Central Bank Impotence and Market Liquidity

By
Henry C.K. Liu

This article appeared in AToL on August 24, 2007

 

After months of adamant official denial of any potential threat of the subprime mortgage meltdown spreading to the global financial system, the US Federal Reserve (Fed) on Friday, August 17, a mere 10 days after declaring market fundamentals as strong and inflation as its main concern, took radical steps to try to halt financial market contagion worldwide that had become undeniable. The Wall Street Journal reports that the emergency measures were hastily taken to promote what the Fed publicly referred to as “the restoration of orderly conditions in financial markets.”  The telling words were “restoration of orderly conditions” in a market that had failed to function orderly. The Fed let the market know that it has shifted to panic mode. 

Restoring Disorderly Market Conditions

The WSJ reports that the crisis of disorderly conditions began two days earlier on August 16 in London where $45.5 billion of short-term commercial paper issued by US corporations overseas was maturing but traders had difficulty selling new paper to roll them over as they normally would have by noon time in London, or 7 a.m. in New York. Demand for commercial paper had dried up suddenly in a tsunami of risk aversion. Less than half of the paper was eventually sold at distressingly high interest rates by the end of the trading day. At 7:30 a.m. in New York, Countrywide Financial Corp., the largest home mortgage lender, announced that it was drawing all of its $11.5 billion of bank credit lines because it had difficulty rolling over its commercial paper IOU.

By noontime in New York, near the end of the trading day in London, the dollar fell against the yen by 2% within minutes to cause traders to rush to unwind their yen carry trade positions. Money rushed into 3-month US Treasury bills, pushing the yield down from 4% to 3.4%, sharply widening the spread with corporate commercial paper, with some GE paper moving as high as 9.5%, which in normal times would be close to the Fed Funds rate which now stands at 5.25%. By evening, Chairman Bernanke of the Fed convened a conference call of board members. The next morning, Friday, August 17, the Fed capitulated. 

To ward off a market seizure, the Fed cut the discount rate at which cash-short US banks and thrift institutions can borrow directly from the central bank as a lender of last resort. The Fed announced that it would grant banks and thrifts such loans from its discount window against a liberal range of collateral, including technically unimpaired triple-A rated subprime mortgage securities of uncertain market value and liquidity. The discount rate was cut from 6.25% to 5.75%, making it merely 50 basis points above the Fed Funds rate target, half of the normal spread for a neutral monetary policy. The Fed also extended the period for loans at the discount window from one day to up to 30 days, renewable by the borrower. These changes “will remain in place until the Federal Reserve determines that market liquidity has improved materially” and “are designed to provide depositories with greater assurance about the cost and availability of funding.”

The New York Fed, which has the responsibility of operating the Open Market Committee to keep inter-bank rates close to the Fed Funds rate target by buying or selling securities and by making overnight loans in the repo market (see: The Repo Time Bomb), had injected substantial amounts of liquidity, $62 billion up to the time of the discount rate cut, by such means into the banking system in previous days.  Earlier, the effective Fed Funds rate had traded at 6%, 75 basis points above Fed target, as banks demanded higher rates to lend to each other.

The Fed then convened an extraordinary conference call for major money center banks to explain its latest moves. It tried to encourage banks to use the discount window, saying to do so would be a “sign of strength” under current circumstances, not a sign of distress as in normal times where banks are conventionally reluctant to use the discount window, fearing that going to the Fed for cash might be interpreted by the market as a sign a distress.

The Fed said in a policy statement on the same day of the unusual discount window moves that financial market conditions had deteriorated to the point where “the downside risks to growth have increased appreciably”. The Fed said it is monitoring closely market situations and is “prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets”.

The language of the 2007 Fed statement is an echo of Greenspan-speak. Notwithstanding his denial of responsibility in helping through the 1990s to unleash the equity bubble, Alan Greenspan, the then Chairman of the Fed, had this to say in 2004 in hindsight after the bubble burst in 2000: “Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences, we chose, as we noted in our mid-1999 congressional testimony, to focus on policies to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.”

