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Fed Balance Sheet: then and now
First, a review of the Fed balance sheet back in February (courtesy of Steve Cecchetti):
The Fed balance sheet now (as of Sept. 24, 2008, my own calculation):
Fed's balance sheet increased from $885 billion to $1,214 billion, a jump of 37%. So far, we haven't seen much money-printing: the Fed reserve notes (the fiat money) just increased from $779 billion to $799 billion. But the composition of Fed's asset holdings worsened, as highlighted in red. The Fed put too much bank junks onto its balance sheet.
Below three extra graphs are taken out from Northern Trust research team, demonstrating the effect in a more dramatic fashion.
Harvard Panel on Current Financial Crisis
McArthur University Professor Robert Merton, a 1997 Nobel laureate in economics for his work on options pricing and risk analysis, advanced the importance of "functional analysis of the financial system." (His experience with the system is both theoretical and actual; he was a principal in Long Term Capital Management, the extraordinarily leveraged investment firm whose collapse in 1998 nearly precipitated a world financial crisis and necessitated a bailout negotiated by the Federal Reserve; see a review of books on that precursor of the current situation here).
Although current concerns focus on liquidity and the credit markets, Merton said, it was essential to note that as too-high housing prices deflated, perhaps $3 trillion to $4 trillion of actual wealth had been lost in the last year alone—and was unlikely to return. With each successive decline in the value of an asset held on a leveraged basis, he said, an owner's effective risk and effective leverage ramped up at an accelerating rate, underlining the destruction of the financial institutions that held the underlying failed mortgage loans and securities based on them. In addition, such deterioration prompts "feedback": for instance, banks and thrift institutions held Fannie Mae and Freddie Mac preferred stock as part of their presumably safest, most reliable capital; when the government took control of those institutions, the banks' and thrifts' capital absorbed immediate, large losses—instantly increasing their own leverage and decreasing their ability to make loans, worsening the underlying housing crisis.
Financial innovation and "engineering" are widely blamed for causing, or worsening, the current crisis, and in a sense, they have, Merton said. Innovations inherently involve the risk that some ideas will fail, and inherently outrun existing regulatory structures. But rather than clamping down so severely that financial innovation is choked off, he argued that regulation must allow for further, future innovation as an engine of growth, because the functional needs—consumers' need to finance their retirements, developing nations' ability to fund economic development—remain intact. Thus, he urged that the focus remain on the necessary financial functions, and not on saving any particular form of institution that currently meets those needs, or did until recently.
Jobs in finance, he told the anxious M.B.A.s, would be "tough" to come by. But the solution for society would not be to rid financial institutions of highly trained, innovation-oriented financial engineers. Rather, he insisted, management teams, boards of directors, and regulators needed much more such expertise in their own ranks so they could understand the products they were offering and acquiring—as they so apparently did not in the recent past.
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Beren professor of economics N. Gregory Mankiw, who teaches the perennially popular Economics 10 introductory course and and is the author of the core introductory textbook in the field, said that "the basic problem facing the financial system is that lots of people made very big bets that housing prices could not fall 20 percent," despite evidence to the contrary in the Great Depression and more recently in Japan. The resulting losses wouldn't matter in classical economic theory, he said—taking risk entails absorbing loss—except that the simultaneous large bets undercut much of the financial system all at once, and that system, as readers of his textbook know, is vital for the economy as a whole. Federal Reserve chairman Ben S. Bernanke '75 (access his June Commencement address here) focused on just this problem in his examination of the role of bank failures in worsening the Great Depression, Mankiw noted.
How should one view the proposed $700-billion federal financing initiative, Mankiw asked. One theory, advanced by President George W. Bush the night before, was that financial institutions' damaged assets have value greater than their current price, and only the federal government has the resources to buy and hold them to maturity. Wall Street economists, Mankiw said, like that interpretation. Their (tenured) academic counterparts are skeptical: the Treasury, they say, will overpay, thus bailing out failed managers who don't deserve it; and/or the funds will be insufficient to recapitalize banks, given the real magnitude of the losses they face.
