"Market Maker of Last Resort"

I think Felix is right, the policy option described below is unlikely to be enacted. However, if things start to get a lot scarier than they already are, then that could change:

Should the Fed Buy Securities Outright?, by Felix Salmon: In a Q&A back in March, Mark Thoma proposed that the Fed should simply buy up distressed assets, rather than simply accept them as collateral:

If it were my choice, .. I'd do more. First, I'd trade for any financial assets at a price that fully reflects the risk of holding that asset. The Fed should trade non-risky assets, money or government bonds, for risky private sector assets at a risk adjusted price... Suppose the Fed takes a mortgage backed security off the hands of a bank that wants to reduce its risk profile, and pays the bank 80% of its value, the 20% "haircut" is to compensate for the risk of holding the asset.
What if the Fed loses money on these trades?
That could happen. But these assets could also increase in value as well, precisely because the Fed is holding them and reassuring markets. If the Fed makes a fair trade, ... it is as likely to make money as lose money. ...

Today, Willem Buiter says something very similar: that central banks can and should be a buyer of last resort when markets fail.

When markets are disorderly and illiquid, it is not just the prices of good or prime assets that fall below their fundamental values. The same holds for the prices of bad, impaired and sub-prime assets. Impaired assets too will have a fair or fundamental value. That fundamental value may well be far below the face value of the security, but it may also be well above the price the impaired asset would fetch in a fire-sale in an illiquid market.
If the central bank, or some other government agency, were to act as Market Maker of Last Resort and buy the impaired asset at a price no greater than its fair value but higher than what it would fetch in the free but unfair illiquid market, such a purchase would not be a bail-out. It would also be welfare-increasing...
This possibility of a capital loss and fiscalisation of this loss does not mean that the transaction ex-ante involved a subsidy by the central bank to the owner of the impaired asset, or a bail-out of the owner.

Both Thoma and Buiter stress that such activity must be combined with more stringent oversight of financial entities, including hedge funds and other leveraged weapons of potential mass destruction. Buiter even gets very specific about the mechanisms that a central bank could use to buy assets: apparently a well-designed reverse auctions "don't require the government buyer to know much or indeed anything at all about the fundamental value of what it is purchasing". Which sounds rather scary, until Paul Krugman comes along to remind us that the Hong Kong Monetary Authority went one step further in 1998, and started buying up not bonds but stocks. And made a fortune. Then again, Krugman is also comparing the idea of central banks buying securities outright to the idea of the US invading Canada, so it's not clear how on board he is.

My feeling is that it's not going to happen, mainly for political reasons. In this particular crisis, the distressed assets the Fed would end up buying would almost certainly be mortgage-backed bonds. But buying up mortgage-backed bonds looks very much like giving money to big banks and investors instead of giving it straight to struggling homeowners: the optics are simply terrible. If the collapse of Bear Stearns is seen as a bailout, this would be much worse. It might be a good idea, but its time has not yet come.

The independent Fed is not supposed to worry about the political implications of its decisions. But independence for the Fed is not unqualified, the degree of independence it has is due to legislative acts, not the constitution, and if the Fed oversteps its bounds then some or even all of its independence can be taken away by congress.

I don't think congress should underestimate the outcry that would occur if it tried to substantially reduce the Fed's independence, and I doubt that members of congress do underestimate that, at least for the most part. And members of congress with oversight responsibilities who disagree with the Fed's policy can use the hearings where the Fed chair testifies before congress to distance themselves from policies that are politically unpopular (posturing is not hard to detect when the chair testifies before congress, starting with the speeches in the form of questions politicians give when it's their turn to ask about monetary policy).

I would hope that if the Fed does not pursue the policy option described above, it is because it does not believe it is the optimal optimal policy, that the political consequences and the fear of losing independence do not play a large role in the Fed's decisions. Otherwise, what's the point of having an "independent" Fed if politics prevent it from pursuing the best possible strategy at the time when it's needed the most?

Comments

[a]

"Which sounds rather scary, until Paul Krugman comes along to remind us that the Hong Kong Monetary Authority went one step further in 1998, and started buying up not bonds but stocks."

Hedge funds were selling both the Hong Kong dollar and stocks short. By buying stocks the Hong Kong Monetary Authority caught them in a short squeeze.

There seems a little too much hope about "fair" values and "distress" values. The hope is that the banks have marked their products down to "fair" values but still can't get rid of them because the only bids are at "distress" prices. It's more likely that the banks are marked to "optimistic" values and that they would go bust at "fair" values. So now what do you do? Isn't the whole point of the exercise - of having the government intercede - to save the banking system? And if it isn't going to do that, why do it? Because the government might make money?? Government as financial tycoon, I love it!

