Thomas Palley posts only occasionally, but just about everything he writes is first rate, and today’s offering is no exception.
Palley argues one of our favorite views, that the Federal Reserve interest rate cuts have had more to do with trying to prop up asset values than with stimulating growth. He points out that this approach has not achieved its aim (asset prices are still falling) and may produce unintended and undesirable consequences. The nature of the crisis on Wall Street demonstrates the need for a systemic as well as firm-specific view of risk, which in turn means there must be an overarching regulator. Yet the Fed remains hostile to this view.
From Palley:
The Federal Reserve’s recent surprise decision to lower its short-term interest rate target by three-quarters of a point has received much attention. Most commentary has focused on the idea that the Fed is trying to stimulate spending in the hope of preventing a recession. Over-looked, and equally important, is the fact that lower interest rates raise asset prices, which is something Wall Street desperately needs to prevent a systemic meltdown.
The Federal Reserve is right to play the interest rate card aggressively since the economy-wide costs of a financial meltdown are so large. But let’s not fool ourselves about Wall Street and free markets. The Fed is using its government granted power of fixing interest rates to bailout Wall Street. That is welfare, Federal Reserve-style.
Normally, economists focus on the effect of interest rates on business investment and consumer spending. The thinking is that lower rates cause increased spending, albeit with long and variable lags and the net impact is also highly uncertain and contingent on the state of confidence.
However, another feature of lower interest rates is that they increase the price of fixed income assets. Thus, when interest rates go down, bond prices go up, and that is critical for understanding recent Federal Reserve policy moves.
The U.S. financial system is currently deeply stressed. Growing perceptions of heightened default risk on mortgages and consumer debts have caused large price declines for securities backed by these assets. That in turn has caused massive losses at banks and insurance companies, eroding their capital. This erosion has placed many firms in danger of regulatory insolvency, unable to meet capital requirements. Some are in deeper danger of bankruptcy with the value of liabilities exceeding assets.
The problem is acutely visible among bond insurers, where rising default rates have reduced asset values while simultaneously increasing potential payouts on insured securities. If the bond insurers are downgraded, this could trigger a cascade of losses that could fracture the system. This is because insured bonds would fall in value, thereby wiping out further capital.
This possibility means maintaining asset prices, and preventing further mark-to-market losses is critical. The Fed’s problem is that as quickly as it has been lowering the federal funds rate, default rates on mortgage and consumer debts have been rising. Consequently, rising credit risk has offset the effect of a lower federal funds rate, so that asset prices have remained weak.
Moreover, there are pitfalls in the low interest rate policy. On one hand lower rates increase bond prices and also reduce defaults on adjustable rate mortgages. On the other hand, lower interest rates could trigger a wave of mortgage re-financing by those good risks still capable of re-financing. That would cause pre-payment losses to holders of existing mortgage backed securities, while also concentrating the proportion of remaining bad risks. The net effect is prices of mortgage-backed securities could fall further.
The fact that Wall Street needs this helping hand has important public policy implications. The existing system of regulation by capital requirements helps discipline risk-taking, but it has proven inadequate. The problem is individual firms do not take account of the impact of their risk-taking on others, so that the system takes on too much risk. This problem can only be solved by a system-wide regulator who monitors and limits total risk-taking. Yet, that is exactly what the Federal Reserve has rejected during the last twenty-five years of de-regulation.
Remedying this failing calls for deep regulatory reform that is nothing less than paradigm change. This is something the Fed will resist and Congress will have to push. But until deep regulatory reform is enacted, the “welfare for Wall Street” problem will persist.
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I am in partial agreement with Palley. I oppose any regulatory “reform”. Any “regulator” will be subject to “industry capture”. My proposal for the umpteenth time: repeal the Federal Reserve Act and let the chips fall where they may.
John Mauldin argues that the huge 75 basis point cut must have been done because the FED knows something that most others do not – that the bond insurance companies are in very bad shape, much worse than generally acknowledged. And that there will be further cuts, one following another until we are at 2%.
“Banks will need at least $22 billion if bonds covered by insurers, led by MBIA Inc. and Ambac Assurance Corp., are cut one level from AAA, and six times more than that for downgrades by four steps to A, as Paul Fenner-Leitao wrote in a Barclays report published today. Barclays’ estimates are based on banks holding as much as 75% of the $820 billion of structured securities guaranteed by bond insurers. (Source: Bloomberg)
The stocks of MBIA and Ambac have risen on speculation of take-overs or a rescue. But MBIA is going to have to cover that $8 billion of CDO squareds. With what cash? MBIA makes about $5 billion a year. It will take almost two years’ earnings just to deal with the losses from CDO squareds. Not to mention the subprime mortgage exposure.
