"Even Running the Princeton Economics Department was easier than this!"

"Even running the Princeton Economics Department was easier than this!"

It's A Solvency Problem, Not A Liquidity Problem!

Discussion is swirling around the Fed’s new quantitative easing program, QE2.

The wisest comment I have heard up to this point about the QE2 exercise is the quote attributed to the economist Allan Meltzer at a recent celebration on Jekyll Island, Georgia commemorating the clandestine meetings that resulted in the creation of the Federal Reserve System 100 years ago.

Mr. Meltzer is quoted as saying, “There isn’t a liquidity problem.” (http://www.nytimes.com/2010/11/08/business/economy/08fed.html?ref=business)

But, one of the problems of this whole exercise is that almost the whole effort to reverse the financial meltdown and the economic slowdown has been attributed to the fact that many of our governmental leaders, Mr. Geithner and Mr. Bernanke, have seen the crisis as a “liquidity” problem. That is, to the problem that financial institutions can’t sell their assets.

And, these leaders continue to assess the situation as a “liquidity” problem. Some of us, however, see the continuing problem as a “solvency” issue. There is a world of difference between the two.

The original response of the government to the financial crisis was to create a program, the Troubled Asset Relief Program (TARP), which would allow the Treasury “to purchase illiquid, difficult-to-value assets from banks and other financial institutions.” This was enacted by Congress on October 3, 2008.

On October 14, 2008, Secretary of the Treasury Paulson and President Bush announced the first revisions to the program. Without going into the revisions more deeply, the Treasury announced their intention to buy senior preferred stock and warrants in the nine largest American banks. For there on, the effort “to purchase illiquid, difficult-to-value assets” all but completely disappeared.

Yet, the leadership in Washington, D. C. continued to speak as if the whole financial crisis was just a “liquidity crisis”.

I have addressed this issue many times before in my writings. But, let me use the words of Richard Bookstaber in his book “Demon of Our Own Design”: “A liquidity crisis is generally related to financial institutions and not to nonfinancial institutions. This is because financial institutions have assets on their balance sheets that have ‘liquidity’. The very ability to liquidate is at the root of the liquidity crisis.”

In a liquidity crisis there is the problem of “asymmetric information”. This problem occurs where one party to a potential transaction has all or most of the information about the value of an asset and other parties do not have the same information.

A liquidity event is most often set off with a shock to the market. In the case of Long Term Capital Management, an arbitrage situation was interrupted by a default by Russia on outstanding bonds. In the case of the Penn Central Crisis, the Penn Central railroad company declared bankruptcy when it had been thought to be a going concern. The buy-side of the market goes away because investors have little or no information.

Exacerbating this situation, Bookstaber states, is the fact that, very often, market participants can identify the seller that MUST sell its assets and this means that the buy side can be even more selective as to when buyers want to enter the market or not. In the recent problem experienced by the French bank, Society General, the market knew who was having problems and that they had to sell a substantial amount of assets to unwind certain transactions on their books.

In many cases associated with a liquidity crisis, without the intervention of the central bank, there is no reason for buyers to re-enter the market until more information becomes available to them. The bottom line to this analysis is that a “liquidity crisis” is a short term affair that requires immediate central bank action. Funds must be made available to the financial markets so that market participants can feel and believe that a “bottom” is reached in terms of the decline in asset values. This is where the Federal Reserves’ “Lender of Last Resort” function comes into play.

The “solvency crisis” is not usually such an immediate problem. Solvency issues can play a part in the liquidity crisis (note the longer term outcomes relating to Long Term Capital Management, Bear Stearns, and Lehman Brothers) but the real solvency crisis relates to a longer period of time and has to do with cleaning up balance sheets and raising new capital. It is not just an issue of “liquidating” an asset in the market place. The value of assets can deteriorate either due to changes in market valuations or due to the financial condition of borrowers. It is a question as to the ability of someone to fully repay another.

A solvency crisis is longer term than a liquidity crisis because the financial institutions need to proceed in an orderly way to work out the situation they face with respect to the value of the assets on their balance sheets. But, this “working out” process may take six months or a year to resolve. The working out of assets requires a substantial amount of time and attention from the managements of financial institutions. Thus, to get back to business as usual requires that a management get the problems behind them so that they can concentrate on what they really should be doing…running a business, not “working out” loans.

If a recession is not to broad or deep then some kind of governmental stimulus can “buy the banks” out of their solvency problems by means of inflation. If the problems have existed for some period of time and are also connected with too much risk taking and excessive amounts of financial leverage, the problems may not be so easily overcome. And, in these latter cases, fiscal and monetary stimulus may not be able to accomplish much in helping financial institutions “get back to business.” Inflation doesn’t help a lot.

How, then, should we interpret the current “crisis”? Well, do you believe that our main problem is still “liquidity” or is our main problem “solvency”?

For those that read this blog regularly, they know that I believe that the “liquidity crisis” occurred a long time ago, in the fall of 2008. I believe that we have been dealing with a “solvency” crisis since then. And, I believe that we are still going through this “solvency” crisis.

If you look at my post of November 8, 2010 you can see that I believe that the “solvency” crisis still has a ways to run. (http://seekingalpha.com/article/235487-the-banking-system-seems-to-be-dividing-large-vs-small-commercial-banks) If you believe as I do that we are still in the midst of a solvency crisis then you also should believe that further additional fiscal or monetary stimulus will have little or no effect on the banking system or the economy. Financial institutions are still “working out” their bad assets and they will not really want to return to “business-as-usual” until they can devote their full attention to making loans.

It is a hard thing to do to run a financial institution. I have been involved in the running of three of them. In order to be successful you need to give your complete attention to running the business and not to “working out loans” which is very demanding and very time consuming. A “liquidity crisis” does not draw this kind of long-time attention.

Federal Resere Non-Exit Watch: Part 3

It is Halloween…is that QE2 I see lurking in the shadows? Oh, my…I’m scared!

Here we are in the third month since the Federal Reserve declared that their program to withdraw all the liquidity they had injected into the banking system was at an end. Of course, during the exit program excess reserves in the banking system rose substantially as total reserves and the monetary base continued to rise.

Funniest “exit” strategy I have ever seen. But, what else can we expect from the current leadership of the Federal Reserve System?

Now the Fed is engaged in a “non-exit” strategy with many analysts believing that the second round of quantitative easy will begin on Wednesday, the day after the mid-term elections. (No politics here!)

In preparation for any changes in monetary policy that might take place in the near future, we still need to get current with how the Fed has been behaving in the recent past.

Over the past thirteen-week period, the Excess Reserves held by commercial banks have declined by about $40 billion. This is consistent with the figures derived from the Federal Reserve data on the Federal Reserve’s H.4.1 release “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks.” In terms of the actual data for the end of the banking week, the comparable figure, reserves with Federal Reserve Banks also declined by about $40 billion over the past thirteen weeks.

