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Thursday, September 18, 2008

Risk Absorption as a Last Resort

Back in March I said:

I’m starting to think that the Fed should drop the term part of the TSLF and instead 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.

Most of you thought I was nuts, and said so. If we were going to do something like this, doing it then would have been better, but it looks like we are about to do something like this now:

U.S. Plans to Clean Up Finance System, WSJ: The federal government, acknowledging the need to take a more comprehensive approach to the financial crisis, is working on a sweeping series of programs that would represent perhaps the biggest intervention in financial markets since the 1930s.

At the center of the potential plan is a mechanism that would take bad assets off the balance sheets of financial companies.... It's size could reach hundreds of billions of dollars...

Treasury Department officials have studied a structure to buy up distressed assets for weeks but have been reluctant to ask Congress for such authority unless they were certain it could get approved. The intensified market turmoil may have changed that political calculus, even with less than two months left until the November elections.

A Treasury spokeswoman said: "Treasury Secretary Paulson joined Federal Reserve Chairman Bernanke in a meeting with House and Senate Republicans and Democrats to discuss current market conditions. They began a discussion with them on a comprehensive approach to address the illiquid assets on bank balance sheets that are at the underlying source of the current stresses in our financial institutions and financial markets. They are exploring all options..."

[Under t]he possible plan..., a new entity might purchase assets at a steep discount from solvent financial institutions and eventually sell them back into the market. ...

Update: See also To whom and for what? by Steve Waldman, and The Bailout of All Bailouts is a Bad Idea by Robert Reich for different opinions.

    Posted by on Thursday, September 18, 2008 at 07:29 PM in Economics, Financial System | Permalink  TrackBack (0)  Comments (22)


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