Welcome to European Tribune. It's gone a bit quiet around here these days, but it's still going.
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?


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.


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"


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


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
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