Monday, September 17, 2007

If the Fed Lowers Interest Rates, It's Not About You

Much of the debate over how to deal with the ongoing credit crunch is whether or not the Fed should assist investors holding real estate-related investments with a cut in the fed funds rate. Free market purists believe that any hint of a bailout would be anathema. Investors, they contend, should be required to act like adults and suffer the consequences of their decisions. If they made a poor investment decision, they should incur the loss. This allows the market to function properly and allocate resources efficiently.

If the Fed bails out investors, moral hazard infiltrates the market and resources are misallocated by government subsidy. The purists note that government subsidies, once created, are never repealed. The misallocation of resources becomes a permanent distortion of the economy. Agricultural interests and homeowners in flood plains are prime examples of this phenomenon. While very little farm subsidy money is paid today to American Gothic-type family farmers, agricultural subsidies have become as permanent a part of America as the freedom of speech and religion. Houses that should never have been built have been constructed and reconstructed dangerously close to threatening waters.

The Fed is clearly intent on protecting the banking system, as is its legal mandate. Banks are at the heart of the financial markets. If the banking system doesn’t function properly, money—which today consists largely of credit, not green pieces of paper—stops flowing. In colonial America, if you had no money, you could swap a few beaver pelts and buckskins for bacon, flour, powder and lead. Today, however, money is the currency of the land. The Fed has been providing liquidity to the banking system in order to keep things steady. However, it has resisted lowering the fed funds rate, to avoid the specter of a government bailout of wealthy, but reckless, investors.

Recently, however, the government has reported a bad job growth number. Even though this datum is one bit of information in a sea of ambiguous information, numerous market participants, observers, and pontificators have seized upon it and cried out for a reduction of the fed funds rate. If monetary policy were dictated by majority vote of the punditocracy, a rate cut would be beyond doubt.

The Fed’s members, by all indications, have no appetite to bail out the Bentley-buying hedge fundies who, in spite of their name brand Bachelor degrees and MBAs, thought that real estate values would rise forever. But one must ask whether circumstances will force the Fed’s hand. What if the banks are among the investors who made foolish real-estate related investments and are now facing serious losses?

As we discussed in our earlier blog (, many large banks have set up affiliated entities not included on the banks’ financial statements, called conduits and SIVs (structured investment vehicles). They use these affiliates to borrow money in the commercial paper market and invest in mortgage backed securities and derivatives. This strategy of borrowing short term to invest long term carries significant risks, as the savings and loan associations found out in the 1980s. It seems especially reckless when one considers the inverted yield curve we’ve had during much of the past few years. To make this risky strategy work, a bank, through its conduit or SIV, would have to find medium or long term investments that provide returns exceeding its elevated short term cost of borrowing. It appears that some institutions climbed up the risk ladder to get higher yields from asset-backed investments. That would be a brilliant strategy as long as real estate values never stopped rising.

The conduits and SIVs were backed by standby lines of credit offered by banks, usually the ones that sponsored them. These lines of credit gave the conduits and SIVs the credibility to borrow in the commercial paper markets. But when commercial paper buyers got the asset-backed heebie jeebies, conduits and SIVs had to draw on their standby lines of credit to repay maturing commercial paper. As a consequence, the mortgages and other assets that the conduits and SIVs held were effectively added to the banks’ balance sheets. In other words, the banks held the risk of loss on these tamales after all. And, as the tamales got hotter, the banks’ losses grew.

There’s the rub for the Fed. The banks, as well as $1,000 a bottle champagne-drinking hedge fund managers, were making reckless investment decisions. They were doing so in conduits and SIVs that they kept off their financial statements, so the risks weren’t immediately obvious. But chickens, even though they strut and peck wherever they might, eventually come home to roost. And the losses for the conduits and SIVs are strutting towards the banking system. While the federal banking regulators might do well to investigate whether or not banks were inappropriately reckless, they also have to worry about the stability of the banking system.

The major banks appear to be well-capitalized. But no one knows the full extent of the credit crunch losses. Banks have direct exposure to conduits and SIVs to which they've loaned money. Enumerating the losses remains a challenge, as many of these assets have been accounted for by mathematical models, and the reliability of those models has been Yugo-like when confronted with the realities of a falling real estate market. (See our blog at And what about the banks' indirect exposure? The credit crunch has pushed down all kinds of asset values. Financial institutions all over the world are sustaining losses in disparate markets. Every week, another bank somewhere needs a bailout. Last week, a U.K. bank called Northern Rock was bailed out by the Bank of England. The American banks surely want a fed funds rate cut, because it would likely improve the third quarter financial results they report in early October. And the Fed, which lives in fear of a run on the banking system, would be sorely tempted to help them in order to maintain confidence in the banking system.

The Fed meets on Tuesday, September 18, 2007. If it lowers interest rates, many will applaud. The applauders will be unable to resist the temptation to think that they had something to do with it. Hedge fund operators will believe that their lobbyists in Washington came through for them. Real estate interests will think that they were astute in manipulating financial journalists to take their point of view. Politicians will take credit in publications mailed to their constituents at taxpayer expense. Editorial page editors across the nation will think that the Fed heeded the outcry from the citizenry.

That the Fed might have been simply discharging its lawful mandate to protect the safety and soundness of the banking system may be lost amidst the surge of acclamation and credit-taking. All of the beneficiaries of a rate cut will think it was done for them, and will conclude that the Fed should always be there for them. Thus it is how government subsidies become a permanent part of our national landscape. The iron rice bowl proved untenable in Communist China. The laws of economics do not make it any more tenable in America. When, however, the iron rice bowl is provided to the wealthy and powerful, learning that lesson will be time-consuming and costly.

Crime News: a bathroom gets its 15 minutes of fame.

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