naked capitalism

Criminals try to ‘copyright’ malware PhysOrg

Next decade ‘may see no warming’ BBC

Nuclear’s CO2 cost ‘will climb’ BBC

Where Are They? Why I hope the search for extraterrestrial life finds nothing MIT Technology Review

Pricing power:
signal versus noise Tim Price

McCain’s Health Care Plan: Why It’s Another Dumb Idea Robert Reich

Republicans Plan a Giveaway: for the Wealthy ataxingmatter

The Slippery Slide Towards Insolvency Michael Panzner

Borders still matter; “the world isn’t as flat as it used to be” Brad Setser

Antidote du jour:

When the Fed’s innovation, the Term Auction Facility, which is in effect an improved discount window, was implemented last December, its size was $40 billion, which was considered extraordinary, a sign of how desperation conditions in the money markets were. Now that several increased put the facility is $100 billion, the banking community and the press treat the idea that it might need to be enlarged yet again as something comparatively routine, rather than a sign that banks are still under serious stress despite concerted measures by central banks,

Yet again, the Fed is acting out the cliche, “if all you have is a hammer, every problem looks like a nail.” Central banks know how to deal with liquidity crises; the TAF and its other facilities are well suited for that sort of problem. But fundamentally, the financial services industry is suffering from a solvency problem. Too many of the assets on its balance sheets contain loans to borrowers who lack the ability (and in some cases the desire) to make good on their debts. Forcing interest rates into negative real interest rate territory will only help a portion of the underwater borrowers. In addition, a distortion this severe is almost guaranteed to produce more misallocation of capital, which is not good for the US in the long term. And if the Fed miraculously manages to keep asset values from falling further, it is merely delaying the day of reckoning, and Japan is the poster child of the results of such a Phyrric victory.

From Bloomberg:

Federal Reserve Chairman Ben S. Bernanke may need to step up his effort to unfreeze bank funding markets as a surge in borrowing costs blunts the impact of the cash auctions the central bank introduced in December.

The cost of obtaining funds for three months has risen by 0.33 percentage point since the Federal Open Market Committee’s last meeting on March 18. The jump may force homeowners with variable-rate mortgages and some companies to pay more on their loans at a time when economic growth is faltering…..

“There’s clearly a need for the Fed to do more,” said Charles Lieberman, a former New York Fed economist who’s now chief investment officer of Advisors Capital Management LLC in Paramus, New Jersey. “The underlying problem” is that banks and other investors are “still nervous” about lending to each other, he said…..

Investors’ focus may instead shift to the Fed’s attempt to stem the surge in bank funding costs that began in August, when the subprime-mortgage market’s collapse spurred concern about losses at financial firms.

The three-month London Interbank Offered Rate for dollars has climbed to 2.87 percent from 2.54 percent on March 18.

Increases in Libor and other rates are “a pretty clear indication that liquidity remains an issue or that term liquidity remains scarce,” said Dean Maki, chief U.S. economist at Barclays in New York and a former Fed researcher. “The Fed’s made pretty clear they’re going to continue to attack those problems as needed.”

The TAF is one of several Fed initiatives to unblock credit markets, along with direct loans to investment banks and $29 billion of financing to secure JPMorgan Chase & Co.’s takeover of Bear Stearns Cos. Investors have responded, buying a record $45.3 billion of corporate bonds last week and spurring an 11 percent rally in the Standard & Poor’s 500 stock index from the year’s low last month…

Another gauge of bank funding costs, the premium on Libor over the overnight indexed swap rate, a measure of what traders expect for the Fed’s benchmark rate, reached 87 basis points on April 21. That was the highest since the Fed announced the TAF on Dec. 12.

Bigger TAF operations would probably slow or reverse the increase in borrowing costs, said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. …

Fed Governor Kevin Warsh, San Francisco Fed President Janet Yellen and three other district-bank presidents voiced concerns about rising prices this month.

“Federal Reserve officials view themselves as about done with policy easing,” said Vincent Reinhart, who was the Fed’s chief monetary-policy strategist from 2001 until September 2007. “They probably want to signal that the easing cycle is over, at least for a while.”

