On bags and their holders

OK, so we know that high-leverage non-recourse loans may result in the lender losing a lot of money to the borrowers. The transfer is large when the leverage is high and when the value of the assets is very uncertain. The transfer is largest when the possible outcomes are heavily weighted toward the extremes; what statisticians call “fat tails” or “platykurtosis”. (If these terms mean nothing to you, relax; I am just throwing words around that I barely understand myself. This is a blog, after all.)

Perhaps the leverage and probability distributions are such that there will be no massive subsidy. More sinisterly, perhaps the transactions will not be at arm’s length, and the banks (and in particular, their creditors) will effectively be both the buyers and the sellers fleecing the FDIC/Fed, and the whole point of this complicated structure is to hide this from the average person. Interfluidity has an excellent piece espousing this view. I am not quite so cynical as to think he is right, but nor am I so trusting as to think he is wrong.

Regardless, we know that the FDIC and Federal Reserve are making these loans. So what happens, exactly, should one of these organizations lose a lot of money?

In the case of the FDIC, they would borrow from the Treasury. But “borrow” implies “repay”, or at least it used to. Assuming the Treasury actually demands our money back, FDIC would have to pay down its credit line over some number of years by collecting higher fees from the banking industry. Those fees would be passed on as “friction” across the banking system. And since approximately nothing happens in our modern economy without the involvement of the banking system, this would be similar to a tax on economic activity in general.

(There is another possibility if you are an optimist: The FDIC might simply charge higher fees to banks that dumped toxic sludge on them. I have no idea whether this is permissible under current law… But if this is the plan, it is an interesting way to make the banks eat their own losses over time. The question is, how will the FDIC recoup any losses, exactly? To my knowledge, Treasury has not answered this question. I wish somebody would ask them.)

In the case of the Fed, things get more interesting. If the Fed makes a loan that never gets repaid, that money “escapes” and is no longer part of the monetary base under their control. In short, if the Fed made enough bad loans, the end result would be some form of currency devaluation, aka. inflation, as the Fed lost control of the money supply.

But the Fed does not intend to let that happen. In a little-noticed joint statement yesterday, the Treasury and Federal Reserve said:

Actions that the Federal Reserve takes, during this period of unusual and exigent circumstances, in the pursuit of financial stability, such as loans or securities purchases that influence the size of its balance sheet, must not constrain the exercise of monetary policy as needed to foster maximum sustainable employment and price stability. Treasury has in place a special financing mechanism called the Supplementary Financing Program, which helps the Federal Reserve manage its balance sheet. In addition, the Treasury and the Federal Reserve are seeking legislative action to provide additional tools the Federal Reserve can use to sterilize the effects of its lending or securities purchases on the supply of bank reserves.

In other words, Treasury needs to be prepared to issue bonds to finance these risky loans being made by the Fed. (Or Congress needs to let the Fed issue such bonds itself.)

In the longer term and as its authorities permit, the Treasury will seek to remove from the Federal Reserve’s balance sheet, or to liquidate, the so-called Maiden Lane facilities made by the Federal Reserve as part of efforts to stabilize systemically critical financial institutions.

In other words, the Maiden Lane facilities — which provided back-stop funding for the Bear Stearns and AIG bail-outs — need to be migrated from the Fed to the Treasury as quickly as practicable. Presumably, if any other risky instruments start accumulating on the Fed’s balance sheet, they will seek to off-load those similarly.

What does this mean? It means when the TALF loans go bad, the taxpayer will be on the hook. Which you probably guessed already, but hey, it is nice to have some clarity in this increasingly uncertain world.

3 comments to On bags and their holders

  • Dimon

    haven’t confused platykurtosis with leptokurtosis (I always thought, that’s called fat tailed distribution) ?

  • Well, this is what I get for throwing around terms I barely understand.

    You are right; “fat tails” are generally associated with leptokurtosis. On the other hand, my original example (a coin toss, $0 or $100) is the most platykurtic distribution of all.

    What this means, I think, is that kurtosis is not what I mean; simple variance is what matters. Shame on me for putting on airs.

  • grr

    > when the value of the assets is very uncertain

    to be unnecessarily pedantic, you are confusing uncertainty (at time 0) with volatility (at maturity) — the value of the assets is currently very uncertain but that does not mean much in terms of the volatility of the distribution where things end up. of course there is no way to know the final values though.

    i say ‘unnecessarily pedantic’ because what you are saying is exactly the right idea.

    > If the Fed makes a loan that never gets repaid, that money “escapes” and is no longer part of the monetary base under their control.

    i’ve been trying to puzzle this through as well — the relationship between money that escapes the fed and inflation.
    clearly the government/fed could destroy money through taxation at any point whether it is related to any particular loan.

    i think that inflation is a cultural thing — if banks lend money to people who spend the money on consumption and do not reduce their future consumption to pay back the loan, and if the banks get broken in the process and are not able or willing to get the money from debt holders — and if the government does not raise money through taxes — then there will be currency debasement. (note all the steps where this could have been dealt with before currency debasement happened.)

    but what i really want to know is why inflation wasn’t more prevalent at the first step. clearly people were getting money loans without the means to pay them back. why doesn’t that cause inflation in and of itself, as there is suddenly more money sloshing around? and why is the last step, printing new money, the step that creates inflation?

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