Author: admin

The UK’s credit guarantee scheme is designed to unclog markets rather than offer banks cheap funding.

The Debt Management Office has announced that the guarantee fee will be 50 basis points per annum plus the median five-year credit default swap spread for the borrowing institution during the 12 months to 7 October. Averaged across banks, this spread is likely to be in the region of 100 bp (see Chart 1.3 in the August Inflation Report), implying a total fee of about 150 bp.

According to Bank of England, the one-year interest rate on unsecured commercial bank borrowing stood at 5.8% late last week, 240 bp above the rate on government borrowing. A fee of 150 bp would therefore allow a significant reduction in banks’ cost of funding compared with recent extreme levels.

Also welcome is that the fee will be not be linked to current CDS prices. As previously argued, the effectiveness of the special liquidity scheme (SLS) has been reduced because it becomes more expensive when LIBOR rates rise – the time banks most need to use it.

However, an all-in cost 150 bp above government borrowing rates still represents expensive funding by historical standards – the differential between one-year rates for unsecured bank and government borrowing averaged 30 bp in the 10 years to mid-2007, before the credit crisis erupted. This suggests the spreads of household and corporate borrowing rates above Bank rate will remain under upward pressure, while banks’ efforts to rebuild capital from retained earnings will be constrained.

The new scheme will be a big earner for the Treasury: 150 bp on an expected £250 billion take-up equates to £3.75 billion per annum. The SLS is likely to generate a further £1.5 billion (based on an assumed average 75 bp fee on take-up of £200 billion), suggesting a total payment from banks to the Treasury / Bank of England of about £5.25 billion pa.

The Treasury statement on recapitalisation plans states that the banks concerned have agreed to maintain lending to homeowners and small businesses at 2007 levels over the next three years. While helpful, this begs the question of why the government is allowing Northern Rock to shrink its mortgage book by £20 billion per annum in 2008 and 2009. Rock borrowers forced to refinance their loans are absorbing a significant portion of other banks’ lending capacity.

In 2002 a colleague suggested I compare the bear market then under way with previous big falls in share prices. The three largest peak-to-trough declines in UK shares over the prior 100 years were 1929-32, 1936-40 and 1972-74. I rebased the respective bull market peaks to the FTSE 100 peak in 2000 and calculated an average of subsequent performance. Smoothing this average generated our “three bears forecast”.

As the first chart shows, the three bears forecast proved remarkably accurate in pinpointing the level and timing of the low in share prices in the early 2000s as well as the tracking the recovery over the subsequent four years.

The second chart decomposes the forecast into its three historical components. The latter began to diverge significantly in late 2007, suggesting the forecast – based on the average – would break down, as it has indeed done.

There may, however, be some life left in this data-mining exercise. As the second chart shows, stocks seem to be following the pattern of the interwar years. The early 2000s bear market tracked the 1929-32 decline while recent falls so far mirror the 1936-40 bear.

The third chart extends the interwar comparison over the next five years. Share prices are now below the historical template, suggesting a near-term rally. An extended plateau is then indicated followed by a final lurch down to a bottom around the levels reached in 2003. A sustainable recovery occurs only in 2011.

The 1936-40 bear market initially reflected a US recession but was extended in duration and magnitude by the onset of the Second World War – the final move down in 1940 coincided with the Battle of Britain. The current financial crisis is momentous but it is hard to believe it represents a threat to the British economy on a par with Nazi invasion.

It would be unwise to place strong weight on mechanical historical comparisons but the suggestion of an imminent base followed by an extended sideways movement is plausible. Valuations are now low – the price to book ratio of UK non-financial stocks is at levels last reached in 1992 – but buyers are likely to be slow to return after the confidence-shattering events of recent months.

The success of the UK banking rescue plan will depend importantly on yet-to-be-announced terms and conditions. The authorities need to strike a balance between protecting taxpayers’ interests and providing some upside for equity holders – necessary to stem the downward spiral in share prices and attract new private sector capital.

A key issue is the fee to be charged by the government for guaranteeing an expected £250 billion of bank debt. As argued previously, the effectiveness of the special liquidity scheme has been reduced by its perverse fee structure. The Bank of England charges banks the spread between three-month LIBOR and the three-month rate on government borrowing. This means the scheme becomes more expensive when LIBOR rates rise – the time banks most need to use it.

The fee charged for guaranteeing debt must reflect the strength of the institution concerned but should not depend on volatile market assessments, such as credit default swaps. One possibility would be to base the charge on the amount borrowed and the credit rating of junior bank debt.

