Risk Absorber of Last Resort

I sent this email earlier this evening:

I’m starting to think that the Fed should drop the term part of the TSLF – trade permanently for risky assets (with the haircut sufficient to provide some compensation for the risk), bonds for MBS, money for MBS, or whatever, and don’t limit trades to banks.

The Fed would act as “risk absorber of last resort.” Why should it do this? There has been an unexpected earthquake of risk, a financial disaster on the scale of a natural disaster like Katrina, and the government can step in and sop some of it up by trading non-risky assets (money, bonds, etc.) for risky assets at an attractive risk-adjusted price. To limit the amount, this could also be done through auction with a ceiling on how much will be traded, except unlike the current auction it wouldn’t be a repo and it wouldn’t be as limited in terms of who can trade and what can be traded.

What am I missing? Moral hazard and worries about the next time? I’d still fix this first, worry about moral hazard later, perhaps through regulatory changes down the road that (hopefully) limit the opportunities for such behavior.

I just came across this from Willem Buiter:

The Fed as Market Maker of Last Resort: better late than never, by Willem Buiter: According to today’s FT: “… the US central bank announced that it would lend primary dealers in the bond market $200bn in Treasury securities for a month at a time and accept ordinary triple-A rated mortgage-backed securities as collateral in return.” … “The latest Fed gambit ... is designed to improve liquidity by allowing dealers to swap their mortgage-backed securities for Treasuries, which they can in turn use to raise cash.” … “The initiative takes the US central bank a step closer to the nuclear option of buying mortgage-backed securities in its own right, although it stopped well short of such an extreme action.”

The last sentence, of course, is rubbish. ... There can be little doubt that the logical next step - the outright purchase by the Fed of non-agency-guaranteed mortgage-backed securities (possibly from a wider range of counterparties than the primary dealers) - won’t be long in coming. ...

[T]he Fed has woken up to the fact that the world has changed and that central banks have to accept an expanded range of eligible collateral from an expanded range of counterparties when key financial market seize up, the Fed should advertise the fact. They are doing the right thing.

It is key, of course, that the illiquid securities accepted as collateral be valued aggressively and subject to appropriate haircuts to minimize moral hazard. The Bank of England has recruited the services of Paul Klemperer to help it design auctions that will serve as (reservation) price discovery mechanisms, to ensure that the Bank (and behind the Bank the tax payer) do not end up with inadequately collateralised loans. I am sure the Fed must be doing the same with Paul Milgrom and other auction theory geniuses.

The Fed could force some of the effectively unregulated shadow banking sector players into a framework of supervision and regulation, by stipulating that it will deal with a wider range of counterparties than the usual suspects, but only if they are subject to a Fed-approved regulatory and supervisory regime.

In future weeks and months, it is possible that the central banks, including the Fed, will have to move from ... repos accepting mortgage-backed securities as collateral to outright open market purchases of mortgage-backed securities and other illiquid private assets, and from an wider range of counterparties. ...

All that remains is for the private financial institutions, banks and shadow banks, to recognise the losses they have incurred and to scale back their operations or go out of business in a reasonably orderly fashion. The Fed’s readiness to act as Market Maker of Last Resort means that the necessary writing down and writing off of impaired assets and the necessary liquidation of non-viable financial institutions is more likely to take place within a framework of reasonably well-functioning financial and credit markets.

The editorial board at the WSJ takes a somewhat different view on permanent trades:

The Fed Rally, Editorial, WSJ: ...The big news on Wall Street yesterday was investor elation in the wake of the Federal Reserve's creative decision to add more targeted liquidity to financial markets. A gang of five central banks made the announcement in the morning, and equities soared.

The move continued what we've argued is the Fed's best policy course in this crisis... This is intended to increase the demand for MBSs, which few seem to want in the current climate. In other words, the Fed is trying to supply liquidity to revive a market locked up by fear.

This is not the same as a "bailout," in the sense of using taxpayer money to rescue banks or home mortgage securities. These are loans or swaps, designed to be a short-term source of liquidity, and it's important that they continue to be temporary.

There is some moral hazard in the Fed accepting MBSs as collateral, though the Fed says its balance sheet remains strong. There is even greater risk if Members of Congress begin to look to the Fed as a way to buy up these MBSs on a permanent basis as a way to "rescue" the mortgage market. ...

The good news is that yesterday's exercise showed signs of working. The flight to the safety of Treasuries eased, while spreads in mortgage securities narrowed considerably. Even better, market expectations for another big cut in the fed funds rate next week fell. If these surgical strikes work, maybe the Fed won't continue to run the risk of tempting inflation and a dollar rout with ever easier monetary policy.

Comments

[Winslow R.]

"(with the haircut sufficient to provide some compensation for the risk),"

Given the leverage at many off balance sheet hedge funds is 33x the haircut can't be more that 3%.

What looks like will happen is the primary dealers become the risk absorber of last resort, rather than the Fed. The primary dealers will likely receive the unspoken 'guarantee' they will not be allowed to fail. In other words, their capital ratios may fall below BASEL standards without consequence.

Expect to see a large expansion in the TSLF.

[bullbust]

There can be little doubt that the logical next step - the outright purchase by the Fed of non-agency-guaranteed mortgage-backed securities (possibly from a wider range of counterparties than the primary dealers) - won’t be long in coming.

That would be a dream come true for the gold nuts. They have been long predicting that this would be the outcome.

It is key, of course, that the illiquid securities accepted as collateral be valued aggressively and subject to appropriate haircuts to minimize moral hazard. The Bank of England has recruited the services of Paul Klemperer to help it design auctions that will serve as (reservation) price discovery mechanisms, to ensure that the Bank (and behind the Bank the tax payer) do not end up with inadequately collateralised loans. I am sure the Fed must be doing the same with Paul Milgrom and other auction theory geniuses.

