The Fed to the Rescue Yet Again, But at What Cost?

This morning’s announcement by the Federal Reserve that it is taking steps to alleviate the bank liquidity crisis was greeted enthusiastically by the stock market. Almost all of yesterday’s losses following the Fed’s “disappointing” 25 basis point interest rate cut (many were expecting a cut twice that size) have been recouped based on this news that the central banks are coming to rescue the credit markets.

How appropriate is this reaction? Don't be surprised if the stock market upon reflection decides this is not such a good thing. To accomplish this rescue, the Fed is once again debasing its own credit worthiness, and sooner or later the stock market is going to have to look seriously at where all this is leading. A central bank with its own credit problems is the last thing the U.S. needs in this crisis.

The Fed’s announcement states that they are now prepared to lend money to member banks for as long as one month on a fully-collateralized basis. The collateral, in this case, has been extended to include the whole panoply of instruments that the Fed decided to accept back in the summer when the credit crisis first erupted.

Traditionally the Fed has accepted only U.S. Treasuries, certain agency securities of the highest quality, and high quality banker’s acceptances used for trade or agricultural financing. In the summer it was willing to accept market instruments with mortgage backing, for loans that had just a few days maturity. While the short term nature of this lending was encouraging, the expansion of acceptable collateral to include the types of securities the market was having trouble financing was less encouraging. Clearly the Fed was expanding its risk profile with these changes.

Now the Fed is expanding its risk profile even more by pushing these loans out to a month. The first such financing will be for $20 billion, a fairly significant amount, and will allow commercial banks to obtain credit over the New Year when money is traditionally tight.

This is in obvious recognition of the fact that lending by banks to each other remains constrained. Banks know as much about their competitors’ exposure to mortgage defaults as they know about their own, which is not much if you go by how frequently major banks are announcing additional reserves for losses and disappointing earnings (see Bank of America this morning).

The second part of the Fed announcement was just as telling: it is entering into foreign exchange swaps with major European central banks in order to provide these banks with dollars. What this says is that the interbank overnight and short term lending markets in dollars remain tight in all global markets, and that European central banks simply can’t access enough dollars to provide liquidity. Hence their need to have new, special swap facilities with the Fed to get dollars. The good news here, looking at this situation somewhat trenchantly, is that the Fed is giving up a weak currency (the dollar) in exchange for all those strong European currencies, though eventually under these swap lines the central banks will do reverse trades and the Europeans will get their strong currencies back.

Let’s add up all the good news. The interbank lending markets remain very constrained, to the point where the Fed is having difficulty keeping even overnight money at the rate it desires. Banks are now having trouble borrowing medium term, especially over year end, and so the Fed has had to institute what it calls term lending to provide liquidity for this period. These problems are global, so the Fed is entering into swap lines with major central banks in Europe to help them provide dollar liquidity. To accomplish all this, the Fed is taking on more risk, not just in maturity, but by accepting weaker quality financial instruments from the banks as collateral.

And the stock market finds this welcome? Of course, the stock market has been weaned for decades on the Greenspan put and now the Bernanke put, which tells it that the Fed will always come to the rescue in times of financial turmoil or economic distress. Investors will be bailed out of bad decisions and poor risk taking, banks will never go under, and any recessions that occur will be mild and short.

But let me take you back to June of this year and any time earlier. Do you remember the mantra of stock market pundits back then? It was “the world is awash in liquidity.” The stock market was confused or willfully blind, because the world wasn’t awash in liquidity, it was awash in debt. The cash proceeds one could obtain from taking out a loan were being confused with liquidity. This confusion or blindness is why the world suddenly went from excessive liquidity to very little liquidity at all – the debt creation machine came to a halt when people’s eyes were opened to the real risks of default.

There are a lot of very smart people at the Federal Reserve, especially the examiners and regulators who spend their time monitoring commercial bank credit standards and liquidity. They know that what the Fed is doing is weakening its own credit worthiness by these rescue operations. It’s not likely that the Board of Governors took these actions without someone in seniority pointing out the risks being assumed. You have to wonder if the Fed didn’t feel compelled to do this, considering the cost, because the financial market situation is so bad.

