Stabilizing Credit Markets: The TSLF and Other Asset Composition Policies

As part of a package of proposals to reduce the risks of a dangerous downward spiral in credit markets, I've been pushing for the Fed to "sop up" some of the existing financial market risk by using open market operations to purchase the risky securities from the private sector and replace them with government bonds or money (e.g., [1], [2], and [3] among others).

Jim Hamilton explains why he believes that the Fed is already moving in this direction by assuming financial market risk through the conduct of "asset-side" Fed policy that changes the composition of balance sheets (though I would like to see the Fed use these policies to take on more risk than they have so far). He also explains the potential downside of these trades, the possibility of default on the assets the government is holding, and - as I have also contended - why the downside may not be as large as some people think. There's also a section where Arnold Kling comments on Brad DeLong's HOLC-type proposal:

TSLF, by Jim Hamilton: Last week the Fed announced yet another new measure to deal with the ongoing problems in credit markets in the form of a just-created Term Securities Lending Facility, which we're apparently invited to refer to affectionately as a TSLF. ...

This is the logical next step in Bernanke's vision of monetary policy using the asset side of the Fed's balance sheet. This strategy shift began last September, when the Fed was simultaneously implementing two kinds of operations. On the one hand, the Fed was conducting repurchase agreements, in which it takes temporary possession of certain private sector assets (including possibly mortgage-backed securities) and gives cash to the recipient by creating new Federal Reserve deposits. Essentially a repo is a short-term collateralized loan from the Fed. On the other hand, the Fed was simultaneously conducting open market sales out of the Fed's holdings of Treasury securities ... which ... would absorb Federal Reserve deposits . The combined effect of the dual operations was to leave the Fed's total assets (and therefore its total liabilities) unaffected. Since there was no change in total liabilities, it had no direct implications for the total volume of Federal Reserve deposits or the money supply, which is how we usually think of monetary policy affecting the economy. But by reducing the Fed's holdings of Treasuries and increasing the Fed's holdings of the procured collateral, the swap allowed banks temporarily to replace problem assets with good funds, at least for the term of the repo. ...

In December, the Fed introduced the term auction facility as a device for implementing such swaps on a bigger scale. In these operations, banks could offer a variety of assets as collateral, and receive loans of Federal Reserve deposits. Again these operations were offset by open market sales of Treasuries so as to keep the total volume of Fed assets and liabilities unchanged. By my calculations, the Fed is currently holding $80 billion in assets under this facility, almost identical to the amount by which it has reduced its holdings of Treasury securities...

And the new TSLF will do the same thing on an even bigger scale-- $200 billion has been announced as the first step. Under the TSLF, the Fed will temporarily swap more of its Treasury holdings for private sector troubled assets, and thereby eliminate the middle man required with repos or the TAF. ...

The Fed announced on Tuesday that it would increase its repos and TAF each to $100 billion, and the new TSLF is proposed as an additional separate $200 billion, which comes to a total of $400 billion, or about half of the quantity of Treasury securities that the Fed had been holding last summer. ...

One measure economists sometimes use for the liquidity of an asset is the bid-ask spread. By that definition, one might be justified in referring to the present problems as a problem of liquidity-- the gap between the price at which owners would like to sell these assets and the price that counterparties are willing to pay is so big that the assets don't move. That illiquidity itself has proven to be a paralyzing force on the financial system. By creating a value for these assets-- the ability to pledge them as collateral for purposes of temporarily acquiring good funds-- the Fed is creating a market where none existed, thereby tackling the problem of liquidity head on.

OK, but if we agree to use that framework to describe the current difficulties..., which is closer to the "true" valuation, the bid or the ask price? If it's not far from the asking price, then the Fed is taking a bold step that may help cure a profoundly serious problem. If it's nearer the bid price, then the Fed has just agreed to absorb a huge chunk of what was formerly private-sector risk. To evaluate the magnitude of that risk absorption, we'd need to know the specific assets pledged as collateral, the specific terms, and the specific borrowers, none of which the Fed appears to have any intention of making public.

It appears to me that the Fed's unconventional new measures surely involve at least some absorption of risk by the Federal Reserve itself. It therefore seems appropriate to try to think through the implications of what will happen if indeed the Fed is not repaid on some of these loans and gets stuck holding the inferior collateral.

