Here is part I:

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Technorati Tags credit crisis, deflation, Economic Indicators, Economics, housing, Housing Market, Inflation, investing, markets, monetary policy, Risk, subprime

The Fed’s massive and numerous liquidity facilities are making things worse. The problem is more than banks unwilling to lend to each other, they are also unwilling to borrow from each other. Banks can get all the funding they need (and then some) from their central bank so they do not need to seek a loan from another bank. I believe it has gotten so bad that they don’t even bother to make a decent market for inter-bank loans anymore. No reason to, they don’t need them anymore as central banks have replaced them.

I would suggest more subtle factors should also be emphasized besides how this distorts rates on loans. If banks do not need each other then they don’t communicate. Thus the hard work of investigating what counterparties real credit risk is goes undone. The market is shunting that off to governments. Furthermore, banks have no incentive to arrive at a believable accounting of their assets, they can wait and hope for a bailout rather than find a way or terms that other banks will accept.

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Technorati Tags banks, central banks, credit crisis, Federal Reserve, lending

JP Morgan is a special discussion, because I point out a rather astonishing fact, they have a notional exposure to around 90 trillion in derivative contracts, or did last March (pdf.) 58 trillion of it swaps of some sort. Probably credit default swaps (CDS) are the majority. Which means…what? I don’t know, and frankly if anybody really does they aren’t telling me. In essence I am left telling people that I have to treat that as a “black box.” Not exactly confidence raising. Personally there are better ways to make money than hoping a company with 90 trillion in derivatives exposure has a handle on it in my book, but then again, I am admitting that I have no idea what I am talking about, and cannot find anyone else who does either.

Warren Buffet often speaks of defining a circle of competency when investing and staying inside it. It doesn’t matter how big the circle is, just knowing when you are inside it. Well, 90 trillion in derivatives exposure is outside of my circle of competency to assess.

The nightmare is what if it is outside of JP Morgans circle? I suspect it is, and the massive exposure of two other banks as well (Citibank and Bank of America have approx. 38 trillion apiece.)

What makes me wonder about it today? Personally I have always felt that there was a good chance that JP Morgan was who was being saved when the Fed brokered the acquisition of Bear Stearns. Bear goes under and JP Morgan would have to come up with huge payments on CDS contracts. Also, I suspect that Bear was a counterparty for a large number of derivatives, which if Bear was insolvent might not have all been paid up. Or maybe not. Then I see this over at Barry Ritholtz’s:

“Lehman Brothers Holdings Inc.’s main lender and clearing agent, JPMorgan Chase & Co., caused the liquidity crisis that led to Lehman’s collapse, creditors said.

JPMorgan had more than $17 billion of Lehman’s cash and securities three days before the investment bank filed the biggest bankruptcy in history on Sept. 15, the creditors committee said in a filing Oct. 2 in bankruptcy court in Manhattan. Denying Lehman access to the assets on Sept. 12, the bank “froze” Lehman’s account, the creditors claimed.

JPMorgan, the biggest U.S. bank by deposits, financed Lehman’s brokerage operations with daily advances, while money market funds and other short-term lenders provided overnight loans, according to bankruptcy court documents. When JPMorgan shut Lehman off from funds, Lehman “suffered an immediate liquidity crisis that could have been averted by any number of events, none of which transpired,” according to the filing.

The creditors asked the judge in charge of the case to let them interview a witness and request relevant documents from JPMorgan and to pursue possible legal claims. U.S. Bankruptcy Judge James M. Peck is scheduled to hold a hearing Oct. 16 on that request, the creditors said.”

Hmmm, so Lehman may have been torpedoed by JP Morgan? Hardnosed but not weird, until this little tidbit in the update:

Ron Kirby notes: “I wrote about a very strange occurrence – the reporting of J.P. Morgan “transferring” 138 billion dollars to Lehman, after Lehman had already filed for Chapter 11 bankruptcy early last Monday morning…It is highly likely [or a certainty on my planet] that J.P. Morgan was INSOLVENT and was “BAILED OUT” last Monday, September 15, to the tune of 138 billion dollars. This would explain why the Fed and Treasury dictated that Lehman fail – to disguise or otherwise obfuscate the recapitalization of or illicit transfer of 138 billion to A MUCH SICKER, TEETERING ENTITY, J.P. Morgan Chase.”

The link is filled with some rather out there speculation (and I have no intention of confirming or discrediting it) but this is a very odd transaction. Immediately after sending Lehman 138 billion they received 138 billion from the Federal Reserve. What were they off loading? Meanwhile they allegedly cut off Lehman.

Back to Bear. Was allowing JPM to take over Bear and the Fed guaranteeing most of their debt a back door method of recapitalizing a banking behemoth? Are the acquisitions that JPM has been making under very favorable terms a sign of strength or weakness? Gifts from the Federal Reserve to recapitalize them? How much trouble is in that book of derivatives?

I have already pointed out the problems in Europe, problems which the failure of AIG would have exacerbated due to their massive involvement in  the CDS market. Is it possible that JPM was also heavily exposed to a failure by AIG? With 90 Trillion in nominal exposure it is hard to imagine they were not. With that much exposure who could possibly be more of a candidate for the “too big to fail” label. Could the Fed be manipulating these events to save them without causing the kind of panic that Bear and the later victims have caused?

I don’t know, which is the real tragedy. Nobody knows what the exposure of anybody is, so we are all left guessing. The Federal Reserve, our government, the financial institutions themselves are all busy obscuring rather than bringing things to light. In order to avoid panic by showing us all how deep the problems are, they are busy spreading suspicion, distrust and panic by keeping everybody, including financial institutions they have to deal with, in the dark. The hope of generous terms from the government keeps banks from admitting what their books really look like, or to try and sell in an orderly manner what they have. Who needs to expose your books to potential lenders when the Federal Reserve will take a used car as collateral and at a lower rate.

How bad off are these institutions? We have no idea. We are left with our imagination and our nightmares.

Technorati Tags AIG, Bank Of America, banks, CDS, Citibank, credit crisis, Credit Default Swaps, Federal Reserve, finance, JP Morgan

1. Glass-Steagall repeal was not a major cause of the financial crisis, nor was government-induced “minority lending.”

I agree on the first, the second charge has some validity, but only in terms very different than the typical charge.

2. We should use regulation to move more of the currently unregulated derivatives markets to the clearinghouse model.

Bingo! Especially Credit Default Swaps.

3. The crisis represents a massive conjunction of both market and governmental failure.

Check.

4. I would not nationalize banks as ongoing concerns, at least not short of a far more extreme emergency than the current status quo.

Check.

5. The modified Paulson plan was better than nothing — especially after the market had been scared — but far from my first choice. In any case the plan would have been revised almost immediately. The Paulson and Dodd plans were never that far apart.

I disagree. No plan was better than the plan as advertised, though Michael has pointed out that it gives Paulson the opportunity to do some useful things.

6. My first choice is to induce and if need be to force more information revelation, identify the insolvent banks, close them up, and give the battle-tested FDIC a much greater role in the whole process.

This is the critical step, and we need to move as quickly as possible and begin a process of financial triage.

7. In the meantime the Fed should not worry much about inflation.

I agree. Deleveraging is inherently deflationary.

8. The critical deregulatory mistake was allowing excess leverage. Many deregulations get blamed but in fact contributed little to the problem.

I couldn’t agree more.

9. Everyone says that letting Lehman die was a big mistake but I’m not yet convinced. Maybe a bracingly high TED spread is what we need.

I am with him here.

10. Libertarians are overrating the moral hazard argument, as many equity holders have been wiped out.

True as to past actions, but they are not overstating the moral hazard of buying the bad assets at a price that might actually add meaningful capital into these institutions.

