An article in the New York Times quoted by Barry Ritholtz on risk management tells some very salutary lessons.  Value-at-Risk, and other systems that rely on liquid tradable markets fail when bid-ask spreads widen.

One of my main lessons on risk comes from the concept of “bicycle stability versus table stability.” As I said at RealMoney: “This emphasis on the size of monthly payments to the consumer reminds me of the 1920s. We have traded table stability for bicycle stability. A bicycle is stable if it continues to move forward; a table is stable regardless. In an effort to ‘lock in’ housing prices in markets that are rising rapidly, many people are doing things that are rational in the short run, but not necessarily in the long run.”

I’ve talked about the the difference between bicycle and table stability before at this blog, notably:

• Bicycle Stability Versus Table Stability
• Update on Indicators (Bearish point #1)
• On Information Cascades and Lemmings

If your risk control methods require liquidity, then they won’t work when you need reduction of risk the most.  There are no free lunches in risk management.  In order to get “table stability” leverage has to be reduced, and in some cases, cash balances carried in order to assure that an enterprise can survive in all circumstances.  It implies a lower ROE in good times, in order to be sustainable in the worst times.

Bloomberg wrote a piece over the puzzlement that many in the Chicago School of Economics feel at the present time with all of the distress in the markets.  After all, don’t markets self-correct?  Sadly, no, not all the time, or, at least not with high speed during credit crunches.  (All of the econometric studies I have done note a weak tendency to mean reversion in financial markets, even excluding periods where there are credit difficulties.)

For markets to self-correct, it requires that economic agents have enough access to capital in order to make the investments necessary to arbitrage the differences between the markets that are in disarray.  It should be no surprise that during a time where credit is hard to come by, that there are potentially profitable arbitrages that are going begging.

Barry did a post today off of the Bloomberg piece, suggesting the death of the Chicago School.  I think that prediction is too early.

I am not a Chicago School economist.  I don’t like the neoclassical synthesis.  It posits human rationality in ways that make us robots, both individually and collectively.  I have been a critic of their methods through both behavioral economics and nonlinear dynamics, a la the Santa Fe Institute.  We need a new paradigm to replace the neoclassical synthesis.  It does not adequately describe how mankind behaves (and we have known that for 25 years — the models don’t predict well, either in micro or macro).

But the answer is not Keynesian policy, in my opinion.  Just because markets are unstable, that doesn’t mean that government action can stabilize them over the long run.  In the short-run, while credit is still easily available, yes, government action can work, whether through the Fed, subsidies, or tax incentives.  But Keynesian remedies don’t work when the government can’t easily tax or borrow in order to provide the stimulus.  We will face borrowing problems soon enough.

The answers are not to be found by asking the Chicago School or the Keynesians.  We need an economic theory that accepts the neccessity of moderate booms and busts, where the government does little to try to correct the imbalances.  Moderate imbalances are normal, and if we try to eliminate the moderate busts, wew get a series of small busts, followed by one humongous one.  We experienced easy money in the 20s, and in the 1990-2000s.  Easy money cured the moderate busts, but at a price.

A quick excursus: I agree that tight regulation of financial institutions is necessary if there is fiat money.  Controlling the money supply means controlling credit.  I don’t like fiat money, and would rather have a gold standard, but if we must have fiat money, then make life tough for the banks.  Restrict what they can invest in.  Regulate lending practices.

The present distress stems from both a lack of regulation and too much regulation.

Lack of regulation:

• Lack of enforcement on bad lending
• Leverage limits on commercial and investment banks were too loose.
• Modest limits on the banks dealings with the non-regulated financials.
• Regulatory arbitrage allowed depositary financial to choose weak regulators.
• Failure to disallow investment in areas the regulators did not fully understand.

Too much regulation:

• Lack of limits on Fed stimulus action (our “independent” central bank was/is compromised)
• Tax deductions for residential real estate, including the home sale capital gains exclusion.
• Limiting the number of rating agencies.

My view is that we eventually have to give our currency some backing and get the government out of the money business.  Until we get there the ride will be bumpy.  We need to transist back to an economy where credit is not easy, but not non-existent, and where total leverage declines.  Saving has to become a virtue again, which our present monetary policies will not encourage.

