Meltdown Moment: What Must be Done

Last week’s default of Thornburg Mortgage had an ominous sound, like the cracking of sheet ice. Wall Street now sits atop a potential collapse of confidence in asset valuations, threatening a panic that will wipe away both sound and unsound financial institutions. The week’s events also reveal how the Federal Reserve’s bail-out policy has failed to address the underlying problem of credit market seizure. Here’s what’s going on, and what must be done to prevent a meltdown.

By way of background, Thornburg Mortgage is a leading lender specializing in Alt-A mortgages for purchases of higher priced homes that exceed Fannie Mae’s and Freddie Mac’s conforming loan limit of $417,000. By all accounts its mortgage backed securities constitute good credit structures with the underlying mortgages still intact. The problem at Thornburg is not classic insolvency, but rather the evaporation of willingness to hold even mortgage backed securities backed by sound assets. This has caused security prices to tumble, lowering the value of Thornburg’s collateral and thereby triggering margin calls from banks that it has been unable to meet.

Similar stories are being played out in many parts of the market. Thornburg and other financial intermediaries are now threatened with bankruptcy that poses two grave public threats. First, if these firms liquidate their mortgage portfolios that will further depress asset prices, thereby potentially triggering margin calls at other firms that could generate dangerous ripple effects. Second, putting additional mortgage lenders out of business will make it even more difficult to buy and sell homes, which promises to further depress house prices. These are exactly the effects policy should be avoiding.

The irony behind this debacle is that part of the problem is due to margin calls from banks. However, banks are currently being bailed-out by the Federal Reserve, which has provided them with tens of billions of dollars of subsidized credit through its term auction facility. In effect, the institutions the Fed is bailing-out are the same ones putting downward pressure on financial markets. Indeed, the banks are being given subsidized credit for problems similar to those experienced by Thornburg. Thus, there was an earlier loss of confidence in banks’ assets that threatened their ability to renew roll-over funding for their activities. This risked causing banks to default, triggering margin calls and fire-sales of their assets that would have caused major asset price deflation and the destruction of credit provision.

The Thornburg story illustrates two things. First, the Fed’s policy privileges banks, bailing them out while letting perish other financial institutions that are no more guilty. Second, the Fed’s current policy has not solved the problem of financial instability. Though the banks have been ring-fenced, they are now causing problems elsewhere through loan margin calls. Moreover, these calls could collectively come back to haunt banks by driving down the price of assets that they also own. Consequently, even the banks remain at risk despite the Fed’s term auction facility.

In today’s crisis environment the problem in financial markets is not the level of interest rates, or even the size of the Fed’s term auction facility. The problem is getting liquidity to those links in the financial chain that are most stressed. Reliance on the normal channels of distribution does not work when confidence has evaporated and markets have seized-up.

There is a very simple and fair solution to this problem. That solution is for the Federal Reserve to open its term auction facility to all publicly traded financial intermediaries rather than just deposit taking institutions. That means giving access to insurance companies, mortgage investment trusts, mutual funds, and hedge funds. These firms would be subject to the same borrowing terms as banks, and would have to post collateral of identical quality.

Such a change would level the playing field in financial markets and remove the unfair subsidy to banks. Most importantly, it would tackle the problem of credit market seizure that is afflicting all financial institutions. In a world where distinctions between financial intermediaries have become increasingly blurred, broadening access to the term auction facility is the logical and correct policy.

The Federal Reserve’s current policy is failing because it is structured for the world of the past in which depository institutions dominated lending. Thus, current policy restricts access to emergency liquidity to deposit taking institutions, ignoring how lending has become detached from deposit taking. The challenge of the day is preventing a meltdown that destroys sound lenders and sound assets. That calls for widening access to temporary emergency liquidity. Afterward, there will be time to visit the question of regulatory reform and more permanent policy change.

Copyright Thomas I. Palley

5 Responses to “Meltdown Moment: What Must be Done”

  1. warren mosler Says:

    ‘The irony behind this debacle is that part of the problem is due to margin calls from banks. However, banks are currently being bailed-out by the Federal Reserve, which has provided them with tens of billions of dollars of subsidized credit through its term auction facility.’

    Not a bail out. Banks already have access to insured deposits.

    It’s about price, not quantity (endogenous money and all that?).

    The Fed’s job is to set an interest rate, in this case the fed funds rate.

    All bank assets are ‘legal’ as per the regulators, and qualify for funding via insured deposits in any case.

    The liability side of the balance sheet is not the place for market discipline- you know the argument for deposit insurance and all that?

    The asset side is instead highly regulated, including capital requirements for market discipline. Imperfect, evolving, and political as it may be.

