In remarks in London today, Fed Chair Ben Bernanke let the world know how he views the risks and benefits of the recent dramatic changes in the assets and liabilities of the U.S. Federal Reserve.
One of Bernanke’s goals was to reassure the public that the many new loans that the Fed is extending and assets it is purchasing do not pose a significant risk to taxpayers. From Bernanke’s remarks:
Importantly, the provision of credit to financial institutions exposes the Federal Reserve to only minimal credit risk; the loans that we make to banks and primary dealers through our various facilities are generally overcollateralized and made with recourse to the borrowing firm. The Federal Reserve has never suffered any losses in the course of its normal lending to banks and, now, to primary dealers.
Left unsaid here is the fact any private lender could equally well have also extended said overcollateralized loans to these same borrowing institutions, but decided that the compensation for absorbing such a risk was inadequate. Bernanke’s core assumption is thus that private lenders are currently mispricing risk, but the Fed can do it correctly. I’m prepared to believe that’s true– there is some degree of overcollateralization that might be inadequate for markets but should be sufficient for the Fed, but what is it? Are the underlying assets really worth 99 cents, 90 cents, or 50 cents on the dollar? Should the overcollateralization therefore be 1%? 10%? 100%? The devil is in the details, and whatever details we know about this aren’t coming from the Fed.
Nor do I take comfort in Bernanke’s observation that the Fed hasn’t lost any money on the new facilities– yet. Didn’t the buyers of subprime MBS say the same thing? It was the wrong answer then for the same reason it’s the wrong answer now– when you drastically change the scale and rules of the game, you can’t base your risk assessment on historical performance. The one thing of which we should be confident at the moment is that the future won’t look like the past.
Bernanke also discussed some of the Fed’s new plans:
In addition, the Federal Reserve and the Treasury have jointly announced a facility that will lend against AAA-rated asset-backed securities collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration. The Federal Reserve’s credit risk exposure in the latter facility will be minimal, because the collateral will be subject to a “haircut” and the Treasury is providing $20 billion of capital as supplementary loss protection. We expect this facility to be operational next month.
Here at least we have a number– $20 billion– that will give us some idea of what Bernanke assesses the ballpark risks to be. If, for example, we see that the Fed lends $100 billion in this program, I’d take that to mean he’s thinking the underlying assets are really worth at least 80 cents on the dollar; if $200 billion, we’re talking about 90 cents on the dollar. If this gets into the hundreds of billions, it’s hard to see how $20 billion would be regarded as a significant equity cushion.
Bernanke also addressed the question of what’s the exit plan for bringing the Fed’s balance sheet back to normal size and safety:
However, at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to unwind its various lending programs. To some extent, this unwinding will happen automatically, as improvements in credit markets should reduce the need to use Fed facilities….
As lending programs are scaled back, the size of the Federal Reserve’s balance sheet will decline, implying a reduction in excess reserves and the monetary base. A significant shrinking of the balance sheet can be accomplished relatively quickly, as a substantial portion of the assets that the Federal Reserve holds– including loans to financial institutions, currency swaps, and purchases of commercial paper– are short-term in nature and can simply be allowed to run off as the various programs and facilities are scaled back or shut down. As the size of the balance sheet and the quantity of excess reserves in the system decline, the Federal Reserve will be able to return to its traditional means of making monetary policy– namely, by setting a target for the federal funds rate.
That sounds to me like an exit strategy for how to get out of this if everything works out just right and the problems all go away.
And what’s the exit strategy if it doesn’t work? I suppose more lending facilities.
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I don’t know if you as the lender can not only control the interest rate, but also control the inflation rate. It would seem to me that the likelihood of loosing money would go down significantly.
Why Bernanke has to reassure the public IN LONDON that the many new loans that the Fed is extending and assets it is purchasing do not pose a significant risk to taxpayers ?
Left unsaid here is the fact any private lender could equally well have also extended said overcollateralized loans to these same borrowing institutions, but decided that the compensation for absorbing such a risk was inadequate. Bernanke’s core assumption is thus that private lenders are currently mispricing risk, but the Fed can do it correctly.
I don’t think it’s as easy as that.
