Thursday, May 15, 2008

William Dudley - May You Live in Interesting Times: The Sequel

Today's Fed speak comes from William C. Dudley, NY Fed Executive Vice President. He thinks that balance sheet pressure on banks is behind the persistent widening in term money market spreads, and disputes that increased counterparty risks and/or diversification of money market mutual funds are the prevailing factor. He concludes if so there are limits what the Federal Reserve can accomplish. The reintermediation and deleveraging process has further to go in his opinion.

So what has been driving the recent widening in term funding spreads? In my view, the rise in funding pressures is mainly the consequence of increased balance sheet pressure on banks. This balance sheet pressure is an important consequence of the reintermediation process. Although banks have raised a lot of capital, this capital raising has only recently caught up with the offsetting mark-to-market losses and the increase in loan loss provisions. At the same time, the capital ratios that senior bank managements are targeting may have risen as the macroeconomic outlook has deteriorated and funding pressures have increased.

Consider, for example, the spread between jumbo fixed-rate mortgages and conforming fixed-rate mortgages, which is shown in the next slide. As can be seen, this spread has widened sharply in recent months, tracking the rise in the LIBOR/OIS spreads. ... Because the credit risk of jumbo mortgages is likely to be comparable to the credit risk of conforming mortgages, the increase in the spread between these two assets is likely to mainly reflect an increase in the shadow price of bank balance sheet capacity.

If balance sheet capacity is the main driver of the widening in spreads, this suggests that there are limits to what the Federal Reserve can accomplish in terms of narrowing such funding spreads. After all, the Fed’s actions cannot create bank capital or ease balance sheet constraints materially.

The Fed's major backstop initiatives (TAF, PCF, TSLF, PDCF) have been successful in bringing down the LIBOR-OIS spread. Dudley goes on:

Perhaps this just represents an announcement or placebo effect. More study is obviously needed. However, it is interesting that those market participants who are the patients have been clamoring for more medicine in the form of both an increase in the size of the TAF auctions and auctions with longer maturities.

It will take time for market function to return to normal. The reintermediation and deleveraging process has, in my view, a considerable ways to go. The Federal Reserve is committed to supplying liquidity to banks and primary dealers as needed to ensure an orderly adjustment.

click here for chart porn

source: May You Live in Interesting Times: The Sequel
William C. Dudley, NY Fed Executive Vice President, May 15, 2008

source: Funding Pressures and the Federal Reserve’s Liquidity Facilities
William Dudley, Head of Markets Group, Federal Reserve Bank of New York, May 2008

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