'Collateral is the Contagion' plaguing swap & securities markets

U.S. weighs options to ease strain on AIG
2008-11-07 12:47:51.230 GMT
“WSJ reports federal officials are considering ways to ease the financial pressure on American International Group … “

Doh! It took the federales two months to figure out that having: a) the Fed borrow money, b) to lend to AIG, c) to buy collateral, d) to deliver to MS & GS, was neither the best nor most obvious solution. It took me all of a day or two to figure this out. (See "The Panic of 2008" a.k.a 'Collateral is the Contagion' -- to be posted later.) The solution to AIG-FP, CDS collateral problems, and many of the other problems plaguing securities markets (record levels of 'fails to deliver'), would be for the Fed to instead step in to the middle of dealers' (banks & brokers) ISDA agreements as the CSA (collateral) support provider. The Fed puts up only its name -- no cash, no securities.

This isn't the only stupid -- er, excuse me, suboptimal thing they've done. Easy examples:

1) Central banks & regulators globally, ours included, bemoan that they can’t make banks lend the money they're stuffing them full of. So what did the Fed do? They started paying interest on reserves, and not just required reserves but excess reserves too! Hmmm ... put my money at risk by lending it, or deposit at the Fed and earn fed funds with zero credit risk and zero liquidity risk (Fed balances are more liquid than cash). Excess reserves at the Fed went from $1,988m in August, to $363,615m on Nov. 5th. Put that in your HP-12C and annualize the growth rate. Doh! (Granted, excess reserves were growing before this decision for other reasons.)

2) Commercial paper (CP): The federal solution to "frozen" CP markets was to leverage (or ‘throw’) their balance sheet at the problem and buy everyone’s CP. From $0.00 two months ago the Fed now holds $243 bln of CP, adding $185b of that just last week! This is crowding out existing market channels as well as inflating the federal fisc. Instead, why not simply guaranty the last 90% of the issued amount, letting "price discovery" continue to function -- i.e., Mr. Market prices & allocates credit based on the 10% first-loss risk. Alternatively, the Fed should repackage this $243b of CP and resell it into the market --i.e., the CPFF becomes a "conduit" or SIV or the Fed’s own ABCP program.

A year ago total "Federal Reserve Credit" was $869.4 bln. Now, it's $2,058bln. By my calculations the federales-- the Fed, Treasury, FDIC, Congress, et al -- have made or proposed over $7 trillion of bail-out measures. (Not counting the Fannie & Freddie loans and guarantees.) Added to $9.5 trillion of gross federal debt outstanding, that’s a $16.6 trln mortgage on our $14.4 trln GDP (excl. pensions, unfunded mandates, etc.).

3) The SEC ... OK, they're too easy. Banning short-selling was really stupid. First, it shatters market confidence as it's arbitrary, capricious, doesn't/didn't work, and it's too late. They had nearly 1000 names on their list of financial services companies. My favorite was the good folks at U-Haul (Amerco). Even if they do own some insurance companies, those orange trucks & trailers seem a lousy short idea given (among other reasons) all those foreclosures creating demand for cheap relocation services.

More intelligent & effective: Require third-party settlement of shorts: the short, their prime broker, and securities lender all enter instructions with DTCC, NYSE, or some other 3rd party who matches & settles. Taking it another step, encourage "dark pools", a service that allows shorts and sec' lenders to find the best trade. This improves market efficiency, "price discovery" -- although maybe this isn't the best time to reduce 'friction' in short-selling!

JRB

11/7/08