Financial Cryptography

Monetary affairs on free reign, but the horse has Boulton'd

The Fed roared into action mid July to rescue IndyMac, one of the USA's biggest banks. It's the normal story: toxic loans, payouts by the government, all accompanied by the USG moving to make matters worse. Chart of the week award goes to James Turk of Goldmoney:

One of the basic functions of a central bank is to act as the 'lender of last resort'. This facility is used to keep banks liquid during a period of distress.

For example, if a bank is experiencing a run on deposits, it will borrow from the central bank instead of trying to liquidate some of its assets to raise the cash it needs to meet its obligations. In other words, the central bank offers a 'helping hand' by providing liquidity to the bank in need.

The following chart is from the Economic Research Department of the St. Louis Federal Reserve Bank. Here is the link: http://research.stlouisfed.org/fred2/series/BORROW. This long-term chart illustrates the amount of money banks have borrowed from the Federal Reserve from 1910 to the present.

This chart proves there is truth to the adage that a picture is worth a thousand words. It's one thing to say that the present financial crisis is unprecedented, but it is something all together different to provide a picture putting real meaning to the word 'unprecedented'.

It is an understatement to say that the U.S. banking system is in uncharted territory. The Federal Reserve is providing more than just a 'helping hand'.

Also check the original so you can see the source!

The problem with the "basic function" of the poetically-named 'lender of last resort' is that it is more a theory than a working practice. Such a thing has to be proven in action before we can rely on it. Unlike insurance, the lending of last resort function rarely gets proven, so it languishes until found to be broken in our very hour of need. Sadly, that is happening now in Switerland. Over at the Economist they also surveyed the Fed's recent attempts to prove their credibility in the same game. FM & FM were bailed out, and gave the dollar holder a salutory lesson. The mortgage backers were supposed to be private:

The belief in the implicit government guarantee allowed the pair to borrow cheaply. This made their model work. They could earn more on the mortgages they bought than they paid to raise money in the markets. Had Fannie and Freddie been hedge funds, this strategy would have been known as a “carry trade”.

It also allowed Fannie and Freddie to operate with tiny amounts of capital. The two groups had core capital (as defined by their regulator) of $83.2 billion at the end of 2007 (see chart 2); this supported around $5.2 trillion of debt and guarantees, a gearing ratio of 65 to one. According to CreditSights, a research group, Fannie and Freddie were counterparties in $2.3 trillion-worth of derivative transactions, related to their hedging activities.

There is no way a private bank would be allowed to have such a highly geared balance sheet, nor would it qualify for the highest AAA credit rating. In a speech to Congress in 2004, Alan Greenspan, then the chairman of the Fed, said: “Without the expectation of government support in a crisis, such leverage would not be possible without a significantly higher cost of debt.” The likelihood of “extraordinary support” from the government is cited by Standard & Poor’s (S&P), a rating agency, in explaining its rating of the firms’ debt.

Now, we learn that FM & FM are government-sponsored enterprises, and the US is just another tottering socialist empire. OK, so the Central Bank, Treasury and Congress of the United States of America lied about the status of their subsidised housing economy. Now what? We probably would be wise to treat all other pronouncements with the skepticism due to a fundamentally flawed and now failing central monetary policy.

The illusion investors fell for was the idea that American house prices would not fall across the country. This bolstered the twins’ creditworthiness. Although the two organisations have suffered from regional busts in the past, house prices have not fallen nationally on an annual basis since Fannie was founded in 1938.

... Of course, this strategy only raises another question. Why does America need government-sponsored bodies to back the type of mortgages that were most likely to be repaid? It looks as if their core business is a solution to a non-existent problem.

Although there is an obvious benefit in paying for good times, there is an obvious downside: you have to pay it back one day, and you pay it back double big in the down times, likely with liberal doses of salt in your gaping wounds. Welcome, Angst!

We keep coming back to the same old problem in the financial field as with, say, security, which is frequently written about in this blog. So many policies eventually founder on one flawed assumption: that we believe we know how to do it right.

However, Fannie and Freddie did not stick to their knitting. In the late 1990s they moved heavily into another area: buying mortgage-backed securities issued by others (see chart 3). Again, this was a version of the carry trade: they used their cheap financing to buy higher-yielding assets.

Why did they drift from the original mission?

Because they could. Because they were paid on results. Because it was fun. Because, they could be players, they could get some of that esteemed Wall Street respect.

A thousand likely reasons, none of which are important, because the general truth here is that a subsidy will always turn around and hurt the very people who it intends to help. Washington DC's original intention of providing some nice polite subsidy would and must be warped to come around and bite them. Some day, some way.

Sometimes the mortgage companies were buying each other’s debt: turtles propping each other up. Although this boosted short-term profits, it did not seem to be part of the duo’s original mission. As Mr Greenspan remarked, these purchases “do not appear needed to supply mortgage market liquidity or to enhance capital markets in the United States”.

References to the comments of Mr Greenspan are generally to be taken as insider financial code for the real story. Apparently also of Mervyn King, yet, evidently, neither is a wizard who can repair the dam before it breaches, merely farseers who can talk about the spreading cracks.

Now, the USA housing market gets what it deserves for its hubris. The problems for the rest of us are twofold: it drags everything else in the world down as well, and it is not as if those in the Central Banks, the Congresses, the Administrations or the Peoples of the world will learn the slightest bit of wisdom over this affair. Plan on this happening again in another few decades.

If you think I jest, you might like to invest in a new book by George Selgin entitled Good Money. Birmingham Button Makers, the Royal Mint, and the Beginnings of Modern Coinage, 1775-1821

Although it has long been maintained that governments alone are fit to coin money, the story of coining during Great Britain’s Industrial Revolution disproves this conventional belief. In fact, far from proving itself capable of meeting the monetary needs of an industrializing economy, the Royal Mint presided over a cash shortage so severe that it threatened to stunt British economic growth. For several decades beginning in 1775, the Royal Mint did not strike a single copper coin. Nor did it coin much silver, thanks to official policies that undervalued that metal.

To our great and enduring depression, the lesson of currency shortage was not learnt until after well after the events of the 1930s. The story of Matthew Boulton is salutory:

Late in 1797 Matthew Boulton finally managed to land his long-hoped-for regal coining contract, a story told in chapter five, “The Boulton Copper.” Once Boulton gained his contract, other private coiners withdrew from the business, fearing that the government was now likely to suppress their coins. Although the official copper coins Boulton produced were better than the old regal copper coinage had been, and were produced in large numbers, in many respects they proved less effective at addressing the coin shortage than commercial coins had been.

Eventually Boulton took part in the reform of the Royal Mint, equipping a brand new mint building with his steam-powered coining equipment. By doing so, Boulton unwittingly contributed to his own mint’s demise, because contrary to his expectations the government reneged on its promise to let him go on supplying British copper coin.

Then, policy was a charade and promises were not to be believed. Are we any better off now?

Posted by iang at August 5, 2008 06:37 AM | TrackBack