I will have a more comprehensive post tomorrow on my thoughts on bank regulation, but I will offer a few thoughts here.  One thing I found interesting at the conference was what did not get much play in terms of what helped to create the crisis.

It was fascinating that no one talked about why the US bailed out holding companies, rather than letting them fail, and merely backing up the operating subsidiaries. This is significant.  The moment you put money into a holding company, it goes everywhere.  Regulators should only care about operating subsidiaries, and let the holding companies fail; let the costs be borne by the stockholders and bondholders of the failed company, but protect the regulated entities.

Also, few fingered the Fed’s monetary policy, where Greenspan and Bernanke created a culture of lenders who knew that the Fed would ride to their rescue when thing got modestly tough.  Unlike William McChesney Martin, who joked that the Fed’s job is “to take away the punch bowl just as the party gets going,” Greenspan and Bernanke were slow to remove the punch bowl, and quick to bring it back, creating lenders who would rely on the Fed to allow them to take too much risk.

Another miss was not blaming the failure of neoclassical economics to explain, much less predict the problems that we experienced.  Why invite any neoclassical economists at all to the conference?  The few economists that were ahead of the asset bubbles were ignoring neoclassical economics.  Neoclassical economics is a failed discipline that needs to be replaced by something that realizes that applying math to economics does not yield significant increases in understanding.  The Austrians, those who follow Minsky, and the non-linear dynamic school understand what is going on better, because they treat economics the same way we understand ecology.  And, no, applying math to ecology doesn’t help that much.

Preventing Too Big to Fail

There are three main ideas as I see it, in preventing “Too Big to Fail.”  The first is changing risk-based capital [RBC] policy to raise capital requirements on larger institutions.  Use RBC to discourage banks from getting too large.

The second idea, which also wasn’t talked about much at the conference, was to limit regulated entities from owning or lending to other financial institutions.  Do you want to limit contagion?  Well, if you do, you must limit the amount that regulated banks own of/lend to other financials.  That even applies to subsidiaries with the same ownership group.  Keep it clean.  If you are going to have financial holding companies let them own all subsidiaries directly to avoid capital stacking.  Ban cross-guarantees among subsidiaries.

The third idea, which I have touched on is that regulators should ignore holding companies and never, never, NEVER bail them out.  Bailouts should only come to regulated entities, and only after the resources of the holding companies have been drained to zero.

On Detecting Fraud

I appreciate what was said on detecting fraud by one presenter: check for adverse selection, honest businessmen won’t do business that way.  Also, it never make sense for a secured lender to accept inflated appraisals.  In short, the originate to securitize model allows originators to make substandard loans that they will not hold onto.

This is why I say look for gain-on-sale accounting. There is something perverse about making money simply because a sale is made.  Under the GAAP principle of release from risk, which I believe is misapplied, financial entities should recognize profits more slowly than is the current practice.

When I was a buy-side analyst, I would analyze a company’s management culture for short-termism. Any management team that seemed too aggressive would get negative marks in my book and I would avoid them, or short them.

Remember you can never get pricing, volume and quality at the same time in lending. Companies that go for volume, or sacrifice quality are begging for trouble.  Financial companies are in a mature industry, so beware companies that grow fast.  Also beware of long dated accruals.  Accrual quality declines with length of time until payment and likelihood of payment.

Those that want to have regulators war-game future problems and predict black swans have their work cut out for them, even considering what I have said already.  But most of their attention should be fixed on the areas of the market where the greatest increase in lending is occurring.  Where debt is increasing the most is usually the area where there will be the most financing problems in the future.

One more note for regulators: look at the high short interest.  The shorts are doing you a favor.  They spend a lot of time analyzing who they think is cheating the system, and then they put their money on the line.  I would tell regulators to use the shorts as a guide.  Don’t automatically trust that there is something wrong, but use it as a guide to now begin your own due diligence into the solvency of the financial institution in question.

More Tomorrow — until then.

Okay, here is tonight’s rule: Governments that scam the asset markets (and their citizens) take all manner of half measures to defend failed policies before undertaking structural reform.  (This includes defending the currency, some asset sales, anything that avoids true shrinkage of the role of government.)  The five stages of grieving apply here.

I know I wrote it 8+ years ago, but it feels very live now.  At present it is most obvious to apply the logic to the PIIGS, and American municipalities that have overextended themselves.

