The Regulation of the Mixed Economy in Action

Both the highly-intelligent Martin Wolf and the highly-intelligent David Wessel, I think, overstate the importance of what has happened in financial markets this month. Both of them--very smart as they are--talk as if there has been a big shift: an end to laissez-faire in financial markets: as if the Federal Reserve's discretionary actions to try to stabilize markets mark "the day the dream of global free-market capitalism died" or "the time the U.S. government discarded a half-century of rules... [o]n the Richter scale of government activism, the government's recent actions don't (yet) register at FDR levels.... But something big just happened."

From my perspective, at least, there never was such an animal as laissez-faire in financial markets. In my first semester as a graduate student I listened to Charlie Kindleberger talk about how as long ago as 1844 it was settled doctrine that a market economy should have a central bank, and that that central bank should exercise its discretion within broad boundaries in times of financial crisis.

Consider Robert Peel, Charlie lectured. Karl Marx and Friedrich Engels hated Robert Peel:

Marx and Engels: Neue Rheinische Zeitung Revue: Peel himself has been apotheosized in the most exaggerated fashion... One thing at least distinguished him from the European 'statesmen' -- he was no mere careerist.... [T]he statesmanship of this son of the bourgeoisie... consisted in the view that there is today only one real aristocracy: the bourgeoisie.... [H]e continually used his leadership of the landed aristocracy to wring concessions from it for the bourgeoisie... Catholic emancipation... the reform of the police... the Bank Acts of 1818 and 1844, which strengthened the financial aristocracy... tariff reform... free trade... with which the aristocracy was nothing short of sacrificed to the industrial bourgeoisie.... His power over the House of Commons was based upon the extraordinary plausibility of his eloquence. If one reads his most famous speeches, one finds that they consist of a massive accumulation of commonplaces, skillfully interspersed with a large amount of statistical data...

British Prime Minister Robert Peel was--Charlies went on to say--the very creator of the "night watchman" state itself: the creator of the London police force, and thus of the idea that one could rely on the state rather than on community self-help refereed by royal judges to protect one's property (police in England are not called "Bobbies" by accident). Yet as Peel put it in 1844 in the debate over the Bank of England's Charter (Anno Septimo & Octavo Victoriae Reginae CAP XXXI), it was vitally important to set out rules for the operation of financial markets that minimized the potential for moral hazard, but equally important that it be understood that the central bank have the role of suspending those rules to take immediate action. Even though Peel was confident that the Bank Charter Act of 1844 was well-designed and "that we are taking all the precautions which legislation can prudently take against the recurrence of a monetary crisis":

Kindleberger quoting Peel: [Nevertheless, a crisis] may occur in spite of our precautions, and if it does, and if it be necessary to assume a grave responsibility for the purpose of meeting it, I dare say men will be found willing to assume such a responsibility. I would rather trust to this than impair the efficiency and probable success of those measures by which one hopes to control evil tendencies in their beginning, and to diminish the risk that extraordinary measures may be necessary...

Kindleberger characterized Britain's mid-nineteenth century handling of financial crises as a "Machiavellian device": the Bank of England would, in crisis, break the law and support the markets

but only after receiving a Letter of Indemnity from the Chancellor of the Exchequer stating that [the Bank] would not be prosecuted for its violation of the law.... As is widely known, the Letter of Indemnity in 1848 and 1866... so calmed the market that there was no need of [market support]... and... in the crisis of 1857 the excess was very small...

Thus supposing we could summon back from the grave Robert Peel himself and ask him what he thought of the Federal Reserve's actions, he would say "of course this is what you do."

Why, then, are Martin Wolf and David Wessel with their Krell-like brains surprised at the fact that the Federal Reserve is composed of men (and women) willing to "assume a grave responsibility for the purpose of meeting" a financial crisis?

I think that they are surprised because they--at some level--drank the koolaid, breathed in the miasma, were deranged by the effluvia of the vast right-wing conspiracy--the "drown the government in the bathtub" types. The argument against progressive income taxation requires a claim that the rich don't need any help from government, and is fatally undermined by any admission that the rich stand to benefit from the safety net as much--nay, enormously more in dollar terms--than the poor. But, as Robert Peel would put it, in financial matters the question is never laissez-faire vs. regulation, but always good smart regulation vs. bad stupid regulation.