This is the very type of “slippery slope” that the Fed warns its banks about. A little risk here, and another little risk there, leads to increasingly inability to refuse taking on ever-greater risks. The United States government has been on this slippery slope for decades, allowing its federal budget deficit to explode, overextending itself abroad, and permitting the current account deficit to fester at untenable levels, all the time ignoring a serious health care crisis and looming retirement burdens. U.S. government credibility has been substantially weakened at home and abroad because of these problems.

Somehow, for nearly a century of operation, the Federal Reserve functioned well by accepting only a limited type of very high quality collateral for very short term periods from its member banks. Now it is on its own slippery slope. Its only real asset is its credibility, which in the markets is currently very high. But central bank credibility can be lost as quickly as liquidity can one day exist in abundance and the next day disappear.

Maybe these risks are worth it if the Fed can forestall a recession and rescue the banking system, but the magnitude of the problems now facing the U.S. are certainly large enough that this bet is 50/50 at best. What needs to be avoided here is the perception that through these new lending programs the mortgage securities problems are now traveling from commercial bank balance sheets to the Federal Reserve balance sheet. After all, if a bank gets into trouble the Fed may have no choice but to roll over its loans to this bank again and again, making a 30 - day loan a 3 year loan, and exposing the Fed to losses from deterioration in the collateral. This is a nightmare situation for any central bank, but that’s what slippery slopes do – they give you nightmares when you contemplate where you can end up.

Numerian December 12, 2007 - 10:54am

Numerian's diary | printer friendly version |

( categories: Analysis | The Markets )

Can we afford the Banks to become bankrupt?

It is what was expected, the Fed will "print money".

What are the other options? Let the Banks go Bankrupt? No gevernment has let a major bank go bankrupt, the banks are always, and probably have to be bailed out. Deja Vu all over again.

The Fed in in between a rock, bad securities, and a hard place, the US Government fighting a war on its credit card, and giving social security monies to the rich. Where's the fiscal discipline?

Where's the white house & congress in all this? Where is the investigation into those who established the underwriting standards? Managing by laissez faire? This is not only an economic problem, it's also a political problem.

All of this looks like a rerun of the Savings & Loan collapse of the late '80s. For the same reasons relaxed underwriting (I sem to remember the appraisers got blamed for the S&L meltdown).

Synoia December 12, 2007 - 11:50am

The Law of Large Numbers

.... I'm running out of time this evening, so I will attempt some concluding comments. First, looking at Q3's record credit inflation, it is not easy to justify Wall Street's call for dramatically lower interest rates. Sure, the pace of fourth-quarter credit growth will be meaningfully slower, especially in the mortgage arena. But I believe the key insight to be drawn from the Q3 2007 "Flow of Funds" is the recognition of the enormous scope of ongoing credit creation now required to sustain the US financial and economic bubbles. I'm tempted to surmise that the Law of Large Numbers has finally caught up with the Great Credit Bubble. In particular, I find it incredibly ominous that the credit system has faltered so badly in the face ongoing financial sector expansion.

Things can clearly get much worse. I don't expect the Wall Street securitization machine anytime soon to return as a major force for credit expansion. And I simply do not view recent spectacular ballooning and zealous risk intermediation in the banking, money fund, and GSE sectors as sustainable. They're clearly fraught with great risk. Messrs Bernanke, Paulson, Bush, Frank and others will, at best, manipulate only the pace of the unfolding credit bust.

[emphasis added]

CREDIT BUBBLE BULLETIN
Wrong call
Commentary and weekly review by Doug Noland

full article

tjfxh December 12, 2007 - 12:27pm

Japan & the bubble

Fighting the irrational one word at a time.

