Strategies For Monetary Policy - Barokong

At that link, you can see the table of contents and read Chapter pdfs for free. You can buy the book for $14.95 or get a free ebook. The conference acara and videos are still up. Much of the conference was about the question, what will the Fed do during the next downturn? Here we are, and I think it is a valuable snapshot. Of course I have some self interest in that view. As long as I'm shamelessly promoting, I'll put in another plug for my related Homer Jones Lecture at the St. Louis Fed, video here and the articleStrategic Review and Beyond: Rethinking Monetary Policy and Independence here. That was written and delivered in early March, about 5 minutes before the lookouts said "Iceberg ahead." John and I don't put a lot of our own work into the conference books, but it sparked a lot of thoughts.  I am grateful to Jim Bullard and the St. Louis Fed for the chance to put those together. Monetary policy is back to "forget about budbahasa hazard, rules, strategies and the rest, the world is ending." This is a philosophy that happens quite regularly and now has become the rule and strategy. So strategic thinking about monetary policy is more important than ever.  This is a philosophy very much due to John Taylor. The last part of my Homer Jones paper delves into just what risks the big thinkers of central banking were worried about on the eve of the pandemic. Pandemic was not in any depresi test.  BIS, BoE, FSB and IMF  wanted everyone to start tertekan testing ... climate change and inequality. This is a story that needs more telling.
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The Fire In Treasurys - Barokong

Just where was the fire that caused the Federal Reserve to buy $1.3 trillion of treasury debt in a month -- financing all treasury sales and then some? I've been puzzling about this question in a few posts, most recently here. Commenter "unknown" impolitely but usefully points me to a nice paper by Andreas Schrimpf, Hyun Song Shin and Vladyslav Sushko that explains some market mechanics. I am still not persuaded that these gyrations motivate or justify the Fed buying these or more trillions of debt, but there is an interesting story here. Treasury yields Their first graph shows stock prices and bond yields. As risk and risk aversion rose, as they always do in bad times, stock prices fell and bond prices rose, with yields falling. Trouble starts on  9 March when "the market experienced a snapback in yields" Look hard at the graph. The blue line rises a bit while the red line continues to fall. OK, but still -- is it a disaster that the US treasury, that had been borrowing happily at 1.8% in January, must borrow at 0.8-1.2% in March? Is it such a disaster that the Fed must buy all new issues of debt? "Arbitrage" redux What caused the "snapback?" here is where the paper gets interesting. Basically a bunch of hedge funds replayed an age-old strategy and got caught. Plus ça change. They bought treasury bonds and simultaneously sold them in futures markets. Since treasury bonds are great collateral they can lever up a small price difference to make a lot with little investment. But even arbitrage opportunities are not risk free.** Prices that are slightly off can get further off before they eventually converge. And then the hedge funds need to post margin, which they don't have. So, they follow the mother of all financial fallacies -- risk management that consists of selling  positions on the way down, trying to synthesize a put option with a stop loss order. But selling to who? Everyone else is doing the same thing, markets get illiquid in times of frustasi (no, they've never done that  before), so the price difference widens even more. Once the funds were no longer able to meet variation margins, their positions were unwound by dealers/futures exchanges, pushing prices lower. This in turn gave rise to a classic “margin spiral” This is similar to the price difference that the funds had been arbitraging. The price widened -- the arbitrage got better. But this means a lot of lost money in the initial positions. Other almost-arbitrage price relationships widened too, a now familiar phenomenon Similarly, the market experienced severe mispricing along the yield curve (yield curve fitting errors) and between benchmark bonds and other similar securities.. indicating a breakdown in arbitrage linking various corners of fixed income markets. How in the world did this happen again, so soon?  LTCM redux? Metallgesellschaft? In the treasury  markets? Didn't 12 years and 100,000 pages of Dodd Frank, and ten times that of academic papers on various "fire sales" and "spirals," and a small army of regulators put a stop to all this? All the massive regulation did, apparently,  was to further restrict dealer and bank balance sheets, as seen in the repo eruption last summer, and make liquidity worse. Their policy summary: ..market monitoring should look beyond current conditions and ask the “what- if” questions that are relevant for potential market stresses. To be effective, such fully fledged tertekan tests must assess the potential scope for forced selling and feedback loops, especially in tranquil periods when leverage is building up. "Should have" is is the right verb tense! Just why in 12 years did none of this perfectly obvious stress testing already happen? They provide one answer implicit: In this context, the reaction function of the central bank is an important background factor. Yes. Everyone knew the Fed will ride to the rescue, so why keep dry powder around? And the expectation proved true once again. The Fed is fueling the adab hazard as we speak. The fire? So,  a bunch of hedge funds sold volatility, again, and lost money, again. Little apparent arbitrage opportunities arose between similar securities. (Is 12 basis points a financial calamity? four?). Not enough investors with the expertise to arbitrage 4 basis points spreads are around willing take mark-to-market risk in a time of immense volatility and uncertainty. Capital does move slowly. It was harder for a while for other people whose idea of risk management is selling on the way down to dump securities. Does this justify buying $1.3 trillion of treasury debt? Is it a masalah if occasionally some traders can't immediately sell out of these kinds of trades and have to invest just a bit of money? Must no bid/ask spread ever widen? Do we want zero incentive to lurk around and move capital more quickly? Financing the treasury and buying the debt I found interesting insights here Under wajar circumstances, dealers would be able to alleviate market stresses by absorbing sales and building up an inventory of securities. But, dealers’ treasury inventories had already been stretched, especially from 2018 onwards, as they needed to absorb a large amount of issuance (Graph 3, right-hand panel). Far from there being a shortage of safe assets, there was a glut* in the run-up to Covid-19. [my emphasis] I found this comment particularly revealing, but opening a lot of questions. We are so used to the claim of a "global savings glut" "safe asset shortage"  that signs of these stories running out of steam are  interesting. This  could be a question to which massive purchases are the answer -- the treasury is finding it hard to sell more debt. Of course, treasuries that turn to central banks to buy their debt is not a circumstance that usually ends well. The recent shifts in the penanam modal base of treasury securities from official sector investors (eg foreign central banks) and long-term investors towards leveraged traders and other negative convexity investors give pause for thought regarding potential future volatility from endogenous feedback loops. Wow. If this is true, the game is up. We can't sell trillions and trillions to, oh, the central bank of China. But "negative convexity investors" are not a fundamental source of demand. They buy treasurys only to sell futures, and quickly close out their positions. They are not funneling a trillion dollars a month of new savings to treasurys. So if this story is true, there are no mendasar investors, and that's why the Fed is buying. The paper attempts to give a different rationale, that the Fed really was buying in order to make the markets more liquid. (Again, just why this is a huge social persoalan is hard to tell) The paper claims that the markets calmed because the Fed bought up all these ekstratreasurys from the dealers , removing the treasurys from the dealer's books. In order to get dealers to arbitrage again, the authorities [Fed] may need to absorb sales directly rather than doing so indirectly by lending to dealers, especially when funding is not the relevant constraint. This may also explain why, on this occasion, the Fed’s rapid purchases of securities out of dealers’ inventories (to the tune of about $670 billion) appeared more effective in stabilising the market than the provision of liquidity via repo operations, where take-up was relatively subdued. Translation: the big puzzle in all of this is how the Fed by simply buying can restore "liquidity." To restore liquidity you have to buy and sell, take the arbitrage trades. Normally (and to the tune of trillions right now in other markets) the Fed simply lends money to dealers who can then trade more. (And make more money. Remember the Volcker rule, don't finance trading by deposits? The idea here is to finance trading by borrowing from the Fed!) But if the dealers are capital constrained, or regulation constrained, that doesn't help. So if the fed buys up all the risky assets from the dealers, the dealers can start up all over again. I presume the last graph doesn't have up to the minute data and would show... -$470 billion on dealer balance sheets? To buy $200 billion from the dealers why did the Fed have to buy $1.3 trillion? Why did dealers accumulate so much treasury debt in the first place? If they didn't want to hold the treasurys they should have sold them, and prices should have gone down -- interest rates should have gone up. They had to want to hold the treasurys. That proved a wise decision as they made  ton of money as interest rates declined. But after yields went from 2 to 0.5%, in the "de-risking" demand for treasurys, why didn't they sell off their book again? How much more money do they want to make? Why did they finally sell to the Fed (at what price?) Bottom line So why did the Fed buy? Is it a  “dealer of last resort” as the paper puts it, or is it the  buyer of last resort? Was there really a fire, or just the usual bunch of hedge funds screaming that they lost money writing out of the money puts, once again? -------------- * Picky comment. Economists should never use the word "shortage" or "glut," at least absent a price control. They carry a pejorative implication that something is wrong about a demand or supply curve shifting, and needs policy response. The original "savings glut" was East Asian countries that decided keeping some liquid assets around was a good idea in case of trouble, a strikingly old fashioned idea that might look mighty good right now as pervasively indebted America looks around to pay bills for a few months. **Update: I meant this as a joke, which is probably too subtle as Monika points out in a comment. A true  arbitrage opportunity is of course a sure profit, with no chance of losing money. If you buy cash and sell futures at a different price, and hold to expiration, that is an arbitrage. But when you look at the path, this "arbitrage" is not really an arbitrage as we in finance define one, because you may have to post cash collateral along the way if prices go the wrong way. This little rincian has ensnared who knows how many clever traders.  The Wall Street use of the word "arbitrage" means exactly the opposite of arbitrage, namely taking bets.
