"To Facilitate the Orderly Functioning of Financial Markets"

The Fed accepted mortgage backed securities as part of today's operations to offset the fall in liquidity from the mortgage market meltdown. More on that below, but first, the Federal Reserve issued this Press Release today:

Press Release, FRB: The Federal Reserve is providing liquidity to facilitate the orderly functioning of financial markets.

The Federal Reserve will provide reserves as necessary through open market operations to promote trading in the federal funds market at rates close to the Federal Open Market Committee's target rate of 5-1/4 percent. In current circumstances, depository institutions may experience unusual funding needs because of dislocations in money and credit markets. As always, the discount window is available as a source of funding.

The Fed is making sure that financial market participants are aware that the discount window is available to banks should they have no other place to find needed liquidity, and that it has committed to providing as much liquidity as needed to stabilize the federal funds rate at, or at least close to, the target rate of 5.25%.

Bloomberg reported that:

Central Banks Add Cash to Avert Crisis of Confidence, by Scott Lanman and Christian Vits, Bloomberg: ...In the U.S., the federal funds rate opened at 6 percent, the highest in six years. The rate fell to 5.25 percent after the New York Fed bought $19 billion of mortgage-backed securities and then followed up with $16 billion of funds in a second operation. ...

''The Fed has almost unlimited ability to supply liquidity if they feel that is appropriate,'' [Alice] Rivlin said. She noted that it was ''symbolic'' that the New York Fed's first operation today involved mortgage-backed debt -- the type of securities that investors are unloading. ...

If that's true - if the Fed purchased mortgage backed securities directly in an open-market operation, that would be very unusual and noteworthy. But further checking leads to the conclusion that the Fed accepted mortgage-backed securities as collateral in a repo agreement, something it does routinely. So which it is - the unusual or the routine?

In another story on this, Bloomberg says:

Fed Adds $35 Bln in Funds, Most Since September 200, by Ye Xie, Bloomberg: The Federal Reserve added $35 billion in temporary funds to the banking system through the purchase of securities including mortgage-backed debt to meet demand for cash...

The Fed's additions totaled the most since September 2001. They came in two weekend repurchase agreements, of $19 billion and $16 billion, for which the Fed accepted securities including mortgage-backed debt, so-called agency debt and Treasuries as collateral...

The central bank probably received only mortgage-backed debt in today's operations, said Louis Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. The central bank likely wanted to avoid taking Treasury debt at a time when government securities are in demand as a safe haven, he said.

''The Street has special demand for the highest-quality Treasury collateral right now, so the Fed chose to leave Treasury collateral,'' Crandall said. ''It should not be taken as a sign that basic Fannie Mae and Freddie Mac mortgage pools are difficult to finance.''

The Fed typically only accepts so-called agency mortgage- backed securities, such as those guaranteed by government- chartered Fannie Mae or Freddie Mac, rather than non-agency home-loan bonds from other financial institutions. ...

In repos, the Fed buys U.S. Treasury, mortgage-backed and so-called agency debt from its 21 primary dealers for a set period, temporarily raising the amount of money available in the banking system. At maturity, the securities are returned to the dealers, and the cash to the Fed. ...

And from the AP:

New York Fed accepts $35 billion in mortgage-backed securities to inject cash in system: Responding to credit crunch fears in the stock market, the Federal Reserve of New York said Friday it would buy a total of $35 billion in mortgage-backed assets to inject more cash into the banking system.

According to the New York Fed's historical data, which goes back to July 2000, the bank in that time has never accepted that much in mortgage-backed securities in a three-day repurchase agreement.

When the New York Fed ... made its huge three-day repurchase of $81.25 billion the Friday following the Sept. 11, 2001 terror attacks, only Treasury securities were accepted and submitted.

In a "repo," the Fed buys securities from dealers, who then deposit the money into commercial banks. ... The central bank did not comment on why it was accepting more mortgage-backed securities than usual, but it's possible that the Fed was trying to remove some of the stigma that these assets currently hold in the financial markets. ...

