1)  Let’s start out with my forecast.  I’ve given it before, but it has become the conventional wisdom — at the next FOMC meeting at the end of April, the Fed will cut by 25 basis points.  They will make the usual noises about both inflation and economic weakness, as well as difficulties in the financial system, and comment that they have done a lot already — it is time to wait to see the power flow.  The only difficulty is whether we get another blowup in the lending markets that affects the banks.  We could see Fed funds below 2% in that case, but absent another crisis, 2% looks like the low point for this cycle.  Now all that said, I think the odds of another crisis popping up is 50/50.  We aren’t through with the decline in housing prices, and there are a lot of mortgages and home equity loans that will receive their due pain.

2) One interesting sideshow will be how loud the hawks will be opposing a 25 basis point cut.  We have comments from voting members Plosser and Fisher already. Price inflation is a real threat to them, and one that is closer to the Fed’s core mission than protecting the financial system.

3)  Okay, give the Fed some credit regarding the TSLF, which is now almost not needed.  The TAF is another matter — there is continuing demand for credit there.  It will be interesting to see when the Fed will stop the the TSLF, and what happens when they try to unwind the TAF.  As it seems, some banks still need significant liquidity from the TAF.

4) Indeed, if the Fed is lending to investment banks, it should regulate them.  I would prefer they didn’t lend to investment banks, though.  Better they should lend to commercial banks that are negatively affected by investment bank failures, and let the investment banks fail.  After all, there is public interest in the safety of depositary institutions, but I’m not sure that if the investment banks disappeared, and the commercial banks were fine, that the public would care much.  It certainly would teach the investment banks and the investing public a real lesson on overdoing leverage.

5)  Okay, so LIBOR rises after it seems that some bankers have been lowballing the rate in an effort to show that they are not desperate for funds.  Significant?  Yes, the TED spread has widened 12 basis points since then.   I’m sure that borrowers with mortgages that float off LIBOR will be grateful for the scrutiny.

Having been in similar situations in the insurance industry regarding GIC contracts, I’m a little surprised that the BBA doesn’t have some requirement regarding honoring the rate quote up to some number of dollars.  On the other hand, can’t they track actual eurodollar trading the way Fed funds gets done, and then just publish an average rate?

6) Onto the last three points, which are the most controversial.  You know that I think the core rate of inflation is a bogus concept.  If you are trying to smooth the result, better to use a median or a trimmed mean, rather than throwing out classes of data, particularly ones that have had the highest rates of inflation.  Given the inflation that is happening in the rest of the world, I find it difficult to believe that we are the only ones with low inflation, unless it is an artifact of being the global reserve currency.

7) I was quoted at TheStreet.com’s main site regarding the Fed. I think that the Fed is caught between a rock and a hard place, but I am not as pessimistic as this piece.

8 ) Finally, how do the actions of the Fed get viewed abroad?  Given the fall in the US Dollar, not nearly as favorably as the press coverage goes in the US.  Do I blame them? No.  They sense that they are losing economic value to the US, and that they are implicitly subsidizing us.  No wonder they complain.

When I wrote my last piece, “The Financings of Last Resort,” I did meant to add that this will be a common phenomenon for a year or so. Pretend you are part of a senior management team of a credit-sensitive financial institution, and your worst nightmare is slowly unfolding in front of you. You’re looking looking at delinquency and loss statistics stratified by year of issuance (”vintage”) and time since issuance. Every vintage since 2003 looks worse than the prior year, and the loss seasoning curves are all pointed upward — in the early vintages, mildly, and in the 2006-2007 vintages, wildly.

You are seeing current losses come through, and they are erasing much of current profits, or, creating crushing losses if you try to get ahead of the loss curve and put in sufficient reserves to handle likely future losses. Any loan loss estimate toward the beginning of a “bust” phase is a wild guess, and management teams are often behind the curve as they hope that the most recent data point was a statistical fluke.

But management teams often think along two tracks. The first is the “best current estimate,” which they give to the market through GAAP accounting. The second is “What if things get bad, and we run short of capital? Better to get financing now, while our stock price is relatively high, and bond and preferred spreads low.”

That reasoning drives two types of capital raising — financings of last resort, and protective financing. That second class of financing was what I commented on at Felix Salmon’s blog regarding JP Morgan.  Borrow when you can, not when you have to.  Get in front of the loss curve, not behind it.

