The political constraint horse left the barn with the JPM conduit loan, the subsequent $ 30 billion financing, and the opening of the discount window to the dealers.

From a technical perspective, Greg Ip's article explains that if the Fed exhausts its existing asset capacity, it can then proceed if necessary to expand its balance sheet through liability management techniques, and still retain control over the level of bank reserve accounts and therefore the desired Fed funds rate.

The only technical limit to Fed balance sheet expansion is the capacity and willingness of the market to absorb treasury debt.

At the end of the day, the Fed is using public funds (monetary base plus debt if desired) to fund its private sector intervention.

One should not overreact to this idea nor overestimate its risk. The idea is fundamentally an extension of pre-existing Fed operations. Various types of collateral are valued and funded by Fed advances. There was already a very wide range of collateral acceptable at the Fed window in the normal course. Because this has been done well into the cycle of valuing the securities in question, the discounted values of this collateral do provide the Fed and the taxpayer with considerable protection, even if not total protection.

Another noteworthy point is that the Fed remits about $ 30 billion annually to Treasury due to the normal profit associated with funding $ 800 billion in assets with interest free money. This can be interpreted as an annual savings to the taxpayer. It is an opportunity cost for the holders of the monetary base – who receive no interest on the very large amount of notes in circulation and the smaller amount of bank reserves on deposit with the Fed. This represents the benefit associated with the Fed providing liquidity to the banking system via its very existence and the nature of its usual liabilities. The public participants in the monetary system pay the cost, and the taxpayer receives the benefit in the form of $ 800 billion in government funding at 0 interest cost.

It is reasonable to view various modes of asset risk taking by the Fed in the context of this cumulative 0 cost funding operation (or equivalently, a $ 30 billion annual windfall against normal funding costs). The Fed's balance sheet is about $ 800 billion. Suppose via liability management it were expanded to $ 2 trillion. Given the late cycle haircuts taken on various forms of collateral, how much risk is rally being taken here? Is it reasonable in the context of what otherwise has been a $ 30 billion risk free annuity? Moreover, and importantly, the Fed has the advantage of not being held hostage to mark to market volatility in viewing this risk; at least not in quite the same way, even though the marks will be disclosed periodically. It will be interesting to see how the annual $ 30 billion remittance is affected if at all by pure mark changes on the collateral (as opposed to cash shortfalls as would occur in defaults).

Finally, at a global and more philosophical level, if China's central bank can subsidize exports to the tune of $ 1.5 trillion in foreign exchange reserves, and if that policy has helped create the global savings glut, and it that phenomenon has led to the US credit crisis, then why can't the Fed get creative by doing some balance sheet ‘subsidization' of its own?

jkh & Fullcarry — There are questions of degree, as well as questions of kind.

As jkh writes, the Fed has already made the decision to bear risk on behalf of private sector actors. They did so first mildly, by accepting dodgy collateral in full recourse loans, so they could only be stiffed if their counterparty went under. They did it more boldly with the Bear/JPM arrangement, accepting the full risk of ownership on questionable collateral, as well as whatever uncertainties come with their undisclosed derivatives book. But that doesn't mean we should be unconcerned with the quantity of those losses.

The risk that the Fed absorbs the public absorbs. That seignorage benefits accrue to the state is not a "windfall". It is one of the reasons we have public money creation as opposed to, say a gold standard, which privatzes gains from mere currency value. The loss of those benefits, and potentially losses that exceed those benefits, is a genuine opportunity cost to taxpayers. Categorizing seignorage benefits to taxpayers as a "windfall" is a poor idea. It's a way of reconciling with the theft of those benefits by private actors.

In fact, one way to view the "credit binge" is a tacit scheme by private actors to capture the benefits of seignorage. By making crappy loans in advance in such a way that widespread defaults would have devastating consequences, the banking system effectively "preprinted" money that the central bank would be forced to ratify. Such a scheme requires little coordination, it amounts to the old schoolboy credo, "If everybody does it, nobody gets in trouble." Letting such a scheme payoff is a policy choice, not a foregone conclusion, whether our currency is elastic or not.

I agree with jkh that the Fed can do a whole lot of things, so why shouldn't it do unorthodox things, as other central banks have, if that's in the public interest? But if it's in the public interest to do what it is doing, that should be a widely agreed political decision, not a technocratic choice by insiders. The question is not what the central bank can do, but what it should do, in the public interest. Even if it has deemed a willingness to absorb some losses on behalf of private parties to be in the public interest, that does not imply that the right amount is a blank check.