But consider New Jersey that has cut back considerably, and the Kansas City School District that has cut almost half of their schools.  Their backs were to the wall, and they took brave actions to cut back.

But many municipalities remain in denial.  They have long distinguished histories, they cannot fail.  They just need to tax (or borrow) a little more to make ends meet.  Maybe they should raise the rate they expect to earn on pension assets, or offer sweeter pensions instead of greater wage hikes.  This is a big part of the crisis now, and is biting hard.

When the taxes do not come in as expected, or budgets were underestimated, and there is more spending than expected (Snow, Flood, Hurricane) there is anger, and anger drives the hopeless negotiations (bargaining) over spending cuts, over which no one wants to budge.  Not only are there priorities in what interest groups want, there are things that are guaranteed by statute, and some guaranteed by constitution.  Consider the constitutional guarantees on public sector employee benefits in Illinois.  Just try to change the Illinois Constitution; that won’t be easy.

The next stage of grieving is depression, and there are some places like California, L.A., Harrisburg, PA, Greece, etc. that are close to the point where one might say, “There’s no hope.”

After that comes the final stage of acceptance, where finally the tough adjustments are made, and solvency restored, or, bankruptcy is entered, with all of the attendant costs.  Deals are made to reduce budget items that were previously sacrosanct, such as entitlements, public sector employee benefits and salaries, etc.  That is not happening today, not even in New Jersey.

One final note: just as the last refuge of scoundrels that run companies is to blame the shorts, so it is for scoundrels that run governments — they blame the speculators.

Roughly three months later than originally scheduled, the fiscal year 2009 Financial Report of the United States Government came out.  I had predicted a few times (latest here) that the final total of debts and unfunded liabilities would be about 4x GDP.  Well, I was close:

As I commented in my piece The Biggest, Baddest Bubble of Them All:

This doesn’t take into account the value of land and certain less tangible assets that the U.S. Government has. It also does not take into account the considerable operating and capital lease liabilities, deferred maintenance, or liabilities for the GSEs, and other lending guarantee programs of the federal government.

That comment was originally written in October 2003.  As I commented at RealMoney a number of times, I felt that it was possible that the GSEs would fail — they held so little in reserve against mortgage losses.  Back then, the figure wasn’t $57 billion, it was $25 billion for fiscal year 2002, which would be 2.4x GDP.

The US Government has made a lot of promises to pay.  I have no idea how big the annual obligations for capital and operating leases are, but it would be cheaper for the Government  to borrow and buy their buildings, rather than hiding the debts through Credit Tenant Leases.  I also can’t quantify the full range of guarantees they have made, including implicit ones to bail out GSEs, big financials, allies, etc.

A reader wrote me asking: Would you please write a post on what will happen if the US goes bankrupt? This government spending continues to get worse and I am wondering what if anything I, a retired person, can do to get in front of this.

Okay, here goes.  Remember that the US Government has choices.  It can raise taxes, inflate, or default.  I don’t think default, even if it is only an external default, is the most likely option.  Also, the promises for Social Security and Medicare are not guaranteed — they can be reduced or canceled by Congress and the President.  Changing Social Security and Medicare would be political suicide, but suicide is an option.

An aside, why have I not mentioned cutting discretionary spending (or defense or entitlements)?  Because they aren’t that large a portion of the budget.  Defense and entitlements are large, but who could get a consensus on cutting those?  Our culture has a “more is better” mentality, even though spending money on “defense” has probably not made us more secure.

In order of highest likelihood, here is how I see the options:

1. Borrow more
2. Raise taxes
3. Inflation
4. Cut discretionary spending
5. Cut defense spending
6. External default
7. Total default
8. Cut entitlement spending
9. Internal default

Much as I would like to see the US Government reduced in size to only core functions, my views are not the consensus.  They will try to raise taxes, and failing that, inflate the currency.

To the one who asked the question, I am not a tax expert, so consult one to limit your taxes.  On inflation, you probably know the drill: Money market funds, TIPS, commodities, and equities with hard assets or pricing power.

The US government talks about cutting discretionary spending, but rarely does so.  Defense is worse; it always expands.  For the US to cut defense spending would be a mindshift requiring closing overseas bases, and a quiet surrender of the idea that the world is ours to guard/rule.  We think we are neutral, when we are genuinely self-interested.

