March 31, 2008
Neither US financial institutions nor the economy are likely to suffer from a lack of central bank liquidity provision. New lending facilities are coming along almost weekly, the safety net has been expanded to include non-bank primary dealers, the Fed has demonstrated a willingness to take on directly the most problematic parts of Bear Stearns’ balance sheet, and the Fed funds rate has been reduced by 200 basis points within 7 weeks.
At the same time, processes are in motion that may lead to new demands for more than $1,000bn in mortgages, directly or indirectly. Recent regulatory actions will enable Federal Home Loan Banks along with Fannie Mae and Freddie Mac (the government-sponsored enterprises) to purchase more than an additional $300bn in mortgage-backed securities.
There is substantial scope for further regulatory action as only a third of the punitive capital charge placed on Fannie and Freddie years ago has been lifted. Moreover, legislation to reduce foreclosures being pushed by Senator Christopher Dodd and Representative Barney Frank could result in the federal government purchasing or providing guarantees that enable the purchase of several hundred billion dollars worth of mortgages.
The confidence engendered by all of this has led to some normalisation in credit markets. Short-term Treasury note yields that had fallen to their lowest levels in a half century have risen to more normal levels as most credit spreads have narrowed considerably and market estimates of future volatility have declined.
It is sometimes darkest before the dawn. For the first time since last August, I believe it is not unreasonable to hope that in the US, at least, the financial crisis will remain in remission. The prices of many assets are discounting a severe recession or worse. Yet the combination of monetary and fiscal stimulus along with growing exports coming from a weaker dollar may limit the downturn, and newly induced demand for mortgages may support the mortgage market.
Just as cascading liquidations have contributed to a vicious cycle of both real and financial contraction, it is possible that recovery can be a virtuous circle in which improved financial and real economic performance are mutually reinforcing. Wise policymakers hope for the best but plan for the worst. Liquidity provision and government efforts to support the mortgage markets can address problems of confidence. But they cannot ultimately prevent asset prices from declining to true values or make troubled financial institutions solvent.
While spreads have come in somewhat, markets continue to price in significant probabilities of default for even the most apparently strong financial institution, reflecting in part concerns about their solvency. At the same time it needs to be recognised that the federal government is bearing credit risk in extraordinary ways through its implicit guarantee to the GSEs, the lending activities of the Fed and the general backstop it is providing to the financial system.
All of this implies that a priority for financial policy has to be increases in the level of capital held by financial institutions. Capital infusions to date fall far short of prospective losses. Without new capital, the financial sector will operate with too much risk and leverage or will put the economy at risk by restricting the flow of credit.
On a favourable economic scenario, increases in capital will accelerate the return to normality in sectors such as municipal finance and student loans where credit has dried up, and will offset the moral hazard created by lending to financial institutions.
On an unfavourable scenario, increased capital will protect the taxpayers who bear the burden of government and Fed guarantees, will make possible more immediate and honest recognition of losses and will reduce the risk of vicious balance sheet contraction if asset values decline again.
The policy approach should start with the GSEs. These institutions’ viability with anything like their current operating model depends on the implicit federal guarantee of their several trillion dollars of liabilities. It is appropriate at a time of crisis in the mortgage markets that they become, as their regulator put it last week, the “lender of first, last and every resort”.
It is not appropriate that their shareholders’ “heads I win, tails you lose” bet with the taxpayer be expanded for this purpose. Given their past and prospective losses, their regulator – supported by the Treasury, the Fed and, if necessary, Congress – should insist that they stop paying dividends and raise capital promptly and substantially as they expand their lending. In the unlikely event that the boards of these institutions refused, policymakers should put them into an appropriate form of administration that insures that their obligations will be met.
Because they do not have a similar public mission and are operated with more financial rigour and closer regulation, the situation is somewhat different with respect to other financial institutions.
As part of its dialogue with financial institutions, the Fed should push for further efforts to raise capital. Consideration should be given to collective actions designed to destigmatise cutting dividends or raising equity. The idea of linking access to Fed credit and measures to attract capital should also be explored. At a time when much is being given to financial institution shareholders and management, action to help the economy and protect the taxpayer should be expected in return.
The writer is the Charles W. Eliot university professor at Harvard University.