PrefBlog

The Financial Post reports:

Deutsche Bank’s decision to skip an opportunity to redeem €1-billion of subordinated bonds at the first scheduled call date because replacing them would be more expensive has rattled the bond market. Some suggested the European investment bank’s move, which surprised both investors and experts, has transformed the subordinated debt market. They fear that other banks will follow, which could threaten their relationships with investors and trigger losses.
…
Deutsche Bank is the first major bank not to call a Lower Tier 2 issue, which rank just below senior bonds. The move has implications for the wider subordinated debt market was well as for extension risk of Tier 1 securities, Mr. Adamson. said.

I, for one, am very happy with this move. As I wrote in A Vale of Tiers:

Investors tend to trade sub-debt as if it will definitely mature on their step-up date – dealer quotations will often reflect a spread to a Canada bond maturing on the step-up date. However, while one may count on them being called, as expected in good times, this will not necessarily be the case in times of trouble. In times of trouble, three-month BAs + 100bp might look awfully skimpy! Investors should tread very carefully when purchasing debt of this nature.

For years, pseudo-managers have been able to outperform actual bonds simply by purchasing sub-debt and Innovative Tier 1 Capital, justifying these moves on the grounds that the tiered structures are included in the Scotia (now DEX) index. The largest corporate holding in XBB, for instance, is RBC Trust Subordinated Notes, with a pretend-maturity of 2012-4-30.

Sub-Debt has been discussed on PrefBlog, particularly in the posts Cracks Appear in European Sub-Debt Market and Banks and Subordinated Debt.

Update, 2024-9-6: There was quite an aftermath to this, as I was reminded when responding to an unrelated comment many years later.

There was material repricing of sub-debt globally:

Broader market implications from Deutsche Bank’s (DB) unexpected decision to extend €1-billion of its lower-Tier 2 debt beyond the first scheduled call date has forced RBC Capital Markets to downgrade its ranking on the subordinate debt of several of Canada’s largest financial companies.

The changes move Toronto-Dominon Bank (TD), Sun Life Financial Inc. (SLF) and Great-West Lifeco Inc.’s (GWLOF.PK) sub-debt ratings from “outperform” to “sector perform,” the same level as Bank of Nova Scotia (BNS), CIBC (CM) and National Bank. RBC rates Bank of Montreal’s sub-debt at “underperform.”

Analyst Altaf Nanji told clients:

We believe Deutsche Bank’s decision to extend its LT2 debt beyond the short redemption date will have repercussions for all debt securities with a step feature – particularly older vintage securities with steps that are well out of the money.

While he expects that Canadian banks and lifecos will continue to redeem these securities on their short date, the same cannot be said for other markets and international developments could hurt all valuations.

“The decision caused material spread widening in the Canadian sub-debt market,” the analyst said, suggesting that Deutsche Bank may have opened up a Pandora’s Box.

… and a buyer’s strike was threatened:

Investors in bank debt are threatening to boycott lenders that follow Deutsche Bank in breaking an unwritten rule and failing to exercise a call option on subordinated debt.

In a co-ordinated action, angry bond investors are writing to bank treasurers and investor relations heads telling them that any failure to exercise a call option will be considered a breach of trust that could cause all the issuer’s debt to be shunned.

Deutsche stunned the debt market last week by choosing not to redeem €1bn (£932m) of subordinated lower tier 2 bonds because to do so was cheaper than refinancing. But though the move saved Germany’s biggest bank up to €150m, it caused fury among buyers of the debt who worked on the assumption that bonds would always be redeemed at their first call date.

The letter, seen by The Independent, said a bank’s decision not to call debt would be taken to mean “the institution is in such difficulty that it is an impossibility to call the instrument or the institution feels that it is in such a strong position that it can afford to alienate itself from the support of a wide portion of the fixed-income institutional investor community”.

Bank of China, a major buyer of bank debt, has gone further in its communication with issuers. The giant Chinese lender’s Hong Kong operation has told banks that “any non-call by a given institution will result in that institution’s debt (not just lower tier 2 but senior and tier 1 as well) being ineligible for future investment consideration”.

Federal Reserve Chairman Ben Bernanke has made a significant speech in Austin Texas:

in my view, the failure of a major financial institution at a time when financial markets are already quite fragile poses too great a threat to financial and economic stability to be ignored. In such cases, intervention is necessary to protect the public interest. The problems of moral hazard and the existence of institutions that are “too big to fail” must certainly be addressed, but the right way to do this is through regulatory changes, improvements in the financial infrastructure, and other measures that will prevent a situation like this from recurring. Going forward, reforming the system to enhance stability and to address the problem of “too big to fail” should be a top priority for lawmakers and regulators.

No more Lehmans!

