The Bernanke put

by John Q on August 18, 2007

The US Federal Reserve has stepped in to bail out the financial sector, cutting its discount rate and, more importantly, encouraging banks to borrow directly from the Fed to finance mortgage lending. This action demonstrates that the famous “Greenspan put” has survived, and is now the Bernanke put.

A “put” in finance jargon is an option to sell an asset to to the issuer of the option at a “strike price”, typically selected to protect the holder of the put against disastrous loss. The put is exercised only when the market price falls below the strike price. Credit markets provide a range of put options for assets including equities, bonds and so on. From the viewpoint of financial market participants, the great thing about the Bernanke put is that it’s free. The masters of the financial universe can make bilions betting that things will go right. If things go wrong, the Fed is there to pick up the tab.

Of course, things have to go wrong in a bad enough way to threaten the stability of the financial system as a whole, and yesterday’s rescue shows what that means. The fact that a large proportion of subprime mortgages were going to go bad, with at least a million families losing their homes, 100 000 workers losing their jobs and so on was known months ago. The big news of the last few weeks is that the losses won’t be confined to this group, but extend to hedge funds, issuers of commercial paper and so on. Another group facing problems were homebuyers seeking mortgages too big to be covered by the quasi-official loan guarantee corporations, cutely called Fannie Mae and Freddie Mac. These ‘jumbo’ loans (over about $400 000) have become very hard to get and will now be effectively guaranteed by the Fed.

So, the Bernanke put is great for Goldman Sachs and JP Morgan and good for high-income homebuyers. But it won’t do any good for the low-income, poor-credit households who lined up for subprime loans. In fact, they represent the first line of defence for the financial system, made more effective by the Bankruptcy Reform Act of 2005, which has closed off this option for many.

It’s hard to criticise Bernanke for the choices he’s made, given the way the system works. On the other hand, it’s equally hard to see why we as a society are rewarding the financial sector so richly for an activity which involves little risk and big payoffs, whether decisions are good or bad.



Tim Worstall 08.18.07 at 8:48 am

A rather far fetched worry perhaps, but this is reminding me a little bit of what happened with the S&Ls back in the late 70s early 80s. The Federal guarantee on deposits (as with now, the implied guarantee provided by the two FMs) was raised from $40k (or was it 60? Bad, bad, middle aged memory) to 100k and the limits on what S&Ls could invest in were lifted.
The net effect of this was to make something that was manageable, if expensive, into something grossly expensive and requiring the creation of the Resolution Trust.
I wonder who is going to be remembered as the Fernand St. Germain of this time?


Walt 08.18.07 at 1:38 pm

I’m pretty sure it was 40k. Didn’t Resolution Trust bail out accounts for the full amount, not just up to 100k, though?


Martin Bento 08.18.07 at 2:54 pm

What are the arguments against returning to the system in place before the Reagan deregulation: Fannie and Freddie, or entities much like them, are government agencies and function to guarantee primary residence loans, much as student loans are guaranteed? After all, it’s just been proven that the government guarantees the loans anyway, but under the current system the borrower does not get the benefit of that ameliorated risk as it does not officially exist. The ameliorated risk itself is a good idea to protect the system from catestrophic failure, but, since the taxpayers are ultimately paying for this sort of insurance, the benefits should go to the general public, not the big financiers.


Francis 08.18.07 at 3:26 pm

For us non-economists, perhaps this post could be clarified a little.

How is it the case that lowering the discount rate is going to prevent the slaughter that will occur?

a. Housing prices in SoCal need to fall by about 40% or more to bring regional prices in line with regional wages.

b. Everyone who got a mortgage based on rising house prices is going to default.

c. None of these people have assets worth chasing, and California has laws against that anyway.

d. So there is literally nothing that can be done to save the various financial instruments that relied on borrowed money to purchase slices of these loans. The lenders will not be getting repaid and the equity positions will be extinguished.

e. There is a lot (can anyone quantify?) of leverage in the market for mortgage backed securities.

f. There’s a lot of uncertainty too, as no one can figure out which securities are going to default.

g. Back in the actual housing market, volumes are plummeting. Only people at the top end of the market, who qualify for standard 80/20 fixed rate loans, are buying.

So we’re facing a ton of misery among the middle to lower-middle income buyers of the last few years who cannot afford their houses and will have to lose them. And misery among the ultra-wealthy whose investments in MBSs are going to get wiped out. And misery in the home builder community who are facing tremendous losses. And misery among local governments who will see revenue plummet as taxes based on valuation fall.

But I don’t see how lowering the discount rate is going to alleviate any of that. A little help please.

btw, this post was written by a lawyer, not an economist. Corrections and/or expansions of the misery analysis welcome.


