Monday, December 03, 2007

Innocent bystanders and government bailouts

 Don Kohn, Vice Chair of the Fed, talks about justifications for the bailout of lenders and borrowers in a November 28, 2007 meeting with the Council on Foreign Relations.

Are these innocent bystanders (lenders) really that innocent?  Didn't they know that a resetting ARM mortgage is a risky way to lend money, and instead of just keeping hands in the pockets of their customers they were pulling off their clothes? Are the banks planning on getting in the business of selling used clothing?

How about the borrowers?  To a lesser extent, they should have understood that there's no such thing as a free lunch, and that debt is usually a bad thing, especially when there's a time-delay bomb attached to the loan.  But free money is hard to refuse.  And being able to borrow free money and make payments on a house you can't affort is a great thing while it lasts.  Especially if you don't need to justify why you need to borrow the money.

The FOMC vice-chair speaks on morals...

The first issue I want to discuss is moral hazard. Central banks seek to promote financial stability while avoiding the creation of moral hazard. People should bear the consequences of their decisions about lending, borrowing, managing their portfolios, both when those decisions turn out to be wise and when they turn out to be ill-advised. At the same time, however, in my view, when the decisions go poorly, innocent bystanders should not have to bear the cost.

And then goes into repricing assets for liquidity

In general, I think those dual objectives -- promoting financial stability and avoiding the creation of moral hazard -- are best reconciled by central banks focusing on the macroeconomic objectives of price stability and maximum employment. Asset prices will eventually find levels consistent with the economy producing at its potential, consumer prices remaining stable, and interest rates reflecting productivity and thrift.

And then he compares the tech bubble to the housing bubble

Such a strategy would not forestall the correction of asset prices that are out of line with fundamentals, nor would it prevent investors from sustaining significant losses. Losses were evident early in this decade in the case of many high-tech stocks, and they are in store for houses purchases at unsustainable prices and for mortgages made on the assumption that house prices would rise indefinitely.

Does this mean they're going to pay me back the money I lost on & Nortel?  Whohoo!

Then he goes on to Joe Economy, and how he is currently being held hostage. 

To be sure, lowering interest rates to keep the economy on an even keel when adverse financial-market developments occur will reduce the penalty incurred by some people who exercise poor judgment. But these people are still bearing the cost of their decisions, and we should not hold the economy hostage to teach a small segment of the population a lesson.

The solution?  Bail out the greater fool!

Third topic: Liquidity provision in bank funding markets. Central banks have been confronting several issues in the provision of liquidity in bank funding. When the turbulence deepened in early August, demand for liquidity in reserve pushed overnight rates in interbank markets above monetary policy targets. The aggressive provision of reserves by a number of central banks met those demands, and rates returned to targeted levels.

In the United States, strong bids by foreign banks and dollar-funding markets early in the day have complicated our management of this rate. And demands for reserves have been more variable and less flexible in an environment of heightened uncertainty, adding to volatility in the overnight rate.

In addition, the Federal Reserve is limited in its ability to restrict the actual federal funds rate to within a narrow band because we cannot, by law, pay interest on reserves for another four years.

That statement caught my eye.  Paying interest on reserves?  Does that mean that bank reserves are now loans to the government rather than insurance against defaults?  That's got to be a substantial drain on taxpayers dollars to pay for the security of the banking system.  Maybe the money's coming from somewhere else?  Peter or Paul?  I hope I'm going to get some interest paid to me when my auto insurance comes up for renewal, instead of having to pay them monthly interest for something I don't really want anyway, but I'm legislated to have for my own protection. 

Of course, if I wasnt legislated to have insurance, I probably wouldn't have had it when my car was stolen or broken into, which caused me to keep buying more expensive car stereos, which caused them to keep getting stolen, which caused my premiums to go up, which caused my personal reserves to go down.  Note to self: next time, don't buy the most stolen car of the year and don't drive around with the stereo blaring.

Most Stolen Autos.

Reminds me of the story one of my former co-workers told me about his first job working for the government out of college.  He found out his starting salary was $28,000 per year.  First thing he did?  Bought a $27,000 Camaro.

His dad was driving around the car by the next year.


Ultimately the banks wouldn't be paying much interest anyway, since they may eliminate reserve requirements altogether.

MR. MEYER: Okay. Well, I hope you appreciate that that was an absolutely brilliant speech. It was incredibly forthcoming. It sounded nothing like anything you've heard since the last meeting from other FOMC members. That's not a surprise, because the only FOMC members that can change the message are the vice chairman and the chairman. And that was an absolutely brilliant speech. I'm breathless. This has answered all the questions I had, so I don't know what I'm doing up here. (Laughter.)

Source: C. Peter McColough Series on International Economics (Transcript) - Council on Foreign Relations

I'm out of breath here too... More on Financial Services Regulatory Relief from the minutes of October 25, 2006 Fed meeting.

The Chairman noted that the President had recently signed the Financial Services Regulatory Relief Act of 2006, which among its provisions gave the Federal Reserve discretion, beginning October 2011, both to pay interest on reserve balances and to reduce further or eliminate reserve requirements. The Act potentially has important implications for many aspects of the Federal Reserve's operations and the Chairman asked Vincent Reinhart, Director of the Division of Monetary Affairs, to form a committee of Federal Reserve System staff to consider these issues.


Ignorance is bliss, and recent Fed transparency & bank transparency changes are the opposite of ignorance.  Not sure if it is a good thing or not.  The Vice Chair isn't sure either...

But I do think the -- and expected some year-end pressures, but I have to admit -- speaking for myself and certainly not for the committee -- the degree of deteriorating that's happened over the last couple of weeks is not something that I personally anticipated. I think the losses that have been announced that seem entrain and have been announced were greater than people expected. This raised questions about financial institutions, how much capital they had, how vigorous they would be in pursuing new loans. Financial institutions became more cautious. And I think this process is one that we're going to have to take a look at when we meet in a couple weeks.

And my favourite question.

MR. MEYER: Okay. My last substantive question: Do you believe there was a Greenspan put?

Let me answer that with what he is obviously going to say anyway... You so crazy!

The questions after the interview are even more forthcoming.  US Dollar valuation, inflation, central bank intervention. Basel II implementation, etc.

Read the full transcript here.  C. Peter McColough Series on International Economics (Transcript) - Council on Foreign Relations

No comments: