Will the Fed's new toy work?

The Fed's new toy to drain the monetary sandbox has arrived, and though the first trial run will be small ($1 billion), there are some interesting observations to be made that will be relevant as the Fed ramps up down the road. Are the new Fed Bills (as I called them in January) simply the Fed issuing its own debt? Will they be effective at all once short term rates begin to rise?

As it announced it would soon do a few short weeks ago, today the Federal Reserve scheduled the first auction for its Term Deposit Facility. The full release is below:

The Federal Reserve has scheduled three small-value auctions of term deposits through its Term Deposit Facility (TDF) over the next two months. These auctions are a matter of prudent planning and have no implications for the near-term conduct of monetary policy.

All term deposit auctions will use a single-price format in which all winning bids will be awarded at the highest rate accepted at the auction. The first auction will offer $1 billion of 14-day term deposits; the auction will be conducted on June 14 with settlement on June 17, and the deposits offered will mature on July 1. Each participating institution may submit up to three competitive bids; the maximum award to any individual bidder will be set at $250 million and the maximum rate at the auction will be set at the primary credit rate [Bob: 0.75%]. Depository institutions may submit noncompetitive bids; each individual noncompetitive bid will be filled up to a limit of $5 million at the highest rate accepted in the competitive auction. The amounts awarded to noncompetitive bidders will be added on to the $1 billion offered at the competitive auction.¹

The second auction will offer 28-day term deposits; the auction will be conducted on June 28 with settlement on July 1, and the deposits offered will mature on July 29. The third auction will offer 84-day term deposits; the auction will be conducted on July 12 with settlement on July 15, and the deposits offered will mature on October 7. The amount of term deposits offered along with other parameters for the second and third auctions will be announced at a later date.

The Federal Reserve may schedule up to two additional small-value TDF auctions later in the summer.

1. Additional details of the first auction will be made available on June 11 on the TDF Resource Center athttp://www.frbservices.org/centralbank/term_deposit_facility.html.

In the final Rule Amendment to Regulation D, the Fed stated it did "not expect to permit pledges of term deposits to third parties" -- a key distinction from Treasury Bills. However, it stated it did expect purchasing banks to be able to pledge them at the Fed's discount window.

Similar to the new ECB facilities, this means in a pinch, a bank would be able to get cash for the TDF at an effective fee equal to the difference between the primary credit rate (now 0.75%) and the interest the bank receives on the TDF. It seems like it would be a more effective policy tool than simply paying interest on excess reserves (IOER) because there is no lockup in banks' reserve accounts. The risk is that volatile short term interest rates could render the IOER policy method impotent. Brian Sack, manager of the world's largest hedge fund (the Fed's System Open Market Account) was acutely aware of this in his speech on December 2, 2009:

A key part of the framework is the ability to pay interest on excess reserves. This authority alone may allow the FOMC to control short-term interest rates to its satisfaction, even if the banking system is saturated with a large amount of excess reserves. Indeed, the interest rate on excess reserves should act as a magnet for other short-term interest rates, keeping them relatively close together. In the current environment, the federal funds rate has remained modestly below the rate paid on reserves, typically by 10 to 15 basis points. If that spread were to remain steady near those levels even as the interest rate on excess reserves was increased, then policymakers would have sufficient control over short-term interest rates without the use of additional instruments. They could still choose a target level of the federal funds rate and could hit it by adjusting the interest rate on excess reserves.

However, policymakers face some uncertainty about how stable that spread will remain as short-term interest rates increase. The behavior of the spread today might not be that informative in this regard, as the proximity of short-term interest rates to the zero bound prevents the spread from getting much larger. In my view, the most likely outcome is that the spread will not widen substantially as short-term interest rates increase. However, if the spread does become large and variable, then policymakers will need other tools for strengthening their control of short-term interest rates.

With that in mind, monetary policymakers have asked the Federal Reserve staff to develop the ability to offer term deposits to depository institutions and to conduct reverse repos with other firms. These tools are similar in nature, as they both absorb excess reserves by replacing them with a term investment at the Fed. By removing reserves that would have otherwise been available for overnight lending, these tools could pull the federal funds rate and other short-term interest rates up toward the interest rate on excess reserves, providing the Fed with more effective control over the policy rate.

