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The answer is, “everything,” including the most mundane transactions in trade — because everything requires insurance. This from the FT this morning:
The front page of Wednesday’s FT runs with the following story - that the UK government’s forthcoming budget is to include a “supply-chain insurance plan”:
The scheme will form a centrepiece of the Budget initiatives to help small to medium-sized businesses cope with the recession. Its unveiling marks the culmination of months of negotiations with insurers spearheaded by Lord Mandelson, the business secretary.The initiative responds to concerns that hundreds of supply chains are threatened by the recession-fuelled reduction in credit insurance, which protects companies that supply goods on credit against the risk that they will not get paid.
Industry has been lobbying for the government to step in for months. The EEF manufacturers’ organisation warned weeks ago: “The speed at which credit insurance is being withdrawn threatens the supply chains that are the heart of the UK’s manufacturing base.”
Supply-chain insurance is crucial to the functioning of the economy and is really one of those things that has been somewhat ignored in the financial crisis so far, what with all the other credit-linked troubles around.
The point is that forms of credit - trust - are critical to lubricating trade. The collapse of the Baltic Dry Index months ago was the thin end of the wedge: global shipping ground to a halt as participants in the market found themselves unable to secure crucial letters of credit from banks and commodity brokers that mitigated counterparty risk.
In fact, as with so much in this crisis, much of the recent ructions in trade credit can be traced back to the activities of very small specialist units at financial sector firms. In the case of trade credit and surety, the activities of the reinsurers are crucial. And the reinsurers are pulling back.
FT Alphaville understands that Swiss Re has cut 45 of 65 jobs in its credit and reinsurance department, with a view, we believe to quitting the trade credit insurance and surety bond reinsurance sector entirely by year end.
Swiss Re confirmed to FT Alphaville that activities are being reduced but precise numbers could not be confirmed. “We will continue to accommodate the needs of key core multi-line clients” a spokesman for the company said.
The numbers might seem small, but such re departments are of huge importance.
Much like the way AIG FP functioned, trade credit and surety reinsurance operations write contracts with, effectively (though not necessarily we stress, directly) a huge amount of leverage, based on the notion that such contracts being written are virtually risk free. (Indeed historically the industry was renowned for reinsurance contracts that came with secret confidential ’side letters’, hidden from regulators, promising in legally binding terms that their contracts would never be exercised). Just as AIG’s 650 people were a primary force in the explosive growth of the multi-trillion dollar CDS market, so too are small trade credit and surety reinsurance departments like Swiss Re’s, then, critical for the functioning of trillions of dollars of global trade credit insurance further down the chain.
And while Swiss Re is not the largest reinsurance player in the trade credit space, it’s pullback is nonetheless instructive. It seems representative of a broader trend - one that has the potential to be so damaging that the UK government is forced to make filling the vacuum in the trade credit space a centrepiece of its upcoming historic budget.
Indeed, brokers, trade credit insurers and surety bond companies are all understood to be very worried about the declining availability of reinsurance - which is critical to their own ability to continue to operate effectively. The government’s move should hopefully do something to fill the vacuum - but until details about what price, terms and conditions new reinsurance - government sponsored or otherwise - are available, trade insurers and indeed trade full stop will continue to languish.
Of course it was a pyramid scheme: of course the insurers who allow a load of kasha to get from Minsk to Pinsk should not have owned the bottom of the banks’ capital structure, and so forth. No-one should have owned bank preferred shares but misers living in caves in the Swiss alps living exclusively on home-grown goats’ milk, so that the vaporization of these securities under nationalization would not even have gone noticed. Bank subordinated debt should have been sold exclusively to the hoards of sleeping dragons who would not hear the crash of the isser thousands of miles away. We know that now. My recommendation is that Larry Summers and Timothy Geithner should be deputized to find sufficient dragons and Swiss misers to place the $135 billion in TARP capital injections to the banks….
…but in the meantime, the only alternative is to allow the banks a zombie existence cannibalizing the “toxic” assets left over from the structuring excesses of the boom."
