TARP was successful

[ThePythonicCow]

Re: TARP was successful

When the Fed prints money, it does not add to the public debt.

Fed monetizing might not add to total debt, but it can convert debt, from some banks's off-balance sheet crap that should have defaulted, to Treasury, Fannie and Freddie debt that will be harder to default.

If you (playing the role of a bank here) have an IOU from my worthless, no-good uncle for $1000, and Mr. Bernanke exchanges that for a T-Bill worth $1000, then total nominal debt has not increased, but the total real, fair market value debt on the U.S. Treasury has increased, by about $999, that being the $1000 nominal value, minus the $1 they might expect to extract from my uncle.

[ASH]

Re: TARP was successful

Fed monetizing might not add to total debt, but it can convert debt, from some banks's off-balance sheet crap that should have defaulted, to Treasury, Fannie and Freddie debt that will be harder to default.

If you (playing the role of a bank here) have an IOU from my worthless, no-good uncle for $1000, and Mr. Bernanke exchanges that for a T-Bill worth $1000, then total nominal debt has not increased, but the total real, fair market value debt on the U.S. Treasury has increased, by about $999, that being the $1000 nominal value, minus the $1 they might expect to extract from my uncle.

The Fed ain't paying anyone in Treasury bonds. Bernanke will pay me $1000 in reserve deposits at the Fed. But I guess you're talking about later using those reserves to buy a Treasury bond when the Fed is selling.

I don't think that round trip operation changes the fair market value of the Treasury's debt (except, of course, through the impact on the money supply, which tends to reduce the 'real' value of the Treasury's debt). It does change the fair market value of the assets held by the bank that gets to exchange its crap for a Treasury bond; but of course, the same change in value is also accomplished as soon as the bank sells its bad asset to the Fed for reserves. Adding the detail of later buying Treasury bonds from the Fed doesn't seem to change anything substantive, to my mind.

[tsetsefly]

Re: TARP was successful

When the Fed prints money, it does not add to the public debt. The difference is that when the Fed "prints" money, it is purchasing an existing asset, whereas in the more familiar case of a commercial bank creating credit, the "asset" that balances the new credit is a new debt. In terms of double-entry bookkeeping, when a commercial bank creates money by extending credit to a borrower, the double entry consists of the credit extended to the borrower and the balancing debt held by the bank. But when the Fed prints money to monetize an asset, the double entry consists of the reserve credit extended to the seller (a bank) and the balancing asset held by the Fed. Although the assets purchased by the Fed are generally debt instruments (traditionally Treasurys, but more recently mortgage-backed securities as well), monetization of these assets by the Fed does not create any new debt in the system. Rather, the debt was created by the US government at an earlier point when it originally sold the bonds, or by the pool of borrowers who originally took out mortgages. Thus, the debt held by the Fed after printing money to buy said assets would already be in the system, regardless of whether the Fed purchased it or not.

Technically, the money created by the Fed is a liability of the Federal Reserve and an obligation of the United State government. But the sense in which a federal reserve note is a "liability" of the Fed, is that you can exchange such notes for assets held on the Federal Reserve's balance sheet... assuming they're selling. The sense in which a FRN is an obligation of the US government is more-or-less meaningless: "They shall be redeemed in lawful money on demand at the Treasury Department of the United States, in the city of Washington, District of Columbia, or at any Federal Reserve bank." Well, since the slips of paper in question are "lawful" money, that doesn't really mean much anymore. Of course, the US government is also obligated to accept such notes as payment for debts you owe to the government, and is obliged to force others to accept such notes as payment for private debts.

Anyway, the sort of "obligations" that the Fed prints don't have the same implications for the taxpayer as the obligations the Treasury takes on by selling bonds. In fact, when the Fed prints money to buy Treasury bonds, it returns the interest paid on the Treasurys by the taxpayer to the taxpayer, less the cost of running the Fed. The same goes for MBS. So when the Fed prints money to buy a Treasury bond held by, say, Goldman Sachs, what happens is that the American taxpayer stops paying interest to Goldman Sachs, and instead gets most of the interest payments refunded by the Fed. See this article, for instance, about how the Fed made ~$45B last year, and refunded most of it to the American people.

