I have come across an interesting difference of opinion between the Fed and the ECB in regards to various Swap-O-Rama-Programs. Let’s start with the Fed.

On May 13th Bernanke said Fed to Boost Loans to Banks as Needed.

Federal Reserve Chairman Ben S. Bernanke said financial markets remain unsettled and the central bank will increase its auctions of cash to banks as needed.

While markets have improved, they remain “far from normal,” Bernanke said today in a speech to an Atlanta Fed conference at Sea Island, Georgia. “We stand ready to increase the size of the auctions if further warranted by financial developments.”

The flight from risk since August has made financial institutions reluctant to lend to each other, driving up banks’ borrowing costs. The central bank has made its own balance sheet available to both banks and bond dealers through three new lending tools, and an expansion of existing programs.

Bernanke said the Fed’s efforts have yielded “some improvement,” while also noting that the steps raise questions regarding moral hazard, or protecting those who take on risk.

The moral hazard Bernanke is referring to is the Fed itself. He just does not know it. The only way to fix the Fed is to get rid of it.

Inquiring minds may wish to consider Want To Fix The Fed? Get Rid Of It.

ECB concern over liquidity scheme

In contrast to Bernanke who seems ready and willing to take on all comers, the ECB has expressed concern over liquidity schemes.

The European Central Bank on Thursday voiced its “high concern” at growing evidence that banks are exploiting its efforts to unblock the frozen funding markets by using its liquidity scheme to offload more risky assets than it envisaged.

Yves Mersch, a governing council member, said the ECB was now “looking very hard at whether there is not a specific deterioration of collateral” which the central bank is accepting in return for funds.

He was speaking amid signs of some banks creating low-rated assets specifically so they can be traded for treasuries at the European Central Bank.

The Bank of England recently created a facility for UK banks to access funding for mortgages and the Financial Times has learnt that almost £90bn ($175bn) worth of bonds are being created to be placed there – almost twice the £50bn in­itially expected when the scheme was launched only three weeks ago.

On Thursday, however, speaking at the International Capital Market Association in Vienna, Mr Mersch said the type of collateral now being accepted was: “A matter of high concern.”

His comments come as banks, whose main centres of operations are not within the eurozone, are structuring new bonds based on assets other than mortgages in order to gain access to ECB funding.

The ECB’s main mortgage-bond exposures so far are believed to be from Spanish, Dutch and some UK deals, but the central bank publishes few details on the collateral it holds.

However, this week Glitnir, the Icelandic bank, is in the process of clearing the use of a €890m ($1.37bn) collateralised loan obligation (CLO) for funding at the ECB. Similarly, Lehman Brothers recently structured a €1.1bn CLO, which it is expected to use for ECB funding.

Meanwhile, Macquarie Leasing, a unit of the Australian bank, has done a securitisation of Australian motor loans, which will have a euro-denominated slice so that the investors who buy the deal can use it at the ECB.

“There is moral hazard . . . and we are not in the business of taking over the market,” Mr Mersch said. “That means there must be an exit strategy.”

Pawned Garbage Expands

The garbage being pawned off on the ECB is expanding: Spanish, Dutch, and UK housing, but more amazingly, securitisation of Australian motor loans. Remember the original premise behind the Swap-O-Ramas?

The Swap-O-Rama was supposed to increase bank to bank lending. Instead, the Fed and the ECB have become veritable garbage dumps. This was easily predictable.

Flashback April 10, 2008

Fed’s Swap-O-Rama Gets Crazier

The Federal Reserve’s Term Auction Facility, TAF, has failed to produce the intended results – encourage more bank to bank lending at reduced rates. That should not be too surprising. If the Fed is willing to be a “swapper of last resort,” why should banks risk lending to each other?

After all, bank-to-bank loans are unsecured. Who wants that risk, especially when banks have every reason not to trust each other?

Since then the Fed has expanded into student loans, auto loans, and credit cards.

Flashback May 2, 2008

Fed expands auction, accepts wider collateral

The Federal Reserve, along with other central banks, said Friday that it was increasing the funding it is providing to banks and announced that, for the first time, it was willing to accept bonds backed by auto loans and credit cards.

“In view of the persistent liquidity pressures in some term funding markets, the European Central Bank, the Federal Reserve and the Swiss National Bank are announcing an expansion of their liquidity measures,” the Fed said in a statement.
The Fed took the move in an attempt to flood the market with supply and lower short-term lending rates, such as the London interbank offered rate, or Libor.

Flashback May 3, 2008

Bernanke rejected Senator Dodd’s request in an April 25 letter to help out with student loans by saying it’s up to Congress and the Bush administration to address diminishing profits on the loans. A few days later he suddenly changed his mind as noted in Bernanke Answers S.O.S. Call.

First Law Of Swap-O-Rama

Let’s apply Parkinson’s Law to the Fed’s and ECB’s Swap-O-Ramas. Here goes: The garbage dump will expand in direct relation to the willingness of the dump to accept garbage.

Second Law Of Swap-O-Rama

Over time, the dump will consist of increasingly toxic waste. That toxic waste will eventually have to be cleared out. If those dumping the toxic waste cannot afford the cleanup, taxpayers will have to foot the bill.

No Exit Strategy In Place

The above laws should be intuitively obvious. However, the ECB seems to have just figured it out. The Fed either has not figured it out, or in typical fashion will not care until the mess blows sky high.

Mike “Mish” Shedlock
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