Twisting in the Wind


While waiting for TALF

Bernanke did everything he could last week, short of a QE3 expansion of the Fed’s balance sheet, but apparently the market was expecting more. A creature of habit, the market was fixated on the balance sheet that has done the global heavy lifting since Lehman, rather than on the balance sheets that are poised to do the heavy lifting now, namely the other central banks that jointly announced unlimited dollar lending last week, especially the ECB.

Bernanke is going to sell $400 billion of Treasury bills (< 3 years maturity) and buy an equal amount of Treasury bonds (6-30 years maturity), in effect an interest rate swap. And he is also going to reinvest the principal payments on current holdings of Mortgage Backed Securities into additional MBS instead of Treasuries, thus maintaining rather than shrinking the Fed’s credit swap position.

Big money, but no big deal in the larger scheme of things. It is not Treasury bonds but rather peripheral Europe bonds (and the banks that hold those bonds) that need the help.

Geithner was in Europe last week to urge a European version of the Fed’s Term Asset-backed Lending Facility (TALF). The idea is to use the 440 billion euro capacity of the European Financial Stability Facility (EFSF) not to buy sovereign debt outright but rather to guarantee it so that private investors will be willing to buy it themselves. And the further idea is to use the unlimited balance sheet capacity of the ECB to lend private investors the money they need to finance those purchases, given the somewhat precarious state of European money markets at the moment.

This is more or less the same strategy that Geithner and the Fed initially proposed two years ago to restart the market in Mortgage-Backed Securities in the U.S. But it didn’t work, so the Fed wound up buying MBS outright instead; that operation is now known as QE1. My sources tell me that the reason TALF didn’t live up to its promise had to do with complications involved in U.S.-style mortgages, but those complications are presumably not present in sovereign bonds. Maybe TALF can work in Europe?

Observe that the ECB is already buying peripheral bonds, and is under pressure to buy more, given the inadequate resources of EFSF. A Euro-TALF would take that pressure off, even as it multiplied the resources of the EFSF several fold in preparation for Italy and/or Spain. (If EFSF took a 20% first loss exposure, the multiple would be five.) The ECB would no longer be exposed to credit risk (no doubt a welcome development), but its balance sheet would expand to a multiple of its current size (probably not so welcome).

What to think about all this?

The first thing to say is that these measures address the liquidity problem, and punt on the solvency problem. Fair enough, according to me, since one thing this crisis should have taught us is that liquidity kills you quick, solvent or not. No doubt the underlying problem is insolvency, of some sovereigns, of some banks that hold the debt of those sovereigns, and therefore also of some creditors of the banks. That is going to play out, and the sooner the better. But meanwhile doubt about how exactly it will play out is freezing markets, and that is the problem at immediate hand.

Remember the slow motion train wreck that started four years ago. Until March 2008, and the collapse of Bear Stearns, the Fed’s main response was simply to lower the Fed Funds rate from 5% to 2%. After that, policy shifted to classic lender of last resort, in which the Fed sold off its holding of Treasury securities and lent the proceeds to a widening collection of needy counterparties against a widening category of eligible collateral. That’s where the Fed was on the eve of Lehman, and that is more or less where the ECB is today.

After Lehman, the Fed’s first action was essentially to backstop the wholesale money market by offering its own balance sheet as counterparty for both lenders and borrowers. That was the origin of the initial balance sheet expansion. In a way that kind of intervention can be viewed as nothing more than an extension of pre-Lehman lender of last resort, now financing loans with borrowing rather than asset sales. In light of what happened after, I prefer to view it as a new kind of intervention, dealer of last resort, in which the Fed in effect posted a bid and ask in the wholesale money market, and absorbed the resultant order flow on its balance sheet.

This kind of money market dealer of last resort is already in view at the ECB, as some lenders are shifting their deposits, and some borrowers are seeking alternative sources of funding. In a way the ECB’s task is easier than the Fed’s was, since the global funding market is primarily a dollar market not a euro market. But the ECB has to be prepared in case the euro funding crisis turns into a dollar funding crisis; that is what the dollar funding commitments are all about.

From this perspective, Euro-TALF looks like nothing more than an extension of money market dealer of last resort. Essentially the ECB offers financing to purchasers of sovereign debt, and raises the funds by offering its own money liabilities, first euro but maybe eventually also dollars.

But the key to making it work is the guarantee by EFSF, which operates to put a floor on the price of the sovereign debt. Here I think we have to see the proposed TALF rather as an extension of the ECB’s bond buying program, which is dealer of last resort in the capital market. The credit risk is to be shifted onto the balance sheet of the EFSF, but the funding comes from the ECB. The bonds may nominally sit on the balance sheet of private investors, but the risk and the funding are both on the balance sheet of the public sector. I’d call that dealer of last resort, wouldn’t you?

In the above, I have so far been focusing on the ECB, and left aside the role of the Bank of England and the Swiss National Bank, much less the Bank of Japan, not to mention the IMF, or Brazil, or China, or…. We are facing a global crisis, and everyone is going to be swept up in it before we are done.

To be continued…

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