Vultures coming home to roost

Why the Paulson plan is not a rescue in 31 words or less

“The central bank action treats a symptom of the disease, not the disease itself,” said Stephen Lewis, chief economist at Insinger de Beaufort. “It is a palliative. At root, there is no way of imbuing worthless financial claims with value.”

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/09/19/ccambrose119.xml

 

Foreign central banks switching into Treasuries, not willing to buy Fannie/Freddie bonds

As noted by many including Brad Setser and Yves Smith, in August 2008, foreign central banks added close to $46 billion ($45.92b) to their custodial holdings of Treasuries at the New York Fed. Also in August, they reduced their holdings of Agencies by a bit over $13 billion ($13.33b).

What this may mean to the U.S. is that if and when Fannie and Freddie cannot find buyers for their bonds at a do-able interest rate, Fannie and Freddie must at that point cease to exist in their current form, by government bailout or otherwise.

Here is the chart:

(Link: http://www.nakedcapitalism.com/2008/09/setser-if-trends-continueagencies-wont.html)

Federal Reserve’s Richmond President speaks out on moral hazard

A very important speech today by Jeffrey Lacker, President of the Federal Reserve Bank of Richmond. Highlights include his views on the moral hazard created by central bank bailing out financial institutions:
“People often think of the moral hazard problem associated with a financial safety net as a “due diligence” problem. That is, investors in protected securities or lenders to protected institutions feel less of a need to assess and monitor the creditworthiness of their counterparties. This is a valid concern, but I think it construes moral hazard too narrowly in this setting. My discussion of the choice of leverage points to broader implications of central bank lending for the contractual structure of financial arrangements, not just on the monitoring of investment portfolios. In particular, the expectation of safety net support can weaken the incentive of counterparties to build provisions in to their financial contracts that reduce their susceptibility to (non-fundamental) runs. More broadly, an intermediary with access to the financial safety net has less incentive to manage their liquidity in a way that suitably minimizes the possibility of disorderly resolution of solvency problems.

Recent work by one of our Richmond Fed economists makes this point very clearly, using the standard model of banking theory. He and his New York Fed coauthor consider a setting in which if there is certainty that no government (or central bank) assistance will be forthcoming, then the banking contracts developed will include provisions that allow for suspensions of payment and these will prevent non-fundamental runs from occurring. On the other hand, if such central bank assistance is possible and a non-fundamental run actually does start, the government will choose to intervene in order to alleviate the ex post inefficiency associated with a run. But, knowing that this intervention is forthcoming, banks do not self-protect, and thus leave themselves more susceptible to runs. So peoples’ expectations regarding central bank policy choices in times of stress can affect the very robustness of the system.

This strikes me as a deeper form of moral hazard than what people usually have in mind. In times of financial crisis, the understandable central bank imperative is to alleviate the stress. But the expectations such actions engender could very well make future crises more likely. The classic time consistency problem is as relevant to central bank credit policy as it is to monetary policy.”
Entire speech: http://www.richmondfed.org/news_and_speeches/presidents_speeches/index.cfm/id=107

The Federal Reserve – Counterparty of (Next to) Last Resort

From Interfluidity, a good explanation of what really happened in the Fed-Bear Stearns-JP Morgan deal: 

http://www.interfluidity.com/posts/1207251546.shtml

The only thing I’d add is that the U.S. Treasury is actually the counterparty of last resort because it has guaranteed any losses from the deal up to $29 billion.  So, the Fed is the counterparty of next-to-last resort.  Hmmm.

United States Treasury promises to pay the Fed for Bear Stearns losses

This is us folks.  The US government, i.e. taxpayers, guarantees the NY Federal Reserve loan of $29,000,000,000 to JPMorgan/Bear Stearns.  Call and write your congressional representatives if you disagree.  Otherwise, you need not do anything.  Click to read the letter →  treasuryletter0308.pdf

Germany’s BaFin Internal report says financial institutions to lose $430 – $600 billion

Germany’s Federal Financial Services Authority is known as BaFin. According to information obtained by SPIEGEL, an internal BaFin report says that shortfalls at finance institutions worldwide could end up totalling $600 billion (€380 billion). The shortfall comes as a result of ill-advised speculation on the US subprime market and resulting jitters in markets worldwide. BaFin says that its prognosis is merely a worst-case scenario. “Given what we know about the current situation on the markets, we presume that a total of $430 billion is more probable,” the 16-page report says.

 Jim Rogers’ reaction to Fed moves on Bloomberg  

Germany’s state owned banks on the verge of collapse

Der Spiegel reports that Germany is facing its worst banking crisis since 1931, with the government fearing the domino effects of allowing the insolvent banks to fail.  For now, capital infusions keep coming and instantly vanishing into thin air.  Included in the report is a very interesting story on WestLB, a bank that was insolvent and which was initially turned away at the door when it went begging for capital to stay afloat.  This shows how ugly can get:  “ In a crisis meeting two weeks ago, the two savings and loan associations in North Rhine-Westphalia that own half of WestLB had to admit that they were unable to come up with €1 billion in fresh capital for the ailing bank. They insisted that it was up to the state to cover another €3 billion in risks.