Mea Culpa: The Fed May In Fact be in a Financial Mess

(8 am. – promoted by ek hornbeck)

In a comment last week, I said,

Treasury Securities are the only assets that can …

… be held be the people that issue the actual fiat money. So, while the US dollar could lose standing abroad and with it would go the top ranking of US Treasuries overseas, it is institutionally entrenched as the AAA ranked US dollar denominated financial asset.

And while the gist of the argument is sound … Treasury Securities are the last financial asset standing if you need financial assets denominated in US dollars, and that is intimately tied up with the way that the Fed works …

… the statement itself is deeply flawed.

In ordinary times, it would be a footnote. The Fed can also hold as assets loan contracts with commercial banks, and other such loan contracts as the legislature may from time to time permit.

Well, how did they keep the current crisis from blowing up? After all, it was late last year that the housing market bubble burst … how did they string it out until September of this year?

How they strung it out was by lending to get financial institutions out of their short term liquidity bind. And as institutions ran out of Treasury Security and “high quality” mortgages to borrow against, the Fed relaxed its standards to allow borrowing against lower quality assets.

Except, the way that the Fed does short term loans with a financial asset as collateral is the same way that the private finance sector does … it enters into a contract to “buy” the financial asset at a set price, and the borrower agrees to “buy it back” at the end of the loan period for a set price. The up-front purchase price is the loan amount, and the difference between the two prices is the interest payment for the loan.

Now, if you are making a temporary bridging loan to a business backed by collateral, and you have to loan more than the collateral is really worth, that ought to raise a red flag that the business is in something more than a liquidity squeeze. This is why it is important to do all your research into bridging loans before you start to move forwards with the loaning process.

As explained by an anonymous banker friend of Jerome a Paris, that is the current crisis and the current proposal by the Bush administration, in a nutshell.

Unpacking the nutshell

The problem is that providing liquidity only fixes a problem of lack of liquidity. That is, there are sound assets sufficient to meet obligations, but because of a mismatch between cash flows, the income from those assets is not available in time to make all payments due.

That is a liquidity crisis. Folding because of an inability to meet current obligations, despite having more than enough assets to cover liabilities. In brief:

• Total assets > total liabilities
• Liquid assets < current obligations

That aint the problem. The problem is that these financial institutions in massively undervaluing systemic risk for more than a decade now have reaped and distributed as profits what should have been accumulated as capital reserves to cover the risk of a systemic crisis killing the value of a majority of their supposed assets.

Let me repeat that:

• The problem is that these financial institutions in massively undervaluing systemic risk for more than a decade now
  
• have reaped and distributed as profits
  
• what should have been accumulated as capital reserves to cover the risk of a systemic crisis killing the value of a majority of their supposed assets.
  

And the symptom is right there in the main section … as soon as the Fed started accepting low quality assets as the instrument for making short term loans, we were already in a solvency crisis. “We” just pretended that “we” weren’t.

• (Note that the first ‘we’ is us, the national population collectively as a participants in an economic system, while the second and third “we” is the powers that be, the establishment, the corporate press … everyone who should have had an eye on the till but were too busy watching the financial fireworks.)

And now the Fed has all these worthless assets it is carrying as the formal collateral for these short term loans, and if the loans are not repaid because the pirates collapse, that formal collateral is worthless.

Next Best Thing to the Fed Going Bankrupt

Now, the Fed cannot be forced into bankruptcy. In extreme cases, the Treasury issues Treasury securities, and then, rather than allowing them to be held by private owners, the Fed holds the Securities instead, crediting Federal Reserve account balances. The income from the Treasuries goes into shoring up the balance sheet instead of returning back to the Treasury as normal, and the Fed recovers its solvency.

If your obligations passed as core, high powered money, you could use them to buy Treasury Bonds and then use the income from the Treasury Bonds to repair whatever holes you had blown in your balance sheet. But you are not in that position, unless you happen to be a Reserve Bank in a reserve banking system.

However, that means issuing money to buy those securities, which is a massive injection of money into circulation, and the side effect of that is a big burst of inflation. That actually rescues debtors from their obligations … but it will be the death knell of the US dollar as the international reserve currency, as reserve banks all over the world will flee to the Euro, and that is the end of being able to afford the massive overseas base network and reckless foreign military adventures.

• (That last might take time to play out, but tenacity in holding onto the base network once it becomes untenable would accelerate the collapse of the US$, and when it comes down to a crunch between buying oil and maintaining the overseas base network, recent politics suggests that the immediate need to fund payments for oil imports will win.)

For reference, consider the Weimer Republic, Brazil in the late 70’s and early 80’s, Argentina at the beginning of this decade, Zimbabwe at the moment. A monetary authority can lose the power to issue currency that anyone overseas cares to hold, but it cannot go bankrupt based on obligations in the currency that the reserve bank itself issues.

So there goes the American “Base Network Empire” up in flames, along with the Bush/McCain foreign policy of acting like a drunken bull in a china shop.

And of course, as part of the process wages are certain to fall behind prices, so a lot of the pain will be felt by everybody on a wage contract, as we have a bout of stagflation that makes the Oil Price Shocks feel mild by comparison.

So instead of that, the Bush administration plan is to issue Treasury securities, buy the toxic waste assets from institutions, they stay afloat long enough to repay the Fed with cash, the Fed can back out of holding the toxic waste as collateral, the Fed’s balance sheet is fixed, and the public is left holding the bag for a pile of toxic waste that is funded by somewhere around 5% of GDP added to the national debt in one lump sum.

Maybe the financial sector companies still go under, at least those that are not buddy-buddy with the Bush administration, but a lot stay afloat, the Bush administration folks get cushy jobs in the firms they bailed out, and for the underlying problem, its a game of kick the can down the road to the next administration to fix.

What Can Be Done

Now that we know that the bail-out is $600b for the Fed and $100b for Bush’s cronies on Wall Street, we need to find a way to keep the finance sector running while penalizing the financial pirates and sheltering ordinary Americans from experiencing the pain of a bout of hyperinflation.

If that’s the target, its straightforward enough.

Set up the Resolution Trust, but make it a Public Trust. For every dollar in toxic debt sold by a financial institution, it has to also sell $1 in a first class preferred share.

Unless the dividends of the first class preferred shares are paid in full:

• termination packages of executives are limited to two weeks of salary
• no stock options can be included in executive compensation that mature in less than five years
• no other preferred or common dividends may be declared
• no new acquisitions of shares in financial institutions or mergers with financial institutions may be made without approval of the Public Trust

IOW, first claim on any profits made as a result of the bail-out goes to the Public Trust. And here is the critical part: the bigger the bail out, the bigger the share of profits that go from that institution to the Public Trust. That’s why its dollar for dollar … the worse they cheat the public on the toxic debt, the longer it will be before they escape the restrictions on firms not meeting their preferred dividends in full, and the more they mortgage their future income to the public to clean up the mess.

Now, sooner or later those profits will be forthcoming, and sooner or later the toxic assets will be liquidated, and given the first class preferred shares, sooner or later the Public Trust will repay the Treasury Securities.

And then it will be generating an income.

Issue that income as a Social Dividend, per month, to each US citizen. Full stop, whatever it is, just hand it out.

When is the Public Trust wound up? Never. The Social Dividend is Permanent.

As a permanent reminder to the would-be pirates in the finance sector that they mortgage another part of their income flow permanently if they do it again.

And also, as a permanent guarantee that those firms that have done in the past have their hands tied behind their back if they get into a position where they cannot meet their Public Trust preferred stock dividend.