Federal Reserve hedges bets on ‘Morphine Rally’


If you were to demand an explanation as to the few isolated waves of hope that have washed over New York’s and London’s financial districts over the past fortnight, I might ask you to join the end of a very long queue.

The biggest Western economies (perhaps with the exception of Germany) are most certainly headed into recession, if they are not already there. And there is no reason whatsoever to suppose that the downturn will be shallow and short lived.

Banks are contracting – seeking to lend less money, but at higher margins. That restricts economic expansion. Full stop.

Yet in the financial markets, there is a growing band of believers who proclaim that as far as financial assets go, we have seen the worst.
The nadir has passed and, while there will be shocks and pain ahead, the price of banks and other financial entities now look attractive on a long-term view.

I am not so sure. But let me try to explain the optimistic viewpoint.

A month or so ago, Federal Reserve Chairman Ben Bernanke surely was staring into an abyss. Wall Street’s finest institutions had hobbled through into 2008, taking painful write-downs, shoring up their balance sheets with new capital from Asia and the Middle East.
This new capital, principally from sovereign wealth funds, was
expensive for the Americans, but it represented a vote of confidence – and “confidence” was trading at a hefty premium at the time. The New Year promised a new beginning. But instead all Bernanke could see and hear was fresh cries of anguish.
The whole process of marking opaque synthetic assets to real-life prices was trickling down from the bulge bracket banks to thousands of market participants. Hedge funds, left right and centre, were suddenly taking deep, life-threatening baths. There were suddenly instances of rogue trading – a telltale sign that the banks had not been quite open and honest in their previous write-downs as they had hitherto asked us to believe.

The credit markets ground to a halt once again; and banks stopped lending to each other once more, evidenced by a fresh widening in the spread between official central banking rates and the various measures of Libor, the London Interbank Offered Rate.

What is more, Bernanke and his colleagues were aware they were running out of treatment options. The choice was stark – apply an untested financial drug in massive doses and hope it works, or simply accept the terminal nature of the situation and let the patient die.

Financial chemotherapy came in the form of the new liquidity providing mechanisms – the largest and most important of which, the Term Securities Lending Facility, finally arrived last week.

Now, bids for liquidity in the TSLF auction, which provides relief by swapping mortgage-backed paper for the “near-cash” certainty of US treasury bills, were rather lower than expected – indicating, at first glance, that Wall Street was not quite as financially dehydrated as previously thought.

But the TSLF auction in itself is not the primary piece of evidence in the optimists’ case that we are through the worst. After all, this was a new financial drug, the effects and symptoms of which we must observe for a long period.

Instead, the optimists’ case is more broadly presented. It says, at its heart, that the Federal Reserve is now prepared to take any action to revive the patient – whatever it costs. All notions of moral hazard, whereby the authorities risk encouraging future recklessness by bailing out those who have been stupid now, has fallen by the wayside. The Fed is now pumping in funds regardless – and the net effect, in short order, will be to make Wall Street banks very profitable.

They are sourcing cheap funds, while being in a position to impose relatively expensive terms on their customers.

One rumoured example of this has a major Wall Street firm borrowing billions of dollars from the Fed through another of its recent drug infusion mechanisms, the Primary Dealer Credit Facility, which the investment bank is then using to scoop up mortgage-backed paper at distressed prices. This paper is then being bundled up into new securities and offered to the firm’s clients as an opportunistic medium- to long-term investment proposition.

Now, that might sound underhand, yet it is exactly how the Fed hopes its new drugs will work. It wants to revive activity in the patient; it wants the credit markets to come out of their coma. And this might be evidence that it is working.

Hence one wag’s description of recent market conditions: “The Morphine Rally”.

(Paul Murphy is associate editor of the Financial Times.)