True leadership may have finally emerged to resolve the subprime crisis, although it was difficult to spot during a tumultuous week at the Federal Reserve.
On Dec. 11 the Fed cut interest rates by 0.25 percent. The Dow Jones index, disappointed in what was another effort by the Fed to claim to be both on top of inflation and the crisis in the credit markets, fell nearly 300 points.
By 6:30 p.m. EST that night, "sources close to the Fed" suggested that banks would be able to borrow money from the Fed directly at rates set through an auction, rather than the discount rate set by the Fed.
This was confirmed the next morning at around 8:13 a.m. EST, minutes before futures trading resumed, together with an announcement that foreign central banks, effective immediately, would be allowed to engage in currency swap agreements with the Fed.
The immediate interpretation was that the Fed was now so data-dependent that a 300 point drop in the Dow would cause it to intervene; announcing such a move after the market closed on a day when the market closed on its lows seemed targeted at punishing those who short the markets.
Given that this was the fourth time in as many months that Fed action whacked short sellers, criticism that the Fed intervenes in free markets, rightfully so, flared up.
Before we elaborate on what the implications of the new policies are, we need to look at another chain of events.
About a minute before the Fed announced its decision on interest rates, Citigroup announced it had chosen a new CEO, Vikram Pandit. Mr. Pandit, himself relatively new to Citigroup, has a reputation of being extremely smart but not particularly charismatic.
The timing of the announcement seemed very odd. That same night, the Fed had decided to introduce its new auction facility; again, the timing was puzzling. Two days later, Citigroup announced it is moving $49 billion of off-balance sheet special investment vehicles (SIVs) onto its books.
In our analysis, there is only one reasonable explanation: These events are all linked. To understand why we come to this conclusion, one must understand a little bit more about the credit markets in which SIVs operate.
Traditionally, the SIVs depended on money-market funds for funding. Money market managers are notoriously risk averse; once those managers realized that asset-backed commercial paper and related mortgage-backed securities are not risk-free, even when AAA rated, they did not want anything to do with them.
Attempts to create a "super-SIV," as promoted by Treasury Secretary Paulson, were doomed to fail because the buyers were gone for good. That doesn't mean that no one wants to touch these papers, just not money-market managers.
However, other, potential buyers want to be rewarded for the risk they take on by offering substantially lower prices.
The financial industry had been fighting this day of reckoning, hoping the problem would somehow go away. That's also the main reason we have been critical of the Fed rate cuts: This wasn't a liquidity problem, this has been a valuation problem all along. While lower interest rates would typically help in a crisis, it doesn't help when those affected have an enormous disincentive to allow price discovery to take place.
The disincentive is that price discovery may cause an extreme strain on major financial institutions, enough to seriously disrupt the world financial system.
One of the bottlenecks has been that SIVs cannot go to the Fed to ask for money. Unless a clause in the Fed's charter is invoked that, to our knowledge, has never been invoked, only banks can do so. By being "off balance sheet," SIVs are in an extremely tight spot.
Add to that a sense of urgency: A lot of institutions roll their debt at the end of a year, or early in a year. Given how the holidays fall this year, liquidity in the best of markets is likely to dry up at noon London time on Dec. 21.
Stressing that this is our interpretation, without first-hand knowledge, it seems clear to us that Vikram Pandit went to Citigroup's board and told them that the right thing to do is to take the SIVs onto Citigroup's books. That way, the bank can ask the Fed to help with any interim financing should the need arise.
More importantly, by being on the books, Citigroup provides an urgently overdue mechanism for price discovery. On the books, the securities can be sold to risk-friendly investors. Free markets ought to have a mechanism for price discovery; this move may be the catalyst.
It also explains why the Fed announced the new auction facility the same night. Rather than trying to yank the markets, the Fed likely lived up to its promise to provide immediate support. There is no time to be lost given the huge amounts involved and the little time left in the year.
There's only one item that does not fit into the chain of events: Why would Goldman Sachs upgrade Citigroup as a result?
We are not giving an investment recommendation on the stock, yet the fact that Citigroup swallowed a tough and necessary medicine does not mean the share price should go up.
It has been widely reported that Citigroup's capital base is getting stretched by moving the SIVs onto the books. Citigroup must raise further capital to retain its flexibility.
Given the ownership structure of Citigroup, a common stock issuance is a likely avenue, unless Saudi Prince Alwaleed provides money through a preferred or convertible stock offering; other avenues may upset the largest Citigroup shareholder as it would further unduly reduce his rights.
No matter how Citigroup intends to shore up its capital base, such a move is likely to negatively impact the share price.
Also note that while we believe that it is good news for the financial system that we are on the way of finding a mechanism for price discovery, we are at the beginning, not the end, of the process.
Other financial institutions must follow suit, and prices must be adjusted downward, and radically so.
Those still under the illusion that we can get through this crisis without losses will need to learn faster if they want to survive. Citigroup under its new leadership seems to know what the stakes are, and seems to show leadership in addressing its problems.
A couple more comments on the new auction facility.
If our understanding is correct, it allows banks to set interest rates, similar to the way interest rates are set at Treasury auctions. If banks collude, they got themselves not a 0.25 percent interest cut, but an interest cut exceeding 2 percent.
The window also seems to be open-ended, providing as much liquidity as the market might demand. Another feature could be that the money obtained from the Fed cannot be added to banks' reserves, that is, the banks cannot leverage on that money to make new loans.
This lack of multiplier may force the Fed to provide enormous amounts; the collateral would then also sit on the Fed's books.
While the Fed has a blank checkbook for political purposes, it would look bad if the Fed owns over hundred billion in subprime paper that banks have offloaded to them. The criticism that you and I may want to give the Fed our old snowmobile in exchange for cash is well-placed.
The other major announcement by the Fed affected a deal worked out with central banks around the world to provide a currency swap facility. This is something that financial institutions outside of the U.S. have desperately sought.
If a European bank owns U.S. subprime paper, they ask for euros from the European Central Bank (ECB). While the ECB has been very forthcoming providing euros, U.S. dollars had been hard to come by.
This new facility will provide enormous short-term relief to many SIVs in Europe. There, just as in the U.S., the primary concern is refinancing obligations late this year and early next year.
We saw the U.S. dollar stage a significant rally last week. It is always difficult to pinpoint the reasons for short-term currency moves. But we would not be surprised if the new swap facility allowed pent-up demand by SIVs to buy U.S. dollars to be satisfied; this may have been amplified by profit taking of speculators.
Our outlook for 2008 remains unchanged, but the turmoil in the credit markets may well contribute to additional volatility in all markets.
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