Friday, May 2, 2008

Things are returning to normal.....not

The US Federal Reserve has just put out a press release. Here is some extracts:

The Federal Reserve announced today an increase in the amounts auctioned to eligible depository institutions under its biweekly Term Auction Facility (TAF) from $50 billion to $75 billion, beginning with the auction on May 5. This increase will bring the amounts outstanding under the TAF to $150 billion.

The Federal Open Market Committee has authorized further increases in its existing temporary reciprocal currency arrangements with the European Central Bank (ECB) and the Swiss National Bank (SNB). These arrangements will now provide dollars in amounts of up to $50 billion and $12 billion to the ECB and the SNB, respectively, representing increases of $20 billion and $6 billion.

In addition, the Federal Open Market Committee authorized an expansion of the collateral that can be pledged in the Federal Reserve's Schedule 2 Term Securities Lending Facility (TSLF) auctions. Primary dealers may now pledge AAA/Aaa-rated asset-backed securities, in addition to already eligible residential- and commercial-mortgage-backed securities and agency collateralized mortgage obligations. The wider pool of collateral should promote improved financing conditions in a broader range of financial markets. Treasury securities, agency securities, and agency mortgage-backed securities continue to be eligible as collateral in Schedule 1 TSLF auctions.

What does it mean?

Starting with the increase resources for the TAF, despite all the happy talk, US banks are still wobbling. The Fed thinks it can calm things down with an even larger exchange of government debt in return for mortgage debt.

The wobbling extends beyond the US. Banks in Europe also have the shakes. Therefore, the Fed is supplying dollars to European central banks who are presumably pumping in liquidity there.

The Fed has relaxed further the collateral quality that it is prepared to accept from troubled banks. The existing collatoral standards are too restrictive. Presumably, those banks shivering the most have run out of high quality assets, and the Fed needs to loosen to rules to offer some protection.

The foreign exchange swap with the Swiss and European central banks is a particularly curious thing. The financial times reported that the "Fed believes that many of the strains in the dollar money markets reflect pressure from European banks that are structurally short of dollars." What? Structurally short of dollars? The world is choking with dollars, any bank short of dollars just needs to go out and buy some on the foreign exchange market. Currently, one euro buys about 1.6 dollars.

A structural shortage sounds like a euphemism for banks who have no cash but need dollars. In other words, capital adequacy ratios are beginning to fall and banks slipping towards that dangerous territory where they fail to meet regulatory minimum standards.

Add to that, we have this week's interest rate cut. With rates down at 2 percent and inflation up at 4 percent, investing in US government paper is a money losing proposition by design.

So, the Fed is still pumping, and the ECB is lending a hand. The press releases are still reporting that everything is fine and gently asks everyone to got back to sleep. There is nothing to worry about; things are returning to normal, the worst of the credit crunch is behind us, .....etc....etc...etc.


  1. I've only one question that matters... How far can the US stretch their privilege as the world reserve currency before it snaps.

    I've absolutely no idea... but there must be a figure. I wonder if the Fed know what it is?

    BTW - I'm reassured that the BoE refused to participate... that's on Reuters now.

  2. Asteve,

    That was my first question; where is the BoE in this caper. I'll have a look at Reuters now.