In the last “Exit Strategy” post (http://seekingalpha.com/article/196931-federal-reserve-exit-watch-part-9) I stated that the Fed balance sheet was getting boring. Over the last four weeks the Fed’s actions continue to be boring.
In the current circumstances, boring is good when it is connected with the non-existent loan growth in the banking sector.
The major change in the Fed’s balance sheet over the last four weeks in terms of factors that supply bank reserves was an increase of almost $28 billion in mortgage-backed securities.
I know, the Fed said it wasn’t going to buy anymore mortgage-backed securities after March 31…but it did. Who can you trust anymore?
The changes in all other factors supplying reserves to the banking system were basically a wash.
However, there was some interesting movement on the other side of the statement. Of course, April is tax time and so the Treasury cash management activities impact the reserves in the banking system. And, we did see U. S. Government demand deposits at commercial banks build up through the month of April, averaging a little less than $8 billion in the banking week ending April 19. (Through most of the year these balances will average in the $1.2 to $1.8 billion range.)
The government lets these deposits build up at commercial banks during tax time so that reserves are not drained from the banking system. They will only be drawn down as the Treasury pays out of its General Account at the Fed which puts reserves back into the banking system. Usually, during tax time the General Account is allowed to decline.
But, there was something else going on at this time. The Federal Reserve, together with the Treasury Department, is using another government account at the Fed, the Supplementary Financing Account, to drain reserves from the banking system.
For more on this see my April 19 post, “The Fed’s New Exit Strategy” (http://seekingalpha.com/article/199444-the-fed-s-new-exit-strategy).
Since the new federal debt limit was passed in February 2010 the Treasury has been increasing the balance in the Supplementary Financing Account. As a consequence, it is difficult to tell exactly how the Treasury is managing its tax receipts and the bond receipts that are finding their way into this supplementary account. On April 28, 2010, the balance in this account was just under $200 billion, the amount the Treasury indicated it would keep there.
In the last four banking weeks, this account has increased by $75 billion while the Treasury’s General Account has declined by almost $35 billion. Hence, roughly $40 billion in bank reserves were absorbed using this method during this time period.
This is interesting because excess reserves in the banking system reached all time highs in February 2010 and stayed relatively high in March. They have declined since then by about $50 billion.
The reason for the increase in excess reserves in the February period was the Fed’s purchase of
mortgage-backed securities. Over the past thirteen weeks, the holdings of mortgage-backed securities rose by almost $127 billion. In January and February, the reserves created by these purchases went into excess reserves in the banking system.
The excess reserves only began to be drawn down as the Treasury Department started to increase the funds it held in its Supplementary Financing Account after the debt limit was increased by Congress in late February. After that the Treasury increased this account by $25 billion per week until it reached the $200 billion level. Therefore, excess reserves in the banking system dropped during this time period.
Since the Treasury maintained a minimum of $5 billion in this account until the debt limit was raised, the Supplementary Financing Account rose by $195 billion over the past thirteen weeks. The Treasury’s General Account rose by $70 billion during this time so that the net affect was an $120 billion absorption of bank reserves which roughly offset the Fed’s purchase of mortgage-backed securities. As a consequence, excess reserves in the banking system on April 28, 2010 were roughly the same as they were at the end of January.
So, excess reserves in the banking system backed off from the all time highs that were reached during the first quarter. A new tool, the U. S. Treasury Supplementary Financing Account, was used to bring the banking system off of this peak. Now where do we go?
Well, another Fed tool was introduced last Friday, the “Term Deposit Facility” or TDF. (See the press release: http://www.federalreserve.gov/newsevents/press/monetary/20100430a.htm.) Under this facility the Fed would offer deposits with maturities of up to six months to member banks. Presumably deposits in the TDF would receive market rates of interest for the idea is that these deposits would be a positive alternative to commercial banks lending out their excess reserves to businesses and consumers. And, it would be risk free.
The Fed has lots of room to provide competitive interest rates because it earns interest on the securities that it has purchased outright and pays little or no interest on most of the funds it has on deposit. The evidence is the large amount of “excess returns” that the Fed gives back to the Treasury every year. This is the benefit of being able to “print money”.
This facility is intended to “tie up” some of the excess reserves the Fed has put into the banking system so as to prevent the banks from extending credit too rapidly thereby increasing money stock growth and threatening excessive inflation in the future.
This is just one more tool that the Fed has created to help it through the “Great Undoing.” Another tool the Fed said it would rely on is “Reverse Repurchase Agreements.” Of course, there is still the old reliable tool, outright sales of securities. The Fed hopes to use these in coordination with each other in order to not only drain excess reserves from the banking system but, in other ways to tie up the excess reserves so that they will not be used in bank lending. This is not a problem right now but could be in the future.
The Fed has indicated that it is continuing the target Federal Funds rate stance it has followed since December 2008. And, because of the weak economy and the weak banking system it is planning to continue this policy for “an extended period” into the future.
The Fed remains in a precarious position since it is still trying to balance itself between a weak economy and banking system and the fear that the economy will begin to strengthen and bank lending will explode using all of the excess reserves that it has available to it. All we can do is sit back and watch what the Fed is doing and hope that things will remain quiet and boring.
Monday, May 3, 2010
Thursday, April 29, 2010
More on Crybabies: No One is Responsible!
I am moving more and more to the belief that we will see some substantial inflation in the Western world in the next few years.
Being an optimist, I keep hoping that the leaders at the Federal Reserve can bring off the Fed’s “Great Undoing” and succeed in reducing the excess reserves in the banking system before these reserves turn into loans and spending.
I keep hoping that the federal government will honestly address the issue of its budget deficits which I see increasing the federal debt outstanding by $15 trillion in the next ten years.
I keep hoping that businesses will reduce how much they are leveraged and concentrate more on the production of goods and services rather than on their trading activities.
I keep hoping that consumers will get their balance sheets back in order and begin to live within their means.
I keep hoping…
But, for these things to take place, someone must take responsibility for their actions.
I am not seeing this happening!
All I am seeing are the crybabies that place the blame for their problems on the backs of someone else.
Alan Greenspan and Ben Bernanke did not see (or, they did see, depending upon which speech you listen to) the looming financial crisis, for no one could (or, they could but could do nothing about it) have recognized the future.
Paul O’Neill, Jack Snow, and Hank Paulson had no idea that such huge deficits would be created during the 2000s and contribute to a decline in the value of the United States dollar of over 40% against other major currencies, for they were all in favor of a ‘strong’ U. S. dollar (whatever that is).
And, the leaders of European nations were not responsible for the current financial disorder in the market for sovereign debt. It is obvious in recent remarks (among others):
Being an optimist, I keep hoping that the leaders at the Federal Reserve can bring off the Fed’s “Great Undoing” and succeed in reducing the excess reserves in the banking system before these reserves turn into loans and spending.
I keep hoping that the federal government will honestly address the issue of its budget deficits which I see increasing the federal debt outstanding by $15 trillion in the next ten years.
I keep hoping that businesses will reduce how much they are leveraged and concentrate more on the production of goods and services rather than on their trading activities.
I keep hoping that consumers will get their balance sheets back in order and begin to live within their means.
I keep hoping…
But, for these things to take place, someone must take responsibility for their actions.
I am not seeing this happening!
All I am seeing are the crybabies that place the blame for their problems on the backs of someone else.
Alan Greenspan and Ben Bernanke did not see (or, they did see, depending upon which speech you listen to) the looming financial crisis, for no one could (or, they could but could do nothing about it) have recognized the future.
Paul O’Neill, Jack Snow, and Hank Paulson had no idea that such huge deficits would be created during the 2000s and contribute to a decline in the value of the United States dollar of over 40% against other major currencies, for they were all in favor of a ‘strong’ U. S. dollar (whatever that is).
And, the leaders of European nations were not responsible for the current financial disorder in the market for sovereign debt. It is obvious in recent remarks (among others):
- “Irish Official Calls Markets ‘Irrational,’” (http://www.nytimes.com/2010/04/29/business/global/29punt.html?scp=1&sq=irish%20official%20calls%20markets%20'irrational'&st=cse);
- “Critics Assail Rating Firms for Fueling Woe in Europe,” (http://online.wsj.com/article/SB20001424052748703648304575212422057151414.html#mod=todays_us_page_one).
Sure, the rating agencies are not to be believed and they always move ‘after-the-fact’, but where there is smoke, there must be fire.
And, what about those people that sell securities short and those that deal in Credit Default Swaps. They are nothing but trouble makers taking advantage of the bad press put out by the sensationalist world media. Greedy bastards!
And, bank managements are not really responsible for any of the trials and tribulations of the past several years. That was obvious in testimony given in Congress this week. All of the emphasis on trading rather than financial intermediation, leverage ratios of 40-to-1, increased assumption of risky assets, and the mis-matching of maturities was just ‘business as usual.’
Families and homeowners were not responsible either.
And, this attitude has existed for the last fifty years.
Moral hazard reigns!
If no one is responsible for what took place over the last fifty years or so, then the way people behaved over the past fifty years or so will be repeated. Why? Because, if no one is responsible then we all have to ‘ante up’ so that those who are hurt by a financial collapse can get bailed out. And, since the music continues to play, the dancing must go on.
This ultimately means that the national government budget deficits will not be reduced. It means that the Fed’s “Great Undoing” will not take place. It means the foundation for price inflation will be in place. It means that consumers, businesses, and other governmental bodies will continue to borrow and leverage up. And, it means that financial innovation will continue to permeate the economy.
The Debt Deflation will be prevented. Another round of Credit Inflation, therefore, seems in store.
There is no indication that attitudes or behavior has changed. “Watch the hips, not the lips!”
Why concentrate on Western countries?
Because, over time, those countries that are disciplined will be the ones that benefit relative to those that do not discipline themselves. In this we see several of the emerging nations becoming relatively stronger as they focus more on the future political alignment of the world rather than on short-run outcomes.
These nations understand that power does not like a vacuum. When a powerful country gives up some of its position, others immediately move in to replace what is lost. And, some of these countries understand that slow and steady win the race and proceed in a disciplined way.
Yesterday, there was a very revealing opinion piece by Gerard Lyons of Standard Chartered Bank in the Financial Times titled “When ‘Made in China’ becomes ‘Paid in renminbi’” (http://www.ft.com/cms/s/0/24307398-525d-11df-8b09-00144feab49a.html). Perhaps the most important line in this piece is the statement that “Gradualism dictates the Chinese approach to most policy measures.” China thinks in decades and not in years I have been told. And, other emerging nations are learning this rule as well.
In the United States and other western countries, economic policy has been focused on the short run. And, by focusing on the short run, outcomes can seem to be the result of random or uncontrollable events. Hence, no one needs to claim responsibility.
However, we are responsible for our actions; for the short run does become the long run and in the longer run success depends upon the acceptance of responsibility and acting with discipline. This is one of the problems that Greece and Portugal and others are having at this time. They are being compared on these terms with other nations, like Germany, and are found wanting. And, they don’t like the implication that they have acted in an irresponsible and undisciplined fashion.
So, cry foul!
Wednesday, April 28, 2010
Is Greece the "Surprise" that Breaks the Camel's Back?
As people move through a financial crisis, the hope is that future ‘surprises’ will be avoided. In making things better and getting the system operating once again, efforts are made to identify problems and then set out to resolve the problems. Problems are not solved over night, but being aware of the problems and then honestly working them out is the way to put things right.
The fear is the unknown...a surprise!
Last Thursday the financial markets got a surprise. Greece’s budget deficit was worse than had previously been reported.
Was this incompetence or lying?
That is not the matter now, the fact is that Greece’s budget deficit is worse than had been expected.
The market sold off and the Wall Street Journal reported in “Traders Bet On a Default From Greece” (http://online.wsj.com/article/SB20001424052748704830404575200573581527764.html#mod=todays_us_money_and_investing) the following:
“Greek bond prices posted a drastic decline Thursday as traders began betting a debt default is inevitable, even if the country receives a massive bailout.
The Greek bond market is now priced for a "catastrophic event," says Sebastien Galy, senior foreign-exchange strategist at BNP Paribas.
Greece's woes helped sink the euro to an 11-month low before the common currency recovered some of its losses.”
Thursday, Moody's Investors Service downgraded Greece's debt rating and warned that additional cuts could be on the way. Tuesday, Standard & Poor’s lowered their rating of Greek debt to “Junk” and at the same time reduced the rating on Portugal’s bonds two levels.
The question plaguing the financial markets now has to be the reality of the ratings on other sovereign debt. This always happens when the market gets a shock! If the figures on the deficit of Greece were wrong, what about Portugal? What about Spain? What about Italy? What about Great Britain? What about the United States?
How far this uncertainty travels depends upon the time and the state of the market. European stock markets sold off yesterday. The Dow-Jones index closed down by 213 points. The Dow stock futures had been down by 30 to 60 points. Markets hate uncertainty!
How can we make the world more transparent?
Eventually the numbers all come out. As Warren Buffet has said, once the tide goes out one discovers who is not wearing a bathing suit.
And, this is an argument for short selling and Credit Default Swaps! Yes, those that cut corners and those that cheat and those that don’t reveal the full extent of budget deficits hate short sellers and the CDS. They hate them because they reveal that the “Emperor is not wearing any clothes” let alone a bathing suit.
The response? Point the finger at the “other guy”, the greedy trader! Divert attention! It is people like those “greedy traders” that give capitalism a bad name! Ban short selling! Eliminate Credit Default Swaps! Those greedy bastards!
Well, the surprise is out! Now we have to see how far the contagion spreads.
The press is having a ball with the title, the PIIGS!
Portugal, Italy, Ireland, Greece, and Spain ate from the trough till they were fat and happy and then they were too bloated to deal with the consequences. So the focus is on them.
