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Fighting for the pooling equilibrium
Citigroup , Bank of America and other top banks took the rare step of borrowing $2 billion from the U.S. Federal Reserve on Wednesday, in a bid to reassure markets and remove the stigma associated with getting financing from the central bank.
U.S. shares rose after the move, as the banks' moves signaled that battered credit markets may start to heal, though bank stocks were mixed amid lingering concern about mortgages.
Borrowing money directly from the Fed has historically been seen as a sign of weakness, but Bank of America, JPMorgan Chase & Co, and Wachovia Corp said they did it for the sake of the financial system. All four banks emphasized they have access to other, cheaper funds.
Here is the story. I don't know if this will work, but it is a neat trick. Imagine that you, as a smart person, went around saying stupid things, in an attempt to limit discrimination against the stupid. You can come up with other analogies of your own.
Posted by Tyler Cowen on August 22, 2007 at 05:55 PM in Economics | Permalink
Comments
The wisdom of George Bush!
Posted by: 8 at Aug 22, 2007 6:01:12 PM
Implicit collusion across management at these firms to raise costs of shareholder oversight?
Posted by: Keith at Aug 22, 2007 6:13:43 PM
"...as the banks' moves signaled that battered credit markets may start to heal..."
Just how short term can "business journalism" possibly be!? The non-crisis of the US economy has played out in the sweep of world-ending tragedy to healing stability in what, two weeks? Is this just me or does the mood swing of the news media seem particularly sharp these days?
Posted by: Eric at Aug 22, 2007 6:40:58 PM
The news media is always quick to change tack. Imagine having to write about the same thing everyday, and trying to make it interesting.
I'm not sure I can buy the story that these banks borrowed money in order to reduce the stigma associated with it. It feels to me like they needed the money, and didn't want to get hammered for it, so made up some crackpot story.
Posted by: Matt Nolan at Aug 22, 2007 8:16:15 PM
haha, it does sound like Bush's wisdom, but it actually makes a lot of sense.
Banks, though competetive by business, probably have an incentive to make the central bank look good, because it is the only institution which has the ability to control them. So individually it is rational for them to make sure that the big brother looks good and is strong at all times, so that its position is not compromised at any point of time.
Does this logic work?
Posted by: rahul at Aug 22, 2007 8:21:14 PM
It makes sense that there would be an incentive for them to co-operate, however i think that incentive would be greater when they are having trouble sourcing credit.
They way I see it, there would be an incentive for an individual bank to defect, get the 'cheaper' credit and then say to the market that it was the only one that didn't need Central Bank funds. Ultimately I think they were only willing to co-operate because they were struggling for credit in the first place. By working together they could alleviate their credit issues, and come up with an excuse for doing it, so that the markets don't hammer them.
Posted by: Matt Nolan at Aug 22, 2007 8:43:39 PM
Er...Tyler, this is my strategy for the macro prelim.
Posted by: Eli at Aug 22, 2007 9:05:22 PM
So you go around saying stupid things, all the while making sure people understand you are not actually stupid yourself, and you expect the village fool to gain a status boost?
And how do the banks' moves signal that battered credit markets may start to heal? Am I missing something?
Posted by: datacharmer at Aug 22, 2007 9:47:48 PM
Datacharmer, from what I can tell the banks are saying that they borrowed the money remove the negative stigma from borrowing from the central bank. This might make markets heal as now other financial institutions will not be punished for borrowing from the bank, removing a possible distortion from the credit market. However, as I said earlier I don't think that this sort of co-ordination could occur unless the banks were unable to get the funds elsewhere for significantly less (which they say they could). I think they needed the funds, and just decided to talk some crack so that the market didn't punish them.
So deep down, I agree with you datacharmer.
Posted by: Matt Nolan at Aug 22, 2007 9:56:35 PM
Datacharmer, from what I can tell the banks are saying that they borrowed the money remove the negative stigma from borrowing from the central bank. This might make markets heal as now other financial institutions will not be punished for borrowing from the bank, removing a possible distortion from the credit market. However, as I said earlier I don't think that this sort of co-ordination could occur unless the banks were unable to get the funds elsewhere for significantly less (which they say they could). I think they needed the funds, and just decided to talk some crack so that the market didn't punish them.
So deep down, I agree with you datacharmer.
Posted by: Matt Nolan at Aug 22, 2007 9:56:41 PM
Interesting tactic, although I'm not sure that $2+ billion is all that much for Wachovia, BoA, Citi, Deutsche Bank, and JPMorgan. The article states that the US based banks each borrowed about $500 million; not chump change by any means but also not the king's ransom. Maybe this strategy is an effective signal just because they borrowed anything at all from the discount window, a previously taboo act.
Posted by: Jim Outen at Aug 23, 2007 3:06:32 AM
It's probably to prepare the ground in case they need to borrow more.
Imagine going around saying stupid things, all the while making sure people know you are smart, in order to ensure that when in a fit of madness you do something really stupid, people will automatically assume that you're still smart.
Posted by: JW Tan at Aug 23, 2007 4:33:04 AM
Matt -
Not a chance. Citigroup, B of A, Wachovia, JPM, and Deutsche Bank individually and collectively are not having problems accessing capital. $500m is pocket change for them.
This was done, essentially, as an endorsement of the Fed's recent moves to try to clam the market. It's a smart move by which, if successful, the entire banking industry will benefit, mostly be the absence of worst-case or near worst case outcomes (which in this case is a liquidity and a credit crisis).
Posted by: glenn at Aug 23, 2007 5:16:03 AM
If Bank of America needed the $500 million, would they have simultaneously purchased $2 billion of Countrywide's preferred? As I understand it, Bank of American cannot purchase Countrywide outright due to the 10% federal cap on deposits. Perhaps both moves were attempts to calm the industry turmoil.
Posted by: John Dewey at Aug 23, 2007 6:49:44 AM
Hi Tyler,
Here's a eMail I sent you last week, with some follow-up thoughts instigated by /this/ article....
---------
Hi Tyler,
Boy, I'm certainly one confused puppy... a couple of months ago I kept reading that the Fed was raising interest rates specifically to cool what they viewed as an impending trend toward inflation.
The last couple of days, however, I have been reading that the Fed has been adding "liquidity" to keep market rates close to the 5.25% target. But doesn't adding liquidity contribute to inflation? So which tail is wagging which dog?
Bow wow,
Jeff C.
-----------
The problem now appears to be that the emperor has no clothes. In other words, when we pull back the veil of banking, financial reporting, and Federal Reserve, there is *nothing* behind the curtain. Actors in the financial market will say whatever they need to say in order to manipulate impressions. Taken logically however none of it makes any sense.
The real risk to the financial system is LOSS OF CREDIBILITY.
Actions that banks have been taking recently tend to reinforce this speciousness.
Best regard,
Jeff
Posted by: Jeff C. at Aug 23, 2007 8:28:17 AM
This is interesting---the reverse of classic oligopolistic behavior. It's as if Chevron, Exxon, B
P, and Shell were feeling political heat from high gas prices and deliberately conspired to fix prices at a lower level. Short-term pain for long-term gain---a cousin of predatory pricing, but not quite the same thing.
Posted by: Steve Yuen at Aug 23, 2007 9:31:46 AM
The four banks didn't go to the discount window. They were arm-twisted to do so, in order to take some of the stigma off the practice. That way, the Fed hopes to prevent a run to the bank that will show up in actual need. It remained to be seen if the trick will work then.
Posted by: TobiaMill at Aug 23, 2007 10:41:13 AM
Sometimes you borrow at a slightly higher rate so that you don't have to tap into the reserve agreements that you have in place. The reserve agreements may have variable rates themselves based upon the condition of these banks at the time that they tap into them.
So, perhaps, borrowing from the Fed has a sort of insurance aspect to it and this makes the transaction not really more expensive.
Sometimes "stupid" reasons are floated for smart reasons. Those doing it have motives they don't want to reveal. The classic one is "I want to spend more time with my family" instead of "I'm about to be indicted and need to spend time with my lawyers".
Posted by: robertdfeinman at Aug 23, 2007 10:49:25 AM
Barry Ritholtz at The Big Picture economics blog, via Abnormal Returns:
I see the Fed trying to accomplish three primary tasks:• Restore Investor Psychology
• Fix the seized up liquidity
• Cushion the blows to a slowing economyBelieve it or not, those items are the easy part. Where the complication comes from is trying to accomplish the above while simultaneously avoiding:
• Rekindling inflation
• Resurrecting the Greenspan Put (i.e., "Moral Hazard")
• Preventing a meltdown in the US Dollar
This is far from over...
Posted by: anonymous at Aug 23, 2007 10:50:18 AM
We are facing a crisis on multiple fronts: a liquidity crunch, housing slowdown, and a global warming crisis resulting in extreme weather.
I for one am willing to step up to the plate and tackle all of these simultaneously. To increase public confidence, I will borrow $100 million from the Fed, and invest it in a company that will build hurricane-resistant luxury housing. The prototype residence will go up in the Cayman Islands, and to demonstrate my confidence I myself will brave the danger and go live in it.
Posted by: anonymous at Aug 23, 2007 11:04:41 AM
It was largely "we're cooperating with the Fed" move to improve market psychology.
It does not hurt, and maybe it will help.
Posted by: spencer at Aug 23, 2007 11:20:26 AM
Until 2003, the discount rate was always below the fed funds rates. After that point it has been 100 basis points above the fed funds rate (it is now 50 bps above fed funds). Despite the discount's rate relation to fed funds (and despite seasonal blips), borrowing at the window has historically been less than $1 billion a week. Considering the trillions that banks borrow and lend from each other over night, $1 billion a week is like a twig on the banks of a mighty river. In terms of solving the liquidity problem, this is really kind of a joke.
The fed may have helped the psychology a little, but if they really wanted to appear to be doing something (without changed fed funds), they would have lowered the discount rate back below fed funds. Even then, I doubt it would have had much of a material effect.
The trading implication for these firms is that will cost them roughly $200K this month for this act of stupidity ($500M * .50/12). The 50 bps is the difference between the discount rate and fed funds (where they currently borrow). It may not sound like a lot, but traders and repo desks work hard to squeeze out 3 bps at a time.
Posted by: Patinator at Aug 23, 2007 2:13:42 PM
This Fortune article calls Wednesday's "nothing to see here" interpretation into question in light of subsequent events on Friday:
Indeed, this move to exempt Citigroup casts a whole new light on the discount window borrowing that was revealed earlier this week. At the time, the gloss put on the discount window advances was that they were orderly and almost symbolic in nature. But if that were the case, why the need to use these exemptions to rush the funds to the brokerages?
Posted by: anonymous at Aug 24, 2007 5:31:09 PM
I wouldn't be surprised if the Fed asked them to borrow those funds.
Posted by: David Zetland at Aug 24, 2007 7:42:16 PM
I have a post responding to this at http://www.rasmusen.org/x/2007/08/25/borrowing-at-the-discount-window/
The answer to Prof. Cowen: Maybe the four banks are saying something stupid because their audience is the group of stupid people who would otherwise launch a run on the banks.
Posted by: Eric Rasmusen at Aug 25, 2007 3:24:13 AM
