Paul Krugman: Very Scary Things

Paul Krugman discusses the potential for problems due to the evaporation of liquidity from financial markets over the last few days:

Very Scary Things, by Paul Krugman, Commentary, NY Times: In September 1998, the collapse of Long Term Capital Management, a giant hedge fund, led to a meltdown in the financial markets similar, in some ways, to what’s happening now. ... The Fed coordinated a rescue..., while Robert Rubin, the Treasury secretary..., and Alan Greenspan,... the Fed chairman, assured investors that everything would be all right. And the panic subsided...

What’s been happening in financial markets over the past few days is something that truly scares monetary economists: liquidity has dried up. That is, markets in ... financial instruments backed by home mortgages ... have shut down because there are no buyers.

This could turn out to be nothing more than a brief scare. At worst, however, it could cause a chain reaction of debt defaults.

The origins of the current crunch lie in the financial follies of the last few years... The housing bubble was only part of it; across the board, people began acting as if risk had disappeared.

Everyone knows now about the explosion in subprime loans ... and the eagerness with which investors bought securities backed by these loans. But investors also snapped up ... junk bonds, driving the spread between junk bond yields and U.S. Treasuries down to record lows.

Then reality hit... First, the housing bubble popped. Then subprime melted down. Then there was a surge in investor nervousness about junk bonds...

Investors were rattled recently when the subprime meltdown caused the collapse of two hedge funds operated by Bear Stearns... Since then, markets have been manic-depressive, with triple-digit gains or losses in the Dow ... the rule rather than the exception for the past two weeks.

But yesterday’s announcement by BNP Paribas, a large French bank, that it was suspending ... three of its own funds was, if anything, the most ominous news yet. The suspension was necessary, the bank said, because of “the complete evaporation of liquidity in certain market segments” — that is, there are no buyers.

When liquidity dries up ... it can produce a chain reaction of defaults. Financial institution A can’t sell its mortgage-backed securities, so it can’t raise enough cash to make the payment it owes to institution B, which then doesn’t have the cash to pay institution C...

And here’s the truly scary thing about liquidity crises: it’s very hard for policy makers to do anything about them.

The Fed normally responds to economic problems by cutting interest rates... It can also lend money to banks that are short of cash: yesterday the European Central Bank ...  lent banks $130 billion, saying that it would provide unlimited cash if necessary, and the Fed pumped in $24 billion.

But when liquidity dries up, the normal tools of policy lose much of their effectiveness. Reducing the cost of money doesn’t do much ... if nobody is willing to make loans. Ensuring that banks have plenty of cash doesn’t do much if the cash stays in the banks’ vaults.

There are other, more exotic things the Fed and, more important, the executive branch of the U.S. government could do to contain the crisis if the standard policies don’t work. But for a variety of reasons, not least the current administration’s record of incompetence, we’d really rather not go there.

Let’s hope, then, that this crisis blows over as quickly as that of 1998. But I wouldn’t count on it.

_________________________
Previous (8/6) column: Paul Krugman: The Substance Thing
Next (8/13) column: Paul Krugman: It’s All About Them

Comments

[Kerry Kirpes]

What should be done to manage the crisis? Should investors investors be insulated from losses by goverment gurantees? Should mortgagees who over extended themselves be subsidized to avoid defaults? I must take the libertarian position on this one. Let the impacts play themselves. Everyone learns a lesson and those who were prudent don't end up paying for for the situation through taxes to support the subsidies.

[megan adams]

I think we should follow Bush's example and double down the bet: we should push the Republican philosophy even farther. We know from the Clinton era that there are no issues of governance more important than the issue of whether public servants are faithful to their spouses. We know that from our Republican leaders that American society and values revolves around this issue. Really, no 'reality based' issue holds a candle to such fundamentals of character and decency.

So, if the credit markets seize up, I suggest we commence with 'fidelity' hearings, and drag out the hordes of tax consuming 'public servants' for open hearings on whether they are keeping their marriage vows. Such a display of character and righteousness will put the scare in any evil market meanies, and we will all feel "safe" at last.