Last year, we were less than impressed with Bush’s tightly bounded but widely touted plan to use the FHA, a traditional source of financing to low and middle income borrowers, to help salvage homeowners at risk of begin dispossessed. Note we have doubts about “rescue debtor” operations. Iin many cases, these borrowers had little to no equity in their home, which begs the question of why it is so awful for them to lose their home. Indignity, yes, tragedy, no.

But a cynical plan to do nothing while pretending to offer relief is even worse than standing pat. It gives homeowners and possibly mortgage investors false hope and forestalls discussion of the tough choices that need to be made (the residential housing market is simply too large for the Feds to rescue), But then again, if your aim is merely to leave this problem in the lap of the incoming regime, a Potemkin program like this is exactly the sort of thing you want.

Better yet, the FHA program appears to be falling well short of its modest goals. The Bushies said it would aid 80,000 delinquent borrowers in 2008. So far this year, the total in that category getting help in 2,000.

From the New York Times:

Fewer than 2,000 homeowners at risk of foreclosure have been helped by a Federal Housing Administration program that President Bush promised would help homeowners who had fallen behind on their mortgage payments, federal housing statistics show.

F.H.A. officials have asserted in recent weeks that more than 150,000 people have benefited from the program, which was intended to help troubled homeowners refinance into stable, government-issued loans. But the vast majority of participants have been homeowners who have made their mortgage payments on time, not the borrowers in crisis who were the targets of the president’s plan, the statistics show…..

More than 400,000 mortgages will be refinanced through F.H.A. Secure this year, officials say. Of those, only about 4,000 will be held by homeowners who have fallen behind on their payments, the statistics show.

“F.H.A. Secure, while a good idea, is not addressing the magnitude of the problem,” Senator Christopher J. Dodd, the Connecticut Democrat who is the chairman of the Banking Committee, said at a hearing this month. He is calling for legislation that would help many more troubled borrowers.

Scott Stern of Lenders One, an alliance of mortgage bankers based in St. Louis, called the program’s record with the neediest homeowners “a tragedy.”

“F.H.A. is helping borrowers who aren’t currently in trouble and that is fine,” Mr. Stern said. “But there is a specific subset of borrowers right now who are in trouble. The program needs to be helping people who need the help immediately.”

Housing officials say they have worked hard to reach such borrowers. In August, the program was tailored toward low-income homeowners who were falling behind because of interest rate increases on their adjustable-rate mortgages. The officials say that interest rate cuts by the Federal Reserve reduced the number of such people….

The F.H.A. still requires borrowers hoping to refinance to have made 10 on-time payments in the 12 months before they went into default. That will block many borrowers, said John Taylor, president of the National Community Reinvestment Coalition, which helps people in underserved communities get credit.

In a bit of synchronicity, food worries are getting prominent billing tonight in the media. The Financial Times” Martin Wolf sketches out some dimensions of snowballing agricultural problems and possible solutions.

Wolf’s piece endeavors to cover a lot of ground, which means of necessity it gives short shrift to depth. It touches on the central yet only-now-meriting-discussion fact that high productivity agricultural production is energy intensive. It mentions only in passing that scarcity of potable water is also increasingly an issue, and as Australians know full well, agricultural uses often compete with household needs. And creating water for human consumption out of low quality water is often energy intensive (desalination reportedly is, membrane-based technologies far less so). While there are no easy answers, looking at problems in isolation is sure to lead to suboptimal solutions.

It also (an increasing pet peeve) fails to mention that the ag problems is a population and diet problem, and does not consider addressing those issues. Weirdly, there is an assumption that people can’t/won’t change their diets. Yet convention and social norms are very powerful forces. In US, but no one here is talking about the need for people in advanced economies to eat less meat and fish protein (as mentioned, it take roughly 10 grain calories to produce one food calorie). Note that does NOT mean becoming vegan, but shifting the proportions in one’s diet (I’m amazed when I go to restaurants how big the piece of protein is relative to everything else). Will this happen quickly? Unlikely, but not talking about it as part of a program will assure it doesn’t happen at all.

From the Financial Times;

Of the two crises disturbing the world economy – financial disarray and soaring food prices – the latter is the more disturbing….

The recent price spikes apply to almost all significant food and feedstuffs (see charts). Yet these jumps are themselves part of a wider range of commodity price rises. Powerful forces are linking prices of energy, industrial raw materials and foodstuffs…..