Academic economists' alternatives are three: let the market handle the situation (as hedge funds and private-equity funds step forward where they see attractive opportunities to invest fresh capital); have the government somehow take equity positions in troubled banks and other institutions, directly infusing them with capital but benefiting as they recover (much as investor Warren Buffett put $5 billion into Goldman Sachs, with the right to invest $5 billion more on favorable terms); or force banks to raise capital, no matter what (in the friendly manner, Mankiw suggested, of a Mafia enforcer dropping by for a chat with management).
As for the presidential candidates, Mankiw said, Barack Obama, J.D. '91, seemed to be saying that the market had run wild, inflicting on the public the downside of unfettered capitalism. Recalling his service from 2003 to 2005 as chair of the president's Council of Economic Advisers, Mankiw said that he had tried to rein in the government-sponsored Fannie Mae and Freddie Mac. Predecessors in the Clinton administration, he said, found the task impossible, too. This was a known "time bomb," he said, not a market problem. Nor was it simply a problem of lax underwriting standards for loans.
Of John McCain's emphasis on Wall Street "greed" and "corruption," Mankiw said, there was scant evidence that corruption was the problem. Many people made ill-advised bets, he said, but that was not criminal. And he suspected that greed would be a factor in the markets that any future administration would encounter.
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Cabot professor of public policy Kenneth Rogoff, former chief economist and director of research for the International Monetary Fund, tried to put the "truly incredible" recent developments in some larger context.
The financial sector of the economy, he said, had become "bloated"—accounting for 7 to 8 percent of jobs (including insurance employees), but capturing 10 percent of wages and 30 percent of profits. Such evidently huge returns naturally attracted torrents of new investment, making the financial sector as a whole a bubble: "It is too big, it is not sustainable, it has to shrink" even beyond its already depleting ranks. The problem, he said, is not merely bad debts held by institutions, but "bad banks" themselves: the whole sector of financial enterprises begs to be restructured. (Rogoff noted that he had for several months forecast the collapse of at least one large investment bank, but even he was surprised at the near-collapse of nearly all the principal investment banks virtually overnight.)
Much as auto makers or steel companies in the past argued that they were basic to the economy and therefore required federal support, he said, today the "country is being ransomed by the financial sector" in the demand for the $700-billion bailout, which would have the effect of maintaining management salaries, bidding up the prices of stock and bond holdings in their companies' portfolios, and so on. Today, unlike during the Great Depression, Rogoff argued, the shrinkage of such institutions would be "not unproductive" for the economy as a whole. (As an aside, he noted that all those Harvard students who marched off to investment banking "will be freed to go into other activities.") Given the difficulties of conducting auctions to buy distressed assets with the government's largess without letting excess funds leak back into the financial sector, Rogoff was sympathetic with Warren's argument for focusing on the needs of homeowners.
In international perspective, he said, the United States "has been running spectacular deficits" for 15 years or more. The availability of foreign funds has enabled the country to keep interest rates low—maintaining abundant liquidity—but has exposed the fragility of the system if federal budget deficits balloon. In the present instance, he said, the issue becomes a question of whether Beijing wishes to lend the United States $700 billion to repair American financial institutions. Americans aren't immediately going to be the source of those funds, he noted: "We're supposed to keep consuming." In other words, the country is saying, "We borrowed too much, we screwed up, so we're going to fix it by borrowing more."
He said a better strategy was required—but not at the expense of excessive regulation that would choke off innovation, one of the few flagships of American economic growth and strength in recent decades (a point also made by Merton at HBS on September 23, and again after Rogoff's presentation). After the dot.com bust of 2000-2001, Rogoff said, the technology sector regained its footing. Today, it is equally important not to overreact, so that a dynamic financial sector, corrected by "tough love," can resume its proper and important role in the economy and in future growth.
Get the auction right!
Thee Treasury proposes to invest $700 billion in mortgage-related securities to resolve the financial crisis, using market mechanisms such as reverse auctions to determine prices. A well-designed auction process can indeed be an effective tool for acquiring distressed assets at minimum cost to the taxpayer. However, a simplistic process could lead to higher cost and fewer securities purchased. It is critical for the auction process to be designed carefully.
The immediate crisis is one of illiquidity. Banks hold a variety of mortgage-backed securities, some almost worthless while other retain considerable value. None can be sold, except at fire-sale prices. The Treasury proposes to restore liquidity by stepping in and purchasing these securities. But at what price?