I have a question to Mark Thoma. There is a huge amount of money parked in short term T-bills and money market funds.
So when Buiter goes on to say

..The Fed’s readiness to act as Market Maker of Last Resort means that the necessary writing down and writing off of impaired assets and the necessary liquidation of non-viable financial institutions is more likely to take place within a framework of reasonably well-functioning financial and credit markets.

it is taken for granted that assets will be written down to their market value.

If that were to be done; i.e these assets were sold with haircuts, at market values, do you really think private investors will refuse to make a market for this?

What makes you think that the Fed can buy at the right price, but the market wont? Isn't the whole concept kind of paradoxical?

The whole thing makes sense only if the Fed is willing to bear a loss which the private market wont.

[Bruce Wilder]

I agree with Winslow.

Any haircut worthy of the name will destroy much of the "shadow banking sector". It is not going to come under regulation, voluntarily or otherwise. It only exists, to escape regulation and to steal.

If we have to nationalize the banks, then we have to nationalize the banks. But, don't call it something else.

And, let's not pretend that this is an Act of Nature or Nature's God, either. This is not Hurricane Katrina. This is a network of deliberate enterprise, brought down by unrestrained greed, arrogance and incompetence.

[Risk Premium or No Risk]

Foreign savers are unlikely to buy any more uninsured mortgages at low interest rates. The only way to continue low interest rate mortgages is for the gov to absorb the risk. If they have to bear the risk, foreign savers would likely demand credit card type interest rates for sub prime mortgages. The default risk is just too high for single digit interest rates to cover losses.

[SGC]

"The primary dealers will likely receive the unspoken 'guarantee' they will not be allowed to fail. In other words, their capital ratios may fall below BASEL standards without consequence."

Um, many of the primary dealers are investment banks, not commercial banks and are thus not affected by Basel.

I think the way to understand the Fed is to picture it crash landing an airplane. It's not really in control, but it's working hard to steer well enough to protect as many lives as possible. The leverage plane's still airborne, so the trick right now is to keep it from picking up too much speed as it careens earthwards. I'd like to think that the Fed knows that it's too late to try to stabilize the plane in flight and is hitting the breaks hard with the goal of landing the plane with at least the fuselage in one piece.

One of the problems with the current crisis that the unwind is dragging on so long. It's easy to say that the Fed should nationalize the banks, but my guess is that almost all the big ones will fall below regulatory capital standards. The Fed will have to nationalize the weakest and extend support to the strongest. But do you really think that enough leverage has been unwound for the Fed to determine which banks are weak and which are strong? I think the unwind must continue with the Fed attempting to steer its unwieldy charge as best it can.

[SGC]

As for the "risk absorber of last resort": Well, it's a crash landing, so you do what you've got to do. But I can't say I like the idea. I don't think that anything the Fed has done so far sets a bad precedent for future policy, but outright purchases of low quality assets at a price that helps the markets (and doesn't panic them even more) is a very risky business. How does the Fed get out of this role once it takes it on? The exit strategy must be very well planned.

[Time]

"One of the problems with the current crisis that the unwind is dragging on so long."

The time problem isn't caused by mortgages per se, since they are only about $12 trillion. If all else failed, it could probably be stabilized by the federal gov directly borrowing another trillion or so from foreign savers (enlarging the federal debt to 10 trillion). The problem is unwinding the unregulated $500 trillion derivatives market that is partly collateralized by the mortgages. Even treasury does not have the ability to raise that kind of money. They can only try to stabilize mortgages, and hope the derivative market somehow fixes itself. This self repair process takes however long it takes.

[Brenda Rosser]

The Federal Government has overseen the destruction of 'the market' in financial securities and in other industries.

It has allowed the long term repeated breaches of the most basic building block of a market economy: the contract of sale.

Financial institutions have been permitted to sell worthless junk to customers by misrepresenting the nature of the goods; by informing the buyers that they have investment value and ensuring that potential buyers had no way of checking their credentials.

The Federal Government has, in the name of the 'free' market openly protected the financial institutions in their ongoing quest to mislead. when the state governments tried to ban the selling of worthless junk the Fed Government intervened and disallowed such precaution.

This is regulation by the Government in order to support theft.

People anticipating the end of capitalism need wait no longer. It has already occurred. Decades ago. Only the empty rhetoric remains.

[Bruce Wilder]

Time: "The time problem isn't caused by mortgages per se, since they are only about $12 trillion. . . The problem is unwinding the unregulated $500 trillion derivatives market . . ."

If your basic point is that problems in OTC derivatives may be harder both to identify and to contain than the problems in mortgages, I can only agree.

The loss in mortgages due to losses in housing value is being magnified by losses and obscurity related to derivatives, credit default swaps and the like.

However, in comparing magnitudes, it shouldn't be $12T in mortgages v. $500T in OTC derivatives. The $500T derivatives number is more flow than stock. The right standard of comparison to outstanding mortgages would put OTC derivatives at about $11 trillion.

[Spectator]

Unbelievable how many economists have their heads so warped they're incapable of common sense. These actions are the equivalent of a society closing it's prisons, and declaring no more punishment for bad decisions. No consequences for the bad actors.

Perhaps thats already been tried someplace, supported by some crackpot academic theories. We're trying the financial economy version. We'll have to wait until there's nothing left to loot, or take up arms to preserve what's left.

