More on The Fed Audit, “Secret Loans”, and Conflicts of Interest

The last couple of days I’ve posted some thoughts on The Fed and the summer 2011 “audit” by the Government Accounting Office (GAO) here and here.  A long time reader and commenter, AZleader, apparently also wrote about The Fed audit.  I like his post a lot.  In particular, AZleader went beyond the press releases and news documents to read the actual report itself, something real historians do and journalists used to a long time ago.  He makes some good points (emphasis is mine):

Politicians and Press Releases

Shock of shocks! What you read in politician press releases doesn’t always jive with unbiased, objective truth. Politician press releases, as is true in the Sanders one, are often a mixture of fact and false implication crafted toward a political agenda.

It is not casual reading but ya gotta study the small print of the GAO’s very complex 253 page report that Sanders based his press release on to get to fundamental truths:

  1. The $16 trillion in “secret” Fed loans are not loans. They are MOSTLY innocuous financial services transactions provided by The Fed for which it was paid banking fees.
  2. There is nothing “secret” about the loans. According to the GAO Report all information it includes is in existing publicly available annual financial statements of the 12 federal reserve banks.
  3. The GAO audit isn’t “The first top-to-bottom audit of the Federal Reserve” as Sanders’ claims.  It isn’t even remotely close to that. Such an audit was proposed by Congressman Ron Paul and others but, as often happens in Congress, it got watered down in Dodd-Frank.
  4. The GAO audit is very limited in scope. It covers only temporary emergency loan programs between December 1, 2007 and July 21, 2010.

The main outcome of The Fed audit was to make recommendations on how The Fed can protect itself against exposure as the “lender of last resort” in emergencies.

Almost all the $16 trillion in transactions by The Fed are money swaps or very short-term 82 day or less collateralize loans to banks.

In other words, not only was The Fed not “out of control” as I noted, but it was instead actually doing what a central bank is supposed to do:  act as lender of last resort, facilitate transactions between banks, and facilitate international currency exchange — the precise things The Fed didn’t do so well in 1929-1933 and we paid for it with a Great Depression.

He also points out that while

…two CEOs were involved in conflict of interest situations. JP Morgan CEO, Jamie Dimon, and NY Fed Bank President, William Dudley, were both in positions of conflict of interest during the crisis.

The Fed was in a crisis mode and needed all the expertise it could get, even at the risk of having some conflict of interest.  I would agree that given the situation at the time, it was probably necessary to involve Dimon and Dudley.  However, what I fault The Fed for is for not having been prepared for such a situation.  The Fed has been too cozy with the banking executives for too long and too slow to move when changes in the industry or markets create a possible conflict of interest.

I agree with AZleader also in noting how the real scandal, the real damning information in the audit hasn’t gotten the attention it deserves.  Specifically:

….The vast majority of actual dollars spent by The Fed was in the “Agency Mortgage-Backed Securities Purchase Program“.

That isn’t even a loan program at all.

That program was created “to support the housing market and the broader economy”. It bought up all the toxic home mortgage loans approved by and backed up by Fannie Mae and Freddie Mac, the home mortgage lending giants.

The Fed had to buy all of Freddie and Fannie’s bad debt because it was required by law. Both companies are government sponsored enterprises (GSEs) created by the government. Those companies went into government receivership in September of 2008.

The total real dollar net purchases in that program was $1.25 trillion. Some of those assets have since been sold. There is still a $909 billion debt balance outstanding.

The Fed paid out about $80 billion in investment management fees to outside vendors, all of them American companies

Again, the problem here isn’t so much that they bought the Freddie and Fannie debt. Something had to be done to help “support the housing market”.  The problem is again a lack of foresight, planning, and consideration of alternatives.  In the reality, what The Fed did was prop up Freddie, Fannie, and the big banks involved in wholesaling mortgages and the MBS market.  The way it was done didn’t really address the fundamental issues in the housing and mortgage market, as evidenced by us being in the fourth year of a continued housing depression, declining house prices, and rising foreclosures.  Sick lenders were a symptom, not the disease in housing.  The Fed only addressed one symptom.  The Fed has also exposed itself to serious losses by taking on much of this mortgage debt.  What options The Fed might have considered is a topic for another discussion.

