AEI Economic Outlook, October 2008: "Panic"

[David Farber <dave () farber net>]

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PANIC
By John H. Makin
October 2008

When you see your neighbor carryin' somethin',
Help him with his load,
And don't go mistaking Paradise
For that home across the road.
--Bob Dylan, "The Ballad of Frankie Lee and Judas Priest," 1968

The credit crisis that followed the collapse of the housing bubble  
turned into a financial panic on Wednesday, September 17, 2008. There  
was a run by households out of money-market funds and into safe  
Treasury bills, pushing their yields to zero for the first time since  
the Great Depression. There was a liquidity trap in the interbank  
market, in which banks that are supposed to lend to each other hoarded  
cash for fear of runs by their depositors and the insolvency of other  
banks. Financial markets simply froze in the midst of chaos.

Reactive to Proactive

The time had come--indeed the time had long since passed--for the  
Federal Reserve and the U.S. Treasury, together with other G7 central  
banks and treasuries, to move from a reactive, piecemeal approach in  
the face of a global financial crisis to a proactive, systemic  
approach. The Fed injected $105 billion into the banking system  
(having already injected $140 billion earlier in the week) to deal  
with a full panic run on money-market funds. Treasury secretary Henry  
Paulson and Fed chairman Ben Bernanke went to Congress, ashen-faced,  
to promise a proposal to provide further systemic support for the  
mortgage market. Other G7 central banks and treasuries did nothing.  
They view this as an American problem.

The proximate problem is simple, but the legislative solution being  
proposed by Paulson--a big bailout for holders of mortgage securities-- 
is going to be messy and expensive. The underlying problem remains the  
continued drop in house prices, which has severely curtailed the  
liquidity and value of trillions of dollars of mortgage-backed  
securities (MBS) held by financial institutions around the world.  
Burgeoning credit problems tied to the bursting of a housing bubble  
have threatened the economy, whose weakness has, in turn, further  
weakened the housing market and further exacerbated credit problems.  
The long-dreaded adverse feedback loop is now a reality. Apparently,  
having named the disease, the Fed and the Treasury have not--until  
now--realized that it needed to be treated, and treated aggressively.

We have reached a point in this highly disconcerting cycle at which a  
collapse of the housing market has totally frozen financial markets to  
a point at which banks are unwilling to lend to each other because  
they must conserve cash for fear of substantial withdrawals by panicky  
depositors. To repeat, the collapse in the housing market could lead  
to a further weakening of the economy and a further collapse of  
housing. This dynamically unstable downward spiral must be interrupted.

The leadership for this daunting task would better have come from the  
Federal Reserve, which, faced with an immense and growing financial  
crisis, has held to a reactive, piecemeal approach concerning the  
rapidly deteriorating U.S. economy, but even more so concerning the  
global financial crisis that has been growing at a terrifying,  
exponential pace in September.

Consider the September 16 statement by the Fed's major policymaking  
arm, the Federal Open Market Committee (FOMC). While the Fed  
acknowledged that "strains in financial markets have increased  
significantly and labor markets have weakened further," it opined  
hopefully that "over time, the substantial easing of monetary policy,  
combined with ongoing measures to foster market liquidity should help  
to promote moderate economic growth." The concluding paragraph in the  
statement suggested that "the downside risks to growth and the upside  
risks to inflation are both of significant concern to the Committee."  
While this seems like a prudent statement, it is virtually unchanged  
from the text of the FOMC's August 5 statement, despite a frightening  
acceleration in the downward momentum of financial markets and the  
real economy since early August.

Panic Prelude

In September alone, financial markets have been hit by wave after wave  
of crisis while the economy has shown signs of abrupt slowing  
highlighted by the jump in the August unemployment rate from 5.7  
percent to 6.1 percent. On September 7, the U.S. government placed the  
two large heretofore quasi-governmental mortgage organizations, Fannie  
Mae and Freddie Mac, into conservatorship--a state usually considered  
a way station on the road to bankruptcy--and removed their top  
management. In effect, the former step wiped out the value of Fannie  
and Freddie's common and preferred shares. In an effort to reassure  
markets, the Treasury pledged to put up to $200 billion in support of  
the two institutions. Unfortunately, while electing to deal with the  
moral hazard problem tied to bailouts, by wiping out common and  
preferred shareholders of Fannie and Freddie, the Treasury's action  
unnerved equity markets further. The idea that a bailout came to ca  
rry with it a total loss of value for common and preferred  
shareholders meant increasing downward pressure on the shares of other  
troubled institutions.