[Time]

Bruce W..."However, in comparing magnitudes, it shouldn't be $12T in mortgages v. $500T in OTC derivatives. $500T derivatives number is more flow than stock. "

While derivatives can be issued on more than stocks, you do have a point. $500 trillion is only the approximate notional value of "reporting entity" transactions (e.g., banks). It would only be realized in the case of complete and total market meltdown of all stocks, bonds, real estate, commodities, etc...(unlikely). IOW, 500 trillion worth of insurance has been issued to hedge against various potential events, but there is no real chance that all 500 trillion would have to be paid off in any given year.

$11 trillion was the market value of the potential risk transfer extant at the time of the latest BIS study (approx. what the derivative contracts could have been sold for at that time, assuming all counter parties lived up to their promises). This value can go up rapidly in the case of extreme market stress (like now). The current market value of the derivative risk extant would be somewhere in between the two numbers, but certainly far closer to 11 than 516. The value could theoretically rise closer to the 500 range if things got a lot worse, but would probably never actually reach that number.

Obviously, there is no chance that counter parties could make good on their obligations at even a fraction of the notional value, so every increase in risk puts the system in greater danger of collapse. Loss of confidence in counter party viability would occur long before risk premiums extant reached even a fraction of the notional value. Most "reporting entity" derivative based credit would cease at that point.

[hari]

@ Mark -

This development yesterday is positive - so far.
Will it hold for more than a day/week, I don't know.
The figs thrown around here are confusing...no one I suppose really understands or knows what the exact figs are at the present time - other than the magnitude of the subprime mortgage market in housing sector.

Few months ago, I used the word "cabal" when discussing the moral hazard due to unregulated derivatives market (AG didn't consider it a policy imperative!).

Now, you are using the "shadow banking sector" as the unregulated part of the puzzle. I suspect they constitute the socalled "cabal" which did the cutting and mixing of the subprime mortages into a AAA global marketing venture! Supported/led by the big banks, I suppose.

If the conclusion, from your piece above is clear, there is abundant need for Fed to consider how to avoid such developments in hi fi markets again. Regulatory regime will become inevitable given the extend of liquidity Fed is now pumping to ensure solvency in the credit markets.

The CBs meeting in Basel/BIS (earlier) is responsible for coordinating their joint action in the credit market. And I expect them to coordinate their actions until the malise is finally corned/identified and then they can devise further intruments to deal with it.

[ndk]

This is getting absurd. Confidence in the economy, markets, and system is deteriorating extremely rapidly and actions like this are not going to help. Haven't you read other message boards? No matter where you go, no matter how mainstream and heavily trafficked, the mood is downright surly. People are angry and itching for a fight.

The theory is becoming entrenched that the Fed is driving up oil and food prices as real wages plunge in the name of saving bankers making millions of dollars a year. This must be part of the policy calculus, and soon.

[ddt]

What is it with economists and their undying allegiance to the pigmen?

BSC should have been nationalized yesterday morning. Everyone knows that Bear Sterns is insolvent. Everyone knows that Bear Sterns was operated in a disgraceful manner (smoking dope in the corner office anyone? talk about fiddling while Rome burns, how about a bridge tournament to keep you mind off things). So why exactly is it necessary to reward BSC shareholders and directors with a government bailout? Shareholder equity should go to zero and it should be nationalized.

[kharris]

The financial sector is in a special position. There is no other (private) sector which represents as high a level of short-term systemic risk. When risk-taking blows up, there are massive consequences for everybody. That is the source of financial firms' leverage for bailouts. Losses in the financial sector are inevitably socialized. I appreciate that, as several responses here indicate, there is a need to see that private failures bite the risk-taker on the ass. How do we deal with the social costs they impose? Our host says better regulation. Tricky. Let's hear how that would work.

[a]

"There has been an unexpected earthquake of risk..."

With all due respect, this is not what has happened. There has been an earthquake of *losses*. Houses in the U.S. have lost, say, 10% of their value from the peak, and should lose at least 20-30% more.

These losses produce losses in securitized paper. While it's true that the risk on these papers has increased, that's less important to the fact that they are worse less, indeed much less. the Fed should be the "risk absorber of last resort" - actually, I don't agree, since the market trades risk in the form of options and other derivative products - but let that pass. Under no circumstances should the Fed be the "loss absorber of last resort." Unless, of course, you believe in the impoverishment of 90% of America in order to ensure that the top 1% continue to receive their bonuses.

[Lafayette]

Off a cliff

SGC: The Fed will have to nationalize the weakest and extend support to the strongest.

No, as Krugman suggested in his article on another thread, the time may come when triage must be the option. If a Credit Institution drops below regulatory capital requirement and IF they stay there, then they should be quietly closed (bankruptcy).

Someone MUST pay the piper, or this mess will just recur in some other form. It is already a recurrence, in another form, of the dot.com boom-and-bust that was considered only a bit of exaggerated exuberance -- when what was clearly necessary at the time was a more regulatory environment (to assure that just such a mess would be avoided).

If no one understands that the situation is grave and that Self-Regulation of the industry is still the best standard, then they've had one too many for the road.

Left to its own devices, the Finance Industry would drive us off a cliff in the search of profits. (The fall isn't difficult, it's the sudden stop that's deadly.)

But do you really think that enough leverage has been unwound for the Fed to determine which banks are weak and which are strong? I think the unwind must continue with the Fed attempting to steer its unwieldy charge as best it can.

Frankly, today, I don't think so. The market seizure is due more to emotion than liquidity. Admittedly, one affects the other. But emotions tend to pass with time.

We've not given enough time to time.

[dd]

"But do you really think that enough leverage has been unwound for the Fed to determine which banks are weak and which are strong?"

