There was a new theme buried in today’s announcements about purchasing $600 billion in mortgage-backed assets $200 billion in assets backed by other debt including student loans, credit cards, car loans, and small business loans. The New York Times story included these two paragraphs (emphasis added):
The action by the Federal Reserve on buying mortgage-backed securities brings the full force of monetary policy to bear on the credit markets. Having already reduced the benchmark federal funds rate to just 1 percent, the central bank is now effectively using what economists call “quantitative easing” to reduce the costs of money.
Instead of trying to reduce overnight lending rates in the hope of influencing longer-term interest rates for things like mortgages, the Fed is directly subsidizing lower mortgage rates. It is doing so by printing unprecedented amounts of money, which would eventually create inflationary pressures if it were to continue unabated.
The Bloomberg article has a similar passage, indicating that this is a message the Fed is consciously putting out, while taking care to deny that they are trying to increase inflation (emphasis added)
The Fed won’t be removing cash from other parts of the financial system to make up for the purchases, government officials told reporters on a conference call. They rejected any comparison with Japan’s so-called quantitative easing effort to combat deflation, saying that the Fed’s objective is to buttress credit markets rather than ramp up money.
What does this mean? It looks like the Fed will be buying securities either by wiring cold, hard cash to sellers, or by increasing their account balances at the Fed itself, without simultaneously selling Treasuries (or asking the Treasury Department to issue new Treasuries) to sop up an equivalent amount of cash. This ordinarily would run the risk of increasing inflation, but with short-term prices falling, arguably a bit of inflation is just what we need, as Simon and Peter argued yesterday.
(If you found the last paragraph confusing, see my Federal Reserve for Beginners post.)
More economics bloggers trying to be funny: Free Exchange reported on today’s $800 billion worth of announcements and concluded with this sentence: “So, you know, hopefully that will work out.”
The Baseline Scenario 
I’m seeing lots of evidence of more ‘bailout math’….wondering how high it can go?? I thought you said $2T in class but that seems a bit low now. :)
The WSJ reports that Tuesday’s action by the Fed led to a drop in 30 yr. fixed rate mortgage rates (to 5.5%) and a flurry of refinances. See “Fed Aid Sets Off a Rush to Refinance”, http://online.wsj.com/article/SB122765938507058417.html.
Wow, that was fast! Is there any way such actions can help subprime borrowers?
Can someone please explain to me why the US Government cannot simple declare a national emergency and void all the CDS that were speculative in nature? i.e. the holder had no direct stake or interest in the CDS they bought. The holders of voided CDS simple get their money back, the financial institutions can come out of the fetal position on the floor and start lending again. The government also declares a Stock Market holiday for a period of one-two months after the announcements on voiding the CDSs. Am I crazy???
Nullifying CDS would create huge and unpredictable shock waves throughout the financial system. Yes, it is a zero-sum system; no money would disappear. But imagine this:
(a) You have banks with lots of loans on their books (in the form of corporate bonds, mortgage-backed securities, asset-backed securities, etc.). Many of these banks have done the sensible thing and hedged their credit risk using CDOs. Now suddenly they get their premiums back, which are small change, but they get all that credit risk back overnight. There is a decent chance that a lot will go bankrupt because of that credit risk.
(b) You have banks and other institutions that have been selling CDS protection for years. Now they suddenly have to pay back all the premiums. They almost certainly don’t have the cash, which means they will have to dump all sorts of other assets (driving their prices down), and they may go bankrupt in the process.
How can this hurt people on both sides of the transaction? Because the risk of default now is greater than when the contracts were signed, group (a) loses: imagine homeowner’s insurance has skyrocketed in price, and your insurance company arbitrarily cancels your existing policy. Group (b) should win in the long term, you would think, except that they can’t come up with the cash in the short term.
Even if you limit group (a) to people who speculated using CDS, you have the same problem: institutions whose current financial position depends on their ability to collect on those CDS and who could go bankrupt without it. Effectively the government would be just taking money away from them.
Oh, and I don’t think it would help at this point. CDS are largely a sideshow at this point. The big problem now is that consumer demand has fallen off a cliff, and even if you could magically eliminate the problems created by CDS that wouldn’t help consumer demand.
“Nullifying CDS would create huge and unpredictable shock waves throughout the financial system.” Agreed. But not nullifying them might be just as bad. The only way for CDS to be predictable and affordable is if all markets behave predictably. The more unpredictable (higher risk) events occurs the more CDS come into play. That is how we got here.
The second problem is that these contracts are still being created. In crisis gamblers gamble.
So we can’t go forward or back and we can’t offer a solution to the problem, and we are are waiting for consumer confidence to return?
Might be a long wait.
Helicopter Ben has taken flight
http://research.stlouisfed.org/fred2/fredgraph?&chart_type=line&graph_id=0&category_id=&recession_bars=On&width=1000&height=600&bgcolor=%23CC6600&txtcolor=%23000000&preserve_ratio=true&&s_1=1&s%5B1%5D%5Bid%5D=BOGAMBNS&s%5B1%5D%5Btransformation%5D=lin&s%5B1%5D%5Bscale%5D=Left&s%5B1%5D%5Brange%5D=Custom&s%5B1%5D%5Bcosd%5D=1990-01-01&s%5B1%5D%5Bcoed%5D=2008-1
Link in last post seems to fail, so try:
http://research.stlouisfed.org/fred2/fredgraph?graph_id=10715&category_id=0#
Link is to a graph of the US monetary base over past decade.
Helicopter Ben’s big speech on Deflation:
http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htm
Mr. Kwak,
Thank you for this site. It’s helpful in trying to understand this crisis. I’m sorry to beat a dead horse but in your response above, group (a) did not apply to Jae In’s question. I tend to agree with Blackeyebart.
If the swaps for speculators only were canceled, and premiums were forced to be paid back how is that worse than what is currently going on? CDS for interested parties could endure and be regulated as insurance.
The government has been pumping money into banks. If they cancel the gamblers’ swaps, couldn’t they put the infusions into the banks who are hurt by having to pay back premiums?
I don’t understand how the CDS are just a sideshow if they’re valued at 60 Trillion, several times the value of the real economy (as I’ve heard?). And because of their not being regulated they are hidden. How does investor confidence truly return when people don’t know what kind of side bets these banks have? Our government can’t infuse enough money to pay off the bets. Seems helping the premiums be paid back would be cheaper.
There is something fundamentally wrong with our economy being brought to its knees because of gambling. It needs to stop- CDS should not be allowed for uninterested parties. Vegas casinos would have never been so stupid. Leave the gambling to them.
This consumer doesn’t trust Wall Street at all and I won’t as long as this shadow system continues. And this is the system where for years we’ve been pinning our retirement hopes. How does consumer confidence return when so many have job insecurity? My job at a small business is tied to the construction industry, retailers are closing everywhere, so many jobs tied to the auto industry in danger.
With stagnant wages, pinning the hopes on consumer confidence seems a hopeless business. The economy has to contract.
I apologize if this sounds like a rant. I’m just an average person trying to understand what’s going on. Hopefully you can answer my questions about the CDS.