[Mark Thoma]

As I've said many times, the point of the exercise is to prevent the economy from going into a downward spiral brought on by the collapse of the financial sector. Saving the financial sector, in and of itself, has nothing to do with it. So, to answer your question, no, that's not the point of the exercise, it's a means to an end.

In addition, that the government might make money also has nothing to do with it, it is not the answer to "then why do it," at least it's not my answer (all of my policies have zero or negative expected values). If the point was simply for the government to make money, there are much better ways than this to do that.

You pretty much leave the same comment every time intervention to stabilize the economy is discussed. Recently, you've ridiculed fiscal policy, opposed any attempt to help homeowners in an attempt to prevent mortgage foreclosures, you've opposed any intervention into asset markets, and you've said monetary policy doesn't work.

You wouldn't do monetary policy, wouldn't do fiscal policy, you would do nothing? Can't remember your views on regulation, but assume you'd diss any attempts there as well.

Doing nothing is a policy, but not a very good one. We've tried that already, and it does not end well.

It's pretty easy to oppose everything and propose nothing. So instead of simply opposing all intervention (as I remember you doing and a brief scan of all your past comments seems to confirm), how about proposing something in its place? Is your policy to do absolutely nothing? If so, good luck. If not, what specific measures would you take to prevent the economy from nose-diving?

[hari]

I'd like to go back to Oct'87 meltdown of the stock market....It was not a cliff hanger. It all happend on a Fri weekend and was over in a short time. My broker couldn't rescue my portfolio - all in options! - I was driving that weekend Bxl-Vienna.

The suggestions above are disengenuous principally because the stock market is an open pit for punters. I think by interfering with the market you're introducing a strategic change on the way the system is supposed to function.

Let's, first, accept given the volume/valuation on the housing foreclosures, and taking into account Feds/BB admonition to Congress in yesterday's hearings, intervention by Congress is now very likely, and also desirable to prevent a cascading meltdown of the credit market.

However, the stock market is a gamblers din and there are risks and rewards which go with the player. Once you start *gaming* the process - one way or another - there's no idea exactly how far such interventions may end up finally by doing the just the opposite - namely, removing risk for punters. We already know individual punter cannot compete with market *institutions* (eg. ML) which apparently make the market every day.

[Luis Enrique]

"But buying up mortgage-backed bonds looks very much like giving money to big banks and investors instead of giving it straight to struggling homeowners: the optics are simply terrible. If the collapse of Bear Stearns is seen as a bailout, this would be much worse."

This seems to be the dominant story already: it's all about bailing out fat cats, while the govt won't lift a finger when it's the little guy in trouble. I know I shouldn't be surprised, but newspaper coverage (I'm in the UK, so I'm thinking The Guardian, for instance) has fueled this perception with gleeful abandon. Details like how us little guys would be hurt if the financial system imploded, or how the fat cats aren't getting helped out as much as it may seem, are routinely omitted from the story.

[hari]

I prefer the Fed to regulate and make sure unforseen crisis are avoided, to the best of its knowledge, in the hi fi market. AGs assertion and acquiesence to market discipline will not hold any logic now given the cascading effect of subprime credit crunch. In order to allow effective Fed oversight, investment banks and hedge funds must be brought under its *direct* oversight - not as proposed by Paulson's Blueprint. The leverage used by hedge funds is critical for their business. But who is funding their overdraft, credits and whatnots?

You'll recall during last summer G-8 Meeting, in Germany, Chancellor Merkel sought to regulate Hedge Funds - in EU markets - and it was refused by GWB and Blair.

[a]

"As I've said many times, the point of the exercise is to prevent the economy from going into a downward spiral brought on by the collapse of the financial sector."

I think I am a better reader than you give me credit for.
Perhaps I was not clear, but my point was the following: if you use "fair" market value, some (many?) banks will go under. Citi, for instance. I guess you would count that as "collapse of the financial sector." So a proposal for the government to pay "fair" value (which I understood to be the proposal on the table) will not achieve your objective. You have to pay *more* than fair value. Are you willing to do this? How much should the government be willing to pay over "fair" value? Anything, to preserve the financial sector? If you're not willing to pay more than "fair" value, and if this does not achieve your goal of saving the financial system (and thus preventing a downward spiral), then why do it? Just to do something?

In fact, at this point, I would do nothing. My proposal is to let the chips fall, and have the government in a position to offer New Deal measures (providing work for unemployed, minimum incomes, health care), should that be needed. Sound harsh? Sure, but in the end, *if* that's what's going to happen by doing nothing, it's going to happen anyway by doing something, only by doing something we will have squandered a few trillion on the way.

