Another Go

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession  (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (Aucontrarian.com, 2009)

Advocates for Federal Reserve disclosure harp on the five-year wait for FOMC transcripts. The reasoning goes that institutions in a democracy should be more democratic: let the people know what the Fed plots behind closed doors. The question arises: to what end?

            The 2008 transcripts were released in late-February. Most media operations published stories about the Fed's absent-minded professors who missed the importance of failing financial institutions during 2008. This was not news. That has been described over the past five years, among other places, in Panderer to Power. The release, however, was an opportunity to remind investors, retirees, florists, and students receiving government financing of their precarious state.

Now, the story of the 2008 transcripts has died, without much in the way of help to the bewildered. Granted, bewilderment is the general state of affairs today, whether at the FOMC, among the media, the people, and those who cannot understand how such as state-of-affairs continues. Nevertheless, the opportunity exists to elevate comprehension. This was the goal in"Those FOMC Transcripts: Watch Out Below," (February 26, 2014). The effort continues, here, to describe how the whirlwind of noise escaping the Eccles Building reflected through the self-serving interpretations of the Wall Street experts is so perilous. 

 

  From the March 3, 2014, King Report: "Due to quivering Fed officials' incessant assertions that the Fed would halt or even reverse QE tapering if economic conditions warrant, an increasing universe of investors and traders see little or no downside equity risk."

There we have the reason various U.S. stock indices alternately hit all-time highs. We should not need The Charge of the Light Brigade to worry investors. The February 21, 2014, issue of Grant's Interest Rate Observer includes a front-page reminder that pre-tax profits of U.S. corporations as a percentage of G.D.P. are the highest since records began in 1946; after 382 of the S&P 500 reported fourth quarter results, average year-on-year gain on profit has been 10.7%; of the same cohort, revenue growth has been 0.7%. Presumably, these are not adjusted for price inflation which is currently raging in the United States, all claims to the contrary deserving ridicule.

At the September 16, 2008, FOMC meeting, Chairman Ben S. Bernanke was not blind to financial woes. He declared: "Conditions clearly have worsened recently, despite the rescue of the GSEs, the latest stressor being the bankruptcy of Lehman Brothers and other factors such as AIG." He did not stop there, acknowledging "[a]lmost all financial institutions are facing significant stress, particularly difficulties in raising capital, and credit quality is problematic, particularly in residential areas."

Nevertheless, Bernanke was not troubled. He concluded this discourse by opining: "We may have to wait for some time to get clarity of the last week or so." As discussed in my first go at the 2008 transcripts, the FOMC voted to sit still, voting unanimously to keep the fed funds rate at 2.0%. The reason for such repose is the central-banking fable that finance can be ignored; its Dynamic Stochastic General Equilibrium model will produce a monetary solution to address a dyspeptic stock market or a dollar meltdown.

In the same discussion as quoted above, Chairman Ben said: "We have been debating around this table for quite awhile what the right indicator of monetary policy is." He mentioned some proposed numbers, but, in any case: "I think the only answer is that the right measure is contingent on a model." And: "[Y]ou have to have a model."

(On a different topic, unrelated to the main discussion here, Simple Ben declared: "The ideal way to deal with moral hazard is a well-developed structure that gives clear indications.... We have found ourselves in this episode in a situation in which events are happening quickly, and we don't have those things in place." He had been Fed chairman for almost three years yet mentions the Fed's negligence in not addressing Too-Big-to-Fail banks as if he forgot to order corn-on-the-cob for the Fed's clambake.)  

This slapdash approach has not changed, is obviously unattached to the real world, and will leave Chairman Yellen helpless the next time markets and financial institutions melt. The otherworldliness of it all is captured in this discussion itself. The world's financial backstop (our man Ben) goes on for several pages at a time when Goldman Sachs and Morgan Stanley could not get funding from a counterparty. This is quite different than at the FOMC meeting on September 29, 1998, after Long-Term Capital Management went belly up. Then-Chairman Alan Greenspan took on a different personality from previous FOMC meetings. He demanded answers to questions about collateral and leverage that made him wonder if modern-day bankers knew what they were doing. (He recovered from this revelatory meeting as soon as LTCM faded, in a sycophantic stunt before the derivatives lobby that pays him so extravagantly today. See pages 189-190 of Panderer to Power. )

Of course, one wants to know: are we up a creek with Chairman Janet Yellen in command? Let us compare and contrast two speeches delivered on February 27, 2014. (I thank Doug Noland, at the Prudent Bear Fund for his transcription of Dr. Issing's comments in Bundesbankification .) 

