The Bernanke put

The US Federal Reserve has stepped in to bail out the financial sector, cutting its discount rate and, more importantly, encouraging banks to borrow directly from the Fed to finance mortgage lending. This action demonstrates that the famous “Greenspan put” has survived, and is now the Bernanke put.

A “put” in finance jargon is an option to sell an asset to to the issuer of the option at a “strike price”, typically selected to protect the holder of the put against disastrous loss. The put is exercised only when the market price falls below the strike price. Credit markets provide a range of put options for assets including equities, bonds and so on. From the viewpoint of financial market participants, the great thing about the Bernanke put is that it’s free. The masters of the financial universe can make bilions betting that things will go right. If things go wrong, the Fed is there to pick up the tab.

Of course, things have to go wrong in a bad enough way to threaten the stability of the financial system as a whole, and yesterday’s rescue shows what that means. The fact that a large proportion of subprime mortgages were going to go bad, with at least a million families losing their homes, 100 000 workers losing their jobs and so on was known months ago. The big news of the last few weeks is that the losses won’t be confined to this group, but extend to hedge funds, issuers of commercial paper and so on. Another group facing problems were homebuyers seeking mortgages too big to be covered by the quasi-official loan guarantee corporations, cutely called Fannie Mae and Freddie Mac. These ‘jumbo’ loans (over about $400 000) have become very hard to get and will now be effectively guaranteed by the Fed.

So, the Bernanke put is great for Goldman Sachs and JP Morgan and good for high-income homebuyers. But it won’t do any good for the low-income, poor-credit households who lined up for subprime loans. In fact, they represent the first line of defence for the financial system, made more effective by the Bankruptcy Reform Act of 2005, which has closed off this option for many.

It’s hard to criticise Bernanke for the choices he’s made, given the way the system works. On the other hand, it’s equally hard to see why we as a society are rewarding the financial sector so richly for an activity which involves little risk and big payoffs, whether decisions are good or bad.

45 thoughts on “The Bernanke put

  1. As you know Terje, I do not agree with you on the use of gold as currency, but the rest is (IMHO) right. The belief that the Fed will ride in on a white charger is a great source of moral hazard.

  2. I pay my taxes, P.M. Lawrence. Do libertarians pay theirs? Or do they justify tax avoidance with a ton of philosophical hokey?

  3. gordon,
    I cannot speak for PML, but I pay mine. That is, I pay them as far as I can understand them. The ITAA is an impossible mess – it could be that I am under- or over-paying them and not know it due to the sheer impossibility of understanding the Act.

  4. As you know Terje, I do not agree with you on the use of gold as currency, but the rest is (IMHO) right. The belief that the Fed will ride in on a white charger is a great source of moral hazard.

    Andrew, do you see a cure to this moral hazard or do you think we should live with this problem because the alternatives are worse?

  5. “It’s easy to pick on the Fed, but I don’t see how this is a bailout.”

    Mugwump, you are half right in the sense that the Fed had little choice when faced with this particular crisis, but that’s the bone of contention. If they didn’t facilitate/allow credit expansion (virtually printing money), then it would not continue to manufacture these crises. Think of it this way. You cannot envisage the dollar in your pocket today buying the same or more in say ten years time than it does now. Why is that? The answer is, there is no reason whatsover that cannot be the case and furthermore if it were the case always, then lenders would be much more circumspect about who they lent their precious asset to. Get the picture?

  6. P.M.Lawrence, where is the proof that “we as a society” does not exist, using the same methodology you would use to prove that a “five sided triangle” does not exist? Until such time I don’t understand a word you are saying.

    Have a look at the proof of existence of a solution to a theoretical model of a competitive private ownership economy which uses the notion of ‘a social system’ (rather than excess demand functions). I should think that the term ‘we as a society’ is a reasonable verbal expression in this context but one which excludes your hypotheses, stated as if they were facts, about other people’s objectives.

  7. I don’t know what you are talking about either PML. There’s huge evidence that human’s are adapted to live in groups, and that comes from multiple domains. In addition, if large groups of people are able to live together, co-operate, and act alturistically, what should people call them? Also, if by rewards, you mean short term rewards that can be calculated (whether monetary or otherwise), you almost certainly wrong. That idea died in the 80s once people started investigating it rather than just assuming people wander around trying to maximize some benefit for themself function (which then leads to complex systems). Some of the reason people act in groups/altrusitically is sure to be thanks to our evolution as social creatures.

  8. Conrad,

    PML has already stated that society exists. You seem to be barking up the wrong tree. What PML said was that “we as a society” does not make sense in the context that it was used. It does somewhat presumes that society can be both the whole and a subset of the whole at the same time.

