Fed Watch: End Game:

Tim Duy assesses the financial crisis, and what the Fed is likely to do at its next rate-setting meeting:

Endgame?, by Tim Duy: News is flowing in faster than the ability to process the implications.  When I went to bed Saturday night, the only sure thing looked like the liquidation of Lehman Monday morning.  A scant 24 hours later, to that liquidation is added the sale of Merrill Lynch to Bank of America and, later the possibility of a collapse of AIG by midweek.  The Fed and Treasury suddenly play hardball, and the floodgates break open.

Mark Thoma is working overtime to keep readers informed. 

Fed officials likely now understand the can of worms they opened with the Bear Sterns bailout.  At that point, Wall Street realized that attempting to solve their own problems was a sucker’s bet – better to string things along with the expectation that the Fed would ultimately solve the problem of bad assets by bringing them into the public domain.  Arguably, this is one reason the Lehman issue was allowed to fester for another six months.  Moral hazard.  With policymakers now drawing a line in the sand, market participants can no longer cling to the hope that the Fed will absorb additional bad debt (notice how quickly Merrill moved when policymakers claimed they will serve only as matchmakers, rather than put additional public money explicitly at risk).  It is looking like the endgame is finally here.

To give the Fed the benefit of the doubt, earlier this year they likely saw the financial crisis as primarily a liquidity event.  Thus, they could make the analogy that market participants just needed a “slap in the face,” and some rapid rate cuts and fresh sources of liquidity would give confidence that much needed boost.  By now, however, officials probably realize this is a solvency crisis.  Too many debt instruments hinge on the state of the US housing market, and too many homeowners took on loans that are simply unaffordable. 

A solvency crisis can only be addressed by eliminating the bad assets (since analogies to Japan are all the rage, note that the unwillingness to eliminate nonperforming assets helped prolong that banking crisis).  Moving the assets onto the Fed’s balance sheet via temporary repo operations does not eliminate the problem, it just moves it around.  Instead, the questionable assets need to be eliminated, and some agent needs to accept the loss.  Who will that agent be?  Wall Street obviously prefers that the taxpayer ultimately absorbs that loss; the Bear Sterns bailout provides the precedence for such an outcome via the Fed’s financial backstop. 

Repeated Bear Sterns type bailouts would eventually force taxpayers to absorb the losses of the entire crisis and, more importantly, do so without legislative approval.  We can cordially debate the appropriateness of taxpayer support, but we should all be clear that that decision needs to be made in a democratic fashion.  It is too big an issue for an “ends justify the means argument,” a justification that Bernanke & Co. need to do whatever is necessary to make the trains run on time.  Bernanke & Co. likely understand this now, encouraging their hesitation to continue down that road.  Of course, if Lehman is forced to liquidate assets, that too has obvious consequences, such as setting prices for those assets that further destabilizes the investment banking community, pushing financial markets to an end game in the crisis.  Still, even with that crisis in the making, the Fed has already pushed their legal boundaries; some would argue they have stepped well beyond those boundaries.  And it hasn’t stopped – the Fed expanded the collateral it will accept in repo operations, putting taxpayer dollars at risk in a less explicit manner (I see no legal justification to open a credit line to AIG – if them, why not Ford or GM?).  Still, despite the Fed’s creative efforts to date, the crisis is moving to a stage that is simply too big for the Fed; Congress needs to step up and define the parameters of any mass bailout of the financial sector.  Some version of the Resolution Trust Corporation is the most likely outcome.  I suspect that taxpayers will ultimately absorb significant losses, but it will be a crime if such a bailout does not entail a radical reevaluation of financial regulation.  But to what extend will Congress be willing to perform a hard look as an industry that has brought the illusion of wealth that hides gaping and undeniable equity flaws in the US?