But what if the above-mentioned monolines are downgraded to junk, as was ACA when it could not raise capital? As the downgrades on various mortgage assets and the CDOs continue to increase, the ability of the monolines to deal with the problems is going to come under increasing question. The losses at major banks could be much worse than $122 billion if they are downgraded to the same junk level that ACA was.
And that is just the credit default swaps (CDSs) from the monolines. What about the trillions that are guaranteed by banks and hedge funds? There are a total of $45 trillion CDSs outstanding.
No one is really sure who owes what and to whom, and what is the risk that there may be no one to pay that CDS when it comes due? The entire mess is going to have to be unwound in the coming quarters. It may take a year or more.
I think the concern that there is the potential for a much worse credit crisis than we are currently experiencing is what is driving the Fed. They are looking at the problem from the inside, and realize that they simply have to engineer a much steeper yield curve to allow the banks to make enough profits so that they might be able to grow their way out of the crisis over time.”
Full article:
http://www.frontlinethoughts.com/article.asp?id=mwo012508
“Consequently, rising credit risk has offset the effect of a lower federal funds rate, so that asset prices have remained weak.”
Why do people never see through this “pushing on a string” nonsense?
The point is that the Fed by lowering interest rates is trying to prevent credit losses from being worse than they would be otherwise – not that lowering rates is going to reverse credit losses in the near term. The same general objective goes for any program of Fed easing.
I didn’t think it was a particuarly perceptive article. Roach has been writing about this sort of thing for years.
Bottom Line: The average Joe six pack is a baby boomer quickly running out of time. His single largest asset, his primary residence, is deflating rapidly. This single largest asset is also the primary collateral for his single largest liability. His balance sheet is rapidly deflating as all his assets, from his home to his equity portfolio, all simultaneously deflate while his debt outstanding may actually still be increasing. His debt servicing are costs not dropping, despite aggressive rate cuts, and may actually be rising. It has also become damn near impossible to refinance certain mortgages as easy credit evaporates. On top of that, Joe six pack should now be seriously concerned about his job security. So when a cheque for $300 to $1500 arrives in the mail, Joe six pack is not going to spend it on a $200 steak dinner or a new computer or on a vacation. Got it people?
More on the stimulous package: (http://benbittrolff.blogspot.com/2008/01/fact-sheet-bush-stimulous-package.html)
TheFinancialNinja
The problem with the “asset price support” approach is that it sows the seeds for bigger declines.
Bernanke, despite the recent criticism, is probably happy with the outcome of Tuesday’s cut: he prevented a 500 point fall in the Dow, so “high fives” around the FOMC boardroom table.
Here’s the problem: when the next 500 point overnight futures fall happens, traders will be glued to thier Bloomberg, waiting for that 75bp announcement. If it doesn’t come, 500 points can quickly become 1000.
And even worse: what if the announcement does come, and traders “discover” that they don’t care. The “no confidence” motion on the Fed would strip it of its EXPECTED power to prop up markets. Take away the prop, and 500 points turn into a 2000 point decline.
Can Fed officials really be so blind as to miss the two risks presented above?
Re: This is something the Fed will resist and Congress will have to push. But until deep regulatory reform is enacted, the “welfare for Wall Street” problem will persist.
Two things, Congress and The Senate are a collective group of idiots that will continue to collect pay and os nothing of importance; that is a fact!
2. It was only a few years ago that we witnessed Enron accounting fraud and Sarbines Ox, in addition to 9/11 and The Patriot Act and all the additional re-engineered reforms and government related regulation. Regulation then did not have any impact at all and any future regulation changes will have the same impact, which goes back to #1, we have boobs and retards running around like idiots as the serve the wallstreet mafia, thus we can all look forward to more of the same and it makes zero % difference if any new president comes along, or if they decide Bush should have a third term as an emergency related to national security…..it dont matter!
“Any “regulator” will be subject to “industry capture”.”
Could you elaborate on that please? I’m curious to read what is meant by “industry capture”.
Thank you
“The nature of the crisis on Wall Street demonstrates the need for a systemic as well as firm-specific view of risk, which in turn means there must be an overarching regulator. Yet the Fed remains hostile to this view.”
Hostile? Really? Pray tell why Congress should care one bit about this Fed’s hostility? Haven’t they had enough of dealing with crises after crises?
Regulation, in nature as in society, is meant to attempt an optimal mastery of chaos. It is rarely optimal within the societal domain, but I surmise we have seen enough already of the consequences of an absence of regulation.
In the present state of affairs, it is always useful to ask: “Cui bono?”
The 75 basis point cut was done when they were expecting to cut either 50 or 75 basis points at the meeting one week later.
True, the stock market was facing meltdown. But the underlying credit problems and banking system solvency are the much larger underlying problems.
