Frederick 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).
"China in Midst of 'Greatest Bubble in History'", Bloomberg told readers on March 17, 2010. That was the opinion of certain experts interviewed by the news service. One expert held the opposite view: "'People making comments about bubbles possibly don't have all the facts,' HSBC Holdings Plc Chief Executive Officer Michael Georghegan said in Shanghai today. Regulators are in control of the banking industry, and have the ability to curb lending as needed, he said."
Aside from the bubble question (which the experts answered), it is the rationale behind Georghegan's chipper comment that deserves attention. "Regulators are in control" seems low on the list to assure clientele. Even though Georghegan is persuaded, investors should be skeptical. What follows is a review of instances when trusted regulators were a good reason to panic.
On September 4, 1929, Roger Babson advised a gathering in Wellesley, Massachusetts to "pay up their loans and avoid margin speculation at this time because a 'crash' of the stock market was inevitable." This was the New York Times summary in its September 6 edition under the headline "Babson Predicts 'Crash' in Stocks."
Forever known as the "Babson Break," stocks fell 3% after the ticker relayed Babson's warning. This was two days after the Dow Jones Industrial Average peaked at 381, which would remain the top until 1954. The Times quoted the most celebrated economist of the time, Irving Fisher: "Stock prices are not too high and Wall Street will not experience anything in the nature of a crash." The persistence of celebrated economists to miss monumental shifts is, or should be, expected.
Alexander D. Noyes, sometimes called the "dean of American financial journalism," cautioned Times' readers that Babson's counsel might be outdated. There are "numerous other considerations now which must nowadays modify ideas about the future. One is the power and protective resources of the Federal Reserve."
There were some inside the Fed who thought differently. In 1928, Carl Snyder of the New York Fed wrote: "Owing to the abundance of credit, in excess of what appears to be about the maximum possible growth of trade, there came a heavy expansion of bank investment.... [P]artly in consequence of the abundant credit, [we have seen what] appears to be the greatest building boom which this country has known in 60 years..."
By the fall of 1929, plans were or had been drawn for five buildings ranging in height from 80 to 150 stories in New York. The "protective resources of the Fed" were no better (or worse) in 1929 than in 2008.
Investors are better off trusting their own judgment than the motivations of government authorities. In the same September 6, 1929, "Babson Break" edition of the Times, a column with the title "Action by Board Doubted" reported the "total of broker's loans by member banks of the Federal Reserve System took another jump... [to] a new peak of $6,354,000,000. Treasury officials indicated that they did not expect any radical step by the Federal Reserve Board at this time to curb the speculative movement."
This instance of an inflated stock market accompanied by a blank stare from the government is known, in contemporary parlance, as the "Greenspan Put," now superseded by the "Bernanke Put." Speculators, in 2010, as in 1929, must decide whether the "power and protective resources of the Federal Reserve" have put a floor on the stock market's price even though it was (and is) floating on borrowed money.
Such calculations aside, there was another story in the Times' "Babson Break" issue that warned the mind of the market was that of the village idiot. The article, "Brokerage Office Set Up On Pebble Beach Golf Course," reported: "Golf enthusiasts who are following the course of the national amateur championship at Pebble Beach, Cal., may watch the stock market while keeping up with the play. A temporary brokerage office, housed in a tent...has been established by the firm of E.F. Hutton & Co.... The temporary office has had a lively bit of business from the crowd following the players and from some of the players, too, many of whom are ardent followers of market quotations."
In 1966, when the Federal Reserve was ceding monetary policy to the Johnson administration, the business editor of the New York Times calmed readers: "Luckily, the Government has the ability and the wisdom not to let inflation break into a gallop as has happened recently in other countries." The inflation rate was 3.3% at the time and rose to 6.1% in 1969. The Times, in its high-minded trust of Washington, did not stoop to consider the authorities might be looking after their own interests. Secretary of Defense Robert McNamara was lying about the financial burden of Vietnam, where the troops deployed were to double (from 184,000) in 1966. The Johnson administration would not consider a major tax increase and the budget deficit rose from $1 billion in 1965 to $25 billion in 1968.
As every schoolchild knows, political independence of the Federal Reserve does not include its unstated mandate to plug Treasury deficits. In late 1965, Federal Reserve Chairman William McChesney Martin had told the Federal Reserve Open Market Committee "I cannot believe that all periods of prosperity float on constantly rising levels of credit or that one can ignore credit quality." Martin's intentions may have been parsimonious, but McNamara's War demanded expansion. Bank credit rose at a 7.2% rate in December 1965 and by 15% in April 1966. At Martin's 1970 White House farewell dinner, he told the assembled: "We are in the wildest inflation since the Civil War."
As goes inflation, so go bonds. Americans who trusted the "ability and wisdom" of the Federal Reserve were scarred. In 1969, Institutional Investor published a front cover story, "The Death of Bonds." Prices of long-term Treasuries fell 14% from the end of 1966 to 1969. Stock investors wished they hadn't. After rising for 17 years, the Dow Jones Industrial Average reached a peak of 995 on February 9, 1966. The Dow was 777 on August 12, 1982. These numbers do not reflect inflation's toll on purchasing power. Consumer prices tripled over the 16-year period.
This brings us to the present and to a regular columnist in the New York Times, Greg Mankiw, professor of Economics at Harvard University, past chairman of President George W. Bush's Counsel of Economic Advisers, and so on. On December 23, 2007, Mankiw outdid Irving Fisher: "The truth is the current Fed governors, together with their crack staff of Ph.D. economists and market analysts, are as close to an economic dream team, as we are ever likely to see.... The best Congress can do now is to let the Bernanke bunch do its job."
The Federal Reserve governors had spent 2007 in a daze; 2008 would show their policy was to panic, overreact to meltdowns the Fed had fostered, and disguise their market manipulations.
Anti-authoritarianism is often simple common sense. Returning to China, the country suffered one of the worst inflations of the twentieth century during the 1930s and 1940s. (In good measure, this was inflicted by the United States. See "America's Beggar-Thy-Neighbor Policy" under "Articles" on the Aucontrarian.com website.)
The Chinese press, controlled by Chinese Communists in 1949, blamed inflation on "Kuomintang agents" and "unscrupulous speculators." (It never changes.) Prices for necessities - rice, bean oil, firewood, soap - were rising daily when the Communists demanded trade be conducted in the new People's Bank note. In June 1949, a New York Times correspondent spoke to a merchant in Nanking who would not touch the paper currency: "Communist currency may be backed by rice, but you can't hold rice. It spoils. A gold bar is always a gold bar."
Frederick Sheehan writes a blog at www.aucontrarian.com
Thursday, March 25, 2010
Friday, March 12, 2010
Municipal Deflation: Consequences of the Greatest Speculation
Frederick 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).
"The financial difficulties of local governments in consequence both of the inflation and deflation of real estate values demonstrates strikingly the unwisdom of a revenue system concentrated so heavily upon real estate...."
-Herbert D. Simpson, Meeting of the American Economic Association, 1933
On March 10, 2010, the Kansas City Missouri School Board voted to close nearly half its schools (28 of 58). On the same day, Illinois Governor Pat Quinn warned that if the state income tax is not raised by 1%, education will face "draconian cuts."
To employ the most hackneyed metaphor of the recent financial meltdown, we are only in the first inning of municipal deflation in the United States. This has not gained much attention in the recovery vs. recession debate. Yet, states and municipalities spend around twice as much money as the federal government. (Since only the federal government can print money, this comparison may have changed in the last year.) The gap between tax receipts and spending is forcing big changes in Missouri and Illinois, though it is probable these cuts are miniscule in comparison to what is ahead. A recovery is expected in tax receipts by those who think the economy is rebounding, but in fact the broad swath of municipalities will suffer deeper reductions in tax receipts for a long time to come. (Municipalities - cities and towns - receive most of their revenue from real estate taxes. State revenues are skewed towards income, corporate, and sales taxes.)
The Great Depression taught this lesson but it was tossed in some ash heap of history. Revered economists are particularly immune to events that contradict their theories. In the 1938 Alfred Hitchcock movie, The Lady Vanishes, the mistaken psychiatrist is told: "You must think of a fresh theory." Doctor Hartz responds: "It is not necessary. My theory was perfectly good. The facts were misleading."
Doctor Hartz had a sound reason not to change his theory since reconsideration may have precluded his intent to murder his victim. In a similar vein, intended or not, Federal Reserve Governor Frederic Mishkin espoused a murderous theory that has claimed many victims: "To begin with, the bursting of asset price bubbles often does not lead to financial instability....There are even stronger reasons to believe that a bursting of a bubble in house prices is unlikely to produce financial instability.... In the absence of financial instability, monetary policy should be effective in countering the effects of a burst bubble." This prediction was made in January 2007 before the Forecaster's Club of New York. (Novelists shy from such parody.)
Current theories and books written about the Depression do not dwell on the 1920s real estate boom. Real estate lending in the 1920s might rival the recent debacle, in form if not degree. There was a flight to the suburbs. The building balloon included houses, roads, sewers, schools, skyscrapers, and highways that crossed the country for the first time. When Treasury "Secretary Mellon endeavored to cut back federal spending, state and local governments stepped up spending at a rate that more than offset the Mellon program...."
This was speculative building on a grand scale, as Professor Herbert D. Simpson of Northwestern University informed the Forty-Fifth Annual Meeting of the American Economic Association in 1933: "Throughout this period there was another form of real estate speculation, not commonly classified as such, but one that has had disastrous consequences. This is the real estate 'speculation' carried on by municipal governments, in the sense of basing approximately 80 per cent of their revenues upon real estate and then proceeding to erect a structure of public expenditure and public debt whose security depended largely on a continuance on the rate of profits and appreciation that had characterized the period from 1922-29."
In The Crash and Its Aftermath, A History of Securities Markets in the United States, 1929-1933, Barrie Wigmore wrote: "Municipal governments were expected to be an active countervailing force in the anticipated business downturn after the Crash. However, many municipalities were not in a position financially to bear the twin burdens of unemployment relief and capital construction...." It is easy to see why. Municipalities were spending because tax receipts rose. Since tax receipts rose, local governments could leverage growth through bond issues. Outstanding municipal bond debt doubled in the 1920s. Over the same period, federal government debt fell by 30%.
With nothing learned, states and municipalities borrowed $23 billion in 2000 and $215 billion in 2007. One reason credit rained on bubbly school committees was the ever-rising revenue stream from real estate taxes: receipts increased from $254 billion in 2000 to $421 billion in 2008.
Federal Reserve Governor Frederic Mishkin dismissed the body blows of real-estate bubbles, but A.M. Hillhouse, author of Municipal Bonds: A Century of Experience, wrote in 1936: "[T]he major portion of overbonding by municipalities arises out of real estate booms.... The prize crop of boom bond troubles of all time came with the collapse of the Florida real estate speculation in 1926." In consequence, the property tax in West Palm Beach, Florida was raised to 42.5% of assessed value. This effort to balance the books failed.
At the 1933 meeting of the American Economic Association, Simpson was not a happy professor: "During this period of prosperity, real estate taxes were paid with little complaint.... [U]nder these conditions, public expenditures expanded and taxes were increased without protest.... The result has been a structure of public expenditure which has been difficult to curtail, and a volume of indebtedness whose solvency is now jeopardized on a large scale."
Simpson delivered his paper at the bottom of the Depression but the number of beleaguered municipalities kept rising until 1935, when there were at least 3,252 municipal issues in default. There are at least three reasons to think current municipal problems will be worse. First, the latest real estate bubble has probably been much bigger and more leveraged than in the 1920s. Second, expenses are not as easy to cut. The earlier retrenchment was not hamstrung by bloated government retiree pension and health benefits. Third, property assessments lag current prices. This promises to be a fierce battle. Towns want to hold the status quo so are in no hurry to tax properties at falling market values; residents do not want to fund comfortable teacher retirements when they are wondering what happened to their own pension plans.
At the One Hundred Twenty-First Annual Meeting of the American Economic Association in 2009, Professor Frederic Mishkin (who has departed the Fed and returned to Columbia University) contributed a paper, "Is Monetary Policy Effective During Financial Crises?" Whatever he had to say, may it gather dust as the world learns the lessons taught and discarded by Professor Herbert D. Simpson.
"The financial difficulties of local governments in consequence both of the inflation and deflation of real estate values demonstrates strikingly the unwisdom of a revenue system concentrated so heavily upon real estate...."
-Herbert D. Simpson, Meeting of the American Economic Association, 1933
On March 10, 2010, the Kansas City Missouri School Board voted to close nearly half its schools (28 of 58). On the same day, Illinois Governor Pat Quinn warned that if the state income tax is not raised by 1%, education will face "draconian cuts."
To employ the most hackneyed metaphor of the recent financial meltdown, we are only in the first inning of municipal deflation in the United States. This has not gained much attention in the recovery vs. recession debate. Yet, states and municipalities spend around twice as much money as the federal government. (Since only the federal government can print money, this comparison may have changed in the last year.) The gap between tax receipts and spending is forcing big changes in Missouri and Illinois, though it is probable these cuts are miniscule in comparison to what is ahead. A recovery is expected in tax receipts by those who think the economy is rebounding, but in fact the broad swath of municipalities will suffer deeper reductions in tax receipts for a long time to come. (Municipalities - cities and towns - receive most of their revenue from real estate taxes. State revenues are skewed towards income, corporate, and sales taxes.)
The Great Depression taught this lesson but it was tossed in some ash heap of history. Revered economists are particularly immune to events that contradict their theories. In the 1938 Alfred Hitchcock movie, The Lady Vanishes, the mistaken psychiatrist is told: "You must think of a fresh theory." Doctor Hartz responds: "It is not necessary. My theory was perfectly good. The facts were misleading."
Doctor Hartz had a sound reason not to change his theory since reconsideration may have precluded his intent to murder his victim. In a similar vein, intended or not, Federal Reserve Governor Frederic Mishkin espoused a murderous theory that has claimed many victims: "To begin with, the bursting of asset price bubbles often does not lead to financial instability....There are even stronger reasons to believe that a bursting of a bubble in house prices is unlikely to produce financial instability.... In the absence of financial instability, monetary policy should be effective in countering the effects of a burst bubble." This prediction was made in January 2007 before the Forecaster's Club of New York. (Novelists shy from such parody.)
Current theories and books written about the Depression do not dwell on the 1920s real estate boom. Real estate lending in the 1920s might rival the recent debacle, in form if not degree. There was a flight to the suburbs. The building balloon included houses, roads, sewers, schools, skyscrapers, and highways that crossed the country for the first time. When Treasury "Secretary Mellon endeavored to cut back federal spending, state and local governments stepped up spending at a rate that more than offset the Mellon program...."
This was speculative building on a grand scale, as Professor Herbert D. Simpson of Northwestern University informed the Forty-Fifth Annual Meeting of the American Economic Association in 1933: "Throughout this period there was another form of real estate speculation, not commonly classified as such, but one that has had disastrous consequences. This is the real estate 'speculation' carried on by municipal governments, in the sense of basing approximately 80 per cent of their revenues upon real estate and then proceeding to erect a structure of public expenditure and public debt whose security depended largely on a continuance on the rate of profits and appreciation that had characterized the period from 1922-29."
In The Crash and Its Aftermath, A History of Securities Markets in the United States, 1929-1933, Barrie Wigmore wrote: "Municipal governments were expected to be an active countervailing force in the anticipated business downturn after the Crash. However, many municipalities were not in a position financially to bear the twin burdens of unemployment relief and capital construction...." It is easy to see why. Municipalities were spending because tax receipts rose. Since tax receipts rose, local governments could leverage growth through bond issues. Outstanding municipal bond debt doubled in the 1920s. Over the same period, federal government debt fell by 30%.
With nothing learned, states and municipalities borrowed $23 billion in 2000 and $215 billion in 2007. One reason credit rained on bubbly school committees was the ever-rising revenue stream from real estate taxes: receipts increased from $254 billion in 2000 to $421 billion in 2008.
Federal Reserve Governor Frederic Mishkin dismissed the body blows of real-estate bubbles, but A.M. Hillhouse, author of Municipal Bonds: A Century of Experience, wrote in 1936: "[T]he major portion of overbonding by municipalities arises out of real estate booms.... The prize crop of boom bond troubles of all time came with the collapse of the Florida real estate speculation in 1926." In consequence, the property tax in West Palm Beach, Florida was raised to 42.5% of assessed value. This effort to balance the books failed.
At the 1933 meeting of the American Economic Association, Simpson was not a happy professor: "During this period of prosperity, real estate taxes were paid with little complaint.... [U]nder these conditions, public expenditures expanded and taxes were increased without protest.... The result has been a structure of public expenditure which has been difficult to curtail, and a volume of indebtedness whose solvency is now jeopardized on a large scale."
Simpson delivered his paper at the bottom of the Depression but the number of beleaguered municipalities kept rising until 1935, when there were at least 3,252 municipal issues in default. There are at least three reasons to think current municipal problems will be worse. First, the latest real estate bubble has probably been much bigger and more leveraged than in the 1920s. Second, expenses are not as easy to cut. The earlier retrenchment was not hamstrung by bloated government retiree pension and health benefits. Third, property assessments lag current prices. This promises to be a fierce battle. Towns want to hold the status quo so are in no hurry to tax properties at falling market values; residents do not want to fund comfortable teacher retirements when they are wondering what happened to their own pension plans.
At the One Hundred Twenty-First Annual Meeting of the American Economic Association in 2009, Professor Frederic Mishkin (who has departed the Fed and returned to Columbia University) contributed a paper, "Is Monetary Policy Effective During Financial Crises?" Whatever he had to say, may it gather dust as the world learns the lessons taught and discarded by Professor Herbert D. Simpson.
Tuesday, March 9, 2010
From the Greenspan Put to the Kohn Put: Our Brilliant Central Bankers
Federal Reserve Vice Chairman Donald Kohn announced his retirement on March 1, 2010. In his obligatory lament, Federal Reserve Chairman Ben S. Bernanke was half right: "The Federal Reserve and the country owe a tremendous debt of gratitude to Don Kohn." What is good for the Fed is generally not good for the country. The influence of Donald Kohn supports this view.
A rarity, Kohn rose through the ranks of the Federal Reserve System. After 32 years of grunt work, he was named a Federal Reserve governor in 2002 and assigned the vice chairmanship in 2006. He participated in Federal Reserve Open Market Committee (FOMC) meetings long before his governorship. He had been a staff economist (Director of Monetary Affairs) and Secretary at FOMC meetings.
Donald Kohn will be smothered in praise from now until his June retirement. The media will quote celebrity economists who will deify the celebrity vice chairman. Alan Greenspan was "the greatest central banker who ever lived," according to former Federal Reserve Vice Chairman Alan Blinder at a 2005 conference. These farewell hosannas are necessarily vague and meaningless, as was the March 6, 2010, appraisal of Kohn in the Economist: "Mr. Kohn is widely considered one of the most experienced and thoughtful central bankers in the world." Given the worldwide failure of central bankers, this may well be true, so a critique of Kohn's brilliance is necessarily specific.
October 15, 1998: Fanning the Greenspan Put
The FOMC held a conference call on October 15, 1998. This remains the most infamous FOMC discussion on record. It was held shortly after Wall Street paid over $3 billion to bail out Long-Term Capital Management (LTCM), a hedge fund. The Nasdaq Composite Index fell 20% from mid-July to mid-October. It had boomed for the past three-and-one-half years (a 160% return), but the Fed decided a hiatus would not do.
In the wake of the conference call, the Fed announced a surprise rate cut at 3:14 p.m. The bond market had already closed for the day, stock-option contracts expired the next day, and investors panicked. A frenzy of buying pushed the S&P 500 futures up 5% in five minutes. The Nasdaq Composite rose from 1,540 on October 14, 1998 to 4,069 on December 31, 1999.
Donald Kohn's contribution, as Secretary of the FOMC, was to announce at the meeting's conclusion: "We are not constrained by the practice followed after regularly scheduled FOMC meetings where the release time is set for 2:15 p.m. We will try to move through the process of preparing the press release as rapidly as possible."
It was after this surprise rate cut that the "Greenspan Put" came into common use. A put option is bought by investors to limit losses when the market falls. Now, instead of buying protection, the Greenspan Put inspired such confidence that speculators replicated the borrowing and leveraging of LTCM. Kohn's faux pas, if that is what it was, served the interests of the Fed but not those of the American people. Around $5 trillion was lost by investors after the Greenspan Stock-Market Put failed in 2000.
Joining the Inflation Targeting Team
The Fed's deflation team was beefed up on August 5, 2002. Both Ben Bernanke and Donald Kohn were appointed as Fed governors, and to the FOMC. Bernanke had devoted his adulthood to inflationary economics. His book, which he wrote with three other economists, Inflation Targeting: Lessons from the International Experience made clear that an economy should always be inflating.
At Bernanke's first FOMC meeting (August 13, 2002), it was the other newcomer, Donald Kohn who sounded as if he was reading from Bernanke's book: "I don't see a zero real rate as a natural bound for monetary policy." He not only was unconcerned about real rates below zero, Kohn stated the opposite case: [I]nflation is already as low as I would like to see it go." He intimated that real rates were already below zero (when inflation exceeds the borrowing rate), and stated a desire for even lower real rates.
