November 2009 – Page 2 – The Aleph Blog

How to Regulate the Banks, and other Financials

Posted on 11 November 2009 by David Merkel

At the Treasury meeting, I commented that the insurers were better regulated for solvency than the banks.? One of the reasons for that is that they do harder stress tests, and they look longer-term.

So, if one is trying to regulate banks for solvency, there are two things to do:

Set risk-based capital formulas so that few institutions fail.
Make it even less likely that larger institutions fail.

As a clever old boss of mine once said, “A banks liabilities are its assets, and its assets are its liabilities.”? The idea is this — banks that focus on their deposit franchises have something of real value — that is hard to replicate.? But any bank can invest their funds aggressively, which will lead to defaults with higher frequency.? It is true of insurers as well, most financials die from bad investing policies, and short-term liabilities that require complacent funding markets.

The essence of a good risk-based capital formula is that it forces intelligent diversification, and forces adequate liquidity.? No assets should be bought that the liability structure of the bank cannot hold until maturity.? There should be no concentration of assets by class, subclass, or credit, that would be adequate to lead to failure.

My view is that a proper risk-based capital regime would start with asset subclasses, and double the capital held on the largest subclass, and 1.5X the capital on the second largest subclass.? After that, within each subclass, the top 10 credits get twice the level of capital, the next 10 1.5x the level of capital.

Having managed assets in a framework like this, I can tell you that it creates diversification.? But the next part is even more important, because short-term funding structures are a recipe for default.

It is almost always initially profitable to borrow short and lend long.? That said, it is a noisy trade.? Who can be sure that short rates will remain below the rates at which one invested long?? The second component of a good risk-based capital formula is that there is no investing in assets that are longer than the liabilities that fund the financial institution.? (For wonks only: regulated financial institutions should be matching assets versus liabilities as their most aggressive posture.? Unregulated financials can do what they want.? And no investing in unregulated financials by regulated financials.)

But after all that, there must be a capital penalty on larger institutions.? Let financial institutions get as large as they like, but once they get to a certain level of assets, say $100 billion, start raising capital requirements so that it is uneconomic to manage more than $500 billion in assets.? If we had regulations like that, the too big to fail issue would not occur.? As they got close to the barrier banks would break themselves up, without any external intervention.

Beyond that, no modeling of asset correlations would be brought into the modeling because risky asset correlations go to one in a crisis. Any advantage derived from diversification should be accepted as earned, and not capitalized as planned for.

Dodd’s Proposals

There are good things in Senator Dodd’s proposals, but I want to focus on a few things.

Either eliminate the Fed, or let it manage systemic risk.? Why?? The Fed creates most systemic risk through its monetary policy.? What tools would a new regulator have to constrain the Fed?? None?? I thought so.? In a fiat currency economy, the central bank must constrain credit in order to constrain monetary policy and systemic risk.

I don’t think there has to be a single regulator, as much as the regulators should choose whom they regulate, rather than vice-versa.? Options are always bad for financial institutions.? One should want them to apply to the Treasury for a regulator, and the Treasury assigns the regulator that will minimize risks to the nation.

As for changing governance of the Fed, Dodd’s bill misses the point.? We don’t care who governs it. We do care what their goals are.? We want them to minimize goods and asset inflation, while not letting the economy go fallow through capital or labor unemployment.

I’m not crazy about Dodd’s plans to select members of the FOMC by a vote from the Fed Board.? That just centralizes power in the hands of incompetent Fed Board members.

Personally, if I can’t eliminate the Fed, I would rather its members be democratically elected each congressional cycle.? Yes, initially the electorate would make errors, electing those that promise greater prosperity, but eventually they would realize that they need to elect those that will restrain inflation, regardless of the consequences.? I trust the people of America more than the elites that have mismanaged it.

My Visit to the US Treasury, Part 7 (Final)

Posted on 10 November 2009 by David Merkel

Things have been busy for me, so this final part should be short.? What did I learn that I did not already know?? Not much, except:

The Treasury wants to convince? the public that it is doing its best, but that Congress is a slave to the Financial Services industries.
When asked about the latest bailout of GMAC, they said that didn’t qualify as a financial — the aid was to help the auto companies.? (If so, send it directly, and let GMAC expire.)
They said that they worried about the same things we did, though they had to maintain public confidence, and did not think it was as likely as we thought.
They did not bring up the GSEs.
They pointed at the financial markets as evidence of recovery, and did not speak of the real economy, which is weak.
There is no acknowledgment of what could go wrong in the long-run.? They are only playing for the next 3-7 years, at most.? Everything is done to goose the next year.
That the Treasury is trying to reduce its footprint in the economy is welcome news to me.
They said that they were trying to be wise stewards of the economy, but that Congress had questionable motives.