[Sarah]

Kerry, if this turns out as badly as some of us are afraid, believe me you won't be talking about 'bailouts'. You and I and everyone else are going to be scrambling for the life boats. Trouble is, most of them have been cut loose long since. As Krugman says, there's really not much the Fed or anyone else can do once people start to get seriously risk-averse. Nobody cares what the interest rates are if they're not sure they'll get their principal back. Likewise nobody wants to try to catch the falling knife if they're afraid asset prices are going down further.

The only bright spot of this for me is I'm looking forward to a lot of crow eaten by young libertarians who, never having experienced so much as a mild recession themselves have been shouting, "Bring it on!"

[cm]

Sarah: A good number of self-proclaimed self-made men (some women too I'm sure) will find how "unfair" and ingrate an indifferent world can be towards their best efforts. Whether they draw the right conclusions is anybody's guess, and empirical evidence of past generations is not particularly encouraging.

But in the end gloating lends only very temporary and unsatisfactory comfort and doesn't improve anything.

[Farrar Richardson]

I fear that a really BIG financial crisis is an absolute prerquisite for any serious progressive reform in the USA. Dare we say bring it on?

[reason]

I had a flash the other day that I hope isn't true. Isn't it possible the big banks set up subprime lenders expecting them to go broke in order to drive up house prices and indebtedness to push up there prime and near-prime cash flows.

As I have said before, misuse of limited liability. Something stinks.

[howard]

kerry, the "crisis" is a result of a much too-belated recognition that there is such a thing as risk.

i don't think there's a damn thing we can do about that other than to let it run its course.

[alphie]

One thing about this fiasco that puzzles me:

You can get around a 5% return by buying government notes.

A mortgage is going for a little over 6% annual interest these days.

After the money guys take their cut...seems like these mortgage backed securities might get you an extra 1% a year return for an almost infinite increase in risk.

Unless I'm missing something...mortgage backed securities can't pay a higher rate of return that what the original borrowing were paying in interest, can they?

[Oupoot]

It is wise to accept that there are risks in the system, that they were not as low as many people thought they were and some of them are being realised. However, it is also unwise to overreact. Though it would be satisfying to many if those that made bad decisions in the past get what is due to them, it is unwise for the whole of society to suffer for their mistakes. The key is to minimise the impact on society (i.e. the economy as a whole). I suggest that many persons simply accept the fact that they may have to make some sacrifices such as higher taxes and federal bailouts or whatever else may be necessary in order to minimise the impact on society. I mean, many that were astute and not going into credit would not feel so good when its their savings that will be wiped out by the collapse in some investment products. Or would be screaming when their banks / venture capitalits do not provide the necessary / promised funds that would have acted as liquidity during a particular bad period in sales.

I am pretty sure that whatever course of action are taken, the the poor and middle class will be the most affected, as they are least able to spread their risks to other assets that may be less affected.

[Firozali A.Mulla MBA PhD]

Sir
Slightly out of way. The scary thing is when the car mechanic goes under your car and whistles.....
I thank you
Firozali A. Mulla MBA PhD
P.O.Box 6044
Dar-Es-Salaam
Tanzania
East Africa.

[Icarus]

I'm not sure there's much to fear here. A market correction, while painful for some, is beneficial for others. There are hordes of people waiting for a market crash in home prices, for example.
Also, our debt instrument models need reality, in order to dialectically improve. Let the failed models die a normal, capitalist death, and new ones arise.
Surely the future has a place for sub-prime loans, but, better due diligence is required. Bankrupcy is the great teacher. If we want a system where people aspire to great profit, and hence incur the risk required, it follows that many will fail, and become insolvent. Let the laws of the economy work, and then we collectively learn.

I don't follow why this is called a "crisis", as opposed to simply a "correction".

