Friday, April 11, 2008
Bernanke is going further than Greenspan ever did in responding to a popping bubble. He has pulled out all the stops, inventing new ways to pump money into a resistant financial system. ...One measure of the size of monetary stimulus is the expansion of M3, a broad measure of the money supply that includes institutional money funds. Capital Economics calculates that M3 is up 15% from a year ago, the biggest increase in 37 years.
This one Friday morning via the New York Times;
...a government report on import prices showed that the cost of foreign goods rose 2.8 percent in March. In the last 12 months, import prices are up nearly 15 percent, the highest year-over-year increase since records began in 1983, the Labor Department said on Friday.
So, unfortunately, whether or not there are further bailouts, the result of such furious easing is that all of us are already being heavily taxed, whether we participated or not, for excesses committed in the credit bubble. For some visual proof, take a look at the charts below of the U.S. Dollar, Crude Oil, and the CRB Index (an index of 22 basic commodities). The vertical line represents the point at which the Fed started their monetary easing via interest rate cuts and the various other means discussed in the linked posts above. Note: Click on the charts to enlarge
Thursday, April 10, 2008
As then and now today in the case of not just Bear Stearns but numerous other market participants, what we are dealing with is trying to avoid potential significant collateral damage to both the financial system and the overall economy as the result of unregulated behavior on the part of over leveraged entities. Back then, for the most part, it was a mere single player involved. Even so, a single player was still enough, at least in the eyes of the regulators, to create the risk of significant systemic and collateral damage.
As a result of that event, didn't we learn that when it comes to the financial sector, where collateral damage can extend to the entire economy, that combining a lack of regulation with extreme levels of leverage is a reckless and even negligent way to run financial markets? Back in April, 1999, didn't the Chairman of the Federal Reserve, the Chairman of the SEC, The Secretary of the Treasury and the Chairperson of the CFTC jointly prepare a 140 page report on the Lessons of LTCM in which they stated that;
The principal policy issue arising out of the events...is how to constrain excessive leverage. By increasing the chance that problems at one financial institution could be transmitted to other institutions, excessive leverage can increase the likelihood of a general breakdown in the functioning of financial markets. This issue is not limited to hedge funds; other financial institutions are often larger and more highly leveraged than most hedge funds...The LTCM episode well illustrates the need for all participants in our financial system, not only hedge funds, to face constraints in the amount of leverage they can assume.
Makes sense to me. So, how to best do it? Some more informative thoughts from the group at the time;
Even if market participants had better information and more fully understood the risks of their investments, their motivation is to protect themselves but not the system as a whole. Every firm has an incentive to restrain its risk taking in order to protect its capital, and firm managers have an incentive to protect their own investments in the firm. No firm, however, has an incentive to limit its risk taking in order to reduce the danger of contagion for other firms.
Again, sounds good. So, what did the group come up with in terms of concrete recommendations? Whatever the reasons, whether blinded by laissez faire ideology (more on this here) and naive belief in computers by the Fed Chairman, or influenced by too strong industry ties by the Treasury Secretary, or by some combination of the above or something else, not really a whole lot of real significance. Check out the recommendations on pages 31-32 for yourself here. For others, I'll save you some time. Effectively, it was a mix of having the participants "provide more frequent and meaningful information" and "enhance their risk practices", while having regulators "encourage", "promote" and "consider stronger incentives" in various ways for market participants. Perhaps, the April recommendations shouldn't have been a surprise, as the participants clearly telegraphed their laissez faire intentions to the G7 (Group of Seven Industrialized Powers) in January, 1999 at the World Economic Forum Annual Meeting in Davos, Switzerland. Per the International Herald Tribune;
The United States and its G-7 partners disagreed sharply Friday about overhauling international financial regulations...officials from Japan, Germany, Britain and France appeared eager to press ahead quickly with measures that would toughen regulation, monitoring and oversight of international flows of money through vehicles such as hedge funds. But American officials, while stressing the importance of more openness and surveillance, were wary of creating new regulatory structures.
