How to End the Fear?

Paul Krugman has a cartoon model of the crisis:

A cartoon model of the crisis (more serious wonkery), by Paul Krugman: The other day I realized how much the Fed’s attempts to resolve the financial mess resemble sterilized foreign exchange intervention. That set me thinking about other parallels — and I realized how much the stories now being told about “systemic margin calls” and all that resemble the stories we all tried to tell about the Asian financial crisis of 1997-98. Leverage, balance sheet effects, self-reinforcing financial collapse — the details are different, but there are some clear common themes.

You can see my old “cartoon model” of the Asian crisis here. What would a comparable cartoon analysis of the current crisis look like?

Think of the demand for “securities” — lumping together all the stuff that’s in trouble, from subprime to Alt-A to corporate bonds, as if it were all the same. Ordinarily we’d think of a downward sloping demand curve. At a given point in time, there’s a fixed supply of these securities that has to be held by someone, so the market would look like this:

The normal case

But in the current situation, a lot of securities are held by market players who have leveraged themselves up. When prices fall beyond a certain point, they get calls from Mr. Margin, and have to sell off some of their holdings to meet those calls. The result can be a stretch of the demand curve that’s sloped the “wrong way”: falling prices actually reduce demand. So the market could look like this:

Mr. Margin adds a twist

In this case, there are two equilibria, H and L. (there’s one in the middle, but it’s unstable) And this introduces the possibility of self-fulfilling panic: if something spooks the market, you can get a “systemic margin call” that causes the whole financial market to go to L, and causes a big, unnecessary price decline.

Implicitly, Fed policy seems to be based on the view that if only they can restore confidence — with extra liquidity to the banks, Fed fund rate cuts, whatever — they can get us out of L and back to H. That’s the LTCM model: Rubin and Greenspan met a crisis with a rate cut and a show of confidence, and the whole thing went away.

But at this point a series of rate cuts and other stuff just hasn’t done the trick — which suggests that maybe there isn’t a high-price equilibrium out there at all. Maybe the underlying losses in housing and elsewhere are sufficiently large that the situation really looks like this:

But maybe it’s not really his fault

And in that case, the Fed can’t rescue the financial markets. All it — and the feds in general — can do is to try to limit the effects of financial crisis on the rest of the economy.

This is all pretty crude — but it’s at least a start to thinking about the mess we’re in. Actually, I’ve been struck by how little analytical thinking I’ve seen about the current financial crisis. Economists, it’s time to come to the aid of your country!

Thomas Palley answers the call:

Meltdown Moment: What Must be Done, by Thomas I. Palley: Last week’s default of Thornburg Mortgage had an ominous sound, like the cracking of sheet ice. Wall Street now sits atop a potential collapse of confidence in asset valuations, threatening a panic that will wipe away both sound and unsound financial institutions. The week’s events also reveal how the Federal Reserve’s bail-out policy has failed to address the underlying problem of credit market seizure. Here’s what’s going on, and what must be done to prevent a meltdown.

By way of background, Thornburg Mortgage is a leading lender specializing in Alt-A mortgages for purchases of higher priced homes that exceed Fannie Mae’s and Freddie Mac’s conforming loan limit of $417,000. By all accounts its mortgage backed securities constitute good credit structures with the underlying mortgages still intact. The problem at Thornburg is not classic insolvency, but rather the evaporation of willingness to hold even mortgage backed securities backed by sound assets. This has caused security prices to tumble, lowering the value of Thornburg’s collateral and thereby triggering margin calls from banks that it has been unable to meet.

Similar stories are being played out in many parts of the market. Thornburg and other financial intermediaries are now threatened with bankruptcy that poses two grave public threats. First, if these firms liquidate their mortgage portfolios that will further depress asset prices, thereby potentially triggering margin calls at other firms that could generate dangerous ripple effects. Second, putting additional mortgage lenders out of business will make it even more difficult to buy and sell homes, which promises to further depress house prices. These are exactly the effects policy should be avoiding.

