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Thursday, 9 October 2008

Follow the Money

The following is a paper published earlier this week by former Sempra Metals economist John Kemp looking in detail at the Fed’s emergency money market operations and its ultimate reliance on Chinese support:

In an underground car park in Washington DC, FBI Deputy Director Mark Felt told the young Washington Post investigative reporter Bob Woodward to “follow the money” in the hunt for the source of the Watergate break-in. The advice remains good today. Tracking the flow of funds through the financial system and across the balance sheets of the Federal Reserve and other banks provides the best way to understand what his happening below the surface.

Even before Congress passed the Emergency Economic Stabilisation Act and approved spending up to $700 billion to purchase mortgage-backed securities from the market in the Troubled Assets Relief Programme (TARP), the Federal Reserve and the United States Treasury were intervening in the market to prop up the banking system in a way that has no precedent in modern history.

By the close of business on Fri Oct 3, the Federal Reserve had already extended various emergency loans to domestic borrowers and foreign central banks totalling more than $600 billion, and the United States Treasury had gone out into the money market to borrow $400 billion and deposit it with the Fed to replenish the central bank’s exhausted balance sheet.

Details of the rescue operation are available in near real-time in two documents published on the internet: The Daily Treasury Statement of Cash and Debt Operations of the United States Treasury published by the US Financial Management Service (FMS), and the tabulation of Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks published weekly by the Federal Reserve System.

These two sources reveal a massive support operation in which the assets and liabilities of the US banking system have been largely merged onto the balance sheet of the Federal Reserve, and the US Treasury has pledged the full faith and credit of the United States to support the central bank. By the end of Oct, the US authorities will have provided more than $1 trillion in support – on top of the $700 billion which Congress has authorised the Treasury to spend buying up impaired mortgage-backed securities.

But even $1 trillion is unlikely to be enough to stabilise the system and end the crisis. The scale of the rescue operation will strain the Fed’s and the Treasury’s resources to the limit, and beyond. Nationalising the debt problem will not make it go away. The United States needs access to a fresh source of funding in order to restore confidence. The only country with sufficient free resources to recapitalise the US banking system is China, with its mountain of foreign exchange reserves.

China’s support is crucial. It could take many forms, and it remains to be seen whether support will be pledged openly (in the form of a loan to the US government, or an operation swapping some of China’s mountain of US Treasury paper for impaired securities) or tacitly (in the form of exchange-rate support, or continued buying of US government bills as the Treasury struggles to roll over its growing debt). But one way or another only China has the resources to stabilise the financial system.

The scale of the Fed’s lending operations is revealed in the weekly Condition Statement, which is similar to the balance sheet of a private firm. In Jul 2007, before the onset of the crisis, the Federal Reserve Bank’s had assets of about $902 billion, mostly held in the form of a huge pile of US Treasury bills and bonds ($790 billion) with a few short-term repo loans to the banking system ($19 billion), some other longer-term loans ($41 billion), gold ($11 billion) and currency ($38 billion) making up the remainder. The Fed’s liabilities consisted of $812 worth of notes and coins in circulation, deposits from its member banks ($18 billion) and one or two other minor items. But the two largest items on the Fed’s balance sheet were the pile of US Treasury bills and notes it owned ($790 billion) and the currency in circulation which it had issued ($812 billion). Lending operations were marginal.

The main reason for owning a large stock of Treasuries was to back the currency issue and provide the Fed with resources to alleviate temporary liquidity shortages arising from lumpiness in tax payments and seasonal swings in credit demand by providing short-term funds through repo operations. More rarely the Fed would undertake reverse repo operations to drain excess funds from the system.

But as the crisis worsened in the autumn and spring, the Fed found itself as almost the only source of liquidity. Officials stepped up the provision of liquidity by vastly increasing the scale of repo operations, by which the Fed credited cash to the borrower’s accounts with the central bank, in return for receiving US Treasury bills to the same amount, and with a pledge that the borrower would buy the securities back within a specified time period, reversing the operation. The volume of funds provided through these temporary repo operations had ballooned from $39 billion in Sep 2007 to $99 billion by Apr 2008.

