Saturday, October 6, 2012

The Divot

In a previous post I showed the following graph and explained it showed 4 events: QE 1.0, QE 2.0, Operation Twist (QE 2.1) and one other event.

Recent Federal Reserve Holdings.  Data goes as far back as available from the source.
From about the beginning of 2008 to the start of QE 1.0 in the first quarter of 2009 the Federal Reserve shed about $250 billion of US treasuries off of its balance sheet.  From the above graph, the event looks like a listric curve or a divot.  In order to see why this occurred I will need to present a little bit of information about the crisis's timeline.
Gross repo deals by the Federal Reserve - repo and reverse repo.  Repos played a role in the decrease of the Federal Reserve's balance sheet.  For more on what is a repo, see my previous blog entry.
The Crisis History
A timeline history of post housing-bubble troubles:

  • February 2007: Freddie Mac announces it will no longer purchase subprime mortgages and risky mortgage-backed securities (MBS).
  • June 2007: S&P and Moody's begin downgrading the credit of hundreds of MBS backed by subprime mortgages - remember the various credit downgrades listed here directly affect securities and their default swaps in the repo and secondary-market.
  • July, August, September and October 2007: Bear Stearns liquidates two hedge-funds; Fed Funds target maintained at 5.25%, Fitch downgrades Countrywide Financial to BBB+; The Bank of England, Citigroup, JPMorgan, and Bank of America announce various liquidity plans.
  • January, February and March 2008: S&P and Fitch downgrade bond insurer Ambac; US Stimulus Act, Federal Reserve $50 billion TAF auction; JPMorgan acquires Bear Sterns.
  • September 2008: Bank of America announces acquisition of Merill Lynch ON THE SAME DAY Lehman files largest US bankruptcy - beginning a run on securitized banking that tightens the repo market.

From there on out, history...

AIG receives $182 billion bailout to cover huge default swap exposure in the US and Europe (over $100 billion loss with over $400 billion exposure at the time of its bailout), government enterprise bailout (Fannie Mae and Freddie Mac), Federal Reserve insures various risky securities, Fed Funds and Discount Window at the Fed reduced to zero, US short-term treasury interest rates reduced to near zero levels, huge off-balance sheet accounts at big headache.

Life Support
Based on the above graph and the above events, it looks as though the Fed stepped in as repoer-of-last-resort at various times starting in 2007.  In August 2007 the Fed increased its repoing activity after Bear Stearns liquidated two hedge-funds, and in March 2008 it aggressively increased its repoing when Fitch and S&P downgraded the various bond insurers.  By the time Lehman and Merill were finished, repoing fell off and the Fed began aggressively reverse repoing.

By the beginning of 2009, the Fed must have concluded that reverse repoing the financial sector back to health was not going to work.  The Fed then settled on a policy of selling the securities that everyone needed and purchasing the worst-of-the-worst (MBS from Fannie and Freddie).

Here is what it looks like:


Relationship between Federal Reserve assets and lending operations.
The Federal Reserve tried to save the financial sector by repoing it back to health.  Investment banks and banks that took on distressed banks needed stronger medicine and so the Fed began its QE program - the bailout program which continues to this day.  I am very certain the Fed knew well in advance what was going on in the securitized banking sector - as far back as 2005 and obviously knew tings were bad throughout 2007.  However, they remained a patient observer until it appeared that damages threatened the financial sector with beyond-repair damages.

Maturity Expiration or Sell-Off?
The first graph shows the relation between US treasuries held by the Federal Reserve with maturities of 1+ to 5 years and 5+ years.  What about those treasuries with 1 year or less maturity?

Treasuries with 1 year or less maturity had a big influence on the divot.  The divot was not caused by the Federal Reserve allowing securities to expire.  If that were the case there should have been a build up in the 1 year or less maturity class prior to the divot.  Taking a look at couple further graphs should shows in more detail why this is. 


These graphs show that the divot is due to an outright sell-off of treasuries - but to who and why?  Well, if you were motivated enough, you could have used the link to the Federal Reserve's crisis timeline and figured this out several paragraphs ago.
On March 11 2008, from the crisis timeline website:
The Federal Reserve Board announces the creation of the Term Securities Lending Facility (TSLF), which will lend up to $200 billion of Treasury securities for 28-day terms against federal agency debt, federal agency residential mortgage-backed securities (MBS), non-agency AAA/Aaa private label residential MBS, and other securities. The FOMC increases its swap lines with the ECB by $10 billion and the Swiss National Bank by $2 billion and also extends these lines through September 30, 2008.
The TSLF was not created to repo but to swap out bad assets for good assets; the TAF was created to repo:

On March 7 2008, from the crisis timeline website:

The Federal Reserve Board announces $50 billion TAF auctions on March 10 and March 24 and extends the TAF for at least 6 months. The Board also initiates a series of term repurchase transactions, expected to cumulate to $100 billion, conducted as 28-day term repurchase agreements with primary dealers.
The Fed took a whack at reviving the financial sector with the first bailout program, but all it did was make a divot on its balance sheet.

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