In 2009 investors will be scanning the globe for signs of economic recovery or deterioration. Among the many tools they should be watching in order to gauge the strength of global trade is the Baltic Dry Index (BDI.) The Baltic Dry Index measures shipping rates for dry bulk carriers that carry commodities such as coal, iron and other ores, cocoa, grains, phosphates, fertilizers, animal feeds, etc. In short, the BDI is an excellent proxy for global trade.
In the chart below, note how the BDI peaked after the S&P 500 index did in 2007 and bottomed after the SPX last month. The BDI may not be a leading indicator, but it is an important way to confirm whether moves in global equities are being reflected in an increase in global shipping. If the BDI fails to rally in 2009, be skeptical of any rally in stocks.
For those who are interested in following stocks of some of the leading dry bulk carriers, a good place to start is with Diana Shipping (DSX), DryShips (DRYS), and Excel Maritime Carriers (EXM).
[source: StockCharts]
At the end of October, we released a B.I.G. Tips report to Bespoke Premium members highlighting that globalization was the biggest bubble of them all based on the sharp decline in the Baltic Dry Index. Click the thumbnail image below to view the report.
At the time of the B.I.G. Tips release, the Baltic Dry Index, which measures changes in the cost to transport raw materials, was down 90.26% from its highs earlier in the year. Well, things have gotten much worse even since our 10/23 report. As shown in the chart below, the Baltic Dry Index is now down 94.2% from its highs, which is 40% lower than where it was on 10/23. On May 20th of this year, the Baltic Dry hit 11,793. It currently stands at 684. Talk about deflation -- maybe even call it leveraged deflation.
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2) The rules for LOLR( from here on down this includes any government guarantee ) intervention should be clear, public, and followed, otherwise Moral Hazard is ineffective. All guarantees must be explicit.
3) The terms must be onerous.
"Who can forget the end of "Planet of the Apes" when Charlton Heston, kneeling before the half-buried remains of the Statue of Liberty, slams his fists into the sand and cries, "You maniacs! You blew it up! Ah, damn you ... damn you all to hell!"
Now imagine the same scene, but with a half-buried Morgan Stanley building standing in for Miss Liberty and a time-traveling Walter Bagehot playing the lead and you've got the perfect Hollywood dramatization of the real-life tragedy that, with luck, is having its denouement on Wall Street.
Bagehot? The great Victorian man of letters, best remembered today as the second and most celebrated editor of the British magazine The Economist, wasn't exactly a hunk. But he certainly could have delivered those futile last lines with real conviction, for he was among the first to recognize the vast destructive potential of that newfangled weapon of Victorian finance: the modern central bank.
Bagehot first alerted readers to this potential and offered his suggestions for containing it in an article that appeared in The Economist after the great panic and credit crisis of 1866. That panic witnessed the spectacular collapse of Overend, Gurney & Co., which had long been Great Britain's premier investment house.
Bagehot understood that, during such panics, the Bank of England alone commanded the confidence needed to serve other financial firms as a "lender of last resort." But as Bagehot put it later in his book "Lombard Street: A Description of the Money Market" (1873), the bank's "faltering way" -- its arbitrary and inconsistent use of its unique lending powers -- tended only to make things worse.
"The public," Bagehot wrote, "is never sure what policy will be adopted at the most important moment: it is not sure what amount of advance will be made. ... And until we have on this point a clear understanding with the Bank of England, both our ability to avoid crises and our terror at crises will always be greater than they would otherwise be."
The ultimate source of trouble, Bagehot believed, was the very existence of the Bank of England and the special privileges it enjoyed. But because nothing save a revolution seemed likely to do away with the "Old Lady of Threadneedle Street," as it was called, Bagehot's preferred, practical solution was for the bank expressly to commit itself to lending freely during crises, though on good collateral only, and at "penalty" rates.
The restrictive provisions were supposed to limit aid to otherwise solvent firms panic had rendered illiquid.
Bagehot's recommendation has since become a sort of master precept of central banking -- albeit one that's mainly honored in the breach by central bankers.