The sticking point may be that the Fed itself has no idea where it is on the "unwind" continuum and so takes it a step at a time hoping it's near the end. Each step so far only indicates it's at the beginning as this is an inverted debt pyramid with very risk subprime mortgages supporting even riskier CDOs, CDS and other assorted derivatives and that is without considering the additional leverage superimposed on those "assets."

[ddt]

"Does this bail out the rest of us? Why should any of us who are not top management at Citigroup, or major shareholders, care if it goes into receivership like Northern Rock did in England? The bank's operations will still continue. Those who have deposits there will still be able to get their money. The only difference is that there will be new management, the stockholders will have lost their money, and the bank would more quickly come clean on its bad debts.

Does the bailout do anything for the tens of millions of homeowners who have seen their life savings disappear because house prices collapsed -- in spite of the fact that all the experts said house prices never fall? How about the families who are now tapping their retirement accounts in a desperate effort to prevent foreclosure, is the Fed bailing them out?

The bubble was driven by incredible incompetence by those calling the shots both at the Fed and other regulatory institutions and in the financial sector. We should clean house as quickly as possible. This bailout is not in the public interest.

--Dean Baker "

[James]

Nice proposal but it really doesn't go far enough.

The Fed should also extend its offer of absorbing the effects of bad investments to:

Anyone who can show a loss on their Schedule D for any and all investements. The Fed can send them a check after the IRS verifies the amount.

Anyone who has purchased any consumer item over $1000 that hasn't met expectations and whose warranty period has expired. Local municipalities can set up centers to receive these goods and create an instant credit on receipt of a proof of purchase with the amount paid. For items older than two years a generous depreciation schedule can be provided.

Has anyone considered all the economic carnage inflicted by bad so-called "personal" decisions? The women who spends money on a man who turns out to be just a player. The man who woos a woman investing sometimes considerable amounts, only to 'strike out.'

SAVE THOSE RECEIPTS PEOPLE!

[James]

Oh, and I have already considered your only plausible objection.

The reason to 'bail out' the banks is that they have cleverly positioned themselves to be able to extort bailouts by being 'too big to fail.' Indeed, there is strong evidence that they pursue this bargaining strategy and play the card with some brazen delight.

So, the proposal is that unless the above credits are granted to all consumers, who invidivually are too small to count, but who together represent the builk of our real GDP, that not only do they 'mail in the keys' for all unpaid homes, but that they simply stop paying for everything, and give themselves a clean slate on all debt, public and private.

Now THAT's too big to fail.

[Winslow R.]

Kharris wrote: "The financial sector is in a special position."

**Why should they retain that position? If economists want to give banks a subsidy, send them a check. Otherwise, make them compete for Fed funds at an auction with everyday American citizens.

Kharris wrote: "There is no other (private) sector which represents as high a level of short-term systemic risk. When risk-taking blows up, there are massive consequences for everybody. That is the source of financial firms' leverage for bailouts."

**Yes but when risk-taking doesn't 'blow up' there are massive rewards for a few. Remember Goldman Sachs bonuses?

Kharris wrote: "Losses in the financial sector are inevitably socialized. I appreciate that, as several responses here indicate, there is a need to see that private failures bite the risk-taker on the ass. How do we deal with the social costs they impose?"

**By abolishing the bank monopoly.

Kharris wrote: "Our host says better regulation. Tricky. Let's hear how that would work."

**How many times should we be fooled? Shame.

[Winslow R.]

James wrote: "So, the proposal is that unless the above credits are granted to all consumers, who individually are too small to count, but who together represent the bulk of our real GDP, that not only do they 'mail in the keys' for all unpaid homes, but that they simply stop paying for everything, and give themselves a clean slate on all debt, public and private. "

Sounds a lot like citizen banking. You forget to include the huge 'Christmas bonuses' issued a few years before we walk away?

I guess ours comes in May.

I'd like to know how large government 'Christmas bonuses' to citizens would have to be to revive the financial sector. All financial sector workers who received previous financial sector bonuses would be excluded of course.

[Winslow R.]

I think there is a case to be made that the Fed was 'forced' by the Primary Dealers into the TSLF.

With the TAF increased to $100 billion, the amount of reserves sloshing around the banking sector would push the Fed funds rate to zero unless the 'excess' could be drained.

The Fed went to their normal conduit, the Primary Dealers to buy up the the 'excess'.

The Primary Dealers, not having the 'excess' as it resides in the small banks who bid at the TAF, would be incapable of pulling the 'excess' reserves from the system.

The Primary Dealers, lacking any thing of value that the small banks might want to trade for the 'excess', tell the Fed, "no can do".

Hence, the TSLF.

The Fed supplies the Primary Dealers with valuable treasury securities (as they pay a higher interest rate than cash) which can then be sold to the smaller banks in return for their 'excess' reserves.

The Primary Dealers temporarily trade worthless MBS for the treasury securities that the small banks desire, in exchange for small bank 'excess' reserves.

Point:

The Fed could have accomplished the same thing and avoided the Primary Dealers moral hazard by offering to allow small banks to deposit any 'excess' at the Fed at an interest rates slightly below the target Fed Funds rate.

[dd]

This financial disaster is much like Katrina. The dangers were known (unregulated instruments/entities/lightly regulated mortgage brokers) and warnings abounded (on this blog for one and many others); but responsible parties did nothing to avert utter disaster as it would interfere with "deregulated" markets. Now an unprecedented bailout is necessary to "save" the too big to fail banks but such an effort was dismissed for NO citizens.
I'm beginning to move toward the pony for everyone camp as that might re-jigger the equation.