So, it is not unprecedented for the Fed to accept mortgage backed securities as collateral, but the amount is unprecedented for a three day period. Two reasons are offered for this move, one is to ensure that the supply of Treasury Bills, which are in demand as a safe haven, does not fall due open market operations (as suggested in the Bloomberg story), and the other is to show faith in the value of these securities (as suggested in the AP story). Update: See Jim Hamilton and William Polley for more on this. After noting that these are agency backed securities (as noted above, and also discussed in comments), William Polley says, "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." 

Comments

[billy]

http://www.nytimes.com/2007/08/10/business/10liquidity.html?_r=2&oref=slogin&ref=business&pagewanted=print&oref=slogin

Adding to the problem is that the questionable securities are widely owned and sometimes have been repackaged to form the basis of other securities. European banks and funds own paper tied to subprime mortgages, and it is not clear who else does, or how investors will react.

Banks that are worried about their own liquidity decided this week to increase their reserves, which they can do by borrowing from other banks. Loans on such rates rose as a result of the added demand. Both the federal funds rate — the rate on loans of reserves between American banks — and the London Interbank Offered Rate leaped sharply yesterday.

The Fed — which conducts monetary policy by focusing on the fed funds rate — was forced to inject money into the system to bring the rate back down to its targeted level. And the E.C.B. lent almost 100 billion euros ($130 billion), to European banks.

If the current panic is just that — unreasoning fear — then such cash infusions may be able to let the new financial system weather the storm. Money can be lent to those owning the dubious securities, obviating the need to sell. As they eventually turn out to be good, the loans can be repaid and all will be happy.

On the other hand, if many of those securities turn out to be as bad as people now fear, some of those loans will not be good, and there may be more financial failures.

If the MBS the Fed is buying (and they bought only MBS yesterday) is crap, and the institution that borrowed the money fails (the institution which holds crap is more or less strongly correlated to one which fails), will the Fed ever get paid back? What happens to the injected money? Wont it be pure inflation?

[Bruce Wilder]

MT: "The Fed is making sure that banks are aware that the discount window is available should they have no other place to find needed liquidity . . ."

I bet they forget all the time, just like I forget where I left my keys.

[Mark Thoma]

Yes - a better statement is that the Fed is making sure that everyone else knows that banks know the window is there... I may reword that slightly.

The Fed is signaling that liquidity will be available, either through open-market operations to stabilize the ff-rate (system-wide medicine), or through the discount window banks (individualized care).

[It's a bit of a clumsy sentence, but changed to "The Fed is making sure that financial market participants are aware that the discount window is available to banks should they have no other place to find needed liquidity"]

[Winslow R.]

All this excitement and I'm on vacation (:(

I find the Fed is crossing the line as mortgage backed securities are not part of the 'people's debt'. Sure these are repo's but who says the MBS's collateral is worth the paper its printed on? Who says the seller will still be around when the Fed wants its money back? Should be buying tsy secs but insufficient amount available without inverting the yield curve further.

China/opec is not doing its part.

[billy]

http://delong.typepad.com/sdj/2007/08/today-is-a-grea.html
Yes, today we have reached the limits to arbitrage: most of the people who spend their lives trying to buy low and sell high using other people's money and leverage have given up extending their positions (and so pushing prices back toward normal-time fundamentals), and are hunkered down simply hoping to survive the next month.

Whether this will have macroeconomic implications is unclear, but I would bet not. The Fed and the ECB are pegging the prices of liquid securities, and injecting as much in the way or safe, liquid, short-term assets into the system as needed to keep that so. They are also in the market in other ways. And the nightmare scenarios always involved a simultaneous collapse in the dollar and in consumer demand, and a Fed that couldn't decide whether to fight the inflation coming from rising import prices or the unemployment coming from collapsing consumer spending. Neither of those show any signs of happening.

Yet.

That's right. The Fed and the ECB are pegging the prices

The Bernanke (Greenspan) put in action. The rich risk the system, make their money and move on. The not-rich get stuck with the inflation tax.

Where are all the free-marketers now?

