Time to Send the Banks to Group Therapy and Sleep Away Camp: 3 Steps to Force Inter-Bank Lending

The Federal Reserve in its weekly report Thursday said overall direct [aka discount] commercial bank borrowings, including direct loans to depository institutions and securities firms, rose to a fresh record of $441.37 billion Wednesday from $430.87 billion in the prior week. Total average daily borrowing also averaged a new high of $437.53 billion per day in the week ended October 15, topping the previous week’s $420.16 billion per day.

Primary credit discount window borrowings hit a record as well by averaging $99.66 billion per day in the latest week, up from $75 billion per day the previous week. Primary dealers and other broker dealers’ credit borrowings were $133.87 billion as of Wednesday October 15, versus $122.94 billion on October 8.

Loans in the “other credit extensions” category, mostly including loans to insurer AIG, were $82.86 billion as of October 15, versus $70.30 billion as of October 8. Lending through the Fed’s primary dealer credit facility also has increased by more than $10 billion to $133.9 billion from $122.9 billion a week ago.

The Fed’s asset-backed commercial paper money market mutual fund liquidity facility, designed to enable money market funds meet demands for spiking redemptions from investors report estimates about $100 billion in redemption requests for funds of hedge funds in Q4′08), was $122.76 billion as of October 15, versus $139.48 billion on October 8.

In sum, this latest data from the Fed discount window shows how much the banking system depends now on the Fed in its new role as the sole lender of last resort as short-term funding, which is necessary for many co.’s to meet temporary shortages of liquidity caused by internal or external disruptions, has become at this point nearly impossible to find elsewhere. So banks need to stop using the discount window as a security blanket.

The third problem is that the interest on reserves program – which I fully support – is not structured to force banks to lend to other banks. Banks' general wariness of other institutions was reflected in the latest European Central Bank data that showed euro zone banks deposited 205 billion euros in overnight funds at the ECB on Thursday. That was the second highest on record, following the previous day's 211 billion euros.

So what has to be done is as follows: (i) revise or restrict LIBOR over time, (ii) restrict access to the discount window so banks have to borrow from other banks, and (iii) structure the conditions under which interest on reserves are structured so as to cause banks to loan to other banks.

If this is not done, then there are other consequences that people need to be aware of. As John Kemp noted in a Reuter’s column today, the assets and liabilities of the U.S. banking system have increasingly been consolidated onto the balance sheets of the Federal Reserve and the U.S. Treasury.

Normally the Federal Reserve finances the Treasury – now the reverse is true. The Treasury has borrowed unprecedented sums in the money market, deposited $500 billion of surplus cash with the Federal Reserve, and in turn enabled the central bank to extend more than $600 billion in special credits to commercial and investment banks, insurers and swap lines with overseas central banks.

As John has noted, the Treasury has borrowed the money banks themselves are unable to raise at present, substituting the full faith and credit of the United States for the impaired credit of the banking system. Almost all the money has been raised through the issue of very short-term cash management bills. In a normal month, the Treasury typically issues no more than $50-70 billion worth of management paper to meet temporary mismatches between spending and revenues before the next regular funding auction of longer-term bills and notes. But as the crisis intensified, the Treasury's issuance of management paper has soared from $66 billion in August to $320 billion in September and $270 billion so far in October. Some $499 billion of the proceeds has been deposited into the Fed's new supplementary financing account.

However, by the Treasury doing this it is taking debt levels close to the statutory ceiling approved by Congress. The statutory ceiling has already been raised twice this year from $9.815 trillion to $10.615 trillion in July, and again to $11.315 trillion in October as part of the Rescue Act.

Total debt outstanding is already up to $10.229 trillion, just $1.086 trillion below the new limit. The Treasury is already committed to raising $350 billion to fund bank capitalizations and asset purchases under TARP. That does not leave a lot of room.

But as the crisis works its way through to the real economy, the deficit is going to worsen even before Congress considers a new economic stimulus package to help troubled homeowners and restart growth. Moreover, the Rescue Act itself contains items that could worsen the deficit further.