11. If someone is pushing conclusions and not identifying the potential weak points in his or her arguments, be suspicious. Also beware of anyone pretending to offer you simple answers.

Who can argue with that? This crisis will not be solved, but worked through. We will be struggling with this for years, not months.

12. I have a long and complicated view on the relevance of Austrian Business Cycle Theory which resists easy summation, but markets could have and should have been more cautious in response to Greenspan’s easy money policies.

Exactly. Whatever poor incentives were in place, whatever regulatory elements were lacking or unfortunately in place, that is no excuse for their behavior, their excess risk taking, the leverage employed or the dishonesty about their books.

13. Insolvent hedge funds and the commercial paper market remain outstanding issues which are not easy to address.

Insolvent hedge funds should die on the vine, the commercial paper market is a tough nut to crack.

14. I agree with Arnold Kling about relaxing capital requirements though at this point I don’t expect it to help much.

Check.

15. The crisis is complex and has many causes; there won’t be a simple or quick solution.

I agree. There is no solution, just trying to keep the ship from going down. We at best will be able to muddle through.

Arnold Kling responds to Tyler and adds several key elements which you will recognize from my comments:

In hindsight, I think that the crisis was caused by
a) creation of the secondary mortgage market (50 percent)
b) low down payment mortgages (30 percent)
c) the “suits vs. geeks” divide (15 percent)
d) other (5 percent)

Read his explanation of each. I can find no real complaint with them. I am going to highlight his suits vs. geeks divide. As someone on the geek side of this i admit to being biased:

My point about suits vs. geeks is that too many people did not understand the risk characteristics of these loans. I disagree with James K. Richards, who claims that the risk modelers got it wrong. The risk modelers told Richard Syron of Freddie Mac not to plunge into subprime lending with so little capital. The risk modelers at Goldman kept that firm from making the sorts of mistakes other companies made.

The decline in house prices was not a Black Swan. It was a highly plausible scenario. The problem is that the suits did not grasp the impact that such a decline would have on mortgage securities. The clueless suits include regulators, which explains why the crisis took them by surprise. It also explains why I do not trust them to come up with the best solution.

Decent, upstanding people say that we have to trust Ben Bernanke, Henry Paulson, Barney Frank, and other leaders. The public are considered rubes for not respecting the establishment. In this case, the public happens to be right. The suits are clueless.

I agree. These are smart people, but I don’t believe they understand what they are dealing with. Unfortunately the people who do are not qualified to make policy or hold office. This is a very troubling issue.

Risks:

The economic ship faces a number of icebergs. Oil markets are taking wealth out of the country. House price declines are taking paper wealth away from ordinary families. On the horizon, there could be an adverse shift in the terms of trade. The number of hours that the average American has to work to earn enough to buy a bottle of French wine, a pair of Italian shoes, or a Chinese-manufactured product could (should?) be much higher than it is today.

In this context, the consolidation in the financial sector is a relatively minor issue. The only policy challenge is to keep banks functioning. There are many ways to do that which do not involve speculating in mortgage securities.

Dead on.

Housing:

We need housing units to be occupied, at whatever rent or price clears the market. We need owners to be legitimate, meaning people who can afford reasonable down payments and mortgage payments. Getting from here to there is not easy, but I suspect that the more government intervenes, the longer and more painful the process will be.

I share that suspicion. The government at best should encourage dissemination of workable solutions and getting rid of legal obstacles to people taking advantage of them.

I do not think that the private sector is blameless. I do not think that the public sector is blameless. I do think that lobbying and corruption are endemic in the mortgage securities business. We ought to be trying to let that cesspool gradually dry up, rather than throwing taxpayer money into it.

I find it unsettling that Congressional leaders would announce that they have a deal and then fail to pass a bill. It used to be that the definition of having a deal was having the votes to pass legislation. It didn’t used to be a form of bluffing.

I find it unsettling that the establishment is promoting fears of another Depression. It used to be that worries about another Depression were confined to obscure books written by crackpots and lunatics. Today, the fear of a Depression is being promoted by the establishment, while those of us who are trying to remain calm and measured are treated as crackpots and lunatics.

My only disagreement is with the last statement. I have already discussed ways in which we are being frightened unnecessarily. I do believe that if not a depression, a severe and lengthy recession and sluggish growth for long afterward is a real possibility, if not probable.

It seems the three of us are not that far apart.

Technorati Tags banks, Chris Dodd, Credit Default Swaps, deregulation, Glass Steagle, Hank Paulson, regulation

• Asset price inflation (at least initially) as opposed to broader price inflation.
• A massive increase in leverage (debt to magnify returns) throughout the financial system and our economy.
• A massive increase in the size of the financial sector relative to the rest of the economy. Since it is built on leverage, financial sector compensation has soared and led to concentration of wealth in financial hands.

The last fascinates me, as a sector which should be a relatively small part of the economy functioning as intermediaries has through leverage achieved profits (a redistribution of wealth from the rest of our citizenry) far from the size their intermediary function can possibly justify. These intermediaries for example accounted for about a third of the market capitalization of the S&P 500 before they crashed and burned. How do the intermediaries deserve a market cap that amounts to around half of those for whom they intermediate?

The answer is increased leverage. I’ll address this in more detail later, but the Federal Reserve has finally decided to expand the monetary base, which has consistently grown at a very slow, or non existent rate. From David Merkel:

Check out the very far left side of the graph and look at the vertical takeoff.

David fills us in on the details:

Look at the H.4.1 report.  We may have finally hit the panic phase of monetary policy, where the Fed increases the monetary base dramatically.  They are pumping the “high-powered” money into loans:

• $20 billion for Primary credit
• $80 billion for Primary dealer and other broker-dealer credit
• $70 billion for Asset-backed commercial paper money market mutual fund liquidity facility
• $40 billion for Other credit extensions
• $80 billion for Other Federal Reserve assets
• -$20 billion netting out other entries

Making it an increase of roughly $270 billion from last week’s average to Wednesday’s daily balance.  Astounding.

In general, the increases are not being pumped into the banks, but into specialized programs to add liquidity to the lending markets.  Now, I’ve written about this before, but it bears repeating.  What happens if the Fed takes losses on lending programs.  It reduces the seniorage profits that they pay to the Treasury, which means the Treasury has to tax or borrow that much more.  The Fed isn’t magic; it’s a quasi-extension of the US Government in a fiat currency environment.  It’s balance sheet is tied to the US Treasury.

Yves Smith at Naked Capitalism is correct.  The US is no longer a AAA credit, particularly if you measure in terms of future purchasing power of US dollars.  I’ve felt that for years, though, with all of the unfunded future promises that the US Government has made with Medicare, Social Security, etc.  The credit of the US Government hinges on foreign creditors (like OPEC and China) to keep it going.  What will they offer them? The national parks?

True, all true, but possibly if they are going to provide monetary stimulus this might be a better way than cutting rates, now and in the future.

Technorati Tags debt crisis, Federal Reserve, leverage, monetray policy, Treasury

Money tends to go where it is best treated, as measured by an asset class, hedge fund or by a traditional investment adviser. As a result, a lot of money will be shifting by year-end, and it is bound to have a disruptive market effect as well as likely to feed continued volatility.

If you delegate investing to an adviser, here are several questions that you may consider asking during a 2008 year-end review of your investment performance:

1. What were your adviser’s expectations for the stock market’s returns in 2008, and how did these expectations compare to the actual results?

2. How did your investment performance compare to that of the major indices? In what areas did you outperform, and in what areas did you underperform — and why?

