Crisis Note 2007-2:  Rate Cuts Will Not Work


Even though I'm no longer an official research geek, I want to clarify that WHAT FOLLOWS ARE MY OPINIONS, AND NOT THOSE OF CANTOR FITZGERALD. What I'm going  to say below is mostly speculation. But, I don't think its any worse than the stuff that is blathered about on CNBC, and its more out on a limb, which may be interesting to some.

One of the big mysteries of the past 2 weeks is why there has been no activityat the Fed's discount window, in spite of the much-heralded discount rate ratecut. Apparently, 4 banks each took out 500mm, but also prefaced it by saying they did not need it. Other than these 4, apparently 1 other institution borrowed 1mm.

I have a cynical (and sinister) speculation: they don't have the balance sheet to use additional funds.

I'm of the belief (no hard evidence, just inference) that the balance sheet leverage of the large banks is maxed out and being limited by their capital ratios - ie risk based capital requirements. And this is because of private equity bridge and equity lending, and also MBS/ABS loan pipelines that they got caught with. All of these should be 100% risk weighted, each tying up 8% ofcapital, and limiting the ability to leverage their balance sheets.

And this is why, a Fed Funds rate cut, which is what the market is almost universally, to a man or woman, praying for, to bail out this terrible market, WILL NOT WORK. It does not matter how cheap money is, it could be at 0%, if they don't have the balance sheet leverage capability to use it, most investment banks will not be able to run a carry trade with it to bail themselves out.

What's needed is a Reserve Requirement Cut.

There. I've gone out on a limb. What's a cut in Reserve Requirements? I wish I still had my old Macro Economics textbook, but my amoebic former boss at Morgan Stanley never returned it when I chose to depart his servitude. Anyway, here's the official explanation:

A cut in this will allow banks to lend more and increase the size of their balance sheets. It will also lead to a drastic expansion in money supply, and will probably lead to inflation. Whats better, inflation or deflation? Thats a decision for Big Ben.

'What about the inflation that will result', sceptics will say, 'thats why he Fed wont do this'.

Well, how about RAISING the Fed funds rate simultaneously. Now, I'm not only out on a limb, but over a precipice!

The reserve requirement cut will allow banks to find the balance sheet for all the trillions in excess assets that we've created over the past 5 years. And the RATE RISE, will help dampen inflation, and also allow Mrs Watanabe (and thehedge fund community) to happily continue shorting the yen to support our stockmarkets. This will defer the yen carry trade liquidity problem for some time, and allow the central banks of the world to deal with it later. In fact, it may allow the BOJ to raise rates, as its been hinting it wants to do.

On a slightly different note, while we are talking about excess assets, one of the more interesting things thats come out of the liquidations and bid lists ofthe past 2 weeks has been the unearthing of what I consider to be the worst AAA  bond(s) currently in existance. To me, this is emblematic of the comment I made in the 8/10/2007 message, namely "the creation of assets to meet the needs of cheap money". In 2006, there was a desperation and competition to get invested by some the hedge funds, money managers, CDOs and SIVs, due to the large numberof people managing money in the space. (This was predicitible for a secondarymarkets specialist like me, you had to try to talk to an ABS pm in 2006 - they were too busy looking at 'new issue' deals to bother with small fry like me trying to add alpha with cheap bonds - buying in volume was what counted).

I refer to SASC 06-2 1A1 and SASC 06-4 1A1 (2 bonds, same structure. I predict legendary status for them, similar to FNR 93-205 H and FNR 93-237 H, call if you don't know what I'm talking about.) There are bound to be others like them buried out there. Write these names down and be careful if you're ever offered these bonds. (Hint: beware of any bond with a PPC curve or pricing speed (likeCPJ) that is different than the convention used for the underlying collateral). AGAIN, this is MY OPINION.

While we're waiting to get through these lists, lets see who can figure out these SASC bonds. Everything you need to know to analyze these bonds is on Bloomberg. Send your explanations to Don't cheat by looking at my prior messages. Winners will be chosen at random from among the correct answers and may get the opportunity to be covered by me.

I bring up these 2 bonds, to make another point: namely that the Fed's decision to allow ABCP as collateral for discount window lending is a REALLY BAD idea, Well intentioned, but naive. They need to learn more about the MBS and ABS game. Thank goodness no one is taking the FED up on it. Those 2 SASC bonds were in a SIV lite that was funded by ABCP, and was forced to liquidate. Had they been in a regular SIV, with a liquidity provider that is a bank, those extended CPs could have been used as collateral.  Do we, as taxpayers, want the bonds like the SASCs as the ultimate collateral for our government's loans to banks? Not me.

So, more SIVs blowing up, ABCP making Yucca mountain look eco-friendly, Yen rallying, stock markets tanking, dead cats bouncing. What's a PM to do? One word: SELL (while you can).

Sorry for the gloomy scenario. I'd love all comments, thoughts, and would love to be proven wrong. Please tell me what I am missing. 

Samir Shah, 8/29/2007