Central banks' easy virtue, easy money

By Julian Delasantellis

There's an old story about the late British statesman Winston Churchill at a party. Probably on one of those many nights where never in the field of human excess had so much cognac, brandy and scotch been consumed by a person who historians now say was not an alcoholic, he staggered up to a socialite matron and posed a question:

Churchill: "Madam, would you sleep with me for 5 million pounds?" (In the 1930s, when the British pound was worth more than twice as much to the US dollar than it is now, this was a particularly impressive sum over which to surrender one's virtue.)
Woman: "My goodness, Mr Churchill ... Well, I suppose ... we would have to discuss terms, of course."
Churchill: "Would you sleep with me for 5 pounds?"
Woman: "Mr Churchill, what kind of woman do you think I am?!"
Churchill: "Madam, we've already established that. Now we are haggling about the price."

Thanks to last week's events in the financial markets, we now know the price at which the world's three largest central banks, the Bank of Japan, the European Central Bank and the Federal Reserve Bank of the United States, will drop their posturings about the importance of setting good examples regarding promoting sound banking, lending and credit usage policies and put their principles up for sale.

If the world's stock markets lose, oh, say, US$2 trillion of valuation or so in a month, well, it looks like it's at that point they start "discussing terms". Since March, I've written a number of times in Asia Times Online about what has come to be known as the "subprime crisis", but it was at the end of that first March 6 article, Rocking the subprime house of cards, where I first postulated that this situation would eventually degenerate to a point where central banks and bankers would be called on to intervene. This happened last week.

The Fed and other central banks put up a good fight for their virtue. After the Fed's August 7 meeting, its board of governors produced a statement aggressively optimistic about the state of the US economy and contemptuously dismissive about the possibility that the subprime crisis might represent a potential cloud or two on this relentlessly blue horizon. After reading it, one might have wondered if chairman Ben Bernanke needed his manic-depressive prescription refilled.

The next day, as markets reacted against the Fed statement and the attendant realization that no immediate central bank help was on the horizon, the Fed and the world's other major central banks reversed themselves and went full-throttle floozy for the rest of the week. According to Reuters, by the end of last week the world's major central banks had put more than $325 billion of extra liquidity into the system; the Fed's contribution to that total is said to be in the neighborhood of more than $100 billion.

The US media report stories like this in much the same way they report baseball statistics or Hollywood blood-alcohol test results - lots of coverage but little real understanding. It is only in knowing the mechanics and causation of these events that one can understand just how serious this crisis is now becoming.

The media verb of choice for these procedures is that the Fed has "injected" reserves into the banking system, but this does not mean this exercise is such that you have bankers reporting to Dr Bernanke's office, wherein they lower their Hugo Boss suit trousers to receive a hypodermic syringe's bolus of bucks into their buttocks.

The core method in which the US Federal Reserve exercises day-to-day control over the economy in its purview is through operations that buy and sell debt securities in what is called the Federal Funds market; these are called open market operations. If a central bank wants to withdraw reserves from the banking system, it will sell from their portfolios a quantity of government debt securities into the market; when the buyer clicks a button on his trading terminal and transfers the purchase price of the securities via the miracle of electronic funds transfer (EFT) out of the institution's account into that of the central bank's, the supply of money decreases in the banking system by an amount concomitant with the worth of the securities.

Many of the transactions in this market are repurchase agreements, or repos, wherein one party, usually a large money-center bank, agrees, for a fee, to lend specific securities to another party with a need to fund its reserve requirements for a short period, sometimes as short as one night. The process is reversed when, as happened last week, the central bank wants to increase the supply of money in the banking system. There it buys securities; when it pays for them via EFT, then the money supply gets increased in a similar fashion. In the United States, this process is effected through the Federal Reserve's ongoing relationship with 21 large commercial banks called "primary dealers".

In the 1980s, when central bankers worshipped pint-sized monetarist economic guru Milton Friedman as the living god of wealth, the purpose of these operations was to set and meet a defined policy objective as to where the absolute quantity of money in the economy should be. These days, central bankers are more likely to target a previously specified interest rate; when the media report the results of a Federal Reserve or other central bank's interest-rate decision, this is this rate to which they are referring.

