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Extradry Martini

Why This New Central Bank Solution Is Nothing New

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To begin with, it is worth defining the problem, and this is that the banking system is in a vicious circle: Having been forced to lend to institution and securities which were previously financed by investors, banks’ balance sheets are at the maximum allowed by Basle rules. The price of credit is falling (way below any rational valuation), which means that the banks have to take losses which reduce their capital. In order to comply with Basle rules (which limit balance sheet sizes to a multiple of capital), they have to reduce the size of their balance sheets. This means that they sell banking assets – i.e. credit assets – which means that the price of credit falls further. And investors, irrationally but understandably, will not buy until prices stop falling.

In the meantime, banks become less and less able to lend to customers – and at some stage, unless the cycle is broken, banks will not be able to lend to anyone.

Ok, the reason why the Fed measure doesn’t solve the problem is that, like all previous measures, it doesn’t make it any easier for the banks to lend - it just makes it easier for them to borrow. In other words, it allows banks to finance themselves, not to finance anyone else.

A proper solution is one which breaks the vicious circle and ends up ultimately with investors buying again and prices of credit returning to a semblance of normality. Among these would be (not in any order):

1. Relaxation of mark-to-market rules - not a big help, but it would at least stop banks having to deleverage further.

2. Relaxation of Basle rules – would do the trick as long as don’t mind too much about the moral hazard implications

3. The setting up of a government guaranteed, self-funded unit (much like Resolution Trust Corp during the Savings and Loans crisis) to buy credit in reverse auction. This would work and would greatly encourage investors back in.

4. Allowing those outside the reserve bank system to access the Fed TAF and TSLF windows. This would enable hedge funds to arbitrage out credit prices and would instil enough stability to bring back “real money” investors.

In my view, the last two (or one of them) would be the most effective measures. In the meantime, you can view the latest measures as being just a bigger version of previous measures – and the problem with the previous measures was not that they weren’t big enough. Someone said to me a few days agao that they wished that the Fed came up with something other than a “band-aid” to put on this wound. Well the Fed has just gone a got a bigger band-aid from the box.

So, a good opportunity to get short stocks and long government bonds again…..

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I thought that the intent behind your 3. and 4. was essentially what they had done. By expanding the range of assets to include agency bonds ...banks and others holding the agency bonds can restore their liquidity and thereby avoid the firesale of assets and maintain prices across the market. And that this applied to hedge funds so that they were no longer reliant on the banks freeing up their new found liquidity to them.

No, it doesn’t matter how much the Fed lends the banks, nor how, if the banks are unable to lend that money on.

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So, a good opportunity to get short stocks and long government bonds again…..

I understood everything but the conclusion, I think. :-)

One question I have relates to the Basel-2 rules. From my simplistic perspective, they were arbitrary political choices - which suggests to me (with my naive hat on) that the rules could be changed at will. Can anyone comment on what would actually be required to change the Basel-2 rules, and how long that might take?

Edited by A.steve

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To begin with, it is worth defining the problem, and this is that the banking system is in a vicious circle: Having been forced to lend to institution and securities which were previously financed by investors, banks' balance sheets are at the maximum allowed by Basle rules. The price of credit is falling (way below any rational valuation), which means that the banks have to take losses which reduce their capital. In order to comply with Basle rules (which limit balance sheet sizes to a multiple of capital), they have to reduce the size of their balance sheets. This means that they sell banking assets – i.e. credit assets – which means that the price of credit falls further. And investors, irrationally but understandably, will not buy until prices stop falling.

In the meantime, banks become less and less able to lend to customers – and at some stage, unless the cycle is broken, banks will not be able to lend to anyone.

Ok, the reason why the Fed measure doesn't solve the problem is that, like all previous measures, it doesn't make it any easier for the banks to lend - it just makes it easier for them to borrow. In other words, it allows banks to finance themselves, not to finance anyone else.

A proper solution is one which breaks the vicious circle and ends up ultimately with investors buying again and prices of credit returning to a semblance of normality. Among these would be (not in any order):

1. Relaxation of mark-to-market rules - not a big help, but it would at least stop banks having to deleverage further.

2. Relaxation of Basle rules – would do the trick as long as don't mind too much about the moral hazard implications

3. The setting up of a government guaranteed, self-funded unit (much like Resolution Trust Corp during the Savings and Loans crisis) to buy credit in reverse auction. This would work and would greatly encourage investors back in.

