...Archive for December 2007

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.

Insolvency is philosophy, illiquidity is fact

Take a look at a snippet of GM’s last-quarter balance sheet (courtesy of Yahoo! Finance). It’s the part that contains what accountants quaintly call “Shareholder Equity”:

Yes, the accounting value of the firm’s equity is negative 41.7 billion dollars. Now, answer me this. Is GM insolvent?

There is no definitive answer. It’s a philosophical question, a matter of opinion. The market says GM’s equity is worth $15B dollars. All we can say with any confidence is that GM is liquid, it has not yet failed to pay its bills, it is capable of borrowing to finance its operational needs despite a balance sheet with no vital signs. The patient walks and breathes, so it is not dead. Somehow.

There is a meme going around the blogosphere, and now the mainstream-press-o-sphere, that the Fed is helpless in the current crisis because the problem is one of solvency, not liquidity. Here’s Paul Krugman (hat tip Mark Thoma):

In past financial crises… the Fed has been able to wave its magic wand and make market turmoil disappear. But this time the magic isn’t working… Why not? Because the problem with the markets isn’t just a lack of liquidity — there’s also a fundamental problem of solvency.

Here, here, Dr. Krugman. And you too, Dr. Roubini. And Michael Shedlock. And Kevin Drum. I agree with you all. From the tiny legal entities known as asset-backed securities, way up through to a couple of large money center banks, there are a lot of entities out there which, by my Victorian standards, are simply insolvent. But by those standards, GM oughtn’t be able to fog a mirror, let alone borrow money from people. It’s the living dead, a zombie, to use a term fashionable when discussing Japan but never, ever appropriate to the hypercapitalist U.S. of A.

Can a determined central bank “wave its magic wand” and make insolvent entities solvent? I have no idea. But I do know this. A central bank can keep almost anything liquid for a long, long time. And as far as financial markets are concerned, only liquidity matters. The little theory called solvency is only relevant to the degree that it predicts liquidity, or illiquidity. Central banks can undo that relationship, if they wish to. Perhaps they wish to.

I have no idea how “aggressive” the U.S. Federal Reserve will become in trying to resolve the present crisis in credit markets. There are in norms of accounting, regulatory frameworks, laws, that might constrain it. But, central bankers have been remarkably candid in describing their willingness to circumvent these constraints in a crisis. (See here or here for examples.) With the new Term Auction Facility, the US Fed has just given itself a tool by which it can ensure the liquidity of “insolvent” assets, at prices the bank itself determines, indefinitely. Some commentators (e.g. Yves Smith) have wondered how a temporary facility, loans with a fixed term of one month, can make much difference one way or another in the liquidity of assets. The answer, of course, is that they can be rolled over (via new auctions, which are already announced for January, or by other means). The same logic that impels the initial extension of credit suggests that loans will be rolled over, must be rolled over, for as long as “crisis” continues. The Fed has bent over backwards to help out financial institutions. Once it has direct loans to those institutions on its balance sheet, it will own their problems in a way it has not until now. Will the Fed pull the plug and demand payment of a bank that says it cannot pay? Will it force a bankruptcy, as private creditors might, if the bank was in default? Is that even conceivable? The day that happens to a bank of any scale is the day you can be sure the credit crisis is no more.

I’m going to end with a bit of a cheap shot, because really, nothing is beneath me. Remember this?

The aide said that guys like me were “in what we call the reality-based community,” which he defined as people who “believe that solutions emerge from your judicious study of discernible reality… That’s not the way the world really works anymore. We’re an empire now, and when we act, we create our own reality.”

Worrying about “insolvency” is a defect of the reality-based community. For everyone else, all that matters is the price at which assets can be sold or borrowed against. The Fed can set that price, if it acts with sufficient, um, determination. Analyzing underlying cash flows is for pansies.

The latest financial innovation cooked up by the banking system might be described as “postmodern pricing”, whereby the exchange/collateral value of assets is intentionally unmoored from quaint ideas like “true” or “fundamental” value. All for the benefit of struggling homeowners and hard-working ordinary Americans, of course. If you are among the macroeconomic mainstream that has nodded along with Fed interventions to support “liquidity”, but you find this brave new world troubling, well, good. Better late than never, and you are welcome among us. Expect to be mocked. Bear it with pride.

