Monday, March 17, 2008

Three hits and three misses for the Fed

(William Buiter in the FT) The Fed made a number of announcements on Sunday March 16.

First, it has created, initially for a period of six months, a Primary Dealer Credit Facility (PDCF) “…a special lending facility that will provide liquidity to primary dealers at terms similar to those available to banks at the discount window …” . The facility is for overnight liquidity. This is the right move: a hit.

I am still unclear as to whether this means that the Fed now has declared that there exist ‘unusual and exigent circumstances’. The Fed statements don’t use the phrase ‘unusual and exigent circumstances’; the fact that the primary dealers of the New York Fed can only access the PDCF through their primary dealers (the same kind of non-recourse back-to-back arrangement as the late Bear Stearns used with JP Morgan) suggests that the Fed may still be trying to finesse the ‘unusual and exigent circumstances’ issue. To be continued.

No doubt the population of those eligible to borrow (against eligible collateral) on primary discount window terms will be further extended in the future beyond the 20 primary dealers if the crisis deepens and widens.

Second, the Fed has announced that this new facility for primary dealers will accept a broad range of investment-grade debt securities as collateral. This too makes sense, provided the collateral is priced properly and subject to an appropriate haircut. A hit.

‘Investment grade’ can be quite illiquid, so the Fed has to make sure that punitive valuations are placed on illiquid investment grade securities offered as collateral, to avoid unnecessary moral hazard and to make sure any credit risk to the tax payer is properly priced. This, regrettably, is not the case. The Fed’s statement on the pricing of the collateral constitutes my third point.

Third, “…the pledged collateral will be valued by the clearing banks used by the primary dealers to access the new facility, based on a range of pricing services.” This suggests that the Fed will accept whatever valuations the clearing banks may come up with. The only qualification is that collateral that is not priced by the clearing banks will not be eligible for pledge under the PDCF.

Collateral eligible for pledge under the PDCF includes all collateral eligible for pledge in open market operations, plus investment grade corporate securities, municipal securities, mortgage-backed securities, and asset-backed securities.

This arrangement is an invitation to the primary dealers and their clearers to collude to rip off the Fed by overvaluing the collateral, including using false markets and/or arbitrary internal pricing models as part of their ‘..range of pricing services’ (what are pricing services anyway?). They can then split the difference. If the Fed wants to be mugged, why not let the primary dealers themselves price the collateral they offer the Fed?

For all collateral that is not priced in verifiable, liquid markets, the Fed should arrange its own auctions to discover the reservation prices of those offering the collateral. Leaving it to the clearers is a written invitation to be offered dross at gold valuations. The tax payer will be the loser. A bad and incomprehensible miss. This can be gamed by a bunch of reasonably smart high school kids.

Fourth, the Fed has extended the maturity of discount window borrowing (but not the loan maturity available to the primary dealers at the PDCF, which is overnight only) to 90 days from 30 days. This too makes sense. For reasons that are not obvious to me, 3-month Libor is the benchmark rate many loans to households and non-financial corporates are priced off. Might as well target the target. A hit.

Fifth, the Fed has cut the discount rate penalty from 50 basis points to 25 basis points. The primary discount rate now stands at 3.25 percent. This new rate applies both to the traditional discount window borrowers and to the new primary dealer facility. Cutting the discount window penalty is a mistake. It compounds the earlier error of the Fed, on August 17, when it cut the discount window penalty from 100 basis points to 50 basis points. It is a straight subsidy from the tax payer to the shareholders of the borrowers at the discount window and now also to the shareholders of the primary dealers at their new facility. This inframarginal subsidy/cut in the discount window penalty maximises moral hazard without any material effect on market liquidity in the securitisation markets or elsewhere. It looks like a further example of Fed capture by the private banking community. It would have been far better to raise the discount window penalty back to 100 basis points. A miss

Sixth and finally, the Fed agreed to fund up to $30bn to help JP Morgan complete its planned purchase of Bear Stearns, a deal that was finalised on Sunday. Why? Which public purpose is served by this take-over? This looks like a straight subsidy to JP Morgan and Bear Stearns shareholders from the tax payer. The exact magnitude of the subsidy will not be known until we know the terms of the funding. A miss.

There were a number of superior alternatives to this sop to Wall Street. Letting JP Morgan fund its acquisition from its own resources or in the market is an obvious one. If JP Morgan was unable or unwilling to do so, letting Bear Stearns sink or swim on its own would have been the obvious choice. If in that event Bear Stearns would have defaulted on its obligations and become insolvent, taking it into public ownership would have been an option if the institution were deemed to be systemically important. The existing Bear Stearns shareholders should in that case have received the right to be last in line as claimants on any future re-privatisation proceeds or on the revenues from the break-up of the firm and the sale of its assets.

The creation of a special resolution facility for investment banks, and for future use, the creation of a special resolution regime and associated legal framework for investment banks, along the lines of what the FDIC runs for deposit-taking institutions, deserves consideration if investment banks are now considered too big and too systemically significant to fail.

Three hits, three misses. It’s time for the Fed to start winning.

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