The Three Problems We Face: Debt, Debt, and Debt!

The focus is wrong. The focus is on the demand side of the economy. As John Maynard Keynes argued, “most practical men are indeed in thrall to the ideas of some long dead economist”…and that long dead economist is John Maynard Keynes. Niall Ferguson refers to the policy makers of today as “born again Keynesians”! And, so the focus remains on stimulating demand.

As a consequence there seems to be a disconnect between what the policy makers are producing in terms of stimulus and bailout and what others, financial markets and individual consumers and families, are experiencing. The debt overhang is stifling everything and this must be corrected before the contraction can be stopped.

This makes the problem in the economy a “supply” problem and not a problem of demand. It is a supply problem because the response to excessive amounts of debt is to save and to reduce leverage. And, this delevering is a cumulative process and either must be overcome by massive inflation…or, it must work itself out.

The explosion of credit is like a house of cards…with the underlying danger being that once the house begins to collapse…the whole house is affected. Given the incentives created by Bush43, the credit pyramid grew. The increases in government debt and the excessively low interest rates maintained by the Greenspan Fed set the standard for the day. And, the private sector followed…the private sector took on more and more risk…and financed their riskier positions with more and more leverage. The whole credit structure became shakier and shakier.

The problem with a house of cards is that once one of the cards on a lower level is removed…the whole house can come down. Experience teaches us that some portions of the house may not collapse…but, if the card removed is at the base of the house…it will likely be the case that a large amount of the house will fall…

The card that was pulled out of the house of cards this time was housing finance. As we know now the subprime market can be identified as the place where the collapse began. But, this level of finance supported a large component of the house of credit in the form of mortgage-backed securities and then other derivative securities and tools that used this base of mortgages as the foundation of the structure. And, the house began to fall.

Of course, we are waiting for other parts of the mortgage house to fall…those connected with the next wave of interest rate re-pricings connected with Alt-A mortgages and options mortgages that will be taking place over the next 18 months or so. And, this does not include other consumer debt like equity lines, credit cards, car loans and so forth. It also does not include the collapse of the banking system and other components of the finance industry.

As we have seen the collapse in the housing market has spread to other areas of the financial market. Contagion is the word to describe this spread. And, the problem has become a world wide problem with problems in financial institutions and beyond throughout the developed world and into the emerging nations.

What is the response to the existence of too much debt?

Well, there are two. The first response is to create inflation. Pour money into the system and artificially create spending so that resources are put back to work…eventually creating sufficient demand so that prices begin rising again. This is the Keynesian way…reduce the real value of the debt outstanding. And, the only way to do this is by “printing money.” If the banking system seems to be clogged up…why then let the Federal government begin to spend…finance the spending by selling Treasury securities…but sell the debt directly to the Federal Reserve where the central bank will just give the Treasury Department a demand deposit at some commercial bank. That is the demand side response.

The other response to the fact that there is too much debt is for people to pull back their expenditures…withdraw from the spending stream…and pay down debt in whatever way they can. This is what is happening now and this has been called historically a debt/deflation. It is basically the process of delevering the economy so that economic units can return to reasonable debt levels on their balance sheet.

Unless people come to believe that the government is going to create a substantial enough inflation to reduce the “real” value of their debt to reasonable levels…they will not stop their attempt to get their lives back in order with a reduced amount of debt on their balance sheets. This is why this process is a cumulative one…a process that eventually must work itself out before the economy bottoms out and a return to growth can occur.

One of solution to this overhang is to write down the debt. I dealt with this issue in my post of February 4, 2009, “Two Painful Proposals to Reduce Our Excess Debt,” http://seekingalpha.com/article/118475-two-painful-proposals-to-reduce-our-excess-debt, so I won’t go into it further here. A plan like this is politically difficult because writing down the debt of those that over-extended themselves looks like we are bailing out the undisciplined or the scoundrels at the expense of the prudent and honest. Such an appearance carries with it severe political risks.

However, if the debt levels have to be reduced at some time…this overhang of excessive debt is going to have to be worked out one way or another. Half-way plans are not going to work. (See my post of February 9, 2009, “Obama Stimulus Plan: Bailout or Wimp Out?”, http://seekingalpha.com/article/119347-obama-stimulus-plan-bailout-or-wimp-out.) The government in Washington, D. C. is going to have to bite-the-bullet sometime…the question is just whether they are going to do it now…or do it later when things get worse.

And, let me just re-enforce my argument of above. Ultimately, this is a supply side problem…not a demand side problem. The attempt to pull off a demand side victory hangs on the balance of when inflation can be restarted and how much inflation can be generated to significantly reduce the “real” value of the debt.

The problem with this effort, however, is that an inflationary environment is one in which the incentive is to add on more debt…just what we are trying to get away from. Hasn’t the experience of the 2000s convinced us that this is not what we want to do?

The problem with supply side solutions is that they take time and are not as showing as are demand side “stimulus plans.” Also, they tend to be directed toward those individuals and organizations that are under a dark cloud these days. For example, there is the proposal put forward by Bob Barro to eliminate the corporate income tax. (See “Government Spending is No Free Lunch,” http://online.wsj.com/article/SB123258618204604599.html?mod=todays_us_opinion.)

The stock market did not respond well to the initial showing of the Obama Bank Bailout plan presented by Tim Geithner yesterday. To me this plan is sending mixed signals…mainly because it is on the tepid side. We have a demand side plan…the Obama Stimulus Plan…and we have a plan to cushion the problem of excessive debt…the Obama Bank Bailout Plan. The two plans don’t seem to mesh and give off the signal that the administration has not yet got its act together. The question then becomes…will it get its act together?

The debt issue must be dealt with…and firmly. At this time…firmly is not a word I would use.

Trillions and Trillions

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

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

That’s Federal budget deficits, of course.

