The Fed Has Become a Prime Broker, Will Lend to Hedge Funds Under Consumer Loan Program

So where is my bailout? Now even hedge funds can borrow super cheap if they invest in securitized consumer loans.

Really, the Fed is going about this all wrong. Why let hedge fund have all the fun? Private citizens have perilous little to show for all the kazillions thrown at the financial system.

The Fed should launch a Bottom-Fishers Loan Facility. Administration would be outsourced to firms with retail brokerage operations. Every household would be eligible for a loan of up to $100,000, with investments restricted to US securities, mutual funds, and ETFs (except the “inverse” or short ETFs, and ones that play in currencies or commodities). The exact amount is determined by a score that looks at age, how underwater your investment portfolio is, and your FICO (being older, having significant investment losses, and FICOs that are low but short of simply dreadful are viewed favorably). If the Fed really wanted to encourage this sort of activity, it could also forgive the loans for the borrowers who achieved the top 1% performance among all program participants.

But in all seriousness, the Fed is going further and further down the path of buying every and any junky asset to try to stimulte lending. But the more it steps in, both on the funding and the distribution side, the more it crowds out private players and impedes the resumption of normal activity.

In addition, when the Fed finally succeeds in creating inflation, it will need to quickly sell assets from its balance sheet to reduce money supply (when the Fed sells assets, buyer payments have the effect of taking money out of circulation). Jim Hamilton points out that the Fed is going to be hard-pressed to find an exit:

My answer here would be the exact opposite in philosophy of the kind of purchases and loans that the Fed has been implementing over the last year. The Fed has been trying to sop up the illiquid assets that nobody else wants. But I think what the Fed should be doing is instead acquiring assets of a type that would allow it to quickly reverse its position if a sudden shift in perceptions causes inflation to come in above the intended 3% target. The Fed can’t afford to dump the illiquid securities it’s been taking on recently, and that leaves it with substantially less flexibility to ease out of an expansionary policy once it starts to be successful. My goal would therefore be to buy assets for the Fed that won’t lose their value with a reversal of expectations and whose sell-off by the Fed wouldn’t be itself an additional destabilizing force.

What specifically would such assets be? I’d start with those clearly undervalued TIPS. Next I’d buy short-term securities in the currencies relative to which the dollar has been appreciating. Here again if the Fed has to sell these off in a sudden change in perceptions, the Fed will have both made a profit and, by selling, be a stabilizing force. If we’re still seeing no improvement, the Fed can start to buy longer-term Treasuries.

Unfortunately, as when Hamilton warned of a risk that the markets would test the implicit guarantee of Fannie and Freddie, no one seems in the officialdom seems to be listening.

From the Financial Times:

Hedge funds will be allowed to borrow from the Federal Reserve for the first time under a landmark $200bn programme intended to support consumer credit.

The Fed said on Friday it would offer low-cost three-year funding to any US company investing in securitised consumer loans under the Term Asset-backed Securities Loan Facility (TALF). This includes hedge funds, which have never been able to borrow from the US central bank before, although the Fed may not permit hedge funds to use offshore vehicles to conduct the transactions.

The asset-backed securities to be funded under the programme are pools of credit card receivables, automobile loans and student loans….

The Fed thinks risk premiums or “spreads” for consumer loans are much higher than would be justified by likely default rates, even assuming a nasty recession.

It attributes this to a lack of buying interest in the secondary market where the loans are sold on to investors. By making loans to these investors on attractive terms it aims to increase market liquidity….

The loans will be secured only against the securities and not the borrower. However, the Fed will lend slightly less than the value of the securities pledged as collateral. The Treasury has committed $20bn to cover potential losses.

Since the credit crisis erupted, hedge funds have complained that they cannot get the leverage they need to arbitrage away excessive spreads and meet high hurdle rates of return.

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41 comments

  1. ndk

    Not too surprising to me, and probably not that important, IMO. I don’t think the status of the Fed’s balance sheet is in much doubt anymore either, though the handwaving about TARP’s profitability for taxpayers makes me grin. It doesn’t interest me much anymore, because it’s clear that it’s dreck. In particular, its inability to appropriately match its new flaming bag of assets to a set of liabilities really limits its policy options.

    It’s also probably not in question anymore whether the Fed will become the banking system itself. Even beyond buying more trash, the Fed is now up to owning 19.3% of the CP outstanding, and on-the-run TIPS continue to underperform the nominal securities. Lending by private entities and securitization continue to be, shall we say, unenthusiastic. Would you try to compete with the sovereign? Anyone have a fresh Treasury CDS quote?

    Anyway, combined with our other policies in place, I continue to believe this replacement of the private financial system with a public system that has limited influence on monetary velocity and multipliers is itself deflationary. I’m not convinced by Buiter’s elegant defense largely because it has no empirical basis, and because he doesn’t address the situation where the sovereign cannot reasonably recapitalize itself through seigniorage.

