First, four months after the August 2007 credit market seizure, the Fed announced on December 12, 2007 the Term Auction Facility (TAF) program, under which the Fed will auction term funds to depository institutions against the wide variety of collateral that can be used to secure loans at the discount window.  By allowing the Fed to inject term funds through a broader range of counterparties and against a broader range of collateral than open market operations, this facility was intended to help promote the efficient dissemination of liquidity when the unsecured interbank markets came under stress. Each TAF auction was to be for a fixed amount, with the rate determined by the auction process subject to a minimum bid rate.  The first TAF auction of $20 billion was scheduled for December 17, with settlement on December 20; this auction provided 28-day term funds, maturing January 17, 2008.  The second auction of up to $20 billion was scheduled for December 20, with settlement on December 27; this auction provided 35-day funds, maturing January 31, 2008.  The third and fourth auctions were held on Mondays, January 14 and 28, with settlement on the following Thursdays.  The amounts of those auctions were determined in January.  The Fed would conduct additional auctions in subsequent months, depending in part on evolving market conditions. 

Experience gained under this temporary program was expected to be helpful in assessing the potential usefulness of augmenting the Fed’s current monetary policy tools--open market operations and the primary credit facility--with a permanent facility for auctioning term discount window credit.  The Board anticipated that it would seek public comment on any proposal for a permanent term auction facility. In other words, the Fed had no idea how the market would react to its TAF program. 

At the same time, the Fed Open Market Committee (FOMC) authorized temporary reciprocal currency arrangements (swap lines) with the European Central Bank (ECB) and the Swiss National Bank (SNB).  These arrangements provided dollars in amounts of up to $20 billion and $4 billion to the ECB and the SNB, respectively, for use in their jurisdictions.  The FOMC approved these swap lines for a period of up to six months.

On December 21, 2007, the Fed announced its intention to conduct biweekly TAF auctions for as long as necessary to address elevated pressures in short-term funding markets. The Board of Governors was to announce the sizes of the January 14 and January 28 TAF auctions at noon on January 4. 

Surging demand for US Treasuries is causing failures to deliver or receive government debt in the $6.3 trillion a day market for borrowing and lending to climb to the highest level in almost four years.

Failures, an indication of scarcity, surged to $1.795 trillion in the week ended March 5, the highest since May 2004, and up from $374 billion the prior week. They have averaged $493.4 billion a week this year, compared with $359.6 billion over the last five years and $168.8 billion back through July 1990, according to data from the New York Fed.

Investors seeking the safety of government debt amid the loss of confidence in credit markets pushed rates on three-month bills today to 0.387 percent, the lowest level since 1954. Institutions worldwide have reported $195 billion in writedowns and losses related to subprime mortgages and collateralized debt obligations since the start of 2007, making firms reluctant to hold anything but Treasuries as collateral on loans.

‘It shows you the kind of anxieties that are going on and the keen demand for Treasuries,’ said Tony Crescenzi, chief bond market strategist at Miller Tabak & Co. in New York. “The rise in fails tells us about the inability of dealers to obtain Treasury collateral.”

In a repurchase agreement, or repo, a customer provides cash to a dealer in exchange for a bill, note or bond. The exchange is reversed the next day, with the customer receiving interest on the overnight loan. A Treasury security is termed on ‘special’ when it is in such demand that owners can borrow cash against it at interest rates lower than the general collateral rate.

The Treasury Department cautioned dealers in January to guard against failing to settle in the Treasury repo market as interest rates fall. It cited periods of such failures to receive or deliver securities, known as `fails' in the repo market, earlier in the decade when rates dropped.

The difference between the rate for borrowing and lending non-specific Treasury securities, or the general collateral rate, has averaged 63 basis points below the central bank’s target rate for overnight loans this year. The spread has averaged about 8 basis points the past 10 years.

Overnight general collateral repo rates have traded lower than the Fed's target rate for overnight lending every day this year. The rate on general collateral repo closed today [March 20] at 0.9 percent, according to data from GovPX Inc., a unit of ICAP Plc, the world's largest inter-dealer broker, compared with 1.25 percent yesterday. Today’s rate is 135 basis points below the Fed's target rate for overnight lending of 2.25 percent.

A spokesman for the New York Fed, declined to comment on the fails data.