In the absence of an appropriate, comprehensive legal or regulatory framework, the Federal Reserve and the Treasury dealt with the cases of Bear Stearns and AIG using the tools available. To avoid the failure of Bear Stearns, we facilitated the purchase of Bear Stearns by JPMorgan Chase by means of a Federal Reserve loan, backed by assets of Bear Stearns and a partial guarantee from JPMorgan. In the case of AIG, we judged that emergency Federal Reserve credit would be adequately secured by AIG’s assets. However, neither route proved feasible in the case of the investment bank Lehman Brothers. No buyer for the firm was forthcoming, and the available collateral fell well short of the amount needed to secure a Federal Reserve loan sufficient to pay off the firm’s counterparties and continue operations. The firm’s failure was thus unavoidable, given the legal constraints, and the Federal Reserve and the Treasury had no choice but to try instead to mitigate the fallout from that event.

Fortunately, we now have tools to address any similar situation that might arise in the future.

But Lehman wasn’t the Fed’s fault!

Indeed, the actual federal funds rate has been trading consistently below the Committee’s 1 percent target in recent weeks, reflecting the large quantity of reserves that our lending activities have put into the system. In principle, our ability to pay interest on excess reserves at a rate equal to the funds rate target, as we have been doing, should keep the actual rate near the target, because banks should have no incentive to lend overnight funds at a rate lower than what they can receive from the Federal Reserve. In practice, however, several factors have served to depress the market rate below the target. One such factor is the presence in the market of large suppliers of funds, notably the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, which are not eligible to receive interest on reserves and are thus willing to lend overnight federal funds at rates below the target. We will continue to explore ways to keep the effective federal funds rate closer to the target.
…
Footnote:Banks have an incentive to borrow from the GSEs and then redeposit the funds at the Federal Reserve; as a result, banks earn a sure profit equal to the difference between the rate they pay the GSEs and the rate they receive on excess reserves. However, thus far, this type of arbitrage has not been occurring on a sufficient scale, perhaps because banks have not yet fully adjusted their reserve-management practices to take advantage of this opportunity.

Acknowledging the puzzle of the Effective Fed Funds Rate and saying he doesn’t know how to fix it either. His provisional explanation – that it’s mainly an administrative log-jam – fits with my earlier hypothesis:

I will suggest, however, that the immense volume of Fed Funds has simply overwhelmed the operational procedures set up in calmer times; accounts need to be opened, credit limits need to be increased, all the bureaucracy of modern banking has to be brought to bear on the issue before we can again deal with a situation in which liquidity may be approximated to “infinite”.

Back to Dr. Bernanke:

Although conventional interest rate policy is constrained by the fact that nominal interest rates cannot fall below zero, the second arrow in the Federal Reserve’s quiver–the provision of liquidity–remains effective. Indeed, there are several means by which the Fed could influence financial conditions through the use of its balance sheet, beyond expanding our lending to financial institutions. First, the Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities. This approach might influence the yields on these securities, thus helping to spur aggregate demand.

Quantitative easing, here we come! This is step one of Econbrowser‘s James Hamilton’s plan, discussed here on November 21.

Bloomberg reports:

Treasury prices rose on Bernanke’s remarks, with yields on 10-year Treasuries tumbling about 10 basis points to 2.74 percent and two-year notes dropping to 0.85 percent.

Also of note was a Bloomberg report that at least one Government Bond fund is being squeezed into guaranteed corporates:

BB&T, BlackRock Inc., T. Rowe Price Group Inc. and Sage Advisory Services Ltd. are looking elsewhere for returns, including bonds of the banks that were almost ruined by $967 billion in losses and writedowns since the start of 2007. Treasury funds are receiving permission to buy debt of Morgan Stanley, JPMorgan Chase & Co. and Goldman Sachs Group Inc. after the Federal Deposit Insurance Corp. finalized plans on Nov. 21 to guarantee their debt.

A Joint Statement by Treasury, Federal Reserve, and the FDIC on Citigroup has been released (just before 11pm):

Washington, DC — The U.S. government is committed to supporting financial market stability, which is a prerequisite to restoring vigorous economic growth. In support of this commitment, the U.S. government on Sunday entered into an agreement with Citigroup to provide a package of guarantees, liquidity access, and capital.

As part of the agreement, Treasury and the Federal Deposit Insurance Corporation will provide protection against the possibility of unusually large losses on an asset pool of approximately $306 billion of loans and securities backed by residential and commercial real estate and other such assets, which will remain on Citigroup’s balance sheet. As a fee for this arrangement, Citigroup will issue preferred shares to the Treasury and FDIC. In addition and if necessary, the Federal Reserve stands ready to backstop residual risk in the asset pool through a non-recourse loan.

In addition, Treasury will invest $20 billion in Citigroup from the Troubled Asset Relief Program in exchange for preferred stock with an 8% dividend to the Treasury. Citigroup will comply with enhanced executive compensation restrictions and implement the FDIC’s mortgage modification program. 

With these transactions, the U.S. government is taking the actions necessary to strengthen the financial system and protect U.S. taxpayers and the U.S. economy.