A simple approach leads to overpayment
A simple but naïve approach would be to invite the holders of all mortgage-related securities to bid in a single reverse auction. The Treasury sets an overall quantity of securities to be purchased. The auctioneer starts at a price of nearly 100 cents on the dollar. All holders of illiquid securities would presumably be happy to sell at nearly face value, so there would be excess supply. The auctioneer then progressively lowers the price—90 cents, 80 cents, etc.—and bidders indicate the securities that they are willing to sell at each lower price. Eventually, a price, perhaps 30 cents, is reached at which supply equals demand. The Treasury buys the securities offered at the clearing pricing, paying 30 cents on the dollar.
This simplistic approach is fatally flawed. The Treasury pays 30 cents on the dollar, purchasing all mortgage-related securities worth less than 30 cents on the dollar. Perhaps, on average, the purchased securities are worth 15 cents on the dollar. The Treasury buys only the worst of the worst, intervening in a way that rewards the least deserving. And, as a result of overpaying drastically, the Treasury can mop up relatively few distressed securities with its limited budget.
In the simplistic approach, competition among different securities overshadows competition within securities and among bidders. The auction merely identifies which securities are least valuable, rather than determining the securities' value. An auction that determines a real price for a given security needs to require multiple holders of the security to compete with one another. This can be achieved if the Treasury purchases only some, not all, of any given security.
A better approach
Thus, a better approach would be for the Treasury to instead conduct a separate auction for each security and limit itself to buying perhaps 50% of the aggregate face value. Again, the auction starts at a high price and works its way down. If the security clears at 30 cents on the dollar, this means that the holders value it at 30 cents on the dollar. (If the value were only 15 cents, then most holders would supply 100% of their securities to be purchased at 30 cents, and the price would be pushed lower.) The auction then works as intended. The price is reasonably close to value. The "winners" are the bidders who value the asset the least and value liquidity the most.
This auction has an important additional benefit. The "losers" are not left high and dry. By determining the market clearing price, the auction increases liquidity for the remaining 50% of face value, as well as for related securities. The auction has effectively aggregated market information about the security's value. This price information is the essential ingredient needed to restore the secondary market for mortgage backed securities.
Handling many securities is a straightforward extension. Different but related securities can be grouped together in the same auction and purchased simultaneously. Each security has its own price. The bidders indicate the quantity of each security they would like to sell at the specified prices. The price is reduced for any security with excess supply and the process repeats until a clearing price is found for each security. Auctioning many related securities simultaneously gives the bidders some flexibility to adjust positions as the market gradually clears. This improves price formation and enables bidders to better manage their liquidity needs. As a result, efficiency improves and taxpayer costs are further reduced.
For this auction design to work well, there needs to be sufficient competition. This should not be a problem for securities with diffuse ownership. For securities with more concentrated ownership, various approaches are possible. The Treasury could buy a smaller percentage of the face value. Alternatively, the Treasury could purchase the securities with the explicit understanding that the securities would be sold by auction some months or years in the future, after the liquidity crisis is over. To the extent that the securities are sold at a lower price, the holder would contractually owe the Treasury the difference, plus interest.
One sensible approach for the sequencing of auctions is to start with the best of the worst; that is, begin the auctioning with a group of securities that are among the least toxic. These will be easier for bidders to assess, and the auction can proceed more quickly. Then, subsequent auctions can move on to the increasingly problematic securities. In this way, the information revealed in the earlier auctions will facilitate the later auctions.
The basic auction approach suggested here is neither new nor untested. It was introduced over the last ten years and has been used successfully in many countries to auction tens of billions of dollars in electricity and gas contracts. It is quite similar to the approach that has been used to auction more than $100 billion in mobile telephone spectrum worldwide. It is a dynamic version of the approach that financial markets use for share repurchases. If implemented correctly, each auction can be completed in less than one day.
Thus, the auction approach meets the three main requirements of the rescue plan:
1) provide a quick and effective means for the Treasury to purchase mortgage-related assets and increase liquidity;
2) yield prices that are closely related to value; and
3) provide a transparent rules-based mechanism that treats different security holders consistently and leaves minimal scope for discretion or favoritism.
Indeed, the second and third requirements may be decisive for obtaining broad political support. The main alternative to auctions put forward by the Treasury is to employ professional asset managers. To the extent that negotiations or other individualized trading arrangements are used, the public will be rightfully wary that favoritism may be exerted and that some security holders will be offered sweetheart deals. By contrast, a transparent auction process is readily subjected to oversight. The Treasury appears to be embarking on the greatest public intervention into financial markets since the Great Depression. The ultimate success or failure of the intervention may depend on the fine details of the auction design. Let's get it right.
Roach on Chinese Economy and Paulson’s Rescue Plan
Note: This is an audio clip about 20 mins.
Why Investment Bank Model Failed
Buffet: Government $700 billion bailout could make money
CNBC interview on Warren Buffet right after his investment in Goldman Sachs.
(click to play)
Contrasting views on the dollar
America will need a $1,000bn bail-out
By Kenneth Rogoff
One of the most extraordinary features of the past month is the extent to which the dollar has remained immune to a once-in-a-lifetime financial crisis. If the US were an emerging market country, its exchange rate would be plummeting and interest rates on government debt would be soaring. Instead, the dollar has actually strengthened modestly, while interest rates on three- month US Treasury Bills have now reached 54-year lows. It is almost as if the more the US messes up, the more the world loves it.
But can this extraordinary vote of confidence in the dollar last? Perhaps, but as investors step back and look at the deep wounds of America's flagship financial sector, the public and private sector's massive borrowing needs, and the looming uncertainty of the November presidential elections, it is hard to believe that the dollar will continue to stand its ground as the crisis continues to deepen and unfold.
It is true that the US government has very deep pockets. Privately held US government debt was under $4,400bn at the end of 2007, representing less than 32 per cent of gross domestic product. This is roughly half the debt burden carried by most European countries, and an even smaller fraction of Japan's debt levels. It is also true that despite the increasingly tough stance of US regulators, the financial crisis has probably already added at most $200bn-$300bn to net debt, taking into account the likely losses on nationalising the mortgage giants Freddie Mac and Fannie Mae, the costs of the $29bn March bail-out of investment bank Bear Stearns, the potential fallout from the various junk collateral the Federal Reserve has taken on to its balance sheet in the last few months, and finally, Wednesday's $85bn bail-out of the insurance giant AIG.
Were the financial crisis to end today, the costs would be painful but manageable, roughly equivalent to the cost of another year in Iraq. Unfortunately, however, the financial crisis is far from over, and it is hard to imagine how the US government is going to succeed in creating a firewall against further contagion without spending five to 10 times more than it has already, that is, an amount closer to $1,000bn to $2,000bn.
True, the US Treasury and the Federal Reserve have done an admirable job over the past week in forcing the private sector to bear a share of the burden. By forcing the fourth largest investment bank, Lehman Brothers, into bankruptcy and Merrill Lynch into a distressed sale to Bank of America, they helped to facilitate a badly needed consolidation in the financial services sector. However, at this juncture, there is every possibility that the credit crisis will radiate out into corporate, consumer and municipal debt. Regardless of the Fed and Treasury's most determined efforts, the political pressures for a much larger bail-out, and pressures from the continued volatility in financial markets, are going to be irresistible.
It is hard to predict exactly how and when the mega-bail-out will evolve. At some point, we are likely to see a broadening and deepening of deposit insurance, much as the UK did in the case of Northern Rock. Probably, at some point, the government will aim to have a better established algorithm for making bridge loans and for triggering the effective liquidation of troubled firms and assets, although the task is far more difficult than was the case in the 1980s, when the Resolution Trust Corporation was formed to help clean up the saving and loan mess.
Of course, there also needs to be better regulation. It is incredible that the transparency-challenged credit default swap market was allowed to swell to a notional value of $6,200bn during 2008 even as it became obvious that any collapse of this market could lead to an even bigger mess than the fallout from subprime mortgage debt.
It may prove to be possible to fix the system for far less than $1,000bn- $2,000bn. The tough stance taken by regulators this past weekend with the investment banks Lehman and Merrill Lynch certainly helps.
Yet I fear that the American political system will ultimately drive the cost of saving the financial system well up into that higher territory.
A large expansion in debt will impose enormous fiscal costs on the US, ultimately hitting growth through a combination of higher taxes and lower spending. It will certainly make it harder for the US to maintain its military dominance, which has been one of the linchpins of the dollar.