---

Martin Wolf:

The rescue of Bear Stearns marks liberalisation's limit: Remember Friday March 14 2008: it was the day the dream of global free-market capitalism died. For three decades we have moved towards market-driven financial systems. By its decision to rescue Bear Stearns, the Federal Reserve, the institution responsible for monetary policy in the US, chief protagonist of free-market capitalism, declared this era over....

Mine is not a judgment on whether the Fed was right.... Mine is more a judgment on the implications of the Fed's decision. Put simply, Bear Stearns was deemed too systemically important to fail.... The implications of this decision are evident: there will have to be far greater regulation of such institutions.... The lobbies of Wall Street will, it is true, resist onerous regulation of capital requirements or liquidity.... But... their position is now untenable. Systemically important institutions must pay for any official protection they receive. Their ability to enjoy the upside on the risks they run, while shifting parts of the downside on to society at large, must be restricted. This is not just a matter of simple justice (although it is that, too). It is also a matter of efficiency....

I greatly regret the fact that the Fed thought it necessary to take this step. Once upon a time, I had hoped that securitisation would shift a substantial part of the risk-bearing outside the regulated banking system, where governments would no longer need to intervene. That has proved a delusion....

If the US itself has passed the high water mark of financial deregulation, this will have wide global implications.... These longer-term implications for attitudes to deregulated financial markets are far from the only reason the present turmoil is so significant. We still have to get through the immediate crisis. A collapse in financial profits (so significant in the US economy), a house-price crash and a big rise in commodity prices are a combination likely to generate a long and deep recession....

These are perilous times. They are also historic times. The US is showing the limits of deregulation. Managing this unavoidable shift, without throwing away what has been gained in the past three decades, is a huge challenge. So is getting through the deleveraging ahead in anything like one piece. But we must start in the right place, by recognising that even the recent past is a foreign country.

David Wessel:

Ten Days that Changed Capitalism: The past 10 days will be remembered as the time the U.S. government discarded a half-century of rules to save American financial capitalism from collapse. On the Richter scale of government activism, the government's recent actions don't (yet) register at FDR levels. They are shrouded in technicalities and buried in a pile of new acronyms. But something big just happened... without an explicit vote by Congress... billions of dollars of taxpayer money were put at risk. A Republican administration, not eager to be viewed as the second coming of the Hoover administration, showed it no longer believes the market can sort out the mess. "The Government of Last Resort is working with the Lender of Last Resort to shore up the housing and credit markets to avoid Great Depression II," economist Ed Yardeni wrote to clients.

First, over St. Patrick's Day weekend, the Fed (aka the Lender of Last Resort) and the Treasury forced the sale of Bear Stearns, the fifth-largest U.S. investment bank, to J.P. Morgan Chase.... To induce J.P. Morgan to do the deal, the Fed agreed to take losses or gains, if any, on up to $29 billion of securities in Bear Stearns's portfolio.... Then the Fed lent directly to Wall Street securities firms for the first time. Until now, the Fed has lent directly only to Main Street banks.... In the first three days of this new era, securities firms borrowed an average of $31.3 billion a day from the Fed.... Republican Treasury secretary leaned on two shareholder-owned, though government-chartered, companies -- Fannie Mae and Freddie Mac -- to raise capital that their boards didn't want to raise.... Fannie and Freddie... accounted for 76% of new mortgages in the fourth quarter of last year, up from 46% in the second quarter... if Fannie or Freddie stumble, taxpayers will get stuck with the tab. And then, the federal regulator of the low-profile Federal Home Loan Banks, which are even less well capitalized than Fannie and Freddie, said they could buy twice as many Fannie and Freddie-blessed mortgage-backed securities as previously permitted -- more than $100 billion worth....

[T]he clear and present danger that the virus in the housing, mortgage and credit markets is infecting the overall economy is too great to ignore. The Great Depression was worsened because the initial government reaction was wrong-headed. Federal Reserve Chairman Ben Bernanke spent an academic career learning how to avoid repeating those mistakes.

Is it working? It is helping. One key measure is the gap between interest rates on mortgages and safe Treasury securities.... The gap remains enormous by historical standards, but has narrowed. On March 6, according to FTN Financial, 30-year fixed-rate mortgages were trading at 2.92 percentage points above the relevant Treasury rates; Wednesday the gap was down to 2.22. Normal is about 1.5 percentage points.... Is it enough? Probably not....