3. What was your adviser’s economic and credit expectations, and how did these expectations compare to the actual events? Where and why were his assumptions wrong?

4. Did your adviser change his strategy as economic and financial events changed? If he didn’t, ask why?

5. Did you experience outsized individual stock or large specific industry or sector share price losses? Did your adviser institute a discipline to stop losses, or were your losses allowed to compound? Did your adviser “double down” on poor investments?

6. Ask your adviser whether he “eats his own cooking” — that is, did he invest along with you in the same investments, and are both of your interests aligned?

Briefly, I think I will answer for those of you who do invest with us, how I would answer the questions. Feel free to question us more closely in person. Note: While this discussion applies broadly to all of our clients, it is specifically addressed to the vast majority of our assets under management, accredited and qualified investors (those with a net worth of 1 million and up) in our model portfolio’s.

1. What were your adviser’s expectations for the stock market’s returns in 2008, and how did these expectations compare to the actual results?

In our case this discussion really should not be constrained to 2008. We believe we are in the midst of a long term bear market that began with the bursting of the tech bubble in 2000, especially for US financial assets. We participated in the cyclical bull that began in 2003, with significant allocations to international, emerging market, real estate and other high flying assets. Starting in 2006 we began to become more defensive as valuations became more and more unreasonable, allowing our portfolio to move forward based on those areas we felt were most attractive. That allocation allowed us to post strong results through the third quarter of 2007, but the portfolio was dominated more and more by assets not dependent on the general direction of the market. By 2007 we felt returns were likely to turn negative, the economy would struggle and a defensive portfolio was the most prudent path. We had by February of 2007 scrubbed nearly all exposure to financial stocks from our portfolio.

In general our expectations have been met. The markets, especially financial stocks have struggled. Following our strong showing through the first three quarters of 2007 we had a strong burst in the fourth quarter as the markets in the US fell. We weathered the storm in January with a small gain and when all was said and done had a solid first half of the year, with positive returns in each quarter, with solid gains in June to finish off the second quarter.

We began to have concerns short term with our exposure to commodity stocks, especially energy, and hedged that exposure somewhat. We assumed that some of the relationships in our hedged positions might have a short term reverse as well. Unfortunately all of our main performance drivers reversed from the middle of July to the middle of August. It was unusual that all would reverse at the same time, as opposed to being spread out. Unfortunately most, if not all, of our gains during 2008 were lost, though we were still positive since the downturn in the broader equity markets began in October. We feel that most of what we are doing now is still well positioned, with the most likely trouble spot being our unhedged positions, specifically commodity stocks and Asia. Depending on their relative performance we will have a flat to positive end to the year. Our expectation is we will finish the year with returns in the high single digits, which is what we expected at the beginning of the year.

What about surprises? The relative strength of small cap and real estate stocks stick out. We feel they will resume their under performance going forward. Commercial real estate is starting to roll over and we expect that to weigh on REITs. Small cap stocks are still very overvalued, and earnings likely to continue to disappoint. As credit markets and the economy become even more strained access to credit will hit them hard. If they struggle greatly relative to larger, higher quality stocks we could see our expected return numbers increase markedly.

2. How did your investment performance compare to that of the major indices? In what areas did you outperform, and in what areas did you underperform — and why?

We have outperformed broad market indices handily year to date, since the downturn began, and for trailing one, three and five year periods. Heck, we are positive for the year! Accomplishment enough, if unspectacular. Compared to the indices the various areas of our portfolio have performed from okay to fantastic. No major underperforming areas.

3. What was your adviser’s economic and credit expectations, and how did these expectations compare to the actual events? Where and why were his assumptions wrong?

We felt the US faced a high probability of a recession coupled with a worldwide slowdown. We felt the credit markets were the most vulnerable, due to a severe housing downturn, and inflation would be an concern. Interest rates were a bit uncertain since, with inflation an issue and growth vulnerable, the fed would be pushed in both directions. More importantly, due to the difficulties in the credit markets we felt interest rates would be relatively insensitive to the federal reserves efforts and interest rates would remain stubbornly high, with credit spreads likely to widen dramatically. Thus we felt diversifying credit exposure internationally would be prudent and bonds would not be as positive a counter to equity risk as they were in the last downturn.

That has all come true, but our moves to diversify in fixed income have not proven of much benefit. However, our emphasis on other strategies to reduce risk versus fixed income has added value, demonstrating that an over reliance on traditional fixed income to protect in a downturn would not be optimal. In fact, fixed income has been a drag on performance on both the upside and downside of the market over the last two years for us.

4. Did your adviser change his strategy as economic and financial events changed? If he didn’t, ask why?

Yes, though our change occurred before the downturn. We have made some small tactical changes as the year has progressed, though our fundamental approach we feel is still sound. We are preparing for some significant changes in the near future, especially if the equity markets weaken substantially from here and we position the portfolio for a more positive market environment.

5. Did you experience outsized individual stock or large specific industry or sector share price losses? Did your adviser institute a discipline to stop losses, or were your losses allowed to compound? Did your adviser “double down” on poor investments?

This question really doesn’t apply to us since we don’t trade individual securities, though we have hedged positions where one side or the other have struggled. That of course is the expectation for a hedged pair of positions targeting an absolute return. Nevertheless we wish some had been more successful, even if as a pair they outperformed the indices.

6. Ask your adviser whether he “eats his own cooking” — that is, did he invest along with you in the same investments, and are both of your interests aligned?

Not only do we, it is a core value at our firm, and that is exactly how we put it. “We eat our own cooking.”

Hat Tip: Barry Ritholtz

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Technorati Tags absolute returns, advisors, assessing performance, bonds, investment performance, markets, stocks

If a recession does occur, it could last longer and be more painful than the past several downturns because of differences in its origin and character. The recessions that began in 1991 and 2001 lasted only eight months from the start of the downturn until the beginning of the recovery. Even the deeper recession of 1981 lasted only 16 months.

But these past recessions were caused by deliberate Federal Reserve policy aimed at reversing a rise in inflation. In those cases, the Fed increased real interest rates until it saw the economic slowdown that it thought would move us back toward price stability. It then reversed course, reducing interest rates and bringing the recession to an end.

In contrast, the real interest rate in 2006 and 2007 stayed at a relatively low level of less than 3%. A key cause of the present slowdown and potential recession was not a tightening of monetary policy but the bursting of the house-price bubble after six years of exceptionally rapid house-price increases. The Fed therefore will not be able to end the recession as it did previous ones by turning off a tight monetary policy.

The unprecedented national fall in house prices is reducing household wealth and therefore consumer spending. House prices are down 10% from the 2006 high and are likely to fall at least another 10%. Each 10% decline cuts household wealth by about $2 trillion, and this eventually reduces annual consumer spending by about $100 billion. No one can predict the extent to which the coming fall in house prices will lead to defaults and foreclosures, driving house prices and wealth down even further. Falling house prices also discourage home building, with housing starts down 38% over the past 12 months.

But the principle cause for concern today is the paralysis of the credit markets. Credit is always key to the expansion of the economy. The collapse of confidence in credit markets is now preventing that necessary extension of credit. The decline of credit creation includes not only the banks but also the bond markets, hedge funds, insurance companies and mutual funds. Securitization, leveraged buyouts and credit insurance have also atrophied.

The dysfunctional character of the credit markets means that a Fed policy of reducing interest rates cannot be as effective in stimulating the economy as it has been in the past. Monetary policy may simply lack traction in the current credit environment.

