Federal Reserve Exit Watch: Part 12

This is the twelfth edition of the Federal Reserve Exit Watch. The first edition was posted in August 2009. The Great Recession, many contend, ended in July 2009 and, at that time, the major task of the Federal Reserve System appeared to be the task of reducing, as judiciously as possible, the massive amount of reserves that the central bank had put into the banking system to combat the threat that the Great Recession might turn into a second Great Depression.

On July 8, 2009 on the Fed’s balance sheet, total factors supplying reserve funds to the banking system totaled over $2.0 trillion, up from around $0.9 trillion one year earlier. It was September of 2008 when the liquidity crisis hit the financial system in the United States which resulted in the rapid injection of funds into the banking system to protect the system from a series of systemic failures. In July 2009, excess reserves in the banking system average around $750 billion.

The concern at that time was that all of these excess reserves in the banking system would eventually end up in the money stock and this would result in inflationary pressures threatening significant increases in consumer and asset prices.

One year later on July 7, 2010, total factors supplying funds to the banking system amounted to about $2.4 trillion. Excess reserves in the banking system totaled more the $1.0 trillion. Obviously, the Federal Reserve System did not remove reserves from the banking system during the past twelve months.

The reason given for not removing reserves from the banking system is that the economy has remained excessively weak: and the Federal Reserve will not start removing reserves from the banking system until the economy seems to be picking up momentum.

My belief has been that the health of the smaller banks in the banking system, those 8,000 or so banks that are smaller than the 25 largest banks, is still not good and the Fed will not begin to remove reserves from the banking system until these non-big banks get in much better shape. With about one in eight banks in the United States on the problem bank list of the FDIC, the banking system is a long ways from being healthy.

And, the Fed has promised that it will continue to keep its target interest rate close to zero “for an extended period” of time. That is, banks should not be afraid of rising short term interest rates any time soon. Many market analysts don’t expect short term interest rates to begin rising until after the start of 2011.

One crucial thing to understand about the operations of the Federal Reserve over the past 12 months is that the injection of funds into the banking system through the fall of 2008 and into the summer of 2009 consisted primarily of “innovative” efforts by the central bank to provide liquidity to specific parts of the money and capital markets. The reserves injected into the financial system were not anything like the classical operations of a central bank which mainly came from the sale or purchase of U. S. Treasury securities in the open market and discount window borrowings from the district Federal Reserve banks.

A major part of the exit strategy of the Fed related to the reduction in these “special” sources of funds and moving back into more traditional forms of central bank operations. Therefore, in the initial stages of the Fed’s exit strategy, efforts were directed at seeing the “special” sources of reserves decline as their needs receded and replacing the reduction in reserves with the purchase of securities from the open market.

The twist in this effort was that the Fed focused, not on the purchase of traditional source of open market securities, U. S. Treasury issues, but on acquiring a lot of mortgage-backed securities, up to $1.250 trillion worth, in order to provide support for the mortgage and housing markets, and on acquiring Federal Agency issues. On July 8, 2009, mortgage-backed securities on the books of the Federal Reserve System totaled about $462 billion. On July 9, 2010, this total reached $1.1 trillion. Federal Agency issues rose from around $98 billion on the earlier date to $165 billion on the latter date. U. S. Treasury securities rose as well, but only by about $104 billion.

Thus, in this 12-month period, total factors supplying reserve balances rose by $341 billion, and the amount of securities the Federal Reserve bought outright rose by $826 billion. The portfolio purchases replaced a lot of the “special” sources of funds supplied to the banking system by the Fed over the past ten months. This was an important part of the Fed’s exit strategy.

So, in the past 12-month period, the Fed actually increased the amount of excess reserves in the banking system. However, in the last 13-week period, excess reserves have actually fallen slightly. One could strongly argue that the decline in excess reserves has come more from operating factors rather than from any overt efforts to reduce bank reserves.

One cause for the reduction in excess reserves was the increase in U. S. Treasury deposits at the Federal Reserve in the Supplementary Financing Account. This is an account set up by the Treasury Department to specifically help the Fed drain reserves from the banking system. (See my post of April 19, 2010, “The Fed’s New Exit Strategy”, http://seekingalpha.com/article/199444-the-fed-s-new-exit-strategy.) During the past 13-week period this account rose by $50 billion, helping to bring down bank reserves. Other operating factors that drained reserves from the banking system was a $12 billion increase in currency in circulation. Also, reducing reserves was a decline in central bank liquidity swaps that fell by about $8 billion during this time period.

Over the past thirteen weeks, these factors draining reserves from the banking system was offset by about $50 billion in Fed acquisitions of mortgage-backed securities.

The net effect of all factors affecting reserve balances: a $50 billion decline in excess reserves.

Over the past four weeks Federal Reserve actions have remained relatively minor. Excess reserves in the banking system fell by about $19 billion, but this primarily resulted from operating transactions like the increase in currency in circulation and a rise in U. S. Treasury balances in the Treasury’s general account which is usually connected with tax receipts. So the last 4-week period can be considered to be uneventful.

One other thing we need to check in this analysis is the behavior of the M1 and M2 measures of the money stock. All that can be said here is that the growth rate of these two measures continues to be modest and actual growth rates have been achieved by people and businesses re-arranging assets rather than from commercial banks making loans. The year-over-year rate of growth of the M1 measure in June was about 6% while the M2 measure rose by only 1.6%.

Note that the non-M1 component of M2 grew by only 0.6% during this time period. This was because, small denomination time deposits at financial institutions have fallen by more than 22% over this time period and Retail Money Funds have dropped by more than 25%. All of these funds seem to have gone into demand deposits, other checkable deposits, and money market deposits, part of M1. This, as I have written before, is not a sign of health in the economy because people continue to transfer funds out of interest-bearing accounts and into forms of money that can be used for spending. This is a sign of desperation not of an improving economy.

A consequence of this has been that the required reserves at commercial banks have continued to rise so that the Federal Reserve must increase the total reserves in the banking system so as to keep excess reserves constant.

One other measure reflecting this shift in assets: monies in Institutional Money Funds have also fallen by 25% year-over-year.

The conclusion to this Exit Watch report is that the Federal Reserve HAS NOT YET started taking reserves from the banking system. That is, over the past year the Fed has not, if fact, exited. And, people and businesses in the aggregate still need to reduce their portfolios of invested funds in order to have money available for spending on their daily needs.

This Issue Is Debt! Too Much of It!

Going forward…the primary issue the world is going to have to face is debt…lots and lots of debt. Debt is clogging the blood vessels of the world financial system!

And the proposal to get us out of this dilemma?

Create even more debt!

