Recently in Financial Markets Category

Full text of speech at the Fed's website.

Here's the money quote:

Regarding interest rate policy, although further reductions from the current federal funds rate target of 1 percent are certainly feasible, at this point the scope for using conventional interest rate policies to support the economy is obviously limited. Indeed, the actual federal funds rate has been trading consistently below the Committee's 1 percent target in recent weeks, reflecting the large quantity of reserves that our lending activities have put into the system. In principle, our ability to pay interest on excess reserves at a rate equal to the funds rate target, as we have been doing, should keep the actual rate near the target, because banks should have no incentive to lend overnight funds at a rate lower than what they can receive from the Federal Reserve. In practice, however, several factors have served to depress the market rate below the target. One such factor is the presence in the market of large suppliers of funds, notably the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, which are not eligible to receive interest on reserves and are thus willing to lend overnight federal funds at rates below the target. We will continue to explore ways to keep the effective federal funds rate closer to the target.

Although conventional interest rate policy is constrained by the fact that nominal interest rates cannot fall below zero, the second arrow in the Federal Reserve's quiver--the provision of liquidity--remains effective. Indeed, there are several means by which the Fed could influence financial conditions through the use of its balance sheet, beyond expanding our lending to financial institutions. First, the Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities. This approach might influence the yields on these securities, thus helping to spur aggregate demand. Indeed, last week the Fed announced plans to purchase up to $100 billion in GSE debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters. It is encouraging that the announcement of that action was met by a fall in mortgage interest rates.

Translation:  They're not done yet.

T.S. Eliot wrote that April is the cruelest month.  In the academic year, November shares some similarities with April in that it's when we start to come to grips with the fact that this semester will end... and soon.  For me, blogging seems to take a hit in November.  I'd tell you what's been keeping me busy, but it really is academic minutiae.  You'd be bored to tears.

November has been a cruel month for the markets as well, especially the last couple days.  Some days I turn on CNBC and literally see things that I never thought I'd see.  Watching the 30 year Treasury yield take a dive like it did yesterday would be one of those things.  Seeing Citi at less than $4 would be another.  Hearing perfectly reasonable people fret about the possibility of deflation would be still another.

How do you title a blog post these days without sounding like a doom-and-gloomer?  I feel like I want to choose my words very carefully to avoid making things seem worse than they are.  (I know how you feel, King!)  But when you hear speculations of a pretty sizeable drop in GDP in the 4th quarter and graphs showing this to be the worst stock market decline since the Great Depression, it's easy to get caught up in it.

So as I work my way back into the swing of things over this Thanksgiving break, let's just set the stage.

The auto bailout:  Not a good idea, but probably going to happen in some way, shape, or form.  At the rate that they're burning cash, I don't see what a bailout would reasonably hope to accomplish.  A fast track to a government assisted bankruptcy would probably be better in the long run.  I would support proposals to protect the pensions of workers, especially those near retirement because that represents a past promise that people took into account when making decisions. That's probably a good topic for a future post.  But this decline has been a long time coming, and trying to stop it is just going to add to the problems later.

Paulson's reversal:  I, for one, found that episode at least somewhat refreshing.  Some say that he realized that $700 billion would not be nearly enough.  Perhaps.  But if that's the case, I'd rather he stopped at the brink of the canyon like he did rather than jumping in and then telling us.  Yes, we could use some more transparency in seeing where the money has gone so far.  But most importantly, the fact that they're holding back some of that money means that at least one agency is doing something to keep its powder dry.  Which brings us to...

What will the Fed do in December?   That's what my macro classes are working on figuring out.  After Thanksgiving, I'll be discussing Poole's 1970 QJE paper with my grad students.  I guess that will be as good a time as any to bring up this development: (Bloomberg)

``There has been a policy shift, but the Fed is not transparently announcing what it is doing and why,'' said former St. Louis Fed President William Poole, now a senior fellow at Cato. ``Monetary policy works best when the markets understand what the central bank is doing.''

Some analysts point to the surplus cash that banks keep on deposit at the Fed as a key gauge of the Fed's monetary-policy stance. The so-called excess reserves have ballooned to $363.6 billion from $2 billion in August as the Fed added to its emergency lending programs.

``It is a move to quantitative easing, to force lots and lots of reserves into the banking system with the expectation that banks will start to trade them for a higher-yielding asset,'' said Poole, a Bloomberg contributor, said yesterday in a Bloomberg Television interview.

Hat tip to Calculated Risk.

Indeed, when you see things like this, it makes you wonder what is going on.  I'm going to be thinking about that a lot this week during the break from classes.

So what about deflation?  I'm not in the camp that thinks it's a big problem yet.  It becomes a real problem if wage declines make it even more difficult for people to make their mortgage payments or if price declines are so widespread and expected that people hold off spending now as they expect prices to go down further.  I don't see us getting there yet, but I stand ready to revise my expectations as new data arrives.

And finally stock market:  I'm just as caught up in it as you are.  My explanations are no better than anyone else's.  It does appear that we're on the verge of something with Citi, and people are getting worried about commercial real estate.  Those make for some strong headwinds. 

As I go around town I hear comments both positive and negative.  Everyone complains about their 401(k)s, but local businesses are hiring.  I do think that we're in a recession as we would define one nationally.  However, the impact is going to be very different for various regions and economic sectors.  It's difficult to fight recessions like this because it becomes more tempting to try to target policies at one area or another, and that's not always good or successful.

But it does give us things to talk about.

FOMC press release:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 1 percent.

