TARP and Fed facilities unravel

November 13, 2008

johnkemp3–John Kemp is a Reuters columnist.  The opinions expressed are his own–

LONDON (Reuters) – Experience shows financial crises escalate very rapidly, and need a swift and decisive response from policymakers to break the cycle of panic. Time to reflect, craft thoughtful policies and consider long-term consequences is a luxury policymakers generally don’t have.

But the problem with bold ad hoc responses is they often have unintended consequences. Individual policy actions may prove inconsistent with one another, fail to achieve objectives, and store up larger problems for the longer term.

Developments over the last week suggest the U.S rescue program has fallen into just this trap and is now rapidly unraveling.

The twin pillars of the rescue program are the multiplicity of liquidity and lending programs being offered by the Federal Reserve and the Treasury’s Troubled Asset Relief Program (TARP).

Both programs are now in deep trouble. In fact the various rescue packages risk becoming a textbook example of how poorly designed programs can fail to achieve their objectives.

LIQUIDITY EVERYWHERE BUT MAIN STREET

The Fed has grown its balance sheet from $884 billion to $2.055 trillion in the space of two months and extended almost $1 trillion in additional support to the banking system through the various emergency lending programs enacted or expanded over the last year.

But precious little of this additional liquidity is finding its way through to households and corporate borrowers. In fact, most of it is now sloshing around the banking system like so much excess ballast.

Banks have increased their reserve holdings on deposit with the Fed from $8 billion to $494 billion. This is $488 billion more than the Fed estimates they would ordinarily need to hold for payment clearing and prudential purposes.

Increased reserve holdings have absorbed perhaps half of the liquidity placed into the banking system from the Fed. Much of the rest has almost certainly been invested into the mountain of Treasury bills the U.S Treasury has been issuing. Only a very small proportion is left for re-lending to the real economy.

It is much safer for the banks to lend surplus funds to the Fed and the Treasury than lend to one another let alone to households and corporations. There is no credit risk. Nor is there any liquidity risk because reserve balances can be accessed on demand, and the Treasury bills have short maturities and can be readily re-discounted.

The Fed has made these perverse incentives worse by agreeing to start paying interest on excess reserves. Previously, the lack of interest payments gave banks an incentive to minimize reserve balances. But now reserves pay interest the net cost is low.

Even low returns on Fed balances start to look attractive when adjusted for the high levels of credit and liquidity risk in extending longer-term credits to other banks and real-sector borrowers.

SURPLUS MONEY, NOT ENOUGH CREDIT

Policymakers have ignored the distinction between money and credit (or to use monetarist terminology between narrow money and broad money). The Fed can create unlimited (narrow) money by adding reserves to the banking system. But it cannot create credit (broad money, or lending from the banking system and other financial institutions to one another and to end customers).

This is precisely the problem the Bank of Japan faced throughout the late 1990s and into the present decade. The bank reduced interest rates close to zero, and even resorted to “quantitativeeasing”.

The result was a huge increase in narrow money but little or no growth in the broader money aggregates as the banks preferred to keep the increased liquidity in their vaults rather than boost lending to customers.

The problem is that credit extensions depend on healthy banks being willing and able to lend, and healthy borrowers willing to borrow and able to repay. Once the economy is trapped into a more than usually serious recession, sound and prudently managed institutions have no incentive to take on more leverage to expand their operations, while lending to weaker institutions that need the money presents an unacceptably high credit and liquidity risk.

Yesterday’s inter-agency statement from the Treasury, the Federal Reserve and the Federal Deposit Insurance Corporation (http://www.federalreserve.gov/newsevents/press/bcreg/20081112a.htm) notes sternly “the agencies expect all banking organizations to fulfill their fundamental role in the economy as intermediaries of credit to businesses, consumers, and other creditworthy borrowers”. But the stern injunction to start lending again is probably futile.

