As correspondents and readers have pointed out, Fed chairman Ben Bernanke and the rest of DC is increasingly resorting to the playbook he suggested in various papers on Japan’s deflation.
The Federal government has said that it is willing to lend or backstop up to $7.4 trillion to get the credit markets moving again. This figure comes from Bloomberg as a tally of all the commitment ALREADY made. Note that many of these have not been drawn down, hence the Fed’s and Treasury’s balance sheet have not (yet) expanded correspondingly. And some of these are in the form of guarantees, such as $1.4 trillion by the FDIC. Note the Bloomberg article fails to provide a tidy table showing how it came up with this figure. Critics will argue that the mixing of guarantees and borrowing facilities is an apples and oranges comparison, but the flip side is that the guarantees are treated by the authorities as a cost-free exercise, which is also incorrect.
And there are a lot of flaws in the underlying logic.
First, while the freeze in lending is admittedly overdone (there is a fair bit of anecdotal evidence that indicates that good borrowers are getting the same treatment as the deadbeats), even if lenders were being dispassionate, they would be lending at a considerably lower level than in the bubble years and trying to get the weaker credits to reduce their balances. The powers that be refuse to acknowledge that the financial crisis is primarily a solvency crisis, that many of the loans made in the bubble years will either default or be renegotiated. Trying to prop up bad loans in place merely ties up valuable lending capacity, throwing good money after bad.
Second, this effort cannot achieve its stated aim. We have said before that the markets are too large for government to salvage. Paul Krugman also made this point in March:
….the financial markets are so huge that even big interventions tend to look like a drop in the bucket. If foreign exchange intervention works, it’s usually because of the “slap in the face” effect: the markets are getting hysterical, and intervention gives them a chance to come to their senses.
And the problem now becomes obvious. This is now the third time Ben & co. have tried slapping the market in the face — and panic keeps coming back. So maybe the markets aren’t hysterical — maybe they’re just facing reality. And in that case the markets don’t need a slap in the face, they need more fundamental treatment — and maybe triage.
The Fed inceasingly has been trying to stand in for private lenders, but it cannot take on the entire private sector. And let’s look at orders of magnitude.
US debt to GDP stood at 350%. as of March 31, 2008. There are some items that are arguably overstated (lines of credit are included at their full amount), but others are not included (second and third mortgages, and perhaps most important, contingent exposures like AIG’s credit default swap guarantees). It isn’t unreasonable to assume they net out.
The Fed’s proposed intervention is a bit more than half of GDP. However, note it (and the Treasury) has already made, and will continue to make, considerable commitments to non-US parties. AIG, for instance, has over $300 billion in CDS exposures in guarantees that permit European banks to evade minimum capital requirements (and AIG also has other, substantial non-US exposures). Similarly, the most likely cause of a Citi meltdown would be withdrawals of uninsured deposits, which were primarily overseas. Moreover, the Fed has also provided considerable indirect support to non-US entities via providing unlimited dollar swap lines to other central banks.
That is a long winded way of saying that not all of that $7.4 trillion applies to exposures that fall in the 350% debt to GDP figure cited above. Just to pick a number, say $6 trillion of the total goes to US debt. The US debt was $49 trillion. The Fed can commit less than 1/8 of the outstanding debt to solve the problem. Per Krugman, do we really think this will work? And if it does not work, it will make matters worse by increasing the size of the debt overhang when it needs to contract.
Third, as Wolfgang Munchau said today in the Financial Times and others have pointed out earlier, the Fed seems worried solely about deflation, and not about a possible US currency crisis. This is a shocking oversight. The Fed (and many others) keep drawing analogies between the US in the Great Depression and its situation now. That is flawed and dangerous.
The US was a massive creditor before the Depression and ran a very large trade surplus, to the point where the gold accumulation by the US was destabilzing to the world financial system. Sound familiar? That is the role China plays now, not the US.
