Monday, September 15, 2008

Federal Reserve Accepting EQUITIES as Collateral

This is going to be a longish post so we'll set the mood with today's theme song. Click and scroll.

From Market Movers:
Fed Taking Equities as Collateral

Is the Fed accepting equities as collateral? Bloomberg says yes, the WSJ says yes, Reuters says yes. So, yes. But if that's the case, why didn't it say so? Here's the relevant bit of the Fed statement:

The collateral eligible to be pledged at the Primary Dealer Credit Facility (PDCF) has been broadened to closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks. Previously, PDCF collateral had been limited to investment-grade debt securities.

Hardly crystal-clear....
He goes on to link to this post at Naked Capitalism:

WSJ: Fed Expands Liquidity Facilities to Include Equities
I guess it is now official. We no longer have functioning trading markets, at least in terms of serving their alleged purpose of giving companies access to capital. The Fed is no longer the lender of the last resort. It is increasingly becoming not merely a lender, but by adding equities to its list of acceptable collateral, has become the funding source of the only resort.

Willem Buiter once remarked that the Fed could accept a dead dog as collateral for lending, and we are getting close to that. I'm sure he'll have more than a few withering words to offer on these moves....
This should not come as a surprise. From our February 8 post "Doom and Gloom: What Can the Federal Reserve Do?":
...I was reminded of a Financial Times story from March 25, 2002:
Fed Considered Emergency Measures To Save Economy

Minutes which summarized the meeting were released last week. A full transcript will not be available for five years but a senior Fed official who attended the meeting said the reference to "unconventional means" was "commonly understood by academics."

The official, who asked not to be named, would not elaborate but mentioned "buying US equities" as an example of such possible measures, and later said the Fed "could theoretically buy anything to pump money into the system" including "state and local debt, real estate and gold mines – any asset"

I don't have the link but the the quote via my notebook is accurate, it struck me as important enough to jot down.
We now have the transcript,
Minutes of the Federal Open Market Committee

January 29-30, 2002
...At this meeting, members discussed staff background analyses of the implications for the conduct of policy if the economy were to deteriorate substantially in a period when nominal short-term interest rates were already at very low levels. Under such conditions, while unconventional policy measures might be available, their efficacy was uncertain, and it might be impossible to ease monetary policy sufficiently through the usual interest rate process to achieve System objectives. The members agreed that the potential for such an economic and policy scenario seemed highly remote, but it could not be dismissed altogether. If in the future such circumstances appeared to be in the process of materializing, a case could be made at that point for taking preemptive easing actions to help guard against the potential development of economic weakness and price declines that could be associated with the so-called "zero bound" policy constraint....
The question arises "Can the fed intervene in the Equities Markets?"
Again, two answers. 1) It's definitely something Central Bankers have thought about. 2) The Fed may need some enabling legislation which they would probably get if they requested it.
The FT reported February 21, 2002 "Japan Suspected of Stock Market Intervention".
A Google search finds 700 references to the "Stock Buying Body".
Here's a pungent one:...
And if folks didn't get the message, here's part of "Doom and Gloom: What Can the Federal Reserve Do? Part II":
...Another paper, this one from the Dallas Fed, addresses the same issues with a distinctly different tone, e.g.

CH-47 Chinook Helicopter

Image from Monetary Policy in a Zero-Interest-Rate Economy.
The post goes on to excert part of a speech to the National Economists Club by Ben S. Bernanke, Nov. 21, 2002:

Deflation: Making Sure "It" Doesn't Happen Here

...Some of the footnotes to the speech:

8. Keynes, however, once semi-seriously proposed, as an anti-deflationary measure, that the government fill bottles with currency and bury them in mine shafts to be dug up by the public

12. The Fed is allowed to buy certain short-term private instruments, such as bankers' acceptances, that are not much used today. It is also permitted to make IPC (individual, partnership, and corporation) loans directly to the private sector, but only under stringent criteria. This latter power has not been used since the Great Depression but could be invoked in an emergency deemed sufficiently serious by the Board of Governors.

15. In carrying out normal discount window operations, the Fed absorbs virtually no credit risk because the borrowing bank remains responsible for repaying the discount window loan even if the issuer of the asset used as collateral defaults. Hence both the private issuer of the asset and the bank itself would have to fail nearly simultaneously for the Fed to take a loss. The fact that the Fed bears no credit risk places a limit on how far down the Fed can drive the cost of capital to private nonbank borrowers. For various reasons the Fed might well be reluctant to incur credit risk, as would happen if it bought assets directly from the private nonbank sector. However, should this additional measure become necessary, the Fed could of course always go to the Congress to ask for the requisite powers to buy private assets. The Fed also has emergency powers to make loans to the private sector (see footnote 12), which could be brought to bear if necessary.

18)...Some have argued (on theoretical rather than empirical grounds) that a money-financed tax cut might not stimulate people to spend more because the public might fear that future tax increases will just "take back" the money they have received.

So there's really no call for the tone of this headline at ClusterStock (the body of the post is pretty good):
Fed Now Taking EQUITIES As Collateral? Have They Gone INSANE?
The Fed's actions are simply informing us that they are one step away from stashing currency filled bottles in exhausted gold mines.