Until collateral values (especially residential and commercial property) stabilize and there is greater certainty about the economic outlook, there is no incentive for creditworthy institutions to borrow, or banks to lend. But without lending, the contraction will deepen.

THE $700 BILLION TARP SLUSH FUND

TARP is beset by even bigger problems. Recall the $700 billion fund was originally created to provide a buyer of last resort for mortgage-backed securities and other assets that had become illiquid and were allegedly trading only at firesale values, if at all, that did not reflect their fundamental underlying worth. TARP was supposed to aid price discovery and deal with a crisis of liquidity.

But the TARP provided the Treasury secretary with almost unlimited authority over how to use the money, subject only to an oversight board composed mostly of executive branch officials and powers for Congress to invoke the “nuclear option” and disapprove further funding beyond an initial $350 billion.

The fund has quickly mutated. The Treasury used $125 billion for capital injections into nine large national banks, some of whom claimed they did not want or need it. Another $125 billion is being made available for capital injections smaller regional and community banks. Some $40 billion is now being used to support AIG. The Treasury now has just $60 billion of TARP authority before it must risk returning to Congress.

PROGRAM CREEP

Yesterday, the Treasury admitted it now has no plans to begin buying troubled assets, gutting the program’s original purpose completely.

Congress came under intense pressure to approve TARP with the promise that asset purchases could begin within a matter of days of the president signing the bill. Legislators show increasing signs of restiveness that TARP has transmuted into a giant $700 discretionary fund outside the regular appropriation process.

There is frustration that TARP funds are being used to bolster balance sheets (and thereby take off pressure to cut dividends and bonuses), and perhaps pursue consolidation, while there is no new credit flow to households and corporations.

Meanwhile an ever-lengthening list of industries are bidding for TARP bailouts. The Treasury has already extended the program to insurers. American Express and other institutions have turned themselves into commercial banks to access all the federal support on offer.

The auto industry is pressing its own claims to be “systemically important” for a share of the bailout funds. Congress and the administration are now arguing over where to draw the line. TARP is not big enough to bail out all these industries.

But the fundamental problem is that neither Fed liquidity nor TARP deals with the root of the problem – the rising tide of defaults in the residential mortgage market, and the continued fall in home prices and collateral values.

There is a popular misconception that the renewed extension of credit will revive the real economy. But that is putting the cart before the horse. Credit will start flowing again only when banks and potential borrowers can see some sign that the economy, cash flows and collateral is stabilizing.

As several senior Fed officials have indicated, monetary policy has done all it can. Only fiscal policy, combined with the systematic rescheduling of loans and write-down of debt principal, can achieve stabilization in the real economy and the housing market.

53 comments

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I think this debate is ignoring the most basic underlying cause of our economic crisis – the mindset of the people. There is a great discord amongst the generations at play here, whether we’re talking about the Boomers who are in control and have basically set up the way we do business, the Gen Xers who are caught in the middle, aloof and selfish, and the up and coming Millennials who want to be catered to and want everything they want and more, yesterday without having to lift a finger to get it.So long as the 3 separate and distinct mindsets remain separate and distinct, this economic flatulence will continue, and nothing will get resolved.Sure, blame it on the lenders who gave the loans to people who weren’t qualified. But what about the pressure to make those loans out of “fairness?” Go ahead, tell me lenders don’t make loans based on a sense of fairness, but then explain why businesses are catering to this generation of workers by doing things like sending acceptance letters to their parents, allowing parents to tour the workplace and sign off on little Johnny or Janey’s job, and are fielding calls from parents because little Johhnny or Janey got a bad review? Like it or not, the workplace has to learn to deal with the new generation, and I think that’s where things are failing.Lenders have fallen into the trap of redoing standards because there is a demand to do so. It’s the tail end of the selfish GenX generation and the beginning of the entitled Millenial generation who have forced this change. Getting something for nothing is the theme of the generation. And that’s exactly what the lending institutions gave them – credit where credit was not due.And now we are paying for it.