If the problem is too much debt then the economy has to go through the pain of working this debt off…and this is called a debt/deflation. As people and companies and government reduce the amount of debt on their balance sheets they withdraw from the spending stream…and save…exactly what people and companies and governments are doing at the present time. But, removing spending from the spending stream reduces the demand for goods and services, causes firms to cut people from their employee rolls…and creates a downward spiral in economic activity. The economy engages in cumulative behavior and gets deeper and deeper into a hole.

This is what the people and the government want to avoid…if possible.

The Obama stimulus proposal is a way to get us out of the current economic crisis.
(There is another way that I will discuss below.) Basically, it is an attempt to inflate our way out of all the debt that exists. The Federal Reserve is doing its part in trying to pump up the amount of cash that exists within the system. But, creating money in this way takes time for the inflation to work its way through the system because it must go through banks and other financial organizations. And, this system, right now, seems to be functioning at a very low level.

Keynes saw this problem in the 1930s and proposed a way of getting around the banking and financial systems…create massive amounts of government expenditures and put this spending directly in the economic system…financing the deficits with government debt. Then, as the economic system starts to turnaround and pick up steam…the banking and financial system will pick up some steam and provide the “kicker” to create the inflationary environment needed to reduce the real value of the debt that had been built up…including the debt the government deficit spending just added to the pile.

Therefore, the first way to reduce the amount of debt that is outstanding in the economy is to create more debt so as to un-clog the banking and financial system…create an inflationary environment…and watch the “real value” of the debt decline.

This is a long term process and has several problems to face along the way. One of these is the question of how much spending should the government undertake? The issue here is about what the “multiplier” of government spending really is. I treated this in a post on January 26, 2009, titled “What will be the impact of Obama’s stimulus plan, http://seekingalpha.com/article/116414-what-will-be-the-impact-of-obama-s-stimulus-plan. Another question has to do with the process of enacting the stimulus plan into law. This I treated in a post on February 2, 2009, titled “the Obama Stimulus plan: Why I’m Concerned”, http://seekingalpha.com/article/117878-the-obama-stimulus-plan-why-i-m-concerned.

However, the ultimate issue relates to the amount of debt that is outstanding…in the United States…and in the world. If the amount of debt HAS to be reduced…and it must be reduced in order to get the economy functioning again…then, following this approach, inflation must take place to reduce the real value of the debt. The danger with this plan is that if inflation is not cut off at some time in the future, the incentives in the economy will be to return to a “go-right-on” and “business-as-usual” approach to living. That is…we will be right back where we were around the middle of this decade, where leverage was good and more leverage was even better, especially within an inflationary environment where things need to be kept “pumped up”! If this happens, we will still be addicted and still have the “monkey on our backs.”

Another way to reduce the amount of debt outstanding in the economy is to basically “write down” or “re-write” the debt and not create any more through an enormous fiscal stimulus plan like that proposed by the Obama administration. This would involve a massive restructuring of existing business balance sheets…both financial institutions as well as non-financial institutions. Insolvent institutions…including the auto companies…need to be recognized as such. In effect, existing shareholders in these companies have lost their investment…so much for good governance and oversight. Bondholders will have to accept an exchange…taking “new” debt at, say, 75% or 50% of the current face value…or preferred shares for the debt they hold…or taking an equity position in the company…maybe even warrants.

These exchanges would have to be negotiated…but the bondholders would have to understand that, as things now stand, the companies are insolvent and they could get nothing if the restructuring does not take place. Plus, the companies or the bondholders…or the public…really does not want the government to take over these institutions. We do not want state-run companies…financial or non-financial…because the fate of the nation would be much worse with a nationalization of industry than it would with an imposed “re-structuring” of the balance sheets of these businesses…financial and non-financial.

In terms of the consumer…a similar thing would have to take place. The major concern has been related to the housing sector and mortgages. But, we are now seeing a massive wave approaching of defaults on credit cards, car loans, and other types of debt that the consumer has taken on. Similar to the re-structuring of the business sector, the balance sheets of consumers must be re-structured. How we do this cannot really be discussed in this short post, but the idea would be that organizations that have extended credit to the consumer sector will have to take a haircut on the amount of debt that is owed by each consumer and the terms of repayment will have to be restructured in order to make the probability of repayment of the debt realistic. Again, this re-structuring would have to be negotiated…but we are talking here about much lower costs than would accumulate if there were more foreclosures and bankruptcies…more lawyers’ fees…and more costs all the way around. And, this could be done in a much shorter period of time than if all these bad assets had to be “worked out”.

I have given two extreme solutions to the problem of the debt overhang. The fundamental crisis is connected with the fact that there is too much debt in the system. For the system to work this dislocation out we would have to go through a period of debt-deflation. The two extremes presented here are, first, the Keynesian approach which is to inflate the economy and reduce the real value of the debt, or, second, to impose a debt-restructuring on the economy which would allow for a negotiated reduction in the debt loads of all economic units in the system.

People will really not be happy with either of these extreme solutions…or, for that matter…any combination of the efforts. But, once one loses their discipline, as the United States and the world did in the 2000s…there are no good solutions available to get out of the hole that has been dug. All people can do is to “take their medicine” and vow not to let such a situation ever occur again. However, looking back at history, one cannot be very confident that we will maintain our discipline once we get over the crisis.

I would like to make just one more suggestion. There is only one real change I would like to see to the regulatory structure…for both financial and non-financial firms…and that is the imposition of almost complete openness and transparency of the business and financial records of companies. Whatever a company does…it should be open to its owners…and to anyone else that might be interested.

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.

When Will Banks Begin Lending Again?

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

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

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

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

We continue to receive news that does not bode well for the value of the assets of banks. For example, the front page article in the New York Times trumpets on page one, ”As Vacant Office Space Grows, So Does Lender’s Crisis” (see http://www.nytimes.com/2009/01/05/business/05real.html?_r=1&hp). We have not yet seen the bankruptcies that will follow the miserable holiday season and this will lead to vacancies in the major malls as well as in strip malls. This will lead to further foreclosures and financial stress in real estate where there are already a lot of empty stores. We still have a wave or two to go through in the residential real estate market as the various ‘no doc-no down payment” loans re-price. And, although unemployment began to rise throughout the fall, many expect this trend to accelerate early in 2009 as the business failures and cutbacks start to add up. These movements and others not mentioned will only exacerbate the uncertainty surrounding the value of the asset portfolios of banks.

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

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

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

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

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

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

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

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

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

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

The Need for Discipline

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

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

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

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


Discipline starts at the top…and if the discipline is not there and this lack of discipline spreads…others began to see that “lack of discipline” is the standard of the day and they too began to feast on the beast. And, the lack of discipline spreads throughout the land.