So why have prices of food risen so strongly? Will these higher prices last? What action should be taken in response?

On the demand side, strong rises in incomes per head in China, India and other emerging countries have raised demand for food, notably meat and the related animal feeds. These shifts in land use reduce the supply of cereals available for human consumption.

Furthermore, rising production of subsidised biofuels, further stimulated by soaring oil prices, boosts demand for maize, rapeseed oil and the other grains and edible oils that are an alternative to food crops. The latest World Economic Outlook from the International Monetary Fund comments that “although biofuels still account for only 1½ per cent of the global liquid fuels supply, they accounted for almost half of the increase in consumption of major food crops in 2006-07, mostly because of corn-based ethanol produced in the US”.

Meanwhile, aggregate production of maize, rice and soyabeans stagnated in 2006 and 2007. This was partly the result of drought. Also important, however, have been higher prices of oil, since modern farming is so energy-intensive. With weak growth of supply and strong increases in demand, cereal stocks have fallen to their lowest levels since the early 1980s. Declining stocks undermine the widely shared belief that speculation has driven the rising prices, since stocks would be rising, not falling, if prices were above market-clearing levels.

Vastly more worrying than speculation is the weak medium-term growth of supply. The rapid increases in yields of the 1970s and 1980s, at the time of the “green revolution”, have slowed. Given the stresses on water supplies, longer-term supply prospects would look poor even if diversion of land for production of biofuels were not adding to the pressure.

Are prices going to remain high? Two opposing forces are at work. The first is the market, which will tend to bring prices back down as supplies expand and demand shrinks. But the latter is also what we want to avoid, at least in the case of the poor, since reducing their consumption is not so much a solution as a failure. The second force is the current intense pressure on the world’s food system. This is true of both demand and costs of supply. Prices are likely to remain relatively elevated, by historical standards, unless (or until) energy prices tumble.

This, then, brings us to the big question: what is to be done? The answers fall into three broad categories: humanitarian; trade and other policy interventions; and longer-term productivity and production.

The important point on the first is that higher food prices have powerful distributional effects: they hurt the poorest the most. This is true both among countries and within them. The Food and Agricultural Organisation in Rome recently listed 37 countries in substantial need of food assistance. Moreover, according to the World Bank, soaring food prices threaten to make at least 100m more people hungry.

Increases in aid to the vulnerable, either as food or as cash, are vital. Equally important, however, is ensuring that the additional supplies reach those in greatest difficulty…..

Now turn to the policy interventions. Protection, subsidies and other such follies distort agriculture more than any other sector. Alas, the opportunity to eliminate protection against imports offered by exceptionally high world prices is not being taken. A host of countries are imposing export taxes instead, thereby fragmenting the world market still more, reducing incentives for increased output and penalising poor net-importing countries. Meanwhile, rich countries are encouraging, or even forcing, their farmers to grow fuel instead of food…

Finally, far greater resources need to be devoted to expanding long-run supply. Increased spending on research will be essential, especially into farming in dry-land conditions. The move towards genetically modified food in developing countries is as inevitable as that of the high-income countries towards nuclear power. At least as important will be more efficient use of water, via pricing and additional investment. People will oppose some of these policies. But mass starvation is not a tolerable option.

The food and fuel crisis of 2008 is a cry for our attention. Nobody knows how long these shocks will last. But they demand rapid policy changes across the globe. We must choose between fragmenting world markets still further and integrating them, between helping the poor and letting even more starve and between investing in improving supply and allowing food deficiencies to grow. The right choices are evident. The time to make them is now.

Dear readers,

I will give more measured impressions of the Milken Conference in a day or so, when I it is over (we have another day, but the last day is far thinner in terms of offerings) and have had a day or so to reflect.

However, to give a highlight, a subtext was was that many pressing world problems had solutions (and better yet, private sector solutions).

Now as much as I like to opine broadly, I (hopefully) maintain a sense of proportion as to where I have good knowledge and where I am sticking my neck out, and try to advise readers when I know I may be sticking my neck out.

By contrast, Gary Becker, a Nobel Prize winner in economics (more accurately, The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, created by Sweden’s central bank) maintained at the Monday and Tuesday lunch presentations (remember, meals have the biggest attendance and so will have the greatest impact) that unlike oil, the problem of agricultural price increases would be old news in a year or two because productivity of agriculture in the third world was so poor. All we need to do is get them to adopt even more advanced techniques). And that’s great because all those people now working the fields will produce much greater GDP per head when they move to cities and free up the land.