Posted by Wendy | Report as abusive

As the jobless rate continues to skyrocket, it should be the role of the government to secure jobs in fields that are or will be lucrative. The U.S. auto industry is a perennial failure, refusing to bail them out will force them to restructure. The markets should be left to sort themselves out, throwing money at the banks has given them the opportunity to weather the storm. Impeach Pelosi.

Posted by Stephen | Report as abusive

Let’s see.An Administration whose mismanagement caused this mess, gets a $700B blank check from Congress and gives the money to the bankers whose mismanagement and greed caused this mess, who then use this money to get richer.Meanwhile Joe the Plumber loses his job and home.No wonder Das Kapital has become popular again.No one is in charge who is competent and willing to fix things.We are doomed.

Posted by John Bannick | Report as abusive

To me there is a common thread here. The criminals who perpetrated the greatest larceny in the history of the world have us believing this is simply a problem of financial transparency, regulatory policy, and the behavior of consumers.The fact of the matter is that we have been betrayed by the leadership for the benefit of their corporate backers. We really need to wake up here and impeach and remove these people, because they clearly intend to keep on doing the same actions (relieving us of our wealth and the wealth of generations yet unborn) by straight out corrupt practices. Why are we still giving these people the benefit of the doubt?It is almost comical how the public keeps falling for the lies that drag the world deeper into the quicksand. We need to wake up, realize that we’ve been had, bring the perpetrators to book and try to get back on some kind of stable footing. Right now we are on the express train to a major Depression and no one is putting on the brakes.Just the opposite. The forces of greed are lining up to try to get their share of the booty. It’s the new age of piracy, except the pirates are in charge!!

Posted by Jonathan Cole | Report as abusive

Please, the bailout was to give the bankers a new way to line there pockets while we on main street struggle to even feed ourselves. Its disgusting, Our country has been robbed of any kind of lively hood by bernake paulson and the international bankers of the fed reserve. Its time to end the fed and get this country back on its feet.END THE FED

Posted by jesse | Report as abusive

When thew Big Three go bankrupt what will be left of U.S manufacturing? New housing is at a virtual standstill. Producing tangible goods is the way societies build wealth. Our society has built an economy based on debt to buy homes, autos and investment”products”. At some pint in time all markets become saturated and demand levels off. For a decade or more GDP growth has been based on profits from the financial sector and services.The challenge is to develop new products( other than just homes, autos and wireless devices) that consumers will buy. Bringing affordable solar panels, hydrogen cell generators, bio-fuels and low current electrical products to the market successfully will solve many of our problems. However, creating demand for such products, in this economic climate, has proven to be impossible.It is clear to me that the previous commentators get it but those in political and economic power do not. High wages paid to defense workers, along with price and wage controls during World War II, created excess income for U.S. workers. Many products were rationed. The American peoples response was to save and buy U.S. bonds which provided more revenue for the war than taxes or Wall Street did. This is what brought the U.S. out of the Great Depression.Free market capitalism, up to this point,has been unable to deliver to this society the things it so desperately needs. We must find a way to lift ourselves(and the world) up, like this nation did for itself in the 1940s, without going to war.

It is not that those in political and economic power don’t get it. They’ve got it and things are going great, for them.check out Michel Chossudovsky or Peter Scot Dale.

Posted by Will | Report as abusive

Let’s see…Greenspan –> flooding the world with play money –> creating enormous asset bubbles –> economic fundamental out of the window –> game of musical chairs stops –> ???As a private institution, the Federal Reserve has the monopoly on money creation. The question is where is accountability and checks and balances?