External default would not be enough to solve the problems the US faces, and, it would enrage the rest of the world.  We would find our assets abroad seized by foreign governments.  Say goodbye to goodwill and globalization.

I don’t know what to say about total default, aside from depression everywhere, with many financial institutions failing in the US and abroad.  If the global reserve currency fails, well, those that rely on it will fail.

I don’t view cutting entitlement spending or an internal default only as likely.  They are political suicide for whoever does it.

My sense is when the ability to raise taxes fails, inflation will be the solution.  If/when the political outcry becomes too great against inflation, then the lesser remedies will be considered.

The pain has to go somewhere — we’ve been really good at ignoring the problem, delaying the payment, etc., but it has only had the effect of building up the eventual pain that will have to be taken.  Our leaders are seemingly opting for a Japan-style solution — stagnation for two-plus decades with debt shifted from private to public entities.  We have better much better demographics, but Japan has had better saving in the past — more of their explicit debts are internally funded compared to the US.

The trouble with offering advice in a situation like this is that the right answer depends on what our officials do.  The best or worst investment could be long Treasury zero coupon bonds.  Or it could be gold.  Remember, many thought the Great Depression would end with inflation, but it didn’t, at least not to the degree that many feared.  Me?  I am invested in a mix of well financed businesses that generate a lot of cash and would be difficult to do without, and some money market funds, where I suffer the punishment of a saver, while retaining flexibility.

There are no easy answers here.

Some follow-up on my last two posts.  I will be talking to those that suggested parties that would be willing to create a definitive bond blog.  But, others brought up a good point, which I am well aware of, but forgot for a moment.  The bond markets are mainly institutional.  Institutional bond investors have no lack of research sources to guide them.  Retail investors get ripped of, or are relegated to government bonds, ETFs, or mutual funds.  So, maybe creating a definitive bond blog would not be a good use of time?  Maybe, maybe not.

What is clear is that such a blog would have to be retail-focused.  It could not dwell on minutiae that would be valuable to institutional investors, but would have to deal with the hard problems that retail investors face with fixed income.

The alternative would be to try to do a blog for institutional investors and bright amateurs, and invite institutional investors to write pseudonymously — think of it as a Zero Hedge for fixed income, without so much attitude.  But would institutional investors read it?  They are inundated already.

Now, John Jansen himself has encouraged the idea, which I appreciate.  He did great work while he was at it.  Could we do as well or better?

Thoughts?  I am still game for this idea, write to me here.

=–=-==–==-=–==-=–=-=-=-=-==–==-=-=-=-=-=-=–=

How long to the point of no return?  I don’t know.  In all of the time that I wrote at RealMoney, I tried to point at directions, but not give timetables.  Giving timing is a mug’s game.

But let me consider some of the commentary that I have received.  My last two posts generated so much traffic that people were not able to access my site for a time.

Promises, promises.  What is a promise to pay worth?  All I know is that the more promises there are outstanding, the less a promise is worth.  The same applies to the Federal Reserve, who issues small-denomination short-duration 0% CP, otherwise known as currency.

Some say that so long as a primary dealer can “repo previously issued govt bonds at the central bank to gain reserves to purchase the new issue bonds at a Treasury auction, that nation can never default, no matter what the level of debt to GDP ratio is….” The effect of that is to raise interest rates.  Higher rates will harm the economy.  As more long-term promises are issued, the safety/value of a promise diminishes.  The same is true of short-term promises, but the effect is more immediate.

Which reminds me that nations with a lot of debt to roll over are most at risk.  There are others in worse shape than the US.  The US Dollar may be the best among bad major currencies, as I have argued on many occasions.  Also, banking crises tend to lead to sovereign debt crises.  The nation absorbs the losses of the banks, and then some fail as a result.

In a true free market, no one would care about currency levels.  They would take spot and future currency rates and factor them in as a cost of doing business.

The Keynesian solutions assume that growth will occur as a result of government spending.  I disagree.  In Japan, there has been no end of such spending, and from what I have read, that spending has not resulted in additional productivity.  Additional productivity only comes from projects that yield more benefits than their costs, and Japan has had more than its share of white elephants.

Throwing a brick through the window and having the glass repairman do his work may raise GDP, but the net worth of society is diminished.  True growth comes from entrepreneurs competing for advantage, and finding places where there are needs to be met.