Otmar Issing, former chief economist of the Bundsebank and ECB, spoke at the Bundesbank Symposium on Financial Stability, in Frankfurt, on February 27. Unlike Bernanke and Yellen, Issing thinks financial bubbles have consequences: "[P]rice stability is not enough. And I think this has dramatic consequences for the conduct of monetary policy. For me, the implication is very clear: policy which relies on a forecast (model) based on a real economy only without a financial sector - without taking into account money and Credit in a sensible way - is not anymore state of the art." Was it ever? Possibly when 59% of American profits came from manufacturing and 9% from finance. That was in 1950.

Issing never made headway during the mortgage madness: "I'm reminded of many, many meetings here or especially in the U.S. with my friends from the Fed. Their reaction was absolutely clear: when I referred to a potential bubble in real estate, what I heard always was 'never in the last 50 years have real estate prices fallen on a nationwide aspect.' For me, this was not a comfort."

He did not stand a chance of making headway with Bernanke and Yellen in 2006 and 2007: "[T]heir reaction to my critique or argument was very relaxed: 'In the meantime, we have had much higher GDP, higher employment, more houses, etc. So compared to the cost of raising interest rates would be much too high - much too high.' I have never seen so far the comparison of the high cost of the mess we are in if we take this 'risk management' approach."

Issing addressed the hostile stupidity of the academics in charge: "I learn that we're allowed to talk of Bubbles now, which was out of the question for a long time in research - "the buildup of Bubbles goes very slowly - softly - but the collapse goes very fast. So it's obvious that that the [central] bank should react in a decisive way one prices collapse." I think Issing may not have ventured to the U.S. lately. The "bubbles do not exist" lobby is pressing its point once again, and, once again, it is from the universities.

Back in Washington, on the same day, Federal Reserve Chairman Janet Yellen talked to the Senators. She is lost in space. A few statements that will not receive interpretation:

"Fiscal policy really has been quite tight and has imposed a substantial drag on spending in the U.S. economy over the last several years..."

"I'm slightly surprised that he [Fed Board Governor Daniel Tarullo] said we are 'nowhere close' [on resolving Too-Big-To-Fail] because I personally think we've made quite a lot of progress in putting in place regulations that will make a huge differences [sic] to this...."

"I agree that an environment of low rates ... and we have had a long period of low interest rates ... can give rise to behavior that poses threats to financial stability and therefore we need to be looking at that very carefully and we are doing so in a very thorough way, I believe."

"Since the financial crisis and the depths of the recession, substantial progress has been made in restoring the economy to health and in strengthening the financial system."

Closing on a higher plane:

Shirley Temple died recently. There have been many accolades but I don't know if the tributes have discussed her admirable character. She serves as a model for children and adults alike.

Her talent was described by Will Friedwald in the Wall Street Journal: "The most obvious thing to remember Shirley Temple for - a point so overwhelming that it barely needs to be stated - is that she was the greatest child star in the history of not just the movies but all of popular culture. No other youngster so dominated the box office and no other individual, other than Franklin D. Roosevelt himself, did more to deliver both Republicans and Democrats alike from the Great Depression. But what isn't said often enough about Shirley Temple Black is that when you compare her to the many dancing ladies in the movies who couldn't really sing (Ginger Rogers, Rita Hayworth, Cyd Charisse) and those terrific singers in films who danced merely passably (Judy Garland, Doris Day), Temple emerges as the major female triple-threat of her era and since. She was a singer of uncommon ability, capable of putting a song over with the best of them in an age when the competition was Al Jolson and Bing Crosby; a dancer worthy of comparison with Fred Astaire, Gene Kelly and even her longtime costar, the great African-American tap dancer Bill "Bojangles" Robinson; and an actress who could break your heart just by looking at you."

She was born with talent; it was her unalloyed resolution that made her an exceptional person. Each morning when she showed up on the set, she knew her lines, her steps, and her songs. This five, six, and seven-year-old girl was angry, joyful, or remorseful when the shooting started. The studio did not require second takes on Shirley Temple's account. It was said her mother pushed her into show business, but such strength is a habit that comes from within. She could have demanded the concessions movie stars are noted for exacting. She never did. Her talent could never have achieved the praise bestowed by Will Friedwald without habits "rooted deep in the whole personality. They have to be cultivated like any other habit, over a long period of time, by experience." (Flannery O'Connor) Few can match her industry, but, as was said above, she is a model of character.

            The actress Louise Brooks wrote: "Anyone who has achieved excellence knows it comes as a result of ceaseless concentration."

It's All in the Flows

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession  (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (Aucontrarian.com, 2009)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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