Comment Hoists, 2008-03-10

There’s been some good conversation in the comments. I thought I’d pull out a few of my favorite bits.


The Fed’s Balance Sheet Constraint

jh writes

The interesting point that no one has commented on is the existence of a Fed balance sheet constraint on limits to the outstanding TAF.

The Fed is limited by the size of the liability side. It doesn’t ‘force feed’ currency note into the system beyond the demand of the banks and the public for currency. And it has no room to expand bank reserve balances in aggregate of it wants to maintain control over the level of the funds rate. That’s why it’s ‘sterilizing’ now.

So the upper limit to TAF is essentially the size of the Fed balance sheet now, allowing for natural growth in currency demands of the banks and the public.

Beyond that, the Fed couldn’t ‘sterilize’ by selling other assets. It would have to start issuing its own liabilities, such as the sterilization bonds issued by the PBOC used to offset their foreign exchange purchases.

Looking at the March 6 Factors Affecting Reserve Balances, in addition to the already announced TAF and repo programs, the Fed could initiate somewhere between $500 and $600B more in “sterilized interventions” (as Paul Krugman first pointed out these are) before it would have to issue bonds rather than selling existing assets.

There’s more discussion of this point over at Brad Setser’s (in the comments section).

Update: The Fed announced this morning that it will use up $200B more of that capacity via a “Term Securities Lending Facility“. After the FAF expansion, repo program, and TSLF, the Fed will have between $300B and $400B in remaining sterilization capacity, unless it issues bonds directly. Paul Krugman, John Jansen, jck at Alea, Yves Smith, Michael Shedlock, Free Exchange, Justin Fox, Zero Beta (and see this!) comment.


Why the special repo program?

Why did the Fed announced the new repo program rather than just more dramatically expand TAF?

livingston guy offers an explanation:

The new repo line… is nothing more than the TAF for the brokers who dont have access to the TAF. Essentially, a Merrill wants to have the same access to liquidity as JPMorgan but doesn’t have it in the current framework of TAF which is only available to depositories. The new repo line just makes the same facility available to Merrill.

So the repo program can be looked at as a partial implementation of what Thomas Palley suggests. (In a pinch, apparently the Fed can lend directly to whomever it deems necessary, but that power has never been used. See David Wessel, “Analysts: Rate Cuts May Not Be Enough“, ht Mark Thoma.)

Update: Livingston Guy wrote on Sunday, and was referring to the expanded repo program announced Friday, not the TSLF program announced Tuesday. However, both the expanded repo program and TSLF are available to primary dealers, whereas TAF is accessible only to depository institutions.


The /Price Spiral

Len writes

[Regarding] a widely held misconception; namely that “inflation is the debtors friend”. That IS kind of the way it worked during the Carter inflation as unions, now largely powerless due globalization, were largely able negotiate wage hikes rapidly enough to stay more or less even with inflation, creating the famous wage/price spiral which made debt an ever shrinking entity to the detriment of lenders. Nowadays we have just the /price part of that spiral, wages have been flat to negative in real terms for years. Without a means of increasing his income along with the inflating currency, the debtors debts in fact, instead of looking smaller, look ever larger as his required spending for necessities crowds out available funds for debt service, hastening insolvency.

Compare to a recent speech by Janet Yellen, President of the San Francisco Fed (via WSJ Real Time Economics):

Even so, I expect both total and core inflation to moderate over the next few years… This… assumes that inflation expectations will remain well-anchored, as they have been, and also that workers will not through their bargaining offset the real losses resulting from higher food and energy prices.

Things look different if you’re a central banker.

Update History:
  • 11-Mar-2008, 10:45 a.m. EDT: Added update re “Term Securities Lending Facility”. Attributed observation that these are sterilized interventions to Paul Krugman directly, rather than only implicitly via a link.
  • 11-Mar-2008, 10:55 a.m. EDT: Cleaned up awkward wording introduced by reattribution in previous update.
  • 11-Mar-2008, 11:05 a.m. EDT: Removed a redundant “in the comments”. Sheesh.
  • 11-Mar-2008, 1:05 p.m. EDT: Added Yves Smith to list of TSLF commenters.
  • 11-Mar-2008, 2:55 p.m. EDT: Added Michael Shedlock to list of TSLF commenters.
  • 11-Mar-2008, 3:55 p.m. EDT: Added update explaining that LG’s comments were wrt repos, not TSLF. Added Free Exchange, Justin Fox, and Zero Beta to list of TSLF commenters.

In praise of active investing

Felix Salmon points us to a column by Mark Hulbert in today’s New York Times. Hulbert reports on Kenneth French‘s effort to quantify the “cost” of active investing, and reports a headline figure of $100B. Felix pulls an excerpt from Warren Buffet’s recent 2007 shareholder letter that serves a great way to frame the issue:

Naturally, everyone expects to be above average. And those helpers – bless their hearts – will certainly encourage their clients in this belief. But, as a class, the helper-aided group must be below average. The reason is simple: 1) Investors, overall, will necessarily earn an average return, minus costs they incur; 2) Passive and index investors, through their very inactivity, will earn that average minus costs that are very low; 3) With that group earning average returns, so must the remaining group – the active investors. But this group will incur high transaction, management, and advisory costs. Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren. That means that the passive group – the “know-nothings” – must win.

Buffet, as always, writes charmingly, and the logic here is unassailable. But there’s a subtle point lost in this analysis. Sure, active investors as a class must earn less than passive investors as a class, if passive investors make the same investments in aggregate and pay lower fees. But it does not the follow that active investors, as a class, would have done better had they been passive investors. Why not? Because investors as a whole, including passive investors, would have earned poorer returns without smart active investors setting market prices. If active investors, as a class, accepted the logic that investment expenditures are just costs, all would become passive investors, and the composition of the aggregate portfolio would reflect nothing but noise. My conjecture is that this would impact long-term returns, adversely.

So active investors, as a class, do better than they otherwise would have by bearing the high cost of active investment, even though in doing so they must endure the indignity of being outperformed on average by those who free-ride off their work! It is perverse, under these circumstances, to accuse active investors of squandering $100B, and recommend that we all move to index funds. On the contrary, it is passive investors who ought be discouraged. Passive investors pay none of the costs of generating good investment decisions, but enjoy the benefits by free-riding on the work of others. Their copycatting reduces compensation to those who have earned returns by performing or underwriting informational work. Passive investing also introduces feedback effects and noise into asset prices, rendering the work of active investors more costly and less effective. (See, e.g. information cascades — ht Mark Thoma — and this interesting model of bubbles and crashes — ht jck of Alea — for ways that copying others’ investment decisions as reflected in price moves can lead to instability and error in markets.)

The world of money management is full of shysters and charlatans who’ll take “active investment” fees and do nothing useful with them, sure. But part of that headline $100B “cost” funds real information work, without which markets would devolve entirely to lotteries. Advising people to buy index funds rather than select investments is akin to advising people not to vote, since the cost of voting far exceeds any individual benefit. Those who don’t vote get the same government everyone else does, but at lower cost! A citizenry that takes this reasoning to its logical extreme will get the government it deserves. An investor class that flocks to index funds may soon have the stock market it deserves.


