"Regardless of the accounting, here's how those losses will show up in practice. When the Treasury auctioned the T-bills for the increase in its supplementary and general accounts with the Fed, and when the Fed sold off its existing holdings of Treasuries, the Treasury started making interest payments to the public. The Fed is also receiving interest on the loans it made, and returns that interest to the Treasury. As long as the loans are performing, it is a wash to the Treasury. But if some of the Fed's loans go bad, it means the Treasury is on the hook for the extra interest costs with no offsetting receipts. In other words, any losses by the Federal Reserve are equivalent to a fiscal expenditure financed by Treasury borrowing."
Here's my comments:
"But if, as argued by John Taylor and John Williams, the spread instead represents compensation for counterparty risk, it doesn't matter how much term lending the Fed does. Its actions would only move that spread to the extent they reduce the counterparty risk itself. The primary consequence of the actions would not be to change the spreads but instead would just shift the risk onto the Federal Reserve's balance sheet."
What worries me is that TARP is also shifting risk, or outright losses, to the treasury, which is why the banks are loathe to lend. They're recapitalizing themselves, or, to put it another way, shifting the losses to the government. Either we'll pay too much for their assets, or the money we get back won't compensate for the losses. Do you have any opinion on this?
Posted by: Don the libertarian Democrat at October 25, 2008 12:47 PM
By the way, excellent post. Please keep it up. It's very helpful.
Posted by: Don the libertarian Democrat at October 25, 2008 12:49 PM
Here's his answer:
"Don, the question of the moment is indeed how much of a loss the Fed will take on these assets. I do not have the answer.
Posted by: JDH at October 26, 2008 07:08 AM"
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