About this proposal, this is a highly unusual action for the Committee and the Board to take, and I think we should consider it very carefully. We should continue to try to be as clinically precise in our diagnosis and our articulation of our understanding of what’s going on. I continue to see this as driven fundamentally by the revision in beliefs about the probability distributions governing the returns on assets backing certain other assets—asset-backed commercial paper in the non-agency space, for example. Buyers have obviously revised down their assessments. Sellers may or may not have revised down their assessments as well. If they haven’t, then it’s a difference of opinion that’s leading markets to lock up at zero quantities. But we’ve heard reports of issuers who are subject to contractual provisions that are strong disincentives for selling at prices that will clear markets so that buyers are willing to buy—things like clauses stipulating that too high a spread will lead to liquidation or require liquidation of a conduit facility or that drawing on a backup line of credit would require liquidation of a conduit facility. Those provisions are contractual mechanisms that they agreed to earlier to solve some time-consistency problem. So what they’re up against would be some ex post regret, but something that stymies the market. For whatever reason, they’re unwilling to sell at prices that will clear the market, and they seem to be willing to bear the consequences by taking it on their balance sheets for a time or by drawing down lines of credit. This looks like a price-discovery process in the sense that information is emerging and being digested and market participants are groping toward a mutually consistent view. It may take some time to resolve. It may involve substantial re-intermediation of some sort or another. It’s very attractive to interpret what’s going on in terms of coordination problems or multiple equilibriums.
I’ll take the liberty of mentioning some models here because I don’t think we can avoid using, either implicitly or explicitly, some theory in interpreting the data we’re seeing and understanding how our actions might affect what’s going on. The models we have in which financial markets are subject to these multiple-equilibrium problems are fragile, tenuous, and often implausible, and they’re indistinguishable from an understanding based on information accumulating and expectations being revised. For evidence in support of models like that, I’d point out that credit-default swap spreads are fairly dispersed and they seem to distinguish very particularly among individual institutions. So it doesn’t look like a broad-brush retreat or a lot of confusion about who is in good shape or who is in bad shape; it looks more like people coming to the conclusion that several people are in bad shape.
In this setting, what would limit individual actions to overcome a coordination problem of this sort? Well, in the asset-backed commercial paper market, there are plenty of actors, plenty of capital on the sidelines, and plenty of opportunities to buy paper if they think it’s at a price that makes it an advantageous opportunity. There are plenty of opportunities and incentives to coordinate. I’m sure that Vice Chairman Geithner is aware of conversations among large players in New York and probably small players as well. They have plenty of opportunities to coordinate an intervention if they view it as in their self-interest. Discount window stigma, is that a coordination problem? I’m highly skeptical. In the past we heard reports from the Manager of the System Open Market Account that banks in New York were borrowing money to lend to banks in the Fifth District when the fed funds rate spiked above the discount rate. That suggests that the price for overcoming stigma might be relatively low. Besides, it’s hard to believe that banks are that illiquid or that constrained by the lack of access to funding if they really want to buy something in the asset- backed commercial paper market. It’s hard for me to believe that they couldn’t do it without our help. Their analysis of their liquidity needs is ongoing. It’s daily. It’s extensive. Our information is that they view themselves as well positioned in terms of liquidity. If they really wanted more money in their reserve accounts and that’s what it took, why wouldn’t they bid the funds rate up, and why wouldn’t we be able to satisfy that at the window?
That brings me to my main point. It’s worth pointing out that this is going to be sterilized, just like a sterilized foreign exchange operation. The classic lender-of-last-resort doctrine— Bagehot, you know, and what you read about that—those operations were all unsterilized. That was how the Bank of England increased the amount of bank reserves in the system. I don’t think we’re in that situation right now. Their insight was that it was a way to prevent an increase in demand for liquid assets from driving up interest rates. What we’re seeing now is that the Desk is able quite well to keep the funds rate at 5¼ or even less. Confidence—are there multiple equilibriums in confidence? Well, confidence is just another word for expectations about where interest rates are going. So I don’t see that as a liquidity problem either. To some extent this looks to me like sort of a sham. I mean, it’s a way of increasing reserves. Anyone who follows central banking is going to see right through it and see what we’re doing. In the context of the likelihood that some large banks will, on the heels of this statement, announce—or even without announcement but the word would get out—begin intervening in the asset-backed commercial paper market, even if they don’t reference our provision of liquidity, my guess is that word of consultations between the Federal Reserve Bank of New York and these large institutions will get out and their operations will inevitably be linked in subsequent commentary to our actions here today. This action is not monetary policy. It is credit policy, and it’s risky just as foreign exchange intervention that’s sterilized is risky. If it works, it will make money for these banks. We’ve been plastered for the past several months about this subprime mess and not doing anything for little people, and here what do we do? We could easily be portrayed as helping large banks make a bunch of money on this. If it doesn’t work, I’m a little concerned that we’re going to be forced to follow through with a fed funds rate cut, whether or not the macroeconomic situation warrants it. I think this will look like a bailout. To me there isn’t that much question about it. To me, this isn’t about liquidity. If it were about liquidity, they could get it in the funds market. It must be about collateral margins and the terms of credit.
I’ll just point out about the statement that I take it that the Board of Governors is considering adopting temporary changes to the primary credit program. Collateral margins are set by the Reserve Banks, and I’m not so confident that our collateral margins are terribly conservative right now. For example, on home equity lines of credit and second liens, the margin is 15 percent, 115 percent. In the marketplace now, banks are discounting that stuff at more like 35 and 40 percent. I’m not sure I’m comfortable with existing collateral margins if we’re going to get a lot of borrowing at the discount window on paper like this. Moreover, I think that Reserve Banks are going to be interested in taking a look at those margins. So I don’t see how the Board of Governors, as a matter of clean and careful corporate governance here within the System, can make a statement about what’s going to happen to the collateral margins. Finally, I’d note about this proposed FOMC statement that it makes no mention of inflation. It’s not going to be missed? Did I miss something? Is it in there? I don’t see it.