The bigger problem is funding. Most of the additional cash has so far been raised through issuing short-term management paper. The Treasury has taken advantage of the huge influx of safe haven money to place an almost unlimited amount of paper at annual interest rates of less than .04%. In effect, investors have been willing to lend to the Treasury for almost nothing to avoid the credit risk of placing funds with a bank. But at some point things have got to give.

The Treasury and the Fed therefore face a problem. To place this mountain of new debt at low yields, they will have to convince domestic and foreign investors the government will keep the regular budget deficit under control; the Fed will keep inflation down; and neither will allow a further depreciation of the dollar. If they cannot, interest costs will rise. This is another reason for the Fed to recede if it can.

I also wanted to mention a couple of other topics.

First, on the issue of mortgage relief, while everyone is wringing their hands on this, Business week.com finally figured out – and hopefully “The PROS” will now get it that it is legally impossible to buy up troubled loans unless you buy up the entirety of the secured asset because of the embedding issue. I should add that the term “toxic” is so pejorative as to be ridiculous.

Secondly, to show how bizarre this has gotten, Dow Jones reported that MBIA Inc.'s insurance unit sued a unit of GMAC Financial Services [Residential Funding Co.] on Wednesday, claiming it made misrepresentations about the quality of loans underlying the securitization of pools of more than $3 billion in home equity loans.

MBIA Insurance Corp., in a lawsuit filed in U.S. District Court in Manhattan, alleged the loans underlying five securitization transactions in 2006 and 2007 were "of a fundamentally different quality and character" than Residential Funding Co. had represented to MBIA, which provided financial guaranty insurance policies for those transactions.

As of September 2008, MBIA said it has paid out about $264 million in claims related to the securitizations. In its lawsuit, MBIA said 1,847 mortgage loans, or about 3% of 60,000 loans in the securitization pools, were in default as of Dec. 31, 2007 - representing "an unexpected and unusually high default rate" given the proximity in time to the closing date of the five securitization transactions. 3% is not per se a high default rate. Of the defaulted loans reviewed by MBIA, less than 7% of those loans were originated or acquired in "material compliance" with Residential Funding Co.'s representations, according to the lawsuit. In the first three months of this year, another 1,195 mortgage loans in the securitization pools became delinquent, MBIA said. The overall default rates while high still show that 93% - if not more – are still paying their loans. What this shows is that the insurers did not do due diligence in this matter.

MBIA has already filed a similar lawsuit against several units of Countrywide Financial Corp. in state court in Manhattan, claiming the lender made fraudulent representations about its loan underwriting standards in connection with the securitization of pools of more than $14 billion in home equity loans. Bank of America completed a $2.5 billion acquisition of Countrywide in July.

Third, as much as I like Tim Geithner it's time to kick Tim out and send his wife [Carole] who knows how to deal with kids in. Carole needs to act as the Hammer to get it done on creating a credit default swap exchange-clearinghouse. While the contracts are traded bilaterally between banks, hedge funds, insurance companies and other institutional investors, and each party faces the risk of losses should their trading partners default, this is affecting other parties. Four groups have been vying to operate clearing operations and it’s time to pick one – end of story.

Last week there was a meeting at the NY Federal Reserve Bank to create a CDS Clearinghouse and another one today. Enough with the meetings, it is now time to make someone an offer they cannot refuse. You have a 50 to 60 trillion dollar situation which is a nuclear time bomb. It’s time for a “Come to Jesus” moment even though US based insurers are working on getting their CDS exposure down by trying to get the assets underlying the CDSs’ into TARP and creating the contemporaneous mortgage insurance program mandated by the rescue law if TARP is created.

Still, there are two reasons for this needing to be done now. One, this uncertainty is not good. Two, the cost of protecting high-risk, high-yield corporate bonds from default rose to a record in Europe after a report that U.S. consumer confidence fell the most on record fueled concern of a global recession. And, three, a number of CDS’s are coming due – including some AIG related activities on the 21st which means that there are taxpayer issues here.

Since the mid 1980's Irwin Nowick has worked for the California State Assembly and State Senate on a plethora of policy issues, most notably firearms legislation. He has been described as "The Assembly's resident genius" by a former Speaker of the Assembly and is seen frequently in the Capitol hallways and offices assisting legislators in drafting and amending pending legislation.