The FOMC is gathering this week for a decision on interest rates.  I imagine all bets are off regarding the outcome; indeed, we may get an emergency rate cut by the time I get to the office.   As of Friday, policymakers were widely expected to keep rates steady; only the language of the statement is in doubt.  Specifically, market participants will be looking to validate growing expectations of a rate cut later this year.  At issue is the use of the term “significant” to qualify the inflation threat.  Given the collapse of commodity prices, there appears to be room to remove that qualifier.  I suspected they would be wary, however, of giving hints that a rate cut is in the making – they are probably just now breathing signs of relief that Dollar/commodity dynamic is no longer working against them.  They do not need to trigger a fresh run on the Dollar; moreover, Chinese policymakers likely are happy that they foreign currency value of their Dollar assets is on the rise, and do not want a reversal of that situation.  After last week’s nationalization of Freddie and Fannie, we can no longer hew to the illusion that policy is based only on domestic considerations. 

Cutting interest rates, I suspect, will make little if any difference at this juncture.  That said, the Fed has delivered a rate cut at each critical juncture of the past year.  I am at a loss to convincingly explain why this week is any different.

Comments

[Winslow R.]

Tim wrote " I suspect that taxpayers will ultimately absorb significant losses, but it will be a crime if such a bailout does not entail a radical reevaluation of financial regulation. "

I suspect the same, though I was hoping you might suggest a good alternative.

[Michael McKinlay]

We are no where near the end game.

All todays excitement failed to produce the unwinding of assets needed. The expected easy settlement of Lehman party CDSs was no such endeavor by all accounts.

Today was all smoke and mirrors as far as any real disposition of the problems of the market for derivatives.

[hari]

If Fed and Congress are in the right frame of mind...this financial crisis must be followed by a complete and through investigation of *why* and *what for* - this type of messy bankruptcy specially in the highly leveraged investment houses on high street. Is it time to separate investment banks from retail banking business and built a barrier between them?

In Germany, Investment Banks are passe...almost all closed down by M & A. Same will follow in rest of EU, I guess.

Fed made some serious errors of judgement and must be made accountable for its policies. The problem, as seen from a distance, is the close links between the banking sector supervised by Fed and its own intrinsic policy management role.

If there is no collusion, as AG clarified in his recent book, the independence of Fed is still an issue.

[Robinia]

Agree that it is only the beginning of endgame. But, we have moved past thinking that we can jolly everybody into "confidence" and are finally acknowledging.... that somebody somewhere has been conned. The long unwinding will find losers, surely, somewhere.

Am finding myself less distressed than I was last December, when the possibility of this scenario first dawned on me. Just sad for suffering that need never have been, and curiously reassured that the btu value of my homegrown firewood has remained utterly stable, come the breakdown of the bull or high water in Houston.

[JKH]

A rate cut has never been entirely off the table, in the minds of those actually making the decision and who think in terms of risk (primarily Bernanke).

[bakho]

De-privatizing Freddie Fannie means that future homeowners can get mortgages so BigCredit can't gouge them to try to recover losses. Congress should not try to bail out housing until the bubble deflates. One move to free up funds would be for Congress to act to buy up properties at pre-bubble prices (to speed up deflation and set a floor to prevent price undershoot) and let BigCredit eat the differences. I would hate to see an RTC organized under GWBush, because he would politicize it (Monica Goodling style) big time. The previous RTC under GHWBush was a hotbed of partisan political hacks.

[Robert Bell]

I noticed that you have achieved your goal of shorter posts, without sacrificing quality. Maybe you can get promoted to large font with no indent now! ;)

[ken melvin]

Don't think it was loans made to those unable to pay that caused this problem. The damned prices are too high.

[A Matter of Trust]

"...this is a solvency crisis..."

The institutions that brokered bad loans, and tried to pass them off to foreign savers, have lost the confidence of foreign savers. Once trust is lost, it can take a long time to restore. It is almost to the point where completely new institutions will have to arise to take the place of the old ones. The new institutions will have to act with complete fidelity to restore trust.

[Too Expensive]

Home prices are far too high. The entire country cannot be gentrified just to maximize the property taxes. One cannot simply wave a magic want and demand that youngsters now produce twice as many chairs or toasters to pay for a McMansion. The 2 earner household is already standard, with a part time job on top of it. They simply can't produce any more toasters to pay for larger McMansions. They can't produce any more chairs to fund schools, parks, and whatever else is mandated to be rolled into the price of land zoned residential.

