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This diary/comment illustrates and greatly clarifies the mechanisms by which the Central Banks use Public Open Market Operations, POMO, such as purchasing bonds, to control interest rates. So let me see if I have got this right.

Mig noted that POMO is the current tool of choice for central bankers. The other major tool available is the "discount window", where banks can receive unrestricted funds for a specified term by posting performing mortgages, etc. with a "haircut" in return for cash, or "high powered money" which is one way banks turn a large portion of performing loans back into lend-able cash. These operations are called repurchase agreements or "repos". The bank posts a $100K face value loan document, takes a 5% "haircut" and gets $95K for one week, one month, one year at a specific interest rate. At the end of the agreed time it pays back the amount loaned and the interest owed. The "haircut" was the margin that protected the CB against a decline in value of the collateral. Is the terminology used and the process described correct?

In a comment on his Minsky's Wheel diary Mig noted that CB practice, prior to the GFC, had been to rely on open market operations almost exclusively, as people had come to associate access to the "discount window" with a bank being in distress. But Mig noted that use of the discount window gave the CB a greater insight into the condition of the bank's balance sheet, and therefore should be a better way of controlling the monetary system than the comparatively crude means of using open market operations. It doesn't seem too surprising that the banks preferred less oversight by the central banks.

When we look at the GFC we see that one of the chief methods by which the great debacle was brought about was through the use of Mortgage Backed Securities, which were private market, presumably permanent alternatives to CB "repo" operations and which were highly profitable to the originators, but which were highly dangerous to the financial system. The same function as performed by the MBSs could have been performed by central banks, but they then would have been responsible to actually look at the mortgages they were taking in for "repo" and the loan originators could not have assumed that they were no longer responsible for any aspect of the loan, as they would be liable to repurchase the loans after a fixed time. Actually, the HFA, Fanny Mae and Freddy Mac were facilities for underwriting and permanently holding mortgages while returning money to the originators, but they had standards, even if inadequate. There were no such problems with the MBS packagers.

This whole process was endorsed by prize winning economists of the highest repute who worked at universities that were supported by people who believed that businessmen should have the fewest restraints possible and would, in their own self-interest, police and restrain themselves. The result is the ongoing, unacknowledged process of debt-deflation which we are experiencing. And in this climate it is acceptable to use the discount window because no one now trusts the large commercial banks that remain to put together a mortgage backed security and not design it to fail and simultaneously bet against it with a CDO.

The remaining question is how many of those involved were consciously involved in a confidence game, how many were victims and how many were both. The remaining task, if it is ever undertaken, is to prosecute those who broke laws. Normally, those who can be shown to have done so knowingly and deliberately would be dealt with more harshly. Who knows what will actually happen.

"It is not necessary to have hope in order to persevere."

by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Fri May 13th, 2011 at 05:06:30 PM EST
Mig noted that POMO is the current tool of choice for central bankers. The other major tool available is the "discount window", where banks can receive unrestricted funds for a specified term by posting performing mortgages, etc. with a "haircut" in return for cash, or "high powered money" which is one way banks turn a large portion of performing loans back into lend-able cash.

Yes, although I dislike the term "lend-able cash," because the bank creates bank-money by the stroke of a pen. And that bank money is perfectly lend-able in and of itself. The repo only comes in as a way to make the central bank happy, by having enough central bank money to cover regulatory requirements.

(Private banks want to make sure the CB is happy, because if the CB is ever unhappy with them, goons with guns will come and shut down their place of business.)

These operations are called repurchase agreements or "repos". The bank posts a $100K face value loan document, takes a 5% "haircut" and gets $95K for one week, one month, one year at a specific interest rate. At the end of the agreed time it pays back the amount loaned and the interest owed. The "haircut" was the margin that protected the CB against a decline in value of the collateral. Is the terminology used and the process described correct?

Yep.

Alternative words for the same process are "rediscounting" (since the original note is, in banker jargon, a "discounted note"), "discount window operations" (in the US) and "main refinancing operations," or MRO (in the €-zone).

I prefer to use "rediscounting," because "repos" may also be carried out between private entities, while rediscounting is only done at the central bank rediscount facility.

I'm also arguing that the haircut should be at least 10 percent, and that the haircut should be measured from the lower of the face value of the note or 80 % of the central bank's valuation of the collateral.