So, getting back to the present, apparently the markets didn't work it out amongst themselves with "encouragement" and "support" from regulators. In fact, quite the opposite occurred in regards to reducing leverage, defined by the group as "the principle policy issue". Today, rather then a single outlier hedge fund running reckless and creating systemic risk, we have players of all sorts both inside and outside the banking community running their balance sheets at 25-35x leverage.
At the same time even the less balance sheet levered commercial banking industry is making, as a whole, a combined on and off-balance sheet notional economic bet at arround 150x, yes 150x, their equity capital. I realize that notional amounts are not at all the best indicators of economic risk, but I also realize that using imprecise, illiquid, non-standardized and unregulated securities traded in completely unregulated markets for a great amount of this notional exposure is not exactly a recipe for safe and conservative banking practices. Take a look for yourself;
To save you the difficulty of trying to interpret the chart, the math as of the end of 2007 for the ratio of Total Notional Exposure to Equity Capital is ($164.77 Trillion off-balance sheet derivatives + $11.18 Trillion balance sheet assets) / $1.14 Trillion balance sheet equity = 153.77. That is, on aggregate for the entire U.S. commercial banking sector, $153+ of notional exposure for each dollar of equity capital. The quarterly report discussing this data and more, as of Q3 2007, is available via the U.S. government here.
So here we sit now with a financial crisis that many are calling the worst since the Great Depression. Even the ultimate free and unfettered market radical himself, Alan Greenspan is classifying the current financial crisis as "the most wrenching since the end of the second World War."
In trying to combat this crisis, the Federal Reserve has found it necessary to throw aside basic tenets of sound banking and even of free market capitalism (some of which previously described here) in various attempts to avoid an even wider crisis. How about forming a Limited Liability Company (LLC) in cooperation with a large commercial bank to manage $30 billion in primarily mortgage securities and related derivatives? Even further, how about having the Fed agree to take losses of up to $29 Billion of taxpayer money in the transaction? Even more eye opening perhaps were the additional steps taken to open up the Fed's balance sheets for the first time ever, yes ever, for the use of investment banks. Finally, again for the first time ever, or at least since the Great Depression depending on your interpretation, the Federal Reserve, and ultimately via extension, the U.S. taxpayer has agreed to accept all types of questionable collateral on the loans that it makes to both commercial banks and these highly leveraged, unregulated investment banks. From a former Fed Chairman (Paul Volcker) who was a bit more willing to perform his regulatory duties;
The Federal Reserve judged it necessary to take actions that extended to the very edge of its lawful and implied power, transcending certain long embedded central banking principles and practices
Also, in summarizing the current financial system as a whole, Volcker stated;
“The bright new financial system, for all its talented participants, for all its rich rewards, has failed the test of the market place”
So, what to do? Beware of the Laissiez Faire regulators who refuse to do their job. Also beware of false choices being offered by either current or ex-industry insiders. For instance, there are those who attempt to frame the issue as a choice of doing nothing (the "invisible hand" will work it out) and unleashing such ineffectual silliness as "swat teams" of regulators (described previously here). These "swat teams", as I'm shocked that the bright and highly accomplished author of this idea wouldn't already know, are set up to fail by asking them to investigate and provide "guidance" from afar and even after the fact for unregulated entities continuing to trade according to no set of clearly defined rules and guidelines, using no 3rd party intermediation of any kind.
So what are the answers? We already have them and they have produced the best and most robust financial markets in the history of the world. They involve a combination of standardized products, exchange-based trading, leverage limitations via margin requirements and / or capital requirements, clear and robust rules of disclosure to assure widely available information and transparency, and finally independent supervision with enforcement authority. Does that mean that every product and every transaction will fit "perfectly" in this scheme. Of course not, there has always been some degree of OTC as well as unregulated trading of various ilk throughout all of market history. The difference is that we are now at the point where unregulated and non-standardized trading is not an exception from an overall economic standpoint, but is clearly the primary overall driving force for our financial markets.
Monday, April 7, 2008
With apologies to Shakespeare, "Mr. Greenspan doth protest too much, methinks."