The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures. Business equipment spending and industrial production have weakened in recent months, and slowing economic activity in many foreign economies is damping the prospects for U.S. exports. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit.

In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate in coming quarters to levels consistent with price stability.

Recent policy actions, including today's rate reduction, coordinated interest rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth. Nevertheless, downside risks to growth remain. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh.

In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 1-1/4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Cleveland, and San Francisco.

There are some new features in the exact wording, such as "the Committee expects inflation to moderate in coming quarters to levels consistent with price stability".  Seems like only six weeks ago that they expected "inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain."

Good to see that some scholars are thinking outside the box.  From the Wall St. Journal op ed by Andrew Caplin, Thomas Cooley, Noel Cunningham, and Mitchell Engler:

The federal government needs to give taxpayers an ownership stake in the future. The SAM does just this. For example, a homeowner unable to support payments on a house purchased for $200,000 that today is worth only $150,000 might be offered a write-down of up to $50,000. But this would not be a free lunch.

With the SAM, once the value began appreciating above $150,000, the mortgage holders would be due their share. The details of the write down and the appreciation sharing could be tailored to different circumstances. But one way to give lenders a share of the upside would be to pay back some of the write down if the house is later sold, in the scenario above, for more than $150,000. This is a model in which both parties benefit, preventing default while giving future taxpayers a fighting chance at some real upside to the investment we're forcing on them.

Read the whole thing.

From the NY Times:

Hundreds of traders who placed bets on Lehman Brothers' creditworthiness before it went bankrupt have settled their positions "without incident," according to a company that tracks derivatives contracts.

The company, Depository Trust & Clearing Corporation, processes large numbers of investment transactions. It said that only $5.2 billion had to change hands for all the traders to close out their positions, a much smaller amount than had been predicted a week ago.

The settlement process had been seen as a major test of the market for credit-default swaps, and whether it could handle the unprecedented stress of a big Wall Street firm going bankrupt. The overall system appears to have borne the shock successfully, although individual firms might have taken painful losses they have not yet disclosed.

Make no mistake.  It's not over.  But we'll take good (or even "less bad") news when we can get it.

From the NY Times:

Treasury Secretary Henry M. Paulson Jr. outlined the plan on Monday to nine of the nation's leading bankers at an afternoon meeting, officials said, in which he essentially told the participants that they would have to accept government investment for the good of the American financial system. This capital injection plan will use a huge chunk of the money authorized for Troubled Assets Relief Program.

Citigroup and JPMorgan Chase were told they would each get $25 billion; Bank of America and Wells Fargo, $20 billion each (plus an additional $5 billion for their recent acquisitions); Goldman Sachs and Morgan Stanley, $10 billion each, with Bank of New York Mellon and State Street each receiving $2 to 3 billion. Wells Fargo will get $5 billion for its acquisition of Wachovia, and Bank of America the same for amount for its purchase of Merrill Lynch.

The goal is to inject massive liquidity into the banking system. The government will purchase perpectual preferred shares in all the largest U.S. banking companies. The shares will not be dilutive to current shareholders, a concern to banking chie executives, because perpetual preferred stock holders are paid a dividend, not a portion of earnings.

The capital injections are not voluntary, with Mr. Paulson making it clear this was a one-time offer that everyone at the meeting should accept.

Two weeks ago, I would not have guessed I'd be writing this tonight.  But here we are.  Now we wait and see what these banks are able to accomplish with that money.  I am reminded of Matthew 25:14-30.

From Time Magazine:

[The price of oil] has plummeted nearly 40% in just three months, from about $147 a barrel in July to below $83 on Friday, with no obvious bottom in sight. If that sounds good, you are probably a driver who winces these days at filling your gas tank. But the downward spiral could mean trouble for oil-rich countries and for the environment.

The title of the article:  "Is Cheaper Oil a Good Thing?"

I can think of about three distinct ways to spin that into an exam question (and a couple more from the rest of the article).  How about you?

Greg Mankiw has a good idea on how to recapitalize the ailing financial sector.  Read the whole thing.

Readers wondering about why coordination among central bankers matters (as in today's coordinated rate cut) may benefit from this old post from 2006.  The subject is a NY Times piece by Hal Varian.

Since this is such an unusual event, I'm just going to print the entire press release complete with links to other central banks.

Joint Statement by Central Banks

Throughout the current financial crisis, central banks have engaged in continuous close consultation and have cooperated in unprecedented joint actions such as the provision of liquidity to reduce strains in financial markets.

Inflationary pressures have started to moderate in a number of countries, partly reflecting a marked decline in energy and other commodity prices. Inflation expectations are diminishing and remain anchored to price stability. The recent intensification of the financial crisis has augmented the downside risks to growth and thus has diminished further the upside risks to price stability. 

Some easing of global monetary conditions is therefore warranted. Accordingly, the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, Sveriges Riksbank, and the Swiss National Bank are today announcing reductions in policy interest rates. The Bank of Japan expresses its strong support of these policy actions.

Federal Reserve Actions
The Federal Open Market Committee has decided to lower its target for the federal funds rate 50 basis points to 1-1/2 percent. The Committee took this action in light of evidence pointing to a weakening of economic activity and a reduction in inflationary pressures. 

Incoming economic data suggest that the pace of economic activity has slowed markedly in recent months. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit. Inflation has been high, but the Committee believes that the decline in energy and other commodity prices and the weaker prospects for economic activity have reduced the upside risks to inflation. 

The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability. 

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. 

In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 1-3/4 percent.  In taking this action, the Board approved the request submitted by the Board of Directors of the Federal Reserve Bank of Boston.

