Chapter 14
Why The Rescue Plan Failed
The cut in the prime rate was a joke. What good was it if the banks reduced their rate but had no money to lend? The capital controls and trade barriers were also out of touch with reality and never pursued, except symbolically.Nevertheless, news that the Federal Reserve was planning to buy Metrobank paper and rumors that it would follow up with purchases of bonds of other firms � even junk bonds � triggered one of the sharpest rallies in the history of corporate bonds which, in turn, spilled over into the stock market. The rally continued for many days, and cheers reverberated through the damaged corridors of Wall Street.
One junk bond issue selling at 72 leaped to 79 in only a few hours. Another jumped twelve points and settled down to a net increase of ten points. Utility bonds, municipal bonds, and even foreign bonds leapfrogged each other.
Within hours, however, trading came to a standstill. If you called your broker, he gave you an "indication" of the market price, way up in the stratosphere. But it was fiction. There were no buyers. This was the first sign of trouble. The next sign of trouble came in the government bond market. Prices went up, but not half as much as the corporate bonds.
Soon, every dollar of buying by US investors was countered by an approximately equal amount of selling from overseas. Here's what came out on the news wires and on the Internet at the end of the week:
"The deeply discounted medium-grade corporates and low-grade corporates have rallied sharply, but dealers and traders are watching quality spreads carefully for some indication of the real impact of the recent Federal Reserve plan to purchase corporate securities in the hope of bringing some much needed support to the high-yield markets which, in recent weeks, had floundered to near collapse as a result of the rapid loss of confidence in those companies most directly impacted by the WTC crisis and in the process of going out of business."
Bond traders who saw this run-on sentence said it left them blank. Most, tired of the constant flow of "gibberish," didn't even bother to read it.
Three days later, the Federal Reserve Chairman called the President on the phone. "It's no good. The benefit of our plan to the stock market and the corporate bond market is a spit in the ocean. On the other hand, to the government bond market, it's a potential hydrogen bomb. The quality spreads are narrowing � and in the wrong direction."
The President didn't know the meaning of quality spreads. "What are the causes and what are the consequences of changes in quality spreads?" he asked.
"I am referring to the difference in yield between a Treasury bond and a corporate bond. A big corporation always has to pay more than the US Treasury to borrow money. Usually the difference is about 75 to 100 basis points (100 basis points = 1%). Then, several months ago, when the threat of bankruptcy was first apparent, the yield on corporate bonds went up by 2 1/4%, but the yield on the governments went up only 1/4%. In other words, the spread increased by 2%, or 200 basis points. Confidence in all corporations � no matter how credit worthy � declined sharply. But that was before our rescue package was announced."
"And now?"
"Now the opposite is happening. Top-grade corporate bond yields are back down sharply, but government bond yields are actually up. The spread between them has narrowed to practically nothing � a very bad sign." The Federal Reserve Chairman felt satisfied that he had put forth a very clear and straightforward explanation.
"Well, isn't that what we had said we wanted � to bring corporate bonds back up toward the level of government bonds?"
The Chairman shook his head, trying to hold his voice steady so that his feelings of frustration with the President's lack of knowledge of debt markets would not be picked up over the phone. In the past he had tried several times to explain to the President how yields and prices moving in opposite directions always meant the same thing, but that spreads, although moving in the same direction, could mean a variety of different things.
How does one make such things simple for a President to understand without sounding condescending? The Federal Reserve Chairman certainly didn't know how. He spent the next half hour going over the events in the marketplace until finally, after considerable effort, the President developed in his own mind an image of bond prices that looked similar to the above graph.
"I see," the President said. "We wanted to bring the corporate bonds up to the level of the government bonds. What's happening is precisely the opposite. The 'governments,' as you call them, are falling down to the level of the 'corporates.' In short, we are not lifting them up; they are dragging us down.
"The question is: Why? Don't they believe our promise, our pledge? Why haven't we restored confidence? At the meeting it was said that we can create cash, that the law gives us the authority to funnel this cash wherever we please."
"The answer is we can create cash. But we cannot create credit."
| Most observers felt that a panic scenario such as the one described here could never occur because the government would step in and bail out all major corporations in trouble. However, as illustrated here, whenever they took any steps to support a corporation's bonds, it merely caused the government's own bonds to fall. The same would occur in any direct bailouts of banks or other financial institutions. |
"There's a very big difference. To create more cash, all we have to do is speed up the printing presses at the mint � or, actually, pump it in electronically. And when we dish it out, no one is going to turn us down. But to create credit, we have to convince investors and bankers to make loans to each other�and in this environment of falling confidence, I can assure you that isn't easy."