This is great for the United States because we now get another “run to quality” boost. Monday, we saw the headline in the Wall Street Journal, “All Signs Point to a Costly Auction”: (http://online.wsj.com/article/SB20001424052748704388304575202493992895602.html#mod=todays_us_money_and_investing). The lead statement: “The U.S. Treasury market faces a challenging week, as investors deal with hefty debt auctions, the uncertainty of a Federal Reserve meeting and key economic data that will likely show the economy continued to grow in the first quarter.
That combination likely means the government may have to pay to sell the $129 billion securities.”
This morning we read in “European Jitters Give Two-Year Auction a Boost” (http://online.wsj.com/article/SB20001424052748704471204575209880025823948.html#mod=todays_us_money_and_investing):
“Treasury prices rose Tuesday as investors sought safety in low-risk securities after S&P cut its ratings on Portugal and Greece, sending Greek sovereign debt to ‘junk.’
The reach for safer securities helped to buoy the $44 billion two-year auction, which attracted good demand and helped keep Treasury prices higher.
The auction, the first of several note sales this week, was more than three times oversubscribed.”
The Euro has dropped below $1.32, a level it had not been at since April 28, 2009.
Unfortunately for Goldman Sachs this news is not yet eclipsing the headlines that it is receiving concerning the government’s case against them. But, at least, there is another “finance” story on the front pages of the major newspapers. Good for Goldman, bad for finance!
Still, the issue is about disclosure, transparency, and openness. There are many in finance who do not like “day light”! If anything comes out of the efforts to reform the financial system it should relate to disclosure. If people want to be in the ‘ballgame’ they must fully disclose. If they don’t want to disclose, then they must be excluded and pay the penalty.
And, full disclosure includes “mark-to-market” requirements. People who place bets by mis-matching maturities must also “fess-up.”
Anyway, we have been surprised! Now, the system must re-evaluate everyone so as to identify any other surprises that might exist. In the process, everyone else pays!
The fear is the unknown...a surprise!
Last Thursday the financial markets got a surprise. Greece’s budget deficit was worse than had previously been reported.
Was this incompetence or lying?
That is not the matter now, the fact is that Greece’s budget deficit is worse than had been expected.
The market sold off and the Wall Street Journal reported in “Traders Bet On a Default From Greece” (http://online.wsj.com/article/SB20001424052748704830404575200573581527764.html#mod=todays_us_money_and_investing) the following:
“Greek bond prices posted a drastic decline Thursday as traders began betting a debt default is inevitable, even if the country receives a massive bailout.
The Greek bond market is now priced for a "catastrophic event," says Sebastien Galy, senior foreign-exchange strategist at BNP Paribas.
Greece's woes helped sink the euro to an 11-month low before the common currency recovered some of its losses.”
Thursday, Moody's Investors Service downgraded Greece's debt rating and warned that additional cuts could be on the way. Tuesday, Standard & Poor’s lowered their rating of Greek debt to “Junk” and at the same time reduced the rating on Portugal’s bonds two levels.
The question plaguing the financial markets now has to be the reality of the ratings on other sovereign debt. This always happens when the market gets a shock! If the figures on the deficit of Greece were wrong, what about Portugal? What about Spain? What about Italy? What about Great Britain? What about the United States?
How far this uncertainty travels depends upon the time and the state of the market. European stock markets sold off yesterday. The Dow-Jones index closed down by 213 points. The Dow stock futures had been down by 30 to 60 points. Markets hate uncertainty!
How can we make the world more transparent?
Eventually the numbers all come out. As Warren Buffet has said, once the tide goes out one discovers who is not wearing a bathing suit.
And, this is an argument for short selling and Credit Default Swaps! Yes, those that cut corners and those that cheat and those that don’t reveal the full extent of budget deficits hate short sellers and the CDS. They hate them because they reveal that the “Emperor is not wearing any clothes” let alone a bathing suit.
The response? Point the finger at the “other guy”, the greedy trader! Divert attention! It is people like those “greedy traders” that give capitalism a bad name! Ban short selling! Eliminate Credit Default Swaps! Those greedy bastards!
Well, the surprise is out! Now we have to see how far the contagion spreads.
The press is having a ball with the title, the PIIGS!
Portugal, Italy, Ireland, Greece, and Spain ate from the trough till they were fat and happy and then they were too bloated to deal with the consequences. So the focus is on them.
This is great for the United States because we now get another “run to quality” boost. Monday, we saw the headline in the Wall Street Journal, “All Signs Point to a Costly Auction”: (http://online.wsj.com/article/SB20001424052748704388304575202493992895602.html#mod=todays_us_money_and_investing). The lead statement: “The U.S. Treasury market faces a challenging week, as investors deal with hefty debt auctions, the uncertainty of a Federal Reserve meeting and key economic data that will likely show the economy continued to grow in the first quarter.
That combination likely means the government may have to pay to sell the $129 billion securities.”
This morning we read in “European Jitters Give Two-Year Auction a Boost” (http://online.wsj.com/article/SB20001424052748704471204575209880025823948.html#mod=todays_us_money_and_investing):
“Treasury prices rose Tuesday as investors sought safety in low-risk securities after S&P cut its ratings on Portugal and Greece, sending Greek sovereign debt to ‘junk.’
The reach for safer securities helped to buoy the $44 billion two-year auction, which attracted good demand and helped keep Treasury prices higher.
The auction, the first of several note sales this week, was more than three times oversubscribed.”
The Euro has dropped below $1.32, a level it had not been at since April 28, 2009.
Unfortunately for Goldman Sachs this news is not yet eclipsing the headlines that it is receiving concerning the government’s case against them. But, at least, there is another “finance” story on the front pages of the major newspapers. Good for Goldman, bad for finance!
Still, the issue is about disclosure, transparency, and openness. There are many in finance who do not like “day light”! If anything comes out of the efforts to reform the financial system it should relate to disclosure. If people want to be in the ‘ballgame’ they must fully disclose. If they don’t want to disclose, then they must be excluded and pay the penalty.
And, full disclosure includes “mark-to-market” requirements. People who place bets by mis-matching maturities must also “fess-up.”
Anyway, we have been surprised! Now, the system must re-evaluate everyone so as to identify any other surprises that might exist. In the process, everyone else pays!
Tuesday, April 27, 2010
Is the United States on the Right Track?
The debate rages on: is the economic policy of the United States on the right track? On one side of the argument we hear that not enough has been done by the government to get the economy going again and to reduce unemployment. On the other side we hear that the government is creating too much debt and that most attention needs to be given to the reduction of the looming federal deficits.
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Which argument is correct?
Well, if we look at the value of the dollar for an answer to this question, it seems as if investors are leaning a little more on the side of the latter.
This chart shows the value of the United States dollar against other major currencies in the world. The grade that is being given the economic policies of the United States government is not a good one. It should be noted that this index includes the Euro and the British Pound, two currencies that have been quite weak against the United States dollar recently.
