"Basically, the Fed is targeting a lower interest rate on GSE debt. Sound familiar? Yup, that’s monetizing government debt."

Rebecca Wilder at News N Economics with an interesting post:

"At some point the Fed may choose to monetize new debt issued by the Treasury (let’s say in order to raise $700 billion to finance TARP), but I doubt it. There is already a new $1 trillion of new liquidity sloshing around in the banking system, posing huge inflationary risks.
Well, circumstances have changed. Twenty-four days later, and in a rather nontraditional manner, the Fed is now monetizing government debt.
The time has come to officially monetize government debt. Yesterday the Fed announced that it would purchase $100 billion in debt obligations from Fannie Mae, Freddie Mac and the Federal Home Loan Bank next week. And furthermore, it will purchase $500 billion in mortgage-backed securities (MBS) – I like to call this FARP (Fed Asset Relief Program).

The purchase of GSE debt is a direct attempt to reduce the spread on government agency (GSE) debt over comparable Treasury debt, the relative borrowing costs. Basically, the Fed is targeting a lower interest rate on GSE debt. Sound familiar? Yup, that’s monetizing government debt.

The chart illustrates the difference between newly issued Fannie Mae debt and a comparable U.S. Treasury through 11/24/08. This spread has widened from an average of 29 bps (0.29%) spanning 2006-2007 to 90 bps spanning 2007-2008. Fannie Mae must pay more in order to finance its mortgage obligations, which limits its ability to roll over current obligations, and tightens the terms on new mortgage loans.

By driving down the spreads on GSE debt now, and later on mortgage-backed securities, the Fed gives the GSEs more flexibility in the mortgage market, and they can offer lower rates and better terms for potential homebuyers. That’s the theory.

I am interested to hear why the Fed is supporting the GSE debt and securitized assets that derive their value from the mortgages (MBS) rather than the mortgages themselves. The Fed could allocate a similar stock of resources to mortgages directly, where the effect would be immediate (mitigating foreclosures or offering better terms directly). However, I assume that the Federal Reserve Act prevents the Fed from doing such a thing – that sort of action probably lies in the hands of Congress. Although the immediate effects do appear to be quite positive.

Expect the Fed’s balance sheet to rise by another $100 billion (at least) in two weeks. It is official: the Fed is monetizing government debt."

So, the Fed is monetizing government debt.

Here's my comment:

Don said...

From Bloomberg: Rebecca, Can you tell me why they won't say so publicly, if you agree that this is what they're doing:

"The U.S. officials, speaking on condition of anonymity, said they don’t see the Fed purchases of mortgage bonds as a way of “quantitative easing,” or using central bank policy to add reserves to the banking system when interest rates are very low, even though the purchases will have that effect. "

Why didn't they just ask Poole? He's not shy.

"Quantitative easing was a tool of monetary policy that the Bank of Japan used to fight deflation in the early 2000s.

The BOJ had been maintaining short-term interest rates at close to their minimum attainable zero values since 1999. More recently, the BOJ has also been flooding commercial banks with excess liquidity to promote private lending, leaving commercial banks with large stocks of excess reserves, and therefore little risk of a liquidity shortage.[1]
The BOJ accomplished this by buying much more government bonds than would be required to set the interest rate to zero. It also bought asset-backed securities, equities and extended the terms of its commercial paper purchasing operation."

I'm not sure why, if it's going to have that effect, it wouldn't be considered a positive side effect.

Don the libertarian Democrat

November 26, 2008 2:20 PM

Here's Rebecca's reply:

"Rebecca Wilder said...

Hi Don,

Good to hear from you?

Honestly, I don’t know what else you could call it – government purchasing MBS and credit directly? That sounds like quantitative easing to me – and Kohn said that the easing has already started. http://blogs.wsj.com/economics/2008/11/19/feds-kohn-deflation-risk-bigger-but-still-small/

In my book, the Fed can call it whatever it likes – monetization, easing, whatever - it’s not like they are going to tell us anyway. To me, the Fed purchasing MBS is better than an outright purchase of Treasuries because the yields on those bonds are already so low. Why not target an market that is actually going to do some macro-economic good, like the MBS market. I wonder if they will purchase CMBS, too? Probably not, but those spreads are very, very wide.

Thanks for reading and Happy Thanksgiving!

Rebecca"

"Instead they are rating based on public relations."

Accrued Interest has an important post about how the Credit Ratings Agencies, as I've said, are erring now in being too tough on companies:

"Here is the problem with Moody's stance. It has nothing to do with their actual view of municipal insurance. Its painfully obvious that this is nothing more than CYA. Its like a referee doing a make-up call. They completely screwed up structured finance ratings from 2002-2007 or there abouts. And thus they have a lot of egg on their face in regards to FGIC, Ambac, MBIA, etc.

