Mitigating the Risk

I see that Brad DeLong has come around to the point I made a couple of weeks ago, that we need to mitigate the risk to the United States of a European meltdown. Here’s his proposal for doing so:

The Federal Reserve needs to buy up every single European bond owned by every single American financial institution for cash before the increase in eurorisk leads American finance to tighten credit again and send us down into the double dip.

The Federal Reserve Needs to do so now.

The greatest merit in that, I think, is that it is something that can be done quickly. It is not without its defects. In particular, it will provide a bonanza for those who have gone long European debt.

I’m open to suggestions for measures that could protect the U. S. without unduly rewarding those who were betting on the rent-seeking. Ideas?

10 comments… add one
  • Ben Wolf Link

    1) Let the banks fail.

    2). Take them into receivership and fire senior management.

    3). Wind down their debts in a controlled fashion.

    4). Chop their remaining assets into little pieces and sell them back to the private sector.

    5). Require that future speculation be tied to providing security for real economic transactions. No more betting pools.

    Under no circumstances should we make the same loser rich into winners again just because they’re too big to fail. Enough already.

  • Drew Link

    You know, Ben, I’m liking you more and more each day. This has essentially been my position for 3 – 3 1/2 years. I’m not exactly sure what you envision in point 5, but we are pretty much in league here.

  • PD Shaw Link

    I did my part by withdrawing money from my money market account a couple of months ago when I noticed the expossure those had to European banks. But I recently noticed that was already changing: “On a dollar basis, MMF exposure to European banks declined by 8% since month-end July and by 27% since month-end May.” LINK

  • TastyBits Link

    “It’s the CDS’s, stupid”

    Instead of using the 2008 playbook, we should use a modified 1933 playbook. If we are going to bailout anybody, let it be the small guys this time.

    What needs to be protected? Commercial banks fall under the FDIC, and all the Wall Street Investment banks turned Commercial banks will be dealt with by the FDIC. “You buys your ticket; you takes your ride.”

    Much like GM, these “too big to fail” institutions can be allowed to go bankrupt. The market will rebuild the parts that are needed, and it will be demand driven. If GM supplies a demand, the demand will be allow another entity to be created out of its parts. Capitalists, including the vultures, would have bought the pieces, and we would have a new automaker.

    Recently, Congress did force the FDIC to take cover some trash investments by the “banks”, and it probably included this European crap. If possible, allow the FDIC to stop covering it. The government may need to backstop the FDIC, but a repayment plan could be worked out.

    If any mutual funds or pension funds are exposed, those should be backstopped. Use something similar to Glass-Steagall (Banking Act of 1933), but it would need to be modified. The Glass–Steagall Act of 1932 should not be used. The trick will be to save the free-market using free-market principles. One free-market principle is to allow the actors the ability to make free choices. If an entity chooses to be governed by an FDIC-like agency, that would not violate free-market principles.

    Any exposed entity would be allowed to come under the FDIC-like umbrella, but they would be subject to the rules of it. If they were found to be insolvent, they would be dealt with similar to the way the FDIC deals with insolvent banks. The trash on their books would be thrown overboard, and any CDS commitment would not be reimbursed.

    For any entity choosing to not be covered, an individual would be allowed to move their account into a government holding account. This holding account would be disbursed later, and the accounts could be transferred to covered entities. When the funds from the original mutual fund ran out, the individual accounts would be reconstituted under the holding account. No money would be transferred to the original mutual fund entity.

    This is assuming the mutual funds and pensions are still at risk. If not, “burn baby burn.” Otherwise, do not allow them to be held hostage while we bailout the CDS’s built on top of them.

    Hedge funds and similar entities do not need to be regulated. CDS’s should fall under commodity trading rules, or they should be classified as gambling. We already have laws for gambling, and there is always RICO.

    This is not a perfect solution, and it would need additional work. The ramifications for the parts would need to be thought through, but it would begin to get at the underlying problem. In addition, raising the Fed rate to 10% or more would help a lot. This is the oxygen that fuels these fires. Remove the money flooding the system, and a lot of this nonsense will go away.

    But what do I know? The geniuses that got us into this mess will be the ones to work out the solution. Of course, they have figured out how to get paid millions of dollars. I guess they really are geniuses.

    “For the Snark was a Boojum, you see.”

  • jan Link

    Four salient, thoughtful posts, all in a row. Enjoyed reading them all!

  • I don’t dislike Ben’s idea, I just think it is one of those good ideas that will never ever come to pass. There are many such ideas, but they go nowhere because they threaten people with investments, money, and access to those with power and who have a legal authority to use violence.

    Is there a good idea that can actually overcome this hurdle? No, not really.

    So where does that leave us, somewhere not very pretty, IMO.

    Have a nice weekend.

  • PD Shaw Link

    @ Tastybits, some nice ideas; I’m still stuck on first questions though which is where is the risk? This strikes me as closer to the auto company problems, than the bank problems, in that it is a slow-moving threat. I don’t think investors are caught off guard — the money market numbers suggest they are selling off. The money markets may have additional means of addressing the risk, but someone else is buying what the MMF are selling, perhaps at a discount.

  • Ben Wolf Link

    A straight asset swap for euro bonds by the Fed would be the least of our worries in terms of continued moral hazard. I’m more concerned with the trillions of dollars in derivatives exposure. Bailing the banks out for that ficticious capital is absolutely the worst thing we can do, but those assets also represent the greatest threat to our financial system.

    If a bailout is coming (and it is), I think the least bad option (in terms of the crappy ideas Bernanke and Obama will float) might be some combination of the Fed acquiring outstanding bonds from U.S. banks while also winding down their derivatives exposure by swapping Treasuries for the contracts. The banks gain security but no windfall profits, at least theoretically.

    The problem is that without some serious reform the banks will just start increasing their exposure again once the dust settles, then we’re right back where we started.

  • TastyBits Link

    @PD Shaw

    The risk depends upon whom you ask. My primary concern is for individual savings especially 401(k)’s. The Commercial banks should have limited exposure, but I have not kept up with this latest crisis. The Commercial banks were recently allowed to take some “investments” onto their books. The FDIC was against it, but Congress forced them to take it. This trash may have included some/many/most of these European bonds. The mutual funds and/or money market funds are also exposed, and many 401(k)’s are in these funds.

    The MF Global disaster is a taste of things to come. This is 2008 again. There will be a run on the mutual funds and money market funds. There will be panic at the Fed and Treasury. TARP II will be established, but it will be called something different. Hundreds of billions of dollars will be funneled to the big boys. TARP II will be paid back with other programs, and it will be be deemed a success. The taxpayer will take it in the ass, but we should expect it by now. New regulations will be created in order to “prevent this from ever happening again”.

    I agree with the first comment @Ben Wolf. In his second comment, I would say “tens of trillions of dollars”. I agree with the overall comment, but the numbers are staggering. I would we rather not go the Treasury swap route, but that may be where we end up. The reforms do not need to be that complicated. Complicated regulations tend to favor the regulated.

    The reason they are trying to classify the Greek bond “haircuts” voluntary is to keep the CDS’s from kicking in.

    “For the Snark was a Boojum, you see.”

  • Ben Wolf Link

    “The reforms do not need to be that complicated. Complicated regulations tend to favor the regulated.”

    Agreed 100%. Had we simply put derivates on a clearly regulated exchange with hard leverage caps and enacted a national requirement of 20% down to qualify for a mortgage, none of this would have happened.

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