Temporary repo operations do not have any impact on the Fed’s own stock of Treasury paper. Although the Fed buys Treasuries from the market, the extra paper is not added to its own stock, because there is a legal agreement to sell them back within a specified period of time. The central bank merely holds them as a form of a collateral.

But officials worried the massive volume of funds being provided by these temporary repos would begin to expand the money supply and add to the upward pressure on already-high inflation. So the Fed tried to sterilise the impact of its temporary repos on the money supply by undertaking other offsetting measures to shrink the amount of money in circulation.

While it was borrowing Treasuries from the rest of the banking system through temporary repos designed to add liquidity to the cash markets, the Fed began to sell Treasuries from its own stock back to the banking system on a permanent basis to withdraw a similar amount of liquidity. The aim was to add short-term temporary liquidity but withdraw longer-term permanent liquidity in a similar amount and leave the overall money supply unchanged. The purpose was to insulate the Fed’s provision of liquidity to the banking system in its role as lender of last resort from the Fed’s need to maintain an unchanged federal funds rate at 2.00% and control money supply growth in its monetary policy role.

Between Mar and May 2008, the Fed sold $143 billion worth of Treasuries back to the banking system through permanent open market operations. The result of these and other operations was that the Fed’s own stock of Treasury notes fell -32% from $713 billion in Mar to $482 billion in May. As a result, there was little change in the size of the Fed’s overall balance sheet (with temporary repos and permanent reverse repos offsetting one another) but a marked change in its balance sheet, with a huge drawdown in the volume of Treasury notes owned outright and a big increase in temporary advances to the banks.

But as the crisis worsened and proved more prolonged than expected, temporary repo lending was inadequate. The Fed introduced a raft of new facilities designed to improve the functioning of the market. The Term Auction Facility, introduced in Dec 2007, and repeatedly expanded, provided as much as $150 billion in longer term repo credits with a maturity of 1-3 months. The Fed allowed commercial banks to borrow as much as $40 billion in loans from its Discount Window facility to ease funding shortages, and granted similar access to investment banks and other broker-dealers, lending as much as another $40 billion. It also provided about $29 billion worth of funding to JPMorganChase to support the acquisition of BearStearns.

But the overall impact of the facilities was marginal. Between Aug 2007 and Aug 2008, the size of the Fed’s balance sheet increased marginally from $903 billion to $936 billion. The main effect was to cut the pile of Treasuries which the central bank owned outright from $790 billion to $480 billion and replace them with a variety of other assets in the form of loans and advances.

In a fateful decision in Mar 2008, the Fed announced a new Term Securities Lending Facility (TSLF) through which it would swap Treasuries from its own stock for mortgage-backed and other securities held by the banks. The Fed has always lent out Treasuries from its portfolio to help alleviate shortages of particular maturities in the market, but normally only overnight. The TSLF enabled borrowers to swap Treasuries in much larger volumes and for much longer periods. By Aug 2008, the Fed had $480 billion of Treasuries in its own stock, but it had lent about $120 billion of them to the banks in exchange for lower quality and less liquid credits, leaving only $360 billion actually available.

But as the banking system descended into crisis from mid Sep onwards, the Fed’s lending surged. Discount Window loans for commercial banks soared from an average of $20 in the week ending Sep 10 to $44 billion by the week ending Oct 1. Credits to investment banks and other broker-dealers went from zero to $148 billion. The Fed also announced a new facility to support money market mutual funds unable to roll over asset-backed commercial paper which went from zero to $122 billion in the space of a fortnight. It extended another $53 billion of other loans, and swap arrangements with other central banks had already drawn down an extra $30 billion, with much more to come.

Worse, the volume of Treasury securities lent out via the TSLF and other facilities surged from $118 billion to $256 billion, cutting the volume of Treasuries left in the Fed’s possession and unpledged from $354 billion to just $232 billion, with the balance falling fast.

