Should Bernanke and the Fed Have Moved Sooner?

The posting for February 4 ended with a concern shared by many, that Bernanke and the Fed did not act in 2007 soon enough or with enough force to advert a major economic or financial dislocation. This week we take a closer look at the accusation. First, let me say that it is important to know how people and agencies have responded in the past so that we can have some view as to how they will act in the future. Learning about how the Federal Reserve acted in 2007, might help us to anticipate what could happen in 2008 or beyond. We still have to be cautious, however, because making monetary policy is an art and not a science and no two market situations are ever exactly alike.

Furthermore, we must continually realize that there is only so much a central bank can do. It needs, in a sense, to ‘keep its powder dry’ so that it can act when it is really needed. If it is always chasing the latest statistic or piece of market psychology then it will not be as effective when its actions are really needed. So, in setting the stage for a review of some of the events that took place in 2007 we must remember that through most of the year the economy seemed to be growing at a relatively decent pace and the rate of inflation experienced tended to be slightly higher than the Federal Reserve had stated was desirable. The value of the United States dollar continued to decline and there was concern that it would decline further in 2007 and 2008. In summary, it seemed as if there was less risk of economic growth declining, especially in the first three quarters of the year, than there was of the possibility of inflation remaining too high and the dollar declining further. Federal Reserve policy statements reflected these factors.

In terms of financial markets, the first real information that became public about the problems in the housing market and in subprime lending came about in February, 2007. I remember the first time information on this really caught my attention. It was early in February when I picked up a small article buried in the third section, the Money & Investing section, of the Wall Street Journal. I began to pay attention to similar articles and I tracked the news as it moved from deep in the third section of the paper to nearer the first page of the third section to the first section, second page and so on. Knowledge of the problems in these areas was limited, little alarm was raised, and that alarm was often dismissed.

As new information on the situation continued to surface, the Federal Reserve had to incorporate this new information into its analysis of the performance of financial markets and the real economy. But, concerns over these two areas were only a small part of the total picture the Fed had to keep track of.

The liquidity of the financial markets is really the first thing that the Fed pays attention to. Why? The Fed is a participant in the money markets because it has to operate in these markets on a daily basis. Thus, the traders on the Open Market Desk in New York have the first knowledge of whether or not the money markets are experiencing a change in liquidity. This is where the story usually begins.

To examine the year 2007, let’s start out with what occurred in the banking system. Here one finds some counter-intuitive results: Total Bank Reserves and Nonborrowed Reserves declined throughout the year on a year-over-year basis. The initial interpretation of these data is that the Federal Reserve was tightening up on bank reserve positions. Digging deeper we see that Required Reserves in the banking system declined as well. The year-over-year rate of decline of Required Reserves was around 4.0% in the first half of the year and around a 2.0% rate of decline in the second half. This seems to re-enforce the interpretation that the Fed was tightening throughout the year. Furthermore, we see that the narrow measure of the money stock, M1, also declined throughout the year. The year-over-year rate of change of this measure was negative throughout the year except for the months of September and October when the rates of growth were modestly positive.

The picture begins to clear up when we examine the year-over-year rate of growth of the broader measure of the money stock, M2, which was positive throughout the year, growing at a rate between 5.3% and 6.4%. The conclusion one draws from this is that people were moving funds from transactions deposits at banks that required bank reserves to time and savings deposits that required few or no bank reserves. That is, bank reserves were being released throughout the year as a result of people moving their financial resources around within the banking system.

The Federal Reserve responded to this release of reserves by reducing the amount of reserves in the banking system. Operationally, the Federal Reserve does not like ‘sloppy’ money markets because it cannot tell where the market is if it is not ‘taunt.’ Therefore, it removed these excess reserves as they were released. This seemingly caused no harm to the money markets. The escape valve for the banking system experiencing undue pressure is the Federal Reserve’s Discount Window. Primary borrowings at the Discount Window remained very low during this time with not much variation up until August. The only conclusion I can draw from this is that through July 2007, the Federal Reserve perceived no extraordinary liquidity pressures in the money markets. Hence, no overt action was needed.

What happened in August and September? The Federal Reserve sensed some pressure in the money markets and wanted to maintain the “orderly functioning” of these financial markets. On August 17 there was a reduction in the Fed’s discount rate to avoid “deterioration of financial markets.’ Looking at the data from the Federal Reserve statistical release H.4.1, Factors Affecting Reserve Balances, we see a jump in Loans to Depository Institutions of about $1.2 billion for the week ended August 22 and these loans stayed near the same level until they jumped another $1.6 billion in the banking week ended September 12 indicating some pressure was being felt within the markets. But, two other things were also happening. First, there was the usual seasonal increase in currency outstanding for the Labor Day weekend which the Fed generally supports with repurchase agreements (Repos). Repos are used because this movement reverses itself once the weekend is over. Second, there was a reduction in Treasury securities held outright of about $10.0 billion through the end of August into early September. The conclusion one can draw is that any pressures that were experienced at this time were relieved.

The target Federal Funds rate was lowered on September 18, to “avoid disruptions to the financial markets” and the discount rate was also dropped at the same time. Loans to Depository Institutions dropped back to a relatively insignificant amount while the Fed conducted repurchase agreements to smooth financial market adjustments during the week ending September 26. Whatever market pressure existed during late August through early September were satisfactorily relieved, for there appear to have been no further operational changes at the Fed through the month of October.

The Federal Funds target was dropped again on October 31 (along with another cut in the discount rate) but nothing out of the ordinary can be seen in the November data only the usual seasonal rise in currency in circulation related to the Thanksgiving/Christmas holiday season. This increase was underwritten, as usual, by a rise in repurchase agreements. So we come to December but this month, along with early 2008, needs its own post. This is because of all the “new” things that occurred, especially the introduction of the Term Auction Credit facility that was begun in that month.

