Last week\u00e2\u20ac\u2122s default of Thornburg Mortgage had an ominous sound, like the cracking of sheet ice. Wall Street now sits atop a potential collapse of confidence in asset valuations, threatening a panic that will wipe away both sound and unsound financial institutions. The week\u00e2\u20ac\u2122s events also reveal how the Federal Reserve\u00e2\u20ac\u2122s bail-out policy has failed to address the underlying problem of credit market seizure. Here\u00e2\u20ac\u2122s what\u00e2\u20ac\u2122s going on, and what must be done to prevent a meltdown. <\/p>\n
By way of background, Thornburg Mortgage is a leading lender specializing in Alt-A mortgages for purchases of higher priced homes that exceed Fannie Mae\u00e2\u20ac\u2122s and Freddie Mac\u00e2\u20ac\u2122s conforming loan limit of $417,000. By all accounts its mortgage backed securities constitute good credit structures with the underlying mortgages still intact. The problem at Thornburg is not classic insolvency, but rather the evaporation of willingness to hold even mortgage backed securities backed by sound assets. This has caused security prices to tumble, lowering the value of Thornburg\u00e2\u20ac\u2122s collateral and thereby triggering margin calls from banks that it has been unable to meet.<\/p>\n
Similar stories are being played out in many parts of the market. Thornburg and other financial intermediaries are now threatened with bankruptcy that poses two grave public threats. First, if these firms liquidate their mortgage portfolios that will further depress asset prices, thereby potentially triggering margin calls at other firms that could generate dangerous ripple effects. Second, putting additional mortgage lenders out of business will make it even more difficult to buy and sell homes, which promises to further depress house prices. These are exactly the effects policy should be avoiding.<\/p>\n
The irony behind this debacle is that part of the problem is due to margin calls from banks. However, banks are currently being bailed-out by the Federal Reserve, which has provided them with tens of billions of dollars of subsidized credit through its term auction facility. In effect, the institutions the Fed is bailing-out are the same ones putting downward pressure on financial markets. Indeed, the banks are being given subsidized credit for problems similar to those experienced by Thornburg. Thus, there was an earlier loss of confidence in banks\u00e2\u20ac\u2122 assets that threatened their ability to renew roll-over funding for their activities. This risked causing banks to default, triggering margin calls and fire-sales of their assets that would have caused major asset price deflation and the destruction of credit provision.<\/p>\n
The Thornburg story illustrates two things. First, the Fed\u00e2\u20ac\u2122s policy privileges banks, bailing them out while letting perish other financial institutions that are no more guilty. Second, the Fed\u00e2\u20ac\u2122s current policy has not solved the problem of financial instability. Though the banks have been ring-fenced, they are now causing problems elsewhere through loan margin calls. Moreover, these calls could collectively come back to haunt banks by driving down the price of assets that they also own. Consequently, even the banks remain at risk despite the Fed\u00e2\u20ac\u2122s term auction facility.<\/p>\n
In today\u00e2\u20ac\u2122s crisis environment the problem in financial markets is not the level of interest rates, or even the size of the Fed\u00e2\u20ac\u2122s term auction facility. The problem is getting liquidity to those links in the financial chain that are most stressed. Reliance on the normal channels of distribution does not work when confidence has evaporated and markets have seized-up.<\/p>\n
There is a very simple and fair solution to this problem. That solution is for the Federal Reserve to open its term auction facility to all publicly traded financial intermediaries rather than just deposit taking institutions. That means giving access to insurance companies, mortgage investment trusts, mutual funds, and hedge funds. These firms would be subject to the same borrowing terms as banks, and would have to post collateral of identical quality.<\/p>\n
Such a change would level the playing field in financial markets and remove the unfair subsidy to banks. Most importantly, it would tackle the problem of credit market seizure that is afflicting all financial institutions. In a world where distinctions between financial intermediaries have become increasingly blurred, broadening access to the term auction facility is the logical and correct policy.<\/p>\n
The Federal Reserve\u00e2\u20ac\u2122s current policy is failing because it is structured for the world of the past in which depository institutions dominated lending. Thus, current policy restricts access to emergency liquidity to deposit taking institutions, ignoring how lending has become detached from deposit taking. The challenge of the day is preventing a meltdown that destroys sound lenders and sound assets. That calls for widening access to temporary emergency liquidity. Afterward, there will be time to visit the question of regulatory reform and more permanent policy change.<\/p>\n
Copyright Thomas I. Palley<\/p>\n","protected":false},"excerpt":{"rendered":"
Last week\u00e2\u20ac\u2122s default of Thornburg Mortgage had an ominous sound, like the cracking of sheet ice. Wall Street now sits atop a potential collapse of confidence in asset valuations, threatening a panic that will wipe away both sound and unsound financial institutions. The week\u00e2\u20ac\u2122s events also reveal how the Federal Reserve\u00e2\u20ac\u2122s bail-out policy has failed […]<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"closed","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[3],"tags":[],"class_list":["post-100","post","type-post","status-publish","format-standard","hentry","category-us-policy"],"_links":{"self":[{"href":"https:\/\/thomaspalley.com\/index.php?rest_route=\/wp\/v2\/posts\/100","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/thomaspalley.com\/index.php?rest_route=\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/thomaspalley.com\/index.php?rest_route=\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/thomaspalley.com\/index.php?rest_route=\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/thomaspalley.com\/index.php?rest_route=%2Fwp%2Fv2%2Fcomments&post=100"}],"version-history":[{"count":2,"href":"https:\/\/thomaspalley.com\/index.php?rest_route=\/wp\/v2\/posts\/100\/revisions"}],"predecessor-version":[{"id":1619,"href":"https:\/\/thomaspalley.com\/index.php?rest_route=\/wp\/v2\/posts\/100\/revisions\/1619"}],"wp:attachment":[{"href":"https:\/\/thomaspalley.com\/index.php?rest_route=%2Fwp%2Fv2%2Fmedia&parent=100"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/thomaspalley.com\/index.php?rest_route=%2Fwp%2Fv2%2Fcategories&post=100"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/thomaspalley.com\/index.php?rest_route=%2Fwp%2Fv2%2Ftags&post=100"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}