Wednesday, January 28, 2009

Are Derivatives the Problem?

Bob Shiller, the Yale economist, has gotten a lot of press in recent days supporting the use of derivatives and arguing against the use of the efficient markets model in understanding financial (and non-financial) markets. I am supportive of what he is trying to say. In this post I present my reasoning for this support…you can go to Bob’s articles in the Wall Street Journal and elsewhere and his upcoming book (along with his many other books) to get his view.

First, human beings are innovators. They are problem solvers and are constantly pushing the edge trying to come up with something new that makes things better.

The problem we are dealing with here is risk. People, investors, don’t like risk. They are constantly trying to reduce risk in their lives…and they are willing to pay to reduce risk.

And, this is the essence of derivatives. Derivatives are risk reducing tools that can be used to hedge cash flows and thereby protect individuals from assuming more risk than they would like. People will pay for this…derivatives will get invented.

Answer me this…will a large number of people pay someone to invent a tool for increasing risk? The answer to this is no! People don’t pay people to build speculative instruments. The expected return to speculation is zero or less. Now how much will you pay for someone to create a tool that can provide you with an expected return of zero or less? Right…nothing!

People will pay innovators to build instruments that help to reduce risk because they are receiving value by being able to reduce the risk. Now this does not mean that people will not use these risk reducing instruments to speculate with. Hedging is providing a cash flow to offset the movements of all or part of another uncertain cash flow. Speculation means that you are taking an uncovered position…that is, you are working with only one of the cash flows.

So, like other innovations, derivatives have been created for a positive reason…but can be used in ways that increase risk. Like cars…or drugs…or nuclear energy plants. All these can be used in positive ways…but they can also be used in other ways as well.

Conclusion: derivatives will continue to be used, created, and, at times, misused. Financial innovation is with us and will continue with us. My experience supports the view that only a minimal amount of regulation will be effective to control the use of derivatives because part of innovation…is to get around the rules. That’s life!

My second point has to do with the efficient market hypothesis. People who support the efficient market hypothesis argue that market prices reflect all the information that is available to the market at a particular time. That is, market prices are correct. In essence, everyone in the market knows what information is available, what that information means, and how that information is translated into market prices…for all time. At least, there is a well informed group of arbitragers that know these things so that “on the margin” market prices can be made “right”.

In the world I live in, individuals have to deal with incomplete information…especially about the future. That is why uncertainty exists and why people have created probability theory as a way to deal with incomplete information and the resulting uncertainty. For prices to be “correct” and for markets to be “efficient” we need complete information which means no probability distributions for we will have certainty. I can’t believe that everyone in the market, given what information is available, knows what the price of every stock will be at every period of time in the future.

When we have incomplete information markets cannot be efficient because we don’t know the exact models to forecast the future with and we don’t know the appropriate probability distributions that surround our forecasts. As a consequence, our risk management models, as well as our risk management controls, have been inadequate. As such, our hedges have contained more risk in them than we had anticipated and our speculative positions have provided way more risk that we had assumed. Thus, our financial structure has been out-of-line with where we thought we were and our financial system has been more fragile than we thought.

My third point concerns the incentives present in an economy. People will use the instruments that are available to them in ways that are consistent with the incentives that exist within the economy at a given time. For example, in the past, the price of a house may have appreciated over time but this was not the real value of the house. The real value of the house was the flow of services that people received over time…it was this which made the house a home. What people acquired was the flow of housing services…not the stock…not the house itself. This was because the house was not going to be sold…at least not for a long time into the future. In this sense the price of the house was only important at the time of purchase.

What changed? In recent years in too many cases the price of the house became more important than the flow of services. Why? Because in many cases, houses were “sold” every two or three years. People with teaser interest rates, or whatever, that reset every three years, “sold” their house to themselves because the game was to refinance the house using the inflated house price to get a better mortgage rate. Living in the home was not the essence of the deal…speculation on the house price was the focus…and this was seen explicitly in the many “speculative” deals that arose at this time. And this was the essence of the asset-based securities used to support these transactions.

Also, remind me sometime to tell you about my friend that ran a mutual fund who avoided moving into stocks until the year before the stock market bubble burst. He did not move into these securities until he saw that too much money was leaving his fund…going into funds showing better results because they had invested in stocks. And he made the front page of the Wall Street Journal when the bubble burst and his “late-in-the-day” bets…collapsed.

Finally, my last issue has to do with the government. Unfortunately, in many cases, government policies can dominate the economy; government policies can create the incentives that people respond to. And, although the government may not mean to, it can create incentives that are detrimental, at least over the longer run, to the health of the economy.

If you have read many of my posts, you know that I believe that the Bush43 tax cuts, the war on terror along with other events that inflated the spending of the government, and the Greenspan “low interest rate” policy set the scene for the bubble in the housing market, the exponential increase in credit over the past eight years, and the overwhelming increase in leverage. The incentives that were created during this time put more and more pressure on business executives to take speculative positions and finance these positions with more and more leverage.