Information on Actions Taken by Other Central Banks
Information on the actions that will be taken by other central banks is available at the following websites:

Bank of Canada
Bank of England
European Central Bank
Sveriges Riksbank (Bank of Sweden)
Swiss National Bank (51 KB PDF) 

Statements by Other Central Banks
Bank of Japan (65 KB PDF)

David Altig takes up the question with links back to Marginal Revolution, DeLong, as well as my post from yesterday.  (Thanks, David!)

Rather than looking at it as what DeLong calls "Operation Twist", Altig opts for the simpler explanation that it will put a lower bound on the effective fed funds rate.  That is, of course, the fundamental effect that this would have in any circumstance--crisis or not.  It puts the Fed in as the residual buyer of the funds and thus establishes the floor.

The apparent lack of a (non-zero) lower bound on the funds rate was first noticed over a year ago when there were trades happening at zero percent.  Here's what I said in August 2007:

So while I don't have a full and definitive explanation [for the zero percent transactions], it would seem that borrower risk is a factor, and the fact that these are excess reserves (which earn no interest) is also a factor. In that case, the low end of the range could stay low until the reserve picture gets back to normal.

When the Fed began discussing it more seriously in May 2008, I said:

I'll go on the record that this is a good idea. It will help to smooth out the recent fluctuations in the funds rate that garnered so much consternation at this blog among other places. It would prevent interest rate policy from getting in the way of policies for directly injecting liquidity into the financial markets by effectively keeping a floor on the funds rate even during a big injection of liquidity.

So I am clearly on board with the stated reasoning behind the move.  Plus, I think it's just a good policy to eliminate what is effectively a tax on reserves.

But I was struck by DeLong's comment about open market operations on the risk premium rather than on the liquidity premium.  The more this drags on and the more we learn, the more I am coming to the conclusion (see here, for example) that this is a problem with the risk premium.  Why else would the CP market freeze up despite the massive injections of liquidity, not to mention the CDS market?  There seems to be a lot of liquidity out there, but it's not necessarily getting to where it needs to go.

And that got me wondering if paying interest on reserves might, as Tabarrok suggested, accomplish the goal of getting that liquidity where it needs to go in an Operation Twist sort of way.  While the Fed is not yet targeting particular assets, we're treading very close to the kind of environment where that might be necessary.  (Have you seen a T-bill rate lately?)  Having the ability to pay interest on reserves would not be counter to that purpose, even if it wasn't the primary reason.  Of course, it should also be noted that the paying of interest on reserves is a permanent change rather than a temporary one meant only for the crisis.

Paying interest on reserves is a good policy for a lot of reasons.  The obvious ones and the ones that might still be a stretch--at least for now.

Press Release from the Fed:

The Federal Reserve Board on Tuesday announced the creation of the Commercial Paper Funding Facility (CPFF), a facility that will complement the Federal Reserve's existing credit facilities to help provide liquidity to term funding markets. The CPFF will provide a liquidity backstop to U.S. issuers of commercial paper through a special purpose vehicle (SPV) that will purchase three-month unsecured and asset-backed commercial paper directly from eligible issuers. The Federal Reserve will provide financing to the SPV under the CPFF and will be secured by all of the assets of the SPV and, in the case of commercial paper that is not asset-backed commercial paper, by the retention of up-front fees paid by the issuers or by other forms of security acceptable to the Federal Reserve in consultation with market participants. The Treasury believes this facility is necessary to prevent substantial disruptions to the financial markets and the economy and will make a special deposit at the Federal Reserve Bank of New York in support of this facility.

The commercial paper market has been under considerable strain in recent weeks as money market mutual funds and other investors, themselves often facing liquidity pressures, have become increasingly reluctant to purchase commercial paper, especially at longer-dated maturities. As a result, the volume of outstanding commercial paper has shrunk, interest rates on longer-term commercial paper have increased significantly, and an increasingly high percentage of outstanding paper must now be refinanced each day. A large share of outstanding commercial paper is issued or sponsored by financial intermediaries, and their difficulties placing commercial paper have made it more difficult for those intermediaries to play their vital role in meeting the credit needs of businesses and households.

By eliminating much of the risk that eligible issuers will not be able to repay investors by rolling over their maturing commercial paper obligations, this facility should encourage investors to once again engage in term lending in the commercial paper market. Added investor demand should lower commercial paper rates from their current elevated levels and foster issuance of longer-term commercial paper. An improved commercial paper market will enhance the ability of financial intermediaries to accommodate the credit needs of businesses and households.

This will bring a sigh of relief to the commercial paper market. Think of it this way.  The Fed is betting that there are a lot of mutually beneficial trades out there that are not happening because the participants either afraid that they will not get paid back or that they will not be able to liquidate the paper they hold if they need quick cash.  In normal times this action would not be necessary.  But these are not normal times.  John Jansen at Across the Curve has been reporting on the CP market for a while, and if what he's been saying is true then this was a very smart and very necessary move.

Text of the press release

So says Reuters (and CNBC)

The statement came after U.S. business television channel CNBC reported the Fed was planning talks with the Chicago Mercantile Exchange, or CME, and the Intercontinental Exchange, or ICE, on the creation of a CDS exchange. The companies declined to confirm the report, although they said they would be willing to participate in any initiative.

And Calculated Risk says:

Apparently CNBC's Steve Leisman reported (I didn't see it) that the Fed might announce tomorrow morning some sort of program to buy commercial paper.

