TLGP and tail-risk in the financial system

On October 31st 2009 one of the most important parts of the crisis measures - the TLGP (Temporary Liquidity Guarantee Program) - expires unless the FDIC chooses to extend it. In the autumn, the failure of Lehman Brothers and Washington Mutual resulted in a wholesale run on the banking system that threatened Mellon-esque liquidation. This program allowed the financial system to once again fund itself, with the backing of the government.

Since April, the amount of debt outstanding in the program has not really increased much, and since the (Un)stress(ful) Test results, very few institutions have issued debt with a guarantee as risk appetite and very large retail flows into bond funds have hoovered up debt across the financial and non-financial universe. Not only that, but political considerations around the fall-out from TARP and a V-shaped recovery in Banker-pay have strongly discouraged banks from accessing such programs (as well as extricating themselves from the TARP). Further, the FDIC (under the incompetent Sheila Bair: http://brontecapital.blogspot.com/2008/11/why-sheila-bair-must-resign.html) appears to be losing the battle for regulatory power - as evidenced by Geithner's use of several expletives in a recent meeting discussing financial sector reform. In a nutshell, it appears highly unlikely that the program will be extended beyond October.

This is interesting, because the presence of this program removed the roll-over risk for the financing of bank balance sheets. If one has the view that this summer's risk rally has mainly been on the back of strong liquidity and easing financial conditions (as well as the turn in the industrial cycle), then the removal of the TLGP opens up an interesting possibility - tail risk in the financial sector is back. If (or when) the risk rally falters, presumably as a result of the inevitable realisation that a production-driven rebound is unsustainable without a recovery in consumption (which, as yesterday's retail sales data showed is not on the cards), then this risk grows significantly. The large overhang of Commercial Real Estate on commercial bank balance sheets threatens the return of roll-over risks and associated solvency fears.

So why am I writing about this?

What is really interesting is the extent to which Libor-OIS spreads have collapsed to about their average level of the last 20yrs (~25bps - see below chart). There is a consensus in the money market that these spreads will be permanently wider than they have been over the last 10yrs, but the exact level, nobody is sure of. For the record, I'd argue that the range should be 15-25bps, but closer to the top-end of that range. The thing is, the Fed's QE (and other liquidity operations) have dramatically increased the amount of cash in the banking system, so these spreads are being held artificially low at the moment due to the excess liquidity (recall, there are several components that make up the spread - two of which are liquidity conditions and credit risk premia).

We know that the Fed is very reluctant to increase QE further, and appears to be preparing the market for no extension in the amount of purchases in October, although some have suggested that they might pool the MBS & UST purchases instead. Either way, base money is unlikely to be increased significantly in the near term unless there is another financial or deflationary shock. Thus, the downward pressure on cash rates due to liquidity in the system is likely to be muted.

To conclude, with the TLGP gone, tail-risk in the financial sector is back, and should the risk rally falter, it is likely that with the absence of this backstop that bank-related credit spreads should widen. The December 2009 forward-starting Libor-OIS spread is currently 29bps, with about 4bps of that pertaining to the year-turn effect, and represents a very high risk-reward to play this theme.