How to fix the markets

Vanity | 18 September 2008 | JasonC

[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.

[petercooper]

the truth bump

[petercooper]

bump

[JasonC]

Thanks... It’s a Friday night (lol).

[Steve Van Doorn]

"It’s a Friday night "

and i can find your posts now that FR is running again. :)

Again very good post. Congress doesn't have a lot to do dealing with this problem. That is good cause I have no confidence in them at all.