An elastic currency is a tool, and perhaps it is useful in moments like this. But there are distributional and future-incentive consequences to the manner in which the Fed is using that tool. If the credit binge was destined to deflate (apparently lots of people assumed otherwise a year ago, but perhaps they weren't rational), fine. Surely the Fed should fight that deflation. But the question of how it uses that elastic currency — to make foolish creditors whole, or to replace lost money post-default, is a nonobvious policy choice. The Fed could explicitly nationalize, and then absorb some of the losses of the newly public enterprises while forcing some private counterparties (shareholders, some creditors) to bear losses. In this case, the public would gain from the recapitalization-by-seignorage when the restored enterprises were sold. Or the Fed could do what it is doing, which is to covertly absorb losses in order to keep foolish private actors as whole as possible, for the sake of public confidence.

There is a case to be made for the Fed's policy. Minimizing disruption has positive externalities, and outright nationalization is traumatic. But the price tag matters, and incrementally increasing the Fed's exposure without pausing for review strikes me as profoundly dangerous. Expanding the Fed's balance sheet is very doable, but it requires new sorts of unorthodox policy, and amounts to a recapitalization of the Fed by the public. That strikes me as not a choice to make lightly.

We may well, as jkh suggests, decide that a central bank subsidy of the financial sector is in the public interest, as the Chinese decided that a subsidy of its export sector was. But you know, if it were up for debate in the light of public scrutiny and the halls of congress, we might come to a different conclusion too. I think we should have that debate.

Fullcarry, no one is disputing the Bagehot rule, the role of a central lender of last resort against high-quality collateral. But that's not what's going on here, as you acknowledge when you write of a "credit binge... deflat[ing]". The Fed is assuming the role, in Mark Thoma's phrase, of "risk-absorber of last resort". Really it is the public that is bearing the risk. That is something different entirely, and not at all foreordained or necessarily appropriate however elastic the currency.

Sorry to ramble on... one of the benefits of conversing in the comments is one doesn't have to edit much...

One small correction. The Bear Stearns non-recourse loan is, of course, real risk being born by the FED. Even I found the FED's actions in that instance surprising.

What are you all talking about? I read Ip's piece and decided it wasn't worth a post at my blog. Why? It's irrelevant. The Fed has no constraints. None! Period! It will do whatever it wants. It wants to protect the banks. I read discussions about the 28-day facility. So? Will the Fed force say Citibank out of business at the end of 28 days? Will Cox demand a publicly-held company file an 8-K when borrowing from the Fed? Will Superman save Lois Lane? Is Mr. Ratzinger Catholic? Fuggedaboutit as we would say in Brooklyn. Inflation's coming. Get used to it. Reading suggestion for those who like "flexible" currencies, The Communist Manifesto by Karl Marx. Read his 10 point plan for implementing communism. As The Mogambu Guru would say, "HaHaHaHaHa".

IA — I don't disagree with you, but you're a bit more cynical than me (and it's pretty hard to be more cynical than me about this stuff!). You may be right that the Fed will do what it will do, serve certain interests and ignore others, regardless of the consequences. But even if you are right, it's a Pascal's wager kind of thing. It doesn't hurt anyone to have people like me tilting against the windmills...

If you think about it the reverse MBS swap is a fancy way of saying that the Fed should step up and guarantee the mortgage securities. That is precisely what you are doing. First you give out tsys for mortgages, then you take the same mortgages and send them back to somebody else with a guarantee for a swap. Why not just provide a fed guarantee. For this reason alone, despite being a very clever idea, I do not believe it is a viable option for the fed. Nor is quantitative easing, which works for a capital surplus country (i.e. Japan) and not a capital deficient country, as it risks crashing the currency. A far better alternative would be for the Fed to issue recapitlaization bonds to the TSY (or the market) and use the proceeds to recapitalize the banks. It has three advantages: 1) You get the gearing -- the new equity capital can be used to buy 12 times the amount of assets that they would have bought themselves directly. 2)It may not require congressional action or involve the TSY directly into the recapilatization. 3) It fundamentally deals with the core issue -- inadequate bank capital for the amount of assets in the system.

