Page 3 of
5 THE SHAPE OF
US POPULISM, Part 4 A panic-stricken Federal
Reserve By Henry C K
Liu
commercial banks pay. Instead, Fed
chairman Bernanke and his colleagues, in emergency
votes on March 16, invoked broader authority in
the Federal Reserve Act to give Wall Street prime
dealers the same rate as banks. Backstopping
securities firms, coupled with action to keep Bear
Stearns afloat before its sale to JP Morgan Chase
represent the central bank’s first lifelines to
institutions other than banks since the Great
Depression.
Under a regulatory regime
dating back to the New Deal of the 1930s, the Fed
oversees commercial banks, but investment banks
are primarily regulated by the Securities and
Exchange Commission, which in recent decades has
become a captured
regulator that resembles
an asylum run by the inmates.
Senior Fed
staffers said the arrangement allows JP Morgan
Chase to borrow from the Fed's discount window and
put up collateral of uncertain value from Bear
Stearns to back up the loans. JP Morgan, a bank,
has access to the discount window to obtain direct
loans from the Fed, but Bear Stearns, an
investment house, does not. While JP Morgan is
serving as a conduit for the loans, the Fed and
not JP Morgan will bear the risk if the loans are
not repaid, officials said. When God sins, the
entire theological structure rots.
Bernanke raced to unveil the new steps
before the Tokyo Stock Exchange opened on March
17. The weekend action, timed to complement JP
Morgan’s rescue of Bear Stearns, included a cut in
the discount rate and the opening of borrowing to
the primary dealers in Treasury securities, not
all of which are banks. The changes were the Fed's
most aggressive response to date to the
eight-month-old credit crisis that has spread to
the entire US economy and around the world. My
article Why the Subprime Bust Will
Spread (Asia Times Online, March 17,
2007) was written five months before the August
credit crisis, at a time when establishment
officials and gurus were assuring the public that
the subprime mortgage problem was well contained.
The "temporary" facilities for 28 days
have been extended on an increasingly larger
scale. If they had a chance at being temporary the
scale should be getting smaller and not larger.
The Fed is putting in jeopardy its credibility by
pretending that the "temporary facilities" might
end or be phased out at the end of some future
28-day period when it knew in advance that was not
possible. Each rollover increases stress in the
precarious financial system as market participants
become dependent on more Fed intervention to
provide temporary adrenaline to unjustified market
exuberance.
The Fed on March 16 cut the
discount rate by 25 basis points to 3.25%. Two
days later, on March 18, the Fed slashed its Fed
funds rate target 75 basis points to 2.25% and the
discount rate to 2.50%. US interest rate has now
fallen to negative rate levels, meaning it is now
below inflation rate.
Another day later,
Government Sponsored Enterprises (GSEs) Fannie Mae
and Freddie Mac received permission from
regulators to pump as much as $200 billion of
liquidity into the beleaguered US mortgage market
without having to add compensatory capital. For
weeks earlier, rumors had been rife about these
two GSEs facing insolvency. Jonathan R Laing of
Barron's characterized their shares as
"worthless".
At year-end 2007, the company
owned in its portfolio or had packaged and
guaranteed some $2.8 trillion of mortgages or 23%
of all US residential mortgage debt outstanding.
The company lost $2.6 billion in 2007 as a surge
of red ink in the final two quarters more than
wiped out a nicely profitable first half.
Shortage of borrowers Still,
even with all the liquidity the Fed has injected
into the market, few are borrowing except to roll
over maturing debts, as new profitable investments
have become hard to find. Oil companies are flush
with cash from windfall profits but they do not
seem to be able to find worthwhile investments to
put the cash to use. Exxon reported a record $39.5
billion annual windfall profits for 2007 from high
oil prices, exceeding the gross domestic product
of nearly two thirds of the 183 nations of the
world, but the company failed to announce any
plans for expansion.