On the same day, the Fed announced an expansion of its securities lending program to include a new Term Securities Lending Facility (TSLF), under which the Fed would lend up to $200 billion of Treasury securities to primary dealers secured for a term of 28 days (rather than overnight, as in the existing lending program) by a pledge of other securities, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS.  The TSLF is intended to promote liquidity in the financing markets for Treasury and other collateral and thus to foster the functioning of financial markets more generally. 

In The Wall Street Examiner, Lee Adler wrote in his article: Bandaid on a Ruptured Jugular:

Why do prime dealers (PDs) borrow securities from the Fed? To sell them short. The PDs are heavily short Treasuries at all times. They are heavily long all other debt securities simultaneously. The level of securities lending in recent months is unprecedented in all of human history, by an order of magnitude of 10.
The Fed is now responding to the pressure of the imminent collapse of the PDs and major banks worldwide, because not only are the PDs heavily short the stuff that is going up, Treasuries, they are heavily long the stuff that is going down, which is all other debt securities. This is the worst of all possible worlds and the Fed’s action is like putting a bandaid on a ruptured jugular vein.

Stealth Nationalization of the Financial Sector

“Bernanke’s intent is to buy the primary dealers time, but it really can’t work. Those securities will not be worth more tomorrow than they are today. For now, a MBS fire sale was averted, but it can’t be put off forever,” writes Adler.

Down the Slippery Slope

Unlike the TAF which swaps cash for MBS and therefore requires sterilization so as not to push the fed funds rate below target, the TSLF is simply a swap of one instrument for another, albeit an inferior one. It is not printing, and it injects no cash into the system. To avoid the need to sterilize the liquidity injection, the Fed exchanged Treasuries in its procession for securities of dubious market value held by Bear Stearns.  Since Bear Stearns is not a banking holding company and does not own a bank, the Fed could only rescue it by providing the funds to JPMorgan Chase, a commercial bank that can access the Fed discount window for funds, to acquire Bear Stearns at a fire sale price of $2 a share, a ceiling dictated by the Fed to avoid the appearance of bailing out Bear Stearns shareholders, while other investors were bidding at $5.98. The shares had traded at $170 at its peak in January 2007 and at $67 two weeks before the rescue. The Fed will guarantee up to $30 billion of potential losses on Bear assets, later reduced to $29 billion with JPMorgan assuming the first billion losses. It was the Fed’s first rescue of a prime dealer broker since the Great Depression and its latest effort to soothe financial markets roiled by fallout from rising mortgage defaults. Latest reports have JPMorgan renegotiating the sale price at $10 per share to ward off shareholder attempts to block the Fed-sponsored deal.

Clearly the bond market does not believe the TAF, the TSLF, or the PDCF, all liquidity actions, are going to solve the insolvency problem facing over-leveraged institutions.

Legal Challenges

In a complaint filed with the Fed a day after the Fed action, Inner City Press labeled the central bank’s brokering of the Bear Stearns deal as “entirely illegal” and anticompetitive, and questioned whether the required number of Fed Board governors had voted for it.

Inner City Press questioned the legality of the Fed approving the Bear Stearns deal without public notice, on the grounds Bear Stearns “is not a banking holding company and it does not own a bank.” It was the Fed’s first rescue of a broker dealer since the Great Depression and its latest effort to soothe financial markets roiled by fallout from rising mortgage defaults. The Federal Reserve bypassed its own normal emergency-lending policies to let securities firms borrow at the same interest rate at the discount window as commercial banks as the central bank sought to stave off a financial-market meltdown. Guidelines revised in 2002 say the Fed should charge non- banks more than the highest rate that commercial banks pay. Instead, Fed Chairman Bernanke and his colleagues, in emergency votes on March 16, invoked broader authority in the Federal Reserve Act to give Wall Street prime dealers the same rate as banks. Backstopping securities firms, coupled with action to keep Bear Stearns Cos. afloat before its sale to JPMorgan Chase represent the central bank’s first lifelines to institutions other than banks since the Great Depression.

Senior Fed staffers said the arrangement allows JP Morgan Chase to borrow from the Fed’s discount window and put up collateral of uncertain value from Bear Stearns to back up the loans. JP Morgan, a bank, has access to the discount window to obtain direct loans from the Fed, but Bear Stearns, an investment house, does not. While JP Morgan is serving as a conduit for the loans, the Fed and not JP Morgan will bear the risk if the loans are not repaid, officials said. When God sins, the entire theological structure rots.

