*The New Lombard Street*

by on December 13, 2010 at 5:12 pm in Books, Current Affairs, Economics | Permalink

The subtitle is How the Fed Became the Dealer of Last Resort (home page here) and the author is Perry Mehrling.  The entire book is good but the paydirt comes in the last two chapters, where we are treated to a persuasive and original account of what the crash- and post-crash Fed is all about.

Mehrling tells us that the Fed is now committed to supplying liquidity in money markets through its role as a dealer, on both sides of its balance sheet, and that is a critical shift in the nature of central banking.  He discusses (pp.126-127) how the collateral behind the shadow banking system relied on CDS markets for its pricing.  In Mehrling's account, insurance companies (including AIG) were indirectly serving as dealers of last resort, believing that they held invulnerable positions but nonetheless exposed.  Investment banks, on their side, thought they held matched books but the higher and lower CDO tranches turned out to be less similar than they had been expecting, based on historical price risk.  None of these expectations survived contact with the reality of the crash.

Now it's the central bank which sells AAA protection because eventually, in Mehrling's view, this activity cannot forever remain a private function (for a start, which insurer is itself safer than AAA?).  A good and indeed central question to ask anyone who is proposing a financial system is to ask who will sell AAA insurance.  

To quote Perry, the new Fed principle seems to be: "insure freely but at a high premium."

Mehrling also suggests that looking at the Fed's balance sheet, or its transactions, is misleading.  The key question is what kind of liquidity dealing option the Fed is promising to the market.

I continue to ponder Mehrling's main claims, but in any case this is an important book about the new Fed.

dave December 13, 2010 at 7:31 pm

"insure freely but at a high premium."

where is the high premium part, they give it away for free

Andrew December 14, 2010 at 12:36 am

"where is the high premium part, "

That's where we come in. Since the bankocracy saved the free market, we can't be allowed to just free ride.

Andrew December 14, 2010 at 5:42 am

I know. Let's have the most powerful institution this side of Tatooine change their role and scope without discussion or even recognition. That sounds like a good idea. After all, they are our buddies because they saved the free market with their monetary and regulatory monopoly. There is after all no alternative to a debt-based, fiat-arbitrary economy, so don't bother thinking about that and embrace our monetary overlords.

Tom Grey December 16, 2010 at 1:39 pm

The housing boom was based on inflated AAA ratings, which actually expanded the money supply in ways A ratings didn't — the SEC allowed AAA rated securities to be part of bank's tier 1 capital, thus allowing them to create money and lend more (to other banks and to buy more AAA junk for more MBS for more … housing).

Ratings need to be tied to insurance somehow, if they're going to be used for monetary policy. As they are, currently.

This looks like an advance towards more honest ratings and, for ratings failures, a gov't / Fed response.

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