Former Federal Reserve Chairman Alan Greenspan has every right to attempt to continue to attempt to "defend his legacy". That he continues to refuse to accept any degree of responsibility for the current problems in financial markets are also, ultimately, his own business I guess. At the Wall Street Journal press stop, in regards to his own potential role in the current crisis, "Mr. Greenspan says he doesn't regret a single decision." The day before, in the Financial Times, Greenspan's own commentary is defiantly titled "The Fed is blameless on the property bubble"
Beyond that though, there is a bigger issue at hand here, as Greenspan himself says in the WSJ article mentioned;
the larger issue at stake, he says, is getting the lessons of the crisis right."The [wrong] evaluation of this period -- and how to avoid the problems associated with it -- will give you the wrong answers and the wrong policies"
Further, in a statement of the obvious, the article states;
If Mr. Greenspan's views carry the day, the trend toward self-policing will continue.
Previously, I discussed here how some of these views played a leading role in the excessive deregulation of this generation I'll save for another time additional discussion on the merits of Greenspan's judgement and actions in regards to market excesses or "bubbles", including the theory he currently espouses regarding the role that excess global savings may have played in the housing excesses that have led us to our current financial crisis.
For this time though, before just "moving on" to the debate, I think its important, as Mr. Greenspan himself does, to make sure that "the record" on his actions are as accurate as possible. Perhaps were not talking about the difference between dodging sniper fire and exchanging pleasantries with children in Bosnia, but none the less, lets in this case also, examine a public figures recollection vs. reality a bit closer. Again from the Wall Street Journal;
Mr. Greenspan says many of the criticisms against him are unjust. He is particularly perturbed by attacks over a 2004 speech in which he suggested that more borrowers would benefit from adjustable-rate mortgages. Mr. Greenspan says the speech merely pointed out that many people who get a 30-year mortgage move or refinance long before it matures. Eight days after giving the speech, he says, he clarified his comments to say he didn't mean to disparage 30-year fixed-rate mortgages. "I find it profoundly disturbing" that critics cite the recommendation and not the retraction."
Let us know examine Greenspan's characterization. First though, as to Greenspan's retraction, I don't doubt that he in some way mentioned fixed rate mortgages 8 days later in a positive sense, but if it was in any way meant to be a significant retraction of his thinking at the time, it sure wasn't captured as such. In fact, unlike the heavy press treatment of the original speech, the retraction doesn't appear anywhere to be found in any significant way in the press at the time. Also, there is no mention of mortgages at all in the text, via the Fed website, of the alluded to March 2, 2004 New York speech. Perhaps he made the "retraction" in response to a question, or even informally before or after the speech, but apparently it wasn't important enough to be either included in the text records of the speech or to receive any real emphasis in the media.
Getting back to the original speech (available in its entirety here) and its characterization, lets take a look here at some excerpts. Early in the speech, as is characteristic of his history of getting caught up in the euphoria of bubbles (as mentioned previously, to be discussed another time), Greenspan extols the virtues of a consumers ability to increase their debt and leverage level via the "extracting" equity from one's home;
Refinancing has allowed homeowners both to take advantage of lower rates to reduce their monthly payments and, in many cases, to extract some of the built-up equity in their homes.Greenspan also waxes poetic on increasing debt and leverage thru the use of lower down payments. In this case, he praises lending institutions for what he describes as their decade long marked improvement in managing the risk of lower down payments;
The ability of lending institutions to manage the risks associated with mortgages that have high loan-to-value ratios seems to have improved markedly over the past decade, and thus the movement of renters into homeownership is generally to be applauded, even if it causes our measures of debt service of homeowners to rise somewhat.