AZleader and I don’t always agree on a lot of things, but I think we’re close on The Fed audit.  Of course, how we fix The Fed is another topic….

What Happens If Debt Ceiling Is or Isn’t Raised – How It Plays Out (updated)

Yesterday I took a stab at describing what the consequences of a government default might be and I added to it here.  There’s basically three lessons to take away from those questions. One, nobody knows now exactly what happens, especially in financial markets.  Two, it all depends on the specifics of a deal or no deal to raise the debt ceiling.  Truth is that many of the proposed “deals” to raise the debt ceiling will have negative consequences for the economy as bad as if we don’t raise the ceiling.  And three, regardless of the specifics in financial markets, it will have very negative consequences on GDP and the real economy where most of us live and work.  What I want to address now is less of what the disaster will be as the how the economic side of crisis will likely unfold.

Reporters and politicians are using the metaphor or image of the economy moving toward a cliff to describe how things will happen economically.  They, and the President is one of them, are conjuring up an image whereby the economy is moving along just fine and dandy and then, if we don’t raise the debt ceiling, we will just fall off a cliff into a giant abyss on Aug. 2.  They’re acting as if there’s this hard-and-fast, unalterable deadline when the machine just stops.  If Congress passes a debt ceiling increase before Aug. 2 then they act like everything will be OK.  The image that comes to my mind is one of Coyote from the old Loony Tunes cartoons racing along a plateau towards a giant cliff.  At his current rate he’ll reach the edge on Aug 2.  If Congress votes an increase before Aug 2, then a bridge will appear out of nowhere and he goes on safely.  If they don’t Coyote just falls into the abyss.  That’s wrong and it’s misleading.

The better metaphor is not of a someone racing toward a cliff. The better metaphor is to imagine thousands of people all standing around at the edge of a cliff looking over the edge. The key is the cliff isn’t made of rock.  It’s made of ordinary sand and dirt and it’s weak.  And the cliff has a bit of an overhand to it.  Nobody can see clearly over the edge.  What will happen is that gradually people will get nervous.  Some folks decide to move back from the  edge – banks, investors, and funds decide to move their money out of US T-bills. But the movement starts to weaken and shake the ground.  Some dirt can be seen sliding over the edge.  More people begin to pull back.  The earth shakes and slips more.  It turns into a mob rush to start getting away from the cliff’s edge. But it’s too late.  The ground starts sliding slowly but it gains momentum.  It turns into a landslide.  The whole cliff slides down in a massive landslide taking huge numbers of people with it.  That’s how I see it.

We’re already seeing the beginning of the movements this week.  We have reports from the New York Times that Debt Ceiling Impasse Rattles Short-Term Credit Markets.  The stock markets aren’t in full panic mode. There’s been no 3-5% decline days of panic selling like we saw in 2008. Yet.  But we’ve seen the market turn decidedly down. It’s been losing about .8% per day all week for a 4% loss on the week.  Interest rates on short-term government T-bills are up a little, indicating that a growing desire to sell by many and get out.  (interestingly, the rate on long-term bonds are actually down a bit – funds appear to still be bullish on the U.S. long-term).  Right now there’s no panic. But as JP Morgan Chase CEO Jamie Dimon said today “We’re praying. And we’re planning”.

How bad could it get?  Again I’ll turn to Jamie Dimon:

Now, here’s what really would happen.

Every single company with treasuries, every insurance fund, every — every requirement that — it will start snowballing. Automatic, you don’t pay your debt, there will be default by ratings agencies. All short-term financing will disappear. I would have hundreds of work streams working around the world protecting our company for that kind of event.

