(Reuters) - "Secretary of State Hillary Clinton on Thursday said 'outrageous' advice from former Federal Reserve Chairman Alan Greenspan helped create record U.S. budget deficits that put national security at risk."
-February 25, 2010
Alan Greenspan lamented U.S. budget deficits in the Wall Street Journal on June 18, 2010 ("U.S. Debt and the Greece Analogy"). For an analysis of Greenspan's flapdoodle, Barry Ritholtz covered the turf on his blog, The Big Picture. The former Federal Reserve chairman should have withheld comment, given his personal contribution to the nation's poverty-stricken state.
Testifying before Congress on February 25, 2010, Hillary Clinton bemoaned the advice of Alan Greenspan: "I remember as vividly as if it were yesterday when we had a hearing in which Alan Greenspan came and justified increasing spending and cutting taxes, saying that we didn't really need to pay down the debt -- outrageous in my view." Reuters continued: "Though she did not give a date, that hearing must have taken place during the presidency of George W. Bush...."
If only it were so simple. During his tenure as Fed chairman, Greenspan's budget positions changed more often than the weather. Always the opportunist, his self-serving opinions continue to bend the truth. During the Greenspan Boom, he was awarded the Presidential Medal of Freedom, the Department of Defense Medal for Distinguished Public Service, and the Enron Prize for Distinguished Service. Now, the Secretary of State looks ready to compile a dossier on his activities. The State Department need look no further. A review of his outrageous activities follows.
In February 2000, the last year of the (William Jefferson) Clinton Administration, Greenspan appeared before the Senate Banking Committee. He recommended the government use the federal budget surplus to pay down the national debt. He amplified: "The growth potential of our economy under current circumstances is best served by allowing the unified budget surpluses...to materialize, thereby reduce Treasury debt held by the public." Meaning: we should use surplus dollars collected by the Treasury Department to reduce the federal debt. (The Treasury can use surplus tax dollars to either purchase U.S. Treasury securities or reduce the size of new debt issues.) This fit the politics of the time. President Clinton was not proposing a tax cut.
One year later, Alan Greenspan worked for new management - the Bush Administration. President Bush wanted a tax cut to kick off his presidency. Greenspan marketed the tax cut as fiscally responsible, given recent surpluses. His advice was rendered on January 25, 2001, to the U.S. Senate Committee on the Budget. This was five days after George Bush's inauguration. The Wall Street Journal reported: "Giving a big boost to President Bush, Chairman Alan Greenspan reversed his long-held view and said he now sees room for significant tax cuts in the federal government's financial future.... '[O]ver the coming decade, the latest budget-surplus numbers show not only room for reductions, but even a need.'" The New York Times reported on the same day: "Alan Greenspan, the Federal Reserve chairman, gave his blessing today to a substantial tax cut.... In a clear shift from his previous position that reducing the national debt should be the focus of fiscal policy, Mr. Greenspan said improvements in the economy's long-term potential and the swelling surplus projections had 'reshaped the choices and opportunities before us.'"
In his testimony, Greenspan expressed concern "that continuing to run surpluses beyond the point at which we reach zero or near-zero federal debt brings to center stage the critical longer-term fiscal policy issue of whether the federal government should accumulate large quantities of private (more technically nonfederal) assets." [Greenspan's parenthesis.]
Here, the Fed chairman anticipated surpluses of such enormous quantity that there would not be a single U.S. Treasury security left to buy. The government could be forced to buy "nonfederal" assets, such as IBM bonds. Of the 100,000 most likely problems the government should consider, this was not one of them.
Greenspan was leaning on a bizarre computation from the Congressional Budget Office (CBO). In January 2001, the CBO had projected a federal budget surplus for the period of 2002 through 2011 of $5.6 trillion. This gem of infinite interpolation gave Greenspan the cover he needed. In 2002, the CBO reduced its surplus estimate by $5.3 billion, to $300 million.
Whether Greenspan's audience succumbed to his flight of fancy, another statement should have awakened its curiosity. Greenspan prefaced his tale of woeful surpluses by discussing "recent projections [which]... make clear that the highly desirable goal of paying off the federal debt is in reach before the end of the decade. This is in marked contrast to the perspective of a year ago when the elimination of the debt did not appear likely until the next decade." Since "a year ago" (actually, the 10 months between March 10, 2000 and when he spoke in January 2001), the Nasdaq had fallen 43%. Tax revenue had risen from 12.5% of personal income to 15.4% during the boom years. In 2000, this 2.9% increase equaled $237 billion - precisely the same as the total 2000 budget surplus. It suited Greenspan's purposes to express mystification during testimony: "We still do not have a full understanding of the exceptional strength in individual income tax receipts during the latter 1990s."
Greenspan could not have been blind to the source of the budget surpluses: capital gains, exercised stock options and bonuses. These tributaries had dried up. Without these flows, his fear of paying down the national debt, or even running a balanced budget, made no sense. And, while Alan Greenspan could claim that paying down the debt was a bad thing, it is a tribute to the man's sway that his audience accepted such a silly pretense approvingly.
The Greenspan Campaign for Re-nomination to Head the Fed in 2004 had kicked off its media blitz a year earlier, on February 11, 2003. The Boston Globe reported that Greenspan viewed Bush's (new) tax cut plan with suspicion: "Greenspan... used the opportunity to admonish the federal government for losing its 'fiscal discipline.'" In the chairman's words, a "return to fiscal discipline should be instituted without delay." That was the stick. The next day, on February 12, Greenspan offered Bush the carrot. The Wall Street Journal reported: "Federal Reserve Chairman Alan Greenspan muted his initially chilly reception of President Bush's tax cut plan, offering more praise for eliminating taxes on dividends and playing down the near term consequences for the Federal deficit." [Italics added.] On February 22, President Bush announced that he would reappoint Greenspan for a fifth term.
On April 30, 2003, having accomplished his mission and with Bush now committed to reconfirm him, Greenspan scolded the president. The New York Times reported: "Alan Greenspan...told Congress today that the economy was poised to grow without further large tax cuts, and that budget deficits resulting from lower taxes without offsetting reductions in spending could be damaging to the economy. Opponents of the large tax cut favored by President Bush took Mr. Greenspan's testimony as support of their position." [Italics added.] The dissembling was obvious; yet, no one questioned Greenspan's motives. No one questioned his logic either, but, few in Washington or Wall Street ever had.
On April 21, 2005, the chairman's bewildering tax and federal budget advice came full circle. At a Senate Budget Committee meeting, Democratic Senator Paul Sarbanes from Maryland pursued a ragged thread in the Greenspan tapestry. The senator contended that Greenspan's endorsement of the president's 2001 tax cut was the "green light" that George Bush needed. (This 2001 testimony is probably what Hillary Clinton remembered.) At this meeting, Greenspan replied that he had not "specifically" endorsed the tax cut plan. The chairman claimed: "[Y]ou will not find anywhere in the public record that I supported the [2001] tax cut."
After the New York Times published Greenspan's "blessing today to a substantial tax" on January 26, 2001, the Federal Reserve chairman never made a speech or provided testimony that his advice had been misunderstood. There was no reason for him to do so. Reading the January 25, 2001, speech today (available for anyone to judge on the Federal Reserve Board of Governors website, under "News and Events" and "Testimony"), his support is obvious. He was rooting for a tax cut.
This civil servant had made false statements to the people's elected representatives before. When a vote to balance the budget loomed early in Clinton's presidency, Greenspan said a Fed study showed a balanced budget would reduce interest rates. The Fed had conducted no such study. Greenspan testified to Congress in 1993 that tapes of Federal Open Market Committee meetings were destroyed after summaries were written. Thus, no transcripts existed. He later admitted to Banking Committee Chairman Henry Gonzales that he had known for years transcripts were kept but only remembered when a "senior staff member jogged my memory in the last few days."
To Sarbannes complaint, Greenspan deflected criticism with a tried-and-true tactic: flattery. The Wall Street Journal reported on April 22, 2005, that Greenspan told the senator "an alternative program of tax cuts and spending increases then proposed by the Democratic Party's leadership would have achieved the same desired reduction in surpluses." The logic of Greenspan's prevarications seemed to mean he had not specifically endorsed the Bush tax cut. Yet, he also told Senator Sarbannes that he "like many economists" had been wrong about the surpluses he warned of in 2001. Three years later, in 2004, the federal government set a new record with its first $400 billion deficit. So why was he now saying the Democratic Party's proposal would have "achieved the same desired reduction" since the budget surpluses had, instead, degenerated into record-setting deficits? We will never know. Greenspan had triumphed once again.
As presidential candidate in 2008, Senator Hillary Clinton fully understood her man. She proposed an "emergency group" to "deal with high-risk mortgages." Greenspan was one of those she would appoint to her brain trust. When an opponent questioned her strange selection of the former Federal Reserve chairman, Clinton offered an enigmatic endorsement. Greenspan had "a calming influence....Don't ask me why, because I never understand what he's saying."