It is too early to declare the demise of the Chicago School, much as it should disappear.  But now we will get the test of the Keynesian School and I predict failure there; they will not solve our crisis.  The crisis will end when enough bad debts have been liquidated, and the financial system can begin lending normally again.  Call it unrealistic; call it the Austrian School if you like (I have not read and von Mises or Hayek), but it is what restores the financial sector, which cannot live with too much leverage once assets are deflating.

PS — The Bible says that the borrower is servant to the lender.  True enough, but if the lender is himself a borrower, like most of our banks, the proverb does not hold.  The only lenders that are truly soverign are those that control their own destinies, because they have no debt.

From 2003 to 2007, we went through a period where the balance sheets of financial entities went through a systemic downgrade.  They became:

• More leveraged
• Less transparent via derivatives
• More reliant of floating rate finance
• Reliant on debt structures with shorter maturities
• More sensitive to calls on cash via ratings-sensitive collateral agreements

That is what has set us up for the problems that we have today.  In the bond markets, those conditions have led to the failures of many large market makers, straining the remaining system.  The remaining market makers in bonds are offering little liquidity amid the panic.  It doesn’t matter what sub-segment of the bond market I point at, every part faces a lack of risk-bearing capacity as parties hoard cash.

Part of this is the fault of the Treasury and Fed, as they proffered their TARP and pullled it back.  The greater the uncertainty from large parties, the more that small parties run and hide.

Away from that, many parties with capital have decided (seemingly) as a group to seek safety all at once, leading to a general malaise in all things risky.  Part of that could be related to the original TARP, as many parties decided to wait on selling until the TARP came along.  With no TARP (as originally conceived), those inclined to sell made offers, and the markets balked.

What can I say? Compared to 2002, there are fewer entities willing to bear credit risk during the crisis, even for short amounts of time.  This allows for arbitrage situations that don’t immediately get resolved, because no one has the balance sheet necessary to do it.

Eventually we wil get to a point wher those with unencumbered cash will make an effort to close those arbitrage gaps, and lend to worthy businesses at exorbitant rates, but it may take some time.  UNtil then, the market will flounder in the volatile way that it does.

I have been of two minds on bailouts.  First, I would prefer we did not do them because bailouts beget more bailouts.  Free money brings out the worst in humanity.  Where is the logical end?  How do we choose what is critical, and what is not?

Second, if we’re going to do bailouts, they should be a last resort to the companies receiving them.  Unlike the relatively sweet terms of the capital offered to the banks, bailout capital should be something that a management says, “Ugh, time to fall on our swords, guys, but at least the business and much of the rank-and-file will survive.”

So, when I look at hopeless cases like the “big” 3 automakers, I think that we need a new chapter in the bankruptcy code for businesses that are “too big to fail.” [TBTF]  The rules would be a little different here:

• Failure of a TBTF institution usually occurs during a major economic crisis.  Other institutions would be stretched too thin, so the US Treasury (together with the Fed) would serve as the Debtor-in-Possession [DIP] lender.
• In addition to being senior to the existing debt, the Treasury would receive some stock in the reorganized entity.
• There would be a special court to deal with the competing claims, with a goal of speedy resolution.  Marginal claims would get thrown out early.  Claims without a lot of variability would get little attention.
• The Court would have the power to throw out contracts, including union and management contracts.
• The idea is to preserve the business while finding who really owns the new equity, and quickly, so that real life can resume with a balance sheet that has little debt.
• The court would choose who puts together the first restructuring plan, aiming for the party that has the most at stake, skipping the current nominal equity, in favor of the parties that practically are the equity.
• A Chapter 11 case could be moved into this chapter if no DIP lender is found, at the option of the Secretary of the Treasury.

A method like this tries to respect the taxpayer, making it unlikely that bailout funds would be tapped, while still allowing for situations where TBTF institutions could be reorganized in an emergency where the banks can’t lend, rather than a quick liquidation.  It’s a tough balancing act, but one that has to be done for the good of the nation as a whole.  Formalizing methods like this could have value for future crises, such that businesses end up saying that they don’t want to go down the TBTF Bankruptcy Chapter, which would be good for the nation.

That’s my reasoning.  I am open to other ideas, and improvements to the concept.