Read the whole thing, but it mirrors much of what we have been saying. Here is Martin on the Charlie Rose show where he stresses that it is not just a subprime issue, that all kinds of assets were not priced appropriately, and frankly still are not:

Hat Tip: Barry Ritholtz

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Technorati Tags Charlie Rose, credit markets, Economics, fiscal policy, Martin Feldstein, monetary policy, NBER, Risk, the economy

NYS Commissioner of Insurance has suggested splitting the Muni bond business from the rest of the insurers. FGIC seems to now think that isn’t a bad idea. Of course, since Elliot Spitzer has told them all to find sufficient capital in the next three to five days, they may have little choice.

Barry Ritholtz thinks this pretty much will lead to ending them as viable organizations:

What’s left is can best be described as a poorly run, derivative hedge fund led by people who have no business running a hedge fund of any sort, much less one of the poorly run derivative variety. But the fact that the NYS insurance commissioner is suggesting this should tell you that this has reached a level of government involvement that cannot bode well for our friends at ABK, MBIA and FGIC

Those vaunted rate cuts which Risk and Return was skeptical would be the driving force behind our economic path?

The Federal Reserve’s interest-rate cuts last month have failed to lower borrowing costs for many companies and households, increasing the chance of further reductions from the central bank.

Companies are paying more to borrow now than before the Fed reduced its benchmark rate by 1.25 percentage point over nine days in January, based on data compiled by Merrill Lynch & Co. Rates on so-called jumbo mortgages, those above $417,000, have increased in the past month, making it tougher to sell properties and risking further price declines.

Barry again:

Bill King noted a similar story on ABC News:

[Monday] night, the lead story on ABC evening news (World News) was ‘though the Fed has cut interest rates sharply in recent weeks, banks and credit card companies are hiking rates on consumers.’

Chase, Bank One and Bank of American were cited. The ABC News reporter said banks are hiking consumer interest rates and fees to cover losses on their crappy paper.

Yes, it’s that blatant and transparent.

Lovely. We get all of the wonderful inflationary effects of rate cuts — but none of the economic benefits.

Can you say “The Fed is pushing on a string?”
(Very good children. I knew you could)

True, though my own opinion is the Fed never has as much strength to push as we think they do. Way too much time is spent on what the Fed is doing. Granted, even though I know better, I do it as well.

While I keep sending you to Barry today, you might as well let him educate you on why the retail sales number that cheered some for a moment on Wall Street are actually looking pretty disastrous. Start here, finish there.

Hat tip: As always, some of this is from Abnormal Returns. Even if not, go there.

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Technorati Tags Economics, economy, Federal Reserve, Inflation, monetary policy, monoline insurers, retail sales

A while back MBIA, AMBAC and other monoline insurers backed sleepy municipal bond portfolio’s. Having entered, and then become ensnared, in the broader credit markets, they face being downgraded. If they are downgraded, the bonds they guarantee are downgraded, even money market instruments:

What’s happening is that tax-free money funds are dumping billions worth of muni securities backed by shaky insurers, and these bonds aren’t attracting many buyers. Funds have the right to sell securities back to their brokers. On occasion, doing this is one way muni managers can meet customer redemptions. But now they’re using it as a convenient exit strategy to get out of troubled securities before they’re downgraded.

The problem with that solution:

The Fed worries that banks could wind up stuck with more of these bonds on their books. That would eat up valuable capital reserves. “The Fed wants banks to lend to corporations and personal borrowers, not to act as a holder of last resort,” says Robert Auwaerter, who oversees $440 billion in fixed-income assets, including $48 billion in muni money-market funds, at Vanguard Group. Retail muni money-market funds have assets of $289.5 billion; institutional versions of the funds hold $182.4 billion.

If muni money-market funds keep them they risk losing capital, if they don’t banks already struggling to stay afloat not only have to take on the liability but will have their capital absorbed by these bonds and unavailable to lend to others. The permutations of this crisis are stretching way past my point of imagination.

HT: Abnormal Returns

Technorati Tags banks, Federal Reserve, investing, monoline insurers, municipal money market

Reactions:

Barry Rithotlz- Q4 GDP: El Stinko!

• Consumption slowed to 2% from 2.8% in Q3; I suspect that only partly reflects real growth, meaning its partly inflated by price rises;

• U.S. exports continue to increase: Up 3.9% for the Q. Overseas trade added nearly half a point to Q4 GDP;

• Overall, the US economy grew 2.2% for the full year 2007 — the slowest since 2002 (1.6%)

• Inventory build, which drove the 4.9% Q3 data, was totally absent. It sliced 1.25% from GDP, after adding nearly a point in Q3.

• Inflation remains sticky: Price index for personal consumption expenditures rose by 3.9% in Q4 after a tepid 1.8% in Q3. This was the second highest PCE # since 2001

• Q4 business spending rose 7.5%. Investment in structures went 15.8% higher (which seems an awful lot to me); Equipment/software purchases rose by 3.8%.

• Biz spending decelerated in the fourth quarter from Q3’s hotter 9.3%.

Calculated Risk:

Since PCE came in at only 2.0%, clearly there was a sharp slowdown in December, and the growth from the last month of Q3 to last month of Q4 was probably negative – suggesting a recession might have started in December.

Edit: The ADP employment data is also available this morning, showing nonfarm private employment grew by 130,000 in January, and without a downward revision, those numbers are definitely not recessionary.

More on those ADP Numbers.

Bespoke delves into historical US GDP numbers.

Real Time Economics notes the weakness was highly influenced by inventory liquidation.

Manufacturers however are feeling pessimistic.

Calculated Risk breaks down the impact of non residential investment.

Dean Baker pretty much chalks up the consumer spending necessary to keep the GDP positive to spending on flat screen TV’s!

Stefan Karlsson says that trade adjusted real GDP turned negative, and thus the recession is underway.

Nouriel Roubini agrees.

The Fed Cuts!

Written before the cut was announced, Yves Smith of Naked Capitalism notes the Fed was already nearing negative real interest rates, and by some measures was already there.

James Hamilton gives us his research on when to expect the rate cuts to affect the housing and mortgage markets. Blog partner Menzie looks at how this is supposed to help and sees it as a positive, but a muted one.

Real Time Economics jumps in with several posts:

• Greenspan doesn’t think central banks have the power to prevent a recession:
  • “Global forces can now override most anything that monetary and fiscal policy can do,” he said in an interview with Germany’s Die Ziet, published today. “Central banks have increasingly lost their capacity to influence” long term interest rates, he said. He added that the solution to bank vulnerability to exotic investments is to have “far higher capital.”
• Personally I am on Greenspan’s side here. The Fed is just not as important or as powerful as people think.
• The Federal Reserve’s lone dissenter about today’s rate cut was Richard Fisher.
• Finally we have a roundup of reactions from various economists.
• Worries about those pesky inflation expectations.
  • The Federal Reserve’s aggressive rate cuts in the last 10 days are having one unpleasant side effect: they’re boosting bond investors’ concern about inflation.

Investors reacted with enthusiasm, and then promptly collapsed. Actually, yesterdays charts were really bizarre. I expected the sell-off, but the market was strangely flat, then spikes up, then down.

Barry Ritholtz thought it was odd as well. Today was a different matter. A very strong day.

Errata

Credit default insurance has gotten much more expensive.

From Abnormal Returns I am copying this mini roundup on an issue that is finally getting substantial coverage these last few weeks:

More talk about the potential demise of the monoline bond insurers. (A Dash of Insight, Big Picture, FT Alphaville, naked capitalism)

Justin Wolfers has a question:

are those who are using the R-word suggesting that the “Great Moderation” is over, or simply that we are facing an especially unusual set of adverse business conditions? Or was there never any real change in the structure of the economy, and the last couple of decades have been simply a statistical fluke?