One factor left out of the above analysis is the eligibility premium – the extra price one is willing to pay for securities that can be used as collateral with the applicable central bank in times of stress.
Another factor is the capital ratios and market aversion to leverage that were important in the analysis of the risk-free Fed Funds rollover. By increasing the leverage ratio, even a small risk-free arbitrage will increase funding costs for the bank’s entire book.
Yet another factor is the extreme risk aversion of the marketplace and the risk that a relatively trivial surprise loss will trigger tumultuous consequences. I, for one, do not find it reasonable that the Lehman default should have caused such dislocation – but it did! Reserve Primary Fund took a loss of a few percent – and not only was their firm destroyed, but the entire commercial paper market locked up.
From the bank’s perspective, I believe, it is not so much credit risk that dissuades them from putting their excess reserves to work; it is funding risk – a risk that does not affect the Fed. This statement may be criticized on the grounds that it does not so much address the issue of the “markets mis-pricing of risk” as simply move the problem to a different segment of the market (from the banks to the banks’ creditors and shareholders) – but that’s an important move. Markets are not monolithic. They are comprised of poor dumb nervous individuals, professional and retail, acting on incomplete information.
Perceptions of informational asymmetry have run amok, the way they do in any banking crisis; only time will heal the markets; only central banks can provide time.
Bernanke assumes some sort of normalization in the outlook, while the market is clearly making a different assumption about downside risks. Those asymmetric beliefs could be rational: Bernanke knows that the policymakers have the tools to stabilize things eventually, and knows/believes that they will likely be used, leading to eventual recovery. In contrast, markets may not be so sure if the policymakers will use those tools effectively. (I am writing as someone who has lost confidence in US macroeconomic policymaking over the past 6 months.)
What practical implications do you see if the Fed took significant capital losses? After twisting my head around it some, and looking at inflation control via raising the interest paid on deposits rather than OMO, it seems frankly somewhat unimportant. I had been quite worried about it before some clever ideas out of JKH and others.
Even if Treasury is unwilling to recapitalize the Fed, there are still policy tools available to fight inflation. The impact of a persistent negative equity position on the economy seems similar to excessive sovereign debt, and muted, because of its relatively smaller size.
Barring a sudden loss of confidence in the central bank, I don’t see any really big drawbacks to a central bank with negative equity and impaired assets.
Bernanke finished this speech: “Finally, a clear lesson of the recent period is that the world is too interconnected for nations to go it alone in their economic, financial, and regulatory policies. International cooperation is thus essential if we are to address the crisis successfully and provide the basis for a healthy, sustained recovery.”
Given that this is also one of the major lessons from the Great Depression and from John Maynard Keynes (as Markwell’s book shows), it is not suprising – but it is very important! – that Bernanke makes this point. I very much hope that the Obama administration provides the leadership that is needed for this international cooperation, including in maintaining an open world trading system.
Why are people so scared that ‘monetizing the debt’ will lead to very high inflation?
Is it because they think that will lead to very big increases in the money supply?
But why should anyone think that increasing the supply of money causes inflation? Some people called monetarists said so and they proved to be wrong, as the 1980s saw an increasing divergence between rates of monetary expansion and rates of inflation.
In any case, increasing the supply of money is quite compatible with falling demand for existing output. The increased cash balances can be used to fund payment of old debts that were taken to buy old outputs—the car or vacation you bought last year—and/or to fund the repayment of maturing government securities. That is, increasing the supply of money need not be inflationary if the demand for money or quasi-money such as Treasury bonds increases by just as much.
Furthermore, if the relevant debt that is being monetized is owed to foreigners and the supply of money in their own countries is increasing just as much, there is no reason to think that handing them new money to retire the debt will result in them bidding up prices for real output in either our country or theirs, since even when the real rate of interest was higher, they had had chosen to purchase government bond rather than purchase real outputs.