May I go back to my original questions:

Haven?t low interest rates boosted speculation and not the real economy?
We are looking at big deficits for the next seven years, but what happens when the flows from Social Security begin to reverse seven years out?? What is your long-term plan for the solvency of the United States?
We talk about a strong dollar policy, but we flood the rest of the world with dollar claims.? How can we have a strong dollar?
None of your policies has moved to reduce the culture of leverage.? How will you reduce total leverage in the US?
Why did you sacrifice public trust that the Treasury would be equitable, in order to bail out private entities at the holding company [level]?? People now believe that in a crisis, the government takes from the prudent to reward the foolish.? Why should the prudent back such a government?
If we had to do bailouts, why did we bail out financial holding companies, which are not systemically important, instead of their systemically critical subsidiaries?
We are discussing giving tools to regulators for the tighter management of the solvency of financials.? There were tools for managing solvency in the past that went unused.? Why should we believe the new ?stronger? tools will be used when the older tools weren?t used to their full capacity?? (The banks push back hard.)

I’ve answered 1 and 2.? The rest are unanswered.? Here are the brief answers.

3) No, there is no strong dollar policy.? Wait for the day when we are net exporters (and our relative wages will be lower then.)

4) They are doing nothing to? reduce total leverage in the US.? My own guess is that it is increasing.

5) And there is the question, aside from fairness, were the bailouts Constitutional?? A narrow reading of the Constitution says no, but our government does many, many things that violate a narrow reading of the Constitution.? The fairness question was not raised either, the bloggers there were attacking effectiveness, not fairness.

6) This is my guess — we bailed out holding companies because it was the simplest way to do it.? More thought would have led to a cheaper solution, but thought is rare during a panic.

7) I have no answer to point 7.? There is no good reason to hand over stronger tools to a culture that has not used weaker tools.

Aside from all that, we could have spent more time on international issues.? There was the joke at the beginning of the session that one fellow tasked with raising money was “fluent in Mandarin.”?? From the chuckles, I gauged it to be a joke.

But that might prove to be the most significant point economically.? The Treasury is putting pressure on the Dollar through high debt issuance, and the Fed through the creation of short-term credit to heal various debt markets.? The benefits are going to debtors, not creditors.? What value should the creditors assign to the Dollar?? The simple answer should be less than previously.? Yet, nations follow many noneconomic goals, many of which benefit the US as the reserve currency in the short-run.

The ultimate answers are complex, because they rely on how other nations will act.

Final Note

I have found interesting the commenters that automatically assume that being willing to go to the Treasury and eat one cookie equals compromise.? There are a lot of scared and frustrated people in the US, and they see their prosperity ebbing, and are looking for someone to blame.

Let me try this — as the world has gone capitalist, the edge of the US has been eroded.? Now we face a world where doing certain jobe should pay the same, regardless of where they are located.? Wages in the US will converge with those from the rest of the world, adjusted for capital investments.

Throughout human history, “middle classes” have been abnormal.? The current adjustment in the US may be showing the once large middle class that it is not a normal thing, and is hard to maintain.

There is no conspiracy.? The US Government is up against economic forces larger than it can combat.? The rest of the world is out-competing the US, and the US? has a shrinking portion of the pie as a result.

My Visit to the US Treasury, Part 6

Posted on 7 November 20098 November 2009 by David Merkel

Now, none of us knew when we came that only bloggers were invited.? Personally, I expected it to be a broader press briefing that some bloggers could come to as well.? “Deep background” is well understood to the press, but new to bloggers.? My blogging friends at the meeting can correct me, but all of us were surprised that it was only bloggers at the meeting.

My only clue that they might have treated us nicer than some other gatherings, was that some staffers not at the meeting came in after the meeting to raid some cookies.? Now, maybe that is normal regardless there.? I’ve seen the same things in corporate settings.? The e-mail announcement, “Open season in room 406!”? That said, the chocolate chip cookies were all gone. :(? I had one, as did Tyler, I think.? Maybe the Treasury officials had the rest.

