Monthly Archives: September 2008

This is what I read this morning on FT.com: “The US Federal Reserve announced that it will lend AIG up to $85bn in emergency funds in return for a government stake of 79.9 per cent and effective control of the company – an extraordinary step meant to stave off a collapse of the giant insurer that plays a crucial role in the global financial system. Under the plan, the existing management of the company will be replaced and new executives will be appointed. It also gives the US government veto power over major decisions at the company.”

I almost decided to go back to bed, convinced I must be dreaming.The proximate cause of the demise of AIG as a private firm were its ‘monoline’ activities, its exposure to massive amounts of credit risk derivatives like CDS, many of them linked to the US real estate sector. The largest insurance supermarket in the world, with a balance sheet in excess of $1 trillion nationalised because it was deemed too big and too globally interconnected to fail!

A cut in the Federal Funds Target rate today would be a pointless and possibly counterproductive move.  Global financial markets are experiencing a renewed liquidity crunch.  Some leading financial institutions, including global insurance giants like AIG, need large injections of new capital.

The liquidity crunch is best addressed by central banks making liquidity available on a large scale.  In the US we have already seen a widening of the range of eligible collateral at the discount window.  We will no doubt seen further relaxations of collateral requirements at central bank discount windows, in open market operations (repos) and at the range of ad-hoc facilities that have been created since August 2007.  In the UK, the plans of the Bank of England to close the Special Liquidity Scheme to new business in October will have to be shelved, unless the SLS is at the same time replaced by an equivalent (or more comprehensive) set of arrangements.  The central bank as lender of last resort and market maker of last resort is what is needed today, making funding liquidity and market liquidity available on a large scale and on terms that ought to ensure a profit for the central bank.

A cut in the risk-free short nominal interest rate is just not relevant under current circumstances, and would look, once again, like panic football.  When the dust settles, there will be time to rethink the path of the official policy rate, in the light of what the fall-out from the panic implies for the macroeconomic objectives of price stability and sustainable growth.

If systemically significant financial institutions need capital and cannot get it in the markets, there may be a role for the Treasury.  Capital injections by the state, through the Treasury should be expensive for the receiving party – financially and in terms of oversight and regulation.  The Federal Funds target rate is completely irrelevant to the resolution of the capital needs of firms like AIG.

The knee-jerk calls for a Fed rate cut by part of Wall Street and its claque whenever something unusual hits the fan  must be resisted if the Fed is to come out of this crisis with its credibility intact.

AIG, the largest US insurance company by assets, is reported to have asked the Fed for a $40bn ‘bridge loan’ to tide it over while it sells assets and attracts new equity.  Unless such support is forthcoming, the company fears a downgrade by the rating agencies before it can shore up its capital base.  Such a downgrade could further weaken its balance sheet, leading to a downward spiral and possible bankruptcy.  While waiting for a Fed decision, AIG’s regulator, NY State Insurance Superintendent Eric Dinallo gave it special permission to access (i.e. to raid) $20 billion of capital in its subsidiaries to free up liquidity.

My first reaction to these stories was !*#\ӣ$%&?!!!

It now looks likely that, unless the US Treasury blinks and makes public resources available to support a private take-over of Lehman brothers, the investment bank will have to file for bankruptcy.

The argument for putting public money into the rescue/take-over by JP Morgan Chase of Bear Stearns was that Bear Stearns was ‘too interconnected to fail’.  As the smallest of the investment banks, its systemic significance was argued to derive from the damage that would be done to the rest of the financial system if Bear Stearns were to attempt a last-gasp escape from oblivion through a desperate fire sale of its illiquid assets.  A vicious downward spiral of market illiquidity and funding illiquidity could have resulted, dragging down potentially viable financial institutions and causing unnecessary harm to the real economy.

Lehman Brothers is larger than Bear Stearns, so what’s different now?

 For quite a while now, the Libor-OIS spread at 3 months and longer has mainly reflected perceptions of counterparty default risk rather than a systemic shortage of liquidity.[i] 

Since the crisis started in August 2007, Libor has been the rate at which banks are unwilling to engage in unsecured lending to each other.  This is not just because even as a measure of the marginal cost of unsecured interbank funding, Libor is fatally flawed:  too few banks are involved in its construction and it is based not on the interest rates attached to actual transactions, but on banks’ (reported) estimates of the terms on which they would be able to borrow.  Cheap talk has never been a good basis for a price index.

Unsecured interbank lending has shrunk to the point of vanishing.  The reason is fear -  at first, fear of counterparty illiquidity or default; increasingly, just fear of counterparty default.

It is a near-universal rule of time management that the urgent but not necessarily terribly important takes precedence over the important but not terribly urgent.  Economic policy making is no exception to this rule.  I was therefore pleasantly surprised to read in the papers that Peter Orszag, Director of the Congressional Budget Office (CBO)   said on September 9 that “It is the CBO view that Fannie Mae and Freddie Mac should be directly incorporated into the federal budget”.  The CBO is the (non-partisan)  federal agency within the legislative branch of the US government that acts as a congressional budget watchdog and among whose responsibilities is the projection of the budgetary consequences of proposed legislation.

The US Secretary of the Treasury, Hank Paulson, has at last pulled the plug on the two giant GSEs (government sponsored enterprises), Fannie Mae and Freddie Mac.

That it was the big man himself who wielded the knife (or should that be the bazooka?) rather than his sidekick Jim Lockhart, Director of the Federal Housing Finance Agency (FHFA, the regulator of the GSEs), is clear from Paulson’s statement on Sunday, September 7, 2008: “I support the Director’s decision as necessary and appropriate and had advised him that conservatorship was the only form in which I would commit taxpayer money to the GSEs.”

What was decided?

No, this blog is not about ways of locking Dick Cheney in the broom closet.  It is about the collateral policy of the ECB at its discount window and in in its repos.

In the recently published Biennial review of the risk control measures in Eurosystem credit operations, the ECB announced some measures to address the problems of excessive credit risk exposure for the ECB and the implicit subsidisation of banks borrowing from the Eurosystem using dodgy ABS as collateral.

I have now watched a brace of US presidential nominating conventions.  This has been a truly mind-numbing and depressing experience – a complete triumph of appearance over substance.

Particularly disturbing has been the willingness (eagerness?) of both the Democratic and the Republican candidates to exploit their minor children in the hope of gaining electoral kudos with the family values crowd. First the Obamas trot out their nine and seven year old daughters (after Michelle Obama had been airbrushed into a tupperware mom).  Then the McCains roll out their seventeen year old daughter.  Not to be outdone, Sarah Palin bounces onto the stage with her newborn baby in her arms.  Even her seventeen year old pregnant daughter was put up for public display, accompanied by the effing and blinding young man earmarked for future son-in-law status.

At least the Obama kids may be too young to suffer lasting psychological damage as a result of their cynical exploitation.  Seventeen-year old teenagers may not be as fortunate.  Should the social services get involved in what has all the hallmarks of emotional child abuse?

The UK government has come up with a package of measures to boost the UK housing market and to help those who find themselves with mortgage servicing bills they can no longer afford.

A very damp and small squib

The first measure is one year stamp duty holiday for property transactions between £125,000 and £175,000. This would cost £615mn, according to the Treasury. Doing away with stamp duty would be a good idea regardless of the state of the housing market. Stamp duty is a stupid tax, which penalises transactions in housing. It taxes labour mobility. If the government wants to tax wealth, let it tax wealth, but not transactions in specific assets. A one year partial stamp duty holiday is better than nothing, but nowhere near as good as a permanent abolition of this fiscal monstrosity. Higher taxes on non-doms could make up the revenue shortfall…

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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