[anon]

Prof. Thoma, and others who are advocating essentially a tax payer-financed bailout of banks, are again providing the ultimate safety net arguments that implicitly allow these white-collar crimes to perpetuate. Bank failures that we are now witnessing are not new! They repeat throughout the course of modern economy and every time the masses have to pick up the pieces. Ten, twenty yrs from now there will certainly be another financial collapse because ten, twenty yrs ago the crooks that looted and plundered the country walked away without any repercussion. Does anyone here know that many of the people that created this sub-prime mess were also involved in the S&L of the early 90's? Amazing isn't it? Economists like Roubini, Baker, etc.. earn my respect because they stuck their necks out and warned the nation of the impending fallout at the time when the housing boom was in full throttle. Had the collective trained economists taken such risks we would be on a better course today. I am just sick of another bailout and continue to lose faith in our institutions.

[Bruce Wilder]

Thanks, Time. That was a much better explanation than my flippant "more flow than stock".

There's an element of, "we lose money on individual items, but we make it up in volume" in derivatives. These unregulated private contracts are not real insurance, where premiums are being invested against the day, but there's no common hazard, either, to fool the law of large numbers. The prospective and on-going loss of $1.2 trillion in U.S. housing values is not going to be multiplied by derivatives, but the distribution of those losses is obscured adding to prolonged panic, and the realization of mortgage losses may well impair other derivatives, which would mean that losses in other economic activities might also show up in unexpected places, making of finance, a giant game of pinball wizard.

[Bruce Wilder]

Some of that pinball wizard stuff is already playing out, not in the obscurity of derivatives, but in people's personal finances.

The big banks have been trying to make up in credit card interest what they are losing in housing. TPMCafe | Talking Points Memo | Credit Squeeze has Elizabeth Warren talking about an aspect of this.

As it is, foreclosure rates have been magnified because people in debt trouble pay their credit card bills before their mortgage.

That kind of multiplier, which arises when the regulatory impulse is held in abeyance, is scary.

[SGC]

"Lafayette:
SGC: The Fed will have to nationalize the weakest and extend support to the strongest.
No, as Krugman suggested in his article on another thread, the time may come when triage must be the option. If a Credit Institution drops below regulatory capital requirement and IF they stay there, then they should be quietly closed (bankruptcy)."

The big banks cannot be put through bankruptcy. Period. They have too many liabilities to too many other members of the financial system. They can be taken over by the FDIC (generally referred to as nationalization in the blogoshere), wiping out shareholders and costing the bondholders quite a bit.

Are you saying that if ALL the "too big to fail" banks fall below regulatory capital standards, you want them put through bankruptcy court. As in let's put an end to the financial system as we know it and see what happens in order to prove that everyone in this country is subject to the same laws.

I agree with Kharris. The banking system is special. That's why, once upon a time, it was highly regulated. Unfortunately, the regulation worked so well, that some "practical men" (a.k.a. slaves of defunct economists) decided that regulation was unnecessary.

The Fed is going to, and should, do everything it can to bring the economy through this crisis -- up to and including supporting undercapitalized banks if it turns out the whole financial system is undercapitalized. And then it is time for the return of regulation.

[Dirk van Dijk]

Is anyone else here pissed off beyond belief that even as the Fed does these bail out strategies, that most banks still pay dividends. Does the Fed have the authroity to require an elimination fo all dividend payments at primary dealers and depositiory institutions. If not legislation is required pronto. At the very least make it a condition of being allowed to participate in the TAF and TSLF. Not enough to slove the problem, but could help a little bit in restoring bank capital. Say a 10 year moritorium on all bank dividends and share repurchases.

[anne]

http://krugman.blogs.nytimes.com/2008/03/12/mission-not-accomplished-not-yet-anyway/

March 12, 2008

Mission not accomplished — not yet, anyway
By Paul Krugman

TED spread not yet dead [Chart]

Is it fair to judge the Fed’s plan yet? No, not in either direction. The big stock rally yesterday reflected investors’ belief that it might work — or maybe investors’ belief that other investors would believe that it would work — rather than an actual demonstration of effectiveness.

This chart shows a less favorable indicator — the TED spread, the difference between the interest rate on three-month Treasury bills and three-month LIBOR, the rate banks charge on loans to each other. The TED spread is an indication of lack of trust in financial markets; its widening was a sign that things were going bad. And the spread has only narrowed a bit since the Fed’s action. Now, for the most part the Fed hasn’t actually done anything yet — just announced its intention to do stuff — so this is an unfair indicator too.

So we’re still up in the air. But I have to say that I wanted to see more action in the chart above.

[billy]

Media Overlook Fed Bailout in Plain View
http://www.prospect.org/csnc/blogs/beat_the_press_archive?month=03&year=2008&base_name=media_overlook_fed_bailout_in

Can’t the media find any economists who don’t think that handing hundreds of billions of taxpayer dollars to the big banks and the incredibly rich people who own and manage them is a good idea?.......

The workings of the Fed and the financial markets can appear complicated, so let’s simplify matters a bit ..... Suppose that it was suddenly discovered that much of the wealth held by the country’s leading financial institutions was in fact counterfeit. ...institutions like Citigroup, Merrill Lynch, and Bears Stearns actually had hundreds of billions of dollars of counterfeit currency. Suppose further that the public did not know exactly who held what ...only that all of them had a lot of it. (The point here is that these banks hold mortgage backed securities, many of which are only worth a fraction of their face value, and therefore can be viewed as the equivalent of counterfeit currency.)

In such circumstances, investors would be very reluctant to accept the credit of any of the major financial institutions. They couldn’t know whether most of their assets were in fact counterfeit, ....

This is in fact the credit squeeze that we’ve have recently witnessed. ...

...Fed today announced that it would lend $200 billion to banks and other financial firms, accepting mortgage backed securities as collateral. ...effectively the same as saying that the Fed is going to... accept the counterfeit currency as collateral, treating it just as though it were real money.