[reason]

Icarus..
please reread my comment above. I have been puzzled by the subprime fiasco because it was obvious to anybody with half a brain that lending money to people who wouldn't otherwise get a loan on conditions that worsened over time was not a long term money spinner. I think the sub-prime lenders were MEANT to go broke. Spinning off losing (but limited liability) subsidiaries could still be a winning strategy. Maybe bankrupcy is not enough of a penalty in a deregulated financial world.

[Sarah]

Farrar Richardson says...

I fear that a really BIG financial crisis is an absolute prerquisite for any serious progressive reform in the USA. Dare we say bring it on?

No, dammit, we don't! I do so wish that people would read a little history, instead of exercising their imaginations on selective facts. ("Falling prices? Woo hoo! What's so terrible about that?")

Serious progressive reform is by no means the only possible response to major economic disruptions. Neither is it the most likely. You have only to look at Germany, Japan and Italy to see what can happen without just the right combination of adroit political leadership, bright economists, and broad societal commitment to democratic principles.

Hell, for a much more recent example, just look at Yugoslavia-- once prosperous, sophisticated and 'Western' -- Communism's show piece.

We don't have those ethnic tensions, you say? Want to bet? What do you think is going to happen when Joe Six-pack loses his house-- but Jose and Maria down the street still have their's? And then he and his wife lose their jobs-- and he sees that not only are Jose and Maria still working-- they each have two jobs now?

Politicians know that the easiest way to gain or maintain power is to set people against each other. The former communist leadership in Serbia and Croatia metamorphosed into nationalists overnight. I really don't want to find out how much of our current political leadership can do the same.

[Farrar Richardson]

Yes Sarah, we have read a bit of history. In fact I read almost nothing else. "Hard times" by Studs Lonegan is the most nitty gritty. Also I grew up in the great depression, when my father suffered a nervous breakdown for fear he might lose his job. Fortunately he didn't. There were racial tensions then, too. You hardly ever hear the words kykes or dagoes nowadays.

With all the above in mind, I think the history of the New Deal is a strong basis for faith that the country would come through another deep crisis with a stronger society and much more collective common sense.

[groucho]

"Politicians know that the easiest way to gain or maintain power is to set people against each other. The former communist leadership in Serbia and Croatia metamorphosed into nationalists overnight. I really don't want to find out how much of our current political leadership can do the same."

Sarah, give the american people a little more credit(no pun intended). The coming fallout from ongoing household wealth destruction is a necessary part of society moving to a fairer more egalitarian one.

As more and more people feel financial pain they will become more emotionally intelligent; and realize that self-centered greedy behavior has consequences for society as a whole.

If Bernanke discontinues the central bank PUT and allows scores to be tallied, as painfull as the fallout will be, it will bring in a more honest system with a much higher standard of living for all.

[Sarah]

Farrar, forgive the unwarranted assumption that you were too young to have personal experience of "Hard Times". I am, myself, a generation removed from them (although I lived through the changes in Eastern Europe). It was my grandfather, rather than my father who experienced the nervous breakdown-- and died at the height of the Depression from stress-related illness. Fortunately by then some measures of relief had been instituted so that all of the brothers and sisters whose taxes he had been paying didn't actually lose their farms.

I still think you, and many other people, are far too sanguine about the inevitability of a New Deal type response to a depression. The quickest and easiest 'ways out' are very ugly indeed. It requires extraordinarily strong, smart, and moral leadership to bring it off. Maybe it will arise, spontaneously, into the breech, but I'd rather not bet my democracy on it.

* Caveat: Actually, a part of me would like to see a depression, too. A part of me was excited when Reagan won, not because I thought it would be good, but because I knew it would mean change. I suspect that if there is anything to the notion of American 'specialness' it's this: we are descended from generations of people who-- voluntarily for the most part-- took huge risks that most of their fellows avoided. I think we may be genetically selected to be risk-takers. This, too, scares me.