This looks more like Japan (although the differences are ominously on the downside) where the BOJ provided ample liquidity to the baking system but the cash just stayed in the banks and was not relent to other sectors. The situation was eventually stabilised by the effective socialisation of credit leaving the Japanese government owing a huge amount of cash in relation to GDP. The differences, Japan never owed a penny to foreigners - it is a massive net creditor so it could all be kept "in the family") and the Japanese show a greater proclivity for collective action (In a US firm the need for a 10% cut in the wage bill would result in pink slips, in Japan everyone would take a 10% pay cut). The Japanese survived their bubble with society essentially intact, lets hope we can say the same down the line.

London Calling December 12, 2007 - 12:38pm

They did try public works projects

On a massive scale for that matter - roads, bridges, tunnels, airports, harbor facilities. None of it seemed to pull the economy out of recession and prices continued to decline for up to 10 years (especially property prices). Of course, one big difference in Japan has always been that the banks have been loath to take their medicine, preferring to nurse bad debts for ever rather than take provisions and lay off their own staff.

In the U.S. the reverse holds - banks are under intense pressure to clean up problems before the next quarter's earnings come out. This will provide an interesting dynamic of layoffs and provisioning that might shorten the crisis to five years, but make the depth of the crisis much worse than Japan's. A true depression, rather than a persistent recession with deflation.

Numerian December 12, 2007 - 12:47pm

My relatives build houses for a living

They are not the massive builders and did not run huge debts with banks to build, so they were able to cut prices on houses by 20% right away and continue to sell homes without too much slowdown. All lots fell by more than that over this period, and the labor to build houses has declined as unemployment rises, and lumber and cement prices have all fallen by about 20%. My relatives have all cut their take from development in half. So 20% looked like a pretty solid 'decline' number.

But then . . .

some groups have come in that take these subprime foreclosure homes from the banks and auction them off. They are going for 50% of original prices. Sometimes much more if the house was stopped midstream and left unfinished. How do you sell houses for 20% less when houses are being sold for 50% less.

There are homes in the area right now being disassembled so the lumber can be used again.

This by the way is utterly deflationary. Money disappears when a house forecloses and is written down. They aren't 'printing money' they are filling a gaping hole of deflation in the housing market.

I know several people who are very flush financially who let their house go into foreclosure. Why not?? The house was $400,000 with a market value of $300,000. They put it back to the bank and then went and bought a house for cash that was going for $80,000 at the auction. They went from a $1700 mortgage to no mortgage at all. That is happening more and more. Why pay a mortgage on $300,000 of house when the market in some areas is half that.

This is what the Fed is fighting.

Scotjen61 December 12, 2007 - 2:28pm

Why pay back your debt?

20 or more years ago the question of paying back your debt was a moral one. You took on the obligation and it was your moral responsibility to fulfill it. Only the direst of circumstances would force you into the shame of bankruptcy.

That moral obligation is now gone. Paying back your debt is optional, and only a fool would keep paying back a debt on an asset that is losing value or is already underwater. William Bennett where are you when the world is losing its moral underpinnings?

But look at this from another angle. Banks have gotten the bankruptcy code altered to their advantage. They sell to the consumer loans with optional payment features. So the consumer is being trained by the banks into looking at mortgage repayments as entirely optional, and no wonder your friends are walking away from their home and mortgage when market values are collapsing in their neighborhood.

This is not just the consequence of changes in loan products, but of the whole market change when home values became disconnected from the rate of inflation. The housing bubble introduced massive amounts of market risk to the consumer's financial profile. For ten years that market risk worked to the consumer's advantage, but now that it is moving against the consumer why should he or she protect themselves by jettisoning the asset that is causing the problem. Especially since homes have become fungible assets, not just things you live in.

It will be fascinating to see if this practice takes hold across the country. It makes economic sense, even if it violates traditional ethics about loan obligations. It also sticks the banks with massive and probably crippling loan losses. If so, we should expect the industry to do everything possible to make this tactic illegal.

Numerian December 12, 2007 - 3:10pm

Coming soon...

...a remake of It's A Wonderful Life starring David Leisure (aka Joe Isuzu).