    ‘In effect, the institutions the Fed is bailing-out are the same ones putting downward pressure on financial markets. Indeed, the banks are being given subsidized credit’

    Not subsidized, but prices at the fed’s target fed funds rate, which is what targeting a bank rate is all about. The fed has to target some rate, and i don’t think you are saying the target rate needs to be higher?

    ‘for problems similar to those experienced by Thornburg. Thus, there was an earlier loss of confidence in banks’ assets that threatened their ability to renew roll-over funding for their activities. This risked causing banks to default, triggering margin calls and fire-sales of their assets that would have caused major asset price deflation and the destruction of credit provision.’

    Again, the Fed should provide unlimited funding for banks at it’s target rate, as the assets have already been deemed ‘legal’ by the occ and other regulators as has bank capital and capital requirements.

    And, as above, that’s what deposit insurance is all about.

    That’s how the bank model functions.

    The shareholders remain at risk for actual losses, which is the source of market discipline. there is not need for interbank lending if the fed understands it’s role and how reserve accounting works.

    And, as loans create deposits, there is little net lending from the Fed regardless.

    ‘The Thornburg story illustrates two things. First, the Fed’s policy privileges banks, bailing them out while letting perish other financial institutions that are no more guilty.’

    Giving banks access to funds at the fed’s target bank rate is not a bail out- it’s the basis for the banking model. It’s the starting point. it’s a failure of Fed policy when member banks in good standing aren’t provided funds for their legal assets at the target rate.

    ‘Second, the Fed’s current policy has not solved the problem of financial instability. Though the banks have been ring-fenced, they are now causing problems elsewhere through loan margin calls. Moreover, these calls could collectively come back to haunt banks by driving down the price of assets that they also own. Consequently, even the banks remain at risk despite the Fed’s term auction facility.’

    Right. They should alway open it to any bank legal assets, in any size, at their target rate. That’s what the Fed banking system is all about. Since loans create deposits, there will also always be little or no net funding by the fed as a point of logic, but their target rate will prevail, which is the point of having one.

    ‘In today’s crisis environment the problem in financial markets is not the level of interest rates, or even the size of the Fed’s term auction facility. The problem is getting liquidity to those links in the financial chain that are most stressed. Reliance on the normal channels of distribution does not work when confidence has evaporated and markets have seized-up.

    There is a very simple and fair solution to this problem. That solution is for the Federal Reserve to open its term auction facility to all publicly traded financial intermediaries rather than just deposit taking institutions.’

    Banks are already the fed’s own ‘designated agents’ for lending. The gov can do all kinds of things if the govt want the banks (and therefore the gov via insured deposits) to take more risk- alter capital requirements, provide fed guarantees, etc. In fact, you could argue that’s how the sub prime issue got started- gov incentives/encouragement to loan to lower income/less qualified borrowers. It’s not ‘wrong’ to do that, but does need a govt check written now and then if it doesn’t quite work out.

    Also, agencies like fnma, freddy, fha, etc. are also fed agents, who can also fund whatever assets the regulators want/allow/incent them to do.

    ‘That means giving access to insurance companies, mortgage investment trusts, mutual funds, and hedge funds. These firms would be subject to the same borrowing terms as banks, and would have to post collateral of identical quality.’

    They can already do this via their friendly banker, if the fed puts regs in place to allow the banks to do it.

    Otherwise the fed has to hire a bunch of specialized loan officers and then look just like the existing banks anyway.

    ‘Such a change would level the playing field in financial markets and remove the unfair subsidy to banks.’

    unfair??? subsidy??? what do you think fed member banks are other than agents of government, set up by govt statue, and therefore presumably for public service vis a vis the rest of the economy?

    ‘ Most importantly, it would tackle the problem of credit market seizure that is afflicting all financial institutions. In a world where distinctions between financial intermediaries have become increasingly blurred, broadening access to the term auction facility is the logical and correct policy.’

    It’s one way to do it. not my first choice.

    ‘The Federal Reserve’s current policy is failing because it is structured for the world of the past in which depository institutions dominated lending. Thus, current policy restricts access to emergency liquidity to deposit taking institutions, ignoring how lending has become detached from deposit taking. The challenge of the day is preventing a meltdown that destroys sound lenders and sound assets. That calls for widening access to temporary emergency liquidity. Afterward, there will be time to visit the question of regulatory reform and more permanent policy change’

    What policy is failing? Unemployment is 4.8%, gdp is flattish after a big year, exports are booming, housing is down but waiting for the new 700k jumbo size to take effect in 50 days so borrowers can save 100 bp, mcdonald’s and walmart sales are way up.

    is there a shortage of agg demand? if so that can be addressed away from the Fed. might add to this bout of inflation, but that’s another story.

    isn’t all about the real economy and agg demand? can’t fiscal policy sustain agg demand as any level govt might want? who cares even if the financial sector goes away entirely if agg demand, and therefore employment and output are ok?

    why are you trying to save the financial sector? Seems it should exist only to support the real sectors, and also seems there’s no evidence it does anything but prey on them???