Who was responsible for the behavior of these business executives? Like my friend that ran the mutual fund…even those that were relatively conservative in their business decisions…ultimately found themselves forced into positions where they had to take on more risk than they would like. Competitive pressures “forced” decision makers to respond to the current environment that existed in the market place. After-the-fact they seem to have been overly greedy. After-the-fact they appear to have been insensitive to the risk they were taking…careless even. And now, people and politicians have dumped on them for their mis-guided behavior. The politicians that created the environment many years ago…although they might have lost the election…walk away defending their legacy in other areas. This is one of the difficult things about economics…results often trail, by many, many years, those policies and programs that were their cause.

Yes, I agree with Shiller that derivatives are here to stay. And, I agree with Shiller that many new kinds of derivative securities will be invented in the future. I just wish that we could invent a derivative that would allow us to hedge against bad policy making in Washington, D. C.

Sunday, January 25, 2009

How Effective Might the Stimulus Plan Be?

The Obama stimulus plan totals $825 billion. This plan is a combination of spending plans and tax relief. The dollar amount needed to be large, we are told, because the American economy is tanking and a lot of effort needs to be exerted to stop the decline and re-establish positive growth once again. Of course, we were told similar things when the legislation relating to the TARP was introduced. We have also been told that the number needs to be large because we don’t really know how much stimulus will be needed to jump-start the economy so we need to throw a lot of cash at the problem in hopes that the effort will be large enough to do the job.

The problem is…how much extra spending will $825 billion of stimulus create in the economy. In the simple Keynesian model this $825 billion will generate something more than $825 billion as new investment and new spending is created from the initial stimulus. The word going around is that the Obama economists are using a “multiplier” of 1.5. Thus, $825 billion in new spending and tax cuts will actually result in another $412.5 billion in spending raising the total affect on the economy to $1.2375 trillion…a hefty sum.

On Thursday, the Wall Street Journal printed an opinion piece by Harvard economics professor Bob Barro (
who argued that the “multiplier” might be something different from 1.5 and might even be as low as zero! Barro contended, supported by his research, that even in times that are most favorable for the multiplier to be toward the higher end of this range, war times, the multiplier comes out to be no higher than 0.8. That is a stimulus plan that totaled $825 billion, could only expect to produce about $660 of real Gross Domestic Product not $1.2375 trillion. But, he adds, this estimate of 0.8 is probably optimistic.

Why would the final impact of the stimulus package be less than the amount of the stimulus package itself? There are several reasons. For one, the government expenditures could be expected to be a substitute for private investment or other private expenditures. Furthermore, whether or not the tax cuts are spent is another question. In the recent Bush43 tax rebate program much of the rebate money either went into savings or it went to pay off existing debt. In a poll released in the middle of last week, pollsters found that, on average, people would apply 70% to 75% of any tax relief from the stimulus plan to savings or to paying off existing debt. So there are arguments…and empirical support…for the contention that the “multiplier” may not be as high as 1.5 and might realistically be below 1.0.

The threat to save or pay back debt is real…not only for consumers…but also for businesses. Some economists who have studied recessions and depressions talk about a period of time called a debt/deflation. In periods like these the future looks bleak…and economic units…consumers and businesses…try to pull back and restructure themselves on a sounder financial basis. That is, they want to reduce the leverage that is on their balance sheet and get away from owing money. The first concern has to do with being unemployed or faced with going out of business…economic units want cash or, at least, near-cash items so as to be able to bridge a period when cash inflows might be low. And, if there is a possibility of deflation, people want to reduce the amount of debt on their balance sheets because the real value of debt and debt payments increase when prices are falling.

Some “Keynesians” have tried to incorporate these ideas about debt/deflation into their economic models. Hyman Minsky was one of the most prominent economists to explicitly discuss the impact of the capital markets on economic expansions and contractions. However, most of the empirical models used by policy makers do not take account of capital market effects on economic activity. (For a discussion of the economic model used for policy forecasting in the Federal Reserve see “Ben Bernanke’s Fed: The Federal Reserve After Greenspan” by Ethan S. Harris, Harvard Business School Press.) It is hard to contemplate “multipliers” as high as 1.5 if one considers these capital market issues.

For people to spend or borrow (if they could borrow) they need to have at least a somewhat optimistic view of the future (even for the possibility of inflation) to maintain or increase spending by either reducing savings or by borrowing. The obvious psychological impact hoped for from the stimulus package is that economic units will have enough confidence in the future or will even be willing to borrow and pay back loans with cheaper real dollars to keep spending or even increase spending. The Obama team is intending to use the rest of the TARP funds released by the Congress ($350 billion) to get people borrowing again.

Of course the concern about achieving this latter effect is the concern over the creation or the re-enforcement of moral hazard in the economy. If the government continues to “bail out” not only financial institutions but businesses, families, and other economic units, these economic units will continue to take on more and more risk in the future because they know that the government will supply a safety net to protect people from their foolish bets. The economists who argue from the viewpoint of the debt/deflation hypothesis contend that sooner or later the economy will take on so much debt that the debt/deflation cannot stop until people finally work off their extreme financial imbalances and return to more normal debt loads and positive amounts of saving. Some of these economists believe that this time has arrived and the economy cannot be turned around until economic units have worked off their excessive debt burdens and taken on a more conservative view of their economic future.

To get a zero multiplier (see the Barro article and Barro’s textbook “Macroeconomics: A Modern Approach” published by Thomson South-Western) one must argue that economic units will anticipate the increased real economic costs, real future taxes, or inflation that result from the way in which the stimulus package is financed and re-arrange their economic and financial activities to be able to cover the future government levies. A zero multiplier means that for every $1.00 the government puts into the stimulus plan, economic units will remove $1.00 from the spending stream. Thus, the $825 billion stimulus plan would increase real Gross Domestic Product by…ZERO DOLLARS!

What is the alternative to the type of stimulus plan proposed by the Obama administration? Barro argues that things must be done to encourage business commitment and innovation. His favorite idea is to eliminate the federal corporate income tax. If people are to be put back to work again…businesses must be hiring. In order to do this the energy and the foresight of the American business community must be put back to work again. The concern with massive public-works programs is that they will just substitute for the innovation and entrepreneurial leadership that still exists in the country and could produce real growth but needs to have the appropriate incentives.

So, what will be the impact of the Obama stimulus plan? You take your guess…I’ll take mine. My guess is that the multiplier is less than 1.0 and is maybe as low as 0.4. A reason for this pessimistic view of the multiplier is that we are at the stage where people/families and businesses finally have to fully restructure their finances to get balance sheets back into some form of conservative position. After many, many years of chasing dreams through betting on rising inflation with increased leverage and new financial instruments…the economy finally needs a break…needs to catch its breath and settle down for awhile.

I could be wrong. The American government could throw so much money at the economy that rising inflation and increased leverage becomes “the thing” again. If such is the case…then we are just postponing for another time, dealing with the monster that the government has created in the first place.

Wednesday, January 21, 2009

Where Will the Federal Reserve Go?

The Federal Reserve evolved over the years to perform three major tasks: to supply liquidity to commercial banks and the financial markets (specifically as the “lender of last resort”); to manage the monetary system so as to encourage economic growth, yet contain inflation; and to oversee the health of the banks who were members of the Federal Reserve System through regulation, examination, and supervision.

Whereas the Federal Reserve System is supposed to fight a liquidity crisis, a very short term phenomenon, it was not set up to resolve a solvency crisis, a longer term situation. The problem faced in a liquidity crisis is that, for one reason or another, an institution or a few institutions want to sell quickly some kind of a financial asset but there are few, if any, buyers. The responsibility of the Federal Reserve is to supply liquidity to the market on a short term basis so that the market will stabilize and buyers of these financial assets will return to the market.

We have gone through our liquidity crises this time around. Liquidity crises are surprises…we are not prepared for them…and this is why the response has to be quick and decisive. I say that we have gone through our liquidity crises this time around because investors are very wary about ALL asset classes now and the surprises that come to light on a regular basis are how deep the losses on assets continue to be…not that there are losses.

The Federal Reserve is not set up to solve a solvency crisis. The solvency crisis is a capital adequacy problem. It is a problem related to how large the losses are related to the book value of the assets. Yes, there are liquidity issues related to these troubled assets…they may not be able to be sold…or they cannot be sold. If this is the case the question becomes whether or not the problems related to these assets can be worked out and if so how much of the asset value will be retained…if any of it can be retained. And, the solvency crisis is of a longer term nature than the liquidity crisis.

The Federal Reserve, over the past 13 months has drastically changed the way it operates in an effort to provide liquidity to financial markets. Attention has been directed to the expansion of the asset portfolio of the Federal Reserve System. In the last 13 months, the line item labeled “Total Factors Supplying Reserve Funds” that appears on the Federal Reserve Statistical Release, H.4.1, “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks,” has increased by approximately $1.2 trillion. The increase is from $0.9 trillion on Wednesday November 28, 2007 to $2.1 trillion on Wednesday January 14, 2009. All of this increase has come since Wednesday September 3, 2008 when the balance totaled $0.94 trillion.

I include December 2007 in this calculation for it was in this month that we first got the innovation called the Term Auction Credit Facility introduced to the Fed’s tools of operation. And, as they say, the rest is history.

The major changes include a decline in the “Securities Held Outright” of $275 billion, the account that includes Treasury securities the instrument that the Federal Reserve has traditionally used to conduct monetary policy. But even this figure is misleading because this category now includes “Federal Agency Debt Securities” and “Mortgage-backed Securities”. These two accounts have gone up by about $23 billion over the past 13 months, so that the decline in Treasury securities held by the Fed has actually declined by about $300 billion.

What has accounted, therefore, for the $1.5 trillion increase? (The $1.5 trillion comes from the $1.2 trillion increase in Factors Supplying Reserves and the decline of $0.3 trillion of Treasury Securities held.) “Term Auction Credit” injections accounted for almost $0.4 trillion, “Other Federal Reserve Assets” rose by almost $0.6 trillion and “Net portfolio holdings of Commercial Paper Funding Facility LLC” rose by a little over $0.3 trillion. The other roughly $0.2 trillion came from minor accounts like the increase in primary borrowings from the discount window, primary dealer and other broker-dealer credit, credit extended to AIG, the assets connected with the Bear Stearns bailout, and Asset-backed Commercial Paper Money Market Mutual Fund Liquidity Facility.

