Really Scary Fed Charts: MAY, False Alarm?

The scary Fed charts are making the rounds on various blogs now.

Over at CalculatedRisk they are being interpreted as a “false alarm” in Non-Borrow Reserves and the Fed’s Balance Sheet.

Over at MarketTicker they are being interpreted as evidence that “the system as a whole is insolvent” in Tall Tale Tuesday.

While I’m not sure (yet) that “the whole system is insolvent”, I definitely do NOT think this is a “false alarm”.

CalculatedRisk: Non-Borrow Reserves and the Fed’s Balance Sheet: ““This graph, from the St. Louis Federal Reserve, shows the non-borrowed reserves of financial institutions. Looks like some serious cliff diving, but with a little research, we discover this graph is misleading.

The explanation is pretty simple. The Federal Reserve decided to classify the TAF and the primary dealer credit facility as borrowed reserves (see this table). If we back out these collateralized borrowings, you get the total reserves, and that has been very steady. False alarm.”

My Comment: First, lets start with “total reserves have been steady” if you exclude the Term Auction Facility (TAF). This, as I understand it, should not be done. This facility was specifically designed for depository institutions to replenish reserves:

Term Auction Facility (TAF): “Under the term auction facility (TAF), the Federal Reserve will auction term funds to depository institutions. All depository institutions that are eligible to borrow under the primary credit program will be eligible to participate in TAF auctions. All advances must be fully collateralized. Each TAF auction will be for a fixed amount, with the rate determined by the auction process (subject to a minimum bid rate). Bids will be submitted by phone through local Reserve Banks.”TAF FAQ

The TAF is currently at $100 billion and that has been drawn (Chart: TERMAUC). Bernanke raised the TAF limit to $150 billion on May 2nd. (Fed Officials Warn About Inflation, Say Markets Still Unsettled) Obviously there is a need for this liquidity. The chart measures exactly what it should: Non-Borrowed Reserves. The TAF is so large now, that Non-Borrowed Reserves are deeply negative.

What does this mean? Is “the system as a whole insolvent”? I would say POSSIBLY. We don’t know for sure YET and it may take years before we find out.

The Federal Reserve requires collateral from those borrowing through the TAF. We need to first understand the collateral, and margin rules on that collateral to determine how risky the TAF facility is.

Collateral FAQ
The Discount and PSR Margins Table

A good chunk of what can be used of collateral is low risk and transparent. For example, US Treasuries and Fully Guaranteed Agencies, Government Sponsored Enterprises, International Agencies, Brady Bonds, Foreign Governments, and Foreign Government Agencies are all liquid, can be valued and are transparent in the sense that you know what it is you’re holding.

BUT, then things get sketchy and they get really sketchy really quickly.

Municipal Bonds are mostly good collateral. I say mostly, because municipal defaults are generally very low. HOWEVER, the last 5 years of revenues and the projections of all future revenues are based on an illusion. That illusion was of perpetually rising real estate prices and therefore perpetually rising property tax income. Furthermore, the churn in real estate, the sheer volume of sales, also generated a large, non-reoccurring revenue stream from one time transaction taxes. Municipal expenditures rose with these income increases and future projections, on which bonds were floated, extrapolated this income stream into infinity. Some municipals are already under severe stress as their tax bases collapse. (See Tax Assessors Nightmare of at Mish’s for an in depth analysis of the pending tax implosion.)

Corporate Bonds Rated AAA are generally fine. On average only 23.3% of all bonds rated AAA were downgraded to AA over a 5-year horizon. This means that the collateral pool will gradually shrink as AAA corporate bonds slowly get downgraded as economic fundamentals deteriorate. Basically as AAA rated bond that gets downgraded won’t be eligible at the TAF any longer. So when the 28 day period expires, the bond is swapped back by the Fed. Default is almost impossible in such a short time frame.

BUT, that assumes that AAA today is as solid and reliable as AAA used to be years ago. Even sudden implosions, such as that of Bear Stearns, don’t tend to be a problem because the ratings of such firms generally aren’t high enough. Bear Stearns had been rated A+ before it imploded and therefore Bear Stearns debt wouldn’t have been eligible as collateral. The ratings agencies don't exactly inspire much confidence in their skills.

Further down the list we hit Asset Backed Securities, Commercial Mortgage Backed Securities, Mortgage Backed Securities, and Collateralized Mortgage Obligations. THIS is where the wheels come off…

First, OBJECTIVELY valuing these instruments is damn near impossible. That is WHY these markets have seized up. Second, they are not transparent. To figure out and hunt down the underlying assets in these derivatives of derivatives is also damn near impossible. Even worse is the fact that both AAA rated and NON-AAA are eligible when we already know that even AAA ratings in these instruments are deeply FLAWED and UNRELIABLE. Unlike corporate bonds, these instruments can suddenly collapse without warning. Therefore, the Fed really is taking a big risk on these.

Furthermore, the ‘haircut’ on all this collateral is ridiculously LOW. Most are only 1% - 3%. The lendable value of the worse of these is still 70% and that is only when there is NO MARKET PRICE AVAILABLE. I can tell you this, when there is no market price, there is also no way in hell the instrument is worth 70 cents on the dollar. No price and you can generously assume you’re not going to get more than 50 cents on the dollar and I say that would be a best case scenario.

“A more interesting chart was present by Dr. Janet Yellen this morning showing the Fed's balance sheet.

This graph shows that about half the Fed's U.S. Treasuries have been committed to fight the liquidity crisis.”

My Comment: Interesting indeed. Frightening as well. The Fed has basically traded in high quality instruments, US treasuries, for low quality instruments that the market doesn’t want at all or is pricing at levels deemed unacceptable by those market participants still denying reality. The Fed has committed half of its $800 billion balance sheet to battle the RESIDENTIAL real estate bubble implosion. The COMMERCIAL real estate bubble implosion has yet to get well underway. Revolving credit, such as credit card debt has yet to implode as well. Job losses have yet to accelerate. The recession has yet to gather steam.

I’ve said it before, The Fed Is Almost Out Of Ammo, Citigroup and UBS Too.

Total Borrowings of Depository Institutions (Chart: BORROW) are fast approaching $150 billion. This does not include the effect of the $50 billion increase in the TAF limit to $150 billion.

This has already pushed Non-Borrowed Reserves (Chart: BOGNONBR) to a NEGATIVE $100 billion. This is likely just to get worse as the balance sheets of financial institutions continue to deteriorate.

The balance sheets of almost all financial institutions, whether they be depository institutions or prime brokers WILL DETERIORATE further. They have to. The vast majority of their balance sheets are now in the Level 2 or Level 3 asset buckets. As I said in Bulltrap: ABCP, and Level 3 Bombs, I can’t imagine that these assets are currently being undervalued or even conservatively valued.

That just NOT how these fellows roll. This is Wall Street man! Privatize the profits, and socialize the losses!

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