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

Paul Krugman, a supporter of this kind of spending, in his New York Times column on Monday, “Fighting Off Depression” (http://www.nytimes.com/2009/01/05/opinion/05krugman.html?em), makes the following statement: “This looks an awful lot like the beginning of a second Great Depression. So will we “act swiftly and boldly” enough to stop that from happening?”

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

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

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

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

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

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

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

To recover…confidence must be rebuilt!

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

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

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

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

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

There is still a lot of uncertainty.

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

However, the numbers are so large…

Uncertainty and the Economy: Some Comments

In this post I attempt to respond to some comments that were written concerning my post of August 25. (http://seekingalpha.com/article/92648-the-reign-of-uncertainty-in-financial-markets) The comments specifically related to the fact that uncertainty always exists and whether or not markets work. I wrote the post of August 25 because I believe that uncertainty is greater now than it has been for a very long time. As a consequence, the volatility of markets is extreme and will continue to be extreme as long as this level of uncertainty continues to exist. I believe that this should be a consideration in the current business and investment decisions being made.

Uncertainty exists because humans make decisions based upon incomplete information. That is, if a decision maker had complete information there would be no uncertainty about what action that individual should take because the decision maker would know precisely the outcome that would result from any action that was available. The decision maker would, therefore, take the action that would be the ‘best’ in terms of the outcome that is being sought.

Uncertainty is defined in terms of variance. That is, because a decision maker has only incomplete information to work with, he/she will not know before the decision is made exactly what the outcome of that decision will be. Usually, there is a range of possible outcomes that can occur given the choice of a particular decision. Uncertainty, therefore, is relative in the sense that a situation in which the range of possible outcomes is somewhat narrow would be considered to be less risky than a situation in which the range of possible outcomes was much broader.

Generally one argues that if the decision maker has less information, the range of possible outcomes will be greater than if there is more information available. With less information available and a consequently larger range of possible outcomes, the situation is said to be riskier than when the decision maker has more information and a resultant narrower range of possible outcomes.

Therefore, to add to my post of August 25 I would state that we are currently working with less information relative to the possible outcomes that we have to deal with than we have in quite some time. From this I infer that in the current environment that businesses and investors are facing greater risk relative to their decisions than they have in a long time. And, as a consequence of this greater risk I would argue that markets will continue to be more volatile in the foreseeable future than they have been in recent history.

There is another issue that is being stressed relative to the current uncertainty. Nassim Nicholas Teleb, in his book “The Black Swan”, writes about two kinds of situations in which a decision maker has incomplete information. The first is what most people are more familiar with. This is a situation which uses the historical information available to create statistics that people can use to make better decisions. These statistics include probability distributions, means, standard deviations, and so on. These statistics can be used in routine, repeatable cases of decision making to help the decision maker incorporate what he or she does not know into their decision making process. Gathering more information in these situations help us to refine the probability distribution related to the specific case under review and its attributes.

The second type of situation, the one that Taleb is most interested in presenting to us, depends upon what we don’t know. That is, this kind of decision does not lend itself to the use of ordinary statistical analysis because these decisions relate to situations in which we have little or no experience relating to the information we don’t know, hence nothing to guide us in our decision making. Taleb tells of the turkey being fattened up to become a Thanksgiving dinner. For 1000 days the turkey is fed very well and treated like royalty. The 1001st day, the turkey is prepared for the Thanksgiving dinner. If the only information one has is the information from the first 1000 days, the prediction for the 1001st day would be to be fed very well and to be treated like royalty. Gathering more of the same kind of information helps very little. What is needed is not known and unless one knows what types of information are missing one can gain little to help in improving one’s ability to make a prediction.

In terms of this latter type of uncertainty, one can argue that in the current situation we don’t know what questions we should be asking or what kinds of information we need. In Taleb’s terms we are in the arena of the Black Swan.

Another question has been asked about whether or not I believe that markets work. The answer to this is yes, I believe that markets work and I have long argued that one must be careful in interfering with markets because, even though the intent of the person wanting to interfere with the working of the market may be the very best, humans, by and large have done much damage to markets, and to people, by interfering with the workings of markets. If one fusses around with markets, one must be very careful, and one must attempt to work with the processes related to markets and not to the outcomes achieved by markets.

Still, I believe that it is necessary to work with markets in order to help the markets function. There are many reasons for this. One of them has to do with incomplete information and the fact that some participants in markets may have more information than other participants do. Also, the existence of asymmetric information in markets in the short run can result in things like a liquidity crises that can cumulate in a dramatic downward spiral of prices. Another reason has to do with the existence of transaction costs and the fact that due to the existence of transaction costs markets may not function as efficiently and effectively as they could, especially with respect to the time it takes for the market to work out of a disruptive situation. Furthermore, incentives can exist that lead to behavior that is dishonest and harmful to others. Human beings are vulnerable to such incentives when the apparent marginal benefit of cheating seems to exceed the marginal cost of getting caught cheating.

Human beings are problem solvers and when they see situations that have seemingly undesirable consequences they attempt to fix them. This characteristic of human beings is what makes them especially unique among living species. It is a characteristic that has substantial survival value. But, humans must be careful when attempting to apply their problem solving skills to markets. First, as I mentioned above, in working with markets, humans need to focus on processes and not outcomes. They need to focus on rules about how individuals are to perform…such as rules pertaining to the importance of full disclosure and openness…and not what results they attain…such as the amount of people that someone hires. This cannot always be done, but it is a methodology that should be strived for.

Second, the crucial issue always has to do with the balance of interference that is achieved. My belief is that humans are always going to try and make things better…help markets operate more efficiently…and so it is a question of the balance between the two extreme goals that is important. If has always been my practice to try and err on the side of less interference with markets than more interference. Furthermore, it is always the case that this balance will change with time as we learn more and as the market adjusts to any interference imposed.

