Wednesday, August 20, 2014

Meet Your Investment Manager

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009), which was translated and republished in Chinese (2014). He is researching a book about Ben Bernanke. He writes a blog at www.AuContrarian.com.


         There is little else left in the asset-pricing world than central bankers. The redoubtable Ben Hunt, chief risk officer at Salient investment managers ($20 billion under management), wrote on David Stockman's Contra Corner: "I've spent the past few weeks meeting Salient clients and partners across the country.... When I had conversations [with clients and partners] six months ago, I would get a fair amount of resistance to the notion that narratives dominate markets and that we're in an Emperor's New Clothes world. Today, everyone believes that market price levels are largely driven by monetary policy and that we are being played by politicians and central bankers using their words for effect rather than direct communication. No one requires convincing that markets are unsupported by real world economic activity. Everyone believes that this will all end badly, and the only real question is when."

This might be referred to as "End-of the-Cycle Mispricing, but, what a cycle! End-of-the-Cycle Mispricing discussed the derangement of prices, in all assets. Money managers as a whole have not considered protection for their funds when everyone runs for the door at once. The "catastrophic bond" paper linked to the discussion was specific, but, there are plenty of avenues to construct such protection.

What follows is a transcription of just how ignorant, moreover, willingly ignorant, and, it may be, enthusiastically ignorant, was the Bernanke Fed when it decided that holding interest rates at zero percent would be its policy. Before plunging through the looking glass, here is the conclusion: If ever there was a time to protect one's assets from further FOMC derangement, this is it. If you do not (and cannot) design a Personal Protection Plan, buy cash, gold nuggets, and silver eagles. 

Reading the transcript from the December 15-16, 2008, FOMC meeting, it is clear the Federal Open Market Committee was embarking on its zero-interest rate policy (ZIRP - which is still all we've got) as an experiment.

By way of background, the FOMC had cut the Fed funds rate cut from 5.25% on June 29, 2006 to 1.00% on October 29, 2014. Most of reduction had been over the previous few months as the pillars fell: Bear Stearns, Merrill Lynch, Lehman Brothers, Goldman Sachs, and Morgan Stanley. The last two converted to commercial banks and received government protection as well as deposit-taking authorization.

The December meeting addressed whether the funds rate should be cut to zero (ZIRP), or, to some halfway house. As has been true throughout Bernanke's chairmanship, the 284-page debate could only have been held in the Eccles Building. The funds rate had been trading below the declared rate for a couple of months. One can only imagine the ecstasy at the Fed on December 12, 2008, when the funds rate traded at 0.00%: the "zero-bound." This had been Professor Bernanke's ad pitch since the early 1990s.

Two members of the Committee stand out as particularly itchy to get on with it, Chairman Bernanke and (then) San Francisco Federal Reserve President Janet Yellen. Bernanke broke with precedent by speaking first. Normally, the Chairman opens with a few remarks but waits until all FOMC members (plus non-voting regional presidents) have voiced their opinions before holding forth.

            In synopsis, there was no debate, not because fed funds were trading at zero already. The FOMC was discussing Fed policy. In Bernanke's words: "[W]e are at a historic juncture.... [o]f necessity, moving towards new approaches.... [T]his is a work in progress." One might wonder if the Fed chairman had created the "necessity" so that he could breathlessly declare this "historic juncture," and he could experiment with his textbook diagrams: His "work in progress."

            Through his great experiment, Bernanke seems not to have blanched at heaving new innovations from the Eccles Building without knowing what might follow. At the October 28-29, FOMC meeting, about three weeks after the Fed first paid banks interest on their reserves, Federal Reserve Governor Elizabeth Duke reported: "I asked [the banks] specifically this question about interest rates on reserves, and every single one of them said: 'We haven't had time to even focus on it. We don't even know what's going on with that.'" Bernanke responded: "Learning theory in practice. Thank you very much."

            You may remember the many borrowing windows opened by the Fed in 2008. The transcript shows there was little coherence to these conduits. At the December meeting, Bernanke said: "We have adopted a series of programs, all of which involve some type of lending or asset purchase.... [of] which even I do not know all of the acronyms anymore." Anymore? A viewer of Bernanke during Senate testimony would question whether he knew what they did to begin with.

St. Louis Federal Reserve President James Bullard lamented later in the same meeting: "I would like to see us work harder, maybe much harder, on the metrics for success of these facilities [the various borrowing windows - FJS] and perhaps rework or discontinue facilities that may not be meeting expectations.... Frankly, I am not sure in all cases what the purpose of the programs is. We have a lot of them out there. We have ideas. We should quantify that. We should be assessing, and then we should turn around and say, 'This one is working. This one is not working.' I would like to see a lot more in that direction. I understand that we haven't done it so far...." The Bernanke Fed tendency might be summed: "Assess the facilities? Why bother? Open another one."

Everyone had their say at the December meeting, During the Greenspan and Bernanke pontificates, members who disagreed with the FOMC vote were talking to a wall. In the meeting under discussion, the topic was whether to confiscate the People's interest rates (and interest earnings) or not.

The chairman opened: "I'd like to ask your indulgence. There's an awful lot here, and I'd like to go first this time and try to clear out some underbrush and to lay down some issues in the hope that it will perhaps focus our discussion a bit more." The message is unmistakable: the FOMC would vote to ZIRP the American people.

There were several members who contested ZIRP. The FOMC member chosen for exposition here is St. Louis Federal Reserve President James Bullard. This choice is two-fold. His concerns were worries a college professor might express, one who talked about - in fact, Bernanke hid behind - models, the "literature," and theory. Bullard has also been selected since he holds the bone fides Bernanke cherishes. Bullard's papers have been published in the American Economic Review, Journal of Monetary Economics, Macroeconomic Dynamics, and Journal of Money, Credit, and Banking.
The St. Louis Fed president explained his demurral: "I do not find the Reifschneider-Williams paper, which I know carries some weight around here, very compelling, so let me give the brief reasons behind that. For one thing, you are taking a model and you are extrapolating far outside the experience on which the model is based. That might be a first pass, but that is probably not a good way to make policy, and I wouldn't base policy on something like that."