"Doing nothing is a policy, but not a very good one. We've tried that already, and it does not end well." When was it tried? The government has already actively intervened since August 2007. Now look at the mess we're in, which is *because* of the government's intervention and not *in spite* of it. (See Footnote 1) Japan "did something" faced with its bubble; that didn't turn out so well either. In any case, you still have the ontological problem first to resolve. Just because policy x does not end well does not mean you should do policy y, unless you have some very good evidence that policy y will end *better*. Indeed, if policy y costs a trillion dollars, things should end up better by at least a trillion-dollars worth. Hope is not just a crappy hedge; it's crappy policy.

(Footnote 1) The recent Fed action - helping the primary dealers - inhibits rather than encourages confidence. Now no one can be sure if a primary dealer is truly solvent, or only solvent because it has unloaded crap to the Fed. Since the Fed program could end at any time, no one in their right mind would now lend to a primary dealer. So the Fed action - which everyone seems to be applauding - is reducing not increasing confidence. The overnight USD traded 3.5% at the beginning of the morning in Europe yesterday. That's just unheard of, and it's *because* of the Fed action, not in *spite* of it. You can't buy love, and you can't buy confidence either.

"If not, what specific measures would you take to prevent the economy from nose-diving?" Well what's nose-diving? If you mean that people will consume less, then that has to happen anyway, but Americans are over-consuming and they've been over-consuming for a generation. If you mean that unemployment will rise, then I have answered you: above a certain level, I would have the government step in to provide work.

[bakho]

I would rather see a government run mortgage program with rules and requirements than to "privatize" the effort by funneling money through third parties. The Student Loan program is a poster child for privatization ripping off the students on interest collected and ripping off the government on subsidies. Both the government and the student would be better off eliminating the middle man.

[reason]

I'd like to reference a comment I made in a thread that has rolled off (and so probably most people missed).

http://economistsview.typepad.com/economistsview/2008/03/financial-marke.html#c108314658

We need to deleverage the system, and that is done best from the bottom. It is time someone took us off the leverage elevator.

[eric]

a, I think you're confusing the present market value with the fair value. The problem here is that the market value seems to be much lower than the fair value, which is why the Fed may want to step in as market maker. As I understand it, the fair value for mortgage-backed securities, for example, would be determined through calculating default risks on mortgages, etc. I don't know how much this has been analyzed, but the losses associated with falling market values for the securities has dwarfed the concrete losses due to failing sub-prime mortgages.

[a]

eric: Well often for the instruments under question, there is no market value, so I'm not sure how you can say that the "fair" value is greater.

"Losses associated with falling market values for the securities has dwarfed the concrete losses due to failing sub-prime mortgages." Well first, the instruments under question don't just have sub-primes as underlyings. There are also ALT-A and prime, the whole gamut of mortgages. Secondly, it's natural that one should be larger than the other, since the value of the instruments depends not just on "concrete losses" but future cash flows. And thirdly, these products are leveraged. So a loss can be magnified.

[OB]

Dear Professor Thoma,
Maybe I am naive, but I'd always thought that market values deviate from 'fundamental' values only if there is some market disruption (the market place has been blown up, say) or there is some information not factored into the market price. Neither seems relevant here - the illiquidity is a result of buyers not wanting the securities because the sellers aren't offering prices that adequately reflect their risk-profile - i.e. the uncertainties about future return on those assets. And the sellers won't lower prices to the equilibrium level because they would be exposed as insolvent.

There is no reason to think that potential buyers in the market (both domestic and foreign) have some aberrant irrational appreciation of risk, which the happy-talkers such as yourself seem to think the fed can take advantage of. The ibanks saddled with all these bad assets are the ones who badly overvalued them.

Bringing back liquidity to the markets involves bringing sellers back to reality. And that involves them admitting to their looming insolvency by recapitalising. The government intervening directly in the market by reducing supply of such assets or increasing demand - however one chooses to phrase it - can achieve the same ultimate aim of equilibrium, but only at a high, and unnecessary, cost to the taxpayer.

[robertdfeinman]

I think the issue of "politicizing" the Fed is only arising these days because there may be some possibility that the Fed will make the financial industry bear part of the pain for their excesses.

When Greenspan was the head and his views coincided with the GOP majority in congress there was no discussion of "independence". In fact when I questioned the propriety of Greenspan meeting frequently with the president, Mark Thoma defended this as appropriate. Whether it is or not, at present it just seems that "what's sauce for the goose is sauce for the gander" is being violated.

The financial sector wants to be bolstered, but doesn't want to have to face any new regulation. If this means contradicting prior positions, well that's how the game is played - ends justify means.

[Mark Thoma]

a:

I've already covered all of that, e.g., from before:

The Fed should trade a non-risky assets, money or government bonds, for risky private sector assets at a risk adjusted price. And to promote these trades, the risk adjustment could be reduced - the amount the discount is reduced would be just like adding reserves to the system.

So, lot of what you write is directed at positions I have not taken - so not sure why I should defend the policies...

And to play your game, that fact that we have done nothing in the past and it's ended poorly does not imply that we have never done anything that works at other times (we have). So both experiences are available.

