The Optimists Once Said a Booming 2019 Would Be Filled with Rate Hikes

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What is it about early August? The middle of summer doesn’t seem like it would be the most likely part of the calendar to keep producing let’s call it market volatility. It can’t be random coincidence since the frequency defies any such notion. There was 2015 and the big CNY surprise; 2011 with Europe’s banks at the brink; in 2008 the forces that would lead to a September filled with Lehman, AIG, and Wachovia were unleashed during the month before; and the original, August 9, 2007.

It has been twelve years now and still we deal in the aftermath of that one day. I wrote five years ago how it at first glance it might not have seemed like all that much:

“To dryly observe what happened understates the severity of the event, as London trading for ‘dollars’ saw an inordinate discrepancy that cannot be fully comprehended by mere factual recollection. On August 9, 2007, 3-month LIBOR rose from 5.38% to 5.50%; a trivial number at first glance. But in the context of global dollar flow, it was an immense tremor that kicked off the spate of ‘emergency’ monetary measures that ultimately followed.”

It was therefore easy to downplay the severity. I mean, 12 bps?

Federal Reserve Chairman Ben Bernanke had said earlier in 2007 that subprime was contained and the head of FRBNY’s Open Market Desk Bill Dudley had on August 7 declared how “nothing was imminent.” And yet, on August 17, 2007, Fed officials were holding emergency phone calls with the biggest banks practically begging them to borrow in Primary Credit.

The first crisis measure undertaken in the US wasn’t the 50 bps rate cut in September 2007. It was instead a reduction in the penalty for borrowing at the Primary Credit window. The rate had previously been set at 100 bps above the federal funds target (FFT). From what officials particularly at FRBNY had been hearing, it was decided on August 17 to reduce it to FFT plus 50 bps.

Not only that, moving forward anyone accessing the line could borrow for more than just the usual overnight term. Policymakers decided to allow any takers in need of liquidity to go out as much as thirty days (eventually expanded to ninety).

Primary credit was nothing more than what everyone used to call the Discount Window. For much of its history, the Fed had used the Discount Rate as its main policy dimension. It fell out of favor because over time it became exclusively associated only with problem institutions. A (global) private market for liquidity had long, long ago supplanted the need to go get spare reserves from the Fed.

Therefore, if you went to the Discount Window you were admitting you were having trouble obtaining funds in the usual fashion. This would only lead to uncomfortable questions, the stigma which became stuck to the policy instrument.

Seeing some severe funding strains emerge on and immediately after August 9, the FOMC decided it was appropriate to prepare for those strains as they were. The Discount Window seemed the logical place to begin, but what to do about the stigma?

The same day the Committee voted to reduce the Primary Credit rate, the old Discount Rate, officials at the central bank held a teleconference with several large supposedly rock-solid institutions proposing that they kick things off by voluntarily accessing the window. It would show the world, they actually believed, how there was nothing unusual about borrowing here.

Immediately after the phones were hung up, Deutsche Bank signed up for it. Several days later, a group of Wall Street’s biggest names including Citigroup and Bank of America had collectively borrowed $2 billion at the window.

No one cared. Despite the big show made of it, the Discount Window remained a suicidal option in the perception of the marketplace. You went there because you had to and when you did everyone would immediately know who and for how much. Transparency was supposed to be a positive, an aspect of shame as a control lever, but it had turned the emergency policy into a virtual no-go zone.

For this reason, central bank officials came up with what they called the Term Auction Facility (TAF). This wasn’t introduced until December 2007, though, and it would be a limited allotment of program liquidity. The key provision was how banks would bid for funds under total anonymity. But anonymity meant caps – central bankers are always afraid of being taken advantage of.

Long before then, back in August, the banking system had already sought out an effective lender of last resort by default. This was supposed to have been the Fed, and that’s what the Discount Window (now Primary Credit) was supposed to accomplish. Unprepared for August 2007, when it all started to go wrong the message was sent far and wide how undependable the central bank backstop really was.

To avoid Primary Credit and the stigma, liquidity-starved banks began drawing down pre-approved lines of credit with the Federal Home Loan Banks (FHLB). The amounts were staggering, and one can only imagine what might’ve happened differently if the Fed had been successful with its teleconference antics.