With investment banks under heavy pressure in view of large losses in  
MBS, their shares were the next to suffer. On September 14, after a  
virtual collapse of its stock price, Lehman Brothers filed for  
bankruptcy. On September 15, Bank of America absorbed Merrill Lynch  
for $50 billion in a purchase deemed necessary to rescue the brokerage  
giant from outright bankruptcy. At 9:15 p.m. on September 16, the day  
it released the complacent FOMC statement, the Fed agreed to lend the  
collapsing insurance giant AIG $85 billion at 12 percent in exchange  
for an 80 percent stake in the company, whose nominal value was $1  
trillion. Its real value was substantially less, but indeterminate.  
AIG's common stock had become all but worthless--the fate of a bailout  
candidate. Its outright failure threatened to precipitate a run on  
money-market mutual funds, the repositories of trillions of household  
cash balances. To underscore the fear surrounding the so lvency of  
money-market funds, on September 17, the Reserve Primary Fund "broke  
the buck," meaning that the face value of its near-cash equivalent  
deposits fell below $1. Withdrawals from the fund were suspended so  
that, for example, if a household had intended to use assets in the  
Reserve Primary Fund either to pay taxes or its mortgage, the funds  
were not immediately available.

The result of these almost surreal events occurring in such rapid  
succession was, as noted above, a panic run into Treasury securities  
by households and businesses, thus pushing yields on Treasury bills  
virtually to zero on September 17 and 18. Households and businesses  
sought the safety of direct claims on the government in favor of  
deposits at money-market funds or even in checking accounts. Thoughts  
about yield were abandoned in favor of wealth preservation, and, on  
September 17, the interest on four-week Treasury bills actually  
dropped to -1 basis point, meaning that investors were willing to pay  
the Treasury to store cash for the first time since the Great  
Depression. That sure sign of panic over the safety of the U.S.  
banking system came less than twenty-four hours after the FOMC  
attempted to reassure markets about "ongoing measures to foster market  
liquidity." With its statement, the Fed was trying to walk the  
difficult line be tween supporting the economy and the financial  
system and showing vigilance against inflation. The events in the  
financial system, however, coupled with the market's assessment of the  
outlook for inflation suggested that, at a very bad time, inflation  
was not a primary concern of markets.

While markets had, until mid-July, been signaling higher expected  
inflation as commodity prices were driven to new heights, that fear  
has since sharply abated. Oil prices peaked at $147 a barrel in mid- 
July but since have plunged by about a third to below $100 a barrel.  
Simultaneously, other commodity prices have dropped as news of a  
rapidly slowing global economy has reversed the upward pressure on  
commodity prices while weakening the outlook for global growth. It is  
hard to square the Fed's persistent concerns about inflation with the  
drop-off in commodity prices as the U.S. and global economies have  
slowed. The yield on ten-year government securities dropped from 4.1  
percent to 3.4 percent on September 16, the day of the FOMC meeting.  
During the same period, the yield on five-year government securities  
dropped from 3.5 percent to 2.5 percent. The measure of expected  
inflation derived from a comparison of yields between Treasury Inf  
lation-Protected Securities and Treasury notes not carrying inflation  
protection suggested that inflation expectations over a five-year  
horizon had dropped from 2.5 percent in July to 1 percent on September  
17. The Fed's continued preoccupation with inflation fears now appears  
near delusional in the midst of financial panic.

