Thursday, August 9, 2007

The Federal Reserve Walks the Line by Holding the Line

Today, Thursday (August 9, 2007) was another day, and another 387 points lost by the Dow Jones Industrial Average. Things got started across the pond when a French bank, BNP Paribas, announced that it had frozen the money in certain investment funds that it managed, evidently because of subprime problems, and would not honor withdrawal requests. The investment funds, it seems, could not figure out what some of their U.S. assets were worth, because the U.S. markets were illiquid. And if a fund can't figure out what its assets are worth, it can't determine how much money to let investors withdraw.

Things pretty much went downhill from there. Reports of liquidity problems came from all over Europe. Another fund froze up. A Dutch bank decided not to go public, apparently not wanting to find out how the markets view financial institutions these days. Banks in the Old World scrambled for cash, and had a hard time borrowing. It was like they bellied up to the bar and couldn't even get a sarsaparilla.

Things in the U.S. weren't much better. Some kinds of commercial paper--the asset backed variety, which constitutes more than half the commercial paper market--found themselves swimming against the tide when they tried to roll over. (To make things worse, the Wall Street Journal reported today on p. C1 that some money market funds hold this asset-backed commercial paper--is nothing safe?) Two hedge funds sponsored by Goldman Sachs reportedly have suffered big losses, evidently because they invested in accordance with computer models that didn't predict the current mess. (Remember what they say about computers: garbage in, garbage out.) AIG, the world's largest insurance company, reported that it had been roughed up by defaulting mortgages. Some mortgage bankers are losing access to money to lend. Rates for jumbo mortgages (those above $417,000) have jumped from below 7% to around 8%, because they can't be re-sold (meaning, investors don't want those tamales any more).

The European Central Bank injected $130.6 billion in the money markets today in order to ease the drought. The Federal Reserve added $24 billion in the U.S. and the Canadian central bank, Bank of Canada, added another $1.5 billion. That's a total of $155.1 billion in cash, injected into the money markets in one day. In its fiscal 2006 (i.e., the year ended Sept. 30, 2006), the U.S. government had a deficit of about $248 billion. So, in a single day, cash equal to about 60% of last year's federal deficit was injected into the European and North American money markets. This isn't meant to be a strict comparison; it's just gives you a sense of magnitude. We could have said that today's cash infusions were equivalent to about 30 billion grande cups of premium coffee, but that's probably harder to get your arms around.

It seems we have an old-fashioned financial panic, like the panics of the late 1800's and early 1900's. In those days, banks were less regulated than they are today, and often made loans that would be considered unduly risky today. When these loans defaulted, they sometimes triggered runs on the banks by depositors fearing that loan losses would render the banks insolvent. The depositors sought to get their money out before the bank collapsed. Of course, the run would often cause the bank to collapse.

These panics had a plague-like way of spreading quickly and remorselessly, and a run at one bank could easily lead to runs at other banks. Things got so bad in a financial panic in 1907 that the U.S. Treasury deposited around $35 million in New York banks to try to stem depositor runs. $35 million was considered real money in those days, but it wasn't enough to stop the runs. So, J.P. Morgan had to personally take the lead in lining up healthy U.S. and European banks to provide lines of credit to ailing banks to keep them on their feet. Had he not stepped in, a number of banks might have failed and the entire financial system could have taken a walloping.

The panic of 1907 was so bad it convinced the New York banking chieftains that private interests couldn't effectively prop up the financial system. They supported the creation of the Federal Reserve System in 1913, which today plays the role that J.P. Morgan played in 1907 of providing liquidity when the tap runs dry.

Let's step back and look at the structure of today's financial system. Lending isn't done that much by banks any more. Banks are just intermediaries that find the borrowers and make the initial credit decisions. But the banks often sell the loans to investors. Many of these loans are packaged into pools of debt, liked CDOs and their first cousins, CLOs. Then derivatives contracts are created from the various "tranches" of these packages and sold to investors such as hedge funds, pension funds, university endowments, etc. These investors are the actual lenders today, since it is ultimately their cash that funds the loans and their butts that bear the risk of defaults.