Dubner and Levitt state very clearly in “Freakonomics” that anytime any kind of incentive system (rules and regulations) is set up, there will be numerous people attempting to take advantage of the new system. This, to me, is another major argument for minimizing interference in markets…interference causes people to focus on beating the new rules and regulations imposed on the market. Thus, any new rules and regulations that are set up need to minimize the payoff for beating the new system so that more people keep their focus on making the market work rather than taking advantage of the new system. The more restrictive or the greater the interference of any new rules and regulations the more benefit that can be gained from “breaking” the system. Thus, I feel that there will be interferences with markets…with the best of intentions…but extreme care must be taken when interferences are imposed.

I hope these responses help readers understand a little bit more of where I am coming from.

The Reign of Uncertainty

The most dominant factor operating in markets at this time, domestic and international, is uncertainty. Yes, the price of oil is down. The price of gold and other commodities is down. The dollar is stronger. And, question have been raised…like has the dollar reached a bottom in value and now will recover (“Historical Trends Suggest That the Buck Is Back”, http://online.wsj.com/article/SB121961240718867281.html?mod=todays_us_money_and_investing.) Is inflation going to drop as the economy weakens so that interest rates don’t need to be raised? And so on, and so on.

What I see in world markets these days is not a “trend” here or a “trend” there. What I see is uncertainty. I see volatility with no clear direction, one way or the other. And, the uncertainty that exists is not connected to events, but to fundamental issues.

Three international issues immediately come to mind. The first of these has to do with Russia, the more active role it now seems to be playing, and the response of the rest of the world to the new feeling of power being exerted by Russia. The United States has expended a lot of its good will over the past seven years or so and is, at present, in no position to lead others against this exertion of will.

The second has to do with the other BRIC countries and the role they are going to play in the world economy in the future. China, of course, coming off the successful execution of the Olympic Games, is gaining in confidence every day. India, although it has its problems, is going to play a major role in the world economy going forward. And, Brazil seems to be growing stronger every day. The United States has little or no influence over the direction these nations move since it forfeited it’s ability to work with them when they were, economically, just emerging countries.

And, of course, there is the uncertainty related to world energy sources and the role that the Middle East plays within these markets. Although the demand for oil seems to have dropped off in the United States due to Americans driving less, the overall demand for energy in the world continues to climb. And, there is always the uncertainty relating to supply…we just don’t know what might happen here in terms of leaders and in terms of cultures. Of course, the militant forces of terrorism play a role in how this issue works itself out.

This just represents a start. We can remain at the world level and talk about the unraveling of the global consensus on trade. (http://www.ft.com/cms/s/0/111b33e6-71ff-11dd-a44a-0000779fd18c.html) Current economic relationships have been built upon the efforts of many people and nations to build a more global economy. This consensus is showing signs of weakness now and is in danger of collapsing. A world with more restricted trade and greater emphasis upon nationalism would certainty have major economic and financial ramifications for the world at this time.

There are other factors causing uncertainty internationally, but let’s take this discussion into the national level and focus on the United States. First, there is great uncertainty concerning the health of the financial system. The number one concern at this time is what is going to happen to Fannie Mae and Freddie Mac. Is the Federal Government going to have to step in and do something about them and if so what is going to be the resultant structure of the companies and what is such a bailout going to cost the American people? But, there is still concern about the health of investment banks and how large the additional write offs are going to be. There is concern about the commercial banking industry, whether or not there will be more bank failures and whether or not there will be a failure of one or more “major” banks. The fact that the FDIC is pulling back former employees that worked in bank examination and bank closures and workouts to augment its current staff is a source of some concern. Furthermore, there is no good estimate of the amount of charge offs that financial institutions will face…first in terms of mortgages, then credit cards, then…

Then there is the housing industry. How much further down will it go and how long will it take before the industry bottoms out and construction really begins again?

What about unemployment? The unemployment rate hit 5.7% last month and the projection is for this number to go higher and higher. But, how much higher? It seems as if layoffs and firings are just beginning. Many industries are going through major restructurings and we don’t know, as yet, what the final effect will be in terms of the employment numbers. Companies are going into bankruptcy. Other companies are reducing the number of retail outlets they have retrenching for the growth at any cost efforts of the past. The auto companies are asking the government for major dollars to help them make adjustments to the changing nature of the industry. And, in this environment, would you be terribly aggressive in expanding output or hiring new employees?

Higher unemployment means higher payments for unemployment compensation. The government will almost certainly give the auto companies financial help. The government is promising relief to people facing foreclosure on their homes. The bailout of “Fannie” and “Freddie” could run up to $200 billion. And, what if commercial bank failures, let alone the possible failure of another investment banking firm, put pressure on the FDIC’s insurance fund requiring the government to set aside more funds, how would that add to the deficit? And, these potentials demands for government monies are just a few of the possibilities along with the worldwide problems that could cause the Federal deficit to become even larger. What price will the United States Government pay to finance all the debt that could be amassed in the near future to handle the multitude of potential crises that could unfold?

Then there is the leadership concern. The Bush Administration is history…yet, it still is in office for almost five months. There are still members of the administration trying to leave some positive legacy behind them. There have been several recent articles discussing the efforts of Condoleezza Rice and Henry Paulson to do something positive before they leave office. The “big one” for Paulson is, of course, the Fannie Mae/Freddie Mac bailout. Everyone else seems to have just disappeared into the woodwork.

And, there is the case of the presidential candidates. I won’t go into that again…you can read my thoughts written in my blog for August 18, 2008 (http://maseportfolio.blogspot.com/). All I will say right now is that I don’t believe that either of the two candidates have given us a clear idea of what we can expect from them in the economics or financial arena if they are elected President.

The world is a highly uncertain place today. Given the nature of many of the factors contributing to this uncertainty, I don’t see how the uncertainty can be resolved in the short run. Because of this uncertainty, the risk associated with any business or investment decision will be higher than it has been for quite some time. Over the past several months we have seen this risk being built into market relationships, especially into the interest rate spreads that exist on financial markets. However, we are also seeing changes in relative pricing in the “real” economy as businesses adjust for the changing assessment of risk that exists within these markets. These re-evaluations, obviously, are not very encouraging for the stock market.