See also:
http://blog.andyharless.com/2009/01/to-monetize-or-not-to-monetize-who.html
Is he expecting a v-shape extraction back out from the world of liquidity facilities? Maybe the narrow confines of one speech, one where he’s responding to the very premature speculation of ‘exit strategy’, is inadequate to extract deeper meaning, but it sure seems that way. It seems to me that a situation dire enough to require the current policy set is not one which simply rebounds, and will require a protracted period where these polies are rescinded. Thet don’t want to make a Japanese-style ‘consumption tax’ bungle, after all. I’m guessing bank profitability will also be constrained for quite some time as profits (when they come back!) are used to make dividend payments, and then are used to actually buy back their banks from the government. The point is, all this takes time, so I’m not sure where all the optimistic drivel comes from. Best to be workmanlike, knuckle down and get on with it. Denial is no antidote. Ask the Japanese.
Safety through over-collateralization. Wasn’t that the sales pitch for CDOs?–buy the Triple A tranches and everything below them had to default before you had any problems.
If you go back to the days when Bernanke initiated his ‘asset side’ strategy, they noted in a FAQ posting that they would take ‘triple-A’ rated privately placed mortgage-backed CDO tranches at discount window rates, which the discount-window table says are 93-98 cents on the dollar, depending on the duration. They later confirmed that that category included subprime-backed CDOs. That is the same kind of paper that MLynch offloaded at 22 cents on the dollar (or 6 cents net of the financing).
I may have missed something, but haven’t seen anything on the FRB web site that suggests that they’ve increased the discounts on such paper.
They have subsequently modified the program to include any ‘investment grade’ securities, which per ABX, is even lower. All in all, it gives little confidence in the rigor of the haircut process.
I go along with stunney. In this modern era of non-convertable fiat currency why does the Fed or Treasury need to “break even” or “turn a profit”. The only “cost” are the “real” economic cost. If the securites the Fed bought turn out to have a value of $0 will this lead to inflation or a misallocation of real resources or a reduction in real output? Isn’t that what economist should be exploring? Not whether the Fed or Treasury actions will cause the taxpayers to take a hit; but will Americans living standards take a hit.
To build a little on some things that have been said
Can the Fed face asset price risk in a deflationary environment?
Presumably one of the Fed’s problems is that it may not be able to induce inflation at the ZLB.
Just as the Fed pushes on the liquidity premium by buying Treasuries, it can push on the risk premium by supporting alternative assets.
stunney, markg, and Karl Smith: As I discussed here, if the Fed takes a loss on these loans, it has identical fiscal implications as if the Treasury had spent an amount exactly equal to the the Fed’s loss, namely, the loss must be made up either by reducing other government spending, increasing taxes, issuing new Treasury debt, or raising new funds through monetary seignorage. If the Fed can accomplish the latter without inflation, then raising revenue through seinorage was also an option available to the Fed and the Treasury had there been no lending facilities, and the statement remains.
I completely agree that these costs may well be outweighed by the potential benefits of these facilities. My main concern is that I think this kind of fiscal decision needs to be made by Congress and the President rather than unelected Fed officials. Towards that goal, in my opinion greater openness and clarity about the exact nature of those risks would be welcome.
JDH,
That makes sense. You are basically saying the Fed is making fiscal policy. On the flip side, with interest rates near zero, can’t the Treasury conduct monetary operations by deficit spending and not selling Treasury Securities. This would have the same effect has the Treasury selling the securities and having the Fed buy those secuities to inject liquidity. In other words, the Treasury would be injecting liquidity. No?
And do I dare suggest do we need both a Treasury and a Central bank. Can the Treasury deficit spend to create liquidity and then offer an interest rate on excess liquidity to control inflation in the same manner the Fed does?
help me understand this: banks swap crap for t-bills. then they may use the latter as collateral before others. the daily price fluctuation will always be creater on the crap rather than the treasuties. why would banks ever take back their crap (unless forced by the fed) when this de-facto will reduce their ability to leverage? does my rationale imply that benny is indeed very stupid or is it me who is?
Professor, I am heartened by your skeptical tone, and thank you for your clearly laid out concerns.
A few more months like this, and I think you may be set to join our pitchfork and torch ‘Abolish the Fed’ brigade.
Note that all this lending by the FRB was independent of the Bailout money provided to the Treasury. It alone has circumventing the immediate problems of banks unwilling to lend to banks.
So, what was the value of the bailout package?