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Treasury Liquidity - Barokong

So just what was the "disruption" in the Treasury market that so spooked the Fed, that now the Fed is buying more than the Treasury is selling? A commenter on mylast post on corporate bonds points to Treasury Market Liquidity during the COVID-19 Crisis by Michael Fleming and Francisco Ruela at the NY Fed, April 17 . Michael and Francisco nicely show us the facts. They make no editorial comment at all, except perhaps in the figure titles, so my questions about just how big a persoalan this is are not directed at them. Bid-ask spreads widened, to financial crisis levels (when the Fed did not, by the way, intervene.) The plot is hard to read in the far right end in order to compare to 2008. (Suggestion to the authors: focus on the last three months so we can see what was happening, not on the comparison to 2008.) As far as I can make it out, the 5 year spread widened form 0.25 /32 to about 0.4 /32; the 10 year from 0.5 to 1.0 and the 30-year from 1 to 5. If I read the caption correctly, each of these numbers is 1/32 of one percent of par, 0.03%, so the 5 year spread went from 0.008% to 0.012% and even the 30 year went from 0.03% to 0.16%. The "order book depth, measured as the average quantity of securities available for sale or purchase at the best bid and offer prices" (my emphasis) declined. There is usually a lot more for sale if you're willing to pay more. The difficulty of trading includes not just the bid ask spread, but a guesstimate of how much you will depress prices if you sell $100 million in a huge hurry. This price impact went up. But, it is measured as "slope coefficients from ...regressions of one-minute price changes on one-minute net order flow." How bad is it to wait a whole minute to sell $100 million? Also, most traders use fairly complex strategies to minimize price impact. And there is lots to complain about in this measure of price impact. (I prefer autocorrelation measures -- how much did the price bounce back.) And the absolute value looks to a layperson remarkably small. 7/32 = 0.22%, two tenths of a percent, on the 5 year bond. OK, 0.75% on a 30 year bond which is almost real money. But 30 year bonds are pretty volatile anyway as we'll see in a moment. Price volatility jumped, especially (actually almost entirely)  for the 30 year bond. The 30 year bond was experiencing 70% annualized volatility, which is 4.4% per day. That puts some of these spread and price impact measures into context. They are orders of magnitude smaller than the daily price volatility. This is not unique to the Treasury market.  Stock price volatility went through the roof too by the way. Here's the VIX, peaking at 80. The Fed has not yet seen fit to buy stocks, and let us hope it does not do so. Throughout all these numbers, the steady march from 1, 5, 10, to 30 year bonds is instructive. Longer bonds are more volatile always. "Liquidity" is usually confined to the shorter maturities. Trading volume was high too. Again you have to squint to see it. ... daily trading volume in the market overall reached a record high for the week ending March 4, averaging over $1 trillion, roughly twice its post-crisis average What does it all add up to? A trillion dollars a week is a lot of buying and selling. What's "disruptive" or dysfunctional about that? This isn't Costco, whose trading volume in toilet paper went to zero after it sold out. To me, there is a sense of utterly normal in all of this. Supply curves slope up, of everything, including "liquidity." Obviously, we hit a period of huge uncertainty, divergence of opinion, and liquidity needs. The fundamental, rational, wajar , functional, whatever you want to call it, price will be quite volatile, as was the stock price. The fundamental, rational, normal, whatever you want to call it desire to trade will rise as well. So how does a market react when there is a large increase in the volatility of prices and demand for trading. Well, supply curves slope up -- that demand is accommodated but at a higher price. Dealers who buy and have to hold securities in inventory for a day or two are more exposed to risk when prices are more volatile, so they buy less other things constant. Bid ask spreads and price impact rise to give them a higher profit, commensurate with that risk. In a time of volatility, there is more asymmetric information, so dealers charge a higher bid-ask spread. This may sound like less of a persoalan for Treasuries, but there is short term information about future order flows and future Federal reserve actions and even interest rates given the huge macro uncertainty. And the price volatility may be both a sign of trading demand and an inducement to it. If you can spot the direction, there is a lot more money to be made. Supply and demand. If trading volume goes up while spreads and price impact are rising, the shock is to the demand for trading. If trading volume went down  while spreads and price impact rose, the shock is to the supply of trading services. This event sure looks like a shock to demand, accommodated pretty well by dealers. (I wrote a paper a long time ago called "stocks as money," documenting a similar case of demand for trading) Where is the evidence that something is wrong with supply, that there is also a shift in the supply curve? Michael and Francisco wryly note the same point: High trading volume amid high illiquidity is common in the Treasury market, and was also observed during the market turmoil around the near-failure of Long-Term Capital Management (see this paper) and during the 2007-09 financial crisis (see this paper). Periods of high uncertainty are associated with high volatility and illiquidity but also high trading demand. also Not surprisingly, volatility caused market makers to widen their bid-ask spreads and post less depth at any given price, and the price impact of trades to increase, illustrating the well-known relationship between volatility and liquidity. So just where is the fire here? Where is the screaming hole in financial markets that justifies the Fed buying $1.3 trillion treasury securities in a month? Even if "intermediation" were the duduk perkara, why is buying up the whole supply the answer, not both buying and selling, to reduce bid-ask spreads? The Fed announced: To support the smooth functioning of markets for Treasury securities and agency mortgage-backed securities that are central to the flow of credit to households and businesses, over coming months the Committee will increase its holdings of Treasury securities by at least $500 billion and its holdings of agency mortgage-backed securities by at least $200 billion. How does buying it all up promote the "smooth functioning" of markets?  