And, what is the point of listing all of these different sources of funds? The point is to highlight that most of the funds were injected into the market in order to provide liquidity to different sectors of the financial markets in an effort to “unfreeze” lending. The securities provided to the Federal Reserve to serve as collateral for these “loans” are supposedly of the highest credit quality. The rest of the funds…really a minor part of them…only about $113 billion…is to hold assets connected with the bailouts of AIG and Bear Stearns. That is, almost all of the funds were supplied to the market for liquidity reasons…not for solvency reasons. Thus, the Fed is sticking to one of its primary functions and not entering into the area of “capital adequacy” problems.

The capital adequacy problem should not be an issue that the Federal Reserve takes up. To do so would cause a major conflict with its primary responsibility…to conduct monetary policy.

To me, this is an issue primarily for the Treasury Department because it is very closely related to ownership...and when we start talking about ownership we start thinking of “nationalization”…and I believe that a lot of people have trouble walking down this road. However, given the depth of the problems of the banking industry, the issue of nationalization is going to come up and must be thoroughly discussed and debated. This is a major step for any nation to take…and most nations around the world that are looking at this problem in the face are treating the issue very gently. Even those nations who have governments that look to more governmental involvement in the economy at being very careful.

Fed Chairman Bernanke has stated that the United States cannot just rely on the Obama stimulus plan to get the economy going…and he is right. But, the Federal Reserve has supplied a lot of liquidity to financial markets…and, they will stand ready to supply more liquidity if it is needed. However, the Fed cannot do much more at this time. I hope it does not have many more tricks up its sleeve to surprise us with as it did this past year. In this respect, I think the Fed needs to be careful going forward and not get impatient and do something way off the wall.

As you may remember, I am not a great fan of Bernanke and I had hoped that he would offer to step down so that President Obama could select a Chairman of the Fed that would be more capable. I believe that Bernanke panicked last September (See “The ‘Bailout Plan: Did Bernanke Panic?” on Seeking Alpha,, November 16, 2008.) Paulson was over whelmed, Bush 43 was absent without leave, and there was no one else in the administration with the intellectual quality to counter Bernanke’s arguments. As a result we got the mess labeled TARP…which was ill-planned, ill-debated, and mismanaged from the start…which has turned into its own source of disaster.

Frankly, I am concerned about where the Fed is headed. There are certainly stronger intellects around in the Obama administration…Larry Summers particularly comes to mind. However, the Fed has a certain independence that forces one to worry when you do not have confidence in its leadership.

Where will the Fed go? One should not be surprised by the central bank. A central bank needs to be steady and secure at the helm. A central bank needs to provide confidence to markets and institutions. I do not sense that participants in the financial markets feel this way at this time about the current Federal Reserve System.

Sunday, January 18, 2009

Can an Economic Expansion take place without the Banking Sector?

The Obama team has put forward the outline of its economic stimulus plan. The United States Congress has released the last $350 bill of the TARP funds. Will this get the United States economy going again?

It seems to me that the answer to this depends upon whether or not the United States economy needs a banking sector to accompany the journey. Again, the earnings reports coming out of the financial sector last week hardly gives us much confidence that banking institutions are in any kind of shape to contribute to a regeneration of economic growth.

Losses are still huge…and one doesn’t gain much confidence from the executives running these institutions that the flow of losses is over. And, it is in the larger financial institutions that the problems are so great. But, this doesn’t mean that smaller institutions are out of harm’s way.

The fundamental issue is about the value of the assets the banks are holding. I don’t see or hear anyone claiming that bank managements really have their arms around the valuation problem. And, after all we have heard from bank presidents trying to build up confidence in their institutions, very little faith can be taken from anything else they might say. My strong feeling is that banks still do not know how deep their problems are right now and whether of not many of them are still solvent. This is a scary fact.

But, that is the past. We are only at the beginning of the real economic slowdown. Bankruptcies are on the rise and will continue to do so through the first half of the year. With the tremendous slowdown in retail sales in the fourth quarter of 2008 the accounting results for the end-of-the-year are bound to be horrible. What will be the fallout from these results is any one’s guess right now. There will not be bail outs for many or most of these poor performers and so there will be more and more doors shut going forward.

One suggested solution to arrest some of these closures is mergers or acquisitions. However, given all the uncertainty that exists in the economy at the present time…who wants to buy anything…and at what price.

Two cases, both in the news, should serve as examples: first the acquisition of Merrill Lynch by Bank of America; and second, the liquidation of Circuit City. The case of Bank of America is a sad one indeed…regardless of how you read the tea leaves. Merrill Lynch…like Citigroup…like AIG…and so on…didn’t know the value of its assets. The CEO of Bank of America wanted Merrill…very badly. Did BOA not do its due diligence? Did it do a crappy job? Did the hubris of the chief executive, as in many other cases in both good times as well as bad, go into the deal with blinders on? Did BOA try to get out of the acquisition of Merrill and the government would not let them out?

Whatever, the Bank of America/Merrill Lynch is a deal that went very, very badly. But, I go back to my main point…Merrill Lynch did not have a good handle on the value of its assets. They may have thought that they did…but they didn’t! And, this seems to be the story over and over again.

Financial institutions do not seem to have any real idea of what is the value of their assets. So, beware…mergers and acquisitions are dangerous to your health!