"...but I am not sure the non-FED side of the government is up to the task."—Fullcarry

Why do you fear the democratic process so much?

I think the answer is obvious, for the verdict is pretty much in from the public. If the people would have had their say concerning the Bear Sterns bailout (much less all the other extraordinary hoops the fed is jumping through to help out Wall Street) it would have NEVER happened. A recent NY Times poll showed respondents more than two-to-one opposed (62% opposed, 30% in favor) to the Federal government helping out banks, even if it could limit any possible recession. http://graphics8.nytimes.com/packages
/pdf/politics/20080403_POLL.pdf

Daniel Yankelovich warned of the "culture of technical control," "creeping expertism" and the impending expert vs. public showdown back in 1991 in his excellent analysis, "Coming to Public Judgment."

But more apropos I think your arguments harken back to other non-democratic proposals such as W.E.B Dubois' "The Talented Tenth."

I forget who it was that did an excellent critique of Dubois' communistic leanings, I think it was either Henry Louis Gates or Cornel West. But the criticism would hold true for your non-democratic impulses as well. For the question becomes, if we do away with the democratic process, then from where will "the correction from below" come?

Big picture. Ignore it at our peril, or at least at the loss of much valuable time and brainpower wasted on chasing relatively minute accounting details. It's much less of a headache to think from a top-down designer's point of view.

The Fed is the flagship of a monetary system, commenced in 1913, and locked in its present form in 1933 with the confiscation of the public's gold.

I'm glad PrintFaster mentioned "gold", for it's tucked away on that "balance sheet", and worth now around $250 billion. The more gold goes up, the more valuable it is on the asset side. And (if it is indeed locked away in Ft Knox or West Point) it IS an asset.

But it won't be rolled out -- or even mentioned -- until absolutely needed as the very last backstop of a new currency system.

The Fed has another next-level-up "ace in the hole", in contrast to regular banks with regular balance sheets. Its ONLY major liability, those green paper "notes", can't be cashed in for anything on the asset side. They're just supposed to be modestly printed, kept within a Friedmanian percentage of annual increase.

The only thing the Green FRNs can be traded in for is goods and services, and not at the Fed, but by American workers. Pretty amazing, to call that a "Liability" of the Fed!

Oh, and that's also what backstops the Tsys, those American workers, via taxation payments to the IRS.

So -- the first order fallback position when the monetary system starts to come unglued: more Treasuries, as Ip mentions, until, within months or years, the burden of eventual taxation is too-obviously stretched thin.

Then, more green paper becomes the second line of defense, until it, too, loses some of its credible effect. (The effectiveness of each of these is calculated at various inflection points, where shifts into the next realm -- along with its attendant propaganda barrage -- are phased in.)

Then, thirdly comes the hint at some form or percentage of gold backing, still not redeemable with the green paper.

Then, greater and greater degrees of physical gold backing.

Now, each of these will be trotted out and used to optimal effect, and no deeper use of real asset hint, promise, or backing will be offered than is proven necessary.

Indeed, the necessary complement of "credit" is Credulity. As long as we will work for the present form of currency they offer, they need offer no other, more "real", form of "money". Lucy. Charlie Brown. Football.

Along with this system will come the flagship bank(s) to implement it on the "private" side. I long suspected that JPM ran up its supreme derivative mountain only because it knew it had the Fed's anointment to not ever have it called in for payment.

Others may have derivatized themselves so extremely in hopes of similar anointment, but I suspect the Fed will neither need, nor be able to integrally save, more than one of these super-entities on its way into rolling out a new monetary order for us to live under.

All other banks, or at least those who threaten to topple the derivative Himalayas, would be folded into JPM. Perhaps a few regional, or private, banks of strong balance sheets or political clout would be permitted to stand, as "evidence of free market banking".

However, most banks have gone along on the wild real estate and commercial lending rides because they knew there was little shelter likely in any monetary Gotterdammerung to arrive on these shores.

You gotta think like a criminal, or a Central Banker. But I repeat myself.

On the minor point, I understand the seignorage interpretation and agree with your conclusions. Although I find the idea of privatized seignorage slightly awkward, and would tend to view it somewhat differently.

The Fed balance sheet is essentially a part of a consolidated government balance sheet. To the degree that central bank assets consist of treasury debt, which is an obligation of the government, this item disappears on consolidation. The net result is that the monetary base normally provides 0 interest cost funding for general government operations.

Seignorage is the interest cost that is saved by having the monetary base as funding. Because of the institutional configuration, it captured in the form of central bank ‘profit' and transferred annually from the bank to the government.

If the central bank starts to accumulate private sector assets, it will sell some of its treasury debt into the market to sterilize the money effect. On a consolidated basis, the government balance sheet has actually expanded, with new private sector assets now funded by additional government debt floated in the market. The marginal contribution to the taxpayer is the net income generated by this combination.

The effect on the normal seignorage case depends on the performance of the private sector assets. These risky assets will typically pay a premium over the cost of government debt. If they remain performing, seignorage will increase. If they default, seignorage will decline relative to the base case. There may also be a capital gain or loss in either event.

I would not describe the income effect as the privatization of seignorage. Rather the central bank has put its seignorage income at risk by investing the monetary base in risky assets while effectively forcing the government to float market debt as a consequence. As a result, the private sector now holds risk free treasury debt and collects income on that, as compared to the losses it would have sustained had it not swapped its risky assets for treasury debt. This gain might be interpreted as the privatization of seignorage, but more directly it is the modification of central bank seignorage resulting from moving out the risk curve.

I have difficulty with the idea of framing the privatization/ socialization debate as a binary choice. I think of it more as a decision about where to be on a continuum of possibilities that have elements of both. In this context, the binary choices are extreme points, while the real world is somewhere in between. Such an approach lends itself to option metrics that focus on the famous central bank/government put or moral hazard.

Take Bear Stearns as an example. Their risk taking culture resulted in a stock price that dropped from $ 170 to $ 10. If Bear Stearns was positioning itself implicitly for a socialized subsidy, I doubt very much they were operating with the idea that this amounted to being long a put option at $ 10. While the Fed's actions had the effect of ‘rescuing' Bear Stearns from bankruptcy and a potential $ 0 value outcome, the fat tail risk assumed in reckless management arguably kicked in well before the stock reached $ 10. In this sense, the social subsidy to Bear's shareholders due to the Fed's actions was a put option that was well out of the money. I think it's difficult to argue forcefully that intervention at $ 10 is encouragement for the risk culture of Bear Stearns to be repeated in the future. The equity was mostly wiped out.

Of course, this is not the only social cost involved in the Bear deal. Risk on the $ 30 billion loan must also be considered. This part of the deal represents a put option for some of Bear's creditors, since they get their money back while the Fed takes on the burden of the credit risk. This is the cost that is most associated with resuscitating a nearly seized up financial system and avoiding a systemic risk disaster. Although it is an at the money put option for those creditors no longer financing that collateral, it is in a sense out of the money for Bear creditors in total since the $ 30 billion financing and credit risk support is a subset of total credit risk.

In the case of the effect of Fed intervention on both the shareholders and creditors, one must weigh the specific social cost of the deal versus the potential systemic social cost of the alternative. I won't attempt that here, but it becomes a question of proportionate response.

One should ask the same question at the macro level of contingencies beyond Bear Stearns. Fed actions with the risk of loss socialization have been taken in the context of an environment where macro loss projections now commonly run $ 1 trillion or more.

It is important to acknowledge that the collateral at the Fed has already been subject to haircuts that for the most part are already included in such a macro loss projection. Therefore, expected Fed losses are low relative to a $ 1 trillion macro loss projection. They could even be considered relatively low, based on existing nominal exposure (and perhaps even potential balance sheet expansion, given the marks on collateral) if the projection escalates to $ 2 or $ 3 trillion, which it may, as any reader of Roubini would recognize. The Fed put is not exactly at the money for the current $ 1 trillion projection.

This is the type of social put metric that must be analysed for proportionality. The question becomes, what is a pragmatic balance between expected private sector losses of this enormity and the social cost of dealing with such an outsized loss experience.

One may ask importantly, why should the social put exist on any of it? The only answer is that it's a reasonable cost to be borne when attempting to moderate even greater systemic breakdown, with further cascading losses in large part due to exaggerated illiquidity and its effect on the sudden crystallization of wildly volatile marks.

