Bernanke Testifies Again...

Further cuts in the federal funds rate are on the way. Ben Bernanke is talking about how we are in a slow-moving financial crisis of DeLong Type II: one in which large financial institutions are insolvent--"pressure on bank balance sheets"--and in which lower short-term interest rates and a steeper yield curve are a way of providing institutions with the life jackets they need to paddle to shore.

Larry Meyers has pointed out that the BBB yield is no lower than it was in July--that all the easing has had no effect on the cost of capital that the financial markets feed to the "real economy," and hence that Fed policy today is no more stimulative than it was last summer.

Comments

[howard]

fed easing on the one hand, increased risk premiums demanded on the other, net = 0....

[Maynard Handley]

Brad, Bernanke is limited in the extent to which he can drop interest rates by the fact that Treasury needs to sell a kabillion dollars worth of bonds every month; bonds that are rather less appealing at lower rates.

I've seen various mutterings (but nothing on this site) that already there is pushback from bond buyers who are simply walking away from the offerings. We likewise saw a local version of this what, yesterday or the day before with NY munis.

So how about an analysis of the collision of these two effects. Everything I've seen posits that Bernanke can do what he likes with interest rates, which simply doesn't seem to match reality.

[esb]

BB lies and long rates rise.

A step on the road to the long bond's demise.

My urgent whisper for BB to know

is

get thee to an academy

to an academy, go.

[Mari]

But look at the 3 month LIBOR rates in the last two months, it has come down by 200bps, which will help companies floating rate borrowings (bank credit facilites)

[rapier]

Since huge swaths of debt are now unsellable, for instance the muni market froze the last two days, there is no alternative but Treasury paper. New money must find a home and so the question becomes can the burgeoning supply of Treasury paper overwhelm that demand? Probably at some point and all we can do is pray it never reaches that point.

In the meantime the lack of liquidity guarantees that markets, in this case the debt markets, will be volatile.

The munis will probably unfreeze when the insurers are forced (by the powers that be) to sell off their muni business. It is unacceptable and impossible for the political economy to have the muni market frozen. A decision must be made to throw the bond insurers under the bus by taking away their best if wounded portfolio of munis. They will be left with the dregs of CDO's and mortgage junk and that paper will only get worse, but at least local and state governments and agencies will be able to function for a month or two or more we can hope.

So when and if the muni crisis ends we will probably have a big rally in various markets and all will be well again, for another bright shining and oh so temporary moment.

[Neal]

Still think it's a liquidity problem?---From the Fed

February 08, 2008
Recent Declines in Nonborrowed Reserves

The H.3 statistical release indicates that nonborrowed reserves of depository institutions have declined substantially since mid-December to a level that is now negative. This development reflects the provision of a large volume of reserves through the Term Auction Facility (TAF) and has no adverse implications for the availability of reserves to the banking system.

By definition, nonborrowed reserves are equal to total reserves minus borrowed reserves. Borrowed reserves are equal to credit extended through the Federal Reserve's regular discount window programs as well as credit extended through the TAF. To maintain a level of total reserves consistent with the Federal Open Market Committee's target federal funds rate, increases in borrowed reserves must generally be met by a commensurate decrease in nonborrowed reserves, which is accomplished through a reduction in the Federal Reserve's holdings of securities and other assets. The negative level of nonborrowed reserves is an arithmetic result of the fact that TAF borrowings are larger than total reserves.

(end quote)

From Federal Reserve Statistical Release H3

Non-borrowed reserve= -$18,009,000,000 as of February 13th.

Yes, a NEGATIVE non-borrowed reserve--kind of the definition of NSF in the checking world. A serious decline from February when non-borrowed reserves exceeded required reserves of about $40B. This means that there is about $60B in borrowed reserve at this time...

Definitely time for another TAF auction and rate cut--what else can they do? Without TAF auctions, where would they be? On the floor, dead?

Solvency crisis anyone?

[Neal]

OOPs, ...a serious decline from NOVEMBER when non-borrowed reserves exceeded required reserves....

[Neal]

OOPs, ...a serious decline from NOVEMBER when non-borrowed reserves exceeded required reserves....

[paul]

Pardon the naive outsider, but does a drop in interest rates actually make it significantly more likely that a face-value-appropriate percentage of all those Big Pile obligations will be repaid? Because if not, then whatever damage is removed from the banks' balance sheets will be added to other entities' balance sheets. And unless you buy the idea that banks are a sacrosanct N+1 sector of the economy (a notion that might usefully be called the Other Nash Equilibrium) that doesn't really fly.

[Dave]

I can tell you that financially solvent municipalities can still sell debt at any time. (Municipalities run balanced budgets, and tend to have pretty good credit ratings, even without bond insurance.)

Less than 5% of the muni auction failed, and that was just becasue the monolines are in so much trouble that Federal securities are currently a better deal (shudder.) Look for municipalities to re-price their securities and use wider revenue streams to keep the ratings high.

As the federal deficit grows, Federal borrowing needs will gradually make the yield curve even more steep. This is not because the Fed is "chasing" dollars that would otherwise go into muni's (even though they are), it is because world markets predict devaluation of the dollar.

Fortunately, the federal government will hide the real inflation rate by fiddling with the published CPI numbers, so the largest burden will be borne by poor people and retired people, rather than by financial service companies.

Want to know how quickly it will happen? Remember that states are suddenly running deficits, and they can't reduce spending or print money. So they take the easy way out and just raid their trust funds. Guess what their trust funds were invested in?