We will continue to use all of our resources to preserve the strength of our banking institutions and promote the process of repair and recovery and to manage risks. The following principles guide our efforts:

• We will work to support a healthy resumption of credit flows to households and businesses.
• We will exercise prudent stewardship of taxpayer resources.
• We will carefully circumscribe the involvement of government in the financial sector.
• We will bolster the efforts of financial institutions to attract private capital.

A term sheet gives the details. The most interesting are:

Institution absorbs all losses in portfolio up to $29 bn (in addition to existing reserves)

Any losses in portfolio in excess of that amount are shared USG (90%) and institution (10%).
…
Institution is prohibited from paying common stock dividends, in excess of $.01 per share per quarter, for 3 years without UST/FDIC/FRB consent. A factor taken into account for consideration of the USG’s consent is the ability to complete a common stock offering of appropriate size.

and the politically popular:

An executive compensation plan, including bonuses, that rewards longterm performance and profitability, with appropriate limitations, must be submitted to, and approved by, the USG

Well, they had to do something, or Monday would be carnage.

Fearless forecast? Geez, you know, it’s hard to say. But in early Asian trading:

Suncorp-Metway Ltd., Australia’s third-largest insurer, dropped 4.9 percent in Sydney after increasing its forecast for bad loans. Standard Chartered Plc fell 5.1 percent in Hong Kong following a Financial Times report that the U.K. lender will sell $3 billion of stock to replenish capital. Financial shares declined as the U.S. agreed to protect $306 billion of loans and securities on Citigroup Inc.’s books against losses. BHP Billiton Ltd., Australia’s largest oil company, climbed 6.4 percent in Sydney after crude prices climbed.

Econbrowser‘s James Hamilton has posted again on the Effective Fed Funds Rate Puzzle – his prior post was discussed on PrefBlog in a post the Professor was kind enough to praise.

In summary: we’re not really all that much forrarder in understanding this!

There’s a couple of points I’d like to comment upon:

Me, I’d like to borrow a few gazillion. And lest somebody else get to the GSEs for some of this easy action ahead of me, I’m happy to leave a standing order with my broker. I’ll pay, say, 0.5% to anybody, any time, to borrow any volume of overnight fed funds.

You can! Just become a Bank Holding Company (very fashionable nowadays).

Just remember that to strap on $1-billion, you’ll need $50-million Tier 1 capital, absolute minimum, in order to stay within the leverage guidelines. Assuming that’s pure profit (and you have a tax rate of ZERO), that makes a 13% ROE … almost as good as Credit Card Banks in 1H08 (Table IV-A) and in line with average performance during the boom:

If you have no other expenses AND counterparties will lend to you, that is. One problem is that this is what might be called a “moat protected business” – at best, it’s a nice way for extant players to make a few extra bucks, but the spread is insufficient to attract new players – or even to attract new capital to extant players – it’s a fill-in, temporary operation at best.

In addition to the two ideas cited by Dr. Hamilton, there’s also the idea that the short bill rate acts as a cap. Players who need very short term liquidity in very large amounts might be relatively indifferent to holding bills or lending Fed Funds to a solid bank (by “relatively”, I mean that the desired rates are not necessarily equal, but there should be some kind of spread at which they are indifferent. Fed Funds are more liquid, but carry some credit risk).

So, whenever the bid on brokered funds rises above a certain level, these players sell bills and lend to banks, knocking the bid right back down again.

I also consider it very important to remember that the Effective Fed Funds rate is comprised solely of brokered transactions – direct transactions are not included in the calculation or even reported (directly) to the Fed. I’m willing to bet (a nickel) that the rate on direct transactions is a LOT closer to 1% than to 0.35%, and I’ll bet another nickel that there are a lot of bright young Fed researchers cackling with glee over the prospect of getting a good paper out of the situation in the next year or two.

In normal times the policy response to an undesirably low Effective Fed Funds Rate is to drain reserves – by selling T-Bills, for instance, to remove cash from the system. This would run counter to virtually every other programme now in place, which aim to flood the system with cash.

So here’s a hypothesis: we no longer have a liquidity problem, per se, we have a capital/confidence problem. There are plenty of players with plenty of cash, but they’re not willing to extend private-market credit due both to their own fears of credit risk, and to their fears of what their creditors might fear about their credit risk (if you follow. That’s kind of convoluted, isn’t it?).

If this hypothesis is correct – and it’s a big if – then it seems to me that the policy response is:

• Flood the system with short bills to soak up liquidity and get short bills to trade at a spread over Fed Funds, at the very least
• Put more capital into the system – perhaps with a matching funds programme, whereby Treasury stands willing to buy half of any public Tier 1 capital issue from a qualified bank
• Gradually increase the spreads required on the Commercial Paper Funding Programme so that the Fed will no longer crowd out private players

At this point, I’m still a little flummoxed. I can’t think of any other hypothesis, but I also can’t think of a good way to test the hypothesis I have and will have to spend some more time thinking about that one. Execution of part 2 of the policy response would be a little tricky as well … I’m unwilling to give up on Bagehot, so I want the capital put in at a punitive rate, but that might cause more problems than it solves. And I might be blinded by wanting idealogical purity with respect to Bagehot. Rule #1: Do whatever works and don’t fuss too much about idealogical purity.