Since January 2001, the value of the United States dollar has declined by about 26% against these major currencies. At one time, in 2008, the value was about 32% lower than in January 2001, but the ‘flight to quality’ during the Great Recession allowed the dollar to recover somewhat, but it then declined again to its current level as confidence rebounded.
Even with the situation in Greece (and Portugal and Spain and Ireland and…) investors in international markets still seem to believe that the United States government is on the wrong path with respect to its fiscal and monetary policies. Federal deficits totaling at least $15 trillion over the next ten years connected with a monetary policy that is keeping its target interest rate close to zero for an unknown length of time is not a combination that builds much confidence.
It could be argued that these international investors are giving the Obama Administration about the same grade it gave the Bush (43) Administration. If it were not for events going on in other countries, the value of the dollar could be even lower.
In fact, the recent performance of the dollar indicates that the international financial community sees little difference between the performance of the current administration and that of the administrations that preceded it over the past forty-five years of so, going back to 1961. Yes, different administrations pursued different specific policies that represented what they thought was best for the country, but in terms of aggregate policies, there has been little difference overall. The general thrust has been more federal debt and more private credit. The result: an almost constant increase in credit inflation.
Now, there is the threat of a debt deflation as a consequence of the Great Recession, but world currency markets don’t seem to think that a debt deflation is the most likely prospect.
With a government whose gross debt doubled since January 2001 and is projected to double again within the next decade and with a Federal Reserve that has injected $1.1 trillion of excess reserves into the banking system, little confidence exists among international investors that the United States government can “exit” this situation without losing control.
You can say all you want to about the policy differences of the different administrations over the last fifty years, but if you look at the aggregate economic data, very little separates the performance of the Republican and Democratic Presidents. President Nixon, perhaps, spoke for all Presidents of the past fifty years: “We are all Keynesians”.
One could argue that the Clinton Administration was the exception in terms of fiscal policy. And, Paul Volcker had to overcome the fiscal prodigals, Carter and Reagan, to achieve some credibility for the United States in international financial markets.
This relatively steady performance has weakened the United States internationally and the continued weakness in the dollar indicates that investors think that the current direction of policy will weaken the United States further going forward. This decline, connected with the ascension of the BRICS and other emerging areas in the world, is shifting power relationships all over the globe. The move from the G8 to the G20 captures this change.
The thing is, power cannot stand a vacuum. If the United States is wobbling a little, China, Brazil and others are there to fill in the spaces. Other nations will not stand still so as to allow the United States to dig itself out of the hole that Bush (43) put it in. In fact, by pursuing the same kind of aggregate economic policies that were followed by the Bush (43) Administration, large deficits and extremely loose monetary policy, the Obama Administration, in many ways, just seems to be digging the hole deeper.
Ben Bernanke is even calling for the Obama Administration to produce an “exit” strategy to reduce future federal deficits. But this just highlights the problems that this administration faces. The government must “exit” both an excessively loose monetary policy as well as an excessively prodigal fiscal policy stance. It will be a truly exceptional performance if this administration can pull it off.
Right now, I believe that world markets think that they cannot pull it off. The place to watch is the foreign currency markets: keep your eye on the value of the dollar!
Monday, April 26, 2010
E-Mails, Investment Banking, and the Rating Agencies
Thank goodness for emails! Now we know what was really going on at Goldman Sachs and Moody’s and Standard & Poor’s. How about Congress including in their bill on financial reform the requirement that all financial institutions and rating agencies and all other organizations having to do with finance (say the Federal Reserve and the Treasury and Fannie Mae and Freddie Mac…and Congress…and the White House) release all of their e-mails a week after they were written.
This would really provide the financial markets with transparency!
The thing that strikes me so much about the release of these e-mails over the past week or so is their humanity. These Wall Street villains talk like human beings, like you and me.
Gillian Tett, in my mind, has a terrific opinion piece in the Financial Times this morning titled “E-Mails throw light on murky world of credit” (http://www.ft.com/cms/s/0/a9da1aa4-508b-11df-bc86-00144feab49a.html). Her reflection on the e-mails is captured in the following sentence: “It is fascinating, almost touching, stuff.”
But, even more important she states that “Reading these e-mails with the benefit of hindsight, there is little suggestion that rating officials were engaged in any deliberate malfeasance. Many appear conscientious and hard-working.” These people are just human beings trying to do their job.
The same can be said of those people that wrote the e-mails at Goldman. This is captured in an article by Kate Kelly in the Wall Street Journal titled “Goldman’s Take-No-Prisoners Attitude” (http://online.wsj.com/article/SB20001424052748703441404575206400921118356.html#mod=todays_us_money_and_investing.)
Kelly speaks of a world, which Tett describes as “so detached and rarefied”, in which betting applied to almost anything. The scene she presents in her article is one in which mortgage traders from Goldman Sachs “cast bets on a White Castle hamburger-eating contest” in December 2007. (Note that the problems in the subprime mortgage market were so severe at this time that the Federal Reserve announced the creation of a Term Auction Facility (TAF) on December 12, 2007 with the first auction being held on December 17, 2007.)
This behavior, Kelly reminisces, “resembled a scene out of ‘Liar’s Poker,’ a book (by Michael Lewis of the book ‘The Big Short’) depicting bawdy antics of (mortgage) bond traders at Salomon Brothers in the 1980s.” She argues that “It was a lower-stakes version of what went on ever day in the group: aggressive, take-no-prisoners trading.”
To Kelly, the world apparently didn’t change much between the 1980s and the 2000s!
Tett draws some conclusions from the picture present in the e-mails. She writes “by 2007 they (the bond raters), like the bankers, had become tiny cogs in a machine that was spinning out of control. Their world was also a strange, geeky silo, into which few non-bankers ever peered.”
And, Tett goes on, “Indeed, this world was so detached and rarefied it is, perhaps, little wonder that S&P struggled to deal with the press, or that Goldman traders felt free to celebrate the mortgage market collapse.”
“Few expected external scrutiny or imagined their e-mails would ever be read.” They were just being human.
But, something was wrong! Something bigger than the traders or the raters had taken control and was driving the system.
And, this leads Tett to the first of two lessons she draws from the information in the e-mails: “what went wrong in finance was fundamentally structural, as an entire system spun out of control! It might seem tempting to lash out at a few colorful traders but that is a sideshow…”
She concludes: “what is needed is systemic reform that removes conflicts of interest.”
This is the only point on which I disagree with her. To me this whole “spinning out of control” was a result of the credit inflation that had been prevalent in the financial system for the past fifty years or so. The whole effort to inflate the American economy had resulted in the excessive creation of credit during this time period, the almost fanatical drive toward financial innovation (led by the federal government), and the assumption of more and more risk by the private sector in a search to sustain its returns.
The reference to the book “Liar’s Poker” is particularly relevant because the main story in that book is about the trading going on in mortgage-backed securities, something that did not exist until the early 1970s when the federal government created the instrument. Please note that the first mortgage-backed security was issued by the Government National Mortgage Association (Ginny Mae) in 1970. Before then mortgage-related issues were not traded on capital markets. By the time of the writing of “Liar’s Poker”, government-related mortgage-backed securities had become the largest component of capital markets.