If the hedge funds and other institutional investors stop lending, then the cash spigot dries up fast. We've seen that in the CDO markets, where some contracts simply don't get cash bids when put up for auction. It's not that they don't necessarily have value (although some tranches may have no value). But there's so little information available about the risks of these puppies that no one is prepared to put anything on a barrel head for them. Notice that the banks haven't stepped forward to buy CDOs, when the hedge funds have stepped back. Banks don't do this .. . uh, stuff. And the Fed doesn't make loans to hedge funds. It's the banker of last resort for banks, not other financial institutions.

Some hedge funds facing withdrawal requests have either refused to honor them and closed the door, or have shut down and proceeded toward liquidation. Neither choice builds investor confidence, and it may be reasonable to expect that investors, if anything, are moving with greater alacrity to retrieve whatever they can from hedge funds. Today's news from Europe certainly indicates that.

So the Fed is confronted by a run on many of today's de facto banks, the hedge funds. It can't directly prop them up. And there's no J.P. Morgan in New York finance today to organize a private sector bailout. (Gosh, did we ever think we'd yearn for the old robber baron?) Yet, hordes of people are screaming at Chairman Bernanke and the other members of the Fed to do something. So what did they do?

They walked the line--the line between giving booze to a substance abuser and causing greater financial panic.

This week's Fed Open Market Committee meeting concluded with a statement that held the Fed's target for the fed funds rate at 5.25%, where it's been for a year. The Fed also acknowledged the problems in the credit and real estate markets and indicated that it would monitor those developments with heightened sensitivity. This balancing act was apparently meant to stem the cross-currents now flowing every which way in the financial markets:

1. Holding rates steady is important to tamp down the flood of easy credit that created the mountains of risk in the debt markets that have been cascading downwards in recent weeks. As we discussed in, the Fed's all too liberal use in the last 20 years of low and lower interest rates to medicate the economy through rough spots has created an enormous pool of easy money that has bubbled up the values of first one class of assets, then another class of assets, and yet another class of assets. All these asset bubbles have popped, which is what bubbles do when they get too big. And we have all suffered the consequences. Lowering interest rates now would only fuel the Brogdingnagian "moral hazard" problem that seems to have made too many investors believe that they shouldn't be held responsible for their decisions.

2. Some acknowledgement of the credit and real estate problems was necessary to assure shaky hedge fund and other investors that the Fed feels their pain. If investors think the government is indifferent, they might redouble their efforts to withdraw their money from the hedge funds, which would only exacerbate the credit crunch. Chairman Bernanke is doing his best portrayal of Jimmy Stewart. If he succeeds, an Oscar would be in order.

3. A large part of the money invested in the U.S. financial markets today comes from overseas. We discussed one aspect of it--the yen carry trade--in the previous blog ( There are many other sources of foreign investment. If the Fed lowers interest rates, the dollar's value will drop in relation to other currencies, and foreign investors will take losses. They then might withdraw their money, which would only push U.S. stock, credit and real estate markets down even more. Much of the foreign money invested here is held by foreign central banks, who won't act precipitously because they understand that the U.S. is the market into which their economies import a lot of goods. But there are plenty of private foreign investors who may not have such a long term perspective. The result could be a run on the U.S. that would make the run on the hedge funds look like peanuts.

Remember the Asian financial crises of 1997, when foreign investors fled the so-called "Tigers" of East Asia--South Korea, Taiwan, Malaysia, Thailand and Indonesia? This capital flight wreaked havoc on the Tigers, tossing large numbers of formerly middle class people literally into the streets or back to third world agricultural lives. Capital flight from the U.S. might not be quite so destructive. But no one wants to find out what it would be like.

So the Fed held the line and offered talk therapy in order to walk the line. Given the speed at which things are happening now, we may find out as soon as tomorrow whether its approach will work.

Crime News: in New Mexico, Billy the Kid's home state, a man's home is his castle, and they aren't kidding.

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