The Moral Hazard Effects of Recent Central Banks’ Liquidity Injections

Nouriel Roubini | Aug 13, 2007

The massive injections of liquidity by the ECB, Fed and other central banks have continued today. Whenever there is a seizure of liquidity in financial markets central banks face a tradeoff: they are the only potential providers of lender of last resort support to the financial system and thus the only ones to be able to stop a liquidity run; but, like in any form of insurance, such liquidity provision may lead to moral hazard, i.e. the risk that reckless investors will expect to be bailed out (see the WSJ article today on "Fed Treads Moral Hazard").

To reduce such moral hazard the famous British economist of the 19th century, Walter Bagehot, suggested that such liquidity support should be provided at a penalty rate and against good collateral. History also suggests that liquidity support is more effective and justified if the economy suffers of a liquidity crisis rather than an insolvency one: if many agents in the economy are insolvent trying to bail them out will create moral hazard, will not solve the problem of insolvency and will postpone the necessary insolvencies and create a bigger set of bankruptcies down the line. Moreover, the lessons of international financial crises in emerging market economies suggests that international lender of last resort support is more effective – and less prone to moral hazard – if it is “conditional” on the troubled borrower taking economic and financial actions that reduce its fundamental financial problems: this is what is called “IMF conditionality”, i.e. lending against macro and financial reforms. IMF support is also limited in its amount – rather than being unlimited - to reduce the moral hazard distortions.

So a sound lending of last resort support that minimizes moral hazard requires:

- an illiquidity rather than insolvency problem

- penalty rates

- good collateral

- conditionality in the lending support

- limits to the amount of support

On all those dimensions the current injections of liquidity by the Fed and the ECB partly fail the test of sound lender of last resort support.

Concerns about a “Bernanke put” and “Helicopter Ben” have been – mostly unfairly – in the minds of investors. The Fed has been criticized in many quarters for feeding the tech bubble of the 1990s, then easing liquidity too much and for too long after the tech bubble burst, thus creating another housing and credit bubble that is now bursting. So, liquidity injections – however justified by the recent liquidity seizure – bear the risk of causing moral hazard and bailing out investors that speculated recklessly. The Fed and ECB – to their credit - have not – so far – cut policy rates but rather injected liquidity to prevent a spike in short rates. But the size and forms of these large liquidity injections has certainly increased moral hazard in a number of ways.

First, as I have discussed in a previous blog we are now partly facing an insolvency crisis, not just a liquidity one. With many households, mortgage lenders, home builders, hedge funds and other leveraged investors, and some non-financial corporations being financially distressed and near insolvent, not just illiquid, a generalized liquidity injection is not justified. Reckless borrowers and investors should suffer serious pain – and insolvency if needed - to prevent future reckless behavior; but the Fed coming to the rescue will not prevent the eventual default of insolvent agents and will feed expectations of further bailouts.

Second, the liquidity support did not occur at penalty rates and in limited amounts (see also De Grauwe’s oped in the FT today on this point). The Fed could have provided tons of liquidity at a higher discount rate at the discount window; it instead decided to provide unlimited liquidity at an unchanged discount rate. Some penalty rate and more limited liquidity injections would have punished those borrowers that behaved recklessly and did not have buffers of liquidity.

Third, the lending did not occur in all cases against good collateral. What was particular bothersome about the repo operations that the Fed undertook last week on Thursday and Friday and again this Monday morning is that the Fed accepted mortgage backed securities (MBS) as collateral against the lending. The Fed did not tell which MBS it accepted as collateral and at which prices (face value when markets are now pricing discounts even of highly rated MBSs?) Did the Fed accept junk rated MBS? Maybe yes, maybe not. The reality is that we do not know. But the perception of having used risky and now very illiquid instruments such as MBSs – rather than only safe liquid Treasuries - for open market operations goes against the Bagehot principle of good collateral.

