Recommended reading: The upcoming FDIC quarterly contains a fantastic article on how, if Dodd-Frank were law then, Lehman Brothers might have been liquidated in a more orderly and rapid fashion after its failure. The article is a nice summary of the events leading up to the Lehman failure, the relevant provisions of the Dodd Frank Act, and a description of how these would have been implemented in the case of Lehman. I learned a number of things about how the financial regulation will look going forward. Something I did not know from Dodd-Frank’s orderly liquidation process is that “The Dodd-Frank Act provides that the FDIC may borrow funds from the Department of the Treasury, among other things, to make loans to, or guarantee obligations of, a covered financial company or a bridge financial company to provide liquidity for the operations of the receivership and the bridge financial company.” At least according to current law, any losses on this mini-bailout are born by the industry, not the taxpayer.
Archive for the ‘liquidity’ Category
The Financial Stability Oversight Council (FINSOB) has proposed a definition of when a financial market “utility” – an entity that runs trading or clearing of assets, payments, or other financial transactions – is systemically important. The document is here. According to Richard Roth, this is determined based on four factors: 1) the raw volume of transactions processes (in number and in dollars), 2) counterparty exposure (credit and liquidity), 3) interdependence with other utilities, 4) an estimate of the impact that the utility’s failure would have on the financial system.
What happens when a utility is deemed systemically important? First, it is given a chance to change so that it is not systemically important. This worries me a little in that we could get a lot of utilities barely missing being labeled systemically important. Second, if a utility is deemed systemically important by the FSOB, the appropriate regulatory agency is to prescribe risk management standards, such as margin requirements, collateral requirements, default policies and procedures, and levels of capital and liquidity adequacy.
While we (and the politicians) sleep, FINSOB is working away on real problems, increasing expected utility.
This week the Federal Reserve announced the creation of the Commercial Paper Funding Facility. The facility allows the Fed to purchase 3-month commercial paper directly from issuers. Why is it doing this, and how much will this cost taxpayers?
Let me start with some background. The commercial paper (CP) market is an important source of quick funds for high-grade firms in the corporate and financial sectors. If a company like GE needs to raise $100 million quickly, it could do so in the CP market. GE is unlikely to issue long-term debt or stock to raise the $100 million—- such funding takes time to source. While the CP market is used to raise money quickly, it is also used as an ongoing source of funds. As of June of this year, GE had $63 billion in commercial paper outstanding. This was one-third of GE’s short-term borrowings and over 10% of its total borrowings (more…)
The U.S. Treasury’s proposed bailout plan raises a number of serious questions, many of which have been well articulated by politicians and pundits. Many of the plan’s merits, however, have been shrouded by confusion. Is the taxpayer losing $700bn to Wall Street? Is the Treasury paying fair value for assets? How will the bailout help Main Street? In fact, there are a number of merits to this proposal which all stem from markets currently being extremely illiquid.
An easy way to illustrate the illiquidity in markets is to look at the price differences between liquid assets and less liquid assets. The figure below plots interest rates over the past month for the 3-month London Inter-Bank Offered Rate (LIBOR) and the 3-month U.S. Treasury bill. LIBOR reflects the rate at which a bank borrows funds from another bank. During less turbulent times, prior to last summer, the spreads between the LIBOR and T-bill rates average around 40 basis points (bps). The spreads recently have been more than 100 bps, punctuated by the surge to 318 bps on September 17.