Ten Notes on the Financial System and Our Quasi-Government

1) Repo rates may not be negative now, but they were so recently. Fails (failures to deliver securities) become common, because of the lack of a penalty. Today we should see whether the TSLF has any impact on the scarcity of Treasuries. We should learn more about the direct landing program as well after the close today. It got off to a big start last week. Watch for the H.4.1 report after the close. Given all that is going on, it is becoming the critical weekly Fed document.

2) Now, because of all these actions on the asset side of the Fed’s balance sheet, some are calling the actions of the Fed, including the Bear Stearns (BSC) bailout, revolutionary. Well, maybe. It’s certainly different than before, but there is a cost to doing business this way. Bit by bit the Fed loses flexibility as more and more of its highest quality assets become encumbered for a time. The more that they do, also, the harder it will be to unwind, in my opinion.

3) Greenspan: If we turn off the spotlight, will he go away? (Then again, he has enough money to buy his own spotlight.) It is tough for anyone to defend a legacy, and I don’t blame him for trying, but the Fed became too integrated with the political establishment under his tenure, which made it too activist in avoiding short-term pain. It made him look like a hero at the time, but now we are paying the price. Overly loose monetary policy and financial supervision led to gluts of borrowing to finance assets that appreciated dramatically, until the ability to service the debt began to decrease. I don’t think history will treat him kindly. He said too much in the past that he is contradicting today.

4) Will the Fed buy agency MBS outright? I think the answer to that one is yes, if the crisis persists. If housing prices drop enough further, like say 15%, the actions of the Treasury, Fed, FHLB, Fannie, Freddie, FHA, and whatever new lending monstrosity our imaginative Government comes up with will have to be closely coordinated. At some level, if the Fed can’t trust the implicit guarantee of Fannie and Freddie, why should the rest of us? That guarantee is as sound as a dollar!

5) It’s interesting to see the tide shift with respect to GSE involvement in the mortgage market:

• Higher limits for conforming loans.
• Fannie and Freddie being pushed to do more, but facing a shortage of capital, even after the recent required capital reduction from their regulator. They are likely to buy $200 billion of residential mortgage bonds. No capital added, just a loosening of a restriction.
• The FHLB is allowed to buy an additional $150 billion of mortgage bonds. No capital added, just a loosening of a restriction.
• And, as I write, the WSJ puts out a front page summary piece on the topic.

6) On a consolidated basis, our government, with its enterprises, are levering up. This is a substitution of public debt for private, and more, just a lowering of capital standards for the GSEs. (I wonder how comfortable the rating agencies are with this?) This works while Treasury yields are low. I wonder, though, how much impact this will have on the willingness of foreign buyers of Treasuries to continue their funding of our government? One thing for sure, this will all get funded by the U.S. taxpayers, together with those who lend to the U.S. (dollar depreciation).

7) Now, it’s not as if the U.S. is the only place in the world with central banking problems. Consider the Eurozone, where there is still no lender of last resort. How would they deal with a financial crisis? I’m not sure; the ECB has quietly helped out some Spanish banks, but it is not really in their jurisdiction. Under conditions of deflationary stress, it would not be impossible to see a nation whose financial system was in trouble either directly bail out the dud institutions, or even, exit the euro (last resort, but not impossible).

Or consider China, where inflation is getting a nice head of steam. Their neomercantilism, with their crawling peg against the dollar is forcing them to import loose monetary policy from the U.S. As the article cited points out, they need to significantly revalue their currency upward, which would whack their exports, at least for a time.

8) For those that remember the files that I created for my piece, A Social View of the FOMC, it looks like I will have to update the file soon. We have a successor to Bill Poole nominated, James Bullard. When he is approved, I will update the file. (I will miss Poole. Though he was occasionally out of step with the rest of the FOMC, he always spoke his mind, which was usually more hawkish than the rest of the FOMC.)