How would the markets have reacted to a quarter trillion or more at the Discount Window in the blink of an eye?

Instead throughout the rest of August and into September 2007, the FHLB’s collectively advanced an additional $165 billion in emergency liquidity. This would grow to nearly $250 billion by the time TAF was ready.

To fund these advances the FHLB’s had to first economize and then borrow, borrow, borrow. As to the latter, they used their quasi-government, part-GSE status to issue bonds at favorable rates. As to the former, the FHLB’s had to pull out of federal funds and repo – the same markets where troubled institutions were finding trouble in the first place.

They were doing the Fed’s job and by being left holding the bag the FHLB’s were increasingly drawn deeper and deeper into the crisis; a fact that would come back to haunt everyone in August 2008.

First, though, who was it that had come knocking at their door? We don’t know, which is why they all went knocking in the first place. That doesn’t mean we can’t guess.

In the aftermath of what would “somehow” become a Global Financial Crisis, one of the few positive aspects of Dodd-Frank was how it had forced open some of these backroom dealings. The law didn’t specify anything with regard to the FHLB’s, but it did require the Fed to disclose who was bidding and for what at each TAF auction.

When the first one was conducted on December 20, 2007, we can now see that the first name on the list is Citigroup. As a courtesy, it seems, the big NYC bank had bid for a minimal $10 million.

The biggest borrowers, though, were other sorts of ostensibly New York banks; firms like, Landesbank Hessen-Thurin, Bayerische Landesbank, Dresdner Bank AG, Deustche Zentra AG, Landesbank Baden Wuerttemb, and WestLB (the LB stands for, as you probably guessed, landesbank). Those six “New York” banks alone accounted for half of the $20 billion allotted. Given the style of these names, you might already be sensing a theme.

Add the $2 billion which went to Dexia and the $1.4 billion handed to BNP Paribas Houston, that’s $14.3 billion out of $20 billion heading to US subsidiaries of overseas institutions in the first major overt liquidity act of the GFC.

Not for nothing, all this had begun back on August 9 when BNP Paribas had decided it couldn’t calculate the Net Asset Value on a few of its funds – money market funds – which hadn’t been directly invested in subprime mortgages, either. They fancied commercial paper which funded many of the structures holding them.

As I wrote on August 9 two years ago:

“BNP’s MMF’s do more to express the utterly complicated (and often contradictory) nature of the mature eurodollar system in comprehensive fashion than perhaps anything else. These were European money market funds domiciled in France and Liechtenstein sponsored by a French bank invested primarily in US$ ABS to beat euro money market rates. What matters about geography here?”

Because so many European (and to a lesser extent Japanese) banks were showing up on the liquidity rolls (though it was never published at the time) they obviously were in deep trouble trying somehow, someway to fund their US$ activities. They quite naturally had to scale back their exposures. If you can’t easily source US dollar funding, you can’t keep holding US$ assets – whether they really are “toxic” or not.

And since a lot of that funding ran through the (global) repo market, it would leave them with a stark choice. When deciding which US$ assets to let go of these overseas banks made clear their preference: can’t risk haircuts on GSE debt.

With questions surrounding these government institutions, why not? Given the state of affairs in this global monetary system, it made sense to ditch first and ask questions later. Without an effective, predictable, dependable lender of last resort, this was simple prudence.

Only, the FHLB’s had been caught up in the growing GSE rejection. What had been the first window lender of last resort was suddenly seeing its own operations downgraded with the rest of the GSE collateral. What happens when one big emergency liquidity provider starts to go dark at the worst possible time?

Maybe again it’s just coincidence, but anyway on August 8, 2008, everyone would find out. That was the day Fannie Mae reported on its second quarter earnings. The press release was intended to be reassuring, playing up the lack of a multi-billion dollar valuation (OTTI) loss like there had been the quarter before. But the market would not overlook a $5.3 billion credit loss which effectively questioned the company’s near-term solvency (especially since the GSE’s had been using the positive value of deferred tax assets to stay afloat in that regard).

FHLB’s could no longer borrow at favorable rates for as much as they wanted, painted with the same growing mistrust as Fannie and Freddie. And if the FHLB’s couldn’t borrow, they couldn’t come up with any more of their backstop. To give you a sense of things, by then these reluctant liquidity providers had advanced $1 trillion in liquidity to starved institutions.

Forgive the tautology, but there couldn’t have been a September 2008 without first an August.

Where was the Fed? Limited TAF auctions to go along with capped overseas dollar swaps. And they still never made the key connection.

In September 2008, the US central bank would conduct two more TAF offerings, one before Lehman on the 11th and one after on the 25th, combined tallying $124.55 billion in presumed liquidity. Of that, $31.6 billion or one-quarter went to just five banks: Depfa, Dexia, Dresdner, Bayerische, and Barclays. Again, the main theme.

Subprime mortgages had been merely the catalyst for participants to begin asking a lot of uncomfortable questions, the kinds of questions everyone including policymakers had been avoiding for decades. These included an uneasy feeling former Chairman Alan Greenspan had expressed in June of 2003 (from the transcript for the policy meeting held that month):

“CHAIRMAN GREENSPAN.  What is useful, as has been discussed, is to build up our general knowledge so that when we are confronted with the need to respond with a twenty-minute lead time—which may be all the time we will have—we have enough background understanding to enable us to make informed decisions. We need to know how the system tends to work to be able to make the necessary judgments without asking one of our skilled technical practitioners to go off and run three correlations between X, Y, and Z.”

Bernanke, who was a part of this 2003 discussion, had nine days from the early dawn hours on August 9 to the afternoon of August 17 in 2007. The problem wasn’t just that their “general knowledge” of monetary affairs had continued to languish in the four years since Greenspan’s unheeded lament, it was further compounded by “skilled technical practitioners” who had only been skilled in the art of regression and statistics.

If you were to ask one of them if they believed the TAF auctions were effective, how would they answer? Several of them did in October 2011 (as another global crisis, sticking with the theme, had erupted). In an article published at FRBNY’s Liberty Street Economics blog they concluded:

“Our analysis shows that the Libor–OIS spread decreased on TAF event days (defined either as days when there was an announcement about the program, or days when there was a TAF auction or some other operation). We find that the average decrease in the Libor–OIS spread was about 2 basis points per TAF event…Therefore, exclusion of the announcement effects would result in a severe underestimation of the benefits of the TAF program, perhaps leading to the erroneous conclusion that it did not bring down interest rates.”

It really does all start to make sense. According to the “skilled practitioners”, the TAF auctions were definitely a success because, only on the days there was an announcement, the announcement had the effect of reducing a terribly destructive spread indicating severe liquidity strains - by about 2 bps on average.

Only on the days of the announcement.

They really don’t know what they are doing. Stating this as fact, because that’s what it is, has several very important implications – starting with Alan Greenspan wondering what happens to the world if it should get into trouble.

The theme of 2008 and afterward spells out for us what trouble means. It doesn’t mean, necessarily, New York banks. It is the answer for why, curiously, there were so many US-based subs of foreign parents sucking up all the available liquidity anywhere they could find it – avoiding, of course, the policy preferred Discount Window since these parent banks wished to remain afloat if for a little while longer (several of those German names wouldn’t make it too far).

How does a relatively small subprime mortgage problem become a Global Financial Crisis? A global dollar shortage. It is that simple. How do you get a global dollar shortage? A global dollar in all its beautiful and frightening dimensions (like global repo collateral) doesn’t appear anywhere in the central bank manual nor in any of the Economics textbooks.

With all those liquidity programs like TAF and dollar swaps, the Fed had created hundreds of billions in bank reserves all throughout the crisis period. It would later on call them “abundant reserves”, add trillions more with QE’s, and the doctrine importantly survives to today. There was an abundance of reserves during the worst financial conditions since the Great Depression because of course there was.

Maybe ask the Germans how they would characterize them.

You might have noticed how it is early August once again. China’s currency just broke below 7, global bond yields are tumbling, and the skilled practitioners have told policymakers a 25 bps rate cut will be more than sufficient to ensure the economy gets back to booming. Then again, they also said 2019 would be filled with more rate hikes than most optimists had planned for.

Why were there so many German names on those early dollar lists? Why would so many foreign names remain there no matter what the Fed had done? Ask anyone at the central bank and they would tell you, who cares! After all, like late 2007 and 2008, reserves remain abundant for the eleventh August in a row.

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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