..effect of this policy is to convince other investors that the counterfeit currency is in fact real currency, or ...(the Fed) which is prepared to treat the counterfeit currency as real currency.

...the counterfeit currency retains its value for a while longer. This allows Citigroup, Merrill Lynch, Bears Stearns .. to dump their counterfeit currency on suckers who haven’t figured out how the game is played.

It is possible that they won’t be able to find enough suckers, in which case these banks will end up defaulting on their loans and the Fed (i.e. the government ) has lost tens or hundreds of billions dollars .... Alternatively, perhaps the big boys are successful and can offload enough of their counterfeit money .... Then the Fed is repaid, but the counterfeit money now sits in the hands of other, less informed, or less inside, investors.

Either way, this is a policy of dubious merit. Why wouldn’t we want the banks to be forced to come clean and eat their losses? This is always the policy that the economists advocate when the parties in question are not the big New York banks. Does anyone remember the East Asian financial crisis when the media was full of condemnations of crony capitalism and the IMF insisted imposed stringent conditions on South Korea, Thailand, and Indonesia as a condition of getting bailed out? At that time, everyone insisted on transparency. Aren’t there any economists who still have this perspective? If so, why aren’t their views appearing anywhere in the news?

... There are people who have shorted the counterfeit notes (mortgage backed securities and related assets) because they recognized that these assets were in fact going to lose.... these short sellers were trying to make money, they were actually performing a valuable public service. ...pushing down the price of these assets towards their true level. If we had many such short sellers in the market we would not have seen the housing bubble grow to such dangerous proportions. The same holds true of the stock bubble.

However, if the Fed acts to sustain bubbles even after they have started to collapse under the pressure of their own weight, it makes it far more risky for short sellers. This means that even investors who realize that Citigroup has nothing but counterfeit currency will be reluctant to short its stock or other assets supported by counterfeit currency. As a result we can expect to see even bigger more dangerous bubbles in the future.

This is not a pretty story and there are economists who can make this point. The media should be talking to them, not just the cheerleaders for the housing bubble.

--Dean Baker

So where are all the honest economists ? Like Diogenes searching for an honest man.

[Winslow R.]

SGC wrote: "I agree with Kharris. The banking system is special. That's why, once upon a time, it was highly regulated. Unfortunately, the regulation worked so well, that some "practical men" (a.k.a. slaves of defunct economists) decided that regulation was unnecessary. "

What????

"Practical men" get a stitch to rewrite banking regulations because of a dead economist (You economists are dangerous even when you're defunct) You are quite sure Citigroup had nothing to do with it? How about slaves to bankers?

What makes these bankers so special that this 'specialness' (monopoly access to gov insured deposits) can't/shouldn't be taken away?

[anne]

Billy, thank you for the analysis by Dean Baker which if there are significant numbers of defaults in high rated mortgage packages is exactly right. The Federal Reserve is offering to exchange Treasuries for problematic debt. I am a little puzzled about the persisting ratings, but we will find out in coming days whether this allows for easier credit flows.

[paine]

very very
good plan mark

but maybe not fast massive or generous enough

take
the well intentioned
tax payer protection
hair cut proviso

run vickrey auctions ...sure

but who will sell in the first round

as the crisis deepens
with expectations of ever nearer
full bail out ....

with each successive auction
prices will rises and thus choke off seller supply
as they wait for the full bail
early sellers could prove to be suckers
since its a systemic rescue
and the insolvency runs soooo deep
and getting deeper as house lot values spiral south

to bail some of these critters
enough to keep em afloat
will require
hair restorers not buzz cut options
(talk about metaphoric punch )

i say open the window at the other end

offer to buy the underlying mortgages
at face value

want to squelch any moral hazard

try this ...
after showing motion pictures
of the results
of the last big
do too little too late policy romp

ie the shakey apple stands and pythonic soup lines of the 30's

let the tax payers know exactly
how much is going on their tab

and simultaneously
give em the list of the culprits

by home address and amount swindled

pay em off
then start to arrest em
put em in protective custody
sling em in the kooler
all the fraud originators
phoney raters crap pushers etc

"its for your own protection guys "

as a spontaneous
green guards movement
hits the streets
ready to string up the purps

[paine]

sgc

its too late to plan
uncle must act

waiting for the unwind ???

we're trying to prevent the unwind
its a naked bankrupt truth to grim to bare

it would be like keeping up
a full frontal assault
on a well entrenched enemy
and taking the casualties
while waiting for them to run out of ammo

[paine]

"I am a little puzzled about the persisting ratings"
anne

the markets can't handle the truth

[paine]

"The problem is unwinding the unregulated $500 trillion derivatives market that is partly collateralized by the mortgages."

voodoo investment leads to utter panic

at risk 500 trill
collat 12 trill
nope not in this world

case closed on this proposition

the d words are naughty imps
not because they don't "really " add up right
but because
people like the author
of the above hysterical line
have no idea
what in hell manner of paper beast
is right now
staring us in the face

[anne]

Darn; but what is the truth? Where did the mortgage debt come from that was packaged as high rated? I have found no answer, and what amounts of suspect high rated debt are we talking about. Was subprime debt packaged with conventional debt?

[paine]

bray of the day

"If no one understands that the situation is grave and that Self-Regulation of the industry is still the best standard, then they've had one too many for the road."

[paine]

anne

who really knows ...for sure

panic abounds

those who can
will sit this out
on their pile of ready cash
till the smoke clears

the problem

by then the globes economy
may be in a near dead experience

[SGC]

Winslow R.:

That was a reference to Keynes: "Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist."

