US Treasury Secretary Henry Paulson proposes that the Federal Reserve be given powers it does not have today, to demand information from/inspect the books of /impose constraints on the behaviour of – the primary dealer-brokers (that is, investment banks), for as long as the Fed is providing these investment banks with money through open market operations (via the Term Securities Lending Facility (TSLF) ) or at the Fed discount window (through the Primary Dealer Credit Facility(PDCF)). Once the investment banks stop suckling at the Federal Reserve nipple, however, the new supervisory/regulatory role of the Fed vis-a-vis the investment banks would shrivel and the ancien regime would re-emerge more or less intact.
This proposal is a recipe for increasing financial instability. The times when the Fed comes to the rescue of stricken investment banks is when the bad investments made during the most recent period of financial excess come home to roost. These are the times that the fundamental worsening in the financial prospects of this sector is amplified by liquidity crises and crunches. Systemically important financial markets (like the interbank market, the ABCP markets, other ABS markets and wholesale capital markets across the board) dry up as lack of trust and confidence, fear and panic replace euphoria, hubris, over-confidence and master-of-the-universe-syndrome. Under those circumstances there is never any objection from the afflicted private financial enterprises to the Fed asking awkward questions and sticking its nose in the books, as long as the central bank is willing to take assets off their books at prices well above what could be realised in an impaired, inefficient, free market. Beggars can’t be choosers.
My friend Professor Avinash D. Persaud recently gave a speech to the Committee of European Securities Regulators (CESR) on why bank risk models failed and are bound to fail. It is today’s guest blog. Avinash is a trustee of the Global Association of Risk Professionals, Chairman of Intelligence Capital Limited and Emeritus Professor of Gresham College.
Sir Alan Greenspan, and others have questioned why risk models, which are at the centre of financial supervision, failed to avoid or mitigate today’s financial turmoil. There are two answers to this, one technical and the other philosophical. Neither is complex, but many regulators and central bankers chose to ignore them both.
The technical explanation is that market-sensitive risk models used by thousands of market participants work on the assumption that each user is the only person using them. This was not a bad approximation in 1952, when the intellectual underpinnings of these models were being developed at the Rand Corporation by Harry Markovitz and George Dantzig. This was a time of capital controls between countries, the segmentation of domestic financial markets and to get the historical frame right, it was the time of the Morris Minor with its top speed of 59mph.
At the House of Commons Treasury Committee hearing on Wednesday March 26, 2008, Mervyn King, Governor of the Bank of England, was asked by Michael Fallon MP why the Bank of England had been so much less aggressive in cutting rates and providing liquidity against a wider range of collateral than the Fed. The Governor proceeded not to answer the question, but answered a different question quite well – one comparing the ECB’s liquidity management with that of the Bank of England.
My good friend Peter Sinclair, Professor of Economics at the University of Birmingham, has writte this wonderfully compact refresher course in finance. Read it, enjoy it and make your fortune.
The Bank of England appears to be gearing up for new initiatives to inject additional liquidity into the sterling money markets. Governor Mervyn King’s appearance before the House of Commons Treasury Select Committee made this clear. I interpret the aim of these imminent actions to be lower liquidity risk premium components of the Libor – OIS (overnight indexed swap rate) spreads and, beyond that, the re-opening of many of the wholesale markets, especially markets for MBS (mortgage-backed securities) and other ABS (asset-backed securities) that have been effectively closed since the crisis started in August 2007.
Governor King was keen to ensure that taxpayers would not be left with the bad debts or stuck with the bad assets of the banks. What are the means at his disposal for extending liquidity to the banking system without taking on credit risk? What are the means at his disposal for extending liquidity to the banking system without taking up credit risk at too low a price?
And there was naive me believing that in the entire Bearn Stearns/JP Morgan debacle at least one tiny blow against moral hazard had been struck: the Bear Stearns shareholders would get next to nothing under the $2 per share offer from JPMorgan. But no, Easter brought resurrection from the dead also for Bear Stearns shareholders. JPMorgan is now offering them $10 per share. Bear Stearns management and board are still in situ, of course.
All this had to be signed off on by the Fed. So what did the tax payer get in exchange? Well, the $30bn de facto first-loss guarantee for Bear Stearns’ cruddiest assets has been changed to JPMorgan taking the first $1bn loss and the Fed the next $29bn. A billion here, a billion there, but you are still not talking real money. Under the new deal, JPMorgan no longer guarantees Bear Stearns’ liabilities for a year even if its offer were voted down. That ought to be worth a few billion to JPMorgan.
