Liberty Forged

the State has no money of its own, so it has no power of its own. ` Nock

Posts Tagged ‘MBS’

Harking back to the beginning of the economic “crisis”

Posted by Jesse on November 27, 2008

[Ben Bernanke: “The U.S. government has a technology, called a printing press, that allows it to produce as many dollars as it wishes at essentially no cost.”]

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(An artificial conversation with a few authors….my comments are in bold text and my guests’ are italic.)

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Did you hear about Bear Stearns Mr Whitney ?

·The New York Times summed it up like this in Saturday’s edition:

“If the Fed hadn’t acted this morning and Bear did default on its obligations, then that could have triggered a widespread panic and potentially a collapse of the financial system.”

What? There’s a financial crisis because of one company?!

That’s the question that will be addressed in the next couple weeks and people are not going to like the answer. For the last decade or so the markets have been reconfigured according to a new “structured finance” model which has transformed the interactions between institutions and investors.

Derivatives trading which, according to the Bank of International Settlements, now exceeds $500 trillion, has sewn together the various lending and investment institutions in a way that one failure can set the derivatives dominoes in motion and bring down the entire financial scaffolding in a heap. That’s why the Fed got involved and (I believe) approached Congress in a closed-door session (which was supposed to be about FISA legislation) to inform lawmakers about the growing possibility of a major economic meltdown if conditions in the credit markets were not stabilized quickly.

Hmm. Sounds like a big big mess. How the heck would one handle a situation like that?

Washington mandarins and financial heavyweights had to decide whether to sit back and let one small investment bank take down the whole equities market in an afternoon or stealthily buy a few futures and live to fight another day? Tough choice, eh?

Heh. That makes sense. So what can we expect then?

The ongoing massacre in real estate has left the structured investment market frozen, which means that the foundation blocks (i.e., mortgage-backed securities) upon which all this excessive leveraging rests; is starting to crumble. It’s a real mess.

The CDS market is roughly $45 trillion, whereas, the aggregate value of the US mortgage market is only $11 trillion; four times smaller. That’s a lot of leverage and it can have a snowball effect when the CDS trades begin to unwind.

Now, in capitalism’s extreme crisis Bernanke, acting beyond his mandate, invokes a law that hasn’t been used since the 1960s so the Fed can become the creditor for an institution that attempted to enrich itself through wild speculative bets on dubious toxic investments which are now utterly worthless.

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(I wonder what the Doc has to say about this?)

What’s the Fed’s role and policy regarding the economy in the 1st decade of the new millenium Dr Paul?

Mr. Bernanke views our system of fiat currency as a tool for creating wealth out of thin air by producing more dollars, whether paper or electronic.

How does this affect the holders of dollars?

It’s called monetary inflation, which destroys the value of the dollar and punishes those who save and invest. The money supply, as measured by the Fed’s own M3 figure, has increased about 5 times since 1980.

Inflation is not in check, as anyone who examines the cost of housing, energy, medical care, school tuition, and other basics can attest. In one sense the remarkable rise in housing prices over the last decade really just represents a drop in the value of the dollar. The artificial boom in the 1990s equity markets, engineered by Mr. Greenspan’s relentless monetary expansion and interest rate cutting, ended badly for millions of Americans holding overinflated stocks. What will happen when the same thing happens with housing?

Right. How about Bear Stearns and what we see in the news today?

The current market crisis began because of Federal Reserve monetary policy during the early 2000s in which the Fed lowered the interest rate to a below-market rate. The artificially low rates led to overinvestment in housing and other malinvestments. When the first indications of market trouble began back in August of 2007, instead of holding back and allowing bad decision-makers to suffer the consequences of their actions, the Federal Reserve took aggressive, inflationary action to ensure that large Wall Street firms would not lose money. It began by lowering the discount rates, the rates of interest charged to banks who borrow directly from the Fed, and lengthening the terms of such loans. This eliminated much of the stigma from discount window borrowing and enabled troubled banks to come to the Fed directly for funding, pay only a slightly higher interest rate but also secure these loans for a period longer than just overnight.

So how bad is it? Is there a way to stem the negative effects?

After the massive increase in discount window lending proved to be ineffective, the Fed became more and more creative with its funding arrangements. It has since created the Term Auction Facility (TAF), the Primary Dealer Credit Facility (PDCF), and the Term Securities Lending Facility (TSLF). The upshot of all of these new programs is that through auctions of securities or through deposits of collateral, the Fed is pushing hundreds of billions of dollars of funding into the financial system in a misguided attempt to shore up the stability of the system.

