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March 24, 2008

A Seriously Terrible Idea

David Beim
Professor of Finance and Economics and Bernstein Faculty Leader
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There have been reports in the press that the Federal Reserve has been meeting with the U.K. and European central banks to discuss a novel idea: direct purchases of mortgage securities by these central banks to “set a floor” under their prices. This is an appalling idea that should be taken straight off the table. Here's why.

The role of a central bank is to maintain the liquidity of the banking system, not to absorb the losses of the banking system. So far, that is what the Fed has been doing, and very creatively. Its various new programs to lend to banks and securities dealers to bolster their liquidity do not involve taking significant risk of loss: they are collateralized loans in which the full faith and credit of the borrower is engaged to repay the loan. In addition, these loans are secured — indeed over-collateralized — by treasuries, agencies or AAA-rated mortgage securities. That’s an extra lock on repayment. But under none of these does the Fed assume true ownership of the assets’ risk. Its actual exposure to the asset values is minimal.

An exception is the Bear Stearns transaction, in which the Fed provided a $30 billion line of credit to JPMorgan that is dependent for repayment solely upon the value of some Bear Stearns assets, presumably the worst $30 billion. But this is in the context of a failed financial institution.

It is widely accepted that government must step in when a bank fails. Best practice is immediately to close or sell the bank, dismiss the management, wipe out the equity, scrub down the balance sheet and require the new owner to recapitalize it. That is pretty much what happened in the Bear Stearns case, though not perfectly. But it is within the failed bank paradigm: the government appropriately accepts bank losses when it resuscitates a failed bank to protect the financial system.

The new idea is a radical departure from all past wisdom and best practice. By trying to put a floor under the prices of mortgage securities, the Fed would be trying to prevent large losses from occurring. This is like trying to hold back the tide. The losses must occur because they are the real result of collapsing asset prices. The (real estate) assets were previously artificially inflated in value and are now trying to find their correct value according to real supply and demand. This correction must be allowed to happen; only then can we fully sort out who has lost how much. Any effort to stop the correction will only add to the confusion over which banks are solvent and which are in doubt.

Government price fixing has failed wherever it has been tried. It has failed in the United States, in the Soviet Union, in Brazil and in many other settings. It only works briefly, then leads to distortions so painful that people begin seeking ingenious ways to game the system. Neither the government nor anyone else is smart enough to know the correct value for any risky security, especially in a period of turmoil. Even though the prices of some mortgage securities seem to imply exceptionally high default rates, given the complexity of the securities and the economy, who can say with confidence what their true value should be?

The quantity of risk and potential loss involved in this proposal is almost unbounded. And the vast potential cost would not buy stability. Financial markets will always have their cycles of over-exuberance and over-pessimism: something in the human psyche requires these cycles. When the government tries to repeal the downside of cycles, and protect people and banks from the losses they have themselves incurred, subsequent risk-taking explodes.

It’s a terrible idea that should never be tried.

Comments

by Alvaro Alesso | March 24, 2008 at 1:31 PM

Government price fixing is failing miserably in Argentina as we speak.

by Dan | March 24, 2008 at 1:54 PM

The Fed is authorized under current law to monetize agency debt/mbs. There would be nothing wrong in doing so because it is largely accpeted by ALMOST everyone that these securities are backed by the full faith and credit of the US Government. Extending such purchases to non-agency currencies would be a corruprion of the system, however, as the professor suggests.

by Mateo | May 11, 2008 at 1:58 PM

Excellent points regarding risk taking by the Fed & the scope of the problems affecting non-agency MBS.

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