Since an interest rate is, in essence, the price of money, as it goes up so does the cost of borrowing money from a lender, and as it goes down the reverse. This is how the world's interest rates act as the world's economic throttle.

Right now, the target interest rate for funds lent and borrowed in this market is 5.25% in the US; on many days the Federal Reserve Bank of New York, operating on instructions from Federal Reserve headquarters in Washington, DC, goes into the market either to add required liquidity or to sop up and remove excess liquidity, to keep the target interest rate, called the Federal Funds rate, in line.

It is not at all uncommon for the Federal Funds rate to vary from the target rate. Around the Christmas holiday season, the system is frequently short of reserves, as people empty their bank accounts to buy presents; this was particularly true during the holiday season of 1999, when people emptied their bank accounts both to buy presents and because of media reports warning that middle America would soon resemble Fred Flintstone's Bedrock City after the biblical-level devastation soon to be visited on the heartland by Year 2000. Likewise, in the spring, as people deposit their income-tax refund checks, bank reserves are plentiful.

This week, the Federal Reserve noticed that the Federal Funds rate had jumped well beyond its target of 5.25% toward the low and middle 6% range. Other world central banks noticed similar increases beyond their target ranges; in Europe, after news that America's subprime problems had jumped the Atlantic and had been found in European financial institutions such as BNP Paribas and Germany's IKB group, rates had moved to 4.5%, a half-point beyond their target range.

The most common factor that traditionally explains rising interest rates is economic growth; more companies and individuals are borrowing from banks to finance their economic expansion plans. This was not the case last week; borrowings from the system were stable.

The problem wasn't the demand for money; it was the supply. The subprime-mortgage banking crisis, which a year or so ago began in far-distant fields of verdant identical pastel highrise condominiums in such places as San Diego and southern Florida, had finally spread into the absolute core of the modern financial system, this interbank market for overnight reserves.

Calling this entire thing the "subprime crisis" evokes the incorrect notion that the entirety of the "storm and stress" of what the world's markets are going through these days is centered on those poor sods sitting in their overpriced houses on which they've stopped making payments, awaiting the morning when the local county sheriff knocks on their door to put all their rented furniture on the sidewalk when evicting them.

This is where the crisis started but, in reality, like a toy balloon filled with too much air that tears apart at a random point on the balloon's surface, the bursting of the credit/liquidity balloon that so inflated this decade could have begun at any number of the places where irrational exuberance-greed had affected allegedly rational economic actors.

So, out there in the hinterlands of economic activity, subprime borrowers are not paying their mortgages. The people who bought these mortgages, rolled and bundled up into interest-bearing bonds called collateralized debt obligations (CDOs) , now find that they have what is delicately called a "liquidity crisis"; in real-people-speak, they have no income. They are no longer receiving the CDO coupon interest that derived from the mortgage interest payments.

That's a problem both for them and for the institutions they might have borrowed the money from to get the funding to buy the CDOs. If they're not receiving any income payments from the CDO owners (because the CDO owners aren't receiving the mortgage interest payments from the subprime borrowers), then soon they'll be suffering their own "liquidity crisis".

And so on and so on, on and on up the finance food chain until you get to late last week, the arrival of the crying baby of this crisis at the doorstep of the interbank market for short-term reserve finance. The problem has been particularly exacerbated by the current trend in finance to manage balance-sheet assets and liabilities aggressively; in essence, at every level the financial system is now continually doubling down on every bet it makes. If you've got an asset worth x, you might use it as collateral to borrow 5x or 10x, and a pretty similar process governs lending as well.

In many of my articles here I have noted that the key component of modern international finance has been the massive "wave of liquidity" that has buoyed prices on everything from private-equity buyouts to 1950s-era TV-show lunch boxes on eBay.

The wave of liquidity is one of the central arguments for those who believe that the entire subprime crisis is just a tempest in a teapot, that it will have little or no effect on the "real" economy. At a news conference last Wednesday, US President George W Bush opined, "Another factor one has got to look at is the amount of liquidity in the system. In other words, is there enough liquidity to enable markets to be able to correct? And I'm told there is enough liquidity in the system to enable markets to correct."