Is there anything more than "because of (big financial gobbledygook which you wouldn't understand anyway so it doesn't matter if it makes any sense) we're going to buy a trillion dollars of treasurys?" Finally, if absolute liquidity in Treasury markets is so important, if the ability to transact at 0.01% or less loss, in minutes, is a crucial social masalah, then why not talk about some mendasar reforms to those markets? As described in this post, roughly half of Treasury securities trading occurs through interdealer brokers (IDBs), in which dealers and other professional traders transact with one another, and roughly half between dealers and clients. Our focus is on the IDB market, and on the electronic IDB market in particular, which accounts for about 87 percent of IDB trading. Wider trading would make a lot of sense. Federal debt is carved up into 250 different securities or more. As I argued here, if you want them liquid, rearranging federal debt to only a few securities would make each one more liquid. If "balance sheet space," i.e. inadequate equity financing and regulatory risk-taking constraints, are stopping those with expertise in market making from making more markets, why in heaven's name after 12 years of Dodd-Frank act, capital requirements, essays on equity-financed banking, Volker rule and the rest, don't broker dealers have enough equity capital to let them trade through the covid-19 virus on top of a new cholera pandemic and a war? "Constrained balance sheets" are not a fact of nature, they are the product of 12 years of regulatory failure. There is a tendency throughout economics to write, "here is my policy," then "here are the problems that motivate my policy." But if you look at the problems, a lot of other policies would solve them better. Economics is too often answers in search of questions. So, bottom line, I'm still looking for evidence. I'm willing to give the Fed the benefit of the doubt. All the people I know at the Fed are smart and well-intentioned looking at a lot more data than I am. Just what is it that motivates buying a trillion dollars of treasury debt, and more trillions to come?
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Bond Liquidity - Barokong

When the Fed stepped in, were corporate bonds "illiquid," the market "dysfunctional," or were the prices just low, as they should be in advance of a Great Recession with larger bankruptcy risk? Did the Fed "liquefy" the market, "intermediate," grease the wheels, or is it just buying, and propping up prices so that bondholders can dump bonds on the Fed before things get really bad? I asked for evidence on bond market liquidity in my last post on the topic, "Bailout redux," and Pierre-Olivier Weill passed on a paper he has recently written with Mahyar Kargar, Benjamin Lester, David Lindsay, Shuo Liu, and Diego Zúñiga,Corporate Bond Liquidity During the COVID-19 Crisis. Here is their estimate of roundtrip trading costs -- if you buy and then sell, how much do you lose in bid ask spread. Feb 19 is the stock market peak.  March 18 is the day after the Fed announced it would lend money to broker-dealers and take bonds such as these as collateral. March 23 the Fed announced it would buy corporate bonds on the secondary market, and buy directly from companies issuing new corporate bonds. So, yes, by this measure, corporate bonds did become less liquid. But they should get less liquid. This is a period of higher risk, so a trader who is going to hold a bond for a few days needs a better price. And this is also a period of more asymmetric information, so bid ask spreads should be higher. Is it really a disaster meriting several hundred billion dollars of printed money that dumping a corporate bond costs you 0.12% of its value (half of 25) rather than 0.07% (half of 15)? The time pattern is also interesting Transaction costs continued to rise through the tumultuous week of March 16-20, despite the announcement of the PDCF (along with additional facilities on March 18), but fell after the March 23 announcement of the Primary and Secondary Market Corporate Credit Facilities. Because, despite, and coincident with are not all the same thing. I am interested that by these measures even the Fed's intervention in one case seemed to go the wrong way, needing a "despite," and in the other did not immediately still the waves. Dealers work in two ways: they buy on their own book, taking the risk for a few days and then selling, or they arrange trades between buyers and sellers, taking a fee and no risk. The next graph shows the proportion of agency trades. Consistent with the idea that intermediaries are not hot to take bond market risk on their own books, agency trades are rising, though by a grand 15 percentage points. Dealers were accumulating inventory until March 5, wound it down (sensibly) as markets were tanking. The figure reveals that dealers absorbed some inventory in late February, before financial markets began to fall rapidly on March 5. At that point, dealers stopped absorbing bonds, and even began to shed some of their inventory despite immense selling pressure. Well, that is what dealers are supposed to do! They don't hold forever, they buy at low prices and hope the prices bounce back. They're intermediaries, not speculators. That inventory takes off after March 23 confirms, I think, the story we're hearing. The Fed, by buying large net quantities, is telling the dealers that there is a lower price