9) Now, Bullard is an Economics Ph. D. (Surprise!) In my earlier piece, Jeff Miller took note of a few of the things that I said, and perhaps attributed to me an anti-academic bias. I don’t have a bias against academics, per se. (Hey, can we put Steve Hanke on the Fed?! One of my professors…) I do have concerns about not having enough real debate. If the neoclassical view of monetary policy is correct, then we don’t have problems, because everyone on the FOMC is either a neoclassical economist, or a monetarist.

Now, I do know the difference between politics and policy formation, and if I hadn’t been trying to keep the number of pages down, I might have had two columns. (Getting it down to 15 pages was hard.) But most of the FOMC members had either one or the other, but not both, so I left it as one column. Next time I'll change the column heading. That said, even if one is in a policymaking capacity in the executive branch, there is typically some political affiliation that helps get that person the job. Those are relevant bits of experience, just as I noted everyone that had foreign experience, or military experience. But what worries me is a lack of real diversity in their views on how economics works. (Perhaps we could get someone from the Santa Fe Institute?)

10) Finally, there will be a lot of pressure in the future to re-regulate our financial system. Personally, I don’t think it is possible to create a regulatory scheme that eliminates crises. The regulator shapes the type of crisis that will come, and when it will come, but it is impossible to wipe out the boom-bust cycle. (We put off this bust for a long time, and now we are getting it with compound interest for time delay.) If a regulatory regime is too tight, the financial companies complain because their ROEs are too low. To the extent that it can, capital begins to exit the industry, or the stock prices languish, and financials trade at low multiples on book, because they can’t earn much off their net worth.

Financial companies find the weak spots in any risk-based capital formula. They also lobby the executive branch and Congress effectively. Unless we slide into Great Depression II, I don’t think things will change remarkably from here.

I agree that we need to re-regulate, but perhaps after this crisis is done, we can consider systemic reforms, and not the piecemeal stuff we have been dished up in the name of crisis management. My re-regulation would be to reduce the Federal Government’s role in the credit markets, but then I am walking out of step, and I do realize that that is not what is going to happen.

Comments

[flow5:]

Re - the red tide: Hope for repayment?

Between 1933 and 1935, the RFC purchased more than $1 billion in preferred stock in individual banks. To gauge the significant size of this agency's activity, in 1935 the total book value of equity capital (including the RFC investment) for all commercial banks was $3.6 billion. New RFC bank investment effectively ended by late 1935, and banks gradually repurchased the government's stock out of their earnings when the banks subsequently returned to profitability.

2008 Mar 27 10:10 AM

[flow5:]

Poole was a conservative at the "Maverick" Federal Reserve Bank of St. Louis. But I am disturbed with people who spend their entire careers at something, & never end up grasping how things work: Dr. William Poole: "The depreciation of the dollar is something that is not explicable. And the way I like to phrase this – I like to put my academic hat back on. If you look at academic studies of forecasts of the exchange rates across the major currencies, you find that the forecasts are simply not worth a damn."

If the world's largest economy ($14b+) has a contraction in its gdp, imports will fall, & export driven countries will suffer, exacerbating the negative (reversal) in the flow of funds, and any currency crisis. Forecasting results (some using 1 & some using 2 different time series:

Mexico crisis 2/17/1982 (not identified) - Peso was pegged

Listed below, currency crisis that were predictable & preventable

(1) Black Monday Oct 19 1987 (same day)

(2) Mexico Peso crisis Dec 1994 (2 months early) Peso was pegged

(3) U.S. dollar fall in Mar. 1995 (same month)

(4) Asian financial crisis July 1997 (one month late)

(5) Russian financial crisis 1998 (same month)

Poole made some brash statements he couldn't defend.

2008 Mar 27 01:28 PM

[gordon:]

GREAT COLUMN, but this is huge! You mean, the investmt banks are not even delivering any collateral, and there's no penalty when they renew in 28 days, they are just paying interest ? something smells here>
ftalphaville.ft.com/bl.../

2008 Mar 27 04:15 PM