    The inference in the original article that people in the financial sector are not part of society is clearly flawed. It is also a form of prejudice along the lines of “why should we as a society tolerate blacks and jews”. Tomorrow “we as a society” will be opposed to economists or immigrants or any other subsection of society that the speaker prefers to pick on. But of society can meaningfully be a reference to something that excludes bits of society.

    I’m not meaning to pick on JQ and I think the hair splitting is a little tedious and probably contains it’s own set of contradictions. I am sure that I use words just as flippantly all the time in the name of expediency. And clearly my grammar stinks much of the time.


  9. People interested in how the “Bernanke Put” works out in practice will obviously be interested in the value of loans at the Federal Reserve’s discount window over the next few months. Working back from a clue in the text of this post at Econbrowser, it seems that the value shown against the heading “Loans to depository institutions ” in the Fed. Reserve’s publication “Factors Affecting Reserve Balances” (available here) is the number to watch.

  10. gordon, I would restrict the “Put” to the value of defaulting loans at the discount window. That’s the amount subsidized by the taxpayer. Performing loans cost us nothing.

    Even more accurate would be the risk-adjusted value of the defaulting loans, since the taxpayer is receiving around 1%-1.5% more interest for our largesse, compared with the “risk free” rate of the equivalent (28 day) Treasury Bill (in other words, if the default rate is less than 1%-1.5%, we’re still ahead.)

  11. “Performing loans cost us nothing”.

    Any comments regarding the existence of ‘us’ versus ‘them’?

  12. Mugwump, do you know what the phrase “existing collateral margins will be maintained” in this Federal Reserve press release precisely means? I would love to know.

    As far as the cost to the taxpayer is concerned, it seems to me that the Federal Reserve is offering to lend against securities that the private sector isn’t prepared to accept as collateral. I take your point about the importance of watching the value of defaults, but if these discount window loans are rolled over again and again over a period of several months, when exactly do we call “default”?

  13. There is certainly a school of thought in the US that the Federal Reserve’s offer at the discount window is more symbolic than anything else, and that the real impact will come when (not if; when) the Federal Funds rate is cut. I suppose for that school the recent recovery in stock prices reflects the anticipation of that cut. Watching the value of loans at the discount window should test that theory; if it doesn’t rise much, they are probably right.

  14. Mugwump, do you know what the phrase “existing collateral margins will be maintained� in this Federal Reserve press release precisely means?

    I do now.

    if these discount window loans are rolled over again and again over a period of several months, when exactly do we call “default�?

    Fed rules prohibit using defaulting loans as collateral. The rules are spelled out in great detail on that site. I think taxpayer funds are pretty safe.

    As for ‘us’ versus ‘them’. ‘Us’ is the taxpayer. So there is no ‘them’ (if you know otherwise, can I have the number of your tax advisor?)

  15. Thanks, Mugwump. It seems we have between 10% and 20% less of a bailout than I thought. But you could still say that we have between 80% and 90% of a bailout (before adjusting for discount window interest)! Is the glass 80% full or 20% empty?

    As far as defaulting loans are concerned, I have been assuming all along that unsaleable collateral (eg. CDOs) presented at the Federal Reserve’s discount window haven’t matured yet (assuming they have maturity dates), so the problem of default by the issuer doesn’t arise. Maybe that is why we have been talking past each other on the default issue. I am saying that it will be hard to define default by the borrower (the bank) because if the borrower can’t redeem the CDOs he can just renew the loan for another 30 days.

  16. It seemed to me when the Federal Reserve put out this press release that it would be interesting to watch the value of loans through the discount window over the succeeding weeks, not only to see whether there was a rush to the window but also to test the theory that the Federal Reserve’s discount window action was mainly symbolic, ie. that it really amounted only to a promise to lower the Federal Funds rate. If there were no sudden interest in the discount window, I reasoned that the “symbolic” school of thought was right.

    The Federal Reserve publication “Factors Affecting Reserve Balances of Depository Institutions” for the week ending 22/8/07 has now come out. At the end of the week preceding the press release, Loans to Depository Institutions stood at a daily average of $271m. In the week ending 22/8/07, the figure was $1,541m., an increase of 468%. The Federal Reserve is now lending an average of $1.5b. daily to banks using the discount window.

    Though this looks like an enormous amount, I find I’m still not really sure whether it is a lot or a little in comparison to the scale of the difficulties in securities markets. And should I now dismiss the “symbolic” theory on the ground that the discount window operations are really where the bailout action is?

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