Personally, I am comfortable with the restrictions on reporting from the meeting.? The Treasury’s high-level staff sound the same tune.? It doesn’t matter if we identify them or not, they reflect the policies of the Obama Treasury.? With restrictions on not identifying who said what, to me it does not matter, because they were senior Treasury officials.? We can quote, or approximately quote.? We can’t tie it to a single person.? That doesn’t affect us much.? We know what they think, and we can write about it.? We just can’t say exactly who said it, or whether they were there.

Making Money or Not

Few areas of the US government are designed to make money.? One of the main points that Treasury made to us was that the TARP would cost little, or might make money.? TARP is a piece of a larger puzzle.? My question is this, counting in all of the bailouts, including all stimulus programs, what is the cost to the taxpayer?? Now, I ask my readers what they know here. E-mail me with any comprehensive pieces that you have seen, or put it in the comments, so that all can see.

When I look at the bailouts, AIG, Fannie, and Freddie have sucked up /are sucking up resources.? With respect to the GSEs, I appreciate the view that the Administration views Fannie and Freddie as a hole in the system that they can use to funnel money to housing without asking Congress for approval.? Certainly their financial result show it.? Fannie lost a lot of money last quarter and is begging for help.? Freddie lost less, but is not asking for money now, but they likely will in the future.? As for the Treasury, they have opted to not maximize the value of Fannie by allowing her to sell of tax credits to others, notably Goldman and Berky.? They are not interested in maximizing the value of the GSEs, only of using them for their policy goals.

One slide the Treasury showed us was that they thought they were making money across all of the TARP bailouts that they did.? Also, that their guarantee programs had made money as well.

True, so far the guarantee programs have made money.? That does not mean that the government should be in that business, as it may encourage greater risk taking later, because they think the government will rescue them in times of trouble.? In England, at least some think it is a bad precedent.

TARP may be doing okay, but the same moral hazard argument applies.? Also, bailouts may come after shareholders have lost a lot, but management teams may (and seem to be now) benefit disproportionately from the bailout.? Away from that, the losses from the GSEs, Auto companies, and AIG swamp other gains.? That’s what it seems to me.? Does anyone else know better?? Please put it in the comments, for all to see.

Away from that, consider how the FDIC is basically broke, and that the FHA is not far behind.? This crisis is not over.

A Place of Agreement

One place where I can agree with the Treasury is that there should be only one regulator of depositary institutions.? The insurance industry can choose among states, but for the most part there are states for big companies,and states for small companies.? The states willing to regulate the big insurance companies have done a great job relative to the banking regulators.? There are few failures.? AIG died for non-insurance reasons.? Penn Treaty was a basket case long before the crisis.? Who else died?

Having one regulator for banks will remove the ability of the banks to choose the weak regulator.? It raises the risk that the one regulator will be corrupted.? That’s a lesser risk, because with many regulators, the odds that one will be corrupt are high, and corrupt institutions will go to them to be regulated.? With one regulator, politicians can more easily watch the troubles, and can more easily assign blame.

I have no objection to one national insurance regulator either.? That said, many states will object, because they have differing standards.? But does Congress really want to do insurance law?? It takes up a lot of time and is complex.

The Final Note for Now

Things always look best for a borrower immediately after his most recent loan.? So it is for most programs in our economy that favor giving loans in this crisis to stimulate demand.? So it was in the 70s and 80s with lesser developed countries.? The finances looked great after the loans, but after they had spent it away on consumption, things looked much, much, worse.

So it is with government programs that interfere with the free market through offering cheap lending terms.? They give a temporary lift that leads to greater problems once the subsidy is spent away.? So it is now with government subsidies and loans.

Other Posts

Two more posts on the meeting, one from a blogger who was there:

A Sit Down With Senior Treasury Officials – Part II

and one who was not, somewhat critical, but constructively so:

Treasury and the?Blogs

As for me, I’m glad I went.? I have a better zeitgeist of the US Treasury.? I am not more impressed, nor less impressed with them.? I do want the Federal Reserve to consider inviting us to meet with them.? They are far less accountable than the Treasury, and many of us would like to counsel them on their behavior that seemed smart at the time, but will likely prove destructive to the republic.? Dare you invite us, Ben, or do you have less courage than the Treasury?