I can take comfort in the idea that Macroblog is flummoxed too, anyway!

Update, 2008-11-17: Bloomberg has a story on Fed Funds & the FDIC Guarantee:

The FDIC is considering charging different fees depending on the maturity of the debt, instead of its previous plan for a flat fee. Companies including JPMorgan Chase & Co. and Bank of America Corp. said the original proposal threatened to make the overnight federal funds market too costly compared with alternatives such as direct loans from the Federal Reserve.
…
The FDIC had proposed charging a standard fee to insure all eligible senior unsecured debt. Banks argued that the federal funds market should be treated differently. If that market costs too much, banks might switch to government lending programs like the Fed’s discount window or Federal Home Loan Bank advance programs, they said.

“Such an outcome would not achieve the FDIC’s goal of improving shorter-term unsecured inter-bank funding markets,” law firm Sullivan & Cromwell wrote in a letter to the agency on behalf of nine large banks, including Goldman Sachs Group Inc., JPMorgan and Bank of America.

High premiums on federal funds lending “could effectively shut down the overnight funds market,” said Louis Crandall, chief economist of Wrightson ICAP in Jersey City, New Jersey. “Most current activity in the overnight funds market would either not take place or be diverted to other instruments such as Eurodollars that are not subject to the FDIC’s new fees.”

The FDIC has received and published a LOT of comments on the Temporary Liquidity Guarantee Programme. The Sullivan & Cromwell letter is here.

Update, 2008-11-18: A commenter on the Econbrowser thread has drawn my attention to a research note by Daniel L. Thornton of the St. Louis Fed, Subprime Side Effects in the Federal Funds Market noting – in pre-interest-on-reserves days – the substituent effect of T-Bills on the Effective Fed Funds Rate.

Update, 2008-11-21: The FDIC Final Rule has been announced:

• The FDIC’s obligation to pay on FDIC-guaranteed debt will be triggered by payment default, rather than bankruptcy or receivership, as provided in the Interim Rule. This change should improve the value of the guarantee and help institutions obtain funding.
• Short-term debt (30 days or less) has been eliminated from the debt guarantee program, but the limit on the amount of debt that the FDIC will guarantee, generally 125 percent of senior unsecured debt outstanding on September 30, 2008, will include short-term debt outstanding on that date.
• The fee under the debt guarantee program will depend upon maturity of the debt. The fee will be lower for shorter-term debt and higher for longer-term debt.
• By December 5, 2008, all eligible entities—all insured depository institutions and almost all holding companies—must take action with respect to both the transaction account guarantee program and the debt guarantee program.

…

For debt with a maturity of:	The annualized assessment rate (in basis points) is:
Less than 180 day	50
181-364 days	75
365 days or greater	100

However, the rates set forth above will be increased by 10 basis points for senior unsecured debt issued by a holding company or by a participating affiliate that is not an insured depository institution if, as of September 30, 2008, the assets of the holding company’s combined depository institution subsidiaries constitute less than 50 percent of consolidated holding company assets.

Update, 2008-11-23 There’s some background, but precious little meat, from the St. Louis Fed – Paying Interest on Deposits at Federal Reserve Banks, by Richard G. Anderson.

Treasury has announced:

the development of credit default swap central counterparties, some of which will commence operations before the end of 2008, and the establishment of a Memorandum of Understanding regarding CDS central counterparties among the Federal Reserve Board of Governors, the Securities and Exchange Commission and the Commodity Futures Trading Commission. The PWG also announced a broad set of policy objectives to guide efforts to address the full range of challenges associated with OTC derivatives and issued a progress summary to provide an overview of the results of ongoing efforts to strengthen the infrastructure of OTC derivatives markets.
…
The [Presidential Working Group]’s top near-term OTC derivatives priority is to oversee the successful implementation of central counterparty services for credit default swaps. A well-regulated and prudently managed CDS central counterparty can provide immediate benefits to the market by reducing the systemic risk associated with counterparty credit exposures. It also can help facilitate greater market transparency and be a catalyst for a more competitive trading environment that includes exchange trading of CDS.

Much of the announcement simply represents Treasury’s imprimatur on the New York Fed’s announces of Big Developments in the CDS Market.

There is more meat in the Statement of Policy Objectives, most important of which is:

Improve Market Transparency and Integrity for Credit Default Swaps
• Public reporting of prices, trading volumes and aggregate open interest should be required to increase market transparency for participants and public.
• Regulators should have access to trade and position information housed at central counterparties (CCPs) and central trade repositories for the purpose of monitoring market trends, identifying potential issues, and preventing market manipulation and insider trading.