    Thus, I still anticipate portfolio crowding out(yes, I know what IS/LM says about liquidity traps and horizontal line segmants; see conversations on Econbrowser). It’s already clear that there is very little empirical evidence that either fiscal policy nor quantitative easing works when moved from Keynesian frameworks to the real world. There are strong theoretical reasons to doubt either program’s success, too. I continue to believe that these are inherently deflationary programs, and see scant solace in the widespread newfound market optimism.

    So, three real questions linger.

    #1: Can the Fed really create inflation, and stabilize inflation if it is successful? I’m spending a lot of time thinking through transmission mechanisms now. How can the Fed create both the expectation and reality of, say, a 5% sustained inflation rate and have that percolate throughout the economy?

    I have strong doubts that such a policy is realistic, which I’ve expressed previously. That leads to the second major question.

    #2: Inflation, if it is to help us out of this hole, needs to feed through to consumers, preferably through wages. Doing so is very difficult while high-quality, cheap foreign labor, services, and goods are available. That means the dollar must weaken against trading partners. But, how well can the USG affect the value of the dollar, which, as a reserve currency, is dependent on many influences beyond the U.S. itself? And, will major surplus nations play along, or does the prisoner’s dilemma cement itself as it appears to be doing? The only alternative is even cheaper debt service, which it seems likely we’ll have. The impact of that is probably limited in our current environment and the consumer’s developing mindset. And, worse, if it succeeds, we only end up deeper in the hole in a few years, as we have after 2002’s low rates.

    #3: The most important question is, does the Fed’s balance sheet matter? It’s clear that in an abstract and eventual sense, it does. But does it matter in any immediate sense? Who knows. It will if and when market participants decide it matters. On this, I have no insights, because I suck at trading. But it’s definitely the most important question you should ask yourself right now.

    p.s. Is the Fed charging 2-and-20?

  2. ndk

    Couple things I forgot. A discussion of the Fed’s debt issuance balloon, which I believe was intended to address asset/liability duration mismatches and increase the credibility of inflation promises/threats.

    Second, I forgot to mention my belief that uncertainty about sovereign activities and fears about the solvency of the aggregate government are a strong policy transmission channel, raising real interest rates throughout the economy.

    Would love some contrary points of view to ponder. Tear into me.

  3. Yves Smith

    ndk,

    Although my gut reaction is in line with your views, I am loath to buck conventional thinking along the line of Bernanke’s “a determined central bank can always reflate” (not an exact quote, but close), particularly since I am contrary on so many fronts.

    Bernanke’s helicopter drop depends on consumers spending (he has said that explicitly) and I don’t see that happening anytime soon, given consumer debt loads, rising unemployment, and falling wages (Fedex 5% wage cut, for instance; I know of management offers in the paper industry of zero wage increases over the next four years with benefit cuts).

    I have heard the claim made that the Fed can set the value of the dollar where it wants via the dollar swap lines. But the Fed has seen quite indifferent to the dollar, save perhaps when its weakness made the commodities bubble look even worse in dollar terms.

    And given the seeming importance of going off the gold standard and devaluing the currency in 1934 in America getting out of the Depression (recovery seemed underway in 1936 until miscues put the economy in reverse gear in 1937), one would think Bernanke would want to engineer a gradual but sustained fall of the dollar. The sharp drop on the QE2 announcement says that traders are well aware that policy + trade deficits ought to lead to a much lower dollar. I think we have a real risk of a disorderly decline.

    Agree that solvency worries could lead to much higher rates. The combination of much bigger fiscal deficits and the burgeoning Fed balance sheet is going to put investors on edge, even more so as it plays out.

  4. mmckinl

    Did I read a different article than all the other posters?

    This is an OUTRAGE !

    Auto companies have to go begging, states and cities need loans AND THE HEDGE FUNDS GET LOANS! THAT IS WHAT THE POST SAID WASN’T IT ? THE FED TO LOAN TO HEDGE FUNDS ? ARE WE REFUNDING REDEMPTIONS ? ARE WE FUNDING RISKY F-ING BETS WITH OUR MONEY ?

    THIS IS BULL SHIT !

    Thank you for your reporting Yves. The New York Times should run this on the front page … Sunday Edition !

  5. ndk

    Although my gut reaction is in line with your views

    And I should’ve credited you and Hamilton explicitly for voicing such views more eloquently, sorry. I’m honored to be nakedly contrary in your comments, even if you feel reluctant. :P

    … one would think Bernanke would want to engineer a gradual but sustained fall of the dollar. The sharp drop on the QE2 announcement says that traders are well aware that policy + trade deficits ought to lead to a much lower dollar. I think we have a real risk of a disorderly decline.