And, hence, we can move on to Circuit City. The rumor was that Circuit City had three parties that were potentially interested in acquiring the company. All three apparently were not willing to pay a price sufficiently high that would exceed what Circuit City thought they could gain by selling off inventories and closing their doors. Again, here is a bet the potential acquirers were not willing to make…a bet on the value of the assets of Circuit City. And, this seems to be the other side of the Bank of America/Merrill Lynch transaction…how can a company buy someone else when they don’t have a good feel for what the underlying assets are worth.

This gets us into the second part of the dilemma of the banks…making loans. If the banks don’t know the value of the assets on their books, how likely is it for potential borrowers to know the value of the assets on their books…consumers as well as businesses? Not very likely at all!

Why should banks get criticized for not lending to potential borrowers and potential acquirers of businesses be excused from any criticism? What is the difference between a potential acquirer that is not willing to pay very much to obtain the assets of another company and a bank that is not willing to loan money to someone because if, in both cases, the value of the assets of the potential acquisition or the potential borrower is highly uncertain? What I am saying is that right now there is so much uncertainty over who is going to be around in the future and what can be salvaged from existing economic units the people are unwilling to commit any more resources for lending or for acquiring.

Furthermore, why should banks be lending more when they are facing over the next two years or so at least two periods where there will be major adjustments of interest rates on mortgages and other loans on assets. These repricings may create many more foreclosure or bankruptcy problems on the banks and this would mean that banks would need even more resources to back up the decline in the value of their assets.

The question that still remains to be discussed is the solvency issue. Financial crises generally follow the pattern that first there is the liquidity crisis. Then there develops the asset crisis. Finally, there is the solvency crisis.

We finished with the liquidity crisis in December 2007. The asset crisis hit in March 2008 and grew into and through the fall of that year. We are, I believe, in the period of the solvency crisis…the life and death struggle of a large number of financial institutions.

Hopefully, TARP has provided a little relief toward the solvency of banks. The big question is whether the funds that have gone to bank capital have reached any where near the total that will be needed. If banks do not know the value of their assets now, there are still big holes to be filled in balance sheets…existing bank capital may be no where near that needed to keep the banking system going. In addition, if there are still shocks that the banks must face in terms of future bad loans…even more pressure is going to be added to the capital needs of the banking system.

There are two issues here. First, how is the government going to keep those banks that are relatively healthy going? Second, how is the government going to close those banks that are not healthy and how is the government going to dispose of the assets of these banks? In the first case…and I never ever thought I would ever be in a situation where I would be saying this…the government may have to nationalize a fair portion of the banking industry…more than it already has.

In the second case, the government is going to need something like the Resolution Trust Corporation (RTC) to manage the assets it takes over from the banks that have to be closed. Furthermore, it would seem as if the government would have to come up with a relatively large amount of funds to cover the losses on assets that would have to be shelled out in the closing of these banks. Many analysts have argued that this is not such a bad solution since the original RTC, formed in 1989 actually made money in its asset sales. However, this organization sold into a rising housing market. A rising market does not seem likely in the near future.

Now back to the original question. Can an economic expansion take place without a banking sector to support it? My feeling is that it would be very hard for an expansion to take place under such circumstances. If the banking system is not functioning…even a large economic stimulus package will not be very effective in getting the economic system going again.

Wednesday, January 14, 2009

The Collapse of Citi

Banking is a commodity business. Banking deals with information…I am holding $100.00of yours in something called a transaction account…I am holding your IOU for $1,000,000.00. Whereas, historically, these sums had to do with a physical quantity…something like gold…now all banking is basically conducted in 0’s and 1’s.

Banking is just information and the movement of information. Banking is a commodity business.

Yes, there are some other products and services connected with the banking business. There is safe keeping…you can get coin and currency back from you transaction account. We will clear payments for you though the banking system so that you can pay people from your account without the use of coin and currency and you can receive payments from other which will be put into your account. That is, we clear transactions through the banking system. We will do your accounting for you and send you a monthly statement. We will make loans to you and provide many different kinds of services for you connected with your loan. And there are many other products and services that banks provide their customers…individuals, businesses, and governments.

Banks used to get paid for these services primarily in interest payments or in deposit balances that were kept at the bank. In the 1980s, however, we got another idea. We can isolate these products and services, account for them, and then charge the customer fees for these particular products and services they use and then we, the banks, won’t have to build in payment for them in the interest rates charged on the loans or by means of the deposit balances that the customer had been required to keep at the bank.

Fees are good because they don’t depend upon loan or deposit balances, but depend upon other products or services rendered.

In the 1980s depository institutions found another way to generate fee income. In the 1970s the government had invented a new financial instrument called a mortgage-backed security that could help financial institutions make more money available to people who wanted to own homes and the depository institution could make these mortgage loans, securitize them so they could sell them and not hold them on their balance sheets, and collect fees for originating and, possibly servicing them. Furthermore, the banks would not have to worry about the interest rate risk that came from holding assets with long term maturities like mortgages and support them with deposits that were available on demand or had short-term maturities.

Banks liked fees and started to build businesses based on fee income. They looked farther and farther in an effort to find more sources of fee income. They built or acquired subsidiaries that generated fee income. And banking companies grew and became diversified…even conglomerate in nature.

But, the banks saw that more than just mortgages could be securitized and they saw that these securitized loans could be traded and in so doing more and more fees could be generated, but they also found that they could make trading profits from dealing in these securitized loans. And so banks began trading in securitized loans…otherwise called derivatives…and developing arbitrage strategies to take advantage of market discrepancies. But, to take advantage of market discrepancies they had to increase the amount of leverage they used so as to earn competitive returns.

