Posted by June 17, 2008
I attended quite a few tri-party repo reform meetings recently and it seems like two camps are emerging regarding how best to tackle the fragility of that market. On the one hand, maybe the Fed should take an incremental approach to reform? We technically do not regulate the tri-party repo market, but we do have oversight over the two large clearing banks, Bank of New York Mellon and JP Morgan Chase, who basically are the only two entities that provide the essential clearing services necessary for the tri-party repo market to function. This approach relies on the Fed to use regulatory guidance to reign in this “monster” $2.5 trillion market. I’m not sure this gets at the heart of the problem though, as JPMC, Bear Stearns’ clearing bank, was put between a rock and a hard place when funding suddenly dried up for Bear Stearns. When exactly is a good time for JPMC to protect the interests of the bank and refuse to unwind dealer repo collateral in the morning, knowing that this would put the dealer out of business immediately and potentially set off panic selling from the repo investors who suddenly find that they own securities instead of cash? Another camp within the Fed is recommending fundamental change to the market, such as requiring participants to pony up for a loss fund to protect the Fed as a condition precedent for the Fed to grant dealers access to the discount window to pledge tri-party collateral. The major benefit of this potential access to the discount window is that clearing banks can get out of the business of shutting down dealers as part of their own risk management exercise. If this plan works, the Fed wouldn’t have to be the judge, jury and executioner in making financial stability decisions, like it did with Bear Stearns.
To my disappointment, it looks like the Fed is going to favor the gradual approach for tri-party reform, which does have the benefit of being a “do no harm” approach. Our focus is going to be on “increasing confidence in the system and making the tri-party platform stronger”. First up, pressuring dealers to reduce their reliance on overnight funding of their relatively illiquid assets.
June 23, 2008
With tri-party reform meetings slowing down, I feel like I may be on the road to irrelevance and for the first time in a long while I’m finding myself looking for something to do. I did give a fairly-well received presentation on financial ratio analysis of dealers, but the main take-away is that we know much more about banks than we do about dealers. At least we’re trying.
The system is still not out of the woods yet. The reaction to the release of second quarter earnings is basically over for Morgan Stanley, Lehman Brothers and Goldman Sachs but it has yet to begin for Merrill Lynch whose actual quarter end date is next week, one month later than the other three. I sent around a chart today showing recent equity price movements over the past six weeks for the four dealers. All of the dealers’ stock prices are down: Goldman is down 5 – 10% after reporting excellent earnings. On the other side of the spectrum, Lehman is down 40% after reporting a fairly large loss. The very recent past is generating some spill-over anxiety about Merrill’s financial health which will likely continue until they release their second quarter earnings numbers, probably in early August.
Negative news on financial guarantors emerged again this week. The Wall Street Journal published an article about the likely impact that the looming financial guarantor rating agency downgrades would have on bank liquidity. The WSJ estimated that about $70 billion of structured municipal securities, known as Variable Rate Demand Notes, might have draws on their liquidity facilities as the investors seek to “cash out” and avoid owning the lower rated municipal securities after the downgrade. For better or worse, I recently told someone that our internal estimate of that number of $70 billion might be too low. Whoa.
There is a two-day FOMC meeting this week and there’s a widely held expectation that the target rate will remain unchanged at 2.00%. I think I read somewhere that implied rates show a 25% chance of a 0.25% increase at the next meeting in August. Interestingly, the two-year Treasury note has moved dramatically higher over the past six months as fixed income investors are suddenly becoming a little concerned about inflation. It’s going to be tough to raise rates in this environment, however. For example, the last Consumer Confidence Survey printed with the lowest reading since 1973. Someone sent me a graph of this e consumer survey with an inverted scale graph of oil prices showing that they pretty much move together. So, my near-term expectations for financial conditions are: high gas prices, low consumer confidence / spending, low fed funds rate.
I had a bit of an anxiety attack this week as I declined an offer to return to the Markets Group. I really appreciate the offer, but accepting it just seems like I would be walking into a cauldron, while not accepting it seems very wimpy. I was torn, but relied on my survival instincts and mentioned that I thought my present area still had important stuff to do and why not let it play out for a while? I hope my “pass” on returning won’t be viewed too poorly. Damned if you do, damned if you don’t. ☹
June 30, 2008
The second quarter-end date of the year 2008 saw more bank funding pressure than is typical for quarter-end dates, even though there typically is a lot of funding pressure on calendar quarter-end dates. The overnight LIBOR fixing rose about 100 basis points this morning. It’s funny how focused I was on these technical money market fluctuations when I was on the Domestic Money Markets desk, now it’s more like “whatever”. I’m more focused on the financial health, including the perceived financial health, of the broker dealers. For some reason, Lehman’s stock price fell 11% today to $19.50. It was only three weeks ago that Lehman issued some shares at the “discounted” price of $28.00. If you were unfortunate enough to have bought those shares, you would have lost 1/3 of your money in three weeks. . . ouch! Lehman’s stock is a clear concern: their stock price fell today on no new information except maybe investors don’t want to report holding this stock on their second quarter financial statements. Lehman’s stock price has no apparent price support level, routinely reaching 8- or 10-year lows. Yikes!
Getting back to that important “stuff” that I’m doing, I’m still plugging away at developing financial ratio analysis for dealers and I’m still on the tri-party repo reform project. I’m also thinking about some scenarios of the Fed potentially lending to dealers through the Primary Dealer Credit Facility. For example, what if a dealer needs to borrow $50 billion from the Fed, but the value of their collateral is only $40 billion. What would happen? Clearly it would be difficult, probably insurmountably so, for us to lend the $50 billion. The real question might be – would we lend the $40 billion if we expected the dealer to go out of business anyway? There’s no shortage of good questions as we turn the page to the second half of 2008.