So now they want to act all tough and refuse to give Aaa ratings to monolines under any circumstances. Does this make any more sense than when they were giving out Aaa like business cards? Aren't they essentially making Assured Guaranty pay for the sins of FGIC?

Consider this. Let's say that a new municipal insurer is created and that insurer acquires all the municipal policies from Ambac. Now let's say that the new insurer has enough capital such that if it immediately went into run off, it could pay all realistic potential premiums with a significant cushion. What is "realistic" and "significant" in the previous sentence would need to be defined, but there is no reason why Moody's can't come up with those numbers.

Why can't such a firm be rated Aaa?

Notice how in the above scenario, the firm's ability to generate new revenue isn't relevant. The firm's ability to raise new capital isn't relevant. Its simply does the firm right now have adequate capital to pay its liabilities. Why is that concept so unreasonable?

For Moody's to claim they cannot rate on this basis is a total cop out, because this is exactly how all securitized deals are rated. A securitization is always a closed loop. The ratings have to be based on available capital versus expected losses. Obviously mistakes were made in rating securitized deals in recent years. But for Moody's to claim they cannot rate on such a basis is complete bullshit. Do we need to alter our models? Absolutely. But Moody's cannot on one hand claim to be a competent ratings agency and on the other hand claim they can't estimate muni losses versus available capital.

Municipal insurance benefited both investors and municipalities. Now it will die, all because Moody's doesn't have the courage to rate insurers based on dollars and cents. Instead they are rating based on public relations."

Here's my comment:

Don said...

"So now they want to act all tough and refuse to give Aaa ratings to monolines under any circumstances. Does this make any more sense than when they were giving out Aaa like business cards? Aren't they essentially making Assured Guaranty pay for the sins of FGIC?"

It made sense going up, because they made a lot more money. It makes sense going down because they were trading on their reputation going up, and they're trying to get it back now. In doing so, they are abetting, once again, not focusing on fundamentals.

The model here is broken. I be interested if you have read this, or I've missed your ideas on this problem:

http://www.glgroup.com/News/White-Paper-on-Rating-Competition-and-Structured-Finance-(Part-1)-23549.html

Don the libertarian Democrat

11/26/08 2:30 PM

I didn't get a reply, or I would have posted it.

"that demand for loans has dipped all suggest we're far from the end of the current downturn"

This is ugly chart day. From Zubin Jelveh:

"Nov 25 2008 3:27PM EST

Chart of the Day

Interest rates on 30-day commercial paper. A2/P2 is the rating given by credit agencies to the least prime -- but still above junk -- paper:

Chart is adapted from a recent presentation by University of Chicago's John Cochrane where he says that the death of the securitized lending system, aka the shadow banking system, may be a good thing:

Many investors thought they were getting 50 basis points at no risk, whereas in fact what they were holding was securitized debt and there was risk. It would be much better not to pretend that there's magic alpha.

The fact that TARP nor the Fed's unspoken quantitative easing policy haven't done anything to reduce borrowing costs for much of the private sector, that fed funds is close to zero, and that demand for loans has dipped all suggest we're far from the end of the current downturn, and why the Fed decided to go full-force into reducing mortgage rates."

Here's my comment:

Posted: Nov 26 2008 1:54pm ET

From my perspective, the two effects go together. The massive flight to safety is driving rates down, while the fear and aversion to risk is so great, that, besides causing the massive flight to safety, it is causing an even more pronounced flight from risk.

Nothing that has happened so far has changed that fundamental perception. Until it does, the numbers will remain poor.

By DonthelibertarianDemocrat

"Foreign demand for any US bond with a smidgen of credit risk has disappeared."

Brad Setser with a continuing theme, the flight from risk:

"This is an example of what Calculated Risk calls cliff-diving. Foreign demand for any US bond with a smidgen of credit risk has disappeared. Indeed, the fall in demand for Agencies over the past three months is more severe than the fall in demand for US corporate bonds (think securitized subprime mortgages and other securitized housing and consumer debt) last August.

Normally, this kind of fall-off in foreign demand would be associated not just with a credit crisis but also with a currency crisis. A country cannot finance a trade and current account deficit without financing, and two big sources of financing for the US deficit — foreign purchases of Agencies and US corporate bonds — has disappeared. The US, though, isn’t a normal country. The fall in demand for risky US assets was offset by a rise in demand for Treasuries and the sale of foreign assets by Americans."

1)Trade & Current Account Deficit needs FINANCING
2) FINANCING from Foreign Purchases of AGENCIES & US CORPORATE BONDS
3) Without FINANCING = Credit & Currency Crisis
4) FINANCING ( now ) from Foreign Purchases of TREASURIES & FOREIGN ASSETS

"This data clearly shows a massive shift from Treasuries to Agencies.