After that warmup, Greenspan delves into what has, interestingly enough, become the heart of the controversy surrounding the speech, i.e. his thoughts on adjustable rate mortgages. Remember, in this regards, Greenspan now says "the speech merely pointed out that many people who get a 30-year mortgage move or refinance long before it matures." Lets see for ourselves in Greenspan's own words again;
One way homeowners attempt to manage their payment risk is to use fixed-rate mortgages, which typically allow homeowners to prepay their debt when interest rates fall but do not involve an increase in payments when interest rates rise. Homeowners pay a lot of money for the right to refinance and for the insurance against increasing mortgage payments. Calculations by market analysts of the "option adjusted spread" on mortgages suggest that the cost of these benefits conferred by fixed-rate mortgages can range from 0.5 percent to 1.2 percent, raising homeowners' annual after-tax mortgage payments by several thousand dollars. Indeed, recent research within the Federal Reserve suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade, though this would not have been the case, of course, had interest rates trended sharply upward.American homeowners clearly like the certainty of fixed mortgage payments. This preference is in striking contrast to the situation in some other countries, where adjustable-rate mortgages are far more common and where efforts to introduce American-type fixed-rate mortgages generally have not been successful. Fixed-rate mortgages seem unduly expensive to households in other countries. One possible reason is that these mortgages effectively charge homeowners high fees for protection against rising interest rates and for the right to refinance.
American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks but are willing to manage their own interest rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home.
Finally, to wrap up, Greenspan concludes that things are just fine in the housing sector and increasing debt levels are not an issue;
Overall, the household sector seems to be in good shape, and much of the apparent increase in the household sector's debt ratios over the past decade reflects factors that do not suggest increasing household financial stress.
So, Mr. Greenspan is "profoundly disturbed" and "particularly perturbed" at the media treatment of him on this speech? To use more "Greenspanism", that's even more irrational then any kind of exuberance that Mr. Greenspan holds to be completely unable to be in any way quelled via competent regulation.
Friday, April 4, 2008
"...if you seek liberalization: Come here to this gate! Mr.
Gorbachev, open this gate! Mr. Gorbachev, tear down this wall!"
"...Looking around, I saw an indescribable joy in people's faces. It was the end of the government telling people what not to do"
For the role that America and Ronald Reagan played in that, it represented to many a moment that came to symbolize the best of what America had to offer. There's another side though, the economic one and specifically deregulation of the financial industry, where the aftermath of the transformational presidency that was Ronald Reagan hasn't exactly gone as planned. In regards to the current financial crisis described by many as the worst in multiple generations, billionaire investor George Soros stated here;
"The cause of the current troubles dates back to 1980, when U.S. President Ronald Reagan and U.K. Prime Minister Margaret Thatcher came to power, Soros said. It was during this time that borrowing ballooned and regulation of banks and financial markets became less stringent. These leaders, Soros said, believed that markets are self-correcting, meaning that if prices get out of whack, they will eventually revert to historical norms. Instead, this laissez-faire attitude created the current housing bubble, which in turn led to the seizing up of credit markets..."
Soros further opines elsewhere;
"...regulations have been progressively relaxed until they have practically disappeared".Let us take a journey just a bit deeper into that process. Note the similar themes in the episodes examined and how if one were to simply substitute a few words here and there, one might mistakenly think that the current credit crisis is being described. Whether attributed to South American philosopher George Santaya, or to Winston Churchill, "those who fail to learn from history are doomed to repeat it" sums it up just about right here.
One of the first targets of financial system deregulation in the Reagan administration was savings banks and commercial banks. As told by the FDIC;
"December, 1982--Garn - St Germain Depository Institutions Act of 1982 enacted. This Reagan Administration initiative is designed to complete the process of giving expanded powers to federally chartered S&Ls and enables them to diversify their activities with the view of increasing profits. Major provisions include: elimination of deposit interest rate ceilings; elimination of the previous statutory limit on loan to value ratio; and expansion of the asset powers of federal S&Ls by permitting up to 40% of assets in commercial mortgages, up to 30% of assets in consumer loans, up to 10% of assets in commercial loans, and up to 10% of assets in commercial leases."
Among other things, some of which were surely helpful in order to adapt to market realities, according to the Social Studies Help Center, the effects of this bill were as follows;
- Deregulation practically eliminated the distinction between commercial and savings banks.