limit it will not let corporate bonds go below. Then the dealers can buy, knowing they only have upside risk. From the Fed's point of view, this is "liquefying" a market. The author's summary: As uncertainty surrounding downgrades and potential defaults grew during the first weeks of March, and withdrawals from corporate bond funds mounted, we find that dealers became increasingly unwilling to absorb inventory onto their balance sheets. As a result, dealers attempted to shift some activity from principal to agency trading and, among the remaining principal trades, they charged a significantly higher price to provide immediacy. We haven't quite shown that. As above, trading costs should rise as the risk of holding securities and asymmetric information both rose. But even if so, per my previous post, why is there so little "balance sheet space?" Why do dealer banks not routinely keep some dry powder, some ekstraequity, on their balance sheet just so they can make a killing in a time of great volatility? After all, if this is true, the potential profits from having some balance sheet space, rose tremendously. And where are the hedge funds, and other high frequency traders? Have they no balance sheet space either? We still haven't really answered the question. Is a rise in the cost of dumping your corporate bonds from 0.07% to 0.12% really a social disaster? Though these are problems of "intermediation," the Fed is clearly not "intermediating," both buying and selling, helping to lower transactions costs at any (even low) price. The Fed is a net buyer, trying to prop prices up. I would be very interested to see price autocorrelation, which is another sign of liquidity. And if anyone has the high frequency data, I would like to see just what trouble the Fed saw in Treasury markets, causing the Fed now to buy all the Treasury is issuing and more. Is the Fed just "liquefying" or is the Fed propping up Treasury prices? The Fed is supposed to buy from markets not the Treasury, so that we see market prices for Treasury debt. But if the Fed is deliberately propping up prices for Treasury debt, the line between direct monetization and secondary purchase is quite blurred. Sure, the Fed buys only from private parties. But if it announced a price, the private parties would know just what to offer the Treasury!
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Forbearance - Barokong

Peter Wallison has a worthy OpEd in the WSJ, "Forbearance." Continuing my earlier thoughts on the financial response here and here, I don't think he goes far enough. Let me tell a little story. Andy runs a restaurant. To run the restaurant, and live, he has a mortgage, he rents the restaurant space, and he borrowed money to buy to buy the equipment. Bob is retired. While he was working he lent Andy the money to buy the house and the restaurant equipment, and he owns the building. He lives off the income from these investments. The virus comes and Andy has no income. He has enough savings to buy food for a while, and other current expenses. But he can't pay rent, mortgage, and debt payments. This is the central masalah our government faces right now. One answer: The federal government prints money and lends it to Andy so he can keep paying Bob. You can see a major masalah here. Andy has no income. Eventually the restaurant may reopen, but then from the same profit stream Andy has to keep paying Bob and also pay back the loan that kept things going in the lockdown. Hmm. Another answer: The federal government prints money and just gives it to Andy. Well, that's a bit better except for the extraordinary amounts involved. We're not just paying Andy enough to buy food and keep the lights on, we're paying all his debts. And all this money is really government debt, which Andy, Bob, Carla, Dave, and Elizabeth will have to pay. Peter zeros in a third answer: What about Bob here? Why does he get off so easy? Peter's answer is that Andy should be able to simply stop paying rent, mortgage, and debt, at least the interest portion. Peter wants to add those to the eventual debt, accruing additional interest. If the answer is going to be that Andy borrows to get through this patch, and if debt markets are "impaired" or something so that Andy can't borrow from Bob through financial markets, well, cut out the middle man and let Andy essentially borrow directly from Bob by delaying payments. I might go a step further. There is a real loss here, a financial hole that is not coming back. Someone is going to cover that financial hole, and presently taxpayers are on the hook. What about Bob? Perhaps the right forbearance is that the rent and mortgage, at least the interest, are not paid at all, and Bob takes the loss. Bob did, after all, invest in a risky business -- home mortgages, restaurants -- and was getting a tidy return on his investment. Why should Bob bear no risk? You recognize my query from my last post. Just why must every creditor and bondholder be paid in full -- and indeed have the right to sell the bond to the Fed at yesterday's prices -- while everyone else is hurting? It sounds simple, but of course it isn't Bob really is part of a pension fund that owns debt securities that funnel through a few more intermediaries to the tamat loans. If Bob is a mortgage service company, Bob can't just stop paying. Working out a delayed or lower schedule of repayments is hard, outside of a bankruptcy court where lender and borrower meet directly. The law and economics tradition that one reinterprets contracts ex-post to have the provisions they might have had ex-ante is tough to follow. Just printing money is easier. But sometimes it's important to keep one's eye on the big picture, and with trillions at stake the principle can be applied here and there. A colleague says that roughly speaking that's what Argentina does in its various crises. Everyone just stops paying for a while. I don't know anything about Argentina, but I wish I knew more about such cases.  Historically debt jubilees have been a method of adapting to shocks, and I wish I knew more financial history. Comments welcome.