As I have stated many times, the purchasing power of the United States dollar declined by roughly 85% between January 1961 and the present time. Although consumer price inflation was kept relatively low over the past decade or so, credit inflation permeated the asset markets as bubbles appeared in stocks and housing. House prices got so out of line with rental prices during this time that the collapse of the housing bubble became inevitable.
So, I agree with Tett in her statement that “what went wrong in finance was fundamentally structural, as an entire system spun out of control!”
But, human beings acted like human beings during this time. Again, to quote Tett: “they (the bond raters), like the bankers, had become tiny cogs in a machine that was spinning out of control.”
And, as Chuck Prince, former CEO of Citigroup, called it: as long as the music is playing, people must keep on dancing. This doesn’t excuse them, but it puts, I think, the behavior in perspective. This was not the well-thought-out plot of evil people.
Lesson: inflation creates incentives that can get out of hand. If the government wants to conduct economic policies with an inflationary bias then they must deal with the consequences at a later time.
I do agree with Tett on her second lesson learned: “the whole murky credit business must be taken out of the shadows. So few people spotted that finance was spinning out of control because the financial system was so separated into silos that its practitioners lost any common sense.”
Tett “welcomes the publication of these emails” but warns us to “keep braced for the next installment.” She “suspects that US regulators and politicians have not finished publishing all those damning e-mails yet.” I look forward to these revelations, as well.
This would really provide the financial markets with transparency!
The thing that strikes me so much about the release of these e-mails over the past week or so is their humanity. These Wall Street villains talk like human beings, like you and me.
Gillian Tett, in my mind, has a terrific opinion piece in the Financial Times this morning titled “E-Mails throw light on murky world of credit” (http://www.ft.com/cms/s/0/a9da1aa4-508b-11df-bc86-00144feab49a.html). Her reflection on the e-mails is captured in the following sentence: “It is fascinating, almost touching, stuff.”
But, even more important she states that “Reading these e-mails with the benefit of hindsight, there is little suggestion that rating officials were engaged in any deliberate malfeasance. Many appear conscientious and hard-working.” These people are just human beings trying to do their job.
The same can be said of those people that wrote the e-mails at Goldman. This is captured in an article by Kate Kelly in the Wall Street Journal titled “Goldman’s Take-No-Prisoners Attitude” (http://online.wsj.com/article/SB20001424052748703441404575206400921118356.html#mod=todays_us_money_and_investing.)
Kelly speaks of a world, which Tett describes as “so detached and rarefied”, in which betting applied to almost anything. The scene she presents in her article is one in which mortgage traders from Goldman Sachs “cast bets on a White Castle hamburger-eating contest” in December 2007. (Note that the problems in the subprime mortgage market were so severe at this time that the Federal Reserve announced the creation of a Term Auction Facility (TAF) on December 12, 2007 with the first auction being held on December 17, 2007.)
This behavior, Kelly reminisces, “resembled a scene out of ‘Liar’s Poker,’ a book (by Michael Lewis of the book ‘The Big Short’) depicting bawdy antics of (mortgage) bond traders at Salomon Brothers in the 1980s.” She argues that “It was a lower-stakes version of what went on ever day in the group: aggressive, take-no-prisoners trading.”
To Kelly, the world apparently didn’t change much between the 1980s and the 2000s!
Tett draws some conclusions from the picture present in the e-mails. She writes “by 2007 they (the bond raters), like the bankers, had become tiny cogs in a machine that was spinning out of control. Their world was also a strange, geeky silo, into which few non-bankers ever peered.”
And, Tett goes on, “Indeed, this world was so detached and rarefied it is, perhaps, little wonder that S&P struggled to deal with the press, or that Goldman traders felt free to celebrate the mortgage market collapse.”
“Few expected external scrutiny or imagined their e-mails would ever be read.” They were just being human.
But, something was wrong! Something bigger than the traders or the raters had taken control and was driving the system.
And, this leads Tett to the first of two lessons she draws from the information in the e-mails: “what went wrong in finance was fundamentally structural, as an entire system spun out of control! It might seem tempting to lash out at a few colorful traders but that is a sideshow…”
She concludes: “what is needed is systemic reform that removes conflicts of interest.”
This is the only point on which I disagree with her. To me this whole “spinning out of control” was a result of the credit inflation that had been prevalent in the financial system for the past fifty years or so. The whole effort to inflate the American economy had resulted in the excessive creation of credit during this time period, the almost fanatical drive toward financial innovation (led by the federal government), and the assumption of more and more risk by the private sector in a search to sustain its returns.
The reference to the book “Liar’s Poker” is particularly relevant because the main story in that book is about the trading going on in mortgage-backed securities, something that did not exist until the early 1970s when the federal government created the instrument. Please note that the first mortgage-backed security was issued by the Government National Mortgage Association (Ginny Mae) in 1970. Before then mortgage-related issues were not traded on capital markets. By the time of the writing of “Liar’s Poker”, government-related mortgage-backed securities had become the largest component of capital markets.
As I have stated many times, the purchasing power of the United States dollar declined by roughly 85% between January 1961 and the present time. Although consumer price inflation was kept relatively low over the past decade or so, credit inflation permeated the asset markets as bubbles appeared in stocks and housing. House prices got so out of line with rental prices during this time that the collapse of the housing bubble became inevitable.
So, I agree with Tett in her statement that “what went wrong in finance was fundamentally structural, as an entire system spun out of control!”
But, human beings acted like human beings during this time. Again, to quote Tett: “they (the bond raters), like the bankers, had become tiny cogs in a machine that was spinning out of control.”
And, as Chuck Prince, former CEO of Citigroup, called it: as long as the music is playing, people must keep on dancing. This doesn’t excuse them, but it puts, I think, the behavior in perspective. This was not the well-thought-out plot of evil people.
Lesson: inflation creates incentives that can get out of hand. If the government wants to conduct economic policies with an inflationary bias then they must deal with the consequences at a later time.
I do agree with Tett on her second lesson learned: “the whole murky credit business must be taken out of the shadows. So few people spotted that finance was spinning out of control because the financial system was so separated into silos that its practitioners lost any common sense.”
Tett “welcomes the publication of these emails” but warns us to “keep braced for the next installment.” She “suspects that US regulators and politicians have not finished publishing all those damning e-mails yet.” I look forward to these revelations, as well.
Friday, April 23, 2010
The Changing Banking System
I remember when there were more than 14,000 banks in the United States. I also remember when there were 12,000 banks in the banking system. Even in those days, the financial industry only accounted for no more than about one-sixth of total domestic profits in America.
Now there are about 8,000 banks in the United States and about one in eight of these banks is either on the problem bank list of the FDIC or in rather serious trouble. The FDIC is closing three to four banks a week and it is expected to continue on this pace for another twelve to eighteen months.
