This morning, markets were woken up by the singing birds of central bank interest rate cuts. We first learned that The Peoples Bank of China cut reserve requirements for all banks by 50 basis points to ease constraints on bank lending. This announcement was quickly followed by more coordinated action from developed world central banks to shore up the global financial system in response to Europe’s rolling debt crisis. The Fed, the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank and the Swiss National Bank lowered the pricing on the existing temporary U.S. dollar liquidity swap arrangements by 50 basis points.
So what does this mean for investors? In a nutshell, it is a step in the right direction. But is it enough?
First, we would note that Chinese policy needs to be relaxed. But odds are the initial move out of the gate will be tentative given the extent of the credit excesses lingering in the system, and as such, are unlikely to reverse slowing economic growth. Historically, policymakers response will be proportionate to the deterioration in the economy which means risk assets will likely be down substantially before policymakers respond in force. If and when, the party undertakes substantial fiscal and credit stimulus, we would turn more bullish on China-related assets. We are not there yet.
It is important to remember that massive reflation and market intervention does not occur in healthy bull markets. Such policies can mark a bottom in price, but these “bottoms” are usually preceded by major crisis. For example, the Fed began easing policy in January 2001 after the tech bubble burst but equities sold off through March 2003. More recently, the Fed began liquidity injections and easing in August 2007 but market only hit bottom in March 2009. The point is that an initial shift in policy is more likely confirmation of a bear market in risk assets and in this case, may indicate an economic acceleration to the downside before policymakers get ahead of the curve.
Regarding the “coordinated action” announced today, investors might be reminded of similar central bank policies that saved us from Financial Armageddon a few years ago, and sparked a massive rally in risk assets which launched in March 2009. Unfortunately, the first coordinated policy response was announced as early as 2007 so investors had a long ride ahead of them before the bottom! For perspective, we compiled a timeline of central bank policy below using excerpts from a St Louis Fed report titled Lessons Learned? Caution – this is somewhat exhausting!
- The crisis first appeared in interbank lending markets in early August 2007, when the London Interbank Offered Rate (LIBOR) and other funding rates spiked after the French bank BNP Paribas announced that it was halting redemptions for three of its investment funds.
- The Federal Reserve sought to calm markets by announcing on August 10 that “the Federal Reserve is providing liquidity to facilitate the orderly functioning of financial markets” and noting that, “as always, the discount window is available as a source of funding.”
- Subsequently, on August 17, the Board of Governors voted to reduce the primary credit rate by 50 basis points and to extend the maximum term of discount window loans to 30 days.
- Then, in September, the Federal Open Market Committee (FOMC) lowered its target for the federal funds rate in the first of many cuts that took the rate essentially to zero by December 2008.
- Financial strains eased somewhat in September and October 2007 but reappeared in November. On December 12 2007, the Federal Reserve announced the establishment of reciprocal currency agreements (“swap lines”) with the European Central Bank and Swiss National Bank to provide a source of dollar funding in European financial markets. Over the next 10 months, the Fed established swap lines with a total of 14 central banks.
- On December 12, the Fed also announced the creation of the Term Auction Facility (TAF) to lend funds directly to banks for a fixed term.
- Financial markets remained unusually strained in early 2008. In March, the Federal Reserve established the Term Securities Lending Facility (TSLF) to provide secured loans of Treasury securities to primary dealers for 28-day terms.
- Later in March, the Fed established the Primary Dealer Credit Facility (PDCF) to provide fully secured overnight loans to primary dealers.
- Shortly after the creation of the PDCF, the Federal Reserve Board authorized the Federal Reserve Bank of New York to lend $29 billion to a newly created limited liability corporation (Maiden Lane, LLC) to facilitate the acquisition of the distressed investment bank Bear Stearns by JPMorgan Chase. The PDCF—and especially the Maiden Lane loan—marked significant departures from the Fed’s usual practice of lending only to financially sound depository institutions against good collateral.
