How close are we to the point where central banks will start to buy impaired securities outright?
In thinking, at least, not far. Professors Willem Buiter and Anne Sibert were talking about central banks making “outright purchases” back in August last year. Insofar as such predictions were predicated by central banks first broadening the scope of their money market operations, how far off can we be now?
On Wednesday this week, Buiter came back to the issue.
When markets are disorderly and illiquid, it is not just the prices of good or prime assets that fall below their fundamental values. The same holds for the prices of bad, impaired and sub-prime assets. Impaired assets too will have a fair or fundamental value. That fundamental value may well be far below the face value of the security, but it may also be well above the price the impaired asset would fetch in a fire-sale in an illiquid market.
If the central bank, or some other government agency, were to act as Market Maker of Last Resort and buy the impaired asset at a price no greater than its fair value but higher than what it would fetch in the free but unfair illiquid market, such a purchase would not be a bail-out. It would also be welfare-increasing.
Felix Salmon at Market Movers, meanwhile, points us in the direction of a few points made by Mark Thoma back in March. Assuming the worst case scenario, says Thoma, with the Fed buying assets which are later rendered worthless, what’s actually the big problem?
…in the end, it is no different than the Fed simply printing that same amount of money and giving it to the banks as new reserves, it is an increase in the money supply. It is a large increase, and it could surely be inflationary, but inflation is not the main worry when financial markets appear on the verge of a downward spiral that could drag the economy down along with them.
Firmly in the realist camp though, Salmon points to the slim political likelihood of the Fed ever following through with asset-purchases. “The optics are simply terrible”.
Like invading Canada, says Paul Krugman at the New York Times, just because the government probably has the plans laid out, doesn’t mean it’s likely to run with them.
Could all this yet change? If the crisis draws out, then it’s certainly a likelihood. The litmus test may well come in how well banks’ just announced plans to “ringfence” bad assets stand up to scrutiny. To us, the idea sounds worse than MLEC, and almost certainly spun on the fly after Wall Street saw what happened to UBS’s shareprice on Tuesday.
Finally, below, a cursory roundup of some of the latest chatter:
The De Long/Summers thesis
Larry Summers in the FT - “Neither US financial institutions nor the economy are likely to suffer from a lack of central bank liquidity provision… At the same time, processes are in motion that may lead to new demands for more than $1,000bn in mortgages, directly or indirectly”
Brad de Long - detailed breakdown of Summers’ points with objections and suggestions.
Yves Smith
Critique of “wishful” De Long/Summers thesis. “What about ‘bubble’ don’t you understand? That high priced equilibrium was not stable, it was created by unsustainable leverage. Per Herbert Stein, ‘That which is unsustainable will not be sustained.’ It is neither good economics nor good policy to try to keep an asset bubble aloft.”
The Japan hypothesis
Gillian Tett and Krishna Guha in the FT. “Japan’s lost decade offers dire pointers for the Fed”
Bill Gross
“…we will likely pull back from our rating service blessed confidence in asset-backed securities. In its place will likely come the increasing reliance on government/agency guarantees as well as the explicit use of the government’s balance sheet to support and then assimilate egregious loans of the past decade.”