From the middle of Sep, the Fed dropped its previous insistence on sterilising credit extensions and began to allow its balance to grow significantly. Officials made no attempt to offset the new credits to money market mutual funds, banks, broker-dealers and other central banks. The Fed’s balance sheet, which had been steady at $905-935 billion for a year surged to an average of $983 billion on the week ending Sep 17, $1.189 trillion on the week ending Sep 24, and $1.441 trillion on the week ending Oct 1, and was still growing rapidly. The Fed’s balance sheet has now increased +53% in the space of three weeks.

Some of the new lending is backed by increased deposits from the banking system itself, as banks conserve cash and raise their balances with the Fed itself. Bank deposits with the Fed have soared from an average of $8 billion in the week ending Sep 10 to $167 billion in the week ending Oct 1. But with the Fed’s balance sheet looking increasingly stretched, the US Treasury has been forced to step in and strengthen the central bank by depositing huge volumes of excess funds.

The Treasury normally issues small volumes of “cash management bills” to meet temporary shortfalls in its accounts when demand is unexpectedly heavy or tax receipts are slower than anticipated. The volume of bills issued is not usually more than $70 billion in any one month, and the bills are usually rolled over rapidly into regular bills and notes at the next funding auction. But in the second half of Sep, the Treasury sold an unprecedented $320 billion worth of cash management bills and deposited all the resulting funds into a special “supplementary financing program account” with the Fed. Another $140 billion were issued in the first three days of Oct, taking the total in the supplementary account to $399 billion.

In effect, the Treasury has taken advantage of the panic-driven flight to quality to issue a mountain of very short-dated cash management bills, and deposited the proceeds with the Fed, which has enabled the Fed to grow its own balance sheet and expand its own lending to the banking system. The Treasury is pledging the full faith and credit of the United States to raise funds in the money market on behalf of the banks who cannot, substituting its own AAA-rating for the impaired creditworthiness of the major financial institutions. Because of the sheer volume of “safe haven” flows, the Treasury has been able to issue most of this paper at annual interest rates of just tenths of a percentage point. The Fed has taken a substantial portion of the banking system effectively onto its balance sheet, while the Treasury is now borrowing in the market to support the central bank.

One consequence of this is that it is too simplistic to assume the massive growth in the Fed’s balance will be inflationary (contrary to the views of some commentators). While the has increased the various loans and advances it makes to the market sharply in the last three weeks, this is counterbalanced by the $400-460 billion of over-borrowing undertaken by the US Treasury from the public, which has removed a broadly similar amount of liquidity from the system. So the bailout is not (yet) a clearly inflationary signal (though to the extent it reduces the risks of a severe recession, it reduces the risk of a DE-flationary spiral).

The volume of support from the Fed and the US Treasury is unprecedented. Once the TARP ($700 billion) and the various lending facilities already announced ($1.0-1.5 trillion) are fully implemented, the Fed and the Treasury will be extending credits and other support equivalent to around 15-20% of US GDP (though the actual cost to the taxpayer should be much smaller as most credits and at least some of the securities acquired under TARP should be repaid for what the authorities bought them for).

But the scale of the operations also highlights the limited usefulness of this type of intervention and has fuelled market doubts about its eventual effectiveness, as was evident in yesterday’s renewed plunge in US equity markets.

The Fed itself has basically run out of money. While the Treasury can continue borrowing to support the central bank, the government is already getting close to the debt ceiling. Before the passage of the Emergency Economic Stabilisation Act, Congress had authorised the Treasury to borrow up to $10.615 billion. By the end of last week, the Treasury had already borrowed $10.120 billion, and had just $494 billion worth of unused borrowing authority left. The Stabilisation Act raised the statutory debt limit by a further $700 billion to $11.315 trillion. But that was done to allow the Treasury to raise money to buy up to $700 billion worth of troubled assets under the TARP; it has no effect on the amount of borrowing authority the Treasury has for other programmes.