At least today, another Nobel winner (was it Edmund Phelps of Columbia or Michael Spence of Stamford?) bothered pointing out that food is 60% of household spending in many parts of developing countries, that 50-100% prices in food means starvation and childhood malnutrition that can lead to permanently impairment.

Moreover, if you recall the early history of the Industrial Revolution, when tenant farmers were en masse forced off their land and decamped to cities, wage rates fell because there simply wasn’t enough work for them. The number bandied about was that 1.5 billion people in China and India are involved in food production. Pray, how will you possibly find other employment for so many people if they no longer till the soil?

Equally appalling: no mention of strategies to slow population growth as part of the solution. no mention that the problem was wasn’t just population growth, but newly affluent people in emerging markets adding more animal protein to their diets (it takes roughly 10 calories of grains to produce one meat calorie). We all need (or will be forced by price) to eat foods lower on the food chain.

And even if you manage somehow to come up with enough fertilizer, it has nasty effects on the oceans. There is no free lunch.

So to the New York Times, It says fertilizer consists of nitrogen, phosphorus, and potassium, and the scarce item is nitrogen in a form plants can use. One reader in comments had said that phosphorus was running out. Anyone who has further information either confirming or denying is very much encouraged to speak up.

From the New York Times:

Truong Thi Nha stands just four and a half feet tall. Her three grown children tower over her, just as many young people in this village outside Hanoi dwarf their parents.

The biggest reason the children are so robust: fertilizer.

Ms. Nha, her face weathered beyond its 51 years, said her growth was stunted by a childhood of hunger and malnutrition. Just a few decades ago, crop yields here were far lower and diets much worse.

Then the widespread use of inexpensive chemical fertilizer, coupled with market reforms, helped power an agricultural explosion here that had already occurred in other parts of the world. Yields of rice and corn rose, and diets grew richer.

Now those gains are threatened in many countries by spot shortages and soaring prices for fertilizer, the most essential ingredient of modern agriculture.

Some kinds of fertilizer have nearly tripled in price in the last year, keeping farmers from buying all they need….

In the United States, farmers in Iowa eager to replenish nutrients in the soil have increased the age-old practice of spreading hog manure on fields. In India, the cost of subsidizing fertilizer for farmers has soared, leading to political dispute. And in Africa, plans to stave off hunger by increasing crop yields are suddenly in jeopardy.

The squeeze on the supply of fertilizer has been building for roughly five years. Rising demand for food and biofuels prompted farmers everywhere to plant more crops. As demand grew, the fertilizer mines and factories of the world proved unable to keep up.

Some dealers in the Midwest ran out of fertilizer last fall, and they continue to restrict sales this spring because of a limited supply.

“If you want 10,000 tons, they’ll sell you 5,000 today, maybe 3,000,” said W. Scott Tinsman Jr., a fertilizer dealer in Davenport, Iowa. “The rubber band is stretched really far.”

Fertilizer companies are confident the shortage will be solved eventually, noting that they plan to build scores of new factories. But that will probably create fresh problems in the long run as the world grows more dependent on fossil fuels to produce chemical fertilizers. Intensified use of such fertilizers is certain to mean greater pollution of waterways, too.

Agriculture and development experts say the world has few alternatives to its growing dependence on fertilizer. As population increases and a rising global middle class demands more food, fertilizer is among the most effective strategies to increase crop yields.

“Putting fertilizer on the ground on a one-acre plot can, in typical cases, raise an extra ton of output,” said Jeffrey D. Sachs, the Columbia University economist who has focused on eradicating poverty. “That’s the difference between life and death.”…

Overall global consumption of fertilizer increased by an estimated 31 percent from 1996 to 2008, driven by a 56 percent increase in developing countries, according to the International Fertilizer Industry Association….

Fertilizer is plant food, a combination of nutrients added to soil to help plants grow. The three most important are nitrogen, phosphorus and potassium. The latter two have long been available. But nitrogen in a form that plants can absorb is scarce, and the lack of it led to low crop yields for centuries.

That limitation ended in the early 20th century with the invention of a procedure, now primarily fueled by natural gas, that draws chemically inert nitrogen from the air and converts it into a usable form.