Now, these are worthy objectives for investors, but will make the market a lot less profitable for dealers. Profitability in the Eurobond market, for instance, plunged in 1988 (or thereabouts) when Bloomberg became pervasive and prices of various bonds became public knowledge. In a large part, this increase in market efficiency simply highlights gross incompetence in the buy-side community, but nevertheless the effect is real.

However, a more important consideration is: can the US enforce these policy objectives, or will the market simply move to Dubai? You only get to make the rules if you control the game.

I’ll bet that the US still has the influence to enforce the stated policy objectives … but I’ll also bet that the Next Big Thing will come out of a relatively unregulated environment – investors in such places own a huge chunk of the Street at this point – and the US will find that he who has the gold, makes the rules.

The Fed has announced:

that it will alter the formulas used to determine the interest rates paid to depository institutions on required reserve balances and excess reserve balances.

Previously, the rate on required reserve balances had been set at the average target federal funds rate established by the Federal Open Market Committee (FOMC) over a reserves maintenance period minus 10 basis points. The rate on excess balances had been set as the lowest federal funds rate target in effect during a reserve maintenance period minus 35 basis points. Under the new formulas, the rate on required reserve balances will be set equal to the average target federal funds rate over the reserve maintenance period. The rate on excess balances will be set equal to the lowest FOMC target rate in effect during the reserve maintenance period. These changes will become effective for the maintenance periods beginning Thursday, November 6.

Econbrowser‘s James Hamilton writes a fine piece on these developments, The new, improved fed funds market, noting wryly:

Yet another week of institutional changes that render all those nice macroeconomic texts and professors’ lecture notes obsolete.

The critical question is:

Why would any bank lend fed funds to another bank at a rate less than 1%, exposing itself to the associated overnight counterparty risk, when it could earn 1% on those same reserves risk free from the Fed just by holding on to them?

… and it may be that the answer is in that mysterious “Other Deposits” line on the Fed’s balance sheet. Dr. Hamilton explains:

Wrightson ICAP (subscription required) proposes that part of the answer is the requirement by the FDIC that banks pay a fee to the FDIC of 75 basis points on fed funds borrowed in exchange for a guarantee from the FDIC that those unsecured loans will be repaid. If you have to pay such a fee to borrow, it’s not worth it to you to pay the GSE any more than 0.25% in an effort to arbitrage between borrowed fed funds and the interest paid by the Fed on excess reserves. Subtract a few more basis points for transactions and broker’s costs, and you get a floor for the fed funds rate somewhere below 25 basis points under the new system.

Dr. Hamilton concludes:

the target itself has become largely irrelevant as an instrument of monetary policy, and discussions of “will the Fed cut further” and the “zero interest rate lower bound” are off the mark. There’s surely no benefit whatever to trying to achieve an even lower value for the effective fed funds rate. On the contrary, what we would really like to see at the moment is an increase in the short-term T-bill rate and traded fed funds rate, the current low rates being symptomatic of a greatly depressed economy, high risk premia, and prospect for deflation.

What we need is some near-term inflation, for which the relevant instrument is not the fed funds rate but instead quantitative expansion of the Fed’s balance sheet. I continue to have concerns about implementing the latter in the form of expansion of excess reserves, which ballooned by another quarter trillion dollars in the week ended November 5. Instead, I would urge the Fed to be buying outstanding long-term U.S. Treasuries and short-term foreign securities outright in unsterilized purchases, with the goal of achieving an expansion of currency held by the public, depreciation of the currency, and arresting the commodity price declines.

Of Dr. Hamilton’s three symptons for low rates, I suggest that “high risk premia” is the dominant force. And thus, perhaps counter-intuitively, I suggest that Fed should have simultaneously raised the required yield on the Commercial Paper Funding Facility by 35bp, to maintain – at the very least – the current spread between what banks can earn at the Fed and the competitive rate of commercial paper. We want the Fed out of the intermediation business!

Before news this week of General Motors’ enormous problems and possible bankruptcy – referenced November 7 – I would have deprecated Dr. Hamilton’s call for massive monetary stimulus. Now … I’m not so sure.

Update, 2008-11-11: Dr. Hamilton has withdrawn his hypothesis that the FDIC guarantee fees are responsible for the difference between the effective fed funds rate and the target rate.

Rebecca Wilder argues that this could not be affecting the current effective fed funds rate due to details of the “opt out” provision. Here I provide some further discussion of this point.

I believe that Rebecca Wilder is correct that I was misinterpreting the FDIC October 16 technical briefing.

The gist of the argument is that the fees don’t start until November 13.

One of the commenters noted Deutsche Bank’s hypothesis, discussed on FT Alphaville:

The main reason for this inefficiency has been that Treasury yields are so low that funds leak from the Treasury bill market to the fed funds market. This suppresses the effective funds rate, as investors seek out the higher return until the spread between bills and fed funds compresses. Another reason is that non-banks can participate in the fed funds market, but are excluded from receiving interest on Federal Reserve balances, which are meant for depository institutions… If the agencies supplied these funds to the fed funds market, they would potentially drive the effective fed funds rate lower. Thus monetary policy has been more stimulative than the Fed has intended by setting the target rate, a symptom of an increasing loss of control over monetary conditions.