That is one reason why I say that the deficit spending of the US is destructive.  It does not reflect the needs of people, but the needs of politicians currying favor with interest groups.  We need to shrink the US Government, so that it cannot meddle with the details of our lives.  Let it focus on defense, justice, internal security, and public health, goals worthy of a government.  Let local governments deal with other issues.

The budget troubles will percolate down to all municipalities.  It cannot be otherwise.  Local governments will toss out less needed actors, such as social workers, and retain those more needed, like policemen.  On the whole, society will be better off, as we reduce unproductive actors.

Growth matters a lot.  We need to focus on eliminating things that constrain the growth of the economy, without sending the government budget into greater deficit.  Let the US government reduce corporate welfare.  Let them eliminate the deduction for employee health care expense — that will shrink the health care sector significantly.  My view is that we need to eliminate all tax preferences in the economy, and tax people/institutions in their increase in value every year.  Get the government out of the social engineering business.  Let’s have true tax reform.  Let government do what it does well, and leave the rest to the people.

I recognize that I have a point of view here.  My contention is (aside from ethical issues) that when there is a high level of debt in an economy, that efforts to stimulate fail.  Better not to stimulate at all, ever.  Rather, focus on constraining credit, so that speculation does not overcome the economy, whether personal or corporate.

As for now, let us encourage short sales, foreclosures and bankruptcies, which eliminate debt.  Prices will reset lower, but predominantly equity-financed businesses will not fail easily.  Once the Debt/GDP ratio gets below 1.5x, the economy will grow on a healthy basis again.

Debt levels in an economy matter.  They matter a lot.  An economy that is financed primarily by debt can be like a chain of dominoes.  If one fixed claim fails, and it is large enough, many other fixed claims that rely on the first claim could fail as well, triggering a chain of failures.  This is a reason why a fiat-money credit-based economy must limit leverage particularly in financial institutions.

Why financial institutions?  They borrow and lend.  They also lend to other financial institutions.  A  big move in the value of some assets can make many banks insolvent, and perhaps banks that lent to other banks.  The banks should have equity bases more than sufficient to absorb losses at a 99% probability level.  That means that leverage should be a lot lower than it is now.

Economies are more stable when they limit fixed claims and encourage financing via equity rather than debt.  Imagine what the economy would be like if interest was not deductible from taxable income, but dividends were deductible.

• People would save money to buy homes, and would put more money down when they borrowed.
• Corporations would lower their debt-to-equity ratios, and would pay more dividends.
• Fewer people and corporations would go broke.

Pretty good, but in the short run, the economy would probably grow slower.  The debt bonanza from 1984-2006 pushed our economy to grow faster than it should have, where people and firms took more chances by borrowing more, and making the overall economy less resilient.  Debt-based economies lose resilience.

What was worse, the Federal Reserve in the Greenspan and Bernanke years facilitated the debt increases because the Fed never took away the stimulus fast enough, and offered stimulus too rapidly.  This led to a culture of unbridled debt and risk-taking.  If only:

• Greenspan had been silent when the crash hit in October 1987.
• Greenspan had not given into political pressure in late 1990, where he set up a process of cutting interest rates too much.
• Greenspan had not cut rates in 1995.
• Greenspan had not cut rates during the LTCM crisis.
• Greenspan would have cut far less 2000-2002.
• Instead of tightening 1/4% at a time 2004-6 , they would have raised the rate far more rapidly, completing the rise in one year.
• Bernanke would not have let the fed funds rate go to zero, but would have limited fed funds to never go lower than 1% below the ten-year Treasury yield.  We never need more than that to stimulate, but some patience is necessary.

What’s that you say?  The economy would have grown more slowly?  Right, and the economy should have grown more slowly, rather than gunning the engine through the overaccumulation of debt.  As it is, the economy will grow more slowly for some time a la Japan, until we delever the economy enough that it can once again grow without stimulus.

The economy is at a fork in the road.  Do we:

• Leave rates low and leave quantitative easing in until price inflation unfolds?
• Let rates rise gradually and drain quantitative easing slowly?
• Raise rates significantly and drain quantitative easing rapidly?

The third view is off the table.  No one wants to see any failure.  Bad decisions of the past must be grown out of, even if it takes a long time of subpar growth to do that.

When Eastern Europe left the Soviet orbit, the countries that did the best were the ones that freed their economies most rapidly.  Well, not in the short-run.  Letting companies fail is always a drag in the short run, but in the longer-run it leads to faster growth, because bad investments fail, and are replaced by better investments.

