It's All in the Flows

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) and "The Coming Collapse of the Municipal Bond Market" (Aucontrarian.com, 2009)

            The 2007 Federal Open Market Committee (FOMC) transcripts were released last week. Media reports have concentrated on the Fed's forbearance during the credit meltdown. Implied, but not stated (in what I have read) is the major reason for such nonchalance: The Fed only acknowledges flows, not stocks. This might sound boring. It is also very important to understand.

            This approach to central banking has not changed. All of the major central banks use the same framework. The media and Wall Street spend most of their time interpreting the meaning of central-bank talk. Central banks will never mention a growing concern about loan defaults since the academics can always thwart potential catastrophes by modeling preventive flows (e.g., liquidity). The catastrophic financial failure that most of us endured in 2007 and 2008 was not a failure at all, according to central bankers. Their models still conclude there is always a central-banking solution that will prevent any catastrophe. In conclusion: when the current financial bubble topples, there will no forewarning from central bankers, the media, or Wall Street. Given their processes of thinking, they will be more surprised than the average hairdresser.  

            "Stocks," in this case, does not refer to common stocks, but the accounts and categories in which assets (and their liabilities) accumulate. The Fed, a creature of academia, knows everything. Knowing everything limits policy to sufficient "liquidity": flows. It - to be more precise - its DSGE model, does not care about accumulations: stocks.

The Fed was taken unaware when credit cracked up in the summer of 2007. Unlike many local realtors and carpenters, the FOMC did not understand the connection between flows (bad loans pouring into off-balance sheet Special Investment Vehicles) and stocks (of mushrooming mortgage credit going sour). The Fed presumably noticed pieces of the mortgage machine (subprime lenders, appraisers, Fannie Mae, commercial banks, investment banks, CDOs) even though it did not comprehend the artificiality of this contrived structure. Hence, the Fed missed the connection between the economic expansion of the mid-oughts and its artificial nature. (As we know now, the Fed does not blanch at running an economy by rigging its prices, so, we know now, central banks do not understand an artificial economy is unsustainable.)

All of which is to say the Fed and its FOMC did not know a loss of forward momentum would be followed by an abrupt shift to backward momentum. Again, this has not changed. Despite talk of deleveraging, the U.S. economy has continued to lever up since the non-catastrophe of 2007 and 2008. Total non-financial debt has risen from 240% of GDP in the fourth quarter of 2008 to 249% of GDP after the second quarter of 2012.

The Fed does not understand the artificial credit created by central banks that has flowed since 1971 has coagulated into unsustainable imbalances around the world. The FOMC will be in the caboose when government debt loses its imaginary, "riskless" character (e.g., banks do not need to reserve against most sovereign bonds). As in 2007 and 2008, the stated price of artificially produced assets is illusory, so the assets cannot stand on their own without ever increasing flows to support prices. The flows accumulate in stocks, the artificial composition of which will topple.

The rate of non-financial debt production in the U.S. economy has slowed down. It increased by 4.6% in the first quarter and 5.1% in the second quarter of 2012. Third quarter growth was 2.4%. When forward momentum is lost, backward momentum will prevail.

The jig was up by the summer of 2007. Those monitoring the Mortgage Lender Implode-o-Meter website were waiting. The mortgage-makers on parade were not necessarily bankrupt but had, at least, abandoned a major segment of their lending activities. By the end of March 2007, the Implode-o-Meter list had grown to 49, including some of the largest vacuums that fed the machine: HSBC Mortgage Services, Ameriquest, ACC Wholesale, New Century, Wachovia Mortgage. Except for those who worshiped liquidity flows, it was impossible to miss the credit crash.

Yet, following are comments from the August 7, 2007, FOMC Meeting:

CHAIRMAN BERNANKE: "I think the odds are that the market will stabilize. Most credits are pretty strong except for parts of the mortgage market."

            Of course, this is to be expected. Bernanke was quoted in October 2008 as not knowing if there was a housing bubble.

            More importantly, the man with his hand on the tiller, who should have enlightened the professors, was just as dense:

WILLIAM DUDLEY: "We've done quite a bit of work trying to identify some of the funding questions surrounding Bear Stearns, Countrywide, and some of the commercial-paper programs. There is some strain, but so far it looks as though nothing is really imminent in those areas. Now, could that change quickly? Absolutely."

