The following is a paper published earlier this week by former Sempra Metals economist John Kemp looking in detail at the Fed’s emergency money market operations and its ultimate reliance on Chinese support. It’s a long read - 5,000 words - so we’ve split it into five parts. If you would like an accompanying selection of charts that are simply too large to publish here email alphaville@ft.com.
In a fateful decision in Mar 2008, the Fed announced a new Term Securities Lending Facility (TSLF) through which it would swap Treasuries from its own stock for mortgage-backed and other securities held by the banks. The Fed has always lent out Treasuries from its portfolio to help alleviate shortages of particular maturities in the market, but normally only overnight. The TSLF enabled borrowers to swap Treasuries in much larger volumes and for much longer periods. By Aug 2008, the Fed had $480 billion of Treasuries in its own stock, but it had lent about $120 billion of them to the banks in exchange for lower quality and less liquid credits, leaving only $360 billion actually available.
But as the banking system descended into crisis from mid Sep onwards, the Fed’s lending surged. Discount Window loans for commercial banks soared from an average of $20 in the week ending Sep 10 to $44 billion by the week ending Oct 1. Credits to investment banks and other broker-dealers went from zero to $148 billion. The Fed also announced a new facility to support money market mutual funds unable to roll over asset-backed commercial paper which went from zero to $122 billion in the space of a fortnight. It extended another $53 billion of other loans, and swap arrangements with other central banks had already drawn down an extra $30 billion, with much more to come.
Worse, the volume of Treasury securities lent out via the TSLF and other facilities surged from $118 billion to $256 billion, cutting the volume of Treasuries left in the Fed’s possession and unpledged from $354 billion to just $232 billion, with the balance falling fast.
From the middle of Sep, the Fed dropped its previous insistence on sterilising credit extensions and began to allow its balance to grow significantly. Officials made no attempt to offset the new credits to money market mutual funds, banks, broker-dealers and other central banks. The Fed’s balance sheet, which had been steady at $905-935 billion for a year surged to an average of $983 billion on the week ending Sep 17, $1.189 trillion on the week ending Sep 24, and $1.441 trillion on the week ending Oct 1, and was still growing rapidly. The Fed’s balance sheet has now increased +53% in the space of three weeks.
Some of the new lending is backed by increased deposits from the banking system itself, as banks conserve cash and raise their balances with the Fed itself. Bank deposits with the Fed have soared from an average of $8 billion in the week ending Sep 10 to $167 billion in the week ending Oct 1. But with the Fed’s balance sheet looking increasingly stretched, the US Treasury has been forced to step in and strengthen the central bank by depositing huge volumes of excess funds.
The Treasury normally issues small volumes of “cash management bills” to meet temporary shortfalls in its accounts when demand is unexpectedly heavy or tax receipts are slower than anticipated. The volume of bills issued is not usually more than $70 billion in any one month, and the bills are usually rolled over rapidly into regular bills and notes at the next funding auction. But in the second half of Sep, the Treasury sold an unprecedented $320 billion worth of cash management bills and deposited all the resulting funds into a special “supplementary financing program account” with the Fed. Another $140 billion were issued in the first three days of Oct, taking the total in the supplementary account to $399 billion.
In effect, the Treasury has taken advantage of the panic-driven flight to quality to issue a mountain of very short-dated cash management bills, and deposited the proceeds with the Fed, which has enabled the Fed to grow its own balance sheet and expand its own lending to the banking system. The Treasury is pledging the full faith and credit of the United States to raise funds in the money market on behalf of the banks who cannot, substituting its own AAA-rating for the impaired creditworthiness of the major financial institutions. Because of the sheer volume of “safe haven” flows, the Treasury has been able to issue most of this paper at annual interest rates of just tenths of a percentage point. The Fed has taken a substantial portion of the banking system effectively onto its balance sheet, while the Treasury is now borrowing in the market to support the central bank.
One consequence of this is that it is too simplistic to assume the massive growth in the Fed’s balance will be inflationary (contrary to the views of some commentators). While the has increased the various loans and advances it makes to the market sharply in the last three weeks, this is counterbalanced by the $400-460 billion of over-borrowing undertaken by the US Treasury from the public, which has removed a broadly similar amount of liquidity from the system. So the bailout is not (yet) a clearly inflationary signal (though to the extent it reduces the risks of a severe recession, it reduces the risk of a DE-flationary spiral).
The volume of support from the Fed and the US Treasury is unprecedented. Once the TARP ($700 billion) and the various lending facilities already announced ($1.0-1.5 trillion) are fully implemented, the Fed and the Treasury will be extending credits and other support equivalent to around 15-20% of US GDP (though the actual cost to the taxpayer should be much smaller as most credits and at least some of the securities acquired under TARP should be repaid for what the authorities bought them for).
But the scale of the operations also highlights the limited usefulness of this type of intervention and has fuelled market doubts about its eventual effectiveness, as was evident in yesterday’s renewed plunge in US equity markets.
Continued…
