Expiring liquidity facilities: bad plan, Stan

The Fed, ensuring a busy quarter ahead, tells us:

In light of ongoing improvements in the functioning of financial markets, the committee and the board of governors anticipate that most of the Federal Reserve’s special liquidity facilities will expire on Feb. 1, 2010, consistent with the Federal Reserve’s announcement of June 25, 2009. These facilities include the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility and the Term Securities Lending Facility.

Thankfully, this date for a fully-loaded round of financial Russian roulette comes with a caveat:

The Federal Reserve is prepared to modify these plans if necessary to support financial stability and economic growth.

Ya think?

I am not, of course, any kind of financial analyst. My comments do not constitute investment advice, never have, and never will. But sometimes a neighbor just got to step up to the plate, get his hand on tha mic and lay down some chronic prophecy. I predict: serious financial disturbances will occur on or before February 1, 2010. Or soon thereafter.

(And if you want to know more: consult my big neighbor, Professor Sethi of Ba—I mean, Columbia. He gots to get his mind off all them little ladies. Plus he says he got some kind of model and shit. Sound like a stone-col’ OG PhD neighbor to me.)

Okay, stop laughing. I also have a serious—i.e., verifiable—prediction. I predict that before the end of 2010, probably well before the end of 2010, possibly even before the beginning of 2010, the Fed will be forced to renew these facilities or others like them. In other words, I predict that its attempt to kick the liquidity junk will not succeed. In the end, I believe all these “temporary” facilities will become substantively permanent—just like the original LF, deposit insurance.

Please bear in mind that this is a guess, rather than a deduction, and is based on assumptions about rational crowd behavior that may simply turn out to be false. If they are false, it is not my explanation of maturity transformation which is false; it is just these assumptions, i.e., the belief that humans are even remotely distinguishable from remote-controlled sheep. Certainly if they were remote-controlled sheep, I would expect no crisis.

With this caveat of my own, let me put it this way: the Fed simply does not understand maturity transformation. It thinks it can just take these collapsed markets, which it suspended by guaranteeing, and turn them back on again. And they’ll just work. This could be described as the therapeutic theory of financial cryonics. If Alcor could freeze your brain and then warm it up, this would be a tremendous achievement. It would not cure your brain tumor, though.

The Fed can freeze the money market, then thaw it back out. An achievement—though hardly unprecedented. Let’s look for a second at how it did this.

What are these temporary liquidity facilities? A “liquidity facility” is simply an open-ended guarantee that the Fed (or some other authorized authority) will issue an arbitrary number of dollars to buy an arbitrary number of goods at a fixed price.

In principle this exact mechanism could be used to fix the price of corn. Or at least, to support it. Although the Fed would wind up owning a lot of corn. What’s neat, though, is a trick that can be played in the securities markets. Through the miracle of loan guarantees, an issuer of currency X can be used to support the price of any debt, i.e., promise of future payment. So long as every principle of good accounting is disregarded, these contingent liabilities can easily be omitted from the sovereign balance sheet.

To fix prices, the sovereign just issues an invisible, parallel, derivative security which is invisibly bundled with the security whose price is to be fixed. (Or at least, supported—I’m not sure whether infinite dollars can be used to suppress dollar prices, though perhaps some trick can be played. It’s always easier to intervene prices upward than downward. Downward you are rationing; upward, you are just taxing.)

Thus, consider the case of FDIC deposit “insurance.” When you make a “deposit,” i.e., a zero-term loan continuously renewed, to a “bank,” i.e., a vampire whorehouse with AIDS, in return you receive not one but two notional securities. For every green dollar you deposit, you receive two dollar-sized instruments: the bank’s promise to repay you on demand (call it a yellow dollar), and FDIC’s promise to pay you if the bank can’t (call it a blue dollar—precisely, a credit-default swap.)

Taped together, the yellow and blue dollars make green. Your loan to the bank is risk-free. And indeed these instruments have to be taped together. Because if you could separate the two, and create separate markets in which yellow and blue dollars traded separately—coeds, what would happen? We’ll return to this question in a moment.

All the liquidity facilities mentioned in the press release are of this class. Your “yellow dollar” in the case of the money-market funds, for instance, is a dollar which is “in” a money-market fund. In reality, this yellow dollar is a zero-term debt (promise to pay on demand) by a financial intermediary, which is backed by “commercial paper,” which is a meaningless word for short-term loans issued by large corporations. These corporations are typically performing maturity transformation in the sense Minsky describes—that is, their financial structure has been designed so that they have to roll over their loans, rather than repay them from cash flow.

