no market, no liquidity.

The Fed is stepping in, not to subsidize anyone, but simply to enable the music for the game of musical chairs to restart. Players, who might otherwise be forced to sit without a chair, are given a three-day reprieve by the Fed, while everyone waits for the professional speculators to regain their nerve.

The volume of speculative transactions, which, in most of these markets, is many times the volume of "real" transactions for principals, is highly leveraged, but, most of the time, low-risk. Without the leveraged, speculative buying and selling, these markets would cease to function effectively and efficiently -- and these markets are key information processing organs for the economy. To allow the leverage to unwind would preclude effective arbitrage and cripple the functioning of these markets for months, possibly years.

So, yes, the root of the problem is that "no one" wants to pay the asking price for MBS, but "no one" in this case is not individuals or institutions that actually want to hold MBS for their income stream -- the "no one" is the mass of professional arbitrageurs involved in keeping the market functioning, by buying, selling, leveraging securities they have no intention of holding.

The market is perfectly capable of processing secular loss in value, just not global surprises. Prices change minute-by-minute in the normal course of business. But, the market cannot function without the arbitrageurs, and the arbitrageurs cannot function when their highly-leveraged, but normally nearly-risk-free transactions cannot be conducted.

The Fed will hold the market, while the professional speculators figure out what is what, and then the game of musical chairs will resume, with the markets intact.

I thought this post by Brad Delong was pretty good, "Today Is a Great Day in Finance!"

[dd]

The MBS is the starting point. The issue is the derivatives written on the tranches and that is in all probability the singularity event. If derivatives were written guaranteeing the tranched ratings the downgrades triggered a derivatives event unprecedented as the downgradings are an anomaly. The inter-bank lending would seize as the liabilities are opaque. So it's a dual problem.

[Sarah]

You're right, Anne-- according to this link: http://www.ginniemae.gov/about/history.asp?Section=About Ginnie Mae pioneered MBS back in the 70's. I imagine it's very much as the guy at the Fed implied: MBS are not the problem-- they are a perfectly good tool for spreading risk. Probably their use has also helped smooth out regional variations so that now you can get pretty similar loans on about the same terms all across the country.

I wonder if there's a way to isolate what factors have contributed the most to this mess? First guess off the top of my head: 1) Huge upfront fees payed to mortgage brokers with little training 2) Unregulated hedge funds hungry for any product promising to generate the huge returns they need 3) The rise of mortgage companies that don't hold any of their own loans and are mostly focused on subprime.

[groucho]

"I wonder if there's a way to isolate what factors have contributed the most to this mess?"

Sarah, that's a softball. The factor is GOV'T programs put in place to "help" america in their search for the dream.

Oh, well looks like america is gonna have to keep dreamin' 4 awhile.

To connect the dots, start with the FED in late 20's. Strong(FED) wanted to help Norman(BOE)return sterling to previous gold price. Because of the way the gold standard worked this allowed a huge credit explosion in the US and the ensuing stock and property bubble that busted in 29. The default-deflation that ensued caused the US govt to get involved in US housing.

Everything starts from that point on....insurance, subsidized loans, securitisation, so on and so forth.......

When will it end? When Bernanke has bought up every single private and agency MBS on the planet........

[Sarah]

Groucho, you are as welcome to the belief that government policies are the source of all evil as you are to trust that enlightenment springs from the touch of the Spaghetti Monster's noodly appendage. But though a comparison of belief systems is often interesting, that was really not the kind of exchange I had in mind...

And no, pulling the odd fact out of the historical record and claiming drastic and decades-long consequences from it doesn't really qualify either.

[dd]

The FT confirmed today that the seizing was from the structured products and gave a little more information how the products were funneled through "conduits" or SIVs (Structured Investment Vehicles):
"In the case of a blip in the market, SIVs and conduits are supported by liquidity facilities from highly rated, mainstream banks. This means banks must step in to provide finance if the SIV cannot raise commercial paper in the normal way, unless the SIVs’ assets suffer significant ratings downgrades. Typically, the credit line provided by the sponsoring bank and a group of others in a syndicate must cover 100 per cent of outstanding commercial paper."
http://www.ft.com/cms/s/8eebf016-48fd-11dc-b326-0000779fd2ac.html

[groucho]

"Groucho, you are as welcome to the belief that government policies are the source of all evil as you are to trust that enlightenment springs from the touch of the Spaghetti Monster's noodly appendage."

Sarah, don't take my word for what has transpired. Do your homework. If you have an open critical mind, I'm sure you will come to similar conclusion.

Bill Clinton's mentor Carrol Quigley spilled the beans on most of this nonsense a long, long time ago.(tragedy & hope).
Maybe you would like to talk to the great historian Paul Kennedy who is still alive. The "odd fact" is not so odd, once you comprehend the history of western civilization.