This isn't to say I'm in love with the Fed, or the policy response to the crisis -- nor do I think that the approach taken is free of negative consequences. But I do think if we're going to hate on the Fed and Treasury, it is important to understand the details of what they actually did, and how it impacts us as taxpayers. (This isn't directed at you in particular, DtoM67, but is meant as a general plea for more wonkish wrath.) It could have been better, but it could have been worse. Personally, I'd rather the Fed monetize a bunch of MBS and kick back what interest they do collect to me, rather than the Treasury borrow money to buy a bunch of MBS... sticking me with a wasting asset AND interest payments.

I dont see how there cannot be more negative consequences than just inflation. And I might need some clarification on this but:
If the fed is monetizing these assets, its basically buying them off the banks?
This takes the liability away from the banks and the fed will obviously not pay that debt(as I understand it). But it is still there? Someone aside form the taxpayers is losing in this equation. I dont see how the fed can use vodoo finance to make it go away?

[ThePythonicCow]

Re: TARP was successful

Adding the detail of later buying Treasury bonds from the Fed doesn't seem to change anything substantive, to my mind.

It changes something very substantive in my mind; it adds to the public debt. Recall that I was responding to your claim that this did not add to the public debt.

Before the shell game, a bank has a toxic debt nominally valued at $1000 but really worth about nothing.

After the shell game, you, me, and our descendants owe the bank $1000 plus interest.

I was trying to look past the double entry bookkeeping details of any particular transaction in this sequence and look instead to the overall affect.

[ThePythonicCow]

Re: TARP was successful

After the shell game, you, me, and our descendants owe the bank $1000 plus interest.

As Li Xiangyang writes in the China Daily, quoted on ZeroHedge at The Empire Strikes Back: China Daily Warns About Currency War, Blames Dollar, and in turn linked from iTulip by Mega at China declares WAR!:

A great amount of bad debts of American financial institutions have been converted to government debt through government aid measures.

[ASH]

Re: TARP was successful

I dont see how there cannot be more negative consequences than just inflation. And I might need some clarification on this but:
If the fed is monetizing these assets, its basically buying them off the banks?
This takes the liability away from the banks and the fed will obviously not pay that debt(as I understand it). But it is still there? Someone aside form the taxpayers is losing in this equation. I dont see how the fed can use vodoo finance to make it go away?

So, the debt in question might be mortgages that got bundled into MBS, and ultimately sold to the Fed for printed money. That is a debt owed by private individuals -- from the standpoint of either a private bank or the Fed, the mortgages are an asset, not a debt. When borrowers default, that destroys the debt.

The problem addressed by the Fed monetizing MBS is not exactly a debt problem, but rather a balance sheet problem. The individual borrowers have a debt problem which they generally solve by going bankrupt. That terminates the debt. But when the debt is discharged by default, that creates a problem on the balance sheet of the creditor. The creditor takes a hit to its capital, and possibly becomes insolvent if a sufficiently large portion of the loans it owns defaults. This is a significant danger because fractional reserve lending works in both ways. When inflating a credit bubble, banks extend many multiples of their capital base in credit, so only a fraction of those loans need to default to wipe out the bank's capital.

Now, if the banks sell the MBS to the Fed for "printed money" before many defaults occur, they are no longer vulnerable to insolvency because they have exchanged a balance sheet asset of dubious worth for reserve deposits with the Fed -- the most fundamental form of capital. So, now if the borrowers default, that solves the "debt problem" of the borrowers by discharging the debts, and it solves the "balance sheet" problem of the lenders because they are no longer going to take a hit to their capital.

So what is the gotcha? The Fed doesn't have a "capitalization problem" in the way that a commercial bank that extends a loan would, because the Fed created the reserve credits to pay for the MBS ex nihilo. If the borrowers default, and the market value of the MBS that the Fed bought drops to zero, the Fed is still essentially solvent in the sense that it isn't on the hook to deliver anything to anyone. The problem default creates for the Fed is more subtle. The reserves that the Fed created can be leveraged by the banks to extend credit. Eventually, all those reserves could be leveraged up by the banks into another explosion of credit, leading to high inflation. The main way the Fed has to remove reserves from the banking system to head off this inflation is to sell assets from its balance sheet in exchange for reserves. If the value of those assets has dropped, then the Fed will lack anything to "sell" to mop up the reserves it created to buy them in the first place. So, the problem created by solving the debt problem (through default) and the balance sheet problem (through monetization) is transformed into an inflation problem that the Fed can't solve by its usual open market operations. In that case, the only option would be to mop up the reserves by some other means, such as changing reserve fraction requirements to reduce the leverage that banks can apply to their reserves.