As the use of such fertilizer spread, it was accompanied by improved plant varieties and greater mechanization. From 1900 to 2000, worldwide food production jumped by 600 percent. Scientists said that increase was the fundamental reason world population was able to rise to about 6.7 billion today from 1.7 billion in 1900.

Vaclav Smil, a professor at the University of Manitoba, calculates that without nitrogen fertilizer, there would be insufficient food for 40 percent of the world’s population, at least based on today’s diets.

Initially, much of the increased production of fertilizer went to grains like wheat and rice that served as the foundation of a basic diet. But recently, with world economic growth at a brisk 5 percent a year, hundreds of millions of people began earning enough money to buy more meat from animals fattened with grains. That occurred at the same time that rising production of biofuels, like ethanol, put new pressure on grain supplies.

These factors translated into rising fertilizer demand. Prices at a terminal in Tampa, Fla., for one fertilizer, diammonium phosphate, jumped to $1,102 a ton from $393 a ton in the last year, according to JPMorgan Securities, which tracks the prices. Urea, a type of granular nitrogen fertilizer, jumped to $505 a ton from $273 a ton in the last year.

Manufacturers are scrambling to increase supply. At least 50 plants to make nitrogen fertilizer are under construction, many in the Middle East where natural gas is abundant, and phosphorous and potassium mines are being expanded. But these projects are expensive and time-consuming, and supplies are expected to remain tight for years.

Fertilizer is vitally important in Iowa, whose farmers grow more corn than in any other state and depend on fertilizer to increase yields.

But the combination of high prices and spot shortages has forced some farmers to revert to older methods of fertilization, making hog manure a hot commodity. Farmers are cutting deals to have hog barns built on the edges of their corn and soybean fields.

On a tour of his rolling farm in Oxford Junction in eastern Iowa, Jayson Willimack pointed to the future sites of two buildings that will hold 2,400 hogs. Their manure will eventually replace commercial fertilizer on 400 acres, about 10 percent of his farm, and save him perhaps $50,000 annually. “Every little bit helps,” he said.

Such a strategy has severe limits — manure contains so little nitrogen that tons are required on each acre. That means farmers in Iowa and abroad have little choice but to pay the higher prices for commercial fertilizer.

In many countries, those cost increases have so far been offset by record high prices for crops. But fertilizer inflation has created a crisis in countries that subsidize fertilizer use for farmers. In India, for instance, the government’s subsidy bill could be as high as $22 billion in the coming year, up from $4 billion in 2004-5.

Once new supplies become available, the rising use of fertilizer will still pose difficulties.

Environmental groups fear increased use, particularly of nitrogen fertilizer made using fossil fuels. Because plants do not absorb all the nitrogen, much of it leaches into streams and groundwater. That runoff has long been recognized as a major pollution problem, and it is growing.

A barometer of the pollution is the rising number of dead zones where rivers meet the sea. In the Gulf of Mexico, for instance, nitrogen runoff from fields in the Corn Belt washes downstream and feeds plant life in the gulf. The algae blooms suck oxygen from the water, killing other marine life.

More than 400 dead zones have been identified, from the coasts of China to the Chesapeake Bay, and the primary reason is agricultural runoff, said Robert J. Diaz, a professor at the Virginia Institute of Marine Science.

“Nitrogen is nitrogen,” Professor Diaz said. “If it’s on land, it produces corn. If it gets in the water, it produces algae.”

This month, a United Nations panel called for changes in agricultural practices to make them less damaging. The panel recommended techniques that offer some of the same benefits as chemical fertilizer, like increased crop rotation with legumes that naturally add some nitrogen to the soil.

But others say those approaches, while helpful, will be not be enough to meet the world’s rapidly rising demand for food and biofuel.

“This is a basic problem, to feed 6.6 billion people,” said Norman Borlaug, an American scientist who was awarded a Nobel Peace Prize in 1970 for his role in spreading intensive agricultural practices to poor countries. “Without chemical fertilizer, forget it. The game is over.”

Thanks for your patience. Still in LA at the Milken Conference (I feel like I have been parachuted into a Pasadena Republican/Chicago School of Economics parallel universe, although I have managed to find some fellow apostates. If I spent enough time here, I might be brainwashed (social assent is very powerful).