But even the new TDFs do not cure this apparent deficiency in IOERs, should short term interest rates move to quickly. Considering the unprecedented monetary and interest rate intervention and the law of unintended consequences, it is conceivable that short term interest rates could rise to close the effective fee gap between the primary credit rate of 0.75% and the rate paid by the Fed on the TDF. At that point, it would be economical for banks to go to the discount window, get their cash back and reinvest it somewhere else.

It will be interesting to watch the results of these auctions to see how TDFs compete with Treasurys and their relation to the IOER. TDFs should auction at a discount (higher yield) to similar tenors along the Treasury yield curve because they are illiquid. If nothing else, we will have an additional set of spreads to watch.

With all its new facilities--TDF, IOER, tri party repos--the Fed is making sure it has as many tools as possible to keep its trillions in monetization from flooding the general economy down the road. So far so good, but it also makes you wonder if they're planning even more monetization.

Surprise of the Day: Treasury Approves of Financial Reform Bill

"Beer: the cause of and solution to all life's problems."

Homer J. Simpson

Deputy Treasury Secretary Neal Wolin preached to the regulatory captured choir today as he remarked in front of the FINRA annual conference about the new financial reform bill--yes, the very same one that will:

empower it to "gather information and activities of persons operating in consumer financial markets," including the names and addresses of account holders, ATM and other transaction records, and the amount of money kept in each customer’s account.

The new bureaucracy is then allowed to “use the data on branches and [individual and personal] deposit accounts … for any purpose” and may keep all records on file for at least three years and these can be made publicly available upon request.

While Wolin did not comment on this particular intended consequence of the bill, he did highlight a few other notable features:

By bringing the derivatives markets out of the shadows, reform will benefit those businesses that use derivatives to manage their real risks. That's good for every farmer and every manufacturer that uses derivatives the way they were meant to be used. And it's good for all of us who have a stake in the basic stability of the financial system.

Aside from the romantic and naive implication that elevates bona fide hedgers above all other market participants, the stability of the financial system is better preserved by non-exponential growth in money supply. When your buddies at 33 Liberty keep interest rates artificially low for extended periods of time, you can regulate until the farmer's cows come home and the money will still find its way somewhere. It also helps if your central bank doesn't intentionally inflate bubbles then lie about it.

When the President signs financial reform, those firms that pose the most risk will be subject to tighter, tougher regulation – regardless of their corporate form;

Looks bad for David Rubenstein, but I'm sure he'll find a way out. And, as has been discussed at EPJ before, when the government is able to define what constitutes risk and impose it on investment firms, it has pen stroke authority to make or break entire industries. If you believe the government is a good assayer of risk and productivity, then this is the law for you.

advisers to hedge funds will have to register with the SEC for the first time, bringing transparency and oversight to these unregulated financial firms;

As I recall, the hedge funds were a blip on the radar during the carnage of 2008, and all the serious problems were vested in the already highly regulated Frankenstein financial institutions.

securitizers of mortgage- or other asset-backed securities will be required to have skin in the game and to disclose the loans that make up those securities;

In unhampered free markets, skin in the game is actually a normal outcome. It's only when you introduce unlimited low cost loans and government guarantees that moral hazard emerges and creates bizarre concepts, such as too big to fail. Much like the old joke about paying for your meal beforehand in Argentina, artificially increasing the velocity of money through printing is what encourages due diligence myopia and hot-potato securitization.

shareholders will have a say in the compensation of senior executives at the companies they own;

Shareholders already have this voice--they can vote their shares or sell them. Excessive compensation is only an issue in government-coddled industries, where shareholders know Uncle Sam will save their company regardless of the poor decisions or compensation structure.

the SEC will have the explicit authority to prohibit or limit the use of mandatory binding arbitration agreements.

Currently, arbitration, such as through the American Arbitration Association, is the last vestige of a free market answer to dispute resolution. It is low cost, generally fair, and efficient, which is why it must be stopped at all costs. Never mind that it was the ability to select competent, efficient and fair judges that led to the creation of common law in the first place. In its place will be the bloated court system, or arbitration performed by the regulatory agencies, which themselves are stacked with industry insiders. As to mandatory, a customer has the right to contract with a competing firm should he not like the terms of contract--that is unless a government sponsored monopoly prevents such competition.

