Monthly Archives: March 2008

I’m talking about the Fed. The Fed is highly likely to cut, later today, the target for the Federal Funds rate by somewhere between 75 basis points and 100 basis points, bringing it down to 2.25 percent or 2.00 percent. How do I know this? I look at what the Federal funds futures market has priced in. On 17 March 2008, the 30 day Fed Funds futures contract with expiration date April 8, 2008, traded at 98.055, implying a Federal Funds rate of 1.945 percent after today’s meeting.

The fact that the market expects the Fed to change rates by a given amount and that the Fed validates that expectation does not tell us whether the markets or the Fed are the tail or the dog, or indeed whether either one is either.

The Fed made a number of announcements on Sunday March 16.

First, it has created, initially for a period of six months, a Primary Dealer Credit Facility (PDCF) “…a special lending facility that will provide liquidity to primary dealers at terms similar to those available to banks at the discount window …” . The facility is for overnight liquidity. This is the right move: a hit.

I am still unclear as to whether this means that the Fed now has declared that there exist ‘unusual and exigent circumstances’. The Fed statements don’t use the phrase ‘unusual and exigent circumstances’; the fact that the primary dealers of the New York Fed can only access the PDCF through their primary dealers (the same kind of non-recourse back-to-back arrangement as the late Bear Stearns used with JP Morgan) suggests that the Fed may still be trying to finesse the ‘unusual and exigent circumstances’ issue. To be continued.

The Board of Governors is supposed to have seven members. It currently has only five. The Senate has been sitting on two nominations, of Elizabeth Duke and Larry Klane.

On Thursday February 7, 2008 President Bush complained about the failure of the Senate to proceed with the confirmation of three nominees – the two still waiting for Godot and Randall Kroszner, who has since been confirmed (Kroszner first took office on March 1, 2006, to fill an unexpired term ending January 31, 2008.). The nominations of Duke and Klane were sent to the Senate on 16 May 2007. It is a scandal that the Senate has not been able or willing to find the time to hold confirmation hearings for these two new Board members. The main guilty parties are the US Senate Committee on Banking, Housing, and Urban Affairs and its Democratic Chairman, Christopher Dodd.

First, I have to declare an interest. I am a part-time Adviser to Goldman Sachs International. The views and opinions expressed in this blog are my own. They do not represent the views of Goldman Sachs International.

With a little help from its friends, especially JP Morgan, Bear Stearns, one of the 20 Primary Dealers (in US government securities) and one of 30-odd prime brokers, is now borrowing at the Fed’s primary discount window. Bear Stearns cannot do so itself, because it is not a deposit-taking institution entitled to access the Fed’s discount window. JP Morgan has access to the Fed’s discount window, so Bear Stearns is, indirectly through the good (and no doubt adequately remunerated) offices of JP Morgan, engaged in collateralised borrowing from the Fed. The loan from the Fed to JP Morgan is non-recourse and the JP Morgan to Bearn Sterns leg is part of a back-to-back arrangement, that is, it is a loan from the Fed to Bearn Stearns via a bank, JP Morgan. The non-recourse bit means that if Bear Stearns defaults on its loan to JP Morgan, JP Morgan does not have to repay its loan to the Fed. It is, effectively, a collateralised loan on discount window terms, from the Fed to Bear Stearns.

This means that Bear Stearns can take advantage of two of the key relaxations in the terms of discount window access introduced by the Fed at the beginning of the current crisis on August 17, 2007: the extension in the duration of the loan to 28 days (from the original overnight maturity), and the reduction in the ‘penalty’ spread of the discount window borrowing rate over the target for the Federal Funds rate to 50 basis points (from the original 100 bps).

Two comments on an earlier blog of mine made the point that the Fed’s swap of Treasuries for MBS with the primary dealers had been motivated by the desire not to increase system-wide liquidity (monetise the MBS), but simply to allow existing pockets of liquidity to be mobilised more effectively. I commented on Miranda Xafa’s post but I had missed Alfred Smith’s remark that “The striking inpact of the Fed’s action is enhancing mortgage market depth without adding to the monetary base. In this respect, it has filled the role of lender of last resort while minimizing the inflationary bias of this role.” The statement is descriptively correct as regards the effect of the Fed’s action on the monetary base/liquidity but analytically wrong as regards the inflationary implications of monetising the MBS. It may be worth repeating the difference, in the context of the quantity of money, between a movement along the demand curve and a shift of the demand curve.

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.

Of all the meaningless rituals in the Parliamentary calendar, the annual Budget show is probably the most pointless. Governments, like companies, should of course every year present retrospective annual accounts and a forward-looking multi-year business plan covering planned public expenditures, expected tax receipts and all planned discretionary changes in the structure of public spending and taxes. Under normal circumstances, a government that has the nation’s best interest at heart won’t have much if anything to announce that is new on the fiscal front (other than some routine updating of forecasts and estimates) after its first year in office.