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

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

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

Let me reiterate the statement I made above…

The culture of an organization starts at the top!

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

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

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

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

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

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

But, this effort is going to require leadership and it is going to require leadership at the very top.

On another note, we still have much to be thankful for…so let us give thanks for what we have.

Everyone…have a Happy Thanksgiving!

Mase

The Coming Stimulus Package

Yes, we do have a President (elect)! (See “A Whiff of Leadership?” posted November 22, 2008 at http://maseportfolio.blogspot.com/ . An economic stimulus package is in the works. The underlying philosophy…the risks of not doing something big are bigger than the risks associated with inflation and an economic cleanup when the economy shifts into first gear rather than reverse.

We have seen this attitude taken by the Federal Reserve. The Fed, as we have been writing about in this blog, has not wanted to be short in supplying liquidity to the financial markets. Federal Reserve assets have more than doubled in the past ten weeks. Chairman Ben Bernanke has been given the name Helicopter Ben during this barrage of funds. But, the argument goes, the risk is too great to not put money into the financial system until the financial markets begin to function again.

Liquidity is apparently not going to get the economy humming again…spending of the private sector is going into the tank. Lending in the financial markets is not going to kick-start consumer spending or investment spending…state and local government expenditure is also in decline…so the belief is that the federal government must step into the gap and stimulate incomes and employment.

The talk seems to indicate that the Obama economic stimulus package is going to be somewhere in the neighborhood of $700 billion…of similar size to the bailout package of a couple of months ago. The idea…like that of the bailout package…is that the stimulus package must be a large number.

One thing that is crucial in all of this is that the Obama administration must give off the impression that it is operating under control…that it is disciplined. This is a hard thing to do when the philosophy of the stimulus package is the one described above. However, the administration must appear to be very intentional, on top of the situation, and ready to do what is necessary in response to new information. That is, the Obama administration must rebuild confidence in the federal government. Establishing confidence at the top is necessary because it will help to rebuild the confidence of the whole system as I discuss in “Discipline or the Lack Thereof” posted November 20, 2009, at http://maseportfolio.blogspot.com/.

President-elect Obama seems to be aware of this need to set the tone for the future. I think people, and markets, will respond very well to this because they are so hungry for leadership at this time…and are very, very anxious. So, we see two things going on right now…first, the appointment of top quality people to important positions…and, second, the intentional effort to create programs and get the discussion in Congress and the economy going so that action can be taken as soon as possible. The important emphasis right now is that the effort is intentional, not passive or just reactive.

Just a final note about the apparent appointment of Larry Summers to head the National Economic Council: this may be an inspired choice. No one questions the intelligence and ability of Summers. Being in the White House, acting as the coordinator of the economic policies of the President, monitoring the President’s economic agenda, and serving as close advisor to the President may not only fit his personality best but may be the real place his talents can fill the needs of the nation. It also superbly complements the other appointments that the President-elect has made to build his economic team.

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!

Discipline or the Lack Thereof

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

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

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

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

Oh, how about the American government?

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

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

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

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

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

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

Let me reiterate the statement I made above…

I believe that culture starts at the top!

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

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

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

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

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

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

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

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

Hopefully.

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

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

Why haven't the financial markets responded?

The stock market has experienced a serious decline since the passage of the Paulson Plan. The money and bond markets still seem to be frozen in spite of a coordinated cut in world central bank target rates. The only way that this behavior can be explained in my mind is that without strong leadership…from the very top…the financial markets will continue to be weak. Even though others…Paulson and Bernanke…have tried to provide some form of leadership, the leadership that must be exhibited from the very top continues to be missing. (See my post of September 25, 2008, “The Absence of Leadership.)

Missing this leadership, members of the Bush 43 administration were hoping and praying that events would be relatively quiet until they were able to sneak out of Washington in January 2009 and let someone else handle the situation.
They didn’t make it!

And, like any other organization that does not have a leader, good people with good intentions when faced with calamities try to come up with some plan or some action that will plug the hole in the dike. The problem with this is that they have to work around the leader. And, there is no unifying force present is such situations, no calm hand on the tiller listening to alternatives, asking questions, and guiding responses. And there is no one around to punish dissidents.

Up until a couple of weeks ago, Treasury Secretary Paulson and Fed Chairman Bernanke tried to band aid the system, proposing temporary responses to the growing crises that would tide things over until the new government came into office to deal with the problems. It seemed as if Paulson and Bernanke had reached a game plan…a bailout took place for Fannie and Freddie…and, Lehman was to fail with no help and nothing would be done for AIG.

Then, it appears by all reports…Bernanke reached a turning point!

Bernanke called Paulson and indicated that the financial markets were falling apart and that if nothing were done the economy might not be there the next Monday. The Congressional leadership had to be informed of this development and brought on board for a major flood of liquidity. In no instance could the financial system and the economy come up short of liquidity!
Paulson set up the meeting with the Congressional leadership and at that meeting Bernanke poured out his story of woe. And, according to some of the members of Congress that were there…Bernanke scared the life out of them!

One question needs to be asked at this point…where was the “decider”?

The Treasury plan was assembled as quickly as possible for passage by Congress as quickly as possible…no hearings…really, no questioning…things were so bad that there was no time for these niceties that could take place when things were not so dire.

And, then the financial markets froze!

Why not?

Here was the Chairman of the Board of Governors of the Federal Reserve System saying that the economy might not be there on Monday. What did he know that market participants didn’t? What was going on in Europe and elsewhere? Here was a major case of asymmetric information. And the people that were without information were the suppliers of funds.

Bear Stearns had failed. Merrill Lynch had failed. Fannie and Freddie had failed. Lehman had failed. Washington Mutual had failed. AIG had failed. Wachovia had failed. Who was going to be next? What did the Fed and the Treasury know that market participants didn’t know?

The initial effort to get “the bill” through Congress failed! There was no one in a leadership position that could call the troops to order. (Even presidential candidate John McCain road out at the head of his Calvary to lead the charge to get the bill passed…only no one followed him! No leadership here.) Paulson could not do it…he was not the leader…there was no leader!

The “decider” was marched out…but he was dazed and only mouthed the words that were given. Why should anyone have any confidence in what was being done?

Is the bill passed last Friday any good? After what went on in the two previous weeks the bill seems somewhat irrelevant…a very costly irrelevant. There is still no vision going forward. There is no strategy. There is no structure. There is little or nothing. At best we are told that maybe in four weeks the “Paulson Plan” will be up and running.

That will be after the election and we will have a president-elect. But, the president-elect will have to wait for over two months before he can do anything about the financial crisis.
Meanwhile the Fed floods world financial markets with liquidity?