This was an about face. At the May 2002, Donald Kohn, speaking as a staff economist, had warned the committee it would soon need to address a fed funds rate hike from "its currently unsustainably low level." He also told the FOMC the fed funds rate "will have to be tightened at some point to forestall increasing inflationary pressures."
Donald Kohn has been an asset inflator since his coming out party at the August 2002 meeting. Although (the current) Chairman Bernanke has led the charge against deflation at all costs, Donald Kohn has been a loyal sidekick.
The FOMC had started cutting the fed funds rate in 2001 and did so until 2003, when it stopped at 1.0%. There are few precedents to a 1.0% borrowing rate. When we sift through the wreckage in future years, the zero-percent school will deserve a healthy portion of the blame.
"[H]ouseholds Have Bought More and Larger Houses and Cars, Have Taken on More Debt..."
Ignorance will not be an excuse. Donald Kohn knew what he was doing. After the Greenspan Stock-Market Put had failed, the FOMC instituted the Greenspan Home-Equity, Cash-Out Put. On April 1, 2004, Kohn spoke at Widener College in Chester, Pennsylvania. He opened by reminding his audience of the gratitude it owed the Federal Reserve: "Starting in January of 2001, the Federal Reserve moved to counter [the weak economy] by lowering the funds rate.... This prompt and aggressive action undoubtedly served to limit the decline in economic activity, and, in fact, the recent recession was one of the mildest on record." Attendees among the cohort that had lost the $5 trillion may not have appreciated this P.R. stunt.
Kohn acknowledged there were dissenters to the Fed's current 1.0% fed funds rate: "[S]ome observers have been calling for the Federal Reserve to begin the tightening process sooner rather than later." They were concerned "that the Federal Reserve, by keeping the funds rate so low and signaling that it is likely to stay low for a while, is sowing the seeds for different kinds of future problems. In particular, these critics worry that a continued environment of low interest rates is giving rise to economic imbalances - excessive indebtedness, and elevated prices of houses, equities, and bonds - that in the longer run will come back to haunt us."
Since the financial meltdown, the Fed has recited from its handbook: "No one saw it coming." The credit crash in 2007 had been widely anticipated and in all its severity. The question was not "if," but "when." The media quotes the Fed without correction, and so, Ben Bernanke was recently awarded another term as chairman.
Kohn dismissed concerns before the Pennsylvania college audience: "[H]ouseholds have bought more and larger houses and cars, have taken on more debt, and generally have spent more than would have been the case if interest rates had been higher.... [T]hese developments... are by-and-large the intended and logical consequences of the Federal Reserve's efforts to reduce economic slack through low interest rates."
Should there be credit "adjustments", Kohn assured his audience: "Commercial banks remain highly profitable and well capitalized...." They were only well capitalized as long as they remained highly profitable.
Of course, Kohn praised the Fed's regulatory vigilance: "Banking supervisors at the Federal Reserve, for example, in the course of the ongoing examination process, have been paying close attention to the sorts of vulnerabilities we have reviewed and have been discussing these risks with the commercial banks they oversee."
Regulation: "It's a Very Hard Sell to the Banks."
On March 4, 2008, Vice Chairman Kohn testified before the Senate Banking Committee about the "Condition of the U.S. Banking System." He made an honest admission: "I don't know that we fully appreciated all the risks out there." He also made a self-serving claim: "I'm not sure anybody did, to be perfectly honest."
Kohn was among the slow minded. In October 2007, Kohn had predicted that once "we get through the near-term weakness caused by the extra downleg from the housing contraction and any spillover from tighter credit conditions, I am looking for moderate growth with high levels of employment."
At the March 2008 hearing, Kohn acknowledged that banks had not priced certain risks appropriately, but "It's a very hard sell to the banks." Senator Richard Shelby, a member of the committee, was not amused: "It's a hard sell to the banks, yes, but you are the supervisor of all the bank holding companies, and you are also the central bank.... So you have not just a little bit of power, but a lot of power." Shelby asked Kohn if the Fed "was afraid of the banks they regulate." Kohn responded in the negative. If this was true, a classroom of rookie bank tellers would have done - and would do - a better job supervising the banks.
Donald Kohn was talking through his hat on September 9, 2009. Again, selling the virtues of the Fed, he claimed the Fed's myriad bailouts (not his description) over the past year had followed the "precepts derived from the work of Walter Bagehot [author of Lombard Street, a central-banking blueprint from Queen Victoria's time.] Those precepts hold that central banks can and should ameliorate financial crises by providing ample credit to a wide set of borrowers, as long as the borrowers are solvent, the loans are provided against good collateral, and a penalty rate is charged." [Italics added]
Bagehot's precepts were stated correctly but Fed practices contradicted the Victorian author. Kohn betrayed a complete ignorance of what the Fed was doing. Kohn and Company had provided loans against collateral that was so damaged it was necessary for the Fed to buy it from the banks and hide it from the public on its own books. We still do not know what the Fed bought and this is probably the main reason the central bank is resisting an audit. As for charging a "penalty rate," the Fed has charged a negative real rate of interest (below the rate of inflation). A double-digit interest rate would meet Bagehot's requirement.
The Kohn Put: Inducing "Savers to Diversify into Riskier Assets"
This past fall, the Kohn Put was announced. Maybe because he was speaking to the choir - at a Federal Reserve conference - he explicitly stated the Fed's grand plan. "[R]ecently the improvement, in risk appetites and financial conditions, in part responding to actions by the Federal Reserve and other authorities, has been a critical factor in allowing the economy to begin to move higher after a very deep recession.... Low market interest rates should continue to induce savers to diversify into riskier assets, which would contribute to a further reversal in the flight to liquidity and safety that has characterized the past few years."
In other words, the Federal Reserve is attempting to rescue itself as it did in 1998 and in 2002. Afraid the LTCM failure would cause financial institutions to freeze, the October 15 Greenspan Put inflated confidence and the stock market. In 2002, Federal Reserve governors, in speech after speech, terrorized Americans into believing it had to lift prices or the United States would suffer another Great Depression. This was the rationale for the 1% fed funds rate, the means by which the Fed inflated another asset bubble, the mortgage market, to compensate for its earlier mistake. And now, with the housing market and economy in despair, Kohn has announced the Fed's zero percent interest-rate policy will induce savers into the stock market and the already inflated municipal and federal government bond markets.
Presidential adviser Larry Summers and Secretary of the Treasury Tim Geithner are leading the search for Donald Kohn's replacement. We can be sure this pair of insiders will identify a candidate who will serve the Federal Reserve first and the American people last.
A rarity, Kohn rose through the ranks of the Federal Reserve System. After 32 years of grunt work, he was named a Federal Reserve governor in 2002 and assigned the vice chairmanship in 2006. He participated in Federal Reserve Open Market Committee (FOMC) meetings long before his governorship. He had been a staff economist (Director of Monetary Affairs) and Secretary at FOMC meetings.
Donald Kohn will be smothered in praise from now until his June retirement. The media will quote celebrity economists who will deify the celebrity vice chairman. Alan Greenspan was "the greatest central banker who ever lived," according to former Federal Reserve Vice Chairman Alan Blinder at a 2005 conference. These farewell hosannas are necessarily vague and meaningless, as was the March 6, 2010, appraisal of Kohn in the Economist: "Mr. Kohn is widely considered one of the most experienced and thoughtful central bankers in the world." Given the worldwide failure of central bankers, this may well be true, so a critique of Kohn's brilliance is necessarily specific.
October 15, 1998: Fanning the Greenspan Put
The FOMC held a conference call on October 15, 1998. This remains the most infamous FOMC discussion on record. It was held shortly after Wall Street paid over $3 billion to bail out Long-Term Capital Management (LTCM), a hedge fund. The Nasdaq Composite Index fell 20% from mid-July to mid-October. It had boomed for the past three-and-one-half years (a 160% return), but the Fed decided a hiatus would not do.
In the wake of the conference call, the Fed announced a surprise rate cut at 3:14 p.m. The bond market had already closed for the day, stock-option contracts expired the next day, and investors panicked. A frenzy of buying pushed the S&P 500 futures up 5% in five minutes. The Nasdaq Composite rose from 1,540 on October 14, 1998 to 4,069 on December 31, 1999.
Donald Kohn's contribution, as Secretary of the FOMC, was to announce at the meeting's conclusion: "We are not constrained by the practice followed after regularly scheduled FOMC meetings where the release time is set for 2:15 p.m. We will try to move through the process of preparing the press release as rapidly as possible."
It was after this surprise rate cut that the "Greenspan Put" came into common use. A put option is bought by investors to limit losses when the market falls. Now, instead of buying protection, the Greenspan Put inspired such confidence that speculators replicated the borrowing and leveraging of LTCM. Kohn's faux pas, if that is what it was, served the interests of the Fed but not those of the American people. Around $5 trillion was lost by investors after the Greenspan Stock-Market Put failed in 2000.
Joining the Inflation Targeting Team
The Fed's deflation team was beefed up on August 5, 2002. Both Ben Bernanke and Donald Kohn were appointed as Fed governors, and to the FOMC. Bernanke had devoted his adulthood to inflationary economics. His book, which he wrote with three other economists, Inflation Targeting: Lessons from the International Experience made clear that an economy should always be inflating.
At Bernanke's first FOMC meeting (August 13, 2002), it was the other newcomer, Donald Kohn who sounded as if he was reading from Bernanke's book: "I don't see a zero real rate as a natural bound for monetary policy." He not only was unconcerned about real rates below zero, Kohn stated the opposite case: [I]nflation is already as low as I would like to see it go." He intimated that real rates were already below zero (when inflation exceeds the borrowing rate), and stated a desire for even lower real rates.
This was an about face. At the May 2002, Donald Kohn, speaking as a staff economist, had warned the committee it would soon need to address a fed funds rate hike from "its currently unsustainably low level." He also told the FOMC the fed funds rate "will have to be tightened at some point to forestall increasing inflationary pressures."
Donald Kohn has been an asset inflator since his coming out party at the August 2002 meeting. Although (the current) Chairman Bernanke has led the charge against deflation at all costs, Donald Kohn has been a loyal sidekick.
The FOMC had started cutting the fed funds rate in 2001 and did so until 2003, when it stopped at 1.0%. There are few precedents to a 1.0% borrowing rate. When we sift through the wreckage in future years, the zero-percent school will deserve a healthy portion of the blame.
"[H]ouseholds Have Bought More and Larger Houses and Cars, Have Taken on More Debt..."
Ignorance will not be an excuse. Donald Kohn knew what he was doing. After the Greenspan Stock-Market Put had failed, the FOMC instituted the Greenspan Home-Equity, Cash-Out Put. On April 1, 2004, Kohn spoke at Widener College in Chester, Pennsylvania. He opened by reminding his audience of the gratitude it owed the Federal Reserve: "Starting in January of 2001, the Federal Reserve moved to counter [the weak economy] by lowering the funds rate.... This prompt and aggressive action undoubtedly served to limit the decline in economic activity, and, in fact, the recent recession was one of the mildest on record." Attendees among the cohort that had lost the $5 trillion may not have appreciated this P.R. stunt.
