How're They Doing?

Ed Koch, a cutting edge lowlife who was made the mayor of New York City in the late 70s – once collapsed in a restaurant from overeating – had a catchphrase. He used to ask, addressing no one in particular, How'm I doing? Not that he gave a damn about the answer, but it was good p.r., this show of going to the rabble for feedback.

How should we respond if the central banks, specifically, the European Central Bank, the Bank of England and the Federal Reserve, ask the same question? How are they doing in handling the ongoing liquidity/credit crisis?

The Financial Times of May 16, under the heading “ECB liquidity scheme fears” gave the answer in black and pink. The highlights are in red:

The European Central Bank yesterday voiced its “high concern” at growing evidence that banks are exploiting its efforts to unlock the frozen funding markets by using its liquidity scheme to offload more risky assets than it envisaged. Yves Mersch, a governing council member ... was speaking amid sign of some banks creating low-rated assets specifically so they can be traded for treasuries at the European Central Banks.

Central banks have become important in providing funding for difficult to sell mortgages on what is intended to be a short-term basis while securitisation markets remain frozen.

The Bank of England recently created a facility for UK banks to access funding for mortgages and the Financial Times has learned that almost £90bn ($175bn) worth of bonds are being created to be placed there – almost twice the £50bn initially expected when the scheme was launched only three weeks ago.

Meanwhile, Macquarie Leasing, a unit of the Australian bank, has done a securitisation of Australian motor loans, which will have a euro-denominated slice so that the investors who buy the deal can use it at the ECB. Investment bankers who work in securitisation say that their main business is structuring bonds that are eligible for ECB liquidity operations. Some analysts have concerns about whether the bonds being created will ever be saleable if markets recover… According to debt market sources, the banks planning to use the scheme are the UK’s eight largest lenders.

Let us see.

As part of its liquidity operations where it exchanges treasuries for junk, the BOE has taken in $175 billion worth of junk – twice the amount it was expecting only three weeks ago.

There is a critical point here that must be understood. When you give your high-yield junk (that you can neither finance nor sell) to a central bank and receive treasuries in return, the transaction is considered a security lending. What it means is that the ownership of securities does not change. You still own the junk and the central bank owns the treasury, so you receive the high coupon rate of junk and pay the low rate of treasuries. This is precisely the sort of arbitrage that triggered the current crisis, only now a central bank is the party to the transaction instead of the jittery and cautious CP investors.

What follows has the inevitability of night following day: Banks – including UK’s eight largest lenders – are specifically creating low rated assets (i.e., junk) so they can take them to the European Central Bank in return for treasuries. In fact, they have investment bankers whose “main business” is structuring bonds that are eligible for ECB liquidity operations.

And the news has spread to the far-flung corners of the “globalized” world. “Macquarie Leasing of Australia is adding a euro denominated slice to its auto loans so investors who buy the deal can swap it for treasuries”. From mortgages in the US to auto loans in Australia in ten months; it is a small world after all.

There is one more thing that must be understood. What do you suppose the banks do with the treasuries that they get from the central banks?

You guessed it. They pledge the treasuries, get cash and, if they are smart banker, buy high-yielding junk so they could take them to central banks for treasuries ... You get the idea.

There seems to be madness in the method. Certainly the central banks’ position that the program was intended to be a short-term exchange invites ridicule. They offer the banks and broker/dealers the risk-free opportunity to launder their junk and in the process earn about 3% spread and then expect them to say “enough” after an appropriate short time.

What we have, however, is neither naiveté nor madness. It is lack of options. With their backs against the wall, central banks had no choice but to do precisely what they have done for the past several months. Now all they can do is hope for the best.

The most outstanding characteristic of the systemic risk is its inevitability, a characteristic that is formed through the elimination of policy options.