What (you may not have the slightest interest in knowing), is the Reifschneider-Williams paper? David Reifschneider and John C. Williams wrote a paper in 2000, "Three Lessons for Monetary Policy in a Low-Inflation Era." The paper describes "limits to policy accommodation attributable to the lower bound on rates." The person who described the paper in that phrase will be identified later, though anyone who's been around the past few years probably has a hunch.

The second of Bullard's concerns: "There are also important nonlinearities. This whole debate is about nonlinearities as you get to the zero bound, and in my view, they are not taken into account appropriately in this analysis. You have households and businesses that are going to understand very well that there is a zero bound. It has been widely discussed for the past year. They are going to take this into account when they are making their decisions, so you have to incorporate that into the analysis. That is a tall order-there are papers around that try to do that, and many other assumptions have to go into that."

The fellow who has been widely published on macroeconomic matters went on: "The third thing I think is important is that, in other contexts, gradualism or policy inertia is actually celebrated as an important part of a successful, optimal monetary policy. Mike Woodford, in particular, has papers on optimal monetary policy inertia, and many others have worked on it. In those papers, it is all about making your actions gradual and making sure that they convey some benefit to the equilibrium that you will get.

"All of a sudden, in this particular analysis, when you are facing a zero bound, that [taking a gradual, deliberate approach towards a zero percent interest rate - FJS] goes out the window, and I don't think that it is taken into account appropriately in the analysis.

"Also, it is thrown out the window exactly at a time when you might think that the inertia and the gradualism are most important, which would be in time of crisis when you want to steer the ship in a steady way." Yes, you might think.

Bullard had plenty more to say at the December 2008 meeting. Others who zapped ZIRP were Dallas Federal Reserve President Richard Fisher, Philadelphia President Charles Plosser, and Richmond President Jeffrey Lacker. One of Plosser's many admonitions: "We still do not understand why having interest rates on reserves isn't working to keep the funds rate at its target, and there may well be unintended consequences of moving our target to zero, beyond those well articulated in the Board's staff notes." Plosser's audience had no interest in whether FOMC steps actually worked or not. Bernanke had already said, regarding Governor Duke's lack of knowledge by the banks: "Learning theory in practice. Thank you very much."

I could probably list another hundred - certainly at least fifty - other objections stated at that meeting against establishing a zero-interest rate policy. Today, at least a thousand problems created by ZIRP are throttling us.

There is not the slightest chance Chairman Yellen will lift rates. The market will do that. Yellen, then San Francisco Federal Reserve President, did not acknowledge any reason to deliberate over ZIRP: "I see few advantages to gradualism, and certainly whenever we approach the zero bound, I think the funds rate target should be quickly reduced toward zero. [Outside of the Eccles Building, it was 0.00% - FJS] As to the level of the lower bound, my default position is that we should move the target funds rate all the way to zero because that would provide the most macroeconomic stimulus."  From current speeches, it is obvious she still believes that final sentence.

            The answer to the pop quiz: Who said the Reifschneider-Williams paper describes "limits to policy accommodation attributable to the lower bound on rates?" Nobody. That is footnote number 24 to Ben S. Bernanke's speech on August 31, 2012, at Jackson Hole, Wyoming, "Monetary Policy since the Onset of the Crisis." He committed murder in his footnotes to speeches. The claim to which he attached the footnote is as improbable as he is, and Bernanke is abusing the paper (as Bullard warned the FOMC) by extrapolating its conclusions to a situation (ZIRP) which is "far outside the experience on which the model is based" to bilge his way past the crowd at Jackson Hole. That is never hard to do. Some investment manager.
           
            Given the FOMC's ad lib policymaking, it is difficult to believe they have any idea what to do when - yes, when - the run on the markets start, other than to close markets. This is the time to construct an avenue of personal protection.

  

Tuesday, August 12, 2014

End-of-the-Cycle Mispricing

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009), which was translated and republished in Chinese (2014). He is researching a book about Ben Bernanke. He writes a blog at www.AuContrarian.com.

The attachment is to a paper Joe Calandro and I wrote for the November 2013 Gloom, Doom & Boom Report.  "CatastropheInsured: Cat Bonds," discusses the money-making potential of a specific cat(astrophe) bond strategy. Such an investment appeals to a small audience but the characteristics apply broadly.

            "What is the price?" should be fundamental to investment decisions. We know that is often not the case. A fund manager who invests in small-cap stocks must buy small-cap stocks. Managers are usually permitted the alternative of holding money in cash, but are wary of doing so. Relative performance is the manager's calling.

            The qualification (above) of a "specific" cat bond strategy is in response to the question: "What is the price?" The answer, at times: "Not what it is should be." Catastrophe insurance is being mispriced, which is not a surprise in the current environment when anything goes. In "soft" markets, insurers cover catastrophe-exposed insurance polices at too low a price. In the cat bond area, there is too little on-the-ground understanding of the insurers' property and financial exposures when a catastrophe hits. Even more so, since catastrophes can come in pairs (e.g., hurricanes and financial panics).

            After selling property insurance to businesses or homeowners (for instance), insurers (or, their investment bankers) bundle the policies into cat bonds as a form of reinsurance. This is meant to be similar to the process of securitizing mortgages or auto loans. Cat bonds have been sold for quite awhile, but it is only in the past couple of years that volume has skyrocketed. We know what happened when mortgage-backed securities boomed up until 2007. In general, investment mangers did not study the quality of the mortgages or the composition of the securities. Those who did crunch the numbers either stayed away or employed strategies to short the securities.

            In defense of the investment managers who did not understand the mortgage securities, to do so required a tremendous amount of work and hiring specialists. For the most part, investors relied on the resourceful credit agencies that stamped sub-prime securities as AAA. So too, with cat bonds, where there is no substitute for exposure identification, cycle management, and contract documentation.

            We are seeing a replay of 2007 across the investment spectrum. It is not a surprise that a burgeoning class of securitized liabilities has been bought by mutual funds and hedge funds. They zip cat bonds through their bond models and buy.

            It will be interesting to see how this turns out.*

*In the spirit, if not the orbit, of Arthur Balfour, who, when signing the so-called Balfour Declaration of 1917, promising a homeland in Palestine for the Jews, commented: "I have no idea what the result will be, but I am certain that it will lead to a very interesting situation."
  