Over the past four-week period, however, the reserve balances at Federal Reserve banks rose by more than $26 billion, a number we shall examine below. The excess reserves held by banks also rose over this time period.

The banking system still remains very liquid although this seems to be just what the commercial banks want.

In terms of the money stock statistics, monetary growth actually increased at a relatively steady pace over the last thirteen weeks. The most closely watched measure of the money stock, the M2 measure, was rising at a year-over-year pace of 1.8% in July 2010. This year-over-year rate of growth increased to 2.8% in September and stands at about 3.0% near the end of October.

The year-over-year growth rate of the M1 measure of the money stock has also increase steadily into the fall. In July 2010, M1 was increasing at a 4.7% rate. This rose to 5.9% in September and was around 6.3% at the end of October.

Money stock measures are showing steady rates of increase and this is good.

The steady increase in the money stock measures seems to have been little affected by the transactions going on within the Federal Reserve’s balance sheet, and this is good.

The questions that need to be asked is what happened on the Fed’s balance sheet and why?

The first series of questions relates to the $40 billion decline over the past thirteen weeks in the reserve balances held by commercial banks in Federal Reserve banks.

This decline primarily comes from three sources. The first source is a rise in Currency in Circulation of over $19 billion. A movement like this reduces reserve balances as coin and currency is withdrawn by the public from commercial bank accounts. In the last three months the year-over-year rate of growth of currency held by the public has increased from 3.8% to 4.0% to 4.4%. This figure is high relative to the five years before the financial collapse in the fall of 2008 and the fact that it is rising is something to pay attention to. Currency in circulation does not usually go up in the fall season relative to July and August because cash needs are usually high in vacation periods but not in the fall when coin and currency is returned to the banking system.

The demand for cash can rise as people having financial difficulties transfer their wealth into cash balances so that they can pay for the necessities of life. This is not good.

Note that of the $19 billion increase over the last thirteen weeks, almost $9 billion of the increase came just in October. Keep a watch on this number.

The second source of the decline in reserve balances came from accounts on the Fed’s balance sheet related to “bail out” items. Almost $17 billion left the Fed’s accounts related to a decline in these “special” accounts. The Fed plans to allow these accounts to run off as these assets are worked out. Hopefully these accounts will continue to decline at a relatively steady pace.

The third source of decline came in the Fed’s portfolio of securities: specifically, the Fed’s portfolio declined by a little more than $15 billion in the thirteen weeks ending October 28, 2010. Of interest is the fact that the holdings of Mortgage-backed securities declined by more than $66 billion and the holdings of Federal Agency securities declined by almost $10 billion, a total of about $76 billion. The Federal Reserve replaced $61 billion of these securities through the acquisition of U. S., Treasury securities.

Note that the Fed is doing pretty much what it said it would do in this regard. The Fed said that as the portfolio of Mortgage-backed securities and Federal Agency securities declined, it would seek to offset this decline by the purchase of Treasury issues. This is another area that bears close attention in the up-coming weeks.

Finally, we look for an explanation of the $26 billion increase in Reserve Balances at Federal Reserve banks over the past four weeks. The primary mover here is operational in nature. The General Account of the U. S. Treasury at the Federal Reserve declined by about $31 billion during this period. This puts reserves back into the banking system. A movement in this account is usually associated with writing of checks at the Treasury, reducing tax monies that have been collected in the past. The Federal Reserve knows that a movement like this is going to take place and is therefore prepared to deal, operationally, with this drain on its balance sheet.

Very little change took place related to factors supplying reserve funds to the banking system. However, the Federal Reserve continued to see its portfolio of Mortgage-backed securities run off during this period (the portfolio declined by almost $28 billion) and Federal Agency securities (a $4 billion decline) run off. This run off was countered by purchases of U. S. Treasury securities which increased this part of the Fed’s portfolio by $26 billion.

The net decline in the securities portfolio was offset by other small movements in accounts so that factors supplying funds to bank reserves was relatively insignificant.

My interpretation of the actions of the Federal Reserve over the past quarter: basically a holding action. Overall, the money stock measures are showing small but steady increases in growth and this is a positive note. The thing to watch here is how much of the increasing growth rate in the money stock figures is related to a rising use of currency in circulation.

Otherwise, the Fed has been true to its statements (so far) in purchasing U. S. Treasury securities to roughly offset the regular runoff from the Fed’s portfolio of Federal Agency issues and Mortgage-backed securities. Obviously, if Quantitative Easy 2 is executed, the acquisition of Treasury issues will more than offset the runoff of these other securities. Stay tuned!

Federal Reserve Non-Exit Watch: Part 2

During the Federal Reserve’s Exit Watch, the excess reserves in the banking system rose by $400 billion or so. Thus, as the Federal Reserve attempted to exit it put more reserves into the banking system.

Remember that in August 2008, the assets on the Federal Reserve balance sheet was no more than $900 billion…total!

Now we are told that the Federal Reserve, still concerned that the economy is not growing fast enough, has entered into a phase of not exiting the banking system, even expanding its stance of monetary ease by the tool affectionately referred to as “Quantitative Easing.”

Well, excess reserves in the banking system fell below the $1.0 trillion level in September for the first time since late October 2009. The decline in excess reserves in the banking system has reached almost $200 billion since the peak in this total was achieved.

Does anyone understand what the Federal Reserve is trying to do? Does the Federal Reserve understand what the Federal Reserve is trying to do?

I have argued many times in recent months that I have never seen such a lack of leadership at the Federal Reserve in my lifetime.

People claim that there is so much uncertainty in the economic and financial world right now that businesses and individuals don’t know what to do!

Well, you can look at the leadership of the Federal Reserve and get a prime example of why there is so much uncertainty around in the world.

The Fed looks positively leaderless!

In looking at the numbers from the Federal Reserve release H.4.1, “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks,” one could argue that over the past four weeks and over the past thirteen weeks the Fed has been facing some “operational” factors that have affected reserve balances and this has clouded the picture.

“Operational” factors are things like seasonal movements in currency outstanding due to cash needs during the summer months or during the Thanksgiving to New Year’s time period or in the management and payment of tax receipts on the part of the United States Treasury.

These factors usually appear of the side of the Fed’s balance sheet that “absorbs” bank reserves. For example, if the Treasury draws funds from commercial banks into its General Account in order to “write checks” this removes (absorbs) reserves from the banking system.

In the last four months, Total Factors Absorbing Reserves rose by almost $26 billion. This increase was centered in three areas. First, currency came out of circulation ($4 billion) as the summer came to an end. Second, the United States Treasury brought about $12 billion into its General Account at the Federal Reserve. And, the Federal Reserve engaged in more Reverse Repurchase Agreements with “Foreign Official and International Accounts” which rose by $9 billion.

The Federal Reserve did not offset these absorbing factors. In fact, Total Factors Supplying Reserves also fell, but only by a little more than $3 billion. This decline seems to have occurred as line items connected with the government’s financial bailout ran off.

So, “operational” factors seem to have accounted for the $29 billion decline in Reserve Balances with Federal Reserve Banks, (part of bank’s excess reserves) over the past four weeks. This is “not exiting”? At one time this amount of decline was about 3.5% of the Fed’s balance sheet!

At the same time the Federal Reserve replaced declines in its’ portfolio of Mortgage Backed Securities and Federal Agency securities by purchases of Treasury Securities. During the four week period ending September 30, 2010, the Mortgage Backed Securities portfolio declined by about $25 billion; the Federal Agency Securities portfolio dropped by about $2 billion.

The Fed upped its portfolio of Treasury Securities by a little more than $25 billion.

So the Fed appears to be replacing maturing mortgage-backed securities and federal agency securities with Treasury securities so that the overall portfolio does not decline by much. This is one thing the Fed said it “might” do.

One should note, however, that in the last 13-week period, the Fed’s portfolio of securities declined by almost $16 billion as the Fed did not replace all of the $40 billion in mortgage-backed securities that left the portfolio and the $11 billion decline in the portfolio of federal agency securities.

One should also note that during this last 13-week period $18 billion in accounts associated with the government’s financial bailout also ran off.

I don’t know what the Federal Reserve is doing. A lot of people don’t know what the Federal Reserve is doing.

All I can add to this is that the value of the United States dollar versus the Euro declined by about 8.3% since Chairman Bernanke spoke at the Fed conference at Jackson Hole, Wyoming in August and the Wall Street Journal index of the value of the United States dollar has fallen by over 6.6% since then.

A real vote of confidence.

The Banking System Continues to Shrink

According to the latest statistics of the Federal Reserve on the banking system, the banking system, as a whole, continues to shrink. Over the last 12 months, the total assets of all commercial banks in the United States banking system shrank by $560 billion or by about 5%. In the three months ending in January 2010, total bank assets dropped about $170 billion, with about $40 billion of the drop coming in January, itself.

Concern is still focused on the small- to medium-sized banks. Last week additional attention was focused specifically on 3,000 of these banks in terms of the problem loans they have on their books. (http://seekingalpha.com/article/188074-problem-loans-still-weighing-on-small-and-medium-sized-banks)

Elizabeth Warren, who heads the TARP oversight panel, is quoted as saying: “The banks that are on the front lines of small-business lending are about to get hit by a tidal wave of commercial-loan failures.”

There are a little more than 8,000 banks in the United States banking system and they had about $11.7 trillion in assets in January 2010. The largest 25 banks in terms of asset size held about $6.7 trillion in assets or about 57% of the assets in the banking system. “Small” domestically chartered banks held about $3.6 trillion in assets or around 31% of the assets in the United States banking system while the assets of foreign-related institutions amount to $1.4 trillion or 12% of the assets of the banking system.

So, there are a very large number of very small banking institutions that make up only about one-third of the bank assets in the country.

The total assets at these “small” banks dropped by $42 billion in January 2010, although by only about $14 billion in the last three months. The more interesting thing, however, is in the composition of this decline.

During this time period the loans and leases at these “small” banks fell by $20 billion in January and by $36 billion over the past three months. These banks are just not lending!

The primary decline came in real estate loans: they dropped $12 billion in January and $22 billion over the last quarter. We have, of course, heard of the problems these banks are facing with respect to commercial real estate loans and the numbers support this concern. At the “small” banks, commercial real estate loans fell by $10 billion in January and by $21 billion since October 2009.

Things were not very robust in other lending areas, but the declines reported in these other loans were not nearly so dramatic. I will call attention to the fact that consumer loans dropped by about $5 billion at these small institutions in January, a rather substantial decline.

Another indication of the difficulties “small” banks were facing is the decline in the securities portfolios at these institutions. Securities dropped by $31 billion in January, a time in which the “large” banks and the “foreign-related” banks both added securities to their asset portfolios.

And, where were the “small” banks building up their assets? In Cash Assets! Cash assets at “small” banks rose by $8 billion in January, and the increase totaled $21 billion over the last three months.

The smaller banks in the United States are putting more and more assets into cash as their balance sheets and loan balances shrink. This certainty supports the idea that many of these banks are in severe straits.

Large banks, on the other hand, actually reduced their holdings of cash assets in January by a whopping $71 billion. Over the past three months they reduced they cash assets by $118 billion.

These banks were not putting funds into loans, however. They were putting funds into their securities portfolio, adding $17 billion in January and increasing the portfolio by $60 billion over the last three months. The vast majority of these funds went into United States Treasury securities or federal agency securities. One can certainly sense a riskless arbitrage-type of strategy going on here.

Loans and leases at these large banks actually dropped in January by $46 billion, being spread fairly broadly over Commercial and Industrial loans (dropping $11 billion), Real Estate loans (dropping $18 billion) and Consumer loans (dropping $11 billion). It should be noted that in the consumer loan area there have been massive declines in credit card and revolving credit, $14 billion in January alone, but $27 billion over the last three months.

American commercial banks are not lending…period!

The largest banks seem to be living off of the riskless arbitrage situations that are available. They are doing little to nothing to help stimulate the economy along. But, why should they get into risky business and real estate loans when they can earn a pretty handy return without risking anything? Thank you, Mr. Bernanke!

The smaller banks seem to be drawing up the ramparts, becoming more and more conservative. This is where the loan problems are and the behavior of these organizations certainly lend credence to that belief. The fact that these banks are even getting out of their securities raises additional concern about the seriousness of their situation.

Note: The behavior of foreign-related institutions during this time period is also of concern. In the last three months, foreign-related institutions reduced their securities portfolio by $19 billion, their trading assets by $26 billion and their loans and leases by $33 billion, a total of $78 billion.

And where did they put the proceeds of this reduction in assets? They increased cash assets by $73 billion!

Foreign-related institutions in the banking week ending February 3, 2010, held $473 billion in cash assets, 38% of all the cash assets held by the banking system in the United States.

I don’t know right now, whether or not this fact should be a concern, but I would like to understand a little bit more about the situation of these banks. The “small” banks in the United States are moving in this direction because of the “poor” state of their loan portfolios. Is this move on the part of the foreign-related institutions of a similar nature? Or, are they going to move assets out of the United States?

The Beat Goes On Concerning the Dollar

More headlines this morning on the dollar strategy of the Obama administration. First, the main headline in the Wall Street Journal contains the blast: “U. S. Stands By as Dollar Falls.” (See http://online.wsj.com/article/SB125498941145272887.html#mod=todays_us_page_one.) Then the lead editorial follows up with “The Dollar Adrift.” (See http://online.wsj.com/article/SB10001424052748703746604574461473511618150.html.)

