$2 trillion more of collateralised loans and outright purchases of private securities, please

This past month or so, the Fed has created facilities capable of pumping about $400bn worth of liquidity into the US financial system. I expect that the Fed will have to do a lot more by way of liquidity injections. Over the remainder of the year, even an additional $1 trillion of collateralised lending by the Fed (over and above the normal levels seen before the second half of 2007) is likely to be inadequate to get key financial markets functioning effectively again and to keep them that way. It would barely be more than $100bn extra per month - too little to make a substantial difference. My guess is that somewhere between $1.5trillion and $2.0 trillion of further above-normal liquidity provision will be required in the US before this crisis is over.

This guestimate is based on the size of the balance sheet of the leveraged sector, the maturity distribution of its liabilities, the likely additional demand for liquidity arising from the need to transfer the assets of off-balance-sheet vehicles onto the balance sheet of the banking sector, and the probable continued disruption of private wholesale financial markets.

I expect that while most of this will be through repo-type operations (using vehicles like the Term Auction Facility’ (TAF) for banks and the ‘Term Securities Lending Facility’ TSFL) for primary dealers), some of it will ultimately be through outright purchases of non-US agency (GSE)–guaranteed private debt instruments like RMBS and corporate bonds. I believe the Federal Reserve Act does not rule this out (although it does not explicitly allow it either). I am assuming that, in a crisis, anything that is not explicitly forbidden is allowed; even some things that are explicitly forbidden will be condoned.

The Federal Reserve Act allows the Fed to invoke ‘unusual and exigent circumstances’ under which it would be allowed to conduct outright open-market purchases of ‘bills of exchange’ and ‘bankers’ acceptances’. The question then becomes how elastic the interpretation of ‘bills of exchange’ and ‘bankers’ acceptances’ would be. It is my belief that in the midst of a financial crisis, it would be hard for any agency or court to stop the Fed from declaring ‘bills of exchange’ and ‘bankers’ acceptances’ to be virtually any kind of private security, including corporate bonds. Perhaps they would draw the line at pure equity.

When it has declared circumstances to be ‘unusual and exigent’, the Fed can also lend, against any collateral it deems appropriate (including second-hand cars and dead dogs), to individuals, partnerships and corporations. Extending the range of eligible counterparties is one way of bypassing the bottlenecks preventing Fed liquidity from flowing freely through the depositary institutions and the primary dealers that hoard the liquidity to other financial institutions and the rest of the economy that need it.

When the Fed, in an outright purchase, takes mortgage-backed securities risk directly on its balance sheet, (rather than the risk it runs in a collateralized loan, that both the borrower and the issuer of the collateral will default), it is even more important that the collateral or the securities that are purchased outright be valued aggressively and subject to a severe haircut or discount on this aggressive valuation. Without that, moral hazard could become rampant.

There is nothing wrong with the Fed or any other central bank taking credit risk onto its balance sheet, as long as that risk is appropriately priced. An appropriately higher expected rate of return compensates for greater risk, including default risk. In the end, the Fed is backed by the US Treasury, so it is always possible to recapitalize the central bank without recourse to the inflation tax.

As long as there is a non-zero probability of default on the securities the Fed acquires as collateral or outright as a result of its liquidity management for the economy, it is possible that the tax payer will have to come to the rescue of the central bank. The appropriate risk premium does not cover the biggest loss that could conceivably occur. But the securities acquired by the Fed should be priced low enough to ensure that their expected rate of return at least compensates (ex-ante) the Fed for the risk of capital losses on these securities.

Thank you for the pings. I really appreciate being kept up-to-date on all of this.

At this point we can probably boil the FED’s strategy down to this: Mooring the securities that now find themselves anchorless to something other than real estate, which in the short term (the band aid) is pure capital and perhaps a commodity bubble. I think we’re printing money right now just to stop credit markets from coming to a complete halt, and we’re doing it buy purchasing all the bad debt notes. The collateral for all this borrowed and authorized capital is the Sub-Prime and Alt-A junk that is worth pennies on the dollar. That’s a purchase, not a collateral-based loan.

Lovely.

Bernanke’s expertise/obsession is the Great Depression. I strongly believe he was appointed to avoid the D word. They all knew this was coming down the pipeline.

This is probably unavoidable in the short term, a ‘bad’ bond structure is polluting the ‘good’ systems (in functional terms, not political) that any capitalist systems needs. We cant let credit markets go bad because credit markets are how we grow the economy based on reasonable expectations of future growth, right? So banks are a neccessary link, the ‘private sector’ part, municipal bond markets are why property taxes arent unstable (bridge goes down, you get a supplemental bill to cover it without municipal credit), you can borrow to buy a car, etc.

So they need to keep the ‘good’ systems up and running by propping up the basis of the system, which is currently going bad. Real estate is contracting at insane multiples, 5-10 % in lost value in some areas in the quarter, and those houses are backing up these bonds, making them toxic.

So, the bailout is not to help the common folk...it's to help the banks to avoid the already crashing dollar from going negative. Hard for the gov to service its debt if it drops below 0.60 in the next 6 months.

Hmmmm.....can we say that maybe 'the wizzes' in government and Wall Street were seriously smoked-up on some crack & pulling belts of bourbon dorkin' high priced escort women when they agreed to start the past credit expansion?

Can we say that maybe, just maybe, that our 'retail-service based economy' has the probability of a 25 year of survival equal to -1????

No, it’s to help all of us.

We need to get out of this ‘small potatoes’ mindset.

I think we’ve been binging on scraps in politics for so long, even to the point that we make big issues out of things morons like Bill O’Reilly say on television (I mean really, BFD about BOR’s opinions), that we’re not seeing a big huge issue for what it is.

The FED is trying to preserve our economy in a way that was clearly benefiting almost all of us. Now, all the basic things that economy needs to work are simply not functioning.

We need credit no matter what. Without credit, our economy, which is scaled to a level of affluence that is dependent on credit, cant go on the working the way it does now.

So even though I hate seeing the dollar killed in value, and the subsequent inflation, this is probably the only way to keep credit markets working until these guys can figure out a big ‘fix’, which is converting these bonds and securities into different bonds and securities.

This isnt about poor people buying houses anymore. It never really was.

It's about unreal expectations of investors, the governments unreal expectations of growth of the economy, government spending out pacing solid sustainable economic growth, and dishonest banking practices.

The airheads have already turned a blind eye to illegal immigration, its associated costs, etc., as a means to create a demand on paper for 'housing'/jobs / finacing.

i.e.: prop up the economy after 9/11. Simple fact.

With so much traditional manufacturing having already left the US by 9/11, there were few sectors to 'stimulate demand' as investors became nervous then.

Believe anything else and you're fooling yourself.

The interference of the gov in the economy is not smart. There is serious error in judgment that they think removing import tariffs stimulates economic activity (trade surpluses) here, domestically.

SO, are you willing to accept the pay here in the US of your counterpart in in your field in China? I think not.

Therefore, no way the US manufacturing sector is able to compete in consumer electronics, furniture, textiles, tooling, etc.

Yup building an economy based upon folks working part-time in retail and service oriented jobs with no benefits is real rock solid as a means to pay for affordable housing....buying a home.

Please forgive me, my comments are not directed at you personally, by no means.

I'm just spouting off and pointing out the obvious of W's agreement to Congress's and the Fed's failed economic policies beginning with Bush senior.

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