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Wednesday, 19 August 2009

The dumbest fool on Wall Street

Government is almost always the most stupid player in the financial markets. One reason is because it doesn't have a profit motive, and thinks that some intangible public god can justify its actions. The other reason is that unlike other dumb players, it won't get wiped out, and will keep coming back for more abuse.

Twenty years ago a swaps dealer told me about a niche market where he would profit from the EIB. The EIB would raise fixed rate funding through bond issuance and would offer funding to potential borrowers that would be held at a fixed rate over the funding tranche. When bond yields moved upwards the swaps dealer would chase down potential borrowers and get them into EIB deals which he would swap into sub-LIBOR floating rate funding, but because the EIB hadn't moved their orrefered fixed rates in line with market rates, the swap margins were humungous.

So it was no surprise yesterday when Wall Street were reported as heaving a sigh of releif when the Fed and the US Treasury announced on Monday that they were extending the $200bn TALF which was supposed to revive the securitisation market.

First of all we had TARP (the Troubled Asset Relief Program) where the US government was supposed to buy impaired assets from the market. This was less than successful because it meant that the banks would have to sell assets at a discounted value, which meant getting a valuation and maybe booking a loss, and worse still losing out on any upside. On the other hand, if there was a far value in the market the banks would have sold there and didn't need the government, so it is safe to assume that where the US government did buy assets it got a raw deal.

Better than TARP for the banks was TALF, which came about when the ABS market came to a standstill in late 2008. Getting banks assets off their books and into the capital markets had become such an integral part of the US credit markets that the government decided it needed to unlock the jam, and it did this by having the Federal Reserve Bank of New York lend up to $1 trillion on a non-recourse basis to holders of certain AAA-rated ABS backed by recent consumer and small business loans. The deal didn't require approval from Congress because it came from the Federal Reserve and not the Treasury. This was a great deal for the banks, giving them assured and cheap funding, and best of all because the loans were non-recourse to the banks, the Fed took all the risk on the securitised assets.

So imagine the squealing when bankers saw that the deal was coming to an end, and sure enough the Fed decided that its friends on Wall Street needed more stimulus.

But in case you think that is as good as it gets, there is more, because as was recently reported Wall Street banks are earning enormous profits by trading with the Federal Reserve. The Fed has become one of Wall Street’s biggest customers during the financial crisis, buying securities to stabilise the markets. In some cases, such as the market for mortgage-backed securities, the Fed is the biggest buyer in the market.

Well, good for Wall Street you might think. The US government is buying securities so traders are bound to make some money, but the game is more loaded in favour of the banks, because in the name of open government and transparency, the Fed announces in advance its intention to buy particular securities, which is about as dumb as it gets. In other markets there are specific rules about trading ahead of customers or "front running", but when dealing with the US government this doesn't apply because they have signalled their intentions in advance.

The big Wall Street banks have the financial muscle to buy up securities that the Fed says it wants to buy, which they turn around to sell to the Fed when they see it open its cheque book, a big factor in the higher profits from fixed income trading reported by banks in the last 6 months.

A former official of the US Treasury and the Fed said the situation had reached the point that “everyone games them. Their transparency hurts them. Everyone picks their pocket.”

William Dudley, president of the New York Fed, has defended the approach to securities purchases, saying “We believe that opting for transparency is a greater good,” he said. “If we didn’t have transparency, we’d be criticised on other grounds.”

If I was a US tax payer, I think there are times when I would rather have some secrecy.

1 comment:

Demetrius said...

Never give a sucker an even break. Old American Proverb.