I like your idea of using the Fed's existing balance sheet as a stop loss point for subsidization, although a facility for public debate around the issue would be a challenge. I can almost visualize competing presidential primary candidates four years from now stumping on such claims like “From the beginning, I did not support the expansion of the Fed's balance sheet” or “While I authorized the expansion of the balance sheet, I never expected the Chairman to act before exhausting other possibilities” : )

I'm sorry, but in a fractional reserve fiat monetary system doesn't it all boil down to:

money = credit (go ahead and quibble...)

credit requires ability to repay

too high a DTI and you're "pushing on a string" trying to reflate

Let the debt deflation begin! The Depression begins in 2012! Let's start a preemptive war to stave it off! Let's hollow out America and take our spoils to Argentina, where we can do what we want!

"
April 3, 2008 -

WMR has learned from knowledgeable sources within the US financial community that an alarming confidential and limited distribution document is circulating among senior members of Congress and their senior staff members that is warning of a bleak future for the United States if it does not quickly get its financial house in order. House Speaker Nancy Pelosi is among those who have reportedly read the document. The document is being called the "C &R" document because it reportedly states that if the United States defaults on loans and debt underwriting from China, Japan, and Russia, all of which are propping up the United States government financially, and the United States unilaterally cancels the debts, America can expect a war that will have disastrous results for the United States and the world.

"Conflict" is the "C word" in the document
The other scenario is that the federal government will be forced to drastically raise taxes in order to pay off debts to foreign countries to the point that the American people will react with a popular revolution against the government.

"Revolution" is the document's "R word"
The origin of the document is not known, however, its alarming content matches up with previous warnings from former Comptroller General David Walker who abruptly resigned as head of the Government Accountability Office (GAO) in February of this year after repeatedly publicly warning of a "financial meltdown" disaster if America's $9 trillion debt was not addressed quickly. Financial experts have warned that the national debt, corrected for inflation, could reach $46 trillion in the next 20 years. A month earlier, Walker warned the Senate Banking Committee about the reaction of creditor nations in Asia and Europe if the U.S. did not address its debt problem."

Massive buying of puts and shorting stock in Bear Stearns

On March 10, 2008, the closing price of Bear Stearns was 70. The stock had traded at 70 eight weeks prior. On or prior to March 10, 2008 requests were made to the Options Exchanges to open new April series of puts with exercise prices of 20, and 22.5, and a new March series with an exercise price of 25.

Their requests were accommodated and new series were opened March 11, 2008.

Since there was very little subsequent trading in the call series with exercise prices of 20, 22.5 or 25, it is certain that the requests were made with the intention of buying substantial amounts of the puts. There was, in fact, massive volumes of puts purchased in those series which opened on March 11, 2008.

For example, between March 11-14 inclusive, there was 20,000 contracts traded in the April 20s, 3700 contracts traded in the April 22.5s, and 8000 contracts traded in the April 25s. In the March 25s there were 79,000 contracts traded between March 11-14, 2008.

Question: Why did the options exchanges not open the far out of the money puts for trading the first time that BSC hit 70, when the Aprils and Marchs had far more time to expiration. Certainly if the requesters were legitimate hedgers or speculators, buying the March and April with two and three months to expiration was more appealing.

Answer: The insiders were not ready to collapse the stock and did not request the exchanges to open the new series then.

Second Request and Accommodation

On or prior to March 13, 2008, an additional request was made of the Options Exchanges to open more March and April put series with very low exercise prices even if that meant those March put options would have just five days of trading to expiration. The exchanges accommodated their requests, knowing that the intentions of the requesters was to buy puts. They indeed bought massive amounts of puts. For example the March 20 puts traded nearly 50,000 contracts (i.e. contracts to sell 5 million shares at 20). The March 15s traded 9600, the March 10s traded 13,000 and the March 5s traded 6300 all on March 14 (the first day of trading of the new March series).

The introduction of those far-out-of-the-money put series in the April and March months immediately before the crash, provided a vehicle whereby extreme leverage was available to the insiders. In other words if you had $100,000 and you knew that Morgan would buy Bear Stearns at two dollars, you could make five to 10 times more on the $100,000 by using the $100,000 to buy the newly introduced March puts. This is so because the soon to expire far out-of-the-money puts were far cheaper than the July or October out of the money puts. And that is why the inside traders requested the exchanges to introduce the far out of the moneys just days before the crash.