The shrinking financial system will also undermine another central foundation of the strength of the US economy. And it is hard to see how the central bank will be able to resist a period of allowing elevated levels of inflation, as this offers a convenient way for the US to deflate the mounting cost of its private and public debts.
It is a very good thing that the rest of the world retains such confidence in America's ability to manage its problems, otherwise the financial crisis would be far worse.
Let us hope the US political and regulatory response continues to inspire this optimism. Otherwise, sharply rising interest rates and a rapidly declining dollar could put the US in a bind that many emerging markets are all too familiar with.
Nationalisation ≠ Currency Weakness
September 19, 2008By Stephen Jen & Spyros Andreopoulos | London
Summary and Conclusions
Conventional wisdom has it that, as a government fiscalises the contingent liabilities of nationalised banks, the currency of the country in question should depreciate. More generally, banking crises are, very often, accompanied by balance of payments (or currency) crises. The US, being a country with still out-sized 'twin deficits' (fiscal and external deficits), will likely see the dollar weaken because of the Treasury and the Fed's decision to effectively nationalise some of the large financial institutions, so the argument goes. An inconvenient fact, however, is that nationalisation of banks, historically, did not tend to lead to further currency weakness. In fact, very often the financial sector and the currency in question reach a trough just as the government takes steps to address the banking crisis. Thus, currency weakness tends to precede, not follow nationalisation.
Popular Thesis on Nationalisation and the Dollar
The notion that nationalisation of banks should lead to currency weakness is popular mainly because it is intuitive. Since nationalisation of banks is 'not good news', and runs counter to the principles of capitalism and the free market, some have the visceral reaction to sell the currency in question.
Further, as highlighted by Kaminsky and Reinhart (K&R) (see Graciela Kaminsky and Carmen Reinhart (1999), "The Twin Crises: The Causes of Banking and Balance-of-Payments Problems", The American Economic Review 89: 3, June), there are many historical examples of 'twin crises', whereby banking crises and currency crises occurred simultaneously. The more memorable examples include Argentina in the early 1980s, Sweden and Norway in the early 1990s, Japan in the late 1990s and Thailand in the late 1990s. In fact, K&R found that, during 1980-1995, of the 23 banking crises, 18 were accompanied by balance-of-payments crises.
This link between banking crises and currency crises is genuine, and the usual dynamics are well-summarised by ex-Governor of the Riksbank (Sweden's central bank) Mr. Bäckström (see What Lessons Can Be Learned from Recent Financial Crises? The Swedish Experience, Kansas City Fed Seminar in Jackson Hole, August 1997): "Credit market deregulation in 1985 … meant that the monetary conditions became more expansionary. This coincided, moreover, with rising activity, relatively high inflation expectations, … (T)he freer credit market led to a rapidly growing stock of debt… The credit boom coincided with rising share and real estate prices… The expansion of credit was also associated with increased real economic demand. Private financial savings dropped by as much as 7 percentage points of GDP and turned negative. The economy became overheated and inflation accelerated. Sizeable C/A deficits, accompanied by large outflows of … capital, led to a growing stock of private sector short-term debt in foreign currency". This description applies quite well to the US right now.
Moreover, nationalisation of banks will increase the fiscal burden of the government. For a country that already has a large fiscal deficit, this is clearly negative for the interest rate outlook. For one that also has an external deficit, a large public borrowing need, ceteris paribus, should translate into a weaker currency, so the logic goes. At the same time, the central bank may be tempted to 'monetise' the debt, or run a monetary stance that is easier than otherwise – again currency-negative.
The Inconvenient Historical Fact
While the arguments above may sound logical and compelling to many, the inconvenient fact is that the historical pattern of how currencies perform before and after nationalisation or bail-outs tells a very different story. Averaged across five episodes of prominent banking crises, the nominal exchange rate tended to fall before nationalisation, but rise thereafter.
The historical pattern suggests that financial markets tend to be forward-looking and try to price in the deterioration in the state of the banking system by selling down the currency and financial sector stocks, but the government is usually not compelled to act until conditions deteriorate significantly. As a result, more often than not, government interventions have coincided with the lows in currency values. In other words, even though K&R's observation that currency crises often occur simultaneously with banking crises is correct, there is no strong proof that nationalisation leads to further currency weakness.