What happened to the nations that were in the US’s shoes at the onset of the Great Depression, the overconsuming, indebted European customers of the US? They devalued their currencies, defaulted (or partially defaulted and forced a renegotiation) on foreign debts, and suffered milder downturns than the US did.
But the authorities are not even considering the possibility of debt default or a dollar crisis in their plans. And if you think recent dollar strength argues against it, think again. The massive dollar purchase are due to unwinding of dollar based debt. Similarly, the unprecedented rally in long-dated Treasuries was due to panicked short covering on shorts written many years ago in connection with funky products to lower the cost of the product. A Treasury short that was then so far from recent yields was seen as free money. It turned out not to be.
From Bloomberg (hat tip reader Rob):
The U.S. government is prepared to lend more than $7.4 trillion on behalf of American taxpayers, or half the value of everything produced in the nation last year, to rescue the financial system since the credit markets seized up 15 months ago.
The unprecedented pledge of funds includes $2.8 trillion already tapped by financial institutions in the biggest response to an economic emergency since the New Deal of the 1930s, according to data compiled by Bloomberg. The commitment dwarfs the only plan approved by lawmakers, the Treasury Department’s $700 billion Troubled Asset Relief Program. Federal Reserve lending last week was 1,900 times the weekly average for the three years before the crisis.
When Congress approved the TARP on Oct. 3, Fed Chairman Ben S. Bernanke and Treasury Secretary Henry Paulson acknowledged the need for transparency and oversight. Now, as regulators commit far more money while refusing to disclose loan recipients or reveal the collateral they are taking in return, some Congress members are calling for the Fed to be reined in.
“Whether it’s lending or spending, it’s tax dollars that are going out the window and we end up holding collateral we don’t know anything about,” said Representative Scott Garrett, a New Jersey Republican who serves on the House Financial Services Committee. “The time has come that we consider what sort of limitations we should be placing on the Fed so that authority returns to elected officials as opposed to appointed ones.”…
The bailout includes a Fed program to buy as much as $2.4 trillion in short-term notes, called commercial paper, that companies use to pay bills, begun Oct. 27, and $1.4 trillion from the FDIC to guarantee bank-to-bank loans, started Oct. 14.
William Poole, former president of the Federal Reserve Bank of St. Louis, said the two programs are unlikely to lose money. The bigger risk comes from rescuing companies perceived as “too big to fail,” he said.
The government committed $29 billion to help engineer the takeover in March of Bear Stearns Cos. by New York-based JPMorgan Chase & Co. and $122.8 billion in addition to TARP allocations to bail out New York-based American International Group Inc., once the world’s largest insurer. Yesterday, Citigroup Inc. received $306 billion of government guarantees for troubled mortgages and toxic assets. The Treasury Department also will inject $20 billion into the bank after its stock fell 60 percent last week.
“No question there is some credit risk there,” Poole said.
Representative Darrell Issa, a California Republican on the House Oversight and Government Reform Committee, said risk is lurking in the programs that Poole thinks are safe.
“The thing that people don’t understand is it’s not how likely that the exposure becomes a reality, but what if it does?” Issa said. “There’s no transparency to it, so who’s to say they’re right?”…
The money that’s been pledged is equivalent to $24,000 for every man, woman and child in the country. It’s nine times what the U.S. has spent so far on wars in Iraq and Afghanistan, according to Congressional Budget Office figures. It could pay off more than half the country’s mortgages.
“It’s unprecedented,” said Bob Eisenbeis, chief monetary economist at Vineland, New Jersey-based Cumberland Advisors Inc. and an economist for the Atlanta Fed for 10 years until January. “The backlash has begun already. Congress is taking a lot of hits from their constituents because they got snookered on the TARP big time. There’s a lot of supposedly smart people who look to be totally incompetent, and it’s all going to fall on the taxpayer.”…
The Fed should account for the collateral it takes in exchange for loans to banks, said Paul Kasriel, chief economist at Chicago-based Northern Trust Co. and a former research economist at the Federal Reserve Bank of Chicago.
