TALF details suggest Obama doesn’t get it

Marshall Auerback here. As Ed lucidly suggested to me by e-mail:

“We see the Fed giving a loan for assets at the price as reported on the institutions’ books. Otherwise, you have to take a write-down just to get the loan. That’s a non-starter. So the Fed is going to take the asset as collateral at its reported value and will administer a haircut of 5-16%. This program is applicable only to certain AAA paper to diminish the possibility that more haircut would be needed (I am sceptical here).

If irrational despondency goes away, the loan is repaid. However, if the asset falls in value, the Fed has no-recourse. Given the fact that they have already mentioned the SPV, it suggests the investment company could then renege and have the collateral seized with no other penalty.”

But a lot of this is not “irrational despondency”. The reality is that large chunks of these toxic “assets” are not “impaired,” or “illiquid,” or “distressed”. They are worthless, now and forever – unless the peak real estate values of the bubble can miraculously be restored and a whole bunch of deceased LBOs can be raised from the tomb. The banks know this, investors know this, Geithner and Co. know this. And everybody knows that the others know. This explains why no bank can secure any interbank funding of size for periods beyond a week. Geithner and Lawrence Summers have concluded the only way to get private investors (many of whom have already lost a few pounds of their own flesh to the bear) to bid on these assets is to make them offers which effectively guarantees them a profit.

So I’m guessing it’s buying the assets on the banks’ books for a small haircut and then eventually having them dumped back on the Fed.

Or they are wagering on creating sufficient inflation that the toxic dump is magically made whole. Call in the “Zimbabwe lite” option – sort of like raising the dollar price of gold to increase the net worth of banks, governments, holding gold. But, I don’t see the latter as a realistic possibility the way things stand right now. Core CPI inflation is now at a 0.9% annual rate over the last three months. As recently as the first half of last year it was 2.3%. Maybe the last three months represents the underlying recent past inflation rate. Maybe the fall from a 2.3% rate to a 0.9% rate is the true pace of decline in core inflation. That’s more than 2 percentage points in half a year. Another 2 percentage points by late this year would take us into outright deflation comparable to that of Japan.

These same economists refuse to predict outright price deflation even though they predict a rise in unemployment to perhaps 5 percentage points over the NAIRU. That constitutes very considerable acceleration in labor market slack since the period prior to September of last year. All Phillips Curve logic says such accelerating labor slack should take the already marginal positive core inflation rate into negative territory. The vast majority of economists refuse to acknowledge such simple economic logic.

I have been looking at economic data for the U.S. and many global economies for decades. I am now seeing something I have almost never seen: announcements by companies of outright cuts in base wages. To this we must add the obvious huge cuts in variable compensation which has become so large a part of total U.S. compensation.

In the end core inflation is compensation inflation minus annual productivity gains. Huge labor slack should take compensation inflation to zero or worse. The anecdotal evidence of a decline in compensation inflation, especially as regards the “variable” component, is everywhere. Productivity gains should take the economy into core deflation. With so much corporate cost cutting positive productivity gains are not going to go away. It seems to me the case for deflation is becoming more compelling.

In a recent analysis by Jan Hatzius in Goldman Sachs When ZIRP Is Not Enough Help Wanted! A Spender of Last Resort, January 23, 2009, Hatzius applies the Taylor Rule to a US economy with a zero federal funds rate, marginally positive (one quarter of a percent) inflation, and an unemployment rate that rises to 9.5% by the end of 2010. He concludes that, according to the Taylor Rule, under such conditions the zero federal funds rate will be a full six percentage points above the appropriate policy rate by the end of 2010. There is another way of looking at this. If the US economy goes into deflation, real interest rates will rise. With a huge excess of private debt and a raging financial crisis, rising real interest rates will be a significant depressant on an already falling economy.

And we’re clearly not doing enough to stop this. I am stunned at the number of people who think Obama has had a great start. This complacency will ensure that the policy response invariably remains well below what is necessary and we’ll get the invariable backlash from the right, as Megan McArdle’s comment suggests:

“There is a very real possibility that in two or three years, America will be in worse shape than it is now-unemployment in the double digits, GDP down by same, corporate and government budgets peeling apart at the seams. I will be curious to see whether the new armchair empiricists of the left see this as casting any doubt on their central theories, or whether they will simply argue the counterfactual.”

I really don’t think Obama “gets it”, despite what he said in his speech. Rome’s burning and Geithner and Summers are fiddling away taxpayers dollars on a futile attempt to prop up destroyed banking edifices.