    I fully agree, but this is where we get into the whole discussion about competitive devaluation and trade wars. An orderly decline in the dollar with the pegs in place mostly helped China and hurt Europe over the last several years, and I see no reason to expect different in the present morass. The market reaction was impressive and benevolent, though it reversed violently today. Asia’s where the real disparity lies, and Japan and China have already explicitly threatened to intervene/are intervening against the USD’s orderly devaluation. That leaves disorderly devaluation or deflation as the only choices…

    gold standard and devaluing the currency in 1934 in America getting out of the Depression

    Fascinating that a gold standard to devalue against almost seems like an advantage at this point, isn’t it? Anyway, it’s nice that the oil standard doesn’t matter much anymore. Still bludgeoning myself for getting that one so wrong.

    Agree that solvency worries could lead to much higher rates. The combination of much bigger fiscal deficits and the burgeoning Fed balance sheet is going to put investors on edge, even more so as it plays out.

    Yes. It will be very difficult to detect this in the markets since deflationary expectations are clouding nominal interest rates, and other risk measures are so high. For the peanut gallery, official debt-to-GDP isn’t a useful metric. That’s why I’m watching the TIPS and Treasury CDS so closely, since it’s the only place I can think of. If any readers or our esteemed blogger have any further suggestions, I’m ears.

  6. doc holiday

    Kinda OT here, but WTF is Franks thinking here, i.e, does he really think the majority of people out there in America already have low interest rates???

    Re: Frank said he wants to include a proposal Paulson is considering that would use Fannie Mae and Freddie Mac, the federally chartered mortgage financers the U.S. seized in September, to reduce 30-year, fixed home-loan rates to about 4.5 percent from an average of about 5.54 percent.

    >> Huh, WTF, the average 30 year rate is 5.54% … since when???? Can someone check that, I have to surf for porn… Nonetheless, 5.54% as an average sounds VERY low as an average, but I have no current proof and have zero faith in anything these bastards say.

  7. Yves Smith

    ndk,

    True, China will just bring the RMB down with the dollar. japan is more complicated. When the yen first went through 95, they weren’t worried, but going above 85 is a different matter. It isn’t the direct effects, but the indirect. The Nikkei and the yen trade in an almost direct inverse. Japanese banks have big equity stakes in other companies that they get to count at 50% of market value in equity for Basel II. So the issue is the impact on banks.

    Now if you have yen appreciating and a higher Nikkei, they’d tolerate a higher yen.

    And from what my (very plugged in) buddies have said, despite the effective (for now) jawboning, the Japanese would not intervene to lower the yen alone. But who possibly would join them?

    Of course, that posture might change, but there is a gap between talk and immediacy of action.

    doc,

    I do not know what Frank is up to, I once had some respect for him, but his conduct during the TARP in particular and some of his recent remarks have been troubling. A lot of pandering too.

  8. David

    > The most important question is, does the Fed's balance sheet matter?

    Yes, exactly. That is the question to ask.

    It seems to me that the root cause of this miserable economy is that US consumers have more debt than they can service.

    I see only two ways to ameliorate this problem. One is the long and painful way. That is Americans consume less for a very long period of time until their balance sheet is much improved. However this will necessitate a long deflationary period and will entail a reduced standard of living for Americans. There is really no one to pick up the slack and spend more. The government really can't do it since it is itself quite deeply in debt and has all those off-balance sheet liabilities such as Medicare etc. It can raise taxes of course to increase its revenues but this is also deflationary. So this route is a surrender to deflation and a very long recession.

    Then there is the way of the magic wand. The Fed simply prints money and reduces the debt load of Americans. There are many ways that they can do this but effectively it means the Fed creates dollars and pays down our debt so that our balance sheet is improved and people can spend again but perhaps at a lessor rate than before.

    You could argue that the first way is the right way, the honest way but I don't think it will be the one chosen by the US government. It doesn't appear to be in our best interest and it doesn't appear to be the one preferred by the Bernanke Fed. If the first road leads to deflation and decades of no growth, they will likely try the second way by default regardless of where it leads.

    But that is the problem. No one knows where the second route leads. Will foreign CBs, China in particular, dump the dollar? Or will they simply surrender to the fact that they traded real goods for depreciated dollars in the interest of creating jobs at home. After all, didn't they realize that this vendor finance would end in a weaker dollar? Does this end in hyperinflation or simply moderate inflation?

    Basically, everyone in the world should realize by now that the aggregate US consumer needs a debt restructuring of some kind. Like in most restructurings, both parties need to give something up. It is in everyone's interest to avoid the world deflation scenario. So they should come to the same conclusion that the Fed needs to bloat up the balance sheet, weaken the dollar and bail out the American balance sheet. China will be giving up some wealth of their dollar holdings and will have to give up some export growth. But in return they get an American economy that can continue to consume and buy Chinese products but at a lesser rate than before. They will not gain by worldwide deflation.