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Kocherlakota On Tabiat Hazard - Barokong

I found a kindred spirit. Narayana Kocherlakota, ex president of the Minneapolis Fed, shares my concerns over the current lending and bailout spree, in particular propping up the prices of corporate bonds. In its last financial stability report of 2019, the Fed highlighted how many nonfinancial corporations were making use of highly risky debt. The report pointed out that “a number of contacts expressed concern that a U.S. recession would expose highly leveraged sectors … concerns related to nonfinancial corporate debt were cited most frequently, with a focus on the growth in leveraged loans, private credit, and triple-B-rated bonds.” The financial stability report, of course, made no mention of pandemics or social distancing. It didn't need to — the risk to the financial system and the economy is posed by any recessionary shock. The coronavirus just happened to be the first one that come along. Narayana hits on a good point here. I think there is a lot of sympathy for corporations, like airlines, because "this wasn't their fault." But a recession is never an individual company's fault. And the premium you get -- the higher interest rate -- for holding corporate debt comes entirely from the fact that corporate bonds lose value in recessions -- in aggregate "bad times." The Fed is willing to let us hold idiosyncratic risk. But idiosyncratic risk is not priced. Or perhaps the market is allowed to absorb risk for little recessions but "this shock was too big." Well, it's also taking the left tail that generates the premium. In the 2007-09 financial crisis, governments around the world engaged in large amounts of subsidized lending to financial institutions. These interventions were rightly seen by many as a subsidy to future risk-taking by those institutions — risk-taking that can deepen any recessionary shock. To prevent this akhlak hazard, financial institutions are now required hold a lot more capital — that is, be much less leveraged, thus lowering the need for future bailouts. We shouldn't let the novel source of the 2020 downturn fool us: The interventions by the Fed and Treasury are creating the same sort of subsidy for risk-taking by nonfinancial corporations. We will need the same kind of post-recession policy response: Congress should use its power to tax or regulate to discourage or even kafe the country's large corporations from being too highly leveraged or using risky financing instruments. Otherwise, corporation will be further incentivized to take on too much risk and force another, possibly larger, bailout when another recession hits.
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Bailout Redux - Barokong

The greatest financial bailout of all time is underway. It’s 2008 on steroids. Yet where is the outrage? The silence is deafening. Remember the Tea Party and occupy Wall Street? “Never again” they said in 2008. Now everyone just wants the Fed to print more money, faster. (Well, there are some free market economists left. But we're a small voice!) Maybe the Fed is right that if any bondholder loses money, if bond prices fall, if companies reorganize in bankruptcy, the financial system and the economy will implode. I am not here today to criticize that judgement. But if so, we must ask ourselves how we got to this situation, again, so soon. Once is an expedient. Twice is a habit.  It is clear that going forward any serious shock will be met by bailouts, and the Fed printing reserves to buy vast quantities of any fixed-income asset whose price starts to fall. Why does the Fed feel the need to jump in? Because once again America is loaded up with debt, because bankruptcy is messy, and because the Fed fears that debt holders losing money will stop the financial system from providing, well, more debt. This crisis is a huge wealth shock. The income lost during shutdown is simply gone. The question is, who is going to take that loss? Borrowing to keep paying bills, the current solution, posits  that future profits will soak up today's losses. We'll see about that. The CARES act puts future taxpayers squarely on the hook to pay today's bills. But where do those bills go? To creditors -- property owners, bond holders, and so forth. If we're looking around for pots of wealth to absorb today's losses, why are bondholders not chipping in? The biggest wealth transfer in history is underway, from tomorrow's taxpayers to today's bondholders, on the theory that if they lose money the economy falls apart? OK, but why did America load up with debt again, apparently all "systemically important?" Could the expectation of a bailout any time there is an economy wide shock happens have had something to do with it? Will we do anything when this is over to stop companies from once again loading up with debt -- especially short term debt -- and forcing the Fed's hand again? Meantime, anyone who hoarded some savings in the hope of profiting from fire sales, in the hope of providing liquidity to "distressed markets" has once again been revealed as a chump. Will we do anything to encourage them? Will lots of debt, private gain, taxpayers take the losses,  be the perpetual character of our financial system. "You can't worry about budpekerti hazard in a crisis," they said, and they didn't. At least last time there was some recognition of budbahasa hazard, and a promise to clean up the moral hazard with reform. Will there be any such effort this time? Is anyone even thinking about the enormous budbahasa hazard we are creating with these precedents? Will  the financial system perpetually a four-year-old on a bicycle, a parent running closely behind with one hand on the seat? Will the "Powell put" on fixed