Kohn acknowledged there were dissenters to the Fed's current 1.0% fed funds rate: "[S]ome observers have been calling for the Federal Reserve to begin the tightening process sooner rather than later." They were concerned "that the Federal Reserve, by keeping the funds rate so low and signaling that it is likely to stay low for a while, is sowing the seeds for different kinds of future problems. In particular, these critics worry that a continued environment of low interest rates is giving rise to economic imbalances - excessive indebtedness, and elevated prices of houses, equities, and bonds - that in the longer run will come back to haunt us."
Since the financial meltdown, the Fed has recited from its handbook: "No one saw it coming." The credit crash in 2007 had been widely anticipated and in all its severity. The question was not "if," but "when." The media quotes the Fed without correction, and so, Ben Bernanke was recently awarded another term as chairman.
Kohn dismissed concerns before the Pennsylvania college audience: "[H]ouseholds have bought more and larger houses and cars, have taken on more debt, and generally have spent more than would have been the case if interest rates had been higher.... [T]hese developments... are by-and-large the intended and logical consequences of the Federal Reserve's efforts to reduce economic slack through low interest rates."
Should there be credit "adjustments", Kohn assured his audience: "Commercial banks remain highly profitable and well capitalized...." They were only well capitalized as long as they remained highly profitable.
Of course, Kohn praised the Fed's regulatory vigilance: "Banking supervisors at the Federal Reserve, for example, in the course of the ongoing examination process, have been paying close attention to the sorts of vulnerabilities we have reviewed and have been discussing these risks with the commercial banks they oversee."
Regulation: "It's a Very Hard Sell to the Banks."
On March 4, 2008, Vice Chairman Kohn testified before the Senate Banking Committee about the "Condition of the U.S. Banking System." He made an honest admission: "I don't know that we fully appreciated all the risks out there." He also made a self-serving claim: "I'm not sure anybody did, to be perfectly honest."
Kohn was among the slow minded. In October 2007, Kohn had predicted that once "we get through the near-term weakness caused by the extra downleg from the housing contraction and any spillover from tighter credit conditions, I am looking for moderate growth with high levels of employment."
At the March 2008 hearing, Kohn acknowledged that banks had not priced certain risks appropriately, but "It's a very hard sell to the banks." Senator Richard Shelby, a member of the committee, was not amused: "It's a hard sell to the banks, yes, but you are the supervisor of all the bank holding companies, and you are also the central bank.... So you have not just a little bit of power, but a lot of power." Shelby asked Kohn if the Fed "was afraid of the banks they regulate." Kohn responded in the negative. If this was true, a classroom of rookie bank tellers would have done - and would do - a better job supervising the banks.
Donald Kohn was talking through his hat on September 9, 2009. Again, selling the virtues of the Fed, he claimed the Fed's myriad bailouts (not his description) over the past year had followed the "precepts derived from the work of Walter Bagehot [author of Lombard Street, a central-banking blueprint from Queen Victoria's time.] Those precepts hold that central banks can and should ameliorate financial crises by providing ample credit to a wide set of borrowers, as long as the borrowers are solvent, the loans are provided against good collateral, and a penalty rate is charged." [Italics added]
Bagehot's precepts were stated correctly but Fed practices contradicted the Victorian author. Kohn betrayed a complete ignorance of what the Fed was doing. Kohn and Company had provided loans against collateral that was so damaged it was necessary for the Fed to buy it from the banks and hide it from the public on its own books. We still do not know what the Fed bought and this is probably the main reason the central bank is resisting an audit. As for charging a "penalty rate," the Fed has charged a negative real rate of interest (below the rate of inflation). A double-digit interest rate would meet Bagehot's requirement.
The Kohn Put: Inducing "Savers to Diversify into Riskier Assets"
This past fall, the Kohn Put was announced. Maybe because he was speaking to the choir - at a Federal Reserve conference - he explicitly stated the Fed's grand plan. "[R]ecently the improvement, in risk appetites and financial conditions, in part responding to actions by the Federal Reserve and other authorities, has been a critical factor in allowing the economy to begin to move higher after a very deep recession.... Low market interest rates should continue to induce savers to diversify into riskier assets, which would contribute to a further reversal in the flight to liquidity and safety that has characterized the past few years."
In other words, the Federal Reserve is attempting to rescue itself as it did in 1998 and in 2002. Afraid the LTCM failure would cause financial institutions to freeze, the October 15 Greenspan Put inflated confidence and the stock market. In 2002, Federal Reserve governors, in speech after speech, terrorized Americans into believing it had to lift prices or the United States would suffer another Great Depression. This was the rationale for the 1% fed funds rate, the means by which the Fed inflated another asset bubble, the mortgage market, to compensate for its earlier mistake. And now, with the housing market and economy in despair, Kohn has announced the Fed's zero percent interest-rate policy will induce savers into the stock market and the already inflated municipal and federal government bond markets.
Presidential adviser Larry Summers and Secretary of the Treasury Tim Geithner are leading the search for Donald Kohn's replacement. We can be sure this pair of insiders will identify a candidate who will serve the Federal Reserve first and the American people last.
Wednesday, February 24, 2010
Prepare for Slim Annuities
Frederick 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).
Barclays Capital recently published its annual Equity Gilt Study. The paper includes data for asset returns in the United Kingdom back to 1899 and in the United States since 1925.
In the February 12, 2010 edition of the Financial Times, columnist John Authers wrote a summary of Barclays’ conclusions. In Authers’ words: “Barclays chose to look at how the bubbles of the past 10 years developed. Economic factors do not much help…. Rather, these bubbles were driven by shifts in the demand for equities and other assets – and these, in turn, were driven by demographics.” Barclays misses the elephant trumpeting in the middle of the room. It is no wonder the People are still dazed by the world’s financial meltdown.
Authers continued: “[T]he baby boomers aged, and the long bull market made them more confident, so they ‘over-invested’ in assets around the world.” Barclays explains the source of this overinvestment: “[T]he size of the pool of capital available to pour into Asian stock markets, or into internet stocks, was disproportionate to the availability of investment opportunities.”
There is no need to go on. The source of the bubbles is simple but not part on a college economics’ curriculum, nor taught in business school, nor explained by Wall Street. The overflow of funds invested by the baby boomers is a product of too much money and credit. Governments hold a monopoly on money. A private citizen (or company, including a bank) would go to jail for producing alternative and additional money. In the United States, the Federal Reserve, in concert with the Treasury Department, prints the money.
Credit is produced by the banking system (by and large, this explanation covers most of the ammunition that has brought the U.S., and the rest of the world, to such a state.) The Federal Reserve sets reserve requirements for banks. For instance, a 10% reserve requirement would limit a bank’s lending to $100 for every $10 on deposit. The Federal Reserve has the authority to increase or reduce bank reserve requirements at any time.
During the late, great bank meltdown, the abuse of credit was barely discussed. Nor, was it a topic at Ben Bernanke’s recent confirmation hearing. It was never mentioned by a member of the Federal Reserve in a public comment. It is still the rare commentator who addresses this fertilizer to bubbles, a great disservice since central banks around the world continue to overproduce money.
During the housing, commercial property, hedge fund, private-equity boom, banks had run out of proper projects to fund, so they financed subprime mortgage lenders, commercial property speculators who did not put a penny of their own money into a development, investment banks that wanted to leverage their portfolios at 30:1, hedge funds that wanted to leverage their portfolios at 40:1, and private-equity firms that bought companies and then leveraged their balance sheets at 6:1.
To whip all this finance into a soufflé, banks ballooned the world derivative trade to several hundred trillion dollars (note: trillion, not billion,). This expansion was (and continues to be) hugely profitable for banks. They lent money to a mortgage lender (mortgage companies such as New Century were not banks themselves; they needed a bank to fund loans). Commercial banks also lent to investment banks (such as Lehman Brothers), which then funded mortgage lenders.
The next step was for New Century to ship mortgages en masse to Lehman Brothers, Citigroup or any of the other too-big-to-fail banks. The banks then packaged several thousand home loans into an asset-backed security (ABS). This mortgage derivative was then sold to an investment manager. Despite talk today about the danger of derivatives, banks still are not required to hold one penny of reserves against these rumbling volcanoes.
Such relatively unimportant subjects as bank bonuses fill the air while the lethal state of finance is left to boil over.
Barclays proposes that aging demographics will reduce the number of bubbles in the years ahead. With this misdiagnosis, and central banks printing away, and without any apparent intention to tighten reserve requirements, we need to look elsewhere for a seer.
Sam Zell, who sold his property kingdom for $39 billion in 2006, sent out a holiday present to friends in 2005. He prefaced the theme of his gift: “The enormous monetization of hard assets has created a massive amount of liquidity….Together with [the rising demand for income in the developed world], these factors…are reducing the relative expectations on equity….”
A large part of the monetization Zell spoke of is the derivatives market: the ability of a bank to collect almost any object or receivable, securitize it, then sell it. A home loan or funeral-parlor receivable no longer sits on a bank’s books. It whirs its way to a pension fund manager’s portfolio, in the form of a derivative, where it may be leveraged (from credit originally lent by a commercial bank), then traded again, and possibly rolled into an even more leveraged and even more profitable derivative.
Zell’s holiday present included a song, the lyrics set to the tune of “Raindrops Keep Falling on My Head.”
It opened:
“Capital is raining on my head.
Everything is liquid, we're awash with cash to spend
The flood has drowned returns,
'Cause assets keep liquefying, monetizing, raining...
So I just did me some Econ 101
Seems like we've gotten out of
Equilibrium:
Liquidity abounds,
But relative yields keep falling as capital keeps raining….”
This basic “Econ 101” lesson is not part of the American college curriculum. As Federal Reserve chairman, Alan Greenspan never mentioned the possibility of too much credit creation. As a private citizen prior in 1959, Greenspan clearly understood the phenomenon. He explained to the New York Times: “[Greenspan’s] general conclusion was that instability of the general economy results from the flexibility of the banking system, which supplies credit for the stock market.” And sometimes, too much credit.
The current Federal Reserve chairman, Ben Bernanke, has never mentioned excess credit either. Unlike Greenspan, he probably never has nor will comprehend it. Thus, as long as he is chairman, Bernanke will continue to think he is solving a problem. Later in his song, Sam Zell explained the consequences of the current Fed chairman’s ignorance:
“The world is monetizing faster every day,
Illiquid assets alchemized
To currency in play
Competing for return.
Black gold prices rising, still more money chasing assets...
