Fed Rescue Programs: No Exit?

The Wall Street Journal tonight, in “As It Starts Programs, Fed Weighs How to Stop Them,” broaches the touchy subject of how Federal Reserve unwinds all the “support lending” initiatives it has underway and is on the verge of launching.

In general, this piece is more wary of party line than the typical WSJ offering, but it does miss a couple of very big issues, which we will get to in due course.

While the Journal does not tease this out, the Fed’s readiness on this issue is a worrisome echo of Timothy Geither: the Fed plans to have a plan:

Fed Chairman Ben Bernanke told community bankers in Phoenix Friday…”We are very much aware that we don’t want to be in the credit markets forever,” he said. “We need to help them now, but we want to have an exit strategy, and allow those markets to recover and become again fully private sector.”

Yves here. Wanting to have an exit strategy and actually having an exit strategy are two different states of affairs. Back to the article:

Part of the Fed’s exit should take care of itself by design. More than $1 trillion of the central bank’s loans are for three months or less, such as liquidity programs and currency swaps with other central banks. The Fed also established rates for many programs that wouldn’t be attractive to markets in normal times, forcing the programs to unwind on their own. When markets pull back from the programs, that would be a signal for the Fed to shrink other elements of its balance sheet, before turning to raising interest rates from their current level near zero.

Yves here. This is all a bit misleading, or more accurately, wishful. The part that is 100% correct is that the currency swap lines are seeing much less usage, although that could reverse if Eastern Europe were to slip into crisis. Some of the facilities, such as the Primary Dealer Credit Facility, have seen a great variation in use of available support over time.

But even looking at the original emergency bank backstop, the Term Auction Facility, whose size per twice-monthly auction has increased from $20 billion to $150 billion, still has bids not that much lower than the levels seen last November, which was considered a crisis month (although the Fed did have more frequent auctions then, two of the four had very low take-up).

The idea that the programs can or will simply roll off is also, shall we say politely, a bit naive. For instance, the FDIC just extended its supposedly temporary Temporary Liquidity Guarantee Program. These programs will continue until banks are ready to wean themselves off them.

And that could be quite some time in coming. The problem is analogous to welfare programs. Any reduction in subsidy is a disincentive. A classic was benefits like food stamps or housing vouchers that were not available to recipients when they crossed a certain income threshold. The net effect was that even if the recipient wanted to get off the dole, there was an income range, often quite considerable, in which he would be much worse off than if he earned less than the ceiling due to the loss of benefits.

The argument, the programs become unattractive “in normal times” which one presumes is when rates are higher, is spurious. The rates and terms will be adjusted if the Fed believes (based on gnashing of teeth and tearing of hair) that banks still need the programs even though circumstances have changed. If we are lucky, the goodies might be skinned down, but don’t get your hopes up that subsidies will end in a mere couple of years. And the story, to its credit, points out that welfare queens participants will fight to keep their lucre:

Each of the portfolios will have its own constituencies — in markets and governments across the country — that could pressure the Fed not to pull back too quickly, or ever. With each of those programs, the Fed faces the risk of becoming more entangled with political authorities — undermining its role in setting interest rates.

And now we get to the part the Journal missed. what happens when the Fed loses money when it sells the stuff it owns, or holds it to maturity and suffers a shortfall? It’s a given the Fed will take hits.

First, it is lending against crappy credit, and the risk of Fed insolvency from them is real, and raises a host of other thorny issues. As Willem Buiter points out:

The Federal Reserve System is not owned by anyone (conspiracy freaks need not bother writing comments to deny this and to attribute ownership of the Fed to the Queen of England, the Vatican, the Rockefeller family or the Elders of Zion). Most of the operating profits of the Fed go to the US Treasury. The twelve regional Federal Reserve Banks issue shares of stock to member banks. However, owning Reserve Bank stock is quite different from owning stock in a private company. Ownership of a certain amount of stock is, by law, a condition of membership in the System. The stock may not be sold, traded, or pledged as security for a loan; dividends are, by law, fixed at 6 percent per year (which is a lot better, actually, risk-adjusted, than you would get these days on stock in commercial banks)….

Behind every viable and credible central bank with a price stability mandate stands a fiscal authority – the only economic entity with non-inflationary long-term deep pockets….

The Fed does not have a full indemnity from the US Treasury even for its outright purchases of private securities. It has no guarantee or indemnity for private credit risk assumed as a result of its repo operations and collateralised lending.