So what the tax payer gets out of this is the first $1bn of its old guarantee in exchange for a warm embrace of moral hazard. There is also the nice touch that the New York Fed $29 bn loan and the JPMorgan Chase subordinated $1 bn note will be made to a Delaware limited liability company established for the purpose of holding the Bear Stearns assets. Special purpose vehicles and other off-balance sheet entities were part of the syndrome that brought us the current mess. It’s therefore charming to see the New York Fed bestow the tax payers’ largesse through such a construct.
Just to round off a great start to a new day, checking this morning on the NY Fed web site, I found that it remains the case that the collateral offered at the Term Securities Lending Facility (lending Treasury securities against collateral to Primary Dealers) will be valued daily by the clearing bank acting as the agent for the Primary Dealer. This is the same cockamamie approach to valuation as was agreed for the Primary Dealer Credit Facility (PDCF), the new arrangement under which Primary Dealers can borrow overnight from the Fed’s discount window. If ever an arrangement was designed for Primary Dealers and their clearers to collude to pass off pig’s ear assets as silk purse collateral to the Fed, this is it.
Time for a tax payer class action suit?
The Monetary Policy Committee of the Bank of England sets Bank Rate – the official policy rate. Un What does it mean and what does it mean operationally in the markets for the MPC to set Bank Rate? Is Bank Rate the UK version of the Federal Funds target rate, that is, does it set the target rate for the overnight sterling interbank market? Does the MPC play any formal, constitutional role in design (or even the implementation) of the Bank of England’s liquidity management in the overnight markets, or its wider liquidity management at longer maturities and at the discount window?
In this blog I want to discuss both the technical issue about what the Bank does when it implements the Bank Rate decision of the MPC, and the wider constitutional issue about the role of the MPC in the whole gamut of decisions the Bank of England takes in the area of liquidity management – both the provision of funding liquidity to individual troubled banks and the provision of market liquidity to illiquid and disorderly financial markets.
The coming and going of Good Friday and the imminence of Easter has prompted some musings about sanctity. Sanctity is the quality or state of being holy or sacred. I run into a lot of sanctity when engaged in political debate with serious-minded people. For free-market economists there is the sanctity of contracts and of property rights. For right-to-lifers there is the sanctity of life. We hear of the sacred bond of matrimony. We all know of the Holy Land. Holy cities are a dime a dozen: for Muslims it includes Mecca, Medina and Jerusalem. For Christians and Jews, Jerusalem. For Hindus Varanasi – Benares – Kaasi. There are holy rivers, from the river Jordan to the Ganges. Roman Catholics used to have holy water (I don’t know whether they still do). There are, God forbid, holy wars. There are reputed to be holy men and women, although I have never encountered any. There are sacred oaths and sacred honour.
Permit me this spontaneous outburst of self-righteousness, delivered from a simplistic protestant perspective: a pox, pest and plague on all those who claim holiness, sacredness or sanctity for any cause, anyone, any being or anything other than the One God. All other claims to sanctity and holiness are blasphemous. Nothing is sacred, except the One God.
The heads of the five biggest UK banks met with Governor Mervyn King of the Bank of England on Thursday 20 March 2008 to ask for more liquidity support. They should get it, but in the right manner and on the right terms. Liquidity should be provided on demand, against a wide range of collateral and at maturities of up to a year. But it should be provided in the right way, and on the right terms. The same applies to the Fed and the ECB. This is the time for tough love, if the resolution of the current crisis is not to sow the seeds for a worse crisis five years from now. Flexibility and responsiveness, by all means. Generosity, no.
My friend and former colleague, Uwe E. Reinhardt, James Madison Professor of Political Economy at the Woodrow Wilson School of Public and International Affairs and the Economics Department of Princeton University, has written the following lovely reflection on the role of the government in the US economy. Its applicability to current discourse in the financial markets throughout the North Atlantic area should be obvious.
Start of Uwe Reinhardt’s guest blog
To provide a proper backdrop for my lecture on “The Government’s Role in the Economy” in Econ 100, I always preface it with the question: “Who in this class has a mother?” In a good year, as many as 25% of the students raise their hand. The rest won’t admit it, because regulating mothers, like regulating government, are the ultimate buzz kills in the human experience.