I'm really glad you aren't at the Fed - the whole system would have likely crashed already (I will leave it to you to look up nose-diving, but it's not something you want to have happen, also, remember - doing nothing means not even adding liquidity as reserves fall - you wouldn't even do that? Yep, glad this isn't in your hands.)

[reason]

OB...
I wonder how you can say
...but I'd always thought that market values deviate from 'fundamental' values only if there is some market disruption ...
and
The ibanks saddled with all these bad assets are the ones who badly overvalued them.
in the same comment and keep a straight face?

[a]

"The Fed should trade a non-risky assets, money or government bonds, for risky private sector assets at a risk adjusted price."

Agh! OK let's call the "fair" value the "risk adjusted" price. Fine. If the banks were to value their instruments at the "risk adjusted" price, then many of them will be bankrupt. Citi in particular. So paying RAP does not and will not stop the financial system (and Citi) from collapsing. The banks need the government to pay a *higher* price. So again, are you willing for the government to pay this higher price? I don't think so. So you are proposing a project to stop an event (Citi from going under), which will not stop the event from happening (under your plan, Citi will still go under). So why do it?

Now, in fact a "risk adjusted" price (RAP) is pretty darn difficult to determine for many of these instruments, because they involve parameters which are not easy to determine, e.g. correlation. Do you use historic correlations or implicit correlations? etc. I asked a question about Blinder a few days ago: Does it worry you that he confessed not to understanding derivatives very well? And the point of the question was, the people at the Fed don't understand derivatives, they don't understand the difference between historic and implicit very well (they understand the definitions, but they *don't understand*).

"I'm really glad you aren't at the Fed - the whole system would have likely crashed already." On the contrary, regulators (and the taxpayers) need people like me - someone who actually understands derivatives and IBs. I'd offer my CV to the Fed, except my wife doesn't want to live in New York (or worse Washington)...

By the way here is Geithner's justification for intervening with BS: "Absent a forceful policy response, the consequences would be lower incomes for working families, higher borrowing costs for housing, education, and the expenses of everyday life, lower value of retirement savings, and rising unemployment."

Let's see, let's check which are happening or are going to happen anyway:

Lower incomes for working families. Check.
Higher borrowing costs for housing. Check.
Higher borrowing costs for education. Check
Higher expenses of everyday life. Check.
Lover value of retirement savings. Check.
Rising unemployment. Check.

All those bad effects are happening or going to happen *anyway*. So why did we put taxpayer money at risk? So Bear's CEO could walk away with 60 M?

[Turbo]

It's a little ironic that you're proposing to effectively turn the Fed into the hedge fund of last resort, while simultaneously calling for greater regulation over hedge funds. That jest aside, I agree that is precisely what is likely to happen. I also think the experience of the Great Depression actually led to the correct regulatory outcome - the separation of commercial banking and investment banking. Commercial banking should be a heavily regulated activity, given it's central role in the real economy, and real and implicit taxpayer guarantees. The heart of the current problem lies in the universal bank concept, where commercial and investment banking occur on the same balance sheet, which allows for imprudent levels of leverage to be attained, both on the bank's balance sheet, and in their lending to leveraged funds. I don't think the problem lies with lightly regulated capital pools per se, but with under-regulated global banks over-extending leverage to them. I don't know if turning back the clock on Glass-Steagall is a practical solution though.

On another point, I don't know why you hold the HKMA's actions in a favourable light, beyond the fact that they stared down the evil speculators. They drove up interest rates to draconian levels in 1997/98, wiping out a good swath of their own banking sector, and being a major (but not only) cause of the property crash that occured in the late 90's/early 2000's. Would you advocate the Fed hike interest rates to the point where property values decline by 40% to maintain the value of the dollar? To maintain the peg now in the face of a weak dollar, they are holding interest at artificially low levels, and allowing inflation to surge. Hardly a central banking policies to be admired.

[Bruce Wilder]

OB: "Bringing back liquidity to the markets involves bringing sellers back to reality. And that involves them admitting to their looming insolvency by recapitalising. The government intervening directly in the market by reducing supply of such assets or increasing demand - however one chooses to phrase it - can achieve the same ultimate aim of equilibrium, but only at a high, and unnecessary, cost to the taxpayer."

"Back to reality" and, as reason has pointed out, a reality which will be reached after a dramatic period of de-leveraging.

Quite apart from the cost to the taxpayer, which I don't think can be entirely avoided, but could and should be better accounted for in other ways, making a market should not be a way to capitalize the banks.

The de-leveraging, which is going on, however, may very well force massive sales of securities.

It is the massive sale of securities into illiquid markets, which might well trigger the downward spiral, which Professor Thoma rightly says, we should greatly fear.