When is a stock safe enough to buy when it becomes difficult for corporations to find financing?  We can answer the question two ways: 1) Why should we buy stocks when the financial markets are choking?  Better to sit on cash.  2) We can’t tell when the turn is coming, so if we buy companies that are cheap with strong balance sheets and free cash flow, we should do okay over the intermediate-to-long run.

I’m going to illustrate this with a single stock tonight: General Electric.  Why GE?  Here’s something I haven’t mentioned recently about how I source stock ideas.  I read widely, and when some one tells me a stock is cheap, I write it down for later analysis.  My initial cursory analysis during this time of credit stress looks like this:

Let’s look at earnings estimates:

Yeah, is does look cheap.  How has it done recently relative to expectations?

Mmmm…. not so good.  Looks like they are still working off all of the bad accruals from the Jack Welch era.

Now, let’s look at the balance sheet:

Mmmm… there are a lot of intangibles on the balance sheet.  Taqngible book value is light.  Perhaps the intangibles have real economic value.  If so, I would expect to see additional earnings over operating cash flow, and the is not there. Let’s look at debt maturities, could there be a call on cash?

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That doesn’t look good.  What if we look at only the holding company?

Okay, not so bad.  Most of the debt is from the finance subsidiary that I have argued for years should spun off.  In a pinch, what are the odds that they would send GE Capital into insolvency?  Very low, so I worry about the refinance risk.  Will GE Capital get attractive financing terms over the next several years?

On to cash flows.  Here are the cash flow screens:

Okay, free cash flow is positive, and congruent with earnings over the last five years.  That’s a good sign.  What else is there to look at?

holding-company-only.gif

Okay, Price-to-sales indicates that GE could be cheap versus their long history, but it could get cheaper.

Let’s look at summary statistics:

From all of the above, as I look at GE, there is a refinancing problem.  Many debts come due over the next 5-10 years, probably matched by debt repaqyments over the same horizon.  The effect of default from these repayments could be significant.  I doubt that GE would be willing to send its finance subsidiary into insolvency.

In conclusion, even at the low levels that GE stock price has reached, I’m not comfortable with it.  GE will have to refinance a lot of its debt over the next five years, unless they sell or default on GE Capital.  The debt load outweighs the seeming cheapness.

Full disclosure: no position

The Audacity of Hope

All we need to do is restore the confidence of investors, and everything will be fine.

We must take measures to make sure that the nominal value of assets that have been borrowed against do not fall further.

There is nothing to fear except fear itself.

There is nothing to fear except an aggressive government with idealists who think they know how to prevent a second depression, but really don’t.

Okay, the last one is what I think.  I have new sympathy for the liquidationist philosophies of Andrew Mellon, Secretary of the Treasury for Harding, Coolidge and Hoover.  Depressions occur because of economy-wide debt levels being too high, which leads to a self-reinforcing negative cycle when asset prices can no longer be supported by debt, because the cash flows from the assets become less than the cash flows needed to finance the debts.

There are two choices in such a situation.  The government can interfere and cause a Japan-style malaise, not all that much different from the last depression, or we can liquidate, which is really, really hard.  Think of what Poland went through with their “Big Bang” post-communism.

Most Americans, particularly Baby Boomers, do not like hard things (I would have loved to have written that article).  Well, who does?  But pain is a normal part of life, and mature people embrace it when it unavoidably comes their way.

In a depression, everything fights against the one trying to restrain it.  Ask the Japanese how successful they have been in restoring normality to their financial system.  Or, how good the economy was when the measures our government is applying today were tried during the last depression.  Then consider:

• Our troubles with the auto industry, and why it might be better to not rescue Detroit.
• The level of historical equity volatility today versus the Great Depression.
• The deteriorating conditions at Fannie and Freddie.  Oh, AIG, too.
• How the lure of cheap capital is luring all manners of institutions to become banks to line up for bailout capital.  (American Express, CIT, various life insurers, etc.)  Seemingly free money brings out the worst in all of us.
• That cities are applying to be covered by the TARP.  (How will they offer ownership interests?)
• Modest efforts to stop home foreclosures may just delay the inevitable.
• The degree to which homes are underwater in the California Bay Area (among other places) is astounding.
• How overvalued housing remains in much of the developed world.
• In a depression everything fights against you at the same time.  Consider seniors try to tap home equity using reverse mortgages. Sorry, door closed.  Or consider trying to avoid bankruptcy when debts are high going into this slump.
• What it would take to go back to a gold standard.  Not likely, but the price of gold could be 8-9x what it is now.
• And finally, my biggest bugaboo: can the US government continue to borrow aggressively without something significant going wrong.  (I.e., dollar troubles, steep curve, or crowding out.)

