–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 “quantitative easing”.
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.
In fact it's not clear what the bailout package was intended to do. The Administration spent months in blissful denial ('strong fundamentals' and all that) then upon slowly noticing the symptoms of the sickness -- not the causes -- cobbled something together in a panic. The current effort is akin to handing out tissues in a pneumonia ward and wondering why none of the patients is getting better.
Trackback
53 comments so far
Previous | 3 | 2 | 1 | Next
So if it has cost 5 trillion dollars thats 1.2 trillion a month. It is an amazing figure and we can pass more laws to pretend that we dont have to have an equitable system. However that is DEBT that can be used for a reconstruction. I would propose that 5 trillion would bring relief for years in crisis. So if the effect of this dash to the past costs 1.2 trillion a month the question should not be how do we save the banks. Rather we should ask how do we stop spending 1.2 trillion a month and what would a plan based on that idea require.
I am a hedge fund manager. What is the Federal Reserve?
At the risk of seeming repetitive, this problem was never going to be solved by the current administration. Their anything goes, corporatist ideology is what created the problem. These people need to be brought to justice, not given trillions of dollars to further feed their corporate masters. Allowing this to go forward is completely dysfunctional and is compounding the problem. Let the trials begin!! Unfortunately, it will have to wait until January 20th.
The underlying problem of the fiscal crises has many parts, but among them is the lack of oversight and regulation of securitization. But Paulson is on record as saying that dramatic efforts to increase the levels of securitization are necessary to stimulate lending.
Paulson’s position is 100% wrong. Outstanding securities need to be accurately valued and properly regulated going forward. Dramatically improved regulation to ensure that securities remain small, simple, and auditable is necessary. This takes time, and indeed, banking leaders and treasuries around the world haven’t any time to spare. What is shameful is that Paulson hasn’t realized that when one finds oneself in a hole, one must stop digging. Accelerating the creation of hastily-reassembled securities for his friends to buy at bargain prices is the most ill-advised policy I’ve ever heard.
I propose a simpler plan:
1) Cap all future credit at 20% interest rate for all lending vehicles, including credit cards. If a lending institution feels that the borrower is too risky to extend a lower rate, then the lending institution should not be allowed to offer such low-value subprime loans.
2) All lenders should be required to hold the loan for a minimum of 25% of the life of the loan (7.5 years for a standard 30-year mortgage). This would be sufficient time to properly value the loan and, if securitization is done, the underlying value would be easily audited.
3) Regulation should mandate the accounting and transparency of complex securities.
4) Credit-default swaps must be outlawed.
5) no publicly held corporation or private enterprise should be bailed out with taxpayer money unless put to a public referendum. Indeed some would vote to bail out companies with guaranteed loans, however, this is the entire purpose of the stock market, NOT the federal government. Those who support private institutions should risk their own investment, not yours and mine.
Only when a firm financial foundation is re-laid will the crisis end. Sadly, Paulson continues to dig a deeper hole for everyone.
You mean that purchasing bad debt with monopoly money didn’t work?
The terms “broad” and “narrow” money actually means wealth and fiat/counterfeit money. This country is broke and had no actual wealth to pay for this bailout, so the Federal Reserve just printed money, or borrowed it from outside the states. Monetary inflation debases the dollar, which now is worth pennies on the, well, dollar.
End the Federal Reserve, they’re the root problem of the government’s economic failure.
The TARP, proposed by hide-bound Republicans, morphed in Congress as the meaning of “assets” broadened. Few economists shed tears for the “gutted” original purpose. Paulsen, Kemp, and others agree that Federal monetary efforts perhaps have run their course for now. Only renewed threat of banking collapse (TED spread above 4 again?), however, could justify this column’s headline.
I second Toney Brooks’ comments (Nov. 13th, 7:44 pm GMT), with the caveat that bubbly house prices must fall further, and many more people will lose their homes. Let’s do what we can while not wasting resources in delaying the inevitable.
The inability of the treasury to control (perhaps dictate) how the TARP money provided to banks is used is troubling. A naive thought is to force banks to originate a certain percentage of the TARP funds as home loans at a fixed percentage rate. For instance, if $250B were made directly available to back home loans at a fixed rate of 4.5%, the avalanche of refinances and new mortgages would certainly do more to bolster the economy than having banks reinvest the money in treasuries, yes?
The root of the problem are the foreclosures. Until the investment houses and lenders are forced to restructure those loans, this is not going to be fixed. Why are they being rewarded with my tax dollars? And why wasn’t Paulson’s massive conflict of interest an issue?
There is one other important observation. GM’s economic impact is so vast that there is an excellent probability that it will try to bully the government. When it does, we must be prepared to walk away from the table, and let GM “go shopping” for a bailout from some other source. This is crucial. TSM.
Someone should give Mr. Kemp an advisory role in the Treasury Department, as his observations are brilliant.
It’s really simple, and basic. Any rescue, or bailout program must contain the triggering mechanisms to implement and activate the desired results, or they can be expected to fail. If they do fail, the confidence in the markets will worsen upon evidence that the government is unable to resolve the problem. That’s where we are right now. The next issue is this: General Motors, is literally killing us with its debt burden. While it is necessary to bailout GM, it is also necessary to force GM to merge its massive retirement funds with the retirement funds managed & administered by the individual states.
GM has neither the capacity, nor the expertise to manage the retirement funds together with the automobile manufacturing business, and it is a MAJOR distraction. GM, has to be forced to decide whether it wants to improve its financial structure, or expire in bankruptcy.
