Arnold Kling  

Bernanke Breaks His Arm at Ski Resort

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His speech today at the famous Jackson Hole conference.


This strong and unprecedented international policy response proved broadly effective. Critically, it averted the imminent collapse of the global financial system, an outcome that seemed all too possible to the finance ministers and central bankers that gathered in Washington on October 10. However, although the intensity of the crisis moderated and the risk of systemic collapse declined in the wake of the policy response, financial conditions remained highly stressed. For example, although short-term funding spreads in global markets began to turn down in October, they remained elevated into this year. And, although generalized pressures on financial institutions subsided somewhat, government actions to prevent the disorderly failures of individual, systemically significant institutions continued to be necessary.

Overall, Bernanke pats himself on the back so hard that I am sure that he broke his arm. Every decision was the most sensible. The choices on Lehman (allowed to fail) and Merrill Lynch (forced onto Bank of America) had nothing to do with Paulson and Bernanke asserting their personal power, but instead were forced by the constraints and circumstances at the time.

Bernanke emphasizes that this was a liquidity crisis, or panic.


Panics arose in multiple contexts last year. For example, many financial institutions, notably including the independent investment banks, financed a portion of their assets through short-term repo agreements. In repo agreements, the asset being financed serves as collateral for the loan, and the maximum amount of the loan is the current assessed value of the collateral less a haircut. In a crisis, haircuts typically rise as short-term lenders attempt to protect themselves from possible declines in asset prices. But this individually rational behavior can set off a run-like dynamic: As high haircuts make financing portfolios more difficult, some borrowers may have no option but to sell assets into illiquid markets. These forced sales drive down asset prices, increase volatility, and weaken the financial positions of all holders of similar assets, which in turn increases the risks borne by repo lenders and thus the haircuts they demand...In such an environment, the line between insolvency and illiquidity may be quite blurry.

...The view that the financial crisis had elements of a classic panic, particularly during its most intense phases, has helped to motivate a number of the Federal Reserve's policy actions

There word "panic" appears 14 times during the speech. The phrase "house prices" appears just twice, and the phrase "mortgage defaults" appears just once.

Clearly, Bernanke was listening to the CEO's of the big financial institutions who were telling him that they would have been fine if their short-term lenders had stuck by them. As far as the big bankers were concerned, this was an immaculate panic, in which their actual bad investments were not the problem. It was just that too many people lost confidence.

If this story is true, then whoever invested in banks and "toxic assets" last year should end up with a huge profit. The taxpayers should be raking in tens of billions, if not hundreds of billions, in windfall gains over the next few years, as the Fed and the Treasury cash in on the investments they made while everyone else was in panic.

We'll see.



COMMENTS (8 to date)
fundamentalist writes:

Of course there was panic, at the heads of the investment banks. Bernanke didn't address the Minneapolis Fed's paper in which they could find no panic or crisis in the financial markets.

8 writes:

There's a lot of optimism going around these days, and I mean that literally, this confidence wasn't around a few weeks ago.

People were confident in 1930 as well.

Monte writes:

There's a lot of optimism going around these days, and I mean that literally, this confidence wasn't around a few weeks ago. People were confident in 1930 as well.

Are you making a prediction?

E. Barandiaran writes:

Arnold,
If you want to see, you'll have to hire an accountant familiar with central bank accounting. For my work on financial crises in other countries I relied on "inside" assistance. You may want to talk to Peter Stella at the IMF who has been studying fiscal and central bank accounting for a long time.

8 writes:

Just noticing the coincidence that this chart displays. (Though it's off as of this week...)

Maybe the Fed has better numbers but I haven't seen economic data that makes me more confident than in May. And if this confidence is due to the stock market, then the burst in China and the behavior of bonds tells me their confidence may be due for a correction.

I don't make predictions, I just consider the probabilities. I would not be shocked if the Fed is right and stocks break to new highs next year, accompanied with inflation, but I think something similar to 1931 is more likely as of today. I'm mentally prepared for 1931 or 1974.

Walt French writes:

I don’t personally remember the pre-Fed banking system, but I read that there were crises and runs on banks with distressing frequency, and these led a reluctant Congress to give power to the Fed to control a fractional-reserve banking system.

Diamond & Dybvig argue that, absent government insurance on banks’ liabilities (then, almost all deposits), runs were inevitable even on the flimsiest of rumors. We slapped FDIC insurance on the system and the banking system worked like a charm as the instrument for the Fed to control money, for almost a century.

2007’s banks, including the hedge fund flavor, continue to borrow liquid assets short (now, from pension funds and wealthy individuals) and lend illiquid and long, but there is no govt liquidity provision (FDIC insurance) for those banks’ liabilities. Ergo, per D&D, runs were inevitable. Given hedge funds’ high fees, we didn’t even need withdrawals per se by nervous investors — a slowdown of inflows plus some stochastic returns would boost the risk that a fund will have a liquidity crisis, and a run was inevitable. That it started at Bear Stearns, where so many hedge funds had their accounts, was “helpful” in the rapid dissemination of information about the Emperor's New Clothes.

It was a commonplace observation in the investment community that housing CDOs “priced in” the loss of half of the nation's housing stock, i.e., that the prices were impossibly low. Why didn't vulture investors step in? A: first, “risk aversion” had risen and nobody was interested in a quick buck given the high likelihood of more assets being dumped, further depressing prices; second, once the fun got going, banks would have had to sell at prices that would utterly destroy their equity, and they would be insolvent, so they toughed it out, railing against “stupid mark-to-market” requirements while praying for a Federal rescue.

Housing wasn't exactly a non-participant, see WaMu, IndyMac and other failures. But those failures need only to have catalyzed the more general failure, which was driven by ordinary investor behavior in the presence of ridiculous, and sometimes hidden, leverage -- hedge funds with 30:1 or 50:1 de facto ratios were publishing client reports showing 2:1 or 3:1.

This simple story doesn't exactly make the Fed into a hero, but, given the massive crisis caused by financials’ leverage starting early in the century, it’s obvious that our ATMs still spit out twenties and merchants still take our credit cards, thanks precisely to the Fed+Treasury stopping the implosion. I

Mike Rulle writes:

We need not analyze the crisis as an either/or between liquidity or solvency. In fact, it would be highly unusual if it were not some of both. Values could have needed to decline to meet demand, but it is also possible they could have declined too much relative to plausible future value. Why was there no visible demand, then, at the lower prices? Well, there were no lower prices--just low bids and high offers---quite a different thing. This is the market behavior of a liquidity crisis, I believe.

Throw in the idea a day behavior during the Fall of the Paulson induced bailouts and indeed a liquidity crisis--caused by Paulson and Bernanke (or enhanced at least!) could have occured. This is what I think is the most consistent explanation.

As "evidence", I still understand that AIG has not had any of its CDS default which have not been unwound--even as the probability of defaults probably rose--but maybe not to a relevent level to have legitimately required a bailout.

I wonder if we will ever find out? Taxpayers will get only their preferred paid back--remember only 200bil went to banks directly from TARP. Then there was the 180 bil---almost as much money to the top 30 banks from AIG than TARP!---to AIG. Some of the CDS (half?) have been unwound by AIG counterparties---hence taxpayers permanently have lost. How much of the 180 was in the unwind? Don't know. As the securities get market back up (isn't that what is happening?), banks get back profits. Not all they lost, of course, just the "liquidity" part. The part we can find out about or should, is the value of the 5-7 hundred billion the Fed has financed or bought in the asset backed market. We should find out soon enough.

I really think AIG is the center of this story---including perhaps serious corruption.

Marcy O'Rourke writes:

The altitude must be depriving Bernanke and co.'s brains of adequate oxygen at Jackson Hole. Haven't they noticed the unemployment figures? Already higher than the Great Depression, if you count the statistics the way they did then. No work leads to no taxes, no money to pay deficits, liabilities, etc, etc. And no sign that the President means to do anything other than keep on spending more money we don't have.

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