Thursday, May 29, 2008

Finance, Credit Cards, and the Fed: Three Comments

In today’s post, I want to reflect on three different subjects, all of which have some relationship with one another. These three subjects are (1) the loss of respect for the field of finance; (2) the increase in credit card losses and the numbers game; and (3) politics and the Federal Reserve.

The Loss of Respect for the Field of Finance

I am concerned that the field of finance has lost…is losing…respect in the world. As finance has come more and more under the sway of “financial engineering” it has lost its ability to lead. To present a simplistic view of this situation, I would argue that in the past, people controlled the numbers. In the current situation, numbers are controlling people. I am not against the use of numbers and I am not against the use of highly sophisticated mathematical/statistical models. (I have a background in mathematics and statistics.) The problem is that because of the sophistication and complexity of the models, they tend to be allowed to run on their own. The assumptions used to build the models are usually chosen to make mathematical manipulation as easy as possible and are dependent upon the historical record. These models are fallible!

Judgment and leadership are still needed in finance and this means that CEOs and Fund Managers must live up to the responsibilities placed upon them. They are to be held accountable and thus they must exercise their authority over those that build models and make investment decisions. If those in charge continue to fail to “be in charge” we will find that the financial system will continue to be fragile and the need for increased legislation and regulation will become a reality. Control will be exercised…either internally, within the financial firm…or externally from the government.

The Increase in Credit Card Losses

Credit card losses are on the rise. We have information from some of the major issuers so far and the news is not good. J.P. Morgan’s chief executive James Dimon has given us a peak of the future charge offs at his bank and the trend is definitely upwards. In April, J. P. Morgan wrote off 4.5% of its credit card loans and is forecasting losses to rise above 5% this year and 6% next year. This is up from a charge of 3.8% in April 2007.

But this is not so bad…Citigroup wrote off 5.7% in April, up from 4.1% in April 2007 while Bank of America charged off 6.9% last month, up from 5.4% a year earlier.

The credit card industry has always been a numbers game. That is, the more credit cards a bank issues, the more the percentage loss centers around a particular figure. The credit scoring is designed so that, on average, an issuer will achieve an “acceptable” rate of charge offs given the interest rates and fees that they charge their customers. The assumption is that the distribution of actual percentage losses will approximate a normal distribution with a relatively small variance around the expected mean of the percentage charge offs.

This approach works relatively well when there are not major disturbances to financial markets or the economy. However, when a major disturbance comes along…as we are going through right now…there is evidence that the assumption about the potential percentage losses being normally distributed is not the case. The evidence points to the possibility that the distribution tends to be skewed toward greater losses with the tail being relatively “fat”. That is, the probability of more extreme results is higher than is captured in a normal distribution of possible outcomes. The consequence is that the losses during major disturbances are greater than planned for and, hence, the provision for potential losses is less than adequate. This, of course, has implications for the bank’s capital position.

It seems to me that this attitude has prevailed at many of the larger financial institutions recently. The “numbers game” has been applied to other areas of lending, mortgages, student loans, equity lines, small business loans, and so forth, and we are now reaping the results of such an approach to lending. Having a large numbers of loans does not protect you all of the time because the assumptions of the statistical tests tied to the historical data sets do not conform with the way the world seems to work. When you have very few data points that relate to extreme outcomes you are always going to under estimate the probability that these events will occur.

The “numbers game” does not overcome the deficiencies of poor credit underwriting standards.

Politics and the Federal Reserve

Frederic Mishkin has resigned from the Board of Governors of the Federal Reserve System, effective August 31, 2008. It seems to me that this resignation has tremendous implications for the future of the Federal Reserve System and the functions it is to perform!

The United States has just gone through a significant liquidity crisis and the Federal Reserve has stepped in to prevent the collapse of a major investment banking organization, Bear Stearns. There is an ongoing crisis in the mortgage market along with a slowdown in the sales in the housing market coupled with a drastic reduction in housing prices. And, there are still major concerns about the revaluation of assets, both in US financial institutions, but also in many other financial institutions around the world.

There have been calls for bail outs, new legislation pertaining to financial activity, and modernizing the regulatory system. The Federal Reserve is at the center of all of this turmoil.

Thus, who controls the Board of Governors of the Federal Reserve System is going to have a lot of say about the future of the financial system and the role the Federal Reserve is going to play within that future. Most ideas that have been floated around have given the Fed broader scope and greater powers in the reconstructed financial network. Who controls the Board of Governors is very, very important!

Christopher Dodd, a Democrat from Connecticut, is the chairman of the Senate Banking Committee. This committee is charged with reviewing the nominations for Governors of the Fed. With the Mishkin resignation, of the seven positions on the Board, three members will be missing and one current member is unconfirmed. The delays in three of these positions have been for more than one year.

Is politics playing a role in this confirmation process?

With the odds in favor of a Democrat being elected as the next President, these four positions are obviously “in play”. Whereas the Republican chosen nominees tend to be more “free-market” types and hence at odds with the Democratic majority, a Democratic President, it is assumed, would be more likely to nominate persons in favor of greater oversight and firmer control of the financial system. This opportunity to appoint a majority of the Governors at one stroke seems too good to pass up.

Two points here: first, a central bank is supposed to have as its major focus the state of the economy and the inflation rate; second, heaping more and more responsibilities on the Fed just diffuses this focus. Already, participants in international financial markets believe that the Fed is not playing by the same rules as are other nations in terms of its lack of focus on inflation. Making the Fed more attentive to current political mood swings is not the way to help the United States live up to its responsibilities in the world.

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