Dead dogs repo

On the heels of yesterday's always entertaining moralizing about the current situation we have a more in depth look at what practical steps are available to policy makers facing a crisis, and a suggestion for a new (somewhat) approach.

"A credit crunch and liquidity squeeze is instead the time for central banks to get their hands dirty..." argues a new article The Central Bank as the Market Maker of last Resort at the excellent Vox EU.

The writers, economists Buiter and Sibert, make a point that where Central Banks were "lenders of last resort" in the old bank-centric credit system, they now ought to be "market makers of last resort" in the new markets based credit system. In particular, they argue that CB's should wade deeply into markets like the current situation with bids and offers to all market participants, hedge funds and institutional investors included, for the most illiquid securities.

This goes against the grain of previous Central Bank crisis management as a more targeted way of alleviating pressure on the asset based credit system. In effect where prior interventions sought to lift the tide for all boats, benefiting the biggest and most seaworthy disproportionately, this approach would target the leaky vessels already taking on water. In light of the Fed's encouragement to banks to repo highly rated mortgage paper in last Friday's injection, raising the issue of how broadly the definition of acceptable collateral may be is a timely point to raise.

The authors go on to say that current practice limiting repo collateral to highly liquid, high quality assets is more tradition than rule. In fact, they state the key Central Banks are legally free to accept almost whatever they may deem acceptable, the subject of a crude attention grabbing headline included. They go further and attribute the blunt instruments of rate cuts and blanket infusions of cash for government debt in prior crises with blame for the drastically distorted credit markets that got us here in the first place.

When it comes to socializing the bad choices of imprudent market participants speculating with other people's money, m* is all for a more targeted approach. (How do we leave out Cramer for example?). However, as described here, the authors posit an understanding of asset valuation that Central Banks are simply unprepared and ill-equipped to manage. More practical perhaps, is an "orchestrated" bailout where larger institutions join together to underwrite a consortium that bids for distressed assets en masse and at a discount before serious due diligence can take place. With prime brokers able to force the sale of these "assets" (to themselves in effect) this is highly possible.

Otherwise, as Tim Bond of Barclays writes in a recent piece on the Central Bank policy debate,"The Money Post," the complexity of the assets in question and the discrediting of the analysis underpinning them is likely to ensure that a secondary market forms only slowly as the mortgages underlying them season, dragging out the de-levering process, and turning a series of Central Bank substitutions of liquidity into permanent additions of liquidity. That is of course inflationary any way one looks at it and is least of what Central Banks need right now.