The Fed's First Response to the Crisis May Not be Enough

Just a brief follow-up to Tim's post. It appears that the Fed's first response to the financial market problems may not be enough. Recall that as the crisis has been developing, firms holding high-quality mortgage-backed securities in need of liquidity have been unable to find buyers for these securities unless they are heavily discounted. The result has been a "new-fashioned bank run" (see also "A New Type of Bank Run"). To try to alleviate this liquidity problem, the Fed has done two things, it has accepted high-quality mortgage-backed securities as collateral on discount loans, and it has also accepted these securities as collateral in repo agreements. The discount loan change, for example, allows firms to essentially borrow from the discount window using banks as go-betweens. (The firm gives the securities to the bank as collateral on a loan, the bank then gives the securities to the Fed to hold against a discount loan. Thus, the bank passes the securities from the firm to the Fed, and then passes the cash in the other direction making a profit on the exchange.)

But a correspondent points to this news from MarketWatch:

"Analysts said the rally in short-term T-bills indicated nervousness remained in credit markets, leading investors to seek the safe-haven of government bonds. Expectations that the central bank will cut its key Fed funds rate was also boosting short-term Treasury bonds.

"But money failed to convincingly return to the commercial bond market on Monday, where liquidity has been drying up in recent weeks.

"Low T-bill yields indicate that liquidity is not yet flowing to those areas of the credit markets that need liquidity most, such as toward the mortgage market and the commercial paper markets, for example, where investors have been on a buying strike," said Tony Crescenzi, fixed-income analyst at Miller Tabak.

And, from Reuters, "Two U.S. Companies Involved in Mortgages Move to Raise Cash":

The struggling mortgage investment firm Luminent Mortgage Capital and the lender Thornburg Mortgage took steps to bolster their liquidity yesterday, but the companies signaled their troubles were not completely over.

Thornburg said it sold $20.5 billion of mortgage assets and reduced its short-term borrowings by an equivalent amount in a bid to reduce its risk of losing access to short-term credit markets. The sale amounted to more than 35 percent of its assets as of June 30.

Luminent said it would sell a majority of itself at a deep discount to shore up its financial condition. Arco Capital, a holding company..., will have the right to buy up to 51 percent of the company at 18 cents a share — a price 76 percent below Friday’s closing price.

So the liquidity crisis, and corresponding new fashioned bank run, do not appear to be over yet.

Comments

[bullbust]

"But money failed to convincingly return to the commercial bond market on Monday, where liquidity has been drying up in recent weeks.

"Low T-bill yields indicate that liquidity is not yet flowing to those areas of the credit markets that need liquidity most, such as toward the mortgage market and the commercial paper markets, for example, where investors have been on a buying strike," said Tony Crescenzi, fixed-income analyst at Miller Tabak.

There is enough liquidity out there. It's all ending up in T-bills.

The reason for that is also well known. No-one wants to buy junk of no value.Buyers are behaving rationally.

Unless the market can identify what is good and what's not good, it's going to be locked up.

As Roubini says, this is about solvency, not liquidity.

[Bruce Wilder]

I have read the several Fed policy articles with great interest, and especially liked the Yves Smith typology.

In addition to all the speculation about what the Fed should/will do, I was wondering if anyone with expertise has noticed the Treasury doing anything.

Sometime back I remember Brad DeLong and others wondering about the implications of a Treasury Department, where most high policy positions are empty or filled by ciphers.

I'm just curious if the political/policy weakness of the present Administration is showing up. What kind of role would the Treasury Department normally play? What have they done?

I forget all the details, but in addition to the bully pulpit, I would think Treasury has some considerable leverage over Fannie Mae, Freddie Mac, etc., not to mention the Comptroller of the Currency's control of banking.

Obviously, I know this Fed Watching territory, but I was curious and thought I would put it out there, to see if other commenters might point to relevant commentary, reports, analysis.

[op]

music to my ears
12 tone
of course

[dd]

A change in collateral?
New York Fed Takes Step To Bolster Credit Market
"In another step aimed at unfreezing the commercial paper market, the Federal Reserve Bank of New York clarified its discount window rules with the effect of enabling banks to pledge a broader range of commercial paper as collateral.
Under the clarification, issued verbally by New York Fed officials to market participants in the last day, banks may pledge asset-backed commercial paper for which they also provide the backup lines of credit.
"This strikes us as a very big deal," said Lou Crandall, chief ..."
WSJ