The fear is that
until prices in the $12 trillion US residential
housing market stop falling and the pace of
foreclosures ebbs instead of rises, the pain for
banks and non-bank institutions, let alone home
owners, will continue to get stronger to threaten
a much deeper and broader economic recession.
The hope is that lower mortgage rates
would enable home owners to cut their borrowing
costs as they opt for better terms and help
cushion the pain of falling home prices. But lower
short-term rates cause the dollar to fall and
long-term rates to rise. Moreover, mortgage
defaults are no longer caused exclusively by high
interest rate resets. Many borrowers have no
incentive to keep making payments on mortgages on
properties with market values lower than the
outstanding value of the mortgage. Is the Fed in a
position to pump $4 trillion into the housing
market to stabilize inflated home prices?
Every few days, a new, stronger fix needs
to be administered by the Fed to sustain a
euphoric high in the market that will dissipate a
few days later, with the inevitable result of a
fatal overdose down the road. All that produces is
a secular bear market, where every rebound is
smaller than the previous fall, until the debt
bubble fully deflates.
The bottom line in
the current financial crisis is no longer one of
credit crunch, but of massive insolvency in the
financial market that will spread to the general
economy, which no amount of Fed liquidity
injection can cure short of hyperinflation.
Further, there is no guarantee that even accepting
hyperinflation will save the economy from
protracted stagnation. The history of central
banking shows that central bank policies can cause
problems more easily than they can solve problems
they created earlier. Economic distress from
monetary dysfunction cannot be solved by merely
printing money, which central banks consider its
divine right.
Central banks of the G7
economies are reportedly actively engaged in
discussions about the feasibility of using public
funds for mass purchases of mortgage-backed
securities as a possible solution to the credit
crisis. This is essentially an option to
nationalize the credit market after wholesale
deregulation has turned free market capitalism
into failed market capitalism.
The policy
debate has shifted from one on fixing an
appropriate interest rate policy to the need for
aggressive intervention in a matter of weeks as
the crisis spread from the subprime mortgage
sector to engulf the entire financial system, as
evidenced by the sudden collapse of Bear Stearns,
a major investment bank, that threatens to touch
off widespread counterparty defaults. Panic
appears to have taken over at the highest levels
in the inner sanctum of the central banking world.
Discord among central banks The
Bank of England reportedly is most enthusiastic to
explore the idea, as it has a long history of
nationalization, the latest example being its
takeover the Northern Rock Bank, a big mortgage
lender. The Federal Reserve is open in principle
to the possibility that intervention in the MBS
market might be justified in certain scenarios,
but only as a last resort. The European Central
Bank appears least enthusiastic, with the German
central bank adamantly opposed to such a heretical
proposition.
Jean-Claude Trichet, the ECB
president, while avoiding immediate critical
comment on the Bank of England's rescue of
Northern Rock, said: "What is important is that we
must not let the mistakes made by some impose a
high cost on those who have made no mistakes."
Neo-liberal market fundamentalists
continue to argue that new international bank
capital rules requiring assets values to be marked
to market rather than marked to models have
exacerbated the credit squeeze, despite the now
proven fact that flawed marked-to-model evaluation
had been responsible for the current crisis.
US policymakers are more inclined to boost
support for the mortgage markets indirectly
through the expanding the role of the Federal
Housing Administration, which provides mortgage
insurance on loans made by FHA-approved lenders,
and by easing regulatory restraints by the Office
of Federal Housing Enterprise Oversight (OFHEO) on
Fannie Mae and Freddie Mac. OFHEO stated that the
required capital surplus for Fannie Mae and
Freddie Mac will be reduced from 30% to 20%,
immediately freeing up $200-$300 billion for the
GSEs to buy mortgages.
This new initiative
and the release of the portfolio caps announced in
February, should allow the GSEs to purchase or
guarantee about $2 trillion in mortgages this
year. This capacity will permit them to do more in
the jumbo temporary conforming market, subprime
refinancing and loan modifications areas.
To support growth and further restore
market liquidity, OFHEO announced that it would
begin to permit a significant portion of the GSEs'
30% OFHEO-directed capital surplus to be invested
in mortgages and MBS. As a key part of this
initiative, both companies announced that they
will begin the process to raise significant
capital. Both companies also said they would
maintain overall capital levels well in excess of
requirements while the mortgage market recovers in
order to ensure market confidence and fulfill
their public mission.
OFHEO announced that
Fannie Mae is in full compliance with its Consent
Order and that Freddie Mac has one remaining
requirement relating to the separation of the
chairman and CEO positions. OFHEO expects to lift
these Consent Orders in the near term. In view of
this progress, the public purpose of the two
companies and ongoing market conditions, OFHEO
concludes that it is appropriate to reduce
immediately the existing 30% OFHEO-directed
capital requirement to a 20% level and will
consider further reductions in the future.
However, like the Fed taking on more risk
to bail out the mortgage market, the GSEs will do
the same, increasing the amount of mortgages they
will hold for each dollar of capital on its books.
Swinging back towards
re-regulation As Congress and the Bush
administration struggle to contain the housing and
credit crises and prevent more Wall Street firms
from collapsing as Bear Stearns did, Edmund
Andrews and Stephen Labaton of the New York Times
report that a split is forming over how to
strengthen oversight of financial institutions
after decades of deregulation that had led to the
meltdown in credit markets to expose weaknesses in
the nation’s tangled web of federal and state
regulators, which failed to anticipate the effect
of so many new players in the industry.
In
the Democrat controlled Congress, key committee
chairmen, such as Massachusetts Representative
Barry Frank of the House Financial Services
Committee, New York Senator Charles Schumer of the
Joint Economic Committee and Connecticut Senator
Christopher Dodd of the Senate Banking Committee,
are drafting separate bills that would create a
powerful new regulator or simply confer new powers
on the Federal Reserve to oversee practices across
the entire array of commercial banks, Wall Street
firms, hedge funds and nonbank financial
companies.
Sheila C Bair, chairwoman of
the Federal Deposit Insurance Corporation (FDIC),
which insures deposits at banks and thrift
institutions and is one of several federal bank
regulatory agencies, said: "Capital levels are the
most important tool we have at the FDIC, and
investment banks have lower capital levels than
commercial banks."
The Treasury Department
of the outgoing Republican administration is
rushing to complete its own blueprint for
overhauling what is now an alphabet soup of
federal and state regulators that often compete
against each other and protect their particular
slices of the industry as if they were
constituents. It will unveil its own blueprint for
regulatory overhaul in the next few weeks.
Treasury Secretary Henry Paulson has
acknowledged that the problems exposed by the
housing crisis were diffuse and complex and could
not be solved with a single action. "There is no
silver bullet," he said repeatedly last week. But
he suggested that he did not want to take any
drastic regulatory steps while the financial
markets remained in turmoil. "The objective here
is to get the balance right," Mr Paulson said.
"Regulation needs to catch up with innovation and
help restore investor confidence but not go so far
as to create new problems, make our markets less
efficient or cut off credit to those who need it."
This attitude has been behind Alan Greenspan’s Fed
policy on regulating financial innovations for the
past two decades.
Ideological divide
allows only cosmetic changes But the two
political parties strongly disagree along
ideological lines about whether, after decades of
freewheeling encouragement of exotic new
instruments like derivatives and new players like
hedge funds, the pendulum should swing back to
tighter control. Wall Street firms have also been
major contributors to both political parties, and
they are certain to oppose tough new restrictions.
Given the philosophical differences about the
value of government regulations, it is unlikely
that a Democratic Congress and the Republican Bush
administration would agree on more than cosmetic
changes.
Except for the Federal Reserve,
all federal bank-regulating agencies receive
funding from fees paid by member
institutions.
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