    Anyway, that is my view. I don't think the Fed's balance sheet matters. As long as the US consumer is willing to spend, I don't see our trading partners dumping the dollar and giving up on exporting to the US. I think it will lead to mild inflation. How much turmoil happens a long the way is hard to predict.

  9. Yves Smith

    I think the line of though below is sufficiently important that I am also putting this post by Tim Duy in Links. He argues that the Fed is not trying to create inflation, they really are (for now) just trying to lower spreads over risk-free assets. Key section:

    The Fed apparently views deliberate expansion of liabilities – a commitment of x% percent growth in some monetary aggregate via Treasury purchases – as quantitative easing. A commitment to increase the balance sheet at a steady pace (the first derivative) rather than maintain a high level. We are not there yet.

    Is this distinction important? Or just semantics? I believe it is important, as the latter, a move to target the liabilities side of the balance sheet, would imply that the Fed is deliberately trying to stoke an inflationary fire. This may become the future policy, but for now the Fed is simply trying to keep the financial system from collapsing. Inflation would be an accident, not a deliberate policy effort, at least from the Fed’s point of view. For the moment, the policy remains insufficient to ward off deflationary pressures long as the rest of the world refuses to accept the burden of global adjustment.

  10. ndk

    David, I like most of your comments, but I’d just point out that the Fed issuing dollars doesn’t really pay down any debts at all(unless it goes truly nuts and buys everything, which I consider neither likely nor interesting). It just exchanges one liability for another: taking a potentially bad asset in exchange for a different asset, with some unique characteristics. Those characteristics still generally involve multipliers and private lending. Thus far, we’ve seen worsening multipliers and lending, so does non-armageddon debt monetization even help? Time will tell.

    Also, I’m not so convinced as you that the actors will take such a long-term, systemic view. I’ve come to believe China is not nearly as comfortable that their vendor financing of the U.S. won’t be paid off as we assume they are.

    He argues that the Fed is not trying to create inflation, they really are (for now) just trying to lower spreads over risk-free assets.

    Yves, that’s an argument to which I’m very sympathetic. I think readers should consider Duy’s proposition against the Fed’s actions, rather than their words, and think about why those words might differ from the actions. The Fed is anything but stupid and arbitrary.

  11. Anonymous

    Yves, ndk
    These are extremely important problems. Still FED is at the stage of backstopping financial system starting from the lower end moving gradually to higher end of the risk spectrum.
    I agree they are still shy of explicit inflation targeting. So they have not started active debt reduction only nationalized private debts.
    It is very difficult to foresee the future course of global economy because now we are away from simple econmic realm and increasingly politics, sociology and mass psychology will matter more. Discontinues, tipping points, reversal of perceptions and social norms will complicate our humble analysis.
    One thing i would like to add is the fact FED will be hard pressed to engineer an symmetrical inflation. Future money injections will be more like to flow to commodities than to wages and discreationary services. So the most unwanted sort of inflation is in the cards which would lead to severe stagflation.
    I spent most of my life where inflation hovered between 40-80 % for more than two decades and economy was far away from full equilibrium.
    So the current focus on japan is a self serving trick of the US mandarins. People should be aware of Latin American,Turkish experience in 80’s and 90’s.

    kaan

  12. ndk

    It is very difficult to foresee the future course of global economy because now we are away from simple econmic realm and increasingly politics, sociology and mass psychology will matter more. Discontinues, tipping points, reversal of perceptions and social norms will complicate our humble analysis.

    I totally agree, kaan. That’s what makes this situation so dang frustrating for me. Good policy, good economics, good foresight? Worthless. Instead, psychology and politics are our proximate drivers.

    That’s why I spend my time thinking about the boundaries of reality that confine the activities of that machine. I have no idea what will emerge from this mass of people, but I can get a pretty good idea of what is possible and what’s not. That knowledge is almost as useful as knowing what’s likely.

  13. baychev

    there are 2 likely outcomes from all this liquidity injection farce:
    1. outright inflation;
    2. increased taxation to cover the losses. i assume the treasury will not let the fed go bankrupt.

    low interest rates might be very attractive to borrowers, but what about lenders? if you are funded at 0% now, you’d better lend only short term otherwise in a few years time you’d be deep underwater… unless ZIRP is here to stay for decades.
    so we can realistically expect growth only in floating rate lending unless the originate-to-distribute lending practice is back to full speed.

    btw the idea that all lending should be nationalized belongs to Marx. so we are all Marxists now!

  14. ruetheday

    ndk said: “Inflation, if it is to help us out of this hole, needs to feed through to consumers, preferably through wages.”

    This is what is starting to worry me more than anything. Inflation has many forms. The economy has demonstrated that it can react very differently to money supply increases under different circumstances. There was the wage price spiral of the 1970’s (which is what many people have in mind when “inflation” is mentioned). But then the easy money policies of the late 1990’s and early 2000’s primarily led to asset market inflation rather than consumer price inflation. Finally, we got a whiff of commodities only inflation late last year and early this year.

