Brad Setser

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It looks like the United States’ no bailout policy lasted all of two days

by Brad Setser
September 16, 2008

AIG’s bondholders got a huge break. That is an observation, not a criticism. The credit markets were not reacting well to Lehman’s bankruptcy filing.

$85 billion is a lot of money. The terms of the loan are onerous. 850 bp over LIBOR (a penalty rate) plus equity warrants. The US government now effectively owns a significant chunk of the US financial system, and provides liquidity to an even bigger chunk of it. To state the obvious, the crisis has entered a new phase.

Rogoff and Reinhart’s paper on the cost of systemic banking crisis looked good when it first came out. It looks even better now.

An anonymous Federal reserve official was quoted recently in the Wall Street Journal saying:

“We’ve re-established ‘moral hazard,'” said a person involved in the talks, referring to the notion that the government should eschew bailouts, since financial firms might take more risks if they’re insulated from the consequences. “Is that a good thing or a bad thing? We’re about to find out.”

Felix is right; the person involved in the talks didn’t quite get the concept of moral hazard. The US government removed ‘moral hazard” — the availability of insurance that protects investors from losses on risky assets — from a portion of the credit market. I am still not sure if it was a good or a bad thing. But it sure seems to have revealed that a significant portion of the US financial system wasn’t strong enough to stand on its own, without a government backstop.

81 Comments

  • Posted by glory

    “how the US is handling the banks is very much like how China ended up handling it’s banking problem”

    state capitalism…

  • Posted by Dave C..

    Fed out of money?

    By John Brinsley and Rebecca Christie

    Sept. 17 (Bloomberg) — The U.S. Treasury said it will sell bills to allow the Federal Reserve to expand its balance sheet, a day after the government agreed to take over American International Group Inc.

    “The Treasury Department announced today the initiation of a temporary Supplementary Financing Program at the request of the Federal Reserve,” the department said in a statement today. “The program will consist of a series of Treasury bills, apart from Treasury’s current borrowing program.”

    Yesterday the Fed announced an $85 billion loan to AIG, in exchange for a 79.9 percent government stake in the largest U.S. insurer. The Fed also has set up several other emergency lending programs to provide Wall Street firms with ready access to funding.

    The new bill program “will provide cash for use in the Federal Reserve initiatives,” the Treasury said.

    The Treasury said it will sell the new bills using its existing auction procedures, giving “as much advance notification as possible.” The bills will not have a uniform fixed term, giving the Treasury the same duration flexibility that it has with cash-management bills.

    To contact the reporter on this story: Rebecca Christie in Washington at rchristie4

  • Posted by bsetser

    full carry —

    after the salaries the street paid themselves (including record 07 bonuses, lest we forget) the us gov cannot bailout the equity holders. tis something some folks should have thought about in advance ….

  • Posted by Jian Feng

    Brad, you know that I am a lay person in economics. Since anyone holding US treasury can sell it for US dollars, how different really is issuing more treasuries from printing more money? I know that printing more money is a very dirty world; only failed states do that. Right now, the total US debts, including the 5 trillion sunk in F&F well excede 100% of US GDP. Is there some kind of warning line (like the highest water line for a levy to be safe) for a regular country (e.g. Switzerland), expressed in % of GDP?

  • Posted by moldbug

    bsetser: “That is intermediation using the government’s balance sheet, not money creation.”

    Given that dollars are (as most would say) Fed liabilities, or (as I prefer) Fed equity – and given that Fed and USG are clearly one entity – this distinction seems a little fragile!

  • Posted by JKH

    Moldbug,

    They won’t be creating money of 0 maturity, which is a non-trivial distinction.

  • Posted by Twofish

    DC: That’s alot different than taxpayers bailing out PIMCO losses on Fannie Mae and Freddie Mac bonds.

    PIMCO made a huge amount of money betting on the Freddie and Fannie. Someone else lost a lot of money making the opposite bet. The money to shore up Fannie and Freddie by and large didn’t end up in hedge funds.

    DC: Very little of the taxpayer bailout goes to depositors and homeowners. America’s Joe6pack is losing his shirt.

    He has a job, still has his bank account and can sell his house. Neither would be true if the economic system fell apart.

    DC: In fact, AIG raided $20 billion from the New York state employee pension and annuity accounts to cover financial derivative losses.

    Because otherwise those losses would have been borne by the banks and then by depositors.

    DC: It’s really an absolute travesty of justice that the US taxpayer is picking up the tap for private-sector casino gambling in the derivatives market.