Enough already. The breaking point has been reached, and the nation is on the verge of collapsing from trying to borrow so much from foreign savers to keep home/land prices rising. Affordable (low) prices. Nothing else will house the nation in a sustainable manner.

[robertdfeinman]

Sorry to be contrarian, but the housing "crisis" was not the cause of this meltdown. It was monetizing everything and then using these "derivative" financial instruments as collateral for borrowing to speculate.

This is what caused the crash in 1929 and its the same thing now. When firms start leveraging credit default swaps and other devices that are based upon no physical assets a crash is inevitable. As soon as any part of the Ponzi pyramid suffers the slightest decline then lenders start making margin calls forcing speculators to sell at a loss.

If too many get calls at the same time the market for the distressed instruments seizes up and you have the present situation. George Soros tries to explain in part in this recent article:

The Perilous Price of Oil

This time it isn't going to just be "Wall Street" that suffers. Municipalities have been dabbling in derivative instruments instead of floating conventional tax-exempt bonds because of the poor advice they got from these same failing investment bankers.

Pension funds have been ignoring the prudent investor laws and buying leveraged instruments as well. People who think they are far removed from Wall Street will be shocked when they see the value of the IRA's or pension funds affected and when their local governments can't pay running expenses.

There have already been a number of such cases, more can be expected.

There was no need to create Fannie and Freddie, the banking world handled mortgages for over 100 years fairly well. It was the desire to monetize mortgages and introduce a new layer of parasites that was the motivation. If the goal had really been to pump more money into the housing market then they could have remained government agencies.

Greed, greed, greed - it is always the cause of economic collapse. And these are the people who want another chance at running government (and I don't just mean the GOP).

[Redistribution via Inflation]

"It was monetizing everything and then using these "derivative" financial instruments as collateral for borrowing to speculate."

Creating new money, and giving the new money to rich hedge funds to leverage speculative bets 30 to 1, is rather silly. That's just taking purchasing power from hapless fixed income retirees, and transferring it to the rich. No wonder inequality is so great, and speculation is out of control.

[homer]

I keep seeing the fannie/freddie bailout blamed on the Chinese Central Bank. Are there any sources or more deeply explanatory links, where we can learn more about this?

[Bailout]

China holds lots of Fan/Fred debt. They refused to buy any more unless the old stuff was bailed out. This would have shut down most US mortgages because we don't have our own mortgage money to loan out. We have to borrow most mortgage money from China et al.

[Robinia]

It was the desire to monetize mortgages and introduce a new layer of parasites that was the motivation. If the goal had really been to pump more money into the housing market then they could have remained government agencies.

Greed, greed, greed - it is always the cause of economic collapse. And these are the people who want another chance at running government (and I don't just mean the GOP).

Precisely. That parasitical layer is what must be pruned off; new jobs for the Wall St. crew, maybe in something that has a tangible product. We are too poor to play any more speculative games.

And, homer, you can't find factual references to vague finger-pointing, blame-the-enemy posturing. If you believe that China, and not our own Masters of the Universe, caused this, well, GW has some WMD he confiscated off of Sadam to sell you.

[Lafayette]

Don't forget Chrysler ...

Article: (I see no legal justification to open a credit line to AIG – if them, why not Ford or GM?)

There is precedence - the Chrysler bailout in 1979 under Jimmy Carter. Treasury Secretary Miller (at the time) made the following justification: In his first public act at the Treasury, Miller spelled out the ideological ground rules of federal aid and warned other troubled companies against expecting similar help. Such assistance, he said, "is neither desirable nor appropriate, being contrary to the principle of free enterprise." But Chrysler was an unusual exception, he added, in which the Administration "recognizes that there is a public interest in sustaining [its] jobs and maintaining a strong and competitive national automotive industry."

Take the words "national automotive industry" and replace them with "national Finance sector" and, abracadabra, an incredulous American public will swallow the bitter pill.

Who ever asked them, anyway?

[gina]

Eventual the interest payment on the federal goverments stupidity will be to large for the taxpayer to fund, then what?

[Winslow R.]

"Eventual the interest payment on the federal goverments stupidity will be to large for the taxpayer to fund, then what?"

Then government spending will have to be redirected to the taxpayer. Hopefully the redirection is achievable through the ballot box.