March 19, 2008
Belly up to the bar: Investment banks are using the new facility
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".
Posted by William Polley at 01:26 PM | Comments (0) | TrackBack
Funny they didn't mention anything about tightening credit markets
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.
Posted by William Polley at 03:08 AM | Comments (0) | TrackBack
March 18, 2008
Quote of the day
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.
Posted by William Polley at 05:23 PM | Comments (0) | TrackBack
March 17, 2008
Some thoughts on the day after: Bring back Glass-Stegall?
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.
Posted by William Polley at 07:29 PM | Comments (0) | TrackBack
A little ironic that this deal was inked today
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)
Posted by William Polley at 01:06 PM | Comments (2) | TrackBack
If you read one article today...
...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.
Posted by William Polley at 12:12 PM | Comments (0) | TrackBack
Link roundup
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.
Posted by William Polley at 02:59 AM | Comments (0) | TrackBack
March 16, 2008
Whatever happens in the morning, we'll still be writing about this twenty years from now
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 banks 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.
Posted by William Polley at 11:10 PM | Comments (0) | TrackBack
How tonight's Fed announcement paves the way for more emergency financing of investment banks
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.
Posted by William Polley at 09:33 PM | Comments (0) | TrackBack
January 23, 2008
A new one for the blogroll
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.
Posted by William Polley at 01:29 AM | Comments (0) | TrackBack
January 22, 2008
Fed cuts 75 basis points
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.
Posted by William Polley at 10:34 AM | Comments (5) | TrackBack
December 06, 2007
Bank of England cuts; ECB holds steady
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.
Posted by William Polley at 03:29 PM | Comments (0) | TrackBack
December 05, 2007
Martin Feldstein's two pronged approach
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.
Posted by William Polley at 12:04 AM | Comments (1) | TrackBack
December 04, 2007
Greg Ip on the upcoming Fed meeting
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).
Posted by William Polley at 11:38 PM | Comments (0) | TrackBack
October 31, 2007
A final thought on today's Fed move
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.
Posted by William Polley at 01:58 PM | Comments (2) | TrackBack
Does 3.9% GDP growth change anything?
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.
Posted by William Polley at 12:45 PM | Comments (1) | TrackBack
October 30, 2007
November fed funds still looking for a cut
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.
Posted by William Polley at 09:41 AM | Comments (3) | TrackBack
October 29, 2007
Open-outcry trading on the decline
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.
Posted by William Polley at 12:23 AM | Comments (0) | TrackBack
September 20, 2007
Bernanke speaks (and other assorted news)
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.
Posted by William Polley at 09:48 AM | Comments (2) | TrackBack
September 14, 2007
Meltzer to Fed: "Don't be afraid to disappoint the market."
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.
Posted by William Polley at 11:10 PM | Comments (1) | TrackBack
September 10, 2007
Some links to start your week
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!
Posted by William Polley at 12:10 AM | Comments (1) | TrackBack
September 05, 2007
Edward Gramlich, Former Federal Reserve Governor, 1939-2007
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.
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
Posted by William Polley at 01:49 PM | Comments (0) | TrackBack
August 31, 2007
Bush addresses subprime lending
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.
Posted by William Polley at 12:31 PM | Comments (0) | TrackBack
Bernanke at Jackson Hole
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.
Posted by William Polley at 11:55 AM | Comments (1) | TrackBack
August 29, 2007
Fed funds market is looking more normal
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.
Posted by William Polley at 12:56 PM | Comments (0) | TrackBack
August 22, 2007
David Wessel has a first-rate column in the Wall Street Journal today
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.
Posted by William Polley at 11:30 PM | Comments (2) | TrackBack
Why did the four large banks borrow from the Fed?
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.
Posted by William Polley at 09:52 PM | Comments (1) | TrackBack
The jawboning appears to be working
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.
Posted by William Polley at 01:05 PM | Comments (1) | TrackBack
August 20, 2007
A good set of articles
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.
Posted by William Polley at 10:30 AM | Comments (0) | TrackBack
August 17, 2007
Fed cuts discount rate
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.