Yet, the nature of banking did not change. Banking is a commodity business.

Not only is the business of borrowing money in the form of deposits and lending that money out to businesses and consumers in different kinds of loans a commodity business, the banks found that competition made all the products and services they offered into commodities as well. And, trading…well no one makes money over the longer haul on trading…because it, too, is composed of transactions in commodities.

Banks can earn a return on capital that is equal to what the capital can earn elsewhere given the normal risk a bank assumes. But, banks cannot mold themselves into institutions that can produce and sustain competitive advantages over other firms and industries. The business model they tried did not work. Yet, like other firms and other industries that come to believe in a business model that doesn’t work, their continued efforts to make the business model work only exacerbated the problem. Generally, this extra effort meant taking more and more risks and then even using extra-legal means to produce the results wanted.

I am not saying that banks committed fraud, but I have very serious concerns about the off-balance sheet practices along with other accounting efforts that the banks used in an attempt to generate the higher returns they felt they had to earn. However, the competitive pressure to perform does push people and organizations to walk the edge of ethical practices.

Citi…whatever…had a business model that did not work. And, this model was tested over about a decade…and it never worked. The investment community realized this and was only luke-warm about the company’s stock. Yet, management stuck with the model and tried all the tricks to make its business model work. They were true believers.

No one stood up, however, and mentioned that the emperor didn’t have on any clothes.

Banking is a commodity business. Citi…whatever…is said to be cutting back its organization by a third…and this is from the reduction in size that had already been achieved. They are supposedly getting back to fundamentals…into areas in which they have a core competency. Supposedly, its management has a better appreciation of the markets it will be working in. Let’s hope so.

And so the debt deflation goes on. The example of the banks…and of Citi-whatever…shows why it is so difficult to achieve a turnaround in the financial system and the economy during a time such as this. In the previous forty years or so, many companies, like Citi-whatever, took advantage of the almost continuous expansion of the economy and the government support of that expansion. Now the re-construction of these companies must take place.

The big question on the table right now concerns the stimulus plan being put together by President-elect Obama and his team. With companies…like Citi-whatever…drawing back and restructuring, how much effect can the stimulus plan have on the economy? The stimulus plan must not only attempt to reverse the economic down-term but must overcome the impact of the companies that are deleveraging their financial structure or are withdrawing from markets. The administration is shooting at a target that is moving away from it.

Sunday, January 11, 2009

The Obama Stimulus Plan and the Dollar

All eyes, right now, are on the forming Obama administration and the economic plan they are constructing. We get the word that we can expect fiscal deficits in the neighborhood of one trillion dollars and we can expect large deficits for several consecutive years.

The Federal Reserve is doing all it can to push liquidity into the system and has thrown just about everything it can into the market to get banks lending again and the financial markets functioning. The Fed’s balance sheet has ballooned so significantly, one has to wonder how they can ever re-establish monetary discipline within a reasonable time period.

The concern is, of course, an economic recession or worse and the economic dislocation and misery that accompanies such an experience. As a consequence, very little attention is being given to the dollar.

I believe that the value of the dollar is something to watch, even at a time like this. The reason being is that the value of the dollar captures how international financial markets are interpreting the economic policies of the United States government relative to the economic policies of other nations. The importance of this price is underestimated and I continually go back to the statement of Paul Volcker: “a nation’s exchange rate is the single most important price in the economy.” (Paul Volcker and Toyoo Gyohten, “Changing Fortunes: the World’s Money and the Threat to American Leadership, (New York: Times Books, 1992), p. 232.)

The Bush 43 administration ignored the value of the dollar for most of its time in office and showed contempt for any fiscal or monetary discipline as the value of the dollar declined by more than 40% against a wide range of important currencies. This decline can be seen in the accompanying chart which presents the value of the dollar relative to the Euro. One can see that from 2001 until August 2008 the value of the dollar fell (represented by upward-moving curve).

Place chart here from St. Louis Federal Reserve Bank.

One can see that once the world financial crises escalated in September 2008 through the fall that the value of the dollar rose (the value of the Euro falls in this chart) as there was a world wide flight to quality…a movement to the United States dollar. Only recently have we seen some decline as the Federal Reserve has let short term interest rates in the United States fall toward zero and has attempted to further push liquidity into banking and financial markets.

The concern is going forward. How are world financial markets going to accept the Obama team and the monetary and fiscal policies that will be implemented by the new administration? With projections for such huge amounts of federal government debt hitting the market and the stance taken by the Federal Reserve system to basically monetize large portions of this debt, there is concern about what will happen to the value of the dollar and the place of the United States dollar as the world’s reserve currency.

Bush 43 was helped considerably by the willingness of the rest of the world…especially China, India, Japan, Middle Eastern countries and others…to finance the huge deficits it created. The Federal Reserve produced negative real rates of interest and private debt soared, much of it placed off-shore. The United States relied on the savings of the rest-of-the-world to pull off its debt binge. But, international investors responded to this debt bubble by selling the dollar.

