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The Weekly Report

Welcome to the weekly report. This week we look at inflation and deflation, the Dow, gold and FTSE but start with a look at a recent speech by William C. Dudley who is the executive vice president of the Markets Group at the Federal Reserve Bank of New York. He is also the manager of the System Open Market Account for the Federal Open Market Committee. The Markets Group oversees domestic open market and foreign exchange trading operations and the provisions of account services to foreign central banks.

If you want to know the effect of the Fed facilities on the markets, Mr Dudley is the man to ask. In a follow up to a speech he gave back in October '07, Mr D looked at the effects that the various Fed facilities had on the LIBOR/OIS spread and whether the facilities had done the job they were designed to do, i.e. introduce liquidity for assets. The speech covers a lot that my readers already know so I'll reproduce the salient paragraphs and charts and then add my comments afterwards. This is the problem as W C Dudley sees it:

  • "Let me first define the underlying problem. The diagnosis is important both in influencing the design of the liquidity tools and in assessing how they are likely to influence market conditions.

    As I see it, this period of market turmoil has been driven mainly by two developments. First, there has been significant reintermediation of financial flows back through the commercial banking system. The collapse of large parts of the structured finance market means that banks can no longer securitize many types of loans and other assets. Also, banks have found that off-balance-sheet exposures-such as structured investment vehicles (SIVs) or backstop lines of credit that are now being drawn upon-are adding to the demands on their balance sheets.

    Second, deleveraging has occurred throughout the financial system, driven by two fundamental shifts in perception. On one side, actual risks-due to changes in the macroeconomic outlook, an increase in price volatility, and a reduction in liquidity-and perceptions about risks-due to the potential consequences of this risk for highly leveraged institutions and structures-have shifted. Many assets are now viewed as having more credit risk, price risk, and/or illiquidity risk than earlier anticipated. Leverage is being reduced in response to this increase in risk.

    On the other side, the balance sheet pressures on banks have caused them to pull back in terms of their willingness to finance positions held by non-bank financial intermediaries. Thus, some of the deleveraging is forced, rather than voluntary."

Mr Dudley then goes on to explain the reinforcing (viscous circle) that has occurred because of these pressures, culminating in the Bear Stearns episode. After looking at the effects of intermediation and deleveraging, the LIBOR cheating and subsequent reset higher, FX swap prices and increased counter party risk W C Dudley still feels these areas may explain some but not all of the reasoning behind the funding pressures.

So Mr Dudley digs a little deeper (they may move slowly at the Fed but the analysis can be good) and pinpoints what he sees as the real problem:

  • "So what has been driving the recent widening in term funding spreads? In my view, the rise in funding pressures is mainly the consequence of increased balance sheet pressure on banks. This balance sheet pressure is an important consequence of the reinter - mediation process. Although banks have raised a lot of capital, this capital raising has only recently caught up with the offsetting mark-to-market losses and the increase in loan loss provisions. At the same time, the capital ratios that senior bank managements are targeting may have risen as the macroeconomic outlook has deteriorated and funding pressures have increased.

    The argument that balance sheet pressure is the main driver behind the recent rise in term funding spreads is supported by what has been happening to the relationship between other asset prices-especially the comparison of yields for those assets that have to be held on the balance sheet versus those that can be easily sold or securitized."

Here comes the good bit, central to Mr Dudley's speech:

  • "Why is this noteworthy? Jumbo mortgages can no longer be securitized, the market is closed. Thus, if banks originate such mortgages, they have to be willing to hold them on their balance sheets. In contrast, conforming mortgages can be sold to Fannie Mae or Freddie Mac. Because the credit risk of jumbo mortgages is likely to be comparable to the credit risk of conforming mortgages, the increase in the spread between these two assets is likely to mainly reflect an increase in the shadow price of bank balance sheet capacity.

    If this is true, then the same balance sheet capacity issue is likely to be an important factor behind the widening in term funding spreads. After all, a bank has a choice. It can use its scarce balance sheet capacity to fund a jumbo mortgage or to make a 3-month term loan to another bank.

    If balance sheet capacity is the main driver of the widening in spreads, this suggests that there are limits to what the Federal Reserve can accomplish in terms of narrowing such funding spreads. After all, the Fed's actions cannot create bank capital or ease balance sheet constraints materially. "

Now for my readers, myself and a few other writers and bloggers out there, most of the above is "old news". We recognised the effect that a re-pricing of assets would have on bank balance sheets, especially when Basel 2 kicked in quite some time ago. Whether Basel 2 caused the re-pricing or not is now mute (in the US B2 only applies to the top 10 international banks). It happened and we have to live with it.

By concentrating on bank balance sheets and the repairs required to capital ratios, investors have an important anchor point for fundamental analysis. For instance (and this is why you love me) in the FTSE 100 we have a large bank sector which has and is being battered, except for

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