To complete the picture I added short-term t-bill purchases by private investors to the long-term purchases and short-term official purchases. Total Treasury purchases over the last 3 months totaled $214 billion. That’s huge."

I think it's from AGENCIES to TREASURIES:

"Combining that inflow with $92 billion in net sales of foreign assets by American investors implies that the “flight to Treasuries” and “deleveraging” combined to provide about $300 billion in net financing to the US. That, in broad terms, allowed the US to run a roughly $175-200b current account deficit and cover a huge outflow from the Agency market.

China is particularly interesting case. SAFE clearly has added to the instability in the credit market over the past few months — and equally clearly contributed to low Treasury yields. That isn’t a criticism — it is just a statement of fact."

Low TREASURY Yields from high demand:

"At the end of July, China stopped buying Agencies and corporate bonds and started to pile into Treasuries. Over the last three months of data (i.e. the third quarter), the US data indicates that China has bought $81.1 billion in Treasuries ($45 billion short-term) and added $17.4 billion to its bank accounts — that is a flow of nearly $100 billion into the safest US assets China can find. Conversely, China sold $16 billion of Agencies, $1.8 billion of corporate bonds and a bit less than a billion of equity."

See this post.

"The September data also should put to rest all the talk about China retreating from Treasuries. The real issue is that China has retreated from the Agency market. True, September is a long time ago — but the Fed’s custodial data doesn’t suggest anything has changed since then.*

I’ll conclude by looking at trends over a somewhat longer time horizon. Starting last August, foreign demand for most kinds of risky US assets dipped. There is a clear break in a chart showing rolling 12m purchases of corporate bonds and equities back then. More recently, Agencies got reclassified as a risk asset. There was a bit of a fall off in demand for Agencies last August — but the really big fall off has come recently.

So the flight from risk started in August. Right now foreigners don’t seem to be interested in any kind of risky US asset.

Instead they are buying Treasuries.

And remember this is just a chart showing foreign purchases of long-term Treasuries. In addition to buying roughly $385 billion in long-term Treasuries, foreign investors snapped up another $240 billion (gulp) in short-term Treasuries. That works out to a net inflow in the Treasury market of over $600 billion …

Of course, Treasuries aren’t entirely risk free. I don’t believe that there is a real risk the Treasury would default. Buying credit-default swap protection on the US is something by colleague Paul Swartz calls an end-of-the-world trade. But foreign investors holding long-term Treasuries are clearly taking a lot of currency risk — especially if they are buying in now, after the dollar has rallied …

The US is taking a risk too. The rising stock of short-term bills held abroad does potentially leave the US more exposed to a rollover crisis."

They're buying now when the DOLLAR IS HIGH.

I'll say this again. I can understand the flight from risk.

NB: This Post:

"The plunging euro

Why is the euro plunging against the dollar and the yen? Why are European banks coming under renewed pressure? Should the emerging financial and foreign exchange crisis of countries gravitating around the euro lead to new EU policy instruments?

The euro is plunging against the dollar because investors, in their scramble for safety and liquidity, are flocking to US and, also to some extent, Japanese government bonds which are considered safer and more liquid than other government-backed paper available in the market – including public debt instruments issued by European governments. In other words, the constellation of separate markets for sovereign debt paper of unequal quality issued by European governments cannot compete with the US market for the huge global financial flows in search of a safe harbour."

And this post:

Saturday, October 25, 2008

``Any sense of rationality and fundamentals is thrown out the window.''

Bloomberg on the flight to safety, with the emphasis on flight:

"Dollar Gains Most Since 1992 on Concern Global Slump Deepening

By Ye Xie

Oct. 25 (Bloomberg) -- The dollar gained the most in 16 years against the currencies of six major U.S. trading partners as a global economic slowdown spurred demand for the greenback as a haven from losses in emerging markets.

``The foreign-exchange market is basically saying we are in a global recession and perhaps a very, very deep one,'' Richard Franulovich, a senior currency strategist at Westpac Banking Corp. in New York, said in an interview on Bloomberg Radio. ``Any sense of rationality and fundamentals is thrown out the window.''

I'm going to start collecting quotes saying that fundamentals are being ignored, as well as quotes showing that investors consider government intervention.

And this post:

Saturday, October 25, 2008

" Investors around the world fled stocks and rushed to the relative safety of the U.S. dollar"

The effects of the crisis are spreading. See this post in the Washington Post:

"Gloom about economic growth translated to low expectations for oil consumption. The Organization of the Petroleum Exporting Countries yesterday announced a cut of 1.5 million barrels a day in output -- a move that still failed to arrest the slide in crude prices. Meanwhile, copper prices fell to a three-year low.

Investors around the world fled stocks and rushed to the relative safety of the U.S. dollar by pouring money into 30-year Treasury bonds, a refuge in times of uncertainty. That drove down the value of foreign currencies, from the ruble to the rupee and the zloty to the peso, forcing central banks to spend billions of dollars to prevent even further deterioration. The turmoil in currency markets threatened to reorder trade relations and complicate recovery efforts."