For the Fed’s up to one trillion dollar potential exposure to private credit risk through the TALF, for instance, the Treasury only guarantees $100bn. They call it 10 times leverage. I call it the Fed being potentially in the hole for $900 bn . Similar credit risk exposures have been assumed by the Fed in the commercial paper market, in its purchases of Fannie and Freddie mortgages, in the rescue of AIG and in a host of other quasi-fiscal rescue operations mounted by the Fed and by the Fed, the FDIC and the US Treasury jointly.

I consider this use of the Fed as an active (quasi-) fiscal player to be extremely dangerous and highly undesirable from the point of view of the health of the democratic system of government in the US.

There are two reasons for this. First, it undermines the independence of the Fed and turns it into an off-budget and off-balance sheet special purpose vehicle of the US Treasury. Second, it undermines the accountability of the Executive branch of the US Federal government for the use of public resources – tax payers’ money.

As regards the threat to the independence of the Fed (whatever is left of it), first, even if the central bank prices the private securities it purchases appropriately (that is, there is no ex-ante implicit quasi-fiscal subsidy involved), it is possible that, should the private securities default, the central bank will suffer a capital loss so large, that the central bank is incapable of maintaining its solvency on its own without creating central bank money in such quantities that its price stability mandate is at risk. Without a firm guarantee up front that the Federal government will fully re-capitalise the Fed for losses suffered as a result of the Fed’s exposure to private credit risk, the Fed will have to go cap-in-hand to the US Treasury to beg for resources. Even if it gets the resources, there is likely to be a price tag attached – that is, a commitment to pursue the monetary policy desired by the US Treasury, not the monetary policy deemed most appropriate by the Fed.

As regards democratic accountability for the use of public funds, even if the central bank has sufficient capital to weather the capital losses it suffers on its holdings of private securities, the central bank should never put itself into the position of becoming an active quasi-fiscal player, nor a debt collector. The ex-post transfers or subsidies involved in writing down or writing off private assets are (quasi-) fiscal actions that ought to be decided by and accounted for by the fiscal authorities. The central bank can act as a fiscal agent for the government. It should not act as a fiscal principal, outside the normal accountability framework.

The Fed can deny and has denied information to the Congress and to the public that US government departments like the Treasury cannot withold . The Fed has been stonewalling requests for information about the terms and conditions on which it makes its myriad facilities available to banks and other financial institutions. It even at first refused to reveal which counterparties of AIG had benefited from the rescue packages (now around$170 bn with more to come) granted this rogue investment bank masquerading as an insurance company. The toxic waste from Bear Stearns balance sheet has been hidden in some SPV in Delaware.

The opaqueness of the financial operations of the Fed in support of the financial sector (which are expanding in scale and scope at an unprecedented rate) and the lack of accountability for the use of tax payers’ resources that it entails, threaten democratic accountability. Even if it enhances financial stability, which I doubt, democratic legitimacy and accountability are damaged by it, and that is too high a price to pay.

Yves again. Now if the dubious risks being assumed wasn’t a big enough source of possible trouble, we also have a second source of trouble: certain losses on the Fed’s quantitative easing (an aside, Bernanke keeps dancing around that notion. The FOMC statement clearly said inflation was suboptimal, but the buying firepower is directly primarily at Agency paper. In addition, Bernanke in his speech Friday talked about managing spreads, not fighting deflationary pressures. So are there multiple objectives or is this a pump up asset prices program in another guise?).

Consider: The Fed is buying Agencies and Treasuries to keep yields down, which means keep their prices up (for bonds, prices and yields move in inverse directions). At some point, the assumption is economic growth will take hold, inflation will rise, the yield curve will steepen (remember, this operation is flattening the yield curve, meaning lowering the normal difference between short term rates and long term rates).

Higher inflation means higher interest rates. The Fed will want to allow interest rates to rise, because once the economy starts moving, the cumulative effect of all of its interventions will mean inflation is likely to accelerate fast. So it not only stops buying all that paper, it starts selling its holding, which will contract money supply (when buyers pay the Fed for the purchases, it takes money out of circulation).

So let’s see, we have the Fed going from being a big buyer, which means higher prices for bonds. Then inflation starts to rise, which lowers bond prices. Then the Fed starts selling bonds, which means even lower prices.