Thursday, June 24, 2010
Thursday, June 10, 2010
Markets Without Guardrails
Two significant changes are pushing markets towards a shakeout.
First, the bond markets are showing strains. For instance, both investment-grade and junk-rated companies are finding it more difficult to issue bonds. To put this in today's context, the momentum money that has pushed asset prices up since the spring of 2009 assumes, or believes, that governments will do whatever is necessary to sustain the upward march. Now there are doubts.
It looks as though institutions may be withdrawing funds from the global banking system as worries of European bank solvency rise. Recent spikes of interbank lending rates (such as LIBOR) suggest this.
The so-called recovery has been artificial. Pete Briger of Fortress Investment Group "poured cold water" on a recent private equity meeting in Boston, the SuperReturn U.S. conference. According to the Wall Street Journal, "the private-equity princes" basked until Briger spoke, when he stated what everyone in the room knew. He "said the improved environment is, in effect a charade, with everyone from central banks to large financial institutions 'in cahoots' to boost lending markets and consumer confidence." [The Journal's quotation marks, my italics.]
The second change is the rising volatility across markets, from currencies to stocks. To some degree, the greater frequency of stock markets rising or falling 2% or 3% in a day is attached to tighter credit market conditions.
A shakeout does not require a reduction of funding. "Charades," also known as bubbles, need ever greater amounts of funding to stay in place. If the pace of funding slows (for example, from a 10% to a 5% rate), the markets are apt to snap.
Prices in the stock market, for instance, flap around as computers decide whether the institution should be a buyer or seller at a certain level. This has led us into the unknown, as explained by the Financial Times: "An explosion in trading propelled by computers is raising fears that trading platforms could be knocked out by rogue trades triggered by systems running out of control."
This is a great worry, but nothing so nefarious is needed to ally a stock market crash. The buy-and-hold investor is in a lonely position. Only 3% of trading was by retail investors in U.S. equity markets during 2009. (For more on our perverted markets, see Aucontrarian.com "blog" Should Investors Boycott the Stock Market?)
We have on our hands a deep-sea oil rig with the safety features for skimming oil off the water's surface. The technology for trading, such as described by the Financial Times, has not been matched by new technology to slay the monster, if necessary. There were such checks-and-balances in the days when stocks were traded on the floors of the exchanges.
At a Grant's Interest Rate Observer conference in November 1999, one speaker was not concerned about the stock market. (For those who were still in school, the Nasdaq had risen 150% over the previous 13 months.) One reason this speaker cited was "strong central bank leadership." Another speaker, Michael Steinhardt, did not think the Fed's leadership would be worth much when it was needed most. Steinhardt had started on Wall Street in the 1960s, the "Go-Go Years." Few investors had gone-and-got as profitably over the prior three-and-one-half decades as Steinhardt. He spoke about Wall Street's abandonment of controls, leadership and responsibility:
"The liquidity safeguards, historically, were the specialists' books, the retail system, and the institutional liquidity providers in the major brokerage firms. They were the mechanisms that the stock exchange itself had provided, and they were all structured for a system where trading was a very, very small fraction of what we're seeing today. Now there are no specialists' books; there is no serious liquidity provided by brokerage firms; and the trading mechanisms of the exchange are hardly relevant to the sorts of volumes that exist today. So yes, the Federal Reserve, if you define that broad context of liquidity in a financial sense, does still exist, but in a securities market sense, none of the former ones do."
The average buy-and-hold investor probably did not realize how the institutional framework was constructed to generate a harmonious flow of buy-and-sell orders and to protect the market from abuses. Now the institutions perpetrate the abuses and the guardrails no longer exist.
The "strong central bank leadership" was absent once the Nasdaq commenced its 78% collapse in March 2000, when the bubble had reached a level that no liquidity safeguards could have prevented. During the plunge, central bank leadership layered the world with paper in an effort to pump economies back up.
Now, that paper cannot be paid back. Since 2007, the world financial system has suffered periodic waves of deleveraging, during which times central bank leadership could not compensate for the discarded institutional mechanisms that had contained disruptions.
As Pete Briger of Fortress Investment Group said, the central banks and large financial institutions are "in cahoots." Their objective, "to boost lending markets and consumer confidence" is to draw the unsuspecting into markets. Beyond that, the institutions trade now to make money for themselves. Such notions as leadership and responsibility are gone with the wind.
Chances are good that volatility will keep rising until we reach a sharp market break. In simpler days, receding liquidity and less stable markets under bubble conditions meant "crash." This is still the likely course, but governments know asset prices are the hedgerows that shield fallow economies from view. Governments want to preserve the façade. They will do what they can to push prices up. Speculators who see governments re-open vast credit lines (as they did in 2008) will probably reverse course in a fit of panic buying.
It looks, though, that central banks will respond after the fact rather than act preemptively. The Federal Reserve has reinstituted swap lines, but even that decision was in reaction to a problem the markets had already identified. Government will inflate, but probably after steep declines across markets.
First, the bond markets are showing strains. For instance, both investment-grade and junk-rated companies are finding it more difficult to issue bonds. To put this in today's context, the momentum money that has pushed asset prices up since the spring of 2009 assumes, or believes, that governments will do whatever is necessary to sustain the upward march. Now there are doubts.
It looks as though institutions may be withdrawing funds from the global banking system as worries of European bank solvency rise. Recent spikes of interbank lending rates (such as LIBOR) suggest this.
The so-called recovery has been artificial. Pete Briger of Fortress Investment Group "poured cold water" on a recent private equity meeting in Boston, the SuperReturn U.S. conference. According to the Wall Street Journal, "the private-equity princes" basked until Briger spoke, when he stated what everyone in the room knew. He "said the improved environment is, in effect a charade, with everyone from central banks to large financial institutions 'in cahoots' to boost lending markets and consumer confidence." [The Journal's quotation marks, my italics.]
The second change is the rising volatility across markets, from currencies to stocks. To some degree, the greater frequency of stock markets rising or falling 2% or 3% in a day is attached to tighter credit market conditions.
A shakeout does not require a reduction of funding. "Charades," also known as bubbles, need ever greater amounts of funding to stay in place. If the pace of funding slows (for example, from a 10% to a 5% rate), the markets are apt to snap.
Prices in the stock market, for instance, flap around as computers decide whether the institution should be a buyer or seller at a certain level. This has led us into the unknown, as explained by the Financial Times: "An explosion in trading propelled by computers is raising fears that trading platforms could be knocked out by rogue trades triggered by systems running out of control."
This is a great worry, but nothing so nefarious is needed to ally a stock market crash. The buy-and-hold investor is in a lonely position. Only 3% of trading was by retail investors in U.S. equity markets during 2009. (For more on our perverted markets, see Aucontrarian.com "blog" Should Investors Boycott the Stock Market?)
We have on our hands a deep-sea oil rig with the safety features for skimming oil off the water's surface. The technology for trading, such as described by the Financial Times, has not been matched by new technology to slay the monster, if necessary. There were such checks-and-balances in the days when stocks were traded on the floors of the exchanges.
At a Grant's Interest Rate Observer conference in November 1999, one speaker was not concerned about the stock market. (For those who were still in school, the Nasdaq had risen 150% over the previous 13 months.) One reason this speaker cited was "strong central bank leadership." Another speaker, Michael Steinhardt, did not think the Fed's leadership would be worth much when it was needed most. Steinhardt had started on Wall Street in the 1960s, the "Go-Go Years." Few investors had gone-and-got as profitably over the prior three-and-one-half decades as Steinhardt. He spoke about Wall Street's abandonment of controls, leadership and responsibility:
"The liquidity safeguards, historically, were the specialists' books, the retail system, and the institutional liquidity providers in the major brokerage firms. They were the mechanisms that the stock exchange itself had provided, and they were all structured for a system where trading was a very, very small fraction of what we're seeing today. Now there are no specialists' books; there is no serious liquidity provided by brokerage firms; and the trading mechanisms of the exchange are hardly relevant to the sorts of volumes that exist today. So yes, the Federal Reserve, if you define that broad context of liquidity in a financial sense, does still exist, but in a securities market sense, none of the former ones do."
The average buy-and-hold investor probably did not realize how the institutional framework was constructed to generate a harmonious flow of buy-and-sell orders and to protect the market from abuses. Now the institutions perpetrate the abuses and the guardrails no longer exist.
The "strong central bank leadership" was absent once the Nasdaq commenced its 78% collapse in March 2000, when the bubble had reached a level that no liquidity safeguards could have prevented. During the plunge, central bank leadership layered the world with paper in an effort to pump economies back up.
Now, that paper cannot be paid back. Since 2007, the world financial system has suffered periodic waves of deleveraging, during which times central bank leadership could not compensate for the discarded institutional mechanisms that had contained disruptions.
As Pete Briger of Fortress Investment Group said, the central banks and large financial institutions are "in cahoots." Their objective, "to boost lending markets and consumer confidence" is to draw the unsuspecting into markets. Beyond that, the institutions trade now to make money for themselves. Such notions as leadership and responsibility are gone with the wind.