Bernanke is realizing very quickly he faces 30’s depression style risk due to the potential failiure of all of the bond insurers.
This is massive deflation risk that must be prevented. Aggressive easing is warranted, including another 50 bp next week.
Given this, why on earth would you wait a week while the stock market also undergoes a generalized crash?
The stock market was a symptom of the target problem (credit deflation)- not the target per se.
A new round of much tighter banking regulation will certainly ensue, but that is in the clean up operation. You can’t invite a depression in order to punish systemic risk failure.
What does Palley mean by “deep regulatory reform?” A return to the regulatory schemes of the past or something new?
Anon of 5:02 PM,
I have to differ with you. First, the stock market is not the credit market. The Fed has no charter to be tinkering with stock prices. Second, a rate cut is not going to improve the lot of the bond insurers. As Nouriel Roubini said early on, this is a crisis of solvency and lack of information. Taking interest rates to zero is not going to make a consumer who can’t meet his credit card or mortgage payments any more able to pay. It is the underlying defaults that are causing the credit crisis. Rate cuts will not remedy that. Monetary stimulus has considerable lags; even if it provides enough of a boost down the road to improve the lot of consumers (unlikely enough to improve their ability to pay) it will be far too late to improve the lot of the bond insurers.
If the Fed really wanted to help, it should roll up its sleeves and get directly involved in Dinallo’s efforts, His initiative isn’t likely to succeed, but it goes from non-starter to remotely possible if the Fed sponsors meetings jointly with him. They get senior people who would in turn throw more resources at analyzing the problem.
One big obstacle (unlike LTCM, where the exposures were clear and everyone agreed on the $ required) is that there are huge differences in the estimates of how bad the losses might be and what would be required to shore up the bond insurers.
The worst case scenario from Wall Street’s perspective isn’t that the insurers are downgraded; it’s that they stump up $5 billion that they can barely afford, discover in six months that Dinallo was wrong, the second installment isn’t another $10 billion but more like $25 billion or even more, they refuse and the insurers get downgraded anyhow, just later. They’ve just wasted precious capital on a failed effort.
Mohamed El-Erian more recently pointed out that Fed cuts will drive liquidity to parts of the system where it is not needed, and will not improve conditions in the institutions that are under stress. Note the El-Erian, unlike Roubini, is not the bearish type. Others have said more or less the same thing.
The real problem is we have too much debt relative to GDP, period. Some of that will have to be written off. Rate cuts to attempt to make bad debt good is a lousy idea and could lead to the creation of even more debt by virtue of interest rates being negative in real terms (we are nearing that point). That means (best case) we will limp along for a bit with low growth and then have an even worse crisis
We are going to take credit writeoffs, and have at least a slowdown as consumers increase savings (paying down debt is saving as far as the macro accounts are concerned). More saving means less consumption.
Richard B,
You are right, Palley was completely unclear, so I can only guess. He probably means a fundamental rethink, not just patchwork to address specific symptoms. That may sound alarming, but the 1933 and 1934 securities acts were the result of a similar sort of thinking, and they’ve done pretty well considering how long they’ve held up.
Just consider: merely dealing with problematic role of rating agencies would probably require root and branch reform to be effective.
None of this would even matter if retirement plans were foolishly invested in the stocks and bonds and if banks were allow to put their depositor money at such great risk.
The Fed is the problem alright, and the problem is that it is and has been acting in the best interest of IB’s instead of the people.
Manipulating interest rates is in NO ONE’s best interest. That’s all the Fed does, they surely aren’t regulators anymore.
Abolish the Fed!
Re: Yves:
The Fed has no charter to be tinkering with stock prices
They have amazing powers if you look very close!
What is the typical organization’s net position with respect to CDSes and other derivatives?
In other words, during a meltdown how much of the money will leave the ownership of the financial companies, and how much will just go on an overnight vacation to someone else’s mainframe?
Is no one else concerned that the investment banks and their clients are being told to ante up or else? If contributing more than $2,000 to a politicians campaign is illegal in this county why should bankers be allowed to “pay off” the rating agencies with $400 m to $500 m in bribes? Although they will argue that what they are doing is shoring up the monolines capital base I would argue that they are being given the opportunity to bribe the rating agencies so that the securities the rating agencies rated AAA are not down graded. This whole episode is truly mystifying for a 21st century economy!
If congress regulates anything it should be the business models of rating agencies so that subjectiveness and naivity can be eliminated once and for all. How much more do we need to be manipulated by the greed and amoral behavior of investment banks??
Globalization of finance is no mere catch phrase but reality. Worldwide financial sector deregulation has, just like the ‘market knows best’ neoliberal development policies it is part of, been a feature of the past 25-30 years.