The prognosis for the future, therefore, is for volatility. Markets are going to go up and markets are going to go down, but it is going to be very difficult to determine longer term trends in such markets. There is just too much noise.

What will get us out of this mess? The answer to this dilemma is time, information, and leadership. Nationally, as well as internationally, we don’t have a vision of where we need to go. There is still much “pain” to be felt in the United States. Someone is going to have to “own up” to this pain and provide a map for getting through it, helping those hurt where possible. Until we get some idea of what is going to be done…uncertainty will reign in financial and economic markets.

The Basics of Financial Regulation

Another cycle of suggestions for financial regulation is upon us. Treasury Secretary Hank Paulson is giving a major speech today, June 19, 2008, calling for increased oversight of financial institutions on the part of the Federal Reserve System and for an understanding of the need for regulators to intervene in the banking system to avoid unnecessary systematic risk. Recently, Tim Geithner, the President of the Federal Reserve Bank of New York, in a speech given in New York, argued that investment banks should operate under the same uniform regulatory framework as other financial institutions so as to encourage appropriate liquidity, capital, and risk management practices.

I believe that it is a certainty, coming out of the financial dislocations of the past 12-18 months, that a new, modified regulatory structure will be forthcoming out of Washington. It is highly unlikely, however, that any action will be taken before a new President and administration is seated. Treasury Secretary Paulson is trying to impact the future by laying out ideas that will serve as the basis for an agenda of the discussions that will follow. How much impact he will have on these future discussions remains to be seen. It is the only hope someone going out of office has of influencing the course of forthcoming decisions.

Control of regulatory restructuring is in the hands of the Democrat-controlled Congress. The Democrats have no reason to hurry any discussion along for they are looking at the highly likely scenario of having a Democratic President take office in January 2009 along with larger majorities in both the Senate and the House of Representatives. They are looking at being able to control the debate and dominate the decisions about how the new financial structure is to be designed. The Democrats in Congress have absolutely no reason to show their cards before these changes take place and the elections this fall will not include debates on regulatory issues because of the esoteric nature of the issues and a lack of insight and interest on the part of the electorate.

Yet, changing the regulatory structure of the United States financial system can have very important implications for the future of the country…and for the world. Without knowing what is “in play” in terms of proposed regulatory changes it is impossible to define what these implications might be. The downside is that the new regulatory system could put the United States financial system at a disadvantage relative to the rest of the world so as to harm the ability of American-based financial institutions to compete in world markets. This would be exactly the wrong time for such restrictions to be imposed because of the growth of other financial capitals throughout the global economy, especially with all the wealth accumulating in the Middle East, China, and India.

The fundamental issue of oversight of financial institutions (actually all business institutions) is openness and transparency. In fact, to me, the essence of good management is openness and transparency. Winners are teams that execute better than other teams. Losers are teams that have to rely on secrecy and tricks. Secrecy and tricks are relied upon when you do not have the resources to perform at a high level. Secrecy and tricks can get you by in the short run, but over time the inability to operate efficiently and effectively will catch up with you. Teams that rely on secrecy and tricks, in my book, seldom, if ever, win championships.

The best teams…and organizations…are the ones who do not disguise what they do best, but execute their plans better than anyone else does. In essence, they say, “this is what we are going to do…try and stop us!” These teams…and organizations…play by the rules and are not afraid of full disclosure.

There are two reasons why strong organizations support this kind of approach to management. First, it causes them to focus on what they do well and staff their organizations so as to refine and perfect the execution of their plans as much as possible. This builds strength and confidence in the organization and provides an environment that people who are talented and highly capable want to join. Strength builds on strength as the culture of success grows and prospers. Nothing can substitute for a culture that supports excellence rather than craftiness.

Second, by creating an environment of openness and transparency, the organization identifies weakness, problems, and mistakes as quickly as possible so that appropriate actions can be taken in a timely manner. Effective organizations do not “win” all of the time, but they minimize weak performance and losses so as to sustain an overall record of high achievement. All too often we see organizations that want to shelter poor performance because they kid themselves into believing that it is just a matter of time before “things will turnaround” and “everything will be alright.” As losses mount, they rely on trickery and ‘innovative” accounting to gloss over the real problems and as the hole they are digging becomes deeper and deeper…they fail to stop digging.

There are three specific issues that I am particularly concerned about in terms of openness and transparency. First, I am against “off balance sheet” items. We have seen how major institutions have used this mechanism to bury what they are doing as well as to avoid concerns over capital adequacy. I could never understand why this practice was allowed and, as far as I am concerned, it should be forbidden in the future. If the asset cannot stand the light of being on the balance sheet there are serious questions in my mind about why the organization should be engaged in such activity.

Second, I believe in marking assets to market on a regular basis. Opponents of this disclosure argue that the markets are so volatile that investors would be confused with the constant marking portfolios up and then marking them down on a regular basis. My question to these people is that if an organization has invested in assets that are so volatile…should they be invested in them at all? Have these organizations “stretched” for yield by investing in longer term assets or “high-yield” assets that are not consistent with their charters? If this is the case, then this decision should be revealed to investors in an obvious way and not covered up because, in the short run, the income streams of the institution are relatively constant. Furthermore, for assets that are not traded on markets or are infrequently traded, efforts should be made on a regular basis to determine their value and openly report them. This, not only is good discipline for the management, but it is also important for the investment and regulatory community to know.

Third, some institutions have argued that they cannot reveal what transactions they are involved in because if they did the spreads that they were operating at would go away. I have two comments to make on this concern. If the spreads are so narrow, the organization will probably be very highly leveraged in order to achieve the gains they believe they need to earn and the risk associated with this extreme use of leverage is probably unrecognized by investors. Also, research has shown that everyone seems to know what the transactions are anyway and that is why the spreads are so narrow in the first place. The question that needs to be ask, therefore, is whether or not the risk associated with the transaction is really commensurate with the return that the organization is promising on its operations. Disclosing the nature of these transactions would be helpful to investors in understanding the risks that they are investing in.