It strikes me that the immediate accounting implications of such a default would be nil... The main cash flow implication that I can see is the following. When those Treasury securities were held by the Fed, the interest that the U.S. Treasury owed on the securities was a line entry for the U.S. Treasury (gross interest expense) that was exactly canceled by another entry (receipts returned from the Fed) to determine the "net interest" that the Treasury had to pay. With those Treasury securities now owned by the private sector instead of by the Fed, the Treasury's going to have to make those payments with actual cash, and if the collateral is nonperforming, the Fed doesn't have any receipts to return to the Treasury. The net cash flow consequences for the Treasury of a default would therefore be identical to those if the Treasury were simply to have borrowed up front a sum equal to the difference between the amount that the Fed lends and the amount that it is repaid.

In other words, the Fed seems to be committing the Treasury to cover any losses that may be incurred.

Even in the worst possible outcome, the ultimate increase in outstanding Treasury debt would be substantially less than $400 billion, because the collateral is far from worthless. And I would trust the Fed to be taking a smaller risk on behalf of the Treasury than I would expect to be associated, for example, with congressionally mandated expansion of FHA insurance, or the unclear implicit Treasury liability that results from increasing the assets and guarantees from Fannie or Freddie. Nevertheless, the doubters seem to me to be correct that the risks currently being absorbed by the Federal Reserve are substantially greater than zero.

You don't get something for nothing.

Turning to the other proposal floating around, some form of the HOLC program where the government purchases mortgages near or in default and reissues them on more attractive terms, Arnold Kling is not a fan of Brad's proposal along these lines, but he's more amenable to a proposal I have discussed recently:

Not Fannie Mae!, by Arnold Kling: Brad DeLong writes,

If I were Treasury Secretary Hank Paulson, I would spend the weekend   building a legislative vehicle to introduce Monday morning on an emergency   basis to give Fannie Mae the resources and the mission to undertake this   mortgage rescue operation...

With all due respect to Brad, this is a horrible, horrible idea.

Granted, it appears that the market loves Treasuries and hates mortgage-backed securities (MBS), and this is causing a lot of indigestion on Wall Street. But tasking Fannie with making a big bet on MBS would be an extreme example of privatizing profits and socializing losses.

If the bet pays off, Fannie Mae shareholders will take the profits. If the bet goes bad, taxpayers will take the hit.

I would rather see the Fed make the bet on MBS. If there is a profit opportunity in shorting Treasuries and buying MBS, then the Fed is in a great position to take advantage of it. The Fed has lots of Treasuries on its balance sheet that it can swap for MBS. ...

I continue to be a liquidationist. Get the unqualified borrowers out of their houses, and let the underlying housing market start to function.

And I continue to believe Brad's plan is not horrible at all, I've supported a similar proposal. But as I've discussed recently, I believe a combination of both plans - the Treasury intervening to purchase mortgages and reissue them on more attractive terms, and the Fed intervening to purchase mortgage backed securities (MBS) - is the safest bet. Even if one of the measures isn't enough on its own, hopefully the combination will prove sufficient. And if things turn out better than expected so that we don't need the Fed to intervene, that's not a big problem, the Fed can simply sell the assets it is holding back to the public at a profit.

Comments

[Transfer to Borrowers]

Someone is going to lose a lot of purchasing power (given to recent home sellers). If the Fed transfers a significant fraction of the loss of purchasing power to the American people in general (inflation), the banks and shadow banks will no longer be technically bankrupt. They will be able to loan money again, at least for sensible purposes. The mortgage market may have to offer somewhat less generous transfers of purchasing power to borrowers for awhile, to restore some semblance of trust in foreign savers.

Arnold K's liquidation policy is interesting, but probably won't work unless zoning regs are loosened up enough to allow people to build homes they can actually afford. The free markets he prefers can't work unless they are free. The current system depends upon large subsidies to borrowers to overcome the high prices generated by restriction of supply, and large home/yard mandates.

[bullbust]

Even in the worst possible outcome, the ultimate increase in outstanding Treasury debt would be substantially less than $400 billion, because the collateral is far from worthless. And I would trust the Fed to be taking a smaller risk on behalf of the Treasury than I would expect to be associated, for example, with congressionally mandated expansion of FHA insurance, or the unclear implicit Treasury liability that results from increasing the assets and guarantees from Fannie or Freddie. Nevertheless, the doubters seem to me to be correct that the risks currently being absorbed by the Federal Reserve are substantially greater than zero.

As Dean Baker says, JD Hamilton has zero credibility when talking about mortgage security valuations. He is the genius who redefined the term "bubble", and used that to claim that there was no bubble in housing.

That is the same guy, who pooh-poohed Roubini, Calculated Risk etc and ridiculed them, citing a study that claims to show even the Tulip Bubble did not exist. (see MT's comment here (economistsview.typepad.com/economistsview/2008/03/easing-financia.html#c107158878)

JDH's delusional view of things...

March 23, 2007
Bubble, bubble, toil, and trouble
www.econbrowser.com/archives/2007/03/bubble_bubble_t.html#more

It didn't look to me like a bubble on the way up, and it doesn't look to me like a bubble on the way down.
.....
Second is the question of what we can or should do about it. If prices can go to any arbitrary values for any arbitrary reason, then I am not sure what to propose in the way of policy recommendations. But if the price run-up was the result of a specific market failure, then correcting that market failure seems like something that should be getting everybody's attention.

Bubbles? Bubbles? I see none. Toil and troubles? Could be plenty.

October 26, 2006
More evidence that housing may be stabilizing
www.econbrowser.com/archives/2006/10/more_evidence_t.html#more

Data on new home sales and inventories released today from the Census Bureau continue to support the view that the market downturn may have reached its bottom.

June 18, 2005
Babble about a housing bubble
www.econbrowser.com/archives/2005/06/the_great_housi.html

There's been much discussion recently of whether the U.S. is experiencing a speculative bubble in house prices. Like previous historical bubble sightings, this one only seems to pop up in situations where the fundamentals on their own might justify significant price increases.

And right now housing bubbles seem to be popping up all over the place. Calculated Risk, writing at Angry Bear, finds one in Miami. Tyler Cowen thinks he maybe sees one in D.C. David Altig expects to hear about one whenever Robert Shiller is on the radio. And Brad Setser is now upping the ante, looking for bubbles in France and all around the globe....
... that if a community experiences a change in its growth rate, property values can increase a great deal over a short time. For the above example, going from 2% to 3% growth would cause the property values to double overnight..the three states with the highest population growth rates as reported by the Census Bureau-- Nevada, Arizona, and Florida-- have also been among the locations that saw the biggest increase in home prices. .Forces such as these, rather than a random distribution of irrational exuberance, seem a more natural explanation for why some communities got bubbled and others didn't.

June 23, 2005
What is a bubble and is this one now?
www.econbrowser.com/archives/2005/06/what_is_a_bubbl.html

...Now, even if you readily believe that large numbers of home buyers are fully capable of just such miscalculation, there's another issue you'd have to come to grips with before concluding that the current situation represents a bubble rather than a response to market fundamentals. And that is the question, why are banks making loans to people who aren't going to be able to pay them back? Maybe your neighbor doesn't have the good sense not to burn his own money, but is the same also true of his bank?.........
.....economic fundamentals look to me like the more obvious place to start in trying to understand exactly what's happened to U.S. house prices over the last 5 years.

[There is more in his blog and comments. His record on housing is one vast series of mistakes, equivocation and reluctance to accept reality.]

So, JDH was mistaken about the bubble, called the bottom in housing, tried to weasel around by redefining the term bubble -- all fine. No one can get it right all the time.

But to now consider him credible on MBS valuations, after getting housing all wrong, with the added incentive of talking his book (to justify his calls which went wrong) is so riddled with, um, "moral hazard".

And finally his comment "You don't get something for nothing."

Who are we talking about? Define "who".Define "something".

What we have seen is the pig men on Wall Street get a LOT for NOTHING.

[lonesome moderate]

How can you live in a $1.5 million house for six years, without paying a dime? It's quite simple, really, at least in Florida. Just stop paying your mortgage, and make anyone who tries to foreclose prove, in court, that they are in fact the mortgage holder: http://www2.tbo.com/content/2008/feb/23/bz-mortgage-note-issues-help-debtors-avoid-foreclo/.

If the battery on you car is dead because you left the lights on, then a jumpstart is just what you need. But if somebody put sugar in the gas tank, a jumpstart will just make the damage worse--you need to take the engine apart and clean everything off before you try to do anything else. The Fed's recent actions seem to me like the equivalent of a jumpstart, but it assumes a certain degree of underlying soundness in the legal framework. I haven't heard of many Joe Lents yet, but if we have a nasty recession with millions of homeowners thrown out of work, there would probably be a lot of them.

