Page 2 of 5 THE FOLLY OF INTERVENTION, Part 2 No easy exit for nationalization By Henry C K Liu
against the Treasury's ideological stare down against granting any pubic funds
for a rescue of Lehman. After Lehman, the market knew that the Fed and the
Treasury would no longer permit another bankruptcy if they could help it,
assuming they could help it without bankrupting the government and the nation.
Nationalization of the finance sector then became the only realistic option.
The Lehman bankruptcy on September 15, 2008 cut off all further private
financing for investment banks. Lending in the interbank deposit market dried
up as money market funds shied away from providing banks with short-term loans
after the bankruptcy wiped out billions of dollars of its impaired debt.
Private funds also pulled
away from the commercial paper market, an important source of finance for
industrial companies and non-bank financial firms.
That breakdown prompted the Fed to announce on October 7, 2008, the creation of
the Commercial Paper Funding Facility (CPFF), which would complement the Fed's
existing credit facilities to help provide liquidity to term funding markets.
The CPFF will provide a liquidity backstop to US issuers of commercial paper
through a special purpose vehicle (SPV) that will purchase three-month
unsecured and asset-backed commercial paper directly from eligible issuers.
The Federal Reserve will provide financing to the SPV under the CPFF and such
financing will be secured by all of the assets of the SPV and, in the case of
commercial paper that is not asset-backed commercial paper, by the retention of
up-front fees paid by the issuers or by other forms of security acceptable to
the Federal Reserve in consultation with market participants. This essentially
nationalized the commercial paper market.
The Treasury believes this facility is necessary to prevent substantial
disruptions to the financial markets and the economy and will make a special
deposit at the Federal Reserve Bank of New York in support of this facility.
Since the end of October, 2008, the central bank has purchased more than US$313
billion in commercial paper alone. The Fed has also implemented a number of
other liquidity programs designed to help banks access funds rather than rely
on the private interbank market.
Most market participants expect the Fed's liquidity programs to remain in place
at least through 2009 and that it would be a challenge for the central bank to
formulate a workable exit strategy from its support of the financial system.
The freeze in lending was best tracked by watching a surge in floating money
market rates. At the daily fixing in London, the three-month dollar London
Interbank Offered Rate (LIBOR) rose to a peak of 4.82% in October 2008.
Since then, the Fed's provision of liquidity and aggressive rate cuts has been
identified as having helped ease some of the strain in LIBOR but the real
reason was a drop in interbank borrowing to keep demand down. On January 9,
2009, LIBOR was at 1.41%. Strong demand for recently issued bank debt that is
backed by the Federal Deposit Insurance Corp has also helped ease funding
strains.
However, as of January 9, 2009, LIBOR still remained elevated when compared
with near zero fed funds rate. With official overnight interest rates near
zero, problems remain for the repurchase (repo) market, an important source of
bank funding, and in which Fed open market actions trade to keep the fed funds
rate on target. Fear of lending securities in exchange for a short-term cash
loans dominated the repo market.
Zero interest rate stalls the repo market
The collapse of investment banks in 2008 showed how short-term funding is
dependent on two factors. One is the federal funds rate, the interest rate at
which depository institutions lend balances at the Federal Reserve to other
depository institutions overnight. The other is the government's participation
in the repurchase or "repo" market.
Data reported by 19 primary dealers and around 1,000 bank holding companies
suggest that by mid-2008 the gross market capitalization of the US repo market
exceeded $10 trillion (including double-counting of repos and reverse repos),
corresponding to around 70% of US GDP.
Over the past decade, many banks also have become dependent on the repo market,
whereby they lend out assets such as Treasuries, top-rated mortgages securities
and other top-rated bonds in return for short-term cash. The freeze in repo
financing helped bring down Bear Stearns as investors lost confidence over
lending cash collateralized by Bear Stearns securities. Lehman's bankruptcy
left investors questioning the creditworthiness of all banks. Consequently, the
repo market seized.
