Thursday, March 13, 2008

More talk of Fed outright buying MBS from banks.

There seems to be more and more talk in the news about Fed potentially just outright buying MBS securities from banks. Some credible people say it's a must-do, while other respected people are calling the entire set of recent Fed experiments criminal. Brad Setser also has some thoughts on what other central banks have been doing and claims that Fed is much tamer than say People's Bank of China. All this talk might be a prelude to the upcoming action and trying to get a feeling for what the public reaction to such a step might be.

I don't really care much if this action would be legal or not, since I think Fed's recent behavior has been equivalent to shedding all pretense that it is a responsible entity independent of the government, like its mandate says. At this point they are likely prepared to do whatever it takes to prevent the big banks from collapsing.

Also, by accepting MBS as collateral, they already accepted the risk of owning these MBS securities in case of a primary dealer default. So, if they see a major bank collapse as imminent lest they do something, they may as well think they got nothing to lose.

What I am really interested in, is if it is even theoretically possible for Fed to start just buying ABS crap outright without generating an inflation spike. The recent TAF and TSLF were not money injections, as Fed has sterilized the money inflow by removing some money from circulation. But they had to use treasuries from their own balance sheet to do that. Fed balance sheet is only $1 trillion dollars. Just recent events alone have put Fed on the hook for about 400 billion of MBS. So, in a few weeks Fed's balance sheet will not be 1000$ billion of Treasuries, but 400$ billion of MBS and 600$ billion of Treasuries. That already seems very dangerous, considering that losses on those MBS are almost certain to be around 50%, AAA rated or not.

So to me, it looks like Fed has almost reached its capacity to sterilize this intervention further. And considering that the size of mortgage market is over $10 trillion, their move is still just a fig leaf on the size of the problem. I do think any further move in this direction would be the equivalent of printing money in some form.

Also, consider this: right now Fed officially deals only with the primary dealers. But there are numerous hedge funds out there in deep trouble right now, holding not only MBS, but all kinds of depreciating stuff. Banks have loaned enormous amounts of money to these funds, and they cannot get it back. Just today Carlyle Capital and several other hedge funds announced that they stopped withdrawals and are likely liquidating. The key problem is the entire financial system is over-leveraged (too much debt), not just the banks. So if hedge funds cannot answer margin calls and repay their loans back to the banks, which is the stage which we have reached, then even removing MBS from banks will not help much.

Fed may have been moderately successful in delaying the big disorderly implosion so far, but that is all it's been doing so far - delaying. I guess Fed's goal is to make sure the unwind stays orderly, but not to prevent the debt unwind from happening. Whether it will reach the disorderly stage or not, remains to be seen - but Fed's odds are getting worse.

So my conclusion:
a) Fed can buy moderate amounts of MBS from the most troubled banks without generating immediate inflation, but it cannot buy enough to really save the banking system. If it does try to buy enough, hyper-inflation will be here.
b) Fed does not have any solution for the hedge fund problem. They appear to be on the verge of blowing up en masse, and I have not yet seen any ideas from policy makers on how to deal with that.

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