I had CNBC on in the background tonight and I think I heard that as well.  John Jansen says he has heard something to that effect from three sources.  And if you haven't been reading his blog lately, you're not fully informed.  From what I'm reading at his blog and other sources, it appears that the levels of risk aversion out there are just incredible.  Institutions are not lending because they have no way to assess the creditworthiness of their counterparties.  As a result, good trades are being passed over.  This cannot go on for very long without causing some significant problems. 

As I've said before, it's an information problem (which has led to a problem of risk assessment).  We are in need of transparency, pure and simple.  Unfortunately, getting it will not be that simple.

From the Federal Reserve:

The Financial Services Regulatory Relief Act of 2006 originally authorized the Federal Reserve to begin paying interest on balances held by or on behalf of depository institutions beginning October 1, 2011. The recently enacted Emergency Economic Stabilization Act of 2008 accelerated the effective date to October 1, 2008. 

Employing the accelerated authority, the Board has approved a rule to amend its Regulation D (Reserve Requirements of Depository Institutions) to direct the Federal Reserve Banks to pay interest on required reserve balances (that is, balances held to satisfy depository institutions' reserve requirements) and on excess balances (balances held in excess of required reserve balances and clearing balances). 

The interest rate paid on required reserve balances will be the average targeted federal funds rate established by the Federal Open Market Committee over each reserve maintenance period less 10 basis points. Paying interest on required reserve balances should essentially eliminate the opportunity cost of holding required reserves, promoting efficiency in the banking sector. 

The rate paid on excess balances will be set initially as the lowest targeted federal funds rate for each reserve maintenance period less 75 basis points. Paying interest on excess balances should help to establish a lower bound on the federal funds rate. The formula for the interest rate on excess balances may be adjusted subsequently in light of experience and evolving market conditions. The payment of interest on excess reserves will permit the Federal Reserve to expand its balance sheet as necessary to provide the liquidity necessary to support financial stability while implementing the monetary policy that is appropriate in light of the System's macroeconomic objectives of maximum employment and price stability.

Tyler Cowen thinks it is what Brad DeLong suggested as "Operation Twist on a Pan-Galactic scale."  I agree.  The effect will be small, but it probably won't hurt.

Alex Tabarrok at Marginal Revolution writes:

The consensus among economists is now clear, the best strategy for dealing with the financial crisis is to recapitalize the banks that need recapitalization.  Paul Krugman, John Cochrane, Luigi Zingales, Douglas Diamond, Raghuram Rajan and many others all advocate some form of recapitalization as do Tyler Cowen and myself.  Krugman would prefer a recapitalization in the form of nationalization.  In my view, there is still plenty of private money to buy banks at the right price and my preferred model is the FDIC leading a speed bankruptcy procedure, as was done brilliantly with Washington Mutual (Cochrane also supports this model.)  In the middle are most of the others who have a variety of good ideas to require the banks to raise equity in various ways.

...

There is also a consensus among economists that the bailout bill is not the right policy.  None of the above economists, for example, is enthusiastic about the bailout.  My bet is that all of us think that the bailout has a substantial likelihood of failing.  The support that exists is born out of hope and fear not judgment and experience.  Nevertheless, the political consensus is that a bailout is what we will get whether it is likely to work or not.  

Count me among those not enthusiastic.  My grudging support is not out of fear, per se--that's too strong a word.  Rather, I am convinced that we're in for a bumpy ride either way, and even a suboptimal plan like this has the potential to make the ride less bumpy.  Furthermore, I think that the moral hazard risks are small in the short term, and there is plenty of time to deal with the long term later.

But what is done is done.  Payrolls fell another 159,000 in September.  The unemployment rate did not rise this month, but it will catch up in time.  And let's be clear once again.  This bailout bill will not prevent a recession.  As James Hamilton says, that's a "done deal".  This bill will not restore calm to the financial markets either.  The best we can hope for out of this bill is that it can help facilitate the revealing of information in the markets sooner than would take place without it.  That might prevent an unnecessarily protracted downturn.

You won't find me celebrating this bill, but I am looking ahead with anticipation to see if it can get counterparties trading with each other again.  If it can do that, it will achieve some measure of success.

It's a familiar phrase to anyone who regularly reads legislation.  Most people would call it "pork."  It's the extra stuff that goes into a bill to make it palatable to legislators who are not totally in favor of the main purpose of the bill.  These items are not necessarily enough to convert a staunch opponent, but enough to get those on the fence to come to your side.  It's a political application of the economist's old friend, "thinking on the margin."

With that as prelude, I offer you this link to the bill passed by the Senate and now before the House.  It is now 442 pages long.  The pork "other purposes," begin on page 110 and continues for the next 330 pages (there are a couple of essentially blank pages at the end).  The math works out nicely to be 75% "other purposes" by volume though not by money.

Ever since this latest and most intense phase of the ongoing crisis began a few weeks ago, I have been convinced of the need for a coordinated approach to unclogging the credit markets.  Efforts to manage the specific incidents (AIG, WaMu, etc.) have been generally pretty good--if pretty good means that there have been no runs on banks and no catastrophic failure of the financial system.  In fact, as I have pointed out in a couple of media interviews lately, the response of the FDIC has been superb.  So far, they have my vote for the "most valuable player" in the handling of the situation.  Because of their experience and efficiency in handling bank failures, I would fully support a measure that would guarantee that FDIC continues to have access to the Treasury to meet its mission.  FDIC was created for just this sort of thing, so let's utilize them.