I wrote in AToL on September 14, 2005: “Greenspan's formula of reducing market regulation by substituting it with post-crisis intervention is merely buying borrowed extensions of the boom with amplified severity of the inevitable bust down the road. The Fed is increasingly reduced by this formula to an irrelevant role of explaining an anarchic economy rather than directing it towards a rational paradigm. It has adopted the role of a cleanup crew of otherwise avoidable financial debris rather than that of a preventive guardian of public financial health. Greenspan's monetary approach has been "when in doubt, ease". This means injecting more money into the banking system whenever the US economy shows signs of faltering, even if caused by structural imbalances rather than monetary tightness. For almost two decades, Greenspan has justifiably been in near-constant doubt about structural balances in the economy, yet his response to mounting imbalances has invariably been the administration of off-the-shelf monetary laxative, leading to a serious case of lingering monetary diarrhea that manifests itself in runaway asset price inflation mistaken for growth.”
(http://atimes01.atimes.com/atimes/Global_Economy/GI14Dj01.html)

Chairman Bernanke has now summoned his own clean-up team into action. The Fed hopes that by assuring banks that they can now access cash on less punitive terms from the Fed discount window, collateralized by the full “marked to model” face value of mortgage-backed securities, rather than the true distressed value as “marked to market”, for which they could find no buyers at any price in recent weeks as the market for such securities has seized up, it can jumpstart market seizure for mortgage-backed commercial paper and securities.

The Fed announced the discount rate and maturity changes a day after a video conference of its Open Market Committee in which the emergency action was “unanimously” endorsed by all voting committee members, except William Poole, president of the St Louis Fed, who had argued publicly a few days earlier against an emergency rate cut short of a “calamity” and who did not take part in the vote.

By its emergency actions, the Fed conceded the existence of a market “calamity”. Equity markets around the world interrupted their week-long losing streak and rose reflexively on the news on the last trading day of the week, albeit doubt remains on the prospect that such market adrenaline is sustainable. The Dow Jones Industrial Average (DJIA) gained 233.30 points, or 1.8%, edging back to 13,079 on hope that the Fed has now finally come to the rescue of a collapsing market.

Still, the yield on the two-year US Treasury note fell 4 basis points to 4.18%, signaling continuing risk aversion in the credit markets and investor flight to safety, not even just to quality. Fed Funds futures indicate that the market expects several quarter-point cuts from the current 5.25 per cent by the end of the year to keep the troubled economy afloat.

Unsustainable Adrenaline

By Monday, August 20, the adrenaline already wore off and the DJIA turned negative by noon on the first trading day after the Fed emergency actions. The flight to safety pushed the 3-month treasury yield to 2.5% at one point. It can be expected that sharp volatility in the equity markets will continue as announcements of assurance are issued by the Fed, the Treasury and key Congressional Committee chairmen to temporarily boost the market on false hopes only to be brought back down later to reality. The market is casting a vote of no confidence in the Fed’s ability to save the market. At best, the Fed can slow down the credit meltdown by extending it out into years rather letting the market execute a needed catharsis. It is not a scenario preferred by true free marketers.

No doubt the Fed has an arsenal of offensive monetary tools at its disposal. But just like the war on terrorism in which all the guns of the Pentagon can have no effect unless the military can find real terrorist targets, the Fed’s monetary tools remain useless unless the Fed knows where to intervene effectively. Just as terrorists morph into the general population to make themselves difficult to identify, the problem with structured finance is that by transferring unit risk to systemic risk, it deprives the Fed of effective targets to intervene on a systemic re-pricing of risk. When contagion has already spread risk aversion to all vital components of the credit market, containment is no longer an effective cure. Financial health will continue to decline in the entire system until the risk appetite virus works its natural cycle. Excess liquidity is like a drug addiction. It cannot be cured with another stronger addictive drug by adding more liquidity. What the Fed is trying to do is not merely to restore market liquidity, but to preserve excess liquidity in the market. It is trying to avoid a crisis by setting the stage for a bigger future crisis.

Low Interest Rates Hurts the Dollar

The problem with the single-dimensional prognosis on the curative power of policy-induced falling interest rates on the ailing economy is that it ignores the adverse impact such interest rate cuts will have on the exchange value of the dollar which has already been falling in recent years beyond levels that are good for the economy.

How the Discount Window Works

Eligible depository institutions are allowed to borrow against high-grade collaterals directly from the Fed’s discount window to meet short-term unanticipated liquidity needs. One category of these collateralized loans, termed “adjustment credit,” comprises loans that are usually overnight in maturity and are made at an administered discount rate. However, banks traditionally only make sparing use of the discount window for adjustment credit borrowing. The discount window is also used for seasonal borrowings, mostly associated with agricultural production loans, and for “extended credit” for banks with longer-maturity liquidity needs resulting from exceptional circumstances.

The most potent power bestowed by Congress on the Federal Reserve System is the setting of the discount rate. Raising the discount rate generally increases the cost of bank borrowing and slows the economy, while lowering it stimulates economic activity, since banks set their loan rates above the discount rate, and not by market forces. In contrast, while the Fed Funds rate is also set by the Fed, it is implemented by the Fed Open Market Committee participating in the repo market to keep the short-term rate close to the Fed’s target. The discount rate affects cost of funds without affecting money supply while the Fed Funds rate changes the level of the money supply. Both rates are set by fiat by the Fed based on the Fed’s best judgment within its theoretical preference. The difference between the two rates is that the discount rate is set independently of market forces while the Fed Funds rate acts through market forces. With the discount rate, the Fed sets the rules of the money market game while with the Fed Funds rate, the Fed acts as a key money market participant.

In response to the October 19, 1987 crash, Alan Greenspan, as the newly appointed Fed chairman, lowered the Fed Funds rate from 7.25% set on September 4, 1987, 45 days before the crash, to 6.5% by early February, 1988, while keeping the discount rate at 6%. On February 23, the Fed increased the spread to 3-1/8 percentage points with the Fed Fund rate at 9-5/8% and the discount rate at 6-1/2%.  The Fed then lowered both rates gradually to 3% with zero spread by September 4, 1992 below the inflation rate for August which was 3.15%. The negative interest rate launched the debt bubble that first fueled the tech bubble which peaked on March 10, 2000 and burst in subsequent months when Greenspan raised the Fed Funds rate to 6.5% on May 16 and the discount rate to 6% before lowering rates starting January 3, 2001 to save the market. By November 6, 2002, the Fed Funds rate was 1.25% and the discount rate was 0.75% to fuel the housing bubble which was also turbocharged by subprime mortgage securitization. That housing bubble is now bursting.

Until January 3, 2003, the discount rate normally was set at 25 to 50 basis points below the Fed Funds rate.  On that historic day, the discount rate was reset by policy to be 100 basis points above the Fed funds rate. On June 25, 2003, when the Fed Funds rate was at a historical low of 1%, the discount rate was set at 2% when the inflation rate was 2.11%. Negative interest rate expanded the housing bubble in a frenzy rate.

Before 2003, to prevent banks from exploiting the spread between the Fed Funds rate and the then lower discount rate, the Fed required banks to document any need for funds as appropriate to the discount facilities’ policy intent. Discount window loans would not be granted as bridge loans to enable banks to wrap up planned investment or to exploit loan opportunities beyond the bank’s normal liquidity range. In addition, banks were expected to have first exhausted all other reasonable sources of credit before borrowing from the discount window and should expect to face greater regulatory scrutiny if they borrow at the window too frequently. These non-pecuniary penalties made many banks reluctant to borrow at the discount window for adjustment credit, concerned over a perceived “negative signal” that such action would send. The volume of borrowed reserves was generally less than 1% of total reserves.

Setting the discount rate above the federal funds rate target was an important change in the administration of the discount window to allow for more reliance on explicit market pricing to determine the volume of discount window borrowing and to remove the perceived stigma to discount borrowing. Eligibility requirements would be streamlined and rendered consistent with reliance on the discount window as a relatively unfettered source of liquidity for financially sound banks during tight money market conditions that would otherwise result in a spike in the Fed Funds rate.

The initial proposal set a cap for the discount rate at 100 basis points above the federal funds rate target. Historically, this cap would have been breached by the average daily federal funds rate only about 1% of the time, with roughly half of those days coming on bank settlement days. However, the frequency with which individual trades throughout the day would have exceeded the cap was significantly higher. The closing Fed Funds rate would have exceeded this cap approximately 4% of the time. As banks adjusted their reserve management practices under the new operating procedures, this cap became binding more frequently than history would suggest. In any case, the average daily cost of federal funds to banks should be reduced and the Federal Funds rate should remain closer to the Fed’s target.

This rule change on the discount rate was expected to have several benefits. First, providing a cap on the federal funds rate by endogenously supplying reserves to meet high periods of demand should reduce interest rate volatility. This might become more significant as continual financial innovation would otherwise further reduce banks’ required reserves and render the demand for reserves more interest inelastic, as required clearing balances assume a larger share of the total demand for reserves. Second, the simplification of discount window borrowing procedures should lead to reduced administrative costs and streamline operations. Third, these simplifications also will help clarify the intent of individual discount window regulatory decisions, since less subjective assessment is required. Finally, monetary policy could be rendered more effective, to the extent that the discount rate could become a tool for capping the federal funds rate. This cap could be adjusted to keep the Fed Funds rate close to the target value, where “close” is determined as a matter of monetary policy decisions that reflect current market conditions. In Fed newspeak, the “discount” rate then becomes more expensive than full price inter-bank borrowing.