Tom T. 08.18.07 at 4:53 pm

Tim W, it’s important to remember the context of the times in which the S&L collapse took place. Interest rates on deposits (i.e., what the S&L’s were paying out) were skyrocketing, but S&L income wasn’t seeing any similar increase, since their investment portfolio was limited to fixed-rate home mortgages issued at the comparatively low interest rates of the previous thirty years (the newest loans featured high interest rates, to be sure, but that was only a small portion of their portfolio). Ultimately, it was that mismatch between regulated income and unregulated expenses that killed the S&Ls.


P O'Neill 08.18.07 at 9:52 pm

I think the way to align the points from #4 with the post is what Krugman was talking about in last column($) — that the principle has to be workouts, not bailouts. There’s a lot of housing in major metropolitan markets that’s under water no matter what the Fed does — barring some feeding of the bubble to provide refinancing to keep houses off the market and support the price, which is not feasible for housing (for cars perhaps it’s another story).

So the framework would be that borrowers get a reduced payment schedule and lenders take a massive haircut. Unless the Fed went all Kudlow and started buying up every mortgage in sight, I don’t see how they can forestall a housing slump. So the issue is whether the default process works well enough to avoid prolonged disruption. One of Krugman’s questions illustrates the problem — who are the borrowers supposed to negotiate with?


Barry 08.18.07 at 10:20 pm

Tim, adding on here. What killed the S&L’s was the 1973-8X inflation. They had loaned out money ~5% for 20 and 30 year mortgages, but their deposits were subject to withdrawal upon demand. The changes in caps for accounts shouldn’t have made much difference (one could always put their money in multiple accounts at $40K each).

The changes in allowed investments were (IIRC) a very ill-advised attempt to allow in-the-red S&L’s to work their way out, through higher-risk investments. The idea was the the successes could be charged fees to help with the failures. This ran into the obvious two problems, first that the successes didn’t want to pay the increased fees, and lobbied successfully against them; second, the failures dug themselves in that much more deeply – if they were honest. The dishonest investors (attracted to the newly deregulated S&L’s) sucked huge sums of cash from the system.


John Quiggin 08.18.07 at 11:44 pm

My impression so far is that nothing is going to be done for the borrowers, except in individual cases where they can convince a court that they were deceived in some crucial respect. The same is true for the building industry.

It’s the issuers and holders of commercial paper and CDOs who are being bailed out here.


abb1 08.19.07 at 5:12 am

Could you explain in simple words the mechanism of this bailout, please. I know what a put option is, but I don’t understand how his offer to supply short-term loans to the banks at 0.5% lower interest amounts to giving them a free put option. They still have to return the loans, correct? I understand that it helps them somewhat, but a put option? I mean, sure, it’ll help them survive, but does it offset their losses? How?



Tom T. 08.19.07 at 5:15 am

By the way, how does the Fed’s action amount to a guarantee or a bailout as such? As I understand it, the Fed is lending the banks cheap money to attract new borrowers, but the defaulting loans are still defaulting, right? No one’s guaranteeing those loans in the sense of paying them off (as would happen with defaulting student loans), are they?


Tim Worstall 08.19.07 at 7:29 am

# 5 and 7. Yes, I know. My (slight, I admit) worry is that one of the proposals is to allow Fannie Mae and Freddie Mac to purchase non-conforming loans (jumbos, low deposit, Alt-A etc). It’s that part of it that seems to me to be roughly equivalent to the S&L process: increasing the scope and reach of the (implicit) Federal guarantee.
Which, as we know and you describe above, worked so well last time.


John Quiggin 08.19.07 at 7:39 am

To restate, the losses on subprime loans will lie pretty much where they fall. The borrowers will lose their homes and the holders of the mortgages will eventually bear the losses from the defaults.

The real risk here was and remains that there will be large scale defaults on obligations within the broader financial system. In particular, this can arise because mortgages have been treated as if they are liquid assets, when the underlying asset is certainly not. But there is a much broader class of transaction, including private equity buyouts, premised on low interest rates and a low margin for risk.

The Fed’s action which signals a more general cut in interest rates in the near future is an indication that, in a situation where bets like this look like going seriously wrong, monetary policy will be relaxed to ensure that they come out all right.

It’s a bailout for a couple of reasons. First, the Fed itself is taking on risk with these loans, but isn’t charging a risk premium for them (in fact the reverse). If things keep getting worse, its’ faced with the choice of losing the money its lent or intervening still further. Second, it’s compromising its primary stated objective of controlling inflation – reflected in its decision not to change the federal funds rate only a couple of weeks ago, which, as I said, will almost certainly be reversed.


Joel Turnipseed 08.19.07 at 7:55 am

I realize that this is rather late in the commenting game, but I had a rather involved discussion about this with my mother, who happens to be a mortgage banker (and board member of a number of mortgage associations) this evening, and her input was as follows:

1) Savvy mortgage holders and banks are currently renegotiating notes as short sales/refis so that they don’t have to face the lesser outcomes of foreclosures.

2) We’re in a gray/black period where, because of rapidly increasing restrictions on loan conditions (Minnesota just passed a law, already enacted, in which bankers are fiduciaries of note holders), fewer people are able to take advantage of refinances/short sales.