[econ grad stud]

We're much more hyper-individualistic than before the Depression. How that's butts up with really hardship is frightening. Without the strong families or social networks to support people I worry that a real crack up would result in suicide, domestic terrorism, and radicalism.

There are simply fewer moderating forces in our society.

[Joe]

Where is Anne in this conversation? She should have an insight or two regarding how those of us not going down with the hedge funds could make a few bucks. Anne?

[evagrius]

The "New Deal" was able to partially succeed because of strong social networks, often based on ethnic identity but not always. Also, people were relatively stable. Mobility was not as high. That's why "The Grapes of Wrath" had such impact. It showed the result of forced migration with the people involved still basing their lives on community values.
I don't think the same will occur now.

[cm]

Icarus: Well let's hope when all those consumers lose (half?) their shirts, there will still be enough paying demand for ABAP programmers.

[Farrar Richardson]

OK, back to today's world. I guess it's better if Pandora's box stays closed.

By the way, it was of course Studs Terkel who wrote Hard Times. sorry

[lonesome moderate]

Where is Anne in this conversation? She should have an insight or two regarding how those of us not going down with the hedge funds could make a few bucks. Anne?

I have the impression that Anne's job in fact involves things like bonds and hedge funds and spreads and liquidity, in which case she's probably been putting in some 16 hour days. Something of a leading indicator, I guess.

says...

The Federal Reserve added $19 billion in temporary funds to the banking system through the purchase of mortgage-backed securities to help meet demand for cash amid a rout in bonds backed by home loans to riskier borrowers.

The effect of this? It raises the prices of MBS than what the market value would be in the a free market without Fed intervention

So the Investment Bankers and Brokers got their multi-million dollar bonuses by engaging in reckless lending - the consequences of which are threatening to bring the financial system to meltdown.

To prevent that, The Fed has to prop up the market. And inflate the money supply.

Private profit, at public expense.

Where were all these Fed bozos when the privateers were compromising the financial system by their reckless behavior for private profit?

Because it's all so complex and indirect does not mean this is not the racket it is.

[robertdfeinman]

George Soros demonstrated to his profit that central banks cannot prop up financial markets. Tossing extra funds into the pot as they are doing now is going to fail.

Interest rates will rise to where they want to be and the central banks can't do anything about it.

Everyone is taking about the fact that risk was under priced, but a lot of this was because the amount of real risk was concealed from the buyers of the debt. This is a standard musical chairs scenario. The one holding the securities when the music stops loses.

What's different now is that each time the instruments were repackaged the sellers kept a bit for themselves. So unwinding this will be complicated. There was a recent story about a woman who got a foreclosure notice and no one could tell her who actually owned her mortgage.

Somewhere there is a calm investor who is quietly buying up under priced securities which are being dumped during a panic. Six months or a year from now he will be on the front page of the business publications being hailed for market acumen. Never sell in a down market.

[paine]

u're
flying too low
not too high
icky

"Bankrupcy is the great teacher"
my lord do you wear
a fresh boiled collar each business day ??

as others here suggest
if this credit refi hifi lofi crunch
has mighty knock on
and
spreads to the product markets
ie
sales rates of goods and services
bought by squoozen households
slow

we 'umble precariously employed
jobblers
may suffer the consequences
whether
we borrowed anything or not

says...

A classic case of moral hazard. Be reckless, take all the risks, earn the fat fees and if it blows up, the Fed will step in to help. And it did.

If factories are to be taxed for pollution, then reckless financial firms that endanger the financial system should likewise be taxed for generating risks, which are afterall negative externalities that spillover to those who do not benefit from profits made. So I say, slap the taxes on hedge funds, private equity firms and those who place huge bets and might possibly need bailouts if their bets turn out wrong.

[paine]

rf
"George Soros demonstrated to his profit that central banks cannot prop up financial markets. Tossing extra funds into the pot as they are doing now is going to fail."

no link here

lesson from george S
a market signal that a currency
must fall in forex value
can't BE THWARTED for long
by the cb of that currency acting alone
once its foreign reserves start to drain off ....

but
if other cbs come forth to prop along side ...

the currency will not necessarily fall
the spontaneous actions of the markets can be stymied

voila
the dollar yseterday and today
vis a vis
the rmb

regardless right now to curb
the real edge
of the credit convulsion
means
adding liquidity to the credit system

this is indeed
the correct short run action
but
it alone is not sufficient
to end payments flow grid lock

the liquidity must be loaned

loaned
to just those firms and households
with a payments problem
to restart the flow of payments
and since their credit rating just took a hit
and
at the same time credit standards are rising .....

no for profit lender will do this

no the feds need to set up some direct bail out mechanisms

private lenders will just sit on their liquidity

we need a social deal
like a temporary holiday
for mortgage payers
and maybe
a walk away free
from foreclosure provision

and just for class neutrality
a comp system for the lenders

moral hazzard ????

plenty of time to sort that out later

for now lets not destroy what we aim to save

sure the set up's
been
on credit heroin for years
but the junkies need methadon now
not kold turkey

much as my sadistic
three sizes to evil heart
desires GGD II
(great global depression II)
my kool mind rings with the maxim
never wish for a bad outcome
we can avoid

cleo tends to double the punishment
and in particular
spread it to unexpected places and persons

[paine]

"Never sell in a down market"
what if its late 1864
and you're holding confederate bonds ????

[Sarah]

A classic case of moral hazard. Be reckless, take all the risks, earn the fat fees and if it blows up, the Fed will step in to help. And it did.

No. See Calculated Risk today for a good discussion of what the Fed is doing and why. What it is buying is AAA Federal Agency MBS -- something it has apparently done often in the past.

I'm trying to work my way through this document:
http://www.federalreserve.gov/pubs/bulletin/1997/199711lead.pdf
before our class goes over to the Fed today. This link:
http://www.newyorkfed.org/markets/openmarket.html apparently explains the process and gives charts showing time series with amounts and types of repos, but unfortunately I can't get Firefox to open most of the pages.

Tanta's succinct and sensible answer to what the Fed is doing is that they giving cover to the banks which have been doing what people on housing blogs have been yelling for them to do: keeping more of their loans so that they have skin in the game.

Of course if you prefer the tin-foil hat, by all means...

[Bruce Wilder]

paine says...
"Never sell in a down market"
what if its late 1864
and you're holding confederate bonds ????

Bruce replies...
Sell for Confederate dollars and buy a good field hand?

[Alex Tolley]

Sarah:

* Caveat: Actually, a part of me would like to see a depression, too. A part of me was excited when Reagan won, not because I thought it would be good, but because I knew it would mean change. I suspect that if there is anything to the notion of American 'specialness' it's this: we are descended from generations of people who-- voluntarily for the most part-- took huge risks that most of their fellows avoided. I think we may be genetically selected to be risk-takers. This, too, scares me.

Funnily enough, the idea that people wanted to see the changed world after global warming was posited as a reason to scare monger against it on another blogsite. Interesting thought indeed.

I guess this is part of the admonistion from safety seekers: "Be careful what you wish for".

[groucho]

"Tanta's succinct and sensible answer to what the Fed is doing is that they giving cover to the banks"

Sarah, Ain't that the truth!!! Covering their bad bets.

The BERNANKE PUT is now on. He instigated the mortgage mess with his "making sure deflation doesn't happen here"
faulty analysis and subsequent flood of liquidity.

Bernanke, Kohn, Greenspan, etc.. brought on this mess. Is it any wonder why the FED is now going to start to monetize MBS?
Nobody in power ever wants to admit they goofed up. Good examples of this are Clinton's fiasco's, Bush's denials; and those working at the FED who want to "save the workers" from declining prices.

Bernanke wanted to save america from deflation. Now he has to monetize US mortgages to keep the mortgage industry on life support.

WHAT A FIASCO!!!!!