The basic conclusion I draw from reviewing the data from 2007 and the actions taken by Bernanke and the Federal Reserve is that financial markets were reasonably benign. Concern arose about possible ‘disorderly markets’ in late August and early September, but this period passed without any major disruption taking place. The Fed seemingly performed well. Should the Fed have been more concerned about a looming crisis? To me, it is hard to develop an argument for a more active central bank during 2007. Apparently, Bernanke and the Fed did not make any major mistakes during the year. There was no indication at any time that a major liquidity problem was brewing…this was to come in early 2008.

Can Interest Rates Resolve a Solvency Crises?

In recent weeks, we have heard a lot about something called a Solvency Crises. In this number I discuss is meant by a Solvency Crises and differentiate it from a Liquidity Crises. A central bank has to be concerned about both types of crises, but it has to be able to distinguish one from the other because the monetary authority must respond differently to each kind.

A Liquidity Crises is a short term phenomenon that arises because someone must relieve themselves of some financial assets. The recent example is that of the French bank which had to unwind a securities position that had been established by a trader working at the bank. The bank had to sell off the position in order to minimize any further losses it might have to take. The amount of the securities that were involved in the position was estimated to be around $75 billion, so we are talking about a substantial amount of securities that must be sold within a relatively short period of time.

In normal times for markets that are relatively liquid, the bid-ask spread between what people will buy a security for and what they will sell the security for is relatively narrow. That is, I can buy a security and then turn around and sell the security and will only lose a small amount of money. The narrow bid-ask spread is an indicator that the market is relatively liquid. Less liquid markets experience bid-ask spreads that are more or less wider depending upon the illiquidity of the market.

If the seller of a security has to sell a noticeably larger amount of securities within a relatively short period of time, potential buyers may reduce the ask price somewhat, but the increased discount is not unusually large. If the discount is not large, this is used as evidence of the liquidity of the market. In other words, if a sizeable amount of a security can be sold relatively quickly without much concession in price then the market is termed a liquid market. Liquid markets are, of course, very important for financial (and other) organizations because securities that trade in liquid markets can be used to adjust portfolio positions under normal circumstances with little or no penalty in terms of price concessions to the market.

However, if a large amount of securities must be sold within a very short period of time, even liquid markets can experience liquidity problems. This is what is termed a liquidity crisis. What happens in these cases is that market participants know that the securities must be sold and they know that a large amount of the securities must be sold. Very often market participants will even know which institution has to sell the securities. Under such circumstances the problem becomes one of price.

In a normal situation when a larger block of securities is sold, potential buyers know that this sale is just a ‘bump’ in the market and that the market will return very quickly to the range that this type of security had been trading within. Thus, market participants know where the market is and they are willing to continue to ‘make a market’ in the security.

In a liquidity crisis this is not the case. Market participants know that price concessions must be made but because of the quantity of the securities that must be sold on the market and the short time span over which they must be sold, confidence wanes as to where the market will continue to trade. Buyers become unsure…sellers become desperate! The problem, therefore, switches to the buy side. Buyers don’t want to buy a security, even if the seller is willing to give up a substantial discount, if there is a concern that they, the buyer, will soon be holding a security for which they overpaid. Buyers withdraw…they head for the sidelines…they go and play golf. And, buyers will stay on the sidelines until the markets exhibit some kind of stability and they can become confident about where prices should be.

The job of stabilizing the market in a liquidity crisis is that of the central bank. There are two actions that the central bank can take that are the classical responses of central banks to such a market situation. Putting these responses within the structure of the Federal Reserve System we call them the lender of first resort response and the lender of last resort response. In terms of the former, the Federal Reserve reduces the operating target for the Federal Funds rate, which, in essence means, that the Fed will become a buyer of securities at a set price so that the market knows there will be a buyer for their securities…hence, institutions that need to adjust their portfolios know that they can sell to the Federal Reserve. The latter response has to do with the Borrowing window at the Federal Reserve. In the case of a liquidity crisis, the Fed, for a short time, will throw open the borrowing window so that banks can borrow funds from the Fed and not have to sell securities into a declining market. In both cases, the Federal Reserve, in classical central banking style, provides liquidity to the money markets in order to stabilize markets and keep buyers at their trading desks. This is how a liquidity crisis can be stemmed.

It is time to get back to the problem of the solvency crisis. The problem of solvency occurs when there is a decline in the value of assets that are being carried on the balance sheet of an organization. Solvency can be an issue within the context of a liquidity crisis when the securities on, say, a bank’s balance sheet lose market value. However, the problem becomes of much greater concern if the institution, the bank, experiences a decline in the value of other assets on its balance sheet, say in its loan portfolio. Here the difficulty may be the ability of the borrower to repay the loan that they have outstanding with the bank. In these cases, the bank knows that it will not receive back the total amount of the loan outstanding and, therefore, must write down the value of the loan.

The concern here is that when asset values on a balance sheet are written down the impact ultimately impacts the capital position of the organization. When we write off a loan, for example, we write it off against income reducing profits, which means that the increase in net worth will be less than it otherwise would be, or, it the charge-offs result in a loss, net worth would actually decline. If the capital position of the bank gets too low, then the bank will have to raise more capital, sell itself to another financial institution, or close. When many banks have this kind of problem there is a solvency crisis!

Raising capital is the only long term way to resolve a solvency problem and there are basically two ways to raise capital. First, over time, profits will increase the level of capital that an organization will have. This takes time and is the solution to the crisis only if institutions have sufficient remaining capital to replenish capital by means of longer run profitability. Second, the institution must go out and obtain capital from other sources. The availability of capital is dependent upon two things…that there are pools of capital available for investing…and that the institution has sufficient viability to justify investors risking their funds by investing in that institution. The Sovereign Wealth Funds have provided the pools of capital required to meet at least some of the needs of the current solvency crisis. One presumes that these Funds have done their due diligence and hence believe that their investments have long term viability.