The case for doing more is twofold. One is to cushion the blow to families and communities, even if some are culpable. The other is to disrupt a dangerous downward spiral in which falling prices of houses and mortgage-backed securities lead lenders to pull back, hurting the economy and dragging asset prices down further, and so on.... So the next step, no matter how it is dressed up, is likely to involve the government's moving in ways that put a floor under prices, hoping that will limit the downside risks enough so more Americans are willing to buy homes and deeper-pocketed investors are willing, in effect, to lend them the money to do so.

Comments

[save_the_rustbelt]

So much for being nice to banks - from Bloomberg....

Banks Fail to Lower Mortgage Rates as Bernanke Cuts (Update1)

By Kathleen M. Howley

March 27 (Bloomberg) -- Marjorie Killian is eager to buy a home in San Diego and is pre-approved for a mortgage. She won't make an offer on a property until she can get a fixed rate of 5.5 percent, she said.

Killian is just the kind of buyer that Federal Reserve Chairman Ben Bernanke needs to entice to revive the U.S. housing market and halt its drag on the economy. Lenders aren't helping the central bank even after they've been given seven interest rate cuts and a new program designed to jumpstart borrowing.

The difference between the 10-year government bond yield and the average U.S. fixed mortgage rate was 2.7 percentage points last month, the widest spread since 1986, data compiled by Bloomberg show. Banks are defying Bernanke and hoarding cash after writing down the value of more than $200 billion of mortgage-related securities since July. The banking industry's earnings fell to a 16-year low of $5.8 billion in the fourth quarter of 2007, ending six years of record profits, according to the Federal Deposit Insurance Corp. in Washington...........etc.

[andres]

Come now. Marx and Engels hated Robert Peel because he was a chief executive of the bourgeoisie, _not_ because he passed legislation that sacrificed the interests of the landed aristocracy to please the business elite. Marx and Engels hated the landed aristocracy even more than they hated the bourgeoisie--nothing else can explain their enthusiastic support for the Union in the U.S. civil war.

As for the Bank Charter Act, history showed that it wasn't a particularly good piece of legislation. In several subsequent 19th century bank runs, its strict gold reserve guidelines had to be set aside by emergency legislation in order to allow the Bank of England to act as a lender of last resort. If Peel had really believed in the importance of central bank intervention, he would not have allowed the Bank of England to be hobbled by policy rules in the way that the Charter Act prescribed. Peel knew that "of course this is what you do", but he valued his skin too highly to actually put that principle in his legislation; either that, or he too had dipped into the kool-aid.

[Neal]

Respnsible men ready to meet the challenges of the crisis, or crony capitalism?

From John Hussman of Hussman Funds:

(quote)

Bear Stearns is trading at $6 instead of $2 because unelected bureaucrats went beyond their legal mandates, delivered a windfall to a single private company at public expense, entered agreements that violate the the public trust, and created a situation where even if the bureaucratic malfeasance stands, the shareholders of Bear Stearns will either reject the deal or be deprived of their right to determine the fate of the company they own. Very simply, Bear Stearns is still in play. Still, when all is said and done, my own impression is that the ultimate value of the stock will not be $2, but exactly zero.

In effect, the Federal Reserve decided last week to overstep its legal boundaries – going beyond providing liquidity to the banking system and attempting to ensure the solvency of a non-bank entity. Specifically, the Fed agreed to provide a $30 billion “non-recourse loan” to J.P. Morgan, secured only by the worst tranche of Bear Stearns' mortgage debt. But the bank – J.P. Morgan – was in no financial trouble. Instead, it was effectively offered a subsidy by the Fed at public expense. Rick Santelli of CNBC is exactly right. If this is how the U.S. government is going to operate in a democratic, free-market society, “we might as well put a hammer and sickle on the flag.”

What is a “non-recourse loan”? Put simply, if the homeowners underlying that weak tranche of debt go into foreclosure, they will lose their homes, and the public will lose as well. But J.P. Morgan will not lose, nor will Bear Stearns' bondholders. This will be an outrageous outcome if it is allowed to stand.

In my view, the deal would be palatable if J.P. Morgan was to remain fully responsible for any losses on the “collateral” provided to the Federal Reserve, assuming shareholders were to consent to the buyout. As it stands, Congress should quickly step in to bust the existing deal and demand an alternate resolution, by clearly insisting that the Fed's action was not legal.

