March 13, 2008
$2 trillion more of collateralised loans and outright purchases of private securities, please
This past month or so, the Fed has created facilities capable of pumping about $400bn worth of liquidity into the US financial system. I expect that the Fed will have to do a lot more by way of liquidity injections. Over the remainder of the year, even an additional $1 trillion of collateralised lending by the Fed (over and above the normal levels seen before the second half of 2007) is likely to be inadequate to get key financial markets functioning effectively again and to keep them that way. It would barely be more than $100bn extra per month - too little to make a substantial difference. My guess is that somewhere between $1.5trillion and $2.0 trillion of further above-normal liquidity provision will be required in the US before this crisis is over.
This guestimate is based on the size of the balance sheet of the leveraged sector, the maturity distribution of its liabilities, the likely additional demand for liquidity arising from the need to transfer the assets of off-balance-sheet vehicles onto the balance sheet of the banking sector, and the probable continued disruption of private wholesale financial markets.
I expect that while most of this will be through repo-type operations (using vehicles like the Term Auction Facility’ (TAF) for banks and the ‘Term Securities Lending Facility’ TSFL) for primary dealers), some of it will ultimately be through outright purchases of non-US agency (GSE)–guaranteed private debt instruments like RMBS and corporate bonds. I believe the Federal Reserve Act does not rule this out (although it does not explicitly allow it either). I am assuming that, in a crisis, anything that is not explicitly forbidden is allowed; even some things that are explicitly forbidden will be condoned.
The Federal Reserve Act allows the Fed to invoke ‘unusual and exigent circumstances’ under which it would be allowed to conduct outright open-market purchases of ‘bills of exchange’ and ‘bankers’ acceptances’. The question then becomes how elastic the interpretation of ‘bills of exchange’ and ‘bankers’ acceptances’ would be. It is my belief that in the midst of a financial crisis, it would be hard for any agency or court to stop the Fed from declaring ‘bills of exchange’ and ‘bankers’ acceptances’ to be virtually any kind of private security, including corporate bonds. Perhaps they would draw the line at pure equity.
When it has declared circumstances to be ‘unusual and exigent’, the Fed can also lend, against any collateral it deems appropriate (including second-hand cars and dead dogs), to individuals, partnerships and corporations. Extending the range of eligible counterparties is one way of bypassing the bottlenecks preventing Fed liquidity from flowing freely through the depositary institutions and the primary dealers that hoard the liquidity to other financial institutions and the rest of the economy that need it.
When the Fed, in an outright purchase, takes mortgage-backed securities risk directly on its balance sheet, (rather than the risk it runs in a collateralized loan, that both the borrower and the issuer of the collateral will default), it is even more important that the collateral or the securities that are purchased outright be valued aggressively and subject to a severe haircut or discount on this aggressive valuation. Without that, moral hazard could become rampant.
There is nothing wrong with the Fed or any other central bank taking credit risk onto its balance sheet, as long as that risk is appropriately priced. An appropriately higher expected rate of return compensates for greater risk, including default risk. In the end, the Fed is backed by the US Treasury, so it is always possible to recapitalize the central bank without recourse to the inflation tax.
As long as there is a non-zero probability of default on the securities the Fed acquires as collateral or outright as a result of its liquidity management for the economy, it is possible that the tax payer will have to come to the rescue of the central bank. The appropriate risk premium does not cover the biggest loss that could conceivably occur. But the securities acquired by the Fed should be priced low enough to ensure that their expected rate of return at least compensates (ex-ante) the Fed for the risk of capital losses on these securities.
Willem, sounds like you expect Fisher’s debt deflation to hit the US hard this year. What is it about you Yalies who think John Q Public can’t see through the veil of money illusion?
What the citizens need are less lifetime claims against them. NOT manipulation of asset prices that increases those lifetime claims.
Just say “NO” to monetizing MBS.
Posted by: groucho | March 14th, 2008 at 12:04 am | Report this commentWillem
it sounds about right. this would be an orderly exit from this mess. the problem is that people and organizations need to be helped through this process. the system cannot devote the time to actually figure out who needs to be helped and who should be thrown to the dogs.
many of these problems were caused by pure greed, over-leveraging, fraud, and downright wanton disregard for every rule of fair play and economics. but we cannot devote the time to let them sink while the rest of the economy is collapsing. we need to work to protect the entire system and then figure out how to prevent these items from occurring again.
tom “iceman” mcgann
Posted by: tom mcgann | March 14th, 2008 at 11:13 am | Report this commenttmcgann@futuredemographics.com
The intervention by the fed is basically a “band aid” solution it will not have any lasting effect int the long run.There is a pressing need for assistance and relief in the credit markets,both in the US and overseas but will the Fed be able to help everyone,should it? I don’t believe so.Just beware of any hidden surprises that may coming from the overseas market!
Posted by: raymonda@kennyconsultinginc.com | March 14th, 2008 at 5:38 pm | Report this commentI wonder, If the Fed is going to buy 1.5 to 2 trillion of MBS in the market which has just about a small size of 11 trillion of MBS securities outstaning how is it going to work?.
Posted by: Ajay | March 15th, 2008 at 12:01 pm | Report this commentDo you think that the world is going to come runing again to start buyig these securities again. Every one is just focussing on the write down, but remember that the way you get out of the hole is that you get demand back, if that is not going to happen than all it would do is transfer the loss to the Fed or soverign, just think what it would do to the dollar and the yields in US……remember what happened to the UK after the second world war and how the pound lost the prominence… The develeraging of the system is utmost important, unless you stem the rot, nothing will grow afresh…
I concur with Groucho on this issue. As one of those John Q. Citizens, I am appalled at the recklessness of the Federal Reserve, whose quick monetary fixes will lead to longer term disaster for our dollar currency, and our economy. I suspect that FED governors, along with their enablers in the economics profession, have come to view money as some kind of socio-political grease, that you spread out to keep the gears of the economy humming along — money as a kind of fiscal cocaine rather than a store of value. These are people who make six, even seven figure incomes and, if travel to Europe they must, can easily afford the cost of that travel even at $2 to the euro! In Bernanke’s case — sorry to sound cynical — he’ll be offered a plush position on Wall Street, along with big-fee lecture opportunities and a seven or eight figure book contract — if he rescues the banks! As for prudent American Main streeters…well, who cares about them? Not the FED. Let the savers subsist on their negative interest rates, in other words, go to the devil.
Posted by: Ted Harwood | March 15th, 2008 at 7:09 pm | Report this commentGood for you to say these things. Would only that the Fed would do it. Brad DeLong is recommending the same - buy the mortgages - just get on with it - and do it soon. Roubini et al seem to take great pleasure and joy in describing our impending doom. What really gets to me is their evident joy in their predictions. They work just as hard as they can to scare people totally silly.
I really do not understand why the Fed doesn’t act. We need a solution to this - not these endless patch-ups - which only make the problem worse and worse.
Posted by: Jim Pinney | March 15th, 2008 at 11:07 pm | Report this commentGet out of Iraq in three months and use the savings to purchase the mortgages.
Posted by: naro | March 17th, 2008 at 12:41 am | Report this comment