Dreams and paranoias aside, The likelyhood of an effective globally overarching regulator is essentially nil.
re your response to my 5:02
I would think that lower short rates should bring at least some relief to ARM resets without the usual monetary policy lag.
And the yield curve has been deflationary for most of the past 20 years. Bank margins should improve apart from all their credit problems if the Fed gets more aggressive about normalizing it in the near term.
The more I read about the bond insurers, the more I fear for the banking system. I don’t think the Fed can afford to assume that lower rates won’t help the banking system, other things equal, particularly when other things are so potentially dire.
The scariest things about the insurers is as you say the divergence of opinion at this stage as to the full risk of the fallout. I also don’t understand how anybody can value these things in terms of takeovers or bail-outs, given the wide range in risk assessment. That’s why Buffet loves the business going forward provided he doesn’t have to deal with any legacy costs and issues.
Anon of 7:31 PM,
The Fed does have considerable powers, but its mandate does not extend to equity markets. And even though there are different schools of thought on what caused the Depression, just about none attribute it to the stock market crash.
daniel newby,
The problem with your question is no one knows the answer. A lot of people like to asset that CDS positions are hedged, yet many investors use them to create synthetic corporate bonds, and hedge funds use them to place bets. Similarly, CDS were one way of credit enhancigng CDOs; those again would be unhedged. So an unknown proportion of players are taking unhedged positions.
Add to that what we and other have worried about: CDS are only as good as the counterparty that wrote it. Now some CDS contracts require that collateral be posted, but I have heard that hedge funds would shop for ones that didn’t, and 38% of the credit protection was written by hedge funds. Similarly, investment banks were big writers of credit protection. They look pretty shaky these days. Exactly how good are these guarantees?
If one or several big counterparties default, positions that were hedged suddenly may not be hedged. That in turn can have nasty cascading possibilities.
That’s what I was afraid of; the transactions are too opaque. A significant portion of the cascading transactions will probably cancel each other out, but the system will lock up before they can unwind.
What we need is a private action circuit breaker. For example, if a systemic event is declared, a distressed organization is required to pay event-triggered obligations at a rate of 4% per business day, no more – no less, with a balloon payment of the balance after 3 months. (Adjust percentages and schedules to taste.) That would sort the salvageable from the doomed, and reduce losses from fire sales.
Re: stock market was facing meltdown
That thinking pisses me off to no end, because who cares if a casino goes up or down, sure yah wanna be part of it and make a capital gain, if yah gets lucky, but its a friggn game and everything about the wallstreet is a game thta uses speculation, which is why wallstreet is based 100% on Monte Carlo Simulations that attept to deal with predicting chaos….its a friggn game and then we have The Federal Reserve playing the game along with The Bush Coup and all its insider stock holders that love the game. Thisis a time of corruption and collusion and the game is highly important to so many people — because everyone in America has lotto fever and they love casinos and they love to speculate like brainwashed retards; then, as they get burned, time after time, they come back to the realization that its the only game in town, which leaves The Fed as a blackjack dealer flipping a friggn switch under the table to goose the gme……..its called The Decay Of A Society!
Yves,
Re: Anon of 7:31 PM
That is getting funny when posts are brisk enough to warrent a reference to a time..LOL!
Nonetheless, in regard to Fed Powers and mandated political functions:
http://www.federalreserve.gov/generalinfo/fract/sect13.htm
Yah would think they would try to bust the crooks and use power to clean this mess up, versus gaming the market and giving the meth/crack/coke wallstreet junkies a taste of what The American People want from them, in the form of power to protect us, versus becoming vampires like them:
8. Advances to Member Banks on Promissory Notes
If any member bank to which any such advance has been made shall, during the life or continuance of such advance, and despite an official warning of the reserve bank of the district or of the Board of Governors of the Federal Reserve System to the contrary, increase its outstanding loans secured by collateral in the form of stocks, bonds, debentures, or other such obligations, or loans made to members of any organized stock exchange, investment house, or dealer in securities, upon any obligation, note, or bill, secured or unsecured, for the purpose of purchasing and/or carrying stocks, bonds, or other investment securities (except obligations of the United States) such advance shall be deemed immediately due and payable, and such member bank shall be ineligible as a borrower at the reserve bank of the district under the provisions of this paragraph for such period as the Board of Governors of the Federal Reserve System shall determine: Provided, That no temporary carrying or clearance loans made solely for the purpose of facilitating the purchase or delivery of securities offered for public subscription shall be included in the loans referred to in this paragraph.
(E) No institution shall accept bills, or be obligated for a participation share in such bills
G) In order to carry out the purposes of this paragraph, the Board may define any of the terms used in this paragraph, and, with respect to institutions which do not have capital or capital stock, the Board shall define an equivalent measure to which the limitations contained in this paragraph shall apply.