But this scenario has enormous implications. It means that the deal was already arranged on March 10 or before. That contradicts the scenario that is promoted by SEC Chairman Cox, Fed Chairman Bernanke, Bear CEO Schwartz, Jamie Dimon of J.P. Morgan (who sits on the Board of directors for the New York Federal Reserve Bank) and others that false rumors undermined the confidence in Bear Stearns making the company crash, notwithstanding their adequate liquidity days before. I would say that the deal was arranged months before but the final terms and times were not determined until maybe March 7 or 8, 2008.

On March 14, the April 17.5s, the 15s, the 12.5s and the 10s traded 15,000 contracts combined. Each put gives the right to sell 100 shares. So for example, these 15,000 April puts gave the purchaser(s) the right to sell 1.5 million shares at prices between 10 and 17.5. Those purchasers expected to make profits on 1.5 million shares because they knew the deal was coming at $2.00.

That is the only plausible explanation for anyone in his right mind to buy puts with five days of life remaining with strike prices far below the market price. So there were requests, during the period of March 10 to 13, to the exchanges to open the March and April series for buying massive amounts of extremely out-of-the-money puts, which were accommodated by the Options Exchanges. Did the Exchanges aid and abet the insider trading scheme? We are not able to have a clear opinion on that.

Media Statements of adequate liquidity

Reuters, however, on March 10, 2008 was citing Bear Stearns sources that there was no liquidity crisis and that there was no truth to the speculation of liquidity problems. And none other than the Chairman of the Securities and Exchange Commission on March 11, 2008 was stating that "we have a good deal of comfort with the capital cushion that these firms have."

We even had the "mad" Jim Cramer proclaiming on March 11, 2008 that all is well with Bear Stearns and that the viewers should hold on to their Bear Stearns.

And on March 12, 2008, Alan Schwartz CEO of Bear Stearns was telling David Faber of CNBC that there was no problem with liquidity and that "We don't see any pressure on our liquidity, let alone a liquidity crisis."

The fact that the requests were made on March 10 or earlier that those new series be opened and those requests were accommodated together with the subsequent massive open positions in those newly opened series is conclusive proof that there were some who knew about the collapse in advance, while Reuters, Cox, Schwartz and Cramer were telling the public that there was no liquidity problem.

This was no case of a sudden development on the 13 or 14th, where things changed dramatically making it such that they needed a bail-out immediately. The collapse was anticipated and prepared for, even while the CEO of Bear Stearns and the SEC Chairman of the SEC were making claims of stability.

What was the reason that Cramer, Cox and Schwartz were all promoting Bear Stearns immediately before its collapse. That will be speculated upon for years to come.

Cramer has admitted that "truth" was not his friend and that he manipulated stocks to influence investors behavior. Was this one of his acts? But no apologies from Cramer as he claims now that he was referring to keeping money in Bear Stearns Bank not in Bear Stearn's stock.

Compelling Evidence of Insider Trading

To prove the case of illegal insider trading, all the Feds have to do is ask a few questions of the persons who bought puts on Bear Stearns or shorted stock during the week before March 17, 2008 and before. All the records are easily available.

If they bought puts or shorted stock, just ask them why. What information did they have access to which the CEO and the SEC did not have? Where did they get the info? Why are Cramer, Cox, Paulson, Faber, and Schwartz not subject to a bit of prosecutorial pressure to get to the bottom of this?

Maybe the buyers of puts and short sellers of stock just didn't believe Reuters, Cox, Schwartz, Cramer, and Faber and went massively short anyway buying puts that required a 70% drop in a week. Maybe they had better information than Schwartz or Cox. If they did then that's a felony, with the profits made subject to forfeiture.

April 4, 2008 Congressional Hearings on the Bear Stearns Bail-out. I watched both sessions and drew the following conclusions.

In the first session there were the following witnesses. Bernanke of the Federal Reserve Board, Cox from the SEC, Geithner representing the New York Reserve Bank and an incidental player Mr. Steel from the Treasury. The only Senators that seem to be willing to attack these bankers were Bunning, Tester, Menedez and Reed. All the rest were useless and very respectful.

Absurdities

All witnesses did their best to keep their stories consistent but they did slip up a bit. They all agree that the bail-out was necessary without any proof that it was.

