Debate seems to be picking up about the Federal Reserve exiting its current policy stance. Last week Thomas Hoenig, President of the Federal Reserve Bank of Kansas City, and Charles Plosser, President of the Federal Reserve Bank of Philadelphia, spoke last week of the forthcoming need to wind down the Fed’s position. Hoenig said that the Fed should end its purchase program of mortgage-backed securities and Plosser talked about the recovery being sustainable even as existing fiscal and monetary stimulus programs recede.
Still, economists are pessimistic about when the Fed will begin to raise its target for the Federal Funds rate. The effective Federal Funds rate in recent months has averaged about 12 basis points. Bloomberg News conducted a survey of economists’ expectations and the median forecast was for the target rate to remain unchanged through September 2010 and then rise by a half of a point in December 2010.
Since the Federal Reserve finally realized in 2008 that there was a financial crisis and began to combat the unfolding chaos, the basic policy of the Fed has been to throw whatever it can at the wall so that a sufficient amount of what is thrown will stick so that a financial collapse can be avoided.
Can people who devised such a policy really be expected to move its target rate up until it is far past the time that a rise is needed? And, the Fed will then face a situation in which rising interest rates will put many holders of Treasury securities and mortgage-backed bonds underwater and the question will then be, “Can the Fed afford to raise interest rates too swiftly because of all the losses it will create?”
Right now, the Fed is subsidizing the profits of the large banks (and not the small- and medium-sized banks) by its interest rate policy (of course, the Obama administration has threatened to tax away a good deal of the profits). It is just amazing the contradictions in monetary and fiscal policy that are coming out of Washington, D. C. these days. Confusion reigns!
It is no wonder that businesses and banks don’t want to do much of anything these days. They don’t know what the economic policy and regulatory environment will be in three years, let alone three months.
Anyway, the Federal Reserve continues to add reserve balances to the banking system. In the past 13-week period ending Wednesday, January 13, 2010, the Fed has added about $84 billion in reserves to the banking system.
Remember in August 2008 when the total reserves of the whole banking system were only about $44 billion!
Of this $84 billion, $62 billion was put into the banking system in the latest 4-week period.
The major contributor to this increase was security purchases by the Federal Reserve in the open market. In the latest 4-week period, the Fed added almost $71 billion to its securities portfolio bringing the total new purchases for the last 13 weeks up to $233 billion.
A large portion of this increase went to offset the decline in several of the special facilities set up to handle the financial crisis. For example, the amount of funds supplied the banking system through the Term Auction Credit facility fell by about $80 billion over the 13-week period, by $10 billion over the last 4 weeks.
The swap facility with foreign central banks also continued to decline dramatically, falling by almost $38 billion in the latest 13-week period and by about $9 billion in the last four weeks.
In total, it appears as if the funds supplied the banking system through special financial crisis facilities fell by $42 billion over the past 13 weeks and by only $2 billion over the last two.
Thus, the Federal Reserve continues to let these special facilities wind down, replacing them in the banking system through open market purchases.
In terms of preparing for the Fed’s exit, there has recently been trading in reverse repurchase agreements with dealers, but there was no “practice” activity in the past four weeks presumably because of the seasonal Thanksgiving/Christmas churning in the banking system.
As of Wednesday, January 13, 2010, the Federal Reserve held $969 billion in mortgage-backed securities in its portfolio. The central bank has authorized purchases of up to $1.25 trillion going into March of this year. As mentioned earlier, there seems to be substantial debate within the Fed as to whether or not this program should reach the maximum total. We shall see.
The Fed now holds $777 billion in Treasury securities and $161 in the securities of Federal Agencies.
So, the Fed Exit watch continues. So far, the Federal Reserve has honored the path that it started out on: purchasing securities to add to its portfolio thereby replacing the funds draining away from the special facilities created to combat the financial crisis.
Obviously, the real test has not begun. Within the next month or two, if the recovery continues, the Fed is going to come under more and more pressure to start raising its target rate of interest. Until then, big banks will continue to arbitrage the Treasury market and the carry trade will continue to prosper. This behavior is based on the assumption that the Fed is not going to let short term rates rise for a while.
When this assumption is broken, expectations will have to be reset and there will be a re-adjustment in the financial markets as investors exit their arbitrage positions.
What the Fed does then remains to be seen.
However, by maintaining its current policy stance, if the economy doesn’t recover or goes into a double dip recession, the Federal Reserve cannot be accused of aborting the upswing by raising its target interest rate too soon.
Showing posts with label current financial crisis. Show all posts
Showing posts with label current financial crisis. Show all posts
Sunday, January 17, 2010
Tuesday, October 27, 2009
Ecomonic Stimulus: Do We Need More?
When the history of the recent financial crisis and Great Recession is written, the basic conclusion that will be presented is that a financial crisis can be ended and a major recession turned around if the government throws massive amounts of money at the economy.
And, even after all this money is thrown at the economy, the calls for more and more stimulus remain. The lead editorial in the New York Times this morning calls for additional stimulus: see “The Case for More Stimulus”, http://www.nytimes.com/2009/10/27/opinion/27tue1.html. The Times struggles to come up with legitimate proposals for additional spending and comes up with only two: extending unemployment benefits and a program to “ease the dire financial condition of the states.” The newspaper bails out with the claim that “To be highly effective as stimulus, cash aid must be targeted to needy populations.” But, the Times can’t do any better than that.
Spending is addictive. Once you start, it is hard to stop.
Another problem, however, is that it takes time for economic systems to work things out. Sure, a “cash for clunkers” program can goose up spending in August, but September turns into a bust.
Real programs take time because the programs not only have to be designed, resources have to be assembled, and the projects have to actually get started. Then the effects of the program must work their way through the economy. “Shovel ready” programs that have an immediate economic impact on a city or a region are really few and far between, as we have seen from the initial Obama stimulus package.
So, what time frame are we looking at for government stimulus to work its way through an economy? Maybe three to five years?
And, how do you measure the effectiveness of the government stimulus? The Wall Street Journal today attempts to provide some idea of how this question might be answered: see “The Challenge in Counting Stimulus Returns”, http://online.wsj.com/article/SB125659862304009151.html#mod=todays_us_page_one. The conclusion of the author of the article is not encouraging.
Then there is the question about whether or not these programs replace or reduce other programs that would have been undertaken at this time. This is the question of the multiplier effect of government expenditures: is it above one or below one. Some of us believe that the multiplier for government spending is below 0.5. Not a very good bang for your buck!
And, what happens when people don’t see any results, or, at best, minor improvements? They start clamoring for more and more stimulus as the New York Times does today. Frustration sets in and people over-react to the situation. They want results and they want them now!
Yes, people and families are hurting. Yes, communities and states and regions are hurting. We don’t like to see the pain and would like to do something about it.
However, sometimes you can only do so much to improve the situation. The abuse that got the economy into this condition leaves no good choices for us to choose from in attempting to get out of the situation.
Was this crisis due to a failure of modern economics? I agree with the economist John Taylor who has written that this crisis actually vindicates the theory developed by modern economics. The problem was that the crisis was created by “a deviation of policy from the type of policy recommended by modern economics.” He goes on to write, “In other words, we have convincing evidence that interventionist government policies have done harm. The crisis did not occur because economic theory went wrong. It occurred because policy went wrong, because policy makers stopped paying attention to the economics.”
The conclusion one can therefore draw from this is that continuing “interventionist government policies” may not resolve the current problems but only exacerbate them. For example, if part of the problem is that families and businesses used too much debt and this helped to create the financial bust, then increasing the amount of debt outstanding in the economy is not going to resolve the problem, but may actually make it worse.
Well, throwing everything including the kitchen sink at the problem may bring the financial collapse to an end and help the economy to bottom out. But, what happens next? What happens after this massive amount of money is thrown at the economy?
For this we don’t have an answer although the New York Times does. “Ongoing economic problems are a sign that stimulus needs to be bolstered. Deficits are a serious issue, but the immediate need for stimulus trumps the longer-term need for deficit reduction. A self-reinforcing stretch of economic weakness would be far costlier than additional stimulus.”
More! That’s the answer!
And, people actually say that the talk about all the deficits is harmful to the situation. We are creating massive amounts of debt, but we can’t talk about them? Come on!!!
But, what if all the discussion about future deficits is causing people to spend less? What if the discussion about future deficits is causing people to fear that the Federal Reserve will not be able to reduce the size of its balance sheet and keep money and credit from soaring? What if the discussion about future deficits continues to result in a decline in the value of the dollar? What if the discussion about future deficits weakens American bargaining power among the rising nations in the world, China, Brazil, India, Russia, and continental Europe?
Should we stop talking about the deficit?
Or should be consider that maybe, just maybe, more is not the answer.
And, even after all this money is thrown at the economy, the calls for more and more stimulus remain. The lead editorial in the New York Times this morning calls for additional stimulus: see “The Case for More Stimulus”, http://www.nytimes.com/2009/10/27/opinion/27tue1.html. The Times struggles to come up with legitimate proposals for additional spending and comes up with only two: extending unemployment benefits and a program to “ease the dire financial condition of the states.” The newspaper bails out with the claim that “To be highly effective as stimulus, cash aid must be targeted to needy populations.” But, the Times can’t do any better than that.
Spending is addictive. Once you start, it is hard to stop.
Another problem, however, is that it takes time for economic systems to work things out. Sure, a “cash for clunkers” program can goose up spending in August, but September turns into a bust.
Real programs take time because the programs not only have to be designed, resources have to be assembled, and the projects have to actually get started. Then the effects of the program must work their way through the economy. “Shovel ready” programs that have an immediate economic impact on a city or a region are really few and far between, as we have seen from the initial Obama stimulus package.
So, what time frame are we looking at for government stimulus to work its way through an economy? Maybe three to five years?
And, how do you measure the effectiveness of the government stimulus? The Wall Street Journal today attempts to provide some idea of how this question might be answered: see “The Challenge in Counting Stimulus Returns”, http://online.wsj.com/article/SB125659862304009151.html#mod=todays_us_page_one. The conclusion of the author of the article is not encouraging.
Then there is the question about whether or not these programs replace or reduce other programs that would have been undertaken at this time. This is the question of the multiplier effect of government expenditures: is it above one or below one. Some of us believe that the multiplier for government spending is below 0.5. Not a very good bang for your buck!
And, what happens when people don’t see any results, or, at best, minor improvements? They start clamoring for more and more stimulus as the New York Times does today. Frustration sets in and people over-react to the situation. They want results and they want them now!
Yes, people and families are hurting. Yes, communities and states and regions are hurting. We don’t like to see the pain and would like to do something about it.
However, sometimes you can only do so much to improve the situation. The abuse that got the economy into this condition leaves no good choices for us to choose from in attempting to get out of the situation.
Was this crisis due to a failure of modern economics? I agree with the economist John Taylor who has written that this crisis actually vindicates the theory developed by modern economics. The problem was that the crisis was created by “a deviation of policy from the type of policy recommended by modern economics.” He goes on to write, “In other words, we have convincing evidence that interventionist government policies have done harm. The crisis did not occur because economic theory went wrong. It occurred because policy went wrong, because policy makers stopped paying attention to the economics.”
The conclusion one can therefore draw from this is that continuing “interventionist government policies” may not resolve the current problems but only exacerbate them. For example, if part of the problem is that families and businesses used too much debt and this helped to create the financial bust, then increasing the amount of debt outstanding in the economy is not going to resolve the problem, but may actually make it worse.
Well, throwing everything including the kitchen sink at the problem may bring the financial collapse to an end and help the economy to bottom out. But, what happens next? What happens after this massive amount of money is thrown at the economy?