Update History:
  • 14-Dec-2007, 5:39 p.m. EST: Replaced the awkward “I want you to take a look at…” with just “Take a look at…”
  • 14-Dec-2007, 6:15 p.m. EST: Cleaned up some wordiness (unnecessary “thus far”), added some wordiness (“help” to “help out”), inserted a missing verb to be.

TAF is a really, really big deal

I haven’t time to write properly, I am caught between a million things. But when I woke up to the Federal Reserve’s press release about the TAF, my jaw dropped. It was one of those moments when the world shook, everything was the same, but everything had changed. So, when I step into the blogosphere to read comments like “solid first step“, I feel compelled to spew some first impressions.

  1. If you think (as I believe most Fed policymakers do) that the goal of monetary policy in reacting to the current financial crisis is to make it go away, this plan is brilliant.

  2. Under traditional discount window borrowing, the best the Fed could do is offer funds at a “penalty” or “premium” and hope that banks borrow, despite a longstanding market perception that direct borrowing from the Fed is a sign of weakness. Now, the Fed has turned the tables. It will set precisely how much money it will lend ($40B just in the next cople of weeks!), and let banks bid on how much they are willing to pay for the use of that money. The scale of this program is immense. Typically direct borrowings from the Fed are under $1B. It was a big deal in August when in a clearly orchestrated and coordinated move, 4 big banks were persuaded to temporarily borrow $2B total, in an attempt to diminish the “stigma”. This is the Federal Reserve saying, “No more pussyfooting around. You will borrow, and not $1 or $2 billion, but $40B, now!”

  3. I agree with several commentators (Felix Salmon, Calculated Risk) that the Bair/Paulson Plan, whatever it is, is not a bailout. But this, this is a bailout,. Nearly all government bailouts take the form of subsidized loans, extending credit at low rates to counterparties or against collateral for which the market would have demanded a high premium. That is precisely what the TAF will do. The Fed’s press release claims, of course, that loans will only be available to “sound” banks, and that they will be “fully collateralized”. But no one who can get the same deal from private markets will use this facility. The need for the program arises because private markets are skeptical about the soundness of counterparties and the quality of the assets they have to offer as collateral. The Fed hints at this when it mentions the “wide variety of collateral” that can be used to secure loans. You can bet that whatever it is private lenders are eschewing will be pledged as collateral to the Fed under TAF. The Fed is going to bear private risk that the market refuses to. That is a bailout.

  4. The rate at which funds are lent could turn out to be be an interesting number, but probably won’t. This rate will be bounded within a narrow range. It can’t go much lower than the expected Federal Funds rate over the term of the loan (there would otherwise be an arbitrage for very creditworthy banks — borrow TAF, lend Federal Funds). Presuming consistent standards for collateral and creditworthiness, it can’t go higher than the ordinary discount rate (since banks would just go to the discount window directly rather than bid in an overpriced TAF program). In theory, the TAF rate could tell us something about the state of the credit markets. If it is close to the Federal Funds rate, it would mean that few parties are experiencing problems borrowing cash against their assets, while if the TAF rate were near the discount rate, that would signal credit market, um, turbulence. But interpretation of this number is going to be made complicated by the scale of monies being offered. To lend 40B cash fast, the Fed may well have to offer the money at near the Federal Funds rate, because the particpation of very creditworthy banks will be required to get rid of the dough. But less creditworthy banks will be participating as well, and, in a single-price auction, these banks will enjoy the low interest rates effectively set by large-bank bidding. So, it is likely that the TAF rate will be very close to the expected Federal Funds rate, but that noncreditworthy borrowers pledging iffy collateral will gain the capacity to borrow at that rate. The effective discount window “penalty” will drop to about zero, even though the formal discount premium will stay at 50 bps.

There’s much more to say about all this. (Systemic implications? will it be effective against the crisis? what’s the role and meaning of the “global coordination” aspect to all this? etc., etc.) I have a meeting. Very blogospherically, I’m going to hit send and go without even a proofread. Please forgive my enthusiasm, and any errors that might come with.