I did indeed mean to include CEOs of major banks who clamored for the harmlessness of deregulation in the term "practical men." The reason they found accessories amongst regulators and in Congress is surely in no small part due to the influence of "defunct economists."

Banks are special: Would you like to explain to me how you hope to keep a modern industrialized economy running without a partial reserve banking system? I don't think it's possible.

[SGC]

"Where did the mortgage debt come from that was packaged as high rated? I have found no answer, and what amounts of suspect high rated debt are we talking about. Was subprime debt packaged with conventional debt?"

The latest generation of CDOs (2006-7 vintage) could only beat rising short term rates by including high yield assets. Brokers were offered premia for high risk loans and were only too happy to fill Wall Streets demand for no doc, 100% loan to value products. In short, yes. Subprime debt was packaged with conventional debt all the time.

Also structured finance offered a way to turn almost junk into AAA, by selling the first 20% of losses to someone else. (Since more than 20% losses were inconceivable based on historical data, the other 80% of the bond issue was AAA). Ergo the term financial alchemy.

[paine]

"modern industrialized economy .."

our's is now post modern and post industrial
so what me worry

"Ergo the term financial alchemy"

that was formulated in the 17th century
paper not base metal
can be converted into gold

proviso
use new paper each time
and new shuffles
and oh ya
pass it all b4
the underlying "real" asset
turns back into a pumpkin

[SGC]

Paine,

I'd be interest in a 17th c. reference (if that is what you meant).

Personally I think that modern life is built on what banks do, so I wouldn't vote for paper money = financial alchemy. Though I am with Minsky on the problem of instability.

[Rational expectations]

The "risk absorber" is the taxpayer. It would be hard to think of a situation more inviting to moral hazard than to directly socialize risk (only the riskiest, of course). I would love to have this franchise. I borrow money at below market rates. Lend it to people, and when they default, I swap the bad paper for treasuries. If we are going to commit this nonsense, perhaps we should at least let everyone play, rather than just the lucky 20. Anti-trust used to mean market share, but now it means "too big to fail". Enough, already.

Also, who determines the "haircut"? We could use the market (some people believe that this is where prices come from), but of course there is no point to the Fed taking paper at rates that can be obtained elsewhere. Alternately, the Fed can leave bankers' locks long and shaggy, but this again sounds alot like Christmas time for billionaire bankers, all on the backs of taxpayers, of course.

Hey, I have a radical idea. Let these sons-of-bitches eat their own paper. Let them fail.

[anne]

http://ebooks.adelaide.edu.au/l/lang/andrew/l26bf/chapter7.html

1929

Cinderella, or The Little Glass Slipper
By Charles Perrault

At last the happy day came; they went to Court, and Cinderella followed them with her eyes as long as she could, and when she had lost sight of them, she fell a-crying.

Her godmother, who saw her all in tears, asked her what was the matter.

“I wish I could—I wish I could—”; she was not able to speak the rest, being interrupted by her tears and sobbing.

This godmother of hers, who was a fairy, said to her, “Thou wishest thou couldst go to the ball; is it not so?”

“Y—es,” cried Cinderella, with a great sigh.

“Well,” said her godmother, “be but a good girl, and I will contrive that thou shalt go.” Then she took her into her chamber, and said to her, “Run into the garden, and bring me a pumpkin.”

Cinderella went immediately to gather the finest she could get, and brought it to her godmother, not being able to imagine how this pumpkin could make her go to the ball. Her godmother scooped out all the inside of it, having left nothing but the rind; which done, she struck it with her wand, and the pumpkin was instantly turned into a fine coach, gilded all over with gold.

[paine]

sgc

dutch folks innovated the paper chase

though we think of it as a tulip

joint stock company
and fractional banking
and the ur-form of much else
we see as financial wizardry

btw
i'm no sabot stuffer
no ban the sorcery type

to wax fog horn jeg horn here

to ME
these financial products
are but prefigurations
of CLIO'S MISSION
total socialization

these security innovations
all can be socialized
since they require
partial socialization to even exist

but the privateers prosper best
if its run by carnival rules
ie
never give a sucker an even brake

house trained
so to speak
these securities will become ho hum facilitations

[paine]

"Hey, I have a radical idea. Let these sons-of-bitches eat their own paper. Let them fail"

rat x samson of wall street

i need my job

so i can't share your old testament righteous wrath

[rdan]

Does anyone follow the OCC for national banks and their subsidiaries regulation? The preemption of state controls was forced...how is future regulation a sure thing to help when the agencies are captured?

[gordon]

So Bernard Connolly was right. The only detail he got wrong was that he thought US Govt. purchase of MBS would require changes to the law. The fiction of a "loan" which effectively will never have to be repaid gets around that.

[Winslow R.]

SGC wrote: "Banks are special: Would you like to explain to me how you hope to keep a modern industrialized economy running without a partial reserve banking system? I don't think it's possible."

I don't think I ever advocated abolishing the banking system just the monopoly access they have. Use 21st century technology to allow U.S. citizens the same access to the Fed window and TAF auction as international banks.

For some reason most economists support corporations, and in particular financial corporations, being given rights superior to those of an individual. Yet, when it comes to markets, individual choice is considered superior to societal choices.

Curious.

[SGC]

Winslow:

Do you really want to go through audits of your personal financial situation every single year, just so you can have the right to borrow against good collateral from the Fed in case of a crisis sometime in the future? I don't think the Fed could actually offer this service to citizens, because it's too darn expensive, but I also don't think many would take the Fed up on it even if the service was offered.

Banks like Goldman clearly don't want to submit themselves to such scrutiny or they would have taken advantage of the abolishment of Glass-Steagall to go commercial.

