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December 3, 2007

The Fed's First Response to the Crisis May Not be Enough

Just a brief follow-up to Tim's post. It appears that the Fed's first response to the financial market problems may not be enough. Recall that as the crisis has been developing, firms holding high-quality mortgage-backed securities in need of liquidity have been unable to find buyers for these securities unless they are heavily discounted. The result has been a "new-fashioned bank run" (see also "A New Type of Bank Run"). To try to alleviate this liquidity problem, the Fed has done two things, it has accepted high-quality mortgage-backed securities as collateral on discount loans, and it has also accepted these securities as collateral in repo agreements. The discount loan change, for example, allows firms to essentially borrow from the discount window using banks as go-betweens. (The firm gives the securities to the bank as collateral on a loan, the bank then gives the securities to the Fed to hold against a discount loan. Thus, the bank passes the securities from the firm to the Fed, and then passes the cash in the other direction making a profit on the exchange.)

But a correspondent points to this news from MarketWatch:

"Analysts said the rally in short-term T-bills indicated nervousness remained in credit markets, leading investors to seek the safe-haven of government bonds. Expectations that the central bank will cut its key Fed funds rate was also boosting short-term Treasury bonds.

"But money failed to convincingly return to the commercial bond market on Monday, where liquidity has been drying up in recent weeks.

"Low T-bill yields indicate that liquidity is not yet flowing to those areas of the credit markets that need liquidity most, such as toward the mortgage market and the commercial paper markets, for example, where investors have been on a buying strike," said Tony Crescenzi, fixed-income analyst at Miller Tabak.

And, from Reuters, "Two U.S. Companies Involved in Mortgages Move to Raise Cash":

The struggling mortgage investment firm Luminent Mortgage Capital and the lender Thornburg Mortgage took steps to bolster their liquidity yesterday, but the companies signaled their troubles were not completely over.

Thornburg said it sold $20.5 billion of mortgage assets and reduced its short-term borrowings by an equivalent amount in a bid to reduce its risk of losing access to short-term credit markets. The sale amounted to more than 35 percent of its assets as of June 30.

Luminent said it would sell a majority of itself at a deep discount to shore up its financial condition. Arco Capital, a holding company..., will have the right to buy up to 51 percent of the company at 18 cents a share — a price 76 percent below Friday’s closing price.

So the liquidity crisis, and corresponding new fashioned bank run, do not appear to be over yet.

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