Recently in Financial Markets Category

Interesting question.  The Wall Street Journal Real Time Economics blog looks to the FOMC members for clarity and finds precious little.

Kansas City Fed President Thomas Hoenig continues to believe rates need to rise, which leaves him in opposition to the decision made just over a week ago to maintain the size of the Fed's balance sheet. St. Louis Fed President James Bullard, meanwhile, has talked of going even further than what's been done thus far, suggesting the Fed could again expand its balance sheet if the recovery falters further. Minneapolis Fed leader Narayana Kocherlakota thinks it's all a tempest in a tea cup, describing the Fed actions as technical and misunderstood by markets as a sign of growing worry over the outlook.

As the article later points out, Hoenig's position is of limited relevance as he is, and has remained, the lone voice calling for a rate increase.  The real action is between Bullard's and Kocherlakota's positions.  About them, the RTE blog continues...

Bullard, however, framed the issue in a way that lined up neatly with the prevailing market view. He told The Wall Street Journal in an interview "I thought we should be in a position to return to a quantitative easing program if we got further disinflation."

Kocherlakota muddied the waters Tuesday, saying the market got the issue wrong. Low rates are driving more mortgage prepayments than the Fed anticipated, so purely for technical reasons, the Fed needs to act to keep its portfolio size up. "I would say that there is no new information about the current state of the economy to be learned from the FOMC's actions or its statement," the policymaker said.

Kocherlakota is refreshingly direct about it.  To say that there is "no new information" certainly puts the markets in their place.  That sort of candor, along with a plausible technical reason, is helpful to outside observers, even if it seems to "muddy the waters."  Kocherlakota's view is consistent with the notion that the Fed needs to make sure that they don't accidentally contract.  Certainly, that is a sensible position.  The question is whether it goes far enough.

Bullard wants to make sure the Fed can go further if they need to.  Will they?  That remains to be seen.  And in the remainder of 2010, that will be the big question.

It remains somewhat unclear to me what the Fed can do to improve the labor market, which is the primary concern now.  Fiscal policy, in a perfect world, would be better suited for that although fiscal policy is being held hostage to politics, and probably will be for a while.  So everyone will be looking to the Fed to do something.  Aside from making sure they don't passively and unintentionally contract the credit supply, it's not clear how they can achieve the effects that people want.

Ultimately, you can't quite square the two positions. The best I can do is to say that I agree with Kocherlakota today, but Bullard might be right tomorrow.  Pulling the trigger too early could be destabilizing and may not necessarily have the positive effects you want.  Policy lags notwithstanding, I wouldn't be ready to take the risk yet.

From Reuters:

SYDNEY (Reuters) - Australia's central bank raised its key cash rate by 25 basis points to 3.25 percent on Tuesday, as surprising economic strength allowed it to withdraw some of the exceptional stimulus doled out during the global credit crisis.

How long before others follow suit?

From the Federal Reserve web site:

Information received since the Federal Open Market Committee met in June suggests that economic activity is leveling out. Conditions in financial markets have improved further in recent weeks. Household spending has continued to show signs of stabilizing but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit. Businesses are still cutting back on fixed investment and staffing but are making progress in bringing inventory stocks into better alignment with sales. Although economic activity is likely to remain weak for a time, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.

The prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year. In addition, the Federal Reserve is in the process of buying $300 billion of Treasury securities. To promote a smooth transition in markets as these purchases of Treasury securities are completed, the Committee has decided to gradually slow the pace of these transactions and anticipates that the full amount will be purchased by the end of October. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.

Summary/highlights:

• No change in the fed funds target
• Fed funds rate will likely remain low for an extended period
• Purchases of Treasury securities that has been announced and ongoing for several months will slow and come to an end by the end of October
• Economy to remain weak for some time, but gradually return to sustainable growth
• Commodity prices rising, but considerable slack suggests that inflation will remain subdued

Not too bad.  But even if (and it is a big "if") the worst is behind us, the recovery looks to be very gradual.

Felix Salmon sent me a note in response to my last post.  He's more optimistic that the new regulations will kill fewer trees and result in clearer and more focused information for the consumer.  Maybe so.  I do believe it would be possible to provide a better, more streamlined set of disclosure documents to the consumer.  I'm not sure it will happen.

It may very well kill fewer trees though.  One of the possibilities mentioned in the white paper is the use of Internet based calculators (see page 63) to help consumers understand what they are getting.

I've purchased two houses and two cars in my lifetime, and I understood exactly what I was getting.  And in each case, there was someone pushing the papers who was ready to explain each part.  Of course in each case, I made it clear that I understood, so there was no way that they were going to lead me astray.  Could a dishonest person have tried to lead me astray?  They could have.  And if I were not financially literate, they might have succeeded.

So there are (at least) two ways for the borrower to mess himself or herself up here.  The borrower may not be financially literate and be led astray by a dishonest agent.  Or the borrower might be financially literate and just get caught up in the madness.

Tell me how an Internet calculator is going to really protect either of these folks with any more certainty that the current system does?  A fast talking salesperson can figure out how to maneuver around the disclosure requirements anyway (just you watch).  And nothing is going to stop the financially literate individual who is just following the herd figuring it won't happen to him or her.

But I do think that financial literacy is a necessary condition to better consumer protection.  And that isn't coming from an Internet calculator.  (By the way there is paragraph mentioning financial literacy in the white paper.  But I've seen that sort of talk for years.  Talk is cheap.)

We're rearranging the deck chairs, folks.

One of the complaints about the Vista operating system is that it assumes the user is an idiot and asks you to confirm everything.  (There is a way to turn that off, however.)  I have a feeling that the new model for consumer protection in the financial markets will be similar--but without the ability to turn it off.  The worst case scenario would be that anyone who wants a loan will have to go through something like one of those web based corporate training programs that forces you to click through bunch of information, answer some true/false questions, and give you a certificate of completion.  Don't say I didn't warn you.

Lest I be seen as being too harsh, let me conclude by saying that the aim here is noble.  I am sure that they have the very best intentions in the world.  I'm also quite sure that they believe that what they are proposing will benefit the consumer.  They want to give the consumer more useful knowledge, and they think that they'll get it right this time where they failed before.  I say it's not that easy.  And all the Internet calculators in the world are a waste of time for that guy who just clicks through the information without really reading it.  How are you going to regulate that?

In the case of Vista, I'm sure that so many people just click "ok" when prompted for all those confirmations that they don't read them anymore.  It ends up being less effective that way.  I don't think that's what we want credit market regulation to look like.

Today's Washington Post gives us a glimpse of Obama's plan to restructure the regulatory environment.

The plan is built around five key points, according to a briefing last night by senior administration officials and a copy of the white paper obtained by The Washington Post.

The proposals would greatly increase the power of the Federal Reserve, creating stronger and more consistent oversight of the largest financial firms.

It also asks Congress to authorize the government for the first time to dismantle large firms that fall into trouble, avoiding a chaotic collapse that could disrupt the economy.

Federal oversight would be extended to dark corners of the financial markets, imposing new rules on trading in complex derivatives and securities built from mortgage loans.

The government would create a new agency to protect consumers of mortgages, credit cards and other financial products.

My response goes something like this.  We live in an imperfect world with imperfect regulations on financial markets.  Hence, there exist policies that would represent an improvement on the current system, but there are also many (more) ways to mess it up even worse.

It would be much easier if we could close our eyes, make a wish, and eliminate stupidity and dishonesty.  But since that won't happen, let's think about whether the Obama plan would represent an improvement.

Hopefully it would put a stop to the "too big to fail" argument.  Obama seeks to give the government (Fed) the ability to break up large bank holding companies that get into trouble.  But the only part of the white paper where this is directly mentioned (that I can find) is pages 74-76.  To say it is short on details would be charitable.  Granted, this is something where the rules would probably be written on the fly, but then, isn't that what we're doing now?  Is it enough to just say that we'll let the Fed do what it needs to do?  If we did write rules for this, could the end up being too constraining?  This is a really tough problem, and I don't think they've solved it.

On the plus side, the document does spend a few pages suggesting a larger role for the Fed in overseeing the payments, clearing, and settlement systems.  Now that's something that is actually within their proper scope of regulation anyway.  That seems like a winner.  (But also short on details.)

More rules on trade in derivatives is also something that I would support if done right.  I'll need to think more about what is the right way.

But the document also spends a disproportionate amount of pages discussing how to protect consumers from "financial abuse."  In fact, in my perusal of the document tonight, I see the most detail in this section.  Among other things, they would like to mandate that a traditional fixed-rate 30-year mortgage ("plain vanilla" as they put it) be offered alongside any other lawful mortgage products, and that the consumer be given the tools to compare the various products.

Sorry, I don't see this as making much difference.  We already have disclosure requirements that kill quite a few trees for every mortgage closing.  With all of the information shoved in front of the homebuyer, most people just shut up and sign.  Will giving them more information (as opposed to useful knowledge--which cannot just be given) really make a difference?  If you're an unethical mortgage broker, don't you think that there will be a way to game this system to your advantage (offering fixed-rate mortgages at exorbitant interest rates to discourage their use, for example)?

Yet this seems to be where the administration is focusing its efforts.

Fortunately, there was some other insightful comment on regulation today.  Arnold Kling writes in a guest column at the Washington Post:

In my view, the worst regulatory error was allowing bank capital regulations to be evaded. In the late 1980s, after many savings and loans had failed in the United States, international bank regulators developed the Basel capital accord. Although this was flawed in many respects, it did represent a formal requirement for banks to hold capital based on risk. Most assets required 8 percent capital. Some low-risk assets required 4 percent capital, and some government securities required even less.

Soon after the capital accords were rolled out, banks began to come up with ways to "game" the system. For mortgages, the two most important techniques were securitizing mortgages and creating off-balance-sheet vehicles. Securitization allowed banks to get large portions of their mortgage portfolios rated AAA, and these AAA ratings in turn lowered capital requirements, particularly after a revision to the capital requirements that was formalized on Jan. 1, 2002. The off-balance-sheet entities were an even bigger scam, because generally-accepted accounting principles (which the regulators copied) allowed the banks not to count the mortgage securities in these entities as assets at all.

All of this was done right under the nose of the regulators. An article in 2000 in the Journal of Banking and Finance,called "Emerging problems with the Basel Capital Accord: Regulatory capital arbitrage and related issues," was written by a Federal Reserve staffer. Although such scholarly articles always carry disclaimers that the contents do not represent the opinions of the Fed, it clearly showed an awareness of how banks were using techniques to evade capital requirements. The author rationalizes this in part by suggesting that without the ability to evade capital requirements, banks would have been less competitive in the market to finance mortgage loans or other low-risk assets.

I think Kling is on the right track.  If financial market regulation is like firefighting, then to prevent this sort of gaming of the system would be like starving the fire of fuel.  A different tactic than pouring water on the fire, but still effective--sometimes more so.

At Marginal Revolution, Tyler Cowen writes:

The broader point is this.  Better regulation comes through many years of experience and gradual process improvements, built upon some reasonable methods for imposing regulatory accountability.  That's how the FDIC got to be good at much of what it does.  Better regulation does not come from sitting down, waving a wand, and hoping that a new name or box will address the problem you are concerned about.  Keep that in mind next time you hear that "now is the unique moment," etc.

Well put.  Doubling or tripling the amount of paper shoved in front of a home buyer at closing won't do it either.  There should be changes.  But there really isn't any need to rush something through by the end of the year. We're not in danger of a repeat of the circumstances that laid the groundwork for the crisis any time soon.  So take some time and do it right.  There might be a few good ideas in the Obama plan, but there is also a lot more alphabet soup without a lot of details about how it will all work.

Felix Salmon calls it a bust as well.

So the FOMC had a meeting today.  Of course with rates already at 0-25 basis points, it just doesn't generate the same level of excitement.  Still, the discussions in the meeting are no less important.  In that spirit, here is the text of the press release.

The Federal Open Market Committee decided today to keep its target range for the federal funds rate at 0 to 1/4 percent. The Committee continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

Information received since the Committee met in December suggests that the economy has weakened further. Industrial production, housing starts, and employment have continued to decline steeply, as consumers and businesses have cut back spending. Furthermore, global demand appears to be slowing significantly. Conditions in some financial markets have improved, in part reflecting government efforts to provide liquidity and strengthen financial institutions; nevertheless, credit conditions for households and firms remain extremely tight. The Committee anticipates that a gradual recovery in economic activity will begin later this year, but the downside risks to that outlook are significant.

In light of the declines in the prices of energy and other commodities in recent months and the prospects for considerable economic slack, the Committee expects that inflation pressures will remain subdued in coming quarters. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. The focus of the Committee's policy is to support the functioning of financial markets and stimulate the economy through open market operations and other measures that are likely to keep the size of the Federal Reserve's balance sheet at a high level. The Federal Reserve continues to purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand the quantity of such purchases and the duration of the purchase program as conditions warrant. The Committee also is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets. The Federal Reserve will be implementing the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Committee will continue to monitor carefully the size and composition of the Federal Reserve's balance sheet in light of evolving financial market developments and to assess whether expansions of or modifications to lending facilities would serve to further support credit markets and economic activity and help to preserve price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Dennis P. Lockhart; Kevin M. Warsh; and Janet L. Yellen.  Voting against was Jeffrey M. Lacker, who preferred to expand the monetary base at this time by purchasing U.S. Treasury securities rather than through targeted credit programs.

I find it interesting that one member, Mr. Lacker, preferred purchasing U.S. Treasury securities.  Recall that at the last meeting, it was reported in the press release that the Fed would be evaluating the benefits of such an action.

Let's turn back the clock to September 15 when we watched BofA acquire Merrill Lynch.  BofA CEO Kenneth Lewis was at the peak of smugness.  I wrote:

I watched the press conference with the John Thain and Kenneth Lewis (CEOs of Merrill Lynch and Bank of America, respectively) as well as the CNBC interview with Lewis.  Mr. Lewis looked like the cat that ate the canary.  He certainly gives the impression that this is the deal of a lifetime.  Who knows?  He may be right.

Of course, it was only after that press conference that the true magnitude of Merrill's problems became known.  Sort of like getting reservations to a five-star restaurant only to find when you get there that the chef has left the building.  So what do you do?  Well, you've been wanting to eat there all your life, and you're not going to get any reservations anywhere else now, so you dutifully take your seat and place your order.

And so BofA went right on with the deal because they've always wanted a piece of that business, and where else are they going to go?

Back at the restaurant without a chef, the only question is not if but how much will the quality suffer.

BofA had no idea how much Merrill had gone down hill.

Back at the restaurant, the food arrives.  It's lousy, but you swallow it down, not wanting to offend... or cause a run for the exits.

BofA considered it their patriotic duty.  (NY Times)

Mr. Lewis told analysts that he was surprised to learn in December, three months after the bank snapped up Merrill Lynch in a shotgun deal, that the magnitude of losses at the brokerage was far greater than expected. He said he had considered walking away from the deal at that point, but was persuaded not to, partly by regulators who feared that a failure to seal the deal could set off a new round of panic in the markets.

The decision to stick with Merrill despite its problems, he said, was patriotic. "I do think we were doing the right thing for the country," Mr. Lewis said.

And then you're handed the bill.  Only then does it sink in.

Mr. Lewis said he had considered trying to renegotiate the price once he learned the extent of Merrill's losses. But he feared that the length of time required for a new shareholder vote would put Merrill and the markets at risk. More important, he said, the government did not want to risk new turbulence in financial markets if the deal were to be delayed.

Rather than argue with the waiter (very undignified), you pay the bill and appeal to a higher authority.

"In recognition of the position that Bank of America was in, both the Treasury and the Federal Reserve gave us assurance that we should close the deal and that we would receive protection," Mr. Lewis said.

Oh, and did I mention that you're paying for this meal with someone else's money?

BofA shareholders aren't exactly thrilled about this patriotic act.