It seems as if there are three possibilities for the value of the dollar given the projected large federal deficits. These are:
1. Foreign investors will continue to acquire the debt of the United States and will continue to use the dollar as a reserve currency;
2. Foreign investors will avoid, to one degree or another, absorbing the new debt of the United States and will flee the dollar;
3. The Federal Reserve will have to monetize a major portion of the new debt issued by the United States government and this will not be good for the dollar.

One hopes that the first of these alternatives will come to pass. Unfortunately, with the experience of the last eight years, the international financial community does not have too much faith in the ability of the United States government to act with appropriate discipline. Therefore, it is important to keep an eye on the value of the dollar and see how the world community is evaluating the new administration.

I have said nothing here about the potential effectiveness of the forthcoming Obama stimulus plan. There are still many questions that remain about how effective the plan might be. No one knows for sure. And, no one has an idea about when the banks might start lending again and when the financial markets might thaw. One hope that these policies will have some degree of success.

Still, we need to keep an eye on the value of the dollar. Discipline in Washington, D. C. has been absent for the last eight years. And, as I have said many times, once discipline has been lost…decisions makers don’t have any really good options that are left them. Bush 43 acted as if the rest of the world did not matter. The Obama administration, as much as it would like to throw everything it can at the economy, must not lose sight of how the rest of the world is reacting to what it is doing. A continuing decline in the value of the dollar not only will weaken the role of the United States in the world, but it will also place more and more American physical assets on the sales block to be scooped up by foreign interests.

The rest of the world already is saturated with American debt. How it receives the massive amounts it is going to receive is anybody’s guess. I think watching the value of the dollar will give us a clue.

Thursday, January 8, 2009

Trillions and Trillions

Carl Sagan only talked about “Billions and Billions” of heavenly bodies out there in the universe.

Barack Obama, President-elect, talks about “Trillions and Trillions.”

That’s Federal budget deficits, of course.

The Federal Government, according to the President-elect, is going to have to spend and spend and create these kinds of deficits if it is to side-track the economic downturn and put people back to work.

Paul Krugman, a supporter of this kind of spending, in his New York Times column on Monday, “Fighting Off Depression” (, makes the following statement: “This looks an awful lot like the beginning of a second Great Depression. So will we “act swiftly and boldly” enough to stop that from happening?”

Bush 43, during his reign, created more debt than all the administrations before him. So what is new in the Obama approach? Just size?

One of the things that is new is that the people coming into the Obama government believe in an active government and the ‘planned’ use of the budget to stimulate the economy. The Bush 43 team did not.

As I have said before, the Bush 43 team reminded me of the Nixon team that administered wage and price controls in the 1971-72 period. I remember very distinctly sitting in the room in the White House with George Schultz, Arthur Burns, Maury Stans, and others, watching these people administer wage and price controls with their noses turned up in disgust, doing the last thing in the world they believed in or wanted to do…control wages and prices.

This is the same feeling I got from Hank Paulson and Ben Bernanke…they really did not philosophically believe in what they were doing and really did not want to be doing what they were doing. And, as a consequence, they were not very good at it.

The general approach taken by Paulson and Bernanke in the financial crises was…throw “stuff” against the wall and see how much of it sticks. The important thing was to throw enough “stuff” at the problem so that enough will stick so as to defuse the crises. In performing in this way they did not look like they knew what they were doing…try this…no, try that…no, let’s do it this way…they were not disciplined…more is better…and they did not inspire much confidence.

Now we have a team coming into power that believes in the use of the fiscal tools they are going to inherit and they have confidence that they can use them in a productive way. This is the difference between the Obama team and the Bush 43 team. How the Obama team executes their plans is very important because both international and domestic financial markets need to have confidence in the United States administration, something they have not had for at least seven years.

The lack of confidence in the Bush 43 administration was exhibited in the relatively steady, six year decline in the value of the United States dollar, a decline in value of more than 40%. This lack of confidence grew out of the undisciplined way Bush 43 conducted the monetary and fiscal policies of the country. This lack of discipline in the Federal government set the tone for a growing lack of discipline in financial practices. International markets proved to be correct in that the whole financial structure built upon government, as well as private, debt and inflationary bubbles ultimately crashed.

To recover…confidence must be rebuilt!

This is why the appearance (and reality) of discipline is vital! Yes, the Obama team is proposing deficits that will be measured in the trillions. But, the spending and tax cuts that produce these large deficits must not be just throwing ‘stuff’ against the wall. There must be well thought out reasons for the expenditures and tax relief…there must be oversight and controls to accompany the programs…and there must be thought given to what is going to happen to all this spending and deficits once the corner is turned and the economy and the financial markets stabilize.

I know that this is asking a lot…yet, it was the lack of discipline that got us into the current situation…and, the only long term way to get us out of the current situation is to re-establish discipline over what is being done. If there is little or no discipline in what the Obama administration proposes…confidence will erode…and relatively quickly…and markets will continue to tank. Market support will only come from a belief in the commitment and execution of a believable plan.

The major parts of the Obama spending programs seem reasonable…build infrastructure, health care reform, education, and investment in new energy programs. Major emphasis on these things, however, is not “quick fix” solutions. They represent a commitment not only to government spending, but also to investments in the future that can build intellectual and social capital.