    What happens if the Fed’s QE policy manages to revive the more recent commodities only variant of inflation? Wages remain stagnant or fall, while food and energy prices skyrocket. Inflation is only a palliative against depression when it reduces the real burden of debts, which it would not do in that case. It would only make things worse.

  15. ndk

    Read more of the Duy stuff, and came to this:

    That securities-lending approach directly affects credit spreads, which is the problem today — unlike Japan earlier, where the problem was the level of interest rates in general, the official said.

    On its face, it’s at least half true. Credit spreads are incredibly wide right now. But explicitly trying to compress credit spreads can only have two outcomes:

    #1: Assume the private sector is irrationally panicked. Once you compress the risk spreads through overt purchases, the private sector comes to its senses and tries to get in on the rally. Normal lending resumes once we remember how profitable securitization once was for everybody except the bagholder. Krugman calls this the face-slap theory, and I think it’s been proven that this isn’t a brief bout of hysteria.

    #2: Assume the private sector is at least a bit rational and the spreads are somewhat justified. The overt purchases of the Fed collapse the spread, decreasing the interest that the private actor could receive in making the loan. This makes such lending less appealing because you’re competing with a non-economic lender. The return on investment moves further from fair value, and private lenders cease acting entirely(or cease acting unless guided by the gentle hands of the government, depending on implementation). Either lending decreases further, or the Fed takes on all lending, as some commentators here have suggested. I think that’s a bad and likely situation.

    But even more to the point, if Duy is right in this case, our policy response has evolved zero throughout this entire crisis. That’s the same dang tactic we’ve been using for a year. Repetition is the key to — something, I forgot what. Anyway, better hope it works this time, I guess.

    What happens if the Fed’s QE policy manages to revive the more recent commodities only variant of inflation? Wages remain stagnant or fall, while food and energy prices skyrocket. Inflation is only a palliative against depression when it reduces the real burden of debts, which it would not do in that case. It would only make things worse.

    ruetheday, I think your worries are insightful, probably correct, fit well with Duy’s writings, and are consistent with us having collectively no friggin’ clue how to ameliorate the situation.

  16. Anonymous

    hehe… I always phrase the question differently.

    Why can’t I have a window at the Fed??

    I can develop and build crappy cars with over paid labor, or any other product so desired. Lend money to bums of all stripes, hedgies, alt A, sub prime etc and award myself a huge bonus into the bargain.

    Fact is, them pouring money into the top to the banks just put us where the Fed was in 1930. They gotta grease the wheels at the bottom. Since they won’t give me my window, how’s about a $1500 stimulus check every month for the next 10 months?? I promise to spend it!!
    Eric

  17. Anonymous

    The best ways and the right ways out of this mess would be to adress main street problems.A massive across the country mortgage writedown program to current real values( banks get repaid the writedown or homeowners in get refund if they had more of loan paid off ) and a massive program to repay retirement investors 401k at least initial investment values plus reasonable interest as if they had invested in safe investments. Big? You betcha.Couple of Trillion ? You bet. But people are the drivers of our economy and people are in trouble.

  18. Anonymous

    I predicted this.

    When Paulson first started making the rounds on TV selling the bailouts, he was asked point blank if hedge funds would be excluded and he completely ducked the question. Citizens helping an enterprise like this is beyond the pale. No wonder they released it on a Friday before a holiday.

  19. David

    ndk,
    The Fed could if they choose remove the debt from the homeowner. For example, they could choose to buy houses at 2006 prices and resell them back to the owner at 2008 prices. So effectively they pay back the bank and eat the loss. But they are printing money so this costs them nothing and reduces overall debt.

    Of course this would fly in the face of everything Capitalistic but it might be needed. It is of course inflationary.

    I think the US is in a very strong position with regard to depreciating its currency and therefore depreciating the real value of its debt. That is to say that it clearly benefits us and is also a better alternative than deflation for everyone else. This might anger a lot of countries that were forced to endure “austerity” in return for IMF help. But the US is not Mexico or Thailand. As the keeper of the reserve currency, we are not in a weak position. They are the ones in a weak position. They will be hurt worse than US if the US forced itself to endure austerity. Don’t you think? What realistic course of action would China prefer we do instead?

  20. Michael Fiorillo

    “so we’re all Marxists now”

    If so, then Marxists of a very odd sectarian bent: immiserating the working and middle classes in order to subsidize the collective delusions, parasitism and predation of finance capital.

    “From most according to their abilities, to a few according to their greed.”

    I doubt if Old Whiskers, who by the way would have been prescient on these matters, would agree.

    Or perhaps we should look at another Golden Oldie: Malthus, where overpopulation (of an increasingly parasitic financial class) amid finite resources (an ever-dwindling and leeched-off-of productive economy) leads to a crash.

