Posted on 09/18/2008 5:36:23 PM PDT by JasonC
Here is my modest proposal to address the immediate crisis in the financial markets.
I have already addressed elsewhere the longer term reforms needed, such as a clearing exchange for over the counter derivatives and swaps, simpler asset backed security structures, bans on deposit institutions lending to deadbeats, better monetary policy next time, etc. But there is also an immediate issue in the capital markets that needs to be solved immediately and on an impressive scale. This post is both a defense of the principle and a method to use.
The proposal is that the Federal Reserve begin conducting open market operations in corporate bonds, specifically buying investment grade securities for newly created dollars, left in the system. And that is do so with the conscious intention of both routing short speculators and making $1 trillion in trading profits. It should keep it up until that profit has been made.
Right now T-bills are well bid at 4 basis points. Basically the markets have such a high demand for safe cash right now, they will take anything safe enough without interest of any kind. Meanwhile, investment grade bonds especially of financial companies are trading at distressed or junk levels, and therefore offer yields of 10% or more. And they are not bid at those prices. This huge spread constitutes a standing invitation to *arbitrage*. And I propose that the Fed accept this invitation with both hands, exactly as would a *for profit* investor with its resources, at this time.
The only reason it hasn't, is that ideologues who pretend they are all for free markets and deprecate the mere existence of the Fed as an instrusion into their functioning, also expect the Fed to act in those markets - or rather, to refrain from acting - like a disinterested eunuch, with no profit motive and no appetite for well rewarded risks. These ideologues have conditioned the men running the Fed to act like machines rather than traders. They should stop, temporarily, and act like traders instead.
There is widespread public opposition to what are loosely called "bailouts", largely because the people are under the quite mistaken impression that these operations are always and must be unprofitable. So I propose we show them that is incorrect, by not intervening in a manner that only takes bum steer trades, but takes the attractive ones. And doesn't hand over the profits to private counterparties, but keeps them, for the public.
There are some conditions under which central banks cannot safely expand money supplied to the market in such a manner, without risking a reduction in trust in and use of the currency they issue. But this is emphatically not one of those times. Dollars are not unbid and avoided and spent as fast as possible. Traders are not demanding 10% and higher rates to hold them --- exactly the opposite. The Fed just had to extend huge swap lines to foreign central banks who did not have enough dollars for their own desired actions in their home financial markets. And rates are bid to zero. T-bills are currently the same in investment terms as currency stuffed under a mattress, and everyone and his brother is trying to pile into them anyway. There is no risk whatever of not finding men willing to take the new dollars.
Moreover, there is no risk whatever in the bonds being bought, either. You can't lose your shirt investing money created out of thin air for nothing and paying nothing, in top rated debts earning 10%. Especially when those bonds will be rendered sound precisely by the extra money made available and by a reduction in the rates corporations actually pay to borrow.
The present crisis is purely one of confidence and of liquidity preferences. No private investor can arb this spread the way the Fed can. Each individual investor faces the collective action problem, that there are two possible outcomes for each financial institution - one, in which is only pays 4% for its funds and is highly profitable, and another in which it must pay 14% and is bankrupt. The Fed can drive the market to the lower point, and can profit in doing so. But let's not be greedy - only drive it halfway, or until the Fed has made a $1 trillion profit. Others can join in at that point, if they like.
A large part of the present crisis is a mere mechanical effect of dedicated shorts getting richer every time they kill another company. They made billions on Fannie and Freddie and they instantly threw those billions at Lehman and Merrill and AIG. They made billions more on Lehman and AIG and threw them instantly at Morgan Stanley and Goldman Sachs, much sounder companies. They are now operating on momentum and their firepower, and not on fundamentals. They are striving to create the fundmentals they need to justify further bankruptcies, in the form of high rates and an inability to raise equity, for financial companies.