3) Borrowers and lenders both who have scruples are subject to negative conditions created by those who did not have such…

and so:

4) There’s a kind of race right now between banks and borrowers who have credit to shore up are doing so, while those who have not had either the ethical or financial basis for lending/borrowing are putting pressure on those who would do good (and, by extension, well) are finding it increasingly difficult to do so.

As a result:

5) The greasier speculators (at least here in the midwest) are going to get squeezed tightest and the better of homeowners (at least those not worst off) are going to come out O.K. in this–so long as banks have the credit available to them to restructure their debts & that only so long as the Fed makes funds available to mortgage companies (and secondary security holders) to restructure things on this new basis.

& so:

6) It’s possible that the current mortgage market meltdown won’t be a complete disaster–even if too many good people get caught in the crossfire: a number of homeowners will be able to keep their homes, a number of unscrupulous speculators will lose their properties (and their banks their notes), and, when things shake out, a fair number of would-be homeowners or tenuous current homeowners will be able to get into homes/loans on a better basis. But only if (and it’s a big if) the lending and buying markets are liquid/flexible enough to make this happen.

Which is a long way of quoting Douglas Adams: “Don’t Panic!”


abb1 08.19.07 at 8:32 am

…a number of homeowners will be able to keep their homes…

That sounds real encouraging.


derrida derider 08.19.07 at 1:02 pm

I’m no monetary economist, but I always understood the cardinal rule for a lender of last resort in a crisis was “lend freely but lend dear” – ie stem the crisis but minimise moral hazard by making sure that it costs private lenders some future profit. Dropping the rediscount rate doesn’t seem to fit that at all.

Based on past episodes (notably the sequence of events on 1987-89) surely printing money like this risks having to jam on the monetary brakes exceedingly tight later. It all seems a funny way to try and resolve the long-building domestic imbalances (for which Greenspan must bear most of the responsibility). But then I admit it’s not my area of expertise.


john c. halasz 08.19.07 at 10:16 pm

I’d tend to disagree that it’s quite clear that a “Bernanke put” has been issued with the discount rate cut. The problem that it seems to most immediately address is the seize-up of the asset-back commercial paper market, (where rates went up 39bp to 5.99% on Friday after the announcement), which has been used by banks to fund their “special investment vehicles” and “conduits”, investing long with leverage in relatively illiquid CDO’s by repeatedly borrowing short-term. The really significant change was not the .5% cut, but the 30 day term and indefinite term for roll-overs, which amounts to a temporary alternative to commercial paper. And, of course, the immediate suspicion was that the Fed feared an imminent bank collapse, with Countrywide the obvious perp. (Friday night another German bank was “rescued” with a 17 billion euro bail-out, due to an SIV failure). So I think the Fed move was intended to slow down the liquidity crunch and permit the unwinding of leverage, so that market participants could begin discovery of where all the bodies are buried. That doesn’t necessarily imply an easing of overall interest rates. We’ll have to wait and see. But the Fed is in a bind, since lowering interest rates would likely depreciate the U.S.$, raise inflation, and result in a rise in long-term rates, which move would be self-stultifying. This is only the beginning of the long unwind. Simply comparing staticly nominal proportions of debt segments to the total misses the interactions between different debt segments and the prices of the assets that secure them and the amount of leveraging that has been built-up in the financial system. The successive feed-back loops between nominal asset prices and debt loads will bleed into the “real” economy, and re-enforce the financial difficulties. For the U.S., at least, a stagflationary recession is clearly on the horizon. And the Fed rate in either direction can do little to ameliorate the situation.


David 08.22.07 at 2:48 am

I find the frequent appeal to the S&L fiasco as a comparanda for the subprime mortgage mess mystifying. The various descriptions/recountings above of factors in the S&L adventure seem right to me, but I always come back to the fact that it was the federal guarantee of most deposits (and even deposits above $100K were kept whole in many cases) that was the sticky part of the messy adjustment process — S&L balance sheets were utterly underwater (as were many of the commercial mortgages that were held by the more adventurous S&Ls — see Texas, Arizona, New Mexico, etc –, once the oil price collapse of the mid 80s took effect — this exacerbated the maturity and interest rate mismatch on “normal” S&L assets and liabilities that others have mentioned). Assets repriced — as others have mentioned, slick investors made out like bandits as a somewhat overwhelmed RTC tried to coax some financial return from these distressed assets, with various financial and real estate sharpies on the other side of the market — but from the perspective of the deposit insurer, liabilities did not. That is what constituted the “bail out” — the keeping whole of deposits, which were owned by many sorts of depositors.

The subprime mortgage situation seems utterly different to me — there is nothing comparable to deposit insurance that is keeping the federal government implicitly but fully in the game. Unless there is a shift to a focus on work outs as Krugman recommends, the bail out this time will be of financial investors who willingly and knowingly (if perhaps stupidly) took on risks by making dicey loans or buying up bits of dicey loans.

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