[Bruce Wilder]

Sarah: "Of course if you prefer the tin-foil hat, by all means..."

What was $19 billion a few minutes is $35 billion as I write this (and Bloomberg is on update 6 of its basic story).

Where did I put my tinfoil hat? I know I was wearing it during Kerry's election in Ohio . . . and then?

[paine]

"the poor and middle class will be the most affected, as they are least able to spread their risks to other assets that may be less affected. "

in a society like ours
based
overwhelmingly on wage labor

lots of folks have but one "asset"
themselves

they can hire themselves out
by the hour day week month or year or n years
to anyone willing to hire em

talk about musical chairs .....

each morning
u come in to the job site
never knowing
how many
new ones will be added
or
old ones removed
but the bells toll on

[paine]

groucho

if i asked you

"your portfolio or your job"
which would you give me ???

my guess based on your comments
....your job

[Robert]

cm

I don't think there is any possibility this is a planned implosion. Most banks have crossed back and forth on the lines between prime and sub prime markets in the fervor of the last 5 years. It's my understanding that MBS's are not delineated on the basis of credit quality, and are fairly homogenous. I can only conclude that no lender will be immune in this crisis.

[Icarus]

CM...

You seem quite smitten with ABAP...what happened?...did you attempt to learn it, and had no luck gaining employment?

[ken melvin]

As a professor of Computer Science at UCB told me in 1970, programming is an art not a science. In the 80s and 90s we saw them go in a tell everyone they had the solution(s) when they usually didn't even know how the process worked. They imposed a new lexicon to make it all mysterious. Carried the programs around on floppies in their pockets. They took the trades away because the old accountants, engineers, draftsmen, couldn't do computer. Am I close, Icarus?

[Robert]

The current problem is not as much a credit problem per say, but a leverage problem. The debt levels of not only this country, but also its individual citizens (consumer credit grew at more than double its expected rate) are untenable. With the burgeoning of sustainable debt levels, there is little credit to be extended in order to absorb the sell offs in the market. Akin to this is the relatively nonexistent regulation of hedge fund positions (some of the biggest speculators in the MBS game). To what degree the central banks will be forced or be able to continue to infuse capital to make up for the shortage in lending is anyone's guess, as these funds continue to exit their positions. The scale and scope of which is generally unknown due to the lack of regulation. This is the truly scary part. As an old teacher of mine was fond of saying, "this is like the sign outside the mortuary...remains to be seen".

[anne]

http://krugman.page.nytimes.com/b/a/258300.htm

August 10, 2007

A Dark Financial Forecast

Terri Arnold, San Diego: I've been puzzled by the reaction to the defaults in the subprime mortgage market? Aren't financial institutions fairly savvy about the percentage of defaults on the loans it issues? Wouldn't the lenders involved in issuing subprime loans have had a pretty good idea of the risks involved? Am I being too cynical when I think this is another case of take the money and run?

Paul Krugman: I think there are a couple of things. One is that as long as housing prices kept rising, the default rate was low, because people could refinance. And there was a lot of denial about the housing bubble. The other is securitization: these loans were chopped up, and the pieces marketed to investors who really had little idea what the real risks were.

Michael M. Ross, Boston: Fixing the liquidity crisis should begin at the bottom of the pyramid, not the top. Any bailout should begin with individual subprime borrowers by starting a program of government-backed zero-percent mortgages. This would do more to restore confidence in the financial markets than all the free money loaned by central banks to big banks — and would probably be cheaper too.

Paul Krugman: Well, I'd go for an active effort to restructure loans. Zero interest is not going to happen — hey, our leader won't even raise gas taxes to keep the bridges from falling down.

Sherri, Rochester, Mich.: Our assets are in stocks and bonds, most managed by Fidelity. We are senior citizens who have always saved and been conservative with our money. Is there anything we can do to protect our assets?

