Central Banks Interference...

[Future 10]

http://www.reuters.com/article/hotStocksNews/idUSN0135773520070810

 

What are your thoughts on the central banks pumping cash into the financial system to provide liquidity? What sort of effect does this behavior usually have? How does this provide liquidity? (having some problem fully comprehending this)

 

Thanks!

[Dogpile 10]

heard an inteview on Friday that explained this pretty well.

 

basically the problem is that financial institutions don't trust each other right now. they do not know what securities the other firm is holding and so they question each others ability to act as a counter-party for transactions.

 

think of it like you borrowing or lending money to another trader. you don't know what derivatives he might hold in his account. is he a credit-worthy or not? will he be solvent tomorrow if he has sold a ton of puts and the market gaps down huge?

 

now keep in mind that the financial services industry is highly regulated and you need to hold a certain amount of 'reserves' against whatever it is you hold (just like the margin requirement in your brokerage account -- you can only 'extend' yourself so much). financial institutions basically have to value their portfolio of securities and show what it is worth on a nightly basis (as I understand it) and hold enough reserves against that just like you or I do on a nightly basis with our brokerage accounts. but with such volatility, it is unclear what tomorrows volatility is going to do to the value of your current (complex) portfolio that is valued today (especially due to the huge growth of derivatives).

 

what the fed can do is loan money to a firm that ensures that they can borrow from the fed to carry them for 1 more day. this comes in the form of a 'repurchase agreement' (a 'repo'). The fed basically agrees to buy securities from you for a day and you agree to 'repurchase' them tomorrow. this buys you a little time to weather a near-term storm because you will now have the 'reserves' necessary to not get a margin call. this time, the fed did a 3-day repo because there was the weekend and thus the banks will 'repurchase' the securities on monday by whatever amount they agreed to on friday plus the days worth of interest. Or of course a new repo could be issued by the fed to go another day or more.

 

what this does is allow financial institutions to trust each other again as even if a firm has an exposed portfolio... that firm can just borrow the amount needed to cover the loss of value in order to maintain its reserve requirement. basically, the confidence it builds is the crucial element. it shows that the fed is not going to let a crisis spiral out of control needlessly. if a firm does really blow up and the lack of confidence was justified in the first place, then everyone is really going to panic and we will probably crash -- no matter what the fed does.

 

that is how I understand it... comments by others would be helpful.

[Dogpile 10]

just to make most pertient point: what the fed is trying to prevent is a meltdown that is based only on panic and mis-trust. if there is a true meltdown because a bank has screwed up and is not hedged in the way it thought it was due to bad models -- then this could be very serious problem as it spirals to other banks that did business with the first bank. this was the problem with LTCM in 1998 -- a bad portfolio will blow-up and there is nothing the fed can do except give money away at that point in the amount of loss that the bad portfolio blew up by.

 

the problem could be much more significant today than 1998 given the massive increase in overall derivatives since then.

[torero 10]

Great explanation, dogpile. But is this an unprecedented act? There were other crashes before but the Fed never intervened or is this a one-time deal? Only because real estate sector problem or they think it's expected to move into other sectors?

[Dogpile 10]

<<But is this an unprecedented act?>>

 

repos are not that uncommon. the size of this one though was biggest since aftermath of 9/11.

 

<<Only because real estate sector problem or they think it's expected to move into other sectors?>>

 

I don't know answer to what the fed thinks. Some have postulated that the Fed might have significant information that isn't public that is really bad but containable if there isn't a panic from here.

 

But the mortgage sector has somewhat stopped working properly. There was news on Friday that Countrywide was citing. Countrywides business is to loan money to investors, roll them up into bonds and sell them to investors of such -- bond funds -- then go do it again. But bond funds aren't buying mortgage bonds right now due to a loss of confidence. So Countrywide is stuck with $1 billion in loans that they can't sell. What does Countrywide do? For one, they stop making new loans. So the system kind of halted there last week and the fed had to do something.

 

The real question is how much of this is loss of confidence (perception) and how much of this is just that we are sitting on major trouble. Nobody really knows the answer to this. There is a good argument that home prices are high but not going to freefall from here because the job market is good and defaults therefore aren't going to take off and spiral out of control.

 

All the fed can do is try to inspire confidence among the participants to go back to each doing their role.

 

The doomsday scenario is that something now triggers to cause the US dollar to start to nosedive and all those foreign countries who hold loads and loads of US bonds start to see their portfolios dropping and sell those bonds to get out of the US dollar. This would cause interest rates to RISE more --- which would obviously be a disaster for bond mangers who are already getting increasingly risk-averse. The key is confidence. Confidence between banks, confidence by foreign countries like China in the US system.

 

I was in the business during the last doomsday -- we got nailed with recession, then 9/11 -- then we go through all that and just as you are starting to regain confidence that we will persevere -- the Enron corporate fraud news hits... the doom and gloomers come out from the woodwork with dire predictions. some try to be optimistic and then in June 2002, the Worldcom fraud hits -- it felt like the system was rigged to go down at that point... Bush starts talking tough on Iraq and the next terrorist attack could happen at any time. CFO's and CEO's were now all considered con-artists and you were considered crazy to trust anyone. Elliott Spitzer was on a crusade to expose everyone. it was like getting hit with a baseball bat over and over again -- anyone who tried to be optimistic about the future was letdown repeatedly.

 

I am not saying that this needs to be repeated. I am just giving an example of how loss of confidence can snowball....

[torero 10]

Yeah, I think in times of excesses and greed, there will be times of exposure of abuse of power, money, etc. that will whip the average investor into panic and distrust, one time or another.

 

I think Bernanke will stand by the same stance as Greenspan made, not to intervene or interfere with the dollar (I think he made this point early in his new job as chairman) so not sure if he's concerned about the dollar falling, his job was to curb inflation and not get into a deep recession, a balance act between the two. The dollar would take care of itself. I could be wrong but I remember his stance as such and the price action of the EURUSD and other crosses made that clear by breaking into new record lows. It's just my perception.

[BlowFish 10]

Maybe I don't get it but wont 'printing' money just make it worthless. Or should I say more worthless when applied to the ole $ hehe only joking. Seriously just injecting money has gotta be a bad thing who wants to have to take a golfing cart full of cash to go and buy a newspaper?

[darthtrader 10]

Check out that paul van eeden video i posted below here.

From what I get it is a loss of confidence but I haven't really read what started it. The best I can put togather is the problem is that collateralized debt obligations have been valued mark to model, you have had billions dumping in to this stuff with probly highly correlated models being used to value what was even being bought instead of in an auction market. I would tend to think someone must have wanted to dump some but the price at auction was much lower than what the models said it should be. Now no one knows what the value is of what they are holding at auction and no one wants to be the one to light the fuse.

[Anonymous 11]

The Fed has only two mandates:

 

1. Control the money supply. (increases in money supply can result in increases in prices-inflation is however defined as an increase in the supply of money)

 

2. Unemployment

 

The Fed's job is not to rigg the stock market.

 

If there is a buyer for every seller, than that means somebody (ies) has been doing very well as the market goes down. Why should their gain be targeted because Ma & Pa are dumb enough to only purchase long only mutual funds?