May 2008

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May 6, 2008

I worked on three different floors in two different buildings today.  Spent some time where I used to work on the 9th floor of the Main building, some time in my new cubicle on the 3rd floor of the same building and most of my time on the 25th floor in a building across the street with (gasp!) bank examiners. Recall that I accepted a transfer to a new area following the bail-out of Bear Stearns creditors and the introduction of the Fed’s Primary Dealer Credit Facility.  One of my initial tasks is to review the liquidity positions of the non-bank primary dealers.  I also moved my cubicle from the 9th floor “Desk” location to the 3rd floor which houses FRBNY’s research function.    My house plant may not survive the transition to the third floor of the Main building, though.  Perhaps all of the offices on the third floor have windows, and every window belongs to an office, leaving the interior of the floor very dark.  I can’t help but think there’s something about a lack of light (transparency) on the third floor being bad for plants (markets).

One this fine day I head off to the building across the street with an attitude of, “hope you don’t mind, but do you have a place where I can sit?  My boss wants me to go over these liquidity calculations.”  The bank examiners on the 25th floor were like, “please, make yourself comfortable.  Pick out a cube over here, etc. and why don’t you stay for a few months?”  It looks like I will.  This job is almost a mirror opposite to my eight months in the Domestic Capital Markets area of the Markets Group, where the work was super high profile, but the pace was unsustainable.  The new workflow appears to be quite civilized, but my visibility is now somewhat impaired, including management’s ability to see me.  It certainly could be worse.

Of course, the “work” itself is just fascinating, but it does feel like we’re stumbling around in the dark a bit. Perhaps we are creating a paradigm to regulate broker / dealers in the 21st century?  Wow, that would be cool.  My time in this job is supposed to last at least another 4 ½ months which corresponds to the minimum amount of time remaining for dealers to access the newly formed Primary Dealer Credit Facility (PDCF).  My guess, though, is that the PDCF is not going away any time soon, so my new gig may last longer.  As long as the Fed is willing to lend non-bank dealers tens of billions of dollars to get them through a rough patch, we should have the right to audit / maybe regulate them, which would help them instill some macroprudential discipline.  The SEC reports to the Treasury and the President.  The Fed is chartered by, and answers to, Congress.  There’s a congressional hearing tomorrow with the SEC to discuss what went wrong with Bear Stearns.  No doubt, well with Congress, there’s always a doubt, the SEC’s narrow regulatory focus will come to the attention of Congress.  It’s clear to me, at least, that broker / dealers pose a lot more risk to the system than just proper safekeeping of individual investor assets.  That’s where the Fed will probably come in.  Hopefully.

The “credit crunch” continues in May, but in a less dramatic fashion.  Pretty high interbank lending rates with a focus on LIBOR, the London Inter Bank Offered Rate.  LIBOR has attracted a lot of attention lately and LIBOR’s sponsor, the British Bankers Association, has promised to look into allegations that banks are under reporting LIBOR rates.  Ironically, even if the LIBOR postings are lower than they should be, nominal LIBOR rates still suggest a LOT of stress in the system.

May 20, 2008

           The British Bankers Association stated today that they were going to make an announcement at the end of the month.  There’s no doubt in my mind that they will be making changes to the way LIBOR is computed.  How does my mortgage reset again?

            Despite the yellow flags, conditions in funding markets have been remarkably calm in May.   The FOMC just released the minutes from their April meeting when they cut the target rate by 0.25 %.  The minutes suggest no more rate cuts, unless things start to get really bad.  The equity markets have rallied 11% since their trough in February, although they have dropped 1.0% a day over the last two days.  So it’s hard to know which direction we’re heading in, but there seems to be a lot of disequilibrium across markets.  The Euro is now 1.58 to the dollar and the price of oil seems really high, around $130 per barrel.  I read somewhere that the inflation adjusted peak price for a barrel of oil during the “Arab Embargo 1970’s” was $103 a barrel, so we’re much higher than that now.  Oil prices look like a bubble that’s still expanding but we’ll only know that for sure until after it pops!