Saturday, July 26, 2014

No Decency

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009), which was translated and republished in Chinese (2014). He is researching a book about Ben Bernanke. He writes a blog at www.AuContrarian.com.


MarketWatch should be ashamed of itself. In a July 24, 2014, interview, Mephistopheles was treated with the respect due a senior statesman, when he should have been asked: "Have you no sense of decency sir, at long last? Have you left no sense of decency?"

            The answer, of course, is "no," though Greenspan does not understand that.

            Left on our own, some comments MarketWatch should have mutilated. Greenspan is quoted in italics:

"[N] o central bank can be oblivious to what is happening, not only in credit markets, which is, of course, the Fed's fundamental mandate...."

Greenspan did not state just what the Fed's mandate concerning credit might be. Of course, he wanted to leave MarketWatch readers with the impression that prudence is paramount, and that "The Greatest Central Banker who Ever Lived" (Alan Blinder, Princeton economics professor; Federal Reserve, rag-sheet propagandist), established the industry standard. From the time Greenspan was named Federal Reserve chairman until he left office, the nation's debt rose from $10.8 billion to $41.0 billion. It had risen to a level at which it was unserviceable.

"Without asset-market surveillance, you do not have an integrated view of how the economy works."

Chairman Greenspan would not allow the FOMC to discuss asset prices. By the mid- to late-1990s, there were many FOMC members who raised the topic of runaway asset prices, including stocks, houses, booming housing debt that was boosting those prices, and out-of-control consumer spending. The most persistent critic was Jerry Jordan, president of the Cleveland Fed.

At the December 16, 1997 FOMC meeting, Jordan said: "Some Board members referred earlier to the dichotomy between the prices of services and the price of goods. That clearly is the case, but the notion of dichotomy also has to be applied in the case of asset prices....I was reading some material about the operations of the FOMC in the early 1930s." That material has been annihilated by the so-called academics.

Jordan concluded, the Fed's myopic concentration in the 1920s on a steady price level of goods and services was wrong: "I think it's a useful reminder of what can go wrong if we are too narrow in thinking about the words 'inflation' and 'deflation'....What do we mean by the word 'inflation?' Clearly, it cannot refer simply to the current price of goods..."

Greenspan ignored Jordan's observation. Later in the meeting, Greenspan thought that "[s]omething very different is happening.... [W]e keep getting reams of ever lower CPI readings that seem outrageous in the context of clearly accelerating wages and an ever-tighter labor market...I was startled by this morning's CPI report. We cannot keep getting such numbers and continue to say that inflation is about to rise." Jordan had just told Greenspan that inflation was out of control: it was Microsoft rather than Mayonnaise that was inflating.

"How to respond to asset-price change is a legitimate issue. But not to monitor it, I think, is clearly a mistake."

            In 1998, Chairman Greenspan told the FOMC, in effect, there would be no further discussion about rising asset prices. He declared asset prices could no longer be mentioned at meetings: "I have concluded that in the broader sense we have to stay with our fundamental central bank goal, namely to stabilize product price levels."

In fact, excesses outside the Eccles Building were not dissimilar to those today. Jerry Jordan, at a 1998 FOMC meeting: "Bankers complain a lot that pension funds and insurance companies are doing deals that no sensible banker would be willing to consider."

Greenspan's rationale was nonsense: "I do know that the presumption we have discussed in the last year or so that we can effectively manage a bubble is probably based on a lack of humility. As I've said before, a bubble is perceivable only in retrospect." My italics.

Greenspan had never said "a bubble is only", etc., anywhere, to any audience. His declaration was accepted immediately. The mental incapacity of this generation of economists is evident in the fact this position would become known as the "Greenspan Doctrine," and accepted by central banks, academic economists, and the media.
        Okay, let's end with a laugh. Alan Greenspan in a commencement address (institution withheld to spare humiliation) on May 15, 2005: "I do not deny that many appear to have succeeded in a material way by cutting corners and manipulating associates, both in their professional and personal lives. But material success is possible in this world, and far more satisfying, when it comes without exploiting others. The true measure of a career is to be content, even proud, that you succeeded through your own endeavors without leaving a trail of casualties in your wake."

Thursday, July 24, 2014

Where to Invest: With Macroinvestors or Macroeconomists?

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009), which was translated and republished in Chinese (2014). He is researching a book about Ben Bernanke. He writes a blog at www.AuContrarian.com.

            Stanley Druckenmiller, the justly renowned investor, spoke at the Delivering Alpha conference on Wednesday, July 16, 2014. Quoting Druckenmiller: "As a macro investor, my job for 30 years was to anticipate changes in the economic trends that were not expected by others - and therefore not yet reflected in securities prices. I certainly made my share of mistakes over the years, but I was fortunate enough to make outsized gains a number of times when we had different views from various central banks."

            Druckenmiller went on to discuss, among much else that deserves reading, how the Fed's emergency 1.0% fed funds rate in 2003-2004 defied conditions observed by him and his colleagues at Duquesne Capital. Where was the emergency? In short: "[W]e were confident the Fed was making a mistake, but we were much less confident in how it would manifest itself. However, our assessment by mid-2005 that the Fed was fueling an unsustainable housing Bubble, with dire repercussions for the greater economy, allowed our investors to profit handsomely as the financial crisis unfolded."

            Today, Federal Reserve Chairman Janet Yellen sounds more preposterous every time she opens her mouth. Last week, maybe it was two weeks ago, she offered America a sector analysis, proposing that small-cap and biotech stocks look overpriced. A few days later, ECB President Mario Draghi offered his opinion of no widespread asset bubbles, although some markets looked "frothy."

            It has been less than a decade since Fed chairman Greenspan declared there was no housing bubble, though he saw signs of "froth." His weasel act warranted derision, which is just what it received, such as in the Economist's headline: "Frenzied Froth" (May 28, 2005). Draghi is acclaimed for his well-tailored suits but they stink of old mothballs. He's a botoxed Greenspan.

            The two of them - that would be Yellen and Draghi - have decided to let markets take their course, now that the Fed and ECB have used every possible mechanism to create mispricings in all markets. They will administer regulatory measures, if necessary.

