March – May 2009

Posted by

March 9, 2009

           This story is getting old: same story, different day and everything still sucks.  Bank nationalization fears are picking up in the marketplace as a legitimate concern has surfaced that if banks were to “mark-to-market” all of their assets, the resulting loss would cause bank equity positions to become negative.  Citibank, the current “poster child” for too much leverage and not enough risk management controls, used to be the largest bank in the country in terms of market capitalization (total market value of all outstanding equity shares).  Citi’s share price is now around $1.00, while Bank of America’s share price is about $3.50, not too much better, but probably higher than the ATM fees they charge non-depositors.

            The nationalization fears have grown, at least in part, on what’s going in the United Kingdom, where two of the largest banks, RBS and Lloyd’s, are now majority owned by the government.  No surprise that the LIBOR fixings are starting to rise, yet again. 

            In my little corner of the world, we continue to make preparations for conducting RRP operations that would temporarily drain reserves (electronic money) from the economy.  In the pre-crisis days, the Fed was almost always adding a little bit of reserves to the system, now we’re preparing to routinely take reserves away.  We can already drain reserves using delivery vs. payment settlement, but we want to do it with tri-party settlement (using a clearing bank) which will increase our capacity.  We’re making progress, but it’s slow.  Elsewhere in the Markets Group, we finally released a much anticipated auction schedule for the first Term Asset backed Lending Facility, or TALF.   This facility is designed to help support prices and market functioning in the asset backed securities (ABS) market.  The Fed will lend money for entities to buy ABS and if prices plummet, the buyers will only lose their down payment.  Hopefully the Fed won’t get into too much trouble (incur losses) with TALF because only ‘AAA’ ABS securities are eligible.  It’s not like we’ve seen big problems before with ‘AAA’ securities.  Oh wait, we have!  A little perspective on just how far the value of a ‘AAA’ rating has declined: General Electric still has a AAA rating and their CDS trades with “points up front”, indicating a fairly high probability of default.  While the TALF really has the potential to stimulate demand in the ABS market, no one expects a return to 2007 price levels any time soon.   By the way, the unemployment rate climbed from 7.6% to 8.1% last month alone.

March 18, 2009

The FOMC concluded their two-day meeting today with a bombshell announcement – they are directing “the Desk” at FRBNY to buy $750 billion of MBS securities, $100 billion more in agency securities and $300 billion of additional Treasury’s, all while keeping the target rate at 0 – ¼ %, naturally.  Wow!

Although both the stock and the bond markets rallied on the announcement, I’m still apprehensive, although I do admit that I don’t know what else to do.  At today’s 4:00 pm meeting, an Executive Vice President indirectly compared the Fed’s actions of purchasing so much sovereign debt to deadbeat creditor nations such as Argentina.  The reason for the comparison is that the Fed is now going to start buying government debt in size, while Congress has also passed a huge stimulus bill enabling the government to spend more money than it is expected to receive in taxes.  So, de facto, the Fed will be financing budget deficits, at least temporarily.  I read somewhere that the new legislation has no fewer than 9,000 specific earmarks for politically favored projects.  Yikes!

Does anyone seriously think that high Treasury yields are contributing to the financial crisis?  To use some card playing analogies, we’re now “doubling down”, or “going all in” to fight the crisis as we can no longer use the traditional means of providing more accommodation by lowering interest rates since they are already at zero percent.  It was mentioned at the 4:00 pm meeting that the Bank of England is really leading the way, they were the first major central bank to start buying sovereign debt.  Who is driving this bus, anyway?  If I was driving, I would try to:  a) remove bad assets from bank portfolios through some sort of competitive bidding process and b) fix the bank regulatory failures that allowed the problem to happen in the first place.  Maybe it’s just easier to start buying MBS and Treasury securities?

May18, 2009

            No entries for two months and the market is … improving!  Three-month LIBOR has declined from 1.40% on March 11 to 0.75% two months later.  Sweet!  Some of the improvement can probably be traced to the new securities buying program announced back in March, but there is a lot of talk about how the market appreciates the “bank stress tests” that the Fed recently concluded on the 19 largest financial institutions in the country.  Although the market has gone down so much since the test were announced that the “stress scenario” looks more like the “baseline scenario”, participants took comfort that the Fed conducted a transparent analysis of capital levels of the large banks and found that only 6 of the 19 need more capital.  The equity market is particularly pleased; the S&P index in mid-May is up a staggering 30 – 35% from the lows reached in early March. 

            There appears to be some way to go in the great deleveraging saga.  Chrysler Motors is literally in bankruptcy proceedings and General Motors is probably not far behind.  Naturally enough, some secured creditors of Chrysler are complaining that the bankruptcy court is not treating them fairly.  Only time will tell.  I think the priority should be to maintain quality, long-term jobs in the US auto industry, which I imagine is also a priority for the bankruptcy judge. 

            It’s now mid-May and the Desk has yet to conduct a temporary open market operation; pre-crisis we averaged about one of these a day.  Of course, things are a little different now: the target rate is now a target range and the range is bounded by zero.  The zero bound is helpful for keeping the fed funds rate within the desired range since “excess reserves”, which used to average between $1 – 2 billion, are now around $800 – 900 billion.  Yes, that’s right excess reserves are about 500 times larger now than they were pre-crisis.  Demand for borrowing under the liquidity facilities is going down although there is still good demand for the Fed’s relatively exotic Term Asset-back Lending Facility.  Overall reserve levels are staying the same as liquidity facility reductions are being offset by the Desk’s purchases of MBS and Treasury securities and the stock market has rallied significantly.  This is leading to talk in the market on how the Fed will gracefully exit from its expanded balance sheet when the time comes to remove monetary policy stimulus.