- Deregulation caused a rapid growth of savings banks and S&L's that now made all types of non homeowner related loans. Now that S%L's could tap into the huge profit centers of commercial real estate investments and credit card issuing many entrepreneurs looked to the loosely regulated S&L's as a profit making center.
- As the eighties wore on the economy appeared to grow. Interest rates continued to go up as well as real estate speculation. The real estate market was in what is known as a "boom" mode. Many S&L's took advantage of the lack of supervision and regulations to make highly speculative investments, in many cases loaning more money then they really should.
- When the real estate market crashed, and it did so in dramatic fashion, the S&L's were crushed. They now owned properties that they had paid enormous amounts of money for but weren't worth a fraction of what they paid. Many went bankrupt, losing their depositors money. This was known as the S&L Crisis.
- In 1980 the US had 4,600 thrifts, by 1988 mergers and bankruptcies left 3000. By the mid 1990's less than 2000 survived.
"The S&L crisis cost about 600 Billion dollars in "bailouts." This is 1500 dollars from every man woman and child in the US."
"In the spring of 1987, the Federal Reserve Board votes 3-2 in favor of easing regulations under Glass-Steagall Act, overriding the opposition of Chairman Paul Volcker. Thomas Theobald, then vice chairman of Citicorp, argues that three "outside checks" on corporate misbehavior had emerged since 1933: "a very effective" SEC; knowledgeable investors, and "very sophisticated" rating agencies. Volcker is unconvinced, and expresses his fear that lenders will recklessly lower loan standards in pursuit of lucrative securities offerings and market bad loans to the public. For many critics, it boiled down to the issue of two different cultures - a culture of risk which was the securities business, and a culture of protection of deposits which was the culture of banking."
Later in 1987 though, the deregulation proponents get a powerful new voice. In August 1987, Ronald Reagan appoints Ayn Rand disciple and strong believer in Laissez-faire markets, Alan Greenspan to become chairman of the Federal Reserve Board, thereby setting in place a series of events that would ultimately lead to the financial industry tearing down its Glass-Steagall wall. Unlike the wonders of the elimination of the Berlin Wall though, the results here were far less positive. Lets follow a few of the tidbits as told once again by Frontline;
"In January 1989, the Fed Board approves an application by J.P. Morgan, Chase Manhattan, Bankers Trust, and Citicorp to expand the Glass-Steagall loophole"
"In 1990, J.P. Morgan becomes the first bank to receive permission from the Federal Reserve to underwrite securities"
"In 1991, the Bush administration puts forward a repeal proposal, winning support of both the House and Senate Banking Committees, but the House again defeats the bill in a full vote."
"In December 1996, with the support of Chairman Alan Greenspan, the Federal Reserve Board issues a precedent-shattering decision permitting bank holding companies to own investment bank affiliates with up to 25 percent of their business in securities underwriting."
"In August 1997, the Fed eliminates many restrictions imposed on "Section 20 subsidiaries" by the 1987 and 1989 orders. The Board states that the risks of underwriting had proven to be "manageable," and says banks would have the right to acquire securities firms outright."
"In 1997, Bankers Trust (now owned by Deutsche Bank) buys the investment bank Alex. Brown & Co., becoming the first U.S. bank to acquire a securities firm."
In 1998, the stakes are raised, as the financial industry goes for the juggular. Again from Frontline;
"On April 6, 1998, Weill and Reed announce a $70 billion stock swap merging Travelers (which owned the investment house Salomon Smith Barney) and Citicorp (the parent of Citibank), to create Citigroup Inc., the world's largest financial services company, in what was the biggest corporate merger in history. The transaction would have to work around regulations in the Glass-Steagall and Bank Holding Company acts governing the industry, which were implemented precisely to prevent this type of company: a combination of insurance underwriting, securities underwriting, and commecial banking. The merger effectively gives regulators and lawmakers three options: end these restrictions, scuttle the deal, or force the merged company to cut back on its consumer offerings by divesting any business that fails to comply with the law....Following the merger announcement on April 6, 1998, Weill immediately plunges into a public-relations and lobbying campaign for the repeal of Glass-Steagall and passage of new financial services legislation"
Ultimately, the efforts succeeded;
"After 12 attempts in 25 years, Congress finally repeals Glass-Steagall, rewarding financial companies for more than 20 years and $300 million worth of lobbying efforts. Supporters hail the change as the long-overdue demise of a Depression-era relic."