The whole QE program is buy high, sell low. That is the inherent profile of this operation. So its unwind will also lead losses, hence a need for a capital infusion from the Treasury.

Ah, but someone at the Fed is a step ahead on this one. Back to the Journal:

In a recent speech, Federal Reserve Bank of Philadelphia President Charles Plosser proposed eventually handing over the central bank’s assets from targeted credit programs to the Treasury Department to separate itself from fiscal policy. The Fed would get liquid government securities, and officials in the Treasury and Congress would be left to make political decisions. That would allow the Fed to maintain independence in monetary policy as it raises rates.

What a clever way to finesse at least a part of the loss problem (the drecky asset one). Just dump the bad portfolio on the Treasury (presumably for the fictive prices at which it was sourced) and let the Treasury realize the losses. A cute way of trying to bury the problem.

But with the Fed in charge of monetary policy, it will have to reverse QE, and I don’t see as easy a way to hide those losses and the associated recapitalization from the public. We have some interesting politics in the offing about the role of the Fed. I wonder if this is part of the push to make it stability regulator, rather than going the more obvious (given the Fed’s complete lack of appetite for regulation) of creating a separate financial uber regulator. If the Fed has a bigger mandate, it may be harder for Congress to mess with it when it inevitably needs more dough.

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  1. Glen

    Well the markets are enjoying the next cash handout at the public feed trough; futures up 159 points. One day the little petals will figure out that this is actually working against them.

  2. alex black

    Zeitgeist watch: San Francisco had another of its endless large street protests this weekend, this one intended to protest the 6th anniversary of the Iraq War. It veered off-topic, and morphed into a big “bank bailout” protest march instead.

  3. Anonymous

    “But with the Fed in charge of monetary policy, it will have to reverse QE, and I don’t see as easy a way to hide those losses and the associated recapitalization from the public. We have some interesting politics in the offing about the role of the Fed.”

    It wouldn’t be able to hide such losses. But the fact is that the Fed can continue to operate if necessary with negative capital. It has no normal exposure to the redemption of its liabilties. Every risky asset it has could go to zero, and the Fed could simply make a negative equity entry (equity on the asset side). Assets going to zero will reduce “seigniorage profits” remitted to Treasury, but they won’t prevent continued operation. Depending on the size of the hole, they conceivably might have to monetize any negative seigniorage profit. And they might face constraints in having sufficient treasury debt to sell into the market if trying to withdraw reserves. Otherwise they continue to pay interest on excess reserves. Which they might have to monetize. It would be difficult. But operationally, they don’t technically require recapitalization simply due to the loss of asset value.

  4. Glen

    Oh, forgot to add, no matter what Turbo Timmy & Tinkerers do with these toxic assets or how they move them around in the system they will still exist somewhere on someone's books and will still be worthless. The problem is not going to go away unless a hit is taken and these worthless assets are written off. Rearranging the deck chairs on the titanic.

  5. IF

    “Just dump the bad portfolio on the Treasury (presumably for the fictive prices at which it was sourced) and let the Treasury realize the losses. A cute way of trying to bury the problem.”

    I don’t see why you have a problem with this. Once the Fed _purchases_ bad stuff it has consequences for seignorage profits flowing to the treasury. Willingly accepting losses with intend to swap with the treasury might be non-democratic, but as this is done openly, Bernanke is hardly trying to cheat Obama.

    The powers that are, are trying to accelerate the money flow. The problem (for us) is, that they cater to the rich and don’t care for the poor. (They could be sending monthly bailout checks to each SSN if they wanted…) And they engage in a wicked communism for bankers. Why not pay a trillion to get every American’s teeth fixed first class? That would be a shovel ready project. And it would appease some voters. (The moral hazard involved? Probably less flossing in the future.)

  6. Yves Smith


    This IS wildly undemocratic. The officials at the Fed have absolutely no business spending taxpayer money, which is what leaving losses to the Treasury amounts to. This is extrabudgetary expropriation, pure and simple.

  7. eh

    Why does the Fed need an “exit plan”? It’s the central bank in a (largely corrupt) fiat money regime. No one cares directly what’s on the Fed’s “balance sheet” etc — the Fed is never audited. People care about indirect indicators, e.g. the dollar and how the economy is doing. And if those two are stable, then everything else will be relegated to the ‘So what?’ file.