Do they recognize the fault in their attempts?

The Treasury Department has recently proposed that the Federal Reserve, which was responsible for the housing bubble and subprime crisis in the first place, be rewarded for all its intervention by being turned into a super-regulator. The Treasury foresees the Fed as the guarantor of market stability, with oversight over any financial institution that could pose a threat to the financial system. Rewarding poor-performing financial institutions is bad enough, but rewarding the institution that enabled the current economic crisis is unconscionable.

I hear that. Thanx Dr Paul

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But what about all the deregulation?. How does all that play into such a highly regulated atmosphere? Prof. Rozeff, would you enlighten us please?

Deregulation was part of a general movement during the 1990s, approved by piecemeal government regulations and deregulations, that allowed both investment banks and banks to become universal banks.

The Gramm-Leach-Bliley Act of 1999, or the Financial Services Modernization Act, loosened control over banking while leaving the rest of the regulated system intact. This heightened the moral hazard. Banks then extended many more questionable loans and entered into complex financial agreements that they never should have been allowed to make. All of this was to our detriment.

So the free market is to blame?

The system we have is the furthest thing from lawful free markets. It is not “financial capitalism,” as France’s President Sarkozy would have it.

There is no excuse for regulators to allow such banks to write inordinate mounts of insurance via credit default swaps, or to extend inordinate amounts of loan guarantees that are another form of insurance. There is no excuse for government to have encouraged home loans to people who could not afford them. There is no excuse for government to encourage people to take on excessive amounts of debt, period. Insured banks shouldn’t have had large obligations hidden away in off-balance-sheet subsidiaries. These banks shouldn’t be so highly levered. Government is fully responsible, not only for the welter of regulation but also for the inept deregulation and the resulting financial tragedy that has unfolded.

So you agree with Congressman Paul when he mentioned moral hazard. Government is both responsible for the regulations they have imposed and for the deregulation they allowed.

(In) depository institutions with insured deposits, the depositors (who are the creditors of the bank) have no incentive to control the moral hazard. It is left up to the government. Whether or not it was recognized at the time, there is good reason why the New Deal put in bank regulation that separated banks from investment banks at the same time that it put in deposit insurance. It helped to control moral hazard by ruling certain activities as off limits for insured banks.

When the government deregulates bank lending without simultaneously removing deposit insurance, the moral hazard increases exponentially. The “too big to fail” doctrine amplifies the moral hazard even more. Uninsured deposits then become quasi-insured, and managers are less likely to lose their jobs. Raising deposit insurance limits and extending them to all types of deposits increase the moral hazard still more. These are steps Congress recently took.

Great.

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Let’s ask Robert Blumen over at Mises.org….

What investments are necessary in-so-far as the US gov’t is concerned

The economic meaning of investment is the employment of real resources toward the construction of more productive capital yielding more consumption goods in the future. Treasury debt is fundamentally different from private savings in that it is simply a claim on the taxing power of the government that issued it with no productive capital behind it. The money that was borrowed upon the issue of the bond has already been spent to fund government consumption for its favored welfare and warfare programs, while the taxpayers were burdened with the obligation to repay.

While the problems with central banks holding Treasury debt are bad enough, the problems with these institutions going into the market for private sector equity are even greater.

So not only is it a matter of moral hazard, but pure economic reasoning proves it’s foolishness.

As Mises showed in his famous critique of central planning, only private owners of capital allocate it in an economically rational way. Prices are only economically meaningful when they are the outcome of individuals risking their own wealth to purchase the asset in competition with other private owners of wealth.

Ownership of capital ultimately requires control over its use in order to realize its economic value. Once government entities hold private sector equities, there can be no doubt that rent-seeking leeches would start to lobby for the politicization of corporate decision making.

So what can be done?

The only exit from this process is a renunciation of monetary interventionism itself: the dissolution of central banks and a return to sound money.

As long as the policy of interventionism is pursued, new “solutions” are required in order to solve the problems caused by the prior interventions. If not stopped, the end of this progression is a system of total central planning.

Sources:

Fractional Reserve Banking Murray Rothbard

More of the Same at the Federal Reserve Ron Paul [Nov 29, 2005]

Bailing out Banks Ron Paul [Apr 16, 2008]

Deregulation Blunders and Moral Hazard Michael Rozeff [Nov 2008]

Bearly Alive Mike Whitney [Mar 2008]

Will Bankers Become Central Planners? Robert Blumen [Jul 2007]

Essential Reading:

The Bailout Reader, The Depression Reader, Understanding the Crisis, So Much for Diversity, The Dollar Crisis, Bernanke: He’s Reviewing the Situation

what-hascase-fed-newknow-inflationt_tmc

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The Fed is saving the Economy?