            The only such declaration of any use would be to administer the two of them, along with their supercilious staffs, out of existence. Instead, the average person who reads newspapers that include even a moderate degree of financial reporting knows multiple crashes are building.

The all-star break results are in. That is, the announcements of how first-half 2014 security issues compare to earlier years. We can congratulate ourselves. Never before has the world shown such indulgence, intemperateness, and unconscionable underwriting as in 2014.

"Megadeals... helped push the number of debt sales by highly rated companies in the U.S. to record levels in the first half of the year. These companies sold about $642 billion of debt." That "outstrips the previous record set in 2009, when $612 billion of bonds was sold..." (Wall Street Journal, July 1, 2014) Aside from the probable default rate (where are you now, TXU?), megadeals are no friend to the workers.


"As investors scour the landscape for income, the first half of the year saw record amounts of new corporate bond issuance as well as record issuance of collateralized loan obligations. CLOs are securitized vehicles that invest in bank loans made to junk-rated companies, first pooling the loans and then dividing them into tranches to be sold to investors at varying levels of income and risk.... The $58 billion of CLO issuance in the first half of this year puts 2014 on pace to top $100 billion and break the previous single-year issuance record...set in 2007." (Wall Street Journal, July 2, 2014) Pension plans and insurance companies are large buyers of such attempts to increase yield; an attempt to reinstitute the yield confiscated by the same central banks that have now declared their forbearance in monitoring default-prone issues.

Doug Noland, manager of the Prudent Bear Fund, in his Credit Bubble Bulletin, written on July 11, 2014, analyzed the seven-year itch, under the appropriate title: "2014 vs. 2007":

"From my perspective, 2014 and 2007 share troubling similarities. Both periods feature overheated securities markets, replete with the rapid issuance of securities at inflated valuations. Both are characterized by investor exuberance in the face of deteriorating fundamentals - and in both cases central bank policymaking was fundamental to heavily distorted market risk perceptions. It's no coincidence that today's overheated backdrop - record securities issuance and meager risk premiums/record high prices - readily garner statistical comparison to 2007.

"This year's booming M&A market has posted the strongest activity since 2007. Second quarter global M&A volume of $1.06 trillion was up 72% from the year ago period. Here at home, M&A more than doubled year-on-year to $473 billion, pushing record first-half volume to $749 billion. The proliferation of deals was fueled by the loosest credit conditions in years. First-half global corporate bond issuance hit an all-time high $2.29 trillion. A record $286 billion of junk bonds were issued globally, as average junk yields traded to the lowest level ever. At $642 billion, first-half U.S. investment-grade company bond sales easily posted an all-time high. The first six months of 2014 also saw record issuance of collateralized loan obligations (CLOs). A record number of global IPOs were sold in the first half, with $90.6 billion of offerings 54% above comparable 2013. Led by technology and biotechnology issues, U.S. IPO sales enjoyed the strongest first-half since the height of the technology bubble back in 2000. According to Dealogic, year-to-date total global sales of corporate stock and equity-linked securities reached an unmatched $510 billion, outpacing 2007's record pace."

It is certain such frivolities are "not yet reflected in securities prices."
 
 

Monday, July 14, 2014

The Old Regime and the French Revolution

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009), which was translated and republished in Chinese (2014). He is researching a book about Ben Bernanke.


            On this 225th anniversary of liberté, égalit́́e, and fraternité, Alexis de Tocqueville's The Old Regime and the French Revolution (L'Ancien régime et la revolution), published in 1856, is, if not as invigorating as La Marseillaise, a worthy reflection upon Bastille Day. Following are some excerpts from Chapter eight, which carries the subtitle: "How, given the facts set forth in the preceding chapters, the Revolution was a foregone conclusion":

            My object in this final chapter is to bring together some of those aspects of the old régime which were depicted piecemeal in the foregoing pages and to show how the Revolution was their natural, indeed inevitable, outcome.

            When we remember it was in France that the feudal system, while retaining the characteristics which made it so irksome to, and much resented by, the masses, had most completely discarded all that could benefit or protect them, we may feel less surprise at the fact that France was the place of origin of the revolt destined so violently to sweep away the last vestiges of that ancient European institution.

            Similarly, if we observe how the nobility after having lost their political rights and ceased, to a greater extent than in any other land of feudal Europe, to act as leaders of the people had nevertheless not only retained but greatly increased their fiscal immunities and the advantages accruing to them individually; and if we also note how, while ceasing to be a ruling class, they had remained a privileged, closed group, less and less (as I have pointed out) an aristocracy and more and more a caste - if we bear these facts in mind, it is easy to see why the privileges enjoyed by this small section of the community seemed so unwarranted and so odious to the French people and why they developed that intense jealousy of the "upper class" which rankles still today.

            Finally, when we remember that the nobility had deliberately cut itself off both from the middle class and from the peasantry (whose former affection it had alienated) and had thus become a foreign body in the State: ostensibly the high command of a great army, but actually a corps of officers without troops to follow them - when we keep this in mind, we can easily see why the French nobility, after having so far weathered every storm, was stricken down in a single night.

            I have shown how the monarchical government, after abolishing provincial independence and replacing local authorities by its nominees in three quarters of the country, had brought under its direct management all public business, even the most trivial. I have also shown how, owing to the centralization of power, Paris, which had until now been merely the capital city, had come to dominate France - or, rather, to embody in itself the whole kingdom. These two circumstance, peculiar to France, suffice to explain why it was that an uprising of the people could overwhelm so abruptly and decisively a monarchy that for so many centuries had successfully withstood so many onslaughts and, on the eve of the downfall, seemed inexpugnable, even to the men who were about to destroy it....

            Since no free institutions and, as a result, no experienced and political parties existed any longer in France, and since in the absence of any political groups of this sort the guidance of public opinion, when its first stirrings made themselves felt, came entirely into the hands of the philosophers, that is to say, the intellectuals, it was only to be expected that the directives of the Revolution should take the form of abstract principles, highly generalized theories, and that political realities would be largely overlooked. Thus, instead of attacking only such laws as seemed objectionable, the idea developed that all laws indiscriminately must be abolished and a wholly new system of government, sponsored by these writers, should replace the ancient French constitution.