But there is a limit to what FDIC can do.  The Fed can do a little bit more.  They have the authority to respond to emergencies by lending to entities outside their normal purview.  While there is always a danger that such authority could be used unnecessarily, in my estimation they have acted responsibly thus far.  But even the Fed is limited to the role of responding to emergencies rather than acting entirely proactively.  To act more proactively, that is, to systematically purchase troubled assets in a way that many think needs to be done, requires Congressional authority.  And that's why we're here having this discussion.

There are, however, many reasons to be cautious about granting that authority.  Obviously it requires transparency and oversight.  Provisions that limit golden parachutes and give the taxpayer a chance to share the upside are also unobjectionable to me.  Assessing financial institutions for a portion of the costs is also a good idea.  Handing the Treasury Secretary a blank check would clearly be a very bad idea.

The biggest problem right now is clearly a lack of information (asymmetric information as well, but in some cases it is truly lacking).  It is evident from the TED spread and other data that lending among the major institutions is being constrained by uncertainty over how to assess counterparty risk.  This is not healthy, and it's not going to go away until some more information is revealed.  Any bailout package should be designed with that in mind.  If the Treasury is allowed to take some of the bad assets off of a bank, it may send a signal to counterparties that they are less risky.  This would help to get funds moving again.

And let me just head off anyone who would say that we don't need to "get funds moving again" because that's what got us into that mess.  That's just wrong.  Getting the counterparties creditworthy again will not create an undue amount of moral hazard.  This market has been slammed--big time.  Getting the funds moving in a more normal way will not bring about a return to subprime, interest only, no-doc loans.  At least not for a long time, and in that time we can talk about smart regulation to prevent that from happening again.

In summary, here's what I like about the proposal going through Congress:

• Wall Street shares the cost (see pages 9-12 of the legislation)
• Limits on executive compensation
• Making the $700 billion available in tranches

Things I don't like as much:

• A temporary increase in the $100,000 per account limit on FDIC insurance to $250,000.  Why?  I don't like fiddling with such important institutions on a temporary basis.  That figure is due for an upward adjustment due to inflation (and an increase in the premiums banks pay).  Why not do that and make it permanent?  (UPDATE:  But don't do it during the crisis, see below).
  
• Ability of the Treasury to suspend mark-to-market rules.  Why?  Similar reasoning.  I rarely would favor a temporary change in rules that are meant to foster transparency.  Mark-to-market may be flawed, but I'm afraid that temporarily suspending it right now would only add to the confusion.

Things I just don't like:

• "...and for other purposes"  Why?  You figure it out.  (Look at page 294 for an example.)
  

Is this legislation better than nothing?  All week I've been wanting to be able to say yes, but I am finding it difficult to do so.  There is something to be said for having a plan in place in case we need it in the next three months that Congress is out of session.  And yet, I find myself disappointed in the process and not that crazy about the final product.

There is no doubt in my mind that on balance this legislation is worse than what was voted down on Monday, but this one might actually pass.  That's how Congress works.  This legislation is not something that we urgently need to prevent a depression, and it simply will not prevent whatever recession may be in the works.  If it passes, it might reduce some of the anxiety in the credit market sooner.  If it fails, the Fed will probably be called on to use its emergency lending authority again.  The latter is not optimal, but it is probably workable.

The really sad thing is that the "other purposes" are not really out of the normal realm of business.  While it grates at me, it is part of the legislative game.  But if you think that facilitating price discovery and getting institutions to show their cards well help reduce counterparty risk, then this might be the best plan you'll get.  It's not a solution.  A solution seems very far away at the moment.  But it's probably marginally better than doing nothing and hoping for the best.

And I think I'll just leave it at that.

For today's other commentary, see Arnold Kling (who has had very good material lately) and Tyler Cowen (with whom I am in general agreement).

UPDATE:  King Banaian doesn't like the increase in the FDIC limit either.  He is worried about the moral hazard and that it would lead to banks taking more risks to try to recover their losses (as in what led up to the S&L crisis).  He's right about that.  I still think the temporary aspect of it makes it worse.  Let me be clear.  I think the limit should be increased permanently to adjust for inflation, but it does not need to be done in this bill.  It is not an urgent matter.  And furthermore, if and when the limit is raised, the insurance premiums paid by banks should increase as well.  In the meantime, the present practice of the FDIC in insuring the first $100,000 with certainty and making any decision to insure deposits beyond that on a case-by-case basis is sufficient for now.

...is by David Altig.  (Though some of his commenters have dissenting views.)

Five days ago, I wrote:

So I am fairly confident that a "workable" solution will be reached before the markets open on Monday.  I do not look for an "optimal" solution.  If an optimal solution exists, it is undoubtedly too complicated to be "workable".  But I believe that a number of ideas on the table have the potential to avert a complete meltdown.  I think that when all the parties (including both McCain and Obama) meet behind closed doors and really come to grips with the magnitude of the problem and the fact that a workable solution exists, we'll get one.

I sure hope I'm right.

I was wrong.  At least for now.  There's always the possibility that something will happen later this week.  I don't know what the likelihood is.  Obviously the party whips don't know either--and they're the ones who should. 

At the moment, the way I am organizing my thoughts about the situation is in the form of questions and answers.  So here are the questions I've been asking myself, and my best attempts at some answers.

Q:  Did we need this bill?
A:  I would be careful not to say that we needed this bill.  That is, neither this bill nor any bill was or is a necessary condition for preventing financial Armageddon.  Certainly there were some other options out there other than this bill that I may have preferred.  But after the bill failed, the Federal Reserve announced additional lending measures.  This represents another stop-gap measure that hopefully will help us limp through tomorrow.  The Fed could (with the assistance of special treasury issues) continue to do this for some time.  But of course this is not what we like to see either.  It would be nice to get a legislative solution.  However, if Congress is too dysfunctional to do it, then so be it.  There are other ways.

