On occasion, when you want to do something that you are not permitted to do, you can circumvent the ban by getting a stand-in to act for you. For example, a bunch of high school sophomores may want to drink beer, but none are old enough to buy it legally, so someone’s older sibling buys it for them. Problem solved, at least in the short run.
That is essentially what the Federal Reserve did Tuesday in announcing that it will loan pristine Treasury bills in exchange for soiled mortgage-backed securities. Whether it solves any real problem is another matter.
Parts of the global financial system are nearly locked up. The problem is that major banks and investment firms own dodgy mortgage-backed securities that no one else is willing to buy. Nor does anyone really know what these financial instruments are worth.
As long as the balance sheets of banks, investment banks, hedge funds, mortgage lenders and other institutions are clogged with questionable assets, they cannot make new loans to households or businesses. Many cannot even renew loans they have gotten from others. Everyone is afraid of doing business with everyone else because no one knows if a potential counterparty suddenly may go belly-up.
If only these financial institutions owned more 100 percent secure, instantly transferable T-bills instead of questionable securities backed by other questionable financial assets, their problems would disappear. Fear would drain out of markets, financial firms would do business again, businesses would be able to get bank loans or sell commercial paper and households would be able to refinance mortgages at favorable interest rates.
The problem is that these financial institutions, like pimply 16-year-olds, are not in a position to just buy what they really want. They need a stand-in, a surrogate, to do the deal for them
Enter the Fed on a white horse. The Fed can buy all the T-bills it wants and pay for them simply by creating new money. That’s what they have to do anyway to lower interest rates. Owning T-bills, they can lend them to bond dealers with whom they do business on a regular basis. The Fed won’t loan T-bills without some collateral, so it will accept ostensibly well-rated mortgage-backed bonds as security.
The bond dealers can sell or lend these T-bills to other financial institutions desperately in need of quality assets on their balance sheets. With stronger balance sheets, financial markets will begin to tick like clocks again, the economy will pick up, stock indexes will resume their upward path and even housing prices may stabilize as more households can refinance their way out of onerous mortgages. Just as for Voltaire’s Candide, “All is for the best in the best of all possible worlds.” At least that is the theory or hope.
There are, however, some reasons for skepticism. The Fed cannot give away T-bills. It is only loaning them for four-week periods. A month down the road, the borrower will have to return the bonds and take back the questionable securities put up as collateral. Or it will have to convince the Fed to roll the deal forward.
So markets have to loosen up expeditiously. But even then,once everyone gets over their panic, will those questionable mortgage securities really have value?
That is the crucial, overriding question in this whole financial crisis. Is the problem one of liquidity — a temporary disruption of financial markets engendered by fear and uncertainty? Or is it one of solvency — a situation where many assets really are worthless and the firms that own them really are bankrupt?
If it is a liquidity issue, then a central bank can supply liquidity while everyone comes to their senses. Eventually, markets can and will return to normal. Indeed, that is precisely why central banks exist, to be “lenders of last resort” keeping temporary panics from becoming long, harsh downturns.
But no central bank, including the Fed, can perform miracles. It cannot turn water into wine and it cannot transform worthless securities into valuable ones. The Fed can do nothing to cure insolvency.
The Fed lending T-bills into markets so firms can beautify their balance sheets may calm panic. Or it may be like the dodge of improving your credit score by adding the name of some friend with a good credit rating to your credit card account. You get approved for a new car loan but your underlying money problems are all still there.
Some early news reports on Tuesday’s Fed action described creative genius that will soon put things aright. Stock values certainly rose. Others see desperation on the part of a Fed that has pulled one stimulus lever after another over the past nine months to little effect. Time will tell who is right.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.