The experiment with unregulated financial engineering is over, and government is making its biggest comeback into financial market in many decades. As Paul Krugman says, "The unthinkable — a government buyout of much of the private sector’s bad debt — has become the inevitable." Nationalization is no longer a dirty word! The "national credit card of the United States", operated by the Federal Reserve, is being used to takeover the sub-prime debt!
There have been numerous calls for a "comprehensive plan" to regulate the financial system. However, while these are undoubtedly important, they may not be the immediate priority. The urgent need is to reassure investors and prevent the crisis from spreading further. In other words, temporary steps involving damage control and crisis management. The Fed needs to buy as much time as possible, so as to give the ailing institutions breathing time to get some semblance of order back, dissipate the fear psychosis hanging over the markets, and for the real economy to adjust to the changed circumstances. The time for hard regulatory decisions of fundamental nature should come later, lest it upsets the delicately balanced applecart.
In such uncertain times, the low interest rates notwithstanding, credit gets squeezed out for even the real economy, as lenders, wary of counter-party risk "go on strike". That this is happening is borne out by the sharply widening interest rate spreads - the average interest rate on three-month interbank borrowing was 3.2%, while the interest rate on the corresponding Treasuries was 0.05%. Further, the spreads in the money markets (between interest rate charges overnight and those charged over a longer period), which indicates the health of the money markets and is a measure of whether banks are willing to lend to one another — and ultimately to consumers, have also been widening.
Given that the financial markets will now need help from a real economy to pull itself out of the deep crisis, it is imperative that conditions be maintained to ensure that the real economy remains robust and healthy. A credit squeeze would depress business spending, already starined by inflationary and recessionary expectations.
Worse still, fears of the crisis engulfing even safe investments like money market funds, certificates of deposit and asset-backed commercial paper, may prompt investors to pull out from these securities, thereby forcing a run on the issuing institutions. This would set off a domino effect on even the hitherto safer areas of the financial system, with catastrophic consequences. There is the danger of a "liquidation trap", with falling asset prices triggering off margin calls and distress sales, causing further asset sales and price declines.
These dangers will persist for atleast a few months, and the Fed should be dextrous enough to swiftly contain these fears and reassure investors. With the double effect of inflation and solvency crisis driving real interest rates (even the nominal ones are close to zero) virtually zero, the standard monetary policy levers have become ineffectual. In these extraordinary circumstances, the Fed will have to, as Mark Thoma and William Buiter suggested a few months back, assume the role of a "risk absorber of the last resort" or "market maker of last resort". The temporary fire-fighting options available include
1. Creation of an agency to buy up bad assets. This entity might purchase assets at a steep discount from solvent financial institutions and eventually sell them back into the market. Precedents include the Resolution Trust Corporation, a government-owned, asset-management company charged with liquidating assets of failed Savings & Loans (S&L) institutions in the eighties, and the Japanese government’s mass purchase of bad debts from banks during the 1990s.
2. Suspend short trading in the securities of embattled institutions.
3. Keep alive the emergency lending program, so as to enable access to credit for troubled insititions.
4. Dilute credit standards for emergency lending.
5. Extend guarantee umbrella to certain safer and liquid instruments like the $3.4 trillion strong money market funds.
6. Expand credit lines available for short-term borrowings by banks from the money markets.
7. Explore ways to relax capital standards and mark-to-market rules, so that bad debts are written down in orderly fashion rather than through panicked deleveraging that pulls down good assets too.
All these efforts should have costs clearly defined and back-ended and the institutions have adequate time to clear off their bad assets and repay the tax payer. Fixing an appropriate risk-adjusted price that penalizes the greedy investors and fund managers, while helping achieve the objective would be a challenge. In the absence of a clear idea of the extent and type of risks involved, the Fed or any other agency cannot hope to have any comprehensive detailed plan, but only respond to crisis in a piece-meal manner and hope that situation eases up. In fact, any comprehensive and general plan, would perversely enough accentuate moral hazard.
One of the biggest concerns is that over how the government will value the assets it takes onto its books. The conventional mark-to-market valuation method, which has been responsible for much of the crisis, is surely not acceptable. As the WSJ suggests, one possible avenue could be some sort of auction facility, so that the government would not have to be involved in negotiating asset values with companies. This would also ensure that the greedy financial companies are adequately punished with big losses.
Whatever the Fed and Treasury does now should be done with the objective of steadying the market so that investors regain confidence in financial institutions and resume conducting business normally with them.
Nouriel Roubini has a scathing indictment of the actions of the Fed and the US Treasury, describing it as "socialism for the rich", and the "biggest government intervention and nationalisations in the recent history of humanity"!
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