[Spectator]

For an inside perspective on the undeniable contribution of moral hazard to this crisis, see this 2006 Treasury talk (via Glen at Russ Winter's blog)

http://www.treas.gov/press/releases/js4338.htm

"The LTCM crisis laid bare the dangers of excessive leverage and perhaps more importantly, put a white hot light on creditors' and counterparties' over-confidence in the "hedged" nature of that fund's portfolio and strategy."

Many people think LTCM was the one bailed out. Rather it was the banks (the overconfident creditors and counterparties mentioned) that should have taken their medicine. I wonder if anyone thinks this crisis would have been as huge if the Fed let the banks take the pain in 1998?

[Dickeylee]

Banks take the pain? Good God man, how would they collect their millions in bonuses if they felt the pain? Why, they'd go bankrupt, then they wouldn't collect--nevermind.

[Blissex]

Arnold Kling writes:

«Granted, it appears that the market loves Treasuries and hates mortgage-backed securities (MBS), and this is causing a lot of indigestion on Wall Street. But tasking Fannie with making a big bet on MBS would be an extreme example of privatizing profits and socializing losses.
If the bet pays off, Fannie Mae shareholders will take the profits. If the bet goes bad, taxpayers will take the hit.
I would rather see the Fed make the bet on MBS. If there is a profit opportunity in shorting Treasuries and buying MBS, then the Fed is in a great position to take advantage of it.»

And here Arnold Kling loses straight away any credibility as a free marketeer, as a liberal, as a libertarian.

If the markets prefer treasuries and hate MBSses, why should any non-market institution spend a single penny of public money to prove the markets wrong?

The markets are *never* wrong, especially the financial markets, aren't they?

And even if the fed was right, why should a public sector institution use public sector privileges backed by taxpayer money make a huge profit crowding out private investors?

Crazy talk from a committed big-government state interventionist!

[Blissex]

«And here Arnold Kling loses straight away any credibility as a free marketeer, as a liberal, as a libertarian.»

For fairness I must add that despite starting with Communist propaganda, his conclusion is then:

«I continue to be a liquidationist. Get the unqualified borrowers out of their houses, and let the underlying housing market start to function.»

which is more like the usual :-).

Because if the financial markets were ever wrong, were ever rigged, no matter in how small a way, then the justification on the basis of efficiency for those immense pay packages would just disappear.

[Blissex]

«I haven't heard of many Joe Lents yet, but if we have a nasty recession with millions of homeowners thrown out of work, there would probably be a lot of them.» Don't worry, there are 2-3 unpopular wars going on and the good times must go on, to keep the home front happy. A "solution" will be found. Which solution? Well, it is pretty obvious... Compare again what [bullbust] wrote on February 29th: http://economistsview.typepad.com/economistsview/2008/02/why-bubbles-occ.html#c105213332 «Economist Brad Delong; Inflate, inflate. It may be unjust and arbitrary, but its better than having the system break down. If the system breaks, it is our economic theory, on which the system is based, that will get discredited. And I want a Fed post one day.» with what Brad deLong wrote on cue: http://delong.typepad.com/sdj/2008/03/post-meltdown-a.html «If I were Treasury Secretary Hank Paulson, I would spend the weekend building a legislative vehicle to introduce Monday morning on an emergency basis to give Fannie Mae the resources and the mission to undertake this mortgage rescue operation...»

[Blissex]

«What we have seen is the pig men on Wall Street get a LOT for NOTHING.»

And here [bullbust] gets is rather WRONG! What do you mean "for NOTHING"? Our political class does not give away anything for nothing!

The pigmen of wall street have paid good money in campaign donations and lobbying fees and good jobs offered to retired politicians and their flunkeys to get Glass Steagall repealed and friendly presidents and congress majorities elected and sympathetic officials appointed, and are entitled to collect on their investment.

[Separation]

Since much of the problem was caused by a few areas driving up valuations to unaffordable levels with excessive zoning regulations, just separate those areas from the rest of the system. That is, let CA et al figure out how to finance their own mortgages, and let the rest of the states set up a sound financial system. If CA ever decides to enact zoning regulations that make sense, they can rejoin the rest of us.

Until then, finance your own absurd valuations with your non existent savings. No sense in letting them drag the rest of us down with them.