Rebecca Wilder also makes the supply and demand argument, with two major influences:

First, the huge influx of bank credit increased the reserve base for all banks, and in spite of a surge in excess reserves, the incentive to loan overnight funds grew. This is seen in the second column of the Table; as soon as the credit affecting reserves rose from $31 billion over the year on 9/10 to $275 billion over the year on 9/24, the effective funds rate traded well below its target by an average of 81 bps from 9/10 to 9/24 (the average of the daily spread, or the blue line, in the chart). And no interest was being paid during this period.

Second, as soon as interest was being paid on excess reserves, the GSEs and other banks that hold reserves with the Fed but do not qualify for the new reserve interest payments were forced to offer very low rates in order to sell the overnight funds. The announcement that the Fed would pay interest on reserves (IOR) went into effect on October 9. During that maintenance period, the average spread between the federal funds target and the effective federal funds rate grew to 68 bps. The GSEs forced the market rate downward with the excess supply of reserve balances.

I don’t understand her second point. Interest on Reserves should – and is intended to – boost the demand for reserves, not supply. What may have happened is a supply shock from the GSEs – the latest H.4.1 report shows that “Other” Deposits were $22.8-billion on November 5, an increase of $21.6-billion from October 29 … which is kind of a massive increase!

All this represents a straightforward supply and demand argument. In order for a supply and demand argument to work, we have to dispense with notions of infinite liquidity – we’ve been dispensing with this notion quite a lot in the past year! To nail this down, we have to ask ourselves – why would the big banks not simply bid, say, 90bp for an infinite amount of fed funds and take out a 10bp spread.

One reason might be balance sheet concerns. A borrow is still a borrow and a loan is still a loan, even if both are in the Fed Funds market. A deposit of Fed Funds to the Fed will not attract any risk weight, but will affect the leverage ratio. There may well be reasons for the banks to maintain their leverage ratios as low as possible – even on a daily basis, even with Fed Funds – at the moment.

Another reason might be simply availability of lines. According to the paper Systematic Illiquidity in the Federal Funds Market by Ashcraft & Duffie (Ashcraft’s paper on Understanding the Securitization of Subprime Mortgage Credit has been discussed on PrefBlog):

Two financial institutions can come into contact with each other by various methods in order to negotiate a loan. For example, a federal funds trader at one bank could call a federal funds trader at another bank and ask for quotes. The borrower and lender can also be placed in contact through a broker, although the final amount of a brokered loan is arranged by direct negotiation between the borrowing and lending bank. With our data, described in the next section, we are unable to distinguish which loans were brokered. In aggregate, approximately 27% of the volume of federal funds loans during 2005 were brokered. Based on conversations with market experts, we believe that brokerage of loans is less common among the largest banks, which are the focus of our study.

It should be noted that the authors were required to do a great deal of analysis to determine which FedWire payments were loans and which were other transactions – banks are not required to report their Fed Funds loans and borrows to any central authority. For example, consider this interview on the WSJ:

WSJ: All banks and thrifts qualify for discount window loans. Who participates in the fed funds market?

[Chief economist at Wrightson Associates] Lou Crandall: Almost all banks make use of fed funds transactions, though not necessarily through the brokered market you see quoted on screens. Smaller banks, which typically have surplus funds they want to lend to other banks in the interbank market, will typically often have a correspondent banking relationship with a larger bank, in which the large bank will borrow those funds every day either for its own purposes or to re-sell in the market. Those rolling contracts are booked as fed funds for call report purposes and so forth, but the rates on them aren’t included in the Fed’s effective fed funds rate calculation, which only reflects the brokered market.

This distinction between the “direct” market and the “brokered” market is confirmed by the New York Fed’s definition of the daily effective fed funds rate:

The daily effective federal funds rate is a volume-weighted average of rates on trades arranged by major brokers. The effective rate is calculated by the Federal Reserve Bank of New York using data provided by the brokers and is subject to revision.

So when we talk about the Effective Fed Funds Rate, we must bear in mind that we are only talking about brokered transactions – and I will assert that the Ascraft estimate of 27%-brokered is probably much higher than the ratio in the current market.

All this is pretty general, and I don’t have any magic explanations. I will suggest, however, that the immense volume of Fed Funds has simply overwhelmed the operational procedures set up in calmer times; accounts need to be opened, credit limits need to be increased, all the bureaucracy of modern banking has to be brought to bear on the issue before we can again deal with a situation in which liquidity may be approximated to “infinite”.