Thus I hope you will bear with me for a bit longer. It also feels a bit weird to post when time constraints mean I haven’t been able to spend much time on other blogs. I worry I am missing good stuff (and might waste time on something done better elsewhere) but will have to do a bit of catch up later.

This post, on how renters are affected by mortgage defaults, is newsworthy by virtue of suppling some data, rather than merely noting that the phenomenon exists.

From MarketWatch:

The rise in foreclosures isn’t just affecting homeowners, it’s also putting pressure on renters, according to a report released Wednesday by the Joint Center for Housing Studies at Harvard University.

For one, the uptick in foreclosures is prompting more households to compete for low-cost rentals. Also significant is the number of renters who face sudden eviction when properties they’re living in are foreclosed on, the report found.

“Today, investor-owned one- to four-family rental properties account for nearly 20% of all foreclosures,” said Nicolas P. Retsinas, director of the Joint Center for Housing Studies, in a news release. “Moreover, because many of the high-risk home-purchase and home-refinance loans now in default are concentrated in low-income and minority communities, the fallout from foreclosures is hitting the same neighborhoods where many of the nation’s most economically vulnerable renters live.”…

Those involved with the study stressed that renters should not be forgotten as housing takes center stage on Capitol Hill….The current conditions provide an opportunity to transform the inventory of foreclosed and vacant properties into affordable rental housing…

The study shows that demand for affordable rental housing is increasing while the supply of low-cost units is declining, said Jonathan Fanton, president of the MacArthur Foundation, which helped in funding the report….
The study also found:

With an abundance of mortgage capital available during the housing boom years, there was a substantial rise in high-risk lending to absentee owners of one- to four-unit rental properties. In 2007, almost one in five foreclosure starts were on loans made to nonresident owners.

Foreclosures are also adding to the number of units that are held off the market, in part because of the long foreclosure disposition process and also because some who are buying the foreclosed properties are waiting for conditions to improve before putting the units back on the market.

While the weak home-buying market is adding to the supply of higher-priced rentals — as owners rent out their vacant condos and homes — many renters don’t have the income required to seize these opportunities.

In 2006, 42.6% of all working families didn’t earn enough to afford an appropriately sized housing unit. Nearly half of all renters paid more than 30% of their incomes for housing in 2006 and a quarter spent more than 50%.

The minority share of renter households increased from 37% in 1995 to 43% in 2005, and Hispanic renters accounted for nearly half of the gain.

Newly built apartments in buildings with five or more units had a median asking rent of $1,057 in 2006, a record high. The median gross rent for all units that year was $766. Only 20,000 new, unfurnished apartments renting for less than $750 were completed in 2006, even though these units were most in demand.

Condo conversions rose from a few thousand in 2003 to 235,000 in 2005. Only 60,000 units were converted from rentals to condos in 2006. Virtually no conversions were completed in 2007.

From 1995 to 2005, two rental units were removed from the inventory for every three units built. The losses to inventory were the highest in the Northeast; there, two rental units were lost for every one built.

Barclays estimates that half the 2006 and 2007 subprime loans are in or close to negative equity status, which means this roughly $800 billion of mortgages is at greater risk of default. Note that their analysis used OFHEO data; Case-Shiller estimates of the fall in housing prices exceed those of OFHEO, which means this forecast is likely to be conservative.

From Bloomberg:

Subprime loans from the period that are underwater, meaning they exceed the value of the related homes, jumped 5 percentage points to 19.8 percent in the fourth quarter, and may reach 26 percent by midyear if property-price drops continue at the same pace, New York-based analysts Ajay Rajadhyaksha and Derek Chen wrote in a report yesterday. Such Alt-A loans, a grade better than subprime, would grow to 23 percent from 16.3 percent.

Many of the loans that are or will soon be underwater are in areas where prices are falling faster than the U.S. average, so the size of the shift is underappreciated, the Barclays analysts wrote…..

Borrowers on about 26 percent of subprime loans from 2006 and 2007 will have equity of less than 10 percent by midyear, down from 29.4 percent at yearend, according to Barclays, as more borrowers slip underwater. The percentage on Alt-A mortgages should hold steady at about 23.5 percent. The report said 10.8 percent of Alt-A loans were underwater on Sept. 30.