We also learn that the administration was worried enough about this type of thinking to send out Chairman Bernanke and presidential advisor Larry Summers to indicate how serious the Obama Administration is in maintaining a strong dollar.

Again the phrase “Watch the hips and not the lips” comes to mind. There is very little the administration can do right now to introduce fiscal responsibility into what they are proposing. The die has already been cast and no one sees a quick reversal of the administration’s mindset.

And, this is the problem. Time-after-time in the last half of the 20th century countries got themselves into predicaments like the one being faced by the United States. Uncontrolled government budgets with the promise of growing amounts of debt outstanding. Connected with this fiscal irresponsibility was the concern that central banks were really not independent of the national government. This is a situation not unlike that currently in place in the United States.

There were a number of books that came out in the late 1980s and early 1990s that basically asked the question: “Is national economic policy in the hands of unknown bankers and financial interests around the world?” The general scenario depicted was that of a national government that proposed large and growing budget deficits that seemed unsustainable without the support of a captive central bank that would monetize the debt as pressure on local interest rates grew. The reaction of these “unknown bankers and financial interests” was to sell the currency of that nation and force the national government to reverse direction and introduce fiscally responsible budgets.

The primary example of such a historical event was that which occurred during the presidency of François Mitterrand in France. The French Franc came under such pressure that Mitterrand backed off his budget proposals and became fiscally quite conservative and supported the independence of the French central bank.

The issue here is not so much the size of the deficits, although that can be important, or the ratio of the deficits to GDP, or the ratio of government debt to GDP. The question relates to whether or not the government is acting in a fiscally responsible way and will it continue to do so in the future. The side question to this is the independence of the central bank.

Absolute numbers are fine, but it is the direction those numbers are going that are the crucial concern.

The facts to me are as follows: since the 1960s, the United States government has erred on the side of fiscal ease in terms of the budgeting process. This has not been a Republican or a Democratic fault. The leadership in both parties has contributed to the stance of fiscal leniency that has existed within the federal government over this time period.

During this time the value of the dollar has trended downward, with one or two side-trips.

During the Bush (43) administration fiscal irresponsibility got way out-of-hand. The fiscal irresponsibility was supported by monetary irresponsibility. Thus, we get to the current situation.

Nothing has changed!

Financial markets are seeing the same behavior in the current administration that they observed in the previous administration. O’Neill, Snow, Paulson, and Geithner are all of one package. Greenspan and Bernanke are linked at the hip. And, the words coming out of the mouths of our leaders seem to be “pre-recorded.”

I have been trying to call attention to this issue for four or five years now. Very little attention has been paid to the issue even though at one time in the Bush (43) administration the value of the dollar had declined by about 40%.

The problem is that there are no good solutions to the situation when you let it go for that long. The obvious picture is that of a binge drinker that has been an alcoholic for a lengthy period of time. More and more people are going to get hurt and this will just add to the many that are feeling pain at the present time. But, that is what happens when people lose their discipline and become addicted.

The event we see over and over again in economics is that ultimately the system has to correct, either on its own or with the help of those that are a part of the system. And, the correction takes place sooner, or, later, but it eventually takes place. Unfortunately along the way, as with alcoholics, some of the best attempts of “friends” to cure the patient only end up exacerbating the situation.

The Future of the Dollar

We live in a global economy. And, unless we destroy the global economy that now exists the way the world destroyed the first global economy starting with the 1914 conflict and proceeding through the next fifty-five years or so, we will continue to face the duties and responsibilities of operating within a world economy. And, those duties and responsibilities begin with the currency of the country.

It is hard to have confidence that the United States accepts this fact.

I know that we are in a recession (depression?). I know that the immediate pressure on the Obama Administration is to “get the economy going again.” I know that the Treasury Department and the Federal Reserve, both dependent partners in the effort to get the financial system functioning, must provide whatever means it takes to avoid further deterioration of financial markets.

Still, there is a need to listen to what markets are saying about what the government is doing. And, the financial markets are saying that the United States dollar is in trouble. And, consequently, the United State government is in trouble.

The value of the Euro relative to the United States dollar climbed to 1.3768 at the close of business yesterday. This represents an 11.7% decline in the value of the dollar since Ben Bernanke became Chairman of the Board of Governors of the Federal Reserve System on January 31, 2006. It represents a 23.0% decline in the value of the dollar since Bush 43 became President on January 20, 2001 when Alan Greenspan was the Chairman of the Board of Governors of the Federal Reserve System.

The numbers are about the same if you look at a trade weighted series. The trade weighted value of the dollar versus major currencies has declined by 23.6% since Bush 43 was inaugurated, and, has declined 5.4% since Ben Bernanke became Chairman.

Of course, the figures look even worse if one focuses upon the lows in the value of the dollar which came about in March, 2008. Using this as the standard we find that the trade weighted value of the dollar declined 33.4% from the beginning of Bush 43 and 17.5% since Bernanke was sworn in. The current numbers look great compared with these, but the current figures benefit from the ‘flight to quality’ that took place following the September 2008 meltdown of the United States financial system.

All during the Bush 43 Administration, both the United States Treasury Secretary, whoever that was, and the Fed Chairmen gave lip service to the importance of the value of the United States dollar, yet no one did anything about it. And, the dollar continued to decline. Certainly someone should have understood that the decline in the value of the currency indicated something was wrong with the way the finances of the United States government were being run.

It is very apparent that the Federal Reserve System is NOT independent of the federal government of the United States. One has to go back to Paul Volcker and then back to William McChesney Martin to find Fed Chairmen that acted independently of the Executive Branch of the government. President Carter knew that Volcker would be independent of his administration if Volcker became the Fed Chairman but believed that he had to appoint him anyway. Certainly Arthur Burns and Bill Miller (remember him?), were not independent of the Presidents they served. And, people are realizing more and more that Alan Greenspan was nothing short of a water-carrier for the Presidents he served.

Not being independent of the Executive Branch means that the Federal Reserve is very subject to the position of the federal budget. Even Paul Volcker was eventually tainted with the huge (at the time) budget deficits run up by the Reagan Administration. Still, during his tenure as Fed Chairman, Volcker saw the trade weighted value of the dollar against major currencies rise by 6.4%.

Overall, during the time that Greenspan was Chairman of the Fed, the trade weighted value of the dollar against major currencies declined by only 16.7%. Greenspan’s grade improved in the 1990s due to the movement of the federal budget from a substantial deficit when the Clinton Administration took over in 1993 to a surplus by the time Bush 43 assumed office. In fact, this measure of the value of the dollar rose 13.9% during the Clinton administration.