Read more: http://www.businessinsider.com/jamie-dimon-debt-ceiling-isnt-raised-and-the-us-defaults-praying-2011-4#ixzz1TX9b0ypB

Even the Aug 2 deadline itself isn’t as hard and fast as the President and Secretary of the Treasury have made it out to be.  The original projected date when new government borrowing would have to stop was in mid-May.  But when that date came, the Treasury began to implement some extraordinary measures.  Instead of making cash payments to some government employee pension funds he gave them IOU’s – promises to make it good soon.  Cash payments to many government vendors have been slowed down.  They implemented tricks that are the big government equivalent of searching the sofa for loose change, or borrowing from the kids’ piggy banks, or using the full 15-day grace period to make the mortgage payment.  At the same time, cash tax collections have a just a tick better than projected.  Eventually these tricks run out.  Right now the latest estimates I’ve seen say the real cash-drop dead date is closer to Aug 10. But it’s likely the Treasury will stop something on Aug 2.  We just don’t know what.

My point here is that it’s not like Tuesday August 2 is calamity day and everything happens then.  It might. But things might fall apart before then.  Or they might fall apart a few days later.  Or things might continue to gradually get worse but without us realizing how bad it’s getting because we’re waiting for the dramatic fall off a cliff.  By the time we realize in mid-August that it’s a real disaster, we’ll be buried in the landslide.

This is crazy.  It’s no way to run a government or an economy, but it’s clear that the Republicans and Tea Party types would rather crash the economy than compromise. Unfortunately Obama is willing to help them do it.

UPDATE:  Some indicators of possible trouble could show up next Monday when the Treasury holds a “routine” auction of T-bills for refunding purposes.  Refunding doesn’t add net debt, it only rolls-over existing maturing debt.  Treasury will also announce it’s plans for future auctions at that time.  According to the Wall Street Journal Marketwatch:

A refunding is a replacement of government debt, often debt that is about to mature, with new debt. Officials typically meet with about half of the primary dealers each quarter to discuss the refunding.

On Monday, Treasury plans to release estimates of future borrowing. Two days later, it will release its refunding decisions, including how much in Treasury securities will be sold.

Income Inequality and Financial Crisis

The Great Recession of 2007-9, like the Great Depression in 1929-33, was triggered by a massive financial crisis: stock market crash, falling asset prices, bank failures, and liquidity crisis. One of the key triggers of instability in banking and the resulting financial crises is what economists call “over-leverage”, meaning too much (private) credit and too much (private) borrowing relative to incomes. When the crisis hits, people start to “de-leverage”, that is pay-off debts and/or write-them-off in bankruptcy.  The process of de-leveraging forces people to use more of their incomes to pay off debt and less on spending. The decline in spending causes a decline in GDP, leading to layoffs, and a downward spiral.

Many of us have been intuitively saying that this over-leveraging (over-borrowing and going into debt) is the result of rising income inequality. Now Michael Kumhoff and Romaine Ranciere have published a study and a formal model to explain how such a process works. They note:

Of the many origins of the global crisis, one that has received comparatively little attention is income inequality. This column provides a theoretical framework for understanding the connection between inequality, leverage and financial crises. It shows how rising inequality in a climate of rising consumption can lead poorer households to increase their leverage, thereby making a crisis more likely.

They further show the similarities between 1929 and 2008.  It’s striking. As income inequality increases, i.e. the rich get richer faster, the rest have to go further into debt to maintain lifestyle or lifestyle progress. Overall debt and leverage rises until a crisis happens and the crash begins.

Figure 1 plots the evolution of the share of total income commanded by the top 5% of households (ranked by income) against household debt to GNP or GDP ratios in the two decades preceding 1929 and 2008. The income share of the top 5% increased from 24% in 1920 to 34% in 1928, and from 22% in 1983 to 34% in 2007. During the same two periods, the ratio of household debt to GNP or to GDP increased dramatically. It almost doubled between 1920 and 1932, and also between 1983 and 2008, when it reached much higher levels than in 1932.

Figure 1. Income Inequality and Household Leverage

 

Excerpt is copyright by Voxeu.org, at Inequality, leverage and crises by Michael Kumhof Romain Rancière