So where do they go from here?  Unfortunately, options are limited.  In the eyes of many, BofA is too big to fail.  They should get assistance from the TARP.  However, this will be a test of the system to see if the government can get an adequate stake in the bank to minimize risk to the taxpayer.  If this is more of a short-term solvency issue, then there is less to worry about.  But there are no easy answers.  The only thing that appears certain is that, ex post, BofA overpaid.  Tough luck.  Cover it with the TARP to contain the damage (this is probably a less objectionable use of it than some uses) and answer to the shareholders.

That meeting will look a lot different than the Sept. 15 press conference.

Reuters is reporting that President-elect Obama will nominate Georgetown law professor Daniel Tarullo for one of the two open seats on the Federal Reserve Board of Governors.  Story here.  Tarullo's bio here.

From the looks of his qualifications, Tarullo will add some expertise to the Board in the area of financial regulation.  Having a legal scholar on the Board will be quite beneficial for the Fed as it copes with changing regulations, both those that they write and those that affect the environment in which they operate.

... to have a zero funds rate.  Well, almost zero.  When I got up this morning to give my final exams, I thought how the FOMC will almost certainly go down to 25 b.p.  They'll want to go all the way to zero, but something in them just doesn't want to say "zero".  They need a way to go to zero without really saying that they're going to zero.

And so they did.  (FOMC Statement)

The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent. 

Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined.  Financial markets remain quite strained and credit conditions tight.  Overall, the outlook for economic activity has weakened further.

Meanwhile, inflationary pressures have diminished appreciably.  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 further in coming quarters.

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability.  In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time. 

The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level.  As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant.  The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities.  Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses.  The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.

It had to be done.  If we were to go another 6 weeks speculating about whether and when we would actually have quantitative easing, I'm not sure the market could cope with the uncertainty.  To go down to 25 b.p. is effectively an admission that they need to go to zero, so you might as well just do it.

Now the game has changed.  Say what you will about the fact that the normal monetary policy channels haven't been working for some time.  That is history now.  Tomorrow when they get up and go to work, they will have to come to terms with the fact that they have committed to operating in a whole new environment.  December 16, 2008 will be right up there with October 6, 1979 in the short list of monetary turning points--but the turn is in the opposite direction.

Tomorrow their real work begins--revealing to the world what it means to "employ all available tools".  That phrase is going to be ringing in my head all night.

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 made in the Great Depression, I end by talking about the many things we have learned since then about how not to let it happen again.  Few people know those lessons better than Mr. Bernanke.  Dithering in the face of these problems only makes them worse.  Better to have swift decisive action and move toward a resolution.

To those who say that this fails to properly punish those who took excessive risk, I agree in part but can only say that protecting the innocent (or perhaps less guilty) is more important right now than punishing the truly guilty.  To those who would say that this is an affront to the free market system, I would simply say that without confidence in market institutions the system doesn't work.  The system's ability to restore that confidence has been compromised by the foolish actions of many people.  Some will get their comeuppance.  Some will not.  It's not a perfect world.  We'll try to reform the system so as to do better next time.  Right now let's focus on doing it better than last time.

In a nice commentary, Calculated Risk appears cautiously optimistic.

There will be more grim news, perhaps for another year or more. And there is definitely some possibility of a systemic financial collapse (see Professor Roubini's excellent discussion of the downside risks). But unlike observers that believe this only marks the end of the beginning, I believe there is a chance that these events mark the beginning of the end of the crisis.

As I said yesterday, I think the end game has begun.  Clearly the push to mark down the values of these assets is in full swing.  The AIG deal could be a catalyst for an orderly sale of these assets, a rebalancing of portfolios, and a fair market valuation of assets on the books of other firms.  In the process, we might find other AIGs, but more than likely any of the truly enormous problems will be discovered first, and that process may not take too long.  Several months, perhaps--but not several years.  Indeed, we are fortunate that these problems are being discovered and dealt with rather than festering for a decade or more.

I've been in class all day, so I haven't had a chance to write about the days events.  Actually, there's not that much more to say other than that I really admire the fact that the Fed held the line on interest rates today.  As I said yesterday, the crisis is one of quantity, not of price.  The new lending facilities are much more important and useful than a 25 basis point cut in the funds rate.  So my confidence has been buoyed by this news.

Here's the link to the Fed's press release.

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 2 percent.

Strains in financial markets have increased significantly and labor markets have weakened further. Economic growth appears to have slowed recently, partly reflecting a softening of household spending. Tight credit conditions, the ongoing housing contraction, and some slowing in export growth are likely to weigh on economic growth over the next few quarters. Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth.

Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain.

The downside risks to growth and the upside risks to inflation are both of significant concern to the Committee. 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; Christine M. Cumming; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. Ms. Cumming voted as the alternate for Timothy F. Geithner.

My quick take is that it is very noncommittal about whether any rate cuts are forthcoming.  The inflation pressure still figures prominently in the press release, though they do expect inflation to ease.  This is an announcement that leaves all avenues open--and that is a very good thing.

In my intermediate macro class today, I lectured against a backdrop of the live (well, actually slightly delayed) tick-by-tick chart of the fed funds futures on the CBOT.  I was teaching macroeconomics as it happened.  You don't get to do that very often.

Seems like the big questions on everyone's mind are whether there will be some kind of development with AIG tomorrow, which firms are most exposed to Lehman, and whether the Fed will cut interest rates.  It goes without saying that everyone is also wondering about whether and how much the Dow may fall.  As I write, the futures market is down, but not drastically, suggesting that the day may start on a down note.

I can't say much about the first two.  But let's think about the Fed for a minute.  When I wrote in the afternoon, it looked like the market was only pricing in a small probability of a rate cut.  Late night coverage on CNBC suggests that the probability has increased substantially now.

The Wall Street Journal acknowledges the uncertainty:

Federal Reserve officials aren't inclined to veer from plans to hold short-term interest rates steady at Tuesday's meeting, even though financial markets are putting strong odds on a quick rate cut.

The Fed's thinking could change, particularly if there is another sharp deterioration in markets and the financial sector Tuesday. And even if officials decide to stay on hold, they could signal in their end-of-meeting statement a greater willingness to consider rate cuts if the economy or markets worsen.

A rate cut would be a confidence booster, to be sure.  Ordinarily, one might expect a rate cut in this case would prevent the financial market problems from spreading to Main Street.  I'm not sure that 25 basis points (or even 50) would really have much of an effect in that regard.  Plus, if the Fed were to cut 50 b.p. tomorrow (as some are expecting), it leave only another 1.50% to go before hitting the zero lower bound.  Given that this could go on for a while, it is imperative that they hold back some ammunition just in case things get much worse.

But most importantly, I don't see how 25 points (or even 50) does anything substantial to ease the credit crisis that the expansion of the quantity of credit through the various lending facilities can't do.

In the end, they may decide that a 25 or 50 point move is necessary to inspire confidence.  I would like to think that in the last year the market has wised up in that regard and can understand that this problem will not be solved by a rate cut any time a financial firm runs into trouble.

These are momentous times, the likes of which we will be talking about for years to come.

I watched the press conference with the John Thain and Kenneth Lewis (CEOs of Merrill Lynch and Bank of America, respectively) as well as the CNBC interview with Lewis.  Mr. Lewis looked like the cat that ate the canary.  He certainly gives the impression that this is the deal of a lifetime.  Who knows?  He may be right.

At this point, I have begun to make a few inferences.  We'll see how accurate they turn out to be.

1. Based on CNBC's reporting, it sounds like Merrill Lynch really cleaned up their act (and their books) in the last few months.  They make it sound like Merrill might have even been able to survive this crisis without being sold.  That's encouraging.  Perhaps some of the other firms that are in less dire condition may be able to heal themselves, even if it takes some time for it to all work out.
2. Either Lehman's position in the market must have been significantly different than that of Bear Stearns a few months ago, or the market is better equipped to deal with a failure of that magnitude.  Both could be true as well.  There was no cataclysmic market meltdown this morning.  Contrast that with the speculation on what might have happened this spring if Bear Stearns had declared bankruptcy.  This is also encouraging.
3. Remember when people criticized the Fed for taking part in the rescue of Bear Stearns?  Remember when people said that it would create moral hazard and make it difficult for the Fed to say no next time?  Well, apparently the Fed is stronger than a lot of people gave them credit for.  While I don't think Mr. Bernanke expected it to play out exactly this way (who would have?), I do applaud him for taking the action with Bear Stearns to prevent the first incident from being such a shock to the system.  A lot of people wanted a sacrificial lamb.  Mr. Bernanke may have been correct in thinking that a better candidate than Bear Stearns would come along.
4. AIG's potential collapse sounds like it would have a greater impact than Lehman's.  I think the Fed is right to hold the line.  The announcement from the governor of New York will help.  The growing pool of private equity might help too.  And of course someone might ride to their rescue as well.
5. Expect another year of write-downs, bankruptcies, and mergers.  But I think that the end game has begun.  By that, I do not mean that the danger is over or that things will get eaiser.  When I say that the end game has begun, I mean that the deals will start happening at a quicker pace in the next 12 months than in the last 12 months and that each one will bring a bit of relief, however slight.  The financial markets will probably not be over this until 2010, and even then they won't be at pre-crisis strength.

So then there is the matter of the FOMC meeting tomorrow.  September futures on the Chicago Board of Trade jumped a little bit this morning on all of the news, but have pulled back a bit.  Traders are pricing in a significant probability of at least a 25 basis point cut.  However, it is far from a sure thing.  I'm hoping they don't.  I don't think they want to.  The expansion of the various lending facilities should do more to ease the strain than a 25 basis point cut anyway.  Plus there is the obvious fact that they would like to save some ammunition in case it is needed later if things don't play out as well as they might.

Let's see how things go tomorrow.

It certainly says something when firms that survived the Great Depression are falling victim to the aftermath of the last decade's credit binge.

And so the venerable Lehman Brothers passes from the scene at the age of 158.  When the sun rises in the morning, we will see how Wall Street deals with this development.  Of course, many people were expecting this, and undoubtedly made contingency plans.  By Friday, it seemed that a Sunday night announcement was almost a sure thing.  After all, we went through this once before with Bear Stearns.  Yet, even though this was possibility for the past few weeks and months, it is now reality.

It is interesting that Bank of America, which as of Friday many people were expecting to buy Lehman, took a pass on that deal and is instead buying the troubled (and storied) Merrill Lynch.  How's that for misdirection? 

But that's not all.  Showing once again that bad things do indeed come in threes, the insurance giant AIG is also in need of assistance.

With these three companies in such dire straits, the Federal Reserve did what it could... quoting in part:

The Federal Reserve Board on Sunday announced several initiatives to provide additional support to financial markets, including enhancements to its existing liquidity facilities. 

"In close collaboration with the Treasury and the Securities and Exchange Commission, we have been in ongoing discussions with market participants, including through the weekend, to identify potential market vulnerabilities in the wake of an unwinding of a major financial institution and to consider appropriate official sector and private sector responses," said Federal Reserve Board Chairman Ben S. Bernanke. "The steps we are announcing today, along with significant commitments from the private sector, are intended to mitigate the potential risks and disruptions to markets."

"We have been and remain in close contact with other U.S. and international regulators, supervisory authorities, and central banks to monitor and share information on conditions in financial markets and firms around the world," Chairman Bernanke said.

The collateral eligible to be pledged at the Primary Dealer Credit Facility (PDCF) has been broadened to closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks. Previously, PDCF collateral had been limited to investment-grade debt securities.

The collateral for the Term Securities Lending Facility (TSLF) also has been expanded; eligible collateral for Schedule 2 auctions will now include all investment-grade debt securities. Previously, only Treasury securities, agency securities, and AAA-rated mortgage-backed and asset-backed securities could be pledged.

By expanding the types of collateral accepted, the Fed addressing the need for liquidity by immediately expanding the quantity available.  At this point, that is what is needed (as opposed to any action on interest rates).

Justin Fox has a pretty good summary:

We'll learn much more about the exact chain of events over the coming days and weeks and months, but the basics go something like this: New York Fed boss Tim Geithner (and his pals from Washington) tried to figure out some way to avert the failure of Lehman Brothers without offering any kind of federal guarantee. But nobody wanted to buy Lehman without help from Uncle Sam, so it looks like Lehman will go under. Which meant Merrill Lynch would take over Lehman's spot as Most Obviously Troubled Investment Bank. So Merrill sold out to Bank of America at $29 a share ($44 billion total). Which is an awful lot less than the $97 a share Merrill was selling for a year-and-a-half ago, but also a lot more than nothing.

So on Monday we'll get to see what the failure of an investment bank with $600 billion in assets looks like. And more important, we'll get to see if the obviously deeply flawed American financial system will be able to retain the confidence of the foreign lenders and investors who keep it going.

One crucial thing to remember in all of this is that none of the experts on Wall Street have any real idea of what they're dealing with. What has worked for the past quarter century or so has stopped working. And nobody knows what American financial institutions are going to look like going forward. Probably a lot more like the universal banks of Continental Europe. But anybody who says they know for sure is lying.

Want to read a little history about the last time something like this happened?  Here's what the NY Times had to say about Drexel Burnham Lambert in 1990.  It reads a lot like today's news, right down to the weekend meetings.  Just replace "junk bonds" with "subprime mortgages".

There are some differences, of course.  The biggest difference is that there are still so many firms in similar condition that there is no guarantee that this crisis is over.  I think that Fox is right in saying that "anyone who says they know [what American financial institutions will look like after this] for sure is lying."  But I am confident that the system will get through this very troubling time.

As this Wall Street Journal piece by Justin Lahart points out, there needs to be quick and decisive action to prevent something like what happened in Japan during the 1990s.  The sooner everybody confronts that reality, the quicker we can get back to business.  It is good to get the "unwinding" process started as soon as possible.  Make sure that the smaller firms don't become collateral damage from counterparty risk, and let the consolidation result in the inevitable (but probably only short-to-medium run) shrinkage of the sector.

Every time one of these trouble firms is finally taken aside and shown the handwriting on the wall, we take one more step toward the day when someone gets to write one pretty massive after-action report.  And of course, now that the extent of the damage to these three firms has been revealed, the rush is on to find who is next.  Until the answer to that question is "no one", there will be more rough days ahead.  I don't think we're there yet.

John Jansen has some excellent commentary and I'm sure will be adding more in the morning.  He is quite worried about how all of this will end.

Government has not been able to hold bank the forces which have taken down financial giant after financial giant. Capitalism demands pain. Good risk is rewarded and imprudent risk is punished. We were engaged in an orgy of imprudent risk taking for nearly a decade and now a heavy price will be paid for the violation of so many simple and common sense precepts of trading.

Very true.  On a related topic, Tyler Cowen opines in the NY Times:

There is a misconception that President Bush's years in office have been characterized by a hands-off approach to regulation. In large part, this myth stems from the rhetoric of the president and his appointees, who have emphasized the costly burdens that regulation places on business.

But the reality has been very different: continuing heavy regulation, with a growing loss of accountability and effectiveness. That's dysfunctional governance, not laissez-faire.

Blame enough to go around, to be sure.  Like I said, it's going to be some after-action report.

Mark Thoma has a good collection of links for your morning reading as well.

Buckle up.  It could be an interesting day.

UPDATE:  Here's one more comment on the AIG situation.  First the Wall Street Journal:

During a weekend scramble to shore up its finances, AIG turned down a capital infusion from a group of private-equity firms led by J.C. Flowers & Co. because an option tied to the offer would have effectively given them control of the company, an 89-year-old giant that does business in nearly every corner of the world.

Which prompted Yves Smith of Naked Capitalism to say:

That is not going to endear them to the Fed, turning down a deal, particularly when Merrill did the right thing and sold itself to avert a possible systemic event. This is brassy and risks overplaying their hand. If I were the powers that be, I'd tell them to stuff it and take the deal.