Posted by Jesse on March 19, 2008

The Fed’s New Tricks Are Creating Disaster

The Federal Reserve is trying a range of new tricks to push new forms of lending as a means of preventing what they fear may otherwise be a major collapse in financial markets. What all these strategies have in common is an unwillingness to come to terms with the reality that the crisis is based on real factors and can’t be merely papered over without grave consequence to economic health.
The Case Against the Feda-personal-view.png
[Mises and Austrian Economics: A Personal View.mp3]

Thus, last Tuesday (March 11), in response to the looming troubles with the Bear Stearns investment bank, the US central bank said that it would offer primary dealers up to $200 billion in Treasury securities for 28 days in exchange for triple A rated mortgage backed securities (MBS) as collateral. As the problems with Bear Stearns intensified and clients started to pull out cash the Fed announced that it was ready to do much more.

Last Sunday, March 16, the Fed announced it would provide direct loans to investment banks through the discount window for the first time since the Great Depression. The Fed has agreed to lend investment banks against a large variety of paper securities including a big chunk of difficult-to-trade securities.

This move by the Fed came in response to Bear Stearns’s cash holdings dropping from $17 billion on March 11 to $2 billion on March 14.

The fact that Bear Stearns was rapidly losing cash posed a serious threat to the repo market. In this market, banks and securities firms extend and receive short-term loans that are backed by securities. Fed officials feared that Bear Stearns’s dwindled cash situation posed a risk that it would not be able to honor its indebtedness. This in turn could undermine the confidence in the large $4.5 trillion repo market and further damage the credit market.

In the end, Fed officials orchestrated the selling of the Bear Stearns to JP Morgan Chase Co for $2 a share, or $236 million. Note that on December 20, 2007, Bear shares closed at $91.42. The main reason given for this deal was to prevent further uncertainty that was poised to destabilize financial markets.

Most commentators have endlessly praised the innovative methods that Bernanke and his colleagues are introducing to counter the financial crisis. Bernanke, who has written a lot about the causes of the Great Depression, is regarded as the ultimate expert on how to counter the current economic crisis. In short, most commentators are of the view that the man knows what he is doing and he will be able to fix the current financial problems.

Bernanke is of the view that by means of aggressive monetary policy the credit markets can be normalized. Once credit markets are brought back to normalcy, this will play an important role in preventing serious economic crisis. Remember Bernanke’s financial accelerator model: a minor shock in the financial sector could result in large damage to the real economy.

In short, Bernanke, by means of his so-called “innovative” policy of fixing the symptoms of the disease, believes he can cure the disease.

What is the source of the disease and why are investment banks so heavily infected by it? The root of the problem is the Fed’s very loose interest rate policy and strong monetary pumping from January 2001 to June 2004. The federal funds rate target was lowered from 6.5% to 1%. It is this that has given rise to various malinvestments, which we label here as bubble activities.

We define a bubble as the outcome of activities that have emerged on the back of loose monetary policy of the central bank. In the absence of monetary pumping, these activities would not have emerged. Since bubble activities are not self-funded, their emergence must come at the expense of various self-funded or productive activities. This means that less real saving is left for real wealth-generators, which in turn undermines real wealth formation. (Monetary pumping gives rise to misallocation of resources, which as a rule manifests itself through a relative increase in nonproductive activities against productive activities.)

When new money is created out of thin air, its effect is not felt instantaneously across all the market sectors. The effect moves from one individual to another individual and thus from one market to another market. Monetary pumping then generates bubble activities across all markets as time goes by.

As with any other business, participants in financial markets like investment banks are trying to “make money.” It is this that gives rise to the creation of various products like collateralized debt obligations (CDO) and mortgage-backed securities (MBS) in order to secure as big a slice as possible of the pool of newly created money. (Financial entrepreneurs are basically trying to exploit opportunities created by the Fed’s loose monetary stance and get as much as possible out of the expanded pool of money.)

As long as the Fed kept pushing money into the system to support the low interest rate target, various activities that sprang up on the back of the loose stance appeared to be for real. When money is plentiful and interest rates are extremely low, investment in various relatively high-yielding assets like CDO’s and MBS’s that masquerade as top-notch grade investment becomes very attractive. The prompt payment of interest and a very low rate of defaults further reinforce the attractiveness of financially engineered investment products. However, once the central bank tightens its monetary stance — i.e., reduces monetary pumping — this undermines various bubble activities.