The Fed did not act to save a bank, but to enrich one. Congress has the power to appropriate resources for such a deal by the representative will of the people – the Fed does not, even under Depression era banking laws. The “loan” falls outside of Section 13-3 of the Federal Reserve Act, because it is not in fact a loan to either Bear Stearns or J.P. Morgan. Bear Stearns is no longer a business entity under this agreement. And if the fiction that this is a “loan” to J.P. Morgan was true, J.P. Morgan would be obligated to pay it back, period. The only point at which the value of the “collateral” would become an issue would be in the event that J.P. Morgan itself was to fail. No, this is not a loan. It is a put option granted by the Fed to J.P. Morgan on a basket of toxic securities. And it is not legal.

The deal was made under duress, to the benefit of a private company, on the basis of financial assurances that the bureaucrats involved had no business making. The Federal Reserve is going to put up public assets and accept default risk so that Bear Stearns' own bondholders are effectively immunized?! That's not sound monetary policy – it's a picnic for insiders, bought and paid for through the abuse of public funds by government officials too unprincipled even to recognize the abuse. The only good thing about this deal is that it buys time while principled ways of busting and restructuring it can be settled.

This is not an issue of letting Bear Stearns “fail” on the claims of its customers and counterparties. Nobody wants that. The issue is the method by which it was rescued – who was protected, and who was not; why a consortium was not used instead of a single firm; why the claims of Bear's bondholders should be secure while the public bears the risk of the toxic waste foisted upon us. This deal should, and I believe will, be restructured. J.P. Morgan will cry foul, but that will be like a child who found the Easter basket and is now forced to share the chocolate. Bear Stearns is worth more than zero in acquisition, provided that the bondholders take an appropriate loss.

As of November's 10K report, Bear Stearns had $9 billion in unsecured short-term debt, and $66 billion in long-term debt. The $12 billion in shareholder equity, of course, is gone. Any portion of the debt that is unsecured should be the first to fall. If Bear Stearns is worth $2 a share to somebody (provided $30 billion of “non-recourse loans” from the Fed), and yet Bear's bondholders and even the unsecured lenders can still expect to be paid off on over $75 billion of debt (J.P. Morgan assumes that obligation as part of the buyout), then the public guarantees aren't required in the first place. What is required is that Bear's bondholders take a loss, as they should, rather than the public doing so.

In the unlikely event the value of Bear Stearns is negative after entirely zeroing out both shareholder equity and bondholder claims – then and only then is there a problem for Bear's customers and counterparties. But in fact, J.P. Morgan is already willing to take on all of Bear's assets and liabilities, including over $75 billion in debt to Bear's bondholders, for $2 a share. This is an indication that bondholder's claims would not even be wiped out in a full liquidation. Surely, whatever loss is required to transfer the ownership of the company should be taken by the bondholders, not by the public.

Again, this is not water under the bridge, and the deal struck last week should not be allowed to stand if we care at all about the integrity of the capital markets. The Long-Term Capital crisis was resolved by a consortium of financial institutions providing capital in return for ownership. The panic of 1907 was resolved the same way. This deal should be busted, and fast. If there's not a single buyer that will take on both the assets and liabilities without the government assuming private default risk, Bear's assets should be put out for bid, Bear's bonds should go into default, and by the unfortunate reality of how equities work, Bear's shareholders shouldn't get $2 – they should get nothing.

Bear's stock is selling at more than $2 for two reasons – one is that the market evidently believes there is some chance for the deal to be busted, either by Congress or by shareholder rejection. And second, because Bear's bondholders are frantic to own the stock so they can vote for this lousy deal to go through. After all, buying up a few hundred million in stock to secure $75 billion of debt doesn't seem like a bad trade. Even if J.P. Morgan raises the bid for Bear Stearns, the assurances by the Fed and Treasury are not legal. That will change only when the "non-recourse" provision is withdrawn. Whatever happens, this is not over, for the simple reason that it is wrong.

The U.S. economy will get through this without the requirement of massive public bailouts. What is required, however, is that the stock and bondholders of financial companies take due losses. Customers and counterparties need not, and I expect will not, be harmed. The value of the shareholder equity and debt issued by most financial institutions is ample buffer. In general, writedowns against shareholder equity alone will be enough, provided that regulations are revised to allow institutions to continue servicing existing financial commitments on the basis of more flexible capital requirements.