The Federal Reserve cannot resolve a Solvency Crisis. That is, a central bank is not in a position to inject capital into banks or other organizations in order to resolve this kind of crisis. If there are not pools of funds available to put capital into troubled institutions then the solvency crisis can cumulate and spin out-of-control like it did in the Great Depression of the 1930s. The only thing the central bank can do is to help create a favorable environment so that the economy can grow and sufficient profits can be generated to replenish capital in this way. But, this takes time and patience…it cannot be done quickly.

It has been argued that Ben Bernanke and the Fed failed to realize the severity of the economic problem soon enough and did not act quick enough to lessen its impact. In my next post I am going to look at the operational behavior of the Fed in 2007 in an attempt to discern whether market conditions existed during 2007 indicating the existence of a liquidity crisis. If a liquidity crisis did not take place in 2007, then this may explain why the Fed did not want to take any precipitous action during that time when the extent of the problem was not obvious…particularly when there were other issues on the table like the decline in the value of the US dollar and the inflation being slightly above the range acceptable to the policymakers.

The Unfolding Economic Scenario

The discussion in the previous post was precipitated by the extraordinary large drop in the target interest rate that the Federal Reserve uses in the conduct of monetary policy and the $150 billion stimulus plan proposed by the Bush Administration and the US Congress. Since then the Federal Reserve has proceeded to drop the target interest rate by another 50 basis points (an ‘unprecedented move’) and congress has forged ahead on the fiscal package. Financial markets, reacting to the Fed’s actions, have seemingly stabilized, although they are still volatile. The movement on the stimulus package has shown the world just how caring and responsive the Federal Government is when it comes to the plight of their political constituencies…even though concern exists that the effort will be ineffective, at best.

All this must be put within the context of the economic and financial developments that were presented in the last posting. The first development related to the financial innovation that has taken place in the United States over the previous 40 years. Although this innovation provided many benefits to individuals and institutions throughout the world, it also resulted in the ramping up of the riskiness of financial markets. Furthermore, the risk associated with innovation is connected with uncertainty as to how financial market volatility might come about as well as with the timing of the volatility. The second development related to the six year decline in the value of the United States dollar that resulted from the Federal Reserve maintaining a Federal Funds target that was at historically low levels for over two years. These two factors represent the back-drop for the events that are unfolding in the current period.

In the past, the economy of the United States has been sufficiently large that government policymakers could act as if it were independent of the other countries in the world. Economists discussed international macroeconomics in terms of ‘small countries’, countries whose balance of trade, etc., were affected by international markets. The United States was usually not considered to be a ‘small country.’ But, globalization has changed all that. The United States is now a ‘small country’ just as is every other country in the world (although still extremely influential). This makes a statement by Paul Volcker, former Chairman of the Federal Reserve System, more relevant today than ever before. Volcker has written that “a nation’s exchange rate is the single most important price in its economy; it will influence the entire range of individual prices, imports and exports, and even the level of economic activity.” (Paul Volcker and Toyoo Gyohten, Changing Fortunes, Times Books, New York, 1992, page 232.) Apparently, Alan Greenspan did not believe this to be the case.

The declining value of the US Dollar has seemingly resulted in a rising dollar price of commodities throughout the world, most importantly in the price of oil (but also in the price of gold). Again, looking at historical data on the price of oil the pattern seems to be inversely correlated with the decline in the value of the US Dollar. As a consequence, large amounts of dollars were accumulated in oil producing areas within the world, particularly in the Middle East, Venezuela, and Russia. The other major country that has accumulated US Dollars has been China. A major reason that China has accumulated US Dollars is that it has ‘not played fair’ in the foreign exchange markets. That is, China has not allowed its currency to float and this has resulted in its exports far exceeding its imports, especially when trading with the United States, and, as a consequence, has accumulated a large amount of dollars.

This is where the world financial markets come into the picture and they cannot be discussed without considering all of the financial innovations that have taken place in recent years. First of all, in the last seven years, the United States government has run large deficits. Countries, especially China, that have accumulated dollars financed a substantial amount of this new Federal debt. Arguments are made that one reason the US government has been able to finance such large deficits without causing interest rates to rise is that dollar holders have used their funds to buy US government securities and just hold them.

Second, eventually the hunt for yield went beyond just safety and looked for higher and higher returns. This is where the financial innovations of the United States became such a boon for foreign investors. Participants in world markets became almost insatiable in their demand for higher yielding US securities, particularly of the asset-backed variety…since they would be safer. United States financial institutions, battling for market share were very willing to create and supply such instruments. Whereas, previous innovations were not as easily duplicated and firms were able to preserve some market power for the creating institutions due to the existence of specific market niches and customer loyalty, many of the innovations of the late 1990s and early 2000s were easily copied and the creating institutions were not able to maintain any market power for their inventions. Returns to originating institutions tended to come from fees and trading profits so buying and holding these securities on their balance sheets was not important; these firms, therefore, emphasized volume rather than quality.

Third, physical assets located in the United States became more and more attractive to the holders of US Dollars. Although people within the United States became concerned with the thought of foreign ownership of US physical assets and politicians did block some deals, it was a natural progression for foreign institutions that held US Dollars to eventually migrate to ownership of physical assets. And, like the previous two developments, investment in these assets increased over time.