income grow ever larger? Or will we, this time, finally cure the financial system so it can survive the next shock? A bailout Small but symbolic: The federal government just bailed out the airlines -- or more precisely airline stockholders, bondholders, unions, airplane leaseholders and other creditors who would lose in bankruptcy. "big airlines will receive 70% of the money as grants—which won’t be paid back—and 30% as loans. The cash comes with strings attached: Airlines must give the government warrants amounting to 10% of a given loan’s value that can be swapped for stocks; they cannot lay off staff until September; and they face restrictions on dividends, buybacks and executive compensation." Oh, and as the article makes clear, this only gets us maybe through the summer. Anyone want to take a bet that planes are full again by September? The big banks got bailed out in 2008 — or more precisely, the stockholders, bondholders and creditors of the big banks got bailed out.  Never again, they said. Again. Now, one can make a case that big banks are “systemic,” that if their bondholders lose money the financial system collapses. Just how are airline bondholders “systemic?” What calamity falls if airline bondholders don’t get paid in full?  Just why is a swift pre-packaged bankruptcy not the right answer for airlines? This seems like a great time to renegotiate airplane and gate leases, union contracts (some require the airlines to keep flying empty planes!) fixed-price fuel contracts and more. If taxpayers have to give airlines cash grants don't we get some reassurance this doesn't have to happen again? Even I would say, no more debt financing. You can see the instinct in "restrictions on dividends, buybacks and executive compensation." Democrats in Congress wanted "stakeholder" board seats, carbon reporting, and more. Why not go full Dodd-Frank on them? Detailed regulation of their financial affairs, frustasi tests to make sure they can survive the next time? Like banks, the existing airlines might not end up minding so much a return to the 1970s status as regulated utilities. Or, more likely, like GM, we just forget about it, let them load up on debt again, and pretend there won't be a 2030 bailout? The Fed's big artillery The real action is at the Fed. The Fed is buying commercial paper, corporate bonds, municipal bonds. The Fed is explicitly propping up asset prices. The Fed is also lending directly to companies. The current guesstimate is $4 trillion, with $2 trillion already accomplished. More is coming. It started "small"On March 17, the Fed bailed out money market fund investors, buying the “illiquid” assets of those funds so that the funds could continue to pay out dollar for dollar.  Recall that in 2008, the Fed and Treasury bailed out money market fund investors, buying assets to stop a run on money-market funds' promise that you can always cash out at $1. Never again, they said. Fixed dollar promises must be backed by Treasuries, other funds must let asset values float. Again. On March 17 the Fed also announced it will buy commercial paper.  “Directly from eligible companies.” Yes, the Fed prints reserves to lend directly to companies that can issue A1/P1 commercial paper. "By eliminating much of the risk that eligible issuers will not be able to repay investors by rolling over their maturing commercial paper obligations, this facility should encourage investors to once again engage in term lending in the commercial paper market. " Why are companies borrowing long term by rolling over commercial paper? Didn't we learn anything about rolling over short term debt in 2008? Are we going to follow up by putting a stop to that? Why don't companies have more equity financing, on which they can just stop paying dividends? "Investors" you say, it's not all the Fed. Read carefully. "By eliminating much of the risk..." The Fed props up prices, and removes risk. Then private investors will come in. The markets won't ride that bike without the Fed's hand on the saddle, apparently. Why do we bother to have private markets? On March 17 the Fed started to lend again to primary dealers. These are the traders, much maligned by the Volcker rule. The PDCF will offer overnight and term funding with maturities up to 90 days...Credit extended to primary dealers under this facility may be collateralized by a broad range of investment grade debt securities, including commercial paper and municipal bonds, and a broad range of equity securities. Let's translate. You're the trading desk at, say Goldman Sachs. You want to buy stocks, as you think people are dumping in a hurry. Great, that's what traders are supposed to do: "provide liquidity." But, sadly, you're in the habit of of funding trading activity by borrowing money, short term. And you can't do that right now. So the Fed will now lend you the money to buy stocks, and will take the stocks as collateral! It's almost as if the Fed is buying stocks -- except you get the gains, and if you go under, the Fed gets the stocks! (A friend in the securities industry say nobody is bothering to investigate and price high grade corporates. The Fed is setting the prices.) Again, the Fed is between a rock and hard place. Yes "balance sheets are constrained." Trading firms don't have enough equity to take on additional risk. The natural buyers at asset fire sales are constrained out of the market. Bail the Fed feels it must. But this is exactly what happened when the Fed first lent to broker/dealers in 2008! Why in the world are we in this position, 12 years after that crisis? On March 20, the Fed expanded into state and municipal markets. The mechanism is the same: Fed lends to a financial institution, which buys the assets, and then gives the Fed the assets as collateral for the loan. Once again the point is  "enhance the liquidity and functioning of crucial state and municipal money markets." On March 23, the Fed rolled out real artillery. Ominously, Treasury markets appeared "illiquid," so the Fed has stepped in buying $1.3 trillion in the first month -- more than the Treasury issued.  