And this is one thing I know
To get things back to normal.
It's a long haul
That's global.
Yields won't improve 'til growth soaks up this liquid free fall….”
The consequence? Bubbles (if that’s the right word, it’s been so overused) and crashes galore, whether the average age of the population is 10 or 90. If it’s 10, too much money and credit will boost bubble gum prices to $100 a pack. If it’s 90, Lawrence Welk DVDs will sell for $1,000 apiece. Since the median age is in between, it may be the prices of stocks, gold, barbequed chicken, or parking tickets that rise.
It is difficult to know what and when but this much is simple: when the amount of money and credit produced exceeds the needs of the real, non-financial economy, these excess claims on goods and services cause price distortions. Some pockets of prices inflate while others deflate (since overinvestment in an area causes widespread losses, credit write-offs, and fire sales).
Whatever the case, it will be very difficult for the real return on investments to keep up with rising prices of necessities.
The final lines from Sam Zell’s warning:
“It's going to be a long time 'til returns meet expectations,
We need to be prepared for slim annuities…."
We can thank our central bankers for this future and their camp followers who make it so difficult for the average person to understand his own predicament.
Barclays Capital recently published its annual Equity Gilt Study. The paper includes data for asset returns in the United Kingdom back to 1899 and in the United States since 1925.
In the February 12, 2010 edition of the Financial Times, columnist John Authers wrote a summary of Barclays’ conclusions. In Authers’ words: “Barclays chose to look at how the bubbles of the past 10 years developed. Economic factors do not much help…. Rather, these bubbles were driven by shifts in the demand for equities and other assets – and these, in turn, were driven by demographics.” Barclays misses the elephant trumpeting in the middle of the room. It is no wonder the People are still dazed by the world’s financial meltdown.
Authers continued: “[T]he baby boomers aged, and the long bull market made them more confident, so they ‘over-invested’ in assets around the world.” Barclays explains the source of this overinvestment: “[T]he size of the pool of capital available to pour into Asian stock markets, or into internet stocks, was disproportionate to the availability of investment opportunities.”
There is no need to go on. The source of the bubbles is simple but not part on a college economics’ curriculum, nor taught in business school, nor explained by Wall Street. The overflow of funds invested by the baby boomers is a product of too much money and credit. Governments hold a monopoly on money. A private citizen (or company, including a bank) would go to jail for producing alternative and additional money. In the United States, the Federal Reserve, in concert with the Treasury Department, prints the money.
Credit is produced by the banking system (by and large, this explanation covers most of the ammunition that has brought the U.S., and the rest of the world, to such a state.) The Federal Reserve sets reserve requirements for banks. For instance, a 10% reserve requirement would limit a bank’s lending to $100 for every $10 on deposit. The Federal Reserve has the authority to increase or reduce bank reserve requirements at any time.
During the late, great bank meltdown, the abuse of credit was barely discussed. Nor, was it a topic at Ben Bernanke’s recent confirmation hearing. It was never mentioned by a member of the Federal Reserve in a public comment. It is still the rare commentator who addresses this fertilizer to bubbles, a great disservice since central banks around the world continue to overproduce money.
During the housing, commercial property, hedge fund, private-equity boom, banks had run out of proper projects to fund, so they financed subprime mortgage lenders, commercial property speculators who did not put a penny of their own money into a development, investment banks that wanted to leverage their portfolios at 30:1, hedge funds that wanted to leverage their portfolios at 40:1, and private-equity firms that bought companies and then leveraged their balance sheets at 6:1.
To whip all this finance into a soufflé, banks ballooned the world derivative trade to several hundred trillion dollars (note: trillion, not billion,). This expansion was (and continues to be) hugely profitable for banks. They lent money to a mortgage lender (mortgage companies such as New Century were not banks themselves; they needed a bank to fund loans). Commercial banks also lent to investment banks (such as Lehman Brothers), which then funded mortgage lenders.
The next step was for New Century to ship mortgages en masse to Lehman Brothers, Citigroup or any of the other too-big-to-fail banks. The banks then packaged several thousand home loans into an asset-backed security (ABS). This mortgage derivative was then sold to an investment manager. Despite talk today about the danger of derivatives, banks still are not required to hold one penny of reserves against these rumbling volcanoes.
Such relatively unimportant subjects as bank bonuses fill the air while the lethal state of finance is left to boil over.
Barclays proposes that aging demographics will reduce the number of bubbles in the years ahead. With this misdiagnosis, and central banks printing away, and without any apparent intention to tighten reserve requirements, we need to look elsewhere for a seer.
Sam Zell, who sold his property kingdom for $39 billion in 2006, sent out a holiday present to friends in 2005. He prefaced the theme of his gift: “The enormous monetization of hard assets has created a massive amount of liquidity….Together with [the rising demand for income in the developed world], these factors…are reducing the relative expectations on equity….”
A large part of the monetization Zell spoke of is the derivatives market: the ability of a bank to collect almost any object or receivable, securitize it, then sell it. A home loan or funeral-parlor receivable no longer sits on a bank’s books. It whirs its way to a pension fund manager’s portfolio, in the form of a derivative, where it may be leveraged (from credit originally lent by a commercial bank), then traded again, and possibly rolled into an even more leveraged and even more profitable derivative.
Zell’s holiday present included a song, the lyrics set to the tune of “Raindrops Keep Falling on My Head.”
It opened:
“Capital is raining on my head.
Everything is liquid, we're awash with cash to spend
The flood has drowned returns,
'Cause assets keep liquefying, monetizing, raining...
So I just did me some Econ 101
Seems like we've gotten out of
Equilibrium:
Liquidity abounds,
But relative yields keep falling as capital keeps raining….”
This basic “Econ 101” lesson is not part of the American college curriculum. As Federal Reserve chairman, Alan Greenspan never mentioned the possibility of too much credit creation. As a private citizen prior in 1959, Greenspan clearly understood the phenomenon. He explained to the New York Times: “[Greenspan’s] general conclusion was that instability of the general economy results from the flexibility of the banking system, which supplies credit for the stock market.” And sometimes, too much credit.
The current Federal Reserve chairman, Ben Bernanke, has never mentioned excess credit either. Unlike Greenspan, he probably never has nor will comprehend it. Thus, as long as he is chairman, Bernanke will continue to think he is solving a problem. Later in his song, Sam Zell explained the consequences of the current Fed chairman’s ignorance:
“The world is monetizing faster every day,
Illiquid assets alchemized
To currency in play
Competing for return.
Black gold prices rising, still more money chasing assets...
And this is one thing I know
To get things back to normal.
It's a long haul
That's global.
Yields won't improve 'til growth soaks up this liquid free fall….”
The consequence? Bubbles (if that’s the right word, it’s been so overused) and crashes galore, whether the average age of the population is 10 or 90. If it’s 10, too much money and credit will boost bubble gum prices to $100 a pack. If it’s 90, Lawrence Welk DVDs will sell for $1,000 apiece. Since the median age is in between, it may be the prices of stocks, gold, barbequed chicken, or parking tickets that rise.
It is difficult to know what and when but this much is simple: when the amount of money and credit produced exceeds the needs of the real, non-financial economy, these excess claims on goods and services cause price distortions. Some pockets of prices inflate while others deflate (since overinvestment in an area causes widespread losses, credit write-offs, and fire sales).
Whatever the case, it will be very difficult for the real return on investments to keep up with rising prices of necessities.
The final lines from Sam Zell’s warning:
“It's going to be a long time 'til returns meet expectations,
We need to be prepared for slim annuities…."
We can thank our central bankers for this future and their camp followers who make it so difficult for the average person to understand his own predicament.
Friday, February 19, 2010
Miami’s Municipal Woes (Again): Exiting Before the Tide Goes Out
Frederick 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).
“Miami's tradition of unruly official behavior is finally bringing painful consequences. After years of reckless financial management and a bribery scandal that produced federal charges against three top city officials, South Florida's largest city stands on the edge of bankruptcy.”
-Time, December 16, 1996, “Gloom Over Miami”
The odor from low tides is often strongest near mud flats. Credit bubbles are similarly disposed. During the high tide of the telecom boom, Global Crossing and WorldCom borrowed with abandon. When revenues did not rise to cover borrowing costs, their lamentable accounting practices smelled like a clam digger’s paradise.
The municipal borrowing boom of the past decade is no different. States and municipalities borrowed $137 billion in 2003 and $215 billion in 2007. This scramble in itself was enough to cause concern. These were flush times. Tax receipts by states and local governments rose from $975 billion in 2003 to $1,304 trillion in 2007. (See The Coming Collapse of the Municipal Bond Market in the Articles section of the Aucontrarian.com website for details.) Municipalities were borrowing at record levels when taxes were producing a flood tide of revenues.
This indicates mismanagement on a broad scale. The municipal bond holder might look at the telecommunications boom for similarities. The great telecom scramble in the 1990s ended after the millennium in a bad stench of bankruptcy, fraud, prison terms and the demise of one accounting firm (Arthur Anderson) that abetted these scandals.
Gary Winnick founded Global Crossing in 1997. He had no technology background. Winnick watched a video to learn how to lay cable. He was a good enough salesman (having developed his techniques with Michael Milken at the latter’s famous x-shaped trading desk at Drexel, Burnham, Lambert) to raise billions of dollars. He intended to build 71,000 miles of undersea, high-speed, fiber-optic cable, linking 159 cities in 19 countries and able to reach 85% of the world’s telecom market. According to Forbes magazine, Winnick made a billion dollars – for himself – in 18 months. Global Crossing filed for bankruptcy in 2002.
Bernie Ebbers was chosen as WorldCom’s CEO in 1985. The company was called Long Distance Discount Services, Inc. (LDDS), with headquarters in Hattiesburg, Mississippi. Ebbers was not much of a technology whiz either. At his trial in 2005, Ebbers told the courtroom: "I don't know technology and engineering. I don't know accounting.”
Ebbers spent money faster than he could raise it (a trait of soon-to-be-busted municipalities). An abbreviated list of the WorldCom family is a short tour through the 1990s. It bought Advanced Communications Corp. (1992), Metromedia Communication Corporation (1993), IDB Communications Group, Inc (1994), Williams Technology Group, Inc. (1995), MFS Communications Company (1996), UUNet Technologies, Inc., (1996), CompuServe (1997), and then the largest combination in U.S. corporate history ($37 billion) when it merged with MCI in 1997. It became the United States’ second biggest long distance telephone company (after AT&T).
WorldCom filed for bankruptcy in 2002. It is probably of little solace to investors that Ebbers is serving a 25-year jail term. Arthur Anderson, its accounting firm, a pillar of American corporate respectability, dismissed its 28,000 employees in 2002 as revelations of accounting fraud at WorldCom, Global Crossing, and Enron ruined the century-old company’s credibility.