The biggest banks in the banking system are doing well, profit wise. The reported earnings this week of JPMorgan Chase, Goldman Sachs, Morgan Stanley, Bank of America, Citigroup, and so on just re-confirmed the recovery of these giant institutions. Of course it is not the banking side of the business that is producing these results, although their loan problems seem to be diminishing. It is the trading side of the business that is creating such significant gains subsidized by the Federal Reserve zero interest rate policy. This is the “quiet” bailout of these banks because it does not require Treasury funds to support the effort and it helps bank assets improve so that insolvency becomes less and less of a problem.
Furthermore, regional banks appear to be recovering. PNC and BB&T have been doing well, but those lagging behind, Fifth Third Bancorp, KeyCorp, SunTrust Banks, and Huntington Bancshares all seem to be showing improvements which respect to their problem loans. PNC and BB&T actually reported profits for the first quarter, $671 million for PNC and $194 million for BB&T. So, the improvements continue down the supply chain (http://online.wsj.com/article/SB20001424052748703876404575200240959419542.html#mod=todays_us_money_and_investing.)
We are still waiting for the small- to medium-sized banks to start perking up. But, this is where more of the problem or troubled banks lie and where most of the bank closures or acquisitions are going to be.
This fact points to one of the major changes taking place in the banking system. We are going through another period where the number of banks in the banking system is declining. I would not be surprised at all if the number of banks dropped to the 5,000 to 6,000 range over the next few years.
This movement will continue the consolidation of the banking industry in the United States. Right now, $2 out of every $3 in domestic banking assets resides in the largest 25 banks in the country. These are the huge banks mentioned above and the large regional banks mentioned above.
How high might this concentration go? I believe that regardless of what Congress does with respect to financial reform and trying to limit the size of banks that the total amount of domestic assets residing in the largest 25 banks in the country will go to about $4 out of every $5 in the relatively near future. This means that there will be at least 5,000 banks competing for that other $1!
Another change that is taking place in the United States banking system is the presence of more and more foreign banks. This seems to be a perfect time for foreign owned banks to pick up acquisitions in the United States and not only gain size but also gain presence in different regional markets. In this respect, note the article “Foreign Firms Scoop Up Failed U. S. Banks” in the Wall Street Journal, http://online.wsj.com/article/SB10001424052748704830404575200134085458128.html#mod=todays_us_money_and_investing. Canadian banks are especially taking advantage of the banking situation in the United States, but banks in Japan and other countries are seizing the opportunity as well.
In March, foreign-related institutions controlled over 11% of the assets in the United States banking system. This is up substantially from thirty years ago and is expected to climb further in the near future. My guess is that this number will be in the 15% to 20% range over the next five years or so. And, these assets will not be owned by small- or medium-sized financial organizations.
This is the problem now faced by President Obama and the Congress in terms of financial reform. I just don’t see these trends reversing themselves. And, as banks get bigger they will also be controlling more and more of the banking assets in the United States. And, as the banks get bigger they will continue to move into more and more areas of the financial market and they will continue to create more and more financial innovations.
And, if they are not done in the United States they will be done somewhere else in the world for commercial banking is, in fact, worldwide and not just the playing field of Americans. Big foreign banks are becoming a bigger part of the United States banking scene just as big United States banks are becoming a bigger part of the banking scene in other countries.
The difficulty in writing regulations that try to control what these banks can do is, in the words of economists Oliver Hart of Harvard and Luigi Zingales of the University of Chicago, “doomed to fail because such regulations are extremely easy to bypass. It takes no time for a clever financier to design a contract that gets around most restrictions.” Finance is just information and information can be restructured in almost any way that someone wants it to be structured.
The evolution of the financial system is going to continue to be fought by those constrained to the old Keynesian fundamentalism. The current financial environment has been created by fifty years of government policy conforming to a dogma that considers an inflationary bias to the economy an necessary pre-requisite for sustaining high levels of economic growth and low levels of unemployment.
Well, this inflationary environment has fostered the undisciplined expansion of credit, the excessive leveraging of financial capital, and the creation of more and more financial innovation to underwrite both the expansion of the debt and the aggressive financial leveraging. It has also resulted in the relative growth of the financial industry.
Many of these same commentators have remarked about how the financial sector has grown relative to the rest of the economy. For example, Paul Krugman in “Don’t Cry for Wall Street”, has written: “In the years leading up to the 2008 crisis, the financial industry accounted for a third of total domestic profits — about twice its share two decades earlier.” He then makes the value judgment that “the fact is that we’ve been devoting far too large a share of our wealth, far too much of the nation’s talent, to the business of devising and peddling complex financial schemes — schemes that have a tendency to blow up the economy. Ending this state of affairs will hurt the financial industry. So?” (See http://www.nytimes.com/2010/04/23/opinion/23krugman.html?hp.)
Well, this is the financial industry that a government following the Keynesian economic philosophy has created. Two final comments: first, care needs to be taken in creating economic policies because the long run effect of the policies may not be what you want even though the short run effects are what you want; and second, once the size and structure of an industry has been created, it does not go away until the industry becomes technologically obsolete. The financial industry is thriving using information technology, a field that is just in its infancy. Finance and information technology have a long way to go.
Now there are about 8,000 banks in the United States and about one in eight of these banks is either on the problem bank list of the FDIC or in rather serious trouble. The FDIC is closing three to four banks a week and it is expected to continue on this pace for another twelve to eighteen months.
The biggest banks in the banking system are doing well, profit wise. The reported earnings this week of JPMorgan Chase, Goldman Sachs, Morgan Stanley, Bank of America, Citigroup, and so on just re-confirmed the recovery of these giant institutions. Of course it is not the banking side of the business that is producing these results, although their loan problems seem to be diminishing. It is the trading side of the business that is creating such significant gains subsidized by the Federal Reserve zero interest rate policy. This is the “quiet” bailout of these banks because it does not require Treasury funds to support the effort and it helps bank assets improve so that insolvency becomes less and less of a problem.
Furthermore, regional banks appear to be recovering. PNC and BB&T have been doing well, but those lagging behind, Fifth Third Bancorp, KeyCorp, SunTrust Banks, and Huntington Bancshares all seem to be showing improvements which respect to their problem loans. PNC and BB&T actually reported profits for the first quarter, $671 million for PNC and $194 million for BB&T. So, the improvements continue down the supply chain (http://online.wsj.com/article/SB20001424052748703876404575200240959419542.html#mod=todays_us_money_and_investing.)
We are still waiting for the small- to medium-sized banks to start perking up. But, this is where more of the problem or troubled banks lie and where most of the bank closures or acquisitions are going to be.
This fact points to one of the major changes taking place in the banking system. We are going through another period where the number of banks in the banking system is declining. I would not be surprised at all if the number of banks dropped to the 5,000 to 6,000 range over the next few years.
This movement will continue the consolidation of the banking industry in the United States. Right now, $2 out of every $3 in domestic banking assets resides in the largest 25 banks in the country. These are the huge banks mentioned above and the large regional banks mentioned above.
