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Tuesday, March 11, 2008

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.

    Posted by on Tuesday, March 11, 2008 at 08:29 PM in Economics, Financial System, Regulation | Permalink  TrackBack (2)  Comments (59)


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