The high tide of municipal finance is retreating. Occasional whiffs of the mud flats are drifting ashore. The Securities and Exchange Corporation (SEC) is probing the City of Miami’s “major bond offerings between 2006 and 2009 and questionable financial transfers to balance the budget.”
Continuing with the Miami Herald’s summary, the hometown newspaper reminded readers of its own investigation in July 2009 that unearthed “the root causes of an emerging financial meltdown [that] focused on a series of questionable money transfers from capital-project accounts to the general fund.”
Many bond investors rely upon rating agency evaluations. Given the agencies’ recent follies, there is already a degree of risk linked to this approach. (Many fund managers who bought WorldCom stock relied on the rating agencies and on Wall Street “buy” recommendations.) The Miami Herald ratchets up the risk profile: “[T]he SEC is exploring whether the city misrepresented its true financial condition when [the agencies examined the city’s books before the city] went to market to float bonds for major projects.”
The regrettable behavior has its precedents. In 1996, Miami suffered a fiscal crisis when the city “tried to hide a $68 million shortfall by shifting money between hundreds of capital accounts.” In January 2010, “Miami leaders are already projecting a $45 million budget shortfall this year that could force the city to deplete its reserves and sell key assets to stay afloat.” (Miami Herald, January 31, 2010)
This shell game seems to be in the municipal handbook. In When America Aged, Roger Lowenstein described the City of San Diego’s accounting manipulations in the mid-1990s. They were orchestrated by city manager Jack McCrery: “He moved expenses around, shifted personnel, offset one account against another. A favorite McCrery tactic was to charge the water or sewer departments for laying pipes under city streets, which effectively transferred costs from the general fund to water and sewer (which had the power to assess fees). [City of San Diego] council members complained they didn’t understand his machinations, that he never explained the budget… but the truth was they were happier not knowing what McCrery was up to.”
This happy ignorance is by no means a preserve of municipal fiduciaries. The Ebbers’ defense (“I don't know accounting”) will be a common excuse when state and city finances unravel. Recently, the star-studded and highly compensated Citigroup board was not familiar with SIVs or CDOs when it mattered, and sat by as Citi’s stock fell over 95% between 2007 and 2009.
If all goes well, municipal bond holders receive 4% non-taxable interest payments. It might be worth foregoing this coupon income until the tide starts to rise again. Zero percent (in Bernanke-starved money market funds) is better than a 20% loss.
“Miami's tradition of unruly official behavior is finally bringing painful consequences. After years of reckless financial management and a bribery scandal that produced federal charges against three top city officials, South Florida's largest city stands on the edge of bankruptcy.”
-Time, December 16, 1996, “Gloom Over Miami”
The odor from low tides is often strongest near mud flats. Credit bubbles are similarly disposed. During the high tide of the telecom boom, Global Crossing and WorldCom borrowed with abandon. When revenues did not rise to cover borrowing costs, their lamentable accounting practices smelled like a clam digger’s paradise.
The municipal borrowing boom of the past decade is no different. States and municipalities borrowed $137 billion in 2003 and $215 billion in 2007. This scramble in itself was enough to cause concern. These were flush times. Tax receipts by states and local governments rose from $975 billion in 2003 to $1,304 trillion in 2007. (See The Coming Collapse of the Municipal Bond Market in the Articles section of the Aucontrarian.com website for details.) Municipalities were borrowing at record levels when taxes were producing a flood tide of revenues.
This indicates mismanagement on a broad scale. The municipal bond holder might look at the telecommunications boom for similarities. The great telecom scramble in the 1990s ended after the millennium in a bad stench of bankruptcy, fraud, prison terms and the demise of one accounting firm (Arthur Anderson) that abetted these scandals.
Gary Winnick founded Global Crossing in 1997. He had no technology background. Winnick watched a video to learn how to lay cable. He was a good enough salesman (having developed his techniques with Michael Milken at the latter’s famous x-shaped trading desk at Drexel, Burnham, Lambert) to raise billions of dollars. He intended to build 71,000 miles of undersea, high-speed, fiber-optic cable, linking 159 cities in 19 countries and able to reach 85% of the world’s telecom market. According to Forbes magazine, Winnick made a billion dollars – for himself – in 18 months. Global Crossing filed for bankruptcy in 2002.
Bernie Ebbers was chosen as WorldCom’s CEO in 1985. The company was called Long Distance Discount Services, Inc. (LDDS), with headquarters in Hattiesburg, Mississippi. Ebbers was not much of a technology whiz either. At his trial in 2005, Ebbers told the courtroom: "I don't know technology and engineering. I don't know accounting.”
Ebbers spent money faster than he could raise it (a trait of soon-to-be-busted municipalities). An abbreviated list of the WorldCom family is a short tour through the 1990s. It bought Advanced Communications Corp. (1992), Metromedia Communication Corporation (1993), IDB Communications Group, Inc (1994), Williams Technology Group, Inc. (1995), MFS Communications Company (1996), UUNet Technologies, Inc., (1996), CompuServe (1997), and then the largest combination in U.S. corporate history ($37 billion) when it merged with MCI in 1997. It became the United States’ second biggest long distance telephone company (after AT&T).
WorldCom filed for bankruptcy in 2002. It is probably of little solace to investors that Ebbers is serving a 25-year jail term. Arthur Anderson, its accounting firm, a pillar of American corporate respectability, dismissed its 28,000 employees in 2002 as revelations of accounting fraud at WorldCom, Global Crossing, and Enron ruined the century-old company’s credibility.
The high tide of municipal finance is retreating. Occasional whiffs of the mud flats are drifting ashore. The Securities and Exchange Corporation (SEC) is probing the City of Miami’s “major bond offerings between 2006 and 2009 and questionable financial transfers to balance the budget.”
Continuing with the Miami Herald’s summary, the hometown newspaper reminded readers of its own investigation in July 2009 that unearthed “the root causes of an emerging financial meltdown [that] focused on a series of questionable money transfers from capital-project accounts to the general fund.”
Many bond investors rely upon rating agency evaluations. Given the agencies’ recent follies, there is already a degree of risk linked to this approach. (Many fund managers who bought WorldCom stock relied on the rating agencies and on Wall Street “buy” recommendations.) The Miami Herald ratchets up the risk profile: “[T]he SEC is exploring whether the city misrepresented its true financial condition when [the agencies examined the city’s books before the city] went to market to float bonds for major projects.”
The regrettable behavior has its precedents. In 1996, Miami suffered a fiscal crisis when the city “tried to hide a $68 million shortfall by shifting money between hundreds of capital accounts.” In January 2010, “Miami leaders are already projecting a $45 million budget shortfall this year that could force the city to deplete its reserves and sell key assets to stay afloat.” (Miami Herald, January 31, 2010)
This shell game seems to be in the municipal handbook. In When America Aged, Roger Lowenstein described the City of San Diego’s accounting manipulations in the mid-1990s. They were orchestrated by city manager Jack McCrery: “He moved expenses around, shifted personnel, offset one account against another. A favorite McCrery tactic was to charge the water or sewer departments for laying pipes under city streets, which effectively transferred costs from the general fund to water and sewer (which had the power to assess fees). [City of San Diego] council members complained they didn’t understand his machinations, that he never explained the budget… but the truth was they were happier not knowing what McCrery was up to.”
This happy ignorance is by no means a preserve of municipal fiduciaries. The Ebbers’ defense (“I don't know accounting”) will be a common excuse when state and city finances unravel. Recently, the star-studded and highly compensated Citigroup board was not familiar with SIVs or CDOs when it mattered, and sat by as Citi’s stock fell over 95% between 2007 and 2009.
If all goes well, municipal bond holders receive 4% non-taxable interest payments. It might be worth foregoing this coupon income until the tide starts to rise again. Zero percent (in Bernanke-starved money market funds) is better than a 20% loss.
Thursday, February 11, 2010
Alan Greenspan: Party Boy
Frederick 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).
“It's important to remember that equity values, stock prices, are not just paper profits. They actually have a profoundly important impact on economic activity. And if stock prices start continuing down, I would get very concerned.”
-Former Federal Reserve Chairman Alan Greenspan, Meet the Press, February 7, 2010
Alan Greenspan is as confused in retirement as when he ran the Fed. Most mortals, quoted as often as Greenspan, would justifiably worry such contradictions of past contentions would ricochet around the media. Vice President Dan Quayle made front page news when he misspelled “potato.” This is the sort of trivial mistake the media can grasp, or, all it thinks its audience can understand.
Alan Greenspan’s about-face on the Fed’s capacity to battle stock market bubbles cost investors several trillion dollars, yet he remains a fixture on the Washington party circuit (Fortune, February 5, 2010). He can say whatever comes into his head since he is still feted by those who matter. He talks on Meet the Press (where he was deferentially addressed as “Dr. Greenspan”) and collects large fees as a dinner speaker.
Like Ted Williams’ head, Alan Greenspan’s reputation is frozen. The skull of the baseball great (Williams) was set in ice when he died. It is to come alive a century from now (or, something equally peculiar is promised). Likewise, Alan Greenspan’s foibles have been frozen into a series of clichés designed to leave the party circuit undisturbed.
The former chairman’s battered legacy actually flatters the man: his errors were “idealistic.” So, have another drink, Alan. We’re all idealistic in Washington. (Ayn Rand asked a half-century back: “Do you think Alan might basically be a social climber?”)
The banks take the blame. They deserve it, but financial firms are more a symptom than a source. The bank cliché is convenient for both politicians and the most malignant contributor to our national woes, the Federal Reserve.
Worse though, than the money lost in the stock market debacle, is the lost decade (and counting). After the stock market burst, Chairman Greenspan attempted to reflate the economy with his one-percent, adjustable-rate mortgage bubble. The consequences need no comment.
The most scandalous aspect of Greenspan’s declaration on Meet the Press last weekend is not that he denied the link between the stock market and the economy when he was Fed chairman (in 1999). Far worse is that long before 1999, he had consistently emphasized the link. His contortions can be seen in a three-act sequence:
Act #1: When Greenspan knew a plunging stock market could sink an economy.
December 28, 1959, in the New York Times, Alan Greenspan explained “that a break in stock market trends was not just a harbinger of boom or recession, as is commonly held, but a crucial factor in causing a boom or a recession.”
March 1959, in Fortune magazine: “[O]ver-confidence finds exuberant expression in a bull stock market…. Once stock prices reach the point at which it is hard to value them by any logical methodology, [Greenspan] warns, stocks will be bought, as they were in the late-1920’s – not for investment but to be unloaded at a still higher price. The ensuing break could be disastrous.”
March 28, 1995, at a Federal Reserve Open Market Committee (FOMC) meeting – GREENSPAN: “I think the downside risks [to the economy] are basically coming from the possibility of significant increases in stock and bond prices…..Ironically, the real danger is that things may get too good. When things get too good, human beings behave awfully."