Update, 2008-11-11: Lou Crandall (or somebody claiming to be him!) has commented on the second Econbrowser post:

Just a quick clarification about FDIC insurance premiums and the fed funds rate. The new 75 basis point insurance premiums won’t go into effect until December, so they are not an explanation for the current low level of the effective funds rate. Our discussion (on the Wrightson ICAP site) of the indeterminacy of the funds rate in that future regime was hypothetical, as we still think there is a chance that the FDIC will choose to exclude overnight fed funds from the unsecured debt guarantee program. As for the current environment, the role of the GSEs and international institutions is in fact a sufficient explanation. Banks have no desire to expand their balance sheets, and so demand a large spread on the transaction before they are willing to accommodate GSEs and others who have surplus funds to dispose of. It’s a specific example of a general phenomenon: the hurdle rate on arbitrage trades has soared due to balance sheet constraints. That fact can be seen everywhere from the spread between the effective fed funds rate and the target in the overnight market to the negative swap spreads in the 20- to 30-year range that have appeared intermittently of late. Finance models that are based on a “no-arbitrage” assumption will need to be shelved, or at least tweaked, for the duration of the financial crisis.

So … he’s saying it’s balance sheet constraints and that it will be a long time until we can return to our comfortable assumptions of infinite liquidity.

2008-11-11, Update #2: This is attracting a lot of attention and Zubin Jelveh of Portfolio.com brings us the views of:

Action Economics’ Mike Englund who argues that there may not actually be one. For example, the average effective rate since the Fed started paying interest on reserves was 0.68 percent. The average excess rate over the same span was 0.70 percent. That’s pretty close and if you look at the last chart again, the market rate does seem to dance around the excess rate until the Fed lowered the target in late-October. Englund tries to explain this last part away:

Note that there is a speculative component to holding excess reserves, as the excess reserve rate for the [reserve maintenance period] RMP is pegged to the “lowest” target in the period, which is not precisely known until the last day of the period. This might explain some “bets” of emergency Fed easing late in the RMP that would lower the excess rate for the entire period, and hence leave a rate that trades through most of the period below the excess reserve “floor.”

I agree with Jelveh … the Englund explanation is not satisfying.

The US Treasury has announced it has:

issued additional documents for publicly traded financial institutions applying for the capital purchase program authorized by the Emergency Economic Stabilization Act. Documents include:

• Securities Purchase Agreement: This document describes the terms of the financial institution’s agreement to issue shares and fulfill other requirements in exchange for Treasury’s investment.
• Form of Letter Agreement: This contractual agreement describes the firm-specific information necessary to implement the securities purchase agreement and represents the financial institution’s commitment to the terms of the Securities Purchase Agreement.
• Certificate of Designations: This document creates the preferred shares.
• Form of Warrant – Stockholder Approval Not Required: This document describes the terms of the warrants Treasury receives when stockholder approval is not required.
• Form of Warrant – Stockholder Approval Required: This document describes the terms of the warrants Treasury receives when stockholder approval is required.
• Term Sheet
• SEC, FASB Letter on Warrant Accounting

It’s all at Treasury’s EESA website, under Capital Purchase Program. Of particular interest is the Transaction Report, which shows nine transactions totalling $125-billion.

The terms were announced previously:

The senior preferred shares will pay a cumulative dividend rate of 5 percent per annum for the first five years and will reset to a rate of 9 percent per annum after year five. The senior preferred shares will be non-voting, other than class voting rights on matters that could adversely affect the shares. The senior preferred shares will be callable at par after three years. Prior to the end of three years, the senior preferred may be redeemed with the proceeds from a qualifying equity offering of any Tier 1 perpetual preferred or common stock. Treasury may also transfer the senior preferred shares to a third party at any time. In conjunction with the purchase of senior preferred shares, Treasury will receive warrants to purchase common stock with an aggregate market price equal to 15 percent of the senior preferred investment. The exercise price on the warrants will be the market price of the participating institution’s common stock at the time of issuance, calculated on a 20-trading day trailing average.

In the UK, Barclays has refused to play along:

Barclays Plc, the bank that opted out of a plan to sell a stake to the U.K. government, will have Sheikh Mansour Bin Zayed Al Nahyan, a member of Abu Dhabi’s royal family, as its biggest shareholder.

Sheikh Mansour will collect interest payments of as much as 14 percent and control 16.3 percent of the London-based bank after putting up 5 billion pounds ($8 billion), the company said in a statement today. Barclays fell 13 percent after analysts at Sanford C. Bernstein & Co. said the bank is paying a “fairly expensive” price for the capital injection.

Barclays has posted details of the transaction.

The UK scheme that Barclays is avoiding was announced on October 8 has various strings attached:

As part of its investment, the Government has agreed with the banks supported by the recapitalisation scheme a range of commitments covering:

• maintaining, over the next three years, the availability and active marketing of competitively-priced lending to homeowners and to small businesses at 2007 levels;
• support for schemes to help people struggling with mortgage payments to stay in their homes, and to support the expansion of financial capability initiatives;
  remuneration of senior executives – both for 2008 (when the Government expects no cash bonuses to be paid to board members) and for remuneration policy going forward (where incentive schemes will be reviewed and linked to long-term value creation, taking account of risk; and restricting the potential for “rewards for failure”);

• the right for the Government to agree with boards the appointment of new independent non-executive directors; and
• dividend policy

The Chancellor’s statement of October 13 contains a few more details, but no actual numbers – he noted:

These conditions are set out in the individual agreements with the banks – copies of which will be placed in the library.