    In casinos, when someone wins money, someone else loses money, and we would not have the problem that we have if it was a casino issue.

    What happened was that people wrote checks assuming that some money existed. When it didn’t you have to figure out who bears the loss. If the Fed didn’t do want it did, then you might have had a domino chain of collapsing banks in which people start losing their jobs, their bank accounts, and are stuck with a house that cannot be sold.

  • Posted by Fullcarry

    Brad,
    I appreciate what you are saying. I just don’t know how we get out of this vicious cycle where counterparty risk needs to be hedged. And the only vehicle available for doing that is a financial firm’s equity which gets driven down to bankruptcy or bailout levels.

  • Posted by InquiringMind

    The $5 trillion of Fannie & Freddie debt are actually *assets* for Fannie/Freddie (& now, I guess, the US gov).

    The problem is that they may not be worth the full $5 trillion face value…there is risk there…

    …but they do not represent a new $5 trillion liability to the US gov, so saying that the US Gov is now +$5 trillion in debt is a hyperbolic misunderstanding of the situation.

    IM

  • Posted by Blissex

    «but they do not represent a new $5 trillion liability to the US gov»

    Ahhh, and where did the GSEs find the money to lend $5 trillion? Their business is to borrow money cheaply with their implicit gov backing and with the borrowed money purchase and securitize mortgages.

    Since they have/had a minuscule amount of capital, less than 1% of their assets, they must have borrowed 99% of the money used to purchase those assets.

    So they have $5 trillion on both sides of the balance sheet (not quite, because part of that of that is debt guarantees, and part
    of that outright loans).

    Now formally/technically that is not part of the USA balance sheet, because of accounting shysterism played by the USA Treasury, but whom are they kidding?

    «The problem is that they may not be worth the full $5 trillion face value…there is risk there…»

    The *net* debt is not 5 trillions; it is pretty sure that there is a net debt, or else the pretend-capital of the Gses would not have been wiped out. Estimate heard so far is that the assets are worth about $300b-600b less than the liabilities, and this is the amount that the USA treasury is looking at having to finance.

    http://www.ft.com/cms/s/0/e30472a6-7e79-11dd-b1af-000077b07658.html

    «The operations of mortgage finance companies Fannie Mae and Freddie Mac, which were placed into a federal conservatorship, should now be treated as part of the federal budget, the head of the Congressional Budget Office said on Tuesday. — That means that revenue earned would be reflected as a receipt, and spending would be reflected as an outlay, — CBO Director Peter Orszag said
    at a briefing.»

    Note that here he is careful to say “operations”, not “assets”, because thanks to technicalities neither the asset nor the liability side of the GSE balance sheet need to be consolidated with that of the USA.

  • Posted by pseudorandom

    Twofish: No. Most of the bailout goes to depositors and homeowners.

    You mentioned this in another thread yesterday and to repeat what I said there: this is nonsense.

    Depositors were already insured through the FDIC they don’t need any bailouts by definition. Bailout money is for those who were not insured and had no right to expect the government to make them whole i.e. unsecured creditors and derivative counter-parties.

  • Posted by Twofish

    pseudo: Depositors were already insured through the FDIC they don’t need any bailouts by definition.

    And FDIC only has enough cash on hand to cover 1.5% of total deposits. In case of a total bank meltdown, they would have gone under. FDIC has about $50 billion in reserves. AIG needed $85 billion in cash. If it had gone under each domino would have been larger and larger.

    Part of the problem is that people thought they were more insured than they really are.

    pseudo: Bailout money is for those who were not insured and had no right to expect the government to make them whole i.e. unsecured creditors and derivative counter-parties.

    Yes. With most of those counter-parties European banks who were relying on credit insurance issued by AIG. If those had gone under and been forced to liquidate, the dominoes would have kept falling. By the time the wave hit the FDIC insured banks it would have overwhelmed FDIC.

    Really scary stuff.

  • Posted by Twofish

    You get into a lot of “who watches the watchmen” issues in finance. It’s not enough to say “we are insured” you have to worry about who insures the insurers. Just because there is an FDIC sign out in front doesn’t mean that you are completely safe.

  • Posted by Twofish

    blissx: Ahhh, and where did the GSEs find the money to lend $5 trillion?

    You gave it to them.