Bernanke’s study of the Great Depression taught him that during such a crisis the world cannot have too much liquidity. And, so “Helicopter Ben” is acting on that premise. Total reserves in the United States banking system, for the two weeks ending September 10, averaged about $44 billion on a non-seasonally adjusted basis. For the two weeks ending September 24, the total reserve figure was about $111 billion. Never has the United States banking system received so many reserves so rapidly. And look at the sources and uses statement of the Federal Reserve System…the H.4.1 release. In the last three weeks the sources of reserves in the banking system increased by more than 50%!!!!!

Never have we seen anything like this! Never!

This is what happens when there is no leadership. One cannot blame this situation on previous administrations or other conditions within the world. The current leader of the free world is MIA.
Unfortunately for the financial markets, for the economy, for workers, for families, for everyone else…there will not be a new president for several months yet. And, we still have to uncertainty with respect to what the newly elected president will do. Will he, when in office, be able to provide the leadership that is so badly needed?

So, there is still an enormous amount of uncertainty with respect to the future and this enormous amount of uncertainty will reign in the markets until such leadership surfaces. And, the financial markets will still remain tentative as they attempt to discern who will fail next…and then next after that…and then next after that…

The Absence of Leadership is Killing Us!

The absence of leadership in the United States government is costing us…and the rest of the world…dearly! (See my post of September 25, 2008, “The Absence of Leadership.) Many have declared that Bush 43 is MIA. Whatever, there is a void at the top of the current administration…and, we are paying the price for this void!

Without any leadership, members of the Bush 43 administration were hoping and praying that events would be relatively quiet until they were able to sneak out of Washington in January 2009 and let someone else handle the situation.

They didn’t make it!

And, like any other organization that does not have a leader…short of staging a revolution and disposing the top man…good people with good intentions when faced with calamities try to come up with some plan or some action that will plug the hole in the dike.

The problem with this is that they have to work around the leader. And, there is no unifying force present is such situations, no calm hand on the tiller listening to alternatives, asking questions, and guiding responses. And there is no one around to punish dissidents.

Up until a couple of weeks ago, Treasury Secretary Paulson and Fed Chairman Bernanke tried to band aid the system, proposing temporary responses to the growing crises that would tide things over until the new government came into office to deal with the problems. It seemed as if Paulson and Bernanke had reached a game plan…a bailout took place for Fannie and Freddie…and, Lehman was to fail with no help and nothing would be done for AIG.

Then, it appears by all reports…Bernanke panicked!

Bernanke called Paulson and indicated that the financial markets were falling apart and that if nothing were done the economy might not be there the next Monday. The Congressional leadership had to be informed of this development and brought on board for a major flood of liquidity. In no instance could the financial system and the economy come up short of liquidity!

Paulson set up the meeting with the Congressional leadership and at that meeting Bernanke poured out his story of woe. And, according to some of the members of Congress that were there…Bernanke scared the life out of them!

One question needs to be asked at this point…where was the “decider”?

The Treasury plan was assembled as quickly as possible for passage by Congress as quickly as possible…no hearings…really, no questioning…things were so bad that there was no time for these niceties that could take place when things were not so dire.

And, then the financial markets froze!

Why not?

Here was the Chairman of the Board of Governors of the Federal Reserve System saying that the economy might not be there on Monday. What did he know that market participants didn’t? What was going on in Europe and elsewhere? Here was a major case of asymmetric information. And the people that were without information were the suppliers of funds.

Bear Stearns had failed. Merrill Lynch had failed. Fannie and Freddie had failed. Lehman had failed. Washington Mutual had failed. AIG had failed. Wachovia had failed. Who was going to be next? What did the Fed and the Treasury know that market participants didn’t know?

The initial effort to get “the bill” through Congress failed! There was no one in a leadership position that could call the troops to order. (Even presidential candidate John McCain road out at the head of his Calvary to lead the charge to get the bill passed…only no one followed him! No leadership here.) Paulson could not do it…he was not the leader…there was no leader!

The straw-leader was marched out…but he was dazed and only mouthed the words that were given. Why should anyone have any confidence in what was being done?

Is the bill passed Friday any good? After what went on in the two previous weeks the bill seems somewhat irrelevant…a very costly irrelevant. There is still no leadership going forward. There is no vision. There is no structure. There is nothing. At best we are told that maybe in four weeks the “plan” will be up and running.

That will be after the election and we will have a president-elect. But, the president-elect will have to wait for over two months before he can do anything about the financial crisis.

And, what about the Fed?

The Federal Reserve System is flooding the world in liquidity. Bernanke’s study of the Great Depression taught him that during such a crisis the world cannot have too much liquidity. And, so “Helicopter Ben” is acting on that premise. Total reserves in the United States banking system, for the two weeks ending September 10, averaged about $44 billion on a non-seasonally adjusted basis. For the two weeks ending September 24, the total reserve figure was about $111 billion. Never has the United States banking system received so many reserves so rapidly. And look at the sources and uses statement of the Federal Reserve System…the H.4.1 release. In the last three weeks the sources of reserves in the banking system increased by more than 50%!!!!!

Never have we seen anything like this!

This is what happens when there is no leadership. One cannot blame this situation on previous administrations or other conditions within the world. The current leader of the free world is absent.

Unfortunately for the financial markets, for the economy, for workers, for families, for everyone else…there will not be a new president for several months yet. And, we still have to worry that one of the two candidates, when in office, will be able to provide the leadership we need.

We still face uncertainty about our leadership for the future. Therefore, uncertainty will reign in the markets until such leadership surfaces. And, the financial markets will still remain tentative as they attempt to discern who will fail next…and then next after that…and then next after that…

Fundamentals 101 (Part 2)

In my post about fundamentals on September 15, 2008, I started at the top…with the administration that has been in office in Washington, D. C. for almost eight years and the (supposedly) independent Federal Reserve System. My point is that the tone, the environment, the culture of the society starts at the top. And, if the leaders of our government are undisciplined and believe that they can do just about any thing they want to do without considering what others are doing, then this will set the pattern for other leaders within the society. It will pay…at least in the short run…to act in an undisciplined and irresponsible way.

Now, I would like to present what I believe to be some fundamentals for moving forward on the personal or business level. I believe that these fundamentals apply most of the time…the difficulty now is to re-establish them in an ambiguous and chaotic world. But, I am assuming that we will soon get some political leaders that will adhere to some of the fundamentals that were discussed in the previous post…we need an overall environment in which our leaders are disciplined and open.