To be fair to today's central bankers, there's never been much agreement on how to apply Bagehot's rule in practice. Just what do "good collateral" and "penalty rates" mean in times like these?
While no one might precisely be able to define good collateral -- and one can debate whether the rate at which banks offer to lend unsecured funds to other banks, known as the London Interbank Offered Rate, or LIBOR rate, plus 8 percent constitutes a "penalty" rate -- who even pretends that recent central bank lending has been based on good collateral?
But rescuing insolvent firms is the least of it. The real damage comes from the Treasury's utter lack of any consistent last-resort lending rule. The recently enacted financial institutions bailout bill does little to clarify this.
That's just the sort of thing that troubled Bagehot almost a century and a half ago, when central banks were still in their swaddling clothes. Yet central bankers and governments still don't get it, despite the lip service they pay to this great thinker from our past."
Neither Barack Obama nor John McCain had much of value to say about the financial crisis as it raged through the headlines this fall. Rather than shred their campaign strategies, they played it safe, as most politicians would have. But in the name of justice we ought to recall that there was one candidate who did foresee our predicament with considerable accuracy when it still lay far in the future. Ron Paul, in almost every speech he made during the Republican primaries, spoke of bubbles, reckless credit growth, and the "unsustainability" of present policy. So why isn't there more demand for the common-sense solutions he put forward? Because common sense is not much use in a financial panic. This was the great discovery of Walter Bagehot, the prolific 19th-century essayist and journalist, who was editor of the Economist from 1860 to 1877. (His name rhymes with gadget.) Ninety-nine percent of the time, common sense is a synonym for practicality. But in a serious banking crisis, doing the commonsensical thing--hunkering down and counting your pennies--has proved to be not practical at all. Bagehot's Lombard Street is an insider's look at the Bank of England, and at the principles on which political and financial leaders act when advanced economies come under pressure. Those principles are depressing in the extreme for anyone with an uncomplicated idea of how a democracy works. But they are effective. That is why, in the so-called Anglo-Saxon world, Bagehot's book still provides the bedrock of policy thinking during financial emergencies, including our present one. Lombard Street was published in 1873, seven years after the sudden collapse of Overend, Gurney & Co., a bank that lost £11 million, spread panic among investors, sparked a run, and became "the model instance of all evil in business." The crisis made such a deep impression on British finance and government that the country did not have another bank run for 141 years--not until Northern Rock collapsed in the summer of 2007. (English investors must have longer memories than American ones. Most of our own noxious subprime mortgages were contracted, and the securities built on them concocted, after Enron became our own model instance of evil in 2001.) It was the Bank of England that took charge of averting panic, during the Overend, Gurney crisis and thereafter. It did so by injecting credit into the economy, by bailing people out. Bagehot approved of this. Many ordinary retailers could not pay their suppliers until they got the money for the things they sold. Without credit, they would be ruined, and the ruin would spread to those to whom they owed money. This was not a question of moral failing, it was just the way a modern economy worked. But the modern economic system interacts with the modern political system--democracy--in a rather uncomfortable way. Indeed, at more than one juncture in Lombard Street, Bagehot framed the problem of booms and busts as part of the "increasingly democratic structure of English commerce." People in a democracy are most comfortable when their institutions do the same things that they would do as individuals. In a crisis, banks--like everyone else--reflexively hoard their money. But a central bank must do the opposite. It must lend freely. This was the most basic affront to common sense that the Bank of England presented, but it was not the worst. The worst was that the bank could carry out its necessary duties as a lender of last resort only by breaking the law. The basis of the bank's operating procedure--and of its soundness--was the Bank Act of 1844. We would call it a regime of sound money. It included stringent caps on the ratio of notes issued to reserves held. These caps were hewed to when the economy was running smoothly. Yet at the time Bagehot was writing, a quarter century later, the law had already been suspended three times. Not just that. "No similar occasion has ever yet occurred," Bagehot wrote, "in which it has not been suspended." So the law on which the solvency of the British nation rested was ironclad, except when someone felt a need to break it. Stranger still, never did the Bank of England acknowledge its duty as the lender of last resort. Some of its governors even denied that any such duty existed. Bagehot thought the bank should come clean about what it really was:
But there was a reason for the central bankers' dissembling. If the bank ever acknowledged a duty to rescue banks by generous extensions of credit, it would create a form of moral hazard. Thomson Hankey, a Bank of England director whom Bagehot much admired (and to whom the financial writer James Grant devotes an admiring essay in his new book Mr. Market Miscalculates), called Bagehot's lender-of-last-resort views "the most mischievous doctrine ever broached in the monetary or banking world in this country." In practice, Bagehot was right and Hankey was wrong. The bank was beyond question the lender of last resort. In principle, Hankey was right and Bagehot was wrong. Unless there was a real, credible threat that a bank would be allowed to fail, the guarantee of rescue would simply get priced into any financial bubble that developed, making things worse when the bubble popped. The situation required what we would now call "strategic ambiguity"--both Hankey's doctrine and Bagehot's practice, which contradicts it. The situation today requires the same mix. Central banking is thus often a high-stakes game of chicken. And sometimes, when banks enter the game insufficiently scared, it will be played out to the end. It certainly was in September when the U.S. Treasury terrified the financial world by not coming to the rescue of Lehman Brothers. This was a catastrophe in terms of Bagehot's practice, but it will produce benefits in terms of Hankey's principle. It will discourage people from paying more than is reasonable for assets on the belief that they come equipped with an insurance policy (the promise of a central bank rescue) that has been underwritten by taxpayers. The Republicans who nearly derailed the Treasury's Troubled Assets Relief Program in September played a similar role. A final problem is that there are limits to how accountable a central bank can be. Everyone is always hollering for clear rules and transparency. But a dirty secret of regulation is that it frequently influences conduct most effectively when it is capricious and opaque. Any regulatory system will reveal its vulnerabilities over long use. If it addresses economic problems in a predictable way, savvy investors will find a way to "game" that predictability. You can draw an analogy with antidepressant drugs. There is no permanent right match of medication for a depressive. Antidepressants work only until the mind (or is it the brain?) finds a way around them, at which point a new, unfamiliar drug must be substituted. In the same way, no matter how good the content of a regulatory regime, it must change periodically if big market players are to be kept from profiting off it. As Bagehot outlined his system, he was conscious that the practical realities of banking required him to heap paradox upon paradox. There is a hint of both Andrew Jackson and Thomas Aquinas in the way he referred to central banking as an "unnatural" thing in its very conception. "The business of banking ought to be simple," he wrote. "If it is hard it is wrong." If it is hard, the banker is either delegating poorly or has entangled his institution in complex transactions where it has no business. According to Bagehot, "Adventure is the life of commerce, but caution, I had almost said timidity, is the life of banking." Centralizing a society's cash reserves is complicated, reckless, and artificial:
In his ideas of company size, Bagehot harkened back to the 18th century rather than ahead to our own. To modern eyes, Bagehot is, as a factual matter, simply wrong. The natural tendency under free-market conditions is towards consolidation, and even monopoly. If you want small firms, you must protect them through government--whether this means Teddy Roosevelt-ian trust-busting, French-style subsidies to tobacconists, the EU's hounding of Microsoft, or the NIMBY anti-Wal-Mart campaigns aimed at preserving Mom-and-Pop stores. Bagehot sometimes contradicted himself on this point, noting also that "a large bank always tends to become larger, and a small one tends to become smaller," but his application of the word unnatural to a large central bank was frequent and must be taken as his settled view. It is curious that Bagehot, a contemporary of Marx, came to the opposite (and false) conclusion about how firms evolve. Where Bagehot would agree with Marx is in his belief that there is something predictably destabilizing about modern economies. You don't need banks to have a precarious economy, or one liable to speculation--Bagehot noted that there were no banks, as we would understand them, in 1720, at the time of the South Sea Bubble and the Mississippi Scheme. But modern banking is precarious by design. "In exact proportion to the power of this system is its delicacy," he wrote. "I should hardly say too much if I said its danger." The power, delicacy, and danger all have the same source. In fact they are just different names for the same thing: leverage. At the very opening of the book, Bagehot illustrates with exquisite simplicity how, at least in a boom economy, traders on margin can "harass and press upon, if they do not eradicate, the old capitalist." The old capitalist in question is the poor sap who believes all this stuff about neither-a-borrower-nor-a-lender-be and is foolish enough to be using his own cash:
Later, Bagehot showed that this need for leverage is no different for those selling money than it is for those selling dry goods. The banker can no more choose not to lend than the merchant can choose not to borrow:
In finance, once you can have leverage, you must have leverage. Once you have some leverage, getting more of it than your competitors is a matter of survival. And when governments and central banks debate whether to loosen or tighten up money, they face a constant clamor from the financial world to permit more leverage still. That is why, even in democracies, the instruments of monetary policy tend to be kept far from the influence of voters, and even hidden from view. Otherwise, credit tends to spiral. Bubbles result. Nothing could be more foolish than to assume that this process of spiraling speculation is unleashed by "greed," unless by greed you mean human nature. Credit spirals are a darker aspect of the world Adam Smith described in The Wealth of Nations and Bernard de Mandeville did in the Fable of the Bees. Just as society can be improved by the uncoordinated action of the selfishly motivated, an economy can collapse for reasons having nothing to do with anybody's cupidity. We should be moral in the way we think about money, but a credit system tends to make a mess of moral accounting. Bagehot described London's financial district as "a sort of standing broker between quiet saving districts of the country and the active employing districts." Decent, puritanical Suffolk farmers want to put their money in a safe place; Lancashire entrepreneurs want money to put to work. Thanks to London bankers, both can follow their wishes and make a profit in the process. We have an idea that the Suffolk dairyman is the "moral" party here (he's saving) and the Lancashire speculator the "immoral" one (he's gambling). But, once a banking system intervenes, they are both gambling and they are both saving. In good times you are welcome to mouth the folkloric cliché that holds farmers to be better people than financiers. When depression looms, you had better realize that the rain falls on the just and the unjust. Many Americans who have wound up underwater on their houses and maxed out on their credit cards are greedy, climbing, brand-intoxicated, materialistic shopaholics who thought the world owed them a living. But just as many of them are not. They are trapped, as surely as financial institutions are, in a system based on wild borrowing. Participation in this system is not exactly required, but it is not exactly optional, either. One's quality of life is determined not just by one's purchasing power but also by one's relative economic standing. Chagrin at seeing one's neighbors get richer faster may be a sign of bad character, but do not for a minute assume there is nothing to feel chagrin about! When it comes to the very goods people deem most essential--the proper mate; the schooling of one's children; the size, location, elegance, and comfort of one's house--relative standing is more important than absolute wealth. Those who kept their money in savings banks in the 1990s lost out to those who did things we are supposed to disapprove of, like "spending money they didn't have," borrowing profligately to invest in stocks and even bonds, which appreciated at an average of 15 percent a year over the decade. Among rich people, how one entered the present decade had more to do with how one had done in the stock market than with how one had done in the labor market. Is that just? Of course it's not! It's easy to see now. But while the boom was going on there was all sorts of rationalizing about why it was okay that the social hierarchy should be reordered through stock and housing speculation. One line of argument was that people who did not have a ton of money in stocks, as well as those who rented rather than bought the houses they lived in, were foolish. This line of argument peaked at the turn of the decade, when Americans elected a president who had argued that the public was foolish for not launching its retirement savings onto the open seas of the stock market. Bagehot saw that a speculative mania eventually sweeps up everyone in its path. "Every great crisis reveals the excessive speculations of many houses which no one before suspected," he wrote, "and which commonly indeed had not begun or had not carried very far those speculations, till they were tempted by the daily rise of price and the surrounding fever." Avaricious people get hurt, but it is in the nature of crashes that they are not the ones who get hurt most. A tragic