  • Posted by pseudorandom

    Twofish: You get into a lot of “who watches the watchmen” issues in finance. It’s not enough to say “we are insured” you have to worry about who insures the insurers. Just because there is an FDIC sign out in front doesn’t mean that you are completely safe.

    That’s all true enough but there is no issue of fairness or moral hazard in paying back depositors of FDIC insured institutions. Depositors have an explicit US government guarantee (upto $100k etc).

    There are huge fairness issues involved in bailing out unsecured creditors and counter-parties. It may sometimes be necessary to do so for the sake of systemic risk, but taxpayers should rightly be outraged and demand corrective steps and if necessary criminal prosecution of anyone guilty of wilful negligence or fraud.

  • Posted by Twofish

    pseudo: That’s all true enough but there is no issue of fairness or moral hazard in paying back depositors of FDIC insured institutions. Depositors have an explicit US government guarantee (upto $100k etc).

    There’s actually a lot of moral hazard. Suppose you two banks that are FDIC insured. One pays 1.5% interest, one pays 3.5% interest. Which one do you choose? Most people will choose the 3.5% interest one.

    Suppose you have two insurance companies. One charges $1000/year for auto insurance. The other charges $500/year for auto insurance. Which one to you choose? You choose the $500/year one.

    The trouble with those choices is you aren’t asking too much *why* a bank is paying more interest or charging less money for insurance. The trouble is that if *no one* is looking at why banks pay more interest or why insurance companies charge less, then its likely that the money where you put your money in aren’t the ones you should be putting your money in.

    But you don’t care, you just see the FDIC rating or the Moody’s AAA rating and assume everything is alright.

    pseudo: There are huge fairness issues involved in bailing out unsecured creditors and counter-parties. It may sometimes be necessary to do so for the sake of systemic risk, but taxpayers should rightly be outraged and demand corrective steps and if necessary criminal prosecution of anyone guilty of wilful negligence or fraud.

    Scapegoats are convenient, but usually if you look at these messes they often are caused by lots of people making the sorts of decisions that involve choosing a 3.0% FDIC insured CD over a 1.5% FDIC insured CD.

  • Posted by pseudorandom

    Twofish: There’s actually a lot of moral hazard. Suppose you two banks that are FDIC insured. One pays 1.5% interest, one pays 3.5% interest. Which one do you choose? Most people will choose the 3.5% interest one.

    This is theoretically possible, but in practice I have not noticed much of a difference in interest on insured deposit accounts. No one that I know of chooses their band based on interest. Similarly no one that I know of picks their auto-insurance co based only on rate – other things matter too. Bank deposits are meant for convenient access. If you want returns on long-term savings, bank deposits are a poor choice in any event.

    Also huge interest rate differentials would be a failure of regulation. The prudent regulator would limit the interest rates on insured deposits.

    Summary: with prudent regulation any moral hazard associated with deposit insurance can be reduced to negligible levels.

    Compare this with the blatant hazard/unfairness involved in bailouts of unsecured creditors of investment banks.

  • Posted by pseudorandom

    Twofish: Scapegoats are convenient, but usually if you look at these messes they often are caused by lots of people making the sorts of decisions that involve choosing a 3.0% FDIC insured CD over a 1.5% FDIC insured CD.

    Sure. Every criminal who gets caught says that he is a scapegoat being unfairly punished. Losses of this magnitude imposed on the tax payer is a serious matter and a tough stance would not only serve the interests of justice but would also deter this sort of behavior in future.

  • Posted by thor

    Brad: “the Fed actually hasn’t been printing money.”
    well, what would happen if Fed starts printing money in this kind of environment? i suppose it’s not the same thing as printing same amount in normal conditions. if u buy assets that were worth $500 billion and now are worth practically $0 for printed 500 billion dollars it wouldn’t have same inflationary pressures as ussualy. amount of money didn’t change.

  • Posted by Rien Huizer

    Brad,

    Excellent post and commentary. What the Fed and the US gvt are doing is just replacing private credit by gvt credit. Not printing money at all. I guess people worry about the morality of this (and there is a lot of morality in this tale) but not really about the implications of this rapid nationalization of the financial system. What will drive allocation, who will allocate using the gvt debit card, when will the system reprivatize, etc. There are instances of countries doing a decent job by using a nationalized (or almost) banking system for rapid development, but even a diehard developmentalist economists like Chang (whose argument is pretty sophisticated) would not believe that the US is at a stage of development where gvt can allocate efficiently. It may try to do so (but, this administration does not have much time left) but then it may degenerate into something that could be inflationary, “soft budget constraints”, the common disease of socialist economies. Democracies are even less well equipped to manage nationalized finance than dictatorships…

  • Posted by moldbug

    JKH,

    It is a nontrivial distinction, but given the ease of borrowing money of 0 maturity against Treasuries… all dollar assets without liquidity or solvency risk look pretty similar right about now.