Who doesn’t own some of this stuff?

The company wrote off $275 million in investments in the quarter, which could rise to as much as $417 million, said Rebecca Goldsmith, a spokeswoman for the New York-based drugmaker …

“Some of the underlying collateral for the auction rate securities held by the company consists of sub-prime mortgages,” the company said today in a statement. If credit and capital markets continue to deteriorate, Bristol-Myers said, it “may incur additional impairments to its investment portfolio, which could negatively affect the company’s financial condition, cash flow and reported earnings.”

Fiscal Stimulus

Jason Furman vs Steven Landsburg on fiscal stimulus.

Alex Brill tells Greg Mankiw a secret behind the numbers.

Menzie Chinn gives her take.

Hat tip: As always, some of this is from Abnormal Returns. Even if not, go there.

Thanks for visiting Risk and Return. Please feel free to contact us with any questions and/or comments. Please note our disclaimer.

Technorati Tags credit, Data, Economics, Federal Reserve, fiscal policy, GDP, housing, monoline insurers, recession, stimulus

China turned in yet another double digit year:

China’s economy grew by 11.4 per cent in 2007, the highest pace in 13 years, but the trend of decelerating exports to a slowing US recorded in the final two quarters is expected to be carried into moderating growth this year.

China’s economy has now grown at double-digit rates for five straight years, an achievement hailed by the government as a “hard won gain” of difficult policy decisions.

New York Insurance officials are pressuring banks to bail out the insurers:

Leading US banks are under pressure from New York state’s insurance regulator to provide as much as $15bn to support struggling bond insurers, people familiar with the matter said on Wednesday night.

I am not sure if that is the right move for the banks, but you have to think they are saying to themselves, “How lovely, we pay these guys to insure bonds, when they cannot pay us they want us to provide the money they need to pay us back. Just lovely.”

The Congress has passed a stimulus bill. Of course, when are the checks supposed to arrive? In June. Haven’t I spoken about the time issue before? I think I have. Yes.

Steven Dubner has a similar observation, and some support. Bruce Bartlett throws in this chart to illustrate history supports we skeptics (click image to enlarge)

Which goes to prove that recessions end and stimulus rarely appears until after they are over.

Are we in recession? Calculated Risk looks at a little covered set of data from the Philadelphia Federal Reserve Bank.

Bespoke compiles some data to help us understand how a Bear Market behaves. That is part of my next post, I have some thoughts on that as well.

I stand by the claim that as investors we should pretty much discount fiscal stimulus as a plus any time soon. Greg Mankiw doesn’t think things are bad enough for this to do much good in any case, and potentially is a long run negative.

Tyler Cowen discusses the law of unintended consequences:

Dubner and Levitt have an article in the NYTimes with three examples of the law of unintended consequences, the Americans with Disabilities Act made it more costly to hire people with disabilities and reduced their employment, ancient Jewish sabbatical law intended to help the poor has made them worse off, and the endangered species act has resulted in habitat destruction.

If it isn’t a law it is certainly a key risk factor.

Oh, and about that fraud, 7.1 Billion dollars worth by a single trader.

Which leads Barry Ritholtz to feel the Fed intervened for the wrong reasons. I lean his way on this. In fact, this kind of makes the point that he is right.

Hat tip: as always, some of this is from Abnormal Returns. Even if not, go there.

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Technorati Tags bond insurers, China, Federal Reserve, fiscal policy, fiscal stimulus, Links, recession

Update: David left me a comment, so I am going to include it, and my response:

I’m not saying regulators won’t be forced to make a choice, or what that choice might be. My opinion on what should be done is not that far away from that of Ms. Schlaes. I just think that the FOMC is in a pickle; no matter what they do, they will continue to face asset deflation, and price inflation for the next few years.

Thanks for citing me, though.

My response:

David,

Thanks for stopping by. Actually, I don’t doubt you are pretty close. I intend short links to engage the reader to read and think it through. In fact, I think you are both saying the same thing, she is just willing to stake out the anti-inflation ground as the most important. The contra was in reference to the title of your piece, not the deeper substance. Probably me being too clever, well clever might not be the right word, but humor isn’t my strong point.

Anyway, I like your stuff. As an aside, I agree with you. We face inflation and deflation in asset prices. In fact, deflation in asset prices can feed consumer price increases, but that is a long discussion.

Technorati Tags Ben Bernanke, deflation, Federal Reserve, Inflation

What does this mean for investors. Quite a number of things – none of which are particularly good over the long term:

1) Why Cut today? What was the motivation for today’s cut? Would waiting 7 days have done anything. other than allowing some of the excesses to get wrung out of the system?

2) Equity Market Dysfunction? Is it that the equity markets are not working properly? Likely not. Are rates too high? I doubt that’s the reason for any of our economic woes. Then what is it – are lowered equity prices a problem?

Globally, equity markets have been in the process of “Repricing Risk” – why is the Fed disrupting that? Further, there is now a recognition that S&P500 earnings were priced way too high – especially in the event of a European and Asian slow down. That lowered “E” in the P/E adjustment is also under way.

3) TANSTAAFL: The free lunch crowd (a/k/a Long & Wrong) has been chanting for Fed cuts. However, these are not with0out consequences, as Inflation remains a pernicious threat.

Here’s a question: What goes to $5 a gallon first – Milk or Gasoline? How about $6?

4) How Independent is the Fed? The Fed is supposed to be an independent entity, whose mission is a) price stability (inflation) and b) maximizing employment (growth).

However, today’s action reveals an apparent third obligatory goal – protecting investors and market prices. I had no idea that back-stopping speculators and hedge funds was part of their mandate…

5) Capitulation? The Market gapped 400 points, and is now climbing higher (off 300 as I type this). My second biggest concern is that the Fed merely delayed the inevitable. This market saving cut prevented a thorough, 5% wash out. In other words, all the Fed did was prevent a healthy capitulation.

6) Pushing on a String? My biggest fear is that we close down 500 points anyway. That would be the worst of all worlds: A compromised, political Fed, working on behalf of speculators, to the detriment of ordinary taxpayers, is proven to be a paper tiger. That scenario would but the “F” in Fugly.

7) Decoupling US Equities from Global Slowdown? Other markets were down much more than the US. But that makes sense, seeing as they have been a whole lot more than the US over the past 5 years . . .

Bill Gross echoes Barry and I:

“It’s a sad testament to think the Fed has to cut interest rates eight days in front of a meeting to salvage the equity markets. The U.S. economy is in a rather sad state of affairs in that it depends on housing and stock prices to keep going.”

-Bill Gross, founder and chief investment officer, Pacific Investment Management Co. (PIMCO)

Paul Desmond in the Wall Street Journal builds on the theme:

In many ways, this is what a classic bear market looks like: After a long period of exuberance, a downturn hits one part of the economy — in this case, the housing market and mortgage-backed securities. Eventually, that leads to broader losses, even for strong companies, and markets begin a prolonged grind downward. . .

The current market looks a lot like the beginning of past bear markets, such as the ones that began in 2000 and in the 1970s and 1987, said Paul Desmond, president of market-research firm Lowry’s Reports in North Palm Beach, Fla. First, the most troubled stocks decline — home builders and financial stocks in the current case — and then others gradually get hit, including small stocks, retailers, technology stocks, and foreign stocks. Finally even stocks of strong companies are affected.

What happens, Mr. Desmond says, is that trading volume and price movement get heavier and heavier for stocks that are declining, and lighter and lighter on the buying side, as more investors look for a way out. When the selling reaches a climax, the bear market is nearing an end, but Mr. Desmond says he doesn’t see any sign of a climax yet.