But nobody can match the firepower of the Fed. If they want to make it just about firepower, I say let's do so, and rout them. We know American business can and will earn trillions in the future. Let's take a trillion of it now, for the public, from the doom-mongering end-of-the-world trade terrorists.
All the Fed needs to do is pretend it is a profit seeking trader for a couple months, and arbitrage the ridiculously wide spreads between pure dollars and corporates. It is what any *for profit* bank with sufficient resources would do right now. Not only will it not cost the rest of us a dime, it will generate a staggering profit. The only losers will be the shorts.
That is my modest proposal. Comments are welcome.
I don't think this is possible in the PC United States. Clinton's requirement that the banks lend in black neighborhoods at the same racial per capita rate as in wealthy less black neighborhoods set the stage. Because banks were lending to people with shaky or negative credit, other, non-black people demanded to be treated the same way. This lowered the bar across the board and eventually led to liar's loans and the whole gamut as banks decided that they were necessarily headed toward bankruptcy and might as well make as much hay as they could while the sun still shone.
The RTC-like idea floated today fills the role of most of what you propose.
Yes, I hate the idea of Gov’t stepping in at any point, but this is a gov’t created problem to begin with.
Carter’s CRA and Clinton’s subsequent hardening of CRA rules, combined with Dhimmi controlled crony handling of Fannie and Freddie caused this problem.
Soak up the non-valued sub-prime debt (at a discount to be repurchaed 5 years from now (with interest) by the banks who decide to sell to the new RTC) and give it a value.
All the other mortgage backed derivatives will then have a value based on the “full faith and credit of the United States.”
Can you honestly - with a straight face - tell me that our representatives in Washington would EVER allow this to happen in such a blatant, outright fashion?
Not a chance...
HEH!
Be a soothsayer born of a god.
Control of individual thought of others helps if doable.
I admit I made some bad financial decisions over my life and need Uncle Sammy to bail out. It's unfair for me to be responsible for my poor monetary decisions.
I really need about 12,000 to be completely debt free, but since Uncle Sammy is willing to bail my ass out and be my sugar daddy, I figured the extra cash can buy a new Benz and the fancy blinge would be really cool
Sorry to step on your thread.
The longer one lives, the more times they will hear this.
If graced by God to live long enough, they will hear it time and time again.
The real problem with your proposal is circumventing the CRA which forces lenders to loan to people they KNOW can’t pay it back. Exacerbated by a Fannie/Freddie which never looked closely at those loans and bundled them off as bonds (with AAA ratings because, after all, they were quasi-governmental-agencies).
The reason the markets are grid-locked is that NO ONE knows the value of what they hold.
Gov’t steps in, gives these securities a value (even artificial) and all of the sudden, the markets can work again.
I do think (well, hope maybe) that any new RTC will require banks to buy back any assets they sell with interest in some future time frame (when these derivatives can be unrolled and the true value can be ascertained to some extent).
I don’t care whether the US makes money off it as long as
a) it doesn’t cost anything
b) it averts a complete meltdown of the global financial system.
ife shouldn't be a b!tch before one dies, should it? /s
Shouldn't government do it's job and create Utopian bliss for us all?
Everyone I’ve ever met who talked about how easy it would be for someone else to make money in the markets, never actually tried to make it themselves.
The IMFs estimate of the likely loan losses on the mortgage crisis, all security types, was around $1 trillion. Sounded big at the time but it was a reasonable estimate. Maybe, worst case, it is $2 trillion. That range. So far the financials have written off $500 billion, and numerous earlier tiers of smaller equity players were wiped out completely, as well.
In the same time frame, capital markets lost $19 trillion in market value.
$4 trillion of that declined happened this week.
The issue is that fighting over who gets left with portions of the original loss, has already destroyed and is currently in the process of destroying, far more value than the original loss itself. An order of magnitude more.
This happens because institutions try to avoid getting stuck with a portion of the loss, by taking actions that are individually risk-reducing, but collectively destructive. A typical collective action problem or prisoners dilemma, in which lack of trust is the root cause of the increased destruction.