In a comment on his Minsky's Wheel diary Mig noted that CB practice, prior to the GFC, had been to rely on open market operations almost exclusively, as people had come to associate access to the "discount window" with a bank being in distress. But Mig noted that use of the discount window gave the CB a greater insight into the condition of the bank's balance sheet, and therefore should be a better way of controlling the monetary system than the comparatively crude means of using open market operations.

Yep.

It doesn't seem too surprising that the banks preferred less oversight by the central banks.

Yep. But private banks should not be setting central bank policy. The CB is, in the final analysis, the one who can dispatch goons with guns, so it has no business cow-towing to the wishes of private banks.

When we look at the GFC we see that one of the chief methods by which the great debacle was brought about was through the use of Mortgage Backed Securities, which were private market, presumably permanent alternatives to CB "repo" operations and which were highly profitable to the originators, but which were highly dangerous to the financial system. The same function as performed by the MBSs could have been performed by central banks, but they then would have been responsible to actually look at the mortgages they were taking in for "repo"

Yep.

and the loan originators could not have assumed that they were no longer responsible for any aspect of the loan, as they would be liable to repurchase the loans after a fixed time.

Weeell, a lot of the players who sold toxic waste in the last bubble also sold their marks repurchase agreements. This allowed them to move the toxic waste off their balance sheet for accounting purposes (and get paid for it), even though they retained the exposure in economic terms. So fully closing that loophole requires a reform of the accounting rules for contingent liabilities.

The strongest protection in the system I propose is that after the fact you'll be able to point to some specific dude at the CB who actively broke the rules if toxic waste gets on the CB's balance sheet and blows up. Whereas in the current system, you cannot point to the specific individual regulator who did not act - because everybody did not act. And the virtue of a full reserve system funded at the discount window is that almost everything important will end up on the CB's balance sheet in some form or another.

My suggestion will not prevent the private banks from creating mortgage-backed securities or other derivatives and playing games with them. Nor will it prevent suckers from being separated from their money when they buy into such scams.

But those are losing battles in any event. Con-men will be con-men and suckers will be suckers no matter how many sorts of snake-oil you outlaw - the only effective way to keep Joe Blow from losing his shirt is to keep him out of the money market altogether.

So effective reform will have to concentrate on protecting the core functions of the system, by giving the financial regulators direct access to the nuts and bolts (and balance sheets) involved. Then you can hang a big sign on the money markets saying "Abandon All Hope, Ye Who Enter Here" and let any sucker dumb enough to enter anyway get parted from his money in an orderly fashion that does not threaten to topple your entire economy into a serious industrial depression.

This whole process was endorsed by prize winning economists of the highest repute

Yep.

The remaining question is how many of those involved were consciously involved in a confidence game, how many were victims and how many were both.

That's easy. "Structured products finance" is a game of intentional obfuscation. Honest businessmen have no need to spend time and money on imaginative ways to obfuscate the nature of the product they are selling. So everybody who put together a "structured product" would have to know (or should be "deemed to have known") that it was toxic shit that would blow up in some poor schmuck's hands.

... they just didn't imagine that they might be the poor schmuck. (And indeed they were not - as they managed to promptly dump a lot of the toxic waste on Uncle Sam's balance sheet...)

The remaining task, if it is ever undertaken, is to prosecute those who broke laws. Normally, those who can be shown to have done so knowingly and deliberately would be dealt with more harshly. Who knows what will actually happen.

The most egregious offenders will receive a few Strongly Worded Letters from Congressional subcommittees. Maybe a subpoena or two. And have to suffer the indignity of having Matt Taibbi tear them a new one in Rolling Stone.

Other than that, nothing will happen to banksters in the best democracy money can buy. And in Europe not even that, as the crisis can be blamed on swarthy furriners who speak funny.

After all, unemployment is only at ten percent, and has almost stopped rising. Last time we had serious, systemic reforms, it involved 20 % unemployment, much greater hardship for the unemployed, a communist revolution still within living memory, and two world wars, which ensured that those 20 % unemployed young men knew how to handle a firearm.