For this we don’t have an answer although the New York Times does. “Ongoing economic problems are a sign that stimulus needs to be bolstered. Deficits are a serious issue, but the immediate need for stimulus trumps the longer-term need for deficit reduction. A self-reinforcing stretch of economic weakness would be far costlier than additional stimulus.”
More! That’s the answer!
And, people actually say that the talk about all the deficits is harmful to the situation. We are creating massive amounts of debt, but we can’t talk about them? Come on!!!
But, what if all the discussion about future deficits is causing people to spend less? What if the discussion about future deficits is causing people to fear that the Federal Reserve will not be able to reduce the size of its balance sheet and keep money and credit from soaring? What if the discussion about future deficits continues to result in a decline in the value of the dollar? What if the discussion about future deficits weakens American bargaining power among the rising nations in the world, China, Brazil, India, Russia, and continental Europe?
Should we stop talking about the deficit?
Or should be consider that maybe, just maybe, more is not the answer.
Friday, September 11, 2009
Accountants Misled Us Into Crisis
This headline is the headline of an article I would recommend everyone read about the financial crisis. This article, by Floyd Norris, can be found in the Friday morning New York Times (see http://www.nytimes.com/2009/09/11/business/economy/11norris.html?ref=business). As readers of this blog know, I have been a strong advocate of more transparent and open reporting from all organizations, but especially from financial institutions. Mark-to-market and the determination of fair values of financial assets, I believe, is a must going forward!
The bankers cry only after-the-fact, that is, once their bets on mismatched maturities on their balance sheets or on the assumption of riskier assets has gone sour. They can’t have it both ways, which is how little children want it. If you are going to take risks, Mr. Banker, then accept the responsibility for the risks that you take. Don’t cry about unfair accounting standards once the milk is spilt.
To me there are two major reasons why shareholders and regulators should be alerted to the bets that bankers have placed. The first has to do with achieving a more appropriate valuation of the stock of the bank or financial institution. Owners should know what bets have been placed so that they can incorporate risk into the valuations they are placing on the stock of the company they are interested in investing in. Regulators need to know as truly as possible the potential danger a bank faces and the treat the bank poses to the bank insurance fund.
The second reason has to do with management, itself. I have led the successful turnaround of three financial institutions. In each case, a major reason the banks got themselves in trouble was that managements repeatedly postponed, and then postponed again, dealing with problems because they could hide the problems from both the investment community and the regulatory bodies. This is also the case in the vast majority of troubled or failed institutions.
Successful managements must own up to the problems that they have created and act to correct those problems as soon as they can. The openness and transparency created by good accounting standards are important tools to create an environment in which managements do identify problems early and then act on them.
In a real sense, however, accounting standards are a crutch. Good executives require full disclosure of asset values and report this information to shareholders and regulators. They also act to resolve problems in a timely manner, as the problems are identified. Good executives create a culture in which they learn about problems as soon as possible because they don’t want surprises. I was taught that this is what good management is all about.
Perhaps we should post a list of all banks and bankers that are in favor of easing these reporting rules and discount the price of their common stock by 30% to 40% from current levels.
The reason?
To me, any banker that wants to ease up the rules on reporting the fair value of assets is, by definition, a poor manager and a poor leader. And, I do not want to invest in any organization that has poor management or poor leadership.
The bankers cry only after-the-fact, that is, once their bets on mismatched maturities on their balance sheets or on the assumption of riskier assets has gone sour. They can’t have it both ways, which is how little children want it. If you are going to take risks, Mr. Banker, then accept the responsibility for the risks that you take. Don’t cry about unfair accounting standards once the milk is spilt.
To me there are two major reasons why shareholders and regulators should be alerted to the bets that bankers have placed. The first has to do with achieving a more appropriate valuation of the stock of the bank or financial institution. Owners should know what bets have been placed so that they can incorporate risk into the valuations they are placing on the stock of the company they are interested in investing in. Regulators need to know as truly as possible the potential danger a bank faces and the treat the bank poses to the bank insurance fund.
The second reason has to do with management, itself. I have led the successful turnaround of three financial institutions. In each case, a major reason the banks got themselves in trouble was that managements repeatedly postponed, and then postponed again, dealing with problems because they could hide the problems from both the investment community and the regulatory bodies. This is also the case in the vast majority of troubled or failed institutions.
Successful managements must own up to the problems that they have created and act to correct those problems as soon as they can. The openness and transparency created by good accounting standards are important tools to create an environment in which managements do identify problems early and then act on them.
In a real sense, however, accounting standards are a crutch. Good executives require full disclosure of asset values and report this information to shareholders and regulators. They also act to resolve problems in a timely manner, as the problems are identified. Good executives create a culture in which they learn about problems as soon as possible because they don’t want surprises. I was taught that this is what good management is all about.
Perhaps we should post a list of all banks and bankers that are in favor of easing these reporting rules and discount the price of their common stock by 30% to 40% from current levels.
The reason?
To me, any banker that wants to ease up the rules on reporting the fair value of assets is, by definition, a poor manager and a poor leader. And, I do not want to invest in any organization that has poor management or poor leadership.
Wednesday, August 26, 2009
The Bernanke Re-Appointment
At first I was not going to comment on the re-appointment of Ben Bernanke to the position of Chairman of the Board of Governors of the Federal Reserve System. I thought I had had my say. See my post “Exit Strategy: An Argument Against Bernanke's Reappointment” of July 27, 2009. Guess this was not to be. Since this post was re-posted on several sites yesterday and people have asked me to comment on the news, I decided to provide a current comment on the situation.
There are seemingly two reasons given for the re-appointment of Ben Bernanke to another term as the Chairman of the Board of Governors. The first is that he was calm throughout the crisis. The second is that his appointment, since he is a “known”, will calm the financial markets.
Calm is “good”! I have just been writing about it: see Banking Sector Stays Quiet on August 10 and The Deleveraging Continues: What This Means on August 24. It is good that the financial markets are calm and everyone is on vacation this last week in August: a great time to make a very important appointment.
But, is “calm” what we need. The financial markets do get over changes in leadership. For example, we change Presidents and the markets get over the change! In fact, changing leadership in a time of calm is the best time to change leadership!
And, what does it mean that Bernanke was “calm” during the financial crisis. Why do I keep remembering management team after management team taking their banks public during the Savings and Loan crisis that kept telling us: “Yes, we got the bank into this mess but we learned our lesson. Now, all you have to do is give us another $100 million in new capital and we will change our ways!” And, that was the last the investors saw of their $100 million. But, these managements were calm as their institutions crumbled.
Bernanke was one of the leaders that got us into this mess. He got us through the crisis? I have over my desk the cartoon from the Financial Times showing Bernanke in front of the Federal Reserve building with two revolvers in his hands shooting off lots and lots of currency. The title of the cartoon: “A Fistful of Dollars”. He is not known as “Helicopter Ben” for nothing.
His policy for the crisis: throw as much money into the market as possible. It is way better to have too much money out there than to not have enough. A good, coherent, concise policy!
And, he did this very calmly!
Or did he? See my post of November 16, 2008: The Bailout Plan: Did Bernanke Panic?
My final concern over this re-appointment is my disappointment with President Obama. I had hopes that he would bring a whole new quality of leadership to Washington, D. C. He has been President for over six months now and I must say that hope has not been fulfilled.
There are seemingly two reasons given for the re-appointment of Ben Bernanke to another term as the Chairman of the Board of Governors. The first is that he was calm throughout the crisis. The second is that his appointment, since he is a “known”, will calm the financial markets.
Calm is “good”! I have just been writing about it: see Banking Sector Stays Quiet on August 10 and The Deleveraging Continues: What This Means on August 24. It is good that the financial markets are calm and everyone is on vacation this last week in August: a great time to make a very important appointment.
But, is “calm” what we need. The financial markets do get over changes in leadership. For example, we change Presidents and the markets get over the change! In fact, changing leadership in a time of calm is the best time to change leadership!
And, what does it mean that Bernanke was “calm” during the financial crisis. Why do I keep remembering management team after management team taking their banks public during the Savings and Loan crisis that kept telling us: “Yes, we got the bank into this mess but we learned our lesson. Now, all you have to do is give us another $100 million in new capital and we will change our ways!” And, that was the last the investors saw of their $100 million. But, these managements were calm as their institutions crumbled.
Bernanke was one of the leaders that got us into this mess. He got us through the crisis? I have over my desk the cartoon from the Financial Times showing Bernanke in front of the Federal Reserve building with two revolvers in his hands shooting off lots and lots of currency. The title of the cartoon: “A Fistful of Dollars”. He is not known as “Helicopter Ben” for nothing.
His policy for the crisis: throw as much money into the market as possible. It is way better to have too much money out there than to not have enough. A good, coherent, concise policy!
And, he did this very calmly!
Or did he? See my post of November 16, 2008: The Bailout Plan: Did Bernanke Panic?
My final concern over this re-appointment is my disappointment with President Obama. I had hopes that he would bring a whole new quality of leadership to Washington, D. C. He has been President for over six months now and I must say that hope has not been fulfilled.
Wednesday, February 18, 2009
Bernanke: His Words of Encouragement?
Ben Bernanke spoke today at the Nation Press Club luncheon in Washington, D. C. (His speech is found at http://www.federalreserve.gov/newsevents/speech/bernanke20090218a.htm.) His pledge to us is that the Fed will do “everything possible within the limits of its authority” to restore stable markets and get the U. S. out of recession.
If the past six months is any indication, we can believe him when he says this. For one thing, we have seen the Federal Reserve increase the “Factors Supplying Reserve Funds” from about $939 billion on September 3, 2008 to a peak of around $2.347 trillion on December 17, 2008 before falling to about $1.879 trillion on February 11, 2009. So from September 3, 2008 to February 11, 2009, “Factors Supplying Reserve Funds” to the banking system doubled…that is in a period of 23 weeks or less than one-half of a year.
Yes, I think we can believe what the Chairman of the Fed has said.
The effort is to “restore stable markets and get the U. S. out of recession.”
One can argue that the financial markets have stabilized somewhat and there have not been the major financial bailouts or nationalizations (AIG) or failures (Lehman Brothers) that we saw in September 2008. If this is restoring stability to the markets then there has been some success. However, with the lending pipeline seemingly paralyzed and the stock market at near-term lows, there is still a long way to go before we can conclusively say that the markets have become stabilized.
Let’s look a little deeper at what has happened in the financial system over the past several months.
First, let’s look at the total reserves in the banking system. Here we see, first hand, the impact of Federal Reserve actions on the banking system. Total reserves at depository institutions (not seasonally adjusted) were around $44.1 billion in January 2008 and were still around $44.1 billion in August 2008. Since August, however, total reserves have increased by approximated $809 billion to $1.853 trillion. Year-over-year (January 2008 to January 2009) this represent an annual rate of increase of 1853%...not bad. (Don’t annualize the rate of increase from the August figure…the figure is kind of silly!)
The next thing we can look at is what Bernanke calls “the narrowest definition of the money supply, the monetary base”. The monetary base is defined as all items that are bank reserves or could become bank reserves (cash held outside of depository institutions). In January 2008, the monetary base (not seasonally adjusted) was at about $831 billion. In August 2008 it had only increased to around $847 billion. But, in January 2009, the monetary base totaled about $1.710 trillion. Obviously, the year-over-year rate of increase in the monetary base was slightly over 100%...a pretty sizeable annual rate of increase…again, most of the increase coming from September 2008 to the present.