It probably played a psychological role. Banks were reassured that they would get some new money. And the funds sent to banks may have contributed to the newly created confidence.
Given the new reality (banks willing to lend to other banks), we need to call the previous question. Does Obama really need or deserve access to an extra $350 billion dollars of cash for him to distribute according to his priorities?
My preference would be to refuse Obama what he wants and to attempt to claw back as much of the money given to AIG as possible, in the hopes that some more major players in this game will go broke, carrying other players with them, and by that means a substantial portion of the contracts that cannot be fulfilled will be erased.
I think that contracts that cannote be fulfilled by the private sector should not be fulfilled. Let the chips fall where they will.
If you don’t accept the above paragraph, what do you propose? Should the Federal Government borrow enough money to make sure that all the existing contracts are honored? What other option exists?
Professor,
Wow. Great post. Thank you for asking all the right questions. I hope we get some answers from the Fed soon, but I don’t think we will.
The danger is that the Fed thinks opacity is the best way to manage expectations. This is kind of like saying our problems would go away if we suspended mark-to-market accounting! The danger comes from the erosion of trust, and the availability of alternatives. Unlike the taxpayer, the dollar holder is not necessarily “on the hook” for the Fed’s losses: he can just elect to hold a different currency or a hard asset. The Fed seems to treat this risk cavalierly.
ReformerRay, “attempt to claw back as much of the money given to AIG as possible”
Money has not been given to AIG nor the banks. The government has entered into investment agreements with those firms.
I sympathize with your point on the contracts… but notion that a mortgage contract is non-binding helped us get into this mess (ie why not buy a second home, I can always walk away)
In 1896 Andrew Dickson White wrote a very informative book FIAT MONEY INFLATION IN FRANCE about the French Inflation leading up to the dictatorship of Napoleon. Compare this excerpt to Bernanke’s speech and what you are reading in today’s NYTimes.
The question was brought up by Montesquieu’s report on the 27th of August, 1790. This report favored, with evident reluctance, an additional issue of paper. It went on to declare that the original issue of four hundred millions, though opposed at the beginning, had proved successful; that assignats were economical, though they had angers; and, as a climax, came the declaration: “We must save the country.”
Upon this report Mirabeau then made one of his most powerful speeches. He confessed that he had at first feared the issue of assignats, but that he now dared urge it; that experience had shown the issue of paper money most serviceable; that the report proved the first issue of assignats a success; that public affairs had come out of distress; that ruin had been averted and credit established. He then argued that there was a difference between paper money of the recent issue and that from which the nation had suffered so much in John Law’s time; he declared that the French nation had now become enlightened and he added, “Deceptive subtleties can no longer mislead patriots and men of sense in this matter.” He then went on to say: “We must accomplish that which we have begun,” and declared that there must be one more large issue of paper, guaranteed by the national lands and by the good faith of the French nation. To show how practical the system was he insisted that just as soon as paper money should become too abundant it would be absorbed in rapid purchases of national lands; and he made a very striking comparison between this self-adjusting, self-converting system and the rains descending in showers upon the earth, then in swelling rivers discharged into the sea, then drawn up in vapor and finally
scattered over the earth again in rapidly fertilizing showers.
He predicted that the members would be surprised at the astonishing success of this paper money and that there would be none too much of it.
His theory grew by what it fed upon,as the paper-money theory has generally done.
“My main concern is that I think this kind of fiscal decision needs to be made by Congress and the President rather than unelected Fed officials. Towards that goal, in my opinion greater openness and clarity about the exact nature of those risks would be welcome.”
Absolutely correct but still frigthening. This crisis has gotten too big for the FED under its authority. I wonder how many members of congress have taken an economics class? When the TARP debates in late September made the evening news, guess what happend to the market fear index: VIX
I would like to second Arthur James’ comment. I am also intrigued by the question raised by ‘David Ricardo’.
I would note that when the risks of the debt held by fannie mae and freddie mac were assumed, the rate on credit default swaps for U.S. Treasuries went up to match that for Germany’s debt. Now, Germany is a staid and steady fiscal player and that thought may comfort some. However, they are the world’s biggest exporter, with an economy that is now smaller than China’s. Gobally, exports are set to fall more than output, perhaps by a lot, and I fear Germany is going to suffer plenty.