I tend to think there is a real danger that Fed market-making will be hijacked. And, I don't see any reason to be at all cavalier about that danger, any more than it makes sense to dismiss the danger from a downward spiral.

There's a Type I error here, and Type II and Type III errors as well.

[anne]

"I don't know why you hold the HKMA's actions in a favourable light, beyond the fact that they stared down the evil speculators. They drove up interest rates to draconian levels in 1997/98, wiping out a good swath of their own banking sector, and being a major (but not only) cause of the property crash that occured in the late 90's/early 2000's."

Nonsense; Hong Kong, not HK, has a currency board and interest rates are automatically adjusted according to possible currency movements to keep a dollar peg. China reacte perfectly to speculation against Hong Kong stocks in 1998.

[Bruce Wilder]

Policy ambition in our present circumstances must embrace a bad choice, because there are no good choices.

A cautious amelioration may well prolong the current pain, and postpose a painful restructuring to even more catastrophic circumstances.

Aggressive restructuring along too optimistic a line risks recreating the whole fiasco on a larger scale at a later date.

And, no Goldilocks choice suggests itself.

[anne]

All undeveloped land in Hong Kong is government owned and is made available as and when the government decides. Property price swings happen, and are taken in stride as they were from 1998 when the decline in property prices was an adjustment to ending colonial control by Britain and the Asian currency crises and recessions. Property was simple kept from market for several ears, an prices recovered.

[Turbo]

I'm sorry Anne, but your interpretation is simplistic to say the least. I fully expect property prices in the US to recover in the future as well, but would precipitating a 40% fall be sound policy at this time? And please don't tell me there was no concern over the plunge in HK property prices at the time - I lived there at the time, outright panic is closer to the truth.

[jalrin]

Are there not other alternatives? It has been several years since I studied Economics but why not combine an increase in the reserve and capital requirements (and its extension to investment banks) with a large monetized fiscal stimulus program that would sterilize each other? Ordinary Americans would beneift from the stimulus while the extra Treasuries the Fed would accumulate could be used to expand the TSLf to ease the pressure on the financial system.

The above would go over much better with ordinary Americans because it would benefit most people directly and would not require people to believe that this time is different and the goodies for the rich will this time benefit them (the market maker idea is not credible after NAFTA/WTO/the Bush tax cuts).

[Turbo]

If you want the true chronology of what happened, the HKMA was acting out of sheer panic. Ironically, they were able to hold the peg because the Fed relented and started cutting interest rates after Russia defaulted. How the tables turn in the world of finance. You have no idea what it was like working in a financial institution in HK at the time - it really felt like the world as we know it was coming to an end. Risking a deep recession to defend a currency level is bad policy, and there were very steep costs involved, whether you chose to believe so or not. I also find it ironic that you hold out the HKMA as a model for government intervention, when HK is one of the more lightly regulated and low tax jurisdictions in the world.

[anne]

Turbo:

"I lived there at the time, outright panic is closer to the truth."

I will re-consider from your perspective then, and ask friends for their perspective as well as looking to past accounts. I have had no such understanding, from past questionings, but could well be wrong. Hmmm.

[anne]

Turbo:

"You have no idea what it was like working in a financial institution in Hong Kong at the time - it really felt like the world as we know it was coming to an end. Risking a deep recession to defend a currency level is bad policy, and there were very steep costs involved, whether you chose to believe so or not."

Yes; I understand, but there is something missing. Hong Kong was part of China in 1998; a devaluation of the Hong Kong dollar would have meant a speculation forced devaluation of the Hong Kong dollar against the Yuan. The only other solution would have been capital export controls.

[anne]

There was no choice; Hong Kong was part of China, not a colony, and there could be no devaluation unless China had devalued. I am thinking; but Hong Kong was not a colony but a part of China.

[Mark Thoma]

a:

I think you should reevaluate your reading skills. I've already talked about the price, many times, and covered that point, but you keep misstating my position.

This is one part of an array of policies designed to deal with various problems, and to provide redundancy in case some measures don't work as well as we hope. I've advocated all the fiscal policy measures you have mentioned, or versions of them, and others as well, as part of that package.

Yes, I'm sure you are much smarter than the people at the Fed (I think you're actually serious in that belief). I see no reason to carry this any further - you simply assume the system can't be saved, and that the system will not crash if nothing is done- - even if the Fed does not add liquidity to offset falling reserves, etc. the system won't crash. Of course if you assume that policy won't work, and that bad things won't happen if the Fed does nothing, you get to your policy positions. But those positions are not supported by the large body of empirical evidence that has accumulated on this - not at all - so they amount to nothing more than assumptions you are making to support your position. There is a risk of a crash, it's happened before in the US and elsewhere and it can happen again, but you deny it. I simply am not willing to think I have the knowledge to conclude with absolute certainty that if nothing is done, the typical household will come out of this unscathed and I am not going to let the arrogance of thinking for sure I know what will happen to put families at risk (I'll leave that to you). It's true the policies might not work, but there are worse ways to spend money than on the purchase of what we hope is insurance for typical households.