Fourth, there was no conditionality in this liquidity support: any bank that needed liquidity could get as much as it wanted at unchanged rates. Actually, of the three interventions on Friday, apparently, the most effective one was the third and last one when the Fed pushed the Fed Funds rate – for a short period – down to 5%, i.e. below its target of 5.25%. A more selective use of the discount window – as the Fed does in regular times – to limit the support given to institutions that had imprudently low levels of free reserves would have been more appropriate. The Fed – whenever it wants – can use its moral suasion tools to limit the support given via the discount window to institutions that are imprudent. None of that moral suasion limited support apparently occurred this time around; rather unlimited liquidity provision.

The Fed had little choice – given the liquidity squeeze in the market – to intervene and provide some lender of last resort liquidity support. But the way such support was provided has increased moral hazard distortions rather than kept them under check. Now financial market participants can happily expect that the Fed will provide unlimited support at unchanged interest rates whenever liquidity crunches occur. This is not a good signal for the long term stability of the financial system: it reduced a short run liquidity crunch at the cost of increasing medium term moral hazard related expectations of bail-out of reckless investors.

Update on Collateral:

I am being told that the Fed accepted three types of securities in these repos: safe Treasuries, agency (GSEs) debt and mortgage backed securities (MBS) guaranteed by Fannie and Freddie. These latter are not subject to credit risk given the guarantee; but can still technically default if the underlying assets are impaired. Still, there are still anomalies in this use of guaranteed MBS in repos: the rate at which the Fed accepted these MBS was apparently the same as the rate at which it acccepted safer Treasuries and Agency debt. This, in turn, implied that mostly MBS were offered and used in the repos; especially on Friday all submitted and accepted securities were MBS and in the last intervention the average rates on this MBS repos was below the Fed Funds rate. Even today about half of the accepted collateral was MBS. See Kevin Drum for more details.

Comments

Nouriel, with all due respect, you can preach or point out a "moral hazard" environment all you'de like but with the entitlement posture taken by both wall street and the body politic, this will NEVER change. They are supposed to watch over the system and maintain a fair market place yet they avoid rules and regulations and lever up irresponsibly becuase tehy know they have the "good 'ol boy's club" watching their backs at the expense of "we the people". It is criminal and the US needs a severe wasshout before this will ever change.

Written by Guest on 2007-08-13 10:58:48

give me a break, you guy talk about moral...??
what's that?

little george

Written by little geroge on 2007-08-13 11:02:48

Today's Fed injections:
"Fed accepts $2.00 bln in repos ... $1.156 were MBS. $52.80
total submitted .. of which $16.95 were MBS. Wtd avg stops
were 5.11% Treasury, 5.23 agency and 5.26% MB"

Written by Anonymous on 2007-08-13 11:02:54

@John Ryskamp,
are you alone?

Written by Guest on 2007-08-13 11:54:54

Free markets ? Hypocrisy.

Written by Guest on 2007-08-13 11:57:56

Well these injections may rescue Wall Street and the big financial companies, but they won't stop the little guy losing his house. Or ordinary people seeing their pensions reduced, eventually. As usual the government takes care of the rich and lets the poor fend for themselves.

Written by Guest on 2007-08-13 12:19:52

Professor Roubini, I hope the Fed reads your blog... This was similar to giving a filling to a great white shark to ease his pain. In the simplest of terms in my amateur view a loan was given by a bank secured by an asset. If we only look at this single loan and realize the asset against it is declining and likely will decline substantially, the borrower defaults, the bank eats the difference between the loan and the asset.
This is without the 21st century financial engineering, branding, marketing and world wide distribution of the credit in its various derivations. Someone here pointed out countrywide's CEO exercised a large number of options recently which the poster suspected may subject him to litigation. You could argue it was a jail trade in other words, worth getting the cash and potentially doing time. There will undoubtedly be failures and who is the most likely to fail ? Gee, how about the biggest "countrywide" player in the largest bubble in real estate history. I hope there are wise players involved in sorting this mess out who view this situation realistically and logically against historical benchmarks for bubbles unwinding. In an interview years ago by the WSJ of the late Charles Kindelberger (Manias, Panics and Crashes) he said if he had time he would write another book about Fannie and Freddie – hint they ultimately IMHO are part of the problem and not as some of their paid supporters in Washington like to say are the solution. Someone somewhere needs to study up and get REAL on the long term solutions to this mess...
Going forward, over the counter derivatives should be banned world wide. There are plenty of exchanges in the world which would happily list EVERYTHING. What do you get when you do this ? liquidity and financial accuracy / reality - crazy idea isn't it ?