My Visit to the US Treasury, Part 5

Posted on 7 November 20097 November 2009 by David Merkel

One other blogger took his nameplate with him — I’m not sure who; the rest left theirs.? But this is what was in front of each one of us as we sat down to discuss matters at the US Treasury.? Treasury officials had similar nameplates.? It dictated where we would sit as well.? From the front of the room on the left, for bloggers it was Financial Armageddon, (Megan McArdle — not there), Accrued Interest, and Across the Curve.? On the right, Naked Capitalism, Kid Dynamite, Interfluidity, Me, and Marginal Revolution.? Aside from putting the two bloggers with the most traffic at the front, there did not seem to be any rhyme or reason to the seating.

The Treasury officials presenting generally sat in front, a few sat to the side and behind us.? It made for an interesting dynamic during the portion of the meeting where some bloggers disagreed over whether derivatives should be exchange traded or not.? The folks from the Treasury grinned.? See?? These aren’t easy questions to answer!? For me, with a middle view (bring interest rate swaps to exchanges first and see how they work, then try other instruments that are less liquid), I found the exchange to be a waste of precious time, but it was revealing of the attitudes of those in the Treasury.? I knew what the bloggers thought already.

The Biggest Financial Problem

I’ve written a number of pieces on why debt matters. (Or, where is the breaking point?)? I am in the process of reviewing This Time is Different: Eight Centuries of Financial Folly — a book that deals with the reality of sovereign defaults over the last 800 years.

Surprise! Over-indebted countries do default on their debt more often than less-indebted countries.? During the current crisis, we have two mechanisms running to blunt the troubles.? The government is running a large deficit, and the central bank is sucking in longer-dated bonds to lower interest rates.? I talked about why lower interest rates are not necessarily a blessing yesterday.? Today’s thoughts are on deficits.

After the meeting, I said to one Treasury staffer, “One of the quiet casualties of this crisis is that you lost your last bit of slack from the entitlement systems.”

“What do you mean?”

“Just this, prior to the crisis, Social Security and Medicare would produce cash flow surpluses for the Government until 2018.? Now the estimates are 2016, and my guess is more like 2014.? The existing higher deficit takes us out to the point where the entitlement systems go into permanent negative cash flow.? This means that the US budget is in a structural deficit for as far as the eye can see, fifty years or more, absent changes to entitlements.”

He looked at me and commented that it would be the job of a later administration.? No way to handle that now.? To me, the answer reminded me of what I say to myself when I go on a scary ride at Six Flags with my kids.? There is nothing we can do to change matters.? The only thing to adjust is attitude.? So, ignore the fact that you are afraid of heights, and enjoy the torture, okay?

Would that I could do that with the present situation.? The long term problems are too numerous, and the present crisis saps attention from what is arguably a larger problem.? Medicare, Social Security, unfunded Federal pensions and retiree healthcare, underfunded state pensions and unfunded retiree healthcare, and underfunded corporate pensions (flowing to the PBGC) are the crisis of the future.? We are talking underfunding and debts equivalent to 4x GDP in total.

The deficits may be helping out areas of our economy for which there is already too much capacity — autos, banks, housing, but isn’t aiding the parts of the economy that don’t have excess capacity.? The one advantage to Americans is that a decent amount of the debt is absorbed by the neomercantilists, who will get paid? back in cheaper dollars (if at all) than the goods that they provided originally.

This all feels like the Japan scenario.? Low interest rates, low growth if any in non-protected sectors, soggy debt-laden protected sectors, excess capacity in areas not salable to the rest of the world, high government debt, and a demographic crisis.? Also speculation using cheap leverage for carry trades.

I’ll try to tie this up in another post or two.? Sorry if this is verbose.

My Visit to the US Treasury, Part 4

Posted on 6 November 2009 by David Merkel

So, who did I recommend for the next meeting at the Treasury? (I think there will be one.)