The irony behind this debacle is that part of the problem is due to margin calls from banks. However, banks are currently being bailed-out by the Federal Reserve, which has provided them with tens of billions of dollars of subsidized credit through its term auction facility. In effect, the institutions the Fed is bailing-out are the same ones putting downward pressure on financial markets. Indeed, the banks are being given subsidized credit for problems similar to those experienced by Thornburg. Thus, there was an earlier loss of confidence in banks’ assets that threatened their ability to renew roll-over funding for their activities. This risked causing banks to default, triggering margin calls and fire-sales of their assets that would have caused major asset price deflation and the destruction of credit provision.

The Thornburg story illustrates two things. First, the Fed’s policy privileges banks, bailing them out while letting perish other financial institutions that are no more guilty. Second, the Fed’s current policy has not solved the problem of financial instability. Though the banks have been ring-fenced, they are now causing problems elsewhere through loan margin calls. Moreover, these calls could collectively come back to haunt banks by driving down the price of assets that they also own. Consequently, even the banks remain at risk despite the Fed’s term auction facility.

In today’s crisis environment the problem in financial markets is not the level of interest rates, or even the size of the Fed’s term auction facility. The problem is getting liquidity to those links in the financial chain that are most stressed. Reliance on the normal channels of distribution does not work when confidence has evaporated and markets have seized-up.

There is a very simple and fair solution to this problem. That solution is for the Federal Reserve to open its term auction facility to all publicly traded financial intermediaries rather than just deposit taking institutions. That means giving access to insurance companies, mortgage investment trusts, mutual funds, and hedge funds. These firms would be subject to the same borrowing terms as banks, and would have to post collateral of identical quality.

Such a change would level the playing field in financial markets and remove the unfair subsidy to banks. Most importantly, it would tackle the problem of credit market seizure that is afflicting all financial institutions. In a world where distinctions between financial intermediaries have become increasingly blurred, broadening access to the term auction facility is the logical and correct policy.

The Federal Reserve’s current policy is failing because it is structured for the world of the past in which depository institutions dominated lending. Thus, current policy restricts access to emergency liquidity to deposit taking institutions, ignoring how lending has become detached from deposit taking. The challenge of the day is preventing a meltdown that destroys sound lenders and sound assets. That calls for widening access to temporary emergency liquidity. Afterward, there will be time to visit the question of regulatory reform and more permanent policy change

Could the Fed do this? From the WSJ Economics Blog:

Fed officials have said that, at times like these, the prudent course is to at least evaluate all sorts of ideas, many of which may be rejected. Since 1932, the Fed has had the authority to lend, against collateral, to individuals, partnerships or corporations other than banks in “unusual and exigent circumstances,” subject to the vote of five members of the Board of Governors. (The board has seven seats, but two are currently vacant.) This power has never been used. ...

Congress in 1966 gave the Fed temporary authority, made permanent in 1979, to purchase obligations of government-sponsored enterprises, such as Fannie Mae and Freddie Mac. So far, the Fed hasn’t purchased GSE obligations except in its short-term repurchase operations. When the federal budget was in surplus, the Fed considered outright purchases of GSE obligations, but judged against such a move as it would reinforce the perception of an implicit government guarantee.

I'm not sure that measures along these lines will be enough. Widening access to liquidity might help, but the problem is fear, and until fear is conquered, markets will remain frozen. That tells me that some sort of insurance that puts a floor under losses is needed to get credit markets moving again, and, since private sector insurance firms can fail, government will have to provide or guarantee the insurance contracts (which could be paid for by promising to share in any gains on the upside). I need to think about how to structure such contracts to get the incentives right, but until people are confident that they can loan money without risking big losses through defaults or large price drops, credit market problems will continue. Ending the fear is the key, and like Paul Krugman, I have my doubts that the Fed will be able to do this using the kinds of policies it has relied upon so far.