    Though not a involved in finance, except for my apparently foolish participation in my pension plan and Tax Deferred Annuity, I’ve found it fascinating to observe as an ecological system that has grown, overpopulated, overshot, and now crashed.

    Fascinating, and frightening in its ramifications.

  21. lineup32

    A Thank you to the above commentors, all very interesting and educational.

    “It is very difficult to foresee the future course of global economy because now we are away from simple econmic realm and increasingly politics, sociology and mass psychology will matter more. Discontinues, tipping points, reversal of perceptions and social norms will complicate our humble analysis.”

    The financial realm has become something of a religious entity with cult thinking and a overbearing sense of importance in our daily life. This should not be a surprise given the role of speculation, advertising, something for nothing in our media,gov’t policies and endless desire for the designer lifestyle.

    The solutions to our financial crisis will not come from the same group that created the problems and will require greater public awareness and participation beyond the political class in D.C.

  22. Anonymous

    Yves and ndk,

    So, I am reading The Shock Doctrine and am wondering if we are facing the economies of Argentina, Bolivia and Poland? What is to keep the overlords from treating labor like in those countries?

  23. Anonymous

    Left to itself, the economy, the invisible hand-machine, would necessitate the long arduous process of consumer balance sheet re-building. However this is politically untenable. So the government and the Fed will intervene. The magic wand will attempt once again to trump the invisible hand. Inflation is not a ‘choice’ the economic machine makes. It is the result of human manipulation. It seems to me you have the invisible hand which no one particualrly likes, especially during corrective phases, and you have a sea of intervening hands directed by cronyism and vested interest. This latter camp wants to rescusitate consumption and fresh debt and wants to prop up a prior, dead banking regime. For its part, the economy wants to curtail debt. To the extent that the macroecomomy is a functioning entity with ideas about its own ‘best interests’, there are times when it has no interest in fresh debt, fresh money and growth. That is the period we are in. The best medicine is to let the economy find itself. But this will never happen. The only certianty is uncertainty and a flurry of unintended consequences.

  24. The Other Katherine Harris

    I’ve been lurking on boards like yours for several years, seeking to understand what even I could see was a lunatic financial system careening toward collapse.

    As an outsider schooled in the arts and humanities, whose only brush with the investment world (besides a lot of reading lately) was writing some analysis back when the the market was sane, I’m hesitant to post anything among so many experts. However, it would be great to have your thoughts on my theory that our “bailout” funds are being used to pay off massive losses on derivative bets. This would seem to be reinforced by letting hedge funds at the public trough, since they’re also huge players in the stupid shadow economy that dwarfs the size of the real one.

    Do you think that’s true? Also, do you think — as I suspect — that we’d have no economic crisis at all, if these bets that should never have been made had simply been nullified on a no-winner/no-loser basis?

    To me, it’s insane that the public would be forced to perpetuate a secret casino in which the richest of the rich are allowed to bet more money than even exists on matters that don’t even concern them directly.

    Am I crazy or am I onto something?

    Thanks so much for all I’ve learned here, Mr. Smith, both from you and your erudite readers.

  25. mmdonner

    another way to look at the fear stated that the fed will have to ‘sell/dump’ bad stuff when inflation rears its head above 3%….would be to assume that the fed does not believe deflation will be defeated anytime soon and might be imagining inflation as much as many years down the road….that they are very very desperate.
    i personally believe this is the case, for what its worth.

    A lingering question i have is:
    who reveiws the books of the FED?
    when will we know that the fed is underwater??? or, it all make believe after all??

  26. doc holiday

    I’m fairly bored with pension stuff these days, but here is an interesting old story, which might be an example of the eagerness of people to burn their cash:

    FYI: “You further represent that Mr. Adler believes that Madoff would effectively manage assets for the IRA, but that Mr. Adler’s IRA does not meet the minimum capital requirements (currently $1 million) for investment management by Madoff. You represent, however, that Madoff will manage the IRA’s assets if it invests with Madoff through the Partnership, even though the IRA by itself otherwise would not meet the minimum capital requirements. You further represent that all of the assets of the Partnership are liquid marketable securities. You also represent that none of the funds contributed by the IRA is required to be used, or will be used, to liquidate or redeem any other partner’s interest in the Partnership.”

    Pension Protection Act, my ass

  27. Mara

    @Michael Fiorillo said: “Or perhaps we should look at another Golden Oldie: Malthus, where overpopulation (of an increasingly parasitic financial class) amid finite resources (an ever-dwindling and leeched-off-of productive economy) leads to a crash.”

    You should win the Nobel prize in economics for that one statement alone. Well, maybe you can share with Yves because she’s been so consistently good.

    Bailing out derivatives players is insane, because we’re talking about $1 quadrillion (or more) of “value” floating out there. Which means that everything else inflates to crazy levels. Sorry, just hit the delete key on those, they must not be redeemable in any form. Otherwise, I will be forced to declare myself a bank holding company and pledge to buy gaudy houses in Greenwich and buy Manolo Blahnicks (even tho they make my feet hurt) to keep the real economy going.