Confidence exists because there is enough transparency and lack of overall leverage that people can have assurance that marginal institutions will not get pulled down in a self-reinforcing cycle of failure.  We are nowhere near that now — if we can get the Debt/GDP down from 3.6x to 1.5x, we would have a chance.  Until then, regardless of the confidence building measures attempted by the Treasury/Fed, we will not get to that level of transparency.

There are a few things different now versus the Great Depression.  The US went into the Great Depression with a clean balance sheet.  We come into this situation with a lot of debt, explicit and implicit (entitlement promises). On the other hand, we don’t have protectionism yet.  We have an aggressive monetary policy, but one designed to stimulate hurting areas, and not the economy as a whole.  The same is true of fiscal policy.  It’s happening a lot faster than the government response during the Great Depression, so this will give a chance to see who was truly correct about what to do then versus now.

Are depressions caused by panics leading to a loss of confidence in the system because a few key areas have failed, and if we patch those up using government/central bank help, everything will go back to normal?  That’s the view of the political powers that be, both now and before the Great Depression.  Or, are they caused by Debt/GDP levels being too high, such that asset values get pushed significantly above their market clearing levels, and incremental new debt is not capable of financing those asset prices anymore?  That’s my view, the view of Mellon, many pre-Great Depression economists, and a number of others today that argue that the problem is not that the markets have failed.  Yes, the markets have failed because we let the credit creation inherent in a fiat money system run out of control.  For the last 20 years, the Fed would never let a recession be severe enough that it would bring debt levels down, as the Fed did from the forties to the mid-eighties.  So the debt levels grew and grew without bounds, because no discipline was imposed in the interests of permanent prosperity.  Congress and the Presidency went along with it happily.  Who wants to get in the way of a perma-boom?

Now the payment for this folly has come due, and the question sits before us: do we take it short and sharp, a Big Bang?  Or, do we eat the elephant one bite at a time, a la Japan, which is still not quite out of its bubble woes after almost 20 years?  I say Big Bang, but that’s not the nature of our culture, so be humble, be realistic, and be ready for a long slump or series of slumps as we enter the not-so-great depression.

This is short notice, and for me as well, but I will be on the Ron Smith Show on WBAL 1090, in the 3PM (eastern) hour today.  We will be talking about the bailouts, monetary policy, debt, etc.  If you aren’t in the Baltimore area, you can listen to it here over the Internet.

I have been on both sides of the table in equity money management.  I have hired and fired managers.  Now I am looking to be hired as a manager, and I face something that distresses me — the consultants that advise potential clients.  Personally, I think the consultants could do a lot better if they abandoned their overly simplistic model that categorizes managers on capitalization, value/core/growth, and domestic/international.  It does not serve their clients well — I believe the most fundamental risk model in a globally connected world considers industry exposures, and ignores other variables.

Why?  Industries tend to occupy specific areas of the “style box.”  At one firm that I worked at, external consultants complained that our risk control procedures were nonstandard, because they were focused on industries and sub-industries.  I counter-argued that our methods were better, because with a given industry, there was little variation in market capitalization and value/growth, but industry performance varied considerably.  Though I am no longer with the firm, it continues to do well, while many that used the consultants’ model have died.

Look at it another way. Isn’t investng about finding attractive opportunities, regardless of how big they are, where they are located, or how quickly they grow?  I think so, as does Buffett, Munger, Muhlenkamp, Heebner, Hodges, Rodriguez, Lynch, and many other successful fundamental investors.

Sometimes largecap names are attractive, sometimes smallcap.  Sometimes deep value is attractive, sometimes growth at a reasonable price.  Good managers analyze where the best value is, regardless of non-economic factors.