Note: I haven’t seen French’s working paper, which might well have some discussion of these issues.

Update History:
  • 9-Mar-2008, 9:28 p.m. EST: Removed a superfluous “but”.
  • 9-Mar-2008, 10:10 p.m. EST: Changed a “his” to a “this”.

Repurchase agreements and covert nationalization

The Fed announced that it would auction off $100B in loans this month rather than the previously announced $60B via its TAF facility. In the same press release, the FRB announced plans to offer $100B worth of 28 day loans via repurchase agreements against “any of the types of securities — Treasury, agency debt, or agency mortgage-backed securities — that are eligible as collateral in conventional open market operations”.

The second announcement puzzled me. After all, the Fed conducts uses repos routinely in the open market operations by which they try to hold the interbank lending rate to the Federal Funds target. In aggregate, the quantity of funds that the Fed makes available is constrained by the Fed Funds target. So, what do we learn from this? Fortunately, the New York Fed provides more details:

The Federal Reserve has announced that the Open Market Trading Desk will conduct a series of term repurchase (RP) transactions that are expected to cumulate to $100 billion outstanding… These transactions will be conducted as 28-day term RP agreements.. When the Desk arranges its conventional RPs, it accepts propositions from dealers in three collateral “tranches.” In the first tranche, dealers may pledge only Treasury securities. In the second tranche, dealers have the option to pledge federal agency debt in addition to Treasury securities. In the third tranche, dealers have the option to pledge mortgage-backed securities issued or fully guaranteed by federal agencies in addition to federal agency debt or Treasury securities. With the special “single-tranche” RPs announced today, dealers have the option to pledge either mortgage-backed securities issued or fully guaranteed by federal agencies, federal agency debt, or Treasury securities. The Desk has arranged single-tranche transactions from time to time in the past.

There are a couple of differences, then, between this new program and typical repo operations:

  1. The loans are of a longer-term than usual. Ordinarily, the Fed lends on terms ranging from overnight to two weeks in its “temporary open market operations”. The Fed will now offer substantial funding on a 28 day term.
  2. The Fed is effectively broadening its collateral requirements by collapsing what are usually 3 distinct levels of collateral which are lent against at different rates to a single category within which no distinctions are made.

The Fed offered the first $15B of repo loans under the program today, so we can see how things are going to work. First, how did the Fed square the circle of ramping up its repos without pushing down the Federal Funds rate? Just as it had done with TAF, the Fed offset the “temporary” injection of funds with a “permanent open market operation”. The Fed sold outright $10B of Treasury securities today at the same time as it offered $15B in exchange for mortgage-backed securities under the new program (at a low interest rate than in traditional repos against MBS collateral). The net cash injection was small, but the composition of securities on bank balance sheets changed markedly, as illiquid securities were exchanged for liquid Treasuries.

In James Hamilton’s wonderful coinage, the Fed is conducting monetary policy on the asset side of the balance sheet. This is an innovation of the Bernanke Fed. Conventionally, monetary policy is about managing the quantity of the central bank’s core liability, currency outstanding. When the Fed wants to loosen, it expands its liabilities by issuing cash in exchange for securities. When it wants to tighten, it redeems cash for securities, reducing Fed liabilities. The asset side is conventionally an afterthought, “government securities”. But the Bernanke Fed has branched out. It has sought to lend against a wide-range of assets, actively seeking to replace securities about which the market seems spooked with safe-haven Treasuries on bank balance sheets without creating new cash. By doing this, the Fed hopes to square the circle of helping banks through their “liquidity crisis” without provoking a broad inflation.

“Monetary policy on the asset side of the balance sheet” is a bit too anodyne a description of what’s going on here though. The Fed has gotten into an entirely new line of business, and on a massive scale. Prior to the introduction of TAF, direct loans from the Fed to banks, including the discount window lending and repos, amounted to less than $40B, the majority of which were repos collateralized by Treasury securities. By the end of this month, the Federal Reserve will have more than $200B of exposure in its new role as Wall Street’s genial pawnbroker. Assuming the liability side of the Fed’s balance sheet is held roughly constant, more than a fifth of the Fed’s balance sheet will be direct loans to banks, almost certainly against collateral not backed by the full faith and credit of the US government (and beyond that we just don’t know). This raises a whole host of issues.

Caroline Baum wrote a column last week poopooing concerns about the Fed taking on credit risk via TAF lending. (Hat tip Mark Thoma.) I usually enjoy Baum’s work, but this column was poorly argued. In it, she points out that the Fed has all the tools it needs to manage credit risk. The Fed offers loans only against collateral, and requires that loans be overcollateralized. If the collateral has no clear market value or if there are questions about an asset’s quality, the Fed has complete discretion to force a “haircut”, writing down the asset (for the purpose of the loan) to whatever value it sees fit. And the Fed can always just say no to any collateral it deems sketchy.

All of that is quite true, and (as Baum snarkily points out) not hard to find on FRB websites. But it fails to address the core issue. Sure the Fed has all the tools it needs to manage credit risk. But does it have the will to use those tools? In word and deed, the Fed’s primary concern since August has been to “restore normal functioning” to financial markets. The Fed has chosen to accept some inflation risk in its fight against macroeconomic meltdown. Why wouldn’t it knowingly accept some credit risk as well? No one has suggested that the Fed is being “snookered”. Skeptics think the Fed is intentionally taking on bank credit risk while still lending at very low rates. Some of us find that troubling.

Which brings us to the more postmodern issue of what credit risk even means to a lender with unlimited cash and an overt unwillingness to let those it lends to default. In a way, I agree with Baum. Until the current crisis is long past, I think it unlikely that any large bank will default and stiff the Fed with toxic collateral. Why not? Because for that to happen, the Fed would have to pull the trigger itself, by demanding payment on loans rather than offering to roll them over. Since TAF started last fall, on net, the Fed has not only rolled over its loans to the banking system, but has periodically increased banks’ line of credit as well. In an echo of the housing bubble, there’s no such thing as a bad loan as long as borrowers can always refinance to cover the last one.

The distinction between debt and equity is much murkier than many people like to believe. Arguably, debt whose timely repayment cannot be enforced should be viewed as equity. (Financial statement analysts perform this sort of reclassification all the time in order to try to tease the true condition of firms out of accounting statements.) If you think, as I do, that the Fed would not force repayment as long as doing so would create hardship for important borrowers, then perhaps these “term loans” are best viewed not as debt, but as very cheap preferred equity.

Let’s go with that for a minute, and think about the implications. One much discussed story of the current crisis is the role of sovereign wealth funds in helping to capitalize struggling banks. Will they, won’t they, should we worry? Sovereign wealth funds have invested about $24B in struggling US financials. Meanwhile, the Fed is quietly providing eight times that on much easier terms.