    Still waiting for an answer to my question.

  8. Anonymous

    So the Treasury (taxpayers) takes the hit, the perps that set the fire walk away safe, and they Fed is gets new powers to regulate its members (finance gets to regulate itself), and Congress’ power over the Fed is weakened…

    sounds great…. (did I oversimplify this? comments?)

  9. Anonymous

    wow, the tax payer will end up holding the $2Trillion bag, forever.

    This got to be the biggest heist in world history.

  10. Steve

    The talk of the Fed exiting the credit markets is nothing but wishful thinking. The Fed has replaced failed markets and no amount of fairy dust will help them `recover’. SWFs, pension funds, insurers, and foreign fixed income investors will shun U.S. ABS and structured credit for years.
    The taxpayer will be saddled with a ton of crap and the only credit flowing will still be from Fed and Treasury. The reg cap requirements for holding whole loans versus `AAA’securitized interests are a multiple, and nobody will be buying equity in firms with dismal earnings prospects from on balance sheet lending. The world changed; the business model of 2006 is dead.

  11. carol7

    ¨At some point, the assumption is economic growth will take hold, inflation will rise, the yield curve will steepen (remember, this operation is flattening the yield curve, meaning lowering the normal difference between short term rates and long term rates).¨

    Thanks to Ben´s actions, currently, 30 year fixed mortgage rate = 4.75 %.
    However, there will be significant inflation down the road.

    What will that do to cash flows of mortgage banks in the future: borrowing at 7, 8, 9 (or even higher) percent, while lending long at 4.75%?

  12. Anonymous

    When one considers that this entire crisis is due to the vanity of one man, one should seriously question whether or not an independent central bank is desirable. Better to constitutionally secure the rights of the citizenry to own and trade for gold (and other currencies) than to hope for the realization of the economist dream of politically untainted money. What a drag it is getting old!

  13. Independent Accountant

    I’ve said for about 17 months, there will be no Fed withdrawal of reserves. This is not wishful thinking, it’s an attempt to mislead the American public and foreigners who hold Uncle Sam’s paper. Got gold? Get more. Got bonds? Give ’em up for Lent. Ash Wednesday was 25 February 2009!

  14. a

    Buying long-dated Treasuries is a ludicrous idea. It makes the U.S. Fed rather than the Chinese or the Japanese the last buyer – the proverbial greatest fool. As Yves says, the Fed will buy from everyone else, then suffer enormous losses when it can’t buy any more and the Treasuries go through the floor. It will then try to pan these losses off on the Treasury, and I guess the Treasury will take them on because at that point it will have little choice. And then the full faith and credit of the U.S. government will be as valuable as the paper found in the nearest toilet.

    What is it that policy makers and economists don’t understand that a system is unsustainable? I just don’t get it. At every point in the crisis they have taken the path of least resistence and made the problem ten times worse. A recession turns into a deep recession. A deep recession is now turning into a depression. And if they now do as they are proposing (to avert the depression), they will turn a depression into either a revolution or mass starvation à la 1840s Ireland. It’s just fricking unbelievable.

  15. Anonymous

    Just another pump and dump,
    Looking for another chump ….

    Nice to find out from dipstick sell out Buiter that, “The Federal Reserve System is not owned by anyone”.

    He then goes on to later say;

    “The opaqueness of the financial operations of the Fed in support of the financial sector (which are expanding in scale and scope at an unprecedented rate) and the lack of accountability for the use of tax payers’ resources that it entails, threaten democratic accountability. Even if it enhances financial stability, which I doubt, democratic legitimacy and accountability are damaged by it, and that is too high a price to pay.”

    Democratic accountability? Now there’s another ha ha! Does he mean like the democratic accountability and legitimacy of the same big business Republican and Democratic duopoly of bought and sold politicians that created the Fed in 1913? You know, back in those good old democratic accountability and legitimacy days when women were considered not good enough to vote. I would love to have been a fly on the wall to watch the ‘pac money, soft money and hard money’ (read graft and bribes) change hands in those times … Buiter is an overpaid system shill who panders in a puddle of complexity and omissions!