Q:  What is the biggest mistake that Congress and others are making?
A:  Actually, I see two misconceptions being perpetrated out there.  One is the framing of this issue as Wall Street versus Main Street.  That is, that the government is taking from Joe Six-Pack to give to big bankers.  On the other side of the aisle, there are those who oppose this or any "bailout" out of an unwavering commitment to free market principles.  That is, the bailout is just socialism by another name and should be rejected outright.

Both views have an element of truth, but both views also miss the point.  I think most of my readers understand the connection between Wall Street and Main Street.  However, it is becoming clearer that many people have never made that connection.  And let's be clear, it's not about the stock market!  The fact that the stock market dropped over 700 points is a symptom--not the disease.  The reason to do the deal is not to prop up the stock market--though that certainly gets (and deserves) a lot of attention.  But the drop in the stock market is just an indicator of the drying up of liquidity.  If you doubt this, just read John Jansen's excellent blog (Across the Curve).  If this continues for much longer, it WILL cause firms to have difficulty meeting payroll, paying for inventory, and financing expansion.  At that point, Main Street is affected.  That is what happened in the Great Depression in a very big way.  We may be able to stave off a Great Depression, but there is the potential for a very severe recession.

Those who say the bailout is socialism may say that a severe recession may be the price we have to pay and is not an excuse for such an intervention.  I understand this argument, and it is not entirely without merit.  If the situation, as I understand it to be, was less dire, I might even agree.  But Ben Bernanke is a student of the Great Depression.  If he's worried, then I am too.  My own study of history tells me that this is the closest we have come to such a scenario since the Great Depression.  So I am willing to put aside the "bailout is socialism" argument and argue that a strong government response is warranted.

Let's take a look at some very smart words from Robert Shiller, an economist that I respect a great deal:

So is the government's bailout a major departure? Hardly. Today's federal involvement offers bailouts as a strictly temporary measure to prevent a system-wide financial calamity. This is entirely in keeping with our basic principles -- as long as the bailout promotes, rather than hinders, financial democracy.

Which, so far, it seems to. Congressional critics may be right to demand more help for homeowners and more accountability for Wall Street blunders, but the core idea of the plan is sound: to protect the financial infrastructure. Remember, Fannie Mae used to be a government entity, and by taking it over, the federal government is merely returning to the status quo ante. The measures to take toxic debts off the hands of financial and insurance firms are intended only to deal with a crisis, not to transform our financial system. The proposals do not represent any landmark change in the American way of prosperity. Everyone should take a deep breath. Changing our thinking about finance does not mean abolishing capitalism, but it does raise questions about what the changes mean.

Indeed.  Whatever "bailout" happens, if any, it will not be a permanent intrusion of socialism into the financial markets.  In fact, this represents a tremendous opportunity to modernize the financial system.  By "modernize", I don't mean the kind of derivatives that got us into trouble, but rather a sensible set of regulations that acknowledge the moral hazard problem and prevent institutions from doubling-down on a bad bet.  Read the rest of Shiller's column for more specifics.  I agree with his assessment.

This is a profoundly unique moment in our financial history.  The Fed and the Treasury will do what they can with or without Congress--they have made that clear.  Hopefully that will allow us to limp along.  But I am really starting to worry about the possibility of a stagnant economy for many months if the normal lending channels are not unclogged very soon.

... comes from Menzie Chinn:

So if we end up delaying until households and small firms individually experience the credit crunch directly for the sake of ideology, well, we'll know where to locate the responsibility.

So says a "smart friend" of Greg Mankiw.

For the last few days, I've been listening/reading rather than talking/writing.  Reflecting on what I have read and heard, there is one thing that stands out.

Everybody's got their own idea of how they would fix the financial markets.

Some are actually pretty good and might even work better than what we'll probably get.  Others sound good but probably wouldn't work in practice.  Others are downright nonsense.

But the purpose of this post is not to list and categorize all of the proposals floating through the blogosphere.  Nor will I offer a complete proposal of my own.  Rather, I just want to offer a few general observations.

I'm generally in favor of getting this toxic paper off of the balance sheets of the banks in the interest of unclogging the system and restoring a sense of normalcy in the markets.  I am genuinely concerned about what could happen if the banks continue to hold this paper for a long period of time.  The crisis of confidence and the inability to lend would lead to a stagnation not unlike Japan in the 1990s.

So if we agree to take this paper off the books of the banks, the next step is to agree on a way of valuing that paper.  Given that the market for this paper is not functioning very well, price discovery is a challenge.  The government would be making the market, and being the only buyer of any consequence, you'd think that they would be able to buy the paper at a pretty good discount.

But...

If the government buys the paper at fire sale prices, you still have the solvency problem and many financial firms could go under.  While many folks may not lose a lot of sleep over this, there still is the matter of making sure that the market participants are on sufficient footing to move forward in the aftermath.  With lots of insolvent firms out there, credit will still be constrained.

Since fire sale prices will not cure the insolvency problem and since paying more than market prices means taxpayers are more likely to lose, there is a reason to look for another way.  It would not be out of line to require troubled institutions to give up some equity in return for the above market price on the assets.  That way, the shareholders will bear some of the cost--as they should.