The President was getting impatient. "So what's the point?"
"The point is that you can create cash; you can't create confidence."
"It would seem to me that the more money we give 'em, the more confidence they'd have."
"No, no! It's exactly the opposite. The more paper dollars we create, the less confidence they have and the more they fear their dollars will decline in value, maybe even become worthless. Look what happened the other day. The money supply went up by $10 billion. This scared bond investors and caused the market to fall by two points, implying $100 billion in losses. And it scared foreign bond investors even more. In effect, for every dollar that was created in new cash, we lost ten dollars in the market value of credit outstanding (bonds)."
"Oh. But why can't we just buy more bonds?"
"When we attempt to support bond prices through direct purchases of US government securities, the money is deposited in the banks, which means the money supply jumps. This scares US dollar buyers and bond buyers all over the world and causes investors to sell more � not only US government bonds, but also corporate, municipal, and foreign bonds.
"If we go ahead and try to make direct purchases of corporate, municipal, and foreign bonds � a radical break with tradition � it will create a tidal wave of selling not only in bond markets, but also in the markets for mortgage, financial futures and bank loans. Nearly all of the $18 trillion in debts outstanding are ultimately marketable in one way or another.
"Next, even assuming the science-fiction possibility that we could somehow eat a big chunk of the $20 trillion in debts in this country, it could not prevent an even more dramatic dollar collapse. Remember what the Wall Street economist � Hartman � said at the meeting: If we splurge and dish out all that money to our friends in the US, they're not going to want to give us their money. And they're going to take back the trillions they've already given us.
"Finally, assuming we reverted to the sheer folly of permitting a rapid disintegration of the dollar, we would then come face to face with the ultimate wall of resistance. We would not be able to purchase the oil from OPEC countries which, by this time, would be demanding payment in foreign currencies, even if they're our staunch allies on the bin Laden thing. We would not be able to provide 300 million Americans with food and shelter which, by this time, would require immediate payment in cash or even precious metals."
"But what about the law?"
"The law gives us the on-paper authority to buy public, private, and foreign bonds. It does not give us the actual power to create real economic wealth."
"Why didn't we recognize this when we began the Metrobank rescue plan?"
"We did. But we hoped that the marketplace might swallow it. We underestimated the sophistication of US and foreign investors."
Still the President sounded perplexed. "You're saying the market is sensitive. I see that now. But ..."
The Federal Reserve Chairman's irritability was becoming more apparent. "Let's say I'm a foreign investor and I own US Treasury bonds. This implies that I trust the US government; that I loaned you my money for the purpose of running your government. Now, you take my money and pass it on to a third party, a private bank.
"And I say to you: 'What did you go and do that for? If I wanted to loan the money to the bank, I would have done so myself � directly � in the first place. But I didn't. I didn't do it because I don't trust the bank. I trusted you. But no more. Now I can't trust you anymore either. Now you're just one of them.' So the investor sells his Treasury bonds and then we are in trouble. Then we, the government, default."
The President hesitated for a few seconds before responding, but it seemed like hours as the tension built.
"Then what?"
The Chairman couldn't believe his ears. The President of the United States had treated the government's default with levity, utter levity. He could no longer control his boiling frustration � and fear. "Do you want to be the last President of the United States? Do you want to risk a new government with a new constitution? Do you want to destroy, with one sweep ... "
The Chairman's voice broke with emotion. Silence reigned.
"Mister Chairman, I appreciate the sincerity of your emotions, but you misunderstood me. What I said, in fact, was 'then what,' indicating to you my surprise and disbelief that this great country of ours could ever reach the point you described so dramatically moments ago.
"I request you take the following actions: (1) dispose of all Metrobank paper purchased thus far; (2) make a pledge that the Federal Reserve, despite its current legal authority to the contrary, will not purchase, even in this new world of terrorist threats, securities of the private sector; and (3) promise to discriminate always between corporates and governments. For my part, I shall proceed to take those actions I deem necessary to correct this extremely dangerous situation."
"But Mr. President," the Fed Chairman murmured. "We never did purchase the Metrobank paper. We only announced our intention to do so. We couldn't follow up yet because no one has been able to get that report on Metrobank's role in the nation's security issues."
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