Indeed.  I think the Fed is really trying to limit the taxpayers' exposure on this one.  If AIG turns down a deal, it gives others license to do so.  I don't like where that leads.

Obviously a lot of people were hoping for some insight on inflation and the course of interest rates. However, the real story is here: (Full text of Bernanke's speech)

An effective means of increasing the resilience of the financial system is to strengthen its infrastructure. For my purposes today, I want to construe "financial infrastructure" very broadly, to include not only the "hardware" components of that infrastructure--the physical systems on which market participants rely for the quick and accurate execution, clearing, and settlement of transactions--but also the associated "software," including the statutory, regulatory, and contractual frameworks and the business practices that govern the actions and obligations of market participants on both sides of each transaction. Of course, a robust financial infrastructure has many benefits even in normal times, including lower transactions costs and greater market liquidity. In periods of extreme stress, however, the quality of the financial infrastructure may prove critical. For example, it greatly affects the ability of market participants to quickly determine their own positions and exposures, including exposures to key counterparties, and to adjust their positions as necessary. When positions and exposures cannot be determined rapidly--as was the case, for example, when program trades overwhelmed the system during the 1987 stock market crash--potential outcomes include highly risk-averse behavior by market participants, sharp declines in market liquidity, and high volatility in asset prices. The financial infrastructure also has important effects on how market participants respond to perceived changes in counterparty risk. For example, during a period of heightened stress, participants may be willing to provide liquidity to a market if a strong central counterparty is present but not otherwise.

and here...

Going forward, a critical question for regulators and supervisors is what their appropriate "field of vision" should be. Under our current system of safety-and-soundness regulation, supervisors often focus on the financial conditions of individual institutions in isolation. An alternative approach, which has been called systemwide or macroprudential oversight, would broaden the mandate of regulators and supervisors to encompass consideration of potential systemic risks and weaknesses as well.

The latter is, of course, much easier said than done. It will be interesting to see what sort of ideas come out of the conference.

From Reuters:

Goldman Sachs plans to test the program sometime this week, a spokesman said. Morgan Stanley Chief Financial Officer Colm Kelleher said his bank has already tested the program, and a spokeswoman for Lehman said the investment bank has also done so.

The Wall Street Journal reports that there still might be some stigma attached to borrowing from the Fed, but that the banks "viewed the new funding source positively".

The Real Time Economics Blog collected some reactions from Wall Street concerning the rate cut. One firm chose to emphasize their concerns about inflation.

These actions were taken despite rising inflation pressures. The Fed expects these pressures will subside as energy and other commodity prices flatten out, and as unused resources rise. Our take, however, is that commodity price strength is in part a function of the easy stance of monetary policy and that inflation is headed higher. –Bear Stearns

Contrast this with what they said in December, also from the pages of the Real Time Economics Blog:

The Fed continues to couch its policy actions in terms of their impact on economic growth rather than admit that the primary motivation for Fed action is the turmoil in the financing market — turmoil which may become worse as a result of the miserly action on the discount rate. –Bear Stearns

I guess it's all a matter of your perspective at the time.

From Felix Salmon:

I'm similarly skeptical about the idea that the Fed is "propping up" Bear Stearns. For a couple of months until it can be deleveraged and subsumed into JP Morgan, perhaps. But that's a world away from allowing banks to operate for years while marking distressed assets on their balance sheets at par, which is what happened in Japan. The Fed was happy leaving the carcass of Bear Stearns to the wolves at 270 Park: this was anything but a "propping up" operation.

I couldn't resist watching a little CNBC tonight. Kudlow was talking about how the Fed should have opened the discount window up to investment banks sooner. After all, Glass-Stegall was repealed in 1999. Since then, the role of investment banks in the financial system has expanded, and they have become intertwined with commercial banks (i.e. depository institutions). But all this time, houses like Bear Stearns have been working without a net. They've been unable to tap the discount window.

So the Kudlows of the world would like to have seen the Fed open the discount window to investment banks sooner. That way, maybe they could have survived this crisis. Hmm... maybe... maybe not. It might have prolonged the agony and the result would have looked more like Continental Illinois which although it came to a head in a day, took weeks for the FDIC to finally take the assets. All the while, they had access to the window and to a number of other banks (who were presumably willing to lend to CI because it had access to the window) to help them liquidate. In terms of restoring confidence to the system, it was probably better this way. Here's the deal. Take it or leave it. They had no choice but to take it.

If it turns out that there is another Bear Stearns out there waiting to happen, you can bet that it will unfold differently now that investment banks have access to the discount window. Should this change be made permanent? Should investment banks have access to the discount window at all times?

That's a tougher question. First, look at the way the Fed's announcement actually reads. They aren't lending directly to the investment banks... they are going through the primary dealers. (It happens that Bear Stearns was a primary dealer so in that case it would have been direct, but it would not necessarily be so in every case.)

First, the Federal Reserve Board voted unanimously to authorize the Federal Reserve Bank of New York to create a lending facility to improve the ability of primary dealers to provide financing to participants in securitization markets.... Credit extended to primary dealers under this facility may be collateralized by a broad range of investment-grade debt securities.

The fact of the matter is that now that this is out there it will be tough to put the genie back in the bottle. It's definitely a good idea in times of crisis. It is probably also a good thing to have on the books so that you don't get caught off-guard in the future. I would only amend it so that the credit is available at a penalty rate. Read Bagehot for the reason why.

Is it necessary to open the window directly to investment banks who are not primary dealers? No, and probably not a good idea either--except as already provided under statute in exigent circumstances. Let's see how this works, and if it works, just keep it on the books as it was announced yesterday.

Now let's look at the other end of the spectrum. For each person like Kudlow who would want to open the discount window to investment banks directly, there is probably a person who would want to reinstate Glass-Stegall and put the wall of separation between investment banks and commercial banks back up again.

But I don't see that as being the problem.

Glass-Stegall was meant to keep the commercial banks from engaging in speculative investment activities that would put customer deposits at risk. That's not what happened here, nor is it likely to be a big issue. The problem is that investment banks dependent on short term repos for daily financing are now as critical (if not more critical) for the stability of the system than the commercial banks of old. They also seem to be as prone (if not more prone) to the kinds of lapses in judgment that led to what we saw this weekend. But walling them off, even if it were realistic to do so now, would not make them go away, get smaller, or suddenly get better judgment.

So how do you get them to behave? Act as their lender of last resort? Lots of moral hazard, not enough moral authority. But perhaps by allowing their peers (here I am referring to the primary dealers) to be their lender (or buyer) of last resort you enforce a kind of market discipline that the Fed alone would have trouble enforcing. Was Bear Stearns a sacrificial lamb on this altar, as many are suggesting? Perhaps. And although I cannot do anything other than speculate as to whether that was the intent, it certainly was the way it worked out. It's too late to do anything about that now, and perhaps it was too late even last week. We'll never know.

But now that a mechanism is in place, I would simply prefer that next time it be done by lending to them at a penalty rate instead of buying at a discount.

On this day when the perils of largely unregulated markets are all to clear comes news of a merger that will in all likelihood mean better diversification of risk in a regulated market. CME Signs Deal for Nymex (Wall Street Journal)

...about the Fed's role in the buyout of Bear Stearns by JPMorgan, let it be this article by Greg Ip in the Wall Street Journal. An excerpt:

In some ways, the initiatives better equip the Fed to help a financial system that has changed drastically from one based on banks for most of its 95-year existence. It took a unanimous vote by the Fed's five governors yesterday to invoke a Depression-era clause in the Federal Reserve Act to waive the usual prohibition on Fed loans to nonbanks. A Fed official told reporters today's circumstances couldn't have been envisioned when the Fed was created, and noted newer central banks like Europe's have many of these powers. But these steps also take the central bank into uncharted territory with new and potentially troublesome risks.

Those risks include the possibility that with the credit crunch showing no sign of lifting, the Fed will be called on to lend to other troubled firms and end up a major creditor of Wall Street, even if at present the risk of any substantial loss appears small. Another risk is that while the Fed used a loophole yesterday in the Federal Reserve Act to expand its lending to nonbanks in "unusual and exigent" circumstances, it has in effect expanded the federal safety net with no political debate. However, the Fed sought and received agreement over the $30 billion loan from Treasury Secretary Henry Paulson, who informed President Bush.

Also check out the Real Time Economics Blog.

Some assorted links that didn't make their way into my previous three posts on tonight's events.

Felix Salmon is optimistic about the effect of the sale of Bear Stearns on the financial markets.

John Jansen has some comments and links on the overnight happenings.

The WSJ Real Time Economics Blog has an absolutely excellent post. Choice quotes:

Fed officials went out of their way to say Bear Stearns was unique in the problems it faced. No other major securities firms are in a similar situation, an official said.

and...

So how much has the financial system changed? Consider securities repo, an essential grease that enables dealers to make markets in a wide variety of credit instruments. In 1990, securities repo credit, at $372 billion was about 13% the size of federally insured bank deposits, at $2.8 trillion.

By last year, securities repo credit had ballooned to $2.6 trillion, 60% of the value of federally insured deposits at $4.3 trillion.

Gross repo among the primary dealers alone (that is, excluding banks but including loans among dealers) was $4.5 trillion on March 5, according to the New York Fed.

How secure is that funding base? Well, consider that two-thirds of repo loans mature or must be rolled over each day. And there is no government guarantee behind them (although Treasurys often collateralize them.) No wonder the Fed worried about a run on the repo market if Bear failed.

They also link to this article from 1992 by Anna Schwartz on "The Misuse of the Fed's Discount Window." That brought back memories for me. The article was required reading in my Money and Banking class back in college.

Calculated Risk links to CBOT Dow Futures. Look out below.

I could paraphrase Paul Krugman thusly: You ain't seen nothin' yet.

Reuters reports that Bear Stearns executives won't be getting any golden parachutes. Good.

Tim Duy expects a big fed funds move (75 or 100 basis points) on Tuesday and worries about a destabilizing fall of the dollar. He uses the word "monetization." Let's hope it doesn't come to that. Check back with me on Tuesday.

This is part three in a series of posts relating to this weekend's sale of Bear Stearns to JPMorgan and the Fed's role in the matter. (First post, second post)

The previous post highlighted a few of the reasons that some will be cynical about what happened tonight. The cynics make some relevant points. Moral hazard is a concern. Some will say that the Fed's role in backing JPMorgan is troubling. Similar points were made during the LTCM debacle. And yes, there might be other episodes like this. All true, and yet....

When I take my students up to Chicago to tour places like the Chicago Fed and the Board of Trade, I make sure to give them a little history lesson. At the corner of Jackson and LaSalle stands a reminder of another financial crisis with particular relevance to today--the old Continental Illinois building. Bank of America now occupies the space, but the name remains carved in stone as a mute testimony to what once was. The name faces out over LaSalle St. directly across from the main entrance to the Chicago Fed building. I have often thought, as I enter the Fed building, that having that name as a constant presence across the street must give anyone who works at the bank a sense of purpose. The Fed's very existence (and that of other regulators) is meant to prevent such bank failures and when prevention fails, to cushion the greater economy from the effects.

To be sure, there are some similarities as well as many striking differences between the Bear Stearns situation and that of Continental Illinois over twenty years ago. Continental Illinois was a commercial bank. Deposits were at risk. In that way, it was quite different from the situation we see today.

Despite these differences, one similarity between Continental Illinois and Bear Stearns is that they will both go down in the history books as a milestone in the Fed's evolution as a lender of last resort. For a great recounting of the Continental Illinois collapse, check out this document on the FDIC website: "History of the Eighties--Lessons for the Future." In particular, look at chapter 7, which details how the events unfolded and what was learned. This passage from page 249 is the appropriate text for today.

As has been noted, however, [Too Big To Fail] was an inaccurate term: “too big to liquidate” would have been more appropriate. Large banks did fail during the period, with shareholders losing their investments and managements being removed. In significant ways, Continental “failed.” But as one regulator observed, the banking agencies were “reluctant to tolerate the sudden and uncontrolled failure of large institutions and therefore generally opt[ed] for managed shrinkage, merger, or recapitalization.” There were several reasons for adopting such an attitude, the most important of which was “systemic risk.” This rubric covered “potential spillover effects leading to widespread depositor runs, impairment of public confidence in the broader financial system, or serious disruptions in domestic and international payment and settlement systems. In addition to systemic risk, the logistical difficulties and potential expense of liquidating a large bank also contributed to regulatory reluctance to close such a bank and pay off insured depositors. Moreover, liquidation would mean tying up uninsured depositors’ funds during the lengthy proceedings, a situation that could have a very disruptive effect on a bank’s community. For all these reasons combined, the larger the bank, the more likely it was that bank regulators would look for alternatives to closing the bank and paying off the insured depositors.

Except for the part about depositors, it could have been written about this weekend. Indeed, Bear Stearns failed. But it proved too big to liquidate without assistance. Continental Illinois essentially did go into receivership. The FDIC guaranteed everything, even beyond the $100,000/deposit limit. The Fed provided the backstop liquidity. It was not without controversy. And it took months to come to a head, and months to finally work out.

How things have changed. When this story first broke, the NY Times reported:

The developments may only postpone the eventual sale of all or part of Bear Stearns, which has had crippling losses on mortgage-linked investments. To keep the 85-year-old firm solvent, JPMorgan, backed by the New York Fed, extended a secured line of credit that gives Bear Stearns at least 28 days to shore up its finances or, more likely, to find a buyer.

One day, folks. One day and the deal was done. Would the markets have gone into a tailspin if it didn't get done that fast? Hard to say. What is not hard to say is that no one wanted to take that chance. You know that everyone involved at the Fed knows that they are doing something that will be scrutinized and criticized. They know about the moral hazard problem. They know that this could have negative consequences. They know that there is only one reason to do it--and that is that the consequences of not doing it are potentially much worse. Mr. Bernanke, scholar of the Great Depression, knows that better than most.

By pulling out all the stops the way that he has, Mr. Bernanke is probably already the most innovative Fed chair in history. I'm sure he would rather not have that distinction, but there are worse ways to distinguish oneself. And so in the final analysis (at least for tonight) I have to applaud Mr. Bernanke and the Fed for taking the steps to allow for an orderly liquidation of a failed institution--a very different thing from a bailout (Ritholtz agrees). JPMorgan can probably liquidate the assets more efficiently than the government could in a short amount of time. With the way that financial markets are connected and positions are so heavily leveraged they could not afford to shop Bear Stearns around the way that they did Continental Illinois. If we are to believe what we're hearing, the wheels were about to come off. The "repo" market moves too quickly and is less forgiving than a depositor in a commercial bank. Undoubtedly banks and other institutions had loaned Bear Stearns large amounts in the repo market and if they didn't get paid, well, that would indeed be the sort of thing that causes the whole market to seize up very suddenly, perhaps catastrophically. Not a slow motion deposit-driven meltdown.

Kind of makes Continental Illinois look like a minor hiccup in comparison. And yet here we are twenty-some years later talking about that event--its aftermath coloring our perception of today's events.

The Fed was presented with a tough choice and probably made a good call. And while some of the critics objections are reasoned (Buiter), some just don't get it. Today's public flogging of the MSM is outsourced to Brad DeLong.

As Buce of Underbelly puts it, Gretchen Morgenson fails to understand the distinction between preserving the lines of business that are the enterprise and rescuing the holders of the equity in the firm:

Rescue Me: A Fed Bailout Crosses a Line: WHAT are the consequences of a world in which regulators rescue even the financial institutions whose recklessness and greed helped create the titanic credit mess we are in? Will the consequences be an even weaker currency, rampant inflation, a continuation of the slow bleed that we have witnessed at banks and brokerage firms for the past year?

Or all of the above?

Stick around, because we'll soon find out. And it's not going to be pretty.

