How I learned to love the Fed
I’ve written about the Federal Reserve a good deal, and I’ve been critical of its willingness to take private sector risk onto its balance sheet by swapping Treasuries for the increasingly dodgy securities produced during the credit bubble.
The (hopefully defunct) Paulson Plan has provided a come to Jesus moment. Having the Fed lend money against overpriced collateral valuations is infinitely superior having the Treasury purchase those securities outright at inflated prices. While the taxpayer is on the hook in either case, at least when the Fed lends, the taxpayer loses only if the borrower first fails. If the Treasury Secretary overpays for an asset, the original owner books the profit and the taxpayer eats the loss directly. A “quiet bailout” from Dr. Bernanke strikes me as much more equitable than a sellers’ market fashioned by Secretary Paulson.
Lending from the Fed even against worthless collateral cannot address undercapitalization of the banking sector. Neither could the Paulson Plan, unless the Secretary were to overpay for bank assets. Removing the ability and incentive to overpay on a permanent sale strikes me as a good thing. Recapitalizing the banking system will require more than easy money from the Fed. But easy money, combined with a bit of temporary forbearance on capital requirements, would help blunt the current panic, while leaving bank stockholders and creditors on the hook before any losses would be taken by taxpayers.
The big hazard of this approach is as it has always been, how to wean the banking system from the mother’s milk of Fed largesse. Many banks are insolvent, and those banks need to be identified, reorganized and recapitalized (or else liquidated). That should happen quickly — not zombie style over the course of a decade — but it needn’t happen instantaneously and simultaneously. In order to even get started, we need to have a fair endgame, a good approach to reorganizing and recapitalizing banks. I’m already on record as supporting either temporary nationalization (a la the Scandinavian model or AIG), or internal recapitalizations via debt to equity conversions. It’s possible that a combination of these two approaches, one that doesn’t give government direct control over reorganized banks and includes both internal and public sector capital injections, might be more palatable than either choice alone. That will be the subject of my next post.
In the meantime, I would support a standalone act authorizing the Fed to pay interest on deposits immediately. I would prefer that Congress impose limits on the quantity of deposits on which interest can be paid, to limit the risk and interests cost to taxpayers, but that limit could be quite loose for the moment. This approach has the advantage of getting liquidity into the banking system far more quickly than the Paulson Plan ever could have, and drawing a clear line between the liquidity and capitalization aspects of the plan. It could be implemented immediately by passing the one sentence Section 128 of the Paulson Plan in isolation (although again, I’d prefer to muck it up with a limit on the quantity of paid deposits).
Freed of its balance sheet constraint, the Fed might consider injecting funds into the banking system by purchasing a diversified portfolio of holdings in money market funds that trade in commercial rather than government paper. This would help relieve the stresses in the commercial paper market very directly, and reduce the likelihood of a disorderly adjustment in nonfinancial commercial credit markets.
that sounds like the Matus/Rosenberg’s proposal, “How to save the world, Libor and make $10 billion”
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The Federal Reserve should step in as the repo clearinghouse for all term repo trades. For a counterparty-risk based fee the Fed would guarantee that, only in the event of counterparty failure, the surviving counterparty would receive your cash, not the collateral that was posted for the funds, back from the Federal Reserve. The Federal Reserve would own the collateral. This has several advantages:
1. There is no cost unless there is a counterparty failure. Any cost that would occur in that unlikely event would be offset by the massive amount of fees that the Fed would generate over time.
2. By making illiquid assets easier to finance, the proposal would free up portions of existing bank balance sheets.
3. By restarting the term securitized lending market it would provide a benchmark for determining the validity of the term LIBOR fixings.
