Let me begin with the point on which I am in complete agreement with Treasury Secretary Henry Paulson and Federal Reserve Chair Ben Bernanke– it is hard to overstate just how scary this week’s developments in financial markets could be.
Prior to the establishment of the Federal Reserve in 1913, the United States would periodically experience events that are often referred to as “financial panics.” Rick Mishkin noted that these usually occurred after a recession began and a major financial institution had failed, and were characterized by a sharp increase in the spread between the interest rate paid by higher risk versus lower risk borrowers.
The graph below plots the difference between the interest rate on 3-month certificates of deposit and 3-month treasury bills. The alarming behavior of this spread began in August 2007, when it spiked up to 243 basis points, higher than anything seen in the previous 20 years. Aggressive responses from the U.S. Federal Reserve and other central banks last August succeeded in bringing banks’ borrowing costs back down, though we saw subsequent comparable spikes in December 2007 and March 2008.
But those events would barely be noticed when compared with what happened last week. Following the bankruptcy of Lehman Brothers, the spread reached 527 basis points on Thursday.
Financial intermediaries, who earn their profit by lending at a modest markup over their borrowing cost, simply can not be expected to function in this kind of an environment. Lending institutions that had been solvent before this week would not remain so for long if this situation were to persist. Only the safest customers could be expected to obtain loans, and only after paying very high interest rates.
To respond to this situation, Treasury Secretary Paulson has proposed a plan whose key feature is the authorization to spend $700 billion to purchase troubled assets from financial institutions.
By my count, the Federal Reserve has already extended something on the order of $455 billion in loans collateralized by some of these same troubled assets, namely $125 billion in repos, $150 billion in the term auction facility, $50 billion in “other loans”, $30 billion from the Bear Stearns deal, and $100 billion in “other Federal Reserve assets”. That $455 billion total does not include this week’s $85 billion loan to AIG, nor the $180 billion in reciprocal currency swap lines.
My primary criticism of these previous unconventional actions by the Fed is that they are better characterized as fiscal policy rather than monetary policy. They unquestionably represent an implicit potential commitment of Treasury dollars. If the latest $700 billion Treasury proposal were to take these assets off the books of the Federal Reserve and put them onto the Treasury’s balance sheet, and have Paulson rather than Bernanke be the guy who makes these calls of when and where to put the taxpayers at risk, I would be all for it.
But I gather that instead the $700 billion is construed to be in addition to the comparable sum that’s already been committed by the Federal Reserve. And it seems to be in addition to the $1.7 trillion in debts from Fannie and Freddie that the U.S. Treasury has now apparently assumed, and is in addition to the guarantees on $3.1 trillion in agency MBS for which the Treasury has again apparently assumed responsibility.
And do you think that this week’s $700 billion is going to be the last such request?
Granted, these numbers I’ve been adding up represent loans or guarantees, which are something very different from outright expenditures. Actual losses should only amount to a small fraction of this sum. But even a small fraction of $6 trillion is still a huge number.
Before we can solve these problems, we need to agree on what caused them. In a narrow mechanical sense, that seems straightforward to answer. Reckless underwriting standards and excessively low interest rates contributed to bidding up house prices to unsustainable levels. Real estate price declines have now engendered current and prospective future default rates that translate into large capital losses for institutions holding assets based on those loans. This erosion of capital makes creditors wary of extending any new funds to these institutions.
But there is also a deeper question here that is harder to answer. How did the financial system come to be susceptible to such a profound degree of miscalculation and inappropriate leveraging of risk in the first place? My answer would be that the core problem was financial arrangements in which the gains went to one group but the downside risk was borne by somebody else. The loan originators offered unsound loans, but still made big profits because they sold those bad loans off to the loan aggregators. Fannie and Freddie earned themselves nice income while the loans were performing, but the taxpayers absorbed the loss when the loans went bad. CEOs and fund managers earned huge bonuses while the boom went on, leaving stockholders and investors holding the bag when things went sour.
And I agree with the Financial Stability Forum that the key changes we need to make to avoid such problems are more transparency in accounting and stronger capital requirements. Transparency is vital so that that creditors, shareholders, fund investors, and regulators can better perceive the risks to which they are exposed. Stronger capital requirements are necessary to ensure that the principal actors are risking their own capital and not just somebody else’s.
How you get from our current situation to one where financial institutions are adequately capitalized is of course one of the key challenges of the moment. We can’t just impose tougher requirements and expect everybody to extricate themselves from the mess they’re in without some federal contributions. But I do not see that a clear vision of exactly what is expected and required, in the way of modified capital standards and risk management procedures, for any institution that receives federal assistance is a key part of any of the proposals. And it should be.
Transparency strikes me as something that ought to be easier to achieve. I would start with a centralized clearing house for reporting all derivative contracts and collateral pledged for them, and requiring financial statements such as annual reports to communicate clearly the specific exposures that those entail. Perhaps there’s a fear that if we had a clear communication of exactly who is holding the bag, that could exacerbate the kinds of destabilizing capital flights with which we’ve been fighting. But I think the uncertainty itself may be even more destabilizing.
Before the taxpayers are asked to commit such sums, we are owed a coherent and compelling explanation of why this kind of problem is never going to occur again.
There’s lots of other good analysis out there in the ‘sphere. Brad DeLong has a nice exposition of the conditions in which a government intervention could be successful and desirable, and when it could fail.
Calculated Risk offers details of how he would run the bailout. Yves Smith and Paul Krugman ,  express their reservations about the Paulson plan. Representative Barney Frank (D-MA) wants to see a cap on executive compensation be part of any bailout. For some comic relief (and heaven knows we could use some at the moment), see
the Washington Post
(hat tip: Greg Mankiw).
And your thoughts, dear readers?