4. Allowing those outside the reserve bank system to access the Fed TAF and TSLF windows. This would enable hedge funds to arbitrage out credit prices and would instil enough stability to bring back "real money" investors.

In my view, the last two (or one of them) would be the most effective measures. In the meantime, you can view the latest measures as being just a bigger version of previous measures – and the problem with the previous measures was not that they weren't big enough. Someone said to me a few days agao that they wished that the Fed came up with something other than a "band-aid" to put on this wound. Well the Fed has just gone a got a bigger band-aid from the box.

So, a good opportunity to get short stocks and long government bonds again…..

Interesting ideas...3 and 4 look better than t'others but 4 is pretty radical IMO.

Can investors really be encouraged 'back in' when real US interest rates are negative?

What are the medium term inflationary consequences of the above?

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I understood everything but the conclusion, I think. :-)

One question I have relates to the Basel-2 rules. From my simplistic position they were arbitrary political choices - which suggests to me (with my naive hat on) that the rules could be changed at will. Can anyone comment on what would actually be required to change the Basel-2 rules, and how long that might take?

No idea I’m afraid, but you are right to say that there is an arbitrary element to them. They are there really in attempt to limit systemic risk (where banks fail because another has failed), but they don’t cover contingent demands on a banks balance sheet (such as stand-by or revolving credit facilities to the banks customers or vehicles), which is why banks have their balance sheets so tied up now.

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I love the hyperbole with which bloomberg et al try and over blow the powers of the fed. In janurary the ECB "injected" 500bn when it really just rolled over most of that. The headline says $200bn and then the article says $45bn. The only real news here is a new facility to accept AAA mortgage debt from fannie mae (ie. not the subprime stuff which is now cents on the $) also only for 28 days. Note they also simply exchange mortgage debt for liquid treasuries to there is only so much an injection of money as they are taking mortgages from the banks for the 28 days. There is no real net injection of funds, and if the mortgages turn out worthless the banks still have to stump up the cash in 28 days.

(was posting this on the news topic but seems to of got deleted)

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Interesting ideas...3 and 4 look better than t'others but 4 is pretty radical IMO.

Can investors really be encouraged 'back in' when real US interest rates are negative?

What are the medium term inflationary consequences of the above?

Much of this stuff is trading at 50% or less of what is genuinely fair valur. It's a steal, but if you are a real money fund manager very hard to justify to to you clients why you bought something at 50 in the middle of all this if tomorrow its at 30... Prices need to stop falling...

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EDM - what's your take on this (shamelessly stolen from Shedfish in another thread)?

http://www.bloomberg.com/apps/news?pid=206...&refer=home

Author seems to disagree with your take on intrinsic soundness of the AAA-rated MBS'?

No, it is talking about sub-prime mortgage backed securities, which are either worthless in the case of cdos or worth very little in the case of abs. What I have been talking about is prime mortgages - i.e. the good stuff. (the difference is very important indeed)

What this piece does bring up which relates to my post above (though I don't know whether it actually mentions it) is the fact that were these sub-prime AAA tranches rated properly, according to basle rules they would have a higher weighting (known as a "capital adequacy ratio") in the balance sheet, which would mean banks having to sell more assets etc...

Edited by Extradry Martini

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I think you missed one solution

5 Let the market do it's job

Which is what will happen in the end anyway.

No, because this vicious circle unless broken leads to all banks going bust and no persons, companies, exporters, suppliers or anybody else having access to finance. It would a collapse not just of the financial system, but of the entire world economy. It would make 1931 look easy. I am not joking - this is what is at stake here.

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11 March 2008 11:00am

Since the co-ordinated actions taken in December 2007, the G-10 central banks have

continued to work together closely and to consult regularly on liquidity pressures in funding

markets. Pressures in some of these markets have recently increased again. We all continue

to work together and will take appropriate steps to address those liquidity pressures.

To that end, today the Bank of Canada, the Bank of England, the European Central Bank,

the Federal Reserve and the Swiss National Bank are announcing specific measures.

Bank of England Actions

The Bank has announced a continuation of its expanded 3-month long term repo open

market operations against a wider range of high quality collateral. It applies to scheduled

operations on 18 March and 15 April which were described in a statement released at 11.00am

this morning (see link below).

http://www.bankofengland.co.uk/publication...ws/2008/017.htm

http://www.bankofengland.co.uk/markets/mon...otice080311.pdf

Pressure building and £10Bn added to the pot, although as they are oversubscribed according to

previous 3 month auctions this should all be taken up?