But, for those that are behind the curve, the financings of last resort are protective, at least for a little while, of management teams and bondholders.  Consider the actions at:

• Citigroup
• CIT Group
• National City

But who loses? Current stockholders get diluted.  I can imagine the management consoling their consciences with the thought, “Yes, the stockholders lose, but what would they get in bankruptcy if things got worse, and we didn’t raise capital?”

So, even if credit-sensitive financial companies avoid going broke, they may not be good equity investments because of the dilution.  I said that early on with the financial guarantors.  The big guys are still alive, but their stock prices are down significantly.  (Oh, and note that the regulators like this approach.  No public funds get used.  No embarrassing front page insolvency news.  “What was the regulator doing?”)

How long will this continue?  Financings of last resort can go on until the stockholders rebel and throw out management (hard to do), or the estimated net present value of the profit stream of the company is negative; no one will finance that.  (Think of ACA Capital Holdings, maybe.)  The nature of a financing of last resort is that the financier hands over cash in exchange for cheap equity that can be recycled into the market.  It’s a coercive way of doing an equity or debt offering, and requires a significant discount to current financing valuations.

So, how long will the bailouts go on?  I think for quite some time, which I why I am avoiding that area of the market.  Avoid the equity “fire sales” if you can.  Remember, management teams usually know more than the average analyst when it comes to knowing the true value of cash that can be generated from illiquid assets.  So when you see financial firms pursuing liquidity during a time of debt deflation, don’t be a hero — avoid those companies.

1)  Picking up on some comments from last night’s post, why I am I not concerned about counterparty exposure?  Because Wall Street has always been very good at cutting off overleveraged clients in the past.  LTCM was an exception there, and only because Wall Street gave in to their request for secrecy.  Wall Street grabs collateral first, and then lets the client argue to get it back.  The investment banks require a significant margin, and when there is significant concern about getting paid, the lines get pulled.

The real worry here is that the investment banks don’t have good enough risk controls for each other.  Note that Bear’s crisis started when other banks stopped extending credit to Bear, and the fear fed on itself.

I liken the investment banks to long-tail commercial casualty insurers.  No one knows whether the reserves are right.  No one can.  Confidence is a necessary part of the game, which is made easier at lower levels of leverage.  But high leverage and opaqueness are a recipe for disaster when volatility rises.

2) Should you worry about Fed policy?  Yes.  The Fed is steering away from the Scylla of a compromised financial sector, and into the Charybdis of inflation.  As I will point out later, that is already having impacts on the rest of the world.  As for now, there are a few ill-informed writers who say that a negative TIPS yield on the short end is a reason not to buy TIPS.  That might be correct if inflation mean-reverts.  Given the short-term resource scarcity building in our world, I don’t think that is likely.

3) Should you worry about the US Government budget deficit?  A little — oh, and worry about the real deficit, one that puts the wars and other emergency appropriations on-budget, and takes out the excess cash flow from Social Security.  In a macro sense, for the nation as a whole, the impact isn’t that great… but it sends a message to foreign creditors who wonder what the value of the dollars will be when they get paid back.  When they see the Fed running an aggressive monetary policy in the face of rising inflation and a weak dollar, it makes their heads spin, as they contemplate the hard choices the weak dollar forces on them.

4) Could the falling dollar cause a crisis in China?  Maybe.  China is levered to US growth, which is slowing, and their export competitiveness versus the US declines as the dollar declines.  And what will they do with all of those dollar reserves?  Beats me.  After a certain point, additional reserves are useless — it is akin to lending more to an entity that you know is insolvent.  My guess is that the yuan will get revalued after the Olympics, and then the real slowdown will hit China.

5)  What of foreign food riots; are they a worry?  (More, and more.)  A little.  They are a canary in the coal mine.  They point to the short-term scarcity of total resources in our world, which only becomes obvious as a large part of the world tries to develop.  But, one practical thing that it implies is that energy and food prices will remain high for some time.  We are one global market at present, and energy and food prices are interlinked through the energy and fertilizer costs of farmers, and through stupid ideas like corn-based ethanol.

6) What of flat crude oil  production?  Yes, worry.  As I have said before, the government oil companies of OPEC countries control most of the supply, but they don’t always manage their resources as well as a capitalistic oil company.  Mexico, Venezuela, and Russia have declining production, to name a few.  The Saudis may not want to produce more, because they don’t know what to do with all the US dollar reserves that they have today.  Or maybe they can’t…

7) Worry about falling housing prices?  Yes.  The problems in the housing market stem from overbuilding.  There are too many houses chasing too few solvent borrowers.  This will eventually affect prime mortgages, because declines of 15-20% in housing prices mean that many prime loans would be underwater in a sale.  Remember, an underwater loan becomes a default after a negative life event — unemployment, death, disability, divorce, and uninsured disaster.

Before all of this is done, one of the major mortgage insurers should fail.  We aren’t there yet.

8 ) What of falling residential real estate prices in foreign countries? Yes, worry.  For Europe, it could lead to the end of the Euro, as countries needing looser monetary policies get tempted to abandon the Euro.  If the Euro’s existence becomes questioned, it will be a systemic risk to the world.

9) What of credit card delinquencies?  Yes, worry.  It shows that total financial stress on the consumer is high, particularly when added to the problems in mortgage and home equity loans.

10) Should you worry about bank solvency?  A little.  All of these previously described stresses have some bearing on the ability of the banking system to make good on their obligations.  Be aware that the FDIC was designed to handle sporadic losses, not systemic crises.  The odds of these problems affecting the depositary financials is still low, but the protective measures will not be capable of dealing with the worst case scenario, should it arise.

Perhaps I have more to worry about.  As I close up here, I haven’t mentioned the PBGC, Medicare, and a variety of other problems.  But, I have to call it a night, and symmetry with last night’s piece is worth a little to me.

There are many that cover the markets that try to get you to worry about things that aren’t real problems.  Here’s a sampling for the evening:

1) Changes in accounting standards, or ineffective/opaque accounting standards.  Take Goldman Sachs and level 3 assets as an example.  The accounting standard is fine, so long as you understand it.  In general, the higher the level of level 3 assets, the more opaque the valuation of assets is, and a valuation haircut gets assigned to the stock.  This is proper, because it happens to all companies with high or cloudy accrual figures.  It makes it hard to estimate free cash flow.

Should we move from US GAAP to IFRS, it should not affect the valuations of stocks on average, though it will make it a little harder to do financial analysis.  What does not change is free cash flow, which is not subject to accounting rules.  The money that can be withdrawn from a business without harming its current prospects (free cash flow) is the key metric for understanding business value.

2) Counterparty risk.  In derivatives, for every loser, there is a winner.  So long as the appropriate margin levels are maintained at the main brokerages, and the main brokers don’t experience conditions that dramatically change their credit quality, counterparty risk is not a problem.  (Or maybe, I should say, worry about the brokers, not the other counterparties.)

3)  Investors moving to cash.  Money rarely leaves the market.  When funds raise cash (and here), others buy their shares at a discount.  Typically, they are stronger holders than those that sold.  I wouldn’t be too bullish over stories of investors moving to cash, but I certainly would not be bearish.

4)  Rating agency downgrades, unless they trigger a debt covenant.  For the most part, market spreads and yields are set independently of debt ratings.  Sophisticated investors dominate the market, not the rating agencies.  As an example, suppose the US were downgraded to Aa1/AA+/AA+.  After a week, I doubt yields would change much at all, because the fundamental view of the US would not be changed by a change in its rating.

5) High credit spreads.  Those are a reason to be optimistic, because it means pain has been taken already.  Spreads can’t get higher than a certain level, or companies start delevering, because it is profitable to do so.  So when you see spreads near record highs, that is a buying signal, at least for the debt.

6) Retailers in trouble.  Some retailers are always in trouble during hard economic times.  It’s a tough business model, so expect some defaults; it is normal and healthy for the economy as a whole.

7) Collapse of a large portion of the auction rate securities market.   Most borrowers will refinance.  In the interim, speculators are driving down the rates that get paid.

Downgrades of the major financial guarantors.  The market has priced it in, and perhaps we just run off MBIA and Ambac.

9) Tranche warfare in CDOs.  Read your prospectus with care, but when the seniors grab hold of a deal after and event of default, that is a step toward normalizing the market, though the mezzanine holders may ineffectively object as they end up getting nothing.

10) The ABX indexes, etc.  I’ve written about this before, but the various synthetic indexes — ABX, CMBX, LCDX, etc., are very hard to arbitrage against the cash market bonds that they represent.  The indexes should not be used for pricing as a result.  Whenever the synthetic market gets too much bigger than the cash market, it becomes a bettors market, and becomes incapable of delivering pricing signals to the underlying cash markets.

There are enough real things to worry about.  Perhaps I will write about those tomorrow.

There have been a lot of bits and bytes spilled recently over whether hedge funds like volatility or not. Here’s a sampling:

• Hedge Fund Losses Blamed on Volatility
• Hedge Funds Come Unstuck on Truth-Twisting, Lies
• Hedgies hate volatility
• Why Hedge Funds Lose Money in Volatile Markets

Here’s the truth, the answer isn’t a simple yes or no.  Hedge funds are limited partnerships that do a wide variety of things in the markets.  Some aim for easily modeled consistent gains through arbitrage.  Others aim for maximum advantage, no matter what.  I call the first group the “nerds” and the second group the “barbarians.”  Neither of these terms are meant to be insulting — I consider myself to be a nerdy barbarian.

Nerds are yield-seekers.  They are attempting to achieve high smooth yields well in excess of the nominal risk-free rate on a constant basis.  They tend to get funded by fund-of-funds who attempt to diversify nerds, and maybe a barbarian or two, who have clients looking for smooth yields in excess of their hurdle rates.

When volatility rises, nerds get hurt.  In the same way that junk bond investors get hurt in volatile times, so do hedge fund nerds.  Almost all simple arbitrages rely on calm markets, where there is enough liquidity to finance every project imaginable, and a few that aren’t imaginable.  Volatility alerts investors to the concept that maybe there will not be enough cash flow to complete the transaction at a positive net present value.

Barbarians are another matter.  They swing for the fences, and are looking for maximum advantage.  They look to earn the returns from big bets that could be right or wrong.  They like increased volatility, because it enables them to take positions when they are despised or enraptured.  They play for the mean reversion, something that the nerds can’t do.

To make matters more complex, some hedge fund groups blend the two attitudes.  Good idea, if you can maintain your competitive advantages.

To close this, there is no simple answer to whether hedge funds like volatility or not.  Some benefit,  some get hurt. In my opinion, because of hedge fund-of-funds, which like nerds, volatility tends to hurt hedge funds in aggregate, but not by much.

With credit spreads wide, and disarray among the nerds, it is probably time to favor high yield investing and nerds in hedge funds.    Don’t jump in with both feet though, I would only allocate 50% of a full position at present.  There is a lot more volatility to be worked out of the system.

1) Note to small investors seeking income: when someone friendly from Wall Street shows up with an income vehicle, keep your hand on your wallet.  One of the oldest tricks in the game is to offer a high current yield, where the yield can get curtailed through early prepayment (typically in low interest rate environments), or some negative event that forces the security to change its form, such as when a stock price falls with reverse convertibles.  Wall Street only gives you a high yield when they possess an option that you have sold them that enables them to give you the short end of the stick when the markets get ugly.

2) When times get tough, the tough resort to legal action.  Financial Guarantee Insurance contracts are complicated, and the guarantors will do anything they can to wriggle off the hook, particularly when the losses will be stiff.

3)  The loss of confidence in financial guarantors has not changed the operations of many muni bond funds much.  With less trustworthy AAA paper around, many muni managers have decided that holding AA and single-A rated muni bonds isn’t so bad after all.  Less business for the surviving guarantors, it would seem.

4) Jefferson County, Alabama.  Too smart for their own good.   So long as auction rate securities continued to reprice at low rates, they maintained low “fixed” funding costs from their swapped auction rate securities.  But when the auctions failed, the whole thing blew up.  There will probably be a restructuring here, and not a bankruptcy, but this is just another argument for simplicity in investment matters.  Complexity can hide significant problems.

5) Spreads were wide one week ago, even among European government bonds, and last week, as these two posts from Accrued Interest point out,  we had a significant rally in spread terms last week.  Now, credit can be whippy during times of stress, and there are often many false V-like bottoms, before the real bottom arrives.  Be selective in where you lend, and if the sharp rally persists for another few weeks, I would lighten up.  That said, an investor buying and holding would see spreads as attractive here.  When spreads are so far above actuarial default rates, it is usually a good time to buy.  I would not commit my full credit allocation here, but half of full at present.

6)  I don’t fear ratings changes, if that is the only thing going on, and there is no incremental credit degradation, or increased capital requirements.  But many investors don’t think that way, and have investment guidelines that can force sales off of downgrades that are severe enough.  Personally, I think Fitch is best served being as accurate as possible here; they don’t have as large of a base to defend, as do S&P and Moody’s.  So, if downgrades are warranted, do them, and then make the other rating agencies justify their views.

7) I have not been a fan of the ABX indices, and I thought it was good that an ABX index for auto ABS did not come into existence.

So what is a auction rate security worth if it is failing?  Par?  I guess it depends on how high the coupon can rise, and the debtor’s ability to pay.  It was quite a statement when UBS began reducing the prices on some auction rate securities.  Personally, I think they did the right thing, but I understand why many were angry.  A complex pseudo-cash security is not the same thing as owning short-term high-quality debt.

9) Then again, there are difficulties for the issuers as well, particularly in student loans.  Not only are costs increased, but it is hard to get new deals done.

10)  GM just can’t seem to shake Delphi.  In an environment like this, where liquidity is scarce, marginal deals blow apart with ease, and even good deals have a difficult time getting done.

11)  Regular readers know that I am not a fan of most complex risk control models that rely on market prices as inputs. My view is that risk managers should examine the likely cash flows from an asset, together with the likelihood of the payoff happening.  With respect to bank risk models, they were too credulous about benefits of diversification, as well as what happens when everyone uses the same model.  Good businessmen of all stripes focus on not losing money on any transaction; every transaction should stand on its own, with diversification as an enhancer in the process.

When I was a investment grade corporate bond manager back in 2002, there were three “false starts” before the recovery began in earnest. The market started rallies in December 2001, August 2002, and October 2002. I remember them vividly, and I behaved like the estimable Doug Kass during that period, buying the dips, and selling the rips.

In this bear market for the financials, we are only through the first leg down. Here is what remains to be reconciled:

• Residential housing prices are still too high by 10-20% across the US on average.
• The same is true of much of commercial real estate.
• The mortgage insurers have not failed yet. Triad Guaranty is close, but at least two of them need to fail.
• There is still too much implicit leverage within the derivative books of the investment banks.
• Too many credit hedge funds and mortgage REITs are left standing.

I have tried to avoid being a pest on issues like these, but the overage of leverage has not been squeezed out yet.

I want to go back to an article that I wrote early in the history of this blog, when nobody read me except a few RealMoney diehard fans — Regulating Systemic Risk From Hedge Funds.  It was a critique of the “Agreement Among PWG And U.S. Agency Principals On Principles And Guidelines Regarding Private Pools Of Capital.”  Yes, the “shadowy” President’s Working Group on Financial Markets.  Some will call it the “Plunge Protection Team.”  Well, if they are that, they are certainly not playing up to their billing.  As an aside, I tend not to believe in conspiracy theories, because most bad plans of our government don’t require them.  As Chuck Colson pointed out regarding the Nixon Administration and Watergate leaks — he felt that information tightness in the Nixon White House was so effective, that if a conspiracy could work, it would have worked there.  (Since it didn’t work, and the information leaked out, it had a surprising effect on Colson’s life, as he concluded that the disciples of Jesus (Y’Shua) could not have conspired to steal the dead body, hide it, and fake a resurrection.  But that’s another story.)   Suffice it to say that I don’t think the government intervenes in the major financial markets of our country — there would be too many accounting entries to hide, and someone would have a real incentive to leak the information, or write a book about it.

Going back to my article, I tried to point out the difficulty of gathering data and analyzing it.  It was also somewhat prescient as I said, “Let me put it another way: if the government wants to reduce systemic risk, let them create risk-based capital regulations for investment banks, and let them increase the capital requirements on loans to hedge funds and investment banks. Or, let the Fed change the margin requirements on stocks. These are simple things that are within their power to do now. In my opinion, they won’t do them; they are friends with too many people who benefit from the current setup. If they won’t use their existing powers, why would they ask for new ones?

We will have to wait for the next blowup for the Federal Government to get serious about systemic risk. They might not do it even then. Upshot: be aware of the companies that you own, and their exposure to systemic risk. You are your own best defender against systemic risk.”

There is another reason why they would not act then, as I had pointed out at RealMoney over the years.  Bureaucrats are resistant to offering changes where if thy would get harmed if the changes led to a market panic.  Once the market panic starts, they can move with greater freedom, because no one will be able to tell whether changes imposed during the panic intensified the panic or not.

So, color me skeptical on efforts to monitor and control systemic risk.  It would be very hard to do effectively, and there are too many powerful interests against it.  Also, it would be difficult to get the gross exposure data necessary for inhibiting crisis, because many financial instruments would have to be split in two or more pieces.

As to the articles I have read on Treasury Secretary Paulson’s plan, they divide into credulous (one, two), mixed, and skeptical/hostile (one, two).  Let me simply observe that any plan for the control of systemic risk has to overcome:

• Political opposition
• Lack of effective data
• Lack of an effective model
• Lack of willingness to implement the conclusions generated by the staff/modeling
• Inter- and Intra-agency disagreements
• Data and action lags

If it is already difficult for the Fed to implement contracyclical monetary policy, just imagine how difficult it will be for them to deal with a problem that is far more tricky because of its multivariate nature.  Imagine them trying to analyze the effects from currencies, commodities, operating businesses, credit, ABS, RMBS, CMBS, equity-related businesses, counterparty risk, etc.  This is not trivial, and Paulson I suspect knows it all too well, which has led him to make a modest proposal that will likely not be effective, but will likely run out the shot clock for the Bush administration, leaving the issue for the next President to deal with.

The Fed is not by nature an activist institution, and it would have to become far more activist in order to effectively regulate the bulk of all financial institutions in the US.  I don’t see it happening.

As an aside, I am ambivalent about Federal regulation of insurance, and this RealMoney article of mine still expresses my views adequately.  Still, it would make sense to hand over oversight of financially sensitive insurers, such as the financial guarantee insurers and the mortgage insurers to the Feds, together with whoever oversees the ratings agencies.  An integrated solution is preferable.  (I still like my proposed name for the new regulator, “Federal Insurance Bureau” [FIB... well, it can't be the FBI].

As for some of the fog that a regulator of investment banks would exist in, consider these two articles on hedge fund distress.  What affects the hedge funds, affects the investment banks.  They are symbiotic.

As a joke, given that it is the first of April, if we do get a regulator for overall financial solvency and systemic risk, I believe it should be called the Federal Office for Oversight of Leverage [FOOL].  After all, I think it is taking on a fool’s bargain.

Personal notes before I get started: I’ve been busy studying for the Series 7 (and also reviewing the compliance manual for my new firm — wow it is big). The two of them fit together, as I get to see how the regulations get applied. I’ve made through the study guide (what do you do when it is wrong — not that I found a lot of errors, maybe half a dozen?), and I am 20% through my first practice test. Went and got fingerprinted for the fourth time in my life yesterday. (The other three times were for adoptions.)

My links are back but I had to give up my descriptive permalinks. Maybe I’ll get them back when I upgrade the blog to WordPress 2.5.1. Beyond that, I am working on a book review for Gene Marcial’s forthcoming book, “7 Commandments of Stock Investing.”

Catching up on the markets:

Our Unorthodox Federal Reserve, GSEs and Government

1) Repo rates may not be negative now, but they were so recently. Fails (failures to deliver securities) become common, because of the lack of a penalty. Today we should see whether the TSLF has any impact on the scarcity of Treasuries. We should learn more about the direct landing program as well after the close today. It got off to a big start last week. Watch for the H.4.1 report after the close. Given all that is going on, it is becoming the critical weekly Fed document.

2) Now, because of all these actions on the asset side of the Fed’s balance sheet, some are calling the actions of the Fed, including the Bear Stearns bailout, revolutionary. Well, maybe. It’s certainly different than before, but there is a cost to doing business this way. Bit by bit the Fed loses flexibility as more and more of its highest quality assets become encumbered for a time.  The more that they do, also, the harder it will be to unwind, in my opinion.

3)  Greenspan…  If we turn off the spotlight, will he go away?  (Then again, he has enough money to buy his own spotlight.)  It is tough for anyone to defend a legacy, and I don’t blame him for trying, but the Fed became too integrated with the political establishment under his tenure, which made it too activist in avoiding short-term pain.  It made him look like a hero at the time, but now we are paying the price.  Overly loose monetary policy and financial supervision led to gluts of borrowing to finance assets that appreciated dramatically, until the ability to service the debt began to decrease.  I don’t think history will treat him kindly.  He said too much in the past that he is contradicting today.

4) Will the Fed buy agency MBS outright?  I think the answer to that one is yes, if the crisis persists. If housing prices drop enough further, like say 15%, the actions of the Treasury, Fed, FHLB, Fannie, Freddie, FHA, and whatever new lending monstrosity our imaginative Government comes up with will have to be closely coordinated.  At some level, if the Fed can’t trust the implicit guarantee of Fannie and Freddie, why should the rest of us?  That guarantee is as sound as a dollar!

5)  It’s interesting to see the tide shift with respect to GSE involvement in the mortgage market:

• Higher limits for conforming loans.
• Fannie and Freddie being pushed to do more, but facing a shortage of capital, even after the recent required capital reduction from their regulator.  They are likely to buy $200 billion of residential mortgage bonds.  No capital added, just a loosening of a restriction.
• The FHLB is allowed to buy an additional $150 billion of mortgage bonds.  No capital added, just a loosening of a restriction.
• And, as I write, the WSJ puts out a front page summary piece on the topic.

6)  On a consolidated basis, our government, with its enterprises, are levering up.  This is a substitution of public debt for private, and more, just a lowering of capital standards for the GSEs.  (I wonder how comfortable the rating agencies are with this?)  This works while Treasury yields are low.  I wonder, though, how much impact this will have on the willingness of foreign buyers of Treasuries to continue their funding of our government?  One thing for sure, this will all get funded by the US taxpayers, together with those who lend to the US (dollar depreciation).

7) Now, it’s not as if the US is the only place in the world with central banking problems.  Consider the Eurozone, where there is still no lender of last resort.  How would they deal with a financial crisis?  I’m not sure; the ECB has quietly helped out some Spanish banks, but it is not really in their jurisdiction.  Under conditions of deflationary stress, it would not be impossible to see a nation whose financial system was in trouble either directly bail out the dud institutions, or even, exit the euro (last resort, but not impossible).

Or consider China, where inflation is getting a nice head of steam.  Their neomercantilism, with their crawling peg against the dollar is forcing them to import loose monetary policy from the US.  As the article cited points out, they need to significantly revalue their currency upward, which would would whack their exports, at least for a time.

8 )  For those that remember the files that I created for my piece, A Social View of the FOMC, it looks like I will have to update the file soon.  We have a successor to Bill Poole nominated, James Bullard.  When he is approved, I will update the file.  (I will miss Poole.  Though he was occasionally out of step with the rest of the FOMC, he always spoke his mind, which was usually more hawkish than the rest of the FOMC.)

9)  Now, Bullard is an Economics Ph. D.  (Surprise!)   In my earlier piece, Jeff Miller took note of a few of the things that I said, and perhaps attributed to me an anti-Academic bias.  I don’t have a bias against academics, per se.  (Hey, can we put Steve Hanke on the Fed?!  One of my professors…)  I do have concerns about not having enough real debate.  If the neoclassical view of monetary policy is correct, then we don’t have problems, because everyone on the FOMC is either a neoclassical economist, or a monetarist.

Now, I do know the difference between politics and policy formation, and if I hadn’t been trying to keep the number of pages down, I might have had two columns.  (Getting it down to 15 pages was hard.)  But most of the FOMC members had either one or the other, but not both, so I left it as one column.  Next time I change the column heading.  That said, even if one is in a policymaking capacity in the executive branch, there is typically some political affiliation that helps get that person the job.  Those are relevant bits of experience, just as I noted everyone that had foreign experience, or military experience.  But what worries me is a lack of real diversity in views of how economics works.  (Perhaps we could get someone from the Santa Fe Institute?)

10) Finally, there will be a lot of pressure in the future to re-regulate our financial system.  Personally, I don’t think it is possible to create a regulatory scheme that eliminates crises.  The regulator shapes the type of crisis that will come, and when it will come, but it is impossible to wipe out the boom-bust cycle.  (We put off this bust for a long time, and now we are getting it with compound interest for time delay.)  If a regulatory regime is too tight, the financial companies complain because their ROEs are too low.  To the extent that it can, capital begins to exit the industry, or, the stock prices languish, and financials trade at low multiples on book, because they can’t earn much off their net worth.

Financial companies find the weak spots in any risk-based capital formula.  They also lobby the executive branch and Congress effectively.  Unless we slide into Great Depression II, I don’t think things will change remarkably from here.

I  agree that we need to re-regulate, but perhaps after this crisis is done, we can consider systemic reforms, and not the piecemeal stuff we have been dished up in the name of crisis management.  My re-regulation would be to reduce the Federal Government’s role in the credit markets, but then, I am walking out of step, and realize that is not what is going to happen.

One trap you can fall into in life is to not learn from those that you disagree with, for one reason or another. George Soros would be an example of that. His politics are very different from mine, as well as his religious views. He’s a far more aggressive investor than I am as well. I am to hit singles with high frequency over the intermediate term. He played themes to hit home runs.

The Alchemy of Finance made a big impression on me 15 years ago. Perhaps it was a book that was in the right place at the right time. It helped to crystallize a number of questions that I had about economics as it is commonly taught in the universities of the US.

First, a little about me and economics. I passed my Ph. D. oral exams, but did not receive a Ph. D., because my dissertation fell apart. Two of my three committee members left, and the one that was left didn’t understand my dissertation. What was worse, I had moral qualms with my dissertation, because I knew it would not get approved.

My dissertation did not prove anything. All of my pointed to results that said, “We’re sorry, but we don’t know anything more as a result of your work here.” I have commented before that the social sciences would be better off if we did publish results that said: don’t look here — nothing going on here. But no, and many grad students in a similar situation would falsify their data and publish. I couldn’t do that. I also couldn’t restart, because I had put off the wedding long enough, so for my wife’s sake, I punted, and became an actuary.

That said, I was a skeptical graduate student, and not very happy with much of the common theories; I wondered whether cultural influences played a larger role in many of the matters that we studied. I thought that people satisficed rather than maximized, because maximization takes work, and work is a bad.

I saw how macroeconomics had a pretty poor track record in explaining the past, much less the present or future. In development economics, the countries that ignored the foreign experts tended to do the best. Even in finance, which I thought was a little more rigorous, I saw unprovable monstrosities like the CAPM and its cousins, concepts of risk that existed only to make risk uniform, so professors could publish, and option pricing models that relied on lognormal price movement.

Beyond that there was the sterility of economic models that never got contaminated by data. I was a practical guy; I did not want to spend my days defending ideas that didn’t work in the real world. And, I felt from my studies of philosophy that economists were among the unexamined on methodology issues. They would just use techniques and turn the crank, not asking whether the metho, together with data collection issues made sense or not. The one place where I felt that was not true was in econometrics, when we dealt with data integrity and model identification issues.

Wait. This is supposed to be a book review. Um, after getting my Fellowship in the Society of Actuaries, I was still looking for unifying ideas to aid me in understanding economics and finance. I had already read a lot on value investing, but I needed something more.

On a vacation to visit my in-laws, I ended up reading The Alchemy of Finance. A number of things started to click with me, which got confirmed when I read Soros on Soros, and later, when I began to bump into the work of the Santa Fe Institute.

I was already familiar with nonlinear dynamics from a brief meeting with a visiting professor back in my grad student days, so when I ran into Soros’ concept of reflexivity, I said “Of course.” You had to give up the concept of rationality of financial actors in the classical sense, and replace them with actors that are limitedly rational, and are prone to fear and greed. Now, that’s closer to the world that I live in!

Reflexivity, as I see it, is that many financial phenomena become temporarily self-reinforcing.   We saw that in the housing bubble.  So long as housing prices kept rising, speculators (and people who did not know that they were speculators) showed up to buy homes.  That persisted until the  effective cashflow yield of owning a home was less than the financing costs, even with the funky financing methods used.

Now we are in a temporarily self-reinforcing cycle down.  Where will it end? When people with excess equity capital look at housing and say that they can tuck it away for a rainy day with little borrowing.  The cash on cash yields will be compelling.  We’re not there yet.

Along with that, a whole cast of characters get greedy and then fearful, with the timing closely correlated.  Regulators, appraisers, investment bankers, loan underwriters, etc., all were subject to the boom-bust cycle.

Expectations are the key here.  We have to measure the expectations of all parties, and ask how that affects the system as a whole.

In The Alchemy of Finance, Soros goes through how reflexivity applied to the Lesser Developed Country lending, currency trading, equities, including the crash in 1987, and credit cycles generally.  He gives a detailed description of how his theories worked in 1985-6.  He also gives you some of his political theorizing, but that’s just a small price to pay for the overall wisdom there.

Now, Soros on Soros is a series of edited interviews.  The advantage is that the interviewers structure the questioning, and forces more clarity than in The Alchemy of Finance.  The drawback (or benefit) is that the book is more basic, and ventures off into non-economic areas even more than The Alchemy of Finance.  That said, he shows some prescience on derivatives (though it took a long time to get to the promised troubles), though he missed on the possibility of European disintegration.

On the whole, Soros on Soros is the simpler read, and it reveals more of the man; the Alchemy of Finance is a little harder, but focuses more on the rationality within boom/bust cycles, and how one can profit from them.

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