If the government supervises that scenario properly, the entire county will rejoice, and confidence in the markets will be restored - world-wide. TSM
Too bad the fed didn’t listen to all the protests of middle America fighting this b/s program from the beginning. Actually, I’m sure they were listening, but didn’t care. Anyway, if Paulson did give out $700 billion to the 380 million people in the country, we all would have been walking around about 2 grand richer. Thanks, Hank, instead of an extra $2000 in my wallet, I get to read about you guys screwing everything up more than it already was!!
It shouldn’t have been rocket science. But it was. Before you can devise a solution, you have to know what the real problem is. Not what you think it might be, but what it actually is. Be that as it may, it seemed to me, the economist neophyte to top em all, that these bailouts were crazy from the get go. Because, first of all, who should benefit from the triage and how to you make sure that happens? Second of all, where is all this money to come from? What are the accounting controls? My third worry is manifesting, and that is the bandwagon effect. The feds are giving away money? OMG, all of a sudden, everybody is a lottery winner. Everybody has their hands out. Nobody is bothering to carry their own weight. Why should they? There’s always these bailouts. FREE MONEY. Who wouldn’t want it? But systemically, what is really the problem? Has anybody identified the problem? What really caused this? I mean subprime lending did not cause the auto industry to tank, did it? I don’t know. I’m confused.
It seems to me that there is an economic virus that is spreading that needs to be isolated and contained. Throwing money at it is not the solution. But I am not an economist and so I don’t exactly know what the solution is. But I would start by saying no to any more bailouts. I would put a moratorium on that. The idea can be revisited. But for now, no bailouts. Yes, a band aid is needed to contain the hemorrhaging. Although, maybe if you let it be, it will stop bleeding on its own. I don’t know. Maybe the doctors should leave the patient alone and see what happens. Let the market players play. For example with the mortgage industry: The banks lent all these mortgages and borrowers borrowed the money, right? Let them resolve it. Force the banks into a position where working out these mortgages is a matter of survival for the banks and their over paid CEOs. How? I don’t know. I am not an economist. But that should be easy to figure out? As far as this auto czar business? Don’t do it. If some big giants go under, new giants will pop up – eventually….omg. forget everything I just said. This is frightening.
By Marion TD Lewis, Esq., New York
http://www.marionlewisesq.com
Underneath the bank’s boar of directors, under its top managment and operating platform leaders is the credit policy department. These are the red headed step children of the banking industry. Typically staffed by quant that lack interpersonal skills to generate revenues or maintain customer relationships. Now, they rule the roost and are savoring the light, as dim as it might be. No one can fault these people if no credit risks are taken. Revenue growth? Sounds very free market and would likely be viewed as “risky” by the financial press. That’s not good for stock price…perhaps the suggestion to extend credit by the Fed should be accompanied by a shot to Eugene’s ribs with a loud…”do your job. Can’t be any worse than your former boss who lost billions.”
O.K. Fine Article… But what about those pesky Credit Default swaps… What becomes of them.? are they not DEBT.
this is a wonderful example of Absolute power corrupting absolutely. Banks do not even Register the Consumer anymore in their lexicon of business. we consumers are mere flys buzzing around the room they would love to SWAT given the chance. Believe Me, Banks would rather you “go Away and Shut Up” than to deal with you… They are just Like Potter in “It’s a Wonderful Life” cranky Old Farts wishing the consumer didn’t exist.
I wonder how far 700 Billion would have gone if it was given equally to every Tax Payer recognized by the IRS.
My Calculater doesn’t have that many “O”’s Had Paulson Given the Money to the People that Pay the Taxes then maybe this mess could have been avoided. But now the Banks will just “Play” with their new found wealth.
Save your Money, the bread lines are forming…
Since when has big government ever successfully fixed a problem (they caused, Clinton administration) by throwing more money at it? Are U.S. citizens so numb between the ears they actually thought it would work? How could it, when they give themselves unlimited control? Any time you give more money to someone who can’t handle their money, will only do the same. Did we forget the real definition of insanity? And while we’re at it, what about the bad behavior of so many American citizens, when it comes to the almighty dollar?
We need a time out. Treasury needs to stop treating only the symptoms of this burst asset bubble. Systemic risk to the financial system is no longer imminent. Mission accomplished. Up to now, Sheila Bair at FDIC has been a voice of reason and consistently has advocated steps to slow housing foreclosures, the root of the problem.
In fact it’s not clear what the bailout package was intended to do. The Administration spent months in blissful denial (’strong fundamentals’ and all that) then upon slowly noticing the symptoms of the sickness — not the causes — cobbled something together in a panic. The current effort is akin to handing out tissues in a pneumonia ward and wondering why none of the patients is getting better.
If you read between teh lines, the only people that have money are the banks. it is time to put a stop to this nonsense. join a protest on 11/22 for ending the federal reserve system. goto endthefed.us
we need sound money and a free market, not gov’t manipulaiton. why would anyone believe they could run this economy? they can’t even run the television conversion rebate.
The rescue packages were not meant to resolve problems but to address perception and behaviour. Because some ninny who watches a lot of television feels that people are rushing to the banks taking all of their savings out. We know that is what happens because I’ve seen this television show. It usually appears around Christmas time. I kind of wonder about the level of nominal thinking that seems pervasive in executive America and which psychology course they were taking together to come up with these wonderful enlightened ideas. So it seems people are not necessarily cashing out because of fear. Believe it or not, some people invest in order to make money - so they can take OUT more money. It’s true. People put money in so they can take money out. Are they in a panic? No, actually, they have been planning to do this for decades. But all of these suits who took basic psychology think it’s some kind of puzzling mental psychosis. Homer Simpson isn’t just operating nuclear power plants, apparently.
What can one say? Deck chairs, Titanic….