How high might this concentration go? I believe that regardless of what Congress does with respect to financial reform and trying to limit the size of banks that the total amount of domestic assets residing in the largest 25 banks in the country will go to about $4 out of every $5 in the relatively near future. This means that there will be at least 5,000 banks competing for that other $1!
Another change that is taking place in the United States banking system is the presence of more and more foreign banks. This seems to be a perfect time for foreign owned banks to pick up acquisitions in the United States and not only gain size but also gain presence in different regional markets. In this respect, note the article “Foreign Firms Scoop Up Failed U. S. Banks” in the Wall Street Journal, http://online.wsj.com/article/SB10001424052748704830404575200134085458128.html#mod=todays_us_money_and_investing. Canadian banks are especially taking advantage of the banking situation in the United States, but banks in Japan and other countries are seizing the opportunity as well.
In March, foreign-related institutions controlled over 11% of the assets in the United States banking system. This is up substantially from thirty years ago and is expected to climb further in the near future. My guess is that this number will be in the 15% to 20% range over the next five years or so. And, these assets will not be owned by small- or medium-sized financial organizations.
This is the problem now faced by President Obama and the Congress in terms of financial reform. I just don’t see these trends reversing themselves. And, as banks get bigger they will also be controlling more and more of the banking assets in the United States. And, as the banks get bigger they will continue to move into more and more areas of the financial market and they will continue to create more and more financial innovations.
And, if they are not done in the United States they will be done somewhere else in the world for commercial banking is, in fact, worldwide and not just the playing field of Americans. Big foreign banks are becoming a bigger part of the United States banking scene just as big United States banks are becoming a bigger part of the banking scene in other countries.
The difficulty in writing regulations that try to control what these banks can do is, in the words of economists Oliver Hart of Harvard and Luigi Zingales of the University of Chicago, “doomed to fail because such regulations are extremely easy to bypass. It takes no time for a clever financier to design a contract that gets around most restrictions.” Finance is just information and information can be restructured in almost any way that someone wants it to be structured.
The evolution of the financial system is going to continue to be fought by those constrained to the old Keynesian fundamentalism. The current financial environment has been created by fifty years of government policy conforming to a dogma that considers an inflationary bias to the economy an necessary pre-requisite for sustaining high levels of economic growth and low levels of unemployment.
Well, this inflationary environment has fostered the undisciplined expansion of credit, the excessive leveraging of financial capital, and the creation of more and more financial innovation to underwrite both the expansion of the debt and the aggressive financial leveraging. It has also resulted in the relative growth of the financial industry.
Many of these same commentators have remarked about how the financial sector has grown relative to the rest of the economy. For example, Paul Krugman in “Don’t Cry for Wall Street”, has written: “In the years leading up to the 2008 crisis, the financial industry accounted for a third of total domestic profits — about twice its share two decades earlier.” He then makes the value judgment that “the fact is that we’ve been devoting far too large a share of our wealth, far too much of the nation’s talent, to the business of devising and peddling complex financial schemes — schemes that have a tendency to blow up the economy. Ending this state of affairs will hurt the financial industry. So?” (See http://www.nytimes.com/2010/04/23/opinion/23krugman.html?hp.)
Well, this is the financial industry that a government following the Keynesian economic philosophy has created. Two final comments: first, care needs to be taken in creating economic policies because the long run effect of the policies may not be what you want even though the short run effects are what you want; and second, once the size and structure of an industry has been created, it does not go away until the industry becomes technologically obsolete. The financial industry is thriving using information technology, a field that is just in its infancy. Finance and information technology have a long way to go.
Thursday, April 22, 2010
Washington Still Doesn't Get It!
The President and Congress just don’t get it!
Financial reform is in the air! The bad guys did it and they need to be brought to account! Protect Main Street and go after those that are on Wall Street!
Unfortunately, this is not going to produce the results that the President and Congress want.
Unfortunately, we are not going to get helpful results until the President and Congress develop an understanding about finance and what their current philosophies about economic policy are doing.
Unfortunately, I don’t see this happening in the near term.
Just two points this morning, but points that I have made before.
The first point pertains to the understanding…or misunderstanding…of what finance is all about. This misunderstanding is captured in the lead editorial in the New York Times this morning titled “After Goldman” (http://www.nytimes.com/2010/04/22/opinion/22thu1.html?hp). In this editorial we read: “The Goldman deal was nothing more than a bet on the mortgage market…WITHOUT ‘INVESTING’ ANYTHING IN THE REAL ECONOMY.”
Guess what? That is what finance ultimately is. Finance is nothing more than information and millions and millions of people operate with this kind of information every day.
What is your dollar bill? A piece of paper…a piece of information.
Well, but it is legal tender!
Right, according to the government you have to accept a dollar bill in payment for debt. What has this got to do with THE REAL ECONOMY?
And, what about the demand deposit account you have at your commercial bank? It is just 0s and 1s in some computer. What has this got to do with THE REAL ECONOMY?
By the way, you are betting that you will be able to access that money when you need it? Is it safe?
Well, you say, the deposit account has insurance on it, doesn’t it? The Federal Government has guaranteed that you will not lose these funds and will not be inconvenienced by a delay in access to them. You have a promise! But, what has that got to do with THE REAL ECONOMY?
What are loans? Well, they are cash flows. Say, an initial cash outflow to the borrower and then a series of cash inflows back to the lender. Just 0s and 1s through bank accounts.
But, I put up a house to back the loan, didn’t I? The house is a real asset.
Yes, but the loan agreement is in terms of cash flows and the house is there for security in case you don’t pay the returning cash flow. Furthermore, that house is 25% underwater now, another piece of information, so how does this impact the cash flows?
Furthermore, it was the government that showed us how to “slice and dice” cash flows in order to tailor cash flows so that potential purchasers would find those “new” cash flows more attractive and purchase them. The first mortgage-backed security was issued by the Federal Government in 1970. The mortgage market went from playing a zero role in world capital markets to becoming, by the middle of the 1980s, the largest component of world capital markets. (See Michael Lewis’ “Liar’s Poker”.)
Thank you Washington for teaching us that cash flows are just bits of information! No real world
here.
Now Washington wants to bring the herd of cats it has unleashed under control. Good luck!
The second point has to do with government policy and how it creates the environment for all else that goes on in the economy. Some of this discussion can be related to the David Wessel’s column in the Wall Street Journal this morning, “Mapping Fault Lines of Crises,” (http://online.wsj.com/article/SB20001424052748704133804575198080507492968.html#mod=todays_us_page_one). Wessel, in his column, discusses the work of Raghuram Rajan, a professor at the University of Chicago and former chief economist at the International Monetary Fund.
Rajan argues that “The U. S. approach to recession-fighting and its social safety net are geared for fast recoveries of the past, not jobless recoveries now the norm. That puts pressure on Washington to do something: tax cuts, spending increases and very low interest rates. This leads big finance to assume that the government will keep money flowing and will step in if catastrophe occurs.”