Openness and transparency not only can assist regulators and investors, it can also help managements. But, there is one more important point that continually needs to be made to those considering a change in the regulatory structure. “Inflation everywhere and at every time is a monetary phenomenon.” This statement, of course, came from Milton Friedman. Regulation of the financial system is needed, but we must not muddy the waters when it comes to the responsibility of the central bank, the Federal Reserve System. The more oversight and regulation it is responsible for the more its focus becomes blurred. The Fed is already hampered by the responsibility to maintain economic growth as well as to control inflation. As is apparent in the current climate, this is an impossible thing to do. Adding, more and more functions to the Fed can only make its task of keeping inflation at low levels more and more difficult.

Finance, Credit Cards, and the Fed: Three Comments

In today’s post, I want to reflect on three different subjects, all of which have some relationship with one another. These three subjects are (1) the loss of respect for the field of finance; (2) the increase in credit card losses and the numbers game; and (3) politics and the Federal Reserve.

The Loss of Respect for the Field of Finance

I am concerned that the field of finance has lost…is losing…respect in the world. As finance has come more and more under the sway of “financial engineering” it has lost its ability to lead. To present a simplistic view of this situation, I would argue that in the past, people controlled the numbers. In the current situation, numbers are controlling people. I am not against the use of numbers and I am not against the use of highly sophisticated mathematical/statistical models. (I have a background in mathematics and statistics.) The problem is that because of the sophistication and complexity of the models, they tend to be allowed to run on their own. The assumptions used to build the models are usually chosen to make mathematical manipulation as easy as possible and are dependent upon the historical record. These models are fallible!

Judgment and leadership are still needed in finance and this means that CEOs and Fund Managers must live up to the responsibilities placed upon them. They are to be held accountable and thus they must exercise their authority over those that build models and make investment decisions. If those in charge continue to fail to “be in charge” we will find that the financial system will continue to be fragile and the need for increased legislation and regulation will become a reality. Control will be exercised…either internally, within the financial firm…or externally from the government.

The Increase in Credit Card Losses

Credit card losses are on the rise. We have information from some of the major issuers so far and the news is not good. J.P. Morgan’s chief executive James Dimon has given us a peak of the future charge offs at his bank and the trend is definitely upwards. In April, J. P. Morgan wrote off 4.5% of its credit card loans and is forecasting losses to rise above 5% this year and 6% next year. This is up from a charge of 3.8% in April 2007.

But this is not so bad…Citigroup wrote off 5.7% in April, up from 4.1% in April 2007 while Bank of America charged off 6.9% last month, up from 5.4% a year earlier.

The credit card industry has always been a numbers game. That is, the more credit cards a bank issues, the more the percentage loss centers around a particular figure. The credit scoring is designed so that, on average, an issuer will achieve an “acceptable” rate of charge offs given the interest rates and fees that they charge their customers. The assumption is that the distribution of actual percentage losses will approximate a normal distribution with a relatively small variance around the expected mean of the percentage charge offs.

This approach works relatively well when there are not major disturbances to financial markets or the economy. However, when a major disturbance comes along…as we are going through right now…there is evidence that the assumption about the potential percentage losses being normally distributed is not the case. The evidence points to the possibility that the distribution tends to be skewed toward greater losses with the tail being relatively “fat”. That is, the probability of more extreme results is higher than is captured in a normal distribution of possible outcomes. The consequence is that the losses during major disturbances are greater than planned for and, hence, the provision for potential losses is less than adequate. This, of course, has implications for the bank’s capital position.

It seems to me that this attitude has prevailed at many of the larger financial institutions recently. The “numbers game” has been applied to other areas of lending, mortgages, student loans, equity lines, small business loans, and so forth, and we are now reaping the results of such an approach to lending. Having a large numbers of loans does not protect you all of the time because the assumptions of the statistical tests tied to the historical data sets do not conform with the way the world seems to work. When you have very few data points that relate to extreme outcomes you are always going to under estimate the probability that these events will occur.

The “numbers game” does not overcome the deficiencies of poor credit underwriting standards.

Politics and the Federal Reserve

Frederic Mishkin has resigned from the Board of Governors of the Federal Reserve System, effective August 31, 2008. It seems to me that this resignation has tremendous implications for the future of the Federal Reserve System and the functions it is to perform!

The United States has just gone through a significant liquidity crisis and the Federal Reserve has stepped in to prevent the collapse of a major investment banking organization, Bear Stearns. There is an ongoing crisis in the mortgage market along with a slowdown in the sales in the housing market coupled with a drastic reduction in housing prices. And, there are still major concerns about the revaluation of assets, both in US financial institutions, but also in many other financial institutions around the world.

There have been calls for bail outs, new legislation pertaining to financial activity, and modernizing the regulatory system. The Federal Reserve is at the center of all of this turmoil.

Thus, who controls the Board of Governors of the Federal Reserve System is going to have a lot of say about the future of the financial system and the role the Federal Reserve is going to play within that future. Most ideas that have been floated around have given the Fed broader scope and greater powers in the reconstructed financial network. Who controls the Board of Governors is very, very important!

Christopher Dodd, a Democrat from Connecticut, is the chairman of the Senate Banking Committee. This committee is charged with reviewing the nominations for Governors of the Fed. With the Mishkin resignation, of the seven positions on the Board, three members will be missing and one current member is unconfirmed. The delays in three of these positions have been for more than one year.

Is politics playing a role in this confirmation process?

With the odds in favor of a Democrat being elected as the next President, these four positions are obviously “in play”. Whereas the Republican chosen nominees tend to be more “free-market” types and hence at odds with the Democratic majority, a Democratic President, it is assumed, would be more likely to nominate persons in favor of greater oversight and firmer control of the financial system. This opportunity to appoint a majority of the Governors at one stroke seems too good to pass up.