The same is true with monetary policy.  The US grew faster during periods where failures were reconciled and liquidated, rather than attempting to smooth the economic cycle — leading to fewer failures in the short run, much but bigger failures when the amount of debt became too large.

Before the crisis, when I was writing at RealMoney.com, I usually encouraged taking the less risky macroeconomic route, suggesting policies that would not increase debt levels.  The trouble was, that all of those ideas were losers in the short-run, and so they were not followed.  In the long run we are all dead, leaving the failures of short-run policies to our kids.

Personally, I would raise the Fed funds rate to 2% immediately, and let it shadow the 10-year rate less 1% thereafter.  But no one likes jolts, except when the Fed is loosening.  After that, I would rather the Fed allow inflation to raise collateral values and end the home and commercial mortgage crises.  But no, what we are likely to get is a Japan-style muddle-in-the-middle where they struggle with a slow raising of rates, and a slow end to quantitative easing, with a premature giving in when the economy has a negative burp before the removal of policy accommodation is complete.  I expect us to move in the direction of Japan.

What may change the story are sovereign defaults as government debt levels get too high.  In the short run, that may favor the dollar — it won’t fail rapidly.  But perhaps the euro might fail.  Even the yen might.  The era we are in is like the mid-1800s, when nations were constrained by their debt levels.

From the recent book “This Time is Different,” we know that countries with high debt levels grow more slowly, and defaul more frequently.  Ignore anyone who tells you that debt levels don’t matter.

I have been thinking about the the forces distorting the global economy.  In the long run, the distortions don’t matter, because economies are bigger than governments, and eventually economies prevail over governments.  Here are my dozen problems in the global economy.

1) China’s mercantilism — loans and currency.  The biggest distortionary force in the world now is China.  They encourage banks to loan to enterprises in order to force growth.  They keep their currency undervalued to favor exports over imports.  What was phrased to me as a grad student in development economics as a good thing is now malevolent.  The only bright side is that when it blows, it might take the Chinese Communist Party with it.

2) US Deficits, European Deficits — In one sense, this reminds me of the era of the Rothschilds; governments relied on borrowing because other methods of taxation raised little.  Well, this era is different.  Taxes are high, but not high enough for governments that are trying to create the unachievable “permanent prosperity.” In the process they substitute public for private leverage, and in the process add to the leverage of their societies as a whole.

3) The Eurozone is a mess — Greece, Portugal, Spain, etc.  I admit that I got it partially wrong, because I have always thought that political union is necessary in order to have a fiat currency.  I expected inflation to be the problem, and the real problem is deflation.  Will there be bailouts?  Will the troubled nations leave?  Will the untroubled nations leave that are the likely targets for bailout money?

4) Many entities that are affiliated with lending in the US Government, e.g., FDIC, GSEs, FHA are broke.  The government just doesn’t say that, because they can still make payments.

5) The US Government feels it has to “do something” — so it creates more lending programs that further socialize lending, leading to more dumb loans.

6) Residential real estate is still in the tank.  Residential delinquencies are at all-time highs.  Strategic default is rising.  The shadow inventory of homes that will come onto the market is large.  I’m not saying that prices will fall for housing; I am saying that it will be tough to get them to rise.

7) Commercial real estate — there is too much debt supporting commercial real estate, and too little equity.  There will be losses here; the only question is how deep the losses will go.

8 ) I have often thought that analyzing the strength of the states is a better measure for US economic strength, than relying on the statistics of the Federal Government.  The state economies are weak at present.  Part of that comes from the general macroeconomy, and part from the need to fund underfunded benefit plans.  Life is tough when you can’t print your own money.

9) The US, UK, and Japan are force feeding liquidity into their economies.  Thus the low short-term interest rates.  Also note the Federal Reserve owning MBS in bulk, bloating their balance sheet.

10) Yield greed.  The low short term interest rates touched off a competition to bid for risky debt.  The only question is when it will reverse.  Current yield levels do not fairly price likely default losses.

11) Most Western democracies are going into extreme deficits, because they can’t choose between economic stimulus and deficit reduction.  Political deadlock is common, because no one is willing to deliver any real pain to the populace, lest they not be re-elected.