Update: Of great significance to the workings of the international financial system… I’m Steve! A couple of very fine bloggers have linked to this post, referring to me as Randy. [Both fixed now! Thanks!] I include my middle name in my punditizing to distinguish myself from a more famous Steve Waldman who most emphatically is not me! Also, my last name has just one ‘n’, and I should not be confused with the much smarter and better looking Robert Waldmann, who is blessed with two letters ‘n’. Finally, I’d like to clarify a bit that my “enthusiasm” for the TAF plan, and my suggestion that it is “brilliant”, should be understood in very narrow terms. From the perspective of policymakers whose goal is to put out a fire while minimizing changes the existing structure, I do think the TAF is a stroke of brilliance, although it may lead to some hard choices down the line (more later). But I want to emphasize, that perspective is not my own. I believe that capital markets and the global financial system are in quite urgent need of reform. I don’t support palliative measures unless attached to credible reasons to believe that they will put us on a path to change, rather than extend a quite awful status quo. So I don’t “like” the Term Auction Facility. But I do admire its cleverness.

Update 2: Note Felix Salmon’s comments (with the help of Alea’s jck) on discount window collateral.

Update History:
  • 12-Dec-2007, 6:32 p.m. EST: Added two “update” paragraphs, moved scare-quotes from discount window to penalty, where they belong.
  • 12-Dec-2007, 7:25 p.m. EST: I’ve messed around with some wording and misspellings in the updates.
  • 12-Dec-2007, 11:10 p.m. EST: Added “Both fixed now. Thanks!” to the first update. Also, added a missing “the”, and replaced an extra “the” with a “to”.

Salmon vs. Salmon on the Bair/Paulson relief plan

The news du jour is a quickening of interest in an idea originally mooted by the FDIC’s Sheila Bair, now adopted by U.S. Treasury Secretary Henry Paulson, that would freeze resets wholesale for certain classes of struggling mortgages. The Victorians among us, cluck and tutt at, yes, the moral hazard and perverse incentives implied by this sort of plan. Fortunately, no one ever listens to us.

Elizabeth Warren offers up a combination of pragmatic and Victorian concerns, among which are that “lawsuits will fly thick and fast, enriching the lawyers and tangling up the homeowners.” Felix Salmon argues not, but he’s mistaken, and he himself explained why. Besides teasing Felix, understanding this issue sheds light on why this plan could be an important tool in resolving the current credit crunch. Big hint: It ain’t (primarily) about helping homeowners.

Here’s Felix, today:

Most loan modifications actually increase the total amount of money that the investors stand to receive. In this case, it’s conceivable that… bondholders might get a bit less money than they would otherwise. But that’s a really hard calculation to make, and unless you can make that calculation with some certainty, it’s going to be very hard for you to show damages. Let’s assume that an investor in an RMBS tranche can compellingly show losses of say 5 cents on the dollar as a result of the Paulson plan. (We’re talking about the difference, remember, between the present value of what that investor will now receive and the present value of what that investor would receive were the plan not in place.) Given the size of individual RMBS tranches, and the number of investors they were sold to, that investor probably has no more than about $20 million invested in the tranche. Which means that he’d be suing for $1 million. Not worth it… What if he put a class action together, and got all the owners of that tranche to sue? Well, maybe the tranche was $50 million in total. We’re still only talking $2.5 million in damages here.

Now, here’s Felix with the answer, on Friday:

In reality, it’s almost certain that some bondholders would benefit from this scheme, while others would lose out.

Suppose it is true that, on-average, cashflows to the whole class of affected securities changes very little under the workout, that the savings to investors from avoiding defaults roughly balances the cost of the reduced income stream. Consider what this workout does to the certainty of cashflows for any particular MBS pool. Prior to the workout, under a low-default scenario cashflows are very high, while under a high default scenario they are very low. In the “good case”, the senior tranches get paid, but so do the tranches a few levels down. In the bad case, the junior tranches lose everything, and the senior tranches lose some fraction of their value. For valuation purposes, the marginal junior tranches now resemble at-the-money call options, valuable when outcomes are volatile, worthless when they are certain.

And what would the Bair/Paulson plan do? It would increase the certainty of the cash flows, to a level where, on average, senior tranches would be made whole, but marginal tranches would lose out. In other words, even if the effect on total cashflows in the aggregate is very small, the Paulson plan would wipe out the option value of tranches at the margin. Holders of these tranches won’t take a 5% haircut, but a 100% haircut off the tranch’s current value. You betcha they’ll sue if they have any hope of relief. [*]

On the other hand, holders of senior debt will be made whole with much greater certainty. The proposal effectively represents a transfer of wealth from junior to senior trancheholders. Which gets us to its clever systemic implications.

The current credit crunch stems not from the absolute scale of writedowns, but from the distribution of the losses. Highly leveraged entities with very little capacity to bear risk, who thought they were holding “supersenior” (but yield enhanced!) securities, are facing catastrophic unexpected losses. If those losses could be shifted to investors with a greater capacity to bear risk, the systemic implications would diminish towards the absolute scale of the losses, that is, towards insignificance.