[cm]

TAF - 3 letters
TSLF - 4 letters

I think it is not unreasonable to expect that the next edition of this series of facilities will have 5 letters and start/end with T and F:

T---F

(I don't expect it to be TSHTF as somebody has suggested.)

[Oupoot]

Reading between the lines, there is pressure building from society in general for govt to take the tough stance with bankers and other individuals that benefitted from the froth in the finance sector over the past decade or two. If they don’t, will some sort of mob justice begin to emerge since society has lost confidence in the govt's ability to govern in a just way?

What would happen if all these individuals, that individually are too small to make an impact, begin to mobilise and collectively demand action? Democracy is suppose to give us all a voice, but does the Fed really have to listen to the small guy? Just compare how often they speak/interact with individuals (or their representatives) and how often they speak/interact with bankers (and other investors). How do all these aggrieved individuals force the Fed to listen? If the existing representative govt system don’t work anymore (elected representatives being "corrupted" by those benefitting from the system), how could we change the system to make it work better? Is the only way through a revolution? Then, is the possibility (risk?) of some sort of revolution increasing?

So many have called for investors and stockholders to take the knock, yet how many realise that the money these investors play around with is our savings (pension funds, medical aid, retirement, life insurance, etc.)? If they loose value, we (the savers) loose. Isn't the Fed's decision really about socialising the risk of a financial meltdown - that all will pay (through higher taxes) to cover the losses, i.e. the losses become more equitably spread through society? Is the existing system of rewards (big salaries) and punishment (getting fired/prosecuted) enough, especially since wealthier individuals are better able to protect themselves from various sources of risk (even jail time)? E.g. those that benefited from the "fraudulent" practices of the past will most likely never face the risk of their actions, by higher the best lawyers that use the justice system to their advantage. Socialising these potential losses ensure that even those responsible pay through higher taxes. How can we increase the likelihood that those that can afford to take the “knock” from these losses (the rich and newly rich), actually do so in a legal and more societable just way - closing tax loopholes, making tax system more progressive, etc? IMO, this may be the only long term "peaceful" way to survive the crises and for teh democratic system to reinforce its influence over the capitalist economic system.

[Winslow R.]

SGC wrote:"Do you really want to go through audits of your personal financial situation every single year, just so you can have the right to borrow against good collateral from the Fed in case of a crisis sometime in the future? "

No need for audits. It is a simple matter of economics. Quantity limits would be sufficient. Let me explain the difference between a citizen, corporation and a banking corporation as they have different costs of creation.

Give me $10,000,000 and I will give you a corporate bank.
Current Borrowing Limit at TAF: 10X capital base, no upper bound
Proposed Limit: Gradually reduce to $10,000,000

Give me $700 and I will give you a corporation.
Current Borrowing Limit at TAF: $0
Proposed Limit: $700

Give me ???(you pick a number) and I will give you a U.S. citizen.
Current Borrowing Limit at TAF: $0
Proposed Limit: Start at $10,000 gradually increase to your number.

A citizen base does not need to be audited as they can not be created out of 'thin air'. If we limited corporate banks and corporations to borrowing to their creation cost, there would no need for audits for them either.

SGC wrote:"I don't think the Fed could actually offer this service to citizens, because it's too darn expensive"

With scalable technology, the cost would be almost zero and in fact would save on current auditing costs.

SGC wrote:", but I also don't think many would take the Fed up on it even if the service was offered."

The quantity limit could be adjusted for those citizens who were interested, to meet quantity targets. Each citizen would be introduced to the TAF at 18 when they would use the TAF to get a noncollateralized student loan.

[cm]

Winslow R.: Not to rain on your parade, but please show me your near-zero-cost "scalable technology". Have you ever come close enough to an IT operation managing thousands of accounts (not just ephemeral server connections)? How about millions nationwide? And those will presumably be "internet" accounts, not some internal system where IT controls all equipment.

Recently reported load issues and trading delays in online brokerages when there was elevated trading volume highlight some of the problems the "technology" has to support.

[Winslow R.]

cm wrote: "Not to rain on your parade, but please show me your near-zero-cost "scalable technology". Have you ever come close enough to an IT operation managing thousands of accounts (not just ephemeral server connections)? How about millions nationwide? And those will presumably be "internet" accounts, not some internal system where IT controls all equipment."

I should have written near zero cost per connection.

Yes, not sure it helps, I do have some IT experience from the low tech 90's, our costs were averaging about $300/connection including monitor for mainframe applications and $2000/connection for a pc based network. I figure those costs have dropped significantly and I wouldn't expect the government to pick up the cost of the monitor/pc. Much of the existing infrastructure, i.e. Internet is already in place. Perhaps someone with better knowledge of such systems could come up with a better estimate.

The Fed currently has a budget of approximately 36 billion of which 28 billion reverts to the Treasury.

http://www.federalreserve.gov/boarddocs/rptcongress/budgetrev/br07.pdf

With a citizen based system, the amount of revenue would increase substantially. I estimate the FED could near rival the IRS (which could then be reduced), with little impact on the ability of the financial system to meet the financial requirements of the nonfinancial sector.

Of course the financial sector would be greatly reduced in size and influence by market forces as you'd think would happen naturally in the production of a product that takes 'no effort' to produce.

The 'industrial sector' or nonfinancial sector would benefit correspondingly.

"Over the past 60 years, the U.S. financial sector has grown from 3% to 9% of private
GDP. I present a model of the equilibrium size of this industry and I study the factors
that might explain why it has increased so much."

http://faculty.fuqua.duke.edu/seminarscalendar/Philippon.pdf

[rawdawgbuffalo]

i am worried about bernanke's plan to exchange MBSs for treas. bonds