They all agreed that what caused the cash liquidity to dry up within one day was the rumor mongers. Apparently it is claimed that some people have the ability to start false rumors about Bear Stearns' and other banks liquidity, which then starts a "run on the bank." These rumor mongers allegedly were able to influence companies like Goldman Sachs to terminate doing business with Bear Stearns, notwithstanding that Goldman et al. believed that Bear Stearns balance sheet was in good shape. (Goldman between March 11-14 warned their average customers that Bear Stearns stock was "hard to borrow" for shorting due to the fact that other customers had used up all of the stock available for borrowing for short sales) .

That idea that rumors caused a "run on the bank" at Bear Stearns is 100% ridiculous. Perhaps that's the reason why every witness were so guarded and hesitant and looked so mighty strained in answering questions.

Loans to J.P. Morgan total $55 Billion from the Fed

The Private New York Fed lent $25 Billion to Bear Stearns and another $30 billion to J.P. Morgan. So the bail out cost was $55 billion not the $30 billion that is promoted. This was revealed at second session of the Senate hearings in a James Dimon response to a question from Senator Reed.

Who gets the $55 billion? J.P. Morgan got the money on a loan pledging Bear Stearns assets valued at $55 billion; $29 Billion is non-recourse to Morgan.

Effectively the Fed got collateral appraised by Bear Stearns at $55 Billion for a loan to J.P. Morgan of $55 Billion.

If the value of the secondary facility of $30 Billion ($29 Billion of which is non-recourse) is worth only $15 Billion when all is said and done, then J.P. Morgan has to pay back only $1 Billion of the $30 Billion and keeps the $14 Billion the the Fed loses. If the $25 Billion primary facility is worth only $15 Billion when all is said and done, J.P. Morgan has to pay $10 Billion of the $25 Billion received. If J.P Morgan can not pay, then the Fed loses the $10 Billion.

If after all is said and done the $25 Billion primary assets are sold for more that $25 Billion, the difference goes to J.P. Morgan regardless of the outcome on the secondary facility of $30 Billion. No matter how you cut it, J.P. Morgan wins. If the $55 Billion assets turn out to be worth only $20 billion when all is said and done, J.P. Morgan owes $1 Billion on the $30 Billion and the difference between $25 Billion and the value received on the primary facility.

The Fed would have been far better to just buy the assets at Bear's and J.P.Morgan's valuation. Now best the Fed can do is get their money back with interest and the worse they can do is lose about $25 -$40 billion.

John Olagues - Truth IN Options

just print money, easier and necessary. No need for complicated schemes. Deflation is ahead. Print money damn it.

What do you guys think the $160B stimulus bill was?

It was a helicopter drop. The Federal government arranged it because Bernanke refused to pull the trigger (he has been shrinking M1).

He will, however have to monetize it. And there will likely be more of these.

There is already too much Treasury supply; we are not going to get much more "safe haven" buying than we already have. We cannot handle $160B for stimulus and $100B for the war on top of the generally expanding fiscal budget, which is on top of the continuing to expanding need to recycle dollars from the trade deficit.

So the Treasury will not be issuing "extra" Treasury securities unless, it is willing to countenance higher interest rates or direct monetization. Something has to give.

It is one ugly corner to be painted into.

Aaron:

I believe you are misrepresenting my claim with regard to the gold standard. My argument is not that a hard money standard supplies insufficient credit. My argument is twofold:

1. The gold standard ties economic performance to an arbitrary variable that is influenced by a myriad of factors (quantity of gold mined, industry demand for gold, external trade balance) that one typically would not want controlling the money supply and thus impacting economic performance.

2. A fractional reserve banking system is inherently unstable, and contributes greatly to the boom/bust cycle. Combining it with a gold standard makes the problem much worse by taking away the tools that can be used to dampen that cycle (or at least mitigate the damage after the fact).

Let's not forget the many panics that led up to the creation of the Federal Reserve, many of which occurred during a time where there was a hard money standard in place or no central bank or both.

Panic of 1819
Panic of 1837
Panic of 1857
Panic of 1873
Panic of 1893
Panic of 1901
Panic of 1907

The Panic of 1837 is particularly instructive with regard to my first point above, as the lead up was not caused so much by speculative lending by American banks as it was by an influx of specie from foreign investors, particularly the British.