    What’s happened to you???!!!

    Cheers!

    Warren

  2. warren mosler Says:

    ‘The irony behind this debacle is that part of the problem is due to margin calls from banks. However, banks are currently being bailed-out by the Federal Reserve, which has provided them with tens of billions of dollars of subsidized credit through its term auction facility.’

    Not a bail out. Banks already have access to insured deposits.

    It’s about price, not quantity (endogenous money and all that?).

    The Fed’s job is to set an interest rate, in this case the fed funds rate.

    All bank assets are ‘legal’ as per the regulators, and qualify for funding via insured deposits in any case.

    The liability side of the balance sheet is not the place for market discipline- you know the argument for deposit insurance and all that?

    The asset side is instead highly regulated, including capital requirements for market discipline. Imperfect, evolving, and political as it may be.

    ‘In effect, the institutions the Fed is bailing-out are the same ones putting downward pressure on financial markets. Indeed, the banks are being given subsidized credit’

    Not subsidized, but prices at the fed’s target fed funds rate, which is what targeting a bank rate is all about. The fed has to target some rate, and i don’t think you are saying the target rate needs to be higher?

    ‘for problems similar to those experienced by Thornburg. Thus, there was an earlier loss of confidence in banks’ assets that threatened their ability to renew roll-over funding for their activities. This risked causing banks to default, triggering margin calls and fire-sales of their assets that would have caused major asset price deflation and the destruction of credit provision.’

    Again, the Fed should provide unlimited funding for banks at it’s target rate, as the assets have already been deemed ‘legal’ by the occ and other regulators as has bank capital and capital requirements.

    And, as above, that’s what deposit insurance is all about.

    That’s how the bank model functions.

    The shareholders remain at risk for actual losses, which is the source of market discipline. there is not need for interbank lending if the fed understands it’s role and how reserve accounting works.

    And, as loans create deposits, there is little net lending from the Fed regardless.

    ‘The Thornburg story illustrates two things. First, the Fed’s policy privileges banks, bailing them out while letting perish other financial institutions that are no more guilty.’

    Giving banks access to funds at the fed’s target bank rate is not a bail out- it’s the basis for the banking model. It’s the starting point. it’s a failure of Fed policy when member banks in good standing aren’t provided funds for their legal assets at the target rate.

    ‘Second, the Fed’s current policy has not solved the problem of financial instability. Though the banks have been ring-fenced, they are now causing problems elsewhere through loan margin calls. Moreover, these calls could collectively come back to haunt banks by driving down the price of assets that they also own. Consequently, even the banks remain at risk despite the Fed’s term auction facility.’

    Right. They should alway open it to any bank legal assets, in any size, at their target rate. That’s what the Fed banking system is all about. Since loans create deposits, there will also always be little or no net funding by the fed as a point of logic, but their target rate will prevail, which is the point of having one.

    ‘In today’s crisis environment the problem in financial markets is not the level of interest rates, or even the size of the Fed’s term auction facility. The problem is getting liquidity to those links in the financial chain that are most stressed. Reliance on the normal channels of distribution does not work when confidence has evaporated and markets have seized-up.

    There is a very simple and fair solution to this problem. That solution is for the Federal Reserve to open its term auction facility to all publicly traded financial intermediaries rather than just deposit taking institutions.’

    Banks are already the fed’s own ‘designated agents’ for lending. The gov can do all kinds of things if the govt want the banks (and therefore the gov via insured deposits) to take more risk- alter capital requirements, provide fed guarantees, etc. In fact, you could argue that’s how the sub prime issue got started- gov incentives/encouragement to loan to lower income/less qualified borrowers. It’s not ‘wrong’ to do that, but does need a govt check written now and then if it doesn’t quite work out.

    Also, agencies like fnma, freddy, fha, etc. are also fed agents, who can also fund whatever assets the regulators want/allow/incent them to do.

    ‘That means giving access to insurance companies, mortgage investment trusts, mutual funds, and hedge funds. These firms would be subject to the same borrowing terms as banks, and would have to post collateral of identical quality.’

    They can already do this via their friendly banker, if the fed puts regs in place to allow the banks to do it.