12) Demographics is one of the biggest  pressures, but it is hidden.  Many of the European nations and Japan face shrinking populations.  China will be there also, in a decade.  Nations that shrink are less capable of carrying their debt loads.  In that sense, the US is in good shape, because we don’t discourage immigration.

Comments

• Hoenig’s dissent is interesting, but not significant.  The regional bank presidents have lost a lot of effective authority since unconventional lending came into existence.
• As has the Fed funds rate – so long as the Fed is buying long dated paper such as agency MBS, the Fed funds rate is not the pinnacle of monetary policy.
• Watch capacity utilization, unemployment, inflation trends, and inflation expectations.
• The FOMC shades up its certainty level on almost everything except real estate, where they seem to express more doubt.
• They think the recovery has begun, and they are definite about it.

Before I begin, I want to tell all of my friends in Japan that I have a great love for their country.  I have not traveled much, but if I were to travel abroad, Japan would be my first choice.  Plus, I have many friends in Kobe, Japan.

Japan is at the leading edge of the demographic wave where many developed countries have a shrinking population.  But beyond that, Japan has high government budget deficits and a very high government debt.  Consider this graph from Bill Gross’ latest missive:

Japan is in the awkward spot of having high government debt, though much is internally funded, and is still running high government budget deficits.

What a mess.  I happened across a blog I had never seen before today, and it gave a simple formula for when government debts would tend to become unsustainable.  It was analyzing Greece, but I looked at it and said to myself: “What about Japan?”

The main upshot of the equation in the article about Greece is that you don’t want the rate your government finances at to get above the rate of GDP growth.  If so, your debt will increase as a fraction of GDP, even if your deficits drop to zero.

So, what about Japan?  Can we say two lost decades?

Oooch! 0.2%/yr average growth of nominal GDP?!  That stinks.  But here is what is worse.  The Japanese government  finances itself at an average  rate of 0.6%.  The debt is walking backward on them unless GDP growth improves.  No wonder S&P has put Japan on negative outlook.

Japanese interest rates could rise.  Like the US. Japan has an average debt maturity around 5.5 years.  Unlike the US, 23% of its debt reprices every year, which makes them more vulnerable to a run on their creditworthiness.

Here are three more links on the Pimco piece, before I move on:

• An eye-catching quote…
• “UK gilts resting on a bed of nitroglycerine”
• Gross on Gilts: ‘On a Bed of Nitroglycerine’

We can think of central banks as equivalent to a margin desk inside an investment bank in the present situation.  Though I can’t find the data on the web, what I remember from the scandal at Salomon Brothers that led Buffett to take control, there was a brief loss of confidence that led the investment banks margin desk to raise the internal borrowing rate by 3-4% or so. Within a day or so, the trades expected to be less profitable of Salomon were liquidated, and Salomon had more than enough liquidity to meet demands.

But this is the opposite situation: what if the margin desk were to drop the internal lending rate to near zero?  Risk control would be hard to do.  Lines of business and people get used to used to cheap financing fast.  If it were just one firm that had the cheap finance, say, they sold a huge batch of structured notes to some unaware parties, it would be one thing, because after the easy money was used up, the margin rate would revert to normal, and so would business activities.

But let’s expand the paradigm, and think of the Central Bank as a margin desk for the nation as a whole.  Pre-2008, before the Fed moved to less orthodox money market policies, this would have been a more difficult claim to make, but the claim could still be made.

Pre-2008, the Fed controlled only the short end of the yield curve, which, with time, is a pretty powerful tool for making the economy rise and fall.  Short, high-quality interest rates move virtually in tandem with the Fed funds rate, but during good times, with the Fed funds rate falling, economic players seek to clip interest spreads off of longer and lower quality fixed claims, causing their interest rates to fall as well, with an uncertain timing, but it eventually happens.

And when Fed funds are rising, the opposite happens — funding rates for those clipping interest spreads rise, and the expectation of further rises gets built in, leading some to exit their trades into longer and riskier debts, which makes those yields rise as well, with uncertain timing, but eventually it happens.

I like to say that every tightening cycle ends with a crisis.  Let’s see it from an old RealMoney CC post:

		David Merkel
		Gradualism
		1/31/2006 1:38 PM EST

One more note: I believe gradualism is almost required in Fed tightening cycles in the present environment — a lot more lending, financing, and derivatives trading gears off of short rates like three-month LIBOR, which correlates tightly with fed funds. To move the rate rapidly invites dislocating the markets, which the FOMC has shown itself capable of in the past. For example:

Or, these two posts, which you can look at if you want… one suggested that housing was the next bubble (in 2004), and the other critiqued Bernanke’s reasoning on monetary policy.  (Aaron Task has an interesting rejoinder to the latter of these.)