- In July 2008, the Federal Reserve Board once again authorized loans to non-bank financial firms when it granted the Federal Reserve Bank of New York authority to lend to the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) if necessary to supplement attempts by the U.S. Department of the Treasury to stabilize those firms. The Fed was not called on to lend to either firm, however, and the Treasury Department placed both Fannie Mae and Freddie Mac under conservatorship in September 2008.
- The financial crisis intensified during the final four months of 2008. Lehman Brothers, a major investment bank, filed for bankruptcy on September 15 after the failure of efforts coordinated by the Fed and Treasury Department to find a buyer for the firm.
- Within hours of the Lehman bankruptcy, the Fed was forced to confront the possible failure of American International Group (AIG). Hence, on September 16 the Fed again invoked Section 13(3) of the Federal Reserve Act and made an $85 billion loan to AIG, secured by the assets of AIG and its subsidiaries.
- The Lehman bankruptcy produced immediate fallout. On September 16, the Reserve Primary Money Fund announced that the net asset value of its shares had fallen below $1 because of losses incurred on the fund’s holdings of Lehman commercial paper and medium-term notes. The Federal Reserve responded to the runs on money funds by establishing the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF) to extend non-recourse loans to U.S. depository institutions and bank holding companies to finance purchases of asset-backed commercial paper from money market mutual funds.
- To help stabilize the financial system, on September 21, the Fed approved the applications of Goldman Sachs and Morgan Stanley to become bank holding companies and authorized the Federal Reserve Bank of New York to extend credit to the U.S. broker-dealer subsidiaries of both firms, as well as to Merrill Lynch. A few days later, the Fed increased its existing swap lines with the European Central Bank and several other central banks to supply additional dollar liquidity in international money markets.
- Financial markets remained in turmoil over the ensuing weeks. To help alleviate financial strains in the commercial paper market, the Fed established the Commercial Paper Funding Facility (CPFF) on October 7.
- The Fed’s next rescue operation came in November, when it participated with the Treasury Department and Federal Deposit Insurance Corporation in a financial assistance package for Citigroup. The Federal Reserve agreed, if necessary, to provide a non-recourse loan to support a federal government guarantee of some $300 billion of real estate loans and securities held by Citigroup.
- Two days later, on November 25, the Federal Reserve announced the creation of the Term Asset-Backed Securities Lending Facility (TALF). Under this facility, the Federal Reserve Bank of New York provides loans on a nonrecourse basis to holders of AAA-rated asset-backed securities and recently originated consumer and small business loans. The TALF was launched on March 3, 2009, and the types of eligible collateral for TALF loans were subsequently expanded on March 19 and May 19, 2009.
“Throughout the fall of 2008, the Federal Reserve Board approved the applications of several large financial firms to become bank holding companies; these firms included Goldman Sachs, Morgan Stanley, American Express, CIT, and GMAC. The Board cited “unusual and exigent circumstances affecting the financial markets” for expeditious action on several of these applications.
“In addition to the Fed’s rescue operations and programs to stabilize specific financial markets, the FOMC reduced its target for the federal funds rate in a series of moves that lowered the target rate from 5.25 percent in August 2007 to a range of 0 to 0.25 percent in December 2008. On November 25, 2008, the FOMC announced its intention to purchase large amounts of U.S. Treasury securities and mortgage-backed securities issued by Fannie Mae, Freddie Mac, and the Government National Mortgage Association (Ginnie Mae). The FOMC increased the amount of its purchases in 2009. The stated purpose of the purchases of mortgage-backed securities was to reduce the cost and increase the availability of credit for the purchase of houses. The move to support a particular market through open market purchases is highly unusual for the Federal Reserve and unprecedented on this scale since before World War II.”
A friend sent me this updated look at the S&P yesterday, which provides some perspective on where we are in this cycle using “the last time around” as a guideline. The chart aligns the bail out of Bear Stearns in March 2008 with the bail out of Dexia this year. The conclusion appears obvious if you are able to step away from the day-to-day noise, rumors, plans, and announcements. This will take some time to fully play out. Until it does, we’d recommend reducing exposure to risk assets on policy-induced rallies. We have not yet learned the most obvious lesson of this ongoing financial crisis. You cannot solve a solvency problem with liquidity.