These reforms are long overdue. These reforms are important. And looking at the House and the Senate bills today, I think we can say with confidence that these reforms – along with many others – are moving swiftly towards enactment. When the President signs financial reform, he will sign a bill that is comprehensive, far-reaching, and that addresses the core causes of the financial crisis.

True to form, the Ministry of Truth has proclaimed from the hills it has weighed the evidence on the blind scales of justice and found both the root cause of and solution to our problems--done with as much obliviousness to irony as Homer Simpson himself.

FLOORED: A hard hitting look inside the Chicago trading pits

If you're sitting at home wondering what to do until Stone releases part deux of his cult classic, Wall Street (or until the SEC launches a media circus by investigating Shia Labeouf), you're just a click away from an entertaining and informative look at how it really goes down in the trenches, in FLOORED:

A world that’s more riot than profession, the trading floors of Chicago are a place where gambling your family’s mortgage is all in a day’s work. Now, when markets are unhinged, FLOORED offers a unique window to this lesser-known world of finance. Traders may not have degrees, but they’ve got guts, and penchant for excess. But like many aspects of our economy, technology is changing their business, and these eccentric pit denizens aren’t the type to take kindly to new tricks.

Computerized trading may take the emotion out of the job, but it may also take these old-timers out- they are dinosaurs in a young man’s game.

At a time when millions have lost fortunes in the fickle stock market and fear abounds about the faltering financial system, FLOORED is a gripping, honest look behind the curtain of the trading floor that few have ever seen.

Pre-order the DVD, or watch it with limited commercial interruption on babelgum.

Will a Greek default sink the Euro?

From ZeroHedge:

Major Investment Bank: "Greece Is Going Down, Germany Drafting Law For Orderly Insolvencies"

...As Neil Hume at Alphaville reports, "Big IB to clients: "they have it all planned: they are going to sink the ship (greece). Merkel is now drafting law for orderly insolvencies, but they don't want anyone to make money out of it, hence the ban."" If this is true, it 's curtains for Europe. Shorting the Euro at this point is like shorting Lehman: you may see savage short covering squeezes but the end result is well known.

One could make the argument, as Jim Rogers has, that a Greek default makes the Euro a much more viable currency long term, despite some expected short term havoc. The reason being that the other Club Med states are forced to return to fiscal sanity, or end up kicked out of the Euro currency club. However, it is critical to watch how the cram downs at the banks are handled.

If the Germans simply play accounting gimmicks to postpone or hide the losses, confidence will continue to erode and the crisis will magnify. If they print their way out with the ECB buying the impaired bonds at par, say, that's likely to be inflationary despite their best (and misguided) efforts at sterilization. If you give a bank $100 and only claw back $90, it can still turn the $10 back into at least $100. And, if they do succeed at sterilization, it could end up with unintended deflationary consequences. Indeed, the kaleidoscope is turning again.

Quietly, the Fed Funds rate ticked up Monday from 0.20% to 0.21% Monday (as reported Tuesday morning) and stayed there Tuesday. Despite the seeming deflationary backdrop it's hinting at inflation, at least according to my read of the dynamics behind the Fed Funds market as partially explained here. It could very well be that real interest rates are beginning to rise. As a reminder, if the Fed Funds rate exceeds 0.25%, the interest rate on excess reserves (IOER), the Fed would be forced to raise the IOER (tighten) or open the money spigots again. It certainly prefers to do neither.

The Ten Crack Commandments (and the Notorious F.E.D.)

Fiat money is like crack. It’s produced cheaply by a central bank cartel whose members will compete and go to war with each other for production and distribution rights. But, when the bond vigilantes come a knocking, the central banks will circle the printing presses to defend the product. When viewed through the lens of a common street hustler, the global central banking system reveals itself to be just that: a hustle. Learn the hustle and you have a chance at profit. Ignore it, and you will lose.