STAGE NOTE: By 1996, fears were rising of a stock market bubble. The Wall Street Journal wrote on November 25, 1996: “Federal Reserve Board Chairman Greenspan isn't talking about the stock market these days. In fact, the word among Fed officials is: don't use the word ‘stock’ and ‘market’ in the same sentence. No one wants the blame for the crash.”
Greenspan gave his famous “irrational exuberance” speech (regarding the stock market) on December 5, 1996. He testified before Congress and the Senate in early 1997, warning both bodies (in his way) of the stock market bubble. The congressmen and the senators told him to mind his own business. He never discussed the bubble again in public, and even forbid the FOMC from talking about it in 1998.
Greenspan then hid in his own bubble.
Act #2: Greenspan couldn’t see bubbles and they might not matter anyway.
It was on June 17, 1999, that the Federal Reserve chairman unveiled his thesis: that the Federal Reserve could not identify a bubble ahead of time and it would therefore make no attempt to do so. This was entirely new and near the peak of the greatest stock market bubble of all time.
(FLASHBACK – FOMC meeting on September 24, 1996 – GREENSPAN: “I recognize that there is a stock market bubble problem at this point....We do have the possibility of raising major concerns by increasing margin requirements. I guarantee that if you want to get rid of the bubble, whatever it is, that will do it.”)
In his June 1999 testimony before Congress, he told Congress don’t worry, be happy:
“While bubbles that burst are scarcely benign, the consequences need not be catastrophic for the economy…. while the stock market crash of 1929 was destabilizing, most analysts attribute the Great Depression to ensuing failures of policy.” (Note: Greenspan had never before attributed the Depression to ensuing policy failures. For instance, see his interview with Fortune above).
The chairman’s contention became known as The Greenspan Doctrine in the media and among so-called economists. With little rebuttal, he contributed addenda to his Doctrine, such as in 2002, when he added a footnote to a speech in Jackson Hole, Wyoming. Discussing the aftermath of the 1987 stock-market crash: “[I]n line with later episodes, the failure of the collapse to have an economic impact seems to have contributed to subsequent higher stock prices.” According to this wrinkle, stock market crashes are good for stock prices. (The footnotes to Federal Reserve governor speeches contain amazing contentions.)
Act #3: Greenspan warns stock market bubbles can cripple an economy.
SETTING: Alan Greenspan retired from the Federal Reserve in early 2006. Among other post-retirement warnings that the stock market and the economy are Siamese twins:
Interview with Reuters, September 30, 2007: "[U]nless stock prices resume their pace of increase of earlier this year, U.S. consumer spending and GDP will be under pressure from declining household wealth."
Again, Meet the Press, February 7, 2010: “It's important to remember that equity values, stock prices, are not just paper profits. They actually have a profoundly important impact on economic activity. And if stock prices start continuing down, I would get very concerned.”
Why is he still on TV?
Whether it is appropriate to invite Greenspan on television is for the media to decide. More of a muddle is why he still attracts an audience. He is as consistently wrong as during his Fed chairmanship.
In October 2006, Greenspan claimed: “Most of the negatives in housing are probably behind us. It's taking less out of the economy."
On February 7, 2010, he told Meet the Press: “I don’t think [home prices will] decline from here. In other words, they seem to be bottoming out.”
On the same day, he also told Meet the Press: “The recession is over.”
Look out below.
Frederick Sheehan writes a blog at Aucontrarian.com
“It's important to remember that equity values, stock prices, are not just paper profits. They actually have a profoundly important impact on economic activity. And if stock prices start continuing down, I would get very concerned.”
-Former Federal Reserve Chairman Alan Greenspan, Meet the Press, February 7, 2010
Alan Greenspan is as confused in retirement as when he ran the Fed. Most mortals, quoted as often as Greenspan, would justifiably worry such contradictions of past contentions would ricochet around the media. Vice President Dan Quayle made front page news when he misspelled “potato.” This is the sort of trivial mistake the media can grasp, or, all it thinks its audience can understand.
Alan Greenspan’s about-face on the Fed’s capacity to battle stock market bubbles cost investors several trillion dollars, yet he remains a fixture on the Washington party circuit (Fortune, February 5, 2010). He can say whatever comes into his head since he is still feted by those who matter. He talks on Meet the Press (where he was deferentially addressed as “Dr. Greenspan”) and collects large fees as a dinner speaker.
Like Ted Williams’ head, Alan Greenspan’s reputation is frozen. The skull of the baseball great (Williams) was set in ice when he died. It is to come alive a century from now (or, something equally peculiar is promised). Likewise, Alan Greenspan’s foibles have been frozen into a series of clichés designed to leave the party circuit undisturbed.
The former chairman’s battered legacy actually flatters the man: his errors were “idealistic.” So, have another drink, Alan. We’re all idealistic in Washington. (Ayn Rand asked a half-century back: “Do you think Alan might basically be a social climber?”)
The banks take the blame. They deserve it, but financial firms are more a symptom than a source. The bank cliché is convenient for both politicians and the most malignant contributor to our national woes, the Federal Reserve.
Worse though, than the money lost in the stock market debacle, is the lost decade (and counting). After the stock market burst, Chairman Greenspan attempted to reflate the economy with his one-percent, adjustable-rate mortgage bubble. The consequences need no comment.
The most scandalous aspect of Greenspan’s declaration on Meet the Press last weekend is not that he denied the link between the stock market and the economy when he was Fed chairman (in 1999). Far worse is that long before 1999, he had consistently emphasized the link. His contortions can be seen in a three-act sequence:
Act #1: When Greenspan knew a plunging stock market could sink an economy.
December 28, 1959, in the New York Times, Alan Greenspan explained “that a break in stock market trends was not just a harbinger of boom or recession, as is commonly held, but a crucial factor in causing a boom or a recession.”
March 1959, in Fortune magazine: “[O]ver-confidence finds exuberant expression in a bull stock market…. Once stock prices reach the point at which it is hard to value them by any logical methodology, [Greenspan] warns, stocks will be bought, as they were in the late-1920’s – not for investment but to be unloaded at a still higher price. The ensuing break could be disastrous.”
March 28, 1995, at a Federal Reserve Open Market Committee (FOMC) meeting – GREENSPAN: “I think the downside risks [to the economy] are basically coming from the possibility of significant increases in stock and bond prices…..Ironically, the real danger is that things may get too good. When things get too good, human beings behave awfully."
STAGE NOTE: By 1996, fears were rising of a stock market bubble. The Wall Street Journal wrote on November 25, 1996: “Federal Reserve Board Chairman Greenspan isn't talking about the stock market these days. In fact, the word among Fed officials is: don't use the word ‘stock’ and ‘market’ in the same sentence. No one wants the blame for the crash.”
Greenspan gave his famous “irrational exuberance” speech (regarding the stock market) on December 5, 1996. He testified before Congress and the Senate in early 1997, warning both bodies (in his way) of the stock market bubble. The congressmen and the senators told him to mind his own business. He never discussed the bubble again in public, and even forbid the FOMC from talking about it in 1998.
Greenspan then hid in his own bubble.
Act #2: Greenspan couldn’t see bubbles and they might not matter anyway.
It was on June 17, 1999, that the Federal Reserve chairman unveiled his thesis: that the Federal Reserve could not identify a bubble ahead of time and it would therefore make no attempt to do so. This was entirely new and near the peak of the greatest stock market bubble of all time.
(FLASHBACK – FOMC meeting on September 24, 1996 – GREENSPAN: “I recognize that there is a stock market bubble problem at this point....We do have the possibility of raising major concerns by increasing margin requirements. I guarantee that if you want to get rid of the bubble, whatever it is, that will do it.”)
In his June 1999 testimony before Congress, he told Congress don’t worry, be happy:
“While bubbles that burst are scarcely benign, the consequences need not be catastrophic for the economy…. while the stock market crash of 1929 was destabilizing, most analysts attribute the Great Depression to ensuing failures of policy.” (Note: Greenspan had never before attributed the Depression to ensuing policy failures. For instance, see his interview with Fortune above).
The chairman’s contention became known as The Greenspan Doctrine in the media and among so-called economists. With little rebuttal, he contributed addenda to his Doctrine, such as in 2002, when he added a footnote to a speech in Jackson Hole, Wyoming. Discussing the aftermath of the 1987 stock-market crash: “[I]n line with later episodes, the failure of the collapse to have an economic impact seems to have contributed to subsequent higher stock prices.” According to this wrinkle, stock market crashes are good for stock prices. (The footnotes to Federal Reserve governor speeches contain amazing contentions.)
Act #3: Greenspan warns stock market bubbles can cripple an economy.
SETTING: Alan Greenspan retired from the Federal Reserve in early 2006. Among other post-retirement warnings that the stock market and the economy are Siamese twins:
Interview with Reuters, September 30, 2007: "[U]nless stock prices resume their pace of increase of earlier this year, U.S. consumer spending and GDP will be under pressure from declining household wealth."
Again, Meet the Press, February 7, 2010: “It's important to remember that equity values, stock prices, are not just paper profits. They actually have a profoundly important impact on economic activity. And if stock prices start continuing down, I would get very concerned.”
Why is he still on TV?
Whether it is appropriate to invite Greenspan on television is for the media to decide. More of a muddle is why he still attracts an audience. He is as consistently wrong as during his Fed chairmanship.
In October 2006, Greenspan claimed: “Most of the negatives in housing are probably behind us. It's taking less out of the economy."
On February 7, 2010, he told Meet the Press: “I don’t think [home prices will] decline from here. In other words, they seem to be bottoming out.”
On the same day, he also told Meet the Press: “The recession is over.”
Look out below.
Frederick Sheehan writes a blog at Aucontrarian.com
Friday, February 5, 2010
Ben Bernanke: The Very Model of a Modern Pliant Bureaucrat
Frederick 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).
Federal Reserve Chairman Ben S. Bernanke was a safe bet to win the Senate’s vote for a second term. “Safe” is what the senators want and Bernanke passed the test. He is not a man inclined to make bold decisions. A former university administrator, his institutional mind will be just as slow to foresee the next financial crisis as it was incapable of forecasting the last.
Despite obvious signs the financial system was about to burst, Congress had no desire to touch Fannie Mae, Freddie Mac, and the banks’ expanding mortgage securitization machine (i.e., derivatives), that made Washington and Wall Street so rich.