But if you have to cram me into the style box, fine, I am a midcap value manager that buys a few foreign stocks.  But there is a huge loss in constraining intelligent investors through the style box.  The better a manager is, the more one should ignore non-economic distinctions, and let him perform.

1) Do Fannie and Freddie deserve some blame for the crisis that we now face? Yes, but not without blaming Congress and the Executive Branch for pushing homeownership far beyond the natural rate of ownership, which I wager is around 60% rather than the 72% that it touched for a brief time.

But here are some ways that F&F went out of their way to help create the current crisis:

• F&F did push loan growth and growth of their retained portfolios in order to benefit their shareholders.
• They bought significant amounts of Alt-A and other lower quality loans for their retained portfolio.
• They aggressively lobbied to protect their position.
• They argued for capital standards that were lower than would be needed in a crisis (so did many financial institutions)
• They lowered underwriting standards in order to meet competition from private lenders. They could have given up business, delevered, and been stronger companies for when the crisis would hit.
• They managed to their GAAP financials. A prudent financial institution manages to a stressed version of their most stringent capital constraint.

Finally, I would add that this was an area where Greenspan was right on policy, along with a few of the more conservative members of Congress. If you are going to have F&F at all, then use them contra-cyclically. When the mortgage markets are lending, F&F should sit on their hands, and let the market do its work. If F&F’s balance sheets weren’t impaired now, they could be doing some real good here, but because their credit quality is suspect, as well as the commitment to their solvency from the Federal Government, their cost of fresh capital is high, making mortgages more expensive than they otherwise would be.

Note the current rise in Fannie 30-year mortgage rates.  This series tends to peak out at 6.20% but I am expecting rates to exceed that and soon.

Personally, I don’t think the government should be in financial businesses. Government agencies tend to overlend, and lend to bad risks with insufficient compensation. Then again, I don’t think governments should be in the money business either; they abuse the privilege, stealing from us in the process.

2) Will contractual terms be honored by the courts? Some hedge funds will press for their rights. My guess is that they won’t win in this environment. The system has a tendency to fight individual rights in a crisis. But, there is no free lunch. To the extent that contractual rights are infringed, rates will rise when lending resumes to compensate for expropriation risk.

3) Get financing when you can, not when you have to. Others have pointed to this post, but it bears repeating. The banks ran for too long on capital bases that were too slender. Now they are paying the price. The only pseudo-equity capital available is that from government sources.

Now, there may be a competition for that capital from the government, and perversely, it might lead to banks using the capital to buy other institutions (PNC has already done it to Nat City), rather than make loans, and on net, I would expect that to result in still fewer loans being made than in the absence of a merger. So let the competition begin for who can gobble their cheap competitors with cheap government capital.

4) Away from that, the Fed is having a hard time controlling Fed funds since they started paying interest on reserves deposited at the Fed.

Though I have written on the changing balance sheet of the Fed [link] and its implications, Jim Hamilton of Econbrowser has a very good post on it as well. The only place where I think we differ is that I think this will eventually be inflationary to goods prices when the Fed is forced to stop sterilizing.

5) Now the Fed is in the business of short-term unsecured lending to corporations via buying CP. (I think this will help lead to the first real CP default since Penn Central.) Early indications are that CP funding costs are higher than before the crisis if CP is funded by the Fed.

6) Never buy something you don’t understand, unless you have a friend who is smart and trustworthy by your side to advise you. Many municipalities got bamboozled by investment banks in much the same way that homebuyers got swindled by those offering subprime loans. Through derivatives, they offered a way to lower the current costs of debt by having the municipality sell options against their position that would force costs higher under certain circumstances which seemed unlikely, but were more likely than not.

The same is true of many investment products created by Wall Street for retail investors.  Sell them something that offers a high yield with safety, subject to some options sold short that are unlikely to come into the money.  I see it often.  Don’t but complex structured products from your broker.  Odds are they are taking you for a ride.

7) Those who have read me for a long time know that I think GM and Ford are eventual zeroes for the equity, and the subordinated debt.  Even the senior debt will get whacked severely.  There is no value in corporations that have huge promises to their employees way out into the future, when competing against better capitalized and better run foreign competitors like Toyota and BMW.