This is a continuation of the arrangements that applied in the December 2007 and January 2008

long-term repo OMOs. The Bank is taking this action in view of continuing elevated pressures in

short-term funding markets.

In its scheduled long-term repo OMO on 18 March, the Bank will offer £10bn at the 3-month

maturity. The Bank will decide the size of the April operation in the light of the results of March’s operation.

The total size of the March operation will therefore be £11.35 billion.

Edited by maxwell

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The Basle 2 rules are there to more accurately reflect the risks that Banks take on in the amount of capital they have to set aside.

Therefore, prime loans with good asset security have to carry less capital than leveraged loans.

This is a good thing.

The negotiations for the rules were probably less political than mind-numbingly boring.

You can get bored too at www.bis.org

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No, because this vicious circle unless broken leads to all banks going bust and no persons, companies, exporters, suppliers or anybody else having access to finance. It would a collapse not just of the financial system, but of the entire world economy. It would make 1931 look easy. I am not joking - this is what is at stake here.

I think you mistake finance for capital.

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No, because this vicious circle unless broken leads to all banks going bust and no persons, companies, exporters, suppliers or anybody else having access to finance. It would a collapse not just of the financial system, but of the entire world economy. It would make 1931 look easy. I am not joking - this is what is at stake here.

Since you imply that this move is neither new nor a solution, I am thinking that you have joined the doomed mongers camp to the far right of cgnao? B)

I am assuming that when the market has digested this and sold off again, the next move will be to extend this solution more widely,yes?

Or are they leaving it a bit late? An American commentator likened the situation to the film 'The Hunt for Red October', and it feels just like that.

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I love the hyperbole with which bloomberg et al try and over blow the powers of the fed. In janurary the ECB "injected" 500bn when it really just rolled over most of that. The headline says $200bn and then the article says $45bn. The only real news here is a new facility to accept AAA mortgage debt from fannie mae (ie. not the subprime stuff which is now cents on the $) also only for 28 days. Note they also simply exchange mortgage debt for liquid treasuries to there is only so much an injection of money as they are taking mortgages from the banks for the 28 days. There is no real net injection of funds, and if the mortgages turn out worthless the banks still have to stump up the cash in 28 days.
No, it is talking about sub-prime mortgage backed securities, which are either worthless in the case of cdos or worth beet little in the case of abs. What I have been talking about is prime mortgages - i.e. the good stuff. (the difference is very important indeed)

Thanks. Very much obliged, on both counts.

(I realised after posting this that the proximity between these two snippets may create a misleading contradiction apparent in the mind of the reader; that was not the intended effect - and for posterity - should not be inferred)

Edited by ParticleMan

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Agabi and Associates.

Solicitors and Advocates.

5th floor, Unity House.

Lagos.

Dear Mr Ben Bernanke,

I am Mr. paul agabi, a Lawyer by profession. I am the personal attorney to Mr. Bernanke (my client's surname) , a national of your country, who used to work with Cheney Oil Exploration Company in Nigeria, herein after shall be referred to as my client.

My client was a philanthropic man, and through his philanthropic tendencies did enable many children, underemployed men and village elders to buy houses. He did so buy lending them money to buy houses, money which they promised to pay back. These mortgages are now very valuable.

On the 21st of February 2008, my client, his wife and their only child were involved in a car accident along Lagos - Ibadan express road. All occupants of the vehicle unfortunately lost there lives.

Since then I have made several enquiries to your embassy to locate any of my clients extended relatives. This has proved unsuccessful. I came to know about you through an enquiry I was making in the internet, and I found out you shared the same surname with my client, which is why I have decided to contact you, in order to assist in repatriating the money and property left behind by my client before they get confiscated or declared unserviceable by the bank.

Particularly, in a local commercial bank here where the deceased had an account valued at about US$200 billion Dollars in mortgage-backed securities, has issued me a notice to provide the next of kin or have the account confisticated within the next ten official working days.

Since i have been unsuccessful in locating the relatives for over 2 weeks now I seek your consent to present you as the next of kin of the deceased since you have the same last name so that the proceeds of this account valued at US$200 billion Dollars can be paid to you and then you can make use of these valuable assets in exchange for US treasuries for me to continue lending to other honest people on my client's behalf.