If we view TAF and the new 28-day, broad-collateral repos as equity, what fraction of bank capitalization would they represent? I haven’t been able to find current numbers on aggregate bank capitalization in the US. In June of 2006, the accounting net worth of U.S. Commercial Banks, Thrift Institutions and Credit Unions was 1.25 trillion dollars. Putting together remarks by Fed Vice Chairman Donald Kohn and data on bank equity to total assets from the St. Louis Fed yields a more recent estimate of about 1.6 trillion. The average price to book among the top ten US banks is about 1.3. So, a reasonable estimate for the current market value of bank equity is 2 trillion dollars. The $200B in “equity” the Fed will have supplied by the end of March will leave the Federal Reserve owning roughly 9.1% of the total bank equity. Obviously, the Fed isn’t investing in the entire bank sector uniformly. Some banks will be very substantially “owned” by the central bank, whereas others will remain entirely private sector entities. As Dean Baker points out, the Fed is giving us no information by which to tell which is which.

What we are witnessing is an incremental, partial nationalization of the US banking system. Northern Rock in the UK is peanuts compared to what the New York Fed is up to.

You may object, and I’m sure many of you will, that our little thought experiment is bunk, debt is debt and equity is equity, these are 28-day loans, and that’s that. But notionally collateralized “term” loans that won’t ever be redeemed unless and until it is convenient for borrowers are an odd sort of liability. Central banks are very familiar with the ruse of disguising equity as liability. Currency itself is formally a liability of the central bank, but in every meaningful sense fiat money is closer to equity.

I do not, by the way, object to nationalizing failing banks. There are (unfortunately) banks that are “too big to fail”, whose abrupt disappearance could cause widespread disruption and harm. These should be nationalized when they fall to the brink. But they should be nationalized overtly, their equity written to zero, and their executives shamed. That sounds harsh. It is harsh. One hates to see bad things happen to nice people, and these are mostly nice people. But running institutions with trillion-dollar balance sheets is a serious business. Accountability matters. These people were not stupid. They knew, in Chuck Prince’s now infamous words, that “when the music stops… things will be complicated.“, and they kept dancing anyway.

But accountability has gone out of style. The Federal Reserve is injecting equity into failing banks while calling it debt. Citibank is paying 11% to Abu Dhabi for ADIA’s small preferred equity stake, while the US Fed gets under 3% now for the “collateralized 28-day loans” it makes to Citi. Pace Accrued Interest (whom I much admire), I still think this all amounts to a gigantic bail-out. And that it is a brilliantly bad idea from which financial capitalism may have a hard time recovering. Like a well-meaning surgeon slicing up arteries to salvage the appendix, the Federal Reserve is only trying to help.


Update: Many thanks to commenter Fullcarry, who noticed that I flipped the sign on Friday’s permanent market op. Changed “purchased outright” to “sold outright”, since that’s what the Fed actually did.

Update History:
  • 8-Mar-2008, 1:00 p.m. EST: Added update re changing “purchased outright” to “sold outright”, since that’s what the Fed actually did.
  • 8-Mar-2008, 2:30 p.m. EST: Changed “trillions dollar” to “trillion-dollar”.

Which kind of credit crisis?

Note: Reading through, this post is unintentionally reminiscent of a much better column by Brad DeLong.


Yesterday I was flabbergasted by a small thing. I came upon this article on Morningstar. The piece, targeted towards potential investors, was called Munis Today: Lots of Yield, without All the Risk. It was chirpishly positive about munis and municipal bonds funds. You might think, given current circumstances, that there’d be some discussion of the monoline insurance crisis and the auction rate securities lockup. Here’s what there is:

By contrast [to corporate bonds], it’s a safe bet that in 10 years, the commonwealth of Virginia–which Fitch rates AAA–will still be free to collect taxes to meet debt and principal payments on general-obligation bonds maturing in June 2018. And across the nation, munis are often insured (the issuer buys default insurance from a handful of AAA rated insurance agencies) or prerefunded (meaning they’re backed by U.S. Treasuries). In fact, according to S&P data, about 67% of munis rated BBB or higher fall into one of these two categories.

As analyst David Kathman wrote in this recent article, bond insurers’ recent issues have thus far weighed primarily (though not exclusively) on the equity funds that own these insurers’ stocks, rather than on the municipal bonds they insure.

Morningstar is a big name. In their own words, “Morningstar is a trusted source for insightful information… Our ‘investors come first’ approach to our business has led to a strong reputation for independence and objectivity.” Really. You’d never know from this piece that several of that “handful of AAA rated insurance companies” have already had their ratings downgraded, that the entire sophisticated financial community is breathlessly fixated by the drama surrounding the rest, that those “AAA” firms have to pay worse-than-junk-bond rates on their own debt issues, and that for months insured bonds as a class have been losing value relative to “natural” AAA munis, approaching the value of comparable debt with no insurance at all. Still, I suppose it’s true that the “recent issues” have “weighed primarily (though not exclusively)” on bond insurer equity, as monoline shares have lost roughly 80% of their value since September, and insured munis have not. The author is misleading without quite lying.

That’s from Morningstar, a firm whose sole raison d’etre is to provide independent advice to investors. We’ve had the rating agencies taking huge fees and slapping their AAA gold standards on complex, untested products that quickly collapsed. We’ve had household names like Citi in trouble for off-balance sheet schemes eerily reminiscent of the Enron scandal. Now tell me, is it any wonder we have a credit crisis? Who would you trust?

The word “credit” comes from the Latin for faith or belief. A “credit crisis” is nothing more or less than a widespread loss of confidence in people or institutions whom we were accustomed to considering trustworthy. This is obvious, but it has implications. Right off, one can imagine two sorts of credit crises. The first, which we’ll call a “panic”, refers to an unreasonable loss of confidence in people or institutions that are fundamentally sound. The second we’ll call a “reckoning”. A reckoning occurs when there is widespread recognition that institutions heretofore deemed reliable are, in fact, not.

The policy implications of these two sorts of crisis are diametrically opposed. In a panic, government liquidity supports and even well-designed “bailouts” are entirely appropriate. When panic subsides, “mark-to-market” losses reverse, and liquidity supports can be removed. “Bailouts” end up costing taxpayers very little, and perhaps even turn a profit for the fisc, as government guarantees expire unused while taxpayers gain from appreciation of assets purchased by the government at a discount.

But in a reckoning, bailouts are dangerous. “Temporary” liquidity supports turn permanent, government guarantees crystallize into taxpayer liabilities, and assets purchased by government continue to lose value. As real wealth is channeled, either via taxation or inflation, from the population generally to the original cohort of unreliable actors, government itself becomes another institution which people reasonably come to consider untrustworthy. In a reckoning, better policy is to let institutions fail. If there are institutions that are too big to fail, they should be allowed to the brink and then nationalized, with equityholders wiped out and other obligations only selectively honored, in order to minimize external costs to the public rather than to satisfy unwise counterparties. (Obviously, this sort of discretion is a magnet for corruption. But paying off all claimants from public funds is corruption by default, and terrible precedent to boot. A reckoning is a bad situation in which quality of government matters, a lot.)

In a reckoning, the overriding policy goal ought not be to restore faith in discredited institutions, but to place firewalls between them and anything worth saving, and, most importantly, to encourage the formation of new institutions worthy of the public’s trust. That’s not as easy as cutting checks to incumbents, and it’s not a matter of “more” vs. “less” regulation. Building a better financial system from the ashes of a broken one is a project for which there are no cut-out recipes, whose inputs cannot be tallied as one-dimensional quantities, and whose results might look different from what we are accustomed to. But it’s not an impossible task, and it may well be unavoidable. A friend of mine, a pilot among other things, once related me the advice of his flying instructor: “The plane is going to land. The only question is whether you are still going to be flying it when it does.” In a reckoning, that’s advice that governments ought take to heart.

Which kind of credit crisis is the current one, a panic or a reckoning? Is the American economy, the US financial system “fundamentally sound”? Is Wall Street, with its current regulatory and institutional structure, worthy of the investors’ trust and simply going through a rough patch? Or has the financial sector failed in a deeper way, either because of uncontrolled “agency costs”, or because it is unable to fulfill its core mission, directing capital to opportunities whose long-term return is sufficient to provide both investors and financiers adequate compensation? What do you think?

Update History:
  • 24-Feb-2008, 12:20 a.m. EST: Added a missing “to”, removed some unnecessary scare quotes, reorganized a link so it highlights less text.

Market manipulation: Which is easier to game, issues or indices?

Generally speaking, the Ben-Stein-o-sphere is one corner of the financial internet from which I’m delighted to absent myself. Yves Smith is more courageous than I am in that regard, and while strolling the mean streets, he offers the following conjecture:

It is one thing to move the prices of single securities, quite another to move entire markets, particularly ones as big as the global equity markets and the US credit markets. We must have a simply staggering number of traders all conspiring together.

That’s a perfectly commonsensical thing to say. But is it true? I don’t know, but I think it’s a fascinating question. Here’s the pro and con as I see it:

Pro: By analogy with price impact behavior on individual securities, market indices should be well-nigh impossible to move. Generally speaking, the price impact of transactions is inversely related to the dollar trading volume of the traded issue and positively related to its volatility. It’s much easier to move a thinly traded small-cap whose value has recently ranged all over the map than to move, say GE. Broad indices are by definition diversified (which reduces volatility), and the dollar trading volume of index components is gargantuan. Ergo, it should be very difficult to move indices.

Con: Perhaps the analogy between indices and issues is misleading. Indices can be traded as though they were single issues, via ETFs and futures, for example. But the market for such instruments is fragmented, and trading in any one is orders of magnitude thinner than the volume of the overall market it mimcs. An ETF or index future would be hard to move not so much by virtue of its own depth, but because it is bound by arbitrage to the price of the market as a whole. But the market as a whole has a great many degrees of freedom, and many stocks whose “true” values are uncertain. If one wants to materially move the price of a single issue, one probably has to push against “informed valuation” by investors who specialize in the stock’s industry and are willing to take bets on relative pricing. But if one pushes against a whole index, arbitrage constraints can be resolved my moving many stocks only slightly, each issue remaining within the bounds of what would be considered noise by those who might trade a deeper mispricing. There’s an elegance to this approach, in that the market itself determines an optimal path to resolve the disconnect created by the manipulator. Stocks for which there is a great deal of valuation uncertainty would move more than those whose prospects are clear, and the market manipulator avoids the transaction costs of trading these tens or hundreds of relatively illiquid issues herself. (Price-weighted or equal-weighted indices would be more vulnerable than value-weighted indices to this sort of attack, as smaller / less liquid / more volatile stocks have disproportionate sway.)

That’s a nice theory, but would it work? I have no idea. If anyone out there has any insight into the question, hypothetically speaking of course, please do comment. It is frequently suggested that, while individual stock prices may be manipulable in the short-term, broad markets are immune. Is that right?

The “Fed put” in action

Felix Salmon writes, regarding this morning’s heroic 75 bp rate cut:

Does this mean that all the talk of “Helicopter Ben” and the “Bernanke put” was justified all along? Well, yes… There’s one reason and one reason only that the Fed took this move, and it’s the plunge in global stock markets on Monday, along with indications that the US markets were set to follow suit…. [T]his action smells a bit like panic to me, and it might also have prevented the kind of stomach-lurching selling which could conceivably have marked a market bottom. I have to say I don’t like it.

James Hamiltion responds:

I doubt very much that anyone on the FOMC has much interest in protecting the investments of stock market participants. Instead, I suspect that the Fed is using equity prices just as I and many other economic analysts do, namely, as a useful aggregator of private and public information about near-term prospects for economic growth. All the recent indicators have suggested a significant deterioration of real economic activity over the last two months. I take the global stock market sell-off as one more confirmation of that assessment, and new information about the global scope of the problems we face.

Hamiltion’s interpretation is charitable, too charitable to fit the evidence. If the Fed were only using world equity prices as an indicator, and were not specifically concerned with altering US stock market outcomes on this day, Tuesday, January 22, 2007, they would not have scrambled over a holiday weekend, perhaps over a single long night, to put together a virtual FOMC meeting prior to market open on a cold, tired winter morning. Nor is this the first time the Bernanke Fed has behaved this way. By my count this is the third unexpected pre-market announcement issued by the Bernanke Fed following indications of turmoil in equity markets. [1]

Let’s recall what William Poole, President of FRB St Louis (and, interestingly, the only dissenter to this morning’s move) said in November, 2007 about the “Fed put”:

I can state my conclusion compactly: There is a sense in which a Fed put does exist. However, those who believe that the Fed put reflects unwise monetary policy misunderstand the responsibilities of a central bank. The basic argument is very simple: A monetary policy that stabilizes the price level and the real economy cannot create moral hazard because there is no hazard, moral or otherwise. Nor does monetary policy action designed to prevent a financial upset from cascading into financial crisis create moral hazard. Finally, the notion that the Fed responds to stock market declines per se, independent of the relationship of such declines to achievement of the Fed’s dual mandate in the Federal Reserve Act, is not supported by evidence from decades of monetary history.

Poole is quite clear that he believes it is within the Fed’s mandate to use monetary policy “to prevent a financial upset from cascading into financial crisis”. That’s a plausible view of what the Fed is after with its surprise, early morning interventions.

Poole goes on to say…

From time to time, to be sure, Fed action to stabilize the economy—to cushion recession or deal with a systemic financial crisis—will have the effect of pushing up stock prices. That effect is part of the transmission mechanism through which monetary policy affects the economy. However, it is a fundamental misreading of monetary policy to believe that the stock market per se is an objective of policy. It is also a mistake to believe that a policy action that is desirable to help stabilize the economy should not be taken because it will also tend to increase stock prices.

Reviewing these two snippets reveals what I think are fatal tensions in the Fed’s practice of asymmetric macroeconomic stabilization (stimulate busts but never prejudge a boom a bubble). Poole is at pains, throughout his talk (whose theme is moral hazard) to claim that stabilization policy uses the stock market as a instrument of policy, but that this does not imply that the stock market can use the FRB as a backstop or guarantee. In the question of who’s using who, Poole wants to make it clear that the FRB is the boss. But, if the Fed must intervene to prevent “panics”, it has placed itself in the role of a parent habitually blackmailed by a self-destructive adolescent. “If you don’t give me what I want want Mommy, I’ll cut myself and maybe I’ll die!” As too many parents know, it’s a bad situation, precisely because the threat of harm can be credible. One can’t condemn a parent for capitulating in any particular squabble. But, it’s also obvious that this is a bad dynamic, one that shouldn’t be lauded as the cutting edge of “intelligent macrofamilial stabilization policy.” It’s not a particular policy action that’s bad, it’s the macroeconomic game that we’ve settled into that has to be changed if we want markets that aggregate external information and make wise allocation decisions rather than focusing on intrafinancial Kremlinology.

I’m not optimistic that the current Fed will transcend heroics and push towards a new dynamic. The Great Depression haunts the Fed chairman like the memory of an older sibling’s suicide. The troubled younger child will be coddled and indulged, and fingers will be wagged only when it is very safe to do so. But, tragically, indulgence and capitulation don’t always work, what appears to be the least risky course can sometimes be a sure route to escalation and destruction. When the last child died, it was blamed on tough love. But that might not be right, or if it was, it might say little about what this child needs.

Anyway, I think recent events have shown pretty clearly that a Fed put does exist. The Fed can be counted on quite specifically to try to forestall extreme lower tail outcomes on very short period US equity returns. That doesn’t mean the Fed is setting a floor under long-term asset prices. They might soberly stand aside as markets fall by 60% over a period of months. But they don’t want it to happen in a day. Long-term, buy-and-hold investors should take little comfort. But short-horizon traders have every reason to truncate the lower tails of the subjective probability distributions that guide their moves.

Still, though Bernanke & Co may fully intend to try, there’s no guarantee that the Fed will succeed at preventing sharp drops or sudden stops. The Fed is doing its best to offer traders a put, but as markets are now learning, counterparty risk can be a bitch.


[1] The first surprise intervention was the announcement on August 17 of the cut in the discount window spread from 100 to 50 bps following an overnight crash on Asian markets. The second was the Fed’s announcement of the TAF and central bank coordination on December 12, following a disappointed reaction in equity markets to a fed funds cut of “only” 25 bps. The third intervention was today’s. The timing of the Dec 12 announcement may have been a coincidence not much related to equity prices behavior, but the Jan 22 and Aug 17 announcements were, in my opinion, clearly intended to affect US stock markets.

Eliminate the business interest tax deduction

I was reading Greg Mankiw dissing a tax increase proposal by Hillary Clinton, and I thought to myself, “If I could invent a tax increase for Greg Mankiw to dis, what would it be?” Suddenly, the screen began to waver, dreamy harp music chimed, and a vision appeared to me on a tablet of balance sheets: Eliminate the tax deductibility of interest payments by businesses. Debt financing externalizes the risks of business activity and magnifies social costs, while equity financing concentrates risk among stockholders who signed up to bear it. Yet under current rules, taxpayers literally pay firms to get rid of stockholders and take on ever more debt.

Here’s the case-in-brief:

Creditors (people who lend to a firm) and equityholders (those who own stock) are fundamentally the same thing. Both are just investors, people who place money in the hands of a firm in hopes of getting it back later on, with a little something extra for their troubles. Whether one chooses to invest as a stockholder or bondholder is an idiosyncratic matter. Bondholders sacrifice potential upside for predictability and a legal right to enforce payments. Equityholders have no guaranteed payment schedule, but retain a potentially unlimited claim on a firm’s future success. Firms pay bondholders according to a predetermined payment schedule, interest and principle. Equityholders are paid via dividends or share buybacks, but only when management is confident it has sufficient resources to pay debt obligations and fund firm operations. For those who grew up in the era of structured finanace, the equityholder/bondholder distinction is basically a primitive version of the tranching you’d find in a CDO. (There is the control thing that, as a historical quirk, usually goes exclusively to equityholders, but we’ll put that aside for now. Creditors “own” a company as much as shareholders do, though the two groups have different sorts of rights associated with their claims.)

You’d think that the organization of investment contracts would be a private matter between people with money and people with good ideas about how to use it. But, that’s not the case. Large-scale investment is crucial to a modern economy, and getting investors to trust strangers enough to give them their money is hard. So pretty much every government takes an interest in helping things out. Governments define forms of business organization, enforce accounting standards, and develop a body of law that mediates between managers and the various classes of investor. To overcome some of the trust issues, the most nervous sort of investor, bondholders, are given the business equivalent of a doomsday device to enforce their claim on timely payments. If, of malice or misfortune, a firm fails to pay out as promised, bondholders can force a firm into bankruptcy and coercively try to recover what they’re owed. Though bankruptcy may be in bondholders’ interest, it is quite traumatic for other firm stakeholders. There are two facts we should take note of: 1) bondholders owe an especial debt to the state, as the state, often at great cost, much more aggressively enforces creditors’ rights than the rights of other investors; and 2) from a systemic perspective, a great predominance of bondholders — too much debt financing — is dangerous.

When an equity-funded firm underperforms, that mostly is a private matter that harms stockholders who knew the risks they were signing onto. When a debt-funded firm underperforms and cannot meet its obligations to bondholders, a sharp “nonlinearity” is provoked that frequently results in widespread harm to a firm’s employees, suppliers, customers, and the communities in which it operates. If debt financing is very prevalent within the firm’s “ecosystem”, one firm’s bankruptcy may cascade into widespread, even systemic, crises. Fundamentally, the right of bondholders to enforce their claims via bankruptcy is analogous to limited liability for investors of all classes — it’s a legal convention we’ve developed to encourage socially useful risk-taking that partially externalizes the downside risks for some investors. While equity-funded firms fail as well, they have more leeway to temporarily underperform and recover, and the impact on firm stakeholders is usually more gradual and predictable.

Don’t get me wrong. The existence of enforceable debt financing is a very good thing. It’s an essential element of the constellation of institutions by which we are able to fund large-scale capital-intensive projects without coercion. But, the public incurs costs and risks by promising to enforce debt contracts. If a project is going to be funded regardless, any state meddling in capital structure ought to tilt the scales towards equity rather than debt financing.

But that’s not what happens. Instead, corporate tax law strongly favors debt financing. One way or another, firms have to pay their investors. When firms pay stockholders, every dollar an investor receives drops off the firm’s balance sheet. But when a bondholder receives the same dollar, a US firm pays as little as 65¢. The other 35¢ is paid for by Uncle Sam, in the form of a tax deduction. This creates a great incentive for firms to buyback shares and borrow money, that is to convert from equity financing to debt financing, when times are good and thoughts of bankruptcy seem remote. For example, here’s Brad Setser, writing today about how the world looked one year ago:

There was no real risk to taking on more debt to reduce the amount of outstanding equity on a firms balance sheet and, in the process, increase the return on existing equity. Private equity firms had shown the way to arbitrage the difference between the pricing of debt and equity; all that remained was for everyone else to follow suit.

According to canonical financial theory a firm’s debt/equity split, or “capital structure”, should have no effect on overall firm value. It’s just different ways of slicing up the same money pie, in a common metaphor. But if you introduce tax deductions for debt payments, the equation changes. Then the theory predicts that a rational firm should load up on debt financing, in order to capture the benefit of the “interest tax shelter”. If bankruptcy were not an issue, rational firms would move to ~100% debt financing in order to extract the largest possible subsidy. With bankruptcy a possibility, a rational firm loads up on debt until the marginal increase in bankruptcy risk outweighs the marginal benefit of the subsidy. But if imperfect managers underestimate bankruptcy risk during periods of stability, they may unwittingly (or purposefully, if there are agency problems) bring firms close to the brink, provoking traumatic failures when the gales of an untamed business cycle blow strong and hard. By covering a large fraction of corporate interest payments, the government effectively subsidizes financial risk-taking that serves no operational purpose but generates real social costs.

So, here’s my proposal: Put payments to stockholders and payments to bondholders on a level playing field. Eliminate the tax deduction for business interest payments. I’m not sure how much extra revenue this would net the Treasury, but by ending a perverse incentive for firms and eliminating a large subsidy to the wizards of debt, it would pay off hugely in the form of a more stable corporate and financial environment.


Note: Another way to level the playing field between debt and equity financing would be to eliminate corporate taxation entirely. I’d be cool with that too, as long as it was accompanied by a tax increase elsewhere whose incidence is at least as progressive as the corporate tax. Actually, eliminating the corporate income tax while making up the difference with a surge in top income tax brackets would be a fine stealth bailout for stock markets, funded by really rich people. Stocks would instantly be more valuable! And really, if we are going to socialize the costs of our financial meltdown, shouldn’t we socialize it disproportionately to the people who gave it to us?

Fix the system? Blame the bankers? Same difference.

I really dig Andrew Clavell. But he is misguided in his criticism of an excellent piece by Martin Wolf.

Here’s Andrew:

[I]ndividual mortgage borrowers demanded their chance to improve their social and financial standing with scant regard for the potential consequences of their actions. MBS Investors (read hedge funds, money market funds, pensions, mutual funds as well as banks) demanded ‘attractive’ yields for the perceived risk, and had incentive structures and abundant liquidity available to encourage risk taking.

Mortgage borrowers and mortgage-asset investors were both long housing assets, the former with a call option on the upside, the latter by shorting puts on the downside for yield premium. Investment banks, at whose doors Mr Wolf et al are laying the blame for the outcome of this misguided speculation, just saw an opportunity to intermediate this activity and did so successfully. It was their own badly conceived warehousing of some of the assets which is causing them so much mark to market pain at present, but that is not the issue.

Are we supposed to blame the bankers for being oil in the cogs in the capitalist engine? Are we suggesting that banks should have desisted as they knew a bubble was developing? Why are we ready to pronounce them the bad-guys again? Purely since their pay is the most public and the most despised by outsiders. So let’s regulate it. Claw it back. Withhold it for 10 years.

Never mind that politicians and central bankers set the tone for investors (loosely, the American dream). They don’t get paid much, so let’s not blame them. Let’s also not claw back their salaries or appropriate large fractions of their fees from lucrative speaking tours or book sales following their exit from public duty.

Never mind that the majority of ordinary people are illogically risk seeking in housing markets, or dot com shares. Ordinary people don’t get paid like bankers, so let’s not blame them. Let’s not try to educate ourselves properly about finance before we wreak such destruction.

Never mind all that. Blame the intermediary who earned too much.

Andrew is quite right to note that there is plenty of blame to go around. Ordinary folk herded into scam mortgages, taking a rational bet that this year would be like last year and they could catapult themselves into the upper middle class by taking a chance on the biggest home they couldn’t afford. Institutional managers herded into structured products promising high yield at next to no risk, products that seemed to violate the most elementary rule of finance (no arbitrage), and were shocked, shocked when after four years of great bonuses, their clients learned there was risk after all. And bankers of all ilks and alphabets, I-bankers, C-bankers, M-bankers, discovered there was great money to be made, intermediating (originate and sell!), dealmaking (LBOs, baby, it’s a new era of infinite leverage and no defaults!), and shoving risks where stockholders and regulators couldn’t see them (SIVs are just innovative!). People who face opportunities with stratospheric upsides and largely externalized downside costs take chances. Fundamentally, the behavior of bankers was no different than that of homebuyers with dollar signs in their eyes, the guy who ran a “mortgage company” from an e-mail server in his basement, or you and me in their situation. So, why should we pick on them?

We should pick on them. It’s not because they’re bad people. Most bankers are very nice people. We should pick on them because, as Andrew says, banks intermediate. They are a point where all the lunatics meet to transact, a point where applying pressure can change everything. We can rant and rail against human nature, but who cares? People is people, God bless ’em. But banks are formal institutions, amenable to laws, regulations, and litigable norms and standards that are easily reshaped. We don’t have to throw up our hands at frailty and corruption and watch reruns from the 1930s over and over again. We can actually mess with banks (and other financial intermediaries) in ways that indirectly shape the behavior of the rest of us (and that are not terribly intrusive to most of us). It simply isn’t true, in the general case, that human desires are exogenous and “demand will find supply”. The explosion of misbehavior on all sides of the credit market over the past several years was not caused by a burst of theta-waves from the Earth’s core. We allowed our institutions to evolve to a place where misbehavior was ordinary, caution uncompetitive, prudence a firing offense. If we change the institutions, we change the behavior. We can do that, and we should do that.

I’m skeptical of proposals (by Wolf and others) with regard to bankers’ pay, not because they are harsh, but because they are circumventable. Escrowed cash and restricted stock can be pledged and hedged, regardless of formal prohibitions. (We simply haven’t invented a decent compensation instrument that can’t be cashed out. That would be a profoundly useful financial innovation.)

Unsurprisingly, when Martin Wolf and Andrew Clavell agree, it’s worth paying attention. Wolf:

An alternative suggestion is “narrow banking” combined with an unregulated (and unprotected) financial system. Narrow banks would invest in government securities, run the payment system and offer safe deposits to the public.

Wolf backs off of this suggestion far too quickly. (“The drawback of this ostensibly attractive idea is obvious: what is unregulated is likely to turn out to be dangerous, whereupon governments would be dragged back into the mess.”) Much of this danger could be ameliorated with one parsimonious regulatory principle for the nonbank financial sector — An absolute prohibition on scale. There should be hard limits on the quantity of gross assets under any one entity’s control, combined with strong norms of independence (copycat investing is prima facie poor practice that opens up managers to investor lawsuits), along with antitrust like scrutiny of coordinated action. This would represent a big change. The current legal environment creates artificial economies of scale (the complexity of securities law), rewards herding (“safe harbor” provisions, “Nationally Recognized Statistical Rating Organizations”) and punishes independence (managers who make unusual choices face investor liability). The maximum permissible size should be absurdly small by today’s standards.

Obviously, this is a radical proposal, unlikely to happen anytime soon. But we may yet get to the point where all our choices are scary, so we’d best have some good options ready to go, just in case. One way or another, we have got to improve a financial sector that extracts a large fraction of collective wealth, allocates capital poorly, and creates periodic bouts of instability and human misery. Most of the men and women who work on Wall Street are fine people. But in Manhattan as much as in Michigan, broken institutions ought not be protected from bouts of creative destruction. America’s vaunted financial system does not adequately serve the purposes it is meant to serve. That has to change. Ideally, we should encourage private innovation and follow a cautious, incremental path to something better. But regardless of how we get there, a lot of people who have been well compensated under existing arrangements aren’t going to like the changes. Too bad.

Link Lovin’ fer the New Year

I decided long ago not to have a “blogroll”, figuring that I would naturally link to the people I read. But it hasn’t really worked out that way. There are lots of amazing authors whose every word I hang on, but whom I rarely have occasion to link. This interweb is an amazing thing. Banks may implode and currencies morph to toilet paper, but intellectually, these are the best of times. There has never been a conversation like this, so many wonderful minds communicating in a forum that is open to everyone, but still relevant, even influentual. Thank goodness for this crazy machine, and for all its cogs and pulleys — writers, commenters, and especially readers.

I want to devote my first post of the year to highlighting and thanking some of the people whose words keep my brain pleasantly marinated. [A note about names — I’m a first-name-basis kind of guy, and will thank accordingly. My use of first names implies neither disrespect of nor any personal familiarity with any of the thankees.]

If I had to nominate one blogger for the role of “hero”, it would be Brad Setser. For years now, Brad has been painstakingly documenting the financial backstory of our times. Bubbles pop, this hedge fund fails, that central bank acts, blah blah blah. Every day another headline, but Brad has focused on the slow grinding of plates beneath, invisible to most but actually the source of the tremors. He approaches the task with a Sisyphean work-ethic, remarkable civility, and openness to new ideas and especially new data. (Brad’s comment section also merits note. It is, I think, the best on the web, thanks largely to the caliber of the headline posts, and Brad’s willingness to engage all comers as colleagues.)

Mark Thoma is a different kind of hero. Economist’s View is the New York Times of the econoblogosphere, the place to find the news of the day treated at length and seriously. Like the Times, there is more reportage than editorial, but the quality of the Mark’s editorial is consistently higher than the Times‘.

Within the ghetto of finance, the first place I turn to for my fix of news is Felix Salmon. I’ve been a Felix fan since he first started scribing as RGE‘s original Economonitor. (They were fools not to have offered thrice whatever it would have taken to retain him there.) I owe Felix a special debt, as he was the first widely read blogger to deem my ravings here linkworthy. It’s been less lonesome ever since. I do have a complaint, though. Back in the day, Felix was the first and only finance blogger who consistently had me spitting up Fruity Pebbles onto my PowerBook. He was hilarious, sometimes hilariously mean, to all comers (including, very gratefully, yours truly). Ever since the snooty Condé Nast franchise got him, he’s been so well behaved. The thoughtfulness, range, and quality of content on Market Movers is better than ever, but I do miss having to replace expensive hardware following a particularly artful post.

Calculated Risk and Tanta have done an amazing job at explaining the housing bubble and the mortgage industry, with clarity, depth, and panache. Yves Smith at Naked Capitalism weaves anthology and editorial, keeping us abreast of the intricacies of the financial world and offering a useful perspective from which to view those goings on. I have occasionally linked Yves to disagree with him, but that’s the exception that overwhelms the rule. Yves is usually right, and always worth listening to. Another person who is usually right and deserves special mention for it is Dean Baker.

If you are interested in finance, and don’t read jck at Alea, you’re unserious. jck reads widely and obscurely and unearths some real gems. His posts are often deceptive in their brevity. jck has mastered that art of packing tart commentary and a pair of X-ray spectacles into a couple of sentences, sometimes just in the highlighting. Another underappreciated master of concision is Scurvon. Scurvon comments with a wide and eclectic range in a style that’s straight, direct, and brief. It’s like intravenous information, and you can’t even feel the needle going in. Of course, the most concise bloggers of all are those who only link, and among finance bloggers, Abnormal Returns does a great job of that, except for a few lapses in judgment and taste (he has linked Interfluidity).

Interfluidity, unfortunately, belongs to the subgenre of finance blogs that might be referred to as the we-are-so-fucked-o-sphere. The demigods of our happy realm would have to be Micheal Panzner and Nouriel Roubini. Michael was kind enough to mail me a copy of his book, Financial Armageddon. Michael’s baseline scenario (he often writes in the simple future tense, rather than any hedging with any conditional) is so dark that most of us doomsayers seem like Pollyannas by comparison. The book is worth reading, and the blog carefully documents a world slowly waking up to how bad a fix it has got itself into. Other excellent members of our dingy neighborhood include Michael Shedlock and Aaron Krowne.

Just about one year ago, I got into a lengthy comment debate with one moldbug, whom I first encountered as a commenter on Brad Setser’s blog. moldbug is a wonderful writer, an unusual intellect, and a sharp cookie on all things monetary. We have divergent views about what money ought to be, but similar views of the problems we face now, and he was delightful to argue with. He now has his own blog, Unqualified Reservations (although much of his best financial writing remains where it began, in Brad’s comments).

In no particular order, other finance blogs that I read pretty much constantly, and to whose authors I am grateful, include The Big Picture, Accrued Interest, Financial Crookery, Credit Slips, Cassandra Does Tokyo, Jeff Matthews Is Not Making This Up, The Mess That Greenspan Made, as well as (with a hat tip to Brad Setser) Macro Man and Michael Pettis.

Of course, finance is just one distateful ghetto in the odd, misshapen galaxy of economics. Liking to think of myself as a worldy galaxyly person, I read the economists as well. All this link lovin’ is leaving my fingers sore (don’t go there), so I hope the following authors will understand themselves to be worshipped and adored, despite being so perfunctorily listed: James Hamilton and Menzie Chinn, Brad DeLong, Tyler Cowen and Alex Tabarrok, Dani Rodrik, Thomas Polley, William Polley, Robert Vienneau, Robert Waldmann, George Borjas, Paul Krugman, Gabriel Mihalache, Greg Mankiw, Jonathon Dingel, and knzn .

Of course, there are a hundred, a thousand, a million people, links, stars I’ve missed. The stars in this galaxy, and in other galaxies near or far, are so numerous as to be grains of sand. The texture of the world is not made of isolated points, however many you might catalog, but by the fact that there is somewhere everywhere, a spark in every crevice. (No, that is not why my fingers are hurting.) To all those I’ve named, and those I’ve unforgivably forgotten, and those I don’t even know but might find with a click, thank you for this amazing conversation. To be a small voice in this cacaphony, in this harmony, is a great privilege.

