The Fed's (long) Term Auction Facility

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

On November 28, 2007 the Federal Reserve started a massive year end injection of liquidity into the financial system. On December 11th, the Fed once again lowered the funds rate a quarter of a point (for a total of 100 basis point drop since the half point cut on September 18th). While neither of these events were extraordinary, what happened the next day was.

On December 12th, the Fed announced the creation of its Term Auction Facility . The TAF program was open to any bank or depository institution, which would be allowed to bid for one-month loans up to the total amount of funds being auctioned off. The winners had a wide-choice of what they could pledge as collateral, including mortgage-backed securities that could not be traded and had no market price. In exchange for their possibly worthless securities, banks and brokers could get cash from the Fed. This new program represented a sea change in Fed operations.

First, the Fed would be offering up sums of money in auctions to banks and depository institutions instead of having them come to the Fed to get a loan. Using the Fed's discount window was usually only done by institutions teetering on insolvency and was carefully avoided by any institution that wanted to preserve its reputation. The Fed finally found a way around this impediment to getting money to struggling banks by offering the money at auction, guaranteeing an injection of liquidity into the system at the amount auctioned off and removing the stigma for those who got the money.

The second major change the TAF introduced was that the Fed was willing to take even worthless paper as collateral for a loan. During its history the Fed usually only accepted treasuries as collateral. With the TAF, it effectively began engaging in subprime lending itself . By doing so, it was bailing out the banks that had foolishly engaged in this practice - and who might have become insolvent if they couldn't get rid of their subprime paper.

When the TAF was announced in December, the original auctions were for $20 billion each. By January 2008, this amount was raised to $30 billion. By March each auction was for $50 billion and two additional Fed lending facilities would be introduced (the TSAF and the PDCF) - breaking even newer ground for Fed operations.

Next: Economic Predictions for 2008

Daryl Montgomery
Organizer, New York Investing meetup

For more about us, please see our web site: http://investing.meetup.com/21

Government Investment Pools Dry Up

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

While the downgrades of the bond insurers threatened U.S. municipalities with higher future interest costs, it became obvious in November 2007 that there were far more immediate risks to public finances when there was a run on Florida's Local Government Investment Pool . The run began when word got out that the Investment Pool had exposure to $1.5 billion in defaulted and downgraded SIVs. Florida had to freeze withdrawals to prevent the fund from collapsing. The municipalities that got out early were lucky, all others had to find emergency funding to meet their payrolls for police, firemen, hospital workers, teachers, and other employees.

Local, State and Government investment pools existed in at least 20 states and were essentially special money market funds that bought short-term debt and were set up to get higher yields that would otherwise have been available. Little did they know that these slightly higher yields were being produced by taking on massively higher risk through exposure to subprime toxic waste that the big brokers (Lehman in Florida's case) were more than willing to sell to them. Problems were by no means isolated to Florida either. In the last days of November, Montana school districts, cities and counties withdrew 10% of the total $2.4 billion in its investment fund after the rating on one of the pool's holdings was lowered to default. The state of Maine had invested 3% of it money, apparently on Merrill Lynch's advice, into a fund only two weeks before its credit rating was lowered to junk status. Financial difficulties with government investment pools were also reported in Orange County, California and Seattle, Washington.

While the losses of the Government Investment Pools were certainly serious, were they isolated of were they likely to spread? If these ultra-sophisticated money-market funds got into trouble, wouldn't it be reasonable to assume that the money market funds open to the individual investor might suffer similar problems in the future? By the late fall of 2007, it had already been reported that Bank of America, SunTrust, Wachovia and Legg Mason had taking steps to prop up money market funds that contained securities of possibly questionable worth. And it looked like the formerly safest of investments were in some cases becoming among the riskiest.

Next: Subprime Freezes Over

Daryl Montgomery
Organizer, New York Investing meetup

For more about the New York Investing meetup, please go to our web site: http://investing.meetup.com/21

Mortgage Insurer Meltdown

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

Bond insurers (Ambac, MBIA, FGIC, XL Capital, ACA, Security Capital) were only one of the many sectors of the financial industry that had gotten themselves into serious trouble by the fall of 2007. While these companies were not large compared to the banks or broker-dealers, they had an out sized impact because they guaranteed most municipal bonds in the United States and the ratings of those bonds couldn't be any higher than the bond insurance companies own ratings. Lowered ratings on bonds would mean higher interest costs, higher insurance costs, and even the possibility of not being able to borrow money for municipalities throughout the country. As with most of the problems created by the credit bubble, the bill would eventually wind up at the doorstep of the American taxpayer. As bad as this was, it was by no means the full extent of the damage that would be caused if bond insurers lost their financial viability.

Bond insurers are also known as monolines because for most of their existence they only operated in one line of business, the low-risk insurance of municipal bonds. That changed however in 1998 when they persuaded New York State regulators to allow them to underwrite high-risk Credit Default Swaps (a type of derivative that is insurance on a bond) on mortgage securities. Other states promptly followed New York's lead. The bond insurers set up shell companies called 'transformers' because they transformed a traditional bond insurance contract into a Credit Default Swap. These swaps in turn allowed investment banks to move commitments off their balance sheets and book profits up front - an accounting illusion that began to implode when the housing market went into decline.

On December 19, 2007, S&P finally downgraded bond insurer ACA from A to a junk rating of CCC. S&P was apparently one of the last to realize that that the company was no longer creditworthy. The company's stock had already fallen to less than a dollar (the price the market sets when a bankruptcy is expected) and had been delisted from the New York Stock Exchange in November, but apparently even that wasn't enough for S&P to give up the fiction of its A rating on ACA. Nor did S&P explain why ACA suddenly went from a creditworthy rating to junk status overnight when it belatedly downgraded ACA in December. S&P and the other rating agencies were quite aware of what would happen if they gave the bond insurers realistic credit ratings. Shortly after their downgrade of ACA, CIBC World Markets announced that insurance for $3.5 billion in securities it held backed by subprime mortgages was possibly no longer viable. In other words, the big banks and brokerage houses would be on the hook for all the subprime garbage on (and off) their books and would have to acknowledge it if the bond insurers were downgraded. One could safely presume that there was a lot of political pressure from many quarters to prevent this from happening.

Next: Sovereign Wealth Funds Bail Out the Banks

Daryl Montgomery
Organizer, New York Investing meetup

For more about us, please see our web site: http://investing.meetup.com/21