            Moreover, since the Church was so closely bound up with the ancient institutions now to be swept away, it was inevitable that the Revolution, in overthrowing the civil power, should assail the established revolution. As a result, the leaders of the movement, shaking off the controls that religion, law, and custom once had exercised, gave free reign to imagination and indulged in acts of outrageousness that took the whole world by surprise. Nevertheless, anyone who had closely studied the condition of the country at the time might well have guessed that there was no enormity, no form of violence from which these men would shrink....

            But when the virile generation which had launched the Revolution had perished or (as usually befalls a generation engaging in such ventures) its first fine energy had dwindled; and when, as was to be expected after a spell of anarchy and "popular" dictatorship, the ideal of freedom had lost much of its appeal and the nation, at a loss where to turn, began to cast about for a master - under these circumstances the stage was set for a return to one-man government....

 

Wednesday, July 9, 2014

June 2014 - Noise

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009), which was translated and republished in Chinese (2014). He is researching a book about Ben Bernanke. He writes a blog at www.AuContrarian.com.

On June 18, 2014, and July 2, 2014, Federal Reserve Chairman Janet Yellen announced her bureaucracy will let inflation do its own thing. She is steadfast in her determination to meet the Fed's dual mandates under the Bernanke-Yellen dispensation, that is, she will not interfere with either the central bank-induced asset or price inflations.

A discussion of asset inflation will follow, with a quick note first about the June 18 press conference. Yellen stated: "Let me just say inflation continues to run well below our objective." This was not true. The Fed's measurement for inflation (Personal Consumption Expenditure) was 1.6% in May (1.8% in June, announced after this press conference.) By every other measure, inflation is above 2.0%. The all-items, PCE price index, published by the Dallas Fed, rose at a 2.8% annual pace in May.

But enough for the numbers. Yellen also said on June 18: "[T]he Committee remains mindful that inflation running persistently below its objective could pose risk to economic performance." This is central-banker talk for inflating at any rate. When the Fed chief was queried about current inflation measures in the danger zone, she said that is "noise." To another press-conference question about inflation, she dismissed these signs as "noisy."

The Rt. Rev. Ronald Knox compared a politician to a baby. Both are "a loud noise at one end with no sense of responsibility at the other" 

It is true that, having achieved this advanced stage of mayhem among economic, financial, and price relationships, Yellen cannot manage a modest adjustment. The shift of costs and prices to a semblance of balance will be chaotic.

 July 2, 2014, will be recorded as the date Janet Yellen announced she would not stand in the way of asset bubbles. This was baked in the cake. She had made this clear for the longest time, but the headlines finally caught up to her long-held stand.

  Chair Yellen spoke on July 2 at an IMF function in Washington, DC. She declared: "Because a resilient financial system can withstand unexpected developments, identifications of bubbles is less critical." On March 23, 2010, Yellen identified asset prices as the cause of the recession. ("It was housing, of course, that led the economy down.") In the summer of 2014, she is still saying it will be years before the American economy recovers from the housing collapse. Go figure.

Bloomberg's headline captured the essence: "Yellen Says Rate Policy Shouldn't Change over Stability Concerns." The Wall Street Journal announced on July 3, 2014: "Yellen Affirms Low-Rate Tack." The story opened: "Janet Yellen pushed back strongly against the notion the central bank should consider raising interest rates to avoid fueling future financial crises, in her most detailed and forceful comments on financial stability since taking the Federal Reserve's helm in February." The New York Times spread the same message on July 3: "Janet Yellen Signals She Won't Raise Rates to Fight Bubbles"  

It was 15 years ago, on June 17, 1999, when Federal Reserve Chairman Alan Greenspan told a dumbstruck Congress the Fed was not in the asset-inflation business. Chairman Lily Liver announced: "But bubbles generally are perceptible only after the fact. To spot a bubble in advance requires a judgment that hundreds of thousands of informed investors have it all wrong. Betting against markets is usually precarious at best." 

Greenspan's announcement was the forerunner to the bubble-blowing central banks that have followed. Everybody who wanted to know was well aware Greenspan had inflated the NASDAQ bubble. A stream of protest followed, but, as Mario Draghi and Janet Yellen have surely noted, they will suffer no establishment criticism for the crashes to come. Our encrusted institutions have paid and continue to revere "Doctor Greenspan."

The New York Times editorial page was in a tizzy the day after Greenspan's abdication of responsibility: "The new Greenspan is brimming with self-assurance. Let us hope the market does not test his new confidence." The author of  Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession continued: "If only the New York Times had brimmed with enough self-confidence to state that the Federal Reserve chairman was abandoning the Federal Reserve's responsibility.Maybe the Times was too stunned for such a response. In one gulp,it learned that the Fed did not, and could not, see the hot-air balloonit had so generously expanded - mostly with Greenspan's hot air. Theeditors had long trusted the chairman. When Greenspan had issued hisstock market warning in February 1997, the Times stood by Greenspanin an editorial with the title: "Wise Warnings to Giddy Investors.".... In the editors' words: "To ward off the bad outcome, Mr. Greenspan gently reminded investors that stock prices fall as well as rise. . . . He also reminded them that the Fed will not shrink from raising interest rates - which will draw money out of stocks." The 1997 Times editorial went on to remind readers that those on Wall Street who "contend that the American economy is heading toward unprecedented prosperity" lack perspective: "like any story that says the future will be unlike the past, the predictions are probably wrong.".... Between May 29 and June 29, 1999 (the month leading up to the June 29-30, 1999, FOMC meeting), the New York Times discussed the stock market bubble in 10 separate articles. (A headline on May 30: "Pop! Goes the Bubble.") The word bubble was used only once at the June 29-30 [FOMC] conclave. The stock market was mentioned 21 times at this meeting."

Here we are again, but the argument that followed Greenspan's disclosure will probably be absent. In August 1999, the Authorities even deemed it necessary to drag an unknown economics professor to its annual Jackson Hole love-in where he obligingly delivered a fourth-rate but fawning speech that dismissed central banks from asset bubble responsibility. That fourth-rate professor was Ben Bernanke.