“We feel we have been in a bear market since July. Everything that we have seen since then has just been a progression, almost like a disease that you are monitoring and the disease is spreading,” he says. “We are still a long way from a major bottom.”

He is watching for a sign of panic selling, but says it hasn’t gotten to that point yet. “Everything we are seeing looks like a typical bear market,” he says.”

Update: Barry has two interviews with Paul:
Q&A: Paul Desmond of Lowry’s Reports
Part II — Q&A: Paul Desmond of Lowry’s Reports

Technorati Tags Barry Ritholtz, bear market, decoupling, Employment, equity markets, Federal Reserve, Inflation, interest rates, monetary policy, Paul Desmond, stocks

WASHINGTON (AP) — The Federal Reserve, confronted with a global stock sell-off fanned by increased fears of a recession, cut a key interest rate by three-quarters of a percentage point on Tuesday.

Quicker and larger than expected.  I am curious whether investors will, at the margin, consider this a move to celebrate or evidence that things will get much worse?

Technorati Tags Federal Reserve, interest rates, stock markets

Stock markets around the world plummeted Monday, prompted by pessimism about U.S. President George W. Bush’s plans to boost the U.S. economy.

Share prices in Asia, Europe and the Americas all plunged by significant amounts; Wall Street only avoided joining the tumble because U.S. markets were closed Monday for Martin Luther King Day.

Markets in Europe reacted with London’s FTSE 100 Index down 5.5 percent at 5,578.20; the CAC-40 in Paris down 6.8 percent to 4,744.15; and Frankfurt’s DAX dropping 7.2 percent to 6,790.19.

In Japan, the benchmark Nikkei 225 index closed on 13,325.954 points, a slide of 3.9 percent and its biggest dip in two years. Shanghai’s Composite index fell 5.1 percent.

Read the rest if you want to feel depressed.

This is probably a mix of the need for stimulus being a bad sign for the world economy, and a realization that the stimulus is also not going to be sufficient. I agree on both conclusions. My concerns over the economy have been expressed in no uncertain terms for some time, and I have given my reasons for doubting the efficacy of fiscal stimulus packages. Fiscal stimulus that relies on increasing spending is an especially false hope, except in rare circumstances. Tax packages that make the adjustments businesses and investors need to make less expensive can help, but to do so they would have to be substantial, and politically I doubt they will amount to much.

Interestingly, Paul Krugman has historically felt similarly. Unlike Paul, I doubt monetary policy can do much either.

An important thing to remember when we discuss the government stimulating the economy, is that the numbers involved are completely out of whack. Let us pretend that the government spending $145 billion actually subtracted not a whit from other people’s spending or investment. That it was all added spending in our economy that would not exist otherwise. This is frankly ridiculous, but let us for the sake of argument pretend it were true. Folks, when we are talking about a 13 trillion dollar economy, that seemingly large $145 billion seems awfully puny. Around 1%. That one percent is supposed to make a difference?

Of course, that is a completely unrealistic scenario, because in fact the government will borrow the money from somewhere, money that would largely have been spent or saved in another fashion anyway. Academic studies show large amounts of the stimulus will be used to pay down credit cards and other debt. Some will be saved. Whatever that is, it isn’t a stimulus.

Similarly, the Federal reserve, for all the sturm and drang in the papers over the massive liquidity injections, is similarly poorly positioned. They control approximately $30 to $40 billion in reserves. That is it. The amount of liquidity “injected” has been essentially nil. Almost all of it was just the federal reserve rolling over existing repurchase agreements with banks. They can attempt to lower interest rates, but that will have a long delayed impact. Politically the Fed and the government need to be seen doing something, but what they can do is vastly overrated.

I bring this up not to scold our politicians, or the Fed, but to emphasize that we as investors should not be fooled about such policies rescuing us if we are not appropriately positioned. Certainly we should be mindful of the last time investors were urged not to “fight the Fed.” Huge losses followed as many investors walked hand in hand with the Fed to interest rates as low as 1%. I chose to fight and I am glad I did.

The economy and markets may recover, but policy will not be the major determinant.

Other views:

Tyler Cowen points out that rebates don’t always accomplish what they are supposed to do.

Menzie Chen looks at business incentives.

James Hamilton makes his case against fiscal policy, and echoing my own thoughts thinks Bernanke was not giving the green light to it that many believe.

Paul Krugman has his own thoughts about what to do now.

Mark Thoma questions the efficacy of making tax cuts permanent.

Finally, via Abnormal Returns, Greg Mankiw asks great questions:

If some journalist out there talks to a member of the Federal Open Market Committee, here is the question I would ask:

If the economy now gets the fiscal stimulus being proposed (about 1 percent of GDP), does that mean that the Federal Reserve will cut interest rates less than it otherwise would?

My follow-up questions:

If the answer to the first question is No, then ask, Why the heck not? Monetary and fiscal policy are two tools available to increase the aggregate demand for goods and services. The goal here is to prop up demand sufficiently to maintain full employment without causing inflation. If the U.S. government is using fiscal policy more, it should use monetary policy less.

If the answer to the first question is Yes, then ask, How much higher will interest rates be kept as a result of the fiscal stimulus? And is it really better to have a fiscal stimulus and higher interest rates than a smaller deficit and lower interest rates?

More from Greg here, and here.

Update: Megan McCardle echoes my concerns:

As talk of stimulus plans grows, readers are asking for my thoughts. Which are: stimulus rarely works unless it is massive and very rapidly applied, and if it is massive and very rapid, it usually has much larger problems.

The difference between tax cuts and spending is irrelevant in theory. In practice, because so few people pay significant income tax, it has distributional effects. Since rich people seem to save more money than poor people, this blunts the effect of the stimulus. On the other hand, spending is generally much more distortionary than tax cuts, because the government picks what the money is spent on. One more reason not to like fiscal stimulus packages.

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Technorati Tags federal government, Federal Reserve, fiscal stimulus, monetary policy

Fortunately, the Fed has some ideas on what they should–and shouldn’t–do. Bernanke’s remarks came with a warning that any fiscal bailout “could prove quite counterproductive” if it’s not done in a timely manner or if it’s not temporary.

Brian Wingfield goes inside the fed chiefs mind:

Translation: Get to work immediately and spread out the costs over time. The price tag? Bernanke says a $100 billion package would have a “significant” impact on the economy.

Here he explains why he is dubious:

“It’s very difficult to engineer a well-timed fiscal stimulus,” says Vincent Reinhart, a former Federal Reserve economist, now a scholar with the American Enterprise Institute. The 2000 recession was resolved by a “happy accident” of circumstances, he says. President Bush ran for office on a proposal to cut taxes, which helped the economy just as it was slowing. At the same time, the Fed took an expansionary view of monetary policy, cutting interest rates to spark growth (fueling a housing boom, which is at the core of the current downturn).

It might be difficult to time such an economic rescue correctly this time around. “You’re just not sure when you start the process where you’ll end up when legislation’s involved,” says Reinhart.

I have made my own concerns known. Read them, my guess is it is pretty much the gist of what Bernanke is driving at, and probably he is managing his public perception more than expecting it to make any large difference. Either way, I don’t expect it to have any meaningful positive effect on longer term investment results. Douglas Elmendorf is skeptical as well:

One circumstance in which fiscal stimulus is an appropriate complement to monetary stimulus is when achieving full employment with higher interest rates is better than achieving full employment with lower interest rates. In particular, further cuts in short-term U.S. interest rates heighten the risk of investors deciding to flee U.S. assets. The result would be further turmoil in financial markets and a large and quick drop in the value of the dollar, which would be disruptive to the U.S. economy and foreign economies and might slow economic growth further. Moreover, any decline in the dollar puts upward pressure on inflation (beyond any inflationary pressure from the level of employment) because higher prices for imported goods act as a negative supply shock.