Chances are good that volatility will keep rising until we reach a sharp market break. In simpler days, receding liquidity and less stable markets under bubble conditions meant "crash." This is still the likely course, but governments know asset prices are the hedgerows that shield fallow economies from view. Governments want to preserve the façade. They will do what they can to push prices up. Speculators who see governments re-open vast credit lines (as they did in 2008) will probably reverse course in a fit of panic buying.
It looks, though, that central banks will respond after the fact rather than act preemptively. The Federal Reserve has reinstituted swap lines, but even that decision was in reaction to a problem the markets had already identified. Government will inflate, but probably after steep declines across markets.
Thursday, June 3, 2010
Should Investors Boycott the Stock Market?
Investing in stocks is marketed as believing in America. Imbedded is the assumption that buying stocks is a fair deal. An investor might make or lose money, but the same chance was taken by all participants.
Although they have received little notice, the recently released 2004 Federal Reserve Open Market Committee (FOMC) transcripts show how the Fed was channeling its attention and distorting markets for the benefit of favored institutional investors. (See AuContrarian.com "blog" The 2004 Fed Transcripts: A Methodical, Diabolical Destruction of America's "Wealth".) The 2004 Transcripts were not so much a revelation as a confirmation. The Fed's valiant attempt to prevent the economy from deflating (its claim at the time) by inflating asset markets is now a matter of public record. FOMC members explicitly stated they were working with hedge funds and pushing housing prices up.
We know how this ended. The Fed's policy was successful until 2007. Then all asset prices collapsed, along with the institutions (banks and brokerages) that believed the Fed could prevent prices from ever falling. The backstop was known as the "Greenspan Put:" the belief that Chairman Greenspan's Fed would always prevent market prices from falling.
A put option gives the buyer an option (a choice) to sell a security at a price previously negotiated with the seller. A put option is valuable if prices fall below the level of the negotiated price. An investor can buy a put with the right to sell the S&P 500 Index at 800. If the Index rises to 1100, the option is worthless. (Why sell it for $800 when it can be sold in the market for $1100?) If the S&P 500 Index falls to 600, the value of the put option is worth at least $200 to the owner of the put: the Index is trading for $600 but can be sold for $800. The put option is an insurance policy against a stock market collapse. The need for the average investor to understand such instruments will be discussed below.
The Greenspan Put begat the Bernanke Put, once the latter became chairman in 2006. Believers in the Put have reason for such faith. The 2004 transcripts show the FOMC toiled to fulfill this zeal. The zealots ignore the failure of the Put in 2007 and 2008.
The credit collapse of 2007 and 2008 ended as all government-sponsored market support programs have ended. In 2010, the federal government's interference in markets is ten-fold, or possibly, one-hundred-fold, greater than in 2004. Distortions created by Fed interference in 2004 (such as, the mortgage market) went hand-in-hand with the collapse in 2007. Given the Fed's iron grip on markets today, the imbalances are much greater. Investors need to plan now for when the contrivances shatter.
The busybodies' catalogue would start with their zero-percent federal funds rate. This is not only an inducement to borrow without fear, it is also part of the Federal Reserve's program to suck the unwashed into higher risk investments, such as the stock market and municipal bonds. Federal Reserve Governor Donald Kohn stated in the autumn of 2009: "[R]ecently the improvement, in risk appetites [have] respond[ed] to actions by the Federal Reserve and other authorities.... Low market interest rates should continue to induce savers to diversify into riskier assets...."(For more on this, see AuContrarian blogs: March 9, 2010: From the Greenspan Put to the Kohn Put: Our Brilliant Central Bankers and March 25, 2010: Government Authorities are Looking Out for Themselves - As Should Everyone.)
Investors should be aware of other means by which the Fed and other authorities are interfering with markets, since the mutations have created phony prices. Again, as we saw in 2007 and 2008, the compounding of illusionary prices finally collapsed.
Four sources of phony prices follow.
First, interest rates are distorted. At one percent (and less) speculators gamble and push up asset prices.
Second, is the housing market. It does not exist. The authorities have warned us. The latest was David Stevens, head of the Federal Housing Administration, who told an audience on May 24, 2010, the housing market is a "government-financed market" that is "purely on life-support, sustained by the Federal government." House prices will sink when the government runs out of lifeboats.
Third, the authorities have handed the stock market to institutions where the computers buy and sell. The Financial Times reported that only 3% of stock market trading is by retail customers. Tradebot, in Kansas City, Missouri, holds stocks for an average of 11 seconds. It made money every day for four years. (See: "Speedy New Traders Make Waves Far From Wall St," New York Times, May 16, 2010)
Fourth, the Federal Reserve is manipulating the currency markets, as Rainer Bruederle, German finance minister, disclosed on May 28. Angst should border on panic, given the man in charge of this operation. The last time the Federal Reserve did so, in July 2009, Congressman Alan Grayson asked Federal Reserve Chairman Ben Bernanke to whom the Fed had lent $500 billion. The chairman had no idea. Bernanke claimed, legitimately, loan collection was the responsibility of the central banks that had received the funds. His detachment is in keeping with the man's tendency to wander through vague abstractions, yet for those weighing the destination of their life savings, or, whether to buy a house or hide in a cave, Simple Ben is a dangerous obstacle to logical thinking.
In the 1970s, many in the United States knew little about personal finance other than the beauty of compound interest. It was during that decade when double-digit inflation chased those who were quick enough into certificates of deposits. The latecomers who did not adapt were left behind.
From certificates of deposit, the household has adapted to changing times (or, been left behind). Now, it is necessary to understand protection, which should not be confused with asset diversification. The put option described above is a potential instrument. There are other approaches; the costs of each should be weighed and this needs to be emphasized: all insurance is a cost.
This leads back to the title: "Should Investors Boycott the Stock Market?" In the current discussion: what is the cost of abandoning stocks, and, for instance, ducking inside a savings account?
For all Bernanke's faults, there is at least a consistency about the man. His mind is as inflexible as a Prussian border guard's. In 1999, he wrote: "A central bank can... extend loans to depositories, other financial intermediaries, or firms and households.... This may be particularly helpful in spurring aggregate demand should the financial sector be under stress and in need of liquefying its assets." [My italics.] If Bernanke sees the economy sinking, there is nothing to stop the mad professor who dreamt up this conflagration from electronically wiring $100,000 to every American's personal checking account. The Dow could pass 100,000 shortly after.
In conclusion, investors need protection on the downside and exposure to the upside. At the moment, the prospect of a stock market crash looks more likely.
Although they have received little notice, the recently released 2004 Federal Reserve Open Market Committee (FOMC) transcripts show how the Fed was channeling its attention and distorting markets for the benefit of favored institutional investors. (See AuContrarian.com "blog" The 2004 Fed Transcripts: A Methodical, Diabolical Destruction of America's "Wealth".) The 2004 Transcripts were not so much a revelation as a confirmation. The Fed's valiant attempt to prevent the economy from deflating (its claim at the time) by inflating asset markets is now a matter of public record. FOMC members explicitly stated they were working with hedge funds and pushing housing prices up.
We know how this ended. The Fed's policy was successful until 2007. Then all asset prices collapsed, along with the institutions (banks and brokerages) that believed the Fed could prevent prices from ever falling. The backstop was known as the "Greenspan Put:" the belief that Chairman Greenspan's Fed would always prevent market prices from falling.
A put option gives the buyer an option (a choice) to sell a security at a price previously negotiated with the seller. A put option is valuable if prices fall below the level of the negotiated price. An investor can buy a put with the right to sell the S&P 500 Index at 800. If the Index rises to 1100, the option is worthless. (Why sell it for $800 when it can be sold in the market for $1100?) If the S&P 500 Index falls to 600, the value of the put option is worth at least $200 to the owner of the put: the Index is trading for $600 but can be sold for $800. The put option is an insurance policy against a stock market collapse. The need for the average investor to understand such instruments will be discussed below.
The Greenspan Put begat the Bernanke Put, once the latter became chairman in 2006. Believers in the Put have reason for such faith. The 2004 transcripts show the FOMC toiled to fulfill this zeal. The zealots ignore the failure of the Put in 2007 and 2008.
The credit collapse of 2007 and 2008 ended as all government-sponsored market support programs have ended. In 2010, the federal government's interference in markets is ten-fold, or possibly, one-hundred-fold, greater than in 2004. Distortions created by Fed interference in 2004 (such as, the mortgage market) went hand-in-hand with the collapse in 2007. Given the Fed's iron grip on markets today, the imbalances are much greater. Investors need to plan now for when the contrivances shatter.