Now the riskiness of the new financial innovations comes into the picture. With all the money going into certain segments of the United States economy, especially housing, a mild inflation was sustained over time. This was not unusual for the housing sector since housing prices had risen on an annual basis for years. But, all of a sudden, the inflation in housing prices stopped and since many mortgages only made sense if the price of the underlying houses continued to climb, many of these loans, particularly in the subprime area where things like credit worthiness and equity in the home were no longer so important became less viable. Thus, the economic value of these mortgages declined and the value of the securities that were backed by these mortgages also declined. Unfortunately, for many reasons, people were unable to put a price on these securities.

There is not space here to give this aspect of the situation further coverage. The important thing is that this decline in the value of financial assets impacted financial institutions all over the world and large write offs had to be taken by many organizations (and will continue into the foreseeable future). The liquidity crises in such an environment never really materialized in 2007 when it was expected. Once this was avoided, the solvency crises had to be dealt with. The resolution of this problem has seemingly progressed more rapidly and more smoothly to this date than could have been imagined several years ago. Because these institutions were more closely tied to markets than they ever had been before, they had to recognize the declining value of these assets. Top executives were let go (and this will continue into the foreseeable future). It was only to be expected that new top executives would try and clean out as much of the bad assets as possible so they could move on. So, balance sheet adjustments were made (and this will continue into the foreseeable future).

But…this means that new capital needs to be raised for these institutions to remain solvent. Where is the money to come from? Aha! Those nations and organizations that have large dollar holdings have become the source. We have learned of a new institution called the Sovereign Wealth Fund, institutions that have billions of dollars to invest. And, as a consequence, we have seen the start of one of the biggest reallocations of wealth around the world that has ever taken place. And, United States monetary and fiscal policy had underwritten it!

Oh, yes, and what of the cuts in the target Federal Funds interest rate by the Federal Reserve and the fiscal stimulus package that is being put together?

There seems to have been a liquidity crisis in financial markets around January 21, 2008. At that time, a large French bank was faced with $75 billion of bad bets created by one of its traders, bets that ultimately cost the bank $7.2 billion in losses. The bank tried to unwind the ‘bad bets’ and, as is often the case in a liquidity crisis, word of the unwinding got out to the market. Liquidity crisis take place when the market knows that someone has to sell and has to sell a large position. No one wants to ‘bet’ on what the price will need to be to accomplish the unwinding. The market, in effect, retires to the sideline and waits to see what happens. The market, therefore, has no liquidity.

The Federal Reserve action on Tuesday morning, January 22 seems to have relieved this situation although it does not seem to have known about the trading activity of the particular French bank. But, if this is the case, then the Federal Reserve, inadvertently, did what it was supposed to do. It helped to avert a liquidity crisis. The additional reduction in the Fed Funds target on January 30, according to the statement that was released by the Fed, came “to promote moderate growth over time and to mitigate the risks to economic activity.” The immediate question, however, has to do with the solvency crises. Will this move help to resolve the solvency crises and then help spur on the economy. Markets and market participants seem to be uncertain this move will accomplish that goal.

And the stimulus package? There is continued skepticism about the effectiveness of the package and growing cynicism concerning the motivation for the package. The skepticism about the effectiveness relates to the argument that most people will not spend the funds they receive from the package but will either save them or use them to pay down existing debts. Economists contend that people spend based on their longer-term expected or permanent income and not on temporary windfalls. The evidence of the past two efforts to provide short-term fiscal stimulus to the economy indicate very little impact on spending from such temporary injections of funds.

In terms of the cynicism concerning the motivation of the package, more and more analysts are contending that the politicians had to do something in order to appeal to the voters. They could not afford to look like they were sitting on their hands and doing nothing. Otherwise, anyone that might oppose them would be able to point to this situation to show that the politician did not care about the state of the economy and was reluctant to help people. Maybe the best one can hope for is that the stimulus package will not do too much damage to the economy. If it does any good…that would be a bonus.

Where does this leave us? In my opinion, there is still too much uncertainty relating to the health of the economy to make a confident prediction about a recession or the depth of such a recession, if one comes. Regardless the exact path, the economy has to transition through the dislocation in the housing market and in other asset markets connected with the financial innovations of the last decade or so.

We still have to be concerned with the US Dollar. The Federal Reserve could raise interest rates. This is the typical action of a central bank that faces a weak national currency. Right now, however, the Fed does not have this option. And, with European central banks unwilling to make any move that will weaken the Euro or the Pound, any drop in US interest rates will just further depress the dollar. There seems to be little or nothing the Fed can do now to resolve this problem at this time.

A weak dollar continues to make US physical assets cheap and continues to encourage more foreign investment in the United States. The Bush Administration has created an environment that is resulting in the greatest sale of ownership of US physical assets to foreign interests in the history of the United States! Globalization has come home!

What a week this was!

Stock markets going crazy all over the world! As a consequence, the Federal Reserve reduced its target interest rate by ¾%, or 75 basis points, the largest reduction in this target rate in many a year. Growing concerns about the United States slipping into a recession (Whoops! The ‘R’ word…). And this was met by the US Government producing a $150 Billion stimulus package that was put together by Republicans and Democrats working together!!!!!!!! Wow! What can top this?

And, what is the response to these actions? Well, the stock markets have seemed to stabilize…for the time being. (Note: the cuts by the Fed were not followed by other central banks throughout the world except in Canada.) The ‘on-the-street’ noise was that Fed Chairman Bernanke panicked, calling a special teleconference meeting on Martin Luther King Day so as to be able to make an announcement before the market opened on Tuesday. This move came the week before a regularly scheduled meeting of the Fed, a meeting in which a target interest rate cut had already been signaled by Bernanke. Now, the futures market is projecting further cuts over the next 6 months bringing the target rate to lows that seemed impossible to consider even two weeks ago.