To close out the earlier episode, there had been considerable angst at FOMC meetings in 1997 and 1998 about the stock market bubble. After the February 1997 warning (not as well known, but more direct, than his December 1996 "Irrational Exuberance" speech), he never uttered a word of caution about stocks again. Behind closed doors, several members of the FOMC continued to warn about NASDAQ indulgence. Jerry Jordan, the Cleveland Fed President, was a persistent critic. He kept discussing books he recently read about the 1920s and the need to evaluate asset as well as price bubbles. Greenspan put a stop to that at the December 1998 FOMC meeting, ordering the Committee to not mention asset bubbles again. It didn't.

Yellen's disavowal was every bit as disgraceful as Greenspan's. On July 2, Yellen admitted to "pockets of increased risk taking" However, she also stated: "I do not presently see a need for monetary policy to deviate... to address financial stability concerns..."  

To this point, one might think she was still on top of "financial stability concerns" since the Fed saw "pockets" of problems. She explained an "increased focus on financial stability risks is appropriate," but the potential costs of diminishing economic performance "is likely to be too great" to give such risks "a role in monetary decisions, at least most of the time." In other words, to raise short-term interest rates by 0.5% would so destabilize the economy, Yellen has decided to sit back, let the asset bubbles burst, then blame the bankers, speculators, and home-buyers who should have known better.

After the deluge, Yellen will be called before some committee, and state, as she did in her confirmation hearing as Federal Reserve governor in 2010: "We failed completely to understand the complexity of what the impact of the decline - the national decline - in housing prices would be in the financial system. We saw a number of different things and we failed to connect the dots. We failed to understand just how seriously the mortgage standards, the underwriting standards, had declined, what had happened with the complexity of securitization and the risks that were building in the financial system around that."

Right out of the box, she should have been stopped by a committee member. "Why did you need to understand "complexity"? This is the camouflage of economists who huddle in damp caves worshipping moldy mathematical equations within a degenerating field freed from matter. This is the language of anti-matter."

Janet Yellen was a Federal Reserve governor from 1994 to 1997. She was president of the San Francisco Federal Reserve district from June 14, 2004 until 2010. She was then appointed to the Federal Reserve Board of Governors in Washington and succeeded Ben Bernanke as chairman on February 1, 2014.

On May 1, 2014, Janet Yellen described her time at the San Francisco Fed to a conference of community banks: "As you may know, before I rejoined the Federal Reserve Board as Vice Chair in 2010, I had the privilege of serving for six years as president and chief executive of the Federal Reserve Bank of San Francisco. The 12th district is the largest of the Fed's districts, covering nine western states, and it is home to a significant number of community banks, the majority of which are supervised by the San Francisco Fed directly or indirectly through bank holding companies. Community bankers helped me, when I served as president, to take the pulse of the local economy and also to understand how regulatory and policy decisions in Washington affect financial institutions of different sizes and types, sometimes in very different ways. During the financial crisis, I saw firsthand the challenges that community banks faced in a crisis they did little to cause, and I have felt strongly ever since that the Fed must do what it can to ensure that the actions taken following the crisis do not place undue burdens on your institutions."

No mention of the elephant in the room she ignored, but, in the media discussion after she had been nominated for the chairmanship, Yellen was made out to be the Fed personage who was right on top of the housing bubble. In addition to the glowing tributes in the Times and Journal, were the Hallelujah bouquets tossed by worthies. On September 29, 2013, Alan Blinder, a professor at Princeton, which says it all, wrote in the Wall Street Journal: "She warned as early as 2005, that the titanic real-estate market was headed to an iceberg." This is a dubious claim, which we may pursue another time. But - let's assume she did foresee the iceberg - other than to other academic economists, that makes her subsequent catatonic response all the more reason to know she was unfit for the chairmanship, since, even accepting Blinder's construction, she held the catbird's view from San Francisco and did nothing.  

The "complexity" she refers to was simple to understand. The San Francisco Fed is responsible for banking in the western states, California, Arizona, and Nevada among them. Between July 2002 and July 2005, the number of houses built in Phoenix doubled. The number of new houses increased in Las Vegas by 53% between August 2004 and July 2005.

The median price for an existing, single-family house in California rose from $237,060 in 2000 to $542,720 in 2005. Over 20% of those who bought houses between 2003 and 2005 devoted over one half of their earnings to mortgage payments. One of the more recent innovations was the "interest-only" mortgage. The buyer might be able to delay principal payments for the first 10 years. These were dangerous instruments. There was general agreement to that assessment in 2002, when only 2% of California mortgages were interest only. Under Janet Yellen's supervision, they could not be sold fast enough. By early 2004, the proportion exceeded 47%. By the second half of 2004, that rose to 67% of all California residential mortgages.   

At the time of Yellen's "warning," house prices were out of reach, so the terms were relaxed. The "2 and 28" mortgage - a two-year "teaser" rate that adjusted ("reset") for the next 28 years - was booming. From $220 billion in two-year ARMS in 2003, the volume rose to $440 billion in 2005. Consumer credit (excluding mortgage payments) had risen from $1.3 trillion in 1998 to $2.36 trillion by 2006: an average of $21,000 per household. More Americans were living on home-equity withdrawal. They were liquefying their equity and monetizing the proceeds. American wages rose a total of $27.5 billion in 2005. Homeowners withdrew $800 billion of equity from their houses - equal to a 13% pay raise. This is the income that allowed Americans to buy (in a way) higher priced houses and empty the shelves at Home Depot.

The most spectacular mortgage factories were in the heart of San Francisco President Janet Yellen's district. We can look at a single town. Irvine, California had been an engine for American "growth," to which Yellen pays homage - no matter the source. New Century of Irvine, the second largest subprime lender in 2005 ($35 billion) closed its doors in March 2007. Option One of Irvine, the fourth largest ($29 billion), also failed. Irvine was home to Ameriquest, the ninth largest sub-prime lender in 2005 ($19 billion in volume). Ameriquest paid a $325 million fine for unsavory practices. It no longer exists. By the time it went to court, its founder, Ronald Arnall, also founder of Long Beach Savings and Loan in 1980 (another story some may remember), had taken his post as U.S. ambassador to the Netherlands. Arnall was a large fundraiser for Bush the Younger. Arnall had spun off another portion of Long Beach Savings and Loan to Washington Mutual. This became Washington Mutual's subprime lending arm. New Century, Option One and Ameriquest sold $83 billion of subprime loans in 2005. All of America bought $161 billion worth of mortgages in 1992. Yellen, being a bureaucrat, would protest she had no jurisdiction over these mortgage factories. So what? Their very presence pushed banks into bad businesses, and she did have authority over Angelo Mozilo's Countrywide Bank as well as Wells Fargo.