Agreeing to guarantee a 28-day credit line to Bear Stearns, by way of JPMorgan Chase, the Federal Reserve Bank of New York conceded last Friday that no sizable firm with a book of mortgage securities or loans out to mortgage issuers could be allowed to fail right now.... But why save Bear Stearns? The beneficiary of this bailout, remember, has often operated in the gray areas of Wall Street and with an aggressive, brass-knuckles approach.... Let's not forget that Bear Stearns lost billions for its clients last summer, when two hedge funds investing heavily in mortgage securities collapsed. And the firm tried to dump toxic mortgage securities it held in its own vaults onto the public last summer in an initial public offering of a financial company called Everquest Financial. Thankfully, that deal never got done.... And so, Bear Stearns, a firm that some say is this decade's version of Drexel Burnham Lambert, the anything-goes, 1980s junk-bond shop dominated by Michael Milken, is rescued. Almost two decades ago, Drexel was left to die...

It does not seem that she gets it.

I have to agree with DeLong. This is far a desirable outcome, but the consequences of inaction were worse. I admit to being uncomfortable with the Fed as a backstop and I worry about the precedent this sets. Tell me who is comfortable with it? It should make one very uncomfortable, and I'm sure that a lot of folks at the Fed are not sleeping well tonight. But sometimes you need to make the uncomfortable choice.

And so now we'll just have to wait and see how much the new lending facility gets used.

I didn't even get to talking about the discount rate. In light of everything else going on, it's a minor part of the story, and the fact that they lowered it is maybe a little bit of overkill. If someone can explain why an extra quarter point today as opposed to Tuesday is going to help the liquidity issues, I'm all ears.

This post continues the discussion from here. The immediate question is, of course, whether the Fed's facilitation of JPMorgan's rescue of Bear Stearns was a good idea. Here is a "no" vote from Willem Buiter (via Felix Salmon)

The Federal Reserve Act (1913) allows the Federal Reserve to lend, in a crisis, to just about any institution, organisation or individual, and against any collateral the Fed deems fit. Specifically, if the Board of Governors of the Federal Reserve System determines that there are “unusual and exigent circumstances” and at least five (out of seven) governors vote to authorize lending under Section 13(3) of the Federal Reserve Act, the Federal Reserve can discount for individuals, partnerships and corporations (IPCs) “notes, drafts and bills of exchange indorsed or otherwise secured to the satisfaction of the Federal Reserve bank…”.

The combination of the restriction of “unusual and exigent circumstances” and the further restriction that the Federal Reserve can discount only to IPCs “unable to secure adequate credit accommodations from other banking institutions”, fits the description of a credit crunch/liquidity crisis like a glove. So why hasn’t the Fed declared “unusual and exigent circumstances” yet, so non-deposit-taking financial and other institutions in need of liquidity and blessed with eligible collateral can go directly to the discount window? When in doubt, leave the middleman out.

...

Since Bear Stearns is not a deposit-taking institution, and appears to be of no other systemic significance, there is no need for a special resolution regime of the kind managed by the FDIC for troubled deposit-taking institutions. The firm could have been left to go into receivership.

If the Fed fears the risk of contagion effects and financial panic, it could have requested the nationalisation of the investment bank. This should have been done at a zero price. The existing shareholders could, if the US government were feeling generous, be granted the privilige of claim on whatever value is left after all other creditors have been paid off.

But the shareholders of Bear Stearns are eating their cake and having it. Shares may have dropped 43 percent in value, but what is left still beats nothing. And nothing seems the only possible fair value for what Bear Stearns would be worth without Fed assistance. Why was Bear Stearns not taken into public ownership, preferably at a zero price?

One would hope that, as soon as the rescue was announced, the existing management and board of Bear Stearns would have resigned en-masse, and without any golden handshakes of the CEO of Citigroup and Merrill Lynch -variety. This should have been a condition of the loan being made. The argument that only the existing management understands the business well enough to see it through the storm is unconvincing, as these are the very people that screwed it up in the first place. Why are the old top management and board members still in their jobs?

Another key issue concerns the terms on which Bear Stearns now borrows. I have always considered the Fed’s decision to lower the spread between the discount rate and the Federal Funds target rate to be a mistake - an inframarginal subsidy to those lucky enough to have access to the facility. Now we see why. If Bear Stearns can borrow at 50 bps over the 28-day OIS rate, or anything in that ballpark, it would be scandal.

Good points. And the first of those points (unusual and exigent circumstances) is what tonight's announcement by the Fed addresses--in a new and innovative way. From the press release,

First, the Federal Reserve Board voted unanimously to authorize the Federal Reserve Bank of New York to create a lending facility to improve the ability of primary dealers to provide financing to participants in securitization markets. This facility will be available for business on Monday, March 17. It will be in place for at least six months and may be extended as conditions warrant. Credit extended to primary dealers under this facility may be collateralized by a broad range of investment-grade debt securities. The interest rate charged on such credit will be the same as the primary credit rate, or discount rate, at the Federal Reserve Bank of New York.

So there it is. A new lending facility which appears to be inspired by the spirit of the "unusual and exigent circumstances" clause to which Buiter refers. But as path-breaking as this is, it is not quite as drastic as if the Fed had invoked that phrase and opened the door even wider. It is limited to primary dealers, which are listed here. These are the institutions that the New York Fed works with on a daily basis in the conduct of open market operations. One could argue that the Fed already uses them as a conduit for routine monetary policy, so they are the natural choice for facilitating these emergency actions.

If they are simply acting as a conduit for loans, that would be odd--sort of a regulatory quirk reflecting a holdover of the post-Depression wall that has now fallen between deposit institutions and investment institutions. It's a patch rather than a permanent fix while we try to figure out how to keep this from happening again and how to address it more effectively if it does. Not what I would suggest if I were designing the system de novo, but an understandable thing to do in the heat of battle.

But if it leads to the primary dealers swallowing up troubled institutions, then it does raise some issues of the sort that Buiter outlines in the second part of the quote. Why not take Bear Stearns (and whoever may be next in line) into public receivership directly?

Such questions are all the more relevant tonight as news comes of the sale of Bear Stearns to JPMorgan for $2 a share.

Reflecting Bear Stearns’s dire straits, JPMorgan agreed to pay just $236 million for the firm, a figure that includes the price of Bear’s soaring headquarters on Madison Avenue in Manhattan. At $2 a share, JPMorgan is buying Bear Stearns for a third of the price at which the troubled firm went public in 1985. Only a year ago, Bear’s shares fetched $170. The cut-rate price reflects deep misgivings about the firm’s prospects.

JPMorgan said it was guaranteeing the trading obligations of Bear Stearns and its subsidiaries, effective immediately. “JPMorgan Chase stands behind Bear Stearns,” Jamie Dimon, JPMorgan’s chief executive, said in a statement. “Bear Stearns’s clients and counterparties should feel secure that JPMorgan is guaranteeing Bear Stearns’s counterparty risk.”

The companies said that the Federal Reserve would provide special financing in connection with the transaction and that the Fed had agreed to fund up to $30 billion of Bear Stearns’s “less-liquid assets.”

If you're a fan of the movie It's a Wonderful Life, this is where George Bailey says "Potter's not selling. Potter's buying!" I mean, the Bear Stearns building alone must be worth....

But it's the last paragraph I quoted that leads to headlines like this, from a blog on the L.A. Times: "With Fed financing, JP Morgan buys Bear Stearns".

I suspect that's not how Mr. Bernanke wants this to be viewed.

But the cynic who has moral hazard on his mind can't help but ask... If they do it once like this, what if it happens again? What if another entity considered too big to fail gets special financing from one of the primary dealers through this new facility? As we saw tonight, it is but a small step from a loan guarantee to a fire sale.

This is a good time to link to Brad DeLong's excellent post in which he tells us what Bernanke, Paulson, et al. should have done this weekend. He would have the Treasury set a (discounted) price for mortgages that look a little shaky, buy them, push the market back to equilibrium, and make money for the taxpayer in the process.

If I were working for the Treasury right now, I would be saying: make this happen on Monday. There isn't time to set up a new bureaucrtacy--a HOLC, which is what Alan Blinder wanted to do as of three weeks ago. So use an existing bureaucracy: Fannie Mae. If I were Treasury Secretary Hank Paulson, I would spend the weekend building a legislative vehicle to introduce Monday morning on an emergency basis to give Fannie Mae the resources and the mission to undertake this mortgage rescue operation, and I think Fannie Mae is the right institution for the task: why does it have its government-sponsored status and guarantee if not to be used for purposes like these at times like these?

And if I were Ben Bernanke and Tim Geithner, I would be spending this weekend thinking about how to first thing Monday morning punish bear speculators on Bear Stearns, Lehman, and others by pushing their CDS spreads back to more normal levels. It seems to me that people on Wall Street need to be taught that betting that the Fed will not intervene to stabilize or that its interventions to stabilize will be unsuccessful is an unhealthy thing to do.

The Bear Stearns sale notwithstanding, it's not too late to do something approximating DeLong's (and Blinder's) suggestions to head off future episodes. (Who thinks that this is the end?)

Whether $2 a share is sufficient punishment for the speculators is left to the reader.

Some closing thoughts (at least for tonight) in the next post.

If you crave an "inside baseball" sort of look at the financial markets, you'll probably enjoy Across the Curve. The blog is authored by John Jansen. His bio lists him as a 30 year veteran of the bond market. I like what I see so far.

This is the largest rate cut in the modern era in which rate changes have been publicly announced. In fact, it's the largest cut going at least as far back as 1990. (UPDATE: This link says that it is the largest cut since October 1984.) Here is the full announcement. I'll be in class most of the day, but occasionally checking to see how the markets are doing.

The Federal Open Market Committee has decided to lower its target for the federal funds rate 75 basis points to 3-1/2 percent.

The Committee took this action in view of a weakening of the economic outlook and increasing downside risks to growth. While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labor markets.

The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.

Appreciable downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Charles L. Evans; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Eric S. Rosengren; and Kevin M. Warsh. Voting against was William Poole, who did not believe that current conditions justified policy action before the regularly scheduled meeting next week. Absent and not voting was Frederic S. Mishkin.

In a related action, the Board of Governors approved a 75-basis-point decrease in the discount rate to 4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Chicago and Minneapolis.

From the NY Times:

FRANKFURT, Dec. 6 — The European Central Bank, caught between fears of rising inflation and subsiding economic growth, walked a middle ground today, leaving interest rates unchanged.

But across the channel, the Bank of England opted to take action, cutting its key rate for the first time in two years, by a quarter-point, to 5.5 percent. The bank said the credit squeeze in the United States had curtailed loans for households and businesses, denting Britain’s growth prospects.

Apparently the ECB was not of one mind on their decision....

In a rare departure from his usual discretion about the bank’s deliberations, Mr. Trichet disclosed that some bankers on the 19-member governing council had argued for raising rates.

Meanwhile, the probability of a 50 basis point ease increased from 31% to 35% (reaching a high of 37%) as measured by the binary options contracts on the Chicago Board of Trade.

Also in the Wall Street Journal today is a piece by Martin Feldstein. Here are some excerpts.

Further interest-rate cuts can reduce the risk of recession and increase output and employment in 2008 and 2009. The current 4.5% fed-funds rate is essentially neutral -- not low enough to stimulate growth and not high enough to reduce inflation. Although there are risks that the rise in oil prices and the falling dollar will raise the inflation rate, the greater potential damage of an economic downturn calls for a more stimulative policy. The Fed should reduce the fed-funds rate at its December meeting and continue cutting toward 3% in 2008, unless there is a clear sign of an economic improvement.

Because of current credit market conditions, there is a risk that interest rate cuts will not be as effective in stimulating the economy as they were in the past. The current credit crunch reflects not only a lack of liquidity, but also a lack of confidence in the creditworthiness of counterparties and in the accuracy of asset prices. This problem is now being compounded by the banks' loss of capital as they recognize past losses, and by their need to use large amounts of the remaining capital to support existing off-balance-sheet credits that have to be shifted to their balance sheets. All of this implies that lower interest rates may not raise lending and economic activity to the same extent that they did in the past.

The latter paragraph is a good follow up to Greg Ip's piece. In old fashioned Keynesian terms, what we've got here by this reckoning, is the basis for a liquidity trap. Later in the article, Feldstein adds the second part of his strategy.

What's really needed is a fiscal stimulus, enacted now and triggered to take effect if the economy deteriorates substantially in 2008. There are many possible forms of stimulus, including a uniform tax rebate per taxpayer or a percentage reduction in each taxpayer's liability. There are also a variety of possible triggering events. The most suitable of these would be a three-month cumulative decline in payroll employment. The fiscal stimulus would automatically end when employment began to rise or when it reached its pre-downturn level.

Enacting such a conditional stimulus would have two desirable effects. First, it would immediately boost the confidence of households and businesses since they would know that a significant slowdown would be met immediately by a substantial fiscal stimulus. Second, if there is a decline of employment (and therefore of output and incomes), a fiscal stimulus would begin without the usual delays of the legislative process.

You're probably familiar with the term "automatic stabilizers". Well this takes the concept to the next level. A tax cut conditional on economic data--that's an interesting suggestion. Unfortunately, the temporary nature of the cuts would tend to reduce their impact. Anyway, read on.

Even if the Fed decides that it should not cut rates further at the present time, it would not raise rates to offset the stimulus effect of the fiscal change. From the Fed's point of view, the tax cuts can provide a desirable short-run stimulus without the inflationary impact that would result from a lower interest rate and an increase in the stock of money.

Dust off your trusty old IS-LM model and let the fun begin.

Some reliance now on a fiscal stimulus rather than easier money would also take pressure off the exchange-rate adjustment. While further declines of the dollar are necessary to shrink the massive U.S. trade deficit, continued rapid declines might lead to counterproductive retaliatory actions by some of our trading partners.

Add a dash of Mundell-Fleming.

The excessive asset-price increases caused by some past monetary expansions -- especially the induced rise in the prices of real estate -- provide a further reason to use fiscal as well as monetary policy. By cutting the fed-funds rate to just 1% in 2003 and promising that it would be raised only slowly, the Fed contributed to the sharp rise in house prices and the market's current weakness. A mixed strategy that included a prospective fiscal stimulus would have reduced the Fed's perceived need for a sustained negative real fed-funds rate, and would therefore have produced a more balanced expansion of demand.

But didn't we cut taxes in 2001 and 2003? Yes, however those cuts were aimed in large measure at increasing long run growth--the success of which is a fair topic of debate. That's not to say that the short-run stimulative effect was nil. But the question is: would a temporary tax cut with a similar order of magnitude to the 2001 and 2003 cuts have any more stimulative effect? Or would people just save it?

Mark Thoma also mentions the permanent income hypothesis, but doesn't mention the 2001 and 2003 tax cuts. Interestingly, a lot of prominent economists opposed the 2003 tax cut because they thought it should be temporary (contrary to Thoma) in order to provide stimulus without threatening the long term budget outlook and that it should include a spending component (in agreement with Thoma).

I think temporary tax cuts won't work very well (in agreement with Thoma) and I have my doubts about temporary spending increases (more bridges to nowhere?), contrary to Thoma. So where does that leave us?

With a lower funds rate in 2008, that's where.

Greg Ip has a knack for giving you tomorrow's news today when it comes to the Fed. Here's what he's got for us today. (Wall St. Journal)

Futures markets expect at least a quarter-percentage-point rate cut and see a two-thirds probability of a half-point cut. Fed officials will likely consider the larger cut, but some might find it hard to justify when just a few weeks ago they thought they were finished cutting rates.

Some analysts say the Fed is more likely to deliver a quarter-point rate cut and drop from its statement last month's characterization of risks of weaker growth and higher inflation as equally balanced. That would implicitly leave the door open to additional easing, without leading investors to presume further cuts were coming.

Analysts also believe the Fed could improve the functioning of financial markets with either an additional cut in the discount rate -- at which the Fed lends directly to banks -- or by lengthening the terms of such loans.