I'm not defending the Federal Reserve or its present actions. In many ways, I believe it is antiquated, and was designed to solve the problems of 100 years ago rather than those of today. I also recognize that as long as we have fractional reserve banking, that a central bank and deposit insurance are both needed to avoid regular economic depressions. However, I cannot accept the simplistic viewpoint that if we only returned to a gold standard or if we only returned to free banking, that all of our financial problems would go away; history shows that this is not the case.

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Federal Reserve May Seek Authority to Pay Interest on Reserves

By happenstance, there is more than usual Fed-related news this early AM. A few weeks ago, Greg Ip of the Wall Street journal recited what some of the Fed's options would be if it ran into balance sheet constraints. One was paying interest on bank reserves:


The Fed could seek to pay interest on reserves. Banks lend out excess reserves at whatever rate they can get because the Fed doesn't pay interest. That's one reason the federal funds rate often crashes late in the day, when banks realize they have more reserves than they need. Paying interest on reserves would put a floor under the federal funds rate. The Fed could then make loans and purchase assets with little concern for the impact on the federal funds rate.

The Financial Times reports that this idea may be getting traction:

Federal Reserve policymakers will discuss paying interest on bank reserves in a closed door meeting on Wednesday. Such a move could in theory allow the Fed to expand its liquidity support operations without limit....

Under a law passed in 2006, the US central bank will gain the authority to pay interest on reserves in 2011.

The meeting on Wednesday is based on that timeframe and will not be followed by any announcements.

However, the meeting could spark an internal debate as to whether the Fed should consider asking Congress to bring forward this authority to help it deal with the current credit crisis.

Many experts think that would be a good idea. Vincent Reinhart, former chief monetary economist at the Fed, said paying interest on reserves would allow the Fed to “expand their liabilities to support more asset purchases”.

A number of other central banks already have the authority to pay interest on reserves, as well as the authority to lend banks money.

In normal times they can use these deposit and lending rates to put a corridor around the main policy rate, and prevent it from being buffeted too far away from the level they aim to set.

But at times of financial market stress, the ability to pay interest on reserves takes on added significance. Currently, the Fed cannot expand or contract its balance sheet without altering the overall supply of reserves and changing its main policy rate, the Fed funds rate...

That would free the US central bank to conduct liquidity operations that were larger than the size of its current balance sheet – roughly $800bn.

“The point...would be to allow the Fed to expand its balance sheet without having to drive the fed funds rate to zero in the process,” said Goldman Sachs.

The problem with this concept, as with many of the Fed's new measures, is that notwithstanding the current improved mood in the credit markets, they have often been ineffective or produced unintended consequences. Per EconWeekly, paying reserves would have a nasty side effect:

Reserve balances are like checking accounts: they don't earn interest. For that reason banks have little incentive to hold more reserves than they need to meet the Fed's requirements and clear transactions. Any excess reserves are loaned to other banks. As Greg Ip explains, “if the Fed paid, say, 2% interest on reserves, banks would have no incentive to lend out excess reserves once the federal funds rate fell to that level.”

This measure would lead to a higher equilibrium level of reserve balances, for a given value of the federal funds interest rate. It would also reduce the amount of inter-bank lending, as banks would keep more of their cash in their safe-deposit box at the Fed. That lending would be replaced by loans from the Federal Reserve.

RueTD:

They want a contingency plan to expand their funding of private credit, if deemed necessary. They've already used up a fair portion of their balance sheet. This would be a plan to increase the size of the program further by facilitating a 'non-disruptive' expansion of their balance sheet.

They can't monetize the additional assets with normal bank reserves, because they need to control the level of non-interest paying bank reserves in order to control the funds rate. Otherwise, banks would drive the funds rate to 0 with any kind of significant excess reserve setting. So they pay interest on excess reserves at a rate that would effectively put in a lower bound for the funds rate. The discount rate is a sort of upper bound. This puts an administered economic collar on the funds range.

As to why they would want to do this for $ 2 trillion, for example, as opposed to $ 900 billion (their current balance sheet size), that horse is out of the barn. The only natural upper limit to this arrangement would be the size of total private sector credit. I doubt their contingency plan goes that far.

This plan would not increase the market float of treasuries, as they are limited to their current balance sheet holdings. Instead, banks would be stuck with low interest paying reserves, forced upon the system by the Fed, which could still control the funds rate.

In addition to increasing the monetary base (including interest paying reserves), balance sheet expansion would also increase broad money supply (not a factor in the current treasury substitution program), which is another risk.