Two points here: first, a central bank is supposed to have as its major focus the state of the economy and the inflation rate; second, heaping more and more responsibilities on the Fed just diffuses this focus. Already, participants in international financial markets believe that the Fed is not playing by the same rules as are other nations in terms of its lack of focus on inflation. Making the Fed more attentive to current political mood swings is not the way to help the United States live up to its responsibilities in the world.

Regulation Fever

It appears as if we are on the other side of the tidal wave of financial disruption that we have been facing over the past eight or nine months. There are still fairly large charge-offs being reported and earnings are not going to recover for a while…but, these are now taking place in an orderly fashion. The hope is that banks and other financial institutions have gotten their arms around their problems and are working things out day-by-day.

This is the way things usually work out during these periods of financial upheaval. There is the shock of realization that things are not as they are thought to be…then there is the sell-off…then there is the intervention of the central bank…and then…people begin working out things in as orderly fashion as possible. Time is what is needed…and the actions of the central bank are aimed at buying time so that the institutions involved will have the time needed to clean up their balance sheets.

It is a scary thing…a liquidity crisis…and a solvency crisis. There is so much uncertainty…because when these events begin there is so little information available. We don’t know what is happening. We don’t know what the problem is. And, we don’t know how severe the problem is.

Markets hate uncertainty!

But, things are being worked out. Institutions seem to be getting their balance sheets under control and are re-constructing themselves for the future. We can only hope that we are not going to be surprised again. We can only hope that all the banks and other financial firms that were impacted have the time they need to regain their strength. The economy is still not ‘out-of-the-woods’ and this, too, will take time. People are aware and are responding to the recession-like environment. The next year or two will not be an easy time.

What is interesting to me is that there are people that are already wringing their hands over the missed opportunity to massively re-regulate the financial system. Paul Krugman writes, in the New York Times of May 5, 2008, http://www.nytimes.com/2008/05/05/opinion/05krugman.html?_r=1&hp&oref=slogin:

“The bad news is that as markets stabilize, chances for fundamental financial reform may be slipping away. As a result the next crisis will probably be worse than this one.”

I don’t want to concentrate on the ‘fear’ connected with the next crisis. That is just Dramatics 101. Let’s look at the other side of this…introducing ‘fundamental financial reform.’ First of all, when was this reform going to be instituted? Trying to legislate reforms of the financial system at the peak of the liquidity crisis is NOT the time to change the regulations and the regulatory structure! One really doesn’t know what the problems are at that time and the responses to the situation usually are about ‘outcomes’ because outcomes are what catch the attention of the press and the public. People want to legislate ‘results’. Instituting good changes require an understanding of the problem and a focus on ‘processes’, on how organizations do business. This understanding only comes with time and study.

Also, is it wise to implement all new sorts of rules and regulations at a time when the banks and other financial institutions are going through their ‘working out’ efforts? These organizations need to focus on the ‘business at hand’ and not on commenting on, fighting for, or implementing any new legislation with regards to the way they do business. If you want to cause further trouble, get these institutions to focus on things that are not the immediate problem! No, they need to keep their attention on working their way out of the mess…and this cannot be done immediately.

Now, let’s look at the next issue Krugman brings up…

“After the financial crisis that ushered in the Great Depression, New Deal reformers regulated the banking system with the goal of protecting the economy from future crises. The new system worked well for half a century.”

I can’t believe that Krugman feels that for 50 years the ‘new’ system worked and then, all-of-a-sudden, banks and other financial institutions began to innovate and create all of these new financial instruments that resulted in the situation we are now facing. That would mean that we made it into the 1980s before all of this innovation began to take place.

If one looks back to the 1960s one can see the beginnings of the financial innovation. The 1940s saw the world at war and the 1950s was a relatively tranquil period that brought back some ‘normalcy’ to life (whatever ‘normalcy means). In the 1960s we saw some financial innovation or innovative use of financial instruments that had not existed before. These were given names like Federal Funds, negotiable CDs, and Eurodollars. These innovations allowed commercial banks to readily obtain funds from sources that were not limited to the bank’s ‘local’ area, whether a state or a more limited area in ‘unit’ banking states.

My experience in the Federal Reserve System going into the 1970s was that the banking system was about 6-9 months ahead of the regulators with respect to some of these instruments. That is, the banks would do something to get around regulations and it would take the regulators from 6 to 9 months to find out what the banks were trying to do and then close the ‘loop hole’. Then the whole process would begin again.

And, this was just a start. With the new electronic technology, banks could cross regulatory lines and break down the barriers to state banking restrictions. When I was teaching at the Wharton School I wrote articles about the fact that commercial banks were already regional or national in scope because the new information technology allowed them to draw from out of their areas to conduct banking business and the regulators could do little or nothing to stop the ‘innovation.’

Innovation is going to take place! Regulation is always going to be behind the curve! Legislators and regulators are always going to be playing ‘catch up’! That is the way the world works!

What do I suggest? There is not much space to go into this too deeply in this post, but I would like to make one suggestion. I firmly believe in openness and transparency. I believe that trying to open up reporting requirements would help the situation immensely. There are several areas that immediately come to mind that would help. Let me present three. The first has to do with the market value of assets. I can understand why some institutions do not want to regularly adjust balance sheets for the market value of their assets…both securities and loans…but these values, even if estimated, should, at a minimum, be noted in their required releases. My belief is that if the people within these organizations know that these data are going to have to be released it will give them greater incentive to act on their problems earlier rather than later. My experience in turning around banks underscores the behavior of organizations that get into trouble…they keep postponing action thinking that the markets will ‘turnaround.’ In most cases, they don’t!

Second, I believe that assets should not be allowed to exist ‘off’ balance sheet. All assets need to be reported and need to have sufficient capital supporting them. Putting something ‘off’ balance sheet does not eliminate the need to support them…and the investment community needs to know of their existence. The more ‘daylight’, the better these assets will be managed.