However, he does cite some potential positives.

Meanwhile housing starts were even worse than expected, and expectations were pretty bad to begin with:

Home construction plunged in December, tumbling to its lowest point in 16 years, while a sign of future groundbreakings also dropped sharply.

Housing starts decreased 14% to a seasonally adjusted 1.006 million annual rate, after falling 7.9% in November to 1.173 million, the Commerce Department said Thursday. Originally, Commerce reported November starts 3.7% lower at 1.187 million.

The big decline surprised Wall Street. The median forecast of economists surveyed by Dow Jones Newswires was a 5.0% drop to a 1.130 million annual rate. The level of 1.006 million was the lowest since 996,000 in May 1991.

Commercial property is not looking immune either:

The credit crunch that roared through the residential real-estate market is starting to bite commercial projects, too.

Yesterday, Ian Bruce Eichner, the developer of a twin-tower casino resort in the heart of Las Vegas, defaulted on a $760 million loan from Deutsche Bank AG after he failed to get refinancing. The default on the loan supporting the $3 billion Cosmopolitan Resort Casino is a signal of trouble for Mr. Eichner, who gained notice during an earlier real-estate downturn in the early 1990s when he lost several projects in New York City.

Merrill Lynch also did worse than the already awful expectations. My emphasis:

The company recorded a net loss of $9.83 billion, or $12.01 a share, compared with year-earlier net income of $2.3 billion, or $2.41 a share. Write-down expectations were running as high as $15 billion. The company recorded $7.9 billion in mortgage-related write-downs in the third quarter.

Net revenue was negative $8.19 billion because of the write-downs.

The mean per-share loss estimate of analysts polled by Thomson Financial was $4.93 on revenue of $399 million.

Twelve dollars in losses a share!

In addition people are wondering about this whole “de-coupling” thesis (also here.)That is the idea that emerging markets and other countries overseas can avoid a downturn if the US slides into a recession. I admit to being skeptical as well, though I suspect they will only slow down, and while they will be volatile, they will not decline as much as US markets will if things get really ugly.

(ed.- haven’t you already said they were ugly?)

Uglier than people have thought, but I am no longer so lonely and markets have discounted the possibility of recession, not it actually happening. That is a key distinction people have missed. I regularly hear that markets have a recession “in the price.” That is why they have gone lower. If so, then why do prices keep going lower when more bad news hits? Markets discount the probability of something. Shares have declined as investors have felt that probability rising, as it becomes more obvious that profits will decline they will go lower still. If things get worse, it will get a lot uglier in the markets. An actual recession is not in the price.

In fact, the prices in my mind still imply earnings growth over the long term which are unreasonable for the broader indices.

Of course, a good question is, are bonds the answer? I don’t think so, and Doug Kass is downright bearish (H/T:Abnormal Returns.)

The bond market is in a bubble that is reminiscent of (and quite possibly as extreme as) other bubbles during previous eras.

From my perch, the only issue is the timing of this trade.

Surprisingly, today’s 3.68% yield on the 10-year U.S. note is lower than the yield during the recession of 2001. This low yield appears to be artificially affected by a number of temporary and backward-looking factors.

His rationale for this shows the uncertainties surrounding this asset class, though I am not sure now is the time to sell. Let us just say we have deemphasized bonds as a defensive measure and concentrated on other techniques. Bonds have been a drag on our portfolios since November, and so far this year. So we are pretty happy with that choice. The other ways of dealing with this have been far more effective. I expect that will remain true.

What about the risk from insurers of debt I have mentioned before? It is looking grim for them as well. Calculated Risk looks at the latest PR from AMBAC:

Translation: You thought 14% was a steep yield for MBIA to pay on the surplus notes (See: “How many other AAA rated companies are raising money at 14%?”). With this possible downgrade, we might not be able to raise capital even at 20%!

Also note, from Merrill this morning, the $3.1B credit valuation adjustments related to hedges with financial guarantors (ACA financial). There is no party in counterparty. (thanks to BR!)

I did notice that little tidbit on Merrill, which goes to the biggest known risk that hasn’t really hit yet, all those insurers, including investors behind credit default swaps, who may not be able to pay up! What is the level of counterparty risk?

Funny you should ask, because the ratings agencies say they don’t know (my emphasis below)and probably will not know:

The complexity of the global financial system and the imbalance of information available to market participants means the ability to track risk has declined “probably forever”, Moody’s Investors Service said . “It is extremely unlikely that in today’s markets we will ever know on a timely basis where every risk lies,” analysts at the ratings agency, led by chief international economist Pierre Cailleteau, wrote in a report.

Read the whole thing.

Various links from Abnormal Returns:

Tech spending does fall in a recession. (Silicon Alley Insider)

You think?

News you should (already) know. A study finds that “..clowns are universally disliked by children.” (Scientific American)

You think?

A new primer on behavioral economics. (Odd Numbers):

From a new blog by M.I.T. economist Dan Ariely tied to his new book Predictably Irrational. I read and would highly recommend the book if you’re looking for case after case of the failure of rational man.

Definitely going on my blogroll.

Thanks for visiting Risk and Return. Please feel free to contact us with any questions and/or comments. Please note our disclaimer.

Technorati Tags AMBAC, behavioral finance, Ben Bernanke, clowns, Emerging Markets, Federal Reserve, fiscal policy, fiscal stimulus, housing, MBIA, Merrill Lynch, Moody's, recession

In retrospect, what should the fed have done differently?

Risk and Return is really about implications for investment policy, and thus identifying which factors have implications is key. Pumping for particular policy choices really isn’t our role. Still, in identifying what probably should have been done we can better recognize the impact of future events. Here is the quick, and therefore somewhat inelegant, response I gave him:

First, I do think interest rates were kept too low, too long. The goal was to inflate asset prices, specifically housing, to stimulate the economy. Of course, high asset prices mean lower returns later, or in this case, declines. That worked, but what do you do next? The loans encouraged by high, and rising, prices don’t make sense when that condition clears.

The fear at the time was a deflationary spiral (see Japan since the end of the ’80’s.) The problem I had with that fear, and it was legitimate, was that for all the issues surrounding the tech and stock bubble (the latter not being over) Japan’s crisis was a financial, and specifically related to a real estate bubble, collapse. In order to avoid the Japan disease, we have put those very same conditions in place. The tech and stock market bubble collapse (once again, that collapse is still in process, and will be for some time) was unlikely to lead to a Japan scenario. I don’t think this will either, but it certainly has much more of a chance, which makes the policy much harder to defend. Recessions come and go, huge financial crises are not to be played with, even if the worst case scenarios are unlikely.

Second, if you are going to inflate housing, and in essence create a strategy for raising prices that may not be sustainable long term, it certainly makes sense to curb speculative excesses and fraud through regulation. I am no fan of regulation, but irrational prices encourage irrational greed. Doing what you can to ensure loan quality in this kind of environment was a no brainer. At minimum fraud needed to be curtailed. That wouldn’t have avoided the crisis, but it would have made it less severe. The Fed created conditions, it then needs to work to ameliorate the risks to the broader economy those artificial conditions create. Low regulation environments make sense when the ultimate investors and home buyers pay for their greed or mistakes. The discipline of the markets. However, if you create a situation where that solution causes broader systemic issues due to your own policy, the market will not work it out, because politicians and economic actors can’t afford for that many people to suffer.

