If you’re a bank and you need to shore up your capital base, you have the option of raising new equity, by selling shares to the public or to your friendly local sovereign wealth fund. There are other options, too. One is to raise what’s known as "tier 2" capital by issuing subordinated debt which has such a long maturity and is junior enough to all other debt that the bank regulators consider it to be tantamount to equity. But if you issue short-maturity, senior debt – that can’t be considered equity. Or can it?
Steve Waldman, in a fascinating and provocative post which is already causing a lot of buzz in the blogosphere, says the Fed’s Term Auction Facility, or TAF, is more or less explicitly designed to provide liquidity to banks until such time as they are ready and able to pay it back. And if that’s the case, then one can consider the Fed’s interventions to be more like equity than debt:
The distinction between debt and equity is much murkier than many people like to believe. Arguably, debt whose timely repayment cannot be enforced should be viewed as equity… If you think, as I do, that the Fed would not force repayment as long as doing so would create hardship for important borrowers, then perhaps these "term loans" are best viewed not as debt, but as very cheap preferred equity…
One much discussed story of the current crisis is the role of sovereign wealth funds in helping to capitalize struggling banks… Sovereign wealth funds have invested about $24B in struggling US financials. Meanwhile, the Fed is quietly providing eight times that on much easier terms.
Yves Smith buys Waldman’s theory that the TAF is "covert nationalization of the banking system". Mark Thoma seems to buy it too, but is relatively unconcerned by the fact that the Fed is now taking on credit risk: defaulting to the Fed, he says, is just another way of the Fed expanding the money supply. And Paul Krugman uses lots of charts to come to the conclusion that the TAF just isn’t going to be very effective:
The financial markets are so huge that even big interventions tend to look like a drop in the bucket. If foreign exchange intervention works, it’s usually because of the “slap in the face” effect: the markets are getting hysterical, and intervention gives them a chance to come to their senses.
And the problem now becomes obvious. This is now the third time Ben & co. have tried slapping the market in the face — and panic keeps coming back. So maybe the markets aren’t hysterical — maybe they’re just facing reality.
My feeling is that the credit markets are hysterical. They’re not clearing, they’re not acting efficiently, and spreads, especially on highly-rated debt, are much higher than credit risk alone could ever account for. On the other hand, the markets are also facing reality, in the form of deleveraging and forced unwinds, in which there are lots of sellers and precious few buyers. The Fed can step in with $100 billion of TAF money if it likes, and that money might well find its way through the banking system and into the choppy credit markets. But as Krugman notes, those markets are so big that they make $100 billion seem negligible.
Krugman has also asked the obvious next question: if the TAF isn’t working, then what is to be done? He has no answer:
Geithner then goes on to describe the policy measures being taken. And here’s the thing: I don’t think it’s just me, the actions sound trivial compared with the problem. He more or less admits that credit markets are worsening faster than the Fed can cut rates, so that money is effectively getting more expensive, not cheaper; the other measures he describes sound minor. Rearranging deck chairs — that may be too strong, but it’s pretty unreassuring.
So what should be done? I’m not sure (and I’m thinking about it, hard.) For now, I’d just say that this is really, really scary.
What we’re seeing here is a kind of financial-world equivalent of a run on the bank. Bank depositors are owed money, but that never normally bothers them: they know their bank is safe. If they all come to the same conclusion at the same time that the bank isn’t safe, however, disaster can strike, and their worries can become self-fulfilling. In this case, it’s not bank depositors who are asking for their money back, but rather prime brokers, repo desks and other sources of lubrication in the world of credit. They used to be happy to lend against ultra-safe assets like triple-A monoline guarantees or agency bonds; now, not so much.
How do you solve a bank run? The government, which is much bigger and safer than the bank, can step in and guarantee the bank’s deposits. How do you solve the present crisis? That’s much less obvious, since the obligations of the agencies and the monolines and so on and so forth are orders of magnitude bigger than any bank that’s ever gone bust. You don’t need to bail out the agencies and monolines directly: the Fed can try to do it indirectly, by pumping liquidity into the banking system. But the Fed’s bucket just doesn’t seem big enough right now to bail out this particular sinking ship.