And later in the article, this key insight which, although it has been expressed, probably hasn't been talked about as much as it should yet:

Fed officials' main concern isn't the current economy, though recent data have been on "the soft side," as Chairman Ben Bernanke said last week. Rather, it's that banks and other lenders, having already tightened mortgage-lending terms, will do the same with loans to small and medium-size businesses as well as credit cards and other consumer credit. Fed officials don't believe banks' reluctance to lend will go away after Dec. 31. And Mr. Bernanke warned that could "impose additional restraint on activity in housing markets and in other credit-sensitive sectors."

Subprime gets all the attention. Mortgage lending is the big story. A general recession is a real concern. But the economy can certainly ride out the subprime mess. The housing market will recover even if it takes many months. The real threat that could potentially cause a serious recession is if other credit markets besides the mortgage market start to seize up because of a generalized lack of liquidity. The Fed is simply taking out some insurance that this won't happen. But there's even so, there are no guarantees... which brings us to our next installment (see next post).

Here's one paragraph from the Wall Street Journal article on the move.

Stocks and bonds sold off on the news. The Dow Jones Industrial Average ,up over 80 points before the Fed's afternoon announcement, initially fell into negative territory. Long-term bond prices, which move in the opposite direction of yields, fell. The statement appears to sharply reduce the odds the Fed will cut rates again at its December meeting, as markets had expected.

Please excuse my shouting for just a moment.... GOOD! Maybe they'll take it to heart this time.

There, now I feel better.

Comments are coming in fast and furious to the Journal's Real Time Economics blog. They are overwhelmingly harsh. Personally, I don't share that harsh assessment that this was the wrong thing to do. I don't think this was a decision that they wanted to make. Certainly it is not a decision that they thought they would have to make a few weeks ago. If they could go back and do a couple things differently, they might be tempted. Given the way things evolved, they did the best they could, came up with a better statement, and maybe learned a thing or two. Could be worse.

In the very short run (like, say, the next couple hours), no. Wall St. Journal story on GDP here. The stock market, quite predictably, rallied a bit. However, it has not moved anyone seriously off of their expectations of a 25 b.p. rate cut. So, if your immediate thought was that this might buy the Fed a way out, I have to say that I don't think it's any easier. In a perfect world, expectations might have been more balanced coming into today and then this data could have tipped the balance towards doing nothing. I might wish that was the world we live in, but it's not. Felix Salmon has more.

On the fundamental question of what the Fed should do--taking everything, including expectations, into account--I'm left with the opinion that while it would be a courageous statement of principle to do nothing (and part of me really wishes they could), I think it might be too risky given the somewhat fragile state of the market. I'm really holding my nose as I say that because I don't like the idea of the Fed being pushed into doing something. But in some sense you also have to play the hand you are dealt...or the hand you dealt yourself... or something.

Commenter Kevin writes:

I think Ben's Fed has really tried to stay away from any commitments about the path of future policy moves. So I think your suggestion that they say that this will be the last cut is a nonstarter. However, what I do expect would be more guidance about the conditions for any changes - which may include taking back the rate cuts (imagine that!).

First, a clarification. When I made reference to them saying that this would be the last cut, I was using some verbal shorthand at the end of a long post (in a three part series!) Of course they will not say it in so many words. They can "say" it in their assessment of the risks to growth and inflation. It's easy to come up with some wording that would say that they are going to have a "neutral bias" (though that language is itself somewhat passé). Whether one could make that language credible is another matter.

So then what about some guidance about the conditions for any changes? Not yet, not in any formal way. That could potentially end up being part of the new communication strategy that the Fed is discussing. But not yet. And they are certainly not going to say anything today about when these cuts are going to be taken back. Not a chance. Personally, I'd like to see that guidance too. I think one could make a credible case that if 4th quarter GDP growth is above X and if average monthly job growth stays above Y and if core PCE stays below Z, then they could raise the funds rate in January or March. But they certainly aren't going to tell us X, Y, and Z (or whatever other indicators would come into play). And I really don't think you're even going to get much of a hint yet. I think the best we can hope for is a strongly worded statement that growth is stronger than anticipated, that the housing problems have not yet spilled over into the broader economy, and that the magnitude of that spillover may be less than anticipated. Furthermore, firms are getting squeezed by higher input prices. While that has not yet passed through to final goods prices, the weaker dollar is going to put more pressure on firms to raise prices. (Except that the Fed will not talk about the weaker dollar, but you get the idea.) Make it so we expect that at least 25 basis points will be taken back if this strength continues. That way, if the 4th quarter ends up being only slightly weaker, they could still get by with holding steady in December and January.

It's almost time.

As of 9:30 (Chicago time) November fed funds were trading at 95.485 after starting the day at 95.495. Greg Ip's article may have spooked Wall Street, but at the corner of Jackson and LaSalle the expectation is, at this hour, still a 25 b.p. cut.

Click the image for the full size version. Source: Chicago Board of Trade (10 minute delayed quotes)

Electronic trading in fed funds continues overnight. You can see that when Ip's article hit the internet, the reaction was immediate but short-lived.

It should be an interesting 27 hours or so.

The NY Times writes about the consolidations that will occur as the Chicago Mercantile Exchange merges with the Chicago Board of Trade. It's not quite an obituary, but close.

As a result of its merger in July with the Chicago Board of Trade, the exchange, also known as the Merc, is moving in May to a new trading floor at the board’s Art Deco headquarters. With the consolidation of the two exchanges, the pork belly pit, formerly emblematic of Chicago’s open-outcry commodity trading, will close and begin operating only by computer.

The open-outcry pits of other low-volume markets, including cash dairy products and South American bean futures, are also closing. Many traders believe that all commodity markets will follow suit.

...

The pits have nurtured their own Darwinian values and an ethic of trust. They have been described as high-stakes chess with a locker-room atmosphere, raw capitalism shed of its corporate skin.

Many traders drift away as they age because they find it difficult to keep up. Traders in the livestock pits tend to be older, however, and have been resistant to a different way of trading.

“It depends on how old you are,” said Bob Lassandrello, 51, who has traded for 27 years in the cattle pit. “I see a lot of the younger guys trying to dip their toe in the water of trading electronically.”

Amid the cacophony — yelling that ranges from desperate to triumphant — Mr. Lassandrello, surrounded by some 50 traders in colorful jackets and sneakers, wades into a pool of discarded orders. He takes pride in his ability to read a competitor, a skill critical in the pits but absent from electronic trading. That is why he is considering early retirement.

“We’re near extinction,” said Mr. Lassandrello, who believes many of his generation will not make the transition to the screen.

In a way it is too bad. There's something exciting about open-outcry trading. There is something almost primal about it. And yet, the computer makes things so much more efficient. As economists we know that technological change does cause changes in the types of skills valued by the market. Just because they did it in the "good ol' days" isn't an argument for keeping it.

And yet, it's still too bad.

So is there an economic argument for keeping some form of open-outcry trading? Perhaps. As long as there's some veteran trader out there who thinks he or she can go up against the machine and win, there will be open-outcry trading. I don't think that species has died out yet; and there might just be some times when they can go up against the machine and win. Hence, it will probably never go away entirely. But one thing is clear. The glory days of trading in the pits have passed into history.

Chairman Bernanke gave testimony to Congress on the subprime situation today. Read it on the Fed's newly redesigned website. The only mention of monetary policy is at the end, and it includes nothing new, only some quotes from the press release Tuesday.

In other related news, initial jobless claims were down, reaching their lowest level since July 28. This suggests that the employment report may have been a blip. Employment is somewhat of a lagging indicator, so don't get too worked up and thinking that the threat is over. More trouble could still be to come. Nevertheless, we'll take good news when we can get it. The Index of Leading Indicators, however, was down slightly.

Meanwhile, a certain former Fed chairman is enjoying his time in the spotlight. It is hard to get used to seeing Alan Greenspan all over the place talking to the media candidly, but get used to it we will. (Reuters)

Asked in an interview on Bloomberg television whether the Fed's half-percentage-point rate cut on Tuesday had lowered the chances of a recession, Greenspan said: "I think so, but remember that we still have a problem out there, which is a large overhang of unsold newly constructed homes."

...

Greenspan said the chances for a recession in the United States were still "somewhat more" than 1 out of 3, despite the cut in the Fed's overnight federal funds rate to 4.75 percent, but cautioned it was hard to be more precise.

"We are often wrong but never in doubt on too many issues," he said.

Indeed.

We're watching history unfold here, folks. The unwinding of the subprime mess is without precedent. But the monetary policy action has parallels in the past. Will this episode be more like 1998 (heading of systemic risk, short lived easing and a return to previous levels in a year) or like 2001 (the beginning of a series of cuts and the re-inflation of a bubble)?

To apply the wisdom of Greenspan, someone who doesn't have some doubt stands a good chance of being wrong.

Allan Meltzer writes in the Wall St. Journal:

With annual inflation at 2% or more and unit labor costs rising at a 5% rate, loose fed policy risks reviving the latent fears that it is willing to permit higher inflation now to respond to a forecast that unemployment may rise. That returns to the policy that made the Great Inflation costly and durable.

The better policy is to wait until the very mixed data of the moment forms a pattern. High-frequency data is often revised. It often has transitory aberrations that do not persist. Unfortunately, after a major change in underlying conditions, we know even less than usual about the future.

86 hours to go.

By now you have probably heard about the speech given by Charles Plosser. Read it. It is destined to be a classic as it is an extremely candid recounting of the events of the last few weeks from an "inside the Fed" perspective. The speech itself clearly shows that Plosser is reluctant to cut rates on the 18th. In an interview afterwards, he makes it crystal clear. (Bloomberg)

"We want to be careful not to overweight one piece of information,'' he said in an interview late yesterday after a speech in Waikoloa, Hawaii. "I've not made up my mind at all'' on whether a rate cut is needed, he said.

Tim Duy doubts that the expected cut on the 18th will be the only one. Unfortunately, they might be in a lose-lose situation. If they cut only 25b.p., people will expect more. If they cut 50b.p., people will infer that it's worse out there than they thought... and thus they will expect more. Knzn has more to say about why he wants 50b.p. I'm still expecting just 25b.p. and even that is causing me a lot of internal struggle. I'm basically in the camp with Plosser and Poole, and if you read the last line of Tim Duy's post, you'll know why.

I was listening to Bob Brinker's Money Talk on the radio this weekend. He says that the Fed is being dragged into this "kicking and screaming." Brinker says the Fed is behind the curve... a statement that neither Duy nor I would agree with. But he's right about the kicking and screaming part.

Finally, I found a brand new blog while ego-surfing this weekend. It will be entirely based on Fedspeak. It's by Marc Shivers and it's called "The Talking Fed." Check it out.

Happy Monday!

Edward "Ned" Gramlich, who warned of the consequences of lax standards in the banking sector while a governor at the Federal Reserve, has passed away at the age of 68.

From a Bloomberg article on Gramlich today:

"Sometimes one's advice must be weighted toward economic practicality, sometimes toward humanity,'' Gramlich told the Senate Banking Committee. "A good economist should know how to balance both objectives.''

By that measure, Ned Gramlich was a "good economist".

Here are some of the links to articles reporting on Gramlich's passing.

Wall Street Journal

Months ago Mr. Gramlich agreed to give a luncheon address at the Federal Reserve Bank of Kansas City's annual symposium in Jackson Hole, Wyo. Since he was too sick to attend, his prepared remarks were delivered Friday by David Wilcox, deputy director of research at the Fed. Mr. Wilcox, before delivering the remarks, said he and the rest of the staff felt a special bond to Mr. Gramlich because he had been a staff economist there in the 1960s. Mr. Gramlich found "it perfectly natural to treat us all truly as colleagues when he returned as a governor."

Reuters
Forbes
Washington Post
Statement from Federal Reserve Chairman Ben Bernanke
Urban Institute Press Release

Via Reuters:

The FHA will soon launch a new program called "FHA Secure" to allow homeowners with good credit history, but who cannot afford their current payments, to refinance into FHA-insured mortgages, Bush said.

"This means that many families who are struggling now will be able to refinance their loans, meet their monthly payments and keep their homes," he said.

For the cynical take, see The Big Picture. Tanta at Calculated Risk is "underwhelmed". Looks like sound and fury to me...not sure it signifies very much.

Here is a link to the much anticipated speech by Fed Chairman Ben Bernanke today at Jackson Hole. And here's the money quote that everyone will be reporting...

Well-functioning financial markets are essential for a prosperous economy. As the nation's central bank, the Federal Reserve seeks to promote general financial stability and to help to ensure that financial markets function in an orderly manner. In response to the developments in the financial markets in the period following the FOMC meeting, the Federal Reserve provided reserves to address unusual strains in money markets. On August 17, the Federal Reserve Board announced a cut in the discount rate of 50 basis points and adjustments in the Reserve Banks' usual discount window practices to facilitate the provision of term financing for as long as thirty days, renewable by the borrower. The Federal Reserve also took a number of supplemental actions, such as cutting the fee charged for lending Treasury securities. The purpose of the discount window actions was to assure depositories of the ready availability of a backstop source of liquidity. Even if banks find that borrowing from the discount window is not immediately necessary, the knowledge that liquidity is available should help alleviate concerns about funding that might otherwise constrain depositories from extending credit or making markets. The Federal Reserve stands ready to take additional actions as needed to provide liquidity and promote the orderly functioning of markets.

It is not the responsibility of the Federal Reserve--nor would it be appropriate--to protect lenders and investors from the consequences of their financial decisions. But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy. In a statement issued simultaneously with the discount window announcement, the FOMC indicated that the deterioration in financial market conditions and the tightening of credit since its August 7 meeting had appreciably increased the downside risks to growth. In particular, the further tightening of credit conditions, if sustained, would increase the risk that the current weakness in housing could be deeper or more prolonged than previously expected, with possible adverse effects on consumer spending and the economy more generally.

The incoming data indicate that the economy continued to expand at a moderate pace into the summer, despite the sharp correction in the housing sector. However, in light of recent financial developments, economic data bearing on past months or quarters may be less useful than usual for our forecasts of economic activity and inflation. Consequently, we will pay particularly close attention to the timeliest indicators, as well as information gleaned from our business and banking contacts around the country. Inevitably, the uncertainty surrounding the outlook will be greater than normal, presenting a challenge to policymakers to manage the risks to their growth and price stability objectives. The Committee continues to monitor the situation and will act as needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets.

The rest of the speech is mostly a history of the housing and mortgage markets from the turn of the 20th century onward. It is really quite interesting, and I would recommend that anyone who teaches money and banking put it on their reading list.

Toward the end, this caught my attention:

The dramatic changes in mortgage finance that I have described appear to have significantly affected the role of housing in the monetary transmission mechanism. Importantly, the easing of some traditional institutional and regulatory frictions seems to have reduced the sensitivity of residential construction to monetary policy, so that housing is no longer so central to monetary transmission as it was. In particular, in the absence of Reg Q ceilings on deposit rates and with a much-reduced role for deposits as a source of housing finance, the availability of mortgage credit today is generally less dependent on conditions in short-term money markets, where the central bank operates most directly.

Most estimates suggest that, because of the reduced sensitivity of housing to short-term interest rates, the response of the economy to a given change in the federal funds rate is modestly smaller and more balanced across sectors than in the past. These results are embodied in the Federal Reserve's large econometric model of the economy, which implies that only about 14 percent of the overall response of output to monetary policy is now attributable to movements in residential investment, in contrast to the model's estimate of 25 percent or so under what I have called the New Deal system.

This struck me as a very subtle way to communicate two important ideas. First, the real estate market is less synchronized with the business cycle than it used to be, and second, the fed funds rate is not the best tool for addressing problems in the real estate market. I agree with both, and if that is the operational view of the FOMC, then that anticipated rate cut on the 18th becomes a little bit less of a sure thing.