So, don’t bother trying to rescue them.  Rather, let foreign competitors buy them out, if they want them.  That will be a good test as to whether there is value there or not.  Possible foreign buyers have worked under the assumption that the Big 3 cannot be bought.  If the US sends a message that they can be bought, would any of them be bought?  My answer is no, unless the US Government or the PBGC sweetens the pot.  Other notes:

• Daimler thinks Chrysler is a zero. (no surprise here)
• The Treasury should give up on lending to the automakers. (Much as other think they are critical.  If the plants are valuable, foreign capitalists will maintain them.)
• The TARP may lend to auto financing arms, but that is probably a mistake as well.
• We should not bail out the auto makers, regardless of how politically expedient is is.  Because of the employee benefit promises made, there is no way any US automaker can beat foreign competition.  It is time to let them fail, and let the unions take the rebuke that they royally deserve.
• GM is not too big to fail.  Let them fail, and then expedite the bankruptcy process, so that senior debt becomes equity, the firm goes non-union, and the firm can compete globally for the first time in 40 years.

8 ) Greg Mankiw asks if we have learned enough.  My view is no, we have learned little, and what Bernanke thinks he learned regarding the Great Depression is wrong.  This is not a crisis of confidence and liquidity, it is primarily a crisis of solvency, which drains liquidity.  High levels of total leverage make a financial system inherently unstable, and the only way to cure it is through expedited bankruptcy procedures.  As it is now, Bernanke and Paulson are trying to save the financial system by wagering the credit of the USA.  (My opinion is that our nation is great enough that we whould risk another Great Depression rather than give up our liberties to the Government.)

9) A young friend e-mailed me from LIthuania (where she has a semester abroad), and asked me how serious the current economic situation is.  My response:

To give you the quick summary, we may be headed into Great Depression 2.  Or, as I sometimes call it, the Not-so-great Depression.

A Depression is a severe recession where the solvency of the banks is compromised.  Debt levels of financial companies, consumers and our Government have gotten to levels where repayment of debts in full is difficult if not impossible.  The system is overleveraged, and funded by leveraged institutions that could fail if they aren’t paid back.  There is kind of a “domino effect” here, where failures can cascade.

That’s why the Government has stepped in, encouraging financial institutions to shift their debts over to the Government.  That will work for a while, but eventually parties will become reluctant to lend to our Government as it becomes a bottomless pit of promises.  Then inflation of the currency will begin.

This is an ugly situation, one that is the product of sloppy monetary policy, poor regulation of financial companies (for two decades), poor risk controls, overlending by government institutions, and a cultural failure where we borrowed too much and saved too little.

I wish I could be more chipper here, but this is ugly, and what the government is doing is not likely to solve the problems at hand.

10) Slow moves tend to persist, sharp moves tend to mean-revert.  Don’t put much confidence in today’s sharp move up.  Strong one-day upside moves are characteristic of bear markets.

11) My post last night neglected one item.  Stable value funds have more flexibility than many other financial entities.  Be wary if the credited rate drops a lot.  Better to withdraw funds in that scenario, because it implies that the market value of assets is significantly less than the book value.

12) Be ready for a surprise in the GDP data, as I highlighted last quarter.  The implicit deflator for Gross Domestic Product will be extra high in the third quarter because of the fall in energy prices.  Just as it pushed “real” GDP higher in the second quarter, it will exact its pound of flesh in the third quarter.

13) My pal Cody is red hot, and though he is less measured than I am, I agree with much of what he says.  We need to vote out Republicans and Democrats.  We need new options.  Personally, I think we need to radically change the Constitution, and move to have a parliment, where the head of state is the head of the majority party.  That will create government that is closer to the consensus.  Eliminate the Presidency — it is too dangerous of an institution.

As Cody put it today: 2. Real headline today: “White House Encourages Money-Hoarding Banks to Start Lending” – I thought profit-motive was what was supposed to encourage banks to lend. And only profits make stocks go up, so why would shareholders want the banks to start lending if the bankers don’t think it’ll be profitable?

I can’t agree more, and the Treasury is pushing on a string if they are trying to force the banks that they have financed to lend.

14) Commercial Real Estate is the shoe yet to fall, yet the CMBS market has anticipated much of the decline.  Are the Fed and Treasury ready for this?  They weren’t ready for residential housing declines.