By happenstance, there is more than usual Fed-related news this early AM. A few weeks ago, Greg Ip of the Wall Street journal recited what some of the Fed’s options would be if it ran into balance sheet constraints. One was paying interest on bank reserves:

The Fed could seek to pay interest on reserves. Banks lend out excess reserves at whatever rate they can get because the Fed doesn’t pay interest. That’s one reason the federal funds rate often crashes late in the day, when banks realize they have more reserves than they need. Paying interest on reserves would put a floor under the federal funds rate. The Fed could then make loans and purchase assets with little concern for the impact on the federal funds rate.

The Financial Times reports that this idea may be getting traction:

Federal Reserve policymakers will discuss paying interest on bank reserves in a closed door meeting on Wednesday. Such a move could in theory allow the Fed to expand its liquidity support operations without limit….

Under a law passed in 2006, the US central bank will gain the authority to pay interest on reserves in 2011.

The meeting on Wednesday is based on that timeframe and will not be followed by any announcements.

However, the meeting could spark an internal debate as to whether the Fed should consider asking Congress to bring forward this authority to help it deal with the current credit crisis.

Many experts think that would be a good idea. Vincent Reinhart, former chief monetary economist at the Fed, said paying interest on reserves would allow the Fed to “expand their liabilities to support more asset purchases”.

A number of other central banks already have the authority to pay interest on reserves, as well as the authority to lend banks money.

In normal times they can use these deposit and lending rates to put a corridor around the main policy rate, and prevent it from being buffeted too far away from the level they aim to set.

But at times of financial market stress, the ability to pay interest on reserves takes on added significance. Currently, the Fed cannot expand or contract its balance sheet without altering the overall supply of reserves and changing its main policy rate, the Fed funds rate…

That would free the US central bank to conduct liquidity operations that were larger than the size of its current balance sheet – roughly $800bn.

“The point…would be to allow the Fed to expand its balance sheet without having to drive the fed funds rate to zero in the process,” said Goldman Sachs.

The problem with this concept, as with many of the Fed’s new measures, is that notwithstanding the current improved mood in the credit markets, they have often been ineffective or produced unintended consequences. Per EconWeekly, paying reserves would have a nasty side effect:

Reserve balances are like checking accounts: they don’t earn interest. For that reason banks have little incentive to hold more reserves than they need to meet the Fed’s requirements and clear transactions. Any excess reserves are loaned to other banks. As Greg Ip explains, “if the Fed paid, say, 2% interest on reserves, banks would have no incentive to lend out excess reserves once the federal funds rate fell to that level.”

This measure would lead to a higher equilibrium level of reserve balances, for a given value of the federal funds interest rate. It would also reduce the amount of inter-bank lending, as banks would keep more of their cash in their safe-deposit box at the Fed. That lending would be replaced by loans from the Federal Reserve.

Um, I thought the problem we were trying to solve in the first place was banks not lending to each other…..

Greg Ip of the Wall Street Journal reports on the harsh criticism of the Fed’s role in the Bear deal by Vincent Reinhart, who rcently was the Fed’s most senior staff member.

What is ironic about the Fed’s bailout is that it is unpopular on the left and the right. The left does not like the spectacle of subsidies to the until-recently-highly profitable financial services sector, particularly when salvage programs for individuals are getting more talk than action. Reinhart, who was on a panel at the American Enterprise Institute, illustrates the views of some (many?) on the right: perhaps Bear should have been saved, but not via the government shouldering the risk.

Two further points: Reinhart describes other options the Fed could have taken, yet omits the most obvious: lending to Bear for 28 days via JP Morgan, which appeared to be the initial plan, but which the Fed retracted and instead made a mere commitment through the weekend. Bear officials had thought they could pull through with the longer loan, particularly since the new Term Securities Lending Facility was going to become operational before that loan matured. The only explanation I can come up with (aside from nefarious ones) is that the Fed did not feel it could lend to Bear after it was downgraded on Friday March 14 by the rating agencies to just above junk.