The essential assumption in that sentiment is that the amount of liquidity, of money and credit, in the system is fixed, as if it's all safely stored away in neat little shrink-wrapped bundles or something.

The very concept of a credit crunch, illustrated in last week's markets, proves this false. We are now seeing that much of the world's liquidity wave can disappear with the same effortless ease with which it was created. Specifically, as the market values of CDOs decline, less can be lent out using them as collateral. With globalized finance meaning that subprimes are now being found in so many more portfolios than previously expected, such as those of BNP and IKB, the process of credit contraction immediately spreads across the planet, much as the global equity-market selloffs are illustrating.

A special factor that spooked the Federal Funds market late in the week, and probably the one that most directly led to the intervention of the Fed and other central banks, was that this market's players can push back from the table any time they want.

The transactions in the Federal Funds markets carry no type of federal deposit-insurance coverage or protection. Thus if you make a deal with another player to be repaid in 24 hours, and if your counterparty goes belly-up in that period, you get right into line at the courthouse door with all the other institutions to which the dearly departed bank owed money; an intended 24-hour transaction might turn into one that lasts a decade, with you paying hefty lawyers' fees the entire time.

Amazingly enough, late last week such gross fear spread through the markets that there were concerns that one or more primary dealers, institutions such as Goldman Sachs, JPMorgan and Credit Suisse, the most cerulean names in US blue-chip finance, might fail to roll up their window-shades and open their doors for business the next morning. Rather than make uncovered loans to these potential cordon bleu deadbeats, other players got up from the table and pulled in their lending to this market. That produced the shortage of lendable reserves in this market that caused the rise in short-term interest rates, and was what drove the central bankers to ride in and attempt their first of what could be many rescue attempts.

Elvis Presley was more likely singing about women than international financial-market liquidity when he sang the title track for a movie in 1967, but the principle is the same. Easy come, easy go.

Illustrative of the fact that, yes, the subprime crisis is having an effect in the "real" economy is the rather anomalous behavior currently going on in the commodity markets, particularly for petroleum products. (See my April 4 article Crude: Barrels of fun to crack you up and the April 24 article Why oil chiefs are feelin' groovy, on last spring's activity in the oil markets.)

In late spring and early summer, it seemed that oil and product futures prices were on a one-way trajectory straight to the moon and stars, as shortages in US refinery capacity were putting tremendous upward pressure on these markets. However, since August 1, oil futures prices have plunged 11% on US markets. Much like equities, there's just not enough money and liquidity around to support the previously high prices anymore; beyond that, there's an extended message that the markets are trying to deliver, that soon a lot of people are going to be focusing their driving efforts more on short trips to the local unemployment office than to some far-flung mall.

The response of Bush and other economic conservatives (such as the ones he appointed to the US Federal Reserve Board) to the rescue of the subprime market now underwater has been in essence similar to his response to the rescue of New Orleans when it was underwater from Hurricane Katrina in 2005. No.

Late last week, a possible solution to the subprime crisis was raised; the US semi-official mortgage guarantor agencies, the Federal Home Loan and Mortgage Corp (called Freddie Mac in the markets) and the Federal National Mortgage Association (similarly called Fannie Mae), suggested they might be willing to buy up at risk subprime paper in the market, thus allowing the homeowners to stay in their homes. More important for Wall Street, it would take the now-radioactive subprime CDOs off its hands and inject more liquidity into the system. Bush sniffed at the suggestion; he said the two agencies had to be first "reformed" of the rampant corruption that economic conservatives always seem to find in public agencies.

In general, economic conservatives say the role of government in ameliorating this crisis should be, at most, virtually non-existent.

Much like pregnant ghetto teenagers, they say that those suffering in the subprime crisis are there wholly through their own misguided actions, specifically, their greed. No government actions, including anything by the Federal Reserve, should be taken on their behalf. They must suffer the pain that is the rightful and just consequence of their imprudent actions. An editorial in Saturday's Wall Street Journal summarized this philosophy very succinctly.

No one wants to see someone lose his home to foreclosure. But many of those most at risk bought their homes with little or no money down, and so have very little at stake economically. Bringing in the feds to bail them out would send precisely the wrong message - that risky or overly aggressive borrowing will be rewarded by the government rather than punished in the marketplace. To the extent that bad loans were made, the market needs to clear, not be propped up by federal aid programs ...