Concretely, a bank holding collateral stops trusting the owner to put up more of his wealth to meet margin calls, and seizes it and sells it immediately, instead. Men sell simply because others sold and it made the price drop. Men sell because they notice circling packs of shorts looking for those slowest to get bad items off their books, or slower to mark them down to the lowest bid yet. The same banks refuse to lend to each other, because they think, if the other guy fails I'll be stuck with his losses, and I can barely hold up mine.
There are some exceptions, of course. A few institutions so well run they can withstand it and show profits, or that are brave enough to buy entire rivals and take their potential losses, themselves. If there were enough doing that, the crisis would not build. But there haven't been. Some, but not enough.
The trillion losses the IMF estimated were on a loan book of over $30 trillion. The interest on the paying parts outweigh all the original losses in a matter of months.
But that isn't the only source of stress. Instead the banks are earning less as they piled into lower risk teasuries yielding 0 (or 2% a while ago) - why? To get out of the way of ongoing market price only losses, and to meet their capital requirements and look stronger and more liquid, to the sharks. They also pay more to borrow - why? Because the marked down securities are offered to yield 8% and 10%, so other investments get bid up to match. Because people think anything issued by a leveraged player is junk-risky.
Changes in the rates they are paying to borrow money have long since cost the banks far more than the original mortgage losses.
They are also earning less from other activities. Mortgage issuance has fallen off drastically, and securitization has ceased, other than government agencies. Investment banks are underwriting less in the way of new offerings. Fewer deals of all kinds happen when rates are high and the parties mistrust each other. Etc. All of this hurts far more than the original mortgage losses. Ten times as much, easy.
That is the reason there is some sense on the RTC proposal, just trying to get all that behind us. It is way overdue as a main approach, though, because the critical issue has moved on. Right now the critical issue is that no bank in the world can afford to pay 10% and 15% to raise money, and expect to lend it to consumers.
The reason the markets are currently punishing the investment banks especially, and are sparing the deposit banks, is the deposit banks can fund most of their borrowings on CDs or savings and checking accounts, paying 3% interest or so. They only need to borrow on the bond market for 10-20% of their needs. Investment banks borrow 50% of their needs there, and much of the remainder in the short term version of the same, where rates are lower sure but where liquidity is an urgent issue, the loans constantly need to be rolled over, etc.
All those problems go away if the rates on corporate debts are 5-6% - as they still are for e.g. the electric utilities Buffett is buying - instead of twice those figures.
The Fed sets monetary policy by controlling the fed funds rate. But it isn't the relevant rate in this crisis. The relevant rate in this crisis is the rate on 5 to 10 year investment grade bonds of financial companies.
And since the trade is also profitable, that is where I propose the Fed intervene, directly.
If banks et al see lower and stable funding costs, they do not need to horde short term risk free investments, as they are now. The hording is designed to get the shorts to pick the other guy as their next target, to avoid a ruinous spike in borrowing costs to double digits. Well, if all the sound names don't have to worry about that, their fear driven actions will abate. The original losses themselves are nothing, nothing they can't all earn out in a year or two tops, at least.
As for CRA, asked and answered. Banks aren't paying much attention to it anyway - the regulators told them to cut out the subprime issuance and they already have. It is the hot potato game with the stuff that already exists, that set off the risk-avoidance logic explained above.
I hope this is interesting.
Jason, interesting thoughts. Recommend some reading material, if you would. Thanks.
The Fed shouldn't 'get paid'. They helped create this mess. They should be declared an illegal entity and all of them thrown into prison for the rest of their miserable lives.
Let the system crash. It's going to anyway. The sooner it happens the quicker the recovery, a real one this time, can begin.
L
Let's instead take every dime from the overleveraged ideologue shorts baying for the end of the world and trying to destroy western capitalism. They are traitors to the bottom of their boots, and utterly worthless parasites.
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