Bernanke concludes by acknowledging Edward (Ned) Gramlich, whose illness prevented him from attending the Jackson Hole symposium. You can buy Gramlich's book on the subprime debacle on Amazon. Watch it on BookTV this weekend. Keep the Gramlich family in your thoughts and prayers.

After a rather wild few days discussed here, the fed funds market appears to be settling down. The standard deviation of fed funds trades is a small fraction of what it was during the height of the liquidity crisis, and the weighted average (effective) fed funds rate is pretty close to the target (data). Calculated Risk has some charts.

There was no "stealth cut". What we saw was a function of a few very low trades when the Fed injected large amounts of liquidity. The injections were large enough so that at the margin its value was zero--and it was priced accordingly. (Micro level data on this would probably be quite illuminating, but I don't believe it is publicly available.) That's not a bad thing to do when people are in the state that they were in. But now that portfolios have adjusted and cooler heads are prevailing, they've removed the slack. Back to, mostly, business as usual.

And there were no real surprises in the minutes from the last FOMC meeting, nicely summarized by the Wall St. Journal. Yes, they acknowledged the possibility that policy action might be necessary if the worsening financial conditions threaten economic growth. Yesterday's consumer confidence numbers notwithstanding, it is not yet clear that we are at that stage. The possibility of a rate cut before the end of the year is not out of the question. But a cut on September 18 is not a foregone conclusion. CBOT Binary Fed Options are saying it's about 2 to 1 odds that they will ease.

But with the meeting three weeks away, you can be sure that a number of events will cause those odds to fluctuate a bit before (maybe) converging toward something we can (almost) count on. Stay tuned.

Tomorrow, actually, as I write this... but in any case...

It seems these days that economists and pundits (myself included) are full of analogies. Here's a good one from David Wessel in the Wall Street Journal.

Think of the nation's economy as an automobile that requires gasoline for power (loans to businesses and consumers) and oil for lubrication (short-term credit among financial players.)

The immediate problem isn't gasoline: Banks are strong, and corporate coffers are full of cash to invest. The problem is lubrication. Countrywide Financial makes mortgages and then sells most of them to investors within weeks, but it needs short-term financing for that interval. It relied on short-term IOUs known as commercial paper but is having trouble selling that paper now.

It's worth your time to read the whole thing. He sums up in one column a lot of things that have been said in a lot of places over the last few weeks about how the financial system has changed since the crises of years past.

The NY Times reports:

With the four largest U.S. banks and a major international bank having borrowed from the Fed through the central bank's discount window, others may be more willing to follow, analysts said.

"The psychology is, if a bank needs to borrow from the discount window, and they think there's a stigma attached to it, they can say, 'Citi has done it, too,"' said Robert Albertson, chief strategist at Sandler O'Neill in New York.

Tyler Cowen cleverly responds:

Imagine that you, as a smart person, went around saying stupid things, in an attempt to limit discrimination against the stupid. You can come up with other analogies of your own.

That's true up to a point. But there's also the fact that no single one of those banks would have wanted to do it alone. No one wanted to be the first to the buffet table with the whole room watching, so the host gently nudged some good friends to go up together. Plus, the banks' motivation is not as altruistic as Tyler's analogy would suggest.

In other news today, Bank of America announced that it was buying a $2 billion equity stake in Countrywide. (NY Times)

Under terms of the deal, Bank of America, based in Charlotte, N.C., acquired $2 billion in the form of nonvoting, convertible preferred stock yielding 7.25 percent annually, Countrywide said.

Let's be clear. Bank of America isn't financing this deal (or even part of it) with borrowed reserves that need to be paid back in 30 days. This is more of a long term decision. However it is interesting that these events happened on the same day. Interesting in the sense that it reaffirms my belief that these four banks, of which Bank of America is one, are not borrowing from the Fed because they are in trouble. King Banaian (SCSU Scholars) agrees and writes

I'm reminded of the Knickerbocker crisis of 1907, when NYC banks did act as a lender of last resort before there was a Fed.

They are trying to show their confidence in the system. How far that will go remains to be seen. Whether others will follow also remains to be seen. But let's remember too that J.P. Morgan didn't organize the 1907 rescue of the banks out of charity. And in the movie It's a Wonderful Life, Potter wasn't selling, Potter was buying. We need to remember that the four banks that borrowed aren't doing something for nothing. They simply didn't want to do it alone. Perhaps today there are no Morgans and no Potters who can do it alone, and perhaps that's a good thing. There's liquidity out there. It just needs to keep circulating. Both of today's tangentially related events show that it is possible.

And that is a good thing.

From today's NY Times:

Fed officials and top Treasury officials continued on Tuesday to talk by telephone with major banks, encouraging them to borrow from the discount window and repeating that there was no stigma associated with such loans. Traditionally, banks have only resorted to the Fed’s discount window when they had no other place to borrow money.

And Reuters now reports (ticker symbols and links removed)

NEW YORK (Reuters) - The four largest U.S. banks, led by Citigroup and Bank of America Corp. took the unusual step of borrowing $2 billion directly from the Federal Reserve on Wednesday, as the Fed tries to stabilize tempestuous financial markets by adding money to the banking system.

U.S. shares rose after the move, but financial stocks declined slightly.

Borrowing money directly from the Fed is usually seen as a sign of weakness, but JPMorgan Chase & Co., Bank of America and Wachovia Corp., said they have ample access to funds and made the move for the sake of the financial system. Citigroup, meanwhile, said it borrowed funds for customers; but the bank has issued at least $2.5 billion of corporate bonds this month.

The Wall Street Journal also carries a story and adds that the borrowing was $500 million by each bank.

It is important to point out that the stigma associated with discount window borrowing is largely a holdover from the days when it really was a discount. And so even today, there is still a reluctance among banks to go to the discount window that goes beyond the fact that now it is above the fed funds target. An excerpt from this Reuters story shows that people haven't totally figured out how to handle this. Again, the reference is to the four major banks stepping up to the window in what was obviously a coordinated move.

Analysts said the move could be encouraging for the market after the Fed said that using its discount window would be considered a sign of strength.

"I'm not sure if it's positive or negative. (But) if there are no problems, then they wouldn't have to borrow, so that could raise a flag," said Steve Goldman, market strategist, Weeden & Co. in Greenwich, Connecticut.

I think it's positive, and here's why. The coordinated nature of the move is meant to inspire confidence. They are not doing this because they had to do it today--and this is why it is important that the term of the discount window loans has been extended to 30 days as well. These four banks just took out a total of $2 billion in reserves over and above what they need. They will now be able to extend short term credit to their clients at nearly the same rate. There is still likely to be some small cost to the banks, so this isn't something that one of them would do themselves unless they had been on the receiving end of those phone calls from the Fed and the Treasury.

But this is going to allow some additional liquidity to circulate privately for a few weeks to help arrange for a more orderly workout of the situation. The four banks benefit from that just as everyone else does. Everyone needs to take a step back and see that this is exactly the sort of thing we've been hoping for.

It looks as if a lot of market participants are in a position where they are not yet ready to go to the lender of last resort, but they are feeling squeezed nonetheless. And this is throwing sand in the gears of the system. The Fed is the lender of last resort, but what can they do if troubled institutions are not yet at the panic stage where they need the Fed's emergency help.

They do exactly what they have done. They extend credit to institutions at the top of the private credit structure and encourage (jawboning or moral suasion) them to act as the "lender of next-to-last resort". In so doing they reaffirm that this is not an interest rate problem but a liquidity problem. This looks like a very encouraging development, and I wouldn't be surprised to see more of it in the coming weeks. Though some see this as a precursor to a cut in the funds rate, I do not. I see it as been an attempt to stave off a rate cut unless these problems affect the broader economy. If this plan works as they want it to, it is more likely to be contained and thus the need for a rate cut is decreased.

The Wall Street Journal has a fine set of articles on the Fed and the recent problems in the financial markets.

Start with this one and then check out these two.

Note: Earlier today my web host had a DNS meltdown. Since I was able to telnet to the site, I typed a makeshift "post" directly into the main blog page, knowing that I might not get a chance to log in until tonight. Now that the DNS issue has been fixed, I am putting the content of that "post" into a proper post. I have also added links to the Fed statements.

If you are reading this, then the DNS issue has resolved. However, I will need to be away from the computer for a few hours this afternoon, so I wanted to get a message up for when things are back to normal.

The irony is that even with all the shake up today, there isn't a whole lot to say that hasn't already been said. The Fed lowered the discount rate (something that I suggested a while back), but did not act to lower the fed funds target. They did, however, issue a statement which announced the new assessment of risk being more tilted towards lower growth than higher inflation. This does pave the way for a change in the target down the road if the need arises. I think it's fairly obvious that they want to hold off on that. If they didn't want to hold off, they would have just gone ahead and done it today. But I think that they correctly realize that we're moving into a period where the decisions are going to be made on a day-to-day basis. This statement, which is rare in announcing a shift in the bias between meetings without a change in the target, is simply an acknowledgment of that fact.

Remember, since the discount rate is a misnomer (it's really a premium rate now), the action today simply lowers the penalty that banks pay to borrow from the Fed directly. As Bagehot famously said, the appropriate thing to do here is to lend freely at a penalty rate. They're still doing that. It's just that in this circumstance a lower penalty is warranted so that if a larger liquidity squeeze develops banks might be encouraged to go to the discount window sooner. I wasn't sure they would do it--thinking that it could cause more panic. That didn't seem to happen, and I think the reason is that in the last few days more market participants have come to the realization that the Fed was going to do "something" and so it wasn't really all that unexpected, even though what they did was a bit unusual.

One final comment about the many commentators who have mentioned the lower effective fed funds rate. I covered this in my previous post, but here's one other thing to consider. I think in this case, it would be more useful to know what the median fed funds rate is. The effective rate is a weighted average and is being pulled down by trades at close to zero, which I think are due to the last trades of the day being excess reserves and have a lower reservation price. I don't think the median rate is computed, but if it was it would be more illuminating.

I still haven't come over to the camp that says that a rate cut in September is a sure thing. Everything I see is telling me that the Fed is doing whatever it can to avoid it. It may not be possible, but they will see how this cut in the discount rate plays out and take it from there.

There will be a rate cut if it looks as if the present situation is spilling over into overall gross domestic private investment (e.g. if commercial real estate, which has been stronger, begins to show signs of failing). That's when a cut in the target fed funds rate (which would lower the effective rate, as well as the high end of the range and the median) would be called for. The discount rate action today was not aimed at stimulating the economy, but rather to provide a marginally more attractive liquidity cushion.

I'm sure there will be lots of good commentary over the weekend and a highly anticipated opening of the markets on Monday.

UPDATE: James Hamilton offers the following excellent observations with which I completely agree.

I think that the Fed would prefer to rely on the automatic functioning of the discount window, rather than the multiple aggressive open market operations that we saw on August 10, to respond to the kind of challenges that have arisen in markets over the last few weeks. If the Fed really wants banks to go to the discount window rather than bid the fed funds rate up to 6% in response to these kinds of pressures, it makes sense to offer to lend through the discount window at the new lower rate of 5.75%, as well as extend the terms of these loans to 30 days, as the Fed did this Friday.

I believe that the Fed adjusted the discount rate rather than the target fed funds rate not because it's a back-door way to lower interest rates, but instead in order to address the specific policy objective of making sure the discount window gets used as part of the automatic response to the kinds of liquidity pressures that have been bobbing up these last two weeks.

Felix Salmon shows that the effective fed funds rate has dipped below 4.75%. Of course, given Friday's events, one would have expected the effective rate to have been low. Even Monday I can understand. But this seems to be lingering more than many would have expected. What's up?

First, let's do a graph showing not just the effective rate, which is a weighted average, but also the range. (Data)

And now we see the larger picture. The reason for that the effective rate has dropped a bit is because there are a few trades at very low (zero for Friday and Monday) interest rates. The high end of the range is right where you would expect it to be--consistent with the last month or so. But why the trades at or close to zero?

Remember, the Federal Reserve does not control this rate precisely. Also, even under normal conditions, the funds trade in a range. Creditworthiness of the borrower matters for a few basis points. So what the Fed does under normal circumstances is to try to get the weighted average... the preponderance of the trades, if you will... as close to the target as possible. It is quite normal to miss by a couple of basis points, but it's a testament to the institutional knowledge of the trading desk in New York that they can get it that close day in and day out.

Remember also that this infusion of liquidity represents reserves, or base money. It doesn't get multiplied through the deposit process unless banks lend those reserves to create new deposits. Something tells me that's not going to be an enormous risk in this case. Intermediaries are more likely to be carrying some excess reserves at this point. And they earn zero interest on those reserves. Hence, it's not entirely out of whack that at a time like this the market rate on those marginal excess reserves is significantly lower than the target. But zero?

Here's what Reuters had to say:

DOWN TO ZERO: According to data from The Federal Reserve Bank of New York, federal funds low trade of the session on both Friday and Monday was zero percent. On Friday, the highest traded intraday level was 6.05 percent, while Monday's intraday high was 5.5 percent.

Market analysts said the low trades showed that the Fed's liquidity infusions had been enough to bring down the cost of overnight money steeply as volume thinned in late afternoon trade. Data for federal funds on the New York Fed Web site goes back to January 2000 and shows that federal funds have not traded at zero before then, although they have come close.

In the aftermath of the Sept. 11, 2001 attacks, fed funds traded at 0.06 percent according to Federal Reserve data. In August 2004, fed funds traded at 0.03 percent.

A zero intraday trade for federal funds may be an even rarer event, analysts say.

"I find no evidence of federal funds trading at zero at any time since at least 1988," said Tony Crescenzi, chief bond market strategist, Miller, Tabak & Co. in New York.

So while I don't have a full and definitive explanation, 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. Soon we should get some data on excess reserves, which may shed some light on this situation.

In other words, I don't see this small fraction of trades at such a low level as being inflationary. Quite the contrary, if intermediaries want to hold more excess reserves as a risk management measure then the Fed is doing the right thing by offering those reserves. It only becomes a problem if those intermediaries run out and make more questionable loans with the money. I don't see that happening, and if it does, then (a) we'll call them on it, and (b) the Fed will likely pull back those reserves. Wouldn't you want intermediaries to respond to the recent turmoil by holding excess reserves? If so, then I wouldn't get worked up by some fed funds trading on the low side, even significantly on the low side.

I would suspect that it will creep slowly away from zero over the next few days (barring any other events), but the standard deviation is likely to remain higher than it was just a couple weeks ago.

Back the Reuters piece referenced above, this should also help:

SUPPLY: Issuance of Treasury bonds and notes can put upward pressure on federal funds, bond analysts say. For example, the settlement of last week's 10-year Treasury note and and 30-year Treasury bond auctions this week could put upward pressure on federal funds, said Josh Stiles, bond strategist and managing director with IDEAglobal in New York.

And of course, the Fed knows that and would have taken it into account when it made the 14 day repo last Thursday.

So don't get the impression that the funds rate has gone down in any meaningful sense until we see what the excess reserve picture looks like.

UPDATE: Tim Duy has some comments on this and on St. Louis Fed President William Poole's interview with Bloomberg. For the record, I agree with Tim that the temporary nature of most of the injection is the main reason that this is not inflationary. But I think the main reason we're seeing a few fed funds trades near zero interest is that those are the marginal trades of excess reserves. That intermediaries appear to be holding excess reserves even after much of last week's injection has been reversed is significant. This also puts some downward pressure on inflation if that practice continues.

UPDATE 2: The Fed injected another $12 billion in a 1 day repo and $5 billion in a 14 day repo this morning. The 14 day repo will correspond with the 14 day maintenance period for reserves which begins today. The Fed also announced that with the new maintenance period starting, they may need to inject more reserves but that should not be interpreted as a sign of a problem. For more, see this Wall Street Journal piece.

