Central bank bailout or acting as pawnbroker?

There seems to be a lot of confusion as to what the injection of liquidity by central banks around the world means. Some are calling it a bailout. That is bailing out brokers and mortgage lenders by buying their impaired mortgage backed securities.

Michael Shedlock posted a good piece on why central banks intervene by pumping liquidity into the market. A few of the main points:

During a "liquidity crisis," the big banks get nervous about risk and become more cautious about doing deals and making trades. They're less likely to extend the easy credit that has fueled the economy in the past few years, and that makes it more difficult to match buyers with sellers. That is what happened to markets around the world Thursday.

The fallout from a liquidity crunch causes a ripple effect. The most immediate impact is that loans could become harder to get. But troubles can spread to the wider economy, hurting peoples' investments and endangering their long-term financial plans. If banks are not lending and no one will extend credit to anyone else, markets seize up and economic growth disappears.

Major financial institutions can absorb hefty losses without toppling. However, liquidity concerns cause institutions to become reluctant to lend money to other banks. Loans between banks on an overnight basis, one of the primary ways they fund their operations, have become more expensive as concerns arise about their ability to repay the loans — and that forces costs up.

In addition, banks also bring debt offerings to the market on behalf of their clients. But, if investors are reluctant to buy them, many times the banks will be left holding the debt.

OK, so does this amount to a bailout? Shedlock adds:

For starters there was no brand new money created by these central bank actions. There were, however, huge emergency repos but those are temporary loans. What happened is that banks fearing a need for capital would not lend money to each other like they normally would. This caused overnight rates to shoot sky high.

In the US, the Fed foolishly defends an interest rate target as does the ECB. To defend that interest rate target, repos or reverse repos (draining money) are used to keep the rates where the Fed / ECB wants them. Of course neither the Fed or the ECB has any real idea where interest rates should be and that is one of the reasons we are in the mess we are in.

At any rate, the money (credit really) the hedgies lost is in money (credit) heaven. It wasn't magically brought back by the ECB's or the Fed's open market operations. Those open market operations can help keep the interbank payment system afloat (at least for a while), but it can't persuade any new borrowers to borrow and it can't fix anyone's losses.

The important points are in bold. Firstly these are temporary loans and secondly the funds are used to keep the interbank payments system going, not to bail out banks and hedge funds that can't get rid of impaired MBS.

To make this clearer in the US the Fed used what are called repos. The following is from the Federal Reserve's website:

Repurchase and Reverse Repurchase Transactions

* Under a repurchase agreement ("RP" or "repo"), the Fed buys government securities from a dealer who agrees to buy them back, typically within one to seven days; a reverse repo is the opposite.

* The Fed uses these two types of transactions to offset temporary swings in bank reserves.

* RPs initially add reserves to the banking system and then withdraw them; reverse repos initially drain reserves and later add them back.

When doing an RP, the New York Reserve Bank, which conducts open market operations for the System, buys a government security from a primary dealer who agrees to repurchase the obligation within a specified period up to 65 business days (usually 1 to 7 days). When repurchasing the obligation, the dealer pays the original price, plus an agreed-upon return to the Reserve Bank as payment for use of the funds acquired in the first part of the transaction.

So banks offer up securities for sale which the Fed buys and then credits the bank's account with funds. The bank then has to buy that security back after the specified time period. So what kind of securities can be offered up for sale by banks? This also comes from the Fed website:

Clarification of Collateral Tranches on Desk RP Operations

Typically, when the Desk arranges RPs it accepts propositions from dealers in three collateral tranches.

* In the first tranche, dealers may pledge only Treasury securities.
* In the second tranche, dealers have the option to pledge federal agency debt in addition to Treasury securities.
* In the third tranche, dealers have the option to pledge mortgage-backed securities issued or fully guaranteed by federal agencies in addition to federal agency debt or Treasury securities.

From time to time, for operational simplicity, the Desk has arranged RPs just in the third tranche, under which dealers have the option to pledge either mortgage-backed securities issued or fully guaranteed by federal agencies, federal agency debt, or Treasury securities. Today's RPs were of this type.
August 10, 2007

So the repo agreements entered into on Friday were of the MBS type. If you click here you can see the details of each days transactions.

For example on Friday there were three tranches with a total of $38 billion accepted. Each tranche was in the form of a repo with a 3-day operation period.

That means the banks or whoever the borrowers are have to turn around and buy back their MBS after 3 days.

Similarly on Thursday there were two tranches with a total of $24 billion accepted. The first tranche has a term of operation of 14 days while the second just one day.

The important point here is that the Fed has not bought troubled MBS and taken them off the balance sheets of banks and other financial institutions for good.

The institutions have to buy the securities back from the Fed specified by the term of operation. Thus as I see it, the Fed is not bailing anybody out. They are simply providing short term liquidity for the banks to conduct their daily operations.

It may be helpful to use the analogy of a pawnbroker. Let's say my monthly rent of $1,000 is due on the 20th of this month. However I only have $700 in the bank and I don't get paid until the 25th. I'm $300 short for my rental payment and I also need to eat and pay for basic living expenses until I get paid.

So I take my Rolex down to the local pawnbroker. It's worth $2,500, the pawnbroker gives me $500 for it and keeps it as collateral in case I can't pay him back. I use $300 of the pawnbrokers loan to help pay the rent and use the remaining $200 to for basic living expenses.

Then on the 25th I get paid, I go down to the pawnbroker pay him his $500 back plus some interest and he gives me my watch back.

Think of the Fed as a pawnbroker to the banks and other institutions that need to fund their short term liquidity requirements. Of course the Fed's terms will be much more generous than your average pawnbroker.

This is how I see it. No doubt I've probably missed something, so if anyone has a better explanation of what the central banks have been up to please feel free to comment.