Having replaced Alan Greenspan as chairman on February 1, 2006, Bernanke performed according to script. He dismissed the worrywarts. In June 2006, Chairman Bernanke told an International Monetary Fund (IMF) gathering: “[O]ur banks are well capitalized and willing to lend.” In the same month, he stamped his imprimatur on the most destitute sector of the economy: “U.S. households overall have been managing their personal finances well.” In November 2006, he calmed fears about subprime lending. Before an audience promoting community development, Bernanke celebrated the rise of subprime mortgages: from only 5 percent of the market in 1995, 20 percent of new mortgage loans were subprime by 2005. (He did advise “greater financial literacy” for “borrowers with lower incomes and education levels.”)
In May 2007, Chairman Bernanke gave an appraisal one expects from a short-sighted bureaucrat: “[W]e believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.”
Bernanke’s specialty is organization. Filing subprime mortgages into a manila folder appealed to the chairman’s tidy mind. John Cassidy discussed Bernanke’s strength in the New Yorker: “In 1996, Bernanke became chairman of the Princeton economics department, a job many professors regard as a dull administrative diversion from their real work. Bernanke, however, embraced the chairmanship…. [Bernanke] bridged a long-standing departmental divide between theorists and applied researchers….” A colleague explained Bernanke’s considerable skill: “Ben is very good at… giving people the feeling they have been heard in the debate….”
Bernanke gives senators the same feeling (with some admirable exceptions, who know Bernanke’s cordial and vague representations are a variant on his predecessor’s, Alan Greenspan). The IMF did not want to hear America’s banks were undercapitalized. The community developers did not want to know subprime lending was an odious racket that was bound to topple. The nation’s most revered economist assured audiences that all was fine.
On December 3, 2009, the Senate Banking Committee held a reconfirmation hearing (prior to the full Senate voting on Bernanke’s second term). The Fed chairman was given great credit for leading the nation through the recent financial crisis. Committee members congratulated Chairman Bernanke for his brilliant restoration of the U.S. financial system.
He was reprimanded, however, for not anticipating the crisis and expressed requisite contrition. Bernanke thought banks should have held more capital and that the banking system had not employed adequate risk management controls. Committee members nodded in solemn agreement.
In truth, the too-big-to-fail banks are bigger, more unstable, and even more undercapitalized than before the bubble burst in 2007. As for risk management tools, Bernanke is full of talk but has done nothing to restrain either the growth of derivatives or to require reserves be held against derivative exposure.
At the December 3 hearing, the Fed chairman stated that he did not see any asset bubbles emerging. This seemed to reassure the senators who ignored the fatuity of even asking his opinion given that he thought banks were well-capitalized in 2006 and did not see the housing bubble.
As night follows day, Bernanke ignores a signal akin to one the derivative markets offered ahead of the 2007 meltdown. Then, there were wide expectations of loan defaults. Investors hedged this risk in the credit-default swap (CDS) market. The CDS market grew from $14 trillion to $42 trillion from January 2006 to June 30, 2007. Any line of business growing at such a rate should alarm bank regulators.
Ben Bernanke, the nation’s leading bank regulator, did not understand that banks could not honor trillions of dollars of claims once the defaults occurred. It was the CDS market that left Bear, Stearns; Lehman Brothers; Goldman, Sachs; and AIG either insolvent or close to it.
Today, galloping derivative growth has moved to interest-rate protection. The fear is of a government bond bubble. Ten-year Treasury bonds yield 3.7% during the greatest money-printing experiment in the nation’s history. Investment managers are protecting themselves against a higher 10-year Treasury yield. (With interest-rate derivative contracts, banks will have to pay the purchasers if rates rise to a specified level.)
During the first six months of 2009, the volume of contracts offering protection against rising yields of Treasury bonds with maturities of 5 years or longer rose from $109 trillion to $150 trillion. When rates rise, banks may once again default on their commitments.
Bernanke aims to please. He told the senators in December 2009 a reevaluation of his zero-percent fed funds rate “will require careful analysis and judgment.” The chairman will raise the rate “in a smooth and timely way.” This paralysis to action fits the stereotype of a municipal data-entry clerk. Bernanke certified his tremulous loyalty when he told an audience on November 16: “It is inherently extraordinarily difficult to know whether an asset’s price is in line with its fundamental value…. It’s not obvious to me in any case that there’s any large misalignments currently in the U.S. financial system.”
Only an apparatchik could believe an economy with zero-percent interest rates is in balance. The purchasers of interest-rate protection (which is not cheap) believe differently, but Ben Bernanke is the man for the Senate. The chairman’s mandate for his second term is to ignore the obvious, deflect attention from the megabanks’ inherent instability, and to accept blame for his ignorance after the deluge.
Frederick Sheehan writes a blog at Aucontrarian.com.
Listen to interviews with Frederick Sheehan:
1 - Thursday, February 4, 4:30 – 5 PM EST, on Bloomberg radio with Pimm Fox on his show Taking Stock
2 - Saturday, February 6 with Jim Puplava at Financial Sense. The one hour interview will be posted at 3 PM EST: http://www.financialsense.com/fsn/main.php
3 - Sunday, February 7, 10 -11 AM EST, with Jim Campbell on Yale University radio WYBC – 1340 AM and streaming live at WYBC.com. Simulcast on Yale’s Internet channel: WYBCX.com
Federal Reserve Chairman Ben S. Bernanke was a safe bet to win the Senate’s vote for a second term. “Safe” is what the senators want and Bernanke passed the test. He is not a man inclined to make bold decisions. A former university administrator, his institutional mind will be just as slow to foresee the next financial crisis as it was incapable of forecasting the last.
Despite obvious signs the financial system was about to burst, Congress had no desire to touch Fannie Mae, Freddie Mac, and the banks’ expanding mortgage securitization machine (i.e., derivatives), that made Washington and Wall Street so rich.
Having replaced Alan Greenspan as chairman on February 1, 2006, Bernanke performed according to script. He dismissed the worrywarts. In June 2006, Chairman Bernanke told an International Monetary Fund (IMF) gathering: “[O]ur banks are well capitalized and willing to lend.” In the same month, he stamped his imprimatur on the most destitute sector of the economy: “U.S. households overall have been managing their personal finances well.” In November 2006, he calmed fears about subprime lending. Before an audience promoting community development, Bernanke celebrated the rise of subprime mortgages: from only 5 percent of the market in 1995, 20 percent of new mortgage loans were subprime by 2005. (He did advise “greater financial literacy” for “borrowers with lower incomes and education levels.”)
In May 2007, Chairman Bernanke gave an appraisal one expects from a short-sighted bureaucrat: “[W]e believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.”
Bernanke’s specialty is organization. Filing subprime mortgages into a manila folder appealed to the chairman’s tidy mind. John Cassidy discussed Bernanke’s strength in the New Yorker: “In 1996, Bernanke became chairman of the Princeton economics department, a job many professors regard as a dull administrative diversion from their real work. Bernanke, however, embraced the chairmanship…. [Bernanke] bridged a long-standing departmental divide between theorists and applied researchers….” A colleague explained Bernanke’s considerable skill: “Ben is very good at… giving people the feeling they have been heard in the debate….”
Bernanke gives senators the same feeling (with some admirable exceptions, who know Bernanke’s cordial and vague representations are a variant on his predecessor’s, Alan Greenspan). The IMF did not want to hear America’s banks were undercapitalized. The community developers did not want to know subprime lending was an odious racket that was bound to topple. The nation’s most revered economist assured audiences that all was fine.
On December 3, 2009, the Senate Banking Committee held a reconfirmation hearing (prior to the full Senate voting on Bernanke’s second term). The Fed chairman was given great credit for leading the nation through the recent financial crisis. Committee members congratulated Chairman Bernanke for his brilliant restoration of the U.S. financial system.
He was reprimanded, however, for not anticipating the crisis and expressed requisite contrition. Bernanke thought banks should have held more capital and that the banking system had not employed adequate risk management controls. Committee members nodded in solemn agreement.
In truth, the too-big-to-fail banks are bigger, more unstable, and even more undercapitalized than before the bubble burst in 2007. As for risk management tools, Bernanke is full of talk but has done nothing to restrain either the growth of derivatives or to require reserves be held against derivative exposure.
At the December 3 hearing, the Fed chairman stated that he did not see any asset bubbles emerging. This seemed to reassure the senators who ignored the fatuity of even asking his opinion given that he thought banks were well-capitalized in 2006 and did not see the housing bubble.
As night follows day, Bernanke ignores a signal akin to one the derivative markets offered ahead of the 2007 meltdown. Then, there were wide expectations of loan defaults. Investors hedged this risk in the credit-default swap (CDS) market. The CDS market grew from $14 trillion to $42 trillion from January 2006 to June 30, 2007. Any line of business growing at such a rate should alarm bank regulators.
Ben Bernanke, the nation’s leading bank regulator, did not understand that banks could not honor trillions of dollars of claims once the defaults occurred. It was the CDS market that left Bear, Stearns; Lehman Brothers; Goldman, Sachs; and AIG either insolvent or close to it.
Today, galloping derivative growth has moved to interest-rate protection. The fear is of a government bond bubble. Ten-year Treasury bonds yield 3.7% during the greatest money-printing experiment in the nation’s history. Investment managers are protecting themselves against a higher 10-year Treasury yield. (With interest-rate derivative contracts, banks will have to pay the purchasers if rates rise to a specified level.)
During the first six months of 2009, the volume of contracts offering protection against rising yields of Treasury bonds with maturities of 5 years or longer rose from $109 trillion to $150 trillion. When rates rise, banks may once again default on their commitments.
Bernanke aims to please. He told the senators in December 2009 a reevaluation of his zero-percent fed funds rate “will require careful analysis and judgment.” The chairman will raise the rate “in a smooth and timely way.” This paralysis to action fits the stereotype of a municipal data-entry clerk. Bernanke certified his tremulous loyalty when he told an audience on November 16: “It is inherently extraordinarily difficult to know whether an asset’s price is in line with its fundamental value…. It’s not obvious to me in any case that there’s any large misalignments currently in the U.S. financial system.”
Only an apparatchik could believe an economy with zero-percent interest rates is in balance. The purchasers of interest-rate protection (which is not cheap) believe differently, but Ben Bernanke is the man for the Senate. The chairman’s mandate for his second term is to ignore the obvious, deflect attention from the megabanks’ inherent instability, and to accept blame for his ignorance after the deluge.
Frederick Sheehan writes a blog at Aucontrarian.com.
Listen to interviews with Frederick Sheehan:
1 - Thursday, February 4, 4:30 – 5 PM EST, on Bloomberg radio with Pimm Fox on his show Taking Stock
2 - Saturday, February 6 with Jim Puplava at Financial Sense. The one hour interview will be posted at 3 PM EST: http://www.financialsense.com/fsn/main.php
3 - Sunday, February 7, 10 -11 AM EST, with Jim Campbell on Yale University radio WYBC – 1340 AM and streaming live at WYBC.com. Simulcast on Yale’s Internet channel: WYBCX.com
Subscribe to:
Posts (Atom)
Posts