figure present in almost every historic account of speculation and collapse in history is the person who believed, year after year, that the boom was an illusion, and held himself aloof until, at the very last minute, whether out of self-doubt or deference to the opinions of his fellow man, he entered the fray and was (having bought at the top, rather than the bottom, of the market) wiped out. What a wicked irony! His punishment is as much for his long and wise forbearance as for his momentary weakness. So the "cultural contradictions of capitalism" run deeper than we thought. The classic idea, as laid out in their different ways by the economist Joseph Schumpeter and the sociologist Daniel Bell, is that capitalism rewards diligence; diligence produces wealth; wealth begets idleness; and idleness undermines capitalism. But when, as now, push comes to shove, we can ask whether there is really anything particularly capitalist about the virtues of diligence and self-restraint. The real capitalist virtues appear to be optimism and luck. From a central-banking perspective, the cultural contradictions are not results of capitalism but elements of it. The problem with central banking is that it reacts to a system that has been mismanaged by rewarding the managers. That is why objections to central banking, although they can come from the right (Ron Paul, Jim Bunning) or the left (Barney Frank, William Greider), tend to be populist. Bagehot was no populist. He was comfortable with the idea that what some people think should be more important than what other people think:
Although he would surely fault Treasury Secretary Hank Paulson for many things, the criticism most often heard at present--that Paulson is too close to former colleagues on Wall Street, where he worked for years as CEO of Goldman Sachs--would strike Bagehot as misplaced. Because it is on Wall Street, alas, that "the state of credit" is to be determined:
To be blunt, credit is successfully reestablished when financial elites say, "When." Credit is close to a synonym for the mood of the ruling class. To say an economy is based on credit is to say it is based on animal mysteries. Glamour, prestige, élan, sprezzatura, cutting a figure . . . that is what the economy is made of. It is a rather terrifying thought. Viewed as Bagehot viewed it, from the perspective of a central bank in a crisis, an advanced economy looks an awful lot like a primitive economy." |
"Loyal readers, please take a moment to check out Gretchen Morgenson’s column this week. She’s taken a close look at the buyout of Bear Stearns organized by the Federal Reserve, and she has come to an intriguing conclusion: that the Fed not only wanted to prevent financial havoc - it also wanted to deter speculators who were betting on big banks to fail.
Adherents of the Walter Bagehot school of central banking - and I have been among them at times - have cried foul at the sight of big bailouts and the granting of emergency credit at low interest rates. The Bagehot argument is that emergencies that arise from the risks that banks have chosen to take should not be treated with overwhelming sympathy. Emergency credit should be offered, yes, but at rates that will make banks think twice about using the safety net again. That’s not the case this time around (neither in the United States nor in Britain, and probably not in Europe either by the time the folks in Brussels are finished), so the central banks may be telling financial institutions that they can take silly risks without fear of disaster.
But if Morgenson is right, there is a long-term purpose here, too: to reduce the winnings of those who bet on failure, and thus to reduce the incentives to bring that failure to pass. And let’s face it, the speculators aren’t operating in a vacuum; their bets can start to snowball with market sentiment, as they did against Lehman Brothers last week. Still, the Bagehot argument (often called moral hazard) is also a powerful one - which one do you agree with?"
Federal Reserve Chairman Ben Bernanke, who has read his Bagehot and kept a copy in his Princeton office when he was a professor, responded to recent developments first by pumping money into the markets through the New York Fed’s open-market operations and then last week by easing the terms on loans to banks from the Fed’s discount window.
Bagehot (pictured at right) still makes for good reading at times like this.
“What is wanted and what is necessary to stop a panic is to diffuse the impression, that though money may be dear, still money is to be had. If people could be really convinced that they could have money if they wait a day or two, and that utter ruin is not coming, most likely they would cease to run in such a mad way for money. Either shut the Bank at once, and say it will not lend more than it commonly lends, or lend freely, boldly, and so that the public may feel you mean to go on lending. To lend a great deal, and yet not give the public confidence that you will lend sufficiently and effectually, is the worst of all policies; but it is the policy now pursued.”