                                                                        # – #

Postscript:  October 2022

           I thought it would be interesting to list a couple of “lessons learned” from the response to the Global Financial Crisis now that we are about 15 years removed the onset of the crisis. Not intended to be a comprehensive list.


I was initially skeptical that QE would work, but it seemed to work great in the 2009 – 2014 period.  How does QE loosen financial conditions?  The best explanation I’ve heard is the “portfolio rebalancing theory”, i.e. as a result of the Fed buying a lot of long-dated public (Treasury and MBS) securities, private entities will be incented to buy longer dated, private (corporate) securities as these investors are displaced from owning Treasury and MBS securities.  As private investors increase their investments in corporate bonds, this lowers the associated interest rates and makes it easier for corporations to raise money for capital expenditures, etc.  Another way that QE works is to effectively communicate the Fed’s ongoing intent to maintain accommodative monetary conditions.  QE also seemed to work like a charm during the market tumult of 2020 following the COVID outbreak. 

Keeping with the backward view of QE, it probably is not a coincidence that stock markets enjoyed a big rally during the QE episodes of 2009 – 2014 and again in 2020 – 2022.  This makes sense; flooding the market with money will likely cause the price of financial assets to rise. If QE prompts rising equity markets, the reversal of QE, or QT, Quantitative Tightening, should cause a decline in equity market pricing, but the jury is still out on this verdict.

With the benefit of hindsight, though, the Fed probably should’ve stopped QE in 2021 once vaccines became available and labor shortages started to emerge.  While this may not have prevented the inflation spike that was to come in 2022, it might have mitigated the magnitude and stopping QE earlier likely would have helped Fed credibility.


            The Fed’s monetary policy implementation framework has changed several times since the onset of GFC.  Reserve levels went from scarce (pre-crisis), to abundant (post-crisis 2009 – 2017), to ample (2018 – early 2022 and then back to abundant (second quarter 2022 – present).  Phew!  What do these terms mean?

Scarce:  There are very few excess reserves in the system prompting the Fed’s money Desk to fine tune the daily level of reserves by conducting open market operations.  Banks actively exchange funds in short-term money markets to smooth out their loan and deposit flows.

Abundant:  Plenty of reserves in the system.  The demand curve for reserves is flat, i.e. day-to-day changes in the nominal level of reserves do not affect conditions in the money markets.  Very little inter-bank lending activity.

Ample:  While there are still a lot of reserves in an ample regime, the level of reserves is near where aggregate bank demand for reserves starts to steepen.  As such, the daily level of reserves can affect conditions in short-term money markets on occasion.  This is what happened in mid-September 2019.  On the corporate tax date in September 2019, an unexpectedly large demand for reserves emerged on a day when banks typically have volatile deposit flows, hence reserve demand moved from the flat portion of the demand curve.  The following day, the Fed’s money Desk conducted its first, non-small value, temporary open market operation to add reserves since 2008.

There are efficiency benefits from operating with an ample vs. abundant level of reserves, as ample reserves require a relatively smaller Fed balance sheet.  However, the smaller balance sheet does expose the system to greater fragility.  One thing to consider is that overnight, unsecured funding markets are not as robust as they were pre-crisis, hence atrophy may prevent an efficient distribution of reserves, suggesting that the Fed may need a relatively large buffer of reserves above baseline bank demand in order to avoid frequent bouts of unexpected reserve scarcity.  Of note, the Fed is now conducting daily reserve adding operations which were not available in September 2019.  These operations should mitigate rate volatility when unexpected reserve demand emerges.

Negative Rates:  I am delighted that the Fed did not use this approach.  Both the BoJ and the ECB used this approach for years and it doesn’t seem to work.  From my perspective, negative rates have the following negative attributes:

  • Counter-intuitive
  • Present a de facto tax on the banking system
  • Distort economic incentives and may discourage transactions in general


            Banks are much better capitalized, and their asset quality is much better, now vs. pre-crisis.  Most derivative contracts are now standardized and trade on standard exchanges.  This greatly reduces the pro-cyclical, systemic risk that AIG posed in September 2008 when its deteriorating financial condition increased its margin requirements.   Tri-party repo is also much safer as clearing banks no longer unwind huge volumes of trades early in the morning, which eliminates the “judge, jury and executioner” risk that JPMC (and the Fed) faced with Bear Stearns in March 2008

            I believe it is now more difficult for the Fed to use 13 (3) facilities (used by the Fed to lend to non-banks under “extraordinary and exigent circumstances”) as usage now requires the Treasury Secretary’s approval.  This is a good thing and it’s also clear to me that it’s helpful for the Fed to have this lending capacity to potentially use in a crisis.  It’s also my understanding that 13 (3) lending cannot be entity specific, i.e. some of the crisis lending facilities that were specifically tailored to support certain entities (e.g. Citi, BofA and AIG) would not be allowed.  This also seems like a good thing.


            It seems odd to me that we have one bank clearing almost all trading in Treasury and GC repo.  We should either encourage clearing bank competition (somehow) or make this clearing function a public market utility.

            I’m not an expert on bank regulations, but one ratio really sticks out as potentially being unproductive:  the Leverage Ratio / the Supplemental Leverage Ratio.  These ratios are intended to make sure banks have adequate capital levels by limiting the maximum amount of leverage they can assume.  The problem with these ratios is that they assume that all bank assets are of the same quality.  For example, it literally makes no sense to treat real estate construction loans the same as investments in US Treasury securities, yet that’s what the leverage ratio does.

Leave a Reply

Your email address will not be published.