It is also not out of line to demand management changes and a reduction of the "golden parachutes".  I am not against multi-million dollar salaries for CEOs whose leadership is valued by the market.  But I do believe that some of the cases we have seen recently are evidence of a collective action problem in which the shareholders have been unable to exert the optimal level of control over compensation issues.  In the long run, that's a problem that deserves more study.  In the short run, in the case of insolvent firms dumping their toxic paper, a more direct approach may be in order.

I'm not against having the firms being "bailed out" suffer a little pain in the process.  But for the sake of the system, that pain cannot be so severe that it threatens the ability of the firms to function in the future.  If you're looking for my bottom line, there it is.

There will have to be regulatory changes going forward.  However, it is impractical, and I believe folly, to require those changes as a condition to passing this "bailout" package as some in Congress would like.

The world markets are watching.  At the moment, the world markets are extending their forbearance to us as they wait to see how we are going to handle the solvency crisis that now looms large even as the liquidity crisis enters its end game.  They have been very patient with their forbearance.  But if inaction means a significant risk of catastrophic failure of these institutions, then the world's patience will wear thin.  And that's a scary thought.

So I am fairly confident that a "workable" solution will be reached before the markets open on Monday.  I do not look for an "optimal" solution.  If an optimal solution exists, it is undoubtedly too complicated to be "workable".  But I believe that a number of ideas on the table have the potential to avert a complete meltdown.  I think that when all the parties (including both McCain and Obama) meet behind closed doors and really come to grips with the magnitude of the problem and the fact that a workable solution exists, we'll get one.

I sure hope I'm right.

By the way, today's award for the best job of explaining the consequences of inaction and the issues inherent in the different approaches to a solution goes to Peter Orszag of the CBO for his testimony to the House Budget Committee.  His complete statement is on the CBO Director's blog.  Excellent explanation.

From the NY Times:

Sweden did not just bail out its financial institutions by having the government take over the bad debts. It extracted pounds of flesh from bank shareholders before writing checks. Banks had to write down losses and issue warrants to the government.

That strategy held banks responsible and turned the government into an owner. When distressed assets were sold, the profits flowed to taxpayers, and the government was able to recoup more money later by selling its shares in the companies as well.

Worth a look.

Here's the NY Times article explaining it.  Calculated Risk explains why it's not quite like the RTC.  Actually, the buying of distressed mortgages from banks that don't want them sounds more like the original Fannie Mae.  There is an important difference from Fannie Mae in that this does not appear to be permanent.  Its temporary nature is one point of similarity with the RTC.  I think we'll just have to wait and see what it looks like when it's all said and done.

I haven't had time to think about it enough to have an opinion.  I'll probably wait until the details are out.  I do have some questions though.  One thing I don't have a feel for is how much of a discount will be taken when the government purchases these assets and what they'll be worth when the government sells them.  Just how quickly will the plan restore these balance sheets to something approaching normal?  For all the attention the other interventions have received, this one has the potential to really be The Big One.

Doesn't the fact that overseas markets are surging in response to this make you the least bit nervous about how this will be interpreted?

What will become of the $70 billion private liquidity fund?  Will it even be tapped now that The Big One is on the horizon?

My working hypothesis is that the connectedness of the markets made this simply impossible to unravel piece-by-piece.

It's been a while since I've said this, but my sentiment right now is approximated most closely by Paul Krugman's latest column.  Go.  Read.  Understand.

This just hit CNBC's website:

Morgan Stanley CEO John Mack held various conversations with potential merger partners Wednesday afternoon including top executives at Citigroup and Wachovia Bank. However, Mack continues to work to keep Morgan Stanley an independent company CNBC has learned.

Executives at Morgan are currently crunching numbers to determine how much of an additional minority stake they need to sell to settle market fears about the company.

Mack's plan is to sell a piece of Morgan Stanley to a Chinese bank. Mack has been dealing with Chinese government officials all day Wednesday to line up money from China.

It's shaping up to be another interesting day tomorrow.

This one comes from Lawrence White at Division of Labour.  It's a Forbes article on the Shadow Financial Regulatory Committee (which is sponsored by the American Enterprise Institute).

Washington, D.C. -

An independent panel of academics Monday cautioned Washington against rushing into an innovation-stifling regulation of investment banking, but urged that structures be put in place to ensure the industry itself bears the cost of any future federal bailouts.

The Shadow Financial Regulatory Committee also took a stand against new restrictions on short-selling and recommended that the government liquidate Fannie Mae and Freddie Mac once the market for mortgage financing has stabilized. The federal government took over the two quasi-private mortgage giants earlier this month.

...

The committee noted approvingly that the Federal Reserve Bank of New York has been pushing industry players to create a central clearinghouse for credit default swaps and other derivatives. In a clearinghouse model, Calomiris said, investment banks would share the costs of a member's default, thus creating an incentive to enforce capital standards and to demand more transparency from other participants.

The committee also recommended that the federal government levy a special assessment on investment banks to pay for any future industry bailouts, thus giving the bankers an incentive to support federal intervention only when a failure would present a true risk to the financial system.

The model for this, the committee noted, was established when Congress passed the Federal Deposit Insurance Corporation Improvement Act of 1991.

...

The $70 billion liquidity fund that 10 financial institutions, including Citigroup, Credit Suisse and Deutsche Bank, agreed to set up over the weekend was an acknowledgment by these institutions that it's appropriate for them to share losses to contain systemic risk, the committee noted.

In his post, White adds:

If the Fed and Treasury are now giving a de facto guarantees to the creditors of investment banks (as in the Bear Stearns intervention), why not require the Fed or Treasury to recoup the cost through an assessment on all investment banks? That would insulate ordinary taxpayers, and it would give healthy investment banks an incentive to oppose unnecessary bailouts. Ditto for guarantees to the creditors of insurance companies (as in the AIG nationalization).