The important thing to remember is that in the last half of the twentieth century world financial markets came to realize that substantial government budget deficits often got financed, one way or another, by the central bank of that country. As a consequence of this realization, participants in these world markets moved against the currencies of countries that began running large deficits if they believed that the central bank’s of that country were not fully independent of the government. The result was that governments became much more conservative in controlling budget deficits and central banks became much more independent of their governments.

The United States, in the latter half of the twentieth century, except for the early years that Paul Volcker was the Fed Chairman and during the 1993-2001 period, seemed to feel that they were exempt from this constraint. Yet, international financial markets responded to United States deficits and the possibility that they could be monetized in the same way that they responded to the “loose living” of other governments. They sold the dollar and the value of the dollar, for the most part, declined.

As participants in world financial markets perceive that things are beginning to settle down and that financial institutions are not going to completely self-destruct, they will continue to move out of United States Treasury securities and will continue to move out of the United States dollar. The foundational belief behind this movement is that the United States government is just putting too much debt out into the world. First, there were the huge budget deficits created by Bush 43 and now there are the huge budget deficits being created by the Obama administration. To people in the world financial markets, the lessons of the last fifty years still apply.

The path the economy and the financial markets follow relating to how the deficit problem works out is anyone’s guess right now. Who would have ever written the script for how the 2000s have evolved up until now? The historical evidence points to the fact that huge amounts of debt issued by governments cause dislocations. These dislocations have to work themselves out. How these dislocations work themselves out is different in every case. The general consequence of large budget deficits, however, is that large amounts of government debt are not good for the value of a country’s currency. I believe that this is as true for the United States as it is for any other country. The value of the dollar will continue to decline over the next several years.

My grades for the past three Fed Chairmen? Paul Volcker gets the best grade. I am assigning him a grade of plus 6.4. Ben Bernanke is second highest with a grade of negative 5.4 and Alan Greenspan comes in last with a grade of a minus 16.7. Unfortunately, when the grade is negative, we all have to pay for it!

Bail Out or Wimp Out?

The Obama administration is going to have to make a decision soon…is it going to try and commit to a program that will actually do something for banking and other financial institutions or is it going to extend the waffling on this issue that began last fall?

People in the administration say that something has to be done…and it has to be done fast…but, there is this problem about buying assets from these troubled institutions…we don’t know what price we should pay for them.

All I can advise them in terms of setting prices is…do the very best you can…at this moment in time! Yes, there is great uncertainty as to the prices of many or most of these assets…but, that is not the issue at this stage of the game.

Beginning in December 2007, things changed in Washington, D. C. The Federal Reserve System did something that had never been done before. It innovated! It created the Term Auction Facility; it introduced a dollar swap facility with other central banks around the world; as well as the Primary Dealer credit facility. Since that time the Fed has developed several other new ways to put dollars into the banking system.

In March 2008, the Fed and the Treasury engineered the Bear Stearns takeover and in September 2008 the world changed even more as Lehman Brothers was allowed to fail and AIG was essentially nationalized. The American model of financial markets and institutions would never be the same again.

And, things continued on from there with the $700 billion bailout bill passed by Congress and the efforts of Treasury Secretary Paulson and Fed Chairman Bernanke to sooth markets and get credit flowing once again.

The Obama administration has taken over from Bush43 and argued that with the crisis at hand…something must be done to avoid a “catastrophe”…in the words of President Obama himself.

My point is…it is not time to waffle on trying to save the banking and financial system from the bad assets they have on the books.

The government IS involved…up to its neck and beyond! The Obama stimulus package is an attempt to stimulate the economy. But, in my estimation, it will not do a lot. If the current size of the package is, being generous, around $850 billion and the multiplier of this spending is between 0.4 and 0.6 (see my post of January 26, 2009, http://seekingalpha.com/article/116414-what-will-be-the-impact-of-obama-s-stimulus-plan) then the effect on the economy will be between $340 billion and $510 billion of additional output. Not a great “bang-for-the-buck”, but, we are told, it is the effort that is so important at this particular moment.

There will be more to come…promises the Obama administration. Additional programs need to follow this package. More dollars need to be thrown at the problem.

Still, there is the problem of bad assets. What is going to be done with all the toxic waste that is now held by our financial institutions?

Well, since there is way too much debt in the financial system, there could be a massive write down of assets…the banks and other financial institutions absorbing the hair cut. (See my post of February 4, 2009, http://seekingalpha.com/article/118475-two-painful-proposals-to-reduce-our-excess-debt.) At this stage of the effort there does not seem to be a lot of interest in this approach so we probably should put this idea on the back burner for another time.

Thus, if something has to be done…along with the $850 billion stimulus plan…let the Federal Government buy these toxic assets from the banks and other financial institutions. Many estimates place the difference between what these institutions value the assets on their books and the price that the Federal Government would buy them at is a minimum of $2.0 trillion. If the banks and other financial institutions took this kind of a hit to their balance sheets…many of the organizations would be bankrupt…kaput…out-of-business.

My question to this is…aren’t they bankrupt…kaput…out-of-business…already?

The issue is that many of these institutions are large…would require a lot of management talent to run them…and what about the shareholders? Well, the shareholders have no rights…because there is no equity left in these institutions. Let us recognize this and get on with it. Many of these institutions are large…which means there is a major need for management talent. But…why should the managements that got these institutions into the positions they now are in be expected to get them straightened out and healthy again?

This reminds me of many of the “dog-and-pony shows” that I observed during the S & L crisis twenty-some years ago. In these “shows” the existing management would get up in front of potential investors and say…”Yes, we have run this bank for the past 20-some years…and, yes, we basically bankrupted the band…but…WE HAVE LEARNED our lessons! Give us $100.0 million so that we can turn this bank around and make it into something you will be proud of!”

In most cases, the potential investors dug into their pockets and forked over the $100.0 million. Few, if any, of the “born again” managements were successful in turning their institutions around. Oh, well…live and learn!

Unfortunately, the same thing seems to be in play here. The managements that got us here claim that they can be the managements that get us back to health again. What did P. T. Barnum say?

A number of these banks and other financial institutions appear to be insolvent…their managements are hanging on by their finger nails…the credit system is not functioning as it might…and the government is dawdling.

Buy the assets. Remove the shareholders…they had their turn to oversee these institutions. Take over these banks…and see that the banks get new top managements. If you are going to do it…then, do it! Cut out the half-fast programs. Postponing government action only creates more uncertainty, and, as we know too well, the market hates uncertainty.

The Obama campaign called for change in Washington, D. C. It said an Obama administration would change things…action would be taken. Well, action needs to be taken. Obama was right the other evening when he said that his administration will be remembered for stopping the economic downturn and getting things moving upwards again…or not. Not much else is going to matter. And, whether or not you agree with the policies and programs that are being presented…and to a large extent I don’t…I do agree with the general feeling that if you are going to fail…or succeed…you will have to do it in a very committed way. Half-measures are bound to fail…if for no other reason than they won’t raise the confidence of the nation.

