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How the Fed made PPIP redundant

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When this blog went online earlier this year in March 2009, plenty of its earliest posts focused criticism on the US Treasury’s public-private investment plan (PPIP). Some five months later, there has been barely a word on the newstands on its fate, and it seems doomed to languish unimplemented. To recap, the PPIP was conceived by US Treasury Secretary Tim Geithner for removing so called “toxic assets” consisting of collateralized debt obligations (CDOs), mortgage backed securities (MBS) and credit default swaps (CDS) which were difficult to price because of the collapse of housing prices and rising delinquent rates among homeowners on mortgages, especially for those whose home values have collapsed below the principal amount owed on the mortgage (negative equity).

Subsequent shunning of these securities earned them the nickname of being “toxic”. That proved to be a problem for financial institutions which had loaded up on a lot of these assets. The original aim of the PPIP was to provide taxpayers’ funds to help subsidise purchases for a public auction for this securities.  That’s the original purpose of the PPIP.

However, sometime in early June signs were surfacing that the PPIP was put on hold, and certain aspects of it were scaled down.  In early July, I wrote an entry on the scaleback.  Since the onset of the crisis, we’ve seen how the banks cheated to ace the sham stress tests and as noted on this blog recent reporting indicated larger than expected Q2 profits by Wall Street banks.

So the question one might ask is, if toxic assets were really a problem and given that the PPIP was never implemented, how on earth did the banks recover?  The answer lies in what the unusually activist Fed Reserve(s), especially the New York branch, has been doing the past year or two.

Earlier this year, the Fed Reserve announced that it would be stepping up purchases of mortgage-backed securities on the open market:

To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion.

Now, the fact that the Fed is doing this is highly unusual.  Normally the Fed would buy and sell US Treasurys only.  Brad Delong’s has an entry from 2007 which expresses astonishment  that the Fed could actually be trading (possibly toxic) securities (especially when there is no objective method of valuing them).  An NY Times article dates the start of the Fed’s buying of MBS’s on 5th Jan 2009.

Apart from these the Fed has also been trading Treasurys (on a temporary loan basis) in exchange for MBS’s with investment banks via recently created (in 2008) loan facilities such as the Primary Dealer Credit Facility and the Term Aseet Backed Securities Loan Facility.

What has been the net effect of such large scale purchases?  In buying possibly toxic MBS’s off the balance sheets of (formerly) troubled financial institutions the Fed is effectively executing the PPIP, except that instead of using taxpayers’ money it relies on its cash reserves (which it may print more of at any given time) to do so. Correction: It doesn’t appear as though the Fed has been buying toxic securities from the banks themselves, but from Fannie Mae and Freddie Mac.  By doing so, it could have an effect of jumpstarting the frozen market for MBS’s and this might have caused the undervalued MBS to appreciate.  Hence the causal link is indirect.

Recent reporting (dated Jul 30th) indicates that the Fed is currently holding up to US$542.89 bn worth of MBS’s:

The Fed’s portfolio of Treasury securities in the latest week rose $3.03 billion to $695.76 billion as holdings of mortgage-backed securities meanwhile dipped to $542.89 billion from $545.47 billion a week earlier.

The Fed’s net portfolio holdings in connection with its commercial-paper funding facility fell $42.55 billion in the latest week to $67.30 billion Wednesday.

The Fed’s holdings under the Term Asset Backed Securities Loan Facility rose to $30.42 billion from $29.98 billion a week earlier.

The reduction in the Fed’s holding’s of MBS’s assets reflect a shift in attitude which manifested as early as April when NY Fed President Dudley announced it was holding off secured loans which allow MBS’s to be used as collaterals.  Two months later in early June, the Fed was still stalling on buying or financing purchases of MBS’s:

Hopes that the Fed would in the coming months start providing financing to investors seeking to buy residential mortgage-backed securities (RMBS) – many of which have lost their triple A credit ratings – have pushed prices on these assets higher in recent months.

William Dudley, president of the Federal Reserve Bank of New York, said on Thursday that a decision had not been made. “We have not made a final decision on whether it is doable and, if it is doable, whether it is worth the cost,” he said.

Despite the apparent slowdown, the fact remains that the Fed’s aggressive purchases of residential MBS’s may have had done the work of PPIP, making it therefore redundant.

Has this been enough to take toxic assets off banks’ balance sheets? I can’t say for sure, but judging from the massive profits earned by investment banks for Q2 2009, it may not be unreasonable to believe that it might have helped.  Especially when reports like this becomes more common day by day:

The Fed has emerged as one of Wall Street’s biggest customers during the financial crisis, buying massive amounts of securities to help stabilise the markets. In some cases, such as the market for mortgage-backed securities, the Fed buys more bonds than any other party.

However, the Fed is not a typical market player. In the interests of transparency, it often announces its intention to buy particular securities in advance. A former Fed official said this strategy enables banks to sell these securities to the Fed at an inflated price.

The resulting profits represent a relatively hidden form of support for banks, and Wall Street has geared up to take advantage. Barclays, for example, e-mails clients with news on the Fed’s balance sheet, detailing the share of the market in particular securities held by the Fed.

Written by defennder

August 3, 2009 at 2:32 PM

Posted in Economics and business, US

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2 Responses

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  1. When the Fed opened its window to broker-dealers during the crisis, it allowed MBS to be used as collateral for short term loans. But these have not been cleaned up:
    http://online.wsj.com/article/SB124804469056163533.html

    I think some of the CDOs/MBS recovered in value allowing the banks to slow its losses due to writedowns.

    I thought the large amount of MBS in the Fed was holding came from Freddie and Fannie when they went into conservatorship:
    http://www.federalreserve.gov/newsevents/press/monetary/20081125b.htm

    Lucky Tan

    August 3, 2009 at 4:00 PM

  2. Yes I think you’re right. I was misled by thinking the Fed purchases included those held by investment banks.

    But at the same time I do believe that Fed purchases of RMBS may have helped revive the market for MBS in general by spurring investor confidence (and hence cause MBS value to appreciate) that not all MBS are toxic. That is, some MBS held by investment banks and their corresponding CDS were severely undervalued in the wake of the credit crunch.
    See this:

    http://marketplace.publicradio.org/display/web/2008/11/25/toxic_assets/

    At the same time I don’t know if the banks have managed to sell some of those assets to other investors on Wall St. absent the PPIP.

    On a related note, Congress (and the public) has been growing more suspicious of the Fed’s activities and there are increasing calls for a Fed audit, most notably by Ron Paul. I’ve never really felt comfortable with any one institution holding so much power (despite the experience in Singapore), but I recognise that should the Fed feel politically pressurised to hold back or withdraw their activist involvement in the economy, we might see a partial return to a pre-2009 credit crunch when consumer and business loan were frozen.

    On a personal note I’d like to see Bernanke re-appointed as Fed chair. Although he has made some off-mark predictions in the past, his recent actions in the wake of the subprime crisis in ’07 ’08 ’09 has shown his capability in responding swiftly and decisively in crisis. I can’t say the same for Larry Summers, whom during the late Clinton years teamed up with Rubin and Greenspan to block regulation of derivatives.

    defennder

    August 4, 2009 at 12:50 AM


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