“There is a lack of transparency here and, given that the Fed is taking on a huge amount of credit risk now, it would seem to me as a taxpayer there should be more transparency,” Kasriel said.
Bernanke’s Fed is responsible for $4.4 trillion of pledges, or 60 percent of the total commitment of $7.4 trillion, based on data compiled by Bloomberg concerning U.S. bailout steps started a year ago.
“Too often the public is focused on the wrong piece of that number, the $700 billion that Congress approved,” said J.D. Foster, a former staff member of the Council of Economic Advisers who is now a senior fellow at the Heritage Foundation in Washington. “The other areas are quite a bit larger.”….
The FDIC, chaired by Sheila Bair, is contributing 20 percent of total rescue commitments. The FDIC’s $1.4 trillion in guarantees will amount to a bank subsidy of as much as $54 billion over three years, or $18 billion a year, because borrowers will pay a lower interest rate than they would on the open market, according to Raghu Sundurum and Viral Acharya of New York University and the London Business School.
Congress and the Treasury have ponied up $892 billion in TARP and other funding, or 12 percent.
The Federal Housing Administration, overseen by Department of Housing and Urban Development Secretary Steven Preston, was given the authority to guarantee $300 billion of mortgages, or about 4 percent of the total commitment, with its Hope for Homeowners program, designed to keep distressed borrowers from foreclosure.
Most of the federal guarantees reduce interest rates on loans to banks and securities firms, which would create a subsidy of at least $6.6 billion annually for the financial industry, according to data compiled by Bloomberg comparing rates charged by the Fed against market interest currently paid by banks.
Not included in the calculation of pledged funds is an FDIC proposal to prevent foreclosures by guaranteeing modifications on $444 billion in mortgages at an expected cost of $24.4 billion to be paid from the TARP, according to FDIC spokesman David Barr. The Treasury Department hasn’t approved the program.
Bernanke and Paulson, former chief executive officer of Goldman Sachs, have also promised as much as $200 billion to shore up nationalized mortgage finance companies Fannie Mae and Freddie Mac. The FDIC arranged for $139 billion in loan guarantees for General Electric Co.’s finance unit.
The tally doesn’t include money to General Motors Corp., Ford Motor Co. and Chrysler LLC. Obama has said he favors financial assistance to keep them from collapse.
Paulson told the House Financial Services Committee Nov. 18 that the $250 billion already allocated to banks through the TARP is an investment, not an expenditure.
“I think it would be extraordinarily unusual if the government did not get that money back and more,” Paulson said.
In his Nov. 18 testimony, Bernanke told the House Financial Services Committee that the central bank wouldn’t lose money.
“We take collateral, we haircut it, it is a short-term loan, it is very safe, we have never lost a penny in these various lending programs,” he said…
Some of the bailout assistance could come from tax breaks in the future. The Treasury Department changed the tax code on Sept. 30 to allow banks to expand the deductions on the losses banks they were buying, according to Robert Willens, a former Lehman Brothers tax and accounting analyst who teaches at Columbia University Business School in New York.
‘Wells Fargo Notice’
Wells Fargo & Co., which is buying Charlotte, North Carolina-based Wachovia Corp., will be able to deduct $22 billion, Willens said. Adding in other banks, the code change will cost $29 billion, he said.
“The rule is now popularly known among tax lawyers as the ‘Wells Fargo Notice,’” Willens said.
The regulation was changed to make it easier for healthy banks to buy troubled ones, said Treasury Department spokesman Andrew DeSouza.
House Financial Services Committee Chairman Barney Frank said he was angry that banks used the money for acquisitions.
“The only purpose for this money is to lend,” said Frank, a Massachusetts Democrat. “It’s not for dividends, it’s not for purchases of new banks, it’s not for bonuses. There better be a showing of increased lending roughly in the amount of the capital infusions” or Congress may not approve the second half of the TARP money.