Economists View http://economistsview.typepad.com/
Cafe Americain http://jessescrossroadscafe.blogspot.com/
Market-Ticker http://market-ticker.denninger.net/
Econbrowser http://www.econbrowser.com/
Greg Mankiw?s Blog http://gregmankiw.blogspot.com/
Carpe Diem http://mjperry.blogspot.com/
Credit Writedowns http://www.creditwritedowns.com/
Gregor Macdonald http://gregor.us/
Jeff Miller http://oldprof.typepad.com/
Floyd Norris — NYT http://norris.blogs.nytimes.com/
Market Beat — WSJ and their real time economics blog, deals, and real estate blog… http://blogs.wsj.com/marketbeat/
FT Alphaville — http://ftalphaville.ft.com/
James Pethokoukis — Reuters http://blogs.reuters.com/james-pethokoukis/ (also Matt Goldstein and Rolfe Winkler at Reuters)
Curious Capitalist — Time http://curiouscapitalist.blogs.time.com/
Matt Taibbi — http://trueslant.com/matttaibbi/ (And others at the same site)
Trader Mark http://www.fundmymutualfund.com/
Dealbreaker http://www.dealbreaker.com/
The Epicurean Dealmaker http://epicureandealmaker.blogspot.com/
Ultimi Barbarorum http://ultimibarbarorum.com/
Zero Hedge http://www.zerohedge.com/ (ask for Tyler Durden or Marla Singer)
The Reformed Broker http://thereformedbroker.com/
Crossing Wall Street http://www.crossingwallstreet.com/index.html
Cody Willard http://cody.blogs.foxbusiness.com/

Add to that good ideas from my readers:

Warren Mosler
Bill Cara

Now, Treasury responded to me, thanking me for the list, but said that the mainstream media bloggers already have access.? Fine with me — I was just gauging talent and reach.

The Nature of a Liquidity Trap

Go back in history over the last 25 years.? How did the Fed manufacture recoveries?? They lowered interest rates enough so that borrowers would be willing to borrow and refinance assets that had cash flow streams that were not financable in the higher interest rate environment, but financable in the lower interest rate environment.

With each successive rescue, interest rates at the trough were lower than before, inviting borrowers that were increasingly marginal to buy assets, borrowing money at cheap rates to pay them off over time.? We thought we saw the bottom, 2002-2004, but no.? The Fed Funds rate can go to zero, and what’s more the Fed can buy longer dated Treasuries, Agencies, and Mortgage Bonds, lowering interest rates on the longer end of the yield curve.? This allows even more marginal borrowers to buy assets. If they face some hiccup in their cash flow, they will default, and quickly.? If you doubt this, consider the high currently expected rate of default on FHA loans originated over the last two years.

Yes, low rates can get them to buy, but it cannot get them to hold on.? But wait, these are criticisms of the Fed, not the Treasury.? Mostly so, but what of the expensive housing tax credit? and cash for clunkers.? Those belog to the Treasury.? They are not economic programs — the costs far outweigh the benefits.? But wait.? Those shouldn’t be pinned on the Treasury; Congress, bought and paid for, are pushing these programs on behalf of their lobbyists.

If so, where is the administration to shame Congress over such behavior?? Where is the President who should press for a line-item veto?? (I like Wisconsin’s version. 😀 )? Let the Treasury, backed by Obama, ascend to the bully pulpit, and say that such programs are a waste of taxpayer dollars.

The Fed and Treasury have been able to touch of a speculative rally in financial assets, which benefits financials, but with weakness in? end-user demand, the lower rates do nothing to stimulate investment in plant and equipment.

All that said, there are three things that could go wrong here:

Contrary to the expectations of the Fed, inflation could rise, and cause the Fed to tighten.
All of the excess dollar claims could lead to greater depreciation of the dollar.
Defaults could cause credit spreads to widen.

Those have not gone wrong yet, but they are all threats.? More tomorrow, when I discuss difficulties with entitlement programs.

My Visit to the US Treasury, Part 3

Posted on 5 November 2009 by David Merkel

Going back to bank stress-testing for a moment, one interesting thing that a Treasury official said at the meeting was that unemployment did not have a big effect on foreclosures.? Unemployment has a big effect on credit card defaults, but not foreclosures.? I disagree.

As a multi-purpose quant, I have learned over the years that it is impossible to estimate an option curve/function when the variable in question has only been “in the money” or “out of the money.”? (As an example, one can’t estimate the withdrawal function on deferred annuities because haven’t had a large sustained rise in interest rates since the product was created.)? With mortgage debt, over the last 70 years, real estate values? have never fallen enough to make default a reasonable choice until now. Thus in the past, when unemployment hit, one could sell, rather than default.? As I have said before, foreclosure typically occurs when someone is inverted on their mortgage, and a life event happens: death, divorce, disability, disaster, disemployment, change in financing terms, or deciding that it is worthless (and doing a strategic default).

But now residential real estate values have fallen.? When someone loses their job, the option to default becomes real.? Do a short sale, and give the bank a hit.

With stress-testing, the devil is in the details.? How do you turn unemployment, housing prices, etc., into losses tailored for each individual company?? Different underwriting standards can make quite a difference in the results.? I would have been more than happy to dig through detailed stress testing models.? That was my job once.

