Helicopter Ben yesterday announced that the Fed would lend $200bn of Treasuries to banks in return for AAA rated collateral. Equity markets were delirious – the S&P recorded its biggest one day jump in over five years. Risky credit also staged a rally, but the reaction was a bit more muted. The iTraxx Europe Crossover Index, an index measuring the default risk of the most liquid European high yield names (see here for more info) rallied from its all time high but spreads are still higher than at the end of February.
What difference will the Fed’s actions make? The liquidity injection is certainly helpful to all the banks that were having liquidity problems, and the extra liquidity will help the market determine the fair price of some of the more esoteric debt instruments. Much of the distressed selling we’ve seen in the past few months has been because investors are trying to sell but nobody’s willing to buy, and prices have spiralled downwards.
But will the Fed’s actions get the global economy out of a hole? No, not really. The value of AAA rated mortgage securities are ultimately determined by house prices and delinquencies. Banks may react to the liquidity injection by slashing mortgage rates, but this is unlikely given that banks are currently trying to rein in lending and patch up their balance sheets. The Fed’s actions will therefore do little to tempt US citizens into buying houses again, and US house prices will therefore continue falling until some of the near-record supply of houses for sale is reduced. I can’t see the Fed’s actions resulting in the US avoiding recession – at very best, it might make things slightly less bad.
The Fed’s decision to allow AAA-rated mortgage securities to be posted as collateral raises some interesting political questions. It’s very hard to imagine that S&P and Moody’s will implement a wave of downgrades any time soon, because this would completely undermine yesterday’s actions from the Fed. As yesterday’s excellent article on Bloomberg explains, none of the 80 AAA securities in the ABX indices (these track subprime bonds) meet the ratings agencies’ normal AAA criteria. Helicopter Ben is loading up with assets that are very heavy in risk. This is alleviating the liquidity pain of the financial system, but is risking his ability to pilot the Fed. If these AAA assets start to turn sour, then the Fed will be yet another bank burdened with the woes of the US housing market.