    When the fuck are people going to wake up to the fact that they are living in scamerica where the ‘rule of law’ is a selectively enforced scam bought and paid for by the wealthy elite. That aggregate generational corruption is the problem, and that it is the entire non responsive system, not just the banking system, that needs a reset. And that plain old vanilla greed has been replaced at the helm by a more devious elite bunch of scum bags that seek to decimate the middle class and create a ruler and ruled world.
    At some point the effects will show the causes. Its not about the details, its about the design …

    Deception is the strongest political force on the planet.

    i on the ball patriot

  16. Stephen Lins

    I laughed out loud at Buiter’s quip about the “Elders of Zion” owning the Fed. There actually was someone here in a Goldman-related thread urging us all to read the “Protocols” to learn all we need to know about the world.

  17. IF

    I might be terribly naive, but it is the Feds mandate to create inflation. It is meant to be a slow process, but the treasury gains every year this happens due to seignorage and decreased real debt value. (“Dirty” money) In a deflationary world the treasury is screwed like any other debtor. This means the discussed Fed actions might be anti-democratic, but they are clearly done to support the republic.

    Now to the big picture. Krugman cites some GS numbers, that show interest rates should be at -6 percent, or alternatively quantitative easing at 9*10^12 dollars. Obama can’t send a law through parliament authorizing this amount. That’s why big numbers start popping up in all places: congress 2 trillion, Fed 1 trillion, FDIC 1/2 trillion. I wouldn’t be surprised if the Pentagon gets involved soon.

    Now, as long as the 9 trillion number is right, we will not get inflation soon. I think Geithner hopes, that these actions preserves the status quo. But as has been argued here before, the bailouts are setup to redistribute from the bottom to the top of the wealth pyramid. Don’t you think this would keep CPI low? I wouldn’t be surprised if the US looks a lot like Brazil after this exercise. With reasonably stable prices. (Oh, and occasionally a military leadership.)

  18. albrt

    “it is possible that, should the private securities default, the central bank will suffer a capital loss so large, that the central bank is incapable of maintaining its solvency on its own without creating central bank money”

    I am a little mystified by this, although I assume it is technically accurate. The way those of us out here in the provinces see it, the money has already been created when it is given to the sellers of the securities. The only question is what percentage of the debtors are going to give money back to the Fed on schedule, thus reducing the money base back to what it was.

    The most likely answer, of course, is that a very large percentage of the money will not come back to the Fed. The Fed simply does not have the same control over repayment that it has when it is loaning money overnight to functioning banks based on unquestioned collateral.

    So the Fed has effectively replaced loaned money with printed money, and is going to have a much harder time getting the printed money back when the Fed decides it wants to reduce the money supply. But for purposes of managing inflation expectations among the hoi polloi, the money printing already happened when the money went out the door, not when the Fed tries to get the money back months or years later.

  19. doc holiday

    I’ll be watching the buck at this point, versus Treasury securities. I think Timmy just nailed the last nail in America’s urn.

  20. FairEconomist

    In addition, Bernanke in his speech Friday talked about managing spreads, not fighting deflationary pressures. So are there multiple objectives or is this a pump up asset prices program in another guise?).

    The size of the purchases – 1 trillion dollars – far exceeds what is needed to fight deflation. It will, in combination with post-Lehman printing, double the money supply. It’s a pump program.

  21. El Bobo

    Riddle me this Bondman, if the Fed is buying long dated treasuries, how will they know when to start selling said treasuries because of rising inflation?

    Here’s a though experiment: Assuming the markets look ahead 6 months, if the Fed waits until real time economic data is showing a robust economy, it would seem that the Fed will be 6 months behind the curve. When they have to start selling these TBonds, there will be 6 months of pent up interest rate pressures in addition to the price pressure of the Fed’s selling. Also there will be the continual fiscal stimulus selling of TBonds at this time.

    If the market wants to increase interest rates, but the Fed won’t let Treasury rates rise, what might the market do? Maybe inflationary pressures start moving corporate interest rates up instead. But if treasury rates are going down and corporate rates are moving up, maybe the Fed will believe this is because of an increasing risk premium and will conclude they are not doing enough to help the economy and need to do even more intervention.

    Of course, if other central banks are also doing QE, that will lessen the downward pressure on the dollar, making dollar weakness less apparent. The only way for inflationary pressures to be evident would presumably be in gold prices and secondarily in commodity prices in general.

    It will be very impressive if Bernanke can make his scheme work.

  22. But What do I Know?

    Can the Fed *ever* end QE–exchanging no maturity zero-interest bills for 30 year, low-interest bonds? The Fed is the Last Buyer of T bonds and notes at these prices–who will take them off their hands?