The other is that Reinhart comments approvingly on the Fed’s role in the LTCM rescue. Yet at the time, a lot of observers were critical of the central bank orchestrating a deal for an institution it did not regulate with a lot of institutions it similarly did not regulate. This was seen in some quarters as a significant and unwarranted increase in the Fed’s reach. But remember even then that while the Fed assembled the exposed firms (not telling them who else would be there) and told them why it would be in their interest to rescue LTCM, the Fed played no role in the negotiations. Thus, while Reinhart says that the Fed can no longer act as an honest broker, that is counterfactual. The Fed was not a broker in the LTCM deal.

From the Journal:

The Federal Reserve’s rescue of Bear Stearns Cos. will come to be seen as its “worst policy mistake in a generation,” a former top Fed staffer said.

The episode will be seen as comparable to “the great contraction” of the 1930s and “the great inflation” of the 1970s, Vincent Reinhart said…

His appraisal is one of the harshest yet by a high-profile observer…..Mr. Reinhart said the bailout “eliminated forever the possibility the Fed could serve as an honest broker.” In 1998, the Fed coaxed private creditors of Long-Term Capital Management to bail out the hedge fund but didn’t have to put up its own money. If it ever tries a similar maneuver on a Wall Street cohort, he said, “The reasonable question any person in the room will ask is, ‘How much will you contribute to the solution?’”

Mr. Reinhart said the Fed’s move may have been justified if the alternative was a chain-reaction run on many other investment banks. But he asked if other options were available, such as taking a “tougher line” with J.P. Morgan, seeking other suitors, removing certain assets from Bear’s portfolio or quickly implementing its previously announced offer to temporarily swap Treasury securities for dealers’ less liquid assets. “All those things were possible but not pursued,” he said.

The Financial Times reports that mutual funds got off to a very bad start this year, with 24 of the 25 biggest managers seeing a decline in funds. Note first that the article is not discussing individual funds (e.g. Magellean) but fund families (e.g. Fidelity).

Note second that the fall isn’t simply the result of declines in market values, but actual withdrawal of funds, but this apperas to be largely the result of investors moving heavily into cash. The article suggests that this is due to a loss of investor confidence. Another factor that may have contributed around the margin is a rise in withdrawals from 401 (k) plans (and presumably also IRA rollovers), a sign of rising consumer stress. But it does not yet appear that raiding capital to support consumption is a significant component of this decline.

From the Financial Times:

All but one of the 25 largest US mutual fund managers saw their long-term assets fall in the first quarter, as returns dived and investors pulled out of funds.

In the worst start to a year for more than a decade, most money managers had retail outflows, and even stalwarts such as American Funds and Vanguard suffered a drop in assets, of 6.6 per cent and 4.3 per cent respectively.

Pimco, the bond manager, was the only one to show a rise in retail assets, according to Financial Research Corporation and industry estimates. Pimco’s Total Return fund had an inflow of $9bn in the three months to March.

The trend is likely to worry economists, because it suggests the credit turmoil is hurting the confidence of mainstream investors. That, in turn, could dampen activity among consumers in the months ahead, since falling investment sentiment is often associated with muted household spending levels.

However, the fall also marks a fresh blow for the financial industry, because mutual fund managers typically make money by charging a percentage of assets – meaning that profits in the industry fall when assets decline.

Last week, a group of publicly traded asset managers announced bleak quarterly results. Affiliated Managers Group, which holds stakes in 26 mutual and hedge fund companies, reported a quarterly profit fall for the first time in five years, with outflows of $8.4bn in the quarter.

Big institutional fund groups – such as AllianceBernstein, a unit of French insurance group Axa – likewise showed asset falls.

One senior industry executive said: “This is the worst I have seen for a long time, the industry-wide outflows, and unfortunately I don’t think it is a short-term situation. The days of domestic [US] equity funds driving profits for us, that could be gone.”

Retail and institutional investors pulled $100bn from US, European and Japanese equity funds during the quarter, according to Strategic Insight.

The trend is accelerating a shift in the money management industry, as investors move away from equity funds, which have been the industry’s profit mainstay, towards either low-margin options such as short-term cash and indexed funds, or high- margin alternative investments such as hedge funds, private equity and hard assets.

Long-term assets do not include money market funds, which have seen big inflows. Several money managers, such as Fidelity, have large money market funds which are offsetting their outflows, although money market funds are low-margin products and do not provide long-term investor loyalty. Fidelity had a drop of long-term assets of close to 10 per cent for the quarter, as investors continued to pull funds from the former market leader despite a lift in performance in its funds.