On Friday, the Financial Times reported Central Banks Float Rescue Ideas. The article states that central banks are considering plans involving the purchase of worthless or nearly worthless mortgage-backed securities from banks. Shortly afterwards, Reuters reported Bank of England denies mortgage purchase plan.
The FT writes,
Such a move would involve the use of public funds to shore up the market in a key financial instrument and restore confidence by ending the current vicious circle of forced sales, falling prices, and weakening balance sheets.
The conversations, part of a broader exchange as to possible future steps in battling financial turmoil, are at an early stage. However, that such a move is being discussed at all indicates the depth of concern that exists over the health of the banking system.
It shows how far the policy debate has shifted in recent weeks as the crisis has spread to prime mortgage assets in the US and engulfed Bear Stearns, the investment bank.
Sun 5pm PST, this just in:
Economist Forecasts Central Bank Action
Central banks and governments in advanced economies will be forced to buy mortgage-backed securities within the next few months to stop the credit crisis, according to a former chief economist of the European Bank for Reconstruction and Development.
“Central banks will be managers for years to come of rather interesting portfolios,” predicted Professor Willem Buiter of the London School of Economics, as the Federal Reserve and the Bank of England sought to play down conversations officials have had regarding purchases of mortgage-related assets.
The Financial Times reported on Saturday that conversations had taken place concerning such plans, as part of a broader, early-stage exchange as to possible future steps in battling financial turmoil.
But why does falling asset prices constitute a “vicious circle”? Do falling prices of cars, computers, or airline tickets constitute a problem? What’s wrong with someone getting a good deal? For the holders of assets, yes, but if you are an investor (such as Warren Buffett) looking to buy assets cheaply, falling asset prices are an opportunity. If some institutions who have excessively leveraged themselves become insolvent, the underlying real factors continue to exist. The financial assets are only paper claims to real things (or in some cases paper claims to nothing). If the banks that holding paper assets goes bankrupt, society as a whole has no fewer productive factors. Only the ownership of these assets changes. How could this lead to destructive macro-economic effects?
The reason is that the same institutions that buy the assets create the money with which to purchase them, out of nothing, a process that Charles Holt Carroll called the organization of debt into currency. As Carroll perceptively wrote in the late 1800s:
When the creditors demand their money, its debtors are called upon to pay money the bank never loaned, never had to loan, and necessarily has not on hand to meet is running demand liabilities: then comes the crisis that many writers call a “panic.” It is such a panic as the wasted sufferer feels whose lungs are losing their power of inflation; it is no panic; it is the inevitable crisis of death.
When loans that were made out of fictitious currency default, the money that created the loan is destroyed. When the supply of money contracts (deflation), there is downward pressure on all prices, including the prices of other assets, and on the incomes of the underlying entities that create the ability to pay back other debts. There is a tendency, then, for the contagion to spread from bank to bank as debt defaults destroy money, and money destruction causes more debt defaults. That is why the unraveling of the credit bubble threatens to bring down the entire financial system.
As Carroll wrote:
Contraction may begin it, but the positive and negative poles of the scheme will very soon change places. When bank accommodation fails, bankruptcy comes into play, soon takes the lead, and one tumbler here and there knocks down a whole line, until the securities, against which the deposits stand, fall, and the deposits with them. Banks being pressed with their notes must redeem them, and avail themselves of their securities in the hands of the Comptroller to purchase greenbacks or specie.
and
But when any such scheme shall be put in operation, its two forces or elements, so to speak, will immediately change places. It will not long be the contraction of the currency that will cause the bankruptcy, but the bankruptcy that will contract the currency.
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Why not just let any borrower with a problem mortgage borrow at 2.25% at the Fed window and post their houses as collateral?
They could then pay off their mortgages and the problem MBS’s would just prepay and go away. This may seem stupid, but is it any more stupid than what is being proposed at the moment?
Much has been written in the FT and weekend press – suggesting the BOE is willing to subsidise banks by taking on the banks’ poor credit risks.
This creates a situation where:
Heads (i.e. profits) – shareholders win
Tails (i.e. losses) – the taxpayer bails out the bank
Surely the right answer is that the banks should raise more capital through rights issues to their shareholders?
Why does the press not see this?????
Ian.
Very sadly the article omits the effect of political intervention in the process which means nonsensical policy making and the tax payer subsidisation of failed managements
In the U.K. this has produced the curious scenario of a major U.K bank proclaiming itself awash with money on Wednesday but aghast on Thursday when offered only a fifth of the money it needs to survive at the taxpayers expense.
The prospect of the taxpayer being saddled with worthless “assets” in order for the bankers to continue their seven figure salaried existence is economically irrational
The reason for the special treatment of the banking subsidy gobblers is not unrelated to examination of the post political careers of virtually all modern politicians
several things should happen here:
1. I agree with Ian that banks should issue new equity to recapitalise their balance sheets.
2. In the US regulators/banks should revisit the huge bonuses paid to their traders and staff over the last year. There is a very clear conflict of interests which I think has clearly incentivised staff into effectively busting their employers in order to earn huge bonuses. Banks should have a view to recovering the same bonuses where it can be demonstrated that any abuses of these conflicts of interests have occurred.