The UK conditions for the preference shares are far more onerous than the US ones:

As the statement says the detailed points about the agreements with the individual banks are set out in the individual agreements contained in Deposited paper 2008/2350.

These are substantial documents and would appear, at the time of their deposit 10 am, 14 October, to still contain draft elements and be partially incomplete. Some elements however,
are worth noting are:

The Lloyds and HBOS shares are being bought at premiums to their nominal value. The precise figures appear to be undecided at time of writing. They will share equal rights with existing preference share holdings. Dividends from HBOS will fall in two periods. First, a period of up to five years will be fixed at 12%. The second period will be 7% plus LIBOR rate until their redemption. Lloyd’s dividends will be 7% plus LIBOR for the duration.

The Federal Reserve Bank of New York has released a package of material with a statement that it “welcomes further industry commitments on Over-the-Counter Derivatives”:

The Federal Reserve Bank of New York welcomes the letter released today by major market participants to further strengthen the operational infrastructure for over-the-counter (OTC) derivatives. Consistent with the objectives of the March 2008 Policy Statement of the President’s Working Group on Financial Market Developments, market participants outline in this letter concrete plans for building a stronger integrated operational infrastructure capable of supporting the important and rapidly growing OTC derivatives market.

The commitments presented in this letter will help address weaknesses in the OTC derivatives market. Although efforts by the Federal Reserve and other U.S. and European regulators over the past three years have led market participants to significantly improve many operational elements of the OTC derivatives infrastructure, financial market events have demonstrated that broader action is warranted to address additional market design elements.

They state that they have the following central priorities:

• Institute a Central Counterparty (CCP) for Credit Default Swaps (CDS).
• Reduce Levels of Outstanding Trades via Portfolio Compression
• Enhance Market Transparency.
• Continue Operational Improvements.

Three documents were released together with the press release.

Participants October 31 Letter. This doesn’t look like just another set of soothing words. Not only is the Fed endorsing it, but the signatories have, shall we say, a certain amount of clout:

Bank of America,
N.A. HSBC Group
Barclays Capital
JP Morgan Chase
BNP Paribas
Merrill Lynch & Co.
Citigroup
Morgan Stanley
Credit Suisse
The Royal Bank of Scotland Group
Deutsche Bank AG
Société Générale
Dresdner Kleinwort
UBS AG
Goldman, Sachs & Co.
Wachovia Bank, N.A.
International Swaps and Derivatives Association, Inc. (ISDA)
Managed Funds Association (MFA)
Asset Management Group of the Securities Industry and Financial Markets Association (SIFMA)

After a certain amount of self-congratulatory bumpf, the letter states seven priorities for the near future:

• Global use of central counterparty processing and clearing to significantly reduce counterparty credit risk and outstanding net notional positions.
• Continued elimination of economically redundant trades through trade compression.
• Electronic processing of eligible trades to enhance T+0 confirmation issuance and execution.
• Elimination of material confirmation backlogs.
• Risk mitigation for paper trades.
• Streamlined trade life cycle management to process events (e.g. Credit Events, Succession Events) between upstream trading and confirmation platforms and downstream settlement and clearing systems.
• Central settlement for eligible transactions to reduce manual payment processing and reconciliation.

It’s going to start soon:

Each Major Dealer in the OMG commits to (i) support a clearing platform and (ii) utilize such platform to clear all eligible products where practicable. Pending regulatory approval, index clearing will begin by Nov 30, 2008 with single names
to follow within the first quarter of 2009.

The Participants’ letter isn’t just about CDSs, many types of OTC derivative are addressed. Most of the plans are along the lines of … ‘Well, we’re going to try to do things a lot more like the way they’d be done if anybody had ever, you know, thought about it’. But the OTC derivatives was never planned … it just growed.

But have no fear – the Fed is here! Another document is a Summary Table of Committments, providing a comparison of the commitments made in July with those currently made and an explanation for each item. This type of thing has an unfortunate propensity to degenerate into a regulatory box-ticking exercise, but we can always hope for the best!

Of most interest to PrefBlog’s Assiduous Readers will be the DTCC Announcement that:

it will begin to publish aggregate market data from its Trade Information Warehouse (Warehouse), the worldwide central trade registry it maintains on credit derivatives. Starting Tuesday, November 4 and continuing weekly, DTCC will post on its website www.dtcc.com/derivserv the outstanding gross and net notional values (“stock” values) of credit default swap (CDS) contracts registered in the Warehouse for the top 1,000 underlying single-name reference entities and all indices, as well as certain aggregates of this data on a gross notional basis only. The data is intended to address market concerns about transparency.

The link has been added to the right-hand sidebar, under “US Fixed Income”.

All very encouraging … it doesn’t look like Accrued Interest will get the public Exchange he wants so badly!