Things are a little different now, because the Fed is not limited to the Fed funds rate any more.  They have a wider array of tools, and the Treasury is in the act as well through the TLG program.  The Fed owns over $1.5 Trillion of longer dated debts, mostly residential MBS.  The Fed as the margin desk has itself become involved in clipping interest spreads, using its cheap short-term funding to buy longer dated paper, directly forcing long rates down.  The Fed may innovate in other ways as well, offering/receiving term financing as well as overnight financing via Fed funds.

But, here’s the rub.  If the Fed brings the margin rate down to near zero and leaves it there, while actively creating expectations that it will stay there “for a considerable period,” and does so in a lesser way for long-dated paper as well, it can manufacture lower interests rates seemingly everywhere for a time.  It’s amazing how fast bond managers can shift from fear to yield lust.  (I leave aside the effects of foreign players for now.)

But as I pointed out in my visit to the US Treasury, you can change the financing rate, but the underlying cash flows don’t change.  The margin desk drops the financing rate, and prior good trades look better, marginal trades look doable, but there are investments that are still losers at a discount rate of zero.  No way to help those.

So what happens when the next crisis arises?  It could be commercial real estate, inflation, a war, a sovereign default (e.g., Greece, Japan, UK, Italy), another wave of corporate defaults, or, a very weak economy, with banks that are willing to clip spreads, but not take any significant financing risks.

Back to Japan.  Two lost decades.  Debt walking backwards on them.  All of the Keynesian remedies they applied.  Government spending and deficits ultrahigh.  Interest rates ultralow.  Start with a government with little debt; end with a government that is the most indebted among developed nations.

This developed world in Bill Gross’s “ring of fire” is pursuing the same strategies that Japan did over the last two decades.  They should expect the same results, until sovereign defaults begin.  Then the game will change — mercantilists like China will see their strategies blow up, and the nations that default will see their living standards decline.

This has gotten too long, but one thing that I will try over the next few days is estimate Nominal GDP growth rates for nations in the “ring of fire,” and their Government’s financing rates.  If I find anything interesting, I will let you know.

Final note: Ben Franklin at the Constitutional convention in 1787 commented that the half-sun on Washington’s chair was a rising sun, not a setting sun.  Though my title plays on a name for Japan, all nations in this predicament may find that their sun is setting as well.  Unwillingness to take short run pain in trading leads to failure in trading — even so, it is the same for nations.

There seems to be some confusion over what threatened to cause major banks to fail.  Let me go over my list of the risks:

• Many relied on AIG to insure their subprime and other structured lending risks.  Note: initially, when an insurer underprices a product dramatically and attracts a lot of business, the sellers of risk chortle, and say, “Sell away to the brain-dead.”  After it has gone on for a long time, a sea change hits, where they think — oh no, we’re the patsies — the industry now relies on the solvency of AIG!  Alas for risk control, and the illusion of the strength of companies merely because they are big.
• As an aside, though I have defended the rating agencies in the past, please fault the rating agencies for one thing: the idea that large companies are more creditworthy than small ones.  Big companies may have more liquidity options, but they also take advantage of cheap financing to bloat in bull markets.  When the tide goes out — oh well,  GE Capital might not have survived without the TLGP program.  Another reason why I sold all my GE Capital debt when I was a bond manager.  Big companies can make big mistakes.  Instead, I bought the debt of well-run smaller companies with better balance sheets, lower ratings, and more spread.
• Most of the real risks came from badly underwritten home mortgage debt, whether conventional (bye Fannie and Freddie), Alt-A and Jumbo, or subprime.  Underwriting standards slipped everywhere.
• Commercial mortgage lending hasn’t yet left its marks — there is a lot of hope that banks can extend maturing loans rather than foreclose and take losses.
• In general, banks ran with leverage ratios that were too high.  Risk-based capital formulas did not properly account for added risks from: securitized assets, home equity loans, construction loans, overconcentration in a single area of lending, the possibility that the GSEs could fail, etc.  Beyond that, there was a dearth of true equity, and a surfeit of preferred stock, junior debt, trust preferreds, etc.
• The high leverage particularly applies to the investment banks, which asked for a change from the SEC and got it in 2004.  The only bank to not lever up was Goldman; Morgan Stanley did it only a little bit.  Guess who survived?
• The Fed encouraged risk-taking by the banks by not allowing recessions to damage them.  They tightened too late, and loosened too early, and that pushed us into a liquidity trap.
• Residential mortgage servicers priced their product in a way that could only work if few borrowers were delinquent.
• Financial insurers took advantage of loose accounting rules, and insured more than they could afford.
• State and local governments came to depend on increased taxes off of inflated asset values.