What about the stimulus package? Many have declared it a victory…a victory for the politicians who want to show voters their concern for ‘the people.’ The argument goes that both Republicans and Democrats, with elections in the works later this year, could not go back to the nation without being able to show people that they had given ‘their best shot’ toward reducing the impact of an economic slowdown.

What can we expect from all this activity? That is not an easy question to answer. An effort will be made to provide some kind of an answer to this in today’s posting and the posting for next week. The reason for this is that I want to spend the remaining space in today’s posting to discuss the possible causes of the current situation so that we have a foundation to examine the potential future consequences of the actions taken last week. Economic actions tend to take quite a long time to work themselves out in the broader economy. And, whereas these economic actions may have many beneficial short run effects, the longer run results may create situations that are not so good and that may be quite difficult to unwind. Often, in the economic sphere, we find ourselves fighting battles that have causes which took place many years ago and are not easily recognizable. Humans, tending to be current orientated, tend to look at recent events for a cause and design responses that are not totally appropriate and may have unpleasant consequences in the future.

Let’s limit this week’s historical review to two factors. The first has to do with the financial innovation that has been a part of the financial scene for over forty years now. This has been a tremendous benefit, not only to the United States, but arguably, to the whole world. The financial innovation that has taken place during this time has resulted in markets becoming much more efficient, as well as broader and deeper. The consequence? More funds have been allocated to segments of the economy than ever before allowing more and more people to obtain financing than could ever have been dreamed of. Of course we think of the subprime market now, but when mortgage backed securities were created in the late 1960s and early 1970s, the concern was with the ability of the financial system to provide mortgages to ‘middle income’ America so that these people could realize the American dream of owning their own homes.

But, what about businesses? In the 1960s it was very, very difficult for a potential entrepreneur to get funds to start up a business. Venture capital was in its infancy and the only real source of funds, besides one’s family and friends, was the commercial bank. Commercial banks, however, required evidence that a loan could be repaid and that a person had some kind of tangible net worth, like equity in a home. An entrepreneur did not have a network of specialized venture capitalists to go to…or private equity funds…or hedge funds. Starting up a company back then was a ‘hard knock life’!

As David Brooks mentions in his New York Times piece of January 25, 2008, there is a tension in a capitalistic society between certainty and innovation. If we believe that innovation is good for the economy and the society, then we must accept the fact that there will be greater uncertainty with respect to future events. (http://www.nytimes.com/2008/01/25/opinion/25brooks.html?ref=opinion) Over the past forty or so years, financial innovation has become a world-wide phenomenon and many have benefited from this innovation and not just the financial types that created the innovation. This innovation has created uncertainties. But, specific uncertainties cannot be forecast, they just happen. What this means relative to the situation we are now facing will be discussed next week.
The second factor is the behavior of the Federal Reserve during the Bush Administration. If one looks at the chart of the Federal Funds Target Rate of Interest for the period beginning in 2002 to the present, it can be observed that the target rate was kept extremely low for over two years beginning in 2002. (http://research.stlouisfed.org/fred2/fredgraph?chart_type=line&s%5b1%5d%5bid%5d=DFEDTAR&s%5b1%5d%5brange%5d=10yrs) The argument given for the behavior of the Fed was the attack of 9/11 and the additional fear that the downside risk for the economy was quite high. In effect, the actions of the Fed underwrote the economic policies of the Bush Administration and supported its re-election in 2004. Arthur Burns was faulted for helping to underwrite the re-election of Richard Nixon in 1972 because of the subsequent impacts his policies had on the economy. One could argue that Alan Greenspan outdid Burns in his support of Bush.

There were immediate consequences of this behavior: the value of the dollar declined. It is remarkable to place the above referenced chart next to one showing the Dollar’s Trade Weighted Exchange Index. (http://research.stlouisfed.org/fred2/fredgraph?chart_type=line&s%5b1%5d%5bid%5d=DTWEXM&s%5b1%5d%5brange%5d=10yrs) Here we see that the measure of the Exchange Index peaked near the same time that the Federal Funds target was placed below 2%. The Exchange Index continued to fall throughout the time the Federal Funds target was kept at very low levels and only seemed to stabilize (not rebound) when the target was raised throughout 2005 and 2006. It can be noted that the Exchange Index began to decline again as the concern about the health of the United States financial system grew in 2007.

Why is it important to recall these two historical facts? The reason we need to recall these is that we are living with their consequences. And, since these events happened many years before the current period we need to refresh our minds as to their presence so that we can better understand the events of today. But, it is not the case that one caused the other. It is just that their co-existence has resulted in an environment that is more combustible in the sense that these two factors have reinforced the uncertainties within the financial markets and have exacerbated the difficulties that policy-makers have to deal with in terms of resolving the perceived problems that have arisen.

Markets hate uncertainty. Furthermore, markets don’t like policymakers in which they have little confidence. Up-to-this-date, the policymakers handling the situation have not provided the markets with a lot of confidence. For example, in an article in the Wall Street Journal on Friday January 25, 2008, Bernanke and the Fed come under much criticism. It is not the policies, per se, that are the subject of criticism, but the way in which Bernanke and the Fed have presented the policies over time. James Bianco, president of Bianco Research LLC is quoted as saying: “…part of the Fed’s job is political theater as opposed to the actual levers they pull, And he (Bernanke) has failed so miserably on the political-theater aspects that it’s overwhelming the things that he might be doing correctly.” (http://online.wsj.com/article/SB120120095796214019.html?mod=todays_us_page_one) The new stimulus package, also, has not garnered much favorable response, from either the right or the left. (http://www.nytimes.com/2008/01/25/opinion/25krugman.html?ref=opinion

Competitive Advantage and Competitive Pressure

Last week we took a quick look at the competitive advantage. This week we will take a closer look at the idea of competitive advantage and how it relates to the whole concept of competitive markets and the existence of market power. First, we need to add some empirical content to the definition. Bruce Greenwald and Judd Kahn in their book Competition Demystified provide some useful parameters for us to use in such an effort. Starting out, they argue, care must be taken to define the industry/market that a firm works within. This is important for two reasons: measurement of market share and calculation of performance of a firm. The measurement of market share is important because one of the criteria for identifying companies with market power is that market shares within an industry must be relatively stable. That is, real competitive advantage must be sustainable. In more competitive industries, market share is less stable and changes can take place relatively frequently.