So the Treasury still has around $494 billion of unused borrowing authority left. That gives it some scope to raise more funding through the sale of cash management bills, but it cannot keep up the current pace of borrowing very much longer. More seriously, it will be using up borrowing authority that it needs for the coming year.

The respected non-partisan Congressional Budget Office (CBO) is already projecting a budget deficit of more than $400 billion in fiscal 2009, and the tax breaks included in the Stabilisation Act to secure its passage second time around by the House of Representatives will increase the deficit further. At the very least, the US Treasury will have to come back to Congress within the next few months and ask for a further substantial rise in the statutory debt limit. Borrowing to support the financial system looks set to crowd out the government’s ability to borrow in order to fund tax cuts and domestic spending programmes, sharpening the budget dilemmas for the incoming administration and Congress next January.

But all this borrowing threatens eventually to undermine the market’s confidence in the financial position of the United States. Of the $10.120 billion of US government debt outstanding at the end of Oct 3, $4.272 trillion had actually been sold to other government entities such as the Social Security and Medicare Trust funds, and was largely an internal accounting transfer. Only $5.914 trillion had actually been placed with the public. The amount of debt placed with the public has already surged +9.5% from $5.401 trillion at the start of Aug and +17.0% from $5.057 trillion at the start of fiscal 2008 in Oct 2007. The $700 billion for the TARP will add even further to the rapidly growing mountain of public debt that has to be sold to the public.

For the time being, the market’s demand for ultra-safe instruments is so huge that the Treasury is having no difficulty placing all the paper it wants at little or no interest. But the cash management bills are all very short term, and the Treasury will soon start having to roll them continuously, or fund them by issuing longer-dated securities, and the longer-dated securities will be much more expensive in terms of interest costs. Funding could become much more difficult once the immediate crisis, and the associated safe-haven flows has passed.

More worryingly, all this borrowing by the US Treasury threatens to crowd out borrowing by the banks and the private sector. I have never really believed in the strict versions of the “crowding out” theory, and the problem is somewhat theoretical at the moment, since the banks and most corporations cannot really borrow from the market at the moment in any event, so the Treasury borrowing is not really crowding them out in any meaningful sense. In fact the Treasury is borrowing into what would otherwise be the vacuum created precisely because others cannot borrow.

But sooner or later, the private sector will need to restore its access to the capital market, and the Treasury’s massively increased public borrowing requirements, up by more than 25% in a year, could start to create problems. Either households and corporations in the United States must be persuaded to save more, and buy more of both government securities and private notes, or foreign investors must be persuaded to increase their holdings of US government paper.

In either event, borrowing costs for both the government and the private sector look set to rise in the medium run, at least in real inflation-adjusted terms. It is notable that the cost of long-term government borrowing through US Treasury bonds has only declined to 3.45% despite the near-collapse of the rest of the financial system, not lower than during some of the troughs of the last recession, when economic conditions were difficult by the financial system was still functioning normally. So for term borrowing, rather than overnight cash, the government’s funding cost is cheap, but not that cheap. Borrowing costs for the private sector have continued to rise even for the highest grade credits. Some of this is due to immense uncertainty about the repayment capability of even high-rated corporations at the moment, and should eventually unwind when the crisis abates. But corporate borrowing costs look set to re-rate upwards in the medium term.

This brings us to the last part of the puzzle: the behaviour of the exchange rate and international capital flows. The current crisis is remarkable because the currency of the country at the centre of the crisis (the US dollar) has strengthened substantially against the currencies of almost all its major trading partners. The dollar’s strengthening is counter-intuitive. It is as if the inhabitants of the building were running towards the seat of the fire rather than away from it after the fire alarm sounded.