Paul Krugman: If the bonds are AAA — or better yet, government — no problem. Stocks are risky, though I would say that right now their value isn't out of line with profits, which are very high.

Len Cassamas, Atlanta: Given the weak dollar and the huge amount of debt the nation has accumulated, I have two questions. First, is there really any difference between a T-bill and a junk bond? Second, is this, in economic terms, the perfect storm brewing? In other words, in your view, how bad could this get?

Ray Copson, Reston, Va.: Here's my question: could this be the beginning of a crisis that forces the United States to balance the federal budget and rein in the trade deficit? Imagine the implications of that!

Paul Krugman: So far that shoe hasn't dropped. If the Chinese start cashing out, then it gets interesting.

George Peng, New York: I agree — I think this has a ways to go.

I suspect we're seeing a classic unwinding. I'm surprised we haven't seen more about how the sudden disappearance of subprime loans effectively takes out a large part of the first-time homebuyers base, which then makes it difficult for second-time homebuyers to move up, and so on. If you consider the A.R.M. resets coming up soon, doesn't this mean that, at least in housing, we're going to see some recursive effects for awhile? This slowing of the housing market has widespread impacts on the overall economy, so when analysts and pundit say the economy is healthy, I have to think that they seem to only be looking backwards, not forwards, which the stock market seems to be doing slightly more effectively.

And the debt instruments backed by these loans trade in illiquid markets, so there can be wide spreads between fundamental and market prices. However, if you're levered up, then your margin lender may not care what fundamental value is and issue a margin call based on this putative market price. I think that's what we're seeing — lenders pick a price, issue the call, which then leads to more panic selling and margin calls as others notice. Of course, the other problem is that nobody knows what fundamental value is because default models are clearly wrong by significant margins.

I guess the question is, how much of what we're seeing is an issue of confidence or is it that the market is really seeing through the cheerleaders in the media who seem unable to admit that this is going to get a bit worse before it gets better? ...

[anne]

Remember, what the Federal Reserve and other central banks is doing is not rescuing holders of questionable mortgage debt but rather facilitating short term financial transactions. This is a market facilitation and not a specific rescue.

[Robert]

I earlier attributed a remark to cm that was voiced by reason. My issue was not as much the author as the idea.

[Robert]

Anne, I would respectfully disagree. This infusion is one possible scenario that was considered in the bailout of LTCM. What has not happened over the past 5 years is the proper assessment(pricing) of risk. One can't be surprised if they tell their child "don't do this, or else", and when they never administer the "or else" the child is back at it again.

[anne]

Robert

"The current problem is not as much a credit problem per say, but a leverage problem."

There is my prime worry, and that is what I do not understand. The leverage issues are a threat, but how deep is just not clear. that is why I keep wondering who holds questionable mortgage debt, especially the derivatives? Goldman Sachs, sure, but in client funds so the company appears insulated. Vanguard on the other hand is untouched.

[anne]

http://delong.typepad.com/sdj/2007/08/the-fed-is-buyi.html

August 10, 2007

The Fed Is Buying Mortgage-Backed Securities?

Brad,

There is a big distinction between outright purchases and collateral taken in repo. On the former, you are basically right that the Fed only holds US Treasuries (although if you look closely you will see that in the past that purchased agencies outright as well). What they are doing in repo is taking collateral.

[Ah. Thanks. Bloomberg had it as a *purchase*, which would have been unusual both in size and in manner...]

This is not "intervention" since they are going to give the stuff back. In the case of todays (admittedly very large) $35 billion operation, it will all automatically reverse on Monday.

A quick look at the history of these temporary open market operations shows that they have been taking mortgage-backed securities as collateral for repo for some time. In the past 30 seconds I could verify that they have been doing it regularly since at least 2000. The quantities have normally been small (between $100 mil and $2 bil), but they have been doing it.

So this is not what I would call an "intervention in the mortgage-backed securities market". And it is not unusual.