But politicians cannot bear the sound of silence. The annual budget slot has to be filled with a raft of announcements of new or recycled fiscal measures, introduced without much thought as to how they shape incentives and income distribution when they interact with the existing mass of tax and benefit schedules and entitlement rules. Gordon Brown was a manic micro tinkerer during his ten years as chancellor. He could not see a social or economic problem without throwing a dozen tax and subsidy incentives at it. This has left the UK with probably the most complex tax and benefit system in the known universe, one whose overall impact on incentives and distribution is incomprehensible but no doubt perverse.

So I looked forward to less frantic fiscal fireworks from the new chancellor. And less frantic it was. Listening to chancellor Alistair Darling deliver his budget speech today in Parliament was like being beaten over the head with a sweaty sock. I will go through the low lights in turn.

According to today’s FT: “… the US central bank announced that it would lend primary dealers in the bond market $200bn in Treasury securities for a month at a time and accept ordinary triple-A rated mortgage-backed securities as collateral in return.” … “The latest Fed gambit, announced as a co-ordinated move with other central banks, is designed to improve liquidity by allowing dealers to swap their mortgage-backed securities for Treasuries, which they can in turn use to raise cash.” … “The initiative takes the US central bank a step closer to the nuclear option of buying mortgage-backed securities in its own right, although it stopped well short of such an extreme action.”

The last sentence, of course, is rubbish. The Fed is now accepting non-agency-guaranteed mortgage-backed securities as collateral in exchange for loans of central bank cash. What it is doing is, from an economic perspective, equivalent to doing repos – sale and repurchase operations – (with primary dealers as counterparties) accepting any triple A-rate mortgage-backed securities as collateral. There can be little doubt that the logical next step – the outright purchase by the Fed of non-agency-guaranteed mortgage-backed securities (possibly from a wider range of counterparties than the primary dealers) – won’t be long in coming.

The Fed appears to be trying to obscure this simple reality by splitting the repo into two legs. In the first leg, the Fed lends US Treasuries to the primary dealers, accepting triple A-rated mortgage-backed securities as collateral. There are two key new features to this first leg, the new Term Securities Lending Facility (TSLF). First, the Federal Reserve will lend up to $200 billion of Treasury securities to primary dealers secured for a term of 28 days (rather than overnight, as in the existing program). Second, it will accept as collateral not just federal agency debt and federal agency residential-mortgage-backed securities (MBS), but also non-agency AAA/Aaa-rated private-label RMBS.

In the second leg, the Fed will accept the Treasuries it just lent to the primary dealers as collateral for loans of central bank cash to the primary dealers.

$800 bn of gains have been made on subprime-related liabilities since August 2007!

The sky must surely be falling on the financial sector. Reported or estimated subprime related losses have, since last summer, gone from $50bn, to $100bn, $200bn, $400bn, even $800bn. Let’s call it $1 trillion, or even $2 trillion, just to be sure we catch most of the likely eventual losses. What has not been reported is the matching subprime-related gains, which without a shadow of a doubt also follow the sequence $50bn, $100bn, $200bn, $400bn, $800bn, $1 trillion and $2 trillion. Why this failure to report the subprime-related gains?

One reason, no doubt, is that there is a lot of ignorance and stupidity around – the distinction between inside and outside assets appears to be a difficult one for economists, especially financial specialists, brought up in a partial equilibrium tradition. I am lucky in having had Jim Tobin as my PhD adviser and mentor. Balance sheet constraints, budget constraints, Walras’ Law, adding up constraints – it was the bread and butter of what he taught. A little general equilibrium does go a long way.

The second reason is that the losses are highly concentrated among a few hundred commercial banks, investment banks, hedge funds and similar shadow banking sector institutions, while the matching gains are widely dispersed among the many millions of homeowners who owed the mortgages that have been written down or written off. Mancur Olson’s Logic of Collective Action strikes again. In addition, many of the winners may not wish to advertise the fact, given the amount by which the value of their property fell, they are better off now because they were able to force the bank that held their mortgage to eat their negative equity.

Gutless politicians prefer paying subsidies to favoured special interest groups by tinkering with the price mechanism to doing it through explicit budgetary transfers. The reasons are obvious. Explicit budgetary transfers can be observed and measured objectively. The transfer of resources is transparent. Explicit budgetary transfer payments have to be financed, either by increases in current taxes or current cuts in public spending, or by government borrowing, that is, by increases in future taxes or cuts in future public spending. Explicit budgetary transfers are on-budget. They can cramp the government’s room for fiscal maneuver through budget rules (the UK government’s golden rule, the budget deficit norms of the EU’s Stability and Growth Pact etc.). Explicit budgetary transfers imply a measure of accountability. For all these reasons, governments prefer to engage in quasi-fiscal operations that are off-budget and off-balance sheet, and that achieve the government’s distributional objectives mainly by mucking about with prices, rules and regulations under the control of the government.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website

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