Less senior trancheholders are being asked to take a hit, because they can, to save other investors who can’t afford their losses. From each according to his ability, to each according to his need. You’ve gotta love capitalism.

[*] To understand this better, recall that the total world of securitized mortgages is divided into distinct pools, each of which (simplifying some) backs a security, which is then subdivided into tranches. Without the Bair/Paulson plan, some of these pools would do well enough to pay the senior tranches and a few junior tranches, while other pools would do poorly, wiping out the junior tranches and forcing the senior tranches to take a haircut. Under the proposal, all of our stylized-just-at-the-margin junior tranches get wiped out, while all the senior tranches are made whole. Prior to the payment streams actually developing, we can’t know which pools would pay-off junior tranches and which wouldn’t, so all these tranches currently have some value, like a lottery ticket. That value would be wiped out under the plan. Note that some junior-tranche investors may have done due-diligence on the quality of credits in the underlying pool (or relied exclusively upon unusually high-quality packagers), and these investors might expect with high probability that the “good scenario” would unfold. Under the Bair/Paulson scheme, these investors would be wiped out anyway, and therefore penalized for their efforts (due diligence is expensive), unless you believe that it’s possible (and equitable) for those executing the plan to separate those who can and can’t afford a reset with very high precision.

Update History:
  • 03-Dec-2007, 3:18 p.m. EST: Added update in second Felix quote…
  • 03-Dec-2007, 6:25 p.m. EST: Took out second sentence of second Felix quote, which is better.

The “Fed Put” and moral hazard

On Friday, St. Louis Fed President William Poole gave a speech called “Market Bailouts and the Fed Put” (hat tip Calculated Risk). Poole discusses “whether Federal Reserve policy responses to financial market developments should be regarded as ‘bailing out’ market participants and creating moral hazard by doing so.” Unsurprisingly, Poole thinks not.

How many investors today measure the value of a bond by the likelihood that it will continue to pay interest “under the acid test of depression”? How many investors today maintain portfolios robust against the possibility of inflation of the magnitude experienced in the 1970s or deflation of the magnitude experienced in the early 1930s? The answer, I believe, is “not many.”

The fact that few investors worry about extreme economic instability is a benefit of sound monetary policy and not a cost; changes in investor practice are conducive to higher productivity growth. The same is true for changes in household and firm behavior reflecting the greatly reduced risk of economic depression or even severe recession of the magnitude of 1981-82. If we did not believe that economic stability is good for the economy and for society, why would a stable price level and high employment be monetary policy goals? Just as a deductible changes behavior of insurance policyholders, so also does economic stability change investor behavior.

In other words, investors do take risks they would not have taken absent the “insurance” implicit the Fed’s stabilization policy. But this is not moral hazard. Rather, it is precisely the point of the policy.

Note the sly rhetorical maneuver in Poole’s last sentence, where he likens the change of behavior induced by the Fed interventions to those induced by an insurance policy deductible. A deductible, of course, encourages the insured to limit their risk-taking, to combat moral hazard, while Poole is claiming the Fed’s behavior increases risk-taking, albeit in manner that he claims is beneficial and should not be called moral hazard. Likening the two makes Fed policy seem conservative or prudential, despite Poole’s admission that its effect is to encourage risk taking.

Putting that aside, Poole is right to note that an increased level of risk-taking due to insurance does not in and of itself imply moral hazard. Insurance is crucial to an entrepreneurial economy precisely because operating a business often entails risks that are simply too great for the entrepreneur to bear alone. If there were no liability insurance, workers comp insurance, property insurance, etc., many small businesses would never come to be, and the best of those small businesses would never become engines of creation and growth that enrich us all. Insurance exists precisely to allow people to take risks they would not otherwise take. That is not moral hazard. It’s the insurance business’ core function, and not something insurers discourage at all.

Insurers call behavior “moral hazard” not when people take on risks that they otherwise would not have taken, but when they take on risks greater than those that were priced into their policy. A well-designed insurance policy does not permit an entrepreneur to escape the costs of their risk-taking. It simply alters the distribution of those costs: Instead of experiencing rare but catastrophically large costs, the insured bears the full expected cost of her behavior, but in the form of regular, predictable payments. Ideally, insurance puts a price on risk, and internalizes the cost of risk-taking, so that actors can rationally choose which risks are worth taking, and which are not.