Primary and Secondary Credit

On January 9, 2003, the Fed adopted this procedure and introduced two levels of discount rate: primary and secondary. Primary credit is available to generally sound depository institutions on a very short-term basis, typically overnight, at a rate above the Federal Open Market Committee’s target rate for federal funds. Depository institutions are not required to seek alternative sources of funds before requesting occasional short-term advances of primary credit. The Fed expects that, given the above-market pricing of primary credit, institutions will use the discount window as a backup rather than a regular source of funding. In reality, as the debt economy developed, banks were able to use the discount widow without regulatory scrutiny to fund planned investment or loan opportunities that yielded returns higher than the punitive discount rate. The Fed in effect became a funding agency of last resort for the debt bubble.

Primary credit may be used by banks for any purpose, including financing the sale of federal funds. By making funds readily available at the primary credit rate when there is a temporary shortage of liquidity in the banking system, thus capping the actual federal funds rate at or close to the primary credit rate, the primary credit program complements open market operations in the implementation of monetary policy.

Primary credit may be extended for up to a few weeks to depository institutions in sound financial condition that cannot obtain temporary funds in the market at reasonable terms; normally, these are small institutions. Longer-term extensions are supposedly subject to increased administration. It is not clear if the Fed’s new term of up to 30 days involves increase administration to subject borrowing banks to face greater regulatory scrutiny.

Secondary credit is available to depository institutions not eligible for primary credit. It is extended on a very short-term basis, typically overnight, at a rate that is above the primary credit rate. Secondary credit is available to meet backup liquidity needs when its use is consistent with a timely return to a reliance on market sources of funding or the orderly resolution of a troubled institution. Secondary credit may not be used to fund an expansion of the borrower’s assets. The secondary credit program entails a higher level of Reserve Bank administration and oversight than the primary credit program. The Fed will require sufficient information about a borrower’s financial condition and reasons for borrowing to ensure that an extension of secondary credit is consistent with the purpose of the facility.

Effect of Discount Borrowing Controversial

Discount window borrowing is sensitive to the spread between the Fed Funds rate and the discount rate. As the spread narrows, discount window borrowing can be expected to increase. Hence, discount window borrowing would offset, at least in part, the effect of open market operations on reserve supply. The effect of this feature of discount window borrowing remains controversial even after an indeterminate debate in 1960 among economists on whether the discount mechanism offsets, as argued by Milton Friedman, or reinforces, as counter-argued by Paul Samuelson, the monetary policy objectives of the Fed.

Discount Borrowing Stigma

During the early 1990s, borrowing from the discount window fell significantly, averaging only $233 million, even though this was a period of banking system stress. Stavros Peristiani, Assistant Vice President in the Banking Studies Function at the Federal Reserve Bank of New York, whose primary areas of research include housing finance, mortgage-backed securities, bank mergers and acquisitions, discount window borrowing, and initial public offerings, argues that this decline may have been due to banks refraining from requesting discount loans because of the perception that it would send a negative signal to the Federal Reserve, bank supervisors, and eventually the market at large. Even when banks’ financial conditions improved in the mid-1990s, banks remained reluctant to borrow from the Fed.

Partly to address this reluctance, the Fed replaced its adjustment and extended credit programs with the new primary and secondary credit facilities. Now, banks in good financial condition could borrow from the Federal Reserve capped at 100 basis points above the Fed Funds rate target. The above-market price of funds serves as a rationing mechanism that dramatically reduces the need for supervisory review of the potential borrower. Because use of the new primary credit facility would not necessarily imply anything negative about a borrower, banks should be more willing to use the facility if market or bank-specific conditions warrant. In fact, since the implementation of this new facility, banking supervisors have specifically announced that “occasional use of primary credit for short-term contingency funding should be viewed as appropriate and unexceptional by both [bank] management and supervisors.”  Still, banking being a traditionally conservative industry, such stigma persists about discount window borrowing. The above-market price of the discount rate has been cut on August 17, 2007 by the Fed by half from its100 basis points cap to 50 basis points over the Fed Funds rate target to facilitate discount borrowing had to be qualified with a public repeat of Fed policy that such borrowing does not reflect weakness in the borrowing banks. Yet the cut in the discount rate reflect weakness in the entire banking system, a message not missed by astute market participants.

When a bank borrows from the Fed’s discount window, it increases the funds it has in its reserve account held at the Fed, which the bank can apply towards meeting its reserve requirement. Thus, ceteris paribus, one would expect that when required reserves are higher, discount window borrowing would be higher.

Reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities. Within limits specified by law, the Federal Reserve Board of Governors has sole authority over changes in reserve requirements. Depository institutions must hold reserves in the form of vault cash or deposits with Federal Reserve Banks. The dollar amount of a depository institution’s reserve requirement is determined by applying the reserve ratios specified in the Federal Reserve Board’s Regulation D to an institution’s reservable liabilities which consist of net transaction accounts, non-personal time deposits, and euro-currency liabilities.

Since December 27, 1990, non-personal time deposits and euro-currency liabilities have had a reserve ratio of zero. The reserve ratio on net transactions accounts depends on the amount of net transactions accounts at the depository institution. The Garn-St Germain Act of 1982 exempted the first $2 million of reservable liabilities from reserve requirements. This “exemption amount” is adjusted each year according to a formula specified by the act. The amount of net transaction accounts subject to a reserve requirement ratio of 3% was set under the Monetary Control Act of 1980 at $25 million. This “low-reserve tranche” is also adjusted each year. Net transaction accounts in excess of the low-reserve tranche are currently reservable at 10%.

Reserve Balance Driven by Interbank Payments

The demand for reserve balances is increasingly being driven by growth in interbank payment activity rather than by minimum reserve requirements.  Interbank payments are processed over Fedwire, the large-value payment system owned and operated by the Fed. The value of aggregate Fedwire payments increased from roughly $1.3 trillion a day in 1992 to roughly $3 trillion a day in early 2004. These payments are funded from an aggregate reserve balance that, as of the first quarter of 2004, averaged only $11.5 billion.

To facilitate an efficient payment system, the Fed allows banks to maintain limited negative reserve balances during the business day at a low cost, currently 27 basis points at an annual rate, but imposes a stiff 400-basis-point penalty on negative balances held overnight. Before 2003, hanks faced with an unexpected negative balance late in the day might have gone to the discount window, but they might have remained reluctant. The new primary credit facility reduces the perceived stigma of borrowing from the Fed, and banks in this situation would borrow from the central bank and pay a penalty capped at 100 basis points over Fed Funds rate.

The Clearing House Interbank Payments System (CHIPS) is a privately operated, real-time, multilateral, payments system typically used for large dollar payments, owned by financial institutions, and any banking organization with a regulated US presence may become an owner and participate in the network. The payments transferred over CHIPS are often related to international interbank transactions, including the dollar payments resulting from foreign currency transactions, such as spot and currency swap contracts, and Euro placements and returns. Payment orders are also sent over CHIPS for the purpose of adjusting correspondent balances and making payments associated with commercial transactions, bank loans, and securities transactions. Since January 2001, CHIPS has been a real-time final settlement system that continuously matches, nets and settles payment orders. In June 2007, CHIPS processed $2.645 trillion of payments. CHIPS typically handles about 300 payments ($90 billion in gross, $36 billion net) in its queue at the end of the day.

Liquidity Risk in the Interbank Payment System

Liquidity risk is the risk that the financial institution cannot settle an obligation for full value when it is due even if it may be able to settle at some unspecified time in the future. Liquidity problems can result in opportunity costs, defaults in other obligations, or costs associated with obtaining the funds from some other source for some period of time. In addition, operational failures may also negatively affect liquidity if payments do not settle within an expected time period. Until settlement is completed for the day, a financial institution may not be certain what funds it will receive and thus it may not know if its liquidity position is adequate. If an institution overestimates the funds it will receive, even in a system with real-time finality, then it may face a liquidity shortfall. If a shortfall occurs close to the end of the day, an institution could have significant difficulty in raising the liquidity it needs from an alternative source.

Systems that postpone a significant portion of their settlement activity in dollars toward the end of the day, such as CHIPS, may be particularly exposed to liquidity risk. These risks can also exist in Real Time Gross Settlement (RTGS) systems such as Fedwire. Systems or markets that pose various forms of settlement risk also pose forms of liquidity risk.

With the average daily turnover in global FX transactions at over US$2 trillion, the FX market needs an effective cross-currency settlement process. Continuous Linked Settlement (CLS) is a means of settling foreign exchange transactions finally and irrevocably. CLS eliminates settlement risk, improves liquidity management, reduces operational banking costs and improves operational efficiency and effectiveness.

CLS Bank based in New York is an Edge Corporation bank supervised by the Federal Reserve. CLS Bank is a multi-currency bank, holding an account for each Settlement Member and an account at each eligible currency’s Central Bank, through which funds are received and paid. Technical and operational support is provided by CLS Services, an affiliate of CLS Bank.

CLS Bank, while eliminating the bulk of principle risk through its payment-versus-payment design, retains significant liquidity risk, as funding is made on a net basis, and pay-in obligations may need to be adjusted in the event that a counterparty is unable to fund its obligations. Other systems, including securities settlement systems, may also be subject to liquidity risks.

To manage and control liquidity risk, it is important for financial institutions to understand the intraday flows associated with their customers’ activity to gain an understanding of peak funding needs and typical variations. To smooth a customer’s peak credit demands, a depository institution might consider imposing overdraft limits on all or some of its customers. Moreover, institutions must have a clear understanding of all of their proprietary payment and settlement activity in each of the payment and securities settlement systems in which they participate.

Clearing balance requirements represent obligations to hold reserves that are set at the discretion of a bank before each reserve maintenance period. Only balances held at the Federal Reserve during the two-week reserve maintenance period are eligible to satisfy clearing balance requirements. A bank is penalized for ending any day overdrawn on its account at the Fed, as well as for failing to meet its requirements by the end of the maintenance period. To obtain the necessary reserves to avoid these fees if unable to borrow the necessary amount of reserves from another bank, a qualifying bank may borrow reserves directly from the Federal Reserve at its discount window facility under the primary credit program, at a rate typically set not more than 100 basis points above the target Fed Funds rate. This spread between the primary credit rate and the Fed Funds rate target is generally viewed as representing a de facto penalty associated with being deficient. This penalty has been cut in half on August 18. The Federal Reserve does not pay interest on reserves held in excess of requirements. Thus, the opportunity cost of holding excess reserves is a bank’s marginal funding cost, which is represented by the Fed Funds rate.

To provide banks with some flexibility in meeting their requirements for avoiding these penalties and costs, the Fed allows banks to apply excess reserve balances held in one maintenance period to meet reserve requirements in the following period, in an amount up to 4% of reserve requirements in the second period. Similarly, a bank may end a period up to 4% short of its reserve requirements and pay no penalty, so long as it holds sufficient excess reserves in the following period to offset this deficiency.

Fed Actions aim at Mutually Contradicting Objectives

The Federal Reserve action on the discount rate tries to meet its short-term responsibility to keep financial markets functioning by injecting funds into the banking system. At the same time, the Fed tries also to macro manage the economy in containing inflation by tightening the money supply through interest rates increases. For almost a century since its establishment in 1913, the Fed has been engaged in a continuous battle between inflation and economic growth by standing on both sides of the conflict to keep a balance. This conflict is a structural malady of market capitalism. Recurring economic recessions or depressions lead to asset depreciation or disinflation or deflation which can only be cured by currency devaluation which translates into inflation. Some economists, including Ben Bernanke, the new Fed Chairman, support inflation targeting as a viable monetary policy option.

Fixing the Market Liquidity Drought

The cut of the discount rate is designed to tackle the liquidity drought in the banking system and to keep banks liquid to prevent financial markets from seizure.  The new policy statement signals that the Fed stands ready to cut interest rates if necessary to deal with the contagion effects of the subprime mortgage generated liquidity crisis on the real economy. The objective is to restore the flow of funds through the banks into the financial system to limit the damage to the real economy. Whether intended or not, the Fed’s new policy stance sparked speculation that the European Central Bank, which injected over 150 million euros into its banking system in previous days, might be forced to back off raising euro interest rates in September to prevent the euro from rising further.

Up to the time of the discount rate cut on August 18, the Fed had to repeatedly pumped liquidity ($52 billion) into the financial system through the repo market to keep the overnight Fed Funds rate from rising above its target of 5.25%. This Fed monetary market tactic has been described by market participants as the Fed practicing “stealth easing” or “synthetic easing”; that is, to inject funds without lowering the Fed Funds rate. But while the Fed hoped to restore liquidity to financial system with an injection of some $52 billion to the overnight money market, this injection failed to impress the market. Three-month lending rates remained high and the asset-backed commercial paper and jumbo mortgage market remained dysfunctional. The stock market continues to fall after a brief reprieve.