            I definitely like my job now.  The environment is totally chill, although my plant at the office is looking worse and worse.  Is that a sign of something?  I now have a person reporting to me, a Research Assistant, otherwise known as an RA.  The RA will help me with this new task I received, breaking down data that we’re getting from the clearing banks on the tri-party repo market.  More on that later.  I did give a well-received ten-minute presentation on the repo topic yesterday.  Hey, it’s a start.  My peer also gave a short presentation on the Weighted Average Cost of Capital for dealers.  He doesn’t have an RA but he is working directly with a PhD economist on the topic.  It’s a crazy world – let’s just hope our efforts will be helpful.

            I’ve been given two assignments at work.  One is to try and conduct fairly standard financial analysis of the four large non-bank broker / dealers (Merrill Lynch, Lehman Brothers, Morgan Stanley and Goldman Sachs).  The other is being a member of task force charged with re-designing the tri-party repo market.  It’s called tri-party because there are three entities in each repo trade:  1) the collateral buyer who is investing money, typically with very short maturities, on a collateralized basis; 2) the collateral seller, who takes the opposite side of the trade and borrows short-term money on a collateralized basis; and 3) the clearing bank who moves the cash and the collateral back and forth between the accounts of the investor and the borrower and also keeps track of the value of the collateral and makes margin calls as appropriate.  Before I discuss some more of the particulars of the tri-party repo market I just want to mention how huge this market is, as in $2.5 trillion huge.  To put that amount of money in perspective, one day’s interest earned at the rate of 2.0%, would be $138 million ($2,500,000,000,000  *  (.02 / 360) ).  To put $138 million in perspective, if you could somehow syphon off that one day’s worth of interest and purchased an ultra-safe long-term US Treasury security with an interest rate of 4.0%, you would receive $5.5 million a year, basically for life. From another perspective, imagine having a fairly large box of money that held $1,000,000 in cash.  If you had 1,000 of those boxes, you would have $1 billion.  To get to $2.5 trillion, you would need to 2.5 million of those boxes.  Once again, wow!

The fundamental problem with the tri-party repo market is the large back and forth movement of collateral between the dealers and the secured investors that the two clearing banks facilitate each day.  The secured investors are lending money to dealers backed by specific assets (securities) that have been pledged, or repo’d, to them.  (Although repo behave like secured borrowing, it technically is a legal sale along with a forward purchase.  “Repo” is short for Securities Purchased Under Agreement to Resell with the forward purchase price representing de facto interest).   At the start of each day the securities are returned to the dealers and the cash is returned to the investors.  This “unwind” results in the clearing bank becoming a secured investor, effectively lending money to the dealers on an intra-day basis until the securities are re-pledged at the end of the day.  If the dealer can’t find investors to fund their positions on any given day, then the clearing bank is stuck lending to the dealer collateralized by the securities that the dealer owns but did not finance with repo investors. This intra-day exposure can be enormous.  In aggregate, it can be greater than a trillion dollars for each clearing bank and the clearing banks’ exposure to individual dealers can be in the hundreds of billions.  The elephant in the room that no one is talking about is that the clearing banks can “refuse to unwind” in the morning by not returning the cash to the investor or the collateral to the dealer.  This “refuse to unwind” feature of tri-party repo would protect the clearing banks if they got wind that a dealer was in trouble, but it would also create great havoc in the overnight markets.  If the clearing banks do not unwind the repo transaction, stress would fall to the overnight repo investors who would not get their money back, but they would maintain control over the collateral that backs up the loan.  Refusing to unwind would be the equivalent to a “death knell” to a dealer who did not receive their collateral back.  Since the consequences of this are so severe, it seems obvious to me, from a system-wide perspective, that this decision should not rest solely with the clearing bank. What’s weird is that the secured investors (money funds, etc.) seem totally oblivious to this exposure.  They continue to think, how risky can an overnight, secured investment be?

On an even more important note, personally, I reached out to President Geithner in my official capacity as Coach of the Markets Fed Club softball team.  The same person who dazzled Congress with his testimony on the Bear Stearns rescue agreed to join the team!   Hopefully he’ll be able to make at least one game. If we’re not careful we might ask him for autographs after the game.


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