I don’t trust Ben. His citation of work by Hufbauer et al in Congressional testimopny, showing truly ridiculous gains from trade, indicates he is as much politician as economist. Looking at the fed’s accumulation of foreign currency reserves, one could make a case that it amounts to currency mercantilism. I think this may be shortsighted policy. The problem is currencies pegged to the dollar (including the implicit and loosely pegged yen), not those that follow the rules.
MiikeR says contracts must be “binding”. That is true in normal times. Some think the British got a leg up on the industrial-trade competition with other countries because they had a court system that enforced contracts. So, I do not advocate considering rejecting some contracts lightly. However, all the info I am getting is saying that the derivatives contracts are so much larger than the ability of anyone to pay them. If that is the case, we are going to see a gradual non-payment of contracts by bankrupcy contiune for months and years. That is a sure way to prevent the Obama stimulus package from working.
I repeat the question – does the private sector have the money to make good on all existing contracts? Does anyone know the answer to that? In the absence of informtion, are we willing to continue to allow the Federal Government to provide money to make good on a few of the “toxic assets”? Where is the fairness in that? Not fair to those not bailed out. Not fair to U.S. taxpayers.
“”Stabilizing the banks through direct capital injections was a good first step but before things can be really stabilized the government’s going to have to find a way to take the toxic assets off the books of the banks,” said Mike Carlson, a partner with Faegre & Benson’s restructuring group in Minneapolis. “Until that happens, things are not going to be able to move very quickly.”
The above quote is from an article posted elsewhere today.
I don’t pretend to know how the toxic assets can be removed from the books of banks. I just have a feeling in my bones that this issue is being avoided because it is too difficult to face.
I do not believe that having the Federal government guarantee or purchase all the bad contracts private firms and individuals have assumed is a good idea.
ReformerRay,
My only problem with your suggestion is the moral hazard leniency creates. If I know I can convince a judge to tear up a contract, I will sign any contract. Derivatives contracts are no different. It because death by a thousand cuts. Let one speculator off the hook and the whole system could collapse. Threaten me with debtors prison, and I will find a way to pay, even if it means canceling my cell phone and cable TV subscription.
Let’s just hope that going forward Ben follows E. Fama’s advice on how the capital injections to banks should be structured. There is no excuse for making the taxpayer pay. The lenders and equity holders should take the full hit. SAFEs appear to have largely moved out of such investments, but to the extent they have not, they should face the same risks as other investors.
It was obvious to anyone who looked at the Case-Shiller homeprice to rent ratio (or regularly read CR’s excellent blog) that housing had further to fall. And it was equally obvious that financial institutions have failed to fully recognize losses already borne. So, Ben’s statement that more bailout work is needed should be no surprise. But the government simply cannot afford to engage in the exercise of wealth maintenance. And it is aggravating that Ben appears poised to do just that. As aggravating as Paulson’s blind trust, built from bonuses and pay for the kind of performance that caused the current mess. If he had any integrity, he would turn over the bulk of these ill-gotten gains to the public.
`”My only problem with your suggestion is the moral hazard leniency creates”.
MikeR is right. Any solution I can think of to resolve this situation is undesirable. I don’t want to let anyone off the hook. But I would rather make that mistake than see all this uncertainity contiue about how large is the liability, who owes it and when will another bank fail. Also, any solution coneived by a thinking person is bound to be better than allowing the Congress and the President to continue to throw money at banks without knowing whether bank A or B or C has unsurmountable debts.
Can’t there be devised some better solution to our current situation than allowing bankruptcy to determine which contract is not fullfilled?
My main point is that this situation should be cleared up quickly. Quick bankruptcy is preferable to allowing the toxic assets to linger in the background like some monster whose dimension is unknown.
Just as recently as this past summer there was worldwide inflation. By September the problem became spiralling deflation. Anybody with an iota of economic sense can see this is not a normal recession. The question now is – can the central bank(s) of fiat currency(ies) use monetary policy to stop deflation? The bears (Austrian economy believers, Elliot Wave types, contrarians) say no.
The neo-Keynesians say that with appropriate fiscal policy stimulus – yes. Let us put aside the arguments as to the size and if it will be appropriately invested. Let us put aside that with fighting two wars there already was quite abit of fiscal stimulus Not being an economist, what jumps out at me is in this financial debacle is that the prime problem is the over over-indebtedness of main engine of the global economy – the American consumer. There was overbuilding – houses, car manufacturing plants , in the steel industry, electronics etc. created by an artificial demand fueled by easy access to credit given to the US government, US business, the US consumer, Eastern European businesses and consumers, Iceland etc etc etc Even mainstream types like Martin Wolf are saying “The bigger point, however, is not that the package needs to be larger, although it does. It is that escaping from huge and prolonged deficits will be very hard. As long as the private sector seeks to reduce its debt and the current account is in structural deficit, the US must run big fiscal deficits if it is to sustain full employment.
That leads to the third point Mr Obamas advisers must make. This is that running huge fiscal deficits for years is indeed possible. But the US could get away with this only if default were out of the question…
First, there must be a credible programme for what Americans call deleveraging…
Second and most important, the structural current account deficit has to diminish. The US private sector is no longer in a position to run huge financial deficits as an offset to the demand-draining external deficits. The public sector can do so only for a few years. In the long run, the world economy must be sustainably and healthily rebalanced. This is a huge challenge for international economic diplomacy. It is also an essential element of sound domestic policy.”
But are any of the Tarps and Fed lending making the financial sector bite the bullet and deal with the bad assets? Has the 7trillion dollars in money,loans and guarantees done anymore than postpone the pain? The banks don’t even trust each other. The money coming from the Fed is just staying in the bank reserves. The velocity of money has – slowed doesn’t begin to describe the deceleration.
This is not even mentioning that probably half the world’s population doesn’t get even the bare essentials of food and clean water.
There was unsustainable production of more objects than some people needed caused by too much debt. This debt created the overcapacity. But somehow Bernanke is going to pump enough money into the system to fix all this. At the same time he is going to be deft enough to withdraw it in a manner that will keep inflation from being a problem. If you believe Bernanke and Geithner et al and Summers et al and Barney Frank and Congress are going to fix this, I have some Citi stock you might be interested in.
gepay “If you believe Bernanke and Geithner et al and Summers et al and Barney Frank and Congress are going to fix this, I have some Citi stock you might be interested in.”
The appointment of Summers gives me hope. I have seen some very astute observations on his part. Geithner? He is not an economist and what I have heard from him seems to support the idea that to advance, follow the old playground rule, “Never say anything that everybody doesn’t already know,” modified to “what everybody thinks they know.”
“Nor do I take comfort in Bernanke’s observation that the Fed hasn’t lost any money on the new facilities– yet”
Didn’t they take a writedown on Maiden Lane?
https://econbrowser.com/archives/2008/10/the_federal_res.html#more
My main concern is that I think this kind of fiscal decision [to take credit risk on the balance sheet] needs to be made by Congress and the President rather than unelected Fed officials. Towards that goal, in my opinion greater openness and clarity about the exact nature of those risks would be welcome.
But part of the function of any central bank is to make credit available against good assets when nobody else will. This entire crisis is a replay of the Panic of 1825 – no more, no less.
If you won’t allow the central bank to make decisions regarding what constitutes a “good asset” (inclusive of haircut), then what are they being paid for? If they’re to have no discretion, you might as well replace them with a couple of clerks sharing a pocket calculator (or a team of gold assayers!).
I will go so far as to agree with your suggestion that a statuatory limit on balance sheet expansion might be prudent – but not necessarily! When things move, they move FAST and the last thing we need is (more) political gamesmanship at the height of a crisis.
and … oh yeah …
In Canada, the Governor of the Bank of Canada has broad discretion, but can be ordered to reverse his decision by the Minister of Finance. It is accepted that this would result in his resignation and, basically, make any situation worse.
What is the legal basis of Bernanke’s tenure? Can the Treasury Secretary fire him? Alone, or with congressional approval?