Similarly, the terms of new government-subscribed capital issues should not be unduly onerous. Demanding a Buffett-style 10% yield along with interference in dividend policy and other decisions affecting future ordinary shareholder returns might generate short-term political plaudits but could prove self-defeating.

The £100 billion expansion to £200 billion in the special liquidity scheme does not represent a new initiative, since there was no previous upper limit on banks’ access to the facility. The extension of the definition of eligible securities for the scheme to include new government-guaranteed bank debt also appears of little consequence – it is unclear why banks would wish to pay a fee (charged on top of the guarantee fee) to swap such government-backed paper for Treasury bills of the same credit rating.

Unlike the Fed and the ECB, the Bank of England has yet to allow securities rated lower than AAA to be used as collateral in its money market operations. This may partly explain the undersubscription of its £40 billion auction of three-month funds this week. It is doubtful that the long-awaited plans for a new discount window facility, to be revealed next week, will loosen collateral requirements further.

The one percentage point rate cut in Australia overnight has increased speculation that major central banks are planning to “shock” markets with large-scale and/or co-ordinated interest rate action.

When analysing past interest rate decisions in order to construct the MPC-ometer, I found the MPC had behaved unusually following the 9/11 terrorist attacks, cutting rates earlier and by more than suggested by economic and financial data. This was counterbalanced by a less dovish stance than warranted by incoming news in later months. I accommodated this behaviour in the model by including a 9/11 “dummy variable”.

Escalating financial turmoil in recent days risks damaging economic confidence in a similar way to the 9/11 attacks, suggesting the MPC will again choose to bring forward easing as insurance against a worst-case scenario.

In terms of the MPC-ometer, this can be analysed by “switching on” the 9/11 dummy variable. Using the model to predict this week’s decision based on the current level of Bank rate, the forecast then changes from a quarter- to a half-point cut. If three-month LIBOR is used instead of Bank rate, a three-quarter point move is predicted.

If the post-9/11 period is a guide, however, any shock move this week will represent a shift in the timing of MPC action rather than implying a lower ultimate level of official rates.

A week ago most economists thought it was too early to cut rates. Now there will be disappointment with a half-point reduction.

My MPC-ometer model has been suggesting an October rate cut for several weeks and recent data have confirmed the forecast. According to Reuters, only 21 out of 66 economists projected an October move in a Reuters poll last Wednesday but opinion had shifted by the end of the week, with 49 respondents expecting a cut, of which four forecast a half-point reduction.

The MPC-ometer was designed to answer the question “How will the MPC vote given incoming data and the current level of Bank rate?” Used in this way, the forecast is for either a 7-2 vote for quarter-point cut this week or – more likely – 1-5-3 (Blanchflower voting for a half-point again).

The trouble with this approach currently is that the model is unlikely to capture fully the impact of the seizure in money markets on the MPC’s thinking. One way of addressing this is to change the question to “How will the MPC vote given incoming data and the current level of three-month sterling LIBOR?” On this basis, the model predicts a unanimous vote for a cut and an evens chance of a half-point reduction. (This is based on today’s 6.27% three-month LIBOR fixing.)

Another issue is that the Committee will have an early look at the September CPI figures, which may show annual inflation moving above 5%. This would have a small effect on the above forecasts but a quarter-point cut would still be odds-on even using the model in the normal way.

While several MPC members may vote for 50bp, I suspect a majority will prefer a quarter-point cut with a follow-up move next month. Current economic risks stem less from the price of money than the complete breakdown in the plumbing of the financial system, a problem better addressed by direct official intervention, including the Bank of England intermediating money and credit flows – see previous post.

Federal Reserve Bank credit – the Fed’s aggregate lending to the banking system – rose by an unprecedented $219 billion, or 22%, in the week to last Wednesday. This reflected increases in currency swaps with other central banks, lending to banks to finance purchases of asset-backed commercial paper, primary dealer and other broker-dealer credit and the AIG loan.

The annual growth rate of Fed credit is now 32%, exceeding the levels reached at end-1999, when the Y2K computer scare led to a precautionary dash for cash, and after the 911 terrorist attacks, which temporarily disrupted the payments system – see first chart.

A key issue is whether the Fed will fully sterilise the impact of its increased lending on the monetary base (i.e. currency in circulation and bank reserves held with the Fed) – failure to do so would amount to “printing money”. As the chart shows, monetary base growth also rose sharply last week but this may reflect the technical difficulty of sterilising such a large injection immediately.