The first of the personal or business fundamentals I would like to argue for today is for people to minimize the use of debt. The question is asked, “Where should I put my money today? In the stock market? In gold? Where?” My response is, pay off your debt as much as possible. I can think of very few instances today where a person or business can earn more on an investment of cash in something than they can reduce costs by paying down their debt. Plus, reducing debt reduces risk…not a bad thing to do in this environment.

A second fundamental of personal or business behavior is to re-focus and cut back on what one is doing. The tendency in times that are robust and heady is to diversify and stick your hand into a lot of different opportunities. Diversification looks good and enhances ones’ ability to grow and expand. Yet, we see over and over again that having a largely mixed portfolio can cause us to lose focus and, in particular, result in problems related to lack of oversight and a failure at risk management. People and businesses need to shed those things that are not within the scope of their primary interest and capability.

Another fundamental of operation that should be adhered to today is…reduce expenses…use resources more efficiently…especially resources that require a long term or fixed commitment. Not only does this protect cash flows…it also allows for greater flexibility of operations. Again, there is a benefit to performance over time, but there is also a reduction in risk because one can respond more rapidly to a changing environment or surprises.

Furthermore, don’t over produce. In such an environment it is better to have people want more of what you produce than to exceed demand and have to deal with unsold goods or services. As we have seen, an excess supply of anything can only be disposed of at ‘fire sale’ prices. This is not healthy for either the bottom line or for the market’s perception of what you do. If the market sees that customers aren’t buying all you produce, they will focus on the unsold inventory and not on the amount that is purchased. This also applies to financial institutions whose business it is to make loans.

Finally, I can’t stress enough the need for openness and transparency. There are two reasons for this. First, in terms of asymmetric information: in times like these where there is a substantial amount of uncertainty in the air, others will pull back from you if they do not know or understand what you are doing. As a consequence, values can drop and often they can drop precipitously. Being open and transparent about what you do and your problems and how you are attacking them is the best way to attempt to keep relationships alive. People will be more willing to do business with you if they believe you are being up front with them and open in your dealings.

There is a second aspect to openness and transparency that I believe is even more important than the first. This is the effect that a policy of openness and transparency has on your own behavior and the behavior of those that work with you. If you have a policy of keeping things out in the open you and your colleagues will respond more rapidly to problems as they arise and resolve these problems as quickly as you can. If you do this you will do your best to not allow problems to grow and become major issues that result in disruptive solutions.

I know that many of these ‘fundamentals’ seem to be conventional platitudes and are obvious. Sometimes, however, they just need to be restated and re-emphasized so as to bring us back to reality. There are reasons these things are called fundamentals. It is because they have long run survival value.

The problem with acting on these fundamental operational principles is that if a lot of people adhere to them there will be ‘macro’ difficulties for the economy as a whole. The general term given to such aggregate behavior is ‘debt deflation.’ If people reduce the amount of debt outstanding and cut back on producing and spending, the economy will spiral downward.

This was the situation John Maynard Keynes believed the world faced when he developed his theory of aggregate demand. His conclusion was that the only way to get out of a situation in which the private sector was withdrawing their expenditures was to substitute government expenditures for the private expenditures to expand aggregate demand. If people were attempting to retrench and get their economic and financial situation under control, government must step in and pick up the slack until confidence returned to the private sector so that its spending would rebound.

It should be noted that in his original work Keynes did not propose tax cuts as a way to stimulate aggregate demand…he proposed government projects that would directly put people back to work again. What is wrong with tax cuts in these circumstances? Well, if people are attempting to protect themselves financially and are becoming more risk averse, tax cuts will primarily be used to pay off debt or to hoard cash. This would not put people back to work again. Employment and confidence could only be regained by direct hiring which would raise incomes.

But, one can’t just keep buying ones self out of their problem.

Since Keynes wrote we have learned that much of what has been described above, when it is applied to business behavior, is a supply side response and not a demand side problem. That is,
businesses and financial institutions have over expanded in the past and now they are attempting to return to a more reasonable and controllable size of operation. Public expenditures that attempt to return them to their over expanded states only perpetrate the situation and postpone any correction for another time. Of course, if the government has continually underwritten business expansion in the past and perpetrated bloated operations and excessive risk taking, the adjustment that finally comes might just be immune to further efforts to keep the bubble from bursting until another time.

The basic problem is that humans, individually, as well as collectively, cannot continuously ignore fundamental principles. Again, to use a sports analogy, a player or a team that neglects the fundamentals of their sport will eventually come up against a competitor that does focus on the fundamentals and will be defeated, even if they are the better athlete. The United States may be in that situation now!

This is a tough time. There is going to be a lot of pain going forward. Eventually, however, the piper will be paid. The best thing that we can do is to get back to the basics and focus on those individuals and companies that also concentrate on the fundamentals and are disciplined enough to execute at a high level.

The Mortgage Market and Incentives

This post is a follow-up to my post of July 27, 2008, “It’s All a Matter of Incentives.” The major concern I was trying to express in that post was that “Incentives are the cornerstone of modern life” (Freakonomics, p. 13) and that Congress and the Administration need to be careful with the incentives they set up because people will not only respond directly to the incentives they set up, but will also attempt to circumvent these incentives if there is economic justification to do so. It is a reality of the situation that this latter behavior may produce results that are contrary to what Congress and the Administration hopes to achieve.

I stated that “The subprime mortgage market is the premier current example” of this type of situation where good intentions have gone awry. These good intentions are captured in the first type of incentive that contributed to the creation of this market: “There were the social and political incentives to develop this market to allow more and more Americans to achieve the ‘dream’ of owning their own home.”

For a long time, owning one’s own home has been the ultimate hope of the American middle class. This dream has been pictured in stories, novels, radio shows, movies, and TV. Supporting this dream has been a foundation stone to the community of politicians. Throughout most of the 20th century politicians have created programs that encouraged and fostered home ownership from the creation of Savings and Loan Associations, dedicated to home finance for the middle classes, to the Federal Housing Authority and other programs developed in the 1930s, to the programs to help GIs after World War II attain their own homes. Helping Americans obtain their own home has been the bedrock of politics for a long, long time.

The effort to create a derivative security that would allow more funds to get into the housing market came about in the late 1960s and early 1970s. This move to create a derivative security with mortgages as the underlying asset was politically driven. The issue was this: insurance companies and pension funds have lots of money to invest in longer term assets. Mortgages are a longer term asset. But, mortgages are held on the balance sheets of depository institutions and when these institutions are fully lent up there are no more funds to support housing ownership and housing construction. How, the question was asked, can mortgages become acceptable assets for insurance companies and pension funds to invest in? At this point investment bankers were brought into the process to help the politicians in Washington, D. C. create an instrument that depository institutions could use to sell the mortgages they previously had held and sell these instruments to those that had so much money available for investment in longer term assets. This would thereby free up funds for the depository institutions so that they could go out and lend more to the housing market spurring on home ownership and home construction. This would result in an economic and social environment in which elected politicians could get re-elected.