The obvious answer is that the currency is benefiting from safe-haven flows, as investors flock to the safety of the US government bond market, and perhaps calculate that the US government’s aggressive stabilisation efforts contrast favourably with the slower and more piecemeal moves in Europe and elsewhere. But while it is easy to see how investors in the United States itself might flock to the apparent safety of the US government bond market, it is less clear why investors in overseas markets would rush to increase their exposure to the country at the very heart of the crisis. The point about running towards the seat of the fire after the alarm has gone off applies.

But at least two factors appear to be supporting the US dollar. US banks and corporations are almost certainly liquidating some of the assets they own overseas and bringing funds home to strengthen their balance sheets and reduce the amount they need to borrow in the short-term. US corporations hold substantial assets overseas, some of them long-term, others short-term funding held in offshore vehicles to minimise tax liabilities.

On Fri Oct 3, the Internal Revenue Service (IRS) relaxed the rules governing how much of these funds corporations can bring back on a temporary basis without having to pay 35% corporate income tax on them. Normally IRS allows corporations to bring funds back from overseas subsidiaries for up to 30 days twice each year. Following Friday’s extension, corporations can bring funds back for up to 60 days, three times per year. The IRS move was explicitly designed to provide some help to corporations experiencing severe funding pressures.

But it is likely corporations were already bringing some funds back, and were liquidating longer-term assets to strengthen the parent company’s financial position, even before the IRS move. Liquidation of overseas portfolios, or borrowing from overseas subsidiaries with surplus cash, is a one-time source of support for the currency, however, and will dry up when the liquidation is completed, or even go into reverse when the borrowing from subsidiaries has to be repaid. So this source of dollar strength could prove to be strictly temporary.

The other source of dollar strength is probably from quiet intervention in the foreign exchange markets by one or more central banks. The final interesting item on the Fed’s Condition Statement is a memorandum item at the bottom of the table which shows the volume of US Treasury securities which the Fed holds as custodian for foreign governments and central banks. The Fed doesn’t own these securities, and it cannot lend them out without authorisation, but it provides a convenient repository for other central banks to hold their US paper, including the People’s Bank of China.

The volume of Treasury securities held in custody by the Federal Reserve Banks for foreign account holders has soared from $732 billion at the end of 2001 to $1.061 trillion at the end of 2003, $1.519 trillion at the end of 2005 and $2.056 trillion at the end of 2007. When foreign central banks buy dollars to prevent their own currencies from appreciating, the proceeds are usually converted into US Treasury bonds, and many of them are held in the Fed’s custody. The Fed’s custody account therefore provides a useful indicator of the volume of foreign exchange intervention, and the surge in custody holdings over recent years is a useful yardstick of the extent to which China, as well as some other countries in Asia and the Middle East running large balance of payments surpluses, have intervened to support the dollar and keep their own currencies from rising too much.

Throughout this year, the level of foreign exchange intervention has been modest. The Fed’s custody holdings have grown by perhaps $10-20 billion per week. But in the most recent week, ending Oct 1, the Fed’s custody holdings surged by almost $44 billion, suggesting heavy intervention by one or more overseas central banks has been supporting the dollar.

The Fed’s custody holdings amount to a staggering $2.466 trillion – of which $1.495 trillion is invested in Treasury securities and another $970 billion is in agency bonds. To put this in perspective, of the $5.850 trillion worth of US Treasury debt which is actually held by the public rather than as an accounting entry in the Social Security and other trust funds, foreign governments hold about 25% of the total in their Fed custody accounts.

Two points follow.

The first is that if the US Treasury is going to issue another $700-1,000 billion of new debt to cover TARP and other credit extensions, finding domestic buyers for all of it may prove difficult, and it will probably need to persuade foreign governments to absorb at least a proportion of the new total. For several years, US legislators have complained vigorously about the volume of foreign exchange intervention by foreign central banks. They have argued that it has kept emerging markets’ exchange rates unusually low and granted an unfair advantage to their exporters, without realising that it has also helped support US government borrowing and kept yields and the whole spectrum of US interest rates lower than they would been otherwise. The recycling of balance of payments from the Middle East and Asia into the US bond market helped finance much of the 2002-2007 expansion, as well as the subprime crisis that ended it. But in the medium term, continued foreign government support for the US bond market will become more important than ever before as the US Treasury tries to borrow its way out of the crisis by replacing impaired bank and mortgage debts with paper newly issued by Uncle Sam.

