Sunday, December 16, 2007

"I Know Nothing", Sergeant Schultz as Economist

"The financial crisis of 2007 is bringing out the creative side of the world's central bankers. ... Central bankers are extremely conservative people. ... Their first rule is to do no harm. ... After improving for several months, the banks are swooning again. ... Simply stated, the problem is that the banks are unwilling to lend for anything more than a few days. ... Clearly, they were worried about the quality of the assets on the balance sheets of the potential borrowers. My guess is that banks were having enough trouble figuring out the value of the things they owned, so they figure that other banks must be having the same problems. The result has been paralysis in the inter-bank lending markets. ... And, as I will discuss in a moment, non-US banks faced an added problem--they could not get dollars. ... Everyone has described the current environment as a crisis. ... The discount lending rate is supposed to put a cap on the federal funds rate in the interbank market. ... Today we have the new problem that dollars are in short supply outside of the United States. ... Okay, so what exactly is the Fed trying to do here? ... To understand why [the Fed is] doing this, we need to think about the fact that the central bank can use operations to either change the size of its balance sheet or the composition of the assets that [it holds]. ... This new mechanism is aimed at shifting assets from US Treasury securities ... to some of the lower quality stuff that is accepted as collateral for discount loans. ... I simply note here that in a crisis it can become almost impossible to distinguish illiquidity from insolvency", Stephen Cecchetti (SC) at, 16 December.

"On Wednesday, the Fed said it was teaming up with four other central banks, including the European Union's, in a scheme to inject capital into the market more broadly than it can through short-term loans at the discount window. ... You may wonder what Bernanke & Co. will take as collateral from banks for this handsome handout--pretty much anything a bank has in its vault short of the old electric typewriter and the battered desk chair with one brokern wheel. ... The Fed also will accept as collateral triple-A-rated [CDOs] and mortgage securities. In fact, it's willing to lend up to 98 percent of the face value of the notes. ... Will the Fed lose money on this? Probably, but that's how bailouts work. The government assumes the risk, and often the losses , when others can't. ... In fairness, the Fed is merely doing its job. Its mission calls for it to safeguard the integrity of our financial markets. To do that, the Fed is basically letting banks know it will shoulder any toxic debt they're holding on their balance sheets", Loren Steffy (LS) at, 14 December.

Uh, oh. Beware central bankers being "creative". Learn from the Trojans, beware central bankers bearing "new anything". See my 28 November post. "Their first rule is to do no harm"? To whom? What about Hjalmar Schacht, a German Reichsbank director in 1922-23? No, SC, the problem is: the banks believe other banks are insolvent and lack good assets to use as collateral. "Dollars are in short supply outside of the United States", SC writes. Really? Communist China has $1.4 trillion in foreign exchange reserves as does Japan. SC, read the newspapers. It is almost always impossible to "distinguish illiquidity from insolvency". Again, many posts are nonsense. We can learn one thing from SC's piece: the banks are in much worse condition than anyone will publicly admit.

Yves Smith (YS) at, 13 and 16 December was comfortable with the new Fed Term Auction Facility (TAF). To YS's credit, he refers and provides a link to a 16 December post by Steve Waldman (SW) at critical of the TAF and YS's analysis. I think SW's got this knocked as does LS. I finally understand my problem with the rating agencies. It's the product of a typing error. When the rating agencies are supposedly rating something "triple-A", what they mean to say is "tripe-A". Now I get it.

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