From Yellen's May 1, 2014, speech ("before I rejoined the Federal Reserve Board as Vice Chair in 2010, I had the privilege of serving for six years as president and chief executive of the Federal Reserve Bank of San Francisco") she mentioned how "[c]ommunity bankers helped me, when I served as president, to take the pulse of the local economy." Assuming that was so, her decision to continue her career in central banking betrays an inability to assess her own limitations.

By April 2008, more than 1,000 houses in California and were auctioned every weekday. Not too far from her San Francisco office was Merced, California. It had been a house-trading casino for out-of-town investors. They sometimes bought two houses at a time and prices rose 30% a year. By June 2008, it had one of the highest foreclosure rates in the country. Harwinder Sharma bought a new house "in a beautiful neighborhood, surrounded by other homes with landscaped front yards." By 2008, the Merced native was "ringed by vacant lots and empty houses, and the neighborhood [was] overrun by dry weeds and brush." Developers built nearly 4,400 new houses in Merced. Three-quarters of the houses were in foreclosure in August 2008.

In San Jose, California, Shawn Forgaard, a 37-year-old software engineer, bought one house for his family and nine for investment. The clock ran out on his negative-amortization loans in May 2008: "Everyone stumbles...I'm confident our lives will be much, much richer as a result."

By 2008, the Los Angeles Police Department's Real Estate Fraud Squad fought an uphill battle with professional squatters who moved from one abandoned house to another, posed as tenants, and demanded cash payments from the banks before they would leave.  

In Beverly Hills, Ed McMahon defaulted on his house.  In Encino, Michael Jackson's Neverland was foreclosed upon on February 26, 2008.  In Hollywood, Jose Conseco lost his house, declaring: "It didn't make financial sense for me to keep paying for a mortgage on a home that was basically owned by someone else." Conseco was better equipped than the pinheads who constructed probabilities for mortgage securities. America had changed: Losing ones house used to be shameful, a disgrace; now it was recommended. The YouWalkAway.com website offered guidelines on how to stay in the house for eight months "payment free (after the owner had stopped paying) and then "walk away without owing a penny." Another novelty of this cycle were the evictees who "stripped out appliances, punched holes in the wall, dumped paint on carpets and... locked their pets inside to wreak further havoc." Real-estate agents estimated that about half of foreclosed properties to be sold by mortgage companies nationwide had "substantial" damage.

In the east-most suburbs of Los Angeles, the Inland Empire, "you think you're staring at a ghost exurb." One in every 43 houses faced foreclosure in May 2008. More than 500,000 people had moved to the Inland Empire (Riverside, San Bernardino) during the previous five years. Now it was home to "infested swimming pools, fetid and green...choked with algae. Thousands of people have walked away without even draining the water. Mosquito control agents now patrol these murky pools..." "Mosquito fish" were "well suited for a prolonged housing slump. Hardy creatures with big appetites, they can survive in oxygen-depleted swimming pools for many months, eating up to 500 larvae a day..." We're lucky the housing bust didn't cause a bubonic plague.

In San Diego, a developer offered a special deal: "buy one, get one free."

Maricopa, Arizona is 40 miles south of Phoenix. It had a population of 600 in the early 1990s and a one-room school house. Then, the developers arrived. Construction crews raised blocks of identical houses (14,000 houses in all), "because it was more efficient to build with as little variation as possible. They built sidewalks on only one side of the street to save money." By 2005, inductees moved to Maricopa at the rate of three per hour. More than one-third of the mortgages were subprime. By 2008, houses traded like CDOs: there were no offers. No schools have been built. At rush hour, the single road to and from Phoenix was a parking lot.

In Las Vegas, Eve Mazzarella and Steven Grimm were charged with bank fraud. Banks lent them $107 million; they bought 277 houses and made a $15 million profit. Their scheme was not particularly conspicuous: The FBI established a special task force in Las Vegas because the size, scale and sophistication of such schemes had grown to monstrous proportions.

Banks offered occupants $1,000 if they moved out without "trash[ing] the house." This was in March 2008, when anger was still in the first inning. A daughter of Bruce Toll, co-founder of Toll Brothers walked away from her purchase agreement. Toll Brothers (the corporation) announced it was pursuing its "rights under the agreement of sale."

If Yellen is correct, and there are only "pockets" of asset bubbles, then America is wearing a clown suit. Yield spreads on junk bonds are at all-time lows, as with leveraged loans, and just about any other bond category. Exactly as in 2007, this has not inhibited issuance. Instead, the Fed-led asset bubble has called into existence weird and amazing nooses.

To the detached observer, the channels of security issuance are teeming with sewerage.   Bloomberg noted the development with a June 17 headline: "Sewerage-to-Fertilizer Plan Shows No Junk Bonds Stink." It went on to describe "the malodorous" offering by the Orange County Industrial Development Authority (in Florida, not the one made famous by Robert Citron) which is offering the $62 million certifiably junk bond. Bloomberg quoted Tom Metzold, co-director of municipal bonds at Eaton Vance in Boston:  "This is like the worst of the worst... yet investors will probably buy it.... When too much money chases too few bonds, deals come to market that have no right coming to market. The risk-reward profile is so out of balance, it's nuts."

In the same spirit, on June 9, Bloomberg investigated the hot car-loan market. "In response to rising default rates on subprime U.S. auto loans, bond investors are deciding the best thing to do is pile into securities backed by them." On the supply side: "With rates near 0%, credit card companies are happy to lower standards and lend."

Let's not forget Yellen keeps touting regulatory oversight as the magic solution to unseemly markets.  

