Wednesday, December 7, 2011

Needless Fed Freakout

A lot of folks from Tea Partiers to liberals are getting worked up about what they think the audit of the Federal Reserve disclosed -

What folks think happened and the reality can be very different, however. (I'm not going to argue that the US banks and the Fed are princes all around, but the reality of some of the stuff people are worked up about was a lot different than what they think was going on.)

Bottom line here is that the Daily Kos and many others are freaking out about stuff that was good for the US economy and very low risk.

I haven't looked at every aspect of what the audit found - but I have looked at two programs which folks are needlessly freaking out about.

(You might want to pour a fresh cuppa - some of this stuff is semi-difficult.)

I. The Commercial Paper Funding Facility

Bottom line: The Fed's Commercial Paper Funding Facility funneled money to "Main Street USA" to promote our economy.

As an example, the Daily Kos noted ( that
"Pages 135 & 196 – Sixty percent of the $738 billion “Commercial Paper Funding Facility” went to the subsidiaries of foreign banks. 36% of the $71 billion Term Asset-Backed Securities Loan Facility also went to subsidiaries of foreign banks."

One can hear the author muttering "Outrageous! Another $738 billion given away to the banks, and most of them subsidiaries of — wait for evil – 'foreign banks!'" Oh the xenophobia!

Let's start with a very simple idea - let's stop and ask what a "Commercial Paper Funding Facility" (a "CPFF") is and what it does.

First, what the heck is "commercial paper?"

Commercial paper is simply short term promissory notes that corporations use to fund their day to day activities - inventory purchases, payrolls, operations, etc. (Much of this is low risk self-liquidating - borrow to buy inventory today and pay it off in, say, 6 months after the inventory is resold.)

The maturities of commercial paper run from 1 day to 270 days. And because the commercial paper is unsecured (no underlying mortgage or security interest in some sort of property) the commercial paper markets are pretty much limited to the highest rated companies.

Typically banks will buy commercial paper from one company (a method of lending to those companies) and resell it at a slight spread to another company which has some excess short term cash to invest at the moment.

The CPFF was simply the Fed providing funds to the banks so they could, in turn lend short term to (by buying commercial paper of) the best corporations so they could operate day to day.

That is money that went to Main Street to keep the economy running.

And the fact that some of it went to "subsidiaries of foreign banks?" Let's stop and ask, "which subsidiaries? The Beijing branch of Deutsche Bank, maybe?

Nope. The CPFFs to such subsidiaries went to the US subsidiaries of the foreign banks - the subsidiaries they set up in the US to do business with US companies. So the Pittsburgh subsidiary of, say the Dutch Bank ABN AMRO does business with US companies (mainly in the industrial midwest, I'm thinking.)

So that $738 billion of CPFF money to "subsidiaries of foreign banks" helped promote the US economy right here on Main Street USA.

Looks like a winner to me....

(The real question to me is what was the spread the banks were charging? Were they getting those CPFF funds at, say, 1% and charging the corporations floating the paper 10%?

That would be objectionable. It would take a lot more research that the Daily Kos indulged itself in to discover that.)

II. Currency Swaps (Buckle up...)

Bottom Line, the risks were much less than the face amounts and they supported the US dollar around the world.

Daily Kos tells us about the outrageous amount of currency swaps:
"Page 205 – Separate and apart from these “broad-based emergency program” loans were another $10,057,000,000,000 in “currency swaps.” In the “currency swaps,” the Fed handed dollars to foreign central banks, no strings attached, to fund bailouts in other countries. The Fed’s only “collateral” was a corresponding amount of foreign currency, which never left the Fed’s books (even to be deposited to earn interest), plus a promise to repay. But the Fed agreed to give back the foreign currency at the original exchange rate, even if the foreign currency appreciated in value during the period of the swap. These currency swaps and the “broad-based emergency program” loans, together, totaled more than $26 trillion. That’s almost $100,000 for every man, woman, and child in America. That’s an amount equal to more than seven years of federal spending -- on the military, Social Security, Medicare, Medicaid, interest on the debt, and everything else. And around twice American’s total GNP."
$10 Trillion! OMG!

Note first: the quotation marks the Daily Kos used around the word "collateral," as if holding one currency as collateral against an obligation in another currency is less than real or valuable.

Heck, when it comes to collateral, you can't ask for anything more liquid or better than actual currency.

So Daily Kos writer is up in arms about something that was a positive in those deals.

And second, what they don't tell you (and I am guessing they just didn't know) is that in currency swaps, the notional value is far more than the real value at risk. The amount at risk is a combination of (1) the opportunity value of the interest accrued, and (2) the amount that one currency might move against another.

Example: Let's say I have US $100 (100 US dollars) and you have 7764.7003 yen (JPY)

You deposit your 7764.7 JPY with me as collateral, and I give you $100 to be repaid in 1 year at 5% interest. In one year, you'll owe me US$105 and I'll owe you JPY7764.7 in return of the collateral you put up.

If the exchange rate doesn't change, all I have at risk is the amount of the interest I'm charging you, US$5. (Which is 5% of the notional value of the deal.) And my loss there is the US$5 I could have earned lending it to someone else.)

But exchange rates always fluctuate, of course.

Suppose the value of the yen appreciates against the dollar. My risk is actually lower, and if the yen appreciates more than 5%, I have no risk!

Say you go out of business and can't repay that US$100 or the US$5 interest. If Yen has gone up against the dollar, I might be ahead of the game, holding collateral which is now worth more than the US$105.

If the yen goes down against the dollar, I might lose (1) the US$5 plus (2) the amount of the exchange lose.

Over the last one year, the value of the yen against the dollar has ranged from JPY 86.67 per dollar to JPY 76.0 per dollar - so the amount at risk over that would be about 1/10th of the notional value.

And because the Fed was dealing with a number of different currencies, and the interactions among the currencies are such that when one goes up others are likely to go down; and because the swaps involved a large number of counterparties, the true amount at risk was well less that even that 10% of the notional values.

In the 80's, commercial banks planned on about 5% losses on commercial loans and built that expectation into their pricing- anything less than that indicated the lenders weren't being aggressive enough. If we assume that in these interest swaps, the Fed would face the same 5% risk of loss, the true amount at risk would have been 0.5% of the notional face amount of those swaps - without any consideration that many of any which might failed would have been fully or largely collateralized.

So, instead of "That’s almost $100,000 for every man, woman, and child in America," it would be more accurate to say "That’s not even$5,000 of collateralized risk for every man, woman, and child in America which helped promote the value of the US around the world."

That looks like a winner to me also.