[Also: Not sure how many times I have to answer the question about why Bear Sterns was bailed out, but it's not the reason you gave. On another point, again, use those reading skills you bragged about to go back and read what I've said about making people face the consequences of their actions - there are other ways to enforce discipline without putting everyone else in the economy at risk.]

This is just going in circles, so I think this will end it for me. Time to move on...

[Turbo]

Correct. At the time the HKD was widely tradable, the Yuan was not, so a HKD re-peg or float would have by proxy meant the same for China, which China was not going to allow to happen. There was a small element of Soros-like speculative attack, but mostly it was people at the time dumping Asian assets. There was a lot of uncertainty over HK's future at the time, and China's apparent willingness to sacrifice HK's economy to maintain the Yuan peg was not taken as a good omen. If you want an example of a central bank doing things right, the RBA's response to the crisis was as surgical and masterful as the HKMA's was politcal, and in the short-run, damaging.

[anne]

Turbo:

"If you want an example of a central bank doing things right, the RBA's * response to the crisis was as surgical and masterful as the HKMA's was politcal, and in the short-run, damaging."

No question; I always understood that Australia handled the Asian currency crisis properly by not defending the dollar. Now, I am asking myself the question about Hong Kong from your perspective where I had always looked at Hong Kong as a Chinese state from 1997.

Did China sacrifice the well-being of Hong Kong's population, for several years? Needlessly? I am thinking.

RBA = Reserve Bank of Australia
HKMA = Hong Kong Monetary Authority

HKMA is a currency board that does not decide policy only reacts to currency pressures by ajusting interest rates.

(No one will understand the code.)

[anne]

Turbo takes precisely the perspective I would take for any other currency flow, so I may be completely wrong in having looked differently at Hong Kong. Never defend a currency unless willing to use capital flow controls, and that is tricky, because defense of a currency absent capital controls will be at the expense of the domestic economy as was the case in Hong Kong. Was China wrong (remember Hong Kong was China in 1998)?

[piglet]

"In this particular crisis, the distressed assets the Fed would end up buying would almost certainly be mortgage-backed bonds. But buying up mortgage-backed bonds looks very much like giving money to big banks and investors instead of giving it straight to struggling homeowners: the optics are simply terrible."

Now, is it a bailout to the big banks, or is it not? Is it really just the "optics" that suggest a bailout? I don't think so.

[john c. halasz]

The problem, as far as I see it, is that some of the "assets" under consideration are at once so illiquid and opaque and complex that they are not merely highly risky, but their value is entirely uncertain. And they are based on convoluted models the assumptions of which have proven or are probably wrong and encode historical data from prior market conditions, when those market conditions have undergone a phase shift. Further, they are likely to contain CDS or other derivatives as "credit enhancement", which may or may not explode, an incalculable contingent liability. The upshot is that these are the very sort of level 3 assets that the IBs are carrying on their books that can't be marketed, and can't be written down for fear of insolvency. Under the assumption of a reverse auction banks would be presumed to offer their worst "assets" at their worst acceptable discount. But these sorts of level 3 assets have the problem that the banks both don't really know and can't admit what they are worth, so such assets are precisely not ones to be offered in a reverse auction. There is simply no market here to be made. Rather to purchase these assets would be to be running them off, such that the FED is acting like an insurer rather than market-maker. On the other hand, if the FED is to act as a market maker for more fungible assets being dumped during deleverage of less complex structures, it's capacities might be quite limited compared to the extent of the assets being dumped, such that it would only be providing a bit of liquidity to markets to facilitate their smooth but rapid decline. Either way the problem is not likely to be resolved, just palliated, since the size of the problem is likely much larger than both the FED and market participants currently estimate, (based on historical behavior to date). (Merril Lynch's top economist currently estimates a credit loss of $480 billion to "leveraged institutions" and $1.2 trillion overall).

So my view is: why not simply prepare for the IB system as a whole to go BK and nationalize and recapitalize it as a whole, wiping out shareholder equity, terminating current top management with prejudice, and beginning the process of restructuring and reregulating radically the banking system as a whole, (among other things eliminating the too-big-too-fail syndrome, revising capital and reserve ratios regulation and inspection/oversight systems, and altering loan securitization procedures so that any originator must have skin in the game, as well as, credit support liability). Those dodgey level 3 "assets" will have to go into run-off anyway, hopefully never to come back into fashion again, but that should not be done in such a way as to provide de facto unbidden insurance support to private speculative financial profiteering.

[John Bishop]

There is a BIG practical problem that Thoma and Buiter did not address. HOW BIG SHOULD THE HAIRCUT BE?