I received an e-mail from King Banaian (SCSU Scholars) inviting me onto his radio program on AM1280 "The Patriot" WWTC in Minneapolis-St. Paul. The show is "The Final Word", part of the Northern Alliance Radio Network, and airs Saturday from 3-5pm Central. Tune in if you're in the Twin Cities. If not, the show streams here.

UPDATE: I was on for the 3:30 to 4:00 segment. Had a great time! Welcome to any listeners who found their way here.

The markets had a roller coaster day, but ended the week on the positive side. It's important to remember that the Fed's action today was not to save the market or prevent a crash or bail out the bankers. None of the above. This was much simpler. A lot of entities holding mortgage backed securities needed liquidity. They were willing to borrow at a higher overnight rate to get that liquidity as evidenced by the spike in the funds rate early in the morning. The Fed, quite understandably, did not want the funds rate to spike, and so they loaned these banks reserves accepting mortgage backed securities of the highest quality as collateral (the Fed was NOT bailing them out by buying distressed subprime loans). This kept anyone from unloading good quality assets at fire sale prices just to get liquidity. That would have been disastrous. The agreement is that on Monday the banks get their securities back and the Fed takes back the reserves.

Of course, on Monday they might have to do it again if there is still a need. And even after this immediate episode quiets down, there may be a need to do it later. As Felix Salmon points out (hat tip to King Banaian), the inability to roll over commercial paper can be the event that leads to problems of systemic risk. And that is very hard to predict whether and when it will happen again. All we can say is that it might happen.

Speculation has raged all day about whether the Fed will need to raise interest rates. Early on I was hearing on CNBC that the market was pricing in a 100% chance of a cut by, I believe, October. That seems to have died down a bit, at least on the binary options market. Now it's basically 50-50 by the September meeting (that includes the possibility of an intermeeting cut. October and December probabilities were 70 and 76 percent--little changed from yesterday. Obviously the Fed is trying to avoid lowering rates. They want to keep this a liquidity issue where the important thing is quantity not price. Price becomes more important if it is felt that this will contribute to the slowing of the economy in aggregate.

It was quite a day. But at the end of the day there was, I think, a feeling that in the aggregate we dodged one for now. High volatility is just something we'll have to get used to for a while.

UPDATE: MSNBC makes it seem worse than it was.

On Friday, as Bernanke faced the first big crisis of his 18-month tenure, the central bank was forced into action, buying up billions of dollars worth of crumbling bonds in an effort to stabilize financial markets that appeared to be coming unglued.

As Calculated Risk says, "Nope." They only accept high quality mortgage backed securities not "crumbling bonds."

This just in from the Fed...

The Federal Reserve is providing liquidity to facilitate the orderly functioning of financial markets.

The Federal Reserve will provide reserves as necessary through open market operations to promote trading in the federal funds market at rates close to the Federal Open Market Committee's target rate of 5-1/4 percent. In current circumstances, depository institutions may experience unusual funding needs because of dislocations in money and credit markets. As always, the discount window is available as a source of funding.

Joellen Perry, Monica Houston-Waesch and Greg Ip have an excellent article in this morning's Wall St. Journal.

I had CNBC on in the kitchen as I was doing some other things so I didn't see who said this, but someone they interviewed reminded the viewers that this is a credit issue not an interest rate issue (or words to that effect). That is spot on. If liquidity is necessary to maintain the target, then so be it. But this is not a time for central bankers to overreact.

UPDATE: CNBC is reporting that the Fed put in $19 billion this morning.

UPDATE: Another $16 billion at 10:55 (EDT). Here is a link to the NY Fed page for temporary open market operations.

UPDATE: Another $3 billion at 1:50 (EDT).

It started in Europe when French bank BNP froze $2.2 billion in funds. (Reuters)

"The complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly, regardless of their quality or credit rating," it said in a statement.

The European Central Bank immediately injected almost 95 billion euros into the market. This morning, the concerns had spread to the U.S. Fed funds were trading at between 5.375 and 5.5% early in the day according to this Wall Street Journal article. In order to keep the funds rate at its target, the Fed injected $24 billion in a two week repo and $12 billion in an overnight repo. The Journal article states:

The average rate at which the money was lent was also marginally higher than normal, an indication of the strength of demand for cash. "What has happened so far is interesting but not extraordinary," said Ray Stone of Stone & McCarthy Associates, an economics and markets research firm. The Fed, he said, is probably having trouble estimating demand for excess reserves because of the "strain in the credit market" which is adding to the pressure on reserves.

That's probably understating it a bit. What spilled over across the Atlantic was not anticipated today. At best, you might expect that something like this could have happened sometime. It happens that today was the day, and thus was a bit of a surprise.

Are we out of the woods? Not really. Again, from the WSJ:

One risk the Fed faces is that if it injects too much cash, the Fed funds rate would plummet later on to below its target. However, unlike in previous eras, that is unlikely to be interpreted as a deliberate easing of monetary policy. Since 1994, the Fed has announced when it is changing its target for fed funds. After the Sept. 11, 2001, terrorist attacks disrupted markets and sent demand for cash soaring in 2001, the Fed poured money into the system and warned this could send the fed funds rate below its target.

Correct. The same is true here, but on (for now at least) a much smaller scale. This is not an emergency, and indeed the Fed's injection is much smaller than the ECB's injection. Furthermore, the Fed's injection was not aimed at calming a panic, but rather at maintaining the target.

The Fed did the right thing in maintaining the target. If there are no other incidents of banks freezing funds, then this may be enough. But the real question is now, what next?

That's a tough question to answer. It is certainly possible that another bank or hedge fund will find itself in trouble before the mortgage mess straightens itself out. In fact, it's probably pretty likely. It's just that no one knows who, when, or how big. So what is the Fed's role? I keep going back to one of my favorite papers by my fellow Iowa alum Chris Neely. Neely chronicles the use of various methods of providing liquidity: repos, discount window lending, and float, in response to various crises.

Let us not forget the discount window, which really is a misnomer these days. The term refers to the fact that it used to be typically a bit lower than the funds rate. A few years ago, the discount window policy changed. Today, there are actually two discount rates, primary and secondary credit rates. Primary credit is available at a rate of 6.25% and secondary credit at 6.75%. You can read about the specifics here.

Today's intervention was just a ripple in an ocean, but in the event that something more is on the horizon, the Fed needs to remind banks that the discount window is always there to meet their emergency liquidity needs. If anything, the Fed might consider lowering the discount rate to marginally encourage borrowing from that source rather than putting strain on the fed funds market. Lowering the fed funds rate should not be the first reaction to this situation despite the fact that many people will call for it. Lower the fed funds target only if it looks like this is not going to be contained by the financial markets.

This is not (yet) a crisis on the scale of others we have seen. Whether more injections from the Fed will be required to prevent counterparty risk and systemic risk remains to be seen, though I am confident that they will supply the liquidity if required. As for the funds rate, the carnage at the CBOT suggests that either others are not as confident that this will be contained, or they believe that the Fed is on the verge of giving in. The first is a possibility that cannot be ruled out. The second is, I hope, a misguided notion.

Still, it was quite a significant event that took place today.

UPDATE: Mark Thoma must have sneaked a peak at the lecture I plan on giving my intermediate macro class on day one this fall. Very nice exposition.

UPDATE 2: Felix Salmon notes this Wall Street Journal piece that says the subprime mess may have extended its reach into the money market. That would certainly raise the risk that this will cause problems in the wider world. That is not something that you like to see.

As I did yesterday, I focus on CBOT binary call options at a strike price of 94750. As of 3pm:

Sept07 down 9, currently at 13
Oct07 down 7, currently at 25
Dec07 up 3, currently at 35

As an aside, a put option with a strike of 94750 last traded at 3 points, up 2 from yesterday. That's a contract that pays if the target fed funds rate is higher than the current 5.25% after the December meeting.

I call the last couple weeks, "Denial."

I just checked the Fed Funds Binary Options on the Chicago Board of Trade. Here is a link, but I do not know how stable it is. When trading opens tomorrow, the quotes will be different anyway.

Note to self: WIU economics faculty and students usually make a trip up to Chicago to see the Board of Trade every year. I am one of the faculty who works on scheduling and arranging the trip. I must do what I can to see if we can get up there on an FOMC day this fall.

From the closing quotes, it looks like it was an exciting afternoon. In fact, I was watching CNBC when the announcement came and at the moment the reporter started reading the statement the trading pit in Chicago erupted. That's the only word that comes to mind. The quotes tell the story of what they were yelling about.

Rather than detail them all, I will focus on just the call options with a strike price of 94750 (pays 100 if the target funds rate is less than 5.25% on the expiration date).

Sept07 down 7 to close at 22.
Oct07 down 6 to close at 32.
Dec07 down 18 to close at 32.

I think these pretty much speak for themselves. Roughly speaking, the market is saying that if they do cut, they cut by October. But it's only a 1 in 3 chance that they do it at all (this year).

UPDATE: The NY Times editors are in denial.

Despite the Federal Reserve’s stay-the-course message yesterday, investors are betting on at least one interest-rate cut by January, intended to quell turmoil in the markets and to juice the slow economy.

A couple days ago the market was saying it was 50-50. Now the market is saying it's (roughly) 2:1 against (or 1 in 3 that they will, if you prefer). Looks to me like some of them switched their bets.

They would have done well to listen to Cassandra.

David Leonhardt explains why records are made to be broken and why one must always adjust for inflation. (NY Times)

The S.& P. 500, which is a much better measure than the Dow, closed yesterday at 1,549, just 1.4 percent higher than the peak it reached in March 2000. Think about what that means. While the price of nearly everything has risen over the least seven years — while the price of bread has increased almost one-third, for instance — stocks have barely budged. They have only marginally outperformed cash sitting in a bureau drawer. So if we are going to talk about a stock market record, we should be doing the same for a whole lot of other things: Loaves of Bread Surge to New Highs

In this excellent post, Brad Setser looks at the growth of reserves of foreign central banks, particularly in Brazil, Russia, India, and China (often referred to as the BRICs), and says that they are "simply too big not to matter".

Last week, James Hamilton led off a post with the line,

Let's admit it-- the other shoe is not yet dropping.

Opinions differ on what it will sound like when it does. April employment numbers came out day (+88,000 non-farm payroll jobs), and PGL doesn't like what he heard.

The fall in the household survey reporting of employment was 468,000. The unemployment rate would have risen even more had it not been for the fall in the labor force participation rate (LFP). The decline in the employment to population ratio (EP) was disappointing. Maybe it’s time that the Federal Reserve lower interest rates.

Then Craig Newmark points us to a Bloomberg article that says,

April 30 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke's assertion that interest rates may need to increase to curb inflation is wrong. That's what Goldman Sachs Group Inc., Merrill Lynch & Co. and UBS AG are saying.

While Bernanke warned last month that the odds of worsening inflation have increased, chief economists at the three firms say the worst housing slump in a decade may drive the U.S. economy into a recession and stifle consumer prices. Their chief economists say the Fed will cut its target for overnight loans between banks at least three times this year.

...

Bernanke is missing ``the linkage between residential housing investment and the broader economy,'' Jan Hatzius, chief U.S. economist at New York-based Goldman, the world's most profitable securities firm, said in an interview. ``The housing downturn is of the first order of importance.'' Hatzius says the Fed will cut rates three times this year, to 4.5 percent from 5.25 percent.

Kash says it's too early to tell if and when rates will fall.

While disappointing, it is hard to imagine today's data having any impact on the outcome of next week's FOMC meeting, at least in terms of the policy action. Whether it will cause policymakers to prepare to soften their stance in the coming months is another question. My guess is, not yet. The change in language in the last FOMC statement made a lot of people thing that rate cuts are now off the table. I don't think that is the case, but rather that a rate cut in 6 to 9 months is more likely than it was a few months ago.

After today's employment report, my subjective probability assessment for the funds rate in 6 to 9 months has edged even a bit more towards a rate cut.

So as we head into the week of the FOMC meeting, the question is whether and when they will make a more direct reference in the press release acknowledging that the risk of slower growth is greater than the risk of inflation. Predicting when and if that will come is like predicting when "measured pace" would disappear last year. Lots of people will call it before it happens, and a few will be surprised. But the Fed knows that they have to choose their words carefully, and in this instance it may mean that a rate cut will come without a lot of advance warning provoking speculation in the financial markets. The relevant reference for you is January 2001. If a rate cut comes, it could very well take us by surprise in terms of its timing. If, on the other hand, things improve this summer and a rate hike becomes necessary, the signs will be much more clear.

And so we sit, still waiting for the other shoe to drop.

From Reuters:

NEW YORK (Reuters) - Hedge funds may now pose the biggest risk of a crisis since 1998, when the implosion of Long-Term Capital Management threatened the global financial system, the New York Federal Reserve said on Wednesday.

The statement represented the bank's sternest warning to date over the possible fate of the $1.4 trillion industry.

"Recent high correlations among hedge fund returns could suggest concentrations of risk comparable to those preceding the hedge fund crisis of 1998," according to a paper written by Tobias Adrian, capital markets economist at the central bank.

So I looked at the paper and the abstract says in part:

...A comparison of the current rise in correlations with the elevation before the 1998 event, however, reveals a key difference. The current increase stems mainly from a decline in the volatility of returns, while the earlier rise was driven by high covariances—an alternative measure of comovement in dollar terms. Because volatility and covariances are lower today, the current hedge fund environment differs from the 1998 environment.

I'm still concerned, but I'm not yet losing sleep over it.

Read the paper here.

Wednesday's trading day has begun in Asia, and it's not good.

The day-to-day swings of the stock market generally don't excite me. But today's spectacle qualifies as economic news--though I'm not sure just how. Was it a response to the Asian markets plunge, which was itself a response to some rumblings by the Chinese government? Was it Greenspan? Was it Drudge? Was it the durable goods orders?

I'm pretty skeptical of those who have a ready explanation for events like this. Felix Salmon gets it, and in turn he names two others who get it (Dan Gross and Andrew Leonard). Truth is, the markets have had a good run in the last few months. Yesterday erased part of that, but only part. The question is what will happen in the next few days to weeks. And I'd say roughly half of the folks with an opinion on this will be wrong.

Lest we forget, there were some 500 point drops in the late 1990s that did not presage immediate disaster. Don't interpret that to mean that I think this is nothing to worry about. Clearly a number of factors are less favorably aligned today than in 1997 and 1998 when we weathered a much more severe crisis from Asia. Of course, when those events hit, the Fed did ease monetary policy, just as many of us wanted them to. Are they more likely to ease because of this? Yes. Twice as likely as a sensible person might have thought last night? That's a tougher sell. But although I have been expecting them to stand pat, I am not above revising my priors. But I'll wait until things settle down a bit before acting on them.

It promises to be an interesting Wednesday.

Felix Salmon is wondering if he should lock in a lower rate on his HELOC. Seems like a good deal, but as seasoned experts here will know, there is a trade-off.

So the way I see it, my main cost of locking in now is that I lose the ability to lock in at a lower rate in the future. Even if the Fed funds rate stays on hold, the curve could invert further between overnight and six years, and the lock-in rate could go lower than 7.25%. I'm no expert in options pricing, so how should I value the option to lock in – the thing I lose if I actually do lock in?

Sounds like something I posted a while back. Unfortunately, it is not possible to refinance a house one room at a time.

Subtitle: One nasty little shock away from recession (thank goodness)

First, look at Tim Duy's take at Economist's View. Solid analysis and a couple of great lines worth quoting.

Are Fed officials just clueless? Don't they see that the end is coming? I think not – I bet Fed officials are not working overtime to spin a negative story out of every number...

and

If you forced the Fed to choose between cutting rates and hiking rates, they would choose the latter. Luckily, they can choose to pause as well.

I agree. Talk of recession is everywhere. A data point that comes in with slower growth, but growth nonetheless (the ol' "increasing at a decreasing rate" as I like to tell my macro classes) leads some to put on sackcloth and ashes. One certainly has to look at the broader picture, as James Hamilton has done, for example.