This, we are told is where the problem with the financial system is…”banks are choosing to leave the great bulk of their excess reserves idle, in most cases on deposit with the Fed.” That’s what financial institutions do when they are scared silly…because they don’t know the value of their assets and might be insolvent…or because they don’t know how good the credit is of people who want to borrow…if there are any that do want to borrow. That is, there is constipation in the lending system.
The increases in total reserves and the monetary base is having an impact on the growth of the two broader measures of the money stock but this increase is coming primarily in cash held outside of banks. That is, people and businesses are holding onto cash rather than spending it. This is consistent with the effort of people to either save or to pay down debt…exactly what one would expect at a time like this. People have too much debt, are risk averse about the future, and so are holding onto things…if they can.
The money stock measures have increased through the end of the year showing some effect of the Federal Reserve action. The year-over-year rate of growth of the M1 measure of the money stock (not seasonally adjusted) is around 13%, up from about 2% in August and a negative number through the first half of 2008. The broader measure of the money stock, M2, is running at an 11% year-over-year rate of increase (on a not seasonally adjusted basis), which is up from about 5.5% in August and around 6.5%for the first half of 2008. Both of these measures are growing at rates that are historically very high, but, again, a lot of this increase is in the cash component of the money stock and is not being spent!
What about lending in the banking system? Loans and leases at commercial banks in the United States have increased since the last week in August 2008 from about $6.9 trillion to around $7.1 trillion in the first week of February 2009…an increase of about $200 billion. Commercial and industrial loans have risen by about $50 billion and real estate loans have risen by around $144 billion. Residential real estate loans have risen by about $32 billion and commercial real estate loans have increase by around $47 billion. Consumer credit has grown by $55 billion, primarily with an increase in credit card debt.
Some increase in credit is occurring…but not a whole bunch…and a lot of this is to help businesses and others keep things going as their cash flows have slowed down. Lending is NOT robust, by any measure.
So, we have words of encouragement being spoken…but we are a long way from getting through this thing. And, the Federal Reserve owns up to this in the projections it released after Bernanke spoke. These projections are a part of the information reviewed by the Federal Open Market Committee at its meeting on January 27-28 2009. The release of these projections is a part of the Fed’s attempt to be open to the world by supplying the forecasts it is basing its decisions upon.
And the forecasts…gross domestic product may contract by up to 1.3% in 2009, although it is expected to increase nicely in 2010 and 2011. Unemployment might rise to a high of 8.8% this year, although it is projected to drop substantially in 2010 and 2011. And, what about inflation, we are told that the Fed is projecting core inflation to be between 0.9% and 1.1% this year and only modestly higher in 2010/2011.
The basic interpretation is that the economy will continue to be in recession throughout 2009 but will be getting better by the end of the year. Then things will get continually better in the following two years.
Inflation…well don’t worry about inflation…even though the Fed has pumped all these reserves into the banking system and the Federal Government is looking at deficits in the trillions of dollars for several years down the road. The Fed’s balance sheet “can be unwound ‘relatively quickly’ given the short-term nature of the assets the Fed holds.” Bernanke assures us that “The principal factor determining the timing and pace of that process will be the Federal Reserve’s assessment of the condition of credit markets and the prospects for the economy.” Okay...
I think I am missing something, however. First, when is credit going to start to flow again, given all the bad assets that are being held by banks? Doesn’t this have to happen before we start to get a smooth acceleration in economic growth? Second, who is going to finance all of the government debt that is going to be issued? Is the Federal Reserve going to print money to take care of the deficits we are facing? Somehow, I am missing some in the encouragement I am being given!
If the past six months is any indication, we can believe him when he says this. For one thing, we have seen the Federal Reserve increase the “Factors Supplying Reserve Funds” from about $939 billion on September 3, 2008 to a peak of around $2.347 trillion on December 17, 2008 before falling to about $1.879 trillion on February 11, 2009. So from September 3, 2008 to February 11, 2009, “Factors Supplying Reserve Funds” to the banking system doubled…that is in a period of 23 weeks or less than one-half of a year.
Yes, I think we can believe what the Chairman of the Fed has said.
The effort is to “restore stable markets and get the U. S. out of recession.”
One can argue that the financial markets have stabilized somewhat and there have not been the major financial bailouts or nationalizations (AIG) or failures (Lehman Brothers) that we saw in September 2008. If this is restoring stability to the markets then there has been some success. However, with the lending pipeline seemingly paralyzed and the stock market at near-term lows, there is still a long way to go before we can conclusively say that the markets have become stabilized.
Let’s look a little deeper at what has happened in the financial system over the past several months.
First, let’s look at the total reserves in the banking system. Here we see, first hand, the impact of Federal Reserve actions on the banking system. Total reserves at depository institutions (not seasonally adjusted) were around $44.1 billion in January 2008 and were still around $44.1 billion in August 2008. Since August, however, total reserves have increased by approximated $809 billion to $1.853 trillion. Year-over-year (January 2008 to January 2009) this represent an annual rate of increase of 1853%...not bad. (Don’t annualize the rate of increase from the August figure…the figure is kind of silly!)
The next thing we can look at is what Bernanke calls “the narrowest definition of the money supply, the monetary base”. The monetary base is defined as all items that are bank reserves or could become bank reserves (cash held outside of depository institutions). In January 2008, the monetary base (not seasonally adjusted) was at about $831 billion. In August 2008 it had only increased to around $847 billion. But, in January 2009, the monetary base totaled about $1.710 trillion. Obviously, the year-over-year rate of increase in the monetary base was slightly over 100%...a pretty sizeable annual rate of increase…again, most of the increase coming from September 2008 to the present.
This, we are told is where the problem with the financial system is…”banks are choosing to leave the great bulk of their excess reserves idle, in most cases on deposit with the Fed.” That’s what financial institutions do when they are scared silly…because they don’t know the value of their assets and might be insolvent…or because they don’t know how good the credit is of people who want to borrow…if there are any that do want to borrow. That is, there is constipation in the lending system.
The increases in total reserves and the monetary base is having an impact on the growth of the two broader measures of the money stock but this increase is coming primarily in cash held outside of banks. That is, people and businesses are holding onto cash rather than spending it. This is consistent with the effort of people to either save or to pay down debt…exactly what one would expect at a time like this. People have too much debt, are risk averse about the future, and so are holding onto things…if they can.
The money stock measures have increased through the end of the year showing some effect of the Federal Reserve action. The year-over-year rate of growth of the M1 measure of the money stock (not seasonally adjusted) is around 13%, up from about 2% in August and a negative number through the first half of 2008. The broader measure of the money stock, M2, is running at an 11% year-over-year rate of increase (on a not seasonally adjusted basis), which is up from about 5.5% in August and around 6.5%for the first half of 2008. Both of these measures are growing at rates that are historically very high, but, again, a lot of this increase is in the cash component of the money stock and is not being spent!
What about lending in the banking system? Loans and leases at commercial banks in the United States have increased since the last week in August 2008 from about $6.9 trillion to around $7.1 trillion in the first week of February 2009…an increase of about $200 billion. Commercial and industrial loans have risen by about $50 billion and real estate loans have risen by around $144 billion. Residential real estate loans have risen by about $32 billion and commercial real estate loans have increase by around $47 billion. Consumer credit has grown by $55 billion, primarily with an increase in credit card debt.
Some increase in credit is occurring…but not a whole bunch…and a lot of this is to help businesses and others keep things going as their cash flows have slowed down. Lending is NOT robust, by any measure.
So, we have words of encouragement being spoken…but we are a long way from getting through this thing. And, the Federal Reserve owns up to this in the projections it released after Bernanke spoke. These projections are a part of the information reviewed by the Federal Open Market Committee at its meeting on January 27-28 2009. The release of these projections is a part of the Fed’s attempt to be open to the world by supplying the forecasts it is basing its decisions upon.
And the forecasts…gross domestic product may contract by up to 1.3% in 2009, although it is expected to increase nicely in 2010 and 2011. Unemployment might rise to a high of 8.8% this year, although it is projected to drop substantially in 2010 and 2011. And, what about inflation, we are told that the Fed is projecting core inflation to be between 0.9% and 1.1% this year and only modestly higher in 2010/2011.
The basic interpretation is that the economy will continue to be in recession throughout 2009 but will be getting better by the end of the year. Then things will get continually better in the following two years.
Inflation…well don’t worry about inflation…even though the Fed has pumped all these reserves into the banking system and the Federal Government is looking at deficits in the trillions of dollars for several years down the road. The Fed’s balance sheet “can be unwound ‘relatively quickly’ given the short-term nature of the assets the Fed holds.” Bernanke assures us that “The principal factor determining the timing and pace of that process will be the Federal Reserve’s assessment of the condition of credit markets and the prospects for the economy.” Okay...
I think I am missing something, however. First, when is credit going to start to flow again, given all the bad assets that are being held by banks? Doesn’t this have to happen before we start to get a smooth acceleration in economic growth? Second, who is going to finance all of the government debt that is going to be issued? Is the Federal Reserve going to print money to take care of the deficits we are facing? Somehow, I am missing some in the encouragement I am being given!
Wednesday, January 21, 2009
Where Will the Federal Reserve Go?
The Federal Reserve evolved over the years to perform three major tasks: to supply liquidity to commercial banks and the financial markets (specifically as the “lender of last resort”); to manage the monetary system so as to encourage economic growth, yet contain inflation; and to oversee the health of the banks who were members of the Federal Reserve System through regulation, examination, and supervision.
Whereas the Federal Reserve System is supposed to fight a liquidity crisis, a very short term phenomenon, it was not set up to resolve a solvency crisis, a longer term situation. The problem faced in a liquidity crisis is that, for one reason or another, an institution or a few institutions want to sell quickly some kind of a financial asset but there are few, if any, buyers. The responsibility of the Federal Reserve is to supply liquidity to the market on a short term basis so that the market will stabilize and buyers of these financial assets will return to the market.
We have gone through our liquidity crises this time around. Liquidity crises are surprises…we are not prepared for them…and this is why the response has to be quick and decisive. I say that we have gone through our liquidity crises this time around because investors are very wary about ALL asset classes now and the surprises that come to light on a regular basis are how deep the losses on assets continue to be…not that there are losses.
The Federal Reserve is not set up to solve a solvency crisis. The solvency crisis is a capital adequacy problem. It is a problem related to how large the losses are related to the book value of the assets. Yes, there are liquidity issues related to these troubled assets…they may not be able to be sold…or they cannot be sold. If this is the case the question becomes whether or not the problems related to these assets can be worked out and if so how much of the asset value will be retained…if any of it can be retained. And, the solvency crisis is of a longer term nature than the liquidity crisis.
The Federal Reserve, over the past 13 months has drastically changed the way it operates in an effort to provide liquidity to financial markets. Attention has been directed to the expansion of the asset portfolio of the Federal Reserve System. In the last 13 months, the line item labeled “Total Factors Supplying Reserve Funds” that appears on the Federal Reserve Statistical Release, H.4.1, “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks,” has increased by approximately $1.2 trillion. The increase is from $0.9 trillion on Wednesday November 28, 2007 to $2.1 trillion on Wednesday January 14, 2009. All of this increase has come since Wednesday September 3, 2008 when the balance totaled $0.94 trillion.
I include December 2007 in this calculation for it was in this month that we first got the innovation called the Term Auction Credit Facility introduced to the Fed’s tools of operation. And, as they say, the rest is history.
The major changes include a decline in the “Securities Held Outright” of $275 billion, the account that includes Treasury securities the instrument that the Federal Reserve has traditionally used to conduct monetary policy. But even this figure is misleading because this category now includes “Federal Agency Debt Securities” and “Mortgage-backed Securities”. These two accounts have gone up by about $23 billion over the past 13 months, so that the decline in Treasury securities held by the Fed has actually declined by about $300 billion.