Written by JMa on 2007-08-13 12:48:11

Well there you go, banks have no fear other than Mortgage:

2:00Majority of banks leave commercial loan standards unchanged
2:00Bank willingness to make consumer loans unchanged: Fed
2:00Banks tighten mortgage standards again: Fed survey

Written by Guest on 2007-08-13 13:04:23

With Treasury rates falling lower, a partial buffer is created against widended credit spreads; traditionally attracted long-term investors such as China and Japan have lost their willigness to finance American debt; but can they become the new lender of last resort? Definitely not if low quality assets are used as collateral agaiinst these loans; but if the Fed discount rate increased...is it possible that their willingness to provide liquidity will increase? If this highly unlikely event did occur, it would be a paradigmatic shift in global supremacy. Or is it possible that Asian countries with excessive foreign exchange reserves come together to form an IMF like institution; which will therefore be used to balance growth in the West?

Written by AKS on 2007-08-13 13:08:42

There are at least two possible reasons for further Fed liquidity today (maybe more):

1) Over the weekend the SEC did a rush audit of the major Wall St banks to check on real holdings of subprime mortages. If some holdings had not been declared, then the Fed would see further possible risk. Hence more liquidity. This would be a sign that the large banks are still not being completely open or transparent about their risks.

2) It's possible the SEC (and Fed) are checking more than just bad loans. They may be trying to get a "quick look" at possible collateral risks in the swap market i.e. how likely is it that bad deals in the credit swap market could put the big banks at risk? If they perceive systemic risk of this sort, they might also pump more liquidity into the system.

Guest said: "As usual the government takes care of the rich and lets the poor fend for themselves. "

Yeah. Funny how the small investors don't get much concern here. Reminds me of an old saying attributed to Anatole France ...

"The law, in its majestic equality, forbids rich and poor alike to sleep under bridges, beg in the streets or steal bread."

Pete, CA

Written by Guest on 2007-08-13 13:14:51

Nouriel –

As you’ve pointed out the Fed’s (and the ECB’s) liquidity injections (now with MBS’s) only postpone the growing insolvency situation. The U.S. consumer is as Atlas holding up the world. (While developing countries [and Japan] have done a great job in building up their export capability, their nation building hasn’t progressed nearly so far relative to indigenous demand.)

However, while largely shoring up the world’s economy through his demand, said U.S. consumer doing so while standing upon his not so stable house.

We’ve seen the subprime house borrower coming under the gun in a big way. We’re told that although some Alt-A borrowers (no docs, but acceptable credit ratings) are experiencing difficulties, yet the bulk of home borrowers are in good shape.

This real estate thing seems to be unfolding into a true recession in a very drawn out manner. It’s true that home demand is down roughly one-fourth, year over year, but housing prices are only down a few percentage points. This is not only from less-believable NAR data, but also from more unbiased reputable sources as Case-Shiller and New England’s Warren Group. (OFHEO data only covers medium and less expensive homes.)

I believe that house prices have to fall by double-digit percentages, before we see the real GDP anguish that you’ve been alluding to. I keep thinking that in this environment of the excessively mortgaged and otherwise (increasingly credit card) indebted homeowners it’s got to happen sooner than later.

But as we're all finding out, timing is everything in forecasting.