The busybodies' catalogue would start with their zero-percent federal funds rate. This is not only an inducement to borrow without fear, it is also part of the Federal Reserve's program to suck the unwashed into higher risk investments, such as the stock market and municipal bonds. Federal Reserve Governor Donald Kohn stated in the autumn of 2009: "[R]ecently the improvement, in risk appetites [have] respond[ed] to actions by the Federal Reserve and other authorities.... Low market interest rates should continue to induce savers to diversify into riskier assets...."(For more on this, see AuContrarian blogs: March 9, 2010: From the Greenspan Put to the Kohn Put: Our Brilliant Central Bankers and March 25, 2010: Government Authorities are Looking Out for Themselves - As Should Everyone.)
Investors should be aware of other means by which the Fed and other authorities are interfering with markets, since the mutations have created phony prices. Again, as we saw in 2007 and 2008, the compounding of illusionary prices finally collapsed.
Four sources of phony prices follow.
First, interest rates are distorted. At one percent (and less) speculators gamble and push up asset prices.
Second, is the housing market. It does not exist. The authorities have warned us. The latest was David Stevens, head of the Federal Housing Administration, who told an audience on May 24, 2010, the housing market is a "government-financed market" that is "purely on life-support, sustained by the Federal government." House prices will sink when the government runs out of lifeboats.
Third, the authorities have handed the stock market to institutions where the computers buy and sell. The Financial Times reported that only 3% of stock market trading is by retail customers. Tradebot, in Kansas City, Missouri, holds stocks for an average of 11 seconds. It made money every day for four years. (See: "Speedy New Traders Make Waves Far From Wall St," New York Times, May 16, 2010)
Fourth, the Federal Reserve is manipulating the currency markets, as Rainer Bruederle, German finance minister, disclosed on May 28. Angst should border on panic, given the man in charge of this operation. The last time the Federal Reserve did so, in July 2009, Congressman Alan Grayson asked Federal Reserve Chairman Ben Bernanke to whom the Fed had lent $500 billion. The chairman had no idea. Bernanke claimed, legitimately, loan collection was the responsibility of the central banks that had received the funds. His detachment is in keeping with the man's tendency to wander through vague abstractions, yet for those weighing the destination of their life savings, or, whether to buy a house or hide in a cave, Simple Ben is a dangerous obstacle to logical thinking.
In the 1970s, many in the United States knew little about personal finance other than the beauty of compound interest. It was during that decade when double-digit inflation chased those who were quick enough into certificates of deposits. The latecomers who did not adapt were left behind.
From certificates of deposit, the household has adapted to changing times (or, been left behind). Now, it is necessary to understand protection, which should not be confused with asset diversification. The put option described above is a potential instrument. There are other approaches; the costs of each should be weighed and this needs to be emphasized: all insurance is a cost.
This leads back to the title: "Should Investors Boycott the Stock Market?" In the current discussion: what is the cost of abandoning stocks, and, for instance, ducking inside a savings account?
For all Bernanke's faults, there is at least a consistency about the man. His mind is as inflexible as a Prussian border guard's. In 1999, he wrote: "A central bank can... extend loans to depositories, other financial intermediaries, or firms and households.... This may be particularly helpful in spurring aggregate demand should the financial sector be under stress and in need of liquefying its assets." [My italics.] If Bernanke sees the economy sinking, there is nothing to stop the mad professor who dreamt up this conflagration from electronically wiring $100,000 to every American's personal checking account. The Dow could pass 100,000 shortly after.
In conclusion, investors need protection on the downside and exposure to the upside. At the moment, the prospect of a stock market crash looks more likely.
Thursday, May 27, 2010
A Speech: "Chairman Greenspan: A Fiat Mind for a Fiat Age"
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).
A speech delivered at the Ludwig von Mises Institute Conference: "Austrian Economics and the Financial Markets," held at the University Club in New York City, May 22, 2010. Comments in brackets and italics were cut from talk due to time constraints. The speech can be heard in the "Interviews" section of the AuContrarian.com website, and, on the Ludwig von Mises website along with those of other conference speakers.
Part 1: Introduction
Alan Greenspan was the right Federal Reserve chairman for his times. His reputation was a creation of inflation and this was a century of inflation. His knowledge was superficial, when America tended towards superficiality. He was a creation of publicity in an age that craved celebrities. He was inarticulate, at a time when minds were growing more confused. He took short cuts to the top, when Americans more readily took the easy route.
Money has been degraded over the past century. It takes at least $20 to buy what cost $1 in 1913. Inflation of money was integrated into the twentieth century inflation of words, constant distractions and media promotion. Thus, the worship of celebrities simply because they are celebrities and the success of one pandering politician and clever opportunist: Alan Greenspan.
The short cuts taken in the 1950s set the course to the present. We bargained for wages and benefits that could not be paid in constant dollars. Americans worked fewer hours. We were buying more from abroad than we were selling. The government was spending more than its revenues by the 1960s.
In 1971, we stopped settling our balances in gold. Governments - and this was true around the world - found deficit financing an opium to the masses. Government programs abounded. The masses grew accustomed to inflation and borrowing in currencies that tended towards depreciation. Thus, debtors paid back less real money than they had borrowed. Bankers could lend more after the link to gold was severed since no final settlement of claims existed.
For this subterfuge of honesty and common sense, the United States employed celebrity economists who would make up new theories on the fly. This was dishonest. It follows that our dealings in dollars became dishonest. The corruption by the government, by economists who satisfied their interests, was matched by the corruption of those who trafficked in money. Since honesty was the enemy of our dealings, dishonesty held an advantage. In the end, credit and government policy have gravitated to fewer hands, those willing to participate in a swindle of the public's savings and of its trust.
At the center is an institution, the Federal Reserve System, which has been a willing accomplice. It employs dishonest economists. In 1987, it elected as its chairman a man of no merit but who could be counted upon to cut whatever corner was necessary to maintain the façade of national solvency. That imposter was Alan Greenspan.
Part Two: Alan Greenspan
1950s
When Alan Greenspan was 26 years old, he made a far-sighted and characteristic decision. He started smoking a pipe.
This was in 1950.
He had just entered Columbia University where he was studying for a doctorate in economics. He signed up for a class under Professor Arthur Burns. Burns was a well-known figure. He was co-author of a well regarded book: Measuring Business Cycles.
Whatever he learned in Burns's class, Greenspan did the important thing: he took up the pipe. This was Burn's trademark, as some will remember when Federal Reserve Chairman Arthur Burns sat before Senate committees and reinvented economics in the 1970s.
For instance, when inflation raged in the 1970s, it was Burns who removed food and energy from the Consumer Price Index.
In 1953, Burns left Columbia to head President Eisenhower's Council of Economic Advisers - the CEA. Greenspan left Columbia at the same time, without receiving his doctorate.
In 1977, he would receive his doctorate degree in economics, from NYU. It is a collection of articles and some economic journal pieces stapled together.
Alan Greenspan made a habit of choosing the easy route.
The media drones on about Greenspan's "ideology." Or, sometimes it's his "libertarianism." Or, it might be his "free-market beliefs." Whatever the case, these are simple labels, and simple labels are about all we will get from the media.
Alan Greenspan has cared about one - and only one - thing. Every nerve ending in his body at every moment in his life has been devoted to the promotion of Alan Greenspan.
Greenspan never had an ideology. He probably never understood what Ayn Rand was talking about. Nathaniel Branden, Rand's number one acolyte in the 1950s and also the Randian closest to Greenspan, wrote years later:
"Now, looking at [Alan], I wondered to what extent he was aware of Ayn's opinions."
Branden continued: Complimenting Ayn on some [paper she had written and read to the group], Greenspan might say, "On reading this...one tends to feel...exhilarated."
Platitudes and assurances also mesmerized the nation 50 years later. By then, that's about all we could get from any public figure. Of course, as a nation we did not demand more.
Ayn Rand seems to have understood why Alan clung to her apron strings, if she wore an apron.
She asked Branden: "Do you think Alan might basically be a social climber?"
She hit the nail on the head.
Alan knew what he was doing. Around that time, a young writer asked Gore Vidal if he had any advice: Vidal replied: "Yes, get on TV as often as possible."
Part 3: Slichter-Martin
At this time, there was a blazing debate in Washington about inflation. Some were for it and some were against it.
In the mid-1950s, academic economists were angling their presence into the media. One was Harvard University Professor Sumner Slichter. Fortune magazine named him the "father of inflation." That might not sound complimentary, but it was publicity.
Slichter told the Senate that the Fed would have to accept inflation to generate sufficient jobs. Slichter argued that costs for materials and labor were rising because "unions [were pushing up] wages and fringe benefits faster than the gains from productivity of labor. The result is a continuation of the slow rise in prices".
Slichter was correct, but ignored the traditional solution to either work harder or reduce benefits. America was not in the mood for either.
Slichter stands at the front of a long list of economists who decided they could abandon common sense in our road to ruin. In my book, I quoted Alfred Jay Nock:
"It is an economic axiom that goods and services can only be paid for with goods and services."
In the opposite corner to Slichter was William McChesney Martin Jr. Martin was chairman of the Federal Reserve board from 1951 to 1970.
After Slichter gave the senators the good news, Martin lashed back. [This was in early 1957:
"I refuse to raise the flag of defeatism in the battle of inflation. If you take [Schlicter's] view, then another bust will surely come."]