The second reason that industry/market definition must be reasonable is that evidence of sustainable competitive advantage can be discerned in situations where a firm earns an after-tax rate of return on invested capital that is in excess of the firms cost of capital. To Greenwald and Kahn this means that a firm that possesses competitive advantage must earn an after-tax rate of return in the 15% to 25% range. (This can be translated into a pre-tax rate of return in the range of 23% to 38% if one assumes a tax rate of 35%.) One problem in finding firms that have competitive advantage is that the firms operate may operate in several market or industry spaces. As a consequence, the ‘company’ rate of return may be rather average whereas they may operate in one or more markets or industries where they really do possess competitive advantage. Internally, it is important for a management (as well as investors) to understand the different market segments or industries that a firm works in so as to be able to identify exactly how the company is performing and why. Note that firms that do not possess competitive advantages will earn in the range below 10% after-tax rates of return.

The important question, of course, is what accounts for sustainable competitive advantage. Michael Porter has identified five elements that a firm must consider when looking for and achieving sustainable competitive advantage. These five forces are labeled barriers to entry, demand advantages, supply advantages, industry rivalry, and the existence of substitute or complementary products. In this posting we will follow Greenwald and Kahn and just focus on barriers to entry and demand advantages. Greenwald and Kahn argue that these two forces tend to be the predominant cause of competitive advantage. Barriers to entry pertain to all those advantages that exist that limit the ability of potential competitors to enter an industry whether they be government rules and regulations, economies of scale, knowledge or specialized resources. Demand advantages are related to customer captivity that result from things like habit, search costs, or switching costs.

Porter has been accused of providing instructions to firms on how to reduce competition. And, in reality, the five forces analysis is a recipe for finding out how a firm can achieve and maintain market power, which is basically the power to set prices at optimal levels. Firms that don’t possess market power are said to be price takers whose primary decision is the quantity that the firm will produce. Thus, the Porter approach is a methodology for creating market power and reducing price competition.

Historically, economists have presented a picture of industry rivalry as a continuum going from perfect competition, say on the left end, to monopoly, on the right end of the spectrum. (In between we list monopolistic competition, to the right of perfect competition but to the left of oligopoly, the latter being to the left of monopoly.) The two extreme models are the most completely defined and hence serve as the starting point for understanding different market structures. (Milton Friedman would only discuss these two extremes because they were the two models that were most rigorously constructed and logically consistent.) The primary assumptions behind the model of perfect competition are as follows: the market is made up of small, identical participants, both on the buy and sell side of the market; all producers supply a product/service that is exactly the same; there are no barriers to entry to or exit from the industry; there are no transaction costs; complete information; and all firms operate under constant costs of production. The primary assumptions behind the model of the monopolist are: one producer; one differentiated product/service; barriers to entry and exit exist; there may be transaction costs; information may be incomplete; and there may and probably are economies of scale. In the perfectly competitive case all buyers and sellers are price takers: no matter how much they buy or sell in the market they cannot affect the price posted in the market. The monopolist is a price maker.

In between there are all sorts of different combinations of characteristics of firms and industries. One can strongly argue that distinctions are not two-dimensional, but multi-dimensional, and the concepts of the oligopolistic industry and the monopolistically competitive industry are just models that were historically relevant at one time or another. What is crucial in the Greenwald and Kahn analysis is that firms tending to have market power or competitive advantage tend to earn after-tax rates of return on invested capital that are in excess of their cost of capital and exhibit relatively stable market shares. Firms that tend to lack market power or competitive advantage tend to be smaller, find that their market share is relatively unstable and earn after-tax returns on invested capital that are around their cost of capital.

It is crucial to understand that competitive pressures are constantly pushing firms with market power or competitive advantage to the left (in terms of the competitive continuum). If there are excess returns being earned, and there are no barriers to entry, firms will compete vigorously to participate in those excess returns. Thus, market power or competitive advantage must be continuously defended and efforts must constantly be made to enhance or expand it. (Microsoft is an obvious choice for an example of this latter behavior. Tiger Woods is another.) This approach must be intentional it doesn’t just happen.

But, you must be realistic. The market and competitive conditions may be such that you cannot maintain competitive advantage and even intentional efforts to sustain it or enlarge it may not be successful. In such case, management must be realistic about their situation and accept the fact that their firm and their industry is moving more toward the competitive end of the spectrum. In such cases, Greenwald and Kahn argue that strategies to attain market power must be abandoned and emphasis must be placed upon tactics such as improving operational efficiencies and cutting costs.

An example relating to this latter case is that of General Electric. When GE evolved into a company where competitive advantages had been lost it needed to head in another direction. Jack Welch was brought in and his early years were spent in improving operational efficiencies and cutting costs. GE companies that didn’t perform up to goals were then spun off and sold. Many now argue that GE is at the stage where it is worth more as separate companies. GE’s days of exceptional earnings may be over.