Ready investors for debt instruments of all sorts have become endangered species in this market seizure. The Fed is determined to restore liquidity in these seized markets to fulfill its mission of keeping markets functioning.  It also believes that the longer credit markets stay seized, the bigger the risk of disrupting the flow of credit to households and businesses in the economy to induce a recession or worse. Yet moving aggressively on the discount window front will ensure availability of funds to the banking system to keep banks solvent but it may not help to get markets working unless the Fed is prepared to drop massive amounts of dollars from helicopters on main street as Fed Chairman Bernanke once quipped before becoming chairman.

The Fed has not changed the nominal rating level of securities eligible for these operations even though the ratings have been decoupled from real market price of the securities. By reducing the penalty rate on discount window lending from 100 basis points over the federal funds rate to 50 basis points, and allowing banks to obtain 30-day loans rather than overnight money, the Fed ensures that banks encountering difficulties securing finance against mortgage-backed and other collateral have assured access to liquidity at reasonable rates. And many banks are encountering such difficulties as they fail to find buyers in the debt market for the asset-back securities they hold as collateral for bank loans made to hedge funds and private equity groups.

Central Bank Impotence

But the time has long passed when central banks adding liquidity to the financial system can help a liquidity crisis in the market. When the Fed injects funds directly into the money market through the repo window, banks and thrifts and other non-bank financial institutions that need funds can participate. With the daily volume of transaction in the hundreds of trillions of dollar in notional value of over-the-counter derivatives, the Fed would have to inject fund at a much more massive scale to affect the market. Such massive injection will mean immediate and sharp inflation. Worse yet, it will cause a collapse of the dollar.

When the Fed adds liquidity directly into the banking system through the discount window, it injects high-power money into banks by making interest rate for overnight interbank banks loans within its set target. The theory is that banks will in turn be able to make loans at interest rates deemed appropriate by the Fed, thus relaying the added liquidity to the market in multiple amounts because of the mathematics of partial reserve.

But just because banks are able to make loans at low interest rate does not mean banks can find borrowers with credit ratings to justify the low rates. John Maynard Keynes' concept of a liquidity trap is that market preference for cash positions can outweigh interest rate considerations. In a financial crisis, there may simple not be enough credit-worthy borrowers at any interest rate level and the number of sellers stay stubbornly larger than the number of buyers because sellers need to sell precisely because they do not have credit worthiness to borrow even at low interest rates and buyers stay on the sideline waiting for even lower prices.

Even when the Fed lowers the discount rate, banks will only see their threat of insolvency reduced. Banks will still be sitting on piles of idle cash that they cannot lend. This is known as banks pushing on a credit string. Keynes insightfully observed that the market can stay irrational longer than most participants can stay liquid. Since central banks are now mere market participants because of the enormous size of the debt market due to the wide-spread use of structured finance with derivatives whose notional value adds up to hundreds of trillion of dollars, the market can stay irrational longer than even central banks can stay liquid, if central banks do not want to drive their currencies to the ground. With deregulated global financial markets, central bank capacity for adding liquidity to the banking system is constrained by its need to protect the exchange value of its currency. For the US, which depends on foreign central banks to fund its twin deficits, any drastic fall of the dollar will itself create a liquidity crisis from foreign central banks shifting out of dollar in their foreign exchange reserves.

Federal Reserve flow of funds data shows outstanding home mortgages in Q1 2007 to be at $10.4 trillion. About $1 trillion in mortgages are due for a reset by the end of 2007 alone. A 4% reset of interest rates on $1 trillion of mortgages would require addition payments of $40 billion. Agency-and GSE-backed mortgage asset amounts to $3.9 trillion. Issuers of asset-backed securities home mortgages asset amounts to $1.9 trillion. The numbers are further magnified hundred of folds by structured finance with high leverage which magnifies the cash flow caused by even the slightest interest rate volatility. Liquidity problem associated with counterparty default could quickly run up to trillions of dollars. What does the Fed hope to accomplish with injecting a mere $50 or 100 billion in the banking system, except to show its impotence? The Fed can keep the banks from failing, but it cannot prevent the harsh reckoning of the debt bubble economy.

What is Market Liquidity?

After all, what is market liquidity? Economists refer frequently to liquidity in the abstract, yet in reality, liquidity is difficult to define and even more difficult to measure and almost impossible to restore because it is hard to know where the weak links are. On Wall Street, liquidity refers to the ability to buy or sell an asset quickly and in large volume without substantially affecting the asset’s price. Shares in large blue-chip stocks like General Electric used to be considered liquid, a description long since rendered invalid because of market volatility.