What has accounted, therefore, for the $1.5 trillion increase? (The $1.5 trillion comes from the $1.2 trillion increase in Factors Supplying Reserves and the decline of $0.3 trillion of Treasury Securities held.) “Term Auction Credit” injections accounted for almost $0.4 trillion, “Other Federal Reserve Assets” rose by almost $0.6 trillion and “Net portfolio holdings of Commercial Paper Funding Facility LLC” rose by a little over $0.3 trillion. The other roughly $0.2 trillion came from minor accounts like the increase in primary borrowings from the discount window, primary dealer and other broker-dealer credit, credit extended to AIG, the assets connected with the Bear Stearns bailout, and Asset-backed Commercial Paper Money Market Mutual Fund Liquidity Facility.
And, what is the point of listing all of these different sources of funds? The point is to highlight that most of the funds were injected into the market in order to provide liquidity to different sectors of the financial markets in an effort to “unfreeze” lending. The securities provided to the Federal Reserve to serve as collateral for these “loans” are supposedly of the highest credit quality. The rest of the funds…really a minor part of them…only about $113 billion…is to hold assets connected with the bailouts of AIG and Bear Stearns. That is, almost all of the funds were supplied to the market for liquidity reasons…not for solvency reasons. Thus, the Fed is sticking to one of its primary functions and not entering into the area of “capital adequacy” problems.
The capital adequacy problem should not be an issue that the Federal Reserve takes up. To do so would cause a major conflict with its primary responsibility…to conduct monetary policy.
To me, this is an issue primarily for the Treasury Department because it is very closely related to ownership...and when we start talking about ownership we start thinking of “nationalization”…and I believe that a lot of people have trouble walking down this road. However, given the depth of the problems of the banking industry, the issue of nationalization is going to come up and must be thoroughly discussed and debated. This is a major step for any nation to take…and most nations around the world that are looking at this problem in the face are treating the issue very gently. Even those nations who have governments that look to more governmental involvement in the economy at being very careful.
Fed Chairman Bernanke has stated that the United States cannot just rely on the Obama stimulus plan to get the economy going…and he is right. But, the Federal Reserve has supplied a lot of liquidity to financial markets…and, they will stand ready to supply more liquidity if it is needed. However, the Fed cannot do much more at this time. I hope it does not have many more tricks up its sleeve to surprise us with as it did this past year. In this respect, I think the Fed needs to be careful going forward and not get impatient and do something way off the wall.
As you may remember, I am not a great fan of Bernanke and I had hoped that he would offer to step down so that President Obama could select a Chairman of the Fed that would be more capable. I believe that Bernanke panicked last September (See “The ‘Bailout Plan: Did Bernanke Panic?” on Seeking Alpha, http://seekingalpha.com/author/john-m-mason/articles/latest, November 16, 2008.) Paulson was over whelmed, Bush 43 was absent without leave, and there was no one else in the administration with the intellectual quality to counter Bernanke’s arguments. As a result we got the mess labeled TARP…which was ill-planned, ill-debated, and mismanaged from the start…which has turned into its own source of disaster.
Frankly, I am concerned about where the Fed is headed. There are certainly stronger intellects around in the Obama administration…Larry Summers particularly comes to mind. However, the Fed has a certain independence that forces one to worry when you do not have confidence in its leadership.
Where will the Fed go? One should not be surprised by the central bank. A central bank needs to be steady and secure at the helm. A central bank needs to provide confidence to markets and institutions. I do not sense that participants in the financial markets feel this way at this time about the current Federal Reserve System.
Whereas the Federal Reserve System is supposed to fight a liquidity crisis, a very short term phenomenon, it was not set up to resolve a solvency crisis, a longer term situation. The problem faced in a liquidity crisis is that, for one reason or another, an institution or a few institutions want to sell quickly some kind of a financial asset but there are few, if any, buyers. The responsibility of the Federal Reserve is to supply liquidity to the market on a short term basis so that the market will stabilize and buyers of these financial assets will return to the market.
We have gone through our liquidity crises this time around. Liquidity crises are surprises…we are not prepared for them…and this is why the response has to be quick and decisive. I say that we have gone through our liquidity crises this time around because investors are very wary about ALL asset classes now and the surprises that come to light on a regular basis are how deep the losses on assets continue to be…not that there are losses.
The Federal Reserve is not set up to solve a solvency crisis. The solvency crisis is a capital adequacy problem. It is a problem related to how large the losses are related to the book value of the assets. Yes, there are liquidity issues related to these troubled assets…they may not be able to be sold…or they cannot be sold. If this is the case the question becomes whether or not the problems related to these assets can be worked out and if so how much of the asset value will be retained…if any of it can be retained. And, the solvency crisis is of a longer term nature than the liquidity crisis.
The Federal Reserve, over the past 13 months has drastically changed the way it operates in an effort to provide liquidity to financial markets. Attention has been directed to the expansion of the asset portfolio of the Federal Reserve System. In the last 13 months, the line item labeled “Total Factors Supplying Reserve Funds” that appears on the Federal Reserve Statistical Release, H.4.1, “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks,” has increased by approximately $1.2 trillion. The increase is from $0.9 trillion on Wednesday November 28, 2007 to $2.1 trillion on Wednesday January 14, 2009. All of this increase has come since Wednesday September 3, 2008 when the balance totaled $0.94 trillion.
I include December 2007 in this calculation for it was in this month that we first got the innovation called the Term Auction Credit Facility introduced to the Fed’s tools of operation. And, as they say, the rest is history.
The major changes include a decline in the “Securities Held Outright” of $275 billion, the account that includes Treasury securities the instrument that the Federal Reserve has traditionally used to conduct monetary policy. But even this figure is misleading because this category now includes “Federal Agency Debt Securities” and “Mortgage-backed Securities”. These two accounts have gone up by about $23 billion over the past 13 months, so that the decline in Treasury securities held by the Fed has actually declined by about $300 billion.
What has accounted, therefore, for the $1.5 trillion increase? (The $1.5 trillion comes from the $1.2 trillion increase in Factors Supplying Reserves and the decline of $0.3 trillion of Treasury Securities held.) “Term Auction Credit” injections accounted for almost $0.4 trillion, “Other Federal Reserve Assets” rose by almost $0.6 trillion and “Net portfolio holdings of Commercial Paper Funding Facility LLC” rose by a little over $0.3 trillion. The other roughly $0.2 trillion came from minor accounts like the increase in primary borrowings from the discount window, primary dealer and other broker-dealer credit, credit extended to AIG, the assets connected with the Bear Stearns bailout, and Asset-backed Commercial Paper Money Market Mutual Fund Liquidity Facility.
And, what is the point of listing all of these different sources of funds? The point is to highlight that most of the funds were injected into the market in order to provide liquidity to different sectors of the financial markets in an effort to “unfreeze” lending. The securities provided to the Federal Reserve to serve as collateral for these “loans” are supposedly of the highest credit quality. The rest of the funds…really a minor part of them…only about $113 billion…is to hold assets connected with the bailouts of AIG and Bear Stearns. That is, almost all of the funds were supplied to the market for liquidity reasons…not for solvency reasons. Thus, the Fed is sticking to one of its primary functions and not entering into the area of “capital adequacy” problems.
The capital adequacy problem should not be an issue that the Federal Reserve takes up. To do so would cause a major conflict with its primary responsibility…to conduct monetary policy.
To me, this is an issue primarily for the Treasury Department because it is very closely related to ownership...and when we start talking about ownership we start thinking of “nationalization”…and I believe that a lot of people have trouble walking down this road. However, given the depth of the problems of the banking industry, the issue of nationalization is going to come up and must be thoroughly discussed and debated. This is a major step for any nation to take…and most nations around the world that are looking at this problem in the face are treating the issue very gently. Even those nations who have governments that look to more governmental involvement in the economy at being very careful.
Fed Chairman Bernanke has stated that the United States cannot just rely on the Obama stimulus plan to get the economy going…and he is right. But, the Federal Reserve has supplied a lot of liquidity to financial markets…and, they will stand ready to supply more liquidity if it is needed. However, the Fed cannot do much more at this time. I hope it does not have many more tricks up its sleeve to surprise us with as it did this past year. In this respect, I think the Fed needs to be careful going forward and not get impatient and do something way off the wall.
As you may remember, I am not a great fan of Bernanke and I had hoped that he would offer to step down so that President Obama could select a Chairman of the Fed that would be more capable. I believe that Bernanke panicked last September (See “The ‘Bailout Plan: Did Bernanke Panic?” on Seeking Alpha, http://seekingalpha.com/author/john-m-mason/articles/latest, November 16, 2008.) Paulson was over whelmed, Bush 43 was absent without leave, and there was no one else in the administration with the intellectual quality to counter Bernanke’s arguments. As a result we got the mess labeled TARP…which was ill-planned, ill-debated, and mismanaged from the start…which has turned into its own source of disaster.
Frankly, I am concerned about where the Fed is headed. There are certainly stronger intellects around in the Obama administration…Larry Summers particularly comes to mind. However, the Fed has a certain independence that forces one to worry when you do not have confidence in its leadership.
Where will the Fed go? One should not be surprised by the central bank. A central bank needs to be steady and secure at the helm. A central bank needs to provide confidence to markets and institutions. I do not sense that participants in the financial markets feel this way at this time about the current Federal Reserve System.
Friday, December 19, 2008
The Declining Dollar--Continued
Please note that today’s Wall Street Journal carries an editorial that makes exactly the same points concerning the decline in the value of the United States dollar that I made in my post yesterday. I refer to the comments made in “A Dollar Referendum” which can be found at http://online.wsj.com/article/SB122965017184420567.html?mod=todays_us_opinion.
Let me just summarize the points made in the Wall Street Journal article.
First, after the dollar rose earlier in the fall due to the international flight to quality to invest in Treasury securities, the value of the United States dollar has fallen precipitously in December as a result of the recent Fed actions opening the gate to flood the world with dollars.
Second, why should international financial markets have any faith in the Federal Reserve to restore discipline to the markets when it “has proven that it is far better at adding liquidity than removing it”? The editorial then refers to the Fed record in maintaining exceedingly low target interest rates earlier in the 2001 to 2003 period.
Third, the editorial discusses the flow of new United States government debt that will be coming to the market…approximately $1.0 trillion…related to the proposed Obama stimulus plan. The implication is that the monetary thrust of the Fed will basically monetize this debt.
Fourth, the concern is expressed that measures of inflation, such as the consumer price index are lagging indicators, and do not capture the market’s lack of confidence in international financial markets that the Federal Reserve will be restore order once the “deflation” psychology has been defeated. The decline in the value of the United States dollar represents this expectation of market participants.
In the words of the Wall Street Journal editorial: “The dollar’s decline is a warning about the future. Mr. Bernanke’s decision to flood the world with dollars will no doubt succeed in preventing a deflation. What everyone wants to know is whether he also has the fortitude—or even the desire—to prevent a run on the world’s reserve currency.”
Let me just summarize the points made in the Wall Street Journal article.
First, after the dollar rose earlier in the fall due to the international flight to quality to invest in Treasury securities, the value of the United States dollar has fallen precipitously in December as a result of the recent Fed actions opening the gate to flood the world with dollars.
Second, why should international financial markets have any faith in the Federal Reserve to restore discipline to the markets when it “has proven that it is far better at adding liquidity than removing it”? The editorial then refers to the Fed record in maintaining exceedingly low target interest rates earlier in the 2001 to 2003 period.
Third, the editorial discusses the flow of new United States government debt that will be coming to the market…approximately $1.0 trillion…related to the proposed Obama stimulus plan. The implication is that the monetary thrust of the Fed will basically monetize this debt.
