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Minyan Mailbag: Has the Fed Added Liquidity to the Markets?


It is not the Fed that creates liquidity in an economy; it is the commercial banking system. What the Fed (mostly) provides is the temporary liquidity for these banks to do so.

Mr. Practical,

It is simply false that the world's central banks have added liquidity to the markets. This is mainstream media spew that ignores the fact that repo expirations were virtually equal to the adds. There has been no net increase in liquidity either from the Fed or any of the other major central banks over the past month. Their asset bases are at virtually the same level they were at, in some cases less than, prior to the onset of the crisis.


Minyan Lee,

It is simply false that the world's central banks have not added liquidity to the markets.

The Fed's balance sheet has risen by $9 bln since the beginning of July – that is permanent monies that the Fed has put into the banking system (upon which banks lever 10 or more to 1). Yes, the nearly $400 bln that have been added via REPOs have been taken back. But to suggest this does not add money to the banking system on a permanent basis is to misunderstand the actual dynamics of how these funds come and go. The world's liquidity game is a shell game. That is what fiat currency is all about. The world's central banks have executed an immense amount of REPOs, as stated over the last month.

But the main point is that it is not the Fed that creates liquidity in an economy; it is the commercial banking system. What the Fed (mostly) provides is the temporary liquidity for these banks to do so.

Large money center banks lever their assets. They take deposits and CDs and REPOs as liabilities and lend money and buy securities as assets with it. Every time they take in money via a liability they earn a spread (taking risk). So first, the writer is not understanding the time value of money: those REPOs, even though they have to be paid back, earns spreads over their life. This is liquidity for banks. And that spread, once earned, gets levered – voila – 10 to 1 or more.

Here is the problem. All those risky securities the banks have been carrying and earning spreads on have fallen slightly in value. Because of the immense leverage, just this small mark down of assets had seized up the banks from lending more money as they have to keep more cash to finance the lower mark on the assets. The temporary REPOs by the Fed act to finance those mark downs. The banks are "hoping" that their value goes up during the duration of the REPO. If they do not, the Fed will have to roll them and that liquidity becomes more permanent. Few people realize just how little the value of those assets held at banks have to fall before all the world's banks' capital is wiped out.

This is why I keep saying that the Fed plus all the world's banks cannot possibly fix this problem once the markets want to reduce risk.

I mentioned that the Fed does not really want to mess up its balance sheet permanently, so there is a limit to what it will do. It cannot – will not – keep rolling these now-lower valued credit market instruments these banks own forever. And perhaps as damning is the billions of temporary liquidity that central banks have already lent pales in comparison to the size of losses banks are likely to experience in a full deflationary spiral.
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