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Thursday October 16, 2008 - 14:13:30 GMT
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Forex Blog - Unintended Consequences

Unintended Consequences


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 let’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 rise…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 – 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 market woes. 


Surely there are other reasons why GSE debt has risen – 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 (California’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 – 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 – 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 today’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.    


David Gilmore






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