Dudley ran the New York Fed's open-market desk. He is now President of the New York Fed. He had been an economist at Goldman Sachs. It is expected the academics are out-to-lunch, but Dudley had dealt in money from Goldman. His misunderstanding is appalling. (On August 16, 2007, Countrywide drew down its entire credit line of $11.5 billion. On August 17, 2007, there was a bank run on Countrywide. This was the real McCoy. The Los Angeles Times published pictures of customers lined up outside branches. The Federal Reserve cut its discount rate (not the fed funds rate) from 6.25% to 5.75% on the same day. After the August 7, 2007, meeting, the FOMC announced: "Economic growth was moderate during the first part of the year." Eight days later (the FOMC held emergency telephone calls on August 10, 2007, and August 16, 2007), the Fed justified the discount-rate cut by declaring: "Financial market conditions have deteriorated and tighter credit conditions and increased uncertainty have the potential to restrain economic growth.")

To conclude, a flavor of what was happening when the FOMC met in August 2007:

July 31, 2007 - "Mortgage insurers MGIC Investment Corp. and Radian Group Inc. said they might write off their combined $1.03-billion stake in a venture that invests in subprime mortgages on which payments were past due."

July 31, 2007 - "American Home Mortgage Investment Corp., which lends to people close to the sub-prime category, postponed payment of its dividend, took 'major' write-downs and said its lenders were demanding that it put up more cash. Its stock plunged 39%. 'Bankruptcy is not out of the question' for American Home, said Matt Howlett, an analyst at Fox-Pitt Kelton Inc. in New York. 'It needs to find a partner with alternative funding and hope the market turns around.'"

July 31, 2007 - "Insurer CNA Financial Corp. wrote down $20 million in sub-prime-backed securities."

July 31, 2007 - "In Germany, shares of IKB Deutsche Industriebank, which 10 days earlier said the [U.S.] sub-prime crisis wouldn't affect it, fell 20% in Frankfurt on Monday after it reported problems with investments in U.S. sub-prime mortgages."
 

August 1, 2007 - "American Home Mortgage Investment Corp. shares yesterday plunged 90 percent after the Melville, New York-based lender said it doesn't have cash to fund new loans, stranding thousands of home buyers and putting the company on the brink of failure."
 

August 1, 2007 - "Bear Stearns Cos., the New York-based manager of two hedge funds that collapsed last month, blocked investors from pulling money out of a third fund as losses in the credit markets expand beyond securities related to subprime mortgages."
 

August 3, 2007 - (Reuters): "AMERICAN HOME MORTGAGE TO CLOSE FRIDAY" - American Home Mortgage Investment Corp plans to close most operations on Friday and said nearly 7,000 employees will lose their jobs.... American Home originated $59 billion in loans last year, and mostly to people with better credit than risky subprime borrowers. About half of those mortgages were adjustable-rate loans, whose defining feature is an interest rate that can be adjusted upward. 'It is with great sadness that American Home has had to take this action which involves so many dedicated employees,' Chief Executive Michael Strauss said in a statement." [My italics - FJS]
 

August 3, 2007 - "Moody's Investors Service said this week it plans to take a harder look at bonds backed by those Alt-A mortgages, which are turning out to look more like subprime loans than it expected."

August 9, 2007 - (Reuters) - "American International Group, one of the biggest U.S. mortgage lenders, warned on Thursday that mortgage defaults are spreading. While saying most of its mortgage insurance and residential loans were safe, AIG made a presentation to analysts and investors that showed delinquencies are becoming more common among borrowers in the category just above subprime. Although acknowledging the "significant declines" in subprime securities, Chief Executive Martin Sullivan said AIG's tight underwriting standards had minimized losses and he was 'poised to take advantage of opportunities' in the mortgage market.'"

A final note: Some media reviews of the 2007 FOMC transcripts have given San Francisco Fed President (as she was then) Janet Yellen an A+ for anticipating the mortgage crash at early 2007 FOMC meetings. I doubt this. Since serving as Federal Reserve governor in 2004, Yellen has consistently wanted to cut rates. At one meeting, she was aghast when she learned the consumer savings rate had risen, since this would reduce consumption, push the economy into recession, so let's cut rates before the world ends. She's as witless as Simple Ben.