US Fed tries to fill the liquidity pool and avoid a drought Wednesday, March 12, 2008
Yesterday's pronouncements by a global consortium of central banks demonstrated how serious the current liquidity drought is.
The US Fed has further relaxed it's market intervention policies and to offered to accept triple-A rated private label mortgage backed securities (MBS) as collateral in exchange for lending primary dealers up to $200bn in Treasury securities for 28 days at a time.
The following example should helps explain how this helps
- Bank "X" funds purchases of securities by a hedge fund and receives mortgage backed securities [MBS] as collateral which the hedge fund owns. Lets assume they receive $112 of MBS for $95 of cash. Bank X will charge interest on the cash loan [the owner of the MBS continues to receive the income from that asset from the MBS issuer]
- Ordinarily Bank X would seek to replenish its cash by either lending or pledging the MBS to other market participants, but usually on improved terms eg $112 of MBS generates $101+ of cash. This can happen because the bank is considered a better credit risk than a hedge fund and so less collateral is demanded. There are other ways the same assets can raise funds but we'll leave that for now. This "excess" cash can now be used by the bank in its' lending operations and generate extra income [difference between the rate it will pay to the lender on $101 and the rate it will charge to others for that money].
- However, because banks have lost confidence in each other and iner the MBS assets, these assets can't be easily recycled and hence Bank X struggles to raise additional cash to recycle.
- Under the new arrangements, Bank X can now swap $112 of MBS with the Fed and receive say $105 of US Treasuries [the haircut being applied by the Fed isn't clear]. These $105 of US Treasuries can now be offered by Bank X to others as collateral and cash raised to recycle in the system eg $102.
Notably, this move doesn't transfer ownership of the credit risk of MBS, which an outright purchase of the MBS by the Fed would do. This remains with the hedge fund in the example above. As I discussed here, falls in the price of MBS assets related to a loss of confidence that the MBS issuer can repay its' loans or make repayments as a result of losses of the underlying mortgages will hit the hedge fund and begin a vicious spiral. It is for this reason that commentators are wondering whether the Fed might ultimately need to actually begin buying the MBS, at which point the Fed [read US Govt] would bear the credit risk and shift lending from the private to public sector.