[ASH]

Re: TARP was successful

It changes something very substantive in my mind; it adds to the public debt. Recall that I was responding to your claim that this did not add to the public debt.

Before the shell game, a bank has a toxic debt nominally valued at $1000 but really worth about nothing.

After the shell game, you, me, and our descendants owe the bank $1000 plus interest.

I was trying to look past the double entry bookkeeping details of any particular transaction in this sequence and look instead to the overall affect.

That is partly true if the Fed is a net seller of Treasurys from its balance sheet at the same time it is a net buyer of MBS. If the Fed is a net seller of Treasurys to anyone, for any reason, that increases the interest burden of the American people because while the Treasurys are on the Fed's balance sheet, they refund the proceeds to the Treasury. Technically, that happens any time the Fed "raises interest rates" through open market operations. It is not causally related to monetization of MBS, because the banks have more than one source of reserves to exchange for balance sheet assets when the Fed is selling on the open market.

If those Treasurys are moved off the Fed's balance sheet, then the public doesn't get its interest rebate. But I disagree with your general interpretation, because the monetization of MBS by the Fed does not require any corresponding change in amount of Treasurys held on the Fed's balance sheet. In fact, during QE1, the Fed monetized both MBS and Treasurys at the same time. I haven't checked the totals, but that implies to me the Fed has not been a net seller of Treasurys during this period. If it turns out that the Fed has actually been a net seller of Treasurys, then yeah -- the public is losing out on an interest rate rebate. But if you consider that we were going to have to pay that interest before the Fed originally monetized the Treasurys in question -- and we were going to have to pay the principal regardless of whether the Fed or a private bank or grandpa Jones held the Treasury -- that's not really adding 'new' public debt. Monetizing the MBS doesn't issue new debt; selling Treasurys does change how much of a rebate the public gets on the interest it pays.

[ASH]

Re: TARP was successful

I think "bad debt of American financial institutions" means debt owed by American financial institutions, rather than debt owed to such institutions. That would be more like backstopping the bonds of the GSEs with explicit federal guarantees.

[ThePythonicCow]

Re: TARP was successful

That is partly true if the ...

I'm going to have to drop out of this sub-thread. Sorry. You're making me think too hard (grin).

[Sharky]

Re: TARP was successful

The difference between TARP and the Fed's programs is that the Fed can only loan money. The Fed doesn't buy toxic assets from banks; through programs like TAF they accept the toxic assets as collateral against a loan, but the loan eventually has to be repaid. The toxic asset is replaced on the bank's balance sheet by a liability. Such an action can help stop their balance sheet from deteriorating further, but it does nothing to replenish bank capital that was lost due to loan defaults--and if a bank's capital drops below a certain threshold, the FDIC will step in and force them to close their doors or to merge with another, larger, bank (the idea being that the combined bank will have adequate capital).

TARP, on the other hand, is run by the Treasury, not the Fed. Actions under TARP were not loans. Instead, the Treasury would step in and make outright purchases -- typically of preferred stock in the ailing banks. The money received by the banks that way became bank capital, since it did not have an offsetting liability on the bank's balance sheet.

TARP was nothing less than a partial nationalization of the banks. Taxpayer dollars were used by the Treasury to purchase ownership in the banks or to guarantee various toxic assets. In addition, that ownership was protected by things like mandatory warrants, that would allow the government to profit if the bank's stock went up in value after they were rescued. The government also put restrictions on executive pay.

All this talk about TARP money being "repaid" is really disingenuous at best. The money was not a loan, so it's not really being "repaid"; instead, banks are purchasing back the assets that the government bought. After the government rescued the banks, it became in their best interest to undo as much of each TARP transaction as they could. The money to do this was often raised by issuing new stock to the public at prices well above what was possible before they were rescued.

Was TARP successful? Yes, in the sense that the bank capital crisis was temporarily averted. However, it did nothing to address the causes of the problem, and the funds provided were, in some cases, used in various forms of market manipulation. It's like taking aspirin when you have a serious fever. Sure, you get some symptom relief for a while, but the underlying cause of the fever is still there, and you would almost certainly get better faster if you let the fever run its course and help kill off the bugs. Also, if you take too much, the "cure" becomes worse than the disease.