4. By gradually increasing the insurance fee each week, the Fed could wean market participants away from this program.
5. The most likely scenario would see the Fed be left holding no assets (but having generated fees).
September 29th, 2008 at 8:37 pm PDT
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Temporary forbearance on capital requirements is isomorphic to a suspension of marked to market accounting. Kling thinks that its somehow meaningful or comforting to distingish between the two. It isn’t. There is no difference. If you prefer capital suspension to marked to market suspension because you think one carries stigma and the other dosen’t, that’s nonsense. Both amount to full disclosure of marked to market valuations while delaying their incorporation in immediate capital requirements and amortizing them into capital positions over time. Both amount to giving the banking system the benefit of time in order for franchise value to generate income to assist with loss coverage and recapitalization. The status quo accleration of capital response to longer term mortgage losses is the enemy in this environment. This is common sense. People need to start getting their heads around it.
So it’s a good idea as a concept, and as part of a bigger package of ideas. I don’t know exactly how it would be implemented, but its certainly something Congress could design given what they’ve already dealt with.
September 29th, 2008 at 9:18 pm PDT
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If Bernanke is so sure the assets are undervalued–as they almost certainly are, as we are in a panic (we were previously manic, now we’re in a panic), then why can’t he just grant forebearance justified by irrational detumescence in capital valuations.
The dangers of excessive accommodation used to be thought to be inflation, but they turned out in the past 20 years to be asset bubbles, as the labor market had been crucified and couldn’t get up a wage-price spiral. However, asset bubbles may not form so quickly in the post-Panic-of-2008 atmosphere, and the labor market is still hanging on the cross.
In a fiat money system with frantional reserve leverage, regulation of credit becomes paramount. Credit needs to be granted in accord with the capacity to repay from economic activity, not price inflation. There are (and were) numerous tools to prick stock market bubbles (margin requirements), real estate bubbles (loan-to-value and debt-to-income requirements).
Lower capital requirements, grant forebearance with a time limit, loan the banks the money and make the winners of the spoils, the Jamie Dimons of the world, pay it back in return for the blood they will extract from their acquirees.
September 29th, 2008 at 10:28 pm PDT
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I wonder about allowing Bernanke such latitude (I’m being diplomatic.) He refuses to acknowledge that some of the collateral he’s accepting is utterly worthless and that much of it is correctly worth much less than face value (i.e. even absent “fire sale” considerations). That is either gross incompetence or outright dishonesty – hardly inspiring confidence.
I would not put past him to quietly forgive many of the “temporary loans” when the coast seems clear. While arguably that would _still_ be better than the Paulson plan because the latter makes official the big-money ownership of our government, it’s still dangerous. So much for checks and balance.
September 30th, 2008 at 2:18 am PDT
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“There is no worse mistake in public leadership than to hold out false hopes soon to be swept away. The British people can face peril or misfortune with fortitude and buoyancy, but they bitterly resent being deceived or finding that those responsible for their affairs are themselves dwelling in a fool’s paradise.”
— Winston Churchill
September 30th, 2008 at 6:53 am PDT
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Steve – I agree 100%. We should certainly be using traditional (as well as creative) monetary policy ops by the Fed as the first line of action (we’re already running bigger deficits, so fiscal policy is taking care of itself). Beyond that, if there is to be a “bailout”, it must focus on the orderly disposition of insolvent institutions and the recapitalization of solvent institutions. As I’ve said numerous times, giving Paulson a $700 billion check and telling him to go buy (at inflated prices) troubled assets in the hope of propping up the market is a futile non-solution.
Benign – Absolutely. The days of the Fed believing that they can (or even should) just ignore asset price bubbles, and rather just clean up the mess afterwards are over. Likewise, leverage and maturity mismatch need to be managed systemically. We don’t let people build nuclear reactors in their backyards, unregulated, under the banner of “free enterprise” nor should we allow the financial sector to expose the community to similar risk.
September 30th, 2008 at 8:17 am PDT
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To “wean the banking system of the mother’s milk of federal largesse”, is what you want. There is one way. The way I have favored for 28 years. Repeal the Federal Reserve Act. No Fed, no largesse. I just came up with another way. Any financial institution which borrows from the Fed must: turn over its CEO, COO, CFO and five vice presidents of its choice. For what? Hanging. A wise man once said that the prospect of hanging in the morning concentrates one’s attention. I suspect the prospect of hanging will induce Wall Steet to avoid risky behavinor. If not, someone can make a profit by selling tickets. I suspect hangings will be a big winner for pay per view TV.