When the Treasury announced the stress-testing results, it was at? a time when the gloom was thick.? It was a positive to the market that the government would not require huge amounts of extra capital, and in most cases, no extra capital.? Thus the market rallied.

With many simple asset classes that were under stress, the Fed and Treasury offered guarantees that would enable them to easily survive the panic.? Absent the guarantees, most short assets would have been “money good,” but there would have been significant doubt for a brief time.

As I commented to a Treasury staffer after the meeting, with financing rates so cheap to buy financial debts, regardless of what kind, it is no surprise that corporate bond spreads have tightened, while there is still little lending to finance growth in the real economy.? That is why there is such a gap between Wall Street and Main Street.

Main Street sees unemployment and low capacity utilization.? Wall Street looks at bond spreads and P/Es.? Those are not the same things.? The current stimulus has emphasized healing the financial sector in an effort to avoid contagion and depression.? It does not directly address slack in the real economy.? The real economy funds the bailout of financials, but does not directly benefit.? Thus the disconnect between Main Street and Wall Street.

Many financial? measures and companies have rebounded, but little expansion has occurred in the real economy.? Even with companies that have done bond offerings, they have often used the proceeds to bolster the balance sheet, rather than expand capacity.? Safety first is the watchword.

Perhaps a change happens when companies with a lot of cash appear as takeover targets in a sluggish market.? Easier to grow market share through acquisition rather than organically, and what’s better, their cash helps pay for the deal.

Housing Initiatives

It seems that the low end of the housing market has bottomed.? Government programs have something to do with it.? The tax credit has made a difference in the short run, as has the efforts of the Fed to support the mortgage markets through the purchase of RMBS.

Mortgage modifications are advertised by the Treasury, but the results are small.? Away from that, I will say that successful modifications occur more likely when there is some degree of principal forgiveness.

Tonight, I will pick up on the risks of low interest rates in part 4.

Who was Invited?

I’ve been in touch with staffers at the Treasury.? One of them gave me a list of the invitees.? Here is the list of those invited that did not come:
Abnormal Returns
Alea
Barry Ritholtz
Clusterstock
Free Exchange at The Economist
Paul Kedrosky
Andrew Leonard
Calculated Risk
Yglesias
Megan McArdle
Mike Konczal
Baseline Scenario
Mish
The Audit at Columbia Journalism Review
Credit Slips
Prudent Investor
Brad Delong
Felix Salmon

If you were in the Treasury’s shoes, who else would you have invited?? E-mail me, or put it in the comments.? Tomorrow I will mention who I thought would have been good additional guests.

Continuing Coverage

Here is a list of posts to date on the meeting:

Friday in Vegas (Kid Dynamite):
“A Sit Down With Senior Treasury Officials – Part I”

Naked Capitalism:
“Curious Meeting at Treasury Department”

The Aleph Blog:
“My Visit to the US Treasury, Part 1”
“My Visit to the US Treasury, Part 2”

Across the Curve:
“Bond Market Open November 04 2009”

Accrued Interest:
“Financial Regulation: How Would You Have It Work?”

Michael Panzner
Treasury Officials Meet With Financial Bloggers

A Few Observations of My Own

Interfluidity
Sympathy for the Treasury

That’s all for now.? Until this evening and part 4.

November 2009 Redacted FOMC Statement

Posted on 4 November 2009 by David Merkel

September 2009	November 2009	Comments
Information received since the Federal Open Market Committee met in August suggests that economic activity has picked up following its severe downturn.	Information received since the Federal Open Market Committee met in September suggests that economic activity has continued to pick up.	Little change; they see the rebound as continuing.
Conditions in financial markets have improved further, and activity in the housing sector has increased.	Conditions in financial markets were roughly unchanged, on balance, over the intermeeting period. Activity in the housing sector has increased over recent months.	That said, the stock market has stopped rallying. Does the FOMC only look at the stock market, and not notice how much risky bond spreads have rallied?
Household spending seems to be stabilizing, but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit.	Household spending appears to be expanding but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit.	No change
Businesses are still cutting back on fixed investment and staffing, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales.	Businesses are still cutting back on fixed investment and staffing, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales.	No change

Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.	Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.	No change
With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.	With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.	No change. The Fed assumes stagflation is not possible.
In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery and to preserve price stability.	In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery and to preserve price stability.	No change. Why is this paragraph needed?
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.	The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.	Gives us a clue as to when they will change policy. Look at labor unemployment, capacity utilization, current inflation readings, and future inflation implied by TIPS.