"thereby insuring that everyone gets hurt even more as foreclosures continue"

Joe Nocera asks whether bundled mortgages can be negotiated:

"You see, all of these programs deal only with “whole loans” — that is loans on the books of the institutions, unencumbered by securitizations. So far, the attitude of all involved when it comes to securitized mortgages is to throw up their hands and say — “it’s too hard to deal with!” And it may well be: mortgages that were sold to Wall Street and wound up in mortgage-backed securities have been sliced and diced and sold and resold to investors with varying risk tolerances. They are serviced by people who owe a fiduciary duty to all these investors, no matter what their place on the risk continuum.

James Grosfeld, the former chief executive of Pulte Homes, summed up the problem in a recent e-mail message:

There are well over $1,000,000,000,000-$1,500,000,000,000 of mortgages trapped within mortgage-backed securities. These are the most risky mortgages ever issued — mortgages poorly underwritten and often with unaffordable payment shock at the end of teaser rate periods. Pool losses will be unprecedented.

However, there has been no successful effort on a broad scale to reform these mortgages because of contractual obligations of trustees and servicers to bondholders. Simply put, these fiduciaries are scared of being sued by bondholders if they modify loans into affordable new mortgages. Every effort to jawbone trustees/servicers to reform these mortgages quickly and on a mass basis has failed and will fail. These fiduciaries fear financial liability, and servicers are overworked and have no meaningful financial incentive to provide this desperately needed refinancing.

Recently, certain hedge funds have threatened to sue fiduciaries of these securitizations if they refinance loans. Congressional hearings are taking place with respect to these threats. Nothing to prevent mass foreclosures of these loans will be effective unless Congress acts affirmatively to remove liability and provide financial incentives for refinancing. Jawboning bondholders and fiduciaries has not and will not work.

The situations borders on the absurd. Investors will not allow mortgage modifications that would hurt them more than some other investors — thereby insuring that everyone gets hurt even more as foreclosures continue. And as foreclosures continue, the financial crisis continues to deepen because foreclosures on Main Street mean billion-dollar write-offs on Wall Street. And struggling homeowners can only pray that their mortgage is still held by the bank and not sold to Wall Street — in which case they are out of luck. It is like flipping a coin to see if you can hold onto your home."

Here's my comment:

“Every effort to jawbone trustees/servicers to reform these mortgages quickly and on a mass basis has failed and will fail. These fiduciaries fear financial liability, and servicers are overworked and have no meaningful financial incentive to provide this desperately needed refinancing.

Recently, certain hedge funds have threatened to sue fiduciaries of these securitizations if they refinance loans. Congressional hearings are taking place with respect to these threats. Nothing to prevent mass foreclosures of these loans will be effective unless Congress acts affirmatively to remove liability and provide financial incentives for refinancing.”

This sounds like moral hazard blackmail. Other people have been bailed out, and we’re willing to risk a blowup against the better odds and terms of getting bailed out.

I see only two choices:
1) Free market: Let them blowup.
2) Government intervention: Force terms upon everyone involved.

The in-between route is just too bitter a pill to swallow in my opinion.

— Don the libertarian Democrat

G-7 Finance Ministers and Central Bank Governors Plan of Action

Via Across The Curve:

October 10, 2008
HP-1195

G-7 Finance Ministers and Central Bank Governors Plan of Action

Washington-- The G-7 agrees today that the current situation calls for urgent and exceptional action. We commit to continue working together to stabilize financial markets and restore the flow of credit, to support global economic growth. We agree to:

1. Take decisive action and use all available tools to support systemically important financial institutions and prevent their failure.
2. Take all necessary steps to unfreeze credit and money markets and ensure that banks and other financial institutions have broad access to liquidity and funding.
3. Ensure that our banks and other major financial intermediaries, as needed, can raise capital from public as well as private sources, in sufficient amounts to re-establish confidence and permit them to continue lending to households and businesses.
4. Ensure that our respective national deposit insurance and guarantee programs are robust and consistent so that our retail depositors will continue to have confidence in the safety of their deposits.
5. Take action, where appropriate, to restart the secondary markets for mortgages and other securitized assets. Accurate valuation and transparent disclosure of assets and consistent implementation of high quality accounting standards are necessary.

The actions should be taken in ways that protect taxpayers and avoid potentially damaging effects on other countries. We will use macroeconomic policy tools as necessary and appropriate. We strongly support the IMF's critical role in assisting countries affected by this turmoil. We will accelerate full implementation of the Financial Stability Forum recommendations and we are committed to the pressing need for reform of the financial system. We will strengthen further our cooperation and work with others to accomplish this plan.

-30-

Again, I think we're there.