What the Fed is doing, when it terminates these liquidity facilities, is canceling its “blue dollars”—i.e., its loan guarantees. Each blue dollar is marked: “not good after February 1, 2010.” My prediction boils down to the prediction that these securities will not in reality be canceled. Rather, I believe they will ultimately remain good.

Bureaucratically, however, turning around on this plan—and effectively admitting that these once-temporary programs have become permanent—represents a significant defeat for the Fed. Therefore, the Fed will have to suffer some pain before admitting this defeat. Thus, I expect market turbulence.

This time around, the market should be pretty sure the Fed will not actually let the money market fail. It was pretty sure of that in 2008, or at least it should have been. But it still had to test the Fed’s intangible commitment to provide liquidity insurance to the money market and the shadow banking system. Once that commitment is withdrawn, it must be tested afresh.

(Those who can predict this turbulence accurately, as always, can make money off it. But this is an exceptionally nontrivial task—you can’t go to Ameritrade and click to short “yellow dollars.” Since my prediction is that any crisis will be ended by the Fed restoring or extending its facilities, no persistent change in any price is implied. I’m sure it is possible to make money off a correct prediction of turbulence—if you know the prediction is correct, which I don’t. But it can be done only by capable and well-trained professionals.)

Again, the backstops will hold. The blue dollars will survive. But after February 1, 2010, they go from being formal guarantees to informal ones—just the same position they held before 2008. Note that the actual financial condition of the banking industry, i.e., its actual balance sheet, has not particularly improved since 2008.

Therefore, the market will have to test the strength and reality of these backstops. It will do so through that phenomenon we have learned to know well and love, here at UR, the “liquidity” (or more correctly, maturity-transformation) crisis. More broadly, the entire wave of temporary powers that were the original fruit of the first wave of the crisis is expiring, dissipating, and vaporizing, as emergency powers do in Washington. It is being sucked up by bureaucracies on all sides, restoring the normal Beltway equilibrium of general administrative paralysis.

In a political context where the administration is weak, the Fed is weak, its chairman is awaiting confirmation, and Congress is actively on the rampage—how easy is it for the Fed to make this U-turn? I suspect the market will want to find out, especially at a time when the first sovereign default crises of the New Depression (Greece, etc.) appear imminent.

One of the serious problems here is that, while the guys at the Fed may not be geniuses, they are not dumb, either. They are, in fact, perfectly competent economists. And they know perfectly well that this whole blue-dollar scheme is a botch, because they have read their Hayek and know that it’s a bad idea to conceal a price signal. In this case, the price of yellow dollars.

Or prices, of course, because the price of a yellow dollar depends on the financial condition of the issuing bank. If the bank is solvent, the yellow dollar is worth $1—i.e., one green dollar. If the bank is insolvent, the yellow dollar is worth whatever it can recover of the assets. Which could be nothing, in extremis, in which case the corresponding blue dollar is worth $1.

Back in 2008, when everyone was pretending there was no such thing as a blue dollar, there was something that looked like a free market for yellow dollars. Unfortunately, this market had to be frozen. It started sending a signal that no one wanted to hear: that the banks were insolvent. In money-market terms, the yellow dollar “broke the buck.”

Formal blue dollars, via the LFs, were hastily issued. As we’ve seen, the blue-and-yellow dollar trades as a green dollar, period. In fact, this is the problem with blue-and-yellow dollars, in the long term, and why the instinct to terminate the LFs and return to a free market is quite sound. Yes, by all means: Washington should get out of the banking business. Canceling the blue dollars on February 1, 2010 is not, I believe, an effective way for it to do so.

With blue dollars, the solvency signal as well as the liquidity signal is laundered. The bank (or corporation, etc.) can borrow money from actors who will bear no loss if it fails. In the medium term, this is a recipe for a lot of bad loans. In the long term, this is a recipe for turning the country into the Soviet Union: a land in which all loans are government loans. Command economics replaces financial sanity as the grounds for evaluating capital investments. Frankly, in the present state of the real-estate market, we are already most of the way there.