To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of $1.25?trillion of agency mortgage-backed securities and up to $200 billion of agency debt.	To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt. The amount of agency debt purchases, while somewhat less than the previously announced maximum of $200 billion, is consistent with the recent path of purchases and reflects the limited availability of agency debt.
The Committee will gradually slow the pace of these purchases in order to promote a smooth transition in markets and anticipates that they will be executed by the end of the first quarter of 2010.	In order to promote a smooth transition in markets, the Committee will gradually slow the pace of its purchases of both agency debt and agency mortgage-backed securities and anticipates that these transactions will be executed by the end of the first quarter of 2010.	No real change.
As previously announced, the Federal Reserve?s purchases of $300?billion of Treasury securities will be completed by the end of October 2009.		Treasury program is done.
The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets.	The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets.	No change. Another useless paragraph.

The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.	The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.	No change. Another useless paragraph.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.	Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.	No change

Comments

1) No big deal on fewer Agencies being bought. But what if they decide to do the same to mortgage bonds? They see the bloat building up on the Fed?s balance sheet, and they are beginning to wonder how they will unwind it. The first part is easy, but it gets hard fast.

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2) Gives us a clue as to when they will change policy. Look at:

o Labor unemployment

o Capacity utilization

o Current inflation readings

o Future inflation implied by TIPS

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3) The FOMC appears to only look at the stock market when reading financial? conditions. Bond spreads have rallied.

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4) The FOMC assumes that stagflation will not happen again, or that their quantitative easing does not put us in a Japan-style liquidity trap.

My Visit to the US Treasury, Part 2

Posted on 4 November 20094 November 2009 by David Merkel

Before I start this evening, to all my fellow bloggers out there, if you were invited to the gathering at the US Treasury and did not come, I have a request and a question:

If you were invited, send me an e-mail.
Tell me why you decided not to come, if you would.

If present trends continue, I can tell you that bloggers are not pushovers for the US Treasury, but neither are they deaf or heartless.? Since my last post, here are the responses to the gathering:

As all bloggers there will note, those from the Treasury were kind, intelligent, funny… they were real people, unlike the common tendency to demonize those in DC.? As for me, I live near DC, and I am an economic libertarian, but I have many friends at many levels inside our bloated government.

They have to do their jobs.? If there is a conspiracy, it is well-hidden.? There are simpler ways to understand the mess that comes out of national politics.? We get the result that is least offensive to the most, and pleasing to few.

We had a good discussion, but I am not the one to put myself forward.? I made some comments, but did not get to ask my questions.? My personality was not the dominant one.

What I propose to do in this series of articles is go through the main arguments of the US Treasury from the handouts that they gave us (sorry, I can’t scan them and put them out for view), and try to give a fair rendering of what they have done.? My audience is dual: I am addressing those who read me in the blogosphere, and those at the Treasury.

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Treasury officials said that they were trying to reduce the footprint of the rescues/bailouts as much as possible, doing it at a rate that would not jeopardize the recovery.? Their goal is to put in place? regulations that will prevent future disasters once the current disaster is past.

David: Well, yeah, that’s what to do if you can.? The question is what will happen to the markets when you start to remove significant stimulus from critical areas, as I said to my pal Cody a year ago.? Much of that is not in the domain of the Treasury, but the Fed.

The Treasury understands that the troubles of 2008 came from poor credit regulation and tight coupling in the financial system.

David: we over-encouraged single family housing as a goal for Americans.? When debt was too high for cash flows from average American households to afford residential housing, the prices of housing began to fall, and the foreclosure process began, as foreclosures happen once someone is inverted on their mortgage.? Residential real estate prices overshot by a lot.? We should be surprised that there are problems now?

I would not only eliminate the tax credit for new buyers, but I would phase out the interest deduction for mortgage interest.? Get people financing with equity, not debt, even if it means the economy is sluggish for a few years.? It will bring a longer-lasting self-sustaining recovery.? Debt-based systems are inherently fragile because fixed commitments remove flexibility from the system.

To the Treasury I would say, “Markets are inherently unstable, and that is a good thing.”? They often have to adjust to severe changes in the human condition, and governmental attempts to tame markets may result in calm for a time, and a tsunami thereafter.