Yes, the point is often made that the Fed's record at producing a soft landing is a bit weak, with the only real success being in the mid '90s. Some say that overtightening in the late '80s brought on the 1990-91 recession. I agree that it was certainly a contributing factor. But that makes them 1 for 3 in the last 20 years (2001 being the other negative result). But I'm not sure that I'd look at the scenarios of the 1970s or the early 1980s as being similar enough to that of the last 10 years to want to make the comparison. Could Chairman Volker have managed a soft landing instead of a recession with the lousy deck of cards that he was dealt? Bernanke isn't sitting on a royal flush, but by the same token this clearly isn't 1979.

Whether or not a recession occurs is probably going to be due less to Bernanke's skill or lack thereof than it will be due to whether or not some additional exogenous shock hits the U.S. or world economy. I don't think I'm alone in saying that despite my overall optimism, I am not at all squeamish about saying that we are one nasty little shock away from a recession.

And that brings us to the news of today. Here, CNN channels Reuters:

NEW YORK (Reuters) -- The Thai baht staged its largest one-day fall in three years Tuesday after Thai armed forces ousted the prime minister, sparking a broad decline in a number of Asian currencies.

...

Prime Minister Thaksin Shinawatra, who was in New York to speak at the United Nations, declared a "severe state of emergency" in a broadcast on Thai television.

Looking ahead, the market will watch to see whether the Thai crisis prompts investors to abandon other risky emerging market trades.

The dollar would be the main beneficiary in such a scenario, said Divyang Shah, strategist at IDEAGlobal in London, as it is "not only a high-yielder but is also an attractive safe haven."

But other market participants said solid economic fundamentals in Thailand and other emerging Asian markets make a mass rush for the door unlikely.

"There's been an immediate reaction and people will move to the sidelines to see how it all unfolds, but what we'll see will probably be a short-term disruption," said Upadhyaya.

...

Karl Jackson, president of the U.S.-Thailand Business Council, said the country has experienced a military coup 17 times since 1932.

"Basically before democracy came to the forefront, this was the their way of changing the government and it continues," said Jackson, who is also director of Southeast Asia studies at Johns Hopkins University.

"There might be a momentary glitch on the part of investors, but as in previous coups, investment and property rights won't be affected. If the coup is successful, I expect everything will be normal in the morning," he said.

Still, investors were watching the situation closely, since the Asian currency crisis in 1997 started with the devaluation of the Thai baht, then grew into an international economic slowdown.

Yes, it may be that everything will be normal in the morning--except perhaps for Mr. Shinawatra. In all likelihood this will not cause the sort of contagion that took place when the baht collapsed in 1997. But as I read the news coming out of the Asian markets tonight as their trading day comes to a close, I can't help but get the feeling that someone is looking over my shoulder and saying, "Made you look!"

Yes, indeed I looked. Because if there is trouble to be made for the U.S. economy, or the world economy for that matter, it will be made by that unexpected exogenous shock. The straw that broke the camel's back--a classic non-linearity. Maybe not today. Maybe not the baht, but it made me look.

For the last year, I've been cautiously optimistic that we could avoid a hard landing, and to this point it would seem that we have. However the tensions of the last year or two (rising interest rates, rising then falling housing markets, questions about the health of the labor market, etc.) are beginning to give even the optimistic among us a little cause to look over our shoulder once in a while.

Yet, this is something we may have to get used to every decade or so. We have not eliminated the business cycle, but we have tamed it a little. That is going to mean sailing close to the rocks now and then. As long as we keep inflation low and stable, there will be less need for major course corrections. A soft landing, while not assured, is then possible if you are fortunate. It's nerve-racking, but it's better than the boom-and-bust alternative that comes from chasing the Phillips curve too hard.

Thus it is all the more important for the Fed to stick it its inflation fighting guns. As Tim Duy said, given a choice between raising and lowering rates, they would probably raise. That would be my choice as well. But given the increased uncertainty about the effect of the housing slowdown and the lagged effect of past rate increases yet to be felt, keeping rates where they are at this point in time (with a bias toward tightening) is an even better idea. Keeping inflation low and stable is the best thing the Fed can do to ensure that we are one nasty little shock away from a recession more often than we are rushing headlong into one.

From the Wall St. Journal:

"The key is that they believe inflation expectations have stopped rising," Peter Frank, currency strategist at ABN Amro said. "They have not been more dovish than was expected, and that's why the dollar has not collapsed."

The as-expected statement from the Fed is therefore unlikely to change the market's general dollar-bearish tone, analysts said.

Ouch.

The yield curve is quite flat at the moment. From 2 to 30 years out, it is actually inverted by 4 basis points as I write. That may not sound like much, but if you're in the business of borrowing short and lending long, it's not a pleasant sight. Inverted yield curves are said to portend recession. Could it also portend a soft landing?

If you're inclined to think that the economy is on the right track and the expansion is not yet over, you're probably thinking that the inverted yield curve will be short-lived. If you are optimistic about such things, the odds are that you look for the long rates to move up rather than the short rates move down, at least in the next few weeks and months.

Lately, the 10 year has shown some signs of moving above its mid-2004 level. When you look at the behavior of the rate over the last couple years, the rise has been slow and steady after a rather precipitous fall in 2004. Clearly the Fed has been trying to stay ahead of the curve. Whether they got too far ahead and where they will go from here is the subject of some discussion. But St. Louis Fed President William Poole is optimistic about the potential for growth and wants to keep the Fed ahead of the curve. (CNN Money)

"Should we get data in the coming months that are consistently strong, particularly if there are substantial upside surprises, then that says we're going to have to step a little harder on the brake," St. Louis Federal Reserve President William Poole told Reuters.

He said the opposite will hold if the data were on the soft side. But he didn't sound very convinced this is in the cards and doubts a cooling housing market could undermine the expansion as some private sector economists have warned.

"My sense is there is a great deal of momentum in the economy. I don't think that it is momentum of the sort that is going to run us off the rails," Poole said, explaining he doesn't think the growth pace would create widespread labor market shortages.

"But I think it is momentum of the sort that says we're going to keep rolling down the expansion here, and you're not going to stop this freight train easily."

This means higher short term rates. If the Fed is wrong, and the growth never materializes, the yield curve will invert further, policy will overshoot, and recession is possible. But, if the Fed is right, the long yields will rise in concert with the short rates until inflation stabilizes and the Fed feels comfortable taking its foot off the brake--the much anticipated "soft landing."

Of course, if the Fed waits too long and inflation takes hold, long rates could rise because of higher inflation expectations. This means even higher short term rates later, possibly another more serious inversion, and a hard, perhaps bumpy, landing.

At the moment, I would ascribe the slow uptick in the long bond yield to be a return to somewhat normal real interest rates (after years of extremely low real rates). Long rates are following the short rates upward, not as fast as some would like, but they are inching up. Prospects for economic growth, not growing inflation expectations, seems the more likely explanation. In the end, we know only marginally more than we did a few months ago when we had the same discussion, but nothing has caused me to dramatically alter my priors. Future policy moves will be data dependent. A couple more rate hikes are likely, and now the 10 year looks like it might keep up a little better. As long as the adjustment doesn't come too rapidly, a soft landing is possible. We might even be experiencing it now. (Is 1.6% GDP growth for a quarter a soft landing?) Ideally I'd like to see some spacing out of the rate hikes (every other meeting perhaps) as things wind down to really grease this economy back onto the runway. But then, with the economy as in an airplane, I'm pretty critical of the landing.

For further reading, I suggest this speech given by Poole from a few months ago. In it he gives some historical perspective on the term structure and discusses implications for policymakers in the current environment. It's from last June, but it still reads well today. It is required reading in my MA level macro course.

UPDATE: Mark Thoma links to a speech by Michael Moskow, and David Altig offers some thoughts that parallel this post.

So what are we to make of the yield curve inversion that happened this week? (See Econbrowser and macroblog for many, many links.)

Crawling the web for observations on this rather rare event led me to this Marketwatch/NY Times article.

The flat and now, inverted, yield curve poses a challenge for banks, hedge funds and other companies. They can't borrow at cheaper short-term rates to fund longer-term loans and investments that in a normal interest-rate environment pay more than their borrowing costs.

The important thing to remember here is that the curve has been flat for some time and, even if the inversion goes away tomorrow, it will still be flat. We're talking about a few basis points in either direction. This week's inversion does little if anything to revise my priors concerning the probability of a recession.

I don't make my living in the bond pit, so I can't say precisely what drives the day-to-day fluctuations of a few basis points. Goodness knows that we've all seen day-to-day gyrations in the bond market that are beyond our powers to explain. I have to imagine that the overall health and strength of the economy both short and medium term as well as some technical rebalancing at the end of the year are all converging. Note that the inversion is at the 2 to 10 year spread. Certainly a valid inversion, but the 2 year is not a maturity that is followed like the 3 month or 1 year maturity. Just to cloud things even further, there was an auction in the 2 year market today. From the same article,

The Treasury Department sold $20 billion worth of new 2-year notes Thursday at a yield of 4.402%, slightly above expectations. Overall demand was the best in three months, with $2.42 in bids received for each $1 of securities sold. But indirect bidders, which includes foreign central banks, took a lean 30.6% of the auctioned notes, lower than the recent average.

It is, of course, too early to discern the significance of foreign central banks taking fewer notes than the recent average. If you read this as being the beginning of a trend, it should mean higher interest rates in the short to medium term and increased danger of a "hard landing". Or, it could be a one-off event. While I'm not ready to place my bets just yet, I do have to admit that out of all of the yield curve inversion commentary, that was the line that gave me the most pause.

And that brings me back to the central message from this episode. A yield curve inversion is not a sure-fire indicator of a recession. It is a warning of a situation where expectations are out of the norm. When that happens, it's always a good idea to pay attention and try to figure out why.

Ordinarily, a day like today should be fairly quiet in the financial markets. The Fed meets tomorrow. Most agree on what they will do, but apparently a subset is not convinced. You would expect market participants to tidy up their portfolios in advance of the meeting. The lull before the storm, as it were.

Unfortunately, those words are ringing all too true in a literal sense. Tropical Storm Rita is bearing down on the Gulf coast. We did not need this right now.

Rita is expected to pass through the Florida Keys tomorrow, before heading into the Gulf's warm waters. It is forecast to reach Texas by Sept. 24, sweeping past the region devastated by Hurricane Katrina last month. The storm prompted New Orleans Mayor Ray Nagin to suspend plans for residents to renter the city and Galveston, Texas, to call for a voluntary evacuation.

``Our guidance points to a large, powerful hurricane in the Gulf of Mexico in the next few days,'' U.S. National Hurricane Center meteorologist Eric Blake said today in a telephone interview from Miami. ``We're forecasting a Category 3 hurricane, but Category 4 is not out of the question.''

The hurricane center's five-day projection has the center of the storm hitting Texas. Rita may, however, strike ``anywhere from the Texas through Louisiana coast,'' National Hurricane Center meteorologist Michelle Mainelli said.

``It's still developing and its path could change,'' Mainelli said.

New Orleans's levees are weak and can't handle more than 9 inches (23 centimeters) or a 3-foot storm surge, Nagin said at a televised press conference. He told residents of the Algiers neighborhood, who were allowed back for the first time today, to prepare to leave as early as Sept. 21.

I don't need to tell you that a direct hit from a category 4 or 5 on the weakened levees would be catastrophic. A 3 foot surge is nothing if they get a direct hit.

Of course, the financial markets are concerned about oil and gas. Also from Bloomberg:

Chevron Corp., Royal Dutch Shell Plc and BP Plc, three of the world's four largest oil companies, are among producers and drillers that are evacuating offshore workers as Rita approaches the Gulf. Crude-oil, natural-gas and gasoline futures surged in New York on concern over Rita. Katrina idled about 10 percent of U.S. refining capacity, sending gasoline prices to record highs.

Houston-based Diamond Offshore Drilling Inc. is idling two rigs for evacuation, and a third is being moved from Rita's projected path, company spokesman Les Van Dyke said today in a telephone interview. Transocean Inc. and Murphy Oil Corp. also plan to evacuate workers.

San Ramon, California-based Chevron, the second-largest U.S. oil company, is evacuating some workers essential to production and some who aren't, spokesman Mickey Driver said.

London-based BP is removing workers not needed for production from platforms in the eastern and central Gulf, spokeswoman Ayana McIntosh-Lee said. Shell pulled out 195 workers yesterday and will evacuate another 350 today.

CNN reports:

U.S. light crude oil for October delivery jumped $4.39 to settle at $67.39 a barrel on the New York Mercantile Exchange as Tropical Storm Rita headed toward the Gulf Coast. Also affecting the oil market are indications that OPEC ministers -- meeting Monday -- are unlikely to boost production quotas.

And James Hamilton comments:

...trading on NYMEX today pushed October oil up 7% and October natural gas and gasoline both up 14%. The latter figure amounts to 26 cents a gallon-- not bad for a day's work. Of the 40 cents a gallon decrease in retail gasoline prices that I promised here and here, we've seen 15 cents so far, but today's two bits could take a good bite out of what you've got left. Ah well, the NYMEX giveth, and the NYMEX taketh away.

Back to CNN (same article):

COMEX gold rose $7.10 to settle at $470.40 an ounce as investors poured money into the safe-haven commodity. Prices for Treasury bonds, another perceived haven for investors, also rose.

Bonds are not a refuge against inflation however. I haven't been reporting on gold until now because I generally don't buy into the hype about it that seems to come and go from time to time. But increases like this are hard to ignore.

Oh, and by now you've probably guessed that stocks are down today. You'd be right to the tune of 84.31 on the DJIA.

There is a lot on the table right now for the Fed to consider, and a lot to keep us occupied chatting away about it like we do. The present situation is quite out of the ordinary. It's going to take some time to sort it out.

Oh, and did I mention that data on housing starts comes out tomorrow too?

Sleep well if you can, we have very interesting day ahead of us tomorrow.

UPDATE: New Economist lists seven reasons the Fed will raise rates.

23 ticks up in price. The yield stands at 4%. (CNN)

Write your own story. You know the drill.

Greenspan called it a "conundrum" back in February. That sure showed the markets. Apparently the Greenspan effect has worn off. From the NY Times:

The yield on the benchmark 10-year Treasury note went below 4.10 percent yesterday for the first time since February, a move that could confound the Federal Reserve's effort to slow economic growth. At the same time, however, the rally in Treasuries appears to reflect a decline in inflationary fears.

I half expect Rod Serling to step out from behind a tree any minute.

The rest of the article tried to explain it. Here's a part of it.

William H. Gross, the manager of the world's biggest bond mutual fund - the Pimco Total Return fund - signaled Tuesday that he was moving in this direction when he said that he thought the 10-year yield would be in a range of 3 percent to 4.5 percent over the next three to five years.

Mr. Gross, in his investment outlook published Tuesday, said that the recycling of billions of dollars from Asia - mostly from China's central bank - into the Treasury market would also help keep Treasury rates low.

This is because China, even if it revalues its currency, the yuan, later this year, will still have to buy dollars and sell yuan to prevent the yuan from becoming less competitive globally too quickly. And those dollars will be used to buy Treasuries, keeping rates lower by about a percentage point than they otherwise would be, according to Mr. Gross.

Lundy Wright, who runs the Treasury desk at Nomura Securities International, said the rally in the Treasury market, was, in part, a flight to quality because of the turmoil in the corporate bond market. He said that money managers were reducing their bets until the smoke cleared. What is not contestable is that the bond market continues to be volatile as investors shift sentiment on a dime in a global economic environment where uncertainty seems to be one of the few constants. This means yesterday's move could reverse quickly.

For related reading, I direct you to Brad Setser's post from May 11.

The bond market, right now, is not for the timid.