September 30th, 2008 at 8:37 am PDT
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Hear, Hear, Independent Accountant
The poverty these leeches impose on the populace causes untold death and misery; I’m all for capital punishment of high officials (public or private) for grave crimes against the nation. There is no difference between the harm they cause and spying for a hostile power, both are treason. Name me one spy who has caused as much harm to the people of the US as these maggots. Not even the Soviet Union having nuclear weapons has caused as much damage to the US as this economic sabotage.
September 30th, 2008 at 9:03 am PDT
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glory — it seems to me that, for a while, the Fed is going to have to take on a more direct role in financial intermediation, rather than just controlling the oney and leaving it to banks, or (as recently) bearing bank risk as a senior creditor. The Matus/Rosenberg is in that vein, though it’d require a lot of care to be sure the Fed isn’t stiffed with bad collateral.
JKH — I think it’s the “full disclosure” that’s at issue. Even if MTM valuation is required as a note, suspending that leaves the front-page financial statements fictional (if you define truth as MTM, which I don’t necessarily, but arguendo…). Reducing capital requirements puts the compromised balance sheet clearly in the face of investors, but permits the company to hobble along.
That said, I agree with you, could be part of a plan, but on its own, there’s little to it. And I worry about proposing a lot of “temporary” things knowing that there will be pressure and momentum to just keep them going…
Benign — I’m very worried about the “winners of the spoils”. I’m very unhappy about the emerging well-connected hegemony of JPM-BOA-Citi. It’s something I want to undo, but obviously that will have to wait…
BSG — I don’t think he can simply forgive. I suppose the FRB, as an enterprise could, but hopefully that’d require significant procedure and documentations. As FRB money is essentially taxpayer money, foregiveness without reasonable process would be tantamount to a gift from the Treasury. I think (hope!) there’d be a lot of legal jeopardy if that were tried. It’s fairly broadly acknowledged now that the Bear Stearns / Maiden Lane deal was beyond the legal power of the Fed, but we’re letting it slide. I don’t think we’d let giveaways slide. They’d have to be well hidden, as though they were a form of embezzlement, even if some legal justification is claimed ex post.
That said, I don’t like trusting the Fed either. But at least with loans taxpayers have some leverage — we get ’em back or some bank gets hurt. It’s not a lot of leverage, ‘cuz when banks get hurt they take hostages, so our threat is pretty empty. But it’s better than just buying crap at high prices. Much better.
Dr. S — Very apropos.
IA — I also want to be rid of the Fed. I don’t think we have a reasonable monetary system. But I think we have to get the world to critical-but-stable before we can start cutting into tumors.
yoyomo — I’m with you on the extent of the damage that has been done, but I’m nervous about the rhetoric. I’m nervous about the variety of violence and coercion-laden societies that might arise from this mess. I’d like to get out of this with a very different financial sector, one that fruitfully guides the real economy rather than parasitically leeching from it. But I still hope to be living in a liberal democracy with the rule of law. In fact, I hope to be living in a more healthy liberal democracy with a stronger rule of law than the America I’m living in right now.
September 30th, 2008 at 1:46 pm PDT
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The assets are not worthless; it’s just that no private entity has the inclination, capital or liquidity to buy them. The private financial sector is in serious trouble; banks are so afraid of parting with a dime that they have actually stopped all banking activity.
The stuff has an inherent and intrinsic value just not a private sector market value.
That’s different from being worthless.
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October 6th, 2008 at 1:31 am PDT
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Warren Buffet suggested on Charlie Rose’s show that (I’m paraphrasing not quoting) if he had the cost of borrowing that the Government had he would take a 1% stake in the Paulson Plan and make a lot of money.
October 6th, 2008 at 1:35 am PDT
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