This philosophy of government was first incorporated into government policymaking in the early sixties and has continued as the foundation for economic policy ever since. A consequence of this has been that the purchasing power of the dollar has gone from $1.00 in January 1961 to $0.15 in 2010. And, as we know, a sustained inflationary environment is one that produces massive debt creation and increasing financial leverage along with extensive amounts of financial innovation.
This leads us to another part of Rajan’s argument: “As incomes at the top soared (in the last half of the 20th century), politicians responded to middle-class angst about stagnant wages and insecurity over jobs and health insurance. Since they couldn’t easily raise incomes, politicians of both parties gave constituents more to spend by fostering an explosion of credit, especially for housing.” And, Wessel states, Rajan goes back in history to support the fact that this is not an atypical reaction.
The latter move not only contributed to general inflation, but eventually led to asset price bubbles in specific sectors of the market which could not be sustained. Hence the financial crisis!
Finance has never really been connected to THE REAL ECONOMY. Take a look at Niall Ferguson’s book “The Ascent of Money.” (See my review, http://seekingalpha.com/article/120595-a-financial-history-of-the-world.) This is especially true since the growth in finance and financial innovation, historically, has been connected with government’s financing of wars and, in the 20th century, the social system.
Furthermore, finance, in the future, is going to be even more connected with the idea of information and the exchange of information. For example, see the book “The Quants” (http://seekingalpha.com/article/188342-model-misbehavior-the-quants-how-a-new-breed-of-math-whizzes-conquered-wall-street-and-nearly-destroyed-it-by-scott-patterson). And, this concept is spreading beyond financial markets. An amazing amount of research efforts and publications are connected with “Information Markets” which are not related to financial markets. Bob Shiller of “Irrational Exuberance” has produced a lot in this area: see his books “Macro Markets” and “The New Financial Order.”
The point is, again, that the President and Congress are fighting the last war. But, the last war is history!
Financial reform is in the air! The bad guys did it and they need to be brought to account! Protect Main Street and go after those that are on Wall Street!
Unfortunately, this is not going to produce the results that the President and Congress want.
Unfortunately, we are not going to get helpful results until the President and Congress develop an understanding about finance and what their current philosophies about economic policy are doing.
Unfortunately, I don’t see this happening in the near term.
Just two points this morning, but points that I have made before.
The first point pertains to the understanding…or misunderstanding…of what finance is all about. This misunderstanding is captured in the lead editorial in the New York Times this morning titled “After Goldman” (http://www.nytimes.com/2010/04/22/opinion/22thu1.html?hp). In this editorial we read: “The Goldman deal was nothing more than a bet on the mortgage market…WITHOUT ‘INVESTING’ ANYTHING IN THE REAL ECONOMY.”
Guess what? That is what finance ultimately is. Finance is nothing more than information and millions and millions of people operate with this kind of information every day.
What is your dollar bill? A piece of paper…a piece of information.
Well, but it is legal tender!
Right, according to the government you have to accept a dollar bill in payment for debt. What has this got to do with THE REAL ECONOMY?
And, what about the demand deposit account you have at your commercial bank? It is just 0s and 1s in some computer. What has this got to do with THE REAL ECONOMY?
By the way, you are betting that you will be able to access that money when you need it? Is it safe?
Well, you say, the deposit account has insurance on it, doesn’t it? The Federal Government has guaranteed that you will not lose these funds and will not be inconvenienced by a delay in access to them. You have a promise! But, what has that got to do with THE REAL ECONOMY?
What are loans? Well, they are cash flows. Say, an initial cash outflow to the borrower and then a series of cash inflows back to the lender. Just 0s and 1s through bank accounts.
But, I put up a house to back the loan, didn’t I? The house is a real asset.
Yes, but the loan agreement is in terms of cash flows and the house is there for security in case you don’t pay the returning cash flow. Furthermore, that house is 25% underwater now, another piece of information, so how does this impact the cash flows?
Furthermore, it was the government that showed us how to “slice and dice” cash flows in order to tailor cash flows so that potential purchasers would find those “new” cash flows more attractive and purchase them. The first mortgage-backed security was issued by the Federal Government in 1970. The mortgage market went from playing a zero role in world capital markets to becoming, by the middle of the 1980s, the largest component of world capital markets. (See Michael Lewis’ “Liar’s Poker”.)
Thank you Washington for teaching us that cash flows are just bits of information! No real world
here.
Now Washington wants to bring the herd of cats it has unleashed under control. Good luck!
The second point has to do with government policy and how it creates the environment for all else that goes on in the economy. Some of this discussion can be related to the David Wessel’s column in the Wall Street Journal this morning, “Mapping Fault Lines of Crises,” (http://online.wsj.com/article/SB20001424052748704133804575198080507492968.html#mod=todays_us_page_one). Wessel, in his column, discusses the work of Raghuram Rajan, a professor at the University of Chicago and former chief economist at the International Monetary Fund.
Rajan argues that “The U. S. approach to recession-fighting and its social safety net are geared for fast recoveries of the past, not jobless recoveries now the norm. That puts pressure on Washington to do something: tax cuts, spending increases and very low interest rates. This leads big finance to assume that the government will keep money flowing and will step in if catastrophe occurs.”
This philosophy of government was first incorporated into government policymaking in the early sixties and has continued as the foundation for economic policy ever since. A consequence of this has been that the purchasing power of the dollar has gone from $1.00 in January 1961 to $0.15 in 2010. And, as we know, a sustained inflationary environment is one that produces massive debt creation and increasing financial leverage along with extensive amounts of financial innovation.
This leads us to another part of Rajan’s argument: “As incomes at the top soared (in the last half of the 20th century), politicians responded to middle-class angst about stagnant wages and insecurity over jobs and health insurance. Since they couldn’t easily raise incomes, politicians of both parties gave constituents more to spend by fostering an explosion of credit, especially for housing.” And, Wessel states, Rajan goes back in history to support the fact that this is not an atypical reaction.
The latter move not only contributed to general inflation, but eventually led to asset price bubbles in specific sectors of the market which could not be sustained. Hence the financial crisis!
Finance has never really been connected to THE REAL ECONOMY. Take a look at Niall Ferguson’s book “The Ascent of Money.” (See my review, http://seekingalpha.com/article/120595-a-financial-history-of-the-world.) This is especially true since the growth in finance and financial innovation, historically, has been connected with government’s financing of wars and, in the 20th century, the social system.
Furthermore, finance, in the future, is going to be even more connected with the idea of information and the exchange of information. For example, see the book “The Quants” (http://seekingalpha.com/article/188342-model-misbehavior-the-quants-how-a-new-breed-of-math-whizzes-conquered-wall-street-and-nearly-destroyed-it-by-scott-patterson). And, this concept is spreading beyond financial markets. An amazing amount of research efforts and publications are connected with “Information Markets” which are not related to financial markets. Bob Shiller of “Irrational Exuberance” has produced a lot in this area: see his books “Macro Markets” and “The New Financial Order.”
The point is, again, that the President and Congress are fighting the last war. But, the last war is history!
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