We don’t need to go into the details of the construction of the mortgage-backed security because that is not the thrust of this post. All that needs to be said is that over the next fifteen years, the market for mortgage-backed securities became the largest part of world capital markets and the dull-as-can-be mortgage became one of the stars of the speculative universe. This latter point is most memorably captured in the book by Michael Lewis, “Liar’s Poker”.

The point: “For every clever person who goes to the trouble of creating an incentive scheme, there is an army of people clever and otherwise, who will inevitably spend even more time trying to beat it…” (Freakonomics, p. 25) The politicians saw to it that the incentive scheme was created…and then human nature took over. And, as they say…the rest is history.

The creation of the subprime market (and others) is just an add-on to this story. The political desirability of such a market is that funds for home ownership could be pushed down below the middle class into segments of society that had not, previously, had access to mortgage funding. With this innovation more and more Americans could live the dream and politicians could walk away knowing that they had contributed to building a better America…and, the best thing was that it cost the taxpayer nothing…or, at least, as originally conceived it cost the taxpayer nothing. Now the incentives spread from mortgage brokers, to depository institutions, to other financial institutions and to the rest of the world. This scheme really worked…and more and more people wanted to get their piece of what they saw as an expanding pie. This ‘new world’ of finance was different from what existed before. This ‘new world’ would continue to grow and grow.

The problem is that the subprime mortgage worked only in periods when there was inflation in housing prices. The scenario is described in an article in the New York Times about IndyMac, the failed mortgage lender. “Executives at IndyMac, like many other people on both Wall Street and Main Street, apparently never dreamed that home prices might fall. To the contrary, IndyMac made many loans on terms that implicitly assumed prices would keep rising.” The bank lent to people that were below standard in terms of credit quality and did not require “documentation to verify their income and assets.”

“As long as home prices continued to go up, the company’s strategy was very lucrative for executive, employees and shareholders…the boom perpetuated an insatiable hunger for mortgages and…the sales culture took over, and the sales division really drove the company. (See, http://www.nytimes.com/2008/07/29/business/29indymac.html?ref=business.) But, if the market provided positive returns at the beginning, the positive returns drew more and more people into the practice and the added competition drove away the returns and resulted in the participants taking on more and more risk in an effort to make their efforts work.

This was the intended focus of my earlier post, to show how incentives can create further incentives and lead people to chase positive returns by seeking an edge over their competitors. In addition, it is important to document how politicians, chasing a particular outcome, can create incentives that end up resulting in behavior just the opposite of what they desire to achieve.

And, the beat goes on. Splattered all over the July 29 newspapers, we see the news that politicians are still attempting to shore up the housing and mortgage markets. (New York Times: http://www.nytimes.com/2008/07/29/business/economy/29place.html?ref=business; Wall Street Journal: http://online.wsj.com/article/SB121727042664390535.html?mod=todays_us_money_and_investing; Financial Times: http://www.ft.com/cms/s/0/056c8604-5ce1-11dd-8d38-000077b07658.html?nclick_check=1.) Hank Paulson, US Treasury Secretary issued guidelines on the development of a covered bond market. Covered bonds are a form of secured bank debt that gives investors recourse to an issuing bank’s balance sheet and a pool of collateral, usually high-quality mortgages or public-sector loans, if the bank is unable to repay its debt. The reason for this…”to increase the availability of affordable mortgages.”

The role or roles of the Federal Reserve? First and foremost, the Federal Reserve is responsible for the amount of inflation in an economy. Inflation is everywhere and at every time a monetary phenomenon. I believe this. Where is the measure of inflation or potential inflation captured? I believe that Paul Volcker is right when he says that the most important price in an economy is the price of a country’s currency in foreign exchange markets and this captures market expectations of inflation, both current and in the future. The Federal Reserve must not have a bifurcated policy directive…price stability and economic growth. It cannot serve two masters. We see this particularly in the behavior of the Fed over the past seven years as it relinquished its independence and under wrote the inflation in the housing sector so as to support the administration’s economic policy. A central bank cannot do this.

There are two secondary roles that the Federal Reserve plays. The first of these is to help the financial markets avoid a liquidity crisis. This function the Fed performed admirably in March and April of this year. But, once the crises period has been passed, the Fed needs to back off. The second role is to see that the banking sector remains solvent. This responsibility has to do with the capital requirements in effect in the banking system. All other roles that can be assigned to the Federal Reserve must be carefully weighed and considered before they are implemented. I hope this clarifies where I position myself on some of these issues.

Leader-less

It all starts at the top!

How desperate are things? Well, the “Decider” stepped out yesterday to calm the American people’s fears about the financial system and the economy. Here is a person who has no credibility…a person that has been put in front of the American people time-after-time to build up their confidence and encourage them to stay-the-course…a person who is worn out and has no energy…and we hear from him that things are “OK”. Thank goodness he didn’t call us a bunch of whiners!

It is apparent, however, that his leadership permeates his whole executive team. The result was dramatically seen elsewhere in Washington, D. C. yesterday. U. S. Treasury Secretary Henry Paulson carries little or no weight in the current exercises. (See, for example, http://www.bloomberg.com/apps/news?pid=20601068&sid=aWssvqlta37Q&refer=home#.) The testimony of Federal Reserve Chairman Ben Bernanke was weak and muddled. Who can we turn to?

In my experience the Chief Executive sets the tone for the organization…the culture, if you will. Everything the Chief Executive does, or says, or seems, is reflected in his or her team and the performance of the institution he or she leads. The “Buck Stops” with the Chief Executive, whether or not the Chief Executive accepts this fact or not.

How are things going in the world? Mister leader…you are the captain of the ship…responsibility falls to you!

Secretary Paulson and Chairman Bernanke are honorable men. They are also capable men. But, so is Colin Powell. The performance of the team is always, for better or worse, overshadowed by the boss. If the Chief Executive is a capable leader…if the Chief Executive has good people around and facilitates the use of their talents…if the Chief Executive doesn’t fall victim to the flattery and ego-inflation of some of his team…that Chief Executive can produce extraordinary results. However, if the Chief Executive does not possess these talents…even good, capable people perform way below what is possible.

In my estimation we are beyond specifics when attempting to judge where the economy is and the soundness of the financial system. We have a leadership void and as a consequence we face a situation in which things can only deteriorate further until some form of real leadership is re-established within the United States government. The scary thing is that we seem to be facing a minimum of six months before the possibility of a change can become a reality. Not only do we have the “Gang that couldn’t shoot straight” in office, but the “Gang” is also a “lame duck”!
What needs to be done, in my estimation, is greater than just specific responses to market conditions. We need leadership in the following areas.

· International cooperation and coordination in economic advancement. The United States is still the one super power in the world but it needs to be a part of the development taking place in other nations and areas. The United States may be disliked and resented by others but the United States is still needed by these nations and areas and can still be a facilitator in the development and advancement of the rest of the world. (You might also look at the T. Friedman editorial this morning http://www.nytimes.com/2008/07/16/opinion/16friedman.html?hp.) And, the United States cannot close itself off from other parts of the world as “Reverse Globalization” takes place. Conversation and communication needs to be expanded from just the G-8 to the G-20.

· The United States must get it monetary and fiscal policy “in sync” with the rest of the world. The government must cease to believe that it can continue to operate its economic policy independently of the world. The budget of the United States government must be brought under control and managed with a firm discipline. Monetary policy must be directed to focus on the value of the dollar and possibilities of future inflation. The Federal Reserve must not be burdened with more and more responsibilities that can present it with conflicting goals and objectives. We have seen what difficulties can arise by just having two objectives—inflation and economic growth.

· The United States must develop a “real” energy policy! Enough of band aids. Enough of political posturing. Enough of catering to the financial interests of a small segment of the economy. If T. Boone Pickens can move on this issue…surely others can also move! (http://www.pickensplan.com/)

These, of course, are longer run concerns, but they pertain to the strategic direction of the United States. If we don’t have a vision of what is needed and if we don’t have leaders that can express a vision we can buy into and trust, then the responses and reactions that happen within the short run result in nothing but a ‘random walk’ and we end up with a hodge-podge of consequences that do not serve us well over the longer run.

Yes, I know…in the long run we are all dead. (Keynes) But, we only become desperate for fixes in the short run when there is an absence of leadership and no one seems to know where we are going.

My short run concern is that since participants in domestic and international markets have little or no confidence in the leadership that exists within the United States…in the business and financial community as well as in the political sphere…the drift in the financial markets and the economy will continue to be on the downward side. Economists and other pundits can continue to come up with suggestions and schemes to contain the trouble or dreamscapes to resolve the whole problem…but, that is all they will be until leadership is established once again. Unfortunately, the current players seem to lack this skill.

The Dollar: the Next Six Months

The last six months was not one of the best for the United States Dollar. The value of the dollar declined by about 7.5% against the Euro; 1.3% against the British Pound; and around 3.5% against an index published by the Federal Reserve System, an index relative to currencies in a broad group of major U. S. trading partners. During this period United States policymakers were focused primarily upon a liquidity crisis that hit full force in March and resulted in an assisted merger transaction and weakness in the domestic economy. The Federal Reserve and the U. S. Treasury Department were continually putting out fires here and there and providing liquidity to securities dealers and investment bankers. The first half of 2008 was not a time these policy makers could pay much attention to the decline in the value of the dollar.

What is the outlook for the next six months?

In my view, the outlook for the value of the United States Dollar over the next six months is not a good one. There are just too many things now in the works that do not favor an emphasis on a strong dollar. The question is, however, whether or not these possibilities are already incorporated in the current value of the dollar? My best guess is that the dollar will remain weak during this time period and will drift lower as more and more information reaches the market concerning the problems the world and the United States are facing.

The first such event on the horizon relates to the possibility that the European Central Bank will raise its base interest rate to combat the inflation that has now spread across Europe and that is twice the level of the ECB’s target rate of inflation. Moving this interest rate will put more pressure on the U. S. Dollar because the Federal Reserve is not expected to raise its target rate of interest due to the weakness of the U. S. economy and it financial institutions. There is also the possibility that central banks throughout the world will be raising their interest rates during the summer or fall months.

This possibility points up a real problem in world financial markets: the ECB, for example, is charged with one objective…to keep inflation under control. Its charter makes it completely independent of the political structure in the European Union. Thus, the ECB can pursue its objective of keeping inflation under control without immediate fear of political consequences.

Due to the independence of the ECB and many other central banks throughout the world, inflation targeting can be the sole focus of these organizations. This contrasts with the goals and objectives of the Federal Reserve System in that the Fed has two objectives it must focus upon…inflation and economic growth. These goals are not always compatible. Furthermore, if nations are “out-of-sync” economically with one another, as the United States seems to be “out-of-sync” with much of the rest of the world, then playing by different rules creates major national conflicts.

The possibility of conflicts, like the current one, is seemingly going to be an issue to be debated in the future. The French president Nicolas Sarkozy has already raised the issue of independent central banks and the problem of focusing on just one goal…inflation. (See the article in the Financial Times, “Elysee attacks ‘misguided’ policy of ECB”, http://www.ft.com/cms/s/0/985c022a-47d1-11dd-93ca-000077b07658.html.) This is the problem that ‘politicians’ always have with independent central banks and it represents the reason why central banks need to be independent of their governments. The current times are going to be ripe for political attacks on this independence. But, any such debate will not be a confidence builder for the support of strong currencies.

There are several other factors that will be hanging over the foreign exchange market over the next six months. Perhaps the most important one is the influence, or, one could argue the lack of influence, the current administration will have on the economy and the financial markets should a crisis arise. There is only one thing, in my view, that the Bush administration can pursue aggressively in the last few months it is in office…it can aggressively move to prevent further financial collapse or economic dislocation. This is the only thing the United States Congress will allow the Bush policy makers to do. Anything of a more positive nature will be postponed…like the efforts of the Treasury Department and the SEC to coordinate and share data collection. The Democratically controlled Congress expects to see a Democratic President seated in January 2009 and also expects to hold greater majorities in both the Senate and the
House. They are not going to allow this administration to initiate anything in its last few months in office.

Administration policymakers are very much in a dilemma. We have recently heard Fed Chairman Bernanke and Treasury Secretary Paulson speak about supporting a strong dollar. Paulson “reaffirmed the importance of a strong dollar” in Europe yesterday. (See “Paulson, in Europe, Finds Misery Loves Company”, http://www.nytimes.com/2008/07/02/business/worldbusiness/02euro.html?ref=business.)
Neither really have the option of doing anything about it at this time except talk. Furthermore, raising interest rates over the next four months and causing greater financial distress and economic misery would only make it more difficult for a Republican to be elected in the fall. So much for central bank independence.