Robert Feldman, Morgan Stanley’s chief economist for Japan, writes in a note today that it’s key to distinguish between internal discredit — private domestic lenders retreating — and external discredit, which Bagehot defined as a foreign drain on a bank’s money. (Bagehot’s solution to the problem of external discredit is to still lend freely but “at very high rates.”) That doesn’t apply in today’s floating rate system, Feldman says, and exchange rates don’t provide a good substitute, with the dollar’s drop against the yen suggesting we have external discredit while the strengthening against the euro saying we don’t.
Feldman writes: “My view is that the modern counterpart of ‘external discredit’ is moral hazard. The credit of the U.S. IS a problem, since no one knows how big the subprime and related housing market problems really are. Given how poorly banks know their clients, the ‘high rates’ part should come into play. There is no way to re-establish confidence unless those who have made loans to questionable borrowers pay a price for rash lending. Only then will markets regain confidence that risk is under control.
“The next stage of the credit problem — and whether it affects the real economy seriously — depend on eliminating the moral hazard,” Feldman says. “The faster the moral hazard in eliminated, the less impact on the real economy.”
Fed officials are acutely aware of the moral hazard, having resisted action for weeks to not be seen as bailing out risky investments. But they also don’t want a crisis to feed on itself. The Fed stressed its statement, in lowering the discount rate for banks, that it would accept “a broad range of collateral…including home mortgages and related assets.” The central bank sought to reassure a market that had been roiled by risky investments in subprime mortgages.
That’s how the Bank of England halted a panic in 1825, as Bagehot recounts: “A panic, in a word, is a species of neuralgia, and according to the rules of science you must not starve it. The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to ‘this man and that man,’ whenever the security is good. In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them. The way in which the panic of 1825 was stopped by advancing money has been described in so broad and graphic a way that the passage has become classical. ‘We lent it,’ said Mr. Harman, on behalf of the Bank of England, ‘by every possible means and in modes we had never adopted before; we took in stock on security, we purchased Exchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on the deposit of bills of exchange to an immense amount, in short, by every possible means consistent with the safety of the Bank, and we were not on some occasions over-nice. Seeing the dreadful state in which the public were, we rendered every assistance in our power.’ After a day or two of this treatment, the entire panic subsided, and the ‘City’ was quite calm.”
"Bagehot advocated in 1873 that a Lender of Last Resort in a crisis should lend at a penalty rate to solvent but illiquid banks that have adequate collateral. The doctrine has been criticised as having no place in our modern interbank market, but this is wrong. Bagehot’s prescription aims to eliminate the coordination problem of investors at the base of the crisis. It is still a useful guide for action when the interbank market stalls.1 It makes clear that discount-window lending to entities in need may be necessary in a crisis.
Bagehot's doctrine, however, is easy to state and hard to apply. It requires the central bank to distinguish between institutions that are insolvent and those that are merely illiquid. It also requires them to assess the collateral offered. Central banks, because of information limitations, are bound to make mistakes, losing face and money in the process. This doesn’t mean they should not try.
Poor collateral versus massive liquidity
The collateral should be valued under “normal circumstances”, that is, in a situation where the coordination failure of investors does not occur. This involves a judgment call in which the central bank values the illiquid assets. A central bank that only takes high quality collateral will be safe, but will have to inject much more liquidity and/or set lower interest rates to stabilise the market. This may fuel future speculative behavior. Some of this may have happened in the Greenspan era, in the aftermath of the crisis in Russia and LTCM, and after the crash of the technological bubble. The ECB and the Federal Reserve have accepted now partially illiquid collateral that the market would not. This seems appropriate and releases pressure to lower interest rates to solve the problem, something that should be done only if there are signs of deterioration in the real economy. The problem is that central banks are extending the lender of last resort facility outside the realm of traditional banks to entities, like Bear Stearns, that they do not supervise and, therefore, over which they do not have first hand information. How does the Fed know whether Bear Stearns or other similar institutions are solvent? It seems that the Fed is not following Bagehot’s doctrine here.
Finally, if banks and investors are bailed out now, why should they be careful next time? This is the moral hazard problem: help to the market that is optimal once the crisis starts has perverse effects in the incentives of market players at the investment stage. The issue is that only when the moral hazard problem is moderate does it pay to eliminate completely the coordination failure of investors with central bank help. When the moral hazard problem is severe, a certain degree of coordination failure of investors - that is, allowing some crises - is optimal to maintain discipline when investing and, amending Bagehot, some barely solvent institutions should not be helped."