Gordon December 12, 2007 - 3:44pm

The finance industry

has lost the moral high ground a long time ago. What goes around comes around. The same attitudes used to exist between employer and employee. I am fond of saying to my clients that if they want loyalty (presumably from their employees/employer as the case may be) they should go out and buy a dog.

AND

Not only that, but these peoples credit for the most part has not been damaged. Those lending institutions whose debts they continue to honor continue to extend credit. Is it the beginning of the end for the nonrecourse home mortgage??

Scotjen61 December 12, 2007 - 3:56pm

Fix by next quarter

In the U.S. the reverse holds - banks are under intense pressure to clean up problems before the next quarter's earnings come out.

This can't happen. So there will be a bleed every quarter.

1. The Banks would probably become insolvent (write off all their capital) between a combination of the fall in their stock price and the size of their losses.

2. The Banks (or investors who bought the loans) have no clue on the extent of their losses, as many consumers have yet to decide if they will default, refinance, or make the payments. We get consumers calling us every day who have yet to make the short sale/foreclosure/litigate/suck it up decision.

Synoia December 12, 2007 - 2:25pm

Welcome to the Jungle

It gets worse here everyday
Learn to live like an animal
In the jungle where we play
Ya got to hunger for what ya need
You'll get it eventually
You can do anything you want
But you better not take it from me
In the jungle
Welcome to the jungle
It's gonna bring you down! Huha!

- Spoken by an unlikely prophet

zot23 December 12, 2007 - 3:33pm

That makes me think of

this video, one of my all time favorite treasures of the web.

Sorry it doesn't have anything to do with the Federal Reserve, but it does have a lot to do with reckless excess. Think of the people depicted in the video as metaphorical Wall Street guys in the ebullient shenanigans that have transpired since 2003.

chalo December 13, 2007 - 2:11am

Ahhh the fate of Bernanke

Market hates what he did, dollar in freefall and oil up nearly $5 gallon. Never seen such bad stats since the early 70's.

Scotjen61 December 12, 2007 - 4:44pm

Saint Joe and the impending global financial crisis

Dec 10, 2007, 00:46

The wreckage in the housing market just keeps piling up. Sales of existing homes in October dipped 23.5 percent from last year. Prices on new homes dropped 13 percent year over year. Third quarter foreclosures skyrocketed to 635,000, a 94 percent increase over last October and an all-time high on the misery-meter. The real estate market is in free-fall and the real trouble hasn't even begun yet.

California, Nevada, Arizona and Florida are mired in a full-blown housing depression. Inventory is off the chart. Presently, there's a 10.8-month backlog and the numbers are steadily rising. If foreclosures continue at the current pace, by the end of 2008, there'll be a 14-month inventory. That means that every builder in the country could drop his tool belt right now and stop working FOR MORE THAN A YEAR before the market would clear. Contractors would be filling out job applications at Red Lobster or, holding a tin cup, looking for an empty street corner.

We're now entering the crisis phase of the biggest housing bust in US history; Greenspan's remake of Three Mile Island; only this time the whole country will be vaporized by a subprime-radioactive cloud.

As bad as the housing market is now; it's going to get a whole lot worse. Judith Levy sums it up in her article “ARM Resets to Hit Fan in 2008”: “In 2008 interest rates will be reset upward on $362 billion worth of adjustable-rate subprime mortgages [ARMs]. . . . The 'real crest of the reset wave' has yet to take place, which promises more pain for borrowers, lenders and Wall Street. . . . In addition to the $362 billion of subprime ARMs, $152 billion of other adjustable-rate loans are scheduled to reset in 2008, including jumbo mortgages and Alt-A loans. The Mortgage Bankers Association estimates that 1.35 million homes will enter foreclosure in 2007 and another 1.44 million in 2008, up from 705,000 in 2005.”

$514 billion in resets; 3.5 million foreclosures.

Did I say Three Mile Island? I meant Nagasaki.

(snip)

The Federal Reserve is now actively trying to forestall “a systemic financial crisis” (Poole's words). The trillions of dollars that were loaned to mortgage applicants -- which ignored traditional criteria for lending -- have created the likelihood of a decades-long downturn in the housing industry, as well as a meltdown in the broader financial markets. The bundling of dodgy subprime liabilities and selling them as valuable assets to unsuspecting investors; is a scam that any competent regulator should have spotted immediately. It doesn't take genius to see that offloading sketchy MBSs and “marked to model” CDOs to gullible institutions is wrong and a danger to the entire system.

Financial innovation has created a dilemma for which there is no easy solution. The Genie cannot be put back in the lamp. Paulson's remedies have no chance of succeeding. Mortgage-backed securities have been so chopped up and spread throughout the system; it would be easier to unravel a bowl of spaghetti, separate each strand, one by one, and lay them next to each other without touching. It can't be done. The bad debts will have to be written down, banks will have to fail, and government will have to investigate affordable housing alternatives for millions of defaulting homeowners.

Deregulation has created a monster. The prevailing Reagan-era “supply side,” free market doctrine has removed tariffs, subsidies and other state-created price-distortions, but it has also eliminated all oversight and accountability. Government agencies no longer play an active role in policing the markets and, as a result, US financial institutions have fallen into disrepute.

This is, first of all, a credibility problem and it will require leaders with a strong moral foundation, not evasive bureaucrats who're looking for a painless way to “cut their losses” and keep the wheels of industry clanking along. Asset-backed commercial paper -- a $2 trillion business -- “is hardly trading at all.” The securitization of credit card debt, mortgages and car loans has slowed to a crawl and is in danger of stopping altogether. Many of the main engines for generating revenue for the banks -- the repackaging of debt and amplifying it through levered derivatives -- have vanished overnight. The financial markets have never been under such stress. There's so much mortgage-backed gunk in the plumbing, institutional lending has been reduced to a dribble. This is no the time for “business as usual” “garbage in, garbage out.” We need people who really understand what is going on to step up to the plate and propose coherent “fiscal” policy options that will steer the global economy away from the reef.

Forget about Paulson's “quick fix” snake oil. It's utter bunkum. The credibility of the system is at stake. It's time to get serious.

I did inhale.

Don December 12, 2007 - 4:49pm

It is Very Very Bad

In lots of sectors of the economy though you can still go to your banker and get a loan, lines of credit, paper, mortgages, equity. The banks aren't trading them like they used to in the derivitives market. Debt needs to be home grown now, or borrowed from the fed and not just originated and sold off. Banks have to HOLD and MANAGE the debt they lend. So certain sectors are shut down, but the ability to get debt for your business is still viable and I believe that is what they are trying to maintain.

The deflationary pressure of the housing market is what gives cover to the rate declines. It could go as low as 3% I think, but I have no idea what that does to the dollar or the price of oil, but every quarter point injects quite a lot of good feeling into the banking industry.

I totally agree with the credibility issue, and in the absence of credibility I have no idea why someone would hang onto a 25% over priced mortgage in this market when they can let it go and without recourse buy back in cheaper. They were cheated when they bought in, where is the 'moral obligation' to hold. Cut the loss and get free, and this attitude is definitely spooking the banking industry.

As I said, in our area I see housing going for half what they were one year ago.

I still think the uncoupling of the finance sector from the energy sector cannot occur. Finance wants to grow at 3% annually and the energy sector has flatlined since 2005, as in 0% growth. If energy flatlines then the economy flatlines, and the financial sector has got to flatline as well. Without growth how do you pay back a debt??? We can call it bad politics, bad policy, deregulation, whatever but someone has pulled the plug from the wall, the air is going out of the balloon. Finance cannot exist without growth and growth cannot exist without a growing energy sector.

The United States oil demand ran 750,000 barrels above what was supplied for the entire year in 2007 (and the cost of oil went from $50 to $90 accordingly); rail has moved coal at a flat rate for two years, natural gas is flatlining. GDP has gone 3.6% - 3.1% - 2.9% - 2.1% 2.0%(est) over the 2004 to 2008 period. It is as if you can watch the toy stop rolling as the batteries run out.