Posted by need answers | Report as abusive

How does an economy continue to grow and expand when the key drivers of the economy, the middle class consumer, has experienced real wage stagnation for over 10 years? By spending money which they have not earned – debt. Debt they are not qualify to obtain, but do so through reduced / eliminated borrowing requirements. That debt was backed by housing prices which were / are artificially inflated due to artificial demand (home loans to those who are not qualified or able to pay drives up demand). This works for a while, but at some point the consumer runs out of money and credit then:- default on home loans- Home prices fall- spending stops- economic contraction.Even if lending is freed up, there will be no qualified borrowers.Bottom line – the economy will not turn around until1. housing prices come in line with average income (median income = $48,000/yr affordable house price is 3.5 times median income = $168,000. Current median single family home price = $235,000. We have a ways to go). Once housing prices come into line the economic contraction will stop.2. If we then want economic growth, we need to create jobs which will increase real wages over time. If folks earn more money they will save and spend more money.Unfortunately we have sent a significant number of these jobs overseas. The engineers and bookeepers and factory workers who used to spend and save a good income are now making half of what they used to make. Hard to grow the economy with that happening.

Posted by Jeff | Report as abusive

I totally agree that low or even zero interest rates in the US will not help the situation as we go into 2009 companies will fail at a faster rate and unemployment will rise to alarming heights, we should be in no doubt that this will be worse than the great depression, what will make this worse if the likes of General Motors are bailed out and not allowed to fail we cannot keep bailing out these companies the demand is not there for the supply and demand will not get back to levels seen pre 2007 because credit will not be available the rules of the game have now changed think of your parents or grandparents if you could not afford it you could not have it people had to go with out, now the party is over this is what it going like be in no doubt this is going to be extremely painful.

Posted by COLIN JAMES OBE | Report as abusive

As an alternative to auto industry bailout it might be better to offer a percentage of low interest financial backing or investment to companies buying bankruptcy automotive assets to produce cars and trucks in this country.This could achieve two main goals:1. It would retain the domestic capability.2. It offer those with better ideas and less stuck in an old “automotive company culture” a chance to change the industry.I believe maintaining a significant domestic automotive capability is essential to national defense. Without such capabilities we would have been hard pressed to win WW II.

Posted by M. Craig Kernan | Report as abusive

I think that we have to tackle the crisis at its roots, which is the price of housing. The lower the price goes, the more people enter into a position of negative equity in their house. The only way to prevent further falls in the price of housing would be to stem the flow of foreclosures and the subsequent sale of the houses a distressed prices, which affects the price of every house in the area.Instead of giving the money directly to the banks bailout money should be used to buy back the mortgages that are in distress. It would be unfair to bail out only those individuals who are unable to pay their mortgage. This would penalize those we bought a house they could afford. However, it would not be unreasonable to negotiate a rental agreement with the current occupants of the house that reflected their ability to pay. For those who are not simply speculators this would allow them to stay in their current house, but they would not build up equity as their more prudent neighbors will be doing.Details remain to be worked out, such as the pricing formula and in the terms of the rental agreement. If the scheme is restricted to those currently living in the house the impact on the rental market should be manageable. Some way of preventing, or reducing the amount of “key money” from being exchanged would have to be found.Is the supply of rental accommodation also in surplus?

Posted by Jim Kirby | Report as abusive

Lynn Tilton (CEO of Patriarch Partners) was on CNBC Squawk Box on Friday…relevant insights to this discussion…Fixing the Financial Crisis: The truth of the situation can be ignored no longer (http://www.cnbc.com/id/15840232?video=9 60926779.)This is the same woman who predicted the financial crisis on Bloomberg TV back in 2006 (http://www.blinkx.com/video/lynn-tilton -on-bloomberg/87JL8lMSQmrDI4ALaa5zdQ) so perhaps she’s worth listening to now.She proposes direct lending to businesses through a new “Provisional Federal Bank (http://www.patriarchpartners.com/Lynn_T ilton_WashPost_NYT.pdf)”…Liquidity must be made available not solely to big banks where Treasury-injected capital has been amassed to fill the cavity left by gambling losses, but rather expressly to deserving American companies and their people who will reignite our sputtering economy. A provisional Federal Bank must be initiated to foster enterprise and to provide job opportunities for every American.”

Posted by TruthSeeker | Report as abusive