To the degree what the Fed does is offer insurance to firms and investors, it is inherently creating moral hazard, because those actors are not paying an appropriate premium for the insurance. Homo economicus, when insured at a premium that bears no relationship his behavior, will maximize risk-taking, since the cost of risks gone bad will be borne by others, while the take from gambles that succeed will be his to keep. Among the fully insured, prudence is idiocy. In a competitive environment, the prudent will simply fail to survive. Eventually, the aggregate costs of other people’s bad risks become too large for the insurer to bear, and then no one survives. Overinsuring private risk creates systemic risk.

Now Poole claims that this kind of thing is not happening, that whatever it is the Fed does, it does not bail out those who take on bad risks:

Federal Reserve policy that yields greater stability has not and will not protect from loss those who invest in failed strategies, financial or otherwise. Investors and entrepreneurs have as much incentive as they ever had to manage risk appropriately. What they do not have to deal with is macroeconomic risk of the magnitude experienced all too often in the past.

Obviously, Poole is right at a certain level. Firms and investors lose money every day. The Fed does not sit behind each and every actor in economy, absorbing every loss while smiling on private gains. But no critic of the Fed has ever suggested any such thing. The Fed’s propensity to intervene in a crisis reduces the private costs of certain kinds of risk-taking, but does not eliminate those costs. To continue with an insurance analogy, the Fed is like an insurer that collects no premiums, but unpredictably pays out only 20% of all claims. To risk-averse actors, that’s like no insurance at all. But to financially strong, risk-neutral (or leveraged, risk-loving) investors, the “Fed put” reduces the average cost of failure substantially. This leads to a broad underpricing of risk, or an overpricing of assets.

“Overpriced assets” sounds anodyne, even benign. That’s wrong. When assets are overpriced, real resources are destroyed. Real people sacrifice real goods and services to some enterprise that is likely to produce less than the value of the goods and services originally sacrificed. If monetary policy shifts so that the investors come out whole in financial terms, that doesn’t alter the fact of real economic destruction. It simply socializes the costs. Monetary policy and microeconomic outcomes sit far from one another, and the trail of tears evaporates quickly. Perhaps, as Alan Greenspan suggests, we owe the new home development ghost-towns appearing across the country to a post-Cold-War peace dividend. But I think the Fed, and, more broadly, the broken US financial sector had a great deal to do with the tremendous misallocation of real resources that was the late housing boom.

It’s common and easy to criticize the Fed. When histories are written about the hard times ahead, I don’t think the Fed will be the central villain of the piece. There are so many deep flaws in the American and global financial system, so many absurd institutions, shortsighted, foolish, and corrupt players, I think the Fed is more likely to be viewed as inept cheerleader than central protagonist. But Poole’s speech is a defense of cheerleading.

It is the job of financial markets to price alternative uses for scarce resources, which is almost entirely about pricing risk. But in the short run, it is always tempting to hide risk, rather than to price it. When financial alchemists tout diversification and securitization as magic bullets, they are hiding risk rather than pricing it. When, as Poole notes, the wizards of the 1980s sold “portfolio insurance” prior to the 1987 crash, they were hiding risk rather than pricing it. When loan “originators” rely upon FICO scores and stated income to produce assets they quickly flip, they are hiding risk rather than pricing it. When the Fed intervenes to stabilize the US financial system despite Wall Street’s increasingly poor stewardship of the nation’s real economy, it is hiding risk rather than allowing risk to be priced. Unpleasant events in financial markets aren’t to be tolerated because they “punish speculators”, but because financial markets must accurately reflect the state of the real economy in order to allocate resources properly. The longer risk is hidden, rather than priced, the greater the pain when the consequences of poor choices can no longer be ignored. We will have to face that pain eventually, despite the fact that it is least well-off who will bear the brunt of it, rather than the bankers, traders, and dealmakers who got us here. Hopefully the hard times will be short, and we will have a chance to do better next time.

Update: For a more enthusiastic reading of Poole’s remarks, try Mark Thoma. Also, Stephen Cecchetti has published an essay which, while not referring to Poole’s speech directly, makes almost precisely the same points. An earlier essay by Cecchetti in favor of contract standardization and clearinghouse-based trading (frequently highlighted by Yves Smith) was wonderful. But on the question of central banks and “moral hazard”, I can’t quite agree with either of these good professors.

Update History: