Year: 2008

Half a Dozen Thoughts on Monetary Policy

Half a Dozen Thoughts on Monetary Policy

Posted on by David Merkel

1) If you are looking for an article that describes how the Fed’s new lending facilities work, look here.? It shows the effects on the Fed’s balance sheet of each program.

2) Well, I guess the Fed is willing to further risk its balance sheet in order to force LIBOR down.? Now, this may have knocked 10 basis points off of the TED spread in the short run, but I am not sure what it will do long term.? It may do nothing, because the LIBOR lending markets are so much larger than the Fed.? As is noted in this piece:

Still, RBS Greenwich Capital chief economist Stephen Stanley cautions that adding AAA-rated asset-backed debt may not do the trick. ?This is not likely to be a major change, as the highest quality ABS were getting financed without too much difficulty already,? he wrote in commentary.

3) As I have noted before, the Fed cannot, and should not solve every lending problem.? There is a tendency for the financial system to adjust to monetary laxity and ask for more.?? This is just another aspect of the way our government operates, absorbing many medium-sized crises at the risk of an eventual run on the Dollar.

4) Should the Fed pay interest on reserves?? At present, the Fed has banks lend to each other through the interbank market; if the Fed paid interest, the Fed funds market could become an explicit market where banks loan money to the Fed, rather than to each other.? Now for the Fed to issue debt would allow them more flexibility in their balance sheet, but at a price.? We would have a central bank with additional liabilities beyond the currency, and that would have an impact on their ability to do monetary policy.

5) Funny how the Republicans grab for something unusual — pointing a finger at the Fed for commodity price inflation.? The Fed does have a small role there, but the bigger factor is the development of China, India, Brazil, and many other placesthat need raw materials in a way they did not previously.

6) Though I disagree with this paper, it is worth a read.? I am not a monetarist, I am more of an Austrian economist.? I acknowledge that economic systems are not stable, and that is a good thing in the intermediate-to-long run.? In my opinion, the main weakness of monetarism is that it fails to recognize asset inflation.? When the money supply is growing too rapidly, the money goes somewhere.? If savers predominate, it goes to assets, if spenders, to goods and services.? We mismeasure savings in the US — it is higher than commonly believed.? As such, growth in the money supply boosted asset prices.? But as the Baby Boomers gray, that balance will tilt as they draw on assets to finance consumption.

What is needed is a willingness for central bankers to stand in the way of investment/lending booms, and raise rates to deflate investment/lending bubbles before they deflate themselves, with large consequences to the economy.? That’s not coming anytime soon.

One Dozen Notes on Markets Around the World

One Dozen Notes on Markets Around the World

Posted on by David Merkel

1) Desperation and the Dollar. In mid-March, pessimism over the US economy and monetary policy were so thick that people were considering the old Greenspanian rate of 1% Fed funds as possible. Well, times change, at least for now. The orange line above is the 2-year Treasury yield which gives a fair read on expectations of monetary policy, which bottomed in mid-March. It took the Dollar a little longer to move along, but the present course of dollar is up in the short-term (consider the Euro). That doesn’t address the possibilities of a wider lending problem, or the overly aggressive fiscal policies that will be employed by the next President. (Deficits don’t matter, until they are big enough to matter.)

2) I’ve talked about the US Dollar and the five stages of grieving. I think the G7 got to the second stage, anger, in threatening action recently. I think they get a respite from fear because of the bounce in US monetary expectations. My guess is that they would intervene when the Dollar gets to $1.70/Euro. Neither the threats nor the intervention will have much impact in the long run, though. This will only change when foreigners stop buying our bonds, and start buying our goods and services.

3) Another thing that correlates with the shift in expectations of US monetary policy are yields in long government bonds around the world. Surprise, as the anticipated future financing rates rise, the willingness to try to clip a spread off of long bonds declines.

4) So what could replace the Dollar as the global reserve currency? The Euro, maybe? The Yen and Pound are too small, and everything else is smaller still. The Yuan might be ready in 15 years when their financial markets are developed. It takes a long time for the reserve currency to shift.

5) So, why not the Euro? I’m still a skeptic that the EU will hang together without political union. Also, a strong Euro is testing the monetary union in places where credit markets are weak, and export markets are weakening because the US is getting more competitive with the weak Dollar. That said a persistently weak dollar raises the incentives for other countries to look for a new reserve currency. Leaving aside the potential instability of the EU (unlikely in the short run) the Euro is probably the best alternative.

6) This piece by Felix Salmon helps point out why why Iceland is the canary in the coal mine. They are the smallest economy with a floating currency. It seems like they are successfully defending their currency at present, at the cost of 15% interest rates.

7) Is the UK economy just a miniature version of the US economy?

8 ) Why is Chinese inflation rising? Loose monetary policy, and an undervalued Yuan, at least versus the Dollar. Now, maybe the Chinese will start buying Euro-denominated bonds, and sell more to the EU than they buy. (Note that I am not the only skeptic on the Euro’s survival.)

9) What of the Gulf States? What will they do with all of the dollars that they have? Along with China, their huge depreciating Dollar reserves are fueling inflation. Personally, if I were in their shoes, I would buy US corporations quietly, perhaps through the purchase of ETFs. But the huge accumulation of dollars threatens to create the same “white elephant” development schemes that they experienced in the early 80s, when the socialist Gulf governments had too many Dollars, and too few places to use them.

10) Inflation is rising in the OECD. This is a “sea change” in terms of economics. Policymakers have enjoyed falling inflation rates for so long that perhaps they aren’t ready for the degree of monetary tightening necessary to squeeze out inflation.

11) Development isn’t easy after a point. It reveals shortages, as India is experiencing in semi-skilled and skilled labor. This will eventually work out, but in the short run, it makes infrastructure and construction projects difficult. Bodies aren’t enough; skills are needed, and many better skilled Indians work abroad, where they can make more.

12) A rice cartel? Everything old is new again. I remember in the 1970s when the US talked about a wheat/corn cartel, in response to the new strength of OPEC. Personally, I don’t think it would be effective. Agriculture is too flexible for cartel-like schemes to work in the intermediate-term. But, let them try. It will be interesting to see what happens.

The Venn Diagram Method for Greatest Common Factors and Least Common Multiples

The Venn Diagram Method for Greatest Common Factors and Least Common Multiples

Posted on by David Merkel

Uh, this is an off-topic piece. One of the benefits of working from home is that I can listen to my wife teaching our children, and every now and then, I drop in and explain some aspect of the topic further. Out of the corner of my ear, I heard my wife Ruth explaining Greatest Common Factors and Least Common Multiples to our fifth child, Jonathan.

When I was a kid, I was kind of a prodigy with math (I am not so now), and when we went through it in school, I remember tutoring my classmates on the two topics. I always thought the two concepts were related, but I never understood how, until it struck me last week.

Consider the numbers 60 and 144. What are their Greatest Common Factors and Least Common Multiples? To start, let’s factor the two numbers:

Then, let’s place the common factors in the intersection set.

The greatest common factor is the product in the intersection set, in this case, 3x2x2 = 12. The product of the union set (just multiply across) is the least common multiple — 5x3x2x2x3x2x2 = 720.

When I realized this, I drew it out for Ruth and Jonathan, and told them “Look at the ravings of a madman.” But later that evening, Ruth came to me and thanked me for it, because it worked with Jon, and clarified it to her.

As a mathematician, I am nothing great, but my intuition has been a great help to me at many points. This was one of them.

Update Saturday Afternoon

As F comments, “Which has the consequence that LCM*GCM = number1*number2.”

I should have written that myself, but didn’t.? Thanks for pointing that out.? It is an application of the rule that:

set A + set B = union of A&B + intersection of A&B

Is This What You Wanted?

Is This What You Wanted?

Posted on by David Merkel

In my blogging, in my other research and in investing, I gain some degree of comfort from being criticized by both bulls and bears. Worst of all would be no criticism; it would mean that I am not saying much. Criticism from both sides means that I am probably not blindly taking a partisan view, or talking my own book.

Briefly this evening, I want to point out some of the costs of our current monetary policies. Now, some things are going well, and the Fed might want to take some credit.? But the costs are soft costs, ones that are preferable to systemic financial collapse. That said, there are smarter and dumber ways to do bailouts. When I criticized the Bear Stearns bailout, I tried to point out how there have been better ways of doing bailouts from history, and that the Fed should have known this. I understand that the Fed may have felt rushed at the time, leading to a suboptimal decision, but they should be better read on economic history. Bailouts should be very painful for those bailed out, or else others line up for them.

Well, now that there has been one bailout, why not more? Other shaky areas of the economy could use a bailout… student lenders, homedebtors, home lenders, etc. Are they less worthy than Bear Stearns? Ignore the student lenders, because they pose little systemic risk. If housing prices fall another 20%, the systemic risk issues could be severe. Consider there two quotes from the article:

“There is no way to put the genie back in the bottle,” Minneapolis Fed President Gary Stern said in an interview with Fox Business Network on April 18. “What worries me most about where we wind up is that we will have an expansion of the safety net without adequate incentives to contain it.”

and

Richmond Fed chief Jeffrey Lacker and policy adviser Marvin Goodfriend wrote in a 1999 paper that central bank lending creates ever-expanding expectations. “The rate of incidence of financial distress that calls for central bank lending should tend to increase over time,” they wrote. That “creates a potentially severe moral-hazard problem.”

We’re on that slippery slope now. Should the Fed bend monetary policy even more to compensate for areas of lending where they have inadequate control? To the extent that you believe in central banking, central banks should deal with the big issues, and leave the little ones alone. Lend at a penalty rate during a crisis; don’t try to make things normal. Where there is systemic risk, stand behind the core but not the fringe; defend debt claims, and wipe out equity claims.

Or, consider the second order effects that our monetary policy creates: the weak dollar and the responses that foreign governments must follow: let their export sector wither, or follow US policy down, and accept more inflation. It will take a long time for the US to lose its reserve currency status, but we are on that path. Here’s to the day when we have to borrow in the currencies of oil exporters, or China. (Please no. 🙁 )

Or, consider the troubles that the states are in, since they have to run balanced budgets, unlike the Federal government, which can borrow in dollars, and inflate the currency as needed. I follow state tax revenues; it is an excellent coincident read on the economy. Well, sales tax revenues are falling. Also, some states are considering one of the “dumbest ideas ever” — pension bonds (borrowing to fund pension plans, relying on clever investing to beat the rate paid on the bonds). New Jersey lost big on their last attempt at pension bonds. Far better to consistently fund municipal pensions through general revenues. For those that have read me before on municipal pensions, their claim to fame is that they make private sector funding look good.

Finally, to end on a less sad note, is Iceland looking better, or , is it just part of an overall bear market rally?? (What of Argentina?) ? My guess is the latter, but maybe they have successfully defended their currency. Then again, we can look at Brazil, which is now investment grade on one side (from S&P). Good news follow good policies, and Brazil has been on the right track — they have become a net creditor, unlike the US. Hey, maybe the Real should be a reserve currency.

Assurant and Intelligent Acquistions

Assurant and Intelligent Acquistions

Posted on by David Merkel

Those who have read me for a long time know that my favorite insurance company is Assurant.? I’m not writing tonight about how they had great first quarter earnings, or how their investment portfolio suffered less than their competitors.? Rather, it springs from a Bloomberg article that is not available on the web.? It seems Assurant is talking to Countrywide about purchasing their Balboa Insurance Group.

What makes for an intelligent acquisition?? Two things: don’t overpay, or flub the integration.

On overpaying, it helps if you are buying:

  • part of a business rather than the whole company
  • a noncore asset of the target
  • and offering noneconomic benefits (e.g. joining Berkshire Hathaway, because Warren doesn’t change the culture…)
  • through a negotiation, not an auction (think of MetLife buying Traveler’s Life)
  • something where you can get significant expense savings
  • and you are known to be prudent and fair as an acquirer

On integrating, it helps if:

  • you are integrating a business that differs from your business in at most one or two ways
  • corporate cultures are similar
  • the differences in technology are small
  • you gain new markets or technologies that you can use in the rest of your business

Assurant has done very well through small in-fill acquisitions where they pick up a new line of business that they can grow organically.? They also have done well in occasionally buying scale in areas where they are already strong, for example, when they bought the pre-need (funeral) insurance business of Service Corp International (a very concentrated niche business line).

With Balboa Insurance Group, Assurant would deepen its penetration into lender placed homeowners insurance.? Assurant is #1, and Balboa I think is #2 because of its business with Countrywide.? Assurant has efficient systems — they will be able to take out costs, and deliver even better service to Countrywide / Bank of America.

Now, if Countrywide is interested in selling, it is likely that the best bid would come from Assurant, not because they will overpay, but because they can offer the best service, and take out the most in expenses.? Bank of America would likely find Balboa to be a small noncore asset, so their interest in retaining it would be low.

Here’s small excerpt from the Bloomberg piece:

“Certainly that is a business we would be interested in,” Assurant Chief Executive Officer Robert Pollock said today in a conference call with investors. “Until things between Bank of
America and Countrywide close, I don’t think that’s going to be a focus” for Bank of America.

Countrywide, based in Calabasas, California, reported a first-quarter loss of $893 million earlier this month, its third straight quarterly loss, as late mortgage payments and home
foreclosures rose. Bank of America said April 21 that its purchase, which would make the Charlotte, North Carolina-based bank the largest U.S. mortgage lender, remained on course forcompletion in the third quarter.

“Even in that case though, we still have to evaluate what we would have to pay for that business versus our ability to win” Balboa, Gene Mergelmeyer, president of Assurant’s specialty
property business, said in the call.

So, I look at this as a possible plus for both Bank of America and Assurant.? Balboa will be most valuable in Assurant’s hands.? Put it this way, why would another insurer want to buy Balboa when it is up against much superior competition?

PS — From the “don’t give a sucker an even break” file, Bank of America may not guarantee the debt of Countrywide.? This should not be a surprise.? They aren’t required to guarantee the debt, and Countrywide bondholders should just be grateful for the equity infusion.? If things get bad, though, Bank of America could walk away from Countrywide, and give it to the bondholders.

Full disclosure: long AIZ

Failing Well

Failing Well

Posted on by David Merkel

Just a quick note on how my equity investing is doing — in April I was slightly ahead of the S&P 500, and year-to-date, things are quite good. This is not to say that I haven’t had my share of failures… Deerfield Capital, YRC Worldwide, Jones Apparel, National Atlantic, and Vishay Intertechnology have hurt. But in a portfolio of 35 stocks, even large percentage whacks get evened out if the stock picking on the remainder has been good enough. And, for me it has, though the successes are not as notable as the failures.

As an investor, I am a singles hitter, but my average is high, and strikeouts low. I have my failures, but the eight rules, which are my risk controllers and return generators, protect me. At least it seems that way for the last 7.7 years, but I know enough that even if the principles are right, they are no guarantee for the next day, year, or decade. “The markets always find a new way to make a fool out of you,” and so I encourage caution in investing. Risk control wins the game in the long run, not bold moves.

So, I keep plugging on, adapting to what I think the market will reward in the future, and ignoring the past for the most part.

Full disclosure: long VSH YRCW NAHC JNY

Book Review: The Fundamental Index

Book Review: The Fundamental Index

Posted on by David Merkel

The Fundamental IndexThe books keep rolling in; I keep reviewing. Given that I am a generalist, perhaps this is a good task for me. Before I start for the evening, though, because I know the material relatively well, I skimmed the book, and read the parts that I thought were the most critical.

The Religious War Over Indexing

Passive investors are often passionate investors when it comes to what they think is right and wrong. For market cap or float-weighted indexers:

  • The market is efficient!
  • Keep expenses low!
  • Don’t trade fund positions!
  • Fundholders buy and hold!
  • Tax efficiency!
  • Weight by market cap or float!

For fundamental indexers:

  • The market is inefficient (in specific gameable ways).
  • Keep expenses relatively low.
  • Adjust internal fund positions as valuations change!
  • Fundholders buy and hold!
  • Relative tax efficiency!
  • Weight by fundamental value!

Some of the arguments in Journals like the Financial Analysts Jounrnal have been heated. The two sides believe in their positions passionately.

For purposes of this review, I’m going to call the first group classical indexers, and the second group fundamental indexers. The first group asks the following question: “How can I get the average return out of a class of publicly buyable assets?” The answer is easy. Buy the same fraction of shares of every member of the class of assets. The neat part about this answer, is everyone can do it. The entirety of shares could be owned in such a manner. Aside from buyouts and replacements for companies bought out, the turnover is non-existent. Net new cash replicates existing positions.

The fundamental indexer asks a different question, namely: “What common accounting (or other) variables, relatively standard across companies, are indicators of the likely future value of the firm? Let’s set up a portfolio that weights the positions by the estimated future values.” Estimates of future value get updated periodically and the weights change as well, so there is more trading.

Now, not all fundamental indexers are the same. They have different proxies for value — dividend yield, earnings yield, sales, book value, cash flow, free cash flow, etc. They will come to different answers. Even with the different answers, not everyone could fundamentally index, because at some point the member of the asset class with the highest ratio of fundamental weight as a ratio of float weight will be bought up in entire. No one else would be able to replicate the fundamental weightings.

So, why all of the fuss? Well, in tests going back to 1962, the particular method of fundamental indexing that the authors use would beat the S&P 500 by 2%/year. That’s worth the fuss. Now, I have kind of a middle position on this. I think that fundamental indexing is superior to classic indexing, so long as it is not overdone as a strategy. Fundamental indexing is just another form of enhanced indexing, tilting the portfolio to value, and smaller cap, both of which tend to lead to outperformance. It also allows for sector and company-level rebalancing changes from valuation changes, which also aids outperformance. In one sense fundamental weighting reminds me of Tobin’s Q — it is an attempt to back into replacement cost. Buy more of the assets with low market to replacement cost ratios.

But to me, it is a form of enhanced indexing rather than indexing, because everyone can’t do it. Fundamental Indexing will change valuations in the marketplace as it becomes a bigger strategy, wiping out some of its advantages. The same is not true of classic indexing, which just buys a fixed fraction of a total asset class.

Though the book is about fundamental indexing, and the intellectual and market battle versus classic indexing, there are many other topics touched on in the book, including:

  • Asset Allocation — best done with forward looking estimates of earnings yields (another case of if everyone did this, it wouldn’t work.. but everyone doesn’t do it. Ask Jeremy Grantham…)
  • The difference to investors between dollar vs time weighted returns by equity style and sector. (Value and Large lose less to bad trading on the part of fund investors… in general, the more volatile, the more fund investors lose from bad market timing.)
  • A small section on assumptions behind the Capital Asset Pricing Model, and how none of them are true. (Trying to show that a cap-weighted portfolio would not be optimal…)
  • And a section on how future returns from stocks are likely to be lower than what we have experienced over the last half century.

One more note: I finally got how fundamental weighting might work with bonds, though it is not explained well in the book. Weight the bond holdings toward what your own models think they should be worth one year from now. That’s not the way the book explains it, but it is how I think it could be reasonably implemented.

The Verdict

I recommend the book. The authors are Bob Arnott, Jason Hsu, and John West. At 260 pages of main text, and a lot of graphs, it is a reasonable read. The tone is occasionally strident toward classic indexing, which to me is still a good strategy, just not as good as fundamental indexing. (It sounds like Bob wrote most of the book from a tone standpoint… but I could be wrong.)

Who should buy this book? Academics interested in the debate, and buyers of indexed equity products should buy the book. It is well-written, and ably sets forth the case for fundamental indexing.

Full disclosure: If you buy anything from Amazon after entering Amazon through any link on my leftbar, I get a small commission. It is my version of the tip jar, and it does not increase your costs at all.

One Dozen Observations on Residential Housing

One Dozen Observations on Residential Housing

Posted on by David Merkel

1) The rating agencies have been running like crazy. They do that when they are behind the curve. Whether it is Moody’s on subprime, or S&P on Alt-A lending, the downgrades are coming in packs. Then there are difficulties with the debts of real estate partnerships, like LandSource Communities Development, which is likely to file for insolvency, together with some residential developers.

2) Now, there have been a few summary pieces on how the rating agencies changed as the housing boom moved on. Here is one from the New York Times, and one from the Wall Street Journal. As I had commented long before in my writings at RealMoney, the rating agencies were co-dependent with those that paid them. That said, it would be hard to construct a system that would not be that way. Buyers don’t have a concentrated interest in ratings. Issuers so.

3) If I were Ambac, I would be doing all that I could to allege fraud on contracts where representations and warranties were not upheld. Ambac is fighting to survive.

4) Mortgage insurers — it is the best of times, if you survive, because you are the almost the only game in town for those wanting to do low down payments, and rates for mortgage insurance are way up. But, it is the worst of times, housing prices are falling, rating agencies are downgrading, and defaults on insured mortgages are rising.

5) Foreclosures:

6) Gotta love OFHEO, which is trying to rein in the GSEs during a lending crisis. Even though they may have traction, I don’t see how they tighten the regulations during a crisis.

7) For that matter, consider the lenders. Countrywide seemed to purposely ignore the creditworthiness of borrowers as they jammed it out the door lent on mortgages. Even with all this, mortgage lenders are complaining that new regulations will make mortgages less affordable. What they mean is that they will issue fewer mortgages, and they will make less profit. Please, let’s stop making it easy for those that can’t afford a home to take the risk of buying one. Higher mortgage rates are bad in the short run, but good in the long run.

8 ) Dr. Jeff reluctantly asks what inning we are in on housing. I understand that it is an overused metric, but it is overused for a reason. Nine is an intuitive number — are we halfway through? Fifth inning. One-quarter? Third. Almost done? Eight or ninth. He also makes a simple request to those of us who opine on the housing slump, to be more definite in what we say, provide more data, and what will be signs that the troubles are turning.

I need to set up some housing recovery googlebots to scan for me, but my guess is that we are in the fifth inning of the troubles. When I get more definitive guesses/answers to the questions, I will post.

9) Delinquencies:

10) Home prices continue to fall, and estimates to the nadir (cycle low) range between 0-50%, with 10-20% being the most common.

11) Falling home prices will lead to many more foreclosures in prime loans, and of course Alt-A and subprime. Foreclosures happen when a sale would result in a loss, and a negative life event hits ? death, divorce, disaster, disability, and unemployment.

12) Second-order effects:

Financial Literacy for Children

Financial Literacy for Children

Posted on by David Merkel

As we were driving down the highway Monday evening, back from our oldest daughter’s symphony concert at U-MD, my wife and I began talking about teaching children about money.? We homeschool, so we have to consider a lot in training our children for the real world.

Some of my children have an interest in the market, some don’t. Personalities differ, but you want to give them some core knowledge that everyone can use. There have been people in our home school get-togethers who when they find out I am an investor, they ask “Do you know of any good books on the stock market for kids?” Lamely, I suggest the out-of-print book by Ken Fisher’s son, Clayton, which is pretty good, but I didn’t think it was definitive.? One has complained to me about the Stock Market Game, which seems to teach speculation, not investment.

That’s true of most stock market contests — the only exception I can think of was the Value Line contest back in 1984 . I managed to place in the top 1%, but not high enough to win. That contest forced you to pick 10 stocks from ten different groups for six months. The stocks were sorted by price volatility deciles, so you had to pick some volatile stocks and tame stocks. The stocks were equal weighted, and there was no trading. Great contest — I would love to run something like that. I have suggested it to The Street.com, but no dice. Hey, maybe Seeking Alpha would like to try it! Nominal prize money, but there would be bragging rights!? (Abnormal Returns, this could work for you as well…)

My wife tells me to think about it. Well, today, as I’m going through my personal e-mail, I run across a note from the Home School Legal Defense Association promoting the National Financial Literacy Challenge. Timely, I think. They are having a competition based off of the national standards published in 2007 by the Jump$tart Coalition for Personal Finance.