Finally, transactions need to be reported. Long Term Capital Management made the point over and over again that the spreads they worked on were so narrow that they couldn’t release the information on them because others could then duplicate their deals. If the spreads are so narrow that the ‘deals’ require massive amounts of leverage to make them work and if the spreads are so narrow that information on the deals cannot be released…I say, let the information be released! Let the spreads go away!

Time Goes By: the Solvency Issue Once Again

In my post of February 25, 2008 I discussed “the solvency issue” and stated how important it was for financial institutions to ‘recognize and disclose problems earlier rather than later’. The crucial thing about acting in this way is that it limits, as much as possible, the deterioration of the value of asset portfolios. Postponing dealing with the issue merely delays the realization that there is a problem and also delays taking actions that might lessen the pain and even turn the situation around.

Here we are now, more than a month later. During this month or so, the Federal Reserve moved to salvage what was left of Bear Stearns. This has seemingly calmed markets and has indicated that the central bank, with the support of the Federal government, will do what is necessary in order to keep the financial system functioning. Greater write-downs and charge-offs have been taken during this time period, both nationally and internationally. Executives have been let go and have been replaced. Additional capital has been sought and, in most cases, found. The system seems to be working through the crises.

It, obviously, is too early to say that we are out-of-the-woods, but it is crucial that time is passing. In the case of liquidity crisis, everything happens within a very narrow window in the time spectrum. Action has to be immediate in order to stem a crisis and allow for order to return to the market. In the case of credit crises it is crucial for firms to have time to work out the problems that are on their balance sheets. Bear Stearns ran out-of-time. But, it seems, other institutions are experiencing the time that they need to discover the value of their troubled assets and to do something about them.

The whole process of resolving a credit crisis is not really in the hands of a central bank or of a central government. The process is really in the hands of the financial institutions themselves: it is dependent upon their willingness to suffer the immediate pain they must suffer; it is dependent upon their willingness to get the right people in place to resolve the problems that exist and restructure the organization. The more time that passes the more hopeful the situation becomes.

Part of the problem in trying to analyze an environment such as the current one and make prognostications about the future is that we are working with very incomplete information. We don’t really have a good handle on how grave the condition is of specific financial institutions and how effective boards and managements have been in attempting to get the situation under control. There is a tremendous amount of uncertainty out there!

This is where time is so important. We get this piece of news about Bank XYZ charging off another billion or two, dollars of loans. We hear that the board of the investment bank of M & M is letting go its CEO and bringing in so-and-so to take charge of their organization. Company ABC is getting additional capital. Yes, there are still problems ‘out there’ but something is being done about them. And, time is passing!

As I have mentioned before, since so much of the dislocation has seem to be centered upon assets that, in one way or another, are connected to some form of security that is ‘traded’ the problems have been determined relatively quickly. When financial institutions just originated assets that were kept on their balance sheets, discovery was not so rapid. Identification of problems and the taking of action seemed to get postponed with the hope that ‘things would work out’ and the loans would right themselves. None of this information, however, was available to anyone else other than the organization, itself.

Now, everything takes place in larger quantities and with a much shorter fuse. This is what we get with the advancement of Information Technology and the innovation in financial assets that have gone alone with it. If information is transferred much more rapidly and is much more public, then markets will be more efficient, but they also may be subject to periods of greater volatility. The reason for this is that traders and arbitrageurs who have tended to take similar positions in certain assets may all have to adjust positions at the same (relative) time and this can create imbalances in the marketplace. With the new technology all this can happen in a very short period of time and in very large numbers.

I use the term ‘relative’ for a very specific reason. The time horizon that is relevant in each case is, of course, dependent upon the particular situation under review. In a case where a position must be ‘unwound’ as, say, in the case of the French bank, Society General, a large volume of assets must be sold within a very short period of time. This results in a ‘liquidity crises’. In the case of the value of assets being written down, the timing is somewhat different. Yet, the identification of such a problem at an earlier time than would have been the case in the past, leads an organization to move on to resolving the problem faster than formerly. This is possible in the current environment.

It is also true that larger numbers are likely to be involved in the current situation than before. The reason is that financial institutions need to be very conservative at this stage of the process. I have heard organizations being criticized because they might be charging off too much so that they can recognize the excessive charge offs later and make the ‘turnaround’ look good. My experience in working with troubled institutions is that the real tendency is to charge off too little, with management hoping, with a false optimism, that things will get better and the managements will be able to hold onto their jobs. The emphasis is on the management trying to protect itself and not on what is the best for the shareholders. I conclude from this is that it is better for managements to be ‘conservative’ in their marking down of asset values and write them down far enough to make sure that you will not have to face another write-down in the future. The reason for this is that you don’t want to have to ‘surprise’ the financial markets with more future write-downs than you have to.

The aim of all of this activity is for order and confidence to be restored to financial markets. If order and confidence are to be restored, the troubled institutions themselves must show that they are ‘in charge’ of the situation and that they have control over the value of their portfolio. Until market participants believe that managements are in charge they will continue to be nervous. This nervousness is because they still do not have sufficient information concerning the quality of the portfolios and the ability of the managements to do what is necessary.

I am sure that there are still surprises ahead. There is still great uncertainty to overcome. We all hold our breaths, hoping that the next week we face will not contain any shocks that may set things off again. Time is important because financial institutions need time to work things out. Financial markets need time in order to digest information and adjust incrementally to the news they are receiving. Each week that goes by without further shocks is good. But, we continue to keep our fingers crossed.

Markets and Uncertainty

This is not the best time to be recommending books to people. But, I thought that, given all the turmoil around, it would be worthwhile for us to remember some relatively recent works that might help us to regain some perspective on markets (financial and otherwise) and guide us back to the fundamental issues we have to deal with during times like these. It is all too easy to get caught up in personalities or specific situations and that, in my mind, is exactly what we don’t want to do. For example, Paul Krugman’s Op-ed piece in the New York Times on March 10, 2008, is an example of emotional reporting and needs to be tempered with a review of the basics on which market participants need to concentrate: http://www.nytimes.com/2008/03/10/opinion/10krugman.html?hp.