    Otherwise the fed has to hire a bunch of specialized loan officers and then look just like the existing banks anyway.

    ‘Such a change would level the playing field in financial markets and remove the unfair subsidy to banks.’

    unfair??? subsidy??? what do you think fed member banks are other than agents of government, set up by govt statue, and therefore presumably for public service vis a vis the rest of the economy?

    ‘ Most importantly, it would tackle the problem of credit market seizure that is afflicting all financial institutions. In a world where distinctions between financial intermediaries have become increasingly blurred, broadening access to the term auction facility is the logical and correct policy.’

    It’s one way to do it. not my first choice.

    ‘The Federal Reserve’s current policy is failing because it is structured for the world of the past in which depository institutions dominated lending. Thus, current policy restricts access to emergency liquidity to deposit taking institutions, ignoring how lending has become detached from deposit taking. The challenge of the day is preventing a meltdown that destroys sound lenders and sound assets. That calls for widening access to temporary emergency liquidity. Afterward, there will be time to visit the question of regulatory reform and more permanent policy change’

    What policy is failing? Unemployment is 4.8%, gdp is flattish after a big year, exports are booming, housing is down but waiting for the new 700k jumbo size to take effect in 50 days so borrowers can save 100 bp, mcdonald’s and walmart sales are way up.

    is there a shortage of agg demand? if so that can be addressed away from the Fed. might add to this bout of inflation, but that’s another story.

    isn’t all about the real economy and agg demand? can’t fiscal policy sustain agg demand as any level govt might want? who cares even if the financial sector goes away entirely if agg demand, and therefore employment and output are ok?

    why are you trying to save the financial sector? Seems it should exist only to support the real sectors, and also seems there’s no evidence it does anything but prey on them???

    What’s happened to you???!!!

    Cheers!

    Warren

    http://www.moslereconomics.com

  3. Winslow R. Says:

    First, I’d like to compliment you for sticking your neck out. You are the first economist offering a solution that could lead to long term public benefit.

    The problem with your solution of allowing nondepository institutions access to the TAF is:

    1)unregulated nondepository institutions have no skin in the game (no capital ratio’s)
    2)the corporate shield opens up all kinds of opportunities for fraud (they could create ‘fake’ debt)

    Any solution requires real accountability. U.S. citizen access would provide that accountibility as no one can escape their Social Security number. Corporate officers do not have their Social Security numbers at risk.

  4. CR Morris Says:

    “The challenge of the day is preventing a meltdown that destroys sound lenders and sound assets.”

    Would that that were true. But in fact there are hundreds of billions of junk assets on financial balance sheets with false AAA ratings and false valuations. On sound principles, many banks and hedge funds are insolvent, not because of a lack of liquidity but because they’ve borrowed much more than their assets are worth.

    We could a/ simply buy all the bad assets with taxpayer money and ask banks and fund managers to behave more responsibly in the future; b/ start rating honestly, purge the garbage (assets and execs) and recapitalize the banks with public money, but at market rates, letting shareholders take the hit that free market theory says they deserve; or c/ paper it over with expedients like Bernanke’s ‘liquidity’ infusions, in effect buying out the banks by stealth over many months, maybe years, with zombie banks, zombie assets, and probably a zombie economy. Where is Paul Volcker when we need him?

  5. Per Kurowski Says:

    “Meltdown Moment: What Must be Done” is a very interesting article
    and Thomas Palley brings forward some great points. Yet I do not
    agree with his conclusions, precisely because we do not know enough
    of what is really happening in that no mans land that lies between
    the primary financial asset, such as a subprime mortgage or a
    municipal loan, and how these finally express themselves in the
    financial markets in the form of some sliced and diced derivative
    contract or collateralized security.

    As an example just take the case of Thornburg Mortgage that Palley
    describes as being in problem even though “its mortgage backed
    securities constitute good credit structures with the underlying
    mortgages still intact.” If you want, freeze proceedings, enter into
    chapter 11, but throwing real money at a virtual world does not seem
    a prudent thing to do when that real money could soon be needed to
    help out real world subprime mortgage debtors banks and even
    municipalities.

    The capital requirements for banks based exclusively on risk
    avoidance, the appointment of the credit rating agencies as risk
    overseers, the financial sophistication that exceeded the limits of
    comprehension, and all this in a globalized world with many
    structural economic imbalances is throwing at us what could turn out
    to be a world shattering crisis and in a case like that you are
    better of saving your real munitions for the clearly identifiable
    problems, instead of behaving like blindfolded children hitting at a
    piñata.

    But then again, and as we all know so little about the problem, who
    am I to say that Thomas Palley is not completely right?

    Per Kurowski