The damage from the loose monetary policies of the Fed from January 2001 to June 2004 cannot be undone by trying to fix symptoms. Various activities or financial bubbles that sprang up on the back of loose monetary policies have weakened the bottom line of the economy. This fact cannot be undone by another dosage of policies that attempt to suppress the symptoms. If anything, such policies are likely only to weaken the bottom line further.

Remember that nonproductive activities are not self funded. Their existence is made possible by the diversion of real funding from wealth-generating activities. The diversion of real funding in turn was made possible by loose monetary policy. Hence the tightening in monetary stance from June 2004 to September 2007 is what is currently undermining various false activities.

Monetary policy manifests itself through the prices of various goods and assets. A price of a good is the number of dollars per unit of a good. When the growth momentum of money supply strengthens, this lifts the number of dollars paid per unit of a good generated by a particular activity — i.e., prices go up. Conversely a tighter monetary stance that slows the flow of money puts downward pressure on the prices of assets, or the prices of the goods of various activities.

A tighter monetary stance generates two things. It weakens the supply of real savings to nonproductive activities and weakens the flow of money to these activities. (Remember that real savings are diverted to bubble activities from wealth-generating activities by means of loose monetary policy.)

A diminished flow of real savings starts to undermine the existence of false activities and their solvency becomes questionable. A fall in the flow of money in turn puts downward pressure on the prices of goods of these activities. In fact, prices of goods that emanate from false activities have a tendency to fall sharply during the economic bust. This in turn reduces the flow of investors’ money to these activities. As a result the prices of the stocks of bubble activities also tends to fall sharply, which puts more pressure on these activities. (With the value of their assets falling, misdirected investments can now only secure less funding from lenders.)

In contrast, wealth-generating activities that do not need an expansion of money for their existence actually start to gain strength. A fall in the prices of their goods is likely to be less severe than that seen in the prices of the goods of bubble activities. In fact their prices may not fall at all. Remember that wealth generators are engaged in the production of goods and services that are on the highest priority list of consumers. In contrast, bubble investments are engaged in the production of goods and services that are on the low priority list of consumers.

As consumers’ real incomes fall because of the damaging effect from loose monetary policy, goods and services produced by various bubble investments may not feature at all on consumers’ priority list.

We suspect that at the moment a tighter stance from June 2004 to September 2007 is dominating the current economic scene. So-called economic growth is always assessed in terms of GDP, which is the amount of money spent on final goods and services. The pace of monetary pumping sets the rate of growth of GDP. A stronger money rate of growth tends to be followed by a stronger GDP rate of growth, while a weakening in the money rate of growth is followed by a weakening in the growth momentum of GDP.

The engine of economic growth is not money, however, but real savings. If the pool of real saving is declining or stagnating, then the economy — also in terms of GDP — will follow suit, irrespective of what the Fed is doing.

How a particular sector responds to a tighter monetary stance depends on the extent to which that sector has been infected by bubble investments. The larger the percentage of bubble activities vis-à-vis all activities in a particular sector, the more severe the effect of a tighter stance.

If the pool of real savings is still expanding, then it means that bubble investments in general do not dominate the economic scene. (They can still be dominant in a particular sector or sectors.) This means that commercial bank expansion of credit is not going to collapse and the growth momentum of money is likely to hold its ground.

However, if the pool of real savings is falling or stagnating, this could mean that bubble activities are dominating the scene, which in turn raises the likelihood that the commercial banks’ expansion of credit will come to a halt. Obviously one can always argue that the Fed could open the money spigots in a big way and flood the economy with money. There is no doubt that the Fed could do it. This does not mean, however, that banks will embark on an expansion of credit if the pool of real savings is falling.

Obviously, then, if the pool of real saving is still healthy, Bernanke’s policies might “work.” In short, after a time lag, financial markets might start zooming ahead and the real economy will follow suit. We suggest that if this were to happen, the recovery shouldn’t be attributed to Bernanke’s policies but, rather, understood to have happened despite his policies.

In the alternative scenario, to which we assign a fairly high likelihood, the pool of real savings is actually falling or stagnating. In the framework of the alternative scenario, Bernanke’s policies will only do further damage to the stock of savings and sound capital investment, and plunge the economy into a severe and prolonged crisis.

Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org. He is chief economist of M.F. Global. Send him mail and see his outstanding Mises.org Daily Articles Archive. Comment on the blog.

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