[Ivan Kitov]

This panic will last a next month or so. Then a period of the stock market stagnation - from 12 to 18 months. Then a burst in stock prices.
The Fed will follow the events:
was lucky to get scaling for my prediction on SP500 returns.
The new scale corresponds to the drop in yearly returns during the last several days. In previous comment (
http://futuresboard.com/?ab=board&forum=2&board=8&thread=3534
July 9, 2007), timing of the current drop was perfectly predicted. SP500 will reach a new bottom value in the next two months of around 1330.

So, the new plot for the MA(12months) SP500 returns is as follows.

Figure 1
http://thumbsnap.com/v/mUXOzUpd.gif
Comparison of observed and predicted monthly returns. The observed returns are MA(12).

Figure 2.
http://thumbsnap.com/v/IJmE0zuQ.gif
Cumulative observed and predicted returns from Figure 1

Figure 3.
http://thumbsnap.com/v/G887ufZJ.gif

[robertdfeinman]

Didn't JP Morgan try to stabilize the stock market? I think he failed.

Who is today's Irving Fisher?

[Idaho_Spud]

OK then. The Fed is evidently lending large amounts of money to entities using MBS as collateral - a very unusual event.

This is being done to "To Facilitate the Orderly Functioning of Financial Markets".

By the above statement, I am guessing that "functioning" part would be the unwinding of leveraged bets and meeting margin calls from lenders who are less generous (or more particular) than the NY Fed.

My big question is whether the Fed's collateral is really worth that much. Suppose this MBS collateral is only worth 10 cents on the dollar.

Wouldn't that imply that the NY Fed just gave some obviously problem/lousy gamblers a huge wad of money to get their affairs back in order? Moral Hazard.

[ECONOMISTA NON GRATA]

It's all so unbelieveable, so brazen...

I think that the gold market spoke on this... We as American need to be seriously concerned... This is not going to go away....

Econolicious

[johnchx]

billy asks:If the MBS the Fed is buying (and they bought only MBS yesterday) is crap, and the institution that borrowed the money fails (the institution which holds crap is more or less strongly correlated to one which fails), will the Fed ever get paid back? What happens to the injected money?

A significant fact that has gotten lost: the New York Fed only accepts MBS's issued by or fully guaranteed by federal agencies. These are very low risk instruments, not the risky ones everyone is trying to unload.

[andiron]

no one is buying my landholdings . I marked it to my model: comes up w/ $500k/acre.
Can i use the discount window to unload it after calling Goldman to securitize it. I need the money for some investor friends who are hassling me for redemption now.

[Sarah]

Winslow R. says...

I find the Fed is crossing the line as mortgage backed securities are not part of the 'people's debt'.

Well, if the mortgages backing those securities is all from Fannie Mae, etc., then in effect it is 'the people's debt'. Since the question was raised here and elsewhere I asked it on our tour of the Fed today. The guy giving our presentation couldn't be 100% positive, but said he would be 'very surprised' if there was anything besides agency mortgages in the MBS the Fed was doing. The Fed, he said, was very unlikely to buy non-agency MBS because, "That's not what we do."

As johnchx says, these are not particularly risky mortgages. They are the ones like my sister and BIL got in '05 -- 20% down, less than 3 times income, conforming loan. Not to say some of those won't fail if we go into a serious recession and people start losing jobs, but if, on the other hand, this is the equivalent of an old-style 'run on the banks' it would be awfully stupid to let the whole financial system collapse and a bunch of banks fail just because a temporary panic.

I remain open to the possibility of being unpleasantly surprised, but so far it looks to me like the Fed is doing exactly what it should -- in this particular case.

[Mark Thoma]

To follow up on that point, from above:

"The Fed typically only accepts so-called agency mortgage- backed securities, such as those guaranteed by government- chartered Fannie Mae or Freddie Mac, rather than non-agency home-loan bonds from other financial institutions. ..."

[Idaho_Spud]

This is from the NY Fed's website: http://www.newyorkfed.org/markets/omo/dmm/temp.cfm#tranches

PLEASE NOTE: In addition to eligible MBS collateral, eligible Treasury and Agency collateral are also accepted.