    One way to think of a Treasury strip is as a restricted dollar, like a dollar bill with a “not valid until” date. MT makes that date a lot less meaningful than it would otherwise be. It’s an interesting question to ask what people would pay right now for a dollar that was not valid until 2038, could not be used as collateral, but was nonetheless risk-free.

  • Posted by Twofish

    pseudo: Also huge interest rate differentials would be a failure of regulation. The prudent regulator would limit the interest rates on insured deposits.

    In which case what people end up doing is to move their money from regulated insured deposits to unregulated deposits with pseudo-insurance. When the pseudo-insurance falls apart, we end up in the current situation.

    The other problem is that you get regulatory arbitrage. You take money that is from low-yield regulated products and then you figure out ways of buying unregulated high-yield products. You end up making a lot of money until everything falls apart.

    pseudo: Summary: with prudent regulation any moral hazard associated with deposit insurance can be reduced to negligible levels.

    I think you are going to find it a lot harder to do this than you think. Especially in 10 years when everyone forgets about this little episode and are complaining about how little they are making in boom times.

    It’s easy to say more and more regulation now. Just wait five to ten years. People have short memories.

    pseudo: Compare this with the blatant hazard/unfairness involved in bailouts of unsecured creditors of investment banks.

    You are an unsecured creditor of an investment bank. You don’t know that you are, but you are. A owes B. B owes C. C owes D. D owes E. When A goes under, you have a chain of dominos falling and you are in that chain.

  • Posted by Twofish

    pseudo: Losses of this magnitude imposed on the tax payer is a serious matter and a tough stance would not only serve the interests of justice but would also deter this sort of behavior in future.

    I really don’t think so, since people have short memories and incredible ability to rationalize behavior, and next time people will come up with fifty reasons why this time is different.

    I think that the focus needs to be less on finding scapegoats and more on increasing regulations to make sure that when you have a downturn the next time, it doesn’t turn into a crisis.

  • Posted by JKH

    Moldbug,

    You really lost me on this one. I’d need a rewording somehow in order to understand it.

    But Brad’s point is quite correct technically. It would be overlooked by 99 per cent of people with an opinion on the subject, but is important to conventional interpretation. I understand your consolidated perspective on the government/treasury/Fed balance sheet and tend to think in those terms myself. You’re probably aware that the Fed has been controlling the monetary base as defined, first with substitution activity on the asset side (bills for “crap” (but “crap” fairly marked down at an inflection point for the substitution decision)), and now with intermediation activity sourced on the liability side that similarly doesn’t affect the monetary base. That’s all in terms of monetary tiers as conventionally defined, prior to your kind of conceptual transformation, of course, but Brad’s point still deserves some credit.

  • Posted by moldbug

    JKH,

    I don’t think we disagree on anything substantive here, but let me explain anyway.

    Basically, while I share the consolidated perspective, I see both FRNs and Treasury obligations as equity, not debt.

    Certainly the dollar, being nonredeemable, is not a promise to pay anything. When it was redeemable for metal it was zero-maturity debt. The transition from debt to equity is the normal result of defaulting on obligations.

    Moreover, “risk-free” debt is an oxymoron. But a T-bill *is* risk-free – the people selling CDS on them are pretty much charlatans. (I’ll sell you as many Treasury CDS as you want to buy. Cheap, too.)

    In the equity space, however, there is an analogous instrument: restricted stock. Google, for instance, compensates its employees with restricted shares which vest over time.

    Therefore it’s very easy to imagine restricted dollars. On the face of the dollar is printed a date, after which it is a valid dollar that you can use to buy a hamburger. Until that date, it has to be priced by a financial market. Try to spend it, and the cashier will get all huffy with you.

    If we accept the premise that Treasury obligations are risk-free – implicit in the consolidated perspective – for any Treasury note, you can construct a precisely equivalent structure of restricted dollars.

    In a non-MT financial market, these restrictions would be extremely significant. I’m very curious as to what 2038 dollars would go for. But under the rules of MT finance, banks can lend 2008 dollars which are backed by 2038 dollars. Naturally this has a considerable positive effect on the price of 2038 dollars.