Other more visible examples are consistent with this link between banking crises and currency crises. The S&L Crisis and its bail-out spanned a protracted period of time. The dollar index did continue to fall from 1986 – the beginning of the S&L Crisis – until 1989 or so. (In 1986, the FSLIC (Federal Savings and Loan Insurance Corporation) – the deposit insurance scheme funded by the thrift industry but guaranteed by the government – first reported being insolvent (incidentally, the main reason why 1986 is remembered as the beginning of the S&L Crisis). The RTC (Resolution Trust Corporation) was established in 1989, and by 2003, the RTC had 'resolved' US$394 billion worth of non-performing assets of US savings and loans. (The total cost of the clean-up of the US S&L Crisis reached US$153 billion, in 'current' terms equivalent to some 2.6% of US GDP in 1991. This translates to US$375 billion in 2008 dollar terms.) The dollar index essentially moved sideways in the early 1990s. The dollar did falter in 1994/95, but that was attributed more to the inflation scare than to the S&L Crisis. Similarly, Japan's government did not explicitly address its banking crisis until 1998-99 and again in 2002-03. After each episode, USD/JPY actually collapsed toward 100, i.e., JPY strengthened in the ensuing quarters. Finally, in the case of Thailand, the banking crisis did indeed lead the currency crisis. But bank bail-outs did not take place until 1998, and USD/THB drifted in the 36-42 range between 1998 and 2000 – significantly below the peak of 56 reached in January 1998.
The case of the US at present is also illustrative. Between the onset of the credit crisis in August 2007 and the collapse of Bear Stearns on March 16, 2008, EUR/USD rose from 1.35 to 1.58, and lingered around the latter level as the Fed and Treasury assisted other financial institutions in the subsequent months. Since July, EUR/USD has collapsed from 1.60 to a low of 1.39 last week. Even with recent dramatic events, there is no evidence that 'nationalisation = currency weakness'. If anything, the dollar has held up remarkably well this week, despite several dollar-negative factors, including: (i) a higher probability of the Fed cutting the FFR than the ECB reducing the refi rate; (ii) a diluted Fed balance sheet, from the substitution of US Treasuries for other lower-rated securities; and (iii) large increases in the future fiscal burden of the US, from the contingent liabilities that are fiscalised. In fact, the only dollar-positive factor this past week was lower oil prices. EUR/USD seems to be drifting back toward 1.45, but we see this move as rather innocuous, given the severity of the financial stress in the US.
In sum, banking crises are unambiguously bad for currencies, but nationalisation per se does not make the situation worse for currencies. In fact, it often marks the low in the currencies.
The US Fiscal Worries Over the Medium Term
Having said the above, the US does have quite a worrisome fiscal outlook in the years ahead, which may eventually have an impact on the dollar. Setting aside the issue of the fiscal burden associated with the assistance the official sector has provided the financial sector, US expenditures may be too high and revenue buoyancy may be undermined by the weak equity and property markets.
The Congressional Budget Office (CBO) released its budget update last week, and predicted that the US federal deficit will rise from US$161 billion (1.2% of GDP) in 2007 to US$407 billion (2.9%) in 2008. This sharp deterioration in the fiscal balance reflects a simultaneous increase in spending and a decline in tax revenues. (Total government spending will increase by US$226 billion, to close to US$3.0 trillion, reflecting both discretionary and mandatory spending.) The CBO forecasts that deficits will remain above US$400 billion in each of the next two years.
Investors will likely see it as key for the next Administration to control spending. However, it is also important for investors to appreciate how sensitive US revenue collection is to GDP. During 2001-02, for example, as the US economy fell into a brief recession, revenue collection plummeted from 21% of GDP to close to 16%. Thus, the strength of the US economic recovery in the coming years will have important implications for the overall budget position. These fundamental trends in revenue collection and 'core' spending are at least as important as the costs associated with nationalisation. The performance of the dollar in the coming years will, therefore, be a function of how the US government deals with spending and how rapidly the US economy recovers, in our view.
Bottom Line
Banking crises are bad for currencies, but nationalisation per se does not necessarily make it worse for currencies. In fact, it often marks the low in the currencies. We believe this is the case for the dollar in the current episode. What remains a lingering risk for the dollar over the medium term is the US fiscal position, unrelated to the costs of nationalisation.