The Fed May Run Low on
Unconventional Ammo

GREG IP / Wall Street Journal 11mar2008

Back in 2003, when the Federal Reserve cut interest rates to 1%, the world worried that the Fed was running out of ammunition and would soon have to turn to unconventional tools.

Now, in 2008, it’s worth asking if the Fed could run out of unconventional ammunition. Tuesday’s offer to lend $200 billion of its Treasury holdings to primary dealers in return for mortgage-backed securities both guaranteed by the government-sponsored enterprises (Fannie Mae and Freddie Mac) and not (private-label MBS) means it will have eventually sold or pledged half of its Treasurys, limiting how many more of these tricks it can pull off.

Since August the Fed has announced a series of steps designed to target those pockets of the financial markets facing the most stress rather than rely solely on the blunt instrument of lower short-term interest rates. These steps have primarily involved taking onto its balance sheet something a bit risky — a loan to a bank or a securities dealer, collateralized with paper ranging from corporate loans to private-label mortgage backed securities (i.e. MBS not backed by the federally sponsored agencies Fannie Mae or Freddie Mac).

Left alone, these operations would result in an increase in cash supplied to the banks, boosting excess reserves and pushing down the federal-funds rate. Since the Fed does not want that to happen, it “sterilizes” the operation by getting rid of an equivalent amount of something else on its balance sheet. That something is usually Treasurys. Last December, it announced the creation of the term auction facility under which it auctions off loans to banks against a wide variety of collateral. To keep its balance sheet constant, it decided to let a roughly equivalent amount of its Treasurys mature. Since then, its Treasury portfolio has fallen from $779 billion to $713 billion.

Last Friday, it announced two additional steps: It would expand the size of the Term Auction Facility loans to a total of $100 billion from $60 billion (and the original $40 billion) and lend up to $100 billion to primary dealers in lengthened, 28-day repo operations. To sterilize those operations, Wrightson Associates estimates the Fed will have to shed $100 billion in Treasurys. Friday, it sold $10 billion of Treasury bills, its first outright sale since 1991. It will have to sell or redeem a lot more to keep its balance sheet from ballooning. One of the beauties of the securities lending facility is that it is self-sterilizing: The addition of MBS to its balance sheet is exactly offset by the loan of Treasurys.

From the point of view of normalizing market conditions, it makes sense to replace Treasurys with other stuff because the federal government is having no trouble borrowing right now. Quite the contrary: The flight to safety has driven Treasury yields to unnaturally low levels. In the securities-lending (or repo) market, someone with Treasurys to offer as collateral can borrow at a rock-bottom interest rate. But it does raise the prospect that with a few more similar-sized steps, the Fed will have run out of Treasurys to sell or pledge.

As Michael Feroli of J.P. Morgan Chase notes: “in a short period of time the Fed could have up to $400 billion of mortgage assets on its balance sheet.” Of course, that would still leave it with $400 billion in other assets to sell or pledge. And the Fed doesn’t have to simply sell Treasurys: It can allow some of its $52 billion in shorter-term repo loans to dealers to expire. It could conduct reverse repos, i.e. start borrowing from primary dealers instead of lending to them (although that would tie up Treasurys as collateral for the reverse repos). Fed officials say they have many other ways of increasing their lending capacity though they were not specific.

And, as David Greenlaw of Morgan Stanley notes: “If the situation were to become sufficiently dire, the Fed has unlimited power to monetize the economy’s debt … . They could finance the entire $10 trillion US mortgage market — and then some — via some combination of outright purchases (of the GSE-backed securities) and repo transactions (for the private debt).” Of course, that would quickly send the federal-funds rate to zero and, with a lag, inflation to the moon. Hello, Zimbabwe (inflation: 100,500%).

There doesn’t seem much risk of that now judging from the Fed’s response to Wall Street dealer suggestions that the Fed purchase GSE MBS and bonds. The Fed has the clear legal authority to do so, unlike with private-label MBS, and indeed held some agency debt as recently as 2003. But Fed staffers told reporters Tuesday that such purchases would inevitably influence the prices of such securities and they don’t want their operations distorting relative valuations. Another philosophical barrier is the Fed’s long standing efforts to strip the GSEs of their implied government guarantee, one reason it has let its holdings of GSE debt fall to zero. A more prosaic obstacle: the Fed’s operations are not well equipped to hold MBS with their unpredictable prepayment patterns.

For a similar reason, the Fed does not, at least for now, want to lengthen any of its lending operations to 90 days, as the European Central Bank and the Bank of England regularly do and as dealers would like. The Fed, staffers say, would become the dominant influence on interest rates at that maturity and it would rather that be a market-determined rate.

Many key aspects of the latest plan remain unanswered, reflecting how quickly it was put together. Money market dealers want to know what kind of private label MBS they can pledge: jumbos? Subprime? Alt-A? (The Fed has nixed commercial MBS). They also want to know what haircuts the Fed will apply. Fed officials decline to be specific except to say they will seem conservative for ordinary times and liberal for tumultuous times. (One starting point may be the haircuts imposed on MBS collateral at the discount window: They range from 2% to 15% depending on the maturity and the availability of market pricing.) Those details will be worked out in coming weeks.

source: 13mar2008