This is an abridged version of an article originally published in the latest The Price Report newsletter


There have been times in the past when central banks have let big firms fail, but concurrently supplied bridging liquidity in order to prevent needless collateral damage to credit markets. A classic – and successful – example was the Fed flooding credit markets in 1970 in the wake of the Penn Central Railroad failure. Penn had sought a federally guaranteed loan bailout to mitigate the effects of, mainly, poor management decisions. They argued they should be saved because bankruptcy would threaten the entire commercial paper market in which they had borrowed heavily.

The specific risk they claimed was that the railroad’s creditors would find their own funding cut off due to their exposure to Penn and a domino effect would be triggered down the commercial paper market line. The Fed did not buy this. It let them fail but provided temporary liquidity to the other actors in the commercial paper market.

An elegant approach and one that gave no reward to the company for its poor stewardship.

In contrast, during the US savings and loans (S&Ls) crisis of the 1980s, all sorts of panic measures were taken to avoid the bankruptcy of thrifts – including the poorly run ones – and thus to preserve political fiefs at state and national levels that it was thought out-of-pocket ex-depositors would otherwise have stormed. The term “insolvent”, for example, was re-defined; bills were passed granting S&Ls retrospective tax-relief on mortgage losses; federal deposit insurance limits were raised; and S&L net worth requirements were debased by broadening qualifying capital criteria.

Some of the results were unintended. Frauds came to light including that of Michael Milken’s linked financing schemes (“I’ll send deposits your way if you buy these worthless junk bonds”); and numerous S&Ls took greater moral hazard related risks than they should have and consequently failed. By the end, estimates of the total cost to the US taxpayer fell in the $200bn range – and that is 1990 money.

Nevertheless, by the time the Long Term Capital Management (LTCM) crisis broke the temptation to intervene prompted by a tendency to overweight and understudy the political considerations was again visible. Or perhaps ingrained. The US central bank took the view – with persuasion from the macro fund itself – that this was one firm too big to fail and stepped in. Or, to be fair, Mr Greenspan’s view was not that LTCM was too big to fail, but that it was too big to liquidate quickly. What the worth of that distinction is in practical terms is debatable.

By intervening the Fed appeared to have discouraged a credible and timely private sector rescue of LTCM by Warren Buffett. This is a disputed point; but it is clear that such an offer was made, rejected and withdrawn whilst the Fed and LTCM were talking. Intervention also amounted to a rejection of the idea that a global capital market valued in trillions of dollars is well able to absorb crises, demonstrate swift refractory snap-back times and make rapid order from chaos. Further, it glossed over the moral hazard dangers the Fed’s actions would engender. The Fed still went ahead and brokered a deal they later labelled a private-sector solution – but one with far better terms for LTCM managers and shareholders than they would have got from Mr Buffett.

It is hard to escape the depressing conclusion that regulators had come to believe only they can save, and know when to save, the market from itself. Is it a surprise, therefore, that when we look at the Northern Rock debacle we can hear distant echoes of all these events?

In today’s credit crisis, of which Northern Rock is a small, visible symptom, regulators are conditioned to believe, partly by precedent and partly by lobbying from the ranks of the distressed, that the potential fallout is of catastrophic scale and warrants major intervention. But there is a new twist: the source of this crisis is too much easy money for too long, a problem that permeates the entire system. Stepping in this time with a strategy of feeding credit markets liquidity does not look an apt policy stance.

There is thus not only the risk that regulators have become too trigger-happy in general saving those who do not merit it and penalising the prudent. There is also the further concern that they are lighting a match in the arsenal. When recession, re-balancing, and regeneration do come – and they cannot be legislated or re-inflated away into perpetuity – the price of such good but distortive intentions may well be that the final denouement is more protracted, painful and expensive than it otherwise could have been. That is the lesson of previous inelegant interventions that have tried to work against the market dynamic.

A light-touch interventionist philosophy that delineates clearly between market order and laissez-faire is what financial overseers ought to be striving for. That does not exclude safety nets: but these should not overly mitigate the downside of risk-taking – however great the political need to be seen to be doing something to smooth that jagged but necessary cornerstone of the market economy.

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Some idle thoughts as equity investors line their pockets. A genuine liquidity issue?


UPDATE: This graphic and text (in addition to comment 1 below) sets out the difference in perspective and expertise on interest rate derivitives between the essentially equity focussed bean counting (cum archair economist) scribe and a quant who trades the instruments and looks to lock down a return no matter what rate permutation the Fed adopts.

TRADEABLE SYNTHETIC BASIS CHART ENCLOSED....


DEC EURO'S.. THEY GO UP CAUSE THE FED WILL EASE..
OR THEY GO UP CAUSE THE "BASIS" WILL NARROW... TWO OPTIONS FOR THE PRICE OF ONE!

FFF8 1/31/2008 50 0.0467 ASSUMING NO OCT AND 32% PROB OF DEC..
FFG8 3/12/2008 42 0.0467 THIS IS WHERE JAN AND FEB FUNDS ARE..

WITH A LITTLE COMPOUNDING =>'S 4.68%
DEC EURO'S WHICH ARE OF COURSE WHERE T THREE MONTH LIBOR IS ANTICIPATED
TO TRADE... 94.05.. OR 4.95%

A) COMPARING FUTURES TO FUTURES ELIMINATES MOST OF THE CASH/FUTURES BIAS..
BOTH ARE JUST EXCHANGES FOR DIFFERENCES.. NO REAL MONEY EXCHANGES..