If you are interested in the data, you can download it from
http://www.newyorkfed.org/markets/omo/dmm/temp.cfm

Steve Cecchetti

[anne]

Steve Cecchetti is right. The Federal Reserve is only facilitating short term financial transactions. Nothing more, and nothing unusual other than scale. So far.

[Robert]

I agree the depth is most worrisome because it is unknown. I believe this is the feeding the volatility of the market as we speak. An additional concern regarding leverage is the spillover effects and their potential to impact any funds ability to meet its short term financing needs.

[Robert]

I want no part of doom saying. I hope the Fed can continue to help absorb the contraction of credit.

[groucho]

"So this is not what I would call an "intervention in the mortgage-backed securities market". And it is not unusual."

Technically, true....but what about intent on "mortgage/housing PUT expectations"?

Fed claims they didn't want to purchase treasuries because of the strong demand for risk free assets by the flight to safety.

Sounds like the same kind of logic Greenie espoused when he told homeowners to take out ARMs when rates were at generational lows.

Fed's balance sheet shows that over time more and more of gov't and agency debt is monetized. The FED was able to limit the expansion of the GSE's books. It's high time to do the same to the FED.

[anne]

What the Federal Reserve has done is to provide liquidity to allow for smooth immediate and short term financial transactions. Nothing more. Institutions need a flow of credit for the shortest of periods to allow for normal financial transaction. Even perfectly secure short term debt needs to be accepted for immediate payment to allow for our common transactions. The Fed is insuring that immediate financial transactions continue by lending to banks as always but in larger amounts through this cautious or even paniky period.

There is no changing of conditions in the mortgage market as such. There is no rescue of institutions that hold difficult mortgage debt and derivatives. What the Fed is doing is protecting what should be normal financial transactions. I agree completely with Paul Krugman about the danger of a cascade of lending limitations, but as such there is no reason to criticize what has been essentially a normal Fed operation magnified to avert a potential financial market freeze.

There has been no rescue, no putting.

The Fed is supposed to insure immediate liquidity needs. Such insurance simply defuses needless risk, where there is no risk to the underlying debt instruments.

[anne]

The effectiveness so far of Federal Reserve immediate credit extension was evident in the Federal Funds rate moving from 5% to 6% and through the day down to 5% and 3% and even 1%.

[groucho]

"There has been no rescue, no putting.

The Fed is supposed to insure immediate liquidity needs. Such insurance simply defuses needless risk, where there is no risk to the underlying debt instruments."

"The effectiveness so far of Federal Reserve immediate credit extension was evident in the Federal Funds rate moving from 5% to 6% and through the day down to 5% and 3% and even 1%."

Anne, if there was no rescue, no putting how was the FED able to drive the FFR to 1%?

Driving the FFR below their 5.25 target rate just shows how much flooding vs demand the NY desk just initiated.

It's time to educate the congress on just how egregious FED/Treasury behavior has become. A new charter with a limit on their book expansion and new mandates on what their mission is, must be forthcoming.

To keep inflating to postpone a debt-deflation while put millions of americans into life long hock is at least as unethical as the current administartions middle east policies.

[Patricia Shannon]

There is uncertainty over who owns all the debt. How much of it is owned by China?

In "The Fourth Turning", William Strauss and Neil Howe examine cycles of history. They claim that there is a cycle of about 80 years, that has been going on for centuries. The cycles are subdivided into subcycles of about 20 years, the length of a generation. In each subcycle, the predominant characteristics of society, including the way children are raised and economic conditions, cause a change in the next generation. If things go according to the pattern they found, we are currently in a downward slide (little argument to that, I'm sure), which will eventually end in a catastrophe, which in the past has usually meant war. The authors think that the next catastrophe might be environmental. I am afraid it will be both, with environmental catastrophe leading to war, as may already be happening in Africa. Looking at history, I see little, if any, reason to think we will deal with any crisis until it occurs.

[Patricia Shannon]

See also the earlier book : "The Cycles of American History" by Arthur M. Schlesinger Jr.