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The Fed's latest bailout

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Wednesday, Mar 12, 2008

Lost in the Spitzer hullabaloo was the Fed’s announcement that it would lend $236 billion to banks by swapping Treasurys for a variety of dubious mortgage-backed securities, from Fannie and Freddie and ones cooked up by private investment banks, that no one else wants to buy. (There is a distinct absence of fools in the marketplace, apparently.) This move had the immediate effect of sending the stock market soaring, but it also may have made the once-unthinkable notion that the U.S. government will default on some of its loans a bit more thinkable.

Still, you may be thinking, So what? A governor was caught with hookers, for god’s sake. Why should I care about this?

Maybe because it means the government is throwing taxpayer money at bad bankers.

CEPR economist Dean Baker offers this explanation:

Suppose that it was suddenly discovered that much of the wealth held by the country’s leading financial institutions was in fact counterfeit. Instead of having hundreds of billions of dollars of real currency in their vaults, institutions like Citigroup, Merrill Lynch, and Bears Stearns actually had hundreds of billions of dollars of counterfeit currency. ...
In response to this situation the Fed today announced that it would lend $200 billion to banks and other financial firms, accepting mortgage backed securities as collateral. This is effectively the same as saying that the Fed is going to lend money to banks and accept the counterfeit currency as collateral, treating it just as though it were real money.
The intended effect of this policy is to convince other investors that the counterfeit currency is in fact real currency, or at the very least that there is a really huge sucker out there (the Fed) which is prepared to treat the counterfeit currency as real currency.
So how does this story play out? Well, insofar as the Fed is successful, the counterfeit currency retains its value for a while longer. This allows Citigroup, Merrill Lynch, Bears Stearns and the rest of the big boys more time to dump their counterfeit currency on suckers who haven’t figured out how the game is played.
It is possible that they won’t be able to find enough suckers, in which case these banks will end up defaulting on their loans and the Fed (i.e. the government ) has lost tens or hundreds of billions dollars paying good money for counterfeit currency. Alternatively, perhaps the big boys are successful and can offload enough of their counterfeit money to restore themselves to solvency before the music stops. Then the Fed is repaid, but the counterfeit money now sits in the hands of other, less informed, or less inside, investors.

In a separate post, he elaborates the consequences of this:

As I’ve written way too many times, the Fed’s actions are keeping banks from having to write down large losses and quite likely go into bankruptcy. The result is that the bank executives, whose inept management pushed them into bankruptcy, get to keep their jobs and their salaries, which run into the tens of millions a year. Stockholders will also have more time to unload their stock before the day of reckoning, and the banks themselves may be able to unload some of their junk if they find enough suckers. With luck, they may even be able to survive the collapse of the housing bubble.
Does this bail out the rest of us? Why should any of us who are not top management at Citigroup, or major shareholders, care if it goes into receivership like Northern Rock did in England? The bank’s operations will still continue. Those who have deposits there will still be able to get their money. The only difference is that there will be new management, the stockholders will have lost their money, and the bank would more quickly come clean on its bad debts.
Does the bailout do anything for the tens of millions of homeowners who have seen their life savings disappear because house prices collapsed—in spite of the fact that all the experts said house prices never fall? How about the families who are now tapping their retirement accounts in a desperate effort to prevent foreclosure, is the Fed bailing them out?

I’m guessing the answer to that is no.

Instead, the Fed seems to be hoping that the inflation that will ensue from its various policy actions will allow the housing market to clear without nominal prices having to drop, eradicating the problem of home prices being sticky (i.e., homeowners refusing to accept the reality that their houses are worth less than they once were). Writes Martin Wolf in today’s FT:

There are two ways of adjusting the prices of housing to incomes: allow nominal prices to fall or raise nominal incomes. The former means mass bankruptcy and a huge fiscal bail out; the latter imposes the inflation tax. In extreme circumstances inflation must be attractive. Even if it is not the Fed’s choice, it is what a reasonable outsider might fear, with obvious consequences for all asset prices.

Thus everything else in our lives will become more expensive, whether we have homes whose value we are worried about or not. The “inflation tax” he mentions—the bite out of our income, which doesn’t have this kind of inflation expectation worked into annual raises, if we are lucky enough to get them—is extremely regressive.

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