    Also, if interest rates ever were to rise to a “normal” 4-5%, the interest payment on the federal debt would prove to be unmanageable. The Fed is committed to permanently keeping interest rates low and never worry about inflation–they just haven’t admitted it to themselves yet.

  23. General Glut

    By my rough calculations, the Powers That Be are enabling private speculators to leverage at 42:1 to have at these toxic assets. Follow me along here and please show me where I’m wrong.

    I become a Treasury approved asset manager through the Legacy Securities Investment Fund. I raise $100 in private capital. Treasury matches my $100 — now I have $200 in equity. Treasury smiles on me and gives me a loan in the amount of 100% of total equity — i.e. $200. Now I have $400.

    I spy some tasty MBS on auction through the Legacy Loans Program. Citibank is trying to dump a $5200 face value pool of MBS and agrees to sell to me for the sum of $4200 — a mere 19% writedown. Citi loves this small write-down, of course, but I don’t have $4200. I only have $400 (of which only $200 is equity).

    But wait! Through the Legacy Loans Program I can get the FDIC to guarantee a loan for 85.7% of the purchase price (6-to-1 debt-to-equity ratio). $4200 * 0.857 = $3600. Plus I can get the Treasury to match my equity stake of $200 with another $200. Plus I have my original $400. $3600 + $200 + $400 = $4200.

    My original $100, with the help of the Treasury and the FDIC, and the Fed, became $4200.

    Have I gone awry somewhere?

  24. Dirk van Dijk

    Ok, we finally have the details of the Treasuries toxic asset plan, and the market seems to like it. Let me try to simplify what is going on with it. Right now the crux of the problem with the legacy (toxic) assets is that they are complicated parts of home mortgages, many of which have gone bad, and many more of which are likely to go bad in the near future. Suppose a bank has $100 million (face value) of these assets on its books. It has already marked these assets down to $80 million, and taken headline grabbing losses as it has done so. It would like to get these assets off its books, but it claims that there is no market for them. We that is not quite a true statement, since there are people out there who might be willing to buy those assets for $10 million. That however would require the bank to write off an additional $70 million. If it did so it would be bankrupt, and the FDIC would have a big pizza party on Friday night, the way they regularly do with smaller banks (as in three of them last Friday). However, this bank is in the class that has been deemed too big to fail.

    What the new plan does is that the Government will pick out a bunch of money managers with some experience managing these sorts of assets. The money manager will be competing with other money managers. Say the money manager is willing to buy these toxic assets for $70 million. It would put up $5 million in equity and the government will also put up $5 million in equity capital. Thus we have $10 million in total equity capital supporting $100 million in face value assets, and $70 million of market value. The government will then lend this partnership (it self being a 50% partner) $60 million on a non recourse basis. The interest rate on this loan was not given, but we can assume it will be quite low (and for simplicity sake will ignore the interest cost in the calculations). The bank will have to take another $10 million write down, which will hurt, but it sure beats marking it down by $70 million.

    Ok what happens now? Let’s consider two different scenarios. I the first case, the “suspend mark to market” crowd is right, and over time it turns out that these assets are really worth $90 million. Then when everything is unwound and the assets either mature or are sold off, the partnership ends up making a $20 million profit, and the $60 million loan is paid back. The profits are split between the investor and the government, each of which will have turned a $10 million profit on a $5 million investment. Hey I wouldn’t mind seeing my $5 million turn into $15 million. The private investor gets a 200% return. The government also makes a 200% return on its $5 million equity stake, but in reality, it put up not $5 million, but $65 million, the loan plus the equity stake. So the government’s real return is a bit over 15%. Still, not all that bad. If the partnership were able to buy the assets for $60 million rather than $70 million, the profits for both sides will be greater, but much more magnified for the private investor. In that case the investor would have only put up $4.16 million (ditto of government equity), and if the assets eventually were with $90 it would be a $15 million profit to each side, or a 260% return to the private investor. Clearly there is an incentive to try to get the lowest price they can for the assets.

    Ok what about the other scenario. Let’s say the assets over time only prove to be worth $50 million and the partnership paid $70. In that case, the private investor loses his $5 million investment, but that is all he loses. He is free to walk away from the deal and the government owns all the assets, and is out $15 million. Remember this is a pretty optimistic bid given that right now, without the loans and guarantees, the private market is only willing to pay $10 million for these assets. If the assets are only worth $30 million, the investor still losses just the $5 million, but the government eats a $35 million loss.