[James Hamilton]

"Redefine" bubble, Bullbust? I used exactly the same definition in my paper, "On Testing for Self-Fulfilling Speculative Price Bubbles", published in the International Economic Review in 1986, as I used in the 2005 post from which you quote as I would use today. I continue today to characterize the primary problem as one of moral hazard rather than a bubble.

But I gather that "moral hazard" to you means the same thing as "bubble", and is indeed sufficiently ubiquitous that one might accuse someone of "moral hazard" as a general purpose insult.

[Bruce Wilder]

I'm just an observor -- I only know what I read in the newspaper, so to speak -- but I find myself, from day to day, growing more and more skeptical of the economic diagnosis.

There's no doubt that housing prices are falling, foreclosures rising, and that those realities are driving forces. But, what are they driving, exactly?

The liquidity crisis is a crisis of trust and uncertainty. If we knew which banks and other institutions were destined to crash and burn, we could get on with it. But, we don't know.

And, the experience of the "lucky" Joe Lents, of having a home on which no mortgage holder can lay a claim . . . maybe that is not so uncommon a problem. Somewhere, there is a mortgage security embodying the mortgage on Joe Lents' home, and that security is made just a little more worthless, because there is no agent capable of exercising the rights supposedly embodied in that security to Joe Lents' house and mortage payments.

Why do I think having the Federal Reserve buy these securities en masse is not a solution?

It is not that I think it morally wrong for the Fed to make a market in these securities, which formerly traded at such velocity.

I think that, to ignore the institutional breakdowns inherent in securitization and the associated willy nilly creation of SIVs, CDOs, and CDSs, and, instead, try to use the Fed as a Canute, ordering the tide of housing prices and mortgage values to turn back . . . well, it seems ill-advised.

You cannot use the Fed or Fannie Mae to close the gap, which has opened up between the prices of Treasuries and the prices of MBS. MBS are worth much less and carry a lot of risk. And, nothing short of rampant inflation is going to stop housing prices to continue to decline markedly in 2008, and to remain stagnant for sometime after. Historical experience would indicate that housing markets will be working this out for the next four to six years. Four to six years, people, for housing prices to stablize and begin rising again.

I suspect that what we really need at this point is the strengthening of ratings and clearinghouses -- maybe even the creation of some new agencies. Let's help the banks mark to market, and certify their financial statements. Let's accelerate that process.

Let's track these mortgages down, get them ALL into a database, and figure out which MBS really are worthless and which are not. Re-rate on the basis of actual data.

We live in a computer age. This is not the first financial crisis to have significant elements of back-office failure. But, it is the first financial crisis to occur in the post-Internet age, when the technology is available to create reliable database transparency.

Rather than compounding uncertainty with the Fed's completely obscure lending strategies, let's go in the opposite direction.

Tie 28-day or even longer Fed loans to structured audits of the underlying securities and the borrowing institution.

When the securities emerge from the Fed vaults, let them have a reliable rating. With a reliable rating, whatever they are worth, they are marketable, again.

[rawdawgbuffalo]

MBSs for treas. bonds tells me bernanke is tripping

[bullbust]

James Hamilton:
But I gather that "moral hazard" to you means the same thing as "bubble", and is indeed sufficiently ubiquitous that one might accuse someone of "moral hazard" as a general purpose insult.

I used the term "moral hazard" to indicate that you have a vested interest in any outcome that serves to validate the no-bubble thesis. You are not an uninterested observer. As an ardent advocate of the no-bubble side, you are not impartial. Academic spats are vicious because there is so little at stake.

As for your paper "On Testing for Self-Fulfilling Speculative Price Bubbles" and use of the term bubble, let me ask you.

Was NASDAQ 2000 a bubble according to your definition?

Will recent housing prices (before this trouble hit ) will ever be considered a bubble?

Will any magnitude of a drop in prices make recent housing a bubble? (A 30% drop? 50% drop? 75% drop)?

Your definition of bubble makes bubbles impossible. Orwellian.

[gordon]

I now await the founding (or re-founding) of the Communist Party of America on a platform of class warfare. After all, we see the war already under way, and it would be sad to see the US working class KO'd without even knowing they had been in a fight.

[gordon]

And on the tonsorial issue, if JPMorganChase is buying Bear Stearns at $2 for shares which traded at $169 dollars in Jan. 2007, that is a "haircut" of 99.99%. Why then in the post "A Subprime Conversation" (to which Prof. Thoma links in this post) are haircuts of 10-20% mentioned? Shouldn't we be getting with current market rates?