The events in the financial markets have taken their toll on risky  
assets, including stocks. The S&P 500 Index began the year at about  
1,500; sold off to a level below 1,300 in mid-March, at the time of  
the Bear Stearns crisis; and then rose back above 1,400 during May, as  
hope returned that the U.S. economy would recover thanks to the  
stimulus package and the supposed end of the financial crisis.  
Thereafter, stocks have continued to drop, especially during  
September. By September, the S&P 500 had fallen to about 1,150, losing  
nearly a quarter of its value since the beginning of the year. Other  
stock markets fared no better, with European stock markets falling by  
about a third since the start of the year and shares in emerging  
markets falling even more sharply in some cases. By mid-September, the  
Chinese stock market had dropped more than 60 percent from the start  
of the year, while the troubled Korean stock market, once a fav orite,  
fell by 26 percent in terms of the Korean currency and by 40 percent  
when adjusted for the decline of the Korean currency against the dollar.

The damage to financial markets worldwide has taken its toll on the  
global economy. Growth in Japan and Europe turned negative at midyear,  
while the Chinese economy appears to be slowing rapidly. In the second  
quarter, the U.S. economy grew, thanks to a huge boost from exports  
and $150 billion of tax rebate checks. In the third quarter, it looks  
as if U.S. growth will drop sharply--probably to -1.5 percent at an  
annual rate. As mentioned earlier, the U.S. unemployment rate jumped  
to 6.1 percent in August. Simultaneously, consumption spending has  
dropped sharply and will probably contract for the first time since  
1991. The near panic in financial markets that has filled newspapers  
in September will lead to sharp drops in consumption, investment, and  
employment as households and businesses try to conserve or actually  
raise cash. (September 15 was a due date for corporate and household  
quarterly tax payments. Preliminary data suggest a s harp drop in  
payments, caused either by lower profits, lower incomes, or a simple  
inability to pay.)

Messy Legislative Response

There are no easy or painless solutions in this extraordinarily  
difficult environment that rivals the financial and economic  
challenges of the Great Depression. A number of concrete, proactive,  
and systemic steps might have averted the September 18 panic that  
resulted in the steps to thwart a run on money-market funds and the  
messy legislative approach to a bailout of the financial system. The  
panic of September 18 and the forced move to an expensive and risky  
legislative approach to stabilize the mortgage market could have been  
avoided if the Fed had moved to expand its balance sheet by printing  
money, as I advocated in the Wall Street Journal on April 14, 2008.[1]

The Fed should be offering a clear promise to nervous depositors of  
banks and money-market funds. (The Fed did, on September 19, provide a  
$230 billion backstop for money-market funds, but on September 21,  
eligibility for that guarantee was limited to include only balances as  
of September 19.) Depositors should instead get a clear, broad  
commitment: "If you want to convert your bank deposit into cash, you  
are free to do so." Once a number of nervous depositors discover that  
they could withdraw as much as they want from either a bank or a money- 
market fund, the run on depositary institutions would cease. After a  
time with cash in hand, depositors would realize that as the system  
stabilizes and as the possibility of a modest, temporary reflation  
rises, it would be wise to redeposit their funds in banks and money- 
market funds in order to receive a market rate of interest.  
Eventually, the stabilization of the financial system would help i n  
turn to stabilize the mortgage and housing markets, and--with luck--a  
serious deflationary crisis accompanied by an economic collapse would  
have been averted.

To reduce the risk of panic among depositors, the Treasury should  
buttress the Federal Deposit Insurance Corporation to insure all  
depository accounts. The insurance ceiling, now at $100,000, is  
grossly inadequate, especially for the small businesses that must  
maintain such depository accounts for the normal conduct of business,  
including the meeting of payrolls. The risks attached to expanding  
depository insurance to cover all deposits are far outweighed by the  
risks of having a number of the nation's small businesses unable to  
meet payroll because of losses on uninsured deposits over $100,000.