So I look at the standards, and I think, “These are pretty detailed… how can you turn this into a usable curriculum?”? I print them out and read a little bit of them to my wife Ruth, who says, “Typical for those that set standards, and aren’t teachers; you can’t work with that stuff.”? My wife was a high school teacher, and despite that hindrance, she still homeschools well.? But she knows the troubles that come to public school teachers as mandates come down from on high.

She asked me, “What would you recommend, then?”? I thought about it and said that the personal finance book that I reviewed recently, Easy Money, would be a good book for high school seniors to read.? It’s not a complex book at all.? Afterward I would discuss it with them.? She asked me why I hadn’t done that for our older two children and I said, “It was published after they went to college.? I’ll ask them to read it this summer.”

For investing, I still think that Buffett’s Annual Reports are understandable to most teens.? Marty Whitman is easy to read as well.? But I always liked Ben Graham, and I think The Intelligent Investor is accessible to the average teenager.? Good investing is not complex… but often we make it so.

Full disclosure: if you enter Amazon from my links and buy anything, I get a small commission.? It is my substitute for the tip jar, and it doesn’t increase your costs at all.

Sternly Bashing the Bear Stearns Bailout

Sternly Bashing the Bear Stearns Bailout

Posted on by David Merkel

I find it interesting that some former senior people at the Fed are breaking the “code of silence.”? I don’t mean that those that leave the Fed go totally silent, but they are usually supportive of the current Fed if they speak.? Even Greenspan, who pushes his own legacy, is largely supportive of Bernanke.? But with Volcker speaking out, others are emboldened, like Vincent Reinhart.? I don’t know exactly what Reinhart said in his speech yesterday, but I would bet that it is similar to what he wrote here.

Some of his comments are similar to what I wrote in point 1 of this blog post of mine:

1) How to do a bank/financial bailout: a) wipe out common and preferred equity and the subordinated debt (and offer some warrants to the debtholders).? Make the senior debt take a haircut of 50% (and offer warrants), and the bank debt a haircut of 20% (and offer warrants). Capital is offered in exchange for the equity interest, together with some senior financing pari passu with the banks.? If the management and other stakeholders do not like those terms (or something like them), then don?t bail them out.

Now, realize I?m not crazy about ?lender of last resort? powers being in the hands of the government, but if we?re going to do that, you may as well do it right, and bail out depositors in full, while having others take modest to large haircuts.? There is no reason why the government/Federal Reserve should bail out common or preferred equityholders, and those that bought risky debt should pay part of the price as well.? This should only be done for institutions where significant contagion effects could affect other financial institutions.? The objective is to create a firewall for depositors, and the rest of the financial system.

There were better ways to achieve the protection of the derivatives market the the Fed wanted to achieve.? Take a page out of the playbook of the insurance regulators that are sweating over the financial guarantors.? Are they worried about the holding companies that own the operating insurers?? No, they are only worried about the operating insurers.? In the same way, the Fed didn’t need to sell off Bear Stearns, and (in a way) backstop the sale.? All they needed to do was say that they would provide credit to the derivatives arm if Bear failed.

Hindsight may be 20/20, but the Fed neglects Bagehot’s rule to lend infinitely at a penalty rate in a crisis.? The penalty has not been there.? Beyond that, Reinhart points to the ways that the Fed is taking credit risk onto its balance sheet, which limits its flexibility.

Can that credit risk have negative impacts on the Fed?? Yes, but maybe those effects aren’t big.? The Fed is a profitable institution.? How profitable?? Who gets the profits?? Well, the US Treasury gets the profits, essentially unifying the Fed with the US government in an economic sense.? From fiscal 2005-2007, the Fed earned $18.1, 21.5, and 28.5 billion respectively.? Any losses from credit risk will diminish what the Fed dividends back to the US Treasury, which will raise borrowing and taxes.? So the impact is minor, in one sense — you can destroy the value of the US Dollar, but the Fed is an arm of the US Government in an economic sense.? It dies only when the US Government dies, or when the US Government eliminates it (hey, it’s happened before in US history).

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