3. Unwinding of cdos. These cdos should be unwound back to their constituent mortgages and the good peforming loans sold on to say Fannie Mae whereas the bad loans are put into a “loan dump” and collected in from there. The good loans would not then be tarred with the same brush as the bad ones and the funds raised from their sale to FM could be returned to the banks and investors holding the CDO paper as a partial repayment. This would help turn the CDOs partly into cash from the good loans contained therein and the banks/investors would receive shares or units in the central “loan dump” which would relate to the individual bad loans contained in the CDOs repayable at a future date, pending collection. This would result in some liquidity being released from an investment that is currently an unknown quantity, but would not create a moral hazard as the banks/investors would still take losses on the bad parts.
4. One big problem in the US is that unlike in the UK most mortgages are non recourse. So in the event that a property is repossessed and sold for less than the mortgage balance owed, the lender cannot pursue the borrower for the balance. This is now a big problem because due to this, prime borrowers who bought with 100% financing at the peak can hand the keys back to their lender and just walk away from property once prices start to fall leaving the lender to take any resultant losses. This just compounds an already difficult problem.
The problem as I see it is Runs VERY deep and lies in the “sins of the past” if you will in the US Mortgage market.
I hear the arnts that “Why should the government (and the taxpayer) bail out the banks or the borrowers on these loans? Why should the Governement get involved?”
The answer is Simple – The Government IS and has been involved from day one… Fannie & Freddie are the largest purchaser of Mortgages from lenders. They set the standards, acceptable default ratios and Played the Music that the lenders danced to the entire time.
What most people do NOT understand is that The Largest lenders in the US – Made loans to the borrower, packaged them in huge loan pools (based on purchase criteria set by the Government Agencies) and then sold these loan pools off for the face value PLUS a small percentage to the END BUYER – Fannie and Freddie.
For example: Countrywide would have brokers all over the US Selling loans to Borrowers and getting paid by the borrower in the form of fees and then would package these into Lets say an $800,000,000 pool of loans. They would then sell these to FNMA and get paid the $800,000,000 + .05% ($400,000) and would then start the cycle over.
In short it’s simple basic economics – The Government was the buyer and created the market. The taxpayer will suffer the loss either way and it is in the short term & long term benefit of the taxpayer to minimize the deflation of those assets.
If those assets are worthless AND are also introduced to the market for open sale the blow to EVERYONE will be two fold.
IF a plan is implemented that “bails out” the borrower, allows an opportunity to ‘eventually’ recoup the losses and payments are made to the ‘entity’, keeps homeowners in their homes and KEEPS these homes off the market my belief is that HAS to be done Post HASTE.
This really goes against everything I believe in a typical situation as I am a pure capitalist at heart and oppose Government involvement in markets and business in almost any and every form.
We, however, have already crossed that bridge with the initial involvement of Fannie and Freddie –
NOW that the mess has been made the ONLY way that I truly see to clean it up is a bail out that involves:
Loan Modification for the borrower, Purchase of HUGE LOAN POOLS (Hopefully with a Checks and Balance system) Perhaps a 1 time offer to the Lenders that have survived – “We will buy your loan pools on the following terms – Pay PAR and 1 A+ loan for Every C loan or worse in the pool”, System to remove and prevent the Government from repeating the same mistakes INCLUDING a permanent withdrawal from involvement and purchasing loans on the secondary market.
Either that or prepare for the “Tent Cities” that will be developing shortly ala “The Great Depression” and the associated Crime, Illness, etc.
“Either that [government bailouts] or prepare for the “Tent Cities” that will be developing shortly ala “The Great Depression” and the associated Crime, Illness, etc.”
But surely you are aware that the the government DID intervene massively in the markets in the 1930s, in the attempt to “do something”, and these interventions were complete failures which greatly exacerbated the economic problems, and inevitably led to the tent cities and soup kitchens.
If government bailouts, relief payments, make-work projects, price floors, etc. were a viable solution then the Great Depression would have lasted no more than a couple of years.
Since George_Reisman’s article isn’t appearing on the blog, except when I choose to view March 08 archives (can anyone even count the ways the site is screwy now?), I’m going to post this in the nearest relevant topic:
In the process, the triple-A rated securities that turned out to be junk served to confirm the old truth that lead cannot be turned into gold: the alleged triple-A securities were backed by collections of mortgages that in the last analysis consisted largely or even entirely of subprimes.
A lot of people say this, but it’s quite frankly ridiculous. Yes, *this specific method* of forming the securities did not warrant a AAA rating. But you can’t make George_Reisman’s larger claim (a claim repeated often) that it’s impossible to legitimately make a AAA security of subprime mortgages. For example: if I bundle up, say, the subprimes that were actually made, ’04-’07, and created a bondholder class that had a claim on the first 5% of the owed payment stream, that would be a legitimate AAA bond.
Why? Because it would be extremely unlikely for 5% of the debt, in the aggregagte, to be unrecoverable. The problem in how the CDOs and MBSes were structured is that they made the AAA class lay claim to something like the first 60% of the payment stream, which does NOT have the same low repayment risk that a GE secured bond has.
But yes, it absolutely is possible to form a AAA security from subprime mortgages, and outright dismissing the concept just shows ignorance.
Ohhh Henry is right – the idea that we have to save the system now that it is going down will only serve to harm it even more.
Better pain now than a whole lot more down the line. To really ‘save’ the system, we are talking many trillions of dollars just in the difference between all of the mortgage backed securities floating around and the houses they represent.
If you start talking about derivatives, on the other hand… it may be many trillion more. Bailing out losses of this kind would absolutely destroy the dollar. But it seems to be the path the Federal Reserve is currently walking down.
Bailing out anyone, be it investment banks, regular banks, hedge funds, prior flippers, or home’owners’, will create moral hazard – they will piss away even more money than they would if allowed to fail now.
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