The Treasury's proposal to Congress to allow the purchase of MBS  
directly from banks, investment banks, and insurance companies will be  
difficult to effect. Currently, such "private label" mortgage  
securities are challenging, if not impossible, to value. Their holders  
refuse to sell them at offer prices that would clear the market  
because such prices would raise questions about the solvency of many  
financial institutions that own the more than $10 trillion of U.S.  
mortgages outstanding. Electing to hold on to mortgage securities in  
the hope of receiving a better price in the future requires financing  
the holdings. With house prices continuing to fall, the cost of  
financing has risen sharply and, in some cases, has become unavailable  
at any price. The result has been acute distress and, in some  
instances, outright failure (as in the case of Lehman Brothers) or the  
need for a firm to sell itself to a large bank (as in the case of  
Merril l Lynch's absorption by Bank of America). As the plight of  
these institutions threatened Morgan Stanley and Goldman Sachs,  
systemic panic set in, and Paulson and Bernanke had to go hats in hand  
up to Capitol Hill for some real money--upwards of $700 billion.

Moving ahead, if the Treasury offers too much for the distressed MBS  
owned by banks and others, the cost of the bailout will skyrocket. It  
could become counterproductive if the prospect of another $700 billion- 
plus in Treasury borrowing pushes interest rates higher or forces the  
Fed to print money. If offer prices are too low--far below current  
make-believe values being placed on MBS by their owners--solvency  
risks will rise.

In short, this new program is not a Resolution Trust Corporation  
program. That program in the early 1990s involved the government  
taking over failed savings and loan institutions and auctioning off  
their assets. Now, the Treasury will be approaching existing  
institutions whose valuation of the MBS they hold is generous, to say  
the least. This knotty issue--among many others--may slow the passage  
of MBS bailout legislation. No doubt it will substantially raise the  
cost as Congress trades a "Wall Street bailout" for Main Street pork  
with, perhaps, a bailout for General Motors and Ford thrown in for  
good measure.

Opportunities Lost

As I said last April:

The policy alternatives in the post-housing-bubble world are painfully  
unpleasant. In my view, the least bad option is for the Federal  
Reserve to print money to help stabilize housing prices and financial  
markets. Yes, use reflation to soften the pain for Main Street and  
Wall Street. If instead we let housing prices fall another 25-30  
percent--as predicted by the Case-Shiller Home Price Index--it's  
almost certain that Washington will end up nationalizing the mortgage  
business.[2]

Now we are seeing Washington move toward nationalizing the mortgage  
business at a cost (initially) of close to $1 trillion once the extra  
cost of the MBS bailout program is added to the cost of GSE bailouts  
and associated pork extracted by Congress in exchange for MBS  
legislation. Further, the resource misallocation that will result from  
the tidal wave of legislation from Congress in response to the  
mortgage mess could cost another trillion dollars. Sadly, the new wave  
of regulation will just replace extant regulation. Had existing  
regulations been implemented, they would have precluded, or at least  
mitigated, the housing bubble whose bursting precipitated a financial  
crisis that turned into a financial panic.

There is a simple solution to the fundamental housing-bubble problem  
that lies behind the panic. An institution that makes a mortgage loan  
should be required to keep that loan on its balance sheet. That will  
mean higher interest rates on mortgages, but that is unavoidable. If  
policymakers understand why that is so, the problem need not be  
repeated. If they do not, we will have another housing bubble.

John H. Makin (jmakin () aei org) is a visiting scholar at AEI.

Notes

1. "[T]he Fed's intervention [to rescue Bear Stearns] has done no more  
than buy a respite from the crisis in the financial markets. The  
monetary easing I'm recommending can occur by having the Fed print  
money to purchase mortgages directly, or purchase Treasury securities  
directly. The latter is probably more desirable because it adds higher- 
quality assets to the Fed's balance sheet. The Bank of Japan was also  
forced to reflate by printing money in 2001, after two years of a zero  
interest-rate policy failed to lift the economy out of a prolonged  
recession that had moved Japan to the brink of a deflationary  
crisis. . . . The Fed should announce its intention to add to its  
holding of Treasury securities in order to provide additional  
liquidity. It should cease pegging the fed funds rate while this  
policy is in effect. While there is no guarantee, direct injection of  
money holds some promise of alleviating the worst of the credit  
crisis. " (John H. Makin, "The Inflation Solution to the Housing  
Mess," Wall Street Journal, April 14, 2008, available at www.aei.org/publication27807/.)

2. Ibid.




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