In a Q&A back in March, Mark Thoma proposed that the Fed should simply buy up distressed assets, rather than simply accept them as collateral:
If it were my choice, If I were king of the Fed, I’d do more. First, I’d trade for any financial assets at a price that fully reflects the risk of holding that asset. The Fed should trade a non-risky assets, money or government bonds, for risky private sector assets at a risk adjusted price… Suppose the Fed takes a mortgage backed security off the hands of a bank that wants to reduce its risk profile, and pays the bank 80% of its value, the 20% "haircut" is to compensate for the risk of holding the asset.
What if the Fed loses money on these trades?
That could happen. But these assets could also increase in value as well, precisely because the Fed is holding them and reassuring markets. If the Fed makes a fair trade, e.g. pays 80% in the example above, it is as likely to make money as lose money. The assets could, of course, be mispriced meaning that the Fed has more or less risk than it thinks, but even in the very worst case – every single asset they hold falls to zero – I’m not sure it would be a disaster.
And I’m not sure you aren’t nuts.
Think of the example above. Suppose that the value of the asset the Fed holds falls to zero after the trade. The trade was permanent, so there’s no margin call or anything like that – the Fed owns the asset and it is worth nothing. Then, in the end, it is no different than the Fed simply printing that same amount of money and giving it to the banks as new reserves, it is an increase in the money supply. It is a large increase, and it could surely be inflationary, but inflation is not the main worry when financial markets appear on the verge of a downward spiral that could drag the economy down along with them.
Today, Willem Buiter says something very similar: that central banks can and should be a buyer of last resort when markets fail.
When markets are disorderly and illiquid, it is not just the prices of good or prime assets that fall below their fundamental values. The same holds for the prices of bad, impaired and sub-prime assets. Impaired assets too will have a fair or fundamental value. That fundamental value may well be far below the face value of the security, but it may also be well above the price the impaired asset would fetch in a fire-sale in an illiquid market.
If the central bank, or some other government agency, were to act as Market Maker of Last Resort and buy the impaired asset at a price no greater than its fair value but higher than what it would fetch in the free but unfair illiquid market, such a purchase would not be a bail-out. It would also be welfare-increasing…
This possibility of a capital loss and fiscalisation of this loss does not mean that the transaction ex-ante involved a subsidy by the central bank to the owner of the impaired asset, or a bail-out of the owner.
Both Thoma and Buiter stress that such activity must be combined with more stringent oversight of financial entities, including hedge funds and other leveraged weapons of potential mass destruction. Buiter even gets very specific about the mechanisms that a central bank could use to buy assets: apparently a well-designed reverse auctions "don’t require the government buyer to know much or indeed anything at all about the fundamental value of what it is purchasing". Which sounds rather scary, until Paul Krugman comes along to remind us that the Hong Kong Monetary Authority went one step further in 1998, and started buying up not bonds but stocks. And made a fortune. Then again, Krugman is also comparing the idea of central banks buying securities outright to the idea of the US invading Canada, so it’s not clear how on board he is.
My feeling is that it’s not going to happen, mainly for political reasons. In this particular crisis, the distressed assets the Fed would end up buying would almost certainly be mortgage-backed bonds. But buying up mortgage-backed bonds looks very much like giving money to big banks and investors instead of giving it straight to struggling homeowners: the optics are simply terrible. If the collapse of Bear Stearns is seen as a bailout, this would be much worse. It might be a good idea, but its time has not yet come.