When Washington cancels the blue dollars—the loan guarantees of the various LFs—it turns the market for yellow dollars back on. Now, note that this market, when it was frozen, was in the throes of a maturity-transformation crisis. What would a rational actor do when the market is turned back on? Redeem his yellow dollars for good, old-fashioned green dollars—while he can still get the official 1:1 exchange rate. Once enough people follow, the rate will no longer be 1:1. And so on. The bank run begins all over again.

We can see this easily by solving the thought-experiment I posed earlier: split the yellow and blue dollars. If holders of yellow dollars can be granted free blue dollars—loan guarantees, credit-default swaps, call them what you like—these securities, presently virtual, can be made tangible. Tangible, they can be made negotiable. In principle, each of these steps is a Pareto optimization.

But look what happens when you have two separate markets! The bank run exhibits reflexivity—in the absence of artificial stabilization, unprotected maturity transformation is like a pencil standing on its point. However precisely it is positioned, the pencil’s state can at best be described as a stable disequilibrium. It can be held standing either by a solid support (the liquidity facilities), or by duct tape (opacity, inefficiency, irrationality, etc.).

When the blue dollars were created, the pencil (really more like a telephone pole) was falling over. The market for yellow-only dollars was frozen in this position. Turn it back on, and what happens? With the solid support gone—what duct tape could hold up this market, now? Anything equivalent to a yellow-dollar market (for instance, actual CDS on banks) is a perfect feedback signal, and should instantly revert to collapse mode.

Just like a falling pencil, a bank run is reflexive—the farther the yellow-dollar price falls under $1, the greater the force pushing it down. If the Fed does not intervene at all, all the banks fail, and so do all the corporations which issued short-term paper for internal maturity transformation. Of course this will never be allowed to happen, because it conflicts with the Fed’s mission, and so on. However, this U-turn cannot be not certain until it happens.

This logic predicts another wave of the crisis. If it is correct, a second tsunami could hit at any time—even tomorrow morning. Again, UR does not provide financial advice. All I’m saying is: make sure you are safe from this great, churning, angry wall of water. Don’t panic, though!

It’s interesting to note the effect of these tsunamis on the gold-dollar exchange rate. If you put a chart of the gold price next to a chart of UR posts which mention gold, you will see immediately that the latter cause the former to drop sharply in the short term, but rise smoothly in the long. Of course, I have no conceivable explanation for this pattern, which I’m sure is just a coincidence. However, I do have some observations regarding liquidity crises and gold.

Broadly, over the last few years, gold builds up a pool of money correlated with “risk assets” which represent anti-dollar bets. When there is any hint of a liquidity crisis in the dollar world, we see a “shortage of dollars” (“shortage of money” is a 19th-century term for “liquidity crisis”), implying a kind of deflationary suction which tends to raise the price of dollars in everything.

Including, for instance, gold. When gold has been going up for a while it always accumulates a population of momentum traders who, not having read UR and not understanding monetary formation, are weak hands. A shock takes the frothy air out of the top of the bubble. Further down, though, gold buyers are notoriously strong hands—quite committed to their decision to bail on paper and head for real metal.

And in the longer term, what the market sees is that the Fed cannot, because of its economic mission, tolerate any sustained deflationary pressure within the dollar economy. (For example, if the Fed canceled all its liquidity programs, we’d be back to the five-cent hotdog, if anyone had any hotdogs—in short, Mad Max Beyond Thunderdome, with Norman Rockwell prices.) Thus, in the longer term, the general instability, stagnation and incontinence of the dollar system is revealed, driving savers to the emerging hard currency outside it.

(The effect of a maturity crisis in the dollar on the dollar-gold exchange rate should not be confused with the effect of a maturity crisis in gold, which (due to the presumed fractional-reserve structure of the futures markets and other bullion-banking institutions) I still believe is possible. Bullion banks, the “commercial” traders on Comex and other exchanges, have issued quite a large number of short-term liabilities in gold and silver. Presumably these traders do not expose themselves directly to price fluctuations—so these liabilities must be backed by other positions, almost certainly not allocated bullion, almost certainly in gold and silver. There is not enough bullion on the exchanges for it to be pure bullion. It cannot consist entirely of mining hedges, i.e., long-term promises of gold and silver—because the positions fluctuate too widely. So there must be something else, and I wonder what the hell it is. My guess: synthetic baskets of mining stocks. Regardless, unprotected maturity transformation is a dangerous game for lender and borrower alike, and no one should be playing it.)