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Sunday, March 16, 2008

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.

    Posted by on Sunday, March 16, 2008 at 12:20 AM in Economics, Financial System, Monetary Policy, Policy | Permalink  TrackBack (0)  Comments (16)


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