Monday, March 10, 2008

Mo' Better

I may be one of the few bloggers who think the Feds policy actions are now moving in exactly the right direction. My long standing view is that we are experiencing the popping of a massive credit bubble that extends far beyond subprime mortgages.

A credit bubble happens when the price of credit becomes to low rather than too high. Low priced credit like asset bubbles can be self-reinforcing. Cheap credit means that people can easily refinance their old debts. This puts more money back into the market at lower risk levels which further encourages cheap credit.

See, essentially the price of credit is determined by two things. First, is the scarcity of money. When you loan someone money, you can't use it to buy things yourself. Therefore, few people want to loan out all of the money they have. However, if the government prints more money, more can be loaned out without running short.

Controlling the quantity and hence the scarcity of money is usually what the Fed does to control the price of credit.


However, there is another factor, default risk. Even if you didn't need your money right now you might be hesitant to loan it out if you thought you wouldn't get it back. Hence, the price of credit rises when people think they might not be repaid. The difference between the price of risk free loans and risky loans is the credit spread.


So, how does this affect the current situation. The subprime explosion and subsequent implosion happened because of collapsing credit spreads. That is, investors stopped worrying as much about getting their money back. In particular they believed they had fancy computer simulations which assured that they could make money even if lots of the loans defaulted. As long many of them did not, it wouldn't be a problem.


Now it turns out that those simulations were based on a world in which credit was relatively hard to come by. This new world, in which investors were loaning to anyone with a pulse operated by different rules. In short, the computer simulations lead to the creation of a world in which the simulation was no longer valid.

Computers in some ways are like extreme autistics who often suffer from these types of recursive mistakes. They fail to realize that the response pattern of the outside world is dependent on the outside world's perception of the computer's response pattern. Thus an infinite cycle of you think, that I think, that you think, . . . is set up. Cognitively normal people can solve these problems intuitively but they form a serious calculation issue for computers and autistics. But, I digress.

The important thing is that the simulations failed to account for the changing nature of the credit market. Thus, investors took on way more risk than their analysis had predicted. In late 2006 and early 2007 it started to become clear that the analysis was wrong. By the summer of 2007 credit spreads were spiking as investors tried to undo what they had done.


The Fed, at first tried to fix the problem by increasing the supply of money. The hope was that this could drive down the price of credit, allow people to refinance and investors to get out of the bad deals they were in. However, the deals were going bad too fast. The Fed could not keep up and despite their best efforts spreads are growing again.

So what do?

The Fed must attack the credit spreads not just the scarcity of money. This is what it is doing now by taking an increasing variety of assets as collateral for up to $200 Billion in loans. What that means is that the Fed is allowing banks to borrow cold hard cash by using your risky asset as collateral. In addition, its going to keep rolling this loan over indefinitely.

This means that some of the risk has shifted from the bank to the Fed. If the asset goes bad and the bank can't repay its loan to the Fed, the Fed ends up with the bad asset. In a sense it implies that risky assets are only so risky because at the end of the day you can always pawn them off on the Fed.

Doesn't this put the Fed at risk? Well, the Fed buys the asset with money that it creates out of thin air. Things get a little complicated when one considers that the Fed has to also keep an eye on the Federal Funds rate, which it manages by creating money out of thin air. Yet, I don't think thats much of a problem. This post is already longer than I intended so why its not a problem will have to be saved for another day.

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