So, Mr. Obama, come out with a strong plan for taking care of these toxic assets and come out with a strong plan for removing the chaff from the banking system. Half-way measures are not going to resolve the issue because there will still need to be further adjustments sometime down the road. Be strong! All you can do is what you think is best for the country!

Discipline or the Lack Thereof

When a person or an organization is disciplined, they usually have plenty of options…many of them good ones.

When a person or an organization is undisciplined, options are usually limited…and none of them are good!

We are seeing or have seen quite a few examples of the second of these statements in recent days and in recent months. Where does one begin?

· The auto industry…
· The financial industry…
· The housing industry…
· And the list goes on…

Oh, how about the American government?

Doesn’t seem like our government has many options these days…and none of them seem to be good ones.

I have made clear over the past eleven months that I believe that culture starts at the top…and in this case, it starts with the leadership of the United States government. Right from the beginning the current administration exhibited an exceptional lack of discipline…except for the requirement of loyalty to its own people and programs. Large tax cuts followed by an expensive war underwritten by the monetary authority could in no way be considered to be a “conservative” economic program. And, this was just the start!

But, the culture spreads…and once others began to see that “lack of discipline” was the standard of the day, they too began to feast on the beast. And, the lack of discipline spread throughout the land.

My biggest disappointment is that financial discipline broke down in a major way. My background is in finance and I was brought up with the idea that finance people were the ultimate arbiters of discipline, both in terms of individual behavior as well as organizational behavior. The first CEO I worked for told me that I had to speak up strongly from the discipline of finance for if I didn’t…there was no one else in the organization that would take that position!

Well, we have seen that when the financial standards break down…there is no one left to maintain discipline.

That is the past. We now have to deal with the future. The options are not good for anyone!

Let me reiterate the statement I made above…

I believe that culture starts at the top!

Right now there is no leadership at the top and we will not have any until January 20, 2009. This is nothing new…we have not had any leadership at the top for quite some time now…and that is one reason for our current dilemma. Those at the top, early on, wanted to sneak out of the door before things broke loose in the financial or product markets…but they didn’t make it. Even though their hearts were not in it and they had no idea what to do, they were forced to act in some way in an attempt to alleviate the financial mess. But, now, more than ever, they are looking for the door.

So here we are…and we still have to do something…invest our money…run our businesses…live our lives…

There are several things, I believe, that have to take place…

First, we have to re-establish discipline…individually…in our families…in our businesses…in our government.

Second, we have got to retrench. Here we have conflicting objectives. On the one side, we have to get back to basics, strengthen our balance sheets, and focus on what we do best. In this we have to do the best that we can…and we should not assume that someone is going to bail us out. If we do…we are bound for disappointment.

The other side of this is that retrenchment weakens the economy because the basic plan is to “pull back”, cut spending, reduce debt, and, if we can, save. This is the other side of the lack of discipline. It is fun on the upside when discipline is eased…it is tough on the down side when discipline is being re-established. This leads to the third point.

Third, we must also be community focused, locally, regionally, nationally, and internationally. While we are establishing discipline once again, we must not isolate ourselves and refuse to talk with one another. We must engage one another, talk and dialogue about what is needed, and work together to introduce solutions that build up communities in this time of trial. This will include government programs to stimulate the economy. This will include new regulations to improve the process of finance and economics. This will include new efforts at international cooperation to help us to work together and support one another. This must include the acceptance of change because the world that is coming is going to be different from the world that we have left behind.

But, this effort is going to require leadership and it is going to require leadership at the very top. Hopefully, we are going to get that leadership.

Hopefully.

People are looking for the bottom…the bottom of the stock market plunge…the bottom of the housing collapse…the bottom of the financial crisis…and so on.

My view is unchanged. Until the United States gets some leadership in place with a strong vision of what it is going to do and moves forward in a very disciplined way…the search for a bottom in these areas is premature.

A Liquidity Trap?

Is this what a liquidity trap looks like?

A liquidity trap gives one the feeling that the monetary authorities are pushing on a string. The amount of liquidity the Federal Reserve and other central banks around the world have provided for the financial markets has been huge. The Paulson Plan was supposed to create confidence that illiquid assets would now have some liquidity. The Fed Plan to purchase commercial paper was supposed to create confidence that illiquid assets would now have some liquidity.

Yet, the financial markets remain silent.

Seemingly, no one wants to commit because no one is sure about the solvency of other participants in the financial markets.

Bernanke spooked the financial markets again yesterday as he talked about a possible cut in interest targets…which he did follow through on. The speech was to the National Association for Business Economists at their 50th anniversary get-together in Washington, D. C.

The message the market heard, however, was how dire things were.

And, the market asked…what does Bernanke know that we don’t?

The absence of leadership seems to reach new heights daily. (See Mase: Economics and Finance for October 7, 2008.)

But, now we are apparently in a liquidity trap. Consumers are pulling back their spending…the latest figures out on consumer credit even show a decline. Businesses are consolidating and cutting spending and hiring plans. State and Local governments are going to the Federal Government to get cash to help them meet payrolls. And, then the Federal Government…

Get out your old copy of Keynes’ General Theory.

When Bandaids Don't Seem to Work! The Current Crises.

Currently, nothing seems to work. Chairman Bernanke and the Federal Reserve are working overtime to calm things down. Still, things seem to be getting worse and worse.

Maybe the reason nothing seems to be working is that these actions are not really attacking the main problem. Maybe these actions are just ‘quick-fixes’ that try to keep things together but do not really solve the underlying difficulty. It is like the ship has been build with a deficient plan and, as a consequence, has sprung holes. The holes certainly need to be plugged in order to keep the boat afloat, but the longer term question relates to how sea worthy is the ship itself. It the ship has been constructed using a plan that cannot weather the current seas, then somehow the ship is going to have to be rebuilt according to different specifications so that it can continue to function. The problem is that we do not have the luxury to bring the ship into dry dock for the rebuilding to take place, the rebuilding must occur on the high seas.

The American financial system has achieved the position it has through the support and encouragement of the United States government. Not only has the government contributed an infrastructure to support the financial system along with rules and oversight, it has also contributed relatively sound monetary and fiscal policies that have helped the system grow and get through some difficult spots. The government and its agencies have not always performed perfectly, but they have performed well enough so that system became the envy of the world.
After the Second World War, the American financial system continued to surpass itself, in volume, in stability, and in terms of innovation. But, the system was constructed upon the foundation of the United States government being able to do pretty much what it wanted to with respect to its fiscal and monetary policy. For the most part, the government behaved pretty well. It ran into a little trouble in the late 1960s and 1970s as it attempted to provide a wider expanse of social programs to the country while, at the same time, it took on the responsibility of financing a war in Southeast Asia. The result was one of the worst bouts of inflation in United States history. Still, the government could act very much as it pleased because the American economy was robust enough and the U. S. dollar was strong enough so that world markets and market participants maintained supreme confidence that the dollar and dollar denominated securities, like the government securities used to finance the Federal deficits, could be held without fear.