Economists have contended that government spending during the Great Depression never reached a level to really stimulate the economy until the spending connected with World War II came along. But, one of the benefits of the government spending during that war period was all of the innovations and new applications that resulted from the spending and ended up in new industries and further innovation in the post-war period that spurred on economic growth in the future. That is, the government spending did not just support the existing, out-of-date industrial structure of the 1930s (like our current car industry), but created the basis for a new structure, new jobs, and a new life.

There is still concern that the fiscal programs being proposed will have the desired effect on the economy and the financial markets. It has still not been proven that government spending can be substituted for private spending in order to create sustainable growth and permanent jobs. In has still not been proven that the world can absorb all of the government debt that is being created. It has still not been proven that the government can generate all of these deficits and not end up monetizing a large portion of them.

There is still a lot of uncertainty.

Financial markets want to believe in the Obama administration. Financial markets want to believe that the Obama team is competent. Financial markets want to believe that the economic package that is being constructed will work. Financial markets want to see discipline re-established.

However, the numbers are so large…

Monday, January 5, 2009

When Will Banks Begin Lending Again?

Commercial banks have always played and, as far as I can see, will always play a role in the health of the economy. Commercial banks represent a kind of fulcrum of economic activity. If commercial banks are not lending at all or are not moving toward an acceleration of lending…then one can bet that the economy will not be moving ahead in the near future. If commercial banks are lending modestly or are accelerating their lending…then it can be anticipated that the economy will be expanding or even over-heating.

Right now, the commercial banks are not lending…and there doesn’t seem to be much reason to believe that they will pick up their lending any time soon.

The Federal Reserve is doing all that it can to infuse liquidity into short term and long term financial markets, but the banks are doing little or nothing in the way of expanding credit. There are two major reasons for this: first, the quality of the assets the banks are holding; and, second, the quality of potential borrowers.

In the first case, I am not convinced that banks have finally gotten their hands around the quality of their assets. There is still too much uncertainty in financial markets…as well as real markets…for banks to fully understand their position. Some financial assets, still, cannot be valued. Assets in foreclosure present an uncertain asset value to the banks. Credit card losses are mounting. Auto loan losses are mounting. And, so on and so on…

We continue to receive news that does not bode well for the value of the assets of banks. For example, the front page article in the New York Times trumpets on page one, ”As Vacant Office Space Grows, So Does Lender’s Crisis” (see We have not yet seen the bankruptcies that will follow the miserable holiday season and this will lead to vacancies in the major malls as well as in strip malls. This will lead to further foreclosures and financial stress in real estate where there are already a lot of empty stores. We still have a wave or two to go through in the residential real estate market as the various ‘no doc-no down payment” loans re-price. And, although unemployment began to rise throughout the fall, many expect this trend to accelerate early in 2009 as the business failures and cutbacks start to add up. These movements and others not mentioned will only exacerbate the uncertainty surrounding the value of the asset portfolios of banks.

Banks will continue to be reluctant to lend if they don’t have a good idea of what the asset side of their balance sheet looks like.

As far as potential borrowers. There used to be a saying in the banking community that banks will not lend to anyone unless they don’t need to borrow any money.

My guess is that this will be the major lending rule that most financial institutions will follow in the near and intermediate future. On the upside, financial institutions stretch and stretch their lending standards to earn extra basis points returns so as to outdo their competition. On the downside, banks focus on the quality of credit because charge-offs dominate bank performance. In the past, banks have not moved into riskier borrowers until other banks have moved and it becomes necessary to compete in lesser credits in order to maintain a competitive position. Here the question becomes…who wants to move first?

My answer is that bankers feel very defensive about their behavior in the recent past…they will not want to be the leader in a new round of stupidity!

And, what of the Obama administration and the new plans for fiscal stimulus?

First of all there are rumors that any stimulus package proposed will not be enacted by January 20, 2009 let alone early in the spring. The Obama team has already responded to this by proposing, as a part of any stimulus program, a substantial package of tax cuts. The reasoning behind this is that it will draw bi-partisan support of the Republicans in Congress, something felt to be desirable to help achieve as much effectiveness for the economic program as possible.

An economic stimulus package, however, will not result in an immediate stimulation of bank lending. So, on top of when the economic program is passed…partially or in full…banks must still solve their own difficulties, as described above, before much real lending takes place.

Secondly, there is the international situation. The world economy is worse than anyone thought it was and is declining from there. The United States is part of this world economy…it cannot act independently of what is going on elsewhere in the world. Almost all of the nations of the world face similar situations and each faces the uncertainties mentioned above. But, how much is the rest of the world going to suffer from the continued decline in the United States economy and how much the United States is going to suffer from the decline in the rest of the world is unknown. The Obama administration must act more responsibly toward the rest of the world than did the administration that left office earlier this past fall.

And, we now have another uncertainty…the events in the Middle East present us with another unknown. War is uncertainty itself! What impact this will have on the rest of the world and how it will work itself out cannot be predicted with any degree of precision. But, it is in the mix now and must be taken into consideration is our potential scenarios for the year.

To summarize these comments: the economy will not begin to turn around until the banks are in a position to start lending again. My expectation for this turnaround is beyond the middle of 2009. And, this might be delayed even further if there is a rash of bank failures during the year. There are still too many uncertainties to be more definite and, as a consequence, the prediction for financial markets will still be…a downward drift…with lots and lots of volatility!