Of the several dimensions of market liquidity, two of the most important are tightness and depth. Tightness is a market’s ability to match supply and demand at low cost (measured by bid-ask spreads) quickly, while market depth relates to the ability of a market to absorb large trade flows without a significant impact on prices (approximated by volumes, quote sizes, on-the-run/off-the-run spreads and volatilities). When market participants raise concerns about the decline in market liquidity, they typically refer to a reduced ability to deal without having prices move against them, that is, about reduced market depth.

Cycles of liquidity crises have been a recurring feature of financial markets. Commonly used indicators of market liquidity are notoriously imperfect as reliable measures of liquidity conditions. While conditions in the autumn of 1998 were indeed identified as reflecting the adverse shock of the 1997 Asian Financial Crisis to liquidity in financial markets, liquidity indicators seemed to suggest that, with the notable exception of the US government bond market, liquidity conditions were broadly restored to pre-crisis levels within a short period in the US. However, the usual indicators typically capture only a single dimension of market liquidity and none of them were forward looking in nature, making it difficult to draw any conclusions as to how long-term future liquidity conditions were being shaped by responses to current liquidity stress. Bubbles are the bastard children of liquidity overshoots.

While idiosyncratic factors might be cited as being responsible for the perception of low liquidity in specific markets, reduced market liquidity is unlikely to be a purely conjuncture phenomenon. From a financial stability perspective, some of the structural factors at work can be highlighted, focusing on developments bearing on liquidity conditions in the integrated global financial system at three different levels, namely:
(i) Firms: developments at the level of major financial firms participating in the core financial markets;
(ii) Markets: developments in the structure and functioning of markets themselves; and
(iii) System: developments across the global financial system as a whole, such as the systemic effects of credit derivatives.

Liquidity and Credit Risks

Such structural developments may have served to reinforce the links between liquidity and credit risks, but also the distinction between normal conditions and abnormal conditions and between normal times and times of stress when confidence declines.  The current challenge is one of returning an abnormal economy of excess liquidity to an economy of normal liquidity without extinguishing the flame of liquidity entirely. The period of stress will be the time it will take to work off the excess liquidity, to turn the liquidity boom back to a fundamental boom. It is not possible to preserve abnormal market prices of assets driven up by a liquidity boom if normal liquidity is to be restored.  All the soothing talk about the fundamentals of the economy being strong notwithstanding the debt bubble is insulting to the thinking mind. This is a debt economy fed by a liquidity boom. When the liquidity boom turns to bust, all the strong fundamental indicators such as corporate earnings will wilt from a debt crisis. Asset value cannot be held up by simply adding excess liquidity forever without creating hyper inflation. Also, some liquidity problems, such as those caused by a loss of market confidence, cannot be solved by merely injecting money into the financial system which in fact will only add to the problem. Restoring market confidence requires a rational restructuring of the economy to absorb excess liquidity.

Liquidity Risks Under-priced

Many market participants had felt that pre-LTCM (a major hedge fund that collapsed in Sept 1998 from wrong bets on Russia sovereign bonds rising in value above US sovereign bonds) liquidity risk in many credit markets had been under-priced, and that the under-pricing led financial institutions to underestimate liquidity risks with a “liquidity illusion” mentality. Such under-pricing inhibited developments that would enhance the market’s ability to retain liquidity in times of sudden stress. There were indeed several occasions since the LTCM crisis, such as the September 2006 collapse of Amaranth Advisors, which lost nearly $6 billion in a single week after a highly leveraged bet on the future price of natural gas prices blew up, when conditions in some markets turned adverse but liquidity, which typically declined sharply in the midst of the crisis, proved to be rather resilient.

The trading strategies employed by LTCM's highly leveraged portfolio were generally uncorrelated with each other in order to benefited from diversification. However, a sudden rise in liquidity preference in the market in late summer of 1998 led to a sharp marketwide repricing of all risk leading these positions to all move in the same direction. As the correlation of LTCM's positions increased, the diversified aspect of LTCM's portfolio vanished and large losses to its equity value occurred. Thus the primary lesson of 1998 is more than one of liquidity which the the effect rather thn the cause of the crisis. Fundamentally, it was a problem of paradign shift that changed the underlying Covariance Matrixused in Value at Riak (VaR) analysis fromstattic to dynamic.

The high leverage employed by the LTCM in order to maximize gain made it highly vulnerable to volatility and credit risk even though the logic of  LTCM's directional bets was valid in thinking that the values of government bonds should  converge. But the high leverage deprived an undercapitalized LTCM the luxuary of needed staying power to benefit from the eventual convergence.