Those that understand chaos theory (nonlinear dynamics) were less surprised by the difficult markets that we have faced.? We saw it coming, but could not predict exactly when the system would face crisis.? Bears are often right, but with significant delays.

The government is not the majority player in the system, but is the biggest player.? At critical points their willingness to offer support helped lead to a market rebound.

Now in the actions of the government, there is some “making virtue out of necessity.”? In supporting Fannie & Freddie in February 2009, they did not have much choice, unless they were to let them fail, which might have been a good thing.? As it is, F&F seem to be black holes where the government is unlikely to recoup their investments.

As for the bank stress-testing, one can look at it two ways: 1) the way I looked at it at the time — short on details, many generalities, not trusting the results.? (Remember, I have done many such analyses myself for insurers.) or, 2) something that gave confidence to the markets when they were in an oversold state.? Duh, but I was dumb — the oversold market rallied when it learned that the Treasury had its back.

I’m tired, and that’s enough for the evening.? I’ll pick this up tomorrow.

My Visit to the US Treasury, Part 1

Posted on 3 November 2009 by David Merkel

This will have to be brief, because I am tired.? I have had to deal with family and work issues today, and only now have time to blog.

You might have seen my fanciful post, Fallowhaven, Part 1.? I wrote that because I thought I could reveal almost nothing of my visit to the US Treasury today.? As it is, I can talk about it, but not quote any officials there, nor say who was there from the Treasury.

My surprise was that only bloggers were there.? I expected reporters from major papers, but that was not the target audience.? The closest to mainstream media would have been Megan McArdle, who presumably said she would be there (there was a placard for her), but did not show.? The rest of us were independents:

As I write now, only John Jansen has commented on the meeting, and only briefly.? I have a lot to say about the meeting, but I can’t get it into one post.? I will spread it out over several posts, and try to explain the? views of the Treasury, are where they make sense, or not.

I appreciated being able to meet my fellow bloggers.? Putting faces to the names is special.? Would that I could bring all of the major investment/finance/economics bloggers together for a gathering.? There would be many disagreements, but it would sharpen us all.

More tomorrow –? I want to talk about the successes and failures of the current rescue, and how the Treasury views them.

Fannie + Goldman + US Treasury + Tax Credits = Complex Mess

Posted on 2 November 2009 by David Merkel

In a prior job, I spent a decent amount of time on Affordable Housing tax credits.? The idea was to reduce my life insurance company client’s taxable income to the point where they would be close to but not subject to the corporate alternative minimum tax.? Occasionally my work would take me on trips to industry conferences on Affordable Housing.? When I would go to these meetings, there would be a panoply of players there — Banks, Insurers, Utilities, perhaps a health insurer or two, and a few other odd tax-focused companies would attend.? In? addition to tax benefits, often banks could get some amount of Community Reinvestment Act [CRA] credits for financing affordable housing.

Oh, there were Fannie and Freddie, also.? They each represented 1/3rd of the investment base, leaving 1/3rd to everyone else.? So at the conferences, there would be a lot of them around.? Throw a rock, hit someone from a GSE.

The tax credits made a lot of sense for Fannie and Freddie back when they were profitable.? The credits/deductions minimized their taxes.? (They had numerous tax reduction schemes, but this was a big one.)? But now Fannie and Freddie are unprofitable, and it is less than certain as to when they will ever be profitable again. It would make a lot of sense for Fannie and Freddie to sell their Affordable Housing deals to some profitable entity that can use the reduction in taxes.

I have gone through a deal like this for a former client back in 2000.? It’s complex but not impossible to do.? The problem for Fannie Mae in this case is that they are now controlled by the US Treasury, and the prospective purchaser is Goldman Sachs.? Very bad optics.? The US Treasury does not want to look like it is favoring Goldman by approving the deal, and it is conflicted in its decision, because allowing the transaction will cause the Treasury to take in less taxes, though it might increase the value of Fannie.

This is what you get for having the Government take stakes in businesses that they regulate, rather than doing a simple liquidation of a very large failed enterprise.? (Stories from NYT, WSJ)? Both business and politics end up worse off when they are not kept as separate as possible, so that the ordinary conflicts between the two stay at the level of business pushing back over regulations and the government attempting to correct business abuses.

I don’t know where this one goes.? Goldman buying the tax credits should have been a moderately complex deal, but the complex interests of the US Treasury make the matter much more difficult.? My intuition says this won’t be the last time we see a conflicted situation like this in the near term.