The second point is that the $2.4 worth of Treasury and agency securities held in custody, including $1.5 trillion worth of Treasury securities, is now very large indeed, especially relative to the Fed’s own rather meagre pool of unlent securities. The Fed has no authority to lend them out without permission of the owning governments and central banks. But it is possible to envisage circumstances in which the Fed could obtain permission to swap those Treasury securities for mortgage-backed and other private securities, while taking on the credit risk itself and guaranteeing the ultimate owners of the foreign reserves against the risk of default. The Fed, and ultimately the US Treasury, would still be liable for the cost of any defaults. But they would not need to issue so many new Treasury bonds to finance the swap programme, and could circumvent the statutory debt ceiling more easily.

The Fed does not divulge the exact owners of the securities in its custody. But by far the world’s largest accumulator of reserves has been China, and the country is widely assumed to own a very large share of the total. China has already expressed some anxiety about its concentration of reserve holdings in dollar-denominated assets and the resulting exchange rate risk. Senior policymakers have repeatedly indicated that they would like to diversify the country’s reserves into other currencies, but the attempt has been frustrated because as the largest holder of dollar reserves China stands to lose the most from any loss of confidence in the currency and consequent devaluation. So while China probably does not want to add to its holdings of dollar assets and its exposure to the United States, the size of its existing holdings, and its need to protect their value, may leave it no choice.

China has other reasons to support the United States. North America and Europe are by far the most important markets for China’s export-dependent economy. China will not avoid a sharp slowdown, and the risk of social instability, in the event of a deep recession in the United States that spreads to Western Europe and Japan. So China’s government has strong reasons of self interest to support the Fed’s and the Treasury’s efforts to stabilise the financial system. Finally, by supporting the United States, China would be playing the role of international lender of last resort, and confirm its emergence as one of the top-tier participants in the world economy and financial system, taking its place alongside the United States, Japan and the eurozone. The gain in prestige would be enormous and it would prove impossible to deny China the right to participate alongside the G7 countries in shaping the future of the financial system.

China’s support for the stabilisation package will be crucial, though what form it will take is unclear. Explicit support via a loan to the US Treasury or swap arrangements using its huge stock of US Treasury securities would probably represent too much of a humiliation for the US authorities. But support could be offered more tacitly in the form of foreign exchange intervention to support the value of the US dollar, especially as the impact of repatriation flows unwinds, and continued support for the government debt market in the form of further purchases of newly issued US Treasury securities is probably essential. Explicitly or tacitly, China’s support is a necessary condition for stabilisation to be a success.

During the 1920s and 1930s, the United States, acting through the Federal Reserve, repeatedly had to support the Bank of England and the Bank of France when periods of tight credit and the outflow of funds threatened to overwhelm their modest balance sheets. The Fed acted, albeit inconsistently, reluctantly and not always reliably, as a sort of international lender of last resort, because it alone had the free reserves, in this case the free gold, to support the other central banks when their own balance sheets came under pressure. Now that China, and to some extent the major oil exporters of the Middle East, have amassed a huge stockpile of US Treasury paper, they alone have the resources to take up the role of international lender of last resort. In one form or another, whether explicitly or tacitly, they will have to support this stabilisation if it is to succeed. They have powerful reasons of self interest to do so, and China’s stock of Treasury bond holdings is so large it has little choice. But as the phrase goes, he who pays the piper names the tune. Just as the Fed’s lending in the 1920s and 1930s bolstered its position in the international financial system relative to London and the centres of Continental Europe, so support for the bailout from China and the rest of Asia will mark a further shift in the financial system’s centre of gravity towards the east.

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