  28. David

    There is actually another way out that the Chinese might prefer. That is the US dramatically raising taxes on the rich so that Keynesian government spending can make up for the demand deficit. The rich do not spend as much anyway and so this does not result in as much deflationary pressure as raising taxes on the middle class. This might be the preferable solution for China. This has to happen to some degree anyway.

    But, as you might imagine, the US will fight this and what can the Chinese do to force the issue? Any kind of protectionist measures would hurt their economy more than ours. Dumping the dollar just leads to what they would be trying to prevent. If they do the opposite and inflate their own currency or buy even more dollars, this just increases their vulnerability to our future devaluation. Plus we can always raise tariffs on China if push comes to shove. Anyway, devaluing the Yuan will lead to inflation at home and ultimately probably make them uncompetitive as a manufacturing powerhouse since they won’t be able to afford commodity imports.

    China is in a weak position for at least three reasons. 1) They hold massive amounts of our currency which we can devalue at will. 2) Their economic strength demands on manufacturing which is in essence a commodity. It goes wherever the labor is the cheapest. 3) massive job losses will likely lead to social revolution and the end of the current government.

    The US’s bargaining position is strong in the same way that Walmart’s is strong. They have an enormous ability to buy. Countries like China are dependent on the US demand in the same way that a commodity pickle company become dependent on Walmart’s demand. Walmart can always find another pickle company if the first one gets too testy. Pickle’s are commodities which gives their producing companies little bargaining power. But the pickle companies can’t find another Walmart. No other company can provide that large source of demand. Likewise China can’t find another US.

  29. ndk

    However, it would be great to have your thoughts on my theory that our “bailout” funds are being used to pay off massive losses on derivative bets.

    Largely, yes, Katherine, but remember that for every winner there’s a loser, and if the bets couldn’t pay off, someone else would get blown up on the other side. This leads to the chain reaction everyone is afraid of. I try to step back and take the systemic view whenever possible, because that’s the one the regulators are seeing.

    who reveiws the books of the FED?
    when will we know that the fed is underwater??? or, it all make believe after all??

    mmdonner, the Fed publishes their balance sheet regularly, but the garbage assets have to be given a subjective valuation no matter who’s holding the bag. It also doesn’t account for all the guarantees and promises they’ve made. So, who the heck knows.

  30. VoiceFromTheWilderness

    oh goody, more support from public institutions and funding for private — explicitly and legally non-public entities.

    The final outcome of ‘free market capitalism’? An entrenched aristocracy which government is the servant of. An aristocracy of ever dwindling numbers using government (public) money for further conquest and consolidation.

    Nobody ever could have predicted that! well, except Karl Marx

  31. The Other Katherine Harris

    ndk, many thanks for your response to my question. What about instances when the counterparties actually have nothing at risk that they were “insuring” against? Why should derivative bets be considered even remotely legitimate for public funding, when nothing was involved but speculators’ opposing opinions about what would happen to something?

    As I understand it, this inflated shadow economy is heavily populated with that sort of rubbish, which has absolutely no connection to the real economy. Mara’s reference to “the delete key” strikes me as extremely appropriate in such cases. It burns me up, to think we’re paying a fortune to these gamblers, who could just call the whole thing off with no repercussions whatever.

  32. Michael Fiorillo

    To Anonymous, re “The Shock Doctrine:”

    Exactly. Naomi Klein is prophetic on this.

    We are probably in the initial stages of structural readjustment programs here in the US, with attacks on labor and the public sector used to shore up credit and (prospective) currency crises, a la Mexico, Argentina, et. al.

    The strong likelihood is that we will see escalating attacks on labor (witness the current aggression against the UAW and teacher’s unions) and the public sector. This will include efforts to privatize public assets, with the fiscal crises of states and localities serving as the rationale. The NYT has already reported that Governor David Patterson of NY is looking into the sale of state assets. Patterson has suggested that those unhappy with his cuts propose an alternative, yet nowhere is there mention of a Stock Transfer Tax, which NYS had from 1907, I believe, until the early ’80’s, and by itself would go a long way toward alleviating the state’s fiscal problems. Governor Corzine, formerly of serial financial conspirator Goldman Sachs, was agitating to sell the Jersey Turnpike even before the crisis reached its full proportions. Public facilities in Philadelphia are at this moment being turned over to private entities. I’m sure that readers of this blog from other regions could add to this very incomplete list.

    We are likely in the early stages of a Final Offensive against the notion of public anything, with public education targeted by the corporate/foundation and academic complex for “reform” (read privatization through Charter and contract schools), eventually to be followed by the gravitational force of capital going after The Big One: Social Security. Though Obama campaigned on a platform of increasing Social Security taxes on high incomes, don’t be too surprised if he betrays that promise. It’s private government, with tax dollars going to opaque financial bailouts, mercenary armies and contractors, publicly funded private schools (aka charters), private-managed prisons, highways, etc.