C) THREE MOVING PARTS.. DEC EUROS.. PROBABILTY OF FED MOVING AND "SPREAD"
GIVEN THE FED ON HOLD DEC EURO'S NOW IMPLY THAT THE SPREAD
WILL BE 20 BASIS POINTS.. TO BE CONSISTENT WITH 95.04 FUTURES
PRICE..

B) FFF8 1/31/2008 50 0.0475 FED DONE...
FFG8 3/12/2008 42 0.0475
DEC EURO'S AT 95.04 IMPLY 20 SPREAD!!!
TO FED FUNDS BETWEEN DECEMBER AND MARCH..

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Last call for gloats before Eng vs Fra tomorrow at 21h00 (French time).

One from the English...
...and one from the French, Australians, South Africans, English etc etc:



In mitigation though, Global Consciousness World leaders are united in praise for the New Zealand All Blacks after hearing they will contribute to the planet's carbon footprint reduction by dropping the Aussies off on the way home.

NB: ... and these were some of the more gracious ones that hit my email...

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The decision today by British Land plc to pull its £1.7bn Meadowhall sale offers a counterpoint to the FT story reporting big banks’ linked financing deals aimed at clearing some of the $200bn of leveraged buy-out debt they carry. Besides the obvious that the excess leverage / high valuations partnership looks to have been carried too far it also demonstrates an encouraging market clearing mechanism – zealous regulators take note.

In fact, they have. Of these developments one is reported by the FT to have said, "When we start seeing innovation on how to fix the problem and bring in new investors, it will be a good sign that things are turning".

Whatever the accuracy of the latter part of that statement, this particular mechanism is not an innovation: during the 1980s savings and loans (S&Ls) crisis a variant was used (with some success) to convince desperately-seeking-deposits thrifts to take on what, in some cases, they failed to spot were toxic syndicated junk bond packages (ie take this cash but buy some junk from us). Then it was the likes of Wall Street-wise Michael Milken doing the convincing; and the by comparison provincial S&L boards were often too willing to believe the supposed merits of the deal.

This time the negotiators looked evenly matched which, with luck, will keep all bank balance sheet transactions economically genuine.

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  1. British Land pulled their attempted sale of the £1.7bn Meadowhall shopping centre in Newcastle. The firm said "the uncertainty in financial markets has made the prospect of realising an appropriate value unlikely". The appropriate price in question would have equated to a yield of 4.6% in what is an unsettled UK commercial property market. Swiss psychiatrist Mrs Kübler-Ross inadvertently did some pertinent economic work on this sort of decision in her 1969 book “On Death and Dying”. A graphic summary:


  2. Big Rugby World Cup weekend and a wistful reminder that the hair quota has again been cut with the exit of Tonga and Finau Maka. It might have been so different – Maka plays professionally in France (Toulouse) and is also a French citizen. That raised the possibility of a hirsute mafia of Maka and Sébastien “Cro Magnon” Chabal both being selected by French coach Bernard Laporte. Didn’t happen and the scribe can’t help but wonder what might have been…


  3. Skivers’ Paradise, also known as Facebook. Mooted price tag of $10bn. Ad click throughs negligible. Alternative revenue models yet to be dreamed up and proven by Steve Ballmer (or whoever). Steve. Baby. It’s a no-brainer: this thing could be as big as Friendster and Geocities. Combined. Back up the truck.


  4. Joga bonita: simulation or crippling, wheelchair foul in the Interbank Lending Crisis Cup Final? This recording of the Financial Select 11 versus the Market Dynamic Squad lets you review the controversial sending off call of the MDS fullback Bill Poole for his tackle on striker Jim Cramer. Were referee Bernanke and (look carefully) his linesman assistant Mr Trichet correct?

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Dear IT Support,

About a week ago, I upgraded to RateCut! 1.0 from LiquidityHog 4.2, which I had used for a couple of years without any trouble. However, there are apparently conflicts between these two products and the only solution was to run RateCut! 1.0 with LiquidityHog 4.2 turned off.

To make matters worse, RateCut! 1.0 is incompatible with several other applications, such as InflationTarget 2.0 and FiscalSoundness 4.5. It does work pretty well with HouseBubble 6.9 though - and that's software that wouldn't even open when LiquidityHog 4.2 was running. But overall, and to cut a long story short, just as with the prior 2001 releases of RateCut! this latest version 1.0 has proved no better for the stability of my system.

I had previously tried a shareware program, TalkTheWalk 2.1, but it had the spyware program IgnoreHim 3.2 and trojan horse HedgeFundsGoneBad 2.8 bundled in which actually left my system worse off than before.

So anyway, I deleted TalkTheWalk 2.1 and installed the Maestro 8.4 browser. However, this does not do what it says it does on the packaging. In fact, since I unpacked it, it does the opposite and keeps giving me warning messages about something called the PunchBowl 9.2 virus.

As a final resort, I bought the web-spider BigBanks 6.2 to try and get a handle on everything. However, this is very unstable software and prone, without warning, to launch the CramerRant and Multi-Whine worms no matter what other program is open. It also keeps demanding the latest version of RateCut! every other day.

The result is that I am now considering running RateCut! 1.0 and RateCut! 1.1 at the same time and simply upgrading to InflationTarget 5.0 to see if that works. I’ve heard FiscalSoundness 4.5 isn’t that essential anyhow and removing it might even help me break my record game scores in WeakDollar 1.5 and GoldBug 2.8. What’s more, I’ve heard WeakDollar 1.5 actually works well alongside BustTheBudget 5.0 and could even help me improve the performance of CurrentAccount 6.2 which, even after so many patches for so many years, still crashes regularly.

Sincerely,

B Bernanke.


NB: Inspired by the Wife 1.0 stories...

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