Monday, December 31, 2007

93 Banks are not Rational Actors -- or they have just been subsidized

by Ken Houghton

I've been trying not to think about this quote from CR:
The Federal Reserve said on Wednesday that it had collected bids from 93 financial institutions in its first auction of short-term credit, a turnout that suggested banks might be more inclined to borrow from the Fed under its auction-based system.

And the more I don't think about it, the more my shoulder hurts.

Because despite the NYT's attempt to paint it as a positive, the results were ugly:
Winning bids were awarded at a 4.65 percent interest rate, lower than the Fed’s so-called discount rate, which normally regulates borrowing from the central bank. The discount rate was lowered to 4.75 percent last week.

Now, that's nice, but the "discount" rate, since the advent of the Bush Administration, has been higher than the Federal Funds rate, currently by about 50 basis points (1/2 of 1%).

In the grand tradition of the Spherical Cow joke, "Assume a bank is a rational investor." But wait; isn't that a tenet of economics?

So we have to assume these investors are rational. Which means that they knew what they were doing when they bid 40bp above the Federal Funds rate (higher yield, that is, they are taking a lower price) to lend securities to the TAF.

Let us assume, for the sake of argument, that there is an "anonymity premium" (though how much anonymity there can be when the NYT says "93 banks"—not 92 or 94 or some other number—is left as an exercise). It's not going to be 40 basis points. So there is, theoretically, money being left on the table—by precisely those institutions that know when money is being left on the table.*

Unless it's not.

And in that case, we can easily construct the equivalent pricing in the market. The formula is straight algebra: Principle * Interest Rate * (Number of Days)/360.

The banks borrowed $20 billion for 28 days at 4.65%. They're spending $72 1/3 million dollars to exchange some securities for cash. If those securities had been traded at those same prices, at the Federal Funds rate of 4.25%, the banks would have spent $66 1/9 million.

The banks, in theory, left $6 2/9 million on the table.

So, if we look at economic reality—in which a bank would not do that—we have to come to the obvious conclusion: the value the Fed was willing to place upon those securities was at least 8.6% higher (40/465) than the price those securities would have fetched were they used as collateral in the open market.

The "technical" term for the TAF is "corporate welfare." Anyone who tells you otherwise is trying to sell something—probably overvalued securities.

*I'm belaboring this point, but it's central. This is not a consumer hoping to spend $1 on a present and finding out that the present costs $1.01 or even $1.05. This is a financial institution that survives based on not paying $1.01 for an asset that is worth $1.00. While Homo economicus has always been a simplifying proxy for consumers, it's a fundament for financial management.

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Fed Funds are overnight, TAF isn't. Thus the comparison with the Discount Window, which isn't overnight either, is appropriate.

Only the gang of 20 primary dealers can participate in the daily open market operation repos. The TAF allows all the banks to do repos with the Fed.

Thus using TAF is rational.
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