The Fed will be unable to exit the quantitative easing in time to prevent a serious inflation because the level of indebtedness, the cleansing collapse of which the the Fed is fighting furiously, would make a ‘market’ level of interest rates unbareably punishing.
Total debt in the US is on the order of 340% of GDP–double the level of the 1980’s. Indeed, including gov’t debt, debt is probably still expanding.
The Fed will keep rates low until inflation forces their hand.
I happened to just be reading the 2002 Berkshire Hathaway annual report and I thought it was fascinating that Buffett essentially predicted this current mess:
“Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system… parties to derivatives also have enormous incentives to cheat in accounting for them… two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth. Of course, both internal and outside auditors review the numbers, but that’s no easy job… expert auditors could easily and honestly have widely varying opinions. The valuation problem is far from academic: In recent years, some huge-scale frauds and near-frauds have been facilitated by derivatives trades. In the energy and electric utility sectors, for example, companies used derivatives and trading activities to report great “earnings” – until the roof fell in when they actually tried to convert the derivatives-related receivables on their balance sheets into cash. “Mark-to-market” then turned out to be truly “mark-to-myth.” I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive “earnings” (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham. Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown. Derivatives also create a daisy-chain risk that is akin to the risk run by insurers… A participant may see himself as prudent, believing his large credit exposures to be diversified and therefore not dangerous. Under certain circumstances, though, an exogenous event that causes the receivable from Company A to go bad will also affect those from Companies B through Z. History teaches us that a crisis often causes problems to correlate in a manner undreamed of in more tranquil times. In banking, the recognition of a “linkage” problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain. When a “chain reaction” threat exists within an industry, it pays to minimize links of any kind. That’s how we conduct our reinsurance business, and it’s one reason we are exiting derivatives. Many people argue that derivatives reduce systemic problems, in that participants who can’t bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants. And, on a micro level, what they say is often true. Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies. Charlie and I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems… One of the derivatives instruments that LTCM used was total-return swaps, contracts that facilitate 100% leverage in various markets, including stocks. For example, Party A to a contract, usually a bank, puts up all of the money for the purchase of a stock while Party B, without putting up any capital, agrees that at a future date it will receive any gain or pay any loss that the bank realizes. Total-return swaps of this type make a joke of margin requirements. Beyond that, other types of derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don’t understand how much risk the institution is running. The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Knowledge of how dangerous they are has already permeated the electricity and gas businesses, in which the eruption of major troubles caused the use of derivatives to diminish dramatically. Elsewhere, however, the derivatives business continues to expand unchecked… Charlie and I believe Berkshire should be a fortress of financial strength – for the sake of our owners, creditors, policyholders and employees. We try to be alert to any sort of megacatastrophe risk, and that posture may make us unduly apprehensive about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
Anyone who tries to claim today that nobody saw this crisis coming is either lying or deeply ignorant, as this was published 5-6 years ago.
Ajay,
My pet peeve with Buffett is that he complains that derivatives are financial weapons of mass destruction, yet he owns insurance and reinsurance companies. Is not a reinsurance contract essentially a derivative?
Warren pretty well described what was going to happen to AIG in 2002. Then there was Bernanke being picked to be head of the FED. Remember the deflation speech he gave also in 2002. One adds Paulson going from head of GS to being treasury secretary. My view is that a very small group of people knew but are being surprised by the severity and the swiftnes of the meltdown. Even Roubini has been surprised by the swiftness of the timing. This is why even the big boys on Wall Street were caught holding. It was too big and couldn’t be unwound in a timely manner. Enron accounting was just the tip of the iceberg. I think even the ‘masters’ are scared now.
Thanks for that very informataive piece by Buffett.
MikeR says “Is not a reinsurance contract essentially a derivative?”
Both are promises to pay if a contract cannot be fulfilled.
However, by law, derivatives cannot be regulated nor are Federal officials allowed to collect information on their distribution (Commodities Future Modernizaton Act of 2000).
I assume reinsurance contracts are public knowledge, subject to audit by insurance regulators. Reinsurance contracts have created problems for Loyds of London, I believe, but that problem did not lead to the meltdown of the English financial system. It did concentrate attention on the dangers of reinsurance.