    In many ways this structure should sound a little familiar to you, at least the non-recourse leverage part of it. You probably engage in it yourself. You do it when you take out a purchase mortgage (and effectively but not legally so when you refinance). You put down say 10% of the purchase price and borrow the other 90%. If the house goes up in value, your profit is determined not by the total purchase price vs. the total sale price, but is 10x that. For example, you buy a $200,000 house and put $20,000 down. A year later, the house rises to $250,000 and you sell. You pay back the $180,000 loan and have $70,000 left, or a 250% return on your $20,000 investment. If the house goes down to $150,000 instead, you mail in the keys and walk away. Yes you are out the $20,000, but the bank has to eat the other $30,000 loss. It probably has, since that is what is causing all these mortgages to go bad in the first place (well at least a big part of it, a few other causes as well).

    Given the size of this program, starting at a total potential market price for $500 billion of assets ($714 billion of face value in the 70% example) the holders of these toxic assets, most notably the big banks like Bank of America (BAC) and Wells Fargo (WFC) will not be able to claim that this is just a liquidity problem. That the only reason that people are only willing to bid $10 million for the $100 face value of assets is that they don’t have the cash to bid more. That’s plenty of cash to do so. If with all this cash in the hands of several of these public private partnerships they start to bid up the price of these assets to $80 million, well then problem solved. The bank that currently owns them will not have to take any more write downs. If they bid them up to $85 million, the bank would actually write up the asset and report a profit (reversal of a previously booked loss).

    There have to be both buyers and sellers for there to be a market. The assumption on the part of the government plan, and of the banks and most of the press is the reason that there is not much activity in this market is that there have been no buyers. But is that assumption true? There are buyers out there, but they are only bidding $10 million right now. Citigroup (C) could sell vast amounts of its toxic sludge at $0.10 on the dollar tomorrow if it so chose too. The result of course though would be that Citigroup would be even more broke than it is now, it would have to take that additional $70 million hit, and you can see what the $20 million hit it has already taken has done to it. This is sort of like someone who is sitting in an underwater home, and needs to sell. He could sell the house he has the $200,000 mortgage on for $20,000, but then would have to bring $180,000 to the closing. But since it is non recourse loan, he would be silly to do so when he can just walk away. Citigroup is not in that position. It also has a highly leveraged balance sheet, but the money it borrows first and foremost deposits but also bonds. Those have to be paid back, regardless of what the assets are worth. Thus it really can’t sell the assets for the price being offered in the market, even if that is the true value of them. In other words, the problem Citigroup (this problem includes Citigroup but is not limited to it) has is a solvency issue, not a liquidity issue. If that is the case, then this plan will simply be throwing taxpayer money down the rat hole.

    The advantage of this plan is that compared to previous plans to buy up the toxic assets, this one has a better chance to actually arrive at what the “true value” of these assets are. The problem is that the private side of the public private partnership will not have much skin in the game. They stand to make huge profits and take relatively low risks. The government will be shouldering most of the risk, but will have much less upside. Ultimately the biggest unknown is how high the bidding war will go for these assets. If it goes only up to $50 million, then the banks will still decide to not sell, and the program will go unused. No damage done really, but the problem is not solved and we still have a zombie bank that is unable to lend because its balance sheet is stuffed with crap. If it goes too high say to $85, the effect will be to help out the banks, which will then be able to report a $5 million profit, but the government will end up losing lots of money. With multiple players in the game though, each with the incentive to buy as much of the assets at as low a price possible, we may get closer to a real answer as to how much these assets are “really worth.”

  25. travis

    What’s interesting and no one is talking about it yet is that certain programs are easy to unwind: direct purchases of assets. Other programs are difficult to unwind: providing loan money for other parties to make purchases (TALF).

    So when the economy starts booming again and the Fed tries to unwind its balance sheet, some assets (such as TALF) are going to be difficult/impossible to dispose of. So the question is what will the Fed do? Does it keep the assets on the balance sheet and try to raise interest rates by selling everything else on the balance sheet? But what if the loans for programs like TALF are so huge that after it sells everything *else* on its balance sheet, it needs to sell still more assets to contain inflation, but it can’t? I guess if push comes to shove, it could sell the TALF loans.

  26. Juan

    @8:58 AM,

    I like the analogy but “freedom fighter” ‘Ollie’ North’s three count sentence was suspended – he never went to jail.

  27. Juan

    IF: This means the discussed Fed actions might be anti-democratic, but they are clearly done to support the republic.

    have you considered how many dictators have relied on just such promise, ‘to support the…, to save the….’, to rescue the…’

  28. Juan

    IF, pardon, didn’t notice your (Oh, and occasionally a military leadership.)

    but my experience, civilian leadership within a ‘regime of internal enemies’ or ‘national emergency’ is no more than façade behind which military rule persists.

  29. john bougearel


    Not to be too cute, but maybe it is precisely because the Fed knows its whole risk profile is to buy assets high, and later sell low at a loss that they have kept the CDS market alive.

    I mean, after all, they are going to have to self-insure themselves, doncha think? So, why would they not go into the cds market and buy insurance against a US govt default while it is rising but still cheap? The trend is your friend and the risk of a US default is a rising trend!

  30. john bougearel

    On all these temporary Fed lending facilities to subsidize welfare queens:

    It is all well and good to speak of “exit strategies” and these being temporary structures to justify their existence. But as pointed out, these temporary structures tend to become more or less permanent, with new rationales and justifications for keeping said structures in place.

    The same thing happened with the federal tax code, which somehow got slipped in around the time of WWI. This tax was supposed to be temporary, but it was later never removed. I am not fluent with the precise details, but the point is new found taxes and subsidies tend to be intractible or inelastic over time. That is, the public outcry against these taxes and subsidies diminish with time, and there is no politically palatable or suitable substitute for them. We acquiesce and just except them for being something we can’t get rid of. We add them to the long list of irritants against the govt. The fingers of political instability begins to grow as a result, and one day, the fomenting political instability will lead to a revolution. With the policy trajectory we are on, and with the lack of political will on the Hill to make the hard and proper decisions, the risk of such a revolution begins to grow by the hour rather than the generation.

  31. Anonymous


    The dollar will tank, which in theory is part of the program (break glass and depreciate currency) but Nixon did that once when the financial system was sound, and it still had pretty bad repercussions (the 1970s stagflation).

    And a broke public might not be too happy about gas going up 40% when wages aren’t going up. Workers had no leverage even in a better economy.

    All sorts of possible weird outcomes possible. Japan did QE, did NOT create inflation because banking system was bust. We aren’t making needed reforms.

    Similarly, the Fed can increase the monetary base, not money supply. Fed increased monetary base in 1930 and money supply still fell.

    So if it starts working, dollar falls and Fed gets reined in (Fed is not independent, despite mythology to the contrary). But it might not work (Steve Keen thinks vastly more intervention needed than Fed would ever undertake).

    And you need to read the Buiter article linked to in comments. There ARE practical constraints on a CB’s balance sheet.

  32. joebhed


    The greatest source of funds, in the private central bankers sense of that word, available to pull off this magic is the cushion-of-credits account that exists between the financial operation of the FED(operating under exigent circumstances of course, and the interest payments that are collected from the federal treasury for repayment.
    The FED can magically assume losses to the private banking operations and have that money back from the taxpayers in the click of a mouse.
    Given that this money also provides reserves to the federal reserve banking system, it creates multiple opportunities to extend the growth of private and public debt.
    Please do not mention to the taxpayers what these obligations may come to, should the interest rates on that debt increase, which would of course be a major functon of FED money policy.

    The Chicago Plan.

    That’s what.

  33. Anon1

    I laughed out loud at Buiter's quip about the "Elders of Zion" owning the Fed.

    Ah yes, VERY clever of Buiter to laugh divert attention. Those "in the know" know that it is really the Rosicrucians that own the Fed!

    Clever misdirection Buiter. Well played.

  34. Anon1

    @Anonymous Juan said…
    "IF: This means the discussed Fed actions might be anti-democratic, but they are clearly done to support the republic."

    have you considered how many dictators have relied on just such promise, 'to support the…, to save the….', to rescue the…'

    As per usual, you need to destroy the village to save it.

    War on terror, etc, and all the lovely accoutrements (Patriot Act, torture, abuse, "state secrets" for everything up the yingyang…).

    With the financial terror, there's a whole new slew of villages that need a good burning to save them here.

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