Last week we examined the financial services industry and discussed the problems in the subprime market. Here financial innovation relating to mortgage-related securities developed products in which there were no barriers to entry and customer captivity never existed. Competition reduced returns and banks, in order to keep up revenues, cut corners in an effort to generate large volumes. Another example of vanishing market power can be found in energy. Energy markets had been regional in nature up until the 1990s. When energy markets became national, there appeared the opportunity to arbitrage between regions where energy costs were low and regions where energy costs were high. Enron became a leader in these arbitrage activities. But, there were no barriers to entry and no customer captivity. In order to try and earn acceptable returns, the company resorted to extra-legal means rather than finding a business model that was more appropriate to the existing market. Lesson learned: be realistic about your markets.

Competitive Advantage and the Financial Mess

There is a strong drive within a market driven economy to create and sustain competitive advantage. Competitive advantage is a concept that is associated with the work of Michael Porter (Competitive Strategy and Competitive Advantage are his best know books) and refers to the ability of a firm to develop a strategy in which they achieve some kind of market power. This market position will allow the firm to continuously produce a superior performance, meaning that it, the firm, will earn a rate of return on invested capital that exceeds the opportunity cost of this capital over an extended period of time.

In this comment, I would like to examine this drive for competitive advantage and apply it to the recent experience of financial institutions with respect to their move into Subprime Mortgages and other Asst Backed Debt Securities. Over the past fifty years or so, financial innovation has been one of the major driving forces in the financial services industry. Whereas, in many cases this has been beneficial to financial firms, the recent meltdown of the subprime mortgage market has provided us with evidence that this innovation can get out of hand. And, since the drive for competitive advantage applies to all firms, I believe that we can gain some insight from this recent experience that can be used in all industries.

One way to achieve competitive advantage is to create a monopoly or a position of market power (a position of having control over pricing decisions in the market). In their book, Competition Demystified, Bruce Greenwald and Judd Kahn argue that monopoly power can only be achieved “locally.” By “local” they mean either in a geographic region or in a product space. Geographic region is self-explanatory. Commercial banks used to have ‘local’ positions of market power created and maintained through the banking laws of the states and the Federal Government. In terms of product space, it is argued that Microsoft has a strong position of market power in Computer Operating Systems.

Having a monopoly position or a position of market power within a market can mean many things, all of which contribute to a firm’s ability to sustain competitive advantage. For example, banking laws provide a barrier to entry for any other group of people that want to form a new bank within a geographic region. An organization that has a position of market power in a “local” region can achieve economies of scale that allow the firm to produce lower prices than anyone else. The example here is Wal-Mart as it was originally conceived. Having market power in a product space can also create barriers to entry as potential entrants must face such economic hurdles as switching costs, network effects, and positive feedback loops within the product space.

One of the biggest dangers faced by the leaders of firms that have a position of “local” market power or monopoly is the urge to expand beyond the “local” position. The “local” position is achieved by focus and persistence. But, ‘larger’ firms provide executives with benefits over and above what might be gained in ‘smaller’ firms. The argument for growth is easily defended: If firms can create competitive advantage “locally” then it can be assumed that they have the ability to perform on a bigger stage. Growth becomes the mantra of the company, displacing return on capital as the major objective: Achieving a higher rate of return on capital is the longer run goal, but the company needs to expand first so as to grow or maintain market share. What executives got personally (higher salaries or bonuses) was not an issue…of course.

Financial innovation has become increasingly important for the financial services industry in the last half of the twentieth century. Most of the innovation has been to fill niches in financial markets so as to make the financial markets more efficient. Thus, it can be argued that financial innovation comes about to improve risk sharing and bring financial services into areas that were not being effectively served. (A good source book in this area is Financial Innovation and Risk Sharing by Franklin Allen and Douglas Gale.) The subprime market was an attempt to bring mortgage finance to people that had not been able to borrow to purchase a home. This, in itself, is a commendable goal and some success has been achieved. However, other problems have obviously arisen.

Allen and Gale present evidence that supports the conclusion that financial innovation created areas in which financial institutions could achieve some form of monopoly power for their innovations. They state that “Innovating (investment) banks that introduce an innovative product subsequently obtain a larger market share than imitators.” (Page 35) Innovation appears to have created competitive advantage for financial institutions within “local” product spaces and hence provided these organizations with superior performance. There appears to have been ample reason for these organizations to continue innovating.

Note, however, that Allen and Gale do indicate that imitators do arise in an attempt to compete away the superior returns. This is normal market behavior and it is a phenomenon that Greenwald and Kahn emphasize in their book. However, normal competitive pressures will tend to eat away at a position of market power, resulting in lower returns for the innovator. There is always incentive to eliminate competitive advantages. [In financial markets, the Quants have contributed to this competition and have caused returns to diminish even further. For an interesting up-to-date article on the Quants see “The Blow-Up: The quants behind Wall Street’s summer of scary numbers” by Bryant Urstadt in MITs, Technology Review, November/December 2007.] Allen and Gale show that in earlier cases of financial innovation, investment banks were able to maintain their market position.

If competitive advantage cannot be maintained, firms become ‘price takers.’ This results in reduced rates of return on each equity dollar invested where total revenues can only continue to grow with a rise in total dollars invested. Only financial leverage (more and more debt relative to equity capital invested) can keep revenues growing. Thus, financial institutions were driven to pour more and more money into a given ‘product space’ in order to achieve growing revenues to overcome the decline in any competitive advantage that might have existed at one time. Volume (growth) became the game in order to make more fees on underwriting and trading. Corners were cut, as on credit worthiness, on the amount of down payment, and on documentation, and excuses were made to justify the behavior. (In the case of housing, the inflation of housing prices that had existed for decades, was used as a rationale for lowering credit standards and minimizing down payment requirements because it created ‘equity’ for the borrower.) The housing market that at one time had been “local,” became national and then global.