This is an illiquid market because AAA rated non-agency RMBS have different risk profiles and therefore different fair market valuations relative to face value. The collateralized dept obligations (CDOS) are very complex instruments and the models used to value them are also extremely complex.

It is clear from today’s testimony that the Fed does not have the in-house expertise to value tens of thousands RMBSs and CDOs. Since many of these assets are valued by risk models or by extrapolating from isolated sales of similar instruments, sellers have an interest in choosing valuation models that offer the most positive valuation of the asset possible. The models used one year ago completely underestimated the likelihood of large nationwide declines in housing values. Shiller and other experts predict big further declines in housing prices. How big will these declines be over the next 12 months? Over the next 24 months?

We certainly want to hear the opinion of advisory firms like BlackRock but taxpayers cannot allow an organization with potential conflicts of interest—eg. currently under contract to other market participants--to decide what price the Fed pays for (or what haircut must be imposed) for the hundreds of billions of dollars of RMBSs the Fed might buy. THINK OF THE MARKET POWER THIS ROLE WOULD CONFER ON BLACKROCK. What assurance is there that the risk models used by BlackRock will make the right call about the magnitude of the next leg of the nationwide housing price decline?

The Fed cannot do what Mark Thoma and Willem Buiter propose unless it develops an in-house capacity to value the individual CDOs and RMBSs. It will need to either purchase an existing firm with necessary expertise or hire experts into the civil service. The Fed could then investigate and value each RMBS offered to the TSLF and set a haircut (or discount) that is appropriate. Since, however, it takes many days to investigate proposed collateral, how can the TSLF respond to a run on a bank?

I suggest that the Fed REQUIRE the investment banks with access to the TSLF to specify what Triple A collateral they would offer to the Fed in an emergency. I say require because adding the TSLF window to the FRBs arsenal increases the information that the FRB must have about what is on the books of the banks it supervises. Having banks voluntarily provide this information could trigger a run if it were to leek out which bank was undergoing such a review. Therefore, all TSLF banks and dealers should be subject to the process.

The FRB would then investigate these RMBS and other eligible AAA securities and decide what the ratio of collateral to Fed loan would be and then inform the bank in general terms what the haircut would be. The FRB should set the haircut at a point where it expects to make a profit if they have to hold the collateral for a couple of years.

Once the FRB has investigated much of the RMBS debt, it is likely to face the question of whether it can announce rules for how it is valuing particular types of this debt when it takes it on the Fed balance sheet through the TSLF or by other means. That might have the psychological impact that Thoma and Buiter want.

[Turbo]

China's motto of one country, two systems is largely true for HK. The HKMA is more than just a currency board, as it also has regulatory authority, but maintaining a currency peg does limit it's monetary policy options. Driving short-term interest rates to extreme levels (100%, extreme spikes to 1,000% plus at times) to force out the speculators, in a system that was starting to experience deflation caused a lot of financial wreckage. The fallout on HK's economy was probably an unintended consequence. Whether this was needless or not depends on your view of currency pegs - I think a dirty float (heavily managed exchange rate - Singapore for example, or the Yuan now) is a much more sensible way to go, so in my opinion it was not necessary.

On the topic of this article, anyone who thinks the Fed should just stand aside at let the financial system sort itself out has to realize that that is precisely how the recession of 1929 became the Great Depression. Given the moral hazard now implicit in the financial system, banking needs to be a heavily regulated activity - and this comes from someone with a typically free market bias.

[billy]

At the bottom of this entire scheme is the American consumer

(1) who spends more than what he earns
(2) thinks that his house will somehow be his retirement savings, even if he spends all he earns. Mark-to-market when prices are rising will do the saving for him.

Economists in academia live in ivory towers

(1)they cannot grasp the concept that people have HELOC'ed the hell out of their houses.
(2)they cannot grasp the mark-to-market valuations created by appraisals in a very illiquid market such as housing

I still haven't heard one argument from a single economist which explains how a few reckless borrowers (who now are defaulting left and right) buying houses at sky-high prices (with dreams of flipping their way to riches) made every other homeowner wealthy due to mark-to-market appraisals.

Can Mark Thoma explain how saving is possible without postponing consumption? How there is saving when people spend all they earn (and in addition HELOC the mark-to-market "wealth")?

People have (1)borrowed and spend this mark-to-market wealth (2) and stopped saving because of this mark-to-market wealth

So at it's core, this is about mark-to-market in the value of housing. Mark-to-market gimmicks does not equal saving. What is really ridiculous, really really ridiculous, is that all these people who are crying about fair values and firesale prices (mark-to-market) never made a peep about mark-to-market and manic prices on the way up.