Recent fixed-income offerings include homeless-shelter bonds, meteor bonds, car-rental bonds (these "obscure asset-backed securities bundle together cash flows from auto leases"), and burrito bonds (that offer "two vouchers for free burritos if you [lend] ... $848"). The most prolific money gatherer among municipal bond ETFs in 2014 has been Market Vectors High Yield Municipal Index (HYD), which has received over $100 million of inflows this year. It was thrashed last week after some Puerto Rican problem

Zero-Hedge reported from down south: "Bond Bubble Goes Full-er Retard: 4x Oversubscribed Kenyan Bond Orderbook is 20% of Country's GDP" (June 17, 2014). "An indication of just how off the charts the 2014 edition of the full retard bond bubble is comes from Kenya, which priced a debut $2bn eurobond yesterday and in the process managed to break the record for the largest debut for an African country in the sovereign bond market..... According to the FT, the orderbook was more than four times oversubscribed which is roughly equivalent to around 20% of the country's GDP according to Bloomberg data. Plus - in Kenya - 49 people were killed on a beach north of Mombasa on Sunday, June 16."

The incident happened the day before the offering. There is a fair chance buyers did not know about the 49 deaths at a beach resort. There is also a good chance the majority could not locate Kenya on a map, if they even know Kenya is a country. A flashback: one that demonstrates how far the financial economy has distanced itself from the real economy. In January 2008, Standard & Poor's rated Kazakhstan's credit even though Kazakhstan had no debt. Why? It attracted a healthy credit-default swap trade. Again, for what purpose? An e-mail seemed as plausible as any: "I doubt the buyers of this thing are even aware there is no debt to insure. Nor do they care. It's just an exotic casino game to have a go at." Reuters posted occasional updates on the credit-default swaps: "Kazakhstan 5-Yr CDS [spreads] Hit Record High." Traders discussed this untoward development; explanations included problems with the credit crunch in emerging markets and with Kazak politics. The issues are also perplexing since CDS reference a real bond, but in the midst of such disarray, then and now, that may have slipped by the legal departments.

Stock offerings are also problematic, including Fantex Vernon Davis (Fantex: VNDSL), which is trading at $11.20. ($10.50 last week.) Marketwatch posts its percent rise at "infinity." Vernon Davis is a receiver for the San Francisco 49ers. A quick check shows he is currently holding out for a better contract, adding octane to this infinity-chasing stock. For the wary, something called the "Fathead Vernon Davis" sells for $99.99 at Dick's Sporting Goods.

 

Uber, the limo-hailing app, was valued at $17 billion upon its June IPO. The U.S. taxi industry receives $11 billion in sales a year.

 

I received a note, after writing about the art market: "Reading your discussion of modern "art" as collateral reminds me of a conversation I had in Japan in 1986.  I was based in Tokyo and handling distribution for a software company. I met a young banker for one of my distributors who was applying to MIT Sloan.  He proudly told me how the bank had loaned an exec several million dollars to buy a coveted golf membership.  Of course the loan was secured by .... the golf membership.  A few years later neither the loan nor the collateral was worth much."  We may have already passed this point.  

It is interesting that news stories about market developments routinely indict the Fed for the excesses, even as Yellen distances herself from responsibility:

Bloomberg: June 27: "Companies are on a borrowing binge that's only accelerating, with investment-grade bond sales poised for a new record year. No one seems to be too concerned because... central banks across the globe are working hard to keep suppressing borrowing costs.... Buyers still can't get enough. Investors are now demanding about the smallest premium over benchmark rates to own the debt since 2007, according to Bank of America Merrill Lynch index data."

Bloomberg: June 3: "Bond investors who see no end to the financial repression that's pushed yields to record lows are piling even more money into notes of the riskiest companies, wagering that central banks will keep propping them up. "

Bloomberg: June 16:"The boom in fixed-income derivatives trading is exposing a hidden risk in debt markets around the world: the inability of investors to buy and sell bonds. While futures trading of 10-year Treasuries is close to an all-time high, bond-market volume for some maturities has fallen a third in the past year. In Japan's $9.6 trillion debt market, the benchmark note didn't trade until midday on two days last week. As a lack of liquidity in Italy caused transaction costs in the world's third-largest sovereign bond market to jump last month, [this] propelled an eightfold surge in Italian futures by relying more on derivatives. The shift reflects an unintended consequence wrought by central banks. Inefficiencies in the $100 trillion market for bonds may make investors more vulnerable to losses when yields rise from historical lows. The worry is that when investors try to exit their positions, 'there may be some kind of squeeze.' That concern has caused investors to pour into derivatives, which are contracts based on underlying assets that can provide the same exposure without tying up as much capital."  

The "inefficiencies in the $100 trillion market [that] may make investors more vulnerable to losses," have escaped former Fed Chairman Ben Bernanke, who had inflated the Federal Reserve balance sheet to 70-to-1 against stated capital by November 2013. In at least one of his $250,000 diners with hedge fund managers, the galloping gourmet claimed the Fed does not have to reduce its balance sheet by "one dime." He never was much of one for details.  

The inefficiencies have not escaped all the central banks. From The King Report, June 23: "Central banks are planning to cut their exposure to longer-term debt to protect themselves from losses.... The survey of 69 central bank reserve managers, polled in May by [Central Banking Publications] and HSBC, suggested many have already started moving into riskier assets, such as equities." From the same day's King Report: "The [Japanese] Government Pension Fund and other public pension plans sold about [$17.4 billion] more in Japanese bonds than they bought in the first three months of the year..."

Back in the Home Land, the Financial Times reported on June 16, 2014, that "Federal Reserve officials have discussed imposing exit fees on bond funds to avert a potential run by investors, underlining regulators' concern about the vulnerability of the $10 trillion corporate bond market. Officials are concerned that bond-fund investors, as with bank depositors, can withdraw their money on  demand...." This is not a problem whipped up by some Fed staffers. From Bloomberg, June 23: "It's never been easier for individuals to enter some of the most esoteric debt markets. Wall Street's biggest firms are worried that it'll be just as simple for them to leave. Investors have piled more than $900 billion into taxable bond funds since the 2008 financial crisis, buying stock-like shares of mutual and exchange-traded funds to gain access to infrequently-traded markets.... [A]nalysts at JPMorgan Chase & Co. are focusing on the problems that individual investors could cause by yanking money from funds.... 'In extremis, this could force a closing of the primary market and have serious economic impact.'"

At a press conference two days later, Federal Reserve Chairman Janet Yellen was asked about this initiative and she claimed not to know anything about it.

There are times to step aside, as best as one can (no easy task). This is one.