The Liquidity Put
(March 17, 2008)
Dear Subscribers and Readers,
Given the events over the last 24 hours and the many questions that I have received from subscribers, I believe an “ad hoc” commentary is warranted at this stage, even though it is almost guaranteed that events will again be fast moving in the next 24 hours.
Since most of you have already read about the Bear Stearns takeover by JP Morgan yesterday, I am not going to bother you with any more details on this, as well as the details on the decision by the Federal Reserve Bank of New York to institute the “Primary Dealer Credit Facility” (“PDCF”) and its request to lower the discount rate by 25 basis points to 3.25%, or just 25 basis points above the Fed Funds rate. Instead, I urge you to read the terms and conditions of the PDCF as well as the FAQs on the Federal Reserve Bank of New York website.
In a nutshell, the Federal Reserve Bank of New York is effectively “bank stopping” the immediate funding needs of the 19 primary dealers (20 before the Bear Stearns acquisition) by allowing these primary dealers to put up all collateral that is current eligible for open market operations (OMO), as well as investment grade corporate securities, municipal securities, mortgage-backed securities, and asset-backed securities that has a price from the clearing banks for overnight loans. This is a very aggressive stance by the Fed – as it greatly expands the amount and variety of securities that primary dealers can pledge to the Federal Reserve Bank of New York for overnight loans, versus the Term Securities Lending Facility (TSLF) which only allowed the pledging of $200 billion worth of OMO-eligible and triple-AAA private-label residential mortgage-backed securities as collateral by primary dealers. The TSLF was scheduled to “go live” on March 27th – it now looks like the PDCF will trump the TSLF. The Term Auction Facility (TAF) program, on the other hand, was merely intended to provide funding to depository institutions via a bi-weekly auction for a much more limited amount. Currently, loans made under the TAF program only total $60 billion.
In essence, the Federal Reserve Bank of New York – with the blessing of Ben Bernanke and the Federal Reserve – has effectively provided a liquidity put to the 19 primary dealers of the NY Fed. These 19 primary dealers are: BNP Paribas, Banc of America Securities, Barclays, Cantor Fitzgerald, Citigroup, Countrywide Securities, Credit Suisse, Daiwa Securities America, Deutsche Bank, Dresdner Kleinwort Wasserstein, Goldman Sachs, Greenwich Capital, HSBC Securities, JP Morgan Securities, Lehman Brothers, Merrill Lynch Government Securities, Mizuho Securities, Morgan Stanley, and UBS Securities. More importantly, as discussed in the FAQs, while the amount of loans outstanding conducted under the PDCF program will be disclosed on a weekly basis, it does not look like the name of the individual primary dealers that directly borrow from the NY Fed will be disclosed. This is very important, as both depository institutions and primary dealers do not want to be seen as vulnerable. This is the reason why not many depository institutions had borrowed from the Fed’s discount window in the first place.
Given this development, and given the significant pullback of commodity prices, the Euro, and the Yen earlier yesterday, it now looks like the liquidity crisis has ended or is about to end. Interestingly, and mainly because of the Bear Stearns takeover by JP Morgan (at $2 a share), the “solvency issue” (this is what started the current liquidity crisis in the first place) is now back on the table, even though the subprime story is now mostly saturated. Many are now asking: Given the severe discount in the offer price from JP Morgan, what does this say about the balance sheets of other primary dealers, such as Lehman Brothers, Merrill Lynch, Citigroup, and Goldman Sachs?
My take on this is that the $2 a share price does not mean much from a solvency standpoint. In such a short timeframe, the only offer that had any validity was the JP Morgan offer – meaning that JP Morgan was essentially naming the price. More importantly, the price of JP Morgan common stock rose 10% earlier yesterday – resulting in a $13 billion increase in the market capitalization of JP Morgan (equivalent to about $100 for each common share of Bear Stearns). If the balance sheet of Bear Stearns was really a wreck, there is no reason to believe the Bear Stearns takeover would have added much value (note that its building was only worth $1.5 billion) to the market cap of JP Morgan earlier yesterday, especially given the severe weakness in the broad market and in particular, the financial sector. Given that Bear Stearns, out of all the NY Fed’s primary dealers, had bought the riskiest and most toxic tranches of subprime mortgage debt, it is also reasonable at this point to believe that the balance sheets of all the 19 primary dealers still remain sound. Hopefully, the Goldman Sachs and the Lehman Brothers earnings calls – before the market opens later today – will shed a little more light on the issue.
In terms of yesterday’s action, it is to be noted that the daily equity put/call ratio hit a reading of 1.35 – a record high (using data extending back to January 1997). The last time the daily equity put/call ratio hit a similar high was March 28, 2003, when it hit a level of 1.32. These are the only two instances in history where the daily equity put/call ratio had hit a high of over 1.3. Moreover, the 10-day moving average of the equity put/call ratio is now at 0.97 – also the highest level in the history of this indicator.
At this point, many Wall Street analysts, ratings agencies’ models, and prices of mortgage-backed securities have already priced in a general housing price decline across the country of at least 10% over the next 12 months. However, the sense (as articulated by Alan Greenspan in a Financial Times opinion article earlier yesterday) is that until housing prices stabilize, both the stock market and the economy will continue to at the very least “tread water” for the foreseeable future. Given the lack of direct intervention by the Administration and Congress in the housing markets so far, my sense is that any slight reversal in their housing policies will dramatically reverse the bearish sentiment on U.S. asset prices and the U.S. economy that is prevalent in the global financial markets today. We are already seeing some of that – as the OFHEO is getting ready to lift a significant part of the 30% “penalty surplus capital” requirements on both Freddie Mac and Fannie Mae – a restraint that was not previously supposed to be discussed until next month (and only then to be lifted gradually). Moreover, there is also reason to believe that a substantial recapitalization ($5 billion to $10 billion) of Washington Mutual could occur as soon as the next two weeks – thus injecting further liquidity into the mortgage markets over the next several months.
The NY Fed “liquidity put” – combined with substantial bearish sentiment among retail investors and inevitable support in the housing markets – is a signal that the bottom has occurred or is close at hand. Coupled with the inevitable rate cut of at least 100 basis points in the Fed Funds rate later today, this would go a long way towards reliquifying the balance sheets of both commercial and investment banks alike – not to mention the fact that it will prop up balance sheets (thus resolving the “solvency issue” once and for all) in the long-run. Three months from now, many investors will look back, with hindsight, and recognize that this was the point to load up on U.S. common stocks. Here at MarketThoughts, we continue to be strongly confident of our 100% long position in our DJIA Timing System.
Henry To, CFA