15) The foolishness that exists today regarding the government buying stakes in financial companies has now transferred itself to policymakers who think the equity market is now cheap, so invest the Social Security surplus in the equity market.  Problems:

• We have always avoided Socialism like this in the past.
• How can a bureaucrat with no profit motive figure out whether out whether this is a good decision or not?  Or, how will the bureaucracy extract maximum value for the taxpayers?
• Is the market really cheap now, or, only seemingly so.  The time to invest is during a baby bust, not a baby boom as it is now.

As with so many of these decisions, the answer will only be clear in hindsight.

Check out this article from the New York Times on the Greenspan legacy.  In my time at RealMoney, I took some heat for being a critic of Greenspan.  I won’t list all of it, but I will echo this one post:

		Aaron Task
		Speaking of Permabears…
		7/26/2006 1:27 PM EDT

Thanks for the response, Rev.

Meanwhile, Merrill’s Rich Bernstein has an interesting note out arguing that the Fed’s 450 basis points of tightening “has not yet severely impacted the U.S. economy” because the expanded use of credit derivatives has created an alternative source of liquidity.

“Whereas the majority of Wall Street is focused on the traditional growth/inflation trade-off, we hope Mr. Bernanke is also considering this new and expanding form of credit creation,” Bernstein writes. “Our belief is that he is indeed quite concerned, and that despite current dovish jawboning, he will ultimately tighten more than investors currently expect.”

Position: Awaiting the Beige Book.

		David Merkel
		By Default, No Credit Where It Is Not Due
		7/26/2006 2:23 PM EDT

Aaron, I read the Rich Bernstein piece. I usually agree with what he writes, but not this time. The amount of yield compression created by credit default swaps is 50 basis points at best, which doesn’t even come close to the 450 basis points that the FOMC tightened. Now, if someone makes the argument that the rates on corporate bonds 10 years and longer haven’t increased significantly over the past 27 months, I would agree with that, but that has little to do with credit default swaps, which are a short maturity phenomenon for the most part.

I thought of writing a note on the article cited in Bernstein’s piece, but ran out of time yesterday. It is a horrendously optimistic article, and too short-sighted. Credit derivatives, as I have noted before, have induced two anomalies into the credit markets. First, they make spreads artificially tight on the short end. Second, they create demand for bonds after they default.

Both of these are “tail wagging the dog” phenomena. When the market for making side bets gets bigger than the main business of financing corporate credit, something weird is going on. The real test will come when we get the next spike in investment grade defaults. When we had the last spike, the credit default swap market had notional amounts smaller than the corporate bond market. Now the credit default swap market is more than four times the size of the corporate bond market in nominal terms. When it happens, all of the negative effect of too much insurance chasing too few bonds to be insured will be revealed.

One more aside, the idea that the low default rates since 2003 is unusual is wrong. We had a longer period in the mid-90s. The effect of credit default swaps and collateralized debt obligations on default in the short run is modest at best (even the article says CDOs lower borrowing costs by 3-5 basis points).

In the long run, it may make the default problem worse. Whenever you lend a debtor money, he immediately looks more creditworthy because of the liquidity. When the liquidity goes away, as it always does for some minority of corporate borrowers, the debt problem is worse not better.

Position: none, but my bet is that Buffett is right on credit derivatives, and Greenspan wrong (why does that seem like an easy bet?)

I’ve always been a skeptic on the macro-level of derivatives, because they don’t change anything for the system as a whole, unless the losing party is undercapitalized.  The seeming calm that derivatives helped to induce merely shifted volatility to parties that could not bear losses under significant stress.  Talking about a “Great Moderation” during a bull market is hooey.  It’s a Great Moderation if lending terms are stable in a bear market.

Greenspan is a bright guy, but like many bright guys who become beholden to the DC establishment, they circumscribe their reasoning to the politics that they live in.  Few of us have the stomach to speak truth to power; I wonder what I would do under the same cirumstances, though my constitution says I would be a short-lived creature in DC, which does not want to hear the truth.

My guess is that Greenspan will fare badly in history books one century from now.  The inflation that he induced, and the false confidence he engendered will be villified.