The “temporary” facilities for 28 days have been extended on increasingly larger scale. If they had a chance at being temporary the scale should be getting smaller and not larger. The Fed is putting in jeopardy its credibility by pretending that the “temporary facilities” might end or be phased out at the end of some future 28-day period when it knew in advance that was not possible. Each rollover increases stress in the precarious financial system as market participants become dependent on more Fed intervention to provide temporary adrenaline to unjustified market exuberance.

Another day later, Government Sponsored Enterprises Fannie Mae and Freddie Mac received permission from regulators to pump as much as $200 billion of liquidity into the beleaguered US mortgage market without having to add compensatory capital.  For weeks earlier, rumors had been rife about these two GSEs facing insolvency. Jonathan R. Laing of Barron’s characterized their shares as “worthless”. At year end 2007, the company owned in its portfolio or had packaged and guaranteed some $2.8 trillion of mortgages or 23% of all US residential mortgage debt outstanding. The company lost $2.6 billion in 2007 as a surge of red ink in the final two quarters more than wiped out a nicely profitable first half.

Still, even with all the liquidity the Fed has injected into the market, few are borrowing except to roll over maturing debts, as new profitable investments have become hard to find.  Oil companies are flushed with cash from windfall profits but they do not seem to be able to find worthwhile investments to put the cash to use. Exxon reported a record $39.5 billion annual windfall profits for 2007 from high oil prices, exceeding the gross domestic product of nearly two thirds of the 183 nations of the world, but the company failed to announce any plans for expansion.

New, Stronger Fixes Every Few Days

Central banks of the G7 economies are reportedly actively engaged in discussions about the feasibility of using public funds for mass purchases of mortgage-backed securities as a possible solution to the credit crisis. This is essentially an option to nationalize the credit market after wholesale deregulation has turned free market capitalism into failed market capitalism.

Jean-Claude Trichet, the ECB president, while avoiding immediate critical comment on the Bank of England’s rescue of Northern Rock, said: “What is important is that we must not let the mistakes made by some impose a high cost on those who have made no mistakes.”

Questions of judicial practice have arisen especially in connection with industrial disputes. We believe that the parties to all judicial proceedings should be treated with rigid impartiality, and that injunctions should not be issued in any case in which an injunction would not issue if no industrial dispute were involved.

The expanding organization of industry makes it essential that there should be no abridgement of the right of the wage earners and producers to organize for the protection of wages and the improvement of labor conditions, to the end that such labor organizations and their members should not be regarded as illegal combinations in restraint of trade.

“… the Democrat belief in the conservation and the development, for the use of all the people, of the natural resources of the country. Our forests, our sources of water supply, our arable and our mineral lands, our navigable streams, and all the other material resources with which our country has been so lavishly endowed, constitute the foundation of our national wealth. Such additional legislation as may be necessary to prevent their being wasted or absorbed by special or privileged interests should be enacted and the policy of their conservation should be rigidly adhered to.”

It pledged to the extension of the work of the bureau of mines in every way appropriate for national legislation with a view to safeguarding the lives of the miners, lessening the waste of essential resources, and promoting the economic development of mining, which, along with agriculture, must in the future, even more than in the past, serve as the very foundation of our national prosperity and welfare, and our international commerce.

Calvin Coolidge, a quintessential New Englander from Vermont, served as the 29th vice president of the United States from 1921 until his succession to the presidency in 1923 upon the sudden death of Republican President Warren G. Harding. Coolidge inherited a nation in the midst of an unprecedented economic boom built on debt-driven speculation and handed it over to fellow Republican Herbert Hoover just before it fell into the Great Depression. A good Republican, Coolidge faithfully balanced the Federal budget, reduced the deficit and presided over the speculative rise of the stock market which he mistook as the happy result of free markets. Coolidge ignored the needs of the poor and instituted a strict, discriminatory immigration policy based on race. “America,” he said proudly, “must be kept American.” The US political economy of the past two decades echoed closely the Harding-Coolidge decades.

The presence in his cabinet of Herbert C. Hoover and Andrew W. Mellon added to the pro-business tone of his administration. Coolidge supported the Mellon program of tax cuts and small government and encouraged the stock market speculation as in tune with the American enterprising spirit. Coolidge’s policies left the nation unprepared for the inevitable economic collapse that followed. Coolidge declined to seek re-nomination in 1928.

A Brookings Institute study shows that in 1929 the top 0.1% of income recipients had a combined income equal to the bottom 42%. That same top 0.1% in 1929 controlled 34% of all savings, meaning a significant of their income were unearned from capital gain and dividends, while 80% of the working population had no savings at all.