Fourth, the concern is expressed that measures of inflation, such as the consumer price index are lagging indicators, and do not capture the market’s lack of confidence in international financial markets that the Federal Reserve will be restore order once the “deflation” psychology has been defeated. The decline in the value of the United States dollar represents this expectation of market participants.
In the words of the Wall Street Journal editorial: “The dollar’s decline is a warning about the future. Mr. Bernanke’s decision to flood the world with dollars will no doubt succeed in preventing a deflation. What everyone wants to know is whether he also has the fortitude—or even the desire—to prevent a run on the world’s reserve currency.”
Saturday, November 22, 2008
A Whiff of Leadership?
In the last hour of trading Friday November 21, the stock market staged a significant rally.
The cause of the rally?
The leaked news that President-elect Obama was going to choose Timothy Geithner, President of the Federal Reserve Bank of New York as the next Secretary of the Treasury.
Market participants…hungry for leadership of any kind…reacted with enthusiasm to this possibility and began to buy. As I wrote in my blog of November 20, “Discipline or the Lack Thereof”, http://maseportfolio.blogspot.com/, the market, more than anything else right now, is thirsting for leadership.
It has also been leaked that on Monday President-elect Obama will introduce his economics team. Doing this will reduce a lot of uncertainty that has been hanging over the markets and provide some insight into the direction an Obama Presidency will head. If anything, Obama is showing with his choices that he is not afraid to have strong and intelligent people around him and will not be cowered by the presence of such people. In fact, he gives off the impression that he will thrive in such an environment.
And, the people he has indicated that he will appoint are pragmatic and successful people. They find what works!
I know there are many that are disappointed in the choices that Obama is making because they don’t think that these choices represent the “change” that Obama promised in the campaign. I think that they are wrong in this charge.
As I have written in many of my blog-posts, LEADERSHIP BEGINS AT THE TOP! It is the top person that sets the culture and it is the top person that sets the agenda. Change will come because the person at the top requests that those that report to him/her provide options that incorporate change. But, this kind of change is not going to take place with a bunch of neophytes that have to learn the ropes of government first and are unproven in working at this level of issue and pressure.
There must be tested members of the team…especially at this time! But, the charge that is given the team and encouraged is to provide some new answers and solutions to the problems that are now being faced. Top quality members of the team will jump at this opportunity and, with the continued strong guidance coming from the chief executive officer, they will produce results. Good leadership raises the level of performance of all those around the leader. As we have seen in the last eight years or so…weak leadership results in the sub-par performance of all those around the leader and none escape with an unblemished record.
One can be happy with the choices that are being made and still be concerned about the future of the financial markets and the economy. There is still a lot of bad news to come in the future. As Obama, himself, has said…there cannot be two Presidents at the same time. The new administration will not take office until January 20, 2009. And, even so, economies do not reverse direction overnight and there are a lot of dislocations in the United States economy and the world that need to be worked out.
There is still great concern that financial institutions have not really discovered or revealed just how badly their assets portfolios are underwater. The layoffs and dismissals of employees are growing and we have not seen how badly this is going to affect the spending of the consumer. The housing market still seems to be declining and no one knows how the situation with respect to foreclosures and mortgages that exceed housing prices are going to be worked out. With respect to businesses, bankruptcies are still increasing and a great deal of industrial restructuring is going to have to take place even though firms don’t go into bankruptcy. State and local governments are in bad shape financially. And, what about nonprofit organizations? Educational institutions? The sports and entertainment industries? And, so on and so on…
We are just in the early stages of this reconstruction of the United States…and the world…economy. Even with the best of appointments, the United States…and the world…is going to have to go through the process of restructuring.
However, let’s concentrate on what seems to be the good news for the present time. President-elect Obama is making appointments that are giving financial market participants some hope. Even though there is still a long, difficult road ahead of us…we will gravitate toward any sign of positive leadership that is available and hang on to the hope that is present in the possibility that that leadership will take us where we need to go!
The cause of the rally?
The leaked news that President-elect Obama was going to choose Timothy Geithner, President of the Federal Reserve Bank of New York as the next Secretary of the Treasury.
Market participants…hungry for leadership of any kind…reacted with enthusiasm to this possibility and began to buy. As I wrote in my blog of November 20, “Discipline or the Lack Thereof”, http://maseportfolio.blogspot.com/, the market, more than anything else right now, is thirsting for leadership.
It has also been leaked that on Monday President-elect Obama will introduce his economics team. Doing this will reduce a lot of uncertainty that has been hanging over the markets and provide some insight into the direction an Obama Presidency will head. If anything, Obama is showing with his choices that he is not afraid to have strong and intelligent people around him and will not be cowered by the presence of such people. In fact, he gives off the impression that he will thrive in such an environment.
And, the people he has indicated that he will appoint are pragmatic and successful people. They find what works!
I know there are many that are disappointed in the choices that Obama is making because they don’t think that these choices represent the “change” that Obama promised in the campaign. I think that they are wrong in this charge.
As I have written in many of my blog-posts, LEADERSHIP BEGINS AT THE TOP! It is the top person that sets the culture and it is the top person that sets the agenda. Change will come because the person at the top requests that those that report to him/her provide options that incorporate change. But, this kind of change is not going to take place with a bunch of neophytes that have to learn the ropes of government first and are unproven in working at this level of issue and pressure.
There must be tested members of the team…especially at this time! But, the charge that is given the team and encouraged is to provide some new answers and solutions to the problems that are now being faced. Top quality members of the team will jump at this opportunity and, with the continued strong guidance coming from the chief executive officer, they will produce results. Good leadership raises the level of performance of all those around the leader. As we have seen in the last eight years or so…weak leadership results in the sub-par performance of all those around the leader and none escape with an unblemished record.
One can be happy with the choices that are being made and still be concerned about the future of the financial markets and the economy. There is still a lot of bad news to come in the future. As Obama, himself, has said…there cannot be two Presidents at the same time. The new administration will not take office until January 20, 2009. And, even so, economies do not reverse direction overnight and there are a lot of dislocations in the United States economy and the world that need to be worked out.
There is still great concern that financial institutions have not really discovered or revealed just how badly their assets portfolios are underwater. The layoffs and dismissals of employees are growing and we have not seen how badly this is going to affect the spending of the consumer. The housing market still seems to be declining and no one knows how the situation with respect to foreclosures and mortgages that exceed housing prices are going to be worked out. With respect to businesses, bankruptcies are still increasing and a great deal of industrial restructuring is going to have to take place even though firms don’t go into bankruptcy. State and local governments are in bad shape financially. And, what about nonprofit organizations? Educational institutions? The sports and entertainment industries? And, so on and so on…
We are just in the early stages of this reconstruction of the United States…and the world…economy. Even with the best of appointments, the United States…and the world…is going to have to go through the process of restructuring.
However, let’s concentrate on what seems to be the good news for the present time. President-elect Obama is making appointments that are giving financial market participants some hope. Even though there is still a long, difficult road ahead of us…we will gravitate toward any sign of positive leadership that is available and hang on to the hope that is present in the possibility that that leadership will take us where we need to go!
Monday, September 15, 2008
Fundamentals 101
Mase: Economics and Finance. September 15, 2008
Fundamentals 101
The United States (and the world) is in a crisis mode. It will continue to stay in a crisis mode for some time. In working through this transition period it is crucial to remember…that fundamentals are important.
Americans are always ones for sports analogies. Let’s start with the need to develop fundamentals. We emphasize the fundamentals of the golf swing in golf. We emphasize the fundamentals of hitting a baseball in baseball. We emphasize the fundamentals in football…and so on and so on.
But, in finance and economics we constantly reflect upon a new economics, a new era in finance, and a new…whatever. We keep finding reasons to believe that we have entered some new period that negates part or all that we have learned. And, when we follow this path, we always end up finding out that…well…that the fundamentals really do still apply.
We can certainly blame the leaders of the corporate world of finance and industry for their putting the fundamentals of finance aside in their quest to become the biggest and “the best”. (What “the best” means we will save for another time.) All I will say here and now is that they were followers…not leaders…and that led to the downfall of those that have failed or will fail.
The leaders I have most scorn for at the present time are those leaders that created the atmosphere…the culture…in which others had to operate. These leaders completely ignored the economic and financial fundamentals that have, over time, proven to be so important in performance. And, the leaders I am talking about here are the political leaders that “set the table” for the period of upheaval that we are now going through.
The number one fundamental that must be adhered to is the one that relates to the value of the currency of a country. The leaders of a country must not…let me repeat…must not…let the value of its currency decline precipitously. I am not talking about slavishly keeping the value of a currency at a particular price. History has shown that this kind of policy does not work either.
Focus upon the value of ones currency causes one to focus upon what your country is doing relative to what other countries are doing. Many people do not like this thought because it seems to make the economic and financial policy of our country dependent upon what everyone else is doing. These people do not want to give up their sovereignty.
The problem with acting independently of everyone else is…we are not independent of everyone else! We live in a world where everyone else is dependent upon everyone else…whether we like it or not!
First finger pointed in blame…the Bush 43 administration. It came into office believing that the United States was so special that it could act unilaterally on anything it chose…it acted that way.
Second finger pointed in blame…Alan Greenspan and the Federal Reserve System. Whether or not they claim that they were paying attention to the value of the United States Dollar they did not act as if the value of the dollar was of any interest to them. They allowed the dollar to decline in value for about seven years. The value of a country’s foreign currency is the NUMBER ONE price that a central bank needs to focus upon!
Why, does a central bank need to focus on the value of its currency in foreign exchange markets? It is because the value of the currency provides information about how market participants are perceiving the economic policy of a specific country vis-Ã -vis other countries. Sure, the markets can be wrong in the short term, but over seven years the markets must contain some pieces of information that are not totally off-the-charts in terms of what is going on.
This is an important fundamental...pay attention to the value of your currency in foreign exchange markets.
But, Greenspan has argued that the Federal Reserve HAD to keep interest rates low because WITH THE BUSH TAX CUTS, FINANCING OF THE DEFICITS WOULD HAVE FORCED INTEREST RATES UP AND THIS WOULD HAVE CAUSED SLOWER ECONOMIC GROWTH!
But, that is why central banks are supposedly independent of the government of a nation.
Greenspan acted as if the Federal Reserve was nothing but a lackey of the Bush Administration!
If the Federal Reserve had acted as a real independent central bank…
Well, it didn’t…and see where it got us.
I am writing these things because we are currently in the midst of a presidential campaign. My concern is that not one of the candidates is addressing the real economic issues that the country faces. Furthermore, I don’t believe that they will before the election in November. This is due to the fact that neither of the major candidates wants to discuss the fundamentals that need to be re-addressed if the country is to get back on its feet. People want to hear what the candidates are going to do for them and not what fundamentals need to be re-established.
First, let me say that I believe that we are going to get through the current period of financial dislocations…there will still be failures, maybe even some large ones…but, we will get through this adjustment in the next eighteen months or so.
The concern seems to be growing that the economic problem will be one of stagflation. Let me just say here that the fundamentals of supply and demand analysis has not been surpassed. The problem with stagflation is that economic growth is slower than desired and that inflation is higher than desired.
NOTE: this is not a DEMAND-SIDE problem, IT IS A SUPPLY SIDE PROBLEM! ! !
Just goosing up aggregate demand with popular economic stimulus programs will not overcome the problem. Focusing just on demand-side solutions will only exacerbate, and not relieve the situation.
So, here is a fundamental teaching that we must not ignore.
Second, we live in an inter-dependent world. The United States cannot…repeat, cannot…just go off on its own and act unilaterally. We must talk with others. We must devise out programs, both economic and financial, within the context of what other nations are doing. Yes, this sacrifices some of our valued independence, but that is the way the world is. We must plan and live in such an inter-dependent world.
Here is another fundamental teaching that we must not ignore.
Third, the Federal Reserve must regain its independence once again. It must focus on what it should focus upon, the value of the United States dollar, and if other areas of the government cannot do what they want to do…then sorry, but this is the discipline that a real central bank bring to its nation.
This fundamental teaching cannot…let me repeat…cannot be ignored!
Fundamentals 101
The United States (and the world) is in a crisis mode. It will continue to stay in a crisis mode for some time. In working through this transition period it is crucial to remember…that fundamentals are important.
Americans are always ones for sports analogies. Let’s start with the need to develop fundamentals. We emphasize the fundamentals of the golf swing in golf. We emphasize the fundamentals of hitting a baseball in baseball. We emphasize the fundamentals in football…and so on and so on.
But, in finance and economics we constantly reflect upon a new economics, a new era in finance, and a new…whatever. We keep finding reasons to believe that we have entered some new period that negates part or all that we have learned. And, when we follow this path, we always end up finding out that…well…that the fundamentals really do still apply.
We can certainly blame the leaders of the corporate world of finance and industry for their putting the fundamentals of finance aside in their quest to become the biggest and “the best”. (What “the best” means we will save for another time.) All I will say here and now is that they were followers…not leaders…and that led to the downfall of those that have failed or will fail.
The leaders I have most scorn for at the present time are those leaders that created the atmosphere…the culture…in which others had to operate. These leaders completely ignored the economic and financial fundamentals that have, over time, proven to be so important in performance. And, the leaders I am talking about here are the political leaders that “set the table” for the period of upheaval that we are now going through.
The number one fundamental that must be adhered to is the one that relates to the value of the currency of a country. The leaders of a country must not…let me repeat…must not…let the value of its currency decline precipitously. I am not talking about slavishly keeping the value of a currency at a particular price. History has shown that this kind of policy does not work either.
Focus upon the value of ones currency causes one to focus upon what your country is doing relative to what other countries are doing. Many people do not like this thought because it seems to make the economic and financial policy of our country dependent upon what everyone else is doing. These people do not want to give up their sovereignty.
The problem with acting independently of everyone else is…we are not independent of everyone else! We live in a world where everyone else is dependent upon everyone else…whether we like it or not!
First finger pointed in blame…the Bush 43 administration. It came into office believing that the United States was so special that it could act unilaterally on anything it chose…it acted that way.
Second finger pointed in blame…Alan Greenspan and the Federal Reserve System. Whether or not they claim that they were paying attention to the value of the United States Dollar they did not act as if the value of the dollar was of any interest to them. They allowed the dollar to decline in value for about seven years. The value of a country’s foreign currency is the NUMBER ONE price that a central bank needs to focus upon!
Why, does a central bank need to focus on the value of its currency in foreign exchange markets? It is because the value of the currency provides information about how market participants are perceiving the economic policy of a specific country vis-Ã -vis other countries. Sure, the markets can be wrong in the short term, but over seven years the markets must contain some pieces of information that are not totally off-the-charts in terms of what is going on.
This is an important fundamental...pay attention to the value of your currency in foreign exchange markets.
But, Greenspan has argued that the Federal Reserve HAD to keep interest rates low because WITH THE BUSH TAX CUTS, FINANCING OF THE DEFICITS WOULD HAVE FORCED INTEREST RATES UP AND THIS WOULD HAVE CAUSED SLOWER ECONOMIC GROWTH!
But, that is why central banks are supposedly independent of the government of a nation.
Greenspan acted as if the Federal Reserve was nothing but a lackey of the Bush Administration!
If the Federal Reserve had acted as a real independent central bank…
Well, it didn’t…and see where it got us.
I am writing these things because we are currently in the midst of a presidential campaign. My concern is that not one of the candidates is addressing the real economic issues that the country faces. Furthermore, I don’t believe that they will before the election in November. This is due to the fact that neither of the major candidates wants to discuss the fundamentals that need to be re-addressed if the country is to get back on its feet. People want to hear what the candidates are going to do for them and not what fundamentals need to be re-established.
First, let me say that I believe that we are going to get through the current period of financial dislocations…there will still be failures, maybe even some large ones…but, we will get through this adjustment in the next eighteen months or so.
The concern seems to be growing that the economic problem will be one of stagflation. Let me just say here that the fundamentals of supply and demand analysis has not been surpassed. The problem with stagflation is that economic growth is slower than desired and that inflation is higher than desired.
NOTE: this is not a DEMAND-SIDE problem, IT IS A SUPPLY SIDE PROBLEM! ! !
Just goosing up aggregate demand with popular economic stimulus programs will not overcome the problem. Focusing just on demand-side solutions will only exacerbate, and not relieve the situation.
So, here is a fundamental teaching that we must not ignore.
Second, we live in an inter-dependent world. The United States cannot…repeat, cannot…just go off on its own and act unilaterally. We must talk with others. We must devise out programs, both economic and financial, within the context of what other nations are doing. Yes, this sacrifices some of our valued independence, but that is the way the world is. We must plan and live in such an inter-dependent world.
Here is another fundamental teaching that we must not ignore.
Third, the Federal Reserve must regain its independence once again. It must focus on what it should focus upon, the value of the United States dollar, and if other areas of the government cannot do what they want to do…then sorry, but this is the discipline that a real central bank bring to its nation.
This fundamental teaching cannot…let me repeat…cannot be ignored!
Wednesday, June 4, 2008
Economic and Financial Power and Leverage
In my post of Thursday, May 29, “Finance, Credit Cards, and the Fed: Three Comments” I made reference to “the loss of respect for the field of finance.” Given some of the comments I have received on this subject over the past week I want to follow up with what, I think, is crucial in understanding the role of finance in the world and how strong leadership in the field of finance is necessary if the goals and objectives of companies and governments are to be achieved. I am willing to accept the criticism that I am saying nothing new and that my comments are so fundamental that they can just be skimmed over before moving on to something more important. The problems that accompany an attitude like this are that they lead to ignoring these fundamentals and the “something more important” cannot really be attained if the fundamentals are ignored.
Finance is secondary to what companies and governments do, including financial companies. Strong financial leadership facilitates and allows companies and governments to focus on what they should be focusing on…the goals and objectives of the company or the government. Weak financial leadership ultimately can result in companies and governments losing their focus because they have to deal with financial dislocations…that is, they have to put out fires and engage in restructurings. Strong financial leadership should contribute to what it is that the company or government does best because a strong financial position enhances the power and leverage a company or government already has achieved. Weak financial leadership reduces and then often overcomes whatever position of strength a company or government has attained.
On a personal level, I have had the opportunity to lead several successful turnaround situations in the financial industry. In all cases I can say that weak financial leadership either caused the difficulty the company faced or exacerbated the results due to the other bad decisions that were being made in the organization. In order to turn these companies around it was necessary to get the financial affairs of the company “under control” so that the organization could “re-focus” on what it could do best. In terms of banking organizations, the re-focusing had to do with becoming a financial intermediary once again. That is, although the institutions were “financial” institutions, their major business was “intermediating” between borrowers and depositors. Re-establishing strong financial fundamentals allowed management to direct its focus to the things that made the banks competitive in their markets.
It is, of course, very easy for managements to lose focus when there seem to be incentives that can “add” to the performance of an organization by dabbling in extra-curricular financial adventures. But, should H & R Block really have been dealing in subprime mortgages? The argument had been given that H & R Block needed to offset the slowing down of it tax-preparation business, but what did it know of the subprime mortgage market? The incentives of making such a move seem so obvious to a management, however, and it is always hard to maintain one’s focus and discipline in the face of such incentives. One has to ask, in retrospect, why the management of H & R Block didn’t keep its focus and re-tool its business model. Where could H & R Block have built on what it did best rather than explore areas it had little or no knowledge of. Maybe, in the face of the competition coming from the Internet, an organization like H & R Block could not sustain the competitive advantage it once held. But, that is another problem. The difficulty that a firm faces is that once management moves away from its primary business it is very hard to reverse the momentum.
Another example pertains to the use of debt and the exorbitant reliance on leverage. For example, we are told over and over again that the only way to make any real money in many arbitrage opportunities where only small spreads exist is to massively leverage a position so as to magnify the returns on a deal. And, of course, the nature of the arbitrage cannot be revealed because if everyone knew about the deal, the spreads would go away. Well, massive arbitrage bets make the spreads go away and raise the question as to whether or not trading really produces, on average, positive returns over time. Also, one has to ask the question about whether or not situations of asymmetric information are really that plentiful in an environment where information is readily available and “super crunching” is becoming ubiquitous. To me, strong financial leadership can stand the glare of openness and transparency.
Governments can also exhibit weak financial leadership which can contribute to a nation’s loss of power within the world community and a lessening of its influence in international relationships. Financial markets can lose confidence in the administration of a country if that administration loses its fiscal discipline. This loss of confidence can result in a consequent decline in the value of a nation’s currency. A depreciating currency weakens the economic position of the country relative to the other countries it trades with. This position of weakness either reduces the other strengths a nation might possess in the world, or, it can exacerbate the problems being created in other areas due to poor government decisions. Strong financial leadership within the government of a country can contribute to the respect and influence a nation has in the world community. Strong financial leadership within a government enhances the other economic strengths that the nation possesses.
There are many other areas where financial leadership can have an influence on the power and leverage a company or government has relative to other companies or governments. Strong financial leadership does not allow financial issues to dominate those things that a company or government should be doing. Strong financial leadership can contribute to the position a company or government can achieve because it allows that company or government to relate to others from a position of strength, a position where the company or government can really do what it does best…and back it up. And, that is what a company or government should do…focus on what it can do best!
I believe that this sermon is especially necessary at this time because of the impending change in the leadership of the government of the United States. I believe that a new administration in Washington, D. C. must exhibit strong financial leadership based on sound fundamental financial practices. I believe in this for two reasons. First, it is important for the United States to re-establish itself as a world leader. Times have changed and although the United States never lost its position as the only superpower in the world, its relative position has changed in that several other nations have economically become much stronger. (See my post of Thursday, May 22, “The World Has Changed. When will America Realize It?”)
Secondly, other leaders within the United States tend to emulate the culture established by the President and his administration. If the government does not follow sound financial principals it sends signals out to the rest of the community that it is not necessary for those within the community to pursue sound financial principals either. In fact, if the government does not follow sound financial principals, it can be expected that incentives will change and it will become more beneficial, at least for a while, for the rest of the community to become less disciplined as well.
In the current campaign for the Presidency, both candidates are presenting programs that lack any appearance of fiscal or monetary discipline. The talk is about tax cuts, universal health coverage, and other programs that resonate with the electorate. This is not unexpected. As a historical example, Bill Clinton ran on such a platform in 1992. Fortunately, after became President, he had an advisor that argued that these programs would just have to wait until the government got its fiscal affairs under control and saw the value of the dollar strengthen. Fortunately, Bill Clinton listened to this advisor. The question is, does either of the candidates have such an advisor at the present time? And, if so, will that candidate listen to the advisor once he becomes the new President? In my view, financial discipline will have to be re-established at some time…the ultimate question is…when will it be done?
Finance is secondary to what companies and governments do, including financial companies. Strong financial leadership facilitates and allows companies and governments to focus on what they should be focusing on…the goals and objectives of the company or the government. Weak financial leadership ultimately can result in companies and governments losing their focus because they have to deal with financial dislocations…that is, they have to put out fires and engage in restructurings. Strong financial leadership should contribute to what it is that the company or government does best because a strong financial position enhances the power and leverage a company or government already has achieved. Weak financial leadership reduces and then often overcomes whatever position of strength a company or government has attained.