The short-term rise in bank reserves has pushed the actual level of the Fed funds rate well below the 2% target – see second chart. This amounts to an effective easing of policy, albeit possibly temporary.

While the jury is out, I doubt the Fed is yet ready to embark on an explicit policy of expanding the monetary base. Unlike Japan before its adoption of “quantitative easing” in 2001, the US still faces inflationary rather than deflationary risks. Flooding the banking system with reserves would risk a collapse in the dollar and a sharp rise in Treasury yields, exacerbating current financial difficulties.

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COMMENT:
AUTHOR: EQ
EMAIL: equityquant@gmail.com
IP: 72.134.107.223
URL:
DATE: 10/01/2008 02:26:13 PM

Simon, can you expand on the comment re sterilization? ie, How would the Fed sterilize this move specifically? And what data would we look for at the Fed site to confirm it? Thanks for sharing.

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COMMENT:
AUTHOR: Joafro
EMAIL:
IP: 83.227.207.149
URL:
DATE: 10/02/2008 05:28:03 PM

If I read the "sloshreport" correctly, the FED has drained capital the latest weeks week:
http://www.gmtfo.com/reporeader/OMOps.aspx
How will that be inflationary? And remember that this is all loans. Loans are deflationary because it comes with interest. As long as they keep it that way they are not printing in my view. Am I correct or am I totally misunderstanding this?

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COMMENT:
AUTHOR: Simon Ward
DATE: 10/03/2008 03:30:58 PM

The Fed sterilises the impact of increased lending on bank reserves by selling Treasuries, reducing its conventional repo lending or conducting reverse repos. These can be monitored on a weekly basis in the Fed’s H.4.1 release, along with banks’ reserve balances at the Fed. The latter have risen from $82 billion to $171 billion over the last fortnight, indicating incomplete sterilisation. It remains unclear whether this is temporary or reflects a deliberate policy shift.

As I understand it, the "Slosh Report" site covers only a sub-set of influences on bank reserves, e.g. it omits the impact of the recent huge expansion of currency swaps as well as the AIG loan. The Fed’s H.4.1 is comprehensive although only available weekly not daily.

Central banks are assuming the role of clearing houses for interbank business. Instead of bank A borrowing directly from bank B, A now accesses generous official credit facilities while B places its excess cash on deposit with the central bank. The new role should ease pressure on the banking system but may prove difficult to reverse.

The latest Fed balance sheet figures illustrate the change. Reflecting various new lending initiatives, total Fed credit rose by $503 billion, or 51%, in the fortnight to Wednesday. Meanwhile, banks with excess cash placed an additional $90 billion on deposit at the Fed and are likely to have taken up part of the recent increase in Treasury bill issuance, with the Treasury onlending the proceeds to the central bank.

The Fed’s increased willingness to extend credit amounts to an implicit guarantee on interbank liabilities. Any bank unable to refinance its wholesale borrowing can bridge the gap using official facilities. In theory, the Fed is protected by collateral requirements but these are now loose and the value of the security in any fire sale is highly uncertain.

The combination of the Fed’s expanded intermediation role with an increase in deposit insurance from $100,000 per account holder to $250,000 implies the US authorities now stand behind the bulk of the banking system’s liabilities. The Irish government has been criticised for introducing a blanket guarantee of its banks’ borrowings but the effect of recent US actions is similar.

Having resisted using its own balance sheet, the Bank of England is finally emulating Fed-style intervention. Its total assets rose by £69 billion, or 58%, in the fortnight to Wednesday. The Bank today announced a further loosening of its collateral requirements for its weekly auctions of three-month funds to include asset-backed securities based on consumer and corporate loans and asset-based commercial paper.

My ECB-ometer model suggests a 37% probability of a rate cut this week, up from 34% last month. See chart.

Assuming no change in the inputs, a reduction before year-end is now viewed as almost certain.

The further move towards easing territory reflects falls in business confidence, inflation expectations, M3 growth, short-term bond yields and stock markets. The main factor holding the model back from predicting a cut this week is the absence to date of any explicit dovish signal from ECB President Trichet.

The statement issued after tomorrow’s meeting is likely to refer to diminishing upside inflation risks and / or increased downside growth risks, giving a clear hint of a move in November or December.

I shall post the MPC-ometer forecast on Monday but initial indications are consistent with my expectation of a rate cut at next week’s meeting.

