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Credit Crisis Developments Explained - China Cut Short-Term Interest Rates

Stock-Markets / Credit Crisis 2008 Sep 15, 2008 - 05:08 PM GMT

By: Fredrick_William

Stock-Markets There appears to be a good deal of opacity in what the Fed has said on Sunday regarding a broadening of the collateral it is willing to hold on short-term emergency loans to primary dealers. The exotic financial instruments created this week-end by the Fed are very difficult to price. The effects are less contained than in the past and they are larger given that they emanate from the subprime crisis and directly affect the net worth of households.


Moreover, a similar housing crisis appears to be growing in England, Ireland and Spain and much of Europe is moving toward recession, as is Japan. Even China cut short-term interest rates overnight for the first time in six years, which underscores how concerns over problems in the U.S. are impacting economic policy worldwide. Inflation is no longer a major concern to the fed with oil and other commodity prices falling, this is fortunate as it is apparent the Fed will do whatever it takes to calm financial markets.

The commodity price declines continue to drive down materials and energy stock prices – perhaps now is the time to start nibbling on select entities that dwell in the tangibles such as gold; when the pendulum swings back towards tangibles in the wake of this new debasing of the US government balance sheet the move could be furious and the deals are out there now. In light of the turmoil and damage going on now, US$1,000/oz gold is likely to become reality by the end of 2008.

The latest developments of the US Fed will have far reaching implications that are difficult to understand just what the longer term cascading effects will be. There appears to be a good deal of opacity in what the Fed has said regarding a broadening of the collateral it is willing to hold on short-term emergency loans to primary dealers. The global media is reporting that “In an obscure but highly important announcement late Sunday evening, the Fed said it would let Wall Street firms post as collateral much riskier assets including equities, junk bonds, subprime mortgage-backed securities and even whole mortgages – in exchange for emergency loans through the Primary Dealer Credit Facility (PDCF)."

Before the Fed 's announcement on Sunday, investment banks could pledge as collateral any kind of "investment grade" debt securities, which meant securities rated BBB or higher and included many securities backed by subprime mortgages.

According to our review of Fed press releases, exactly what the Fed said was "the collateral eligible to be pledged at the PDCF has been broadened to closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks ". The markets are scrambling for the precise meaning of this statement. In addition, it is unclear just how much in the way of high-risk collateral the Fed would be willing to accept. The central bank said it would broaden its list of eligible collateral to "closely match" the practices of the" tri-party” overnight lending facilities run by two major clearing banks - JPMorgan Chase and Bank of New York. Those programs allow about 15% of their collateral to be in equities or debt that is below investment-grade, and most of that is reserved for equities.

Many are quite concerned that the Fed is debasing its balance sheet, providing extraordinary volumes of liquidity to help prevent a freeze in credit. The Fed, in agreeing to loosen terms under which it lends money to firms, is potentially putting more taxpayer money at risk. A quick look at the Fed' s balance sheet today compared to one year ago shows that holding of U.S. Treasuries have fallen from 91% of its Reserve bank credit to only 54% today. In place of these triple-A government bills, bonds and notes has been the assets taken on the Fed' s balance sheet in the $261.8 billion in collateral in repurchase agreements and term auction credit. Most of that would be Treasuries and very high-quality debt, but we know that at least $29 billion is in mortgage-backed securities assumed to coax JPMorgan Chase to buy Bear Stearns.

The PDCF has not been used in recent months after a surge in March and April immediately following the Bear Stearns takeover. How much will be used in coming weeks is uncertain, but to the extent the Fed does take lesser-quality assets onto its books, the potential for losses (or, I suppose, gains) does become meaningful. The Treasury and the Fed made it very clear on Friday evening that there is no political will for a federal bailout of Lehman. Although this caused Barclays and B of A to walk away from Lehman, it encouraged John Thain at Merrill to seriously consider a takeover by Bank of America. This is great news for the markets because it took Merrill off the critical list. In the end, the government succeeded in getting Wall Street to create its own insurance policy.

The Fed is willing to be flexible in other ways as well. For example, if Bank of America completes its acquisition of Merrill Lynch, its capital reserves would immediately fall below the minimum requirements for bank holding companies. The Tier One capital ratio of B of A will fall to around 7.4% (from 8-1/4% currently). Regulators, including the Federal Reserve, would have to show lenience for as long as it takes the capital markets to regain their confidence - which might be quite a while. The Tier One capital ratio fell even more when B of A bought LaSalle bank.

By Fredrick William

MarketEquitiesResearch.com

Sept 15, 2008 – 8PM GMT/Market Equities Research Group

Fredrick William, Senior Financial Editor, fwilliam@marketequitiesresearch.com Market Equities Research Group, MarketEquitiesResearch.com

This article may contain forward-looking statements regarding future events that involve risk and uncertainties. Readers are cautioned that these forward-looking statements are only predictions and may differ materially from actual events or results. Reports herein are for information purposes and are not solicitations to buy or sell and of the securities mentioned. Full terms of use http://www.marketequitiesresearch.com/disclaimer.htm online.

Fredrick William Archive

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