While lending for overnight continues, term repo, any agreement with a lifespan
of more than one day, remained impaired by the fear factor. The breakdown in
the repo market also upset the trading of interest rate swaps as dealers often
hedge the derivative with government paper. The cost of financing swaps in the
repo market helps influence where swaps trade relative to Treasury yields.
Heightened volatility in daily LIBOR settings made it extremely difficult to
trade swaps, which involve exchanging two cash flows. One flow is a fixed rate
that is priced off Treasury yields, while the floating rate references
three-month LIBOR. The problems in the repo market peaked in October 2008 when
failed trades rose to a record $5 trillion. A repo "fail" occurs when a
security that was previously borrowed is not returned on time. (See
THE SHAPE OF US POPULISM, Part 4: A panic-stricken Federal Reserve,
Asia Times Online, April 2, 2008. )
Given the entrenched links between dealers and investors, once a security
fails, it can ripple along a long chain and shut down the repo market, which
was what happened in the aftermath of the Lehman bankruptcy on September 15,
2008.
Although repo fails have since been cleaned up, the repo market faces renewed
problems as the Fed's infusion of liquidity has lowered the effective fed funds
rate to nearly zero per cent. This interest rate environment negates the profit
from lending out a Treasury security in exchange for a short-term cash loan.
The repo market will implement in May 2009 new rules proposed by the Treasury
Market Practices Group (TMPG), which comprises senior members of security
dealers, banks and investment firms who are involved in the repo market and
endorsed by the Fed. The primary goal is to alleviate repo fails by introducing
a penalty rate for dealing with failed securities. That will enable a security
to trade at a negative level capped at 3% below current fed funds rate targets.
With official rates now in a band between zero and 0.25%, the cost of failing
to deliver a borrowed Treasury is minimal and in such a climate, the amount of
failed trades usually rises.
The TMPG said in its release: "Since November, short-term interest rates have
declined to unprecedented levels, increasing the urgency to implement new
practices to enhance liquidity and improve functioning of the US Treasury
market."
The use of repo is a crucial source of short-term funding for financial firms
as they can lend out their holdings of Treasuries and other securities as
collateral in return for cash loans. Treasury traders and investors also value
a smoothly functioning repo market as it allows them to sell bonds short by
borrowing them from others.
Under the new rules, a charge for failing to return a borrowed security on time
is computed as being 3% minus the lower end of the current Fed funds rate band,
which is zero per cent. Once the penalty rate is enacted at the start of May,
the TMPG says the first monthly submission of claims by repo participants is
expected on June 12, 2009.
As the repo market struggles to adjust to a new regime of low and negative
interest rates, and investors wait for signs that money market funds have
started trusting banks again, there is no certainty that the worst is past. The
wild card is another unanticipated shock to the system.
In the aftermath of the September 11, 2001, terrorist attacks, by definition
"unprecedented" events, the Treasury moved on October 4, 2001, to hold an
unscheduled auction of 10-year Treasury notes in an effort to improve
conditions in the repo market. The Treasury auctioned $6 billion more of the 5%
10-year notes maturing in August 2011. The Treasury still sold 10-year notes as
part of its regularly scheduled quarterly refunding in late October 2001. It
acted to ameliorate risk triggered by a cascade of failed trades subsequent to
the attacks of September 11, 2001.
The situation was exacerbated by several factors, including increased demand
for Treasury securities, disrupted telecommunications, and the reluctance of
repo market participants to enter into trades, particularly as the end of the
third quarter 2001 passed, out of concern for the ability of the system to
regain its smooth functioning. The "fails rate", a measure of trades that do
not settle, which typically ranges below $3 billion, had surged as high as $40
billion by Q3, 2001.
The repo rate for general collateral that prevailed before September 11, 2001,
was typically close to the federal funds rate, which was cut twice by 50 basis
points each after the attacks. The first cut coming on September 17, before the
halted stock market first reopened, and the second occurring on October 2, at
the Federal Open Market Committee's regular meeting. For the
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