Detailed monetary statistics for August released by the Bank of England yesterday suggest a further deterioration in near-term economic prospects. In particular:

• M4 excluding money holdings of financial corporations rose by 5.4% in the year to August, the lowest annual growth rate since 2000 and barely higher than retail price inflation of 4.8%. The increase in the three months to August was just 3.3% annualised.

• Narrow money M1, comprising currency holdings and sight deposits, was 0.6% lower in August than a year before, the first annual decline since 1969.

• M4 held by private non-financial corporations (PNFCs) fell for the fifth month out of the last six and is now down 2.8% from a year ago. With bank lending to PNFCs continuing to rise, the corporate liquidity ratio – money holdings divided by borrowing – reached its lowest level since 1991.

• Public sector deposits with UK banks rose by £18 billion in August, offsetting a £16 billion decline in interbank deposits. There may be an innocent explanation but this suggests covert official support for one or more struggling banks.

M4, M1 and the corporate liquidity ratio are inputs to my recession probability model, designed to estimate the chances of an annual decline in GDP three quarters ahead. Also taking into account recent upward pressure on unsecured interbank interest rates and credit spreads, the model now suggests a 55% chance of an annual fall in GDP by the second quarter of 2009 – see first chart.

While above 50%, the probability estimate is still significantly lower than the 80% plus levels reached before the last three recessions. The model projects an annual GDP decline of 0.2% in the second quarter of next year, implying a stagnant or mildly contracting economy rather than a full-scale downturn – see second chart.

According to the model, the outlook is less negative than before prior recessions because of a smaller rise in interest rates and the large fall in the effective exchange rate over the last year, which will support net exports. The latter effect is already evident: trade contributed 0.5 percentage points to GDP growth between the fourth and second quarters.

Incidentally, revised GDP figures released today support my view that the economy had not entered a recession before recent financial eruptions. Excluding volatile oil and gas production, output edged 0.05% higher in the second quarter. Available evidence suggests activity remained broadly flat in July and August.

Unsecured interbank lending rates have shot up in the wake of the multiple financial shocks of the last fortnight.

In the US, banks can partially offset the impact of rising unsecured rates on their average cost of funds by increasing their borrowing from the Fed’s discount window (or “primary credit facility”). Cash is available for up to 90 days at an interest rate of 2.25% (a 25bp premium to the Fed funds target rate) versus today’s three-month dollar LIBOR fixing of 3.77%. While borrowing is secured, collateral rules are loose, with mortgages, corporate securities and asset-backed commercial paper eligible.

UK banks are at a disadvantage to their US counterparts because there is no equivalent Bank of England credit line. The Bank’s version of the discount window is its “standing lending facility”, which offers overnight funds at 1% above Bank rate against only the highest-quality collateral. The facility has remained unused throughout all of the last year’s financial calamities. The Bank has promised reform of its money market operating arrangements but it is unclear how the SLF will change.

The Bank’s alternative to the Fed’s generous discount window is the special liquidity scheme, under which banks can swap lower-quality collateral for newly-minted Treasury bills. These bills can then be used to obtain cheaper secured funds in the gilt repo market. However, banks must pay the Bank a fee equivalent to the spread between three-month LIBOR and the three-month gilt repo rate. The SLS improves liquidity but banks still end up paying LIBOR to raise funds. By contrast, the Fed’s lending both boosts liquidity and reduces average funding costs.

The Fed effectively creates money at the 2% Fed funds rate and lends it out via the discount window at 2.25%, earning a 25bp margin. The Bank of England is raking in much larger profits from the SLS, with the spread between three-month LIBOR and the three-month gilt repo rate ranging from 50bp to the current extreme 150bp since the scheme’s inception. Assuming average usage of £200 billion in the first year at a spread of 75bp, the Bank will earn £1.5 billion or £4 million a day.

The Bank argues that the current fee structure is necessary to avoid subsidising banks. However, this assumes LIBOR is a valid price determined in functioning markets by rational agents – clearly not the case at present.

Any bank using the SLS to obtain collateral and raise funds this week will lock in current high LIBOR borrowing costs for three months. Only those in severe difficulty are likely to accept such terms. By design, the scheme becomes more expensive precisely when banks need it most.

Two modest changes to address these deficiencies would be: 1) base the fee on the average LIBOR / gilt repo rate spread over the following three months rather than its starting level; and 2) set a maximum of 75bp (there is already a floor of 20bp).

Such modifications would probably have little impact on LIBOR itself but would partially relieve upward pressure on banks’ funding costs and, by extension, household and corporate borrowing rates.