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On the Goldman Sachs client call last week, we heard ex-Fed governor Larry Meyer intone that the Fed intended to stop the credit bubble collapse using the discount window in new and creative ways, providing liquidity selectively without lowering the Fed funds rate and flushing the whole system with money, Greenspan-style.
We have long wondered how the Bernanke Fed planned to fight an asset price deflation. As expressed in No Deflation. Disinflation followed by lots of inflation, we heard the Fed saying it planned to fight asset price deflation using every trick in the book, and then a few that aren't in the book.
Now we appear to have our answer, or at least a good part of it. What the Bernanke Fed has for the past few weeks been trying to do is prevent a runaway asset price deflation, keep the banking system whole, and at the same time not create a moral hazard by bailing out speculators who should be allowed to fail, all without producing excess liquidity that will lead to another set of asset bubbles.
Here's the Fed's program.
Federal Reserve Bank of New York Staff Reports
Rediscounting under Aggregate Risk with Moral Hazard - Staff Report no. 296 - August 2007
James T. E. Chapman and Antoine Martin
This paper presents preliminary findings and is being distributed to economists and other interested readers solely to stimulate discussion and elicit comments. The views expressed in the paper are those of the authors and are not necessarily reflective of views at the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.
What is says is that there will be no Fed Funds rate cut in response to the credit bubble collapse. The easy money Greenspan Fed put is gone. Welcome to the Open Market Operations Fed or OMOF. It's motto: Liquidity Without Asset Price Inflation.Rediscounting under Aggregate Risk with Moral Hazard - Staff Report no. 296 - August 2007
James T. E. Chapman and Antoine Martin
This paper presents preliminary findings and is being distributed to economists and other interested readers solely to stimulate discussion and elicit comments. The views expressed in the paper are those of the authors and are not necessarily reflective of views at the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.
Mechanically, here's how it works. The Fed will only do business directly with banks that maintained good loan practices and are the most credit-worthy. Lenders of various flavors such as investment banks and hedge funds that took on a lot of bad loans can only deal with the banks that deal directly with the Fed. They do not have access to the new and improved discount window on their own. The credit-worthy banks can use the weak creditors' assets as collateral to borrow from the Fed.
For example, a distressed hedge fund can't access the Fed directly but can take the mortgage-backed securities they hold and bring them to a credit-worthy bank that does have access to the Fed. That bank uses the paper as collateral for a one month loan. That's why Bank of America, Wachovia, Citigroup, and JP Morgan all hit up the discount window at the same time, each for the same $500 million amount yesterday, to let hedge funds and others know where to go to put up their asset backed securities and CDOs and other paper as collateral for loans. The banks borrow from the Fed, and the hedge funds borrow from the banks. Hedge funds and others can still fail, but in an orderly way versus a simultaneous dumping of assets into a frozen market. The Fed can turn the discount window knob as need to control the rate of failure, averting the dreaded "break in the chain of payments."
While its too early to call an all-clear on the debt deflation at the top of the debt pyramid, evidence is that this new system is working–so far. Even the secondary market in CDOs is opening up, as we heard from a company that structures them that contacted us yesterday. While these events are not definitive, we will use the occasion to invite our respected friends Mish and Rick Ackerman, who were expecting at this point in the process an uncontrolled deflation, to come over the dark side, the one that acknowledges that central banks have a big bag of tricks to fight asset price deflation. C'mon down, boys!
Of course, there are still plenty of signs that the debt default danger is far from over, even at the top where cures can be targeted and the crisis is thus more readily managed. iTuliper Charles Mackay posted this note today from Justin Oliver at Canaccord Adams:
The unprecedented spread between US TBill and LIBOR rates is suggesting a heretofore unseen attack on the global financial system. There is clearly something going on that the large banks are privy to, that we are not as they are clearly not willing to lend to each other without a massive risk premium. It is inconceivable that equities can continue to trade relatively unaffected by a complete backing up of the credit markets.
For now the new OMOF approach appears to be succeeding, but it is far too early to say whether this approach, while very clever, will ultimately allow $13 trillion in fictitious value in the housing market dissipate without causing significant damage to either the credit markets or economy. There remain millions of homeowners underwater on their mortgages.Today iTulip's recently appointed new ShadowFed Chairman Finster discusses Bill Gross's appeal today to the Bush administration to bail out homeowners for prevent a "destructive housing deflation."
Pimco's Gross Urges Bush to Bail Out U.S. Homeowners... with taxpayer money
Today Bloomberg published the following report.
If Gross is asking, clearly at the street level a bailout is needed that the OMOF system will not address.Today Bloomberg published the following report.
Pimco's Gross Urges Bush to Bail Out U.S. Homeowners
By Patricia Kuo
Aug. 23 (Bloomberg) -- Bill Gross, manager of the world's biggest bond fund at Pacific Investment Management Co., urged the Bush administration, rather than the Federal Reserve, to bail out U.S. homeowners to avoid ``destructive housing deflation.''
Let’s dig into this a little bit.By Patricia Kuo
Aug. 23 (Bloomberg) -- Bill Gross, manager of the world's biggest bond fund at Pacific Investment Management Co., urged the Bush administration, rather than the Federal Reserve, to bail out U.S. homeowners to avoid ``destructive housing deflation.''
Pimco's Gross Urges Bush to Bail Out U.S. Homeowners
No, Bill. Bush doesn’t have that kind of money.Gross advised President George W. Bush to set up a ``Reconstruction Mortgage Corporation'' and ``write some checks'' to bail out homeowners
Oh … I see. You want Bush to use MY money. How generous of you. more...What are the implications of OMOF for the equity markets? Short term negative, and long term negative.
Short term, markets have priced in at least one rate cut. If it's needed, that's because the U.S. economy has fallen into recession; the drop in primary demand that is now pushing down oil prices has created self-reinforcing recessionary processes in the economy. Long term, markets have already priced in a Next Bubble, as if Greenspan were still in charge. Markets are still digesting this new evidence that the new Fed chair who rode in on a helicopter full of money turns out to be the first asset inflation fighter we've seen in over 20 years.
He talks dove and acts the hawk. What does this mean long term? We don't know yet. But it looks like our expectations of creative asset deflation management were well founded. And, as usual, you heard it here first.
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