Refusing to raise the white flag, Martin gave one of the finest speeches ever delivered by a central banker. He might not have much competition. It was on August 13, 1957, that he spoke before the U.S. Senate Committee on Finance.
He told the assembled: "There is no validity whatever in the idea that any inflation, once accepted, can be confined to moderate proportions." Martin responded to "some segments of the community" - probably economists - who were arguing for "a gradual rise in prices...perhaps 2 per cent a year," Martin warned that such a prospect would work incalculable hardship." "Losses would be... inflicted upon millions of people..."
[These included: "pensioners...people who have their assets in savings accounts and long-term bonds...."]
Chairman Ben Bernanke has stated the economy should have a minimum inflation rate of 2% per year. There is not necessarily a contradiction here. Simple Ben doesn't seem to care if he inflicts hardship upon hundreds of millions, if he knows what he's doing at all.
Martin believed, fears of inflation would "cause people to spend more and more of their incomes and save less...."
Martin told the politicians that the composition of savings would change. It would "tend towards speculative commitments...and the pattern of investments and other spending - the decisions on what kinds of things to buy - will change in a way that threatens balanced growth."
Martin warned that "a spiral of mounting prices and wages seeks more and more financing" with a "considerable volume of the expenditure...financed at all times out of borrowed funds."
Martin was not an economist. This may be obvious. He had studied Latin at Yale.
"Finally" Martin said, "we should not overlook the way that inflation could damage our social and political structure....Those who would turn out to have savings in their old age would tend to be the slick and the clever rather than the hard-working and the thrifty. Fundamental faith in the fairness of our institutions and our Government would tend to deteriorate."
We know who won that battle.
Part 4: Greenspan's Rise
Speaking of the slick and the clever, by 1970, Alan Greenspan was a millionaire. By then, he owned an apartment at United Nations Plaza, a new and fashionable address where Walter Cronkite, Truman Capote and Johnny Carson also lived.
But what had he done - that is - as an economist to live among such company? It really isn't clear. He was a minor figure. Those who respected him said he was a whiz with numbers. A far larger group remembers, yes, he was full of numbers, but he was always wrong.
In the words of biographer Justin Martin: "[T]he general impression among people who knew Greenspan in those days was that he wasn't exactly marked for real greatness.... His old friends were destined to watch his career unfold - Nixon adviser, Ford adviser, [five]-term Fed chief-in stunned amazement."
Another to witness the curious elevation of Alan Greenspan was Marc Faber, who joined the Wall Street firm of White, Weld in 1970. Shortly after, [White Weld] hired Alan Greenspan, then as a consulting economist.
Part of Marc's job was to attend the monthly economic presentations by Greenspan and interpret his comments for the overseas offices.
Quoting Marc:
"Looking back....I... had no idea what Mr. Greenspan was talking about, but I may not have been the exception. When Mr. Greenspan first came on board at White, Weld as a consultant, 30 or 40 people from the firm's various departments would attend the meetings. Within a few months, however, attendance had dropped to just a handful.... By then I had also learned that the easiest way for me to communicate the (to me) incomprehensible remarks... was simply to summarize the previous day's news from the front page of the Wall Street Journal..."
Marc noted that one of the best investment decisions White, Weld ever made was to "get rid of Mr. Greenspan in late 1972 and hire instead the economist Gary Shilling."
Martin Mayer, who has written several books about Wall Street, first met Alan Greenspan in the 1960s. The millionaire economist was making a specialty of "statistical espionage" - that was Greenspan's description. Mayer later wrote: "the book on him in that capacity was that you could order the opinion you needed."
Greenspan's girlfriend Barbara Walters, wrote in her recent autobiography: "How Alan Greenspan, a man who believed in the philosophy of little government interference and few rules or regulations, could end up becoming chairman of the greatest regulatory agency in the country is beyond me."
This was the road to his success: he would do anything and he would say anything. He worked on his relations with the press much harder than he worked as an economist for his clients. He went one step further than other fast-track economic consultants - he even dated the press, then finally married it.
Even though he was a minor figure during the 1960s, he was getting his name in the New York Times, making market predictions. The funny thing is, he was almost always the voice of doom in those days. That was the 'sixties, so he was always wrong. In the seventies he was always wrong too, since he was always bullish.
Part 5: Back to the 1950s
William Martin's insight - that "a spiral of mounting prices and wages seeks more and more financing" and a "considerable volume of the expenditure...financed at all times out of borrowed funds." was a feature of the 1960s. That was the decade of the conglomerate.
Some who built mountains from molehills in the 1950s and 1960s were Meshulam Riklis, Carl Lindner and Saul Steinberg. They used paper instead of cash to buy out companies.
It ended in a baleful scrapheap of waste with such absurdities as Mary Carter Paint [relabeled Resorts International] attempting to swallow Pan American Airways. (It was unsuccessful.)
It is not a coincidence that American living standards probably plateued around 1970, since capital was so badly mishandled.
Part 6: The 1970s
By 1974, price inflation was in double digits: "incalculable hardship" was suffered by millions. [Capital was again mishandled, one reason being there were so many distractions from running a business. In 1973, Time magazine reported: American businessmen [could] accomplish much [by] "speculation." A U.S. executive "may enclose a check with his order rather than wait until the steel is delivered and the dollar's value may have fallen."]
On June 28, 1978, Federal Reserve Board Member Henry C. Wallich addressed the graduating class at Fordham University. "Inflation," he informed the graduates, "is a means by which the strong can more effectively exploit the weak. The strategically positioned and well-organized can gain at the expense of the unorganized and aged."
At this moment every graduating member of the Fordham class of '78 ran out of the stadium to the closest Goldman, Sachs recruiting booth. [Wallich spoke from first-hand experience. He was born in Germany in 1914, so had lived through the Weimer hyperinflation as a child.]
Wallich explained inflation "is technically an economic problem. I mean the breakdown of our standards of measuring economic values, as a consequence of inflation." The strong are smart enough to understand that inflation "introduces an element of deceit into our economic dealings." Contracts are no longer made to "be kept in terms of constant values" but, one party understands this better than the other.
Wallich went on to emphasize "the increasing uncertainty in providing privately for the future pushes people who are seeking security toward the government."
Part 7: The 1980s
Moving forward - to the 1980s, we had the savings and loan free-for-all. We also were adding mounds of debt that would have been inconceivable when Martin spoke in 1957.
In 1980, we - the United States, borrowed $1.40 for every $1 we added to GNP. By 1985, we were adding $4.00 for every $1 increment in GNP.
Savings and loans were perfectly designed for clever operators. S&L deposits were insured by the government and they had been deregulated. In the wrong hands, the S&Ls were sponges for questionable investments.
Meshulam Riklis, Carl Lindner, Saul Steinberg used their conglomerate platforms to swap paper.
Barrie Wigmore, then at Goldman, Sachs, wrote an excellent book, Securities Markets in the 1980s.
Wigmore wrote, of Riklis, Lindner and Steinberg: "it is tempting to conclude they... represented a cabal.... [They] cooperated and invested with each other extensively and were old hands in the market aspect of "Chinese paper" from the merger wave of the 1960s." .... Their "activities illustrate the combination of native cunning and access to leverage that made them effective."
Wigmore wrote, they [Riklis, Lindner and Steinberg] had a common involvement with Michael Milken's group at Drexel Burnham that probably helped to create enough liquidity for their junk bond securities..."
William Seidman, who headed the Resolution Trust Corporation, the body that cleaned up the savings and loan mess, wrote later that Michael Milken had "rigged the market by operating a sort of daisy chain among the S&Ls to trade the bonds back and forth across his famous X-shaped trading desk in Los Angeles. By manipulating the market, he maintained the façade that the bonds were trading at genuine market prices... When... [Milken] was brought down, and his trading operation with him, so were the S&Ls that depended on the value of his bonds to stay afloat."]
In 1984, Alan Greenspan was hired by the most notorious criminal in the savings and loan racket: Charles Keating. Keating laundered money through Lincoln Savings and Loan. He needed someone to write a letter to his regulator, [the Federal Home Loan Bank of San Francisco] that stated Lincoln Savings and Loan's investments were sound.
In 1985, Greenspan wrote to the Federal Home Bank that Lincoln's management "is seasoned and expert in selecting and making direct investments." By that time, Lincoln was not only loaded up with deals through Milken, it was swapping them at a profit with its holding company, American Continental Corporation. American Continental Corporation - and Charles Keating - had been spun out of Carl Lindner's American Financial Corporation. Keating was known as Lindner's hatchet man. [In 1978, Keating had offered no defense when the SEC charged him - in the words of Martin Mayer - with: "arranging fraudulent loans to himself... from a bank owned by his friend and employer Carl Lindner."]
Greenspan surely knew who he was dealing with. He had been on Wall Street in the 1960s. He trafficked in knowing who he should be schmoozing. In the 1980s, he must have known Lincoln was part of the Riklis, Steinberg, Lindner, Boesky, Milken crowd.
[Lindner had been in the news when he extorted greenmail from Combined Communications (1979), and Gannett (1981). "Greenmail" - was a neologism for the word "blackmail," - when a "corporate raider" acquired shares in a company and the company then bought the shares back at a premium to rid itself of the raider. Steinberg's most publicized success was also his most profitable - when he extorted $60 million from Walt Disney in 1984.
Lindner used Keating when greenmail efforts went awry and he wanted to dump shares. An example was Gulf Broadcast - Keating's first big investment, in 1984. Keating paid $132 million to Lindner's American Financial. This was 30% above that day's market price. The $132 million was also twice Lincoln's net worth - a violation of California regulations. All of this was before Greenspan's 1985 high praise for Lincoln Savings and Loan's "expert[ise] in selecting and making direct investments.".
I should note that Riklis and company had not introduced some fractured ethos of their own. Wall Street was financing greenmail and corporate raiders; investment bankers led raids on their own clients. This conduct was nurtured in the 1970s and bloomed in the 1980s. The rise in debt financing, and leverage, was one reason.]
This was just the man to inherit the Federal Reserve chairmanship in 1987. Four years before, in 1983, a poll of Wall Street executives found that 31% of them had a special confidence in Alan Greenspan, should he be named chairman. He was second in that poll, behind Paul Volcker.
Part 8: Proxmire
Greenspan's hearing for Federal Reserve chairman was in August, 1987. Senator William Proxmire, a Democrat from Wisconsin, was the chairman. He did not like Greenspan. He had voted against Greenspan's confirmation as chairman of the Council of Economic Advisers in 1974 because he thought Greenspan would pass information back to the companies with whom he had consulted.
I don't know why he thought that, but it is an odd suspicion of a candidate for a senior government post. [At least it was in 1974.] He may have known about Greenspan's reputation: "the book on him was that you could order the opinion you needed."
Proxmire opened the hearing by chastising Greenspan for his abysmal forecasting record.
More than Greenspan's habit of always being wrong - and by such a wide margin - Proxmire was probably more concerned by Greenspan's less-than-honest "full disclosure" statement he had submitted to the White House and the Senate.
He had not revealed services rendered to [Sears and] Lincoln Savings & Loan. Greenspan distinguished the two by slipping them in the side pocket of "advocacy projects."
Proxmire was a foe of bank deregulation. He feared big banks would squash smaller banks. He feared Alan Greenspan would to be only too happy to squash them.
The senator lectured the candidate for the Fed chairmanship:
"As chairman of the Federal Reserve you play the key role in approval or disapproval of these massive bank mergers.... I would feel much better about this appointment if there was somewhere in your record an indication of your awareness of the dangers to our economy of excessive financial concentration."
Well, there was no such indication, and oddly for Greenspan, he didn't try to spin some preposterous middle path.
Part 9: Greenspan's Chairmanship
After becoming Federal Reserve chairman, Alan Greenspan could not fulfill Senator Proxmire's fears fast enough. (Proxmire had retired.)
In 1989, the Federal Reserve permitted J.P. Morgan, of which Greenspan had been director before becoming Fed chairman, to underwrite Xerox debt. This was the first such debt issue from a commercial bank since 1933, the year of the Glass-Steagall Act.
In 1990, the Federal Reserve permitted J.P. Morgan to underwrite stock. Time magazine called this "the widest breach of Glass-Steagall yet."
Greenspan was as permissive when it came to money printing as he was on mega-banking. He had to be. Americans were impatient and Greenspan did not want to disappoint: He loved to be liked. He would not wait for a proper recovery after the recession of 1990. He reduced the fed funds rate from 9-3/4% in 1989 to 3% in 1992. Banks and hedge funds leveraged up and refloated the economy.
This was the first time a recovery in the U.S. was driven by finance rather than production. Money and credit was concentrated more and more in the hands of "the slick and the clever" who had nearly unlimited access to "more and more financing." By now, the middle class was getting trounced.
From that point forward, every time the economy coughed, Greenspan cut rates and pumped up a bubble. Loose money attracts characters who should never deal in money.
The economy had become badly unbalanced. Federal Reserve Governor Larry Lindsey warned the Federal Reserve Open Market Committee (FOMC) of the growing income disparity, in every FOMC meeting from 1993 to 1996. The other Fed governors did not understand what he was talking about. For example, Lindsey spoke and Janet Yellen worried that Americans were saving too much, which would reduce the GDP. Not only was the underclass getting crushed, it was borrowing in a desperate attempt to keep up.
In what might be called his farewell address, Lindsey spoke at the September 1996 FOMC meeting:
MR. LINDSEY. Our luck is about to run out in the financial markets because of what I would consider a gambler's curse: We have won this long, let us keep the money on the table.... But the long-term costs of a bubble to the economy and society are potentially great. They include a reduction in the long-term saving rate, a seemingly random redistribution of wealth, and the diversion of scarce financial [and] human capital into the acquisition of wealth.... I think it is far better that we [burst the stock-market bubble] while the bubble still resembles surface froth and before the bubble carries the economy to stratospheric heights. Whenever we do it, it is going to be painful however.... If the optimists are wrong, then indeed not only our luck but that of the markets and of the economy has run out. Thank you.
CHAIRMAN GREENSPAN. On that note, we all can go for coffee.
Greenspan sat there and drank coffee for the next 10 years. He blew up the stock market, then the mortgage and credit markets while the sorts of characters who were reaching the top on Wall Street were of a persuasion that you wouldn't allow to fill your gas tank.
Part 10: Standards Keep Eroding
In 2001, David Tice testified before the House Financial Services Committee: "The most reckless fund managers, the most reckless auditors, the most reckless investment bankers, the most reckless corporate officers made the most money. So you had greater and greater incentives to promote the most reckless guys." Meanwhile "the most reckless CEOs hired the most reckless [chief financial officers.]"
That was in 2001 - a generation of CEOs before those who were promoted and reached the top ran us off the cliff, as such types could be expected to do.
But, the worst racketeers in the country have gravitated to the Federal Reserve Board. To prevent the economy from collapsing they rigged more markets than the Politburo.
The 2004 transcripts from the Federal Reserve Open Market committee - the FOMC - were just released.
At the March, 2004 meeting, Federal Reserve Governor Donald Kohn stated the FOMC's mission: "Policy accommodation - and the expectation that it will persist - is distorting asset prices. Most of the distortion is deliberate and a desirable effect of the stance of policy. We have attempted to lower interest rates below long-term equilibrium rates and to boost asset prices...."
In other words, Federal Reserve policy was to distort asset prices. Kohn also said this was deliberate and desirable. In other words, distorted asset prices were not an unfortunate consequence of such-and-such Fed policy. The Fed's goal was to distort asset prices.
Kohn went on: "It's hard to escape the suspicion that at least around the margin some prices and price relationships have gone beyond an economically justified response to easy policy. House prices fall into this category".
So note: the Fed was deliberately driving up the prices of houses.
I wrote about the 2004 transcripts last week on my blog. Having read all the transcripts from 1994, I can say this latest batch was of a different character. The Fed was now - in 2004 - holding long-term Treasury rates within a narrow band - for the benefit of the carry trade. The FOMC was now managing the size of the carry trade, and Greenspan was now asking whether hedge fund managers were properly delta hedging the extension of mortgage security duration due to changes in interest rates.
That was in 2004 - and we know how badly this central planning effort failed. Now in 2010, what in the world is the FOMC trying to manage to prevent an even larger blow up? [Those who own stocks: take note.
In retirement, Alan Greenspan claimed that he really didn't get it about subprime housing until late 2005.
He can be a particularly incurious fellow.
The center of the subprime universe was Irvine, California. Lincoln Savings and Loan was in Irvine, California. This was not a coincidence. Some of the same characters who had used their "combination of native cunning and access to leverage" in the 1980s were back.
In 2005, New Century ($35 billion), Option One ($29 billion) and Ameriquest ($19 billion) - all of Irvine - sold $83 billion of subprime loans in 2005. That is just subprime. In a single year.
All of America bought $161 billion worth of mortgages in 1992.]
And what is Fed policy today?
This policy was stated by Donald Kohn in the fall of 2009:
"Recently 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."
So, we have it:
One reason for the Fed's zero percent interest-rate policy, in the words of former Federal Reserve Board member Henry C. Wallich: "is [as] a means by which the strong can more effectively exploit the weak. The strategically positioned and well-organized can gain at the expense of the unorganized and aged."
The old can not live on zero percent, so the Fed has been able to chase them into riskier assets.
Part 11: Conclusion
In conclusion, Chairman Greenspan was a fiat chairman for a fiat age. His credentials were inflated to serve in a position of responsibility where he would justify that "special confidence" Wall Street executives had vouched for in 1983.