The Fed is funding Treasury borrowing with newly printed reserves.  The Fed now buys mortgage backed securities. And now.. corporate bonds. This is well past 2008. the Primary Market Corporate Credit Facility (PMCCF) for new bond and loan issuance and the Secondary Market Corporate Credit Facility (SMCCF) to provide liquidity for outstanding corporate bonds. Translation: The Fed will buy new corporate bonds, thus directly lending to corporations. And it will buy  outstanding bonds. Why would it do that? Well, to "provide liquidity." This is a word that ought to set off BS detectors. Yes, there is such a thing as an "illiquid" market. There is also such a thing as a market whose prices are dropping like a stone. Sell all you want but at 50 cents on the dollar. "I wish I had sold at yesterday's prices" is not illiquidity. You have to pay people a lot to take risk right now. Which is it? Hard to tell. There are ways to tell, of course. For example, illiquid markets have negative price autocorrelation -- a low price today bounces back. I am not aware of the Fed having applied this or any other test. (Research topic suggestion.) Again, I don't want to criticize, but there sure is a danger of propping up prices under the guise of "illiquidity." The Fed's view that if the Fed takes all risk off the table "liquidity" will reappear is also pretty close to taking risk off the table so prices will rise. The Fed is already buying new bonds from companies to finance their new expenditures. Propping up prices of existing bonds is a way to let old bondholders cash out at high prices, now before the deluge. Just why can't old bondholders even take mark-to-market losses? And, if corporate bondholders need to be bailed out in this way, are we going to do anything about it going forward? Do you get to buy junk bonds, high interest municipal debt, and the Fed will let you out if anything bad happens? Wrap up OK, I haven't even gotten through March and the Fed is just getting going. Let's wrap up. The Fed has felt the need to take over essentially all new lending in the economy. The Fed is also propping up most fixed-income prices. The Fed is deliberately removing risk from holding these assets. Once again, I will be told, "this isn't the time to think about susila hazard." But having done this twice, the first time with huge protest, the second time as if it is perfectly normal, this is the pattern, and the sopan santun hazard is there. The economy will load up on debt, especially short term debt. People will not keep stashes of savings around to provide liquidity or jump on buying opportunities. And the need for bailouts will be larger in the next crisis. "But the Fed made money in 2008" you may retort. And it has a half chance of making money again. If the recession wraps up in September and these "loans" get paid back, it will do nicely. If the recession goes on a year and all these "loans" go sour, it will not look so pretty. Yes, in 2008 the Fed and treasury successfully operated the world's largest hedge fund, printing money to buy low-price assets. But is this really the function of the Federal Reserve? Do we want it driving private hedge funds out of the liquidity provision business, by its ability to print rather than borrow money, and by the off-balance-sheet put that the US taxpayer will in the end take losses if this massively leveraged portfolio doesn't work out? Where is the outrage? Where are the financial economists? Where is the reform plan so we don't do this again? At a minimum, can we say tha  the government could stop subsidizing debt, via tax deduction and regulatory preference for "safe" (ha!) debt as an asset? Hello out there? In 2008, everyone was writing financial crisis papers. Now everyone is playing amateur epidemiologist. Finance colleagues, you have a bigger crisis and intervention to study, and a deeper set of regulatory conundrums. Is everyone just too scared of sounding critical of the Fed? Get to work! The Fed and Treasury's actions are telling us we are on the verge of financial apocalypse . Let's wake up and look at what's coming, especially if it doesn't all get better by September. Some links This post continues fromFinancial Pandemic. I had planned a longer post on the details of many of these programs, but this is long enough. A great explanation by Robert McCauley in FT. Section heads include  1) Acting as a lender of last resort to securities firms, 2) acting as a lender of last resort to investment funds, 3) acting as a securities dealer of last resort, 4) acting as a securities underwriter of last resort and finally 5) acting as a securities buyer of last resort. A simple tweet storm by Victoria Guida Via the indefatigable Torsten Slok, Financial Policy During the COVID-19 Crisis MIT opeds on financial affairs A great list of policy trackers. Financing Firms in Hibernation During the COVID-19 Pandemic The YaleFinancial Stability Tracker and especially theFinance Response Tracker are very useful list of what's going on. Fed Intervention in the To-Be-Announced Market for Mortgage-Backed Securities by Bruce Mizrach and Christopher J. Neely is a very nice description of what's going on there The United States as a Global Financial Intermediary and Insurer by Alexander Monge-Naranjo. More contingent liabilities waiting for Uncle Sam bailouts. A data set of international fiscal responses
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