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Friday, October 10, 2008

Fixing the money markets is more important than bailing out the banks

The US Federal Reserve is stepping beyond efforts to bolster and support short-term financial markets: it is replacing them.




Its special purpose vehicle to buy three-month commercial paper direct from top-quality issuers may well be used extensively by banks, but it also makes the Fed a direct lender to industrial corporations. That raises the question: if the banks are failing in their function to provide short-term cash loans to the broader economy, then what is the point of them? The logic of the vehicular finance system – whereby banks originated garbage assets and then created spurious structured vehicles to sell them to – is that banks become detached from the real economy. If, as a result, GE now struggles to raise short-term cash to pay suppliers or meet payroll, the Fed should lend directly to the company in recognition that it is a good credit and of value to society...unlike the broken banks.

For now, it is banks that are most at risk from high pricing or non-availability of short-term credit from the commercial paper market. And the price at which the Fed will provide funds to the new SPV, collateralized against the commercial paper it buys, suggests that it will be more attractive to banks. However US Treasury secretary Hank Paulson was quick to spell out that: “I expect this initiative to significantly improve the availability of funding for financial institutions and corporations that depend on the commercial paper market.” The Treasury is making a special deposit at the Fed to support the facility.

How big could this Commercial Paper Funding Facility be? Neither the Fed nor the Treasury has announced a figure but the Fed has said that its aim is “eliminating much of the risk that eligible issuers will not be able to repay investors by rolling over their maturing commercial paper obligations”. Taking this at face value, Bank of America suggests that this could be a $1.3 trillion programme.

The earliest signs of whether or not the programme is encouraging investors to resume term lending in the commercial paper market are not good. In the week ending October 8, commercial paper outstandings declined by $56 billion. That’s not good: but at least it’s an improvement on the week before, when outstandings fell by $98 billion and the Fed expended its lending to financial issuers by $38 billion to help make up that funding gap. Libor continued to rise, reflecting continued risk aversion towards financial companies.

Getting the commercial paper market working again remains an urgent priority, though perhaps the best that market participants can now expect form official sector support is the avoidance of outright, catastrophic failure.

Analysts at JPMorgan suggest that prime money market funds, which had $2 trillion of assets under management in early September and are a leading provider of short-term liquidity to the banking system, suffered between $350 billion and $400 billion of redemptions after the Prime Reserve fund broke the buck following losses on its holdings of Lehman commercial paper.

Other funds also might have broken the buck in the week beginning September 15 had not their parents injected cash.

At the surviving prime money market funds, these vast redemptions have eaten into the substantial cash cushions – between 10% and 20% of assets under management – all must hold to meet forecast investor calls for their cash back.

These funds must now sell good-quality assets to rebuild cash levels. They are selling some of their longer-maturity holdings to do this, shortening their funds’ average maturities and further reducing supply of one-month and particularly three-month money which banks roll over to fund loans and build assets.

As well as funding banks, money-market funds are a key source of day-to-day working capital for US corporations – the source of short-term cash to pay suppliers, to pay wages. To have this source of finance suddenly cut off would be the corporate equivalent for a householder, not of having a mortgage loan application to buy a house turned down, but of finding a credit card rejected and cut up at the supermarket check-out line. The authorities had to act rapidly in September to avoid that.

First, on September 19, the US Treasury announced a $50 billion guarantee fund to insure participating money market mutual funds so that investors would be guaranteed to be able to retrieve their cash at full net asset value.

Of course, all government action can have unintended consequences. Presumably some bright spark somewhere in the Treasury spotted, or perhaps a banking industry lobbyist pointed out, that a federal guarantee on money market funds risked prompting retail depositors to pull their money out of the banks and place it in the funds.

So, two days later, the Treasury issued clarification that the guarantee extended to amounts held in money market funds up to close of business on September 19.

In a perhaps more significant and certainly subtler move, the Federal Reserve opened the discount window to money market funds, using the banks as an intermediary.

It created assured liquidity for the $300 billion or so of asset-backed commercial paper held by 2a-7 money market funds by allowing banks to buy the paper from funds at amortized cost – effectively at par – and then post it as collateral to raise cash from the Federal Reserve with a zero haircut and zero risk-capital weighting.

Use of this facility helped inject $73 billion of liquidity into money market funds in the first three days of operation. The immediate crisis in money market funds appeared to pass. But the market did not return to health.

That $400 billion coming out of prime money market funds, reducing available funding to banks, is unlikely to return quickly. It has mostly been recycled into short-term government bills and more conservative money market funds that invest exclusively in them, helping to drive down treasury yields and lower the government’s cost of short-term borrowing, even to zero at moments of extreme panic.

Only the US government now has unlimited access to low-cost funding. It may yet be required to use this capacity not just to ease markets but to take on their function of passing money from investors to users.







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