It is a bad idea to extend federal guarantees to the creditors of investment banks and insurance companies. First-best is to let those industries organize their own cross-supports (on the model of pre-Fed bank clearinghouses) if they think it worthwhile. But extending federal guarantees to an industry at a zero price, subsidized by ordinary taxpayers, is the worst idea of all.

I could certainly get behind such a proposal going forward.  The liquidity fund setup over the weekend is definitely a step in the right direction.  To the extent that the Fed and Treasury used moral suasion to make it happen, they deserve some credit.  Providing government guarantees to insurance companies is not something that I like to see either, but I'm willing to give the benefit of the doubt to the front line troops in the heat of battle.  I would agree that for the next firm in this position, the Fed and Treasury need to lean on them really hard to use the private liquidity fund.  I mean really hard.

Another good comparison that may be more familiar to people would be the way that we fund unemployment insurance.  Unemployment insurance is funded by a tax on employers that is experience rated.  That is, firms that have more layoffs are taxed more heavily.  Likewise, the government could set up an assessment (i.e. tax) on investment banks, perhaps even make it dependent on an audit of their financial position and transparency.  I think that idea deserves some attention.

There is a way forward.  And it is definitely appropriate to start thinking creatively about ways to prevent the moral hazard which could lead to another crisis.  The door is broken and the cows are out of the barn.  Our first priority is rounding up the cows, but it doesn't hurt to put a few smart minds to work on the problem of fixing the door--it may even keep in some of the cows that have not yet escaped.

Here's an interesting comment from the WSJ MarketBeat blog:

"With this move the Fed and Treasury have blinked in the face of market pressure once again," writes Drew Matus, economist at Merrill Lynch. "They continue to react to situations rather than getting in front of them and now they have created uncertainty about what firms qualify for bailouts and which do not."

Let's think about this.  If there was an easy way to tell which firms pose the most potential for systemic risk and if the Fed started to "get out in front" of those situations, what do you think the result would be?

Yeah.  Not pretty.

A little uncertainty is a good thing here.

The other important thing to remember in all this is that the size of the AIG "bailout" may be much less than the $85 billion that has people worked up.  This is really just an extension of the Fed's credit facilities that have always been available to commercial banks and have recently been extended to investment banks.  AIG would not qualify for such help from the lender of last resort, but the harm to the system from its failure would be at least as great as the harm from failures of a traditional bank.  Therefore the Fed used its emergency power to extend that credit to them.  AIG will essentially reorganize as if it were going through bankruptcy but without the agony to the system that a bankruptcy would cause.  There's a very real probability that the Fed could come out ahead on this deal.

Tyler Cowen explains why no one else was willing to do it, and Felix Salmon also agrees with me on the possible upside.

The next big problem in the short term is getting the money market through all of this.  No sighs of relief until they are, at least temporarily, out of the woods.

Here's the statement from the Fed:

The Federal Reserve Board on Tuesday, with the full support of the Treasury Department, authorized the Federal Reserve Bank of New York to lend up to $85 billion to the American International Group (AIG) under section 13(3) of the Federal Reserve Act. The secured loan has terms and conditions designed to protect the interests of the U.S. government and taxpayers.

The Board determined that, in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance.  

The purpose of this liquidity facility is to assist AIG in meeting its obligations as they come due. This loan will facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy. 

The AIG facility has a 24-month term. Interest will accrue on the outstanding balance at a rate of three-month Libor plus 850 basis points. AIG will be permitted to draw up to $85 billion under the facility. 

The interests of taxpayers are protected by key terms of the loan. The loan is collateralized by all the assets of AIG, and of its primary non-regulated subsidiaries.  These assets include the stock of substantially all of the regulated subsidiaries.  The loan is expected to be repaid from the proceeds of the sale of the firm's assets. The U.S. government will receive a 79.9 percent equity interest in AIG and has the right to veto the payment of dividends to common and preferred shareholders.

The Wall Street Journal gives a very thorough rundown of all the details.

Opinions are surely going to be divided on whether this is a good thing or not.  John Jansen sees the Fed as "careening down a very slippery slope".  I have a feeling that most commentators will be against it even though their specific reasons will differ.

Mark Thoma thinks it is a good idea.  And while I would have rather seen them tap the private equity market, something had to be done.  Recall that AIG has been turning down private assistance for the last couple days because they didn't want to give up control of the company.  With the Fed deal, they will surely give up some control, but exactly what the company will look like going forward remains to be seen.

Is it a bailout?  Is it a takeover?  To me it looks more like bankruptcy by another name.  Effectively it gives AIG some time to sell a lot of its assets--more than just the junk--and reorganize itself.  In the meantime, its creditors will be made whole.  Equity holders may properly bear some of the cost as the government has veto power over dividends.  At the end of the 24 month period...hopefully...the company, in whatever form it takes, can resume something approaching normalcy.  Assuming, of course, that it has any reputation left.  Perhaps sometime during or after that 24 months a suitable buyer can be found.  These are questions that no one can answer now.

Make no mistake, this is not something that the Fed should enter into lightly, and I am quite confident that they took this step only when it became apparent that it was the last option.  But this might have been one of those turning points where a decisive action had to be made.  Anyone who has not read chapter 7 of Friedman and Schwartz needs to do so right now.  Every time I tell a macroeconomics class about the mistakes the Fed ma