To elaborate, moral hazard is in play. Politicians will try and fix it, leading to a spiral of further regulation and short term fixes, reinflating of assets and a rescue which encourages the same excesses. Worse, these solutions are unlikely to make much difference in the short term. Their impact will be after the current problems are likely to have worked themselves out systemically already. If they haven’t, the problem is therefore likely beyond the policies ability to accomplish much and will sow the ground for future crises from declining asset prices, that is if there are any assets left to inflate. Housing doesn’t seem likely to easily recover merely due to lowering rates again, and long run, do we want their prices to stay artificially high?

To put it another way, wasn’t using interest rates and a hands off regulatory policy in tandem to inflate housing values among the root causes of what got us here in the first place? If so, then stretching the pain out too much may help avoid a true Japan scenario, though I don’t think that is likely, but it is very likely to set us up for problems for years to come. I don’t envy Bernanke, his choices are pretty unappetizing all the way around at this point.

As an aside, I think this is a good time to read about Ben, here is a thorough biographical article by Roger Lowenstein that has taken the financial blog world by storm. (via Crossing Wall Street)

Technorati Tags Anna Schwartz, assets, bubbles, Federal Reserve, Housing Market, Inflation, interest rates, Japan, loans, monetary policy, moral hazard, mortgages, regualtion

I have to agree with Frederic Mishkin of the Fed:

I think there is too much focus on what decision will be made about the federal funds rate target at the next FOMC meeting. What is important for pricing most financial assets is the path of monetary policy, not the particular action taken at a single meeting.

One of the great myths of the market is the over-agency of the Federal Reserve. In reality, the Fed is much less powerful than is commonly believed.

I think some people have to believe that there’s some mysterious group that’s in charge and running things. Ron Paul even blames the Fed for higher oil prices.

Nobel Laureate, Edward Prescott, wrote in the Wall Street Journal:

I am not saying that there are no real costs to inflation — there certainly are. And if we get too much inflation we can exact high costs on an economy (witness Argentina as an example). However, I am talking here of the vast majority of industrialized countries who live in a low-inflation regime and who are in no danger of slipping into hyperinflation. It is simply impossible to make a grave mistake when we’re talking about movements of 25 basis points.

I would add that even if they do not make a mistake it is unlikely to change the outcome for investors in any dramatic fashion. The Fed is just not the main determinant of asset prices, nor is the yield level of treasuries.

That doesn’t mean the Fed hasn’t made mistakes which have contributed to our present woes. Milton Friedman’s old partner, Anna Schwartz, brings out the wood (via Greg Mankiw)

As rebukes go in the close-knit world of central banking, few hurt as much as the scathing indictment of US Federal Reserve policy by Professor Anna Schwartz.

The high priestess of US monetarism – a revered figure at the Fed – says the central bank is itself the chief cause of the credit bubble, and now seems stunned as the consequences of its own actions engulf the financial system. “The new group at the Fed is not equal to the problem that faces it,” she says, daring to utter a thought that fellow critics mostly utter sotto voce.

“They need to speak frankly to the market and acknowledge how bad the problems are, and acknowledge their own failures in letting this happen. This is what is needed to restore confidence,” she told The Sunday Telegraph. “There never would have been a sub-prime mortgage crisis if the Fed had been alert. This is something Alan Greenspan must answer for,” she says.

[...]

Her fame comes from a joint opus with Nobel laureate Milton Friedman: A Monetary History of the United States. It revolutionised thinking on the causes of the Great Depression when published in 1965. The book blamed the Fed for causing the slump. The bank failed to use its full bag of tricks to stop the implosion of the money stock, and turned a bust into calamity by raising rates.

“The book was a bombshell,” says British monetarist Tim Congdon. “Until then almost everybody thought the free-market system itself had failed in the 1930s. What Friedman-Schwartz say was that incompetent government bureaucrats at the Fed had caused the Depression.”

I guess restoring confidence that they won’t make things worse is better than nothing, but monetary policy in the range within which they operate will not be the answer, or the cause, for regulatory problems, investor and homeowner myopia and irresponsibility that has already occurred, or overvaluation.

“Steve Jobs is one powerful dude.” (Silicon Alley Insider) (From Abnormal Returns)

Mark Hulbert asks if we really want to assume that the bond market is wrong in betting that inflation will be below 2.5%?

Retail sales in December fell. Barry Ritholz points out:

Credit card debt turned up, the home ATM turned down, inflation was rampant, real income gains non-existent, the job market mediocre. On top of that, we had much higher prices for daily requirements like Food and Energy — and still, there was total denial about how healthy retail is.

How about a chart to back that up?

Obviously we don’t need to just worry about financials being rocked just by mortgages in the consumer space. Actually, I think corporate debt is going to be an issue as well, and of course the derivatives market, especially credit default swaps, are bound to become a major issue. Throw in all the insurers of this debt…I think we better move on.

Despite much wailing, the LBO loan market may not add much to Wall Street’s problems in the great scheme of things. See, I moved on. Million dollar losses seem so small now.

Meanwhile, in addition to the tens of billions evaporating from their earnings, banks such as Merrill and Citibank are busy diluting investor capital by selling huge chunks of ownership to overseas investors. Also read this followup. Probably the best their shareholders can ask for is to lose money and have future earnings sold to others. Better than bankruptcy I guess.

John Paulson bet against the housing market and cleaned up. Join the club John, though unfortunately our clients didn’t make quite the killing you did, but we are happy enough.

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Technorati Tags Alan Greenspan, Anna Schwartz, Barry Ritholtz, Ben Bernanke, Citibank, credit, debt, Economics, Edward Prescott, Federal Feserve, FOMC, Frederic Mishkin, Housing Market, Inflation, John Paulson, LBO, Merrill Lynch, Milton Friedman, monetary policy, mortgages, recession, Steve Jobs, subprime, Wall Street

Hat tip: Barry Ritholtz

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Technorati Tags Andrew Ross Sorkin, Barry Ritholtz, bear, bull, debate, Dottie Herman, economy, Housing Market, Noah Rosenblatt, Nouriel Roubini, recession

Fourth, in their desperation to “do something” politicians will often do something foolish. If a spending increase or tax cut isn’t worthwhile on its own merits then it’s highly unlikely to be worthwhile once we add in the benefits of “stimulus.” Thus, it’s one thing to argue for extending unemployment benefits as a matter of welfare it’s quite another to think that an increase in unemployment benefits will so increase spending as to reduce unemployment! (The implicit view of Larry Summers.)

I admit to being dubious of legislation and federal government action being useful for short term economic swings. Here are the other quite compelling reasons why:

First, the money for any new spending or tax cuts has got to come from somewhere, right? Thus there is usually substantial crowding out of any stimulus.

Second, by the time the new spending or tax cut gets through the political process the economy has moved on and the stimulus is no longer relevant except by accident.

Third, there just isn’t that much discretionary spending to play with and even a large increase in spending, say tens of billions, is too small to make much of a difference in a 13 trillion dollar economy.

My emphasis above. I am always amused at the power people ascribe to what seems to be a large action, but in the context of the US economy and financial system is actually pretty paltry. That goes for most actions undertaken by the Federal Reserve as well. Finally, even for those amongst us, especially economists, who find those arguments uncompelling, we should all remember this:

Economists may call for “temporary,” “conditional,” and “targeted” stimulus but they won’t be the ones designing the plan. Spending increases and tax cuts are policies with long term consequences that we need to think about carefully.

My own view relates to the first reason I quoted. Spending and tax decisions should make sense in and of themselves, not because of some quixotic attempt to influence the short term course of the economy.

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Technorati Tags Alex Tabarrok, Economics, Federal Reserve, fiscal policy, Larry Summers, recession, spending, tax cuts, tax policy