What I don’t see is problems from private equity or proprietary trading.  These were not big problems in the current crisis, but the Obama Administration is focusing on these as if they are the enemy.

Look, my view is that banks should be able to invest in equity-like investments up to the level of their surplus, and no more.  By this, I mean real common equity, not hybrid equity-debt financing vehicles.

I believe that bank risk-based capital structures need to be strengthened.  I don’t care if it means that lending diminishes for a few years.  Far better tht we have a sound lending base than that we head into a Japanese-style liquidity trap, which Dr. Bernanke is sailing us into.  (He criticized the Japanese, and he does not see that he is doing the same thing.)

President Obama can demagogue all he wants, and make the banks to be villains.  In the long run, what makes economic sense will prevail, not what scores political points.

I am no fan of Ben Bernanke, longtime readers know.  There are many reasons to find fault with him:

• His actions on the Fed while Greenspan was Chairman provided the intellectual support for over-providing liquidity to the market.  Dropping the Fed funds rate below 2% was indefensible.  All the economy needs is a small positive slope to the yield curve, and after a few years, the economy will normalize.  Steep yield curves work faster, but they encourage bad investments because when the yield curve is steep, many people will try to clip free income.
• Rather than encouraging liquidation of broken financial institutions, he gave money to holding companies in exchange for ownership, with few strings attached.  The Fed should not have power to bail out any financial institutions; that power should belong to Congress or the Treasury directly, so that we can hold them accountable.
• He resisted giving information regarding the bailouts by denying FOIA requests.  There is no good reason to avoid those requests.  The insurance industry has to reveal every asset, and material liabilities in aggregate.  The is no reason why the banks could not do the some thing.
• He has been intellectually certain that the Great Depression occurred because monetary and fiscal policies were too tight, and a trade war disrupted commerce, rather than the more likely hypothesis that loose monetary policy led to an increase  in debts financing an asset bubble, and the Depression only ended when enough of the debts were extinguished (around 1941).

To any Senator that might be listening (I dream), I would simply say this — it doesn’t matter whether Bernanke is reappointed or not because the greater question is reforming the Fed.  The Fed has a self-perpetuating nature, and resists real change.  The faces change, but it remains business as usual.  Would Congress consider:

• adding Governors that are not neoclassical economists?  Bring real diversity of thought to the Fed?
• slimming down the Fed so that it does not dominate research on monetary policy?  Employment of economists at the Fed is too big, and not justified by their output.  You could fire half of the people at the Fed, and there would be no effect on its effectiveness.
• making the Fed solely responsible for all depositary institutions?  Note: I don’t like the Fed, but I do like accountability.  Let there be one institution responsible for credit, and one institution responsible for creating bubbles.  The Fed has created bubbles, and denies it.  No.  Let the Fed take care of credit, and when they blow it, hold them accountable.  Either fire those that made the bad decisions, or, move back to a commodity/gold standard.  It would constrain our government that attempts to mandate prosperity with out the power to do so and fails.

Senators, if you need to vote down Bernanke for political reasons, there is no reason not to do so.  The American people will not think the worse of you for doing so, and while the markets may blip down, they will recover once a new Chairman is appointed.  Among conventional candidates, I would favor John Taylor, who formulated the Taylor Rule of monetary policy, which Greenspan and Bernanke violated.  Unconventional candidates?  Elizabeth Warren, Sheila Barr, Ron Paul, Barry Ritholtz, jck at Alea, and I could name many more people who understand our crisis better than Bernanke.

PS — the same logic applies to Timothy Geithner; he is dispensable as well.  We think that the institution will change if we change the person at the top, but structural change is needed, refocusing or reducing the institution as a whole.  I could generate another list of complaints against Mr. Geithner, but truly, if he were gone. without structural reform, the Treasury would not change.