And in only roughly half the places where that systemic change took place did it result in improvement. In the other half of the places, the brownshirts won.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Fri May 13th, 2011 at 06:36:36 PM EST
[ Parent ]
ARG:
When we look at the GFC we see that one of the chief methods by which the great debacle was brought about was through the use of Mortgage Backed Securities, which were private market, presumably permanent alternatives to CB "repo" operations and which were highly profitable to the originators, but which were highly dangerous to the financial system. The same function as performed by the MBSs could have been performed by central banks, but they then would have been responsible to actually look at the mortgages they were taking in for "repo" and the loan originators could not have assumed that they were no longer responsible for any aspect of the loan, as they would be liable to repurchase the loans after a fixed time. Actually, the HFA, Fanny Mae and Freddy Mac were facilities for underwriting and permanently holding mortgages while returning money to the originators, but they had standards, even if inadequate. There were no such problems with the MBS packagers.
Jake:
"Structured products finance" is a game of intentional obfuscation. Honest businessmen have no need to spend time and money on imaginative ways to obfuscate the nature of the product they are selling. So everybody who put together a "structured product" would have to know (or should be "deemed to have known") that it was toxic shit that would blow up in some poor schmuck's hands.
Myself (2 years ago)
Let me give you a couple of quotes. (Emphasis mine)
Role of the SPV

To understand the role of the SPV, we need to understand why a corporation would want to raise funds via securitization rather than simply issue corporate bonds. There are four principal reasons why a corporation may elect to raise funds via a securitization rather than a corporate bond. They are:

  1. The potential for reducing funding costs
  2. To diversify funding sources
  3. To accelerate earnings for financial reporting purposes
  4. For regulated entities, potential relief from capital requirements

We will only focus on the first of these reasons in order to see the critical role of the SPV in a securitization.2
----
2For a discussion of the other reasons, see W. Alexander Roever and Frank J. Fabozzi, "Primer on Securitization," Journal of Structured and Project Finance, Summer 2003, pp. 5-19.
(This is from Chapter 14 of Fabozzi's Bond Markets, Analysis, and Strategies)

Wikipedia: Frank J. Fabozzi

Frank J. Fabozzi is the Frederick Frank Adjunct Professor of Finance at Yale School of Management. He has taught at Yale University since 1994. Fabozzi, an investment management expert, is a Wall Street authority and editor of the Journal of Portfolio Management. He is a consultant to several financial institutions. He was inducted into the Fixed Income Analysts Society Hall of Fame in November 2002. He is also a Fellow at the Yale International Center for Finance.
Wikipedia: Special purpose entity
Often it is important that the SPE not be owned by the entity on whose behalf the SPE is being set up (the sponsor). For example, in the context of a loan securitisation, if the SPE securitisation vehicle were owned or controlled by the bank whose loans were to be secured, the SPE would be consolidated with the rest of the bank's group for regulatory, accounting, and bankruptcy purposes, which would defeat the point of the securitisation. Therefore many SPEs are set up as 'orphan' companies with their shares settled on charitable trust and with professional directors provided by an administration company to ensure there is no connection with the sponsor.


Economics is politics by other means
by Migeru (migeru at eurotrib dot com) on Sat May 14th, 2011 at 05:34:51 AM EST
[ Parent ]
IIRCC, there is a single building in Grand Turks that is home to several hundred corporations, one of which the Houston, Texas former billionaire felon Stanford owned. Enron had SPVs there. Others are there for tax purposes. An international corporation will show the majority of its profits as originating out of a file cabinet in that building in Grand Turks so as to shelter them from taxes in real countries, etc.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Sat May 14th, 2011 at 09:47:05 AM EST
[ Parent ]
I dislike the term "lend-able cash," because the bank creates bank-money by the stroke of a pen.

Point taken. I was unsatisfied with the term myself and artlessly rewrote the sentence at least once, but still came up with garbage. Compliance with regulatory requirements is the concept. Perhaps I should have written "...to reload their pen with Central Bank approved ink."

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Sat May 14th, 2011 at 09:57:04 AM EST
[ Parent ]
....or to charge their computer system with Central Bank approved electrons.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Sat May 14th, 2011 at 10:02:18 AM EST
[ Parent ]
I like the ink pen analogy. It is perhaps the only universal symbol of true business power - the expensive traditional phallic pen, and the signature. The pen also denotes a resistance to IT and technological innovation.

It's all about contracts and signatures. The rest of us use PIN codes.

You can't be me, I'm taken

by Sven Triloqvist on Sat May 14th, 2011 at 10:18:47 AM EST
[ Parent ]

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