On a personal level, I have had the opportunity to lead several successful turnaround situations in the financial industry. In all cases I can say that weak financial leadership either caused the difficulty the company faced or exacerbated the results due to the other bad decisions that were being made in the organization. In order to turn these companies around it was necessary to get the financial affairs of the company “under control” so that the organization could “re-focus” on what it could do best. In terms of banking organizations, the re-focusing had to do with becoming a financial intermediary once again. That is, although the institutions were “financial” institutions, their major business was “intermediating” between borrowers and depositors. Re-establishing strong financial fundamentals allowed management to direct its focus to the things that made the banks competitive in their markets.
It is, of course, very easy for managements to lose focus when there seem to be incentives that can “add” to the performance of an organization by dabbling in extra-curricular financial adventures. But, should H & R Block really have been dealing in subprime mortgages? The argument had been given that H & R Block needed to offset the slowing down of it tax-preparation business, but what did it know of the subprime mortgage market? The incentives of making such a move seem so obvious to a management, however, and it is always hard to maintain one’s focus and discipline in the face of such incentives. One has to ask, in retrospect, why the management of H & R Block didn’t keep its focus and re-tool its business model. Where could H & R Block have built on what it did best rather than explore areas it had little or no knowledge of. Maybe, in the face of the competition coming from the Internet, an organization like H & R Block could not sustain the competitive advantage it once held. But, that is another problem. The difficulty that a firm faces is that once management moves away from its primary business it is very hard to reverse the momentum.
Another example pertains to the use of debt and the exorbitant reliance on leverage. For example, we are told over and over again that the only way to make any real money in many arbitrage opportunities where only small spreads exist is to massively leverage a position so as to magnify the returns on a deal. And, of course, the nature of the arbitrage cannot be revealed because if everyone knew about the deal, the spreads would go away. Well, massive arbitrage bets make the spreads go away and raise the question as to whether or not trading really produces, on average, positive returns over time. Also, one has to ask the question about whether or not situations of asymmetric information are really that plentiful in an environment where information is readily available and “super crunching” is becoming ubiquitous. To me, strong financial leadership can stand the glare of openness and transparency.
Governments can also exhibit weak financial leadership which can contribute to a nation’s loss of power within the world community and a lessening of its influence in international relationships. Financial markets can lose confidence in the administration of a country if that administration loses its fiscal discipline. This loss of confidence can result in a consequent decline in the value of a nation’s currency. A depreciating currency weakens the economic position of the country relative to the other countries it trades with. This position of weakness either reduces the other strengths a nation might possess in the world, or, it can exacerbate the problems being created in other areas due to poor government decisions. Strong financial leadership within the government of a country can contribute to the respect and influence a nation has in the world community. Strong financial leadership within a government enhances the other economic strengths that the nation possesses.
There are many other areas where financial leadership can have an influence on the power and leverage a company or government has relative to other companies or governments. Strong financial leadership does not allow financial issues to dominate those things that a company or government should be doing. Strong financial leadership can contribute to the position a company or government can achieve because it allows that company or government to relate to others from a position of strength, a position where the company or government can really do what it does best…and back it up. And, that is what a company or government should do…focus on what it can do best!
I believe that this sermon is especially necessary at this time because of the impending change in the leadership of the government of the United States. I believe that a new administration in Washington, D. C. must exhibit strong financial leadership based on sound fundamental financial practices. I believe in this for two reasons. First, it is important for the United States to re-establish itself as a world leader. Times have changed and although the United States never lost its position as the only superpower in the world, its relative position has changed in that several other nations have economically become much stronger. (See my post of Thursday, May 22, “The World Has Changed. When will America Realize It?”)
Secondly, other leaders within the United States tend to emulate the culture established by the President and his administration. If the government does not follow sound financial principals it sends signals out to the rest of the community that it is not necessary for those within the community to pursue sound financial principals either. In fact, if the government does not follow sound financial principals, it can be expected that incentives will change and it will become more beneficial, at least for a while, for the rest of the community to become less disciplined as well.
In the current campaign for the Presidency, both candidates are presenting programs that lack any appearance of fiscal or monetary discipline. The talk is about tax cuts, universal health coverage, and other programs that resonate with the electorate. This is not unexpected. As a historical example, Bill Clinton ran on such a platform in 1992. Fortunately, after became President, he had an advisor that argued that these programs would just have to wait until the government got its fiscal affairs under control and saw the value of the dollar strengthen. Fortunately, Bill Clinton listened to this advisor. The question is, does either of the candidates have such an advisor at the present time? And, if so, will that candidate listen to the advisor once he becomes the new President? In my view, financial discipline will have to be re-established at some time…the ultimate question is…when will it be done?
Thursday, May 29, 2008
Finance, Credit Cards, and the Fed: Three Comments
In today’s post, I want to reflect on three different subjects, all of which have some relationship with one another. These three subjects are (1) the loss of respect for the field of finance; (2) the increase in credit card losses and the numbers game; and (3) politics and the Federal Reserve.
The Loss of Respect for the Field of Finance
I am concerned that the field of finance has lost…is losing…respect in the world. As finance has come more and more under the sway of “financial engineering” it has lost its ability to lead. To present a simplistic view of this situation, I would argue that in the past, people controlled the numbers. In the current situation, numbers are controlling people. I am not against the use of numbers and I am not against the use of highly sophisticated mathematical/statistical models. (I have a background in mathematics and statistics.) The problem is that because of the sophistication and complexity of the models, they tend to be allowed to run on their own. The assumptions used to build the models are usually chosen to make mathematical manipulation as easy as possible and are dependent upon the historical record. These models are fallible!
Judgment and leadership are still needed in finance and this means that CEOs and Fund Managers must live up to the responsibilities placed upon them. They are to be held accountable and thus they must exercise their authority over those that build models and make investment decisions. If those in charge continue to fail to “be in charge” we will find that the financial system will continue to be fragile and the need for increased legislation and regulation will become a reality. Control will be exercised…either internally, within the financial firm…or externally from the government.
The Increase in Credit Card Losses
Credit card losses are on the rise. We have information from some of the major issuers so far and the news is not good. J.P. Morgan’s chief executive James Dimon has given us a peak of the future charge offs at his bank and the trend is definitely upwards. In April, J. P. Morgan wrote off 4.5% of its credit card loans and is forecasting losses to rise above 5% this year and 6% next year. This is up from a charge of 3.8% in April 2007.
But this is not so bad…Citigroup wrote off 5.7% in April, up from 4.1% in April 2007 while Bank of America charged off 6.9% last month, up from 5.4% a year earlier.
The credit card industry has always been a numbers game. That is, the more credit cards a bank issues, the more the percentage loss centers around a particular figure. The credit scoring is designed so that, on average, an issuer will achieve an “acceptable” rate of charge offs given the interest rates and fees that they charge their customers. The assumption is that the distribution of actual percentage losses will approximate a normal distribution with a relatively small variance around the expected mean of the percentage charge offs.
This approach works relatively well when there are not major disturbances to financial markets or the economy. However, when a major disturbance comes along…as we are going through right now…there is evidence that the assumption about the potential percentage losses being normally distributed is not the case. The evidence points to the possibility that the distribution tends to be skewed toward greater losses with the tail being relatively “fat”. That is, the probability of more extreme results is higher than is captured in a normal distribution of possible outcomes. The consequence is that the losses during major disturbances are greater than planned for and, hence, the provision for potential losses is less than adequate. This, of course, has implications for the bank’s capital position.
It seems to me that this attitude has prevailed at many of the larger financial institutions recently. The “numbers game” has been applied to other areas of lending, mortgages, student loans, equity lines, small business loans, and so forth, and we are now reaping the results of such an approach to lending. Having a large numbers of loans does not protect you all of the time because the assumptions of the statistical tests tied to the historical data sets do not conform with the way the world seems to work. When you have very few data points that relate to extreme outcomes you are always going to under estimate the probability that these events will occur.
The “numbers game” does not overcome the deficiencies of poor credit underwriting standards.
Politics and the Federal Reserve
Frederic Mishkin has resigned from the Board of Governors of the Federal Reserve System, effective August 31, 2008. It seems to me that this resignation has tremendous implications for the future of the Federal Reserve System and the functions it is to perform!
The United States has just gone through a significant liquidity crisis and the Federal Reserve has stepped in to prevent the collapse of a major investment banking organization, Bear Stearns. There is an ongoing crisis in the mortgage market along with a slowdown in the sales in the housing market coupled with a drastic reduction in housing prices. And, there are still major concerns about the revaluation of assets, both in US financial institutions, but also in many other financial institutions around the world.
There have been calls for bail outs, new legislation pertaining to financial activity, and modernizing the regulatory system. The Federal Reserve is at the center of all of this turmoil.
Thus, who controls the Board of Governors of the Federal Reserve System is going to have a lot of say about the future of the financial system and the role the Federal Reserve is going to play within that future. Most ideas that have been floated around have given the Fed broader scope and greater powers in the reconstructed financial network. Who controls the Board of Governors is very, very important!
Christopher Dodd, a Democrat from Connecticut, is the chairman of the Senate Banking Committee. This committee is charged with reviewing the nominations for Governors of the Fed. With the Mishkin resignation, of the seven positions on the Board, three members will be missing and one current member is unconfirmed. The delays in three of these positions have been for more than one year.
Is politics playing a role in this confirmation process?
With the odds in favor of a Democrat being elected as the next President, these four positions are obviously “in play”. Whereas the Republican chosen nominees tend to be more “free-market” types and hence at odds with the Democratic majority, a Democratic President, it is assumed, would be more likely to nominate persons in favor of greater oversight and firmer control of the financial system. This opportunity to appoint a majority of the Governors at one stroke seems too good to pass up.
Two points here: first, a central bank is supposed to have as its major focus the state of the economy and the inflation rate; second, heaping more and more responsibilities on the Fed just diffuses this focus. Already, participants in international financial markets believe that the Fed is not playing by the same rules as are other nations in terms of its lack of focus on inflation. Making the Fed more attentive to current political mood swings is not the way to help the United States live up to its responsibilities in the world.
The Loss of Respect for the Field of Finance
I am concerned that the field of finance has lost…is losing…respect in the world. As finance has come more and more under the sway of “financial engineering” it has lost its ability to lead. To present a simplistic view of this situation, I would argue that in the past, people controlled the numbers. In the current situation, numbers are controlling people. I am not against the use of numbers and I am not against the use of highly sophisticated mathematical/statistical models. (I have a background in mathematics and statistics.) The problem is that because of the sophistication and complexity of the models, they tend to be allowed to run on their own. The assumptions used to build the models are usually chosen to make mathematical manipulation as easy as possible and are dependent upon the historical record. These models are fallible!
Judgment and leadership are still needed in finance and this means that CEOs and Fund Managers must live up to the responsibilities placed upon them. They are to be held accountable and thus they must exercise their authority over those that build models and make investment decisions. If those in charge continue to fail to “be in charge” we will find that the financial system will continue to be fragile and the need for increased legislation and regulation will become a reality. Control will be exercised…either internally, within the financial firm…or externally from the government.
The Increase in Credit Card Losses
Credit card losses are on the rise. We have information from some of the major issuers so far and the news is not good. J.P. Morgan’s chief executive James Dimon has given us a peak of the future charge offs at his bank and the trend is definitely upwards. In April, J. P. Morgan wrote off 4.5% of its credit card loans and is forecasting losses to rise above 5% this year and 6% next year. This is up from a charge of 3.8% in April 2007.