[ASH]

Re: TARP was successful

The difference between TARP and the Fed's programs is that the Fed can only loan money. The Fed doesn't buy toxic assets from banks; through programs like TAF they accept the toxic assets as collateral against a loan, but the loan eventually has to be repaid. The toxic asset is replaced on the bank's balance sheet by a liability. Such an action can help stop their balance sheet from deteriorating further, but it does nothing to replenish bank capital that was lost due to loan defaults--and if a bank's capital drops below a certain threshold, the FDIC will step in and force them to close their doors or to merge with another, larger, bank (the idea being that the combined bank will have adequate capital).

My understanding is that this describes the various Fed loan facilities, but not the purchase of MBS and agency debt under QE1, which is what I was referring to. Am I mistaken?

[jk]

Re: TARP was successful

i've just looked over this thread for the first time and have one comment: ash, you repeatedly refer, in one form or another, to the round trip of the fed buying, and then selling, a treasury instrument. in essence, you are referring to the fed's exit strategy. however, i don't think it's ever going to happen. earlier this year the fed made lots of noise about how they were thinking about their exit strategies. now, instead, they are about to launch qe2. now i know "ever" is a long time. so i'll modify that statement to say that the fed can't execute any exit strategy until or unless there is some reform of the financial system and a cram down of debts, or until the economy has struggled for the many, many years it will take to reduce overall private leverage via individual defaults and repayments. by that time, however, the federal debt will by so large that any exit strategy would trigger an interest rate spike which would kill whatever life there is in the economy. so now i have to modify my statement again, this time to say that there will be no exit strategy until there is reform of the financial system and a cram down of debts. period. ain't gonna happen any time soon.

[ASH]

Re: TARP was successful

i've just looked over this thread for the first time and have one comment: ash, you repeatedly refer, in one form or another, to the round trip of the fed buying, and then selling, a treasury instrument. in essence, you are referring to the fed's exit strategy. however, i don't think it's ever going to happen. earlier this year the fed made lots of noise about how they were thinking about their exit strategies. now, instead, they are about to launch qe2. now i know "ever" is a long time. so i'll modify that statement to say that the fed can't execute any exit strategy until or unless there is some reform of the financial system and a cram down of debts, or until the economy has struggled for the many, many years it will take to reduce overall private leverage via individual defaults and repayments. by that time, however, the federal debt will by so large that any exit strategy would trigger an interest rate spike which would kill whatever life there is in the economy. so now i have to modify my statement again, this time to say that there will be no exit strategy until there is reform of the financial system and a cram down of debts. period. ain't gonna happen any time soon.

I agree. I talked about the Fed selling assets from its balance sheet to illustrate the theoretical problem with monetizing MBS which might drop substantially in value, to contrast the sort of problem "bad" assets create for the Fed to the problems that would be created for a commercial bank holding the same assets. Later, I talked about selling assets held by the Fed in connection to the seigniorage issues involved with interest payments on such assets. The point was didactic, since I thought I was responding to "how does this work?" rather than "what happens next?".

[jk]

Re: TARP was successful

I agree. I talked about the Fed selling assets from its balance sheet to illustrate the theoretical problem with monetizing MBS which might drop substantially in value, to contrast the sort of problem "bad" assets create for the Fed to the problems that would be created for a commercial bank holding the same assets. Later, I talked about selling assets held by the Fed in connection to the seigniorage issues involved with interest payments on such assets. The point was didactic, since I thought I was responding to "how does this work?" rather than "what happens next?".

fair enough. but if the fed never "exits" its mbs trade, it doesn't matter in an acute sense, at least, when the mbs defaults. it just means the fed has pumped that much more liquidity into the system, liquidity it will never withdraw.

[we_are_toast]

Re: TARP was successful

Nice discussion about the FED.

If the FED is buying treasuries (we know they are) and if QE2 buys more treasuries, they won't have to sell what they bought, it'll just get paid down. This would slowly remove liquidity from the system.

What happens if QE2 fails and does not spark growth (Revenue growth in the federal government)? Now we're in a really big bind. The FED will be forced to try something new, quickly. If the FED can't stimulate real growth, Tbill holders will start running for the exits, then it's crash austerity, or print the deficit. Bernanke telegraphed he's rolling the dice and people are standing around the table to see if he'll be a winner.