With the current market turmoil, Mr Bernanke faces his first big test as chairman of the Federal Reserve. The biggest favor he could do for himself and the markets is not to give in to the temptation to do favors for Wall Street or anyone else, and to remain focused on his price-stability mandate.

What this editorial is trying to say is that the markets must be disabused of the notion that some institutions are, like those that lent billions to hedge fund Long-Term Capital Management in 1998, or the banks that lent to Mexico in 1982, "too big to fail". Much as the ghetto teenager who loses her welfare benefits and so, like a modern-day Flying Dutchman of the service sector, is sentenced to push a broom at McDonald's for all eternity, those who make mistakes must forever pay for their actions.

Warnings against the dangers of excessive credit utilization are also a regular part of Federal Reserve communications with the general public. In a publication titled Building Wealth, the Federal Reserve Bank of Dallas provides these dictums.

Liabilities are your debts. Debt reduces net worth. Plus, the interest you pay on debt, including credit-card debt, is money that cannot be saved or invested - it's just gone. Debt is a tool to be used wisely for such things as buying a house. If not used wisely, debt can easily get out of hand ...

Develop a budget and stick to it. Save money so you're prepared for unforeseen circumstances. You should have at least three to six months of living expenses stashed in your rainy-day savings account, because as the poet [Henry Wadsworth] Longfellow put it, "Into each life some rain must fall." When faced with a choice of financing a purchase, it may be a better financial decision to choose a less expensive model of the same product and save or invest the difference. Pay off credit-card balances monthly.

This is all sound, prudent and conservative financial advice; the underlying cause of the subprime crisis is that, for much of this decade, America's financial elite has basically not practiced any of it. Do as I say, be cautious and careful, not as I do; I'm borrowing and lending like a drunken sailor with free tickets to a beer fest.

With this as intellectual background, you might have expected the conservative-libertarian economic community to have decried the Federal Reserve money-market interventions. After all, if a few or more primary dealers had imprudent connections, even if they were once, twice or more removed, with the subprime market, their insolvency and bankruptcy could only have a proper disciplining effect on the market. The example of their misery and penury will act to ensure that future market participants eschew the next upcoming financial-market inanity.

Not on your life. While it's true that these economic conservatives are cradle-to-the-grave misanthropes who decry everything from government funding of infant inoculations to Meals on Wheels for elderly shut-ins, still they are proving themselves to be a lot more sanguine about the prospect of government assistance if the assistance is directed at members of their own elite class.

As former Ronald Reagan-era (1980s) economic official and current CNBC economic commentator, Larry Kudlow, put it in his National Review Online blog, "The Fed and other central banks are prudently injecting $131 billion of new cash to 'facilitate the orderly functioning' of markets. Fed chairman Ben Bernanke has the story right."

Of course he has. Principles and ideologies are fine on a sunny day, but the subprime crisis is now threatening core institutions of the financial system that has rewarded the elite so generously - beliefs be damned, Bernanke, get in there and save our portfolios. For all the "financial education" the US Federal Reserve provides the masses, and all the verbiage about what cautious, exacting, circumspect bankers they are, this crisis, like all the rest that came before them and all those that are to follow, prove that they are, at crunch time, just Wall Streetwalkers, always available to compromise their principles to pleasure their masters.

In 1925, George Orwell lyrically described an encounter he had with a member of the sisterhood of the oldest profession in the world.

When I was young and had no sense
In far-off Mandalay
I lost my heart to a Burmese girl
As lovely as the day.

Her skin was gold, her hair was jet,
Her teeth were ivory;
I said, "For twenty silver pieces,
Maiden, sleep with me."

She looked at me, so pure, so sad,
The loveliest thing alive,
And in her lisping, virgin voice,
Stood out for twenty-five.

That's also sage counsel for Bernanke. As the credit crisis continues to deepen, and as calls rise for a 50-basis-point cut in Federal Reserve interest rates, he can always provide an effective palliative for his conscience by saying he "stood out for twenty-five".

Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.

(Copyright 2007 Asia Times Online Ltd. All rights reserved.)