Scotjen61 December 12, 2007 - 5:24pm

Where do you get your numbers?

Sales of existing homes in October dipped 23.5 percent from last year. Prices on new homes dropped 13 percent year over year.

California, Nevada, Arizona and Florida are mired in a full-blown housing depression. Inventory is off the chart. Presently, there's a 10.8-month backlog.

Where do you get your numbers? Here are mine, for one city in Orange County, CA and they are worse. Out in Riverside & San Bernardino Counties its much, much worse.
Month Sales Inventory Average Price Years Decline
Nov-06 60 206 $576,611 -4.99%
Nov-07 30 565 $512,313 -14.09%

Sales of homes down 50%, prices down 15% after a 5% drop from the prior year, over 18 months of inventory. The October numbers were a bit worse.

Synoia December 12, 2007 - 5:30pm

I am describing

houses that have sold in my neighborhood, and houses in two counties around me. These are foreclosed houses being sold at auction. Many times they do not show up in the 'official' numbers. They are viewed as distressed and not a market transaction. Which is hilarious, what is this market if not distressed through and through?

Scotjen61 December 12, 2007 - 5:36pm

Worldwide crisis.

I found this link interesting and a good read.
http://www.opendemocracy.net/article/globalisation/institutions_government/sleepwalking_disaster

_{repressive governments mix administrative clumsiness & inefficiency with authoritarian tendencies.}

kimmy December 12, 2007 - 6:12pm

Hi kimmy Thanks for

Hi kimmy
Thanks for the link
jo6pac

jo6pac December 12, 2007 - 8:07pm

Reuters, Dec 16

The U.S. Federal Reserve will auction $20 billion on Monday and again on Thursday. The European Central Bank will hold auctions on the same days, with up to $20 billion in funding available while the Swiss National Bank is offering $4 billion in its auction on Monday.

If the auctions go well, that should boost banks' confidence and help push down the lofty Libor rates. But analysts cautioned that the auctions were a small first step in a crisis that has already cost banks tens of billions of dollars.

And over at The Independent: Stephen King: Central bankers ride to the rescue – or is this Custer's Last Stand? (December 17)

Policymakers preach the free-market credo but when the going gets tough, pragmatism takes over

I'm still not quite sure how best to describe last week's collective action from the Federal Reserve, the Bank of England and other major central banks. Did their decision to pump money into the global financial system represent the long-awaited heroic arrival of the Seventh Cavalry, a re-run of a 1950s cowboy movie? Or, less charitably, was this the equivalent of Custer's Last Stand, a failure which will leave the central banking community metaphorically scalped?

So far, the news is hardly encouraging. One pundit described last week's actions as "shock and awe", but this is not the most cheering of metaphors. After all, the "shock and awe" tactics used at the beginning of the campaign in Iraq didn't ultimately work quite as well as the generals had expected.

Indeed, if the aim of the central banks was to get the financial system working again, the policy so far has been a bit of a failure. Despite the offer of lots of additional cash, the lack of trust in money markets is still very much in place. On Friday, three-month interbank rates – the rates at which banks lend to each other – were still remarkably high. In the UK, they stood at 6.5 per cent, even though official interest rates are just 5.5 per cent. In the US, three-month interbank rates stood at 5.0 per cent, even after a Federal Reserve rate cut earlier in the week which took Fed funds down to just 4.25 per cent.

The gap between official interest rates and interbank rates is extraordinary. We've never before seen a gulf of this kind persisting for so long, despite cuts in official interest rates and frequent central bank injections of cash. And never before have we seen a money market fissure in so many different financial markets at the same time. Something is rotten in the state of financial markets, and central banks have yet to come up with a cure.

The medicine, though, is becoming more desperate...

_{"Vanity, Vanity, all is Vanity."}

Raja December 16, 2007 - 9:10pm

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The Fed to the Rescue Yet Again, But at What Cost?

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