SeriousBull

Freefall Fed Policies?

Tags: Banks + Comptroller + Economy + FDIC + Fed + GNMA + Treasury

This week the credit markets again seized up culminating in across-the-board sell-offs of mortgage-backed security holding entities. Thornburg Mtg reportedly was forced to liquidate some high quality mortgages at 70 cents on the dollar to meet margin calls.  Soon thereafter Carlyle

Capital, a subsidiary of private equity firm Carlyle Group reported receiving substantial margin calls they did not have capital to meet and began liquidating its 21 billion + mortgage-backed securities portfolio. As of the close yesterday, Thornburg’s various preferred series had lost 50%-58% of their value while Carlyle Capital’s bond fund closed off 60%.

In response to this malaise, and on top of the pending news of an inevitable, declining US jobs report, the Fed vowed to increase its short term auction facility size and extend the range of eligible securities banks may offer for collateral.  The Fed additionally said it would pump additional funds into the credit markets by boosting repurchase agreement amounts to a total of $200 billion.

Meanwhile, at fixed income trading desks AAA rated mortgaged-backed agency issues (GNMAs) are beginning to catch the hex. Astute investors are calculating that there’s no need to pay 100 cents on the dollar when forced liquidation is occurring. Soon this astuteness (duh!) will surely cause them to ponder if GNMAs, though backed by the full faith and credit of the US, should not be discounted with a risk premium since the inventory is quite large and getting larger as margin calls force greater liquidations and because after all GNMAs are really sub-prime paper dressed up like an insured Ambac or MBIA guaranteed bond. That is, though the US Government backs them by tax dollars, it has backed a factor of two, or three, or twenty+ times its ability to pay and additionally faces a $9 trillion budget deficit, has considerably greater liability to its citizens in Social Security and Medicare payments, and has yet to fund pension liabilities for its growing work force–all reflected, you might say in the US Dollar’s value.

The problem is reactionary policy instead of pre-emptive policy and the failure to fully assess and address the magnitude to the current financial crisis because of vested interests of all involved.  These failures are largely perpetuated by the same people who created the problem who are now trying to fix the problem, albeit without Greenspan. The inherent problem is that they have a vested interest in backpedaling and denying something so bad happened with them on the watch. But the fact of the matter is the Federal Reserve, the FDIC, and the Comptroller all failed to exercise sound judgement and act to curtail the abuses of excess leverage and exotica in lending. Their constant state of denial (or hiding) has them dipping water out of a bucket to put out the flames when a fire is raging out of control just over the hill.

Let’s dissect the seriousness of the problem at hand. First there is too much leverage in the financial system. Second, there are inflated collateral values and therefore a lack of underlying loan and deposit collateral. Third, there are exotic securities with trigger events of enormous potential sufficient to wreck the world’s financial system. 

While it is apparent that a massive ’deleveraging’ must take place, pumping out trinkets of rate cuts does not adequately address the issue of inflated collateral value and ensuing insolvency of lenders and their borrowers.  Furthermore, banks hoarding the benefits of rate cuts to shore up their profits instead of passing the benefits down line to consumers to lower mortgage rates does nothing to forestall additional foreclosure much less to extend consumer spending which is our best shot at averting even greater, spiraling, economic woes. Moreover,  the uncertainty surrounding the tranches of securitized debt and credit swaps all financed with high impact leverage destabilizes traditional credit markets–that’s why they need to be regulated (ditto duh!  hello, Dr. Greenspan).

So what should the Federal Reserve do instead? To address leverage and inadequate capital reserves, the Fed should cut the discount rate, but at the same time increase capital reserve requirements at banks holding mortgages and high risk loans. Focus should be placed in two key areas: Government sponsored entities (including Ginnie Mae) and sun-belt banks where housing values climbed the most.  Security portfolios should be evaluated and a calculation of adequate, excess reserves made. Equity of senior management should be seized, sold, and held in escrow presuming that the judgement is made that a workout is probable. If not, the bank, lender, broker, or insurer, should be placed in trusteeship with all equity cancelled.  A court should appoint a successor management group and the assets auctioned if the failed entity is deemed beyond salvage. The Justice Department should then pursue cases of fraud which underscores why entrenched players, particularly at Treasury, FDIC, the Federal Reserve, and Comptroller should not solve this problem with the same people or those conflicted because of past affiliations (think Paulson, Goldman, China, GNMA).

Because consumer spending drives trade and the US economy, Federal funds rate cuts must be mandatorily passed down. In addition to these normal rate cuts, interest rates on credit cards should be capped at no more than 12-15% for an indefinite period of time. Doing this would have 12-15 times the impact of a 1% interest rate cut. Lowering consumer interest rates is not only fair, but also stimulative to the economy and jobs and serves to reduce the impact of less consumer spending.

As far as the exotic mortgages and derivative securities are concerned, the government must regulate bank, brokerage, and lending entities operating under statutory capital reserve requirements to liquidate and unwind derivative contracts in excess of a 1:1 ratio, not of capital reserves, but of capital on hand in excess of capital reserves. Banks and government licensed-to-leverage entities should not gamble with depositor money. They should speculate only with shareholder equity capital without recourse to deposit collateral securities and probably in an entity legally separate from the regulated entity.

The effect of these initiatives would extend Federal interest rate benefits to the consumer greatly offsetting their higher cost of living while diminishing uncertainty and rebuilding confidence in the financial system–something just adding liquidity will not do. Surely numerous banks would downsize and others go out of business, but the government and the taxpayer would ultimately not be stuck with the entire tab for mounting losses as equity would be escrowed, assets would be auctioned, and financial institutions would be required to again manage conservatively when using the public’s money.

March 7, 2008 - Politics