The Fed's Swap Meet

Mike "Mish" Shedlock
Mar 12, 2008

Stocks soared on Tuesday as Central Bankers "Pulled Out All The Stops". Certainly the market was bleeding and some primary dealers, notably Bear Stearns (BSC) and Lehman (LEH) were getting pounded over liquidity and leverage issues.

In an attempt to restore liquidity the Fed came up with a new facility called the Term Securities Lending Facility (TSLF). This program allows primary dealers to exchange a total of $200 billion mortgage backed securities (MBS) for treasuries. The period is 28 days instead of the traditional overnight lending. Why $200 billion? Because primary dealers hold $139.7 billion agency securities and $60.2 billion mortgage-backed securities. Minyanville cited Tony Crescenzi at Miller Tabak for those numbers early Tuesday.

Unlike the Term Auction Facility (TAF), which swaps cash for MBS and therefore requires sterilization so as not to affect the target funds rate, the TSLF is simply a swap of one instrument for another. It is not printing, and it injects no cash into the system even though there are misleading headlines such as this one bandied about by MarketWatch: Fed turns on the spigot of money again.

Lee Adler in Bandaid on a Ruptured Jugular explains what the Fed is up to with the TSLF.

"The Primary Dealers are heavily short Treasuries at all times. They are heavily long all other debt securities simultaneously. The level of securities lending in recent months is unprecedented in all of human history, by an order of magnitude of 10.

Securities lent by Fed to Primary Dealers

"Why is that? Because they were heavily short Treasuries and are being subject to the greatest Treasury short squeeze in history. Their only out was to borrow more securities from the Fed and short more into the market as the public clamor and panic for "safe" Treasury securities rose to a mad crescendo.

"The Fed is now responding to the pressure of the imminent collapse of the Primary Dealers and major banks worldwide, because not only are the PDs heavily short the stuff that is going up, Treasuries, they are heavily long the stuff that is going down, which is all other debt securities.

"This is the worst of all possible worlds and the Fed's action is like putting a bandaid on a ruptured jugular vein."

Lord only knows why primary dealers were short treasuries when interest rates were falling and the Fed was cutting rates, but that is what was happening.

28 Days Later

Interfluidity addresses the question of What Happens 28 Days later?

In the past few days, the Fed has announced two new programs, and again, we are left to wonder what happens 28 days later. This weekend, I argued that since the Fed cannot retire loans made via TAF and its repo program without adding to those "elevated pressures", the loans should be considered an equity infusion, because they'll be repaid at the convenience of the borrower rather than on a schedule agreed with the lender.

Does the same argument apply to the new Term Securities Lending Facility (TSLF)? On face, it's harder to view TSLF as an equity infusion, since the Fed is giving no one any cash. But to firms holding illiquid securities that the Fed is accepting as collateral, the program is equivalent to a not-so-efficient cash infusion, because the Treasuries the Fed is lending are liquid and can be converted to cash easily in private markets.

So, this new facility might well be a form of equity, if the Fed is willing to roll it over indefinitely and require payment only at the convenience of borrowers. We'll have to wait and see what happens, 28 days later.

What happens after 28 day is pretty clear. The swap will be rolled over and over and over until the mortgage backed security market stabilizes. This could be a year from now, or perhaps 10. That may sound ridiculous but it's essentially what happened in Japan. It's also part of the Zombification process I described in The Great Pretender.

Inquiring minds might be asking what happens if the value of the MBS drops. Will the Fed issue a margin call or just look the other way? One might think we just have to wait and see, but since the Fed will probably never say, it's more likely we have to wait and not see.

One thing is for sure: The more liberal the Fed is in valuing the MBS the more likely a margin call situation arises. However I strongly suspect the Fed will not disclose who is doing the swapping, in what size, or whether the swap ratio is 1:1 or not. The TAF does not abide by freedom of information so I would be amazed if this does. So much for transparency.

This may temporarily stop a further squeeze against dealers who are short treasuries and long MBS, but it is will not do much of anything to restore a bid in the MBS market. Nor will it cure the massive leverage problems at many of the primary dealers and banks.

Here's an interesting paragraph from the MarketWatch article referenced earlier: "Counting the currency swaps with the foreign central banks, the Fed has now committed more than half of its combined securities and loan portfolio of $832 billion, Lou Crandall, chief economist for Wrightson ICAP noted. 'The Fed won't have run completely out of ammunition after these operations, but it is reaching deeper into its balance sheet than before."

Bernanke's intent is to buy the dealers time, but it really can't work. Those securities will not be worth more tomorrow than they are today. For now, a MBS fire sale was averted, but it can't be put off forever.

The ongoing tsunami of housing related bankruptcies and foreclosures will seal the fate. Meanwhile the zombification of banks continues.

Mike Shedlock / Mish
email: Mish

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