    Capisce? (I, too, am a huge Cedric fan.)

  • Posted by pseudorandom

    Twofish: The other problem is that you get regulatory arbitrage. You take money that is from low-yield regulated products and then you figure out ways of buying unregulated high-yield products.

    The people who do this “regulatory arbitrage” are mostly the financiers. Ordinary depositors don’t normally bother partly because without leverage the small arbitrage gains are simply not worth it. Do you do your banking (I mean checking/savings accounts not long-term investments) at institutions based on how much interest they offer instead of convenience, location etc? This is purely a theoretical problem that does not exist in reality.

    We can sit here all day and invent theoretical problems with any regulatory regime. In the real world well-designed regulatory policies work extremely well.

    Twofish: It’s easy to say more and more regulation now. Just wait five to ten years. People have short memories.

    Sure the financiers will whine and moan about any regulations that limit their windfall profits. They are a hypocritical bunch. The job of the regulator is to stay firm and say no.

    This thing about short memories etc is just a cliche. People who lived through the 1930’s still remember lessons from that period. Normal people outside of Wall St are just not that short-term oriented.

    Twofish: You are an unsecured creditor of an investment bank. You don’t know that you are, but you are. A owes B. B owes C. C owes D. D owes E. When A goes under, you have a chain of dominos falling and you are in that chain.

    It’d be wonderful if creditors are forced to do their due diligence before lending to LEH or Citi in future. I see it as entirely a good thing.

  • Posted by Blissex

    «The other problem is that you get regulatory arbitrage. You take money that is from low-yield regulated products and then you figure out ways of buying unregulated high-yield products.»

    Such an innocent statement! With BoA/ML merger and the suspension of 23A, that’s no longer regulatory arbitrage, that’s regulatory policy — in effect the Fed is *requiring* banks to do that. Isn’t it funny?

  • Posted by Blissex

    «But a T-bill *is* risk-free»

    Again, only for people who do their accounting in dollars. For those who do their accounting in other currencies, there is a huge currency risk, because they are only denominated in dollars, so the currency risk cannot be separated.

  • Posted by JKH

    Moldbug,

    Your view of government liabilities as equity is intriguing. Is that an Austrian slant or your own?

    Government and CB liabilities are uniquely strange. I’ve always thought of the consolidated balance sheet as having a hole that is plugged with the present value of taxation – which technically is a component of human capital rather than physical or financial capital.

  • Posted by moldbug

    JKH,

    My own, I’m afraid. The thing about Mises, IMHO, is that while he was basically right, he was basically right in the context of Austro-Hungarian finance. (Mises actually had more or less Bernanke’s job in 1920s Austria, not exactly a placid lake of financial stability – he was no armchair theorist.)

    There is not really anything new in the Austrian canon after Mises. If fact, if you only read one book by Mises, I favor his _Theory of Money and Credit_ – 1912. Rothbard was a titan, but he was also an orthodox Misesian, and his ideology tends to interfere with his economics. Everyone else, including Hayek, is just not in the same class. And worse, the modern Austrians are mostly focused on defending, rather than upgrading, the legacy. Quite understandably! But still…

    Basically what I mean by “Austro-Hungarian finance” is that the Misesians took the gold standard for granted and considered fiat currency an abomination. Well, it is an abomination – in retrospect, it’s pretty hard to call it a good idea. But that doesn’t mean you can’t use the basic Misesian methodology to think about a fiat system.

    So take this Ron Paul speech from 2002, on the GSEs. Prescient? Sure. The speech was probably written by Lew Rockwell (don’t even start me on Lew Rockwell), who was a student of Mises and Rothbard. But note that the only solution offered for the problem is to liquidate, liquidate, liquidate.

    Well – in Austria in the ’20s, liquidating back to gold was an option. Almost, sort of. And theoretically now it is an option. I really think you might be able to get the gold price back to $20, or at least $33, if you liquidated to M0. But is this a *good* option?

    As for government liabilities, I think of USG as a sovereign corporation – basically, it owns America. The only difference is that this ownership is enforced by its own guns and bombs, not some higher (temporal) power. And this is not a financial difference.

    So you would expect USG’s paper, whatever we call it, to be pretty valuable. As indeed it is. Whether the source of the future payment streams USG can generate is taxation, real estate sales, or natural resources, it’s – as Cedric would say – money.

  • Posted by JKH

    I’ll let Cedric’s classification prevail for now. Thx #2.