Messing around with credit

Each time Ben comes out to speak these days I open my drawer to reach for a glass of scotch. Not that I keep a bottle of scotch in my drawer… I’m just saying… that’s what I’d do if I had one.

So here is what gets me flustered.. Credit markets are broke, so the guy sets up all these liquidity facilities—the TAF, TSLF, PDCF or (my favorite acronym) the ABCPMMMF . Great! I mean, slow, piecemeal, reactive but still.. At least banks now have access to all the dollars they need to finance their day-to-day business, including (you would think) lending to the private sector.

But things remain broke, so then Ben comes up with the CPFF and the TALF. Even better… Now the Fed has the infrastructure to lend to the non-financial private sector, so long as financial markets refuse to do so, and thus keep the flow of new credit to creditworthy borrowers.

What I have trouble with is the Fed’s program to purchase Fannie and Freddie debt and mortgage-backed securities (MBS)… and Ben’s stated motivation behind it: “…to provide support to the mortgage and housing markets.” (from today’s FOMC statement).

Here is my problem… problemS rather: First the MBS purchases are intended to support the mortgage and housing markets by trying to directly affect the yields of MBS (and, by extension, of mortgages). That surely can’t work in a sustainable way unless (1) you address the imbalances in the housing market; and (2) you fix the balance sheets of mortgage providers so that they can actually afford to make new loans.

You can fix (1) by letting the private sector work its way through the imbalances. Unfortunately, this means letting house prices fall further, so long as valuations warrant it. Now, if you, government, actually want to do something, you could help prevent prices from undershooting… e.g. with schemes to stem foreclosures and avoid additional supply coming on the market. But as long housing remains overvalued, supporting house prices through artificially low mortgage yields is not sustainable, nor even desirable.

When it comes to banks’ balance sheets, you know my story already… You can fix those by taking steps to directly alleviate the pressures both on the asset side (carving out the toxic stuff) and on the liability side (refilling the hole in their capital). But buying MBS won’t do the job unless it’s part of a bigger plan to deal with this problem—in which case the program should be designed accordingly.

So I said problemS. Here is my #2: With the MBS purchase program in its current form, Ben is messing around with credit allocation. I mean, why pick housing over other credit markets? Like, investment grade firms or even high-yield corporate bonds? If anything, American firms on aggregate are far less indebted than American households! And they could actually use the money to produce stuff.

No, no “corporate elitism” intended. I’m just baffled by the intention to support more household debt, when such over-indebtedness was what caused our problems in the first place! Especially when the support comes from the Fed, of all institutions, which has been insisting for years that it should not be in the business of credit allocation!

Finally my third problem: Unlike the Fed’s other facilities, most of which have been established under the premise of “exigent conditions,” and will be law or by design be allowed to expire once conditions normalize; the Fed can hold its agency MBS and Treasuries as long as it pleases.

Some have feared that this could bind Ben’s hands when it comes to absorbing all the excess money floating around, once conditions normalize… with the concomitant threat of inflation. But that’s not the problem: The Fed has the ability to control monetary conditions, no matter the size of its MBS holdings, by virtue of its recently-established authority to pay interest on bank reserves.

What one may question though is the Fed’s willingness to do so. Nothing personal, Ben, it’s just that the track record of the Fed in this respect has been arguably undermined by its actions in the not-so-distant past.

So I’ll go back to the very same call, again: Let’s see whatever MBS purchases occurring in the context of purchases of a broader set of (toxic/troubled) assets, aimed at bringing back the financial sector to a healthy footing. Let’s see all of that being managed by a Structure Investment Vehicle (SIV), financed by the Treasury/Fed but acting independently from them, including from the monetary policy process. And let’s set as an explicit mandate for this SIV to maximize profits for the taxpayer!

So, Scotch anyone?


Originally published at the Models & Agents blog and reproduced here with the author’s permission.