And thank you, whoever you are, who takes the time to read these words. I am blessed by the company of your eyeballs, as creepy as that sounds. (Don’t worry. I’m not hungry.)

Update History:
  • 06-Jan-2008, 5:31 a.m. EST: Let the unforgivable omissions guilt begin! Added knzn, whom I mysteriously missed in my first perusal of my well-worn feeds.
  • 06-Jan-2008, 3:34 p.m. EST: Restored a missing ‘n’ to Michael Panzner’s name.
  • 07-Jan-2008, 3:28 p.m. EST: Fixed the name of moldbug’s blog, “Unqualified Reservations”, not “Unqualified Offerings”. Thanks to commenter nadezhda, who recommends the original Unqualified Offerings. And also to commenter Independent Accountant.
  • 08-Jan-2008, 2:52 a.m. EST: Removed an excess ‘l’ from the end of Jonathon Dingel’s name. Sorry to all — this was truly a masterpiece of typos.

When a rose is not a rose: TAF is not “just” the discount window

Yves Smith at Naked Capitalism and Accrued Interest have both taken very measured views of the Fed’s new Term Auction Facility, which gets its big start on Monday. As Smith puts it, TAF is the “discount window with no stigma and another pricing mechanism”. He also notes that the Fed’s novel device looks just like the same old auctions the ECB has been using as a monetary policy tool for years, and observes pessimistically that “the gap between non-dollar Libor and the ECB’s target rate is higher than the spread between Libor and Fed funds. Not a good sign.” (Bloomberg reports that Friday’s markets shared Smith’s skepticism.) Accrued Interest, responding to my ravings, suggests that TAF is no more a “bail-out” than any other lending at the discount window.

Yves Smith and Accrued Interest are two of the finest financial bloggers out there. If you are dallying here without having read every word they’ve written, your priorities are out of whack. Nevertheless, both are missing a forest of difference among trees of similarity. To call TAF the discount window without the stigma is like calling a person a corpse that is not dead.

In theory, TAF and the discount window are quite similar. In practice, it never mattered what the discount window was, because it was so little used. TAF is the discount window remastered. It is designed to be used, in quantities heretofore inconceivable. James Hamiltion, in an excellent discussion of the facility, shows a graph of historical direct lending by the Fed. Thanks to TAF, the graph through December 2007 will show a spike so tall you’d need a screen three times as tall as a typical monitor just to accommodate. Prior to TAF, the Fed had no effective tool for getting funds to banks in trouble, since loans at the Federal Funds rate are only available to banks that other banks trust, and borrowing at the discount window is expensive, financially and reputationally. With TAF, the Fed can lend directly to the sketchiest banks, and on very generous terms, without spooking depositors. As the ECB’s experience suggests, this funding mechanism can made quite routine. Some commentators view TAF as a temporary means of addressing end-of-year liquidity issues, but I suspect that TAF will be an active part of the Fed’s monetary policy arsenal for the foreseeable future.

If TAF is so similar to the ECB’s facility, why should it matter? After all, the ECB hasn’t succeeded at calming European interbank markets, yet. But, in the words of the maestro (Eric Clapton), “It’s in the way that you use it.” In order to reduce interbank spreads, central banks have to (1) auction money in quantities sufficient to ensure that the “market price” is quite close to the interbank rate policymakers view as healthy; (2) accept a wide variety of bank assets as collateral, and place high valuations on those assets relative to the market bid; and (3) credibly signal that it is willing and able to continue these policies in perpetuity, or until the crisis is abated, whichever comes first. Point (1) immediately drops the cost of borrowing by troubled banks to “ordinary” levels. However, this alone will not immediately reduce spreads on loans are still made between banks. Private banks will still fear counterparty defaults even if the central bank is blasé. Interbank spreads might even widen, as lenders view failure to anticipate and secure adequate funding at auction as a sign of trouble. Point (2), over time, will remedy this. Easy lending against a broad panoply of assets helps ensure that banks have the capacity to bid for all the funding they need. At the same time (as Yves Smith was quick to point out), the price at which assets are accepted as collateral suggests a floor for accounting valuations, helping to assure counterparties that borrowers won’t be thrown into crisis by a sudden write-down. Again, the effect here won’t be immediate — as long as collateral values and market bids are divergent, there will be valuation uncertainty. But, that’s where point (3) comes into play. There’s an arbitrage between exchange value and long-maturity collateral value. If the traders view collateral values as stable, eventually market bids will rise to approach the central-bank set asset prices.

This medicine will take time to work. Central banks will have to establish credible expectations of continued support. Don’t expect “forward looking markets” to reprice spreads until central bankers establish a track record. The ECB is not auctioning enough money yet, but it will. I suspect that, despite Europe’s institutional head start, it will be Bernanke’s radical Fed that shows the way.

Many commentators view TAF as an odd, desperate attempt by the Fed to do something, or to seem to do something, in a desperate situation. That is not my view. I think the Fed is acting quite deliberately here, that it is working out of a playbook that the Chairman developed and described years ago. I am optimistic that the Fed’s approach, if pursued tenaciously, can succeed in undoing the widespread perception of risk and instability in the banking system.

Of course, “optimistic” is not quite the right word here, because I oppose the whole enterprise. All the talk about moral hazard and burning houses misses the point. The financial sector has underwritten gargantuan misallocations of real resources in the United States, and profited handsomely from doing so. The cost of these errors is not just a matter of homes foreclosed, or a period of commercial turbulence and unemployment. We face the prospect of a serious decline in living standards, increased danger of conflict between large powers (which hopefully, but not certainly, will be confined to the economic sphere), and the possibility of social instability of a kind we’ve not witnessed for decades. There are actors in this drama who “deserve” to be punished, under a nineteenth century view of moral hazard. But that is not why we should endure rather than resist a painful restructuring of the financial sector. If we could let bygones be bygones and move on, that’d be great. But the reason for institutional accountability in any setting is not to shame and punish, but to create the conditions under which future actors will not misbehave. Contra Nouriel Roubini, the real economy cannot be “bailed out”. It must be built and repaired via the wise application of present scarce goods and services, rather than salved with promises of future goods and services. We require a financial sector capable of aggregating widely dispersed information into wise choices regarding the use of present resources. We absolutely do not have such a financial sector right now. Which is why the very expensive financial sector that we do have should be let go.

Existing players, including the Fed, won’t see it this way. The Fed will lend to support collateral values at levels higher than conventional valuations would merit. They will work with financial institutions to roll over loans as necessary, even against decaying collateral, rebundling assets to maintain some veneer of plausibility when underlying cash flows develop poorly over time. The proud titans of Wall Street can and probably will be bailed out. The rest of us are not so lucky.

Update History:
  • 17-Dec-2007, 3:42 p.m. EST: Cleaned up / reworded third paragraph quite a bit.