Americans were beguiled by this fixture on television, who gained more credibility simply because he was the central attraction on television. Americans were also taken in by corrupt economists, who were advertised as experts. They propelled a system that needed constant infusions of propaganda, convincing Americans they were getting richer even though they were getting poorer. By 2001, the "slick and the clever" had to be "the most reckless auditors [and] the most reckless investment bankers" since their dealings were divorced from any real, economic function. Thus "fundamental faith in the fairness of our institutions and our Government has deteriorated."
Hear Frederick Sheehan interviewed by Lisa Chase, "The Political Chick," on May 24, 2010, in "Interviews" on AuContrarian.com
A speech delivered at the Ludwig von Mises Institute Conference: "Austrian Economics and the Financial Markets," held at the University Club in New York City, May 22, 2010. Comments in brackets and italics were cut from talk due to time constraints. The speech can be heard in the "Interviews" section of the AuContrarian.com website, and, on the Ludwig von Mises website along with those of other conference speakers.
Part 1: Introduction
Alan Greenspan was the right Federal Reserve chairman for his times. His reputation was a creation of inflation and this was a century of inflation. His knowledge was superficial, when America tended towards superficiality. He was a creation of publicity in an age that craved celebrities. He was inarticulate, at a time when minds were growing more confused. He took short cuts to the top, when Americans more readily took the easy route.
Money has been degraded over the past century. It takes at least $20 to buy what cost $1 in 1913. Inflation of money was integrated into the twentieth century inflation of words, constant distractions and media promotion. Thus, the worship of celebrities simply because they are celebrities and the success of one pandering politician and clever opportunist: Alan Greenspan.
The short cuts taken in the 1950s set the course to the present. We bargained for wages and benefits that could not be paid in constant dollars. Americans worked fewer hours. We were buying more from abroad than we were selling. The government was spending more than its revenues by the 1960s.
In 1971, we stopped settling our balances in gold. Governments - and this was true around the world - found deficit financing an opium to the masses. Government programs abounded. The masses grew accustomed to inflation and borrowing in currencies that tended towards depreciation. Thus, debtors paid back less real money than they had borrowed. Bankers could lend more after the link to gold was severed since no final settlement of claims existed.
For this subterfuge of honesty and common sense, the United States employed celebrity economists who would make up new theories on the fly. This was dishonest. It follows that our dealings in dollars became dishonest. The corruption by the government, by economists who satisfied their interests, was matched by the corruption of those who trafficked in money. Since honesty was the enemy of our dealings, dishonesty held an advantage. In the end, credit and government policy have gravitated to fewer hands, those willing to participate in a swindle of the public's savings and of its trust.
At the center is an institution, the Federal Reserve System, which has been a willing accomplice. It employs dishonest economists. In 1987, it elected as its chairman a man of no merit but who could be counted upon to cut whatever corner was necessary to maintain the façade of national solvency. That imposter was Alan Greenspan.
Part Two: Alan Greenspan
1950s
When Alan Greenspan was 26 years old, he made a far-sighted and characteristic decision. He started smoking a pipe.
This was in 1950.
He had just entered Columbia University where he was studying for a doctorate in economics. He signed up for a class under Professor Arthur Burns. Burns was a well-known figure. He was co-author of a well regarded book: Measuring Business Cycles.
Whatever he learned in Burns's class, Greenspan did the important thing: he took up the pipe. This was Burn's trademark, as some will remember when Federal Reserve Chairman Arthur Burns sat before Senate committees and reinvented economics in the 1970s.
For instance, when inflation raged in the 1970s, it was Burns who removed food and energy from the Consumer Price Index.
In 1953, Burns left Columbia to head President Eisenhower's Council of Economic Advisers - the CEA. Greenspan left Columbia at the same time, without receiving his doctorate.
In 1977, he would receive his doctorate degree in economics, from NYU. It is a collection of articles and some economic journal pieces stapled together.
Alan Greenspan made a habit of choosing the easy route.
The media drones on about Greenspan's "ideology." Or, sometimes it's his "libertarianism." Or, it might be his "free-market beliefs." Whatever the case, these are simple labels, and simple labels are about all we will get from the media.
Alan Greenspan has cared about one - and only one - thing. Every nerve ending in his body at every moment in his life has been devoted to the promotion of Alan Greenspan.
Greenspan never had an ideology. He probably never understood what Ayn Rand was talking about. Nathaniel Branden, Rand's number one acolyte in the 1950s and also the Randian closest to Greenspan, wrote years later:
"Now, looking at [Alan], I wondered to what extent he was aware of Ayn's opinions."
Branden continued: Complimenting Ayn on some [paper she had written and read to the group], Greenspan might say, "On reading this...one tends to feel...exhilarated."
Platitudes and assurances also mesmerized the nation 50 years later. By then, that's about all we could get from any public figure. Of course, as a nation we did not demand more.
Ayn Rand seems to have understood why Alan clung to her apron strings, if she wore an apron.
She asked Branden: "Do you think Alan might basically be a social climber?"
She hit the nail on the head.
Alan knew what he was doing. Around that time, a young writer asked Gore Vidal if he had any advice: Vidal replied: "Yes, get on TV as often as possible."
Part 3: Slichter-Martin
At this time, there was a blazing debate in Washington about inflation. Some were for it and some were against it.
In the mid-1950s, academic economists were angling their presence into the media. One was Harvard University Professor Sumner Slichter. Fortune magazine named him the "father of inflation." That might not sound complimentary, but it was publicity.
Slichter told the Senate that the Fed would have to accept inflation to generate sufficient jobs. Slichter argued that costs for materials and labor were rising because "unions [were pushing up] wages and fringe benefits faster than the gains from productivity of labor. The result is a continuation of the slow rise in prices".
Slichter was correct, but ignored the traditional solution to either work harder or reduce benefits. America was not in the mood for either.
Slichter stands at the front of a long list of economists who decided they could abandon common sense in our road to ruin. In my book, I quoted Alfred Jay Nock:
"It is an economic axiom that goods and services can only be paid for with goods and services."
In the opposite corner to Slichter was William McChesney Martin Jr. Martin was chairman of the Federal Reserve board from 1951 to 1970.
After Slichter gave the senators the good news, Martin lashed back. [This was in early 1957:
"I refuse to raise the flag of defeatism in the battle of inflation. If you take [Schlicter's] view, then another bust will surely come."]
Refusing to raise the white flag, Martin gave one of the finest speeches ever delivered by a central banker. He might not have much competition. It was on August 13, 1957, that he spoke before the U.S. Senate Committee on Finance.
He told the assembled: "There is no validity whatever in the idea that any inflation, once accepted, can be confined to moderate proportions." Martin responded to "some segments of the community" - probably economists - who were arguing for "a gradual rise in prices...perhaps 2 per cent a year," Martin warned that such a prospect would work incalculable hardship." "Losses would be... inflicted upon millions of people..."
[These included: "pensioners...people who have their assets in savings accounts and long-term bonds...."]
Chairman Ben Bernanke has stated the economy should have a minimum inflation rate of 2% per year. There is not necessarily a contradiction here. Simple Ben doesn't seem to care if he inflicts hardship upon hundreds of millions, if he knows what he's doing at all.
Martin believed, fears of inflation would "cause people to spend more and more of their incomes and save less...."
Martin told the politicians that the composition of savings would change. It would "tend towards speculative commitments...and the pattern of investments and other spending - the decisions on what kinds of things to buy - will change in a way that threatens balanced growth."
Martin warned that "a spiral of mounting prices and wages seeks more and more financing" with a "considerable volume of the expenditure...financed at all times out of borrowed funds."
Martin was not an economist. This may be obvious. He had studied Latin at Yale.
"Finally" Martin said, "we should not overlook the way that inflation could damage our social and political structure....Those who would turn out to have savings in their old age would tend to be the slick and the clever rather than the hard-working and the thrifty. Fundamental faith in the fairness of our institutions and our Government would tend to deteriorate."
We know who won that battle.
Part 4: Greenspan's Rise
Speaking of the slick and the clever, by 1970, Alan Greenspan was a millionaire. By then, he owned an apartment at United Nations Plaza, a new and fashionable address where Walter Cronkite, Truman Capote and Johnny Carson also lived.
But what had he done - that is - as an economist to live among such company? It really isn't clear. He was a minor figure. Those who respected him said he was a whiz with numbers. A far larger group remembers, yes, he was full of numbers, but he was always wrong.
In the words of biographer Justin Martin: "[T]he general impression among people who knew Greenspan in those days was that he wasn't exactly marked for real greatness.... His old friends were destined to watch his career unfold - Nixon adviser, Ford adviser, [five]-term Fed chief-in stunned amazement."
Another to witness the curious elevation of Alan Greenspan was Marc Faber, who joined the Wall Street firm of White, Weld in 1970. Shortly after, [White Weld] hired Alan Greenspan, then as a consulting economist.
Part of Marc's job was to attend the monthly economic presentations by Greenspan and interpret his comments for the overseas offices.
