Wednesday, July 9, 2014

June 2014 - Noise

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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


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

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

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

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

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

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

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

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

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

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

No comments:

Post a Comment