By comparison, Bill Clinton and Al Gore in their 1991 populist campaign for the White House repeatedly pointed out the obscenity left by the Reagan administration, of the top 1% of Americans owning 40% of the country’s wealth. They also said that if home ownership is not counted and only counting businesses, factories and offices, then the top 1% owned 90% of all commercial wealth. Unfortunately, once in office, President Clinton did little to correct the situation. Clinton has been described as the best president the Republican would wish for. After eight years of George Bush, with home prices falling with no end in sight, the top 1% could end up with 99% of the nation’s wealth even when home ownership is counted.

Not all could be blamed on the Republicans. Jimmy Carter (1977-81) was the president who reversed many of the regulations put in place by Franklin D. Roosevelt’s New Deal. See my AToL article Carter the Granddaddy of Deregulation. He deregulated airlines, railroads, trucking, long distance communication and banks regulation, particularly repealing Regulation Q which prohibits banks from paying interest on demand deposit accounts. The repeal of Regulation G eventually led to the Savings and Loan crisis  In 1980 the Interstate Commerce Commission still regulated both trucking and the railroads. AT&T (Ma Bell) had a nationwide monopoly in which long distance calls were carried via copper wires, each with the capacity of 15 calls. Technological innovation in fiber optic line allows 2 million calls per line. The most important long-term effect of transportation is the uneven development of the national economy favoring big population centers at the expense of rural small towns.

Carter made it easier for Reagan to implement antigovernment actions. The deregulation movement started under Jimmy Carter was continued by Ronald Reagan and Bill Clinton. In 2008, calls for new regulation to rein in the excesses and abuse of market fundamentalism are hear from all quarters.

The Coolidge prosperity of the 1920's was not shared equitably among all citizens. The disparity of income between the financial elite and the average wage earner widened throughout the 1920’s. While the disposable income per capita rose 9% from 1920 to 1929, those with income within the top 1% enjoyed a stupendous 75% increase from a much higher base in per capita disposable income.

In 2006, the CEOs of the 500 biggest US companies averaged $15.2 million in total annual compensation, according to Forbes business magazine’s annual executive pay survey. The top eight CEOs on the Forbes list each pocketed over $100 million.

University of Chicago economist Austan Goolsbee points out that a CEO like Ellison literally cannot spend enough on personal consumption to stop his fortune from growing. Goolsbee calculates that Ellison would have to spend over “$183,000 an hour on things that can’t be resold for gain, like parties or meals, just to avoid increasing his wealth.”

On the 1920s, a major reason for the large and growing gap between the investing rich and wage earners was the increased manufacturing output throughout this period. From 1923-1929 the average output per worker increased 32% in manufacturing, but average wages for manufacturing jobs increased only 8%. From 1923-1929 corporate profits rose 62% and dividends rose 65%. The created wealth was going mostly to investors rather than workers.

In the 1920s, the Federal government also contributed to the growing gap between the investing rich and wage earners. The Revenue Act of 1926, similar to the 2000 Bush tax cuts, reduced federal income and inheritance taxes dramatically. Secretary of the Treasury Andrew Mellon lowered federal taxes to enable a taxpayer with a million-dollar annual income to reduce income tax from $600,000 to $200,000. Even the Supreme Court played a role in expanding the gap between the socioeconomic classes. In the 1923 case of Adkins v. Children’s Hospital, the Supreme Court ruled minimum-wage legislation unconstitutional.

In the 1920’s, the wide disparity of wealth between the rich and the average wage earner increased the vulnerability of the economy. For an economy to function with stability on a macro scale, total demand needs to equal total supply. Disparity of income eventually will result in demand deficiency, causing over supply. The extension of credit to consumers can extend the supply/demand imbalance but if credit is extended beyond the ability of income to sustain, a debt bubble will result that will inevitably burst with economic pain that can only be relieved by inflation. 

The US economy was also reliant upon luxury spending and investment from the rich to stay afloat during the 1920's. The problem with this reliance was that luxury spending and investment, unlike general consumption on basic needs, can fluctuate widely based on the wealthy’s confidence in the U.S. economy. More investment normally increases productivity. However, if the rewards of the increased productivity are not distributed fairly to workers, production will soon outpace demand. The search for high returns in a low demand market will lead to consumer debt bubbles with wide-spread speculation.

Next: The Great Depression, the New Deal and the 2007 Financial Crisis