    Obama (“Change We Can Deceive In”) is integral to this process, having received the nod of finance capital years ago. His appointment of Geithner, Summers, etc., along with Duncan as Ed Secretary, suggest that there is consensus regarding this among political and economic elites. How ironic – but actually not that surprising, since corporate America has spent a fortune cultivating and domesticating the new generation of Black leadership, who by and large are awful – that our first Black president should be the point of the spear of declining living standards in the US.

    If I am right, look for an ever-louder chorus of attacks on Greedy Baby Boomers and their entitlements, in an attempt to disguise class warfare as generational warfare, and the opening PR attack against Social Security.

  33. ndk

    What about instances when the counterparties actually have nothing at risk that they were “insuring” against?

    Katherine, this is certainly often the case, but there are at least two flies in the ointment.

    The first is that it’s basically impossible to distinguish between gambling and insurance on such a large scale when there are so many opaque and inconsistent contracts(which is a pretty strong clue that this should never have been permitted). There’s no way to do a case-by-case evaluation of all this trash because there’s so much of it. Clueful staff and time are both in short supply.

    The second is that CDS don’t affect just themselves, but are involved in basically every market by association. If we knock out the CDS leg of a stool, who knows what else collapses? What would funds liquidate when part of their strategy and holdings get nullified? Who would blow up? With perfect knowledge and unlimited staffing we could anticipate results, but we have neither, and I think the regulators have had their fill of chain reactions after LEH.

    Personally, I still want to permit failure and chain reaction. It’d destroy untold assets along with it and most of our financial system, but assuming we’re collectively solvent, at least there would be good scorched earth to grow new roots in. I think that’s better than a zombie banking system, but it’s easy to be a Saturday morning quarterback.

  34. Anonymous

    The FT article and Yves’ commentary needs to be disseminated — this is indeed an outrage – This is an important development

  35. The Other Katherine Harris

    Thank you again, ndk. I’m with you in wishing the “zombie” were laid to rest.

    Hmmm, maybe it’s more of a vampire, really, since the system is certainly sucking us dry.

    Michael Fiorillo and Anon: “The Shock Doctrine” is the most instructive book I’ve read in ages and I agree with your analysis of our present perils — although I’d hoped Obama would reverse the evil decree. All his appointments to date, other than of Solis, do raise gooseflesh, though. We’ll need to be very wary, indeed.

    Did you know that Shrub permitted the first IMF investigation of US financial affairs to begin on his watch — provided that no report is issued until he’s gone? Scares the bejeezus out of me. This whole bailout is looking more and more like a giant takedown.

  36. Anonymous

    Hasn’t this been rehashed and rehashed before? US Treasury asks and is granted immunity…it’s all downhill from there.

    Taking the bailout monies to start a new National bank instead of propping up principles and/or at the very least just sending the consumers the money directly so they can prop up the economy…..would have done wonders (deposits never hurt a bank). Just enforcing monetary laws and regulations would help.

    It will take some time for all the request money to filter through the system but then when it does, price inflation will arrive.

    Stop whining and plan accordingly.

  37. mxq

    So instead of paying for the assets outright, the fed will just finance them. I’m not sure that’s any different than the original proposal for the tarp to buy bum loans off of troubled banks.

    But the problem isn’t a lack of buyers…It never has been!

    There is literally trillions of $ in capital on the sidelines waiting to buy these bum loans…look at whitney tilson…they guy has never invested in fixed income yet he allocates 25% of his fund to abs?

    The problem (as its always been) is that there is a lack of sellers willing to unload inventory and take lower marks. Stuff that is marked at 70c is really only worth 30-40c…but the capital raise triggered by that type of realized mark would be devastating.

    1.) They should suspend mark to market (only for a few years), so an asset sale doesn’t affect other banks.

    2.) If indeed the low marks are just a problem of no liquidity, then the Fed should just finance/guarantee the spread between the mark and the actual selling price…so its marked at 70…sold for 70 but the fed pitches in 30 and the investor pitches in 40 and the fed gets a piece of the $ once the security matures. Private does the due dilligence and paperwork and the fed is just a limited partner.

    The point is, its still a problem of a lack of sellers willing to take the marks.

  38. Bernard

    The dilemma of dilemmas:

    You need to devalue the currency in order to prevent a deflationary debt death spiral.

    That same currency has been amassed in staggering quantities by foreign creditors.

    What do you do???

    (P.S. Bernanke studied the Great Depression and based on that undoubtedly looks at devaluation as the “solution”)

  39. DanyBoy

    The Fed may believe that they are combatting an economic Depression, but they are stoking a psychological Depression by diluting confidence in a fair and open capitalist society. Capital “on the sidelines” will continue to pull in their horns

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