Other major countries in the world did not find this to be the case. The world financial system had been constructed to allow, as much as possible, sovereign nations to conduct their monetary and fiscal policies independent of the rest of the world. Building such a system was one of the major goals of many of the participants who were a part of the peace negotiations following the First World War. This carried into the 1920s, the economist John Maynard Keynes being one of the major intellectual forces behind the effort.

Why did Keynes and others want to build such a system? There was great concern at that time over the social unrest amongst the ‘working classes.’ The Russian Revolution was a real example of what could happen in a country if this discontent got out-of-hand and became inflamed by radical leaders. Nations that did not want this to happen could only combat the situation by creating economic policies aimed at attaining the highest amount of employment possible. But, all agreed that conducting such policies could tend to be inflationary and when inflation occurred, bankers sold the currency in foreign exchange markets and the value of the country’s currency declined.

The question Keynes and others posed was how could countries conduct policies to maintain high levels of employment if their currencies would come under attack because of such policies? They believed that such a system would require fixed foreign exchange rates so that some, at least, short run stability could be achieved in their foreign exchange rate while the government could focus on the construction of a fiscal and monetary policy built to achieve high levels of employment.

This system became an institutional reality with the Bretton Woods Conference held in the United States in July 1944. It was said that Keynes ‘dominated’ this conference. In the same spirit, the United States Congress, in 1946, passed an “Employment Act” that emphasized the government’s responsibility to seek and maintain ‘maximum employment’ within the country. Other major governments supported such efforts to maintain high levels of employment in their own countries. This allowed governments to conduct economic policies in a relatively independent manner, changing foreign exchange rates from time to time as market conditions warranted. The U. S. dollar, the strongest currency in the world, was also tied to the price of gold, at $35.00 per ounce, giving it further importance in world financial markets.

The breakdown in this system started to occur in the late 1960s and 1970s. In the early 1970s, the dollar’s tie to gold was severed and the value of the U. S. dollar was allowed to float freely in the world’s foreign exchange markets. Other currencies were also freed from time-to-time as economic and political conditions warranted. Still sovereign governments continued to act independently of the rest of the world as envisioned by the Bretton Woods agreements even through currencies were allowed to trade freely.

Then the system began to break down. Major government after major government found that devising their economic policies independent of the rest of the world would not be tolerated by ‘international bankers.’ Governmental policies that were inflationary in nature were met with these ‘bankers’ selling their currency so that it became impossible for the governments to act without a consideration of what would happen to the value of their currency once the path of their fiscal and monetary policies were determined. And, the reaction of these ‘bankers’ became swifter and swifter the longer a government delayed changing its approach. As a consequence, budget deficits were reduced or eliminated and central banks were made independent of their national governments. “Inflation targets’ were introduced as guides to policy.

The United States government was able to maintain its independence relatively well through the 1980s and the deficits created by the Reagan administration. Perhaps one very strong reason for this was that Paul Volcker led Federal Reserve System at this time. As the story goes, Volcker was not the choice of President Jimmy Carter to become Chairman of the Board of Governors of the Federal Reserve System…he was too independent. But, the Fed, under Volcker’s leadership put the United States through the necessary pain in order to constrain prices increases and bring inflation under control. Alan Greenspan seemed to be a worthy successor to Volcker as the 1990s began. The Clinton Administration then proceeded to bring the Federal budget under control leaving the budget in surplus as it left office, a fiscal stance that provided the best of all possible worlds for the conduct of monetary policy.

In these twenty years, however, the world changed. First of all, globalization really took hold along with the development of world financial markets. Second, inadequate energy policies meant that the nations that produced oil could accumulate massive amounts of wealth to become an offset to American economic dominance in the world. Third, China and India became more important as world powers with sufficient economic clout. Fourth, the United States government put itself in a hole by creating substantial budget deficits, primarily caused by a massive tax cut and the need to finance a ‘bottomless’ series of wars. This situation was exacerbated by a monetary policy that kept interest rates excessively low for around three years. The result…the last nation that conducted its economic policy independently of the rest of the world came under attack.

The recent actions of the Federal Reserve System and the Federal government have only confirmed what the world financial markets have been betting on for the past six or seven years. The United States is now monetizing the debt that it had created through its ill-advised tax cuts and its very expensive wars. The old ship is no longer sea worthy and plugging holes that have sprung leaks will not provide the blue print for the future. Yes, the holes need to be plugged in order that the world financial system can limp along. But, there must be a new plan for the ship that takes into account the new water it is sailing in.

The Fed: A new operating tool--the TAF--and a Liquidity Crisis

The February 11 post reviewed the operations of the Federal Reserve in 2007. The analysis stopped short of the full year because of the innovations that the Fed introduced in December. This post picks up the story. On December 12, 2007, the Federal Reserve announced, along with the Bank of Canada, the Bank of England, the European Central Bank (ECB), and the Swiss National Bank (SNB) “measures designed to address elevated pressures in short-term funding markets.” The actions taken by the Federal Reserve included the establishment of a temporary Term Auction Facility (TAF) and the establishment of foreign exchange swap lines with the European Central Bank and the Swiss National Bank. Under the TAF program, the Federal Reserve auctions term funds to depository institutions against a broader range of collateral than under normal open market operations. The effort is to “help promote the efficient dissemination of liquidity when the unsecured interbank markets are under stress.” In effect, the Federal Reserve used the TAF to supply reserves to the banking system for terms of roughly one month while reserving the use of its standard tools— repurchase agreements and reverse repurchase agreements—for shorter term reserve adjustments. The temporary reciprocal currency arrangements with the ECB and the SNB will provide dollars for these organizations to use for supplying liquidity within their jurisdictions. The swap lines were approved by the Federal Open Market Committee of the Federal Reserve System for up to six months.

One can observe the use of these facilities on the Federal Reserve release H.4.1, Factors Affecting Reserve Balances of Depository Institutions. The Federal Reserve release can be obtained from the website of the Federal Reserve under “Economic Research and Data” and then “Statistical Releases and Historical Data.” There is a new line item on this release called TERM AUCTION CREDIT: an increase in Term Auction Credit supplies reserves to the banking system. The information on the swap lines is a little more difficult to come by…it is aggregated in the line item labeled OTHER FEDERAL RESERVE ASSETS. The only thing one can say about this line item is that it usually does not change very much. The swap transactions with the ECB and the SNB are usually relatively large and hence can be estimated by the magnitude of the changes in Other Federal Reserve Assets. An increase in Other Federal Reserve Assets supplies reserves to the banking system.