[OB]

Dear Reason, not to get into a pointless argument here, but you misrepresent my meaning. you say:
"OB, I wonder how you can say

...but I'd always thought that market values deviate from
'fundamental' values only if there is some market disruption ...
and
The ibanks saddled with all these bad assets are the ones who badly overvalued them.
in the same comment and keep a straight face?"

That first sentence ends "or there is some information not factored into the market price". My point was that the price paid by the ibanks currently holding such assets was Not factoring in adequately the risk, and that the current price buyers are willing to pay for such assets is probably just about the right one, now that the utter uncertainty of return - due to the opaque nature of the instruments, etc. - has been made apparent. More generally, its not that I'm against doing anything, its just that the most direct way to address the roots of the problem - i.e. illiquidity, solvency, deleveraging - is to have the banks recapitalise. And that can be done with private funds or with public funds as in Japan. Buying up overpriced assets is a very expensive way of getting to the same point, but happens to also have the added bonus of lining the pockets of irresponsible shareholders.

[gordon]

Prof. Thoma: "As I've said many times, the point of the exercise is to prevent the economy from going into a downward spiral brought on by the collapse of the financial sector. Saving the financial sector, in and of itself, has nothing to do with it".

This raises two questions. First, what parts of the financial sector need saving in order to save the economy? Second, what sort of "saved" financial sector should we aim at? I think commenter a's point is largely that the investment banks like Bear Stearns aren't necessarily the parts that need saving. And many commenters (including me) have suggested that the "saved" sector will need to be much more comprehensively regulated than the financial sector which presently exists.

Saving the financial sector in order to save the economy doesn't imply saving all of the present financial system, nor does it imply saving the current regulatory (or perhaps one should say non-regulatory) regime intact either.

I thought about another rant on the subject of the Commonwealth Bank of the United States, but thought better of it.

[reason]

OB
essentially you are saying bubbles never happen, and I don't believe you. They don't happen under the efficient markets hypothesis, but the map is not the territory.

[reason]

OB
P.S.
I may well be that I think your arguments for what should be done about the crisis, but I think your argument supporting it is transparently rubbish.

[reason]

... about the crisis are OK, ...

[OB]

Dear Reason,
I appreciate the responses, but its beyond me how you can glean that meaning from my posts. I'm saying the assets were Very overpriced - i.e. there was a bubble, and that there are more or less expensive and morally hazardous ways of having those prices adjust to fundamental value in an orderly manner. I'm basically siding with Krugman's suggestion against Delong in holding that there may be no goldilocks equilibrium out there to find (or to create- by adjusting the demand or supply curves). There is most likely only the stone-cold lower equilibrium that sellers are going to have to prepare themselves to live with - by recapitalising. Take a look at their stuff on the reverse S curve as a model for understanding the present circumstances. Hope this is helpful, (because its the last time I'll try, my friend).

[reason]

OB
Bubbles and this:
I'd always thought that market values deviate from 'fundamental' values only if there is some market disruption
are somewhat incompatible.

See for instance Brad DeLong's recent musings about the (possible?) inadequacies of neo-classical pricing models.

[OB]

Reason, would you read to the end of that sentence, please:
"I'd always thought that market values deviate from 'fundamental' values only if there is some market disruption ... or there is some information not factored into the market price."
i.e. in this case, a bubble due to buyers not factoring in the risk profile of the assets adequately. You're a bit too quick to the trigger, methinks.

[reason]

No I just don't think missing information (in this google age) is a sufficient explaination.

[reason]

To me it is like saying that people smoke because they don't know it damages their health. People know that when they gamble on average they will lose, but they do it none the less. People knew prices were rising and assumed they would not be caught out when prices fell. People knew the risk they were taking, they just didn't take the risk seriously because of false expectations. There is no reason if people were too optimistic in the past, they can't be too pessimistic now. I think your argument just doesn't add up. That doesn't mean necessarily that I think your policy prescription is wrong.

[reason]

Think about what limited liability, high leverage and agency issues mean in these markets. Risk is seen asymetrically. It is not that risk is not understood, it is that people individually see huge upsides and limited downsides.

[OB]

I think most of what you say is what I mean by "not adequately discounting risk". As for your ultimate bone of contention, you say:
"There is no reason if people were too optimistic in the past, they can't be too pessimistic now."
Well, ok. But by the same token the price offered by buyers may still be too optimistic. who knows? After all, the rest of the market - equities especially - hasn't factored in a serious recession yet, and you've got AAA rated MBSs with half the underlying already in default.

That skepticism is precisely my point. I'm saying that those who talk down the risk involved in the Fed buying up these assets don't have an argument apart from blind hope. There is a bizarre presupposition that potential buyers are necessarily being irrationally pessimestic.

The issues of insolvency and deleveraging can be dealt with either by a capital infusion or by buying up the dodgy assets. The first simply seems to me a better option from all points of view except that of the culpable shareholders.