Fresh off of this "victory", incredulously, the man who was charged with being the banking systems chief regulator, Fed Chairman Alan Greenspan continued to lead the charge towards a completely unregulated financial system as he turned his sites towards championing the growth of unregulated derivatives. From a February 2000 New York Times article;
"The Federal Reserve chairman, Alan Greenspan, urged Congress today to encourage the growth of complex financial contracts known as derivatives...United States laws impede its development, Mr. Greenspan said in testimony..."
The ensuing years saw the accelerating phenomenon where, with the last major regulatory impediment removed, and more importantly perhaps, not replaced with any form of updated regulation, the credit bubble accelerated, fueled heavily by the explosive growth in unregulated derivatives. In early 2007, Financial Sense described the parabolic growth occurring in unregulated derivatives since 1999;
"For the latest data ended 1H 06, the prior six month growth in worldwide OTC notional derivatives outstanding was a little in excess of $72 trillion, standing at $370 trillion as of 6/30/06, up from $298 trillion at 2005 year end. For a bit of perspective, total planet Earth did not have $72 trillion in total derivatives outstanding eight years ago, and now we're growing by that total amount in six months."
The result of this is that today we have what is called the $516 trillion shadow banking system, the "secret banking system built on derivatives and untouched by regulation" according to the worlds largest bond fund manager, Bill Gross.
Further, in getting back to the current credit crisis, here we are today, in somewhat of a repeat of the S&L deregulation followed by bailout scenario, in that we have the Glass-Steagall deregulation followed in a similar amount of time by the bailout brigade. This time though, the stakes are much higher. The great engine and facilitator (U.S. large investment banks) of the most potent financial market in the entire free world are literally reduced to begging, hat in hand, for the government to bail them out, whether via historically unprecedented access to the government's balance sheets via the Federal Reserve, via an unprecedented bailout by the U.S. government of investment banking firm Bear Stearns, or even by the apparent various forms of directly pleading for a bailout to banks. One example of the bailout plea is characterized here, via the New York Times, by Howard P. Milstein, chairman and chief executive of New York Private bank;
"If banks of all sizes could regain their capital immediately and easily, it would be a tremendous benefit to the American economy. The federal government could make this happen by entering into an arrangement with American banks that hold subprime mortgages...Here’s how it would work: The government would guarantee the principal of the mortgages for 15 years. And in exchange the banks would agree to leave their “teaser” interest rates on those loans in effect for the entire 15 years. "
In regards to the Bear Stearns bailout, according to Timothy F. Geithner, president of the Federal Reserve Bank of New York;
“We judged that a sudden, disorderly failure of Bear would have brought with it unpredictable but severe consequences for the functioning of the broader financial system and the broader economy,” Mr. Geithner said in prepared remarks, adding that stock markets and home prices could have fallen significantly in the event of a collapse. Absent a forceful policy response, the consequences would be lower incomes for working families, higher borrowing costs for housing, education, and the expenses of everyday life, lower value of retirement savings, and rising unemployment..."
Is this what we have reduced our financial system to? Where it is so weak and fragile that the failure of a single investment bank threatens a widespread financial calamity. If so, how did we let it reach this point? In my mind, extremist laissez-faire deregulation surely played a heavy part.
So where do we go from here? By no means am I advocating that we turn back time and reinstall the regulations that previously existed "as is". Further, of course regulation can just as easily go too far (see India here). Free markets are constantly evolving and innovating. Rather then always turning to deregulate though, perhaps its time to work more towards liberalization & modernization but not to the point of removing the systems of checks and balances that helped to make America the great economic power that it is. Although of course we can never know, perhaps even Reagan himself would think that deregulation has gone too far. For isn't he the one who said "Trust but verify"?