Clarification of Collateral Tranches on Desk RP Operations
Typically, when the Desk arranges RPs it accepts propositions from dealers in three collateral tranches.
In the first tranche, dealers may pledge only Treasury securities.

In the second tranche, dealers have the option to pledge federal agency debt in addition to Treasury securities.
In the third tranche, dealers have the option to pledge mortgage-backed securities issued or fully guaranteed by federal agencies in addition to federal agency debt or Treasury securities.

From time to time, for operational simplicity, the Desk has arranged RPs just in the third tranche, under which dealers have the option to pledge either mortgage-backed securities issued or fully guaranteed by federal agencies, federal agency debt, or Treasury securities. Today's RPs were of this type.
August 10, 2007

[prostratedragon]

Thank you for shedding some light, Professor. The remark that fed funds trading had opened at 6 percent —well above the announced target of 5¼ percent— should be given wider, um, currency, since it should make it easier to see that what the Fed did today is not so contradictory to its just-announced policy.

I hope there will be some information forthcoming from the Fed about how the MBS purchase was done, and whether they were agencies.

[anne]

http://delong.typepad.com/sdj/2007/08/the-fed-is-buyi.html

Brad,

There is a big distinction between outright purchases and collateral taken in repo. On the former, you are basically right that the Fed only holds US Treasuries (although if you look closely you will see that in the past that purchased agencies outright as well). What they are doing in repo is taking collateral.

[Ah. Thanks. Bloomberg had it as a *purchase*, which would have been unusual both in size and in manner...]

This is not "intervention" since they are going to give the stuff back. In the case of todays (admittedly very large) $35 billion operation, it will all automatically reverse on Monday.

A quick look at the history of these temporary open market operations shows that they have been taking mortgage-backed securities as collateral for repo for some time. In the past 30 seconds I could verify that they have been doing it regularly since at least 2000. The quantities have normally been small (between $100 mil and $2 bil), but they have been doing it.

So this is not what I would call an "intervention in the mortgage-backed securities market". And it is not unusual.

If you are interested in the data, you can download it from
http://www.newyorkfed.org/markets/omo/dmm/temp.cfm

Steve Cecchetti

[anne]

Notice Steve Cecchetti's exchange with Brad DeLong with which I agree and had been my conclusion yesterday. I do not understand quite what is happening but the Federal Reserve action was just not that unusual. Psychology is important in markets, but I still think there is far more reason to be watchful than alarmed.

[anne]

Look to the movement of the Federal Funds rate which was last at 3%, which suggests to me the Fed repo of collateral was just what was needed and can be reversed Monday. I need to read more, and there is the weekend, but the analyst shoutings strike me as being a psychological and artificial factor.

[anne]

The Federal Funds rate, I notice, fell below 2%.

[anne]

Notice as well, there was no noticeable problem in the non-mortgage short, intermediate or long term bond markets these last several days. If insulation is the issue, the Federal Reserve has insulated the bond market well. As usual, the question is who holds private mortgage-backed debt? This is becoming clearer each day.

says...

Mark Thoma says...

To follow up on that point, from above:

"The Fed typically...."

I love the word 'typically' and 'routinely'. Everyone is entitled to their opinion on whether the Fed should be issuing repos based on MBS's issued by fannie mae or not. As a voter, I say not.

The system is of faulty design and needs to be changed. How does johnchx etc. justify these actions even if they are short term? What are your limits to fed actions? Are there no limits to the power of a 'nonpolitical' entity entrusted with the people's currency. Just because it is not unusual doesn't make it 'right'.

Happen to own stock in FNMA? Perhaps ownership is blurring your ethical boundary? If not, where is your boundary? Why not redesign the system so that the Fed can keep within its political boundary no matter what the crisis?

"The Federal National Mortgage Association (FNMA) (NYSE: FNM), commonly known as Fannie Mae, is a government sponsored enterprise (GSE) sponsored by the United States government. As a GSE, it is a privately-owned corporation authorized to make loans and loan guarantees. It is not backed or funded by the U.S. government, nor do the securities it issues benefit from any explicit government guarantee or protection."

http://en.wikipedia.org/wiki/Fannie_Mae

[Winslow R.]

Previous post was mine.