If the market was “certain to crash” in the event that Bear Stearns failed, then the market is certain to crash anyway, because Bear Stearns wasn't the last shoe to drop – it was one of the first. Unfortunately, we're standing in a shoe store. Wasn't the market “certain to crash” without the Fed's surprise rate cut in January too? At what point will investors figure out that the liquidity problems are nothing but the precursors of insolvency problems? At what point will investors stop begging the government to save private companies and recognize that the losses should be taken by the stock and bondholders of the offending financial institutions? If the Fed and the Treasury are smart, they will act quickly to figure out how to respond to multiple events like we've seen in recent days, to expedite turnover in ownership and quickly settle the residual claims of bondholders, without the kind of malfeasance reflected in the Bear Stearns rescue.

As for the future of the free markets, Dylan Thomas comes to mind:

Do not go gentle into that good night
Rage! Rage against the dying of the light

The Fed overstepped and the Treasury overstepped. At the point where unelected bureaucrats pick and choose who to subsidize – who prospers and who perishes – in a free capital market, and use public funds to do it, more is at risk than just $30 billion. Instead, we cross a line, and stumble off a very clear edge down an interminably slippery slope. We speak up now, or forever hold our peace.

(end quote)

[Bernard Yomtov]

" Rick Santelli of CNBC is exactly right. If this is how the U.S. government is going to operate in a democratic, free-market society, “we might as well put a hammer and sickle on the flag.” "

Oh for Pete's sake. Get a grip. And get Santelli one too.

[Matt]

The fed is liberating the financial industry, by letting them become monetary banks, which they needed to do to "hedge cash" as one of the hedge fund managers pointed out.

The regulation we need is to make available, even require, people to log onto the discount window. I meet the reserve requirements, I should be able to log on and get the cheapest interest rate, just like any other favored fed customer.

The way to do this is to create a monetary bond market, and anyone can issue monetary bonds if they meet requirements. The bonds have to be traded in open market, and each bond issuer is required to keep capital reserves in the form of a collection of monetary bonds.

The Ben can simply trade bonds such that the majority of them fall within the gaussian window that represents the current random walk of the economy. As weak bonds arise, bond holders, including the fed, will slowly weed them out, the fed will get early signals with this approach.

The problem we have is this lunatic idea that we can change the value of money and cause people to do something useful as a result. Like I say, that is like changing the yardstick so carpenters unknowningly build bigger houses.

[RedCharlie]

"From my perspective, at least, there never was such an animal as laissez-faire in financial markets."

...or for that matter, in any other market as well. Kevin Phillips makes a good argument in "Wealth and Democracy" that government has always been instrumental in building wealth in this country. "Laissez-faire" is really just an excuse to ignore calls to action with which one doesn't agree.

[christofay]

I regularly succeed in having my posted comments cut.

This place should be gasping for reality

[polo]

Instead of alll this "On March 14 we lost pure market capitlism" crap, wouldn't it be better for them to say, "On March 14 the government finally realized it needed to keep a closer eye on investment banks as a potential systemic risk like commercial banks were 80 years ago"? This wasn't a loss moment -- it was a wake up moment.

[Frank the sales forecaster]

What was "normal" is not going to be "normal" going forward.

"Wednesday the gap was down to 2.22. Normal is about 1.5 percentage points.... Is it enough? Probably not...."

The baby boom has moved through the mortgage market (the egg through the snake) and now it is the post-baby boom generation's time. They, as consumers, are different in their behavior and statistical likelyhoods, particularly when it comes to credit worthiness. Going forward mortgages will have to provide additional gross margin to first, make up for the decline in credit quality, and second, to make up for the decline in dollar volume being borrowed. Its a tough time for mortgage lenders. Increasing costs with decreasing demand does not make for happy market conditions.

[Charles]

Brad, as a member of a faculty, you know that there is nothing more dangerous than precedent. What made the Bear deal such a bad precedent is that it is not a bank. What now constitutes an institution whose failure endangers the health of the US financial system?

Verisign?

Microsoft?

Paypal?

The failure of those would arguably cause more disruption than Bear.

[zak822]

People may not like the "sickle" comment, but was this wrong? "the Federal Reserve decided last week to overstep its legal boundaries – going beyond providing liquidity to the banking system and attempting to ensure the solvency of a non-bank entity."

It looks to me like the Fed overstepped its mandate. My understanding of these matters is limited, so please, educate me. Was the statement wrong? Misleading? Inaccurate?

[me]

STR,

That is why this is a bank bailout. Screw the savers (old folks) and increase the spread to make bank profits.

[walkingtheline]

Appears the Federal Reserve has just gifted the management of Bear Sterns at least 60 million.

http://biz.yahoo.com/t/37/915.html