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Central Banks to Buy Junk Mortgages...or Not

March 23, 2008
On Friday, the Financial Times reported Central Banks Float Rescue Ideas. The article states that central banks are considering plans involving the purchase of worthless or nearly worthless mortgage-backed securities from banks. Shortly afterwards, Reuters reported Bank of England denies mortgage purchase plan. The FT writes,
Such a move would involve the use of public funds to shore up the market in a key financial instrument and restore confidence by ending the current vicious circle of forced sales, falling prices, and weakening balance sheets. The conversations, part of a broader exchange as to possible future steps in battling financial turmoil, are at an early stage. However, that such a move is being discussed at all indicates the depth of concern that exists over the health of the banking system. It shows how far the policy debate has shifted in recent weeks as the crisis has spread to prime mortgage assets in the US and engulfed Bear Stearns, the investment bank.
Sun 5pm PST, this just in: Economist Forecasts Central Bank Action
Central banks and governments in advanced economies will be forced to buy mortgage-backed securities within the next few months to stop the credit crisis, according to a former chief economist of the European Bank for Reconstruction and Development. "Central banks will be managers for years to come of rather interesting portfolios," predicted Professor Willem Buiter of the London School of Economics, as the Federal Reserve and the Bank of England sought to play down conversations officials have had regarding purchases of mortgage-related assets. The Financial Times reported on Saturday that conversations had taken place concerning such plans, as part of a broader, early-stage exchange as to possible future steps in battling financial turmoil.
But why does falling asset prices constitute a "vicious circle"? Do falling prices of cars, computers, or airline tickets constitute a problem? What's wrong with someone getting a good deal? For the holders of assets, yes, but if you are an investor (such as Warren Buffett) looking to buy assets cheaply, falling asset prices are an opportunity. If some institutions who have excessively leveraged themselves become insolvent, the underlying real factors continue to exist. The financial assets are only paper claims to real things (or in some cases paper claims to nothing). If the banks that holding paper assets goes bankrupt, society as a whole has no fewer productive factors. Only the ownership of these assets changes. How could this lead to destructive macro-economic effects? The reason is that the same institutions that buy the assets create the money with which to purchase them, out of nothing, a process that Charles Holt Carroll called the organization of debt into currency. As Carroll perceptively wrote in the late 1800s:
When the creditors demand their money, its debtors are called upon to pay money the bank never loaned, never had to loan, and necessarily has not on hand to meet is running demand liabilities: then comes the crisis that many writers call a "panic." It is such a panic as the wasted sufferer feels whose lungs are losing their power of inflation; it is no panic; it is the inevitable crisis of death.
When loans that were made out of fictitious currency default, the money that created the loan is destroyed. When the supply of money contracts (deflation), there is downward pressure on all prices, including the prices of other assets, and on the incomes of the underlying entities that create the ability to pay back other debts. There is a tendency, then, for the contagion to spread from bank to bank as debt defaults destroy money, and money destruction causes more debt defaults. That is why the unraveling of the credit bubble threatens to bring down the entire financial system. As Carroll wrote:
Contraction may begin it, but the positive and negative poles of the scheme will very soon change places. When bank accommodation fails, bankruptcy comes into play, soon takes the lead, and one tumbler here and there knocks down a whole line, until the securities, against which the deposits stand, fall, and the deposits with them. Banks being pressed with their notes must redeem them, and avail themselves of their securities in the hands of the Comptroller to purchase greenbacks or specie.
and
But when any such scheme shall be put in operation, its two forces or elements, so to speak, will immediately change places. It will not long be the contraction of the currency that will cause the bankruptcy, but the bankruptcy that will contract the currency.

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