Investment Management Blog - Montague Capital

The Fed acts yet again………….

US Federal Reserve made US$200bn of new liquidity available yesterday by offering to lend mainstream banks (and now brokers and dealers too) US Treasury bills for a 28-day period against a laxer definition of qualifying collateral. A further US$50bn-odd was also extended by the European Central Bank, the Swiss National Bank, the Bank of England and the Bank of Canada. Markets celebrated wildly, Wall Street rising 3.5% and the US bank sector closing up 7.4%. Once again the Fed has not waited for a routine interest-rate setting meeting (the consensus is still for a 0.5-0.75% cut next week) to take steps, leaving the suspicion that it was seriously worried at some of the individual company developments in recent days. Specifically, Bear Stearns had seen its share price fall more than 20% in just two days on rumours that it was in big trouble.

The key question is, will it work?

The answer to that question is, only when banks recover their confidence and begin lending to each other once more. Interest rate cuts have been gleefully swallowed up by the banking system without there being any improvement in their willingness to lend. Indeed, the continuous undermining of faith in the “real” value of all the synthetics created (at great personal reward to the inventors) over the last six years of super-easy money has paradoxically witnessed an increase in risk-aversion despite the apparently lower cost of funding or refinancing these positions. Hedge funds are seeing margin calls even though they protest that their positions are sound and can see the theoretical availability of cash at their lending banks to roll over their positions. And once the pullover develops one “snaggy” to catch on a nail there is a serious danger that the whole thing will unravel with cartoon-like speed. There’s no reason for believing that this scenario will come about, but banks want to get their retaliation in first and protect against it anyway.

Can this latest initiative then change the mindset?

Banks’ business models are unsophisticated for all their apparent intellectual rigour. When times were good the models took the last three or four data observations, got out a ruler and drew a straight line through them that went upwards for ever. When times are bad (like now) the exercise is repeated, just the piece of paper gets rotated 90° clockwise (try it). And when the data observations no longer obligingly lie around a straight line, the model fails to think far enough ahead to come up with any answer at all. That is the best that the Fed can hope for now. It’s not about finding reasons to buy, because the US economy is now clearly in a mess that can not be cleared up overnight, but about having fewer reasons to sell.

Unfortunately, that’s where even this latest massive initiative falls short of the mark. Apart from extending seats on the lifeboat to brokers and dealers it doesn’t push the assistance out to the borrowers that need it. Companies still risk collapse if they can’t refinance and banks will take every step to protect themselves (but risk the entire system) against that threat. This deal (unless it is extended, which it will probably have to be) only runs for 28 days, whereafter those who have taken advantage of it will have to return their Treasuries. With the panic prevailing at the moment that is very little time to persuade a counterparty to loosen the purse strings. “Mature consideration” and “a greater appreciation of risk”, rather than the old ATM-style approach, is the philosophy of lending that prevails today.

A final thought……..

Give it long enough and things would probably sort themselves out. However, that would require a few fatalities along the way and the modern way of finance is all about fighting death-free wars. Central banks have a “responsibility” to bail out the imprudent and avoid those fatalities, or so the imprudent banks are telling us. “We can’t help ourselves – you’ve got to do it for us.” It is probably going to take outright purchases by the Fed of the worst sort of mortgage-backed securities and collateralised debt obligations to give, at last, a firm idea of the real “value” of these things and so unblock the market. Sadly, that will be a mis-use of US taxpayers’ dollars which will make HMG’s handling of Northern Rook look like the epitome of prudent financial management. US Treasuries will then no longer be the “safest financial instruments in the world”. Something else for commodities speculators to hedge against.