To repeat Bagehot's Rule: "very large (domestic) loans at very high rates are the best remedy for the worst malady of the money market when a foreign drain is added to a domestic drain." The Fed, and the U.S. government more generally, have so far got it only half right."
http://findarticles.com/p/articles/mi_m2751/is_56/ai_55015114/pg_6"In a number of recent blog contributions, we have sketched the role of a modern central bank as ‘market maker of last resort’ (MMLR). This MMLR is the analogue, in a world where intermediation is increasingly through financial markets, to Bagehot’s lender of last resort (LOLR) in a world where most intermediation took place through banks (see e.g. Willem H. Buiter and Anne C. Sibert “The Central Bank as the Market Maker of last Resort: From lender of last resort to market maker of last resort"; Willem H. Buiter “Central banks as market makers of last resort, again”; Willem H. Buiter and Anne C. Sibert “A missed opportunity for the Fed”).
The market maker of last resort function can be fulfilled in two ways. First, the central bank can make outright purchases and sales of a wider range of securities than they currently do. Second, central banks can accept a wider range of securities as collateral in repos, and in collateralised loans and advances at the discount window than they currently do. Following Bagehot’s rule, the MMLR should buy these securities outright or accept them as collateral only on terms that would imply a stiff financial penalty to the owner. The central bank of course already applies a liquidity ‘haircut’ even to liquid instruments offered as collateral in repos or at the discount window. Because the MMLR would have to establish a buying price ‘in the dark’, that is, unaided by recent relevant market prices, and would inevitably take on much more credit risk than central banks have become accustomed to, the ‘haircuts’ should be severe – a financial version of ‘short back and sides’.I doubt a week has gone by since last summer during which I haven't seen some pundit or other trot out Walter Bagehot's dictum that in the event of a credit crunch, the central bank should lend freely at a penalty rate. More often than not, this is contrasted with the actions of the Federal Reserve, which seems to be lending freely at very low interest rates.
Ben Bernanke, in a speech today, addressed this criticism directly:
What are the terms at which the central bank should lend freely? Bagehot argues that "these loans should only be made at a very high rate of interest". Some modern commentators have rationalized Bagehot's dictum to lend at a high or "penalty" rate as a way to mitigate moral hazard--that is, to help maintain incentives for private-sector banks to provide for adequate liquidity in advance of any crisis. I will return to the issue of moral hazard later. But it is worth pointing out briefly that, in fact, the risk of moral hazard did not appear to be Bagehot's principal motivation for recommending a high rate; rather, he saw it as a tool to dissuade unnecessary borrowing and thus to help protect the Bank of England's own finite store of liquid assets. Today, potential limitations on the central bank's lending capacity are not nearly so pressing an issue as in Bagehot's time, when the central bank's ability to provide liquidity was far more tenuous.
I'm no expert on Walter Bagehot, and in fact I admit I've never read Lombard Street. But I'll trust in Bernanke as an economic historian on this one, unless and until someone else makes a persuasive case that Bagehot's penalty rate really was designed to punish the feckless rather than just to preserve the Bank of England's limited liquidity."
"So, we have, what I will call "Grant's Graham For Investing":
1) Decent Size
2) Current Assets Exceed Liabilities By Two Times
3) 10 Continuous Years Of Profit
4) 20 Continuous Years Of Dividends
5) 10 Years Of Earnings Growth Exceeding 33%
6) Price To Earnings Ratio Less Than 15
7 ) Price To Book Ratio Less Than 1.5"The Government will succumb and will lend taxpayers' money to non-financial companies.
In a way, there's no choice, because we'll be hobbled for years as an economy if our few remaining manufacturers and exporters are wiped out."
"Trader's Narrative's Due Diligence":
"The process of investigation undertaken by an party to gather material information on actual or potential risks involved in a financial transaction or relationship."
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