What do Greenwald and Kahn say about a situation like this? Competitive pressures that cannot be offset by barriers to entry, economies of scale, or other means, can only be combated by expense control or cutting costs. Porter also concludes this as well. Unless you can establish and sustain competitive advantage in some way, price competition, or, in the case of financial markets, arbitrage, will eliminate the superior returns. A firm cannot grow itself out of a loss of competitive advantage. Experience has shown that the existence of competitive advantage is the exception rather than the rule and one must intentionally create it, protect it and promote it as diligently as one can. However, one must be willing to change focus when it becomes obvious that competitive advantage cannot be sustained. (Remember the classic response of Dustin Hoffman in The Graduate? Plastics!)

The lessons: first, competitive advantage can come about through the creation of “local” monopoly, either geographically or within a specific product space. Second, competition will arise and, sometimes become quite fierce, to participate in the superior returns that are being earned by the firm with market power. Third, a firm must continuously work to protect the factors that contribute to competitive advantage or create new factors. Fourth, competitive advantage may not be able to be sustained and managements must be realistic about this and change their tactics in such cases. Fifth, growth can destroy competitive advantage and executives must not become blinded by its allure.

Uncertainty/Volatility

A lot has already been written about the volatility of the financial markets in 2007 and the expectation that volatility in 2008 will be even greater. Perhaps a good place to start a discussion of this is the graphic display that was presented in the New York Times on Sunday, January 6, 2008 in the business section. Here is the link to this article titled “The Pulse of Uncertainty”.
http://www.nytimes.com/imagepages/2008/01/05/business/20080106_soapbox_graphic.html
The basic idea here is that volatility is created by uncertainty and uncertainty is connected with risk. But, we can be more specific than this. Economists define risk as volatility, or more explicitly as variance. And, it is important to note, that variance here not only relates to a decline in market prices, but also to an increase in market prices. That is, all movements in market prices are associated with risk and this is because all movements in market prices can be associated with uncertainty as to where the market prices should be. Not knowing where market prices should be means that we do not have sufficient information to predict, with certainty, where those prices should rest. If we had complete information concerning the determination of market prices we would know exactly what those prices should be. Hence, uncertainty arises because we only have incomplete information available to us and our decisions to buy or sell must be made in the face of this incomplete information. Thus, when the volatility (variance) of market prices increase, we can draw the conclusion that uncertainty has increased because market participants believe that they need (much) more information upon which to make their decisions concerning the future than they have.

The volatility of market prices can be observed, as in the New York Times graphic, but it is also argued that changes in the perceptions of risk by market participants should be reflected in the relationship of market prices themselves. For example, in the market for fixed income securities ( bonds), perceptions of changes in credit risk can be discerned from the spreads that exist between the interest rate yields of different classes of bonds of the same maturity. U. S. Treasury securities are assumed to be risk free, credit-wise. So the spread in yield between corporate bonds that are rated Aaa and U. S. Treasury securities of the same maturity provide us with an estimate of the difference in credit risk between risk free bonds and bonds issued by the most credit worthy corporations. Changes in this spread reflect a change in the market perception of the riskiness of the two types of issuers. Furthermore, one can look at the spread between corporate bonds rated Baa and those rated Aaa in order to see how market participants are judging the credit risk of these two segments of the market. One additional measure is the spread between yield on High Yield (or junk) bonds and the yield on Aaa corporate bonds. The crucial thing in all of these measures is not the spread itself, but how the spread is changing over time. As spreads change we need to try and understand what this is telling us about the perceptions of market participants in terms of relative assessments of risk.

A recent article in the Wall Street Journal by David Ranson, the President of H. C. Wainwright examines the recent movement in the Baa/Aaa spread. The URL for this article is http://online.wsj.com/article/SB119846436682348345.html . In this article Dave discusses the mess in the market for subprime mortgages and the securitized instruments created from them and examines why the Baa/Aaa spread had not increased until December. He argues that the concern over credit risk due to the subprime scare had not spread throughout the market until this late date. The data used come from the Federal Reserve System. The URLs for these data are: Daily http://www.federalreserve.gov/releases/h15/update/;
Weekly http://www.federalreserve.gov/releases/h15/.

An additional problem of financial markets needs to be mentioned, that of the liquidity crises. Liquidity crises are not uncommon and can be quite treacherous. A liquidity crisis is a short term affair and can result in the failure of one or more organizations. (The 1997 collapse of Long Term Capital Management (LTCM) is an example of what can happen in a liquidity crises and how companies can fail as a result of them.) The first component of a liquidity crisis is that financial assets must be sold and the market place knows that the assets must be sold. The second component of the liquidity crises is that market participants don’t know what market prices should be and these market participants just ‘go away’ and don’t return to the market until they have sufficient information about where market prices should be so that they can, with some confidence, come back into the market on the buy side. In essence, the market is in free-fall. What is needed is something to stabilize the market and this is often the Federal Reserve System. There must be a buyer, and in the case of the Fed, the central bank becomes the ‘buyer of last resort.’ But, as mentioned above, a liquidity crisis tends to be a short term affair unless the market fails to stabilize and the downward spiral becomes cumulative.

If a liquidity crisis does not occur during a time of financial distress it means that the markets are absorbing the problems faced by market participants and are adjusting to the new situation in a relatively smooth manner. That is, market participants are working things out. What is always hoped for is that markets will adjust incrementally thereby avoiding the discontinuities that result from a discrete decline in market prices that might come from a liquidity crisis.

Thus, although volatility has increased in the financial markets, indicating a rise in perceived market risk, so far the financial distress of certain market participants is being worked out as smoothly as possible and has not yet resulted in a liquidity crisis. This does not mean that we are out-of-the-woods, but it does give us some hope that the problems now being faced by financial institutions are being addressed and are being resolved even though that resolution may be quite painful. These adjustments must be made and must be made in a timely manner. We just don’t want the adjustments to result in a cumulative downward spiral.