When policymakers wade, or
more like dive, into private markets like they have in the last few days, there
are sure to be unintended consequences that will at times raise doubts about
the efficacy of the rescue. But letâ€™s not confuse a negative externality
with a death sentence. The banking system failure was taken off the table
in the last week starting with the unprecedented simultaneous rate cut by major
central banks. But UK and then rest of the developed markets degrees of
nationalization was the exclamation point behind systemic salvation.
Okay then why are credit
spreads widening today, mortgage rates rising, equities (financials) sliding
and CDS moving out?
Mortgage rates have moved up
as Fannie and Freddie debt has widened out from Treasuries. This is a
good example of unintended consequences. No official wants to see US mortgage rates riseâ€¦they want them to fall to
improve housing affordability. But FDIC guarantees over new debt issued
by banks (through 2012) is making for government guarantee arbitrage. Why
pick up GSE debt with the same government guarantee as bank issued debt (new
issue) that trades at a price discount/yield premium to GSE debt? In
theory this guaranteed note program from banks will address longer-term funding
needs and should see new bank issues soar. Look for some crowding out â€“
of even US Treasuries as well as GSE debt. If this negative consequence
becomes a trend, arguably the FDIC insurance of bank debt will add to housing
Surely there are other
reasons why GSE debt has risen â€“ new mandates to buy subprime and Alt-A
mortgages from banks. And foreign central banks in weekly Fed H.4.1
remain net sellers of GSEs and buyers of Treasuries.
Crowding out issue ahead is
likely to become prominent as debt issuance from the public sector soars.
State and local governments will be scrambling to issue debt (Californiaâ€™s notes sold this week said to be sloppy). And
federal debt issuance by most developed nations will be unprecedented with
revenues challenges by weak or negative growth and rising outlays.
Fed guarantees for
commercial paper also provides potential for unintended consequences â€“ why
issue any term debt when CP is backed by the Fed? Seems to me the
cheapest source of corporate funding ahead will be CP â€“ sure the Fed is not
planning on seeing large mismatching in firm debt programs against liabilities.
And how do central banks
wean commercial banks off cheap overnight, 7-day, 24-day and 84-day funding
when nearly daily the net for acceptable collateral continues to widen?
Banks can rely on the cheapest source of funds borrowing directly from central
banks and not return to private capital markets for some time. Moreover,
there are no stigmas for borrowing emergency funds from central banks.
Banks if given a chance will game the system and there are ever more liquidity
systems to game outside private capital markets. We have a real addiction
problem in the making that may go beyond a simple absence of trust in
counterparties. Japanese banks gamed the BOJ liquidity system for
years before resuming lending and taking risk.
And then the world of risk
pricing is complicated by false or casual causalities. Officials need to
know if credit spreads are wider because of signs of weak economic activity
like todayâ€™s retail sales or represent some other brewing problem like an
unintended consequence. The Fed and Treasury need to know where to point
the fire hose.
Surely more unintended and
negative consequences will emerge from measures as dramatic as the policy
actions in the last week. But hopefully none will be fatal to the banking
system and most likely officials will need to do some additional tidying up to
prevent new inefficiencies from clogging up the banking system.
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