The economy is also going through its adjustments and there are many uncertainties connected with how strong or weak the economy will be. On one hand, the United States economy has stayed stronger than expected through June of this year…but there is plenty of evidence that events over the next six to eighteen months may be rather unpleasant ones, especially for workers and businesses, both large and small. We are only beginning to see the impact that the higher price of oil is going to have on the economy. The auto industry is reeling…airlines are facing huge problems…retail trade is suffering…financial institutions are not out of the clear (there is great concern over the condition of regional and smaller banks for example)…and there is still the housing industry. What this is going to do to labor markets and workers and families is still to be determined. (For an interesting take on this see “Dispelling the Myths of Summer”,
http://www.nytimes.com/2008/07/02/business/02leonhardt.html?ref=business.)

The uncertainty with respect to how the economy is going to evolve connected with the inability of the “lame duck” administration to do much of anything leaves the candidates for president in an awkward position. The state of the economy is certainly going to have an impact on the election, but the issue is, what approach to projected policies should the candidates take? Right now the candidates are presenting programs representing what they would do if they are elected president…and the economy were not a problem. We are hearing nothing about what they would do if the economy is not in very good shape…or if the economy is “in the tank.” We have no idea who they would install as cabinet members or advisors. As a consequence, we have no idea about how either candidate would respond to the issues now facing the financial world over the value of the dollar.

Thus, the outlook for the dollar over the next six months is for little or no support to come from the United States government. And, with no insight as to how a next presidential administration would respond to the dollar situation there can be little or no confidence as to whether the dollar would be supported in the future. I don’t see how one can attach any confidence at this time to a sustained near term recovery in the value of the dollar.

Economics and the Regulation of the Housing Market

One of the more difficult aspects of understanding economics is the fact that in many cases it takes a long time for the full affects of economic policies to work themselves through the economy. As a consequence of this it can be difficult for people to identify cause and effect.

This allows those responsible for the economic policies to avoid blame because what they started…and continued…began a long time ago and it is difficult for people to specifically identify these policy makers as the culprits for what is currently taking place. In my estimation, one has to go back six or seven years to find the beginnings of the monetary and fiscal policies that have resulted in the present dilemma. One has to go back even further than that to find the beginnings of the United States energy policy that we are finally having to pay the price for.

And, since it is much easier to place the blame on something that people are doing now rather than on what people did a while ago, our leaders can point their finger at speculators, at dishonest real estate brokers and lenders, and at foreigners as the perpetrators of our current problems. Furthermore, if our leaders can shift the blame to these villains then they can escape from dealing with the hard problem of correcting the economic policies that really did create the situation. (See the piece by Paul Krugman in the June 27 New York Times, “Fuels on the Hill”, http://www.nytimes.com/2008/06/27/opinion/27krugman.html.)

The ultimate problem that results from a situation like this is that policy makers usually end up facing a real dilemma. Let’s pretend we are the Chairman of the Board of Governors of the Federal Reserve System. What is the dilemma we are in, if we are the Chairman of the Board? The value of the dollar has been declining for over six years. People are saying that the fall in value has helped to fuel the increases in the price of commodities worldwide, especially that of oil. They are also saying that this decline in value has resulted in a flood of United States wealth flowing into other countries…to the Middle East, to China, to Russia, to India, to Brazil…and this is going to come back to bite us. And, now, other central banks around the world are considering raising their interest rates which will only exacerbate the situation. We should raise our target interest rate to help strengthen the value of the dollar…or at least protect it from declining more.

But, if we raise interest rates that will only cause further economic distress and dislocation here in the United States and our financial institutions are not that strong…some forecasters are saying that some banks are going to have to write off another $65.0 billion in assets. Unemployment is increasing…home foreclosures continue to rise and housing prices continue to fall…the auto industry is in the tank…and so on and so on…

This is the problem of mismanagement…of getting away from fundamentals…of letting ideology dominate reality. Bad management results in situations in which there are no good or easy choices available. Something is going to have to be done about the value of the dollar…but what price are we going to have to pay to strengthen the value of the dollar? We can continue to postpone the day of reckoning…but the longer we postpone that day…the larger the cost will be!

Another rule in economics is that the day of reckoning does ultimately arrive!

One of the short run responses to the current situation is to change regulations…to create programs that alleviate the problems created by the economic distress being experienced. An example of this is the effort to produce a housing bill that will help people who face the possibility of losing their home…and most or all of their wealth. People want to help those in dire straits. There is no question that this is a worthy cause. However, are legislators want “results”!

Short run solutions always focus on “results”. One can understand that politicians want programs that create “results” so that can justify the expenditure of large amounts of money. Individual personal problems are a great help to politicians in generating a rationale for the legislation they want to enact. And, individual personal success stories are a great help to politicians who are explaining to voters why they should be re-elected. But, programs that are based upon the achievement of “results” hardly even come close to achieving what is needed or what is hoped for. “Results” are based on idealistic goals and objectives and seldom have any relationship to the reality of the situation.

Furthermore, “results” based legislation sets up rules and procedures that people can take advantage of. The writers of the Housing Bill seem to be aware of this and are concerned about how the bill will be administrated. Still, “results” orientated programs are taken advantage of because there always seems to be many individuals that find ways to circumvent the rules and procedures to their own benefit.

One final point on this issue relates to the organization that is going to administer the new Housing Bill. The designated institution in this case…the Federal Housing Administration. This is an institution that already has many problems and has rightly been criticized for its weaknesses. The others to be involved? Fanny Mae…and Freddie Mac. Oh, boy…where is FEMA when you need it?

There is another issue to consider in the creation of legislation and additional regulatory oversight. This is the issue of time. One of the big problems that regulators have in today’s environment is that things change so rapidly. Let’s just look at the housing market that the congressional leadership is attempting to help. Earlier this year it was estimated that the number of homeowners having financial troubles with respect to paying their mortgages was around 2.6 million. The figure is currently said to be around 3.0 million. Within the next year or so analysts are forecasting that another one to two million will be added to this total. And the Housing Bill…it is aimed to help around 400,000. The response to this shortfall? Legislators say that more housing bills will have to be enacted.

The other side to this is that legislation and regulation always tends to fight the last war. That is, legislators are responding to the behavior of individuals and the market instruments they believe got us into the current situation. My experience leads me to believe that while the legislators are responding to these historical issues there are already some people, somewhere in the markets thinking about what can be done in the future. Legislation and regulation will not be created to deal with these “new things” until sometime after they have been introduced and seem to need some kind of oversight.

Leaders in the United States have some hard decisions to face. The question is whether or not they will deal with them in the near term, or, will they, in whatever way that they can, postpone the hard decisions to some undefined time period in the future. What is sad to me is that the leaders seem to be postponing the hard decisions once again. This is why I believe that there is a growing discussion around the world about the credibility of those guiding the country at this time. Can you imagine China questioning the credibility of our economic policy makers?