Now, let’s review Federal Reserve actions for the period that includes December 2007 through the most recent statistical releases. I will divide this period up into the time before the banking week ending January 23, 2008, the banking week ending January 23, and the time period after this. The crucial date in all of this is January 21, 2008 which is the day that information became available about the $7.2 billion write-off to be taken by a French bank due to the actions of one of its traders. This knowledge and the fact that the bank was trying to sell off the positions established by this trader led to a ‘liquidity crises’ in world security markets. The next morning the Federal Reserve announced that it was lowering its target Federal Funds rate by 75 basis points, an extraordinary amount. But, let’s go back to early December.

Up through the banking week ending January 16, 2008, two factors dominate the statistics. First, there is the normal Christmas season/end-of-year swing in various items that are a part of the Fed’s basic operations. Currency in circulation always increases in the holiday season and then declines right after the first of the year. This season was no exception and was handled in the usual way. Second, however, there was the introduction of the TAF. The first auction settled on December 20 and was for $20.0 billion; the second auction settled on December 27 and it, also, was for $20.0 billion. These can be seen clearly on the H.4.1 for the banking weeks ending December 26 and January 2. One can also notice from these releases that OTHER FEDERAL RESERVE ASSETS increase by $14.3 billion and $11.2 billion, respectively. We assume that these increases reflect the use of the swap lines set up with the ECB and the SNB. The Federal Reserve offset these increases by allowing parts of its Treasury bill portfolio to mature without being replaced ($29.0 billion) along with a decline in repurchase agreements ($16.0 billion). Roughly, the Federal Reserve added $65.5 billion in reserves to the banking system through the new measures announced on December 12, 2007, and allowed $45.0 billion in securities to run off which reduce reserves in the banking system. The difference between the two offset other factors influencing bank reserves with nothing else out-of-the-ordinary occurring. Thus, the initial implementation of the new facilities seemed to go ahead without any disruption to the financial markets.

World financial markets dropped precipitously on Monday, January 21, a day which fell into the banking week ending January 23. On that Monday afternoon members of the FOMC got together by phone and voted to reduce the Fed’s target Federal Funds rate by 75 basis points. The Fed had already injected the third round of TAF funds into the banking system on January 17 in the amount of $30.0 billion, $20.0 to replace those funds maturing from the first auction plus an additional $10.0 billion. The financial markets stabilized: the only market comment being on the size of the reduction of the target rate. In terms of the statistical data, even with all the turmoil in the world markets, there was very little movement in the Fed’s major operating areas.

Three important things events took place in the next three banking weeks. First, at the January 29 meeting of the FOMC, the committee lowered the target Federal Funds rate another 50 basis points, bringing the total reduction to 125 basis points in ten days. This was huge, historically! Second, the Fed held another auction on January 28 for $30.0 billion, $20.0 to replace the funds maturing from the second auction and another $10.0 million in new auction funds. Third, in the banking week ending January 30, the Fed put about $8.0 billion of reserves into the banking system by means of repurchase agreements. These were allowed to expire in the banking week ending February 6 along with another $3.3 billion of repurchase agreements that expired in the banking week ending February 13. One can assume that these repurchase agreements had provided liquidity to help settle the market turmoil mentioned above and as the disruption receded the Fed just allowed these positions to unwind.

The market sell-off on January 21 represented a true liquidity crisis. Here a banking organization HAD to sell securities. The bank was identified and the market realized that A LOT of securities had to be sold. As has been described in earlier posts, this meets the definition of a liquidity crisis where the question becomes, “Where should market prices be?” Until the market is able to answer this question sellers in the market tend to outnumber buyers and prices continue to fall. The classic response of the central bank is to provide liquidity to the marketplace. And that is what the Federal Reserve did.

Operationally, the Federal Reserve seems to have acted quite well during this whole period. It handled the normal seasonal swings without any trouble. It also proceeded with the transition to the TAF and the swap agreement without difficulty. Basically, the Fed put $60.0 billion in Term Auction Funds into the banking system while allowing $65.0 in it holdings of US Treasury securities to mature without replacement. Finally, here we are four weeks after the ‘liquidity scare’ and markets are functioning without problems. Yes, there are still solvency problems that must be resolved, but that is another story, a longer-term story. One can argue that the Fed’s actions in January and beyond helped to short-circuit the liquidity crisis which is exactly what a central bank is supposed to do.

People in the financial markets, as well as analysts, still have some questions about the leadership of the Fed. Many market participants feel that last fall there was a disconnect between what the Fed said and what the Fed eventually did. Also, the substantial drop in the target interest rate raised a flag about the stability of Fed decision making. Concerns like these contribute to a lack of complete confidence in the abilities of those currently guiding the Fed. Public officials, until their credibility is proven, always face confidence issues early on in their tenure.

Bernanke's Fate

The Chairman of the Federal Reserve System is one of the most prominent targets of pundits on the planet…even though the public may not show much name recognition. Once again question marks are being raised about the tenure of Ben Bernanke, both for now and in the future. Particularly in times when financial markets are unsettled and there is substantial uncertainty about the future course of the economy, the Fed Chairman becomes the focal point of almost all points of view. This just goes with the job. See for example, “Bernanke’s Fate May Hang on Economy” in the Wall Street Journal (http://online.wsj.com/article/SB120294740288166689.html?mod=hpp_us_whats_news).

It is true, as stated by Douglas Holtz-Eakin, economic advisor to John McCain, that the actions of the Fed Chairman can only really be judged in hindsight. Thus, although Alan Greenspan was highly praised for much of his term as the Fed Chairman, he has come under increasing criticism as his leadership has been reviewed since leaving the position. (See for example, Greenspan’s Bubbles, by William Fleckenstein.) Still, close scrutiny of the current Chairman will continue to remain intense.

In terms of real-time operating performance, however, the most important thing a Fed Chairman must possess is trust. And, trust must be earned. Every Fed Chairman comes to the position with the good will of all…even Bill Miller (who?) was wished well when Jimmy Carter appointed him. Being in such a powerful position and being so exposed to the analysts usually means that the trials begin relatively soon for a new Chairman.

One could argue that, up to this point, Bernanke has not earned that trust. It has not helped that he and the Fed made statements that seemingly reversed themselves in the fall within relatively short periods of time, even though the reversals may seem to have been rather small. Also, it seems as if financial market participants were a little unnerved by the January performance of the Fed in which the target for the Federal Funds rate was dropped by 75 basis points, twice in eight days. The bottom line is that people are not seeing consistency in performance and, hence, trust remains elusive, and criticism grows.

Market participants want to trust Bernanke…he needs to give them reason to do so.

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.