I have great admiration for former Treasury Secretary Robert Rubin and have found his book (written with Jacob Weisberg) titled “In An Uncertain World: Tough Choices From Wall Street to Washington (Random House: 2004) to be helpful in the sense that Rubin has apparently systematically applied the techniques of decision making under uncertainty to both business and governmental situations. (I, like a lot of other people, are waiting for his next book in which he will discuss his role in the recent events at Citibank.) In terms of dealing with uncertainty there are two important ‘take-aways’ from this book. The first is that uncertainty in pervasive in human decision making. The thing that differentiates one situation from another is whether greater uncertainty or less uncertainty applies. The second pertains to the methodology used: the decision maker must be try to identify all of the possible outcomes related to the decisions that are available to her or him; and the decision maker must, in some way, assign probabilities to each of the possible outcomes.

Of course, the methodology that Rubin proposes is not an easy one to apply, particularly when one is under stress and is having to deal with markets that can move quite rapidly. Difficulty, however, is no excuse for not attempting, even in a simple way, to deal with the uncertainty that the individual is facing. We must do our research, we must read a lot and listen to many different opinions, and we must then make the best effort we can. There are no objective criteria for determining a comprehensive list of possible outcomes and the probabilities to assign to each outcome: everything is ‘subjective’. Intuition and experience are important factors alongside knowledge and skill.

Another book that is helpful in understanding the process of decision making under conditions of uncertainty is that of Michael J. Mauboussin titled “More Than You Know” (Columbia University Press, Updated Expanded Edition: 2007). There are several ‘take-aways’ from this book that should be remembered in dealing with uncertain markets. One of the first is that people tend to consider too narrow a range of potential outcomes. Thus, it is always relevant for people to expand their perspective and give attention to the possible outcomes they might otherwise exclude. It is a good discipline to force yourself to consider outcomes that you think only have a small probability of occurring. In doing so, you protect yourself from unintentionally eliminating outcomes that you might ordinarily dismiss from careful consideration.

A second thing that Mauboussin discusses which might be important in our analysis of uncertain situations is that all analysts and commentators will not be correct all of the time. Thus, we must not rely on one or just a few individuals for their view of the market. However, we should pay more attention to those analysts and commentators that have a higher ‘batting average’ than others. Even though we know that all will be wrong some of the time, those with a higher’ batting average’ will tend to have more ‘streaks’ of being right and longer ‘streaks’ than those whose ‘batting average’ is much lower. Thus, there are some analysts and commentators we should review more than others even though we know that they will be wrong a fair percentage of the time.

A third relevant factor is that individuals, according to the research that Mauboussin cites, do not always act in a completely rational way. For example, they may weigh possible losses more heavily than gains in their decision making. However, even though individual participants in the market may not be completely rational, if these participants generally act independently of one another, markets will ‘tend’ to be priced appropriately. This is because that, when aggregated into the whole market, the deficiencies of the individual decision makers seem to cancel out and the resulting prices tend to be a relatively adequate reflection of all the information that is available to the market at that time.

The time when this will not be true is when individuals do not behave independently of one another. At these times, the market becomes unbalanced because opinion tends to congregate on the buy side of the market or on the sell side and people act more like a ‘herd’ than independent individual decision makers. These are the times when the markets become ‘disorderly’ and present the greatest problem to policy makers. We have given special names to some of these disorderly situations such as ‘liquidity crisis’ or ‘credit crisis’ or ‘market collapse’.

There are two other books on markets and uncertainty that provide a good deal of insight into the world of decision making under uncertainty. Both of the books are by Nassim Nicholas Taleb: the first of these is titled “Fooled by Randomness” (Random House, 2005); and the second is “The Black Swan: The Impact of the Highly Improbable” (Random House, 2007). Both of these books contribute to our understanding of the point made by Robert Rubin that there are, at most, only a limited number of situations in life that are not subject to uncertainty. Uncertainty comes from not having all the information we need in order to make a decision or to solve a problem. The idea that we have complete information on every situation we face in life is just a fantasy. The tendency to narrow the range of possible outcomes we consider in any specific case is related to our desire for greater certainty in life: humans tend to act as if they had complete information. Taleb presents us with example after example of the absence of complete information in our decision making or problem solving.

One additional fact is emphasized by both Mauboussin and Taleb: the probability distributions that apply to most uncertain market situations are not normal distributions. Although the probability distributions used should all conform to the general rules of probability theory, it has been shown that the tails of these probability distributions are ‘fatter’ than those of a normal distribution. That is, extreme events should have more probability assigned to them than would be the case if the probability distributions were normally constructed. Thus, these extreme events may not be very probable, but the expected impact of their occurring can be more substantial than might be thought. This conclusion is not meant to frighten, but only to serve as one more piece of information that will help us to understand the performance of the markets in which we operate.

Recently in a talk, Federal Reserve Governor Fred Mishkin indicated how uncertainty can impact price relationships within a market. The case that Mishkin discussed related to the calculation of inflationary expectations measured by the difference between the yield on the10-year Treasury bond and the yield on the 10-year inflation protected Treasury securities, TIPS. This differential has been increasing since the first of the year and the general interpretation given the increase is that financial market participants now expect more inflation over the next 10 years than they had expected last fall. Mishkin argued that the increase in this differential was not due to an increase in inflationary expectations but was due to an increase in the ‘uncertainty’ of what inflation will be. In this respect, uncertainty can affect markets. But, we must deal with uncertainty as analytically as possible, for that is the best way to make decisions because it tempers the impact of the more dramatic events that we generally see in the headlines.

Should Bernanke and the Fed Have Moved Sooner?

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

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

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

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

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

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

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

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

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

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

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

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