Wednesday, November 26, 2008

Bring it on

I can’t help entertaining the idea that Ben has been reading my blog.

No sooner than I challenged the size of his “cojones” (pardon my Spanish), do we get a commitment by the Fed to buy $600 billion worth of Fannie and Freddie debt and mortgages and another $200 billion to finance private purchases of other asset backed securities (ABS).

Talk about instant gratification! I mean, I’m now tempted to post a piece calling for the Fed to finance ABS backed by Caribbean vacation loans to, urh, myself, my pet iguana and maybe those poor investment bankers who suddenly have to live with government restrictions on executive pay.

But I won’t. Instead, I would like to hail the Fed’s decision as a (significant) step in the right direction—the endpoint of which should be an unclogged, clean and well-capitalized system of competitive, “survivor” banks. So what’s missing?

A number of things. First, a clear communication about the endgame. For example, I just gave above the Chevelle version of “an” endgame, but it would be a tad more helpful if Ben offered his. I’m sure we concur, of course, but it would be nice to hear it.

In fact, it would be nice to hear that the Fed (and the Treasury) finally have a sense of the true size of the problem, the size of government intervention needed, and the timeframe they envisage for the clean-up. Else, we remain with a discomforting feeling of ad hocness, which can’t be good.

Second, call me greedy but I personally wonder whether the $200 billion facility (named TALF) available for the ABS is enough for whetting private appetite for that market. This is a market which, at its peak, was producing $1.2 trillion of securities annually—the bulk of which likely still lies, in carcass form, in the books of banks, hedge funds or even the pension plans of Belgian grandmas, waiting for a buyer.

A related issue is the credit rating. Under the TALF, the Fed can only accept triple-A rated ABS as collateral for the loans it will offer—presumably with the interest of taxpayers (like you and me) in mind. But what about the lower-quality ABS? Who will remove those carcasses from banks’ books? Any hope that the Fed’s financing of the AAAs might free up private capital for the other stuff is likely wishful thinking.

You can get a taste of that by looking at the commercial paper (CP) market: While the yields on the highly-rate CP declined substantially after the Fed got into that market, the yields of lower-rated companies diverged higher. So, with all due respect to the American taxpayer, we may well have to go for a Bigger and Braver TALF, and some Fed guidance on this would help.

Third, let’s go back to the desired endgame: A clean, well-capitalized system of “survivor” banks—by which I mean that the Fed’s (and Treasury’s) facilities should, well, “facilitate” the extinction of the weak. Unfortunately, this process may have to involve some non-meritocratic picking of survivors, based primarily on the too-big-to-fail principle.

Such a process is already happening, by the way, by virtue of the government’s Capital Purchase Program which has been injecting capital in financial institutions of (its) choice. No, not because they are the most “deserving,” but because they are the most “systemic.” Cruel? Yes. Unfair? Perhaps. But, in a world of limited resources, that’s life.

As to what's missing on this front, it's basically still unclear how prepared the government is for dealing with more bank failures, which are bound to (and should) occur. I mean, you would expect that after the Nth failed institution to have gotten it straight, no? Yet, the hasty and ad hoc resolution of the Citi case, after the company's stock collapsed to the level of a Starbucks latte, gave the inevitable impression that these guys are still experimenting.

Finally… To those who bombarded me with emails of outrage in the aftermath of my proposal of a Big Bang Fed intervention: If you want to go ideological, bring it on, though let’s pick a more appropriate forum, like the Journal of the Collective Contemplation of a Laissez-Faire Utopia, to which I've been dying to become a regular contributor.

But when it comes to policy, and our sorry state of affairs, let’s face it: We screwed up on the way up, let us not screw up on the way down too!

Glossary: Asset backed securities, commercial paper, structured investment vehicle, survivor

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