Reader FairEconomist left a short comment on an earlier post which we hoisted along with some other material, on why the bailout bill could make the illiquidity in money markets worse. He left a longer comment j that sets forth the issues, as he sees them, in more detail.
I hope readers do not mind my failure to add my own observations, but I found this discussion to stand on its own (and I think my value added is greater in cranking out some other posts!). Further comments very much appreciated.
For new readers’ benefit, commerical paper is short-term unsecured paper, up to 270 days, but most is 30 to 90 days (there is also asset backed CP, but that’s not the subject of discussion here). Large companies and banks use it actively to manage short term cash needs. It is good practice to have commercial paper backed up with a standby line of credit at a bank. Thus, if for some reason a company cannot roll maturing CP (ie., sell new commercial paper to replace maturing paper), they will use their bank back-up line. Those lines, when used, require a lot of equity relative to other bank products, and of course, also require banks to hand out cash when they worried about extending credit. So even when companies can solve their short-term funding needs by turning to their bank instead, it puts a further strain on already stressed banks.
From reader FairEconomist:
I’ve been thinking mostly about the durations issue, mostly because it’s really obvious something is going badly wrong in the commercial paper market. If you look at the volume report http://www.federalreserve.gov/releases/CP/volumestats.htm overall paper is actually *up* but the longer durations (20+ days) are way down. For example: the overall market average for the week of Oct 3 is 183,610, up from 2008 average of 148,710. But 20-40 day paper is only 6,778, *way* down from the yearly average of 15,864.
So the market has lost about 2/3s of its ability to convert liquidity to 30-day loans. 90-day is probably similar although there are technical issues with analyzing the chart because 90-day would expire during the end of year crunch so there probably isn’t much demand. Next week we’ll be able to look at 90-days again.
One of the most critical functions of the banking system is converting short-term deposits into longer-term loans for businesses. Much of the working capital market, for decades has come via money market funds (MM). Joe public or Joe CFO deposits money into a MM. That MM loans it to a bank (usually by buying paper, and usually at a medium duration) and then that bank loans it out to business for inventory, payroll or whatever. The MM has converted Joe’s demand deposit into a fixed-duration loan.
The problem we’re having is that people are fleeing commercial MM for treasury MM. Those are buying treasuries and thus converting the money to the desirable medium duration BUT that money is loaned to the Fed, and the Fed doesn’t make working capital loans. So the deposited money that had been made into working capital has been diverted into the Fed and lost to working capital.
The Fed is kind of trying to address this by loaning out money via various auction/discount windows. BUT, those loans have been overwhelmingly overnight – a particularly nasty demand deposit because it goes back so fast. For a bank to convert that to a 90-day loan it’s got to win 90 auctions in a row – a very risky deal with a crunch on. So the Fed undoes the duration conversion, and then some, converting the liquidity into a form that the banks can’t make into useful-duration loans.
Right now we have both commercial and treasury MMs. Deposits have shifted from commercial MMs to treasury MMs, and consequently we have less working capital (a commercial MM product) and better credit for the Fed (a treasury MM product). But, treasury MM rates are now very low and the gap between treasury and commercial fairly high, which creates an incentive for depositors to put money into commercial funds, producing some working capital.
When Paulson dumps out his 700 billion in treasuries it’s going to be at the short end. That will drive up rates for short-term treasuries. This will obviously draw even *more* deposits into the treasury MMs. That means even less in the commercial MMs and thus less working credit, the eventual commercial MM product. Hence Paulson’s billions remove working capital by competing for the deposits that could get used to make working capital loans. That 700 billion is going to go to fairly long-term mortgage securities. So Paulson’s billions divert credit from working capital to long-term mortgages – from where it’s most needed to where it’s most wasted.
Even if the giveaway adequately props up the banks, which I doubt, they still can’t make working capital loans, because the raw material they used (commercial MM deposits) will be desperately short.
I think it’s very telling that in two days of hearings and two weeks of discussion we have yet to see *any* detailed mechanism for how Paulson’s plan will increase the supply of, say, inventory loans. It’s not that every economist in the world is an idiot, it’s just not going to help. I think people have fallen into the fallacy that if it costs a lot it must be valuable. Paulson’s plan falls into the category of very expensive way to hurt ourselves.
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Yes the House has 2 days until it votes on Friday. It should use the time to call in experts. Paulson can send an expert too but there should be independent ones with different points of view also.
Guy, it’s only the country that’s at stake, do it!
Very interesting post, kudos to faireconomist
yves
you REALLY have to read this…
http://online.wsj.com/article/SB122291076983796813.html
The public is asleep in the backseat while the Treasury is driving and Congress is along for the ride.
As long as they vote to invalidate market-to-market vehicle values everything else is just pomp and circumstance. Most talk about how they detest this bill then vote for it. Others claim want to stop the damage when they created it.
In this bailout a few banks will be taken care of then the taxpayers are slammed into the wall.
I also want to throw in what I see as the solution to this problem. (This is largely independent of the Paulson plan). When people put their short-term deposits in treasury MM funds, or in treasuries themselves, they’re basically depositing money into Fed CDs. The Fed has become the Bank of the US. So the Fed needs to loan some of that money back out – basically the extra amount that wasn’t in Treasuries a year ago. (The rest has been effectively diverted to the federal deficit; but it’s been there for years and we should leave it alone for now.)
The Fed can’t loan directly – it lacks the expertise. So we should probably work through collateralized auction windows. One nice thing about collateralized auction windows is that the Fed can *force* some lending into a particular market by taking only that lending, or asset-backed-paper derived from that lending, as collateral. With the lending market as crazy as it is the Fed should probably force a lending into working capital simply because even short period without it are catastrophic. Things like credit card and equipment loans aren’t quite as time-critical.
Obviously we want to get out of the “Federal Reserve Bank of the US” as soon as we can. The Fed will need to allocate capital on a fairly fine scale. I don’t think the Fed should be doing this in general; but it will allow us to keep the economy going while we audit/nationalize/recapitalize/what-have-you the banks.
fred55,
I looked at the piece quickly. Yikes. I have this picture of the Fannie/Freddie mortgage black hole that sucks the economy into it.
Yves,
Thanks for the summary on short-term paper. If most or your readership is advanced (which seems to be the case)
you might use foot-notes for the benefit of earthbound non-specialists such as myself.
-keep up the good (sane) work. And you can’t have too many fuzzy animals for my taste.
Agreed.
The Treasury is crowding out the short end of the credit market’s yield curve by using its advantage of sovereign AAA+ credit rating. It’s debt schedule is unbalanced towards the short term which will force other credit market users to longer dated debt and force them to pay the costs of increased risk (cash flow uncertainty, inflation)
The liquidity trap is solved when there is excess credit, credit holders who could fill that gap are not because of obfuscation of financial balance sheets, rapidly deteriorating economy globally, unprecedented intervention in markets by government (new debt issues, short sale ban/reporting)
Since the economy is not on the verge of exiting the liquidity trap, the demand side will have to adjust. Like saving yourself by holding still in quicksand, many short term credit market users will need to change their business model. Credit Cards and Auto Loans will need to increase their gross margins so they can sustainably rely on longer term debt.
If the adjustment is drawn out, then the businesses that will suffer are medium sized businesses that have property as their choice of collateral, those in the service industry with little collateral and not enough cash flow history, and most politically important of all — manufacturers whose collateral are factories and heavy machinery that are difficult to liquidate (good luck finding a bank to take auto inventory as collateral beyond scrap value). The $25bn auto industry ‘loan’ is no coincidence, and it will be insufficient to see them through to 2010 when their new lineups will be ready. Chrysler will fail and that event will secure further loans.
Businesses will be destroyed because of the credit misallocation before the ship can be righted, deepening the recession. What is absolutely required are for the banks to publicly cleanse their balance sheets — using Japan as an example, and political donations by industry as support, this will not happen in the United States.
Nice post dude!
Re: "I think it's very telling that in two days of hearings and two weeks of discussion we have yet to see *any* detailed mechanism for how Paulson's plan will increase the supply of, say, inventory loans."
>> I spent the morning looking over The Proposal looking for duration, maturity and signs of contract substance relating to terms and obligations. I still have no clue who needs bailed out, who will get a loan, when it will be paid back, how cash flow will be structured, when, who, why, where, any details at all!
Last night I was screaming that this proposal had no clock and loans usually have time connected to them, versus just empty space. The Chrysler Bailout was an excellent example of a bailout that used time to in some way connect an entity to a contractual obligation, but all we have tonight is a bunch of retarded government politicians that gave us pork in the form of general bullshit related to some excise tax for Black Lung and Arrows for Children and shit that has no connection to the accounting fraud on wall street!
What we have here, is a group of mafia-backed pirates that are using this political opportunity to siphon $700 Billion from taxpayers to wall street. Nonetheless, the one smart thing they may have done, is to cut out the influence of corrupt lobby groups and just cut a crooked deal on TV and say who gives a shit about duration or honesty!
Because I mentioned the auto industry, one analyst published an 18% reduction in dealerships estimate
For what it’s worth, I had an estimate of 23.5% of dealerships over the next 2 years along with an annual new car sales of below 11 million in the United States by then as well
@ Anon 1:11
I think a big reason TPTB haven’t thought of this is that interconversion of durations is something the investment banks did very well for a long time. They could convert even money market accounts into multi-year consumer credit. But now investment banks are very much weaker, and now instead of demand deposits that will be in the bank days or weeks they’re having to work with overnight loans. And they just can’t do it, so for the first time in decades different durations are completely separate markets, rather than being fairly good substitutes for each other. It’s kind of a fish out of water situation – they’ve been in water so long they aren’t prepared to be in air and have been having trouble figuring out what to do.
The shift from commercial MM to treasury MM (and treasuries) is pretty similar to a traditional liquidity trap but with treasuries replacing cash. This is something that basically hasn’t even happened before, so again I don’t think they were even considering it. Fortunately we can operate even while in this particular liquidity trap if the Fed simply starts treating those treasury MM as demand deposits at the Bank of the Fed.
@evilhenrypaulson: I see you’re advocating a fix to this quasi-liquidity trap on the demand side (real interest rates going up) rather than my supply side. Theoretically, that’s a good approach when interest rates are so low. The A2/P2 spread is frightening, but the interest rate to the A2/P2 company is 6-7%, which seems pretty manageable. However, this adjustment isn’t happening. Do you have any idea why?
This kinda shows some (weak) stuff:
Daily Treasury Bill Rates
http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/daily_treas_bill_rates.shtml
Daily Treasury Bill Rates: These rates are the daily secondary market quotation on the most recently auctioned Treasury Bills for each maturity tranche (4-week, 13-week, 26-week, and 52-week) that Treasury currently issues new Bills.
Two more things:
Volume is way off and this related item:
Yields over benchmark rates on U.S. speculative-grade corporate bonds widened to the highest on record, according to Merrill Lynch & Co. index data.
The gap between high-yield bonds and similar-maturity Treasuries jumped 28 basis points to 1124 basis points, the widest since at least Dec. 1996, according to Merrill's U.S. High-Yield Master II Index. The previous high was 1120 basis points on Oct. 10, 2002.
The Pigout Proposal isn't intended to increase inventory loans, advertently or inadvertently. Paulson and Co. know this, and so studiously avoid any discussion. Not that there has been any economically meaningful discussion regarding the Steal-o-thon Proposal.
I appreciate FairEconomist's perspective, which encapsulates the issue very clearly. The Fed has the wrong tools; the Treasury has the wrong ideas; the Congress has the wrong friends—but they are all hard at work deploying what they have. This is an illustration of why the country needs a _publicly owned_ banking sector, which could intervene to loan to the public for inventory loans &etc. in a pinch with the government guarantee behind it. And again, all of the Fed's repo facilities do NOTHING to require the recipients of public protection to actually, yah know, lend to normal sound borrowers. The faciliated get something for nothing, while the public gets billed for everything. Sounds like a bad deal, am I right? (Vastly) more of the same, if Congress gets its way.
I wish the posters on this blog were running Treasury and the Fed.
I agree with the poster who said Paulson & Co. are not dummies either.
It's clear to me that this isn't supposed to "work". Or maybe it depends on what your definition of work is.
It might work very well for those who want to save their cronies and cause distress for everyone else.
Sorry.
@doc holliday: those unbelievable spreads imply default predictions of 11% per year for risky companies. Ouch.
@richard kline wrong tools, wrong ideas, wrong friends lol, very pithy!
faireconomist,
Short term rates likely will rise quickly/prohibitively and/or demonstrate significant volatility. Businesses in turn will seek longer term MM debt in part to allow them to proceed with their business, and in part to protect themselves from volatility.
I think the shift to watch will be on the demand side, the supply side is too disorganized and unresponsive for a myriad of reasons. Credit suppliers are gaming with each other as well as with credit seekers. It is a simpler decision making process to raise prices and move out of the way of the Treasury’s deluge.
I should seek out some data so I’m not just postulating, thanks for the encouragement to do so. Perhaps bank lines of credit have been preventing borrowers from restructuring their own business ? And in the mean time they need what they need, it’s too late because the deal was signed and work has begun?
A shift could take 6 months, but it will probably still be the right move in 6 months time
I can’t really figure out Paulson’s intent. The first version was a defrauding scheme (which is why the Nigerian-style fake emails were funny) but holy cow, seven hundred billion dollars! That’s some greed!
Bernanke is also behind this plan and he doesn’t have Paulson’s lifetime record of greed. I would think he thinks it could help. I don’t understand whhy he’d advocate a plan when he can’t explain how it works. That’s a very strange position for an academic.
My guess is that Paulson thinks his scheme would help but wanted to slip in some massive graft and unlimited power to punish and reward people. As an ex-CEO the power to make former rivals grovel before him for his essentially unlimited largesse has to be intensely satisfying.
fred55
Propping up house prices will turn what should have been a sharp, painful correction into a decade(s) long slump. Because there is no way the median American can afford housing at current or higher price levels unless incomes go up (not going to happen) or mortgage terms are even more lenient than they are now – multigenerational option ARMs, anyone?
It is painfully obvious they're just trying to kick the can across the finish line – some people imagine this finish line to be after the November elections, I think it's more like 2-3 years from now. When that day comes, you had damn well better be prepared.
On the subject of stock futures:
I see futures are down a bit, this does not surprise me. The S&P would have closed lower yesterday but for the rally in the financials. The financials have taken a serious beating over the past 3 months, it is time for a bear market rally with or without the 'good news' of the bill passing. Everything else has no reason to rally with all the bad data coming out.
My understanding is that Paulson will be able to buy anything he wants with his pile of paper. So what’s to stop him from wading into the CP market?
@evilhenrypaulson
I like the idea of a demand-side shift in the long term. I wouldn’t be surprised if it took some time. For that reason I think we do need a “Bank of the Fed” supply-side approach for at least a while, although I would like the “Bank of the Fed” approach to be short-duration.
My inclination would be to provide liquidity, but not quite enough, so the market will do some adapting to the new credit regime, which is going to be tighter than the old one. The businesses and consumers being squeezed by the credit crunch are mostly ones that should keep going; but of course there are some businesses that should be closed and some consumers who should stop borrowing. Closing everybody down is catastrophe; but continued operations/ borrowing by the insolvent is still a pretty substantial loss and needs to be stopped as soon as possible.
Honestly first time I have even looked at this report, very interesting.
Interesting things I see..
In the AA financial, monthly averages, huge jump in the sep 1-4day, none at the end of last quarter like that. Seems to come at the expense of 21-40 and 81 plus, probably seeing the same thing you are on that one.
On the daily AA financial, where does the money go after the 30? Huge drop off n the 1-4 day, no uptick in any others really. Again I assume that the end of the quarter has something to do with it…
That AA asset backed is getting completely crunched, especially on the daily. Who is sticking their neck out on the long end of that? seems to be rising just a little bit….
Very interesting report…
Seems to me the good news is that most lenders will not be in a hurry to default their borrowers if they can help it. A cooperative semi-performing borrower is a better prospect than a bankrupt borrower under current circumstances.
I have posting disease tonight, hope this doesn't piss anyone off. Sorry to be like a grasshopper but this is just a reaction:
"When Paulson dumps out his 700 billion in treasuries it's going to be at the short end. That will drive up rates for short-term treasuries. This will obviously draw even *more* deposits into the treasury MMs."
>> There has been a worry that too much supply would crash yields, because as with housing, this is like a bubble, adding too much inventory into the system. This is the problem with synthetic support to try and un-freeze this system, i.e, they could push in too much inventory, drop yields and make the cost of buying liquidity more and more expensive, which dilutes the value of the present value "investment". This is a liquidity trap IMHO, so adding money into the wrong hole is meaningless, thus the way to de-thaw the freeze-up and create liquidity and make cash flow is a matter of building macro/global confidence and allowing people to see realistic future values. If the stock market drops another 10%, that would create a buying opportunity (for many) but would it generate liquidity to de-freeze things?
What you want IMHO, is for people to buy bargains and take cash out of a panic state and get people interested in future value securities; the only way to do that is to let stocks drop in value — because stocks are still overvalued IMHO and obviously, so are short-term Treasuries.
I think I saw that longer term things were actually ending up attracting some attention from some people that were selling securities and then dumping that cash into longer maturities, where the investment would just weather this hurricane, like a shrimp boat in Forest Gump.
The other matter, I always harp on is the fact that confidence is related to a state of arms length exchanges which are not risky, i.e, people gain confidence and have trust to do a deal. That confidence is a matter of social norms more than market norms at this point, i.e, people distrust the market, they distrust wall street, distrust washington and thus this freeze is a social condition that requires stability and obviously the political circus with this bailout has poisoned the well even more and if they had asked to steal $2 Trillion instead of $700 Billion, the level of distrust would be even greater — so these retards all need to back off and stop screwing around. They need to allow the market time to correct and then give time for people to evaluate investing in a calm … more relaxed … environment. As these elected clowns manipulate this event into a chaotic casino, they risk taking the current financial temperature of about 40 degrees and plunging it far closer to zero and below.
The system has problems, but as with TARP, they have failed to identify where the clogs are, which banks need bailed out, they fail to provide confidence in a solution and thus they add to the problem and have an on-going accountability problem and fail address fraud and corruption — instead, they reward it and roll around in it without any shame and they fail to gain confidence or instill trust!
Oops..
@slimcarlos: The legislation allows Paulson to wade into the CP market and indeed to serve as the Bank of the US if he chooses. However, his stated intents and the plans in the industry conference call are not compatible with that; he’s planning to buy assets relatively slowly and presumably hold them a while. If Paulson gets his powers, I hope he realizes that he needs to be in CP (and other important short-term markets), not mortgages before he’s completely throttled the economy.
Geez, if Paulson gets his powers. I am still shocked and horrified that the idea of giving one man virtually unlimited control over 700 billion dollars is under serious consideration and indeed inspires anything besides hysterical laughter.
FWIW, long article at the NY Times discusses the panicky markets of Sept. 17 and 18, with reactions from officialdom. It makes it sound as if the choice to use mortgage assets for the TARP was a quick decision made early on that was never questioned. So if it later comes under question, it looks like this will be seen as a “fog of war” decision.
I betcha Dean Baker has some withering comments about the piece…
Doc hoilday,
Get paid to make the problem, sell it to someone else, wait, offer to help fix it, get paid to fix it, and then buy it back at the end for a lot less than you sold it for.
The guys who put this crap together must be the most valuable guys in the world right now, only they know how to take it apart, and what parts are worth buying. We get to pay to them to take it apart, and end up with what is left. Thanks.
First of all, kudos to FairEconomist, EvilHenryPaulson, and Yves for a great post and comments.
Second of all, that WSJ article on home prices is exactly what I figured would happen when Fannie and Freddie were nationalized. I’m not some nut anarcho-capitalist, but the idea of the government being in charge of the vast majority of the mortgage market is so stupid, I don’t have words for it.
Do not doubt that what that article proposes is what will happen. Now that the majority…the democracy…has its hands on the means to lift home prices, that is exactly what is going to happen. If you don’t think it will happen, do you also think the bailout was ever in jeopardy? Do you also believe the government is going to repeal the mortgage interest deduction?
The article speaks of loans, but without down payments (the article suggests that the problem preventing “normal functioning mortgage markets” is “down payment requirements”), THE GOVERNMENT WILL REALLY JUST BE BUYING HOUSES FOR PEOPLE in return for a small mortgage payment at low rates. This is insane…and will end in a total disaster…and no matter how much we fight it, it is going to happen. The die is already cast.
{Maybe the perma-bulls are right…this site is making me a pessimist).
@doc holliday:
I have thought for some time that the correction from a bubble serves the purpose of reducing excessive asset prices (in general, not just stocks). As long as prices are out of whack resources are misallocated (in our case all those ghostburbs-to-be out in the desert, inter alia). It’s kind of an Austrian attitude although I believe in the value of traditional economic tools like indifference curves strict Austrians reject. This is actually another reason Paulson’s plan is bad – it props up asset values for MBS and thus will delay adjustment to “true” prices. But the Fed doesn’t publish a daily report on capital misallocations so my main argument is against the short-term capital diversion issue.
@yves: I notice the article focuses a lot on the threats to Goldman Sachs and Morgan Stanley. To me it seems the money market run is far more consequential. Paulson might look on it differently. Certainly there’s nobody who’ll benefit more than MS and GS, who have lots of heavily-written-down MBS to sell without taking a capital hit. Save Wall Street, save the world?
@ 2:24 Yes, US governments at all levels are eager to push up house prices for a variety of reasons and that’s going to produce an efficiency loss. The likely politicization of Fannie/Freddie will probably make things worse. Perhaps we can make affordability part of their goal.
faireconomist,
My apologies for not reading your post close enough. I took the comments about the Federal Reserve to be about how they are the only ones do lending with the banks, and thus increasing the liquidity premium of treasuries.
I completely agree with the sentiment of your posts that MM impairment should be where the government should set up a line of defense. I’m just not sure if it can coexist with the Paulson plan, there is only so much money they do have.
$700bn is more than the market capitalization/book value of how many banks? They could ensure the continuity of liquidity by establishing new government-capitalized banks, with the goal of later privatizing them OR they could force the existing banks to cleanse their balance sheets and have guaranteed full recapitalization by the government in exchange for equity on an equal basis to the percentage of Tier 1 capital the government injected.
Those are the 2 ends of the spectrum of domestic solutions that I see. We have to wait until Paulson hires fund managers before we get to find out what his plan is, but I remain unconvinced that it is a solution.
Who the treasury deals with and on what terms will be a subjective decision, it can’t help them all and there are few objective metrics (state pension fund vs money center bank).
The chance of properly allocating the money properly is slim. The Treasury is choosing to deal with individual securities, of many different compositions, and many different parties, of many different incorporations. The plan is unmanageable if it is equitable to all participants (and not let’s get Goldman Sachs $100bn, JPM $300bn, BoA $300bn). The plan will also take a long time to start, a long time to act, and provide no immediate resolutions.
Finally, even if Paulson’s plan is perfectly executed the problems spurring the passing of the bill remain. Establishing confidence for interbank lending is not addressed. Establishing strong capital ratios is not addressed.
Counterparty failures and money market lockups should remain.
This wasn’t a plan to restore the banking system, this was a plan to get banks enough money so they could make their own choices in the next quarter or two. Paulson still thinks like an industry exec, unlike Bernanke who is unfortunately overwhelmed.
Let’s assume Paulson did consider alternate plans we have discussed and has no self-interest — why would he might not choose them, what does he know?
> Equitable rescue of institutions too large (say $4tn shortfall), need to play god in choosing winners
> There is no solution, calm the situation until the next Treasury Secretary can have a chance to fail
> Any solution requires a global accord, something not possible under Bush
@faireconomist:
>> However, his stated intents and the plans in the industry conference call are not compatible with that;
I don't dispute this, but since when has consistency been hallmark of this briantrust? Especially over the last couple of months?
My sense — and this is reenforced by the initial 3-pager — is that Paulson wants a pile of money to deploy as he likes, without oversight. He wants to turn the Treasury into a prop desk. If he has to pin himself down to specifics to get the bill through, then so be it. But since when has a pitch doc been a good basis to evaluate any proposal?
If this bill passes Paulson will have umtrammeled powers to throw as much money as he fits fit whereever and however he likes. Without oversight.
This may rub some of you the wrong way, like those who care about sound money and, say, the constitution. Gripe gripe gripe! I just don't think one has any other choice. Bubbles don't go backwards. The debt has to be monetized and the sooner the better.
@evilhenrypaulson
Equitable rescue of institutions too large (say $4tn shortfall), need to play god in choosing winners
That’s a VERY attractive hypothesis. It’s very possible that it would take too much for the US to reasonably provide and that Paulson/Bernanke would know it. It would also provide a functional goal they would not want to admit to Congress.
That’s a daunting thought, though. What if we really can’t recapitalize the banking system? We’re in for a really rough time then. Makes me wonder what the meaning of an economy-wide decrease in credit it. Time to try to wrap my neoAustrian brain around that.
@ slimcarlos – Agreed, Paulson wants THE POWER. That said, I do think we have some idea of his intents. The conference call, for example, was partly to tell financial firms what they are supposed to do under dictator Paulson.
I don’t have a problem with partial monetization. I mentioned above I think the “purpose” of recessions/crashes/panics is to correct mispricing. But if currency stays stable while real assets drop, you have a problem with everybody abandoning other assets for cash. If the inflation rate matches the asset price decline rate, though, the asset price stay level in nominal terms and there’s no reason to dump them.
1. Re: 2:45: "The guys who put this crap together must be the most valuable guys in the world right now, only they know how to take it apart, and what parts are worth buying. We get to pay to them to take it apart, and end up with what is left. Thanks."
>> I often think of this (wall street) as a nuclear reactor which is currently run by drunks and meth addicts. As a group, they know the system, but run it with reckless abandon and have given us a financial chernobyl. It is insane to allow these people to continue and it is also insane to allow plutonium derivatives to be swapped around like bottles of booze at a casino.
2. Re: faireconomist said…This is actually another reason Paulson's plan is bad – it props up asset values for MBS and thus will delay adjustment to "true" prices.
>> I still think there is TARP language that allows for derivative extensions of MBS things, i.e, as in exchange traded indexed, linked-backed casino chips — connected to thin air, which never had any value, beyond being bad bets.
If these types of bad bets are propped up, then why not prop up the floating price of rice, nickel, art, arrows or any possible side bet on any activity that someone took an economic interest in at one point?
Government intervention prevents the proper valuation of free exchanges by interfering with market reality and thus I agree with your train of thought on bubbles as a mechanism for reducing excessive asset prices — to a point where there is mutual agreement about true value.
These derivatives that I think will be in TARP have no value and there never will be an agreement as to the value. I often use JDSU circa 2001'ish at $1000 per share as an example of where this is headed, because those shares are now worth closer to $5.00 per share and never, ever will get close to $1000, unless they get placed into something like TARP. TARP is where by magic, Paulson will bless unknown asset values with holy water, which will make them very rare and thus the value will explode exponentially, because everyone will demand an opportunity to obtain shares that are connected to rolls of 10 year old fiber cable that were worthless, but now have value because they were made of copper — it's a friggn gold mine, just sitting there (worth a fortune baby), these shares are worth over $2000 an ounce ….
TARP is a conduit for fraud which takes derivatives and then buries them deeper, for a longer time, and in the meantime, as they buy time, no one will remember or care about Ken Lay or Paulson.
I enjoyed your post and sorry to get off track! I do think yields will fall from lower corporate earnings and too much government inventory, so, I'm still scratching my head as to how this may work out.
@faireconomist:
>> But if currency stays stable while real assets drop, you have a problem with everybody abandoning other assets for cash. If the inflation rate matches the asset price decline rate, though, the asset price stay level in nominal terms and there's no reason to dump them.
Printed money, especially en masse, will be almost impossible to direct. It is certainly not the most efficient way to allocate capital. But on one thing can we be certain: the more paper printed, the less worth the paper. As measured against everything. And, frankly, that's the idea. The less the money is worth, the less onerous the debt.
I believe this is how it will play out. I mean, this is how every other bankrupt country does it and there is no reason to think the US is any different.
That 3-pager from Paulson was the writing on the wall. Johny got his gun.
So FairEcocnomist, I’m a poet and a jackleg cultural historian, specifically a civilizationist, so I have to hoe this one with the tools _I_ own. But I greatly appreciate when those with specific expertise on the technical issues hold forth here. Keep it up; we need to hear what you know and surmise. —And this is how I learn, too.
So EvilHenryPaulson at 2:08, “raise short-term rates” and demand siders “increase prices.” From a reasoned if non-technical perspective that is _exactly_ what I expect once we get past the immediate delationary air bubble in the credit stream. Can’t fight the Treasury tsunami, so crank up the rotors on the inflation swamp buggy.
<< I'm not some nut anarcho-capitalist >>
Hey, wait a minute. I resemble that remark! Free markets are free of regulation. No freedom, no market.
The villian in this scenario is Bernanke, trading AAA for trash, which Paulson wants to trump with bigger sugarplums, instead of letting the market decide which firms should die. Take away GSE slapstick, there wouldn't be any crisis today.
Slander not the anarchists. We did not elect Congress, voted for no President, kept our powder dry and bought gold as an example of good sense and right reason.
evilhenrypaulson wrote:
If the adjustment is drawn out, then the businesses that will suffer are medium sized businesses that have property as their choice of collateral, those in the service industry with little collateral and not enough cash flow history, and most politically important of all — manufacturers whose collateral are factories and heavy machinery that are difficult to liquidate (good luck finding a bank to take auto inventory as collateral beyond scrap value). The $25bn auto industry ‘loan’ is no coincidence, and it will be insufficient to see them through to 2010 when their new lineups will be ready. Chrysler will fail and that event will secure further loans…..
For what it’s worth, I had an estimate of 23.5% of dealerships over the next 2 years along with an annual new car sales of below 11 million in the United States by then as well
I work for small/mid-size company delivering atuo parts to dealers for one of the big 3. When I hired in a few years back, I asked what they would do if the automaker filed ch 11, the answer was they owned the trucks and trailers free and clear and could borrow against them. Plus while the pre-bankruptcy receivables would be worthless, all the post bankruptcy bills were as good as gold.
My life could get interesting before this is all over.
Have a question … The problem we’re having is that people are fleeing commercial MM for treasury MM…
Why? is it security.. if so, then the guarantee provided to MM should have taken care of that .. why is that not happening then?
So Yves re: the NYT piece on the ‘sudden decision’ to buy mortgate securities wholesale, I know that you know that this concept has been pushed from within the financial industry _for over a year_. NOT a new idea. I don’t believe for an instant that this was a sudden decision. Rather, I believe that a window of opportunity to force it through was suddenly perceived, and instantly acted upon.
The stench of this entire _process_ behind the pushing of the Pigout Proposal, even more than the proposal itself, is mentally asphyxiating.
While I would be against the TARP if I were a US taxpayer, I think FairEconomist is too gloomy here. He seems to be forgetting that the whole point of the extra treasury sales is to fund the purchase of the banks’ crud. What are the banks going to do with that money? Answer, buy some asset that is safer than crud (unless they want to upset the authorities). In the extreme, the banks might buy all the extra treasury bill supply, in which case there is no net increase in treasury supply. Alternatively, they might leave some treasuries for the money market funds and buy some CP. And the banks are certainly left no more risky (probably less risky assuming that the TARP overpays).
Overall, the TARP takes long term, credit-risky assets out of the private sector and replaces them with treasuries, while enhancing the banks’ capital to the extent that it overpays, so I do not see that it can reduce confidence in the private sector.
Of course, what the TARP does to government credit, and by implication the taxpayer, and to moral hazard is another matter, which is why I would be against it if I was a US taxpayer. Come to think of it, since the private sector includes UK banks, I suppose I should be grateful!
I think it was a comment by Krugman, and he may have been quoting others, that the Treasury is likely to exchange its Paper directly for the Bad Assets it is buying, rather than a market sale of Paper by Treasury to raise the cash to buy the Bad Assets.
Did you know many of the fat cats who circulate from board to board and from job to job throughout the financial industry are also members of the Bilderberg Group and or the Trilateral Commission, founded respectively in 1954, and in 1973, in New York City? When someone takes your money and steals your car, it makes an impression. When they belong to such a shadowy political clique, it leaves an indelible impression. Many elected officials even belong to these cabals. When Bill Clinton eased banking restrictions, he dished out $8-billion dollars for “community reinvestment loans.”
When the financing schemes fell through, as is their wont whenever 30-million Mexican nationals buy inflated properties and default, it left banks in the lurch. Hillary Clinton counted on the loan giveaways to buy votes. Interestingly enough, had Hillary secured the nomination; she, instead of Barack Obama would preside over the bailout. So, where’s that $8-bilion plus dollars? Where’s Hillary? Why the caveat in Section 8 of the bailout: “Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency?”
The Global Initiative people (code speak for car thieves) took my money; they did in fact steal my car. If you or I did half the things these people have done, we’d be serving consecutive life sentences. Wise up, get angry, and let the bubble burst. A bailout buys us nothing. World markets will not rebound; they know the bailout does not address the fundamental reason(s), wholesale corruption, illegal immigration, and dependence on foreign oil, that there is a problem. As a result, after cashing in on the Politically Correct loans, Hillary herself even held her nose and voted yea on the odious bill. Gentlemen, I want my money back: http://theseedsof9-11.com
If i understand this correctly, without all the details–Foreign central banks for years have picked up much the federal deficit. This plan pushes us to the point that our large overseas creditors cannot afford the required loans to the Fed and the money will have to come from domestic savings and the money market, depleting both. This hastens the recession that “they” have so desperately tried to avoid
Future commercial– “Can’t get a personal or business loan– That’s OK — Come on down to your local branch of the NEW FEDERAL RESERVE CONSUMER BANK just approved by congress. Now you can get loans for any thing you need, car, vacation, business, personal, at VERY good rates”..
@ Richard Kline –So Yves re: the NYT piece on the ‘sudden decision’ to buy mortgate securities wholesale, I know that you know that this concept has been pushed from within the financial industry _for over a year_. NOT a new idea. I don’t believe for an instant that this was a sudden decision.
That’s very interesting. Do you know who’s been pushing this and do you have any links?
@rebeleconomist –
The 700B may not be enough to truly salvage the banks. They may still not have adequate equity. But in any case, banks don’t make loans directly from equity (basically). They use equity to lever up loans from the public/other companies and then loan out *that*. Even if the banks have equity, they will be able to make very few working capital loans because the quasi-liquidity trap and the TARP will suck their loans into Treasuries, both ones made to the banks and made by the banks.
You’re certainly right that the UK gets the benefits without the obvious direct costs. The frightening part is that the TARP’s intensification of the quasi-liquidity trap into Treasuries *can* spread worldwide through the Eurodollar markets. Maybe even affect capital markets in other currencies; I haven’t thought about that yet. So it’s possible even you might be hurt more than helped.
The urgent problem addressed here, of all parties shortening their intermediation horizons, makes a future “Operation Twist” by the Federal Reserve all the more likely.
I don’t want to spam the Board, but here is an excerpt of what I posted recently on that subject. Because this topic is rarely addressed and seems quite timely, I thought it appropriate to revisit it briefly:
“As Senior Economist Gordon Sellon of the Kansas City Federal Reserve discussed in his seminal paper “Monetary Policy and the Zero Bound: Policy Options When Short-Term Rates Reach Zero” published in the Fourth Quarter 2003 edition of the Kansas City Federal Reserve’s “Economic Review”, the Federal Reserve should now consider under taking “twist” operations in the open market.
That paper is available here at the bottom of the link:
http://tinyurl.com/4o9a82
A “twist” operation by the Federal Reserve in the current context would consist of the Fed SELLING 3-month Treasury Bills while simultaneously PURCHASING 5-year Treasury Notes. Such operations, applied judiciously, would affect the term structure of various markets in a positive way.
Such “twist” operations are not without precedent. It was performed during the Kennedy Administration:
http://tinyurl.com/524lk5
This is not a cure-all, but it is clear that it should be on the short list of our policy options.”
Matt Dubuque
FairEconomist,
I do not see why the TARP sucks loans into treasuries. Let’s keep it simple; let’s make the conservative assumptions that the TARP pays fair value for the crud (so that the operation does not increase banks’ capital) and that the banks use all the proceeds of selling the crud to the government to invest in the treasuries created to fund the TARP (in the other, more concise words of Erich Riesenberg, the banks get to exchange bad assets for good). Now the banks have the same capital and a less risky asset portfolio. How is that going to suck loans into treasuries?
From a financialist/monetarist point of view(Paulson/Bernanke) its not hard to see their intent. The problem to them at the foundation is MBS, if they prop them up, things will get better.
This is the final stand of the monetarists and they’re basic misunderstanding of the 30s. It was never about dropping loads of money to pump up a deflating bubble, it was not to allow the bubble to form in the first place.
The fact is all the pork put in the Senate bill will be more helpful than the 700 billion.
Good luck to all
RebelEconomist said…
FairEconomist,
I do not see why the TARP sucks loans into treasuries. Let’s keep it simple; let’s make the conservative assumptions that the TARP pays fair value for the crud (so that the operation does not increase banks’ capital) and that the banks use all the proceeds of selling the crud to the government to invest in the treasuries created to fund the TARP (in the other, more concise words of Erich Riesenberg, the banks get to exchange bad assets for good). Now the banks have the same capital and a less risky asset portfolio. How is that going to suck loans into treasuries?
You just answered your own question. The fresh capital is going right back into Treasuries, not into loans to the rest of the economy. It’s a closed loop transaction.
Money trickles UP in our present economic structure, not down.
The people should be borrowing from themselves FOR themselves, not for banks. Banks are too high up in the pecking order.
I share with you a major concern about the proposed Wall Street bailout bill and its many little understood implications. Nonetheless, the focus for the next day should be on getting the House of Representatives to once again dump the bill.
As the WSJ Real Time Economics blog reflects, our Congressmen don’t know much about economics. So address that limitation, I have sent a letter to my Congressman and House leaders that focuses on what I believe are the understandable top-level issues. The following is the text of that letter which any of you may use if you wish:
———————–
I ask that you vote “NO” on the Wall Street bailout package now before the House. No matter what amendments have been made, the various “sweeteners” are no more than more lipstick, rouge, earrings, a tight fitting dress, and maybe a girdle on a very ugly pig. In some cases, they actually make the pig uglier. Here are the key reasons the Wall Street bailout pig is so ugly:
The proposed legislation does not focus on the right problem. The critical underlying problem in our economy is the growing number of foreclosures and related decline in the US real estate market. This bill does not address this core problem in any meaningful way.
The proposed legislation is inadequate to the task it intends to tackle. Even if all the $700 billion were extended as credit by the receiving banks, it would be insufficient to bail them out of the multi-trillion dollar liquidity shortfall they face. The Treasury and Federal Reserve have already extended over a trillion dollars in direct aid or guarantees to Wall Street—and credit conditions have worsened. Remember Einstein’s definition of stupidity: Stupidity is doing the same thing over and over again and expecting a different result.
The proposed legislation will not result in significantly expanded credit availability from Wall Street to Main Street. Because of their huge leverage—20-30 times their capital—the banks will need virtually every cent to shore up their capital reserves and will be able to use little of it to reduce the credit crunch. The Fed and Treasury’s trillion dollars-plus already extended to Wall Street has accomplished nothing in easing credit conditions. Many major and regional banks are illiquid and some are nearly insolvent. They are in no position to loan money.
The proposed legislation rewards the outrageously pathetic, if not outright corrupt, financial management of the banking industry. Banks that knowingly failed to be diligent about risk management and some that participated in fraud will be bailed out. Indeed, the mismanagement of major banks is systemic and has metastasized the illness in the housing industry into a global financial cancer. It needs to be cauterized, not subsidized.
The proposed legislation will ultimately leave the US taxpayer with hundreds of billions of dollars in losses added to the national debt and our taxes. To make any sense at all in achieving its intended goal, Treasury will have to pay a premium for this toxic financial waste. The taxpayer will ultimately eat this waste no matter what warrants, equity, or other arrangements are introduced.
I appreciate the political compulsion to “do something,” but doing the wrong thing—and this bill is a costly wrong thing—will be worse than doing nothing. Take time to consider what the right investment in renewing America’s economy is—an investment that focuses on causes, not symptoms, the suffering, not the self-indulgent, and the many, not the few. Please vote “NO.”
Anonymous,
Effectively, there is no money and no fresh capital when treasuries are swapped for crud. The government could achieve the same risk transferring result by entering into a total return swap with the banks.
Like I said, I am against the TARP on public expenditure and moral hazard grounds, but it is important to be careful about the arguments against it, so that the good ones are not obscured by noise.
FairEconomist, I still don’t get it. Why are you so convinced that banks will invest in t-bills, and furthermore, even if they do, won’t it be a form of tier-1 capital vs. tier-3, thus improving their solvency even if the $ amounts are the same?
If you want to increase the supply of CP, let life insurance companies hold non-AAA rated CP as permitted assets.
Problem solved.
Next?
@faireconomist:
>> The 700B may not be enough to truly salvage the banks. … Even if the banks have equity, they will be able to make very few working capital loans because the quasi-liquidity trap and the TARP will suck their loans into Treasuries…
I again think we're being presumptuous with regards to what Paulson will do with this facility. As I mentioned above, he wants to turn the Treasury into a prop desk. There are no constraints within the legislation that will prevent him from doing this. He can, according to the bill, drop cash from helicopters. This is not a figurative statement. Literally, he can drop cash from helicopters. If you disagree, pls tell me where in the bill it says he can't.
Secondly, this is not a $700b fund. The $700b number is simply a headroom number for the balance sheet which says his inventory cannot exceed $700b at any one time. It is not a cap on losses.
So, to re-phrase, this bill will enable Paulson to drop an infinite amount of money from helicopters.
Where am I wrong?
This is one of the last places left to provide feedback on the US government bailouts…sigh.
Citizens are being blocked from contacting our representatives by email and locked out of editorial commentary, letters to the editor, and other feedback mechanisms that were, until recently, available. We are being silenced.
We are being subjected only to misinformation, illogical arguments, and propaganda on our airwaves & print media regarding this PIGGY, fascist bailout promoted by the US government and US corporations. And when the media chooses not to engage in these direct tactics, they are resorting to myriad distractions.
The media is not alone in creating confusion and silencing the opposition. Yesterday, I got an email supporting the “Emergency Economic Stabilization Act of 2008" from Fidelity Investments. (I sent them an outraged email back…no response was received.)
If any term in this piece of legislation was economically, financially, or politically justifiable, none of this public abuse would be necessary. If we actually lived in a democracy, none of the public abuse would be tolerated.
I have a question re: the original post… My understanding is that Treasury will be taking bad assets off the books of banks. In so doing, they’ll be giving banks $700 billion of cash in exchange, which the banks can then use to either pay liabilities (if they’re looking to reduce their leverage) or redeploy by lending out. Either way, the $700 billion is cash that will be available for lending to businesses, consumers, etc.
Seems to me that the “crowding out” dynamic that you mention doesn’t account for the other side of the coin of this bail out plan, which is critical. Am I missing something here?
There are of course still many questions about how this plan will be implemented fairly yet expeditiously, but big picture, so long as the banks play ball and the prices at which Treasury is buying their bad assets don’t bankrupt the banks (a big issue, granted), doesn’t the bail out achieve the intended effect of getting credit flowing again?
Thanks,
Raj
@12:22 PM FairEconomist, I still don’t get it. Why are you so convinced that banks will invest in t-bills, and furthermore, even if they do, won’t it be a form of tier-1 capital vs. tier-3, thus improving their solvency even if the $ amounts are the same?
Remember, the banks don’t invest their own money, they invest the money loaned to them. People have already shifted from commercial MM to treasury MM. Issue lots of 3-month T-Bills, T-Bill rates go up, T-Bill MM accounts pay more, and more people switch their deposits from commercial to T-Bill MM. The banks are then required to invest that money in T-bills.
@ SlimCarlos: I again think we’re being presumptuous with regards to what Paulson will do with this facility. As I mentioned above, he wants to turn the Treasury into a prop desk. There are no constraints within the legislation that will prevent him from doing this.
But there’s nothing that makes him either. Everything he’s said so far indicates he’ll do exactly the wrong things. You can’t trust the future of the world to a man who said he will (unknowingly) destroy the world because he *might* come to his senses and let us live.
Raj,
I’ve been wondering exactly the same thing you wrote about – it seems that the $700 billion+ bailout could get credit flowing again since it’s money that banks could deploy. However, I think this might not happen for several reason:
1) For all their public comments, my guess is that banks know that they have lots of problems, for example ARM resets coming up that are tied to LIBOR, that could lead to more write-offs. In anticipation then, banks keep bailout money to offset these forthcoming losses.
2) Many customers who would qualify for loans in the past would no longer qualify under today’s stricter lending environment, especially if they already have large outstanding debts. Thus, no loans and no credit flowing.
Having said this, I must also say that I’m no economist or financial expert, so I’d welcome comments from people more informed than I am on this question that Raj has raised.
So faireconomist, re: intentions of the banking industry to get their paper bought up, I’m not suggesting this as ‘a nefarious plan,’ or even one _explicitly_ touted. Even a year ago, however, in publicly reported _and unexceptional remarks_ there were bond fund execs calling for the goverment to buy up MSBs directly from the market. The idea, ostensibly, was to support the prices of the same, from August 07 when they really started to slide and the CP of those with exposure locked up. I’m sorry, I don’t have links. These reports were sufficiently numerous that I took them as common knowledge.
Of course, there was no immediate response—but the idea NEVER went away. Fed and Tresury did what they usually do because Ben and Hank totally misread the situation in Aug-Sep 07, if you recall. ‘Just a liquidity gas attack,’ so ease. But _the industry_ wanted their bad paper bought up at par from the first. And I think that this has remained their plan. Almost every time big financials put out paper for bids, to the extent that these actions received coverage in the press and blogosphere, they placed totally unrealistic numbers on the stuff, and snatched their offers back. Thain at MS was just about the only big player to move a chunk of mortgage paper _for what the MARKET_ would give him. Why then, if everybody else ‘is so smart?’ didn’t any of the other big players try to move their paper and save their ships?? To me, that is the 6.4 Trillion Dollar Question.
And you have my reasoned answer: The financial industry has been hoping from the first for an ‘RTC-like public toxic waste dump’ to buy the stuff off them at prices near to face. Originally, Big Money still convinced itself that this stuff was worth near to face but thought the markets were panicking. Now, Big Money knows the stuff isn’t remotely worth face, but their survival is threatened daily and will only be protected if the Guvmint vastly overpays. But either way, the industry’s Masterplan A has been to have the government buy up stinking securitized debt, and at the industry’s price not vice versa. To me, this has always been topic A in discussions between Paulson and insiders, that is why Paulson is so fixated on it: this is what the industry tells him to go and flog, so he is. Don’t think for a second that Paulson has independent thoughts pop into his skull; he does what he’s told. And again, I don’t mean that in conspiracy speak. Just look at his actions, and they tell the tale.
As a final note, faireconomist, I don’t attribute any special knowledge to myself. A lot of historical research and reasoning is simply a matter of 1) collecting observable facts, 2) sequencing them, and 3) connecting the dots. I do try to remember what policy positions took, when, how these related to their stakes, and then to follow those alignments over time. If I do so on MBSs, the only reasonable conclusion I draw is that the industry has been holding out for a public buy-up. This ‘makes sense’ of their action-statement-position matricies as I see them, whereas nothing else really does. Big financials manifestly cannot now hold their ASBs to maturity, they cannot sell them and stay solvent, and they cannot admit either condition. The only solution is exactly what their plan has been for years: Find a greater fool to buy. But that fool must be very, very rich to buy the lot. Who qualifies?? Uncle Sam and God. And God stays out of these things; that’s called Real Smart Money.
Basically this bill and a few cuts in the interest rate will at best postpone a train wreck in the stock market. None the less, a train wreck is coming regardless of this infusion of funds in the short term.
If panic sets in after the Fed runs out of ammunition and can not cut rates any further then we will see a crash in the stock market. If the stock market breaks down below 9500, we could test 2003 levels all over again. We are talking Dow 7500. The other negative effect of this bill is that it will cause more debt burden on the tax payer and the Fed will print more money. This will in turn cause hyper-inflation and the dollar will crash relative to other major currencies like the euro and the yen. I am seriously worried about an economic melt down and possibly a depression. Comment by Buck McHugh former VP of Investments at A.G.Edwards and graduate of Cambridge University’s Judge Institute of Management Studies.
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