As Buffett explained, it is the secrecy,intertwining and scale relative to firm resources of these derivative contracts that created the problem.
Buffett also warned, in Fortune magazine, Sept. 2003, I believe, that the tolerance of a massive trade deficit was harmful to the U.S. That prophesy is also going to be fulfilled, someday.
I was heartened by a report that said Obama liked to talk with Buffett. I was disappointed that no one linked to Buffett was picked on his economic team. Well, after Obama learns that the current crew is too wedded to mainstream economics to give good advice, I expect him to call up Buffett and get some reasonable advice on what to do.
Forgive me, please, for going tangential here.
I cannot help but wonder if a more efficacious macroeconomic policy than subsidizing consumption might be subsidizing savings via a grant of savings to households. We all seem to understand that stimulating consumption through tax cuts or related means of income transfers appears self-defeating in a time when households are compelled to restore their balance sheets (akin to banks restoring their balance sheets by cutting back on lending). They save what you give them through until some future time period when they are feeling secure enough to resume spending — perhaps when they are well off enough to be saving, say, 5% to 9% of their income. Either that, or they are so broke that they are spending every centime on food along the way
With savings in the bank, households ostensibly should be more willing to spend more from their income.
This brings up another paradox, which is that of accumulating savings (= wealth) in a deflationary setting when there is, in effect, zero return or less on assets (= wealth). Wealth would be de-cumulating, in effect. A household earns, it saves, and the value of its savings goes down. Therefore, perhaps the savings grants would have to come with returns guaranteed by government. And, certainly, the savings grants should be subject to vesting. Indeed, perhaps the vesting could be back-loaded in that the longer a household waits to draw on the grants, the higher the return, calculated retrospectively.
Is the challenge, then, to accumulate wealth faster than its erosion by deflation? That is difficult when, ostensibly, incomes are going down in a deflationary environment.
An extreme scenario suggests we will be reduced to a nation of day traders and hoarders of cash.
Beyond its superficial efficacy, an obvious question is whether promulgation of savings is a cheaper route for government at the end of the day than the fiscal stimuli aimed at increasing consumption.
You are the expert, and I defer to you.
Jeffrey: You have things a little confused.
When you save, you increase a cash position (or decrease a debt position). Cash becomes more worthwhile in a deflationary environment. Every dollar you save today is worth more tommorow.
Just as well, being in debt is dangerous in a deflationary environment because you will make less money in the future (as wages fall) or even be at more risk than ever to successfully service that future debt, as it actually increases in real terms even if in notional (dollar amount) terms it remains the same.
A contrary position in today’s environment is to take long asset / short dollar positions, as you are betting the dollar will be worth less going forward.
It is fascinating, since due to expansionary monetary policy, ever since breaking from the gold standard, that we’ve been in a strong inflationary trend for the last 35 years. We haven’t seen deflation in ages, yet most (those who are levered to assets already) are willing to take a pro-deflation position if not only for the sake of not having enough cash savings already and simply fearing a loss of future cash sources.
I for one would be fascinated to see what would happen if the US govt sent a $15K check to every member of society. Primarily, this might shift the bias away from cash hoarding to asset hoarding, and thus stimulate aggregate demand. But I think it might be wise to get a head start on bumping up energy supply (200 nuke plants + $500B electric car subsidy?), just so the inflation isn’t in the wrong places… (places that give US political enemies leverage over our economy)
This would quiet the dissent a little concerning the inherent wealth transfer that the Fed is doing to banks by design.
“This would quiet the dissent a little concerning the inherent wealth transfer that the Fed is doing to banks by design”.
But that would be wrong. We need more, not less, objection to “the inherent wealth transfer the fed is doing”.
Whether the Fed loses money on lending is too narrow a question. When a bank fails, the FDIC generally repays the Fed’s loan immediately and takes the assets itself. In the past, Fed lending has allowed some banks to remain open longer than they otherwise would, and has resulted in larger losses for the FDIC. This was documented in a study published in the FDIC’s Banking Review in 1999: http://www.fdic.gov/bank/analytical/banking/1999oct/2_v12n2.pdf