UPDATE: I think reader Brian’s points on the TALF are well taken and I may have to revise my view on TALF somewhat. I still think this is an attempt to restore the shadow banking system via other means and that this is wrong, but it appears to me that what the Fed is seeking to do with TALF is BYPASS a diseased banking system and establish new credit channels for consumer loans, auto loans, other asset backed securities etc., which have been shut down by the credit crunch. As Brian said, key is that the TALF will only be used for asset backed securities issued after Jan. 2009, so that you do avoid a lot of the toxic crap. True, the taxpayer might still take a haircut ultimately, but the risks of that are considerably lower with stuff issued now than stuff issued in 2007.

The only flaw is not with TALF per se but the fact that neither the Fed nor the Treasury are grasping the nettle in the banking system by dealing with the pre-existing buildup of toxic assets still on the balance sheets of the money center banks, but simply trying to bypass it altogether. So in its attempt to establish fresh credit flows, the Fed risks establishing another parallel banking system. Is this really what we want?

The power of government – Megan McArdle

  1. georgem says

    I dislike these proposals as much as anyone, but I think you’re being unfairly negative here. The TALF terms clearly stipulate that the only eligible ABS are those created on or after January 1, 2009. I believe the intent of this plan does lean more toward helping restart securitization markets than to hand out free money to those holding toxic assets.

    Granted, the underlying credits in the eligible ABS could have been originated as far back as mid ’07 and there could be some ugly stuff in there. But I’d venture to say some of that late 07 paper is already out, and not covered by TALF. Also, the market for this stuff slowed down quite dramatically from that period until now, meaning, not a lot of junk got floated in 2008. Had they said that any and all ABS was eligible and there was going to be a bunch of 2005-2007 vintage dumped on the FED, then I would howl with you.

    Will the taxpayer still be the loser? Yes. Will there be the unscrupulous that abuse TALF? Yes. Is this the intent? No. The intent is to help start ABS origination going again by giving new investors a backstop on losses going forward, thereby lowering the risk to participate from here (technically, January 1, 2009) on out.

    Now, is it a good idea to even try restarting this market, especially with this backstop as the bait? That we can debate. (I’d say no.)

    Source: https://www.newyorkfed.org/markets/talf_faq.html

    1. Marshall Auerback says


      You said:

      Now, is it a good idea to even try restarting this market, especially with this backstop as the bait? That we can debate. (I’d say no.)

      We can agree on that. And you are correct: I am being utterly negative. It’s yet another horrible deal for the taxpayer. A form of corruption. As I said before, it appears that AIG and Bear Stearns/Maiden Lane LLC are the templates. This bears all of the hallmarks of Geithner. TALF is his way of restoring the credit creation process to the private sector under the guise of private sector risk taking when really it is the government taking the bulk of the risk but not letting the public know.

      So it gives the perception of private sector lending while at the end of the day if there is a bigger loss than the “haircut” the government is holding the bag.

      If economy improves then the government may get by without loss but that’s not the issue.

      It is another handout and I am not sure the Congress understands or wants to muck up the process if it will get things going (which it won’t, but that’s a separate issue). Why should the taxpayer agree to this egregious arrangement, when there is a vastly superior and more equitable alternative out there?

  2. fred1234456 says

    A period of significant deflation would lead to defaults on obligations of a large chunk of the global financial system. Governments, states, banks, pension funds, employers, individuals; every conceivable form of default would occur and it wouldn’t take long to happen. The current global state of leverage is not amenable to deflation.

    Our governments know this. Every action, every word makes that clear. We are approaching the point of fiat meltdown, currency tsunami. Governments will start buying their own debt, all the while issuing more debt, spending more “stimulus” money, bailing out more institutions. It will not be subtle, nor fair, nor controlled.

    There will be a wave of understanding sweeping over the globe simultaneously, that fiat money must be spent and not held. Velocity of money will skyrocket and central bankers will blink, for just long enough to allow the accumulated GDP multiples of looseleaf paper currency to explode into the economy. When that happens there will never be an opportunity to call them back. Absolute anti-deflation is coming.

  3. ijames says

    “but it appears to me that what the Fed is seeking to do with TALF is BYPASS a diseased banking system and establish new credit channels for consumer loans, auto loans, other asset backed securities etc., which have been shut down by the credit crunch.”

    I don’t think they they are trying to bypass the banking system, they are trying to revive the “shadow” banking system. At the height, banks accounted for roughly 6tr in lending while the shadow banking system accounted for roughly 4tr. The financial crises was, in many ways, simply a run on the shadow banking system. So 40% of lending capacity has been almost entirely wiped out. Getting the shadow banking system up and running again (albeit in a more regulated format) is critical to restoring the economy.

  4. Marshall Auerback says


    I think this is correct. I would prefer completely restructuring the financial system, but in the absence of doing something that radical (which clearly isn’t going to happen whilst Geithner is at Treasury), this is the best alternative we have.

    And if I am to judge from your email address, your firm might be one of the leading beneficiaries!


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