I have all necessary legal documents that can be used to back up any claim we may make. All I require is your honest co-operation to enable us see this business through. I guarantee that this will be executed under a legitimate arrangement that will protect you from any breach of the law.

Please get in touch with me by email and send to me your telephone and fax numbers to enable us discuss further about the details of this transaction.

Best regards, Mr. paul agabi.

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No I am not, I mean finance. But what do you care – neither exist as far you are concerned, no? :-)

That's right.

How long do you think it will be after a system collapse that people realise they need real things in the real world to make capitalism work, and not permission slips from the bank of bumwad?

Finance is a means to an end, which has been hijacked by parasites. Bye bye parasites, healthier all around.

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Since you imply that this move is neither new nor a solution, I am thinking that you have joined the doomed mongers camp to the far right of cgnao? B)

I am assuming that when the market has digested this and sold off again, the next move will be to extend this solution more widely,yes?

Or are they leaving it a bit late? An American commentator likened the situation to the film 'The Hunt for Red October', and it feels just like that.

No it's not too late, but they need to get a move on and do something which will actually address the problem.

I don't know what the other guy thinks, but I have no ulterior motive whatsoever. I certainly have never sought to portray a bearish situation for any other reason than I think it likely. My success or failure in my career depends on my finding out as much as I can about what is going on, understanding its mechanics, and deriving the most probable outcomes, and what I write here is an extension of that.

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No, because this vicious circle unless broken leads to all banks going bust and no persons, companies, exporters, suppliers or anybody else having access to finance. It would a collapse not just of the financial system, but of the entire world economy. It would make 1931 look easy. I am not joking - this is what is at stake here.

Why wouldn't fresh money be introduced into the banks capital accounts before they go bust? Surely it is just a case of when the price is right. There might be serious damage done before that stage is reached but usury (now banking) has proven to be pretty resilient since money was first introduced.

p-o-p

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I love the hyperbole with which bloomberg et al try and over blow the powers of the fed. In janurary the ECB "injected" 500bn when it really just rolled over most of that. The headline says $200bn and then the article says $45bn.

Domo - after several rereads - the article refers to the Fed injecting $200bn in concert with European banks (who are injecting a further $45bn). But yes, it's sloppy journalism, given that no cash is being injected at all (Treasuries are being lent) and regardless, "injection" is a contextually misleading-enough-to-qualify-as-outright-innacurate term.

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Why wouldn't fresh money be introduced into the banks capital accounts before they go bust? Surely it is just a case of when the price is right. There might be serious damage done before that stage is reached but usury (now banking) has proven to be pretty resilient since money was first introduced.

p-o-p

Yes absolutely correct - and that is one I left out. Some banks have been re-capitalising (which essentially means selling shares via rights issues) - particularly with sovereign wealth funds (UBS with GIC, Abu Dhabi with Citi) - but the amounts involved so far have not made any tangible difference. A lot more needs to be donw, but much as credit investors are staying out until credit prices stop falling, SWF (or other potential bank investors) are staying out until bank stock prices stop falling.

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No it's not too late, but they need to get a move on and do something which will actually address the problem.

I think your post is spot on and not exagerated in the least but here is something I'd like to submit to you as another angle to the situation: I think there is a game of chicken going on between the banks and the Treasury / Fed.

To resolve the current crisis which is one of under-capitalisation, the banks should by all means recapitalise. The Treasury and Fed have been asking the commercial banks to do just that but they don't want to (dilution of capital, worthless executive options, etc.).

Instead, the banks are proposing to selectively reduce their loan book in a way that will have dramatic consequences for the US. Note that the banks are not desperate: you might have noticed they are still shopping around in Rusia and Asia and extending or increasing loans to their own hedge funds (while making margin calls on hedge funds they don't run).

To a cynic like me the banks' position seems to be: give us a government bailout at the taxpayers' expense (by buying our worthless securities) or we'll put you in recession.

On the other side the government doesn't want to give the commercial banks a free lunch on 'moral' grounds and probably because such theft of taxpayers' money would result in a regulatory backlash that would also hurt the US.

Hence the status quo and today's gimmickery IMO.

For what it's worth I reckon the banks are likely to win this contest.

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  • 292 Brexit, House prices and Summer 2020

    1. 1. Including the effects Brexit, where do you think average UK house prices will be relative to now in June 2020?


      • down 5% +
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      • Even
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      • up 5%



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