But this is not so bad…Citigroup wrote off 5.7% in April, up from 4.1% in April 2007 while Bank of America charged off 6.9% last month, up from 5.4% a year earlier.
The credit card industry has always been a numbers game. That is, the more credit cards a bank issues, the more the percentage loss centers around a particular figure. The credit scoring is designed so that, on average, an issuer will achieve an “acceptable” rate of charge offs given the interest rates and fees that they charge their customers. The assumption is that the distribution of actual percentage losses will approximate a normal distribution with a relatively small variance around the expected mean of the percentage charge offs.
This approach works relatively well when there are not major disturbances to financial markets or the economy. However, when a major disturbance comes along…as we are going through right now…there is evidence that the assumption about the potential percentage losses being normally distributed is not the case. The evidence points to the possibility that the distribution tends to be skewed toward greater losses with the tail being relatively “fat”. That is, the probability of more extreme results is higher than is captured in a normal distribution of possible outcomes. The consequence is that the losses during major disturbances are greater than planned for and, hence, the provision for potential losses is less than adequate. This, of course, has implications for the bank’s capital position.
It seems to me that this attitude has prevailed at many of the larger financial institutions recently. The “numbers game” has been applied to other areas of lending, mortgages, student loans, equity lines, small business loans, and so forth, and we are now reaping the results of such an approach to lending. Having a large numbers of loans does not protect you all of the time because the assumptions of the statistical tests tied to the historical data sets do not conform with the way the world seems to work. When you have very few data points that relate to extreme outcomes you are always going to under estimate the probability that these events will occur.
The “numbers game” does not overcome the deficiencies of poor credit underwriting standards.
Politics and the Federal Reserve
Frederic Mishkin has resigned from the Board of Governors of the Federal Reserve System, effective August 31, 2008. It seems to me that this resignation has tremendous implications for the future of the Federal Reserve System and the functions it is to perform!
The United States has just gone through a significant liquidity crisis and the Federal Reserve has stepped in to prevent the collapse of a major investment banking organization, Bear Stearns. There is an ongoing crisis in the mortgage market along with a slowdown in the sales in the housing market coupled with a drastic reduction in housing prices. And, there are still major concerns about the revaluation of assets, both in US financial institutions, but also in many other financial institutions around the world.
There have been calls for bail outs, new legislation pertaining to financial activity, and modernizing the regulatory system. The Federal Reserve is at the center of all of this turmoil.
Thus, who controls the Board of Governors of the Federal Reserve System is going to have a lot of say about the future of the financial system and the role the Federal Reserve is going to play within that future. Most ideas that have been floated around have given the Fed broader scope and greater powers in the reconstructed financial network. Who controls the Board of Governors is very, very important!
Christopher Dodd, a Democrat from Connecticut, is the chairman of the Senate Banking Committee. This committee is charged with reviewing the nominations for Governors of the Fed. With the Mishkin resignation, of the seven positions on the Board, three members will be missing and one current member is unconfirmed. The delays in three of these positions have been for more than one year.
Is politics playing a role in this confirmation process?
With the odds in favor of a Democrat being elected as the next President, these four positions are obviously “in play”. Whereas the Republican chosen nominees tend to be more “free-market” types and hence at odds with the Democratic majority, a Democratic President, it is assumed, would be more likely to nominate persons in favor of greater oversight and firmer control of the financial system. This opportunity to appoint a majority of the Governors at one stroke seems too good to pass up.
Two points here: first, a central bank is supposed to have as its major focus the state of the economy and the inflation rate; second, heaping more and more responsibilities on the Fed just diffuses this focus. Already, participants in international financial markets believe that the Fed is not playing by the same rules as are other nations in terms of its lack of focus on inflation. Making the Fed more attentive to current political mood swings is not the way to help the United States live up to its responsibilities in the world.
Thursday, April 3, 2008
The New Environment for Financial Regulation
It seems as if almost everyone agrees that the United States should take a long look at the system that regulates its financial institutions. Many argue for the need to reform or modify the system so as to take account of the existence of new financial instruments and the new, global nature of financial institutions and relationships. However, this is not going to happen overnight. First, we have to get beyond the current period of financial market disarray. Second, we have to elect a new President and a new Congress. Third, we need to have a substantial debate and dialogue concerning the nature of the new regulatory system.
Furthermore, these events are all going to take place within a time period where discipline must be brought to the Federal budget in order to strengthen the value of the United States dollar. (See “What is Possible in the Next Four (Eight) Years?” http://masepoliticalcommentary.blogspot.com/.) It is going to take time to create the ‘new’ regulatory structure and this is not necessarily a bad thing. In fact, it is much to be preferred to a ‘quick fix’ solution. Rushing to implement a new regulatory system is not going to ease the current situation, but we can’t let the discussion of what this system should look like fade away.
There is no doubt that the regulatory system that exists in the United States needs to be reviewed and reconstituted. Much of the existing system goes back to at least the 1930s if not before. Little or nothing in the system relates to the events and innovations of the last ten to fifteen years. And, we still don’t fully understand many of the instruments and the risks that are related to them that have been constructed during this time.
The Treasury plan introduced this week provides us with a starting point. It presents something in black and white that can lead to discussion and dialogue. I think it was smart of the administration to get such a proposal out into the open to foster the interchange that is going to take place. I don’t believe it is anywhere near what will result from such deliberations. But, we had to start somewhere.
That said, I would like to add three points to the discussion that seem to me to be very relevant.
First, we need to be very wary in terms of acting ‘during’ a financial crisis. This seems obvious, but needs to be reiterated over and over again. People tend to over-react in such situations…especially politicians. We don’t fully understand what has happened over the past year or two and what this implies for specific suggestions about the regulatory environment. There are a lot of questions that must be asked and many of them we can’t really articulate at the present time. We need time to reflect on the ramifications connected with the changes that might be selected. A time when emotions are high is not the time to overhaul or revamp the financial regulatory system. We also need to be wary of politicians who like to hog the spotlight during periods such as these and bask in the drama of the situation.
Second, we need to take full consideration of the fact that we are a member of the world financial community and not act in a unilateral fashion. A major reason we are in the current situation is that the Bush administration acted in a unilateral way with regard to its conduct of monetary and fiscal policy (as well as with regard to its conduct of foreign policy). In working through a restructuring of the United States regulatory environment, major thought needs to be given to how a ‘new’ regulatory system will exist within the operation of world financial markets. Any resulting regulatory system that is achieved without including discussions with other nations will not only create further resentment towards the United States, but will not be nearly as effective as it might be. It seems to me that a good start has been made in this direction in the efforts of the Federal Reserve System to bring foreign central banks into the effort to calm world financial markets through a common borrowing facility. The only way a truly effective system can be constructed is with input from the different players in the world’s financial markets.
Third, in developing a regulatory system for financial institutions, consideration must be given to the speed at which new financial innovations are brought to market and the speed at which markets move. Oversight is always ‘after the fact’ and regulatory enforcement is usually slow and cumbersome. This is true in almost all other areas of the modern economy and is not just present in the financial industry. As a consequence, the regulatory system will always lag behind the actions of financial institutions. Thus, the evolution of the regulatory system must be more toward a ‘principles-based system’ rather than just a ‘rules based system.’ People and organizations respond to incentives and a ‘rules-based system’ tends to create incentives for people and organizations to work around or create new instruments or structures to avoid the existing rules. This not only is costly to those ‘getting around’ the rules, but it puts a lot of pressure on the regulatory system to ‘catch up’ with these ‘avoiders’. Then, when the regulators do ‘catch up’ with the innovators, the innovators have usually moved on to something else. A ‘principles-based system’ is more concerned with process than it is with specific outcomes or rules and hence avoids this problem.
Regulatory reform of the United States financial system is going to take place in some fashion. Let’s hope that it is achieved with due deliberation and is inclusive, not only of all that are affected in the United States itself, but of those nations that play a role in world financial markets.
Furthermore, these events are all going to take place within a time period where discipline must be brought to the Federal budget in order to strengthen the value of the United States dollar. (See “What is Possible in the Next Four (Eight) Years?” http://masepoliticalcommentary.blogspot.com/.) It is going to take time to create the ‘new’ regulatory structure and this is not necessarily a bad thing. In fact, it is much to be preferred to a ‘quick fix’ solution. Rushing to implement a new regulatory system is not going to ease the current situation, but we can’t let the discussion of what this system should look like fade away.
There is no doubt that the regulatory system that exists in the United States needs to be reviewed and reconstituted. Much of the existing system goes back to at least the 1930s if not before. Little or nothing in the system relates to the events and innovations of the last ten to fifteen years. And, we still don’t fully understand many of the instruments and the risks that are related to them that have been constructed during this time.
The Treasury plan introduced this week provides us with a starting point. It presents something in black and white that can lead to discussion and dialogue. I think it was smart of the administration to get such a proposal out into the open to foster the interchange that is going to take place. I don’t believe it is anywhere near what will result from such deliberations. But, we had to start somewhere.
That said, I would like to add three points to the discussion that seem to me to be very relevant.
First, we need to be very wary in terms of acting ‘during’ a financial crisis. This seems obvious, but needs to be reiterated over and over again. People tend to over-react in such situations…especially politicians. We don’t fully understand what has happened over the past year or two and what this implies for specific suggestions about the regulatory environment. There are a lot of questions that must be asked and many of them we can’t really articulate at the present time. We need time to reflect on the ramifications connected with the changes that might be selected. A time when emotions are high is not the time to overhaul or revamp the financial regulatory system. We also need to be wary of politicians who like to hog the spotlight during periods such as these and bask in the drama of the situation.
Second, we need to take full consideration of the fact that we are a member of the world financial community and not act in a unilateral fashion. A major reason we are in the current situation is that the Bush administration acted in a unilateral way with regard to its conduct of monetary and fiscal policy (as well as with regard to its conduct of foreign policy). In working through a restructuring of the United States regulatory environment, major thought needs to be given to how a ‘new’ regulatory system will exist within the operation of world financial markets. Any resulting regulatory system that is achieved without including discussions with other nations will not only create further resentment towards the United States, but will not be nearly as effective as it might be. It seems to me that a good start has been made in this direction in the efforts of the Federal Reserve System to bring foreign central banks into the effort to calm world financial markets through a common borrowing facility. The only way a truly effective system can be constructed is with input from the different players in the world’s financial markets.
Third, in developing a regulatory system for financial institutions, consideration must be given to the speed at which new financial innovations are brought to market and the speed at which markets move. Oversight is always ‘after the fact’ and regulatory enforcement is usually slow and cumbersome. This is true in almost all other areas of the modern economy and is not just present in the financial industry. As a consequence, the regulatory system will always lag behind the actions of financial institutions. Thus, the evolution of the regulatory system must be more toward a ‘principles-based system’ rather than just a ‘rules based system.’ People and organizations respond to incentives and a ‘rules-based system’ tends to create incentives for people and organizations to work around or create new instruments or structures to avoid the existing rules. This not only is costly to those ‘getting around’ the rules, but it puts a lot of pressure on the regulatory system to ‘catch up’ with these ‘avoiders’. Then, when the regulators do ‘catch up’ with the innovators, the innovators have usually moved on to something else. A ‘principles-based system’ is more concerned with process than it is with specific outcomes or rules and hence avoids this problem.
Regulatory reform of the United States financial system is going to take place in some fashion. Let’s hope that it is achieved with due deliberation and is inclusive, not only of all that are affected in the United States itself, but of those nations that play a role in world financial markets.
Subscribe to:
Comments (Atom)