The late Christopher Wallace, a/k/a, the Notorious B.I.G. a/k/a Biggie Smalls, wrote the definitive street hustler manual with the Ten Crack Commandments. As we’ll see, the Notorious F.E.D. is a devoted disciple.

1. Rule numero uno: never let no one know how much dough you hold

Right off the bat, Biggie nails it. The greatest threat to a hustler is for people to know just how good he’s getting it. The NY Fed conducts all open market operations on behalf of the Fed, and nearly all are done at a loss because, by definition, it is attempting to distort real market prices. Buying high and selling low is the Fed’s hidden graft to the primary dealers, so it would be instructive to know just how much this comprises the nearly spotless trading records of Goldman, BAC and others. In addition, all holdings in the Fed’s piggy bank, the System Open Market Account, are reported at par, or face value. How much of a hit have the taxpayers taken on the $1.25 trillion in mortgage backed securities it bought? Because the Fed only reports at par and on a cash flow basis, we won’t know how worthless its holdings are until the cash flows simply cease. It would also be nice to know if our gold actually exists beyond a ledger entry.

Ron Paul’s audit the Fed Bill (and not the watered down version) is like a gun to the Fed’s head, and the release of a marked-to-market Fed balance sheet would pull the trigger. The public knows those eight figure Wall Street bonuses are coming from them, they just have yet to realize exactly how. “The cheddar breed jealousy,” indeed.

2. Number two: never let em know your next move

Don't you know Bad Boys move in silence or violence

Wallace takes no prisoners here. In the good old days, the FOMC could simply shutter its doors for a couple of days, then let the NY Fed trading desk in on the scheme. No public announcement, no minutes, no transcript (hey, they could even lie about its existence). After decades of arm twisting, the Fed has slowly dribbled some morsels but, to this day, keeps its most precious information secret. This goes back to that pesky audit. So silence, yes, but violence?

A war’s greatest ally is the printing press. It used to be the case when the world was on a (loose) gold standard, that the bond vigilantes would force some restraint after the war ended (or end the war because of it). With a pure fiat and global reserve currency behind it, there have been very few limits on the Pentagon budget and, hence, no reason to take some time off. Oh, and there are those “bizarre” incidents where the Fed is directly implicated with Saddam and Watergate.

3. Number three: never trust nobody

Well, that goes without saying. The conundrum the global banksters find themselves in is that they all know they’re playing the same game. They don’t trust each other because they (correctly) assume everyone else is doing what they are.

4. Number four: know you heard this before

Never get high on your own supply

Here, Biggie foreshadows the end game. There’s a point in many a hustlers’ lives when they start imbibing on what they’re slinging. It’s easy at first, as it seems like the supply is unlimited. But in the end, they don’t consume it--it consumes them. Theoretically, the Fed could print an unlimited number of dollars, but those dollars are all chasing the same goods and services. You can’t print purchasing power or productivity. Fiat money printing dilutes the money supply and eventually results in inflation. This is a redistribution scheme that stops working when the money loses too much purchasing power too quickly. It’s like a dealer cutting the product too much, or worse, selling fakes.

5. Number five: never sell no crack where you rest at

This too tells us when the end was in sight. Use to be, we would send pieces of (Treasury) paper to China—actually, add zeros to their account with the Fed—and get back DVD’s, plasma TV’s and MP3 players. China’s currency peg to the dollar assured their prices would be artificially low and that they would continue recycling their dollars back to the Treasury. That all changed with quantitative easing, where the Fed started buying not only Treasurys, but Fannie and Freddie paper, and even home loans packaged in MBS. The government really began buying its own crack decades ago, with the social security administration and others acquiring Treasury debt. But that is quickly coming to an end, if it has not already. The Fed is now both the lender and buyer of last resort, and it can’t keep that shell game going forever.

Who, but Oscar Wilde, would suspect that a song written by a self-styled street hustler thirteen years ago (just before his own violent death) would anticipate and mould the great financial crisis of the twenty first century? The banksters have clearly been taking cues from Wallace's playbook, but are also breaking some cardinal rules. He's gone five for five so far, so stay tuned for part two, where we’ll see if he continues his sage winning streak (hint: he does).