Quoting Marc:
"Looking back....I... had no idea what Mr. Greenspan was talking about, but I may not have been the exception. When Mr. Greenspan first came on board at White, Weld as a consultant, 30 or 40 people from the firm's various departments would attend the meetings. Within a few months, however, attendance had dropped to just a handful.... By then I had also learned that the easiest way for me to communicate the (to me) incomprehensible remarks... was simply to summarize the previous day's news from the front page of the Wall Street Journal..."
Marc noted that one of the best investment decisions White, Weld ever made was to "get rid of Mr. Greenspan in late 1972 and hire instead the economist Gary Shilling."
Martin Mayer, who has written several books about Wall Street, first met Alan Greenspan in the 1960s. The millionaire economist was making a specialty of "statistical espionage" - that was Greenspan's description. Mayer later wrote: "the book on him in that capacity was that you could order the opinion you needed."
Greenspan's girlfriend Barbara Walters, wrote in her recent autobiography: "How Alan Greenspan, a man who believed in the philosophy of little government interference and few rules or regulations, could end up becoming chairman of the greatest regulatory agency in the country is beyond me."
This was the road to his success: he would do anything and he would say anything. He worked on his relations with the press much harder than he worked as an economist for his clients. He went one step further than other fast-track economic consultants - he even dated the press, then finally married it.
Even though he was a minor figure during the 1960s, he was getting his name in the New York Times, making market predictions. The funny thing is, he was almost always the voice of doom in those days. That was the 'sixties, so he was always wrong. In the seventies he was always wrong too, since he was always bullish.
Part 5: Back to the 1950s
William Martin's insight - that "a spiral of mounting prices and wages seeks more and more financing" and a "considerable volume of the expenditure...financed at all times out of borrowed funds." was a feature of the 1960s. That was the decade of the conglomerate.
Some who built mountains from molehills in the 1950s and 1960s were Meshulam Riklis, Carl Lindner and Saul Steinberg. They used paper instead of cash to buy out companies.
It ended in a baleful scrapheap of waste with such absurdities as Mary Carter Paint [relabeled Resorts International] attempting to swallow Pan American Airways. (It was unsuccessful.)
It is not a coincidence that American living standards probably plateued around 1970, since capital was so badly mishandled.
Part 6: The 1970s
By 1974, price inflation was in double digits: "incalculable hardship" was suffered by millions. [Capital was again mishandled, one reason being there were so many distractions from running a business. In 1973, Time magazine reported: American businessmen [could] accomplish much [by] "speculation." A U.S. executive "may enclose a check with his order rather than wait until the steel is delivered and the dollar's value may have fallen."]
On June 28, 1978, Federal Reserve Board Member Henry C. Wallich addressed the graduating class at Fordham University. "Inflation," he informed the graduates, "is a means by which the strong can more effectively exploit the weak. The strategically positioned and well-organized can gain at the expense of the unorganized and aged."
At this moment every graduating member of the Fordham class of '78 ran out of the stadium to the closest Goldman, Sachs recruiting booth. [Wallich spoke from first-hand experience. He was born in Germany in 1914, so had lived through the Weimer hyperinflation as a child.]
Wallich explained inflation "is technically an economic problem. I mean the breakdown of our standards of measuring economic values, as a consequence of inflation." The strong are smart enough to understand that inflation "introduces an element of deceit into our economic dealings." Contracts are no longer made to "be kept in terms of constant values" but, one party understands this better than the other.
Wallich went on to emphasize "the increasing uncertainty in providing privately for the future pushes people who are seeking security toward the government."
Part 7: The 1980s
Moving forward - to the 1980s, we had the savings and loan free-for-all. We also were adding mounds of debt that would have been inconceivable when Martin spoke in 1957.
In 1980, we - the United States, borrowed $1.40 for every $1 we added to GNP. By 1985, we were adding $4.00 for every $1 increment in GNP.
Savings and loans were perfectly designed for clever operators. S&L deposits were insured by the government and they had been deregulated. In the wrong hands, the S&Ls were sponges for questionable investments.
Meshulam Riklis, Carl Lindner, Saul Steinberg used their conglomerate platforms to swap paper.
Barrie Wigmore, then at Goldman, Sachs, wrote an excellent book, Securities Markets in the 1980s.
Wigmore wrote, of Riklis, Lindner and Steinberg: "it is tempting to conclude they... represented a cabal.... [They] cooperated and invested with each other extensively and were old hands in the market aspect of "Chinese paper" from the merger wave of the 1960s." .... Their "activities illustrate the combination of native cunning and access to leverage that made them effective."
Wigmore wrote, they [Riklis, Lindner and Steinberg] had a common involvement with Michael Milken's group at Drexel Burnham that probably helped to create enough liquidity for their junk bond securities..."
William Seidman, who headed the Resolution Trust Corporation, the body that cleaned up the savings and loan mess, wrote later that Michael Milken had "rigged the market by operating a sort of daisy chain among the S&Ls to trade the bonds back and forth across his famous X-shaped trading desk in Los Angeles. By manipulating the market, he maintained the façade that the bonds were trading at genuine market prices... When... [Milken] was brought down, and his trading operation with him, so were the S&Ls that depended on the value of his bonds to stay afloat."]
In 1984, Alan Greenspan was hired by the most notorious criminal in the savings and loan racket: Charles Keating. Keating laundered money through Lincoln Savings and Loan. He needed someone to write a letter to his regulator, [the Federal Home Loan Bank of San Francisco] that stated Lincoln Savings and Loan's investments were sound.
In 1985, Greenspan wrote to the Federal Home Bank that Lincoln's management "is seasoned and expert in selecting and making direct investments." By that time, Lincoln was not only loaded up with deals through Milken, it was swapping them at a profit with its holding company, American Continental Corporation. American Continental Corporation - and Charles Keating - had been spun out of Carl Lindner's American Financial Corporation. Keating was known as Lindner's hatchet man. [In 1978, Keating had offered no defense when the SEC charged him - in the words of Martin Mayer - with: "arranging fraudulent loans to himself... from a bank owned by his friend and employer Carl Lindner."]
Greenspan surely knew who he was dealing with. He had been on Wall Street in the 1960s. He trafficked in knowing who he should be schmoozing. In the 1980s, he must have known Lincoln was part of the Riklis, Steinberg, Lindner, Boesky, Milken crowd.
[Lindner had been in the news when he extorted greenmail from Combined Communications (1979), and Gannett (1981). "Greenmail" - was a neologism for the word "blackmail," - when a "corporate raider" acquired shares in a company and the company then bought the shares back at a premium to rid itself of the raider. Steinberg's most publicized success was also his most profitable - when he extorted $60 million from Walt Disney in 1984.
Lindner used Keating when greenmail efforts went awry and he wanted to dump shares. An example was Gulf Broadcast - Keating's first big investment, in 1984. Keating paid $132 million to Lindner's American Financial. This was 30% above that day's market price. The $132 million was also twice Lincoln's net worth - a violation of California regulations. All of this was before Greenspan's 1985 high praise for Lincoln Savings and Loan's "expert[ise] in selecting and making direct investments.".
I should note that Riklis and company had not introduced some fractured ethos of their own. Wall Street was financing greenmail and corporate raiders; investment bankers led raids on their own clients. This conduct was nurtured in the 1970s and bloomed in the 1980s. The rise in debt financing, and leverage, was one reason.]
This was just the man to inherit the Federal Reserve chairmanship in 1987. Four years before, in 1983, a poll of Wall Street executives found that 31% of them had a special confidence in Alan Greenspan, should he be named chairman. He was second in that poll, behind Paul Volcker.
Part 8: Proxmire
Greenspan's hearing for Federal Reserve chairman was in August, 1987. Senator William Proxmire, a Democrat from Wisconsin, was the chairman. He did not like Greenspan. He had voted against Greenspan's confirmation as chairman of the Council of Economic Advisers in 1974 because he thought Greenspan would pass information back to the companies with whom he had consulted.
I don't know why he thought that, but it is an odd suspicion of a candidate for a senior government post. [At least it was in 1974.] He may have known about Greenspan's reputation: "the book on him was that you could order the opinion you needed."
Proxmire opened the hearing by chastising Greenspan for his abysmal forecasting record.
More than Greenspan's habit of always being wrong - and by such a wide margin - Proxmire was probably more concerned by Greenspan's less-than-honest "full disclosure" statement he had submitted to the White House and the Senate.
He had not revealed services rendered to [Sears and] Lincoln Savings & Loan. Greenspan distinguished the two by slipping them in the side pocket of "advocacy projects."
Proxmire was a foe of bank deregulation. He feared big banks would squash smaller banks. He feared Alan Greenspan would to be only too happy to squash them.
The senator lectured the candidate for the Fed chairmanship:
"As chairman of the Federal Reserve you play the key role in approval or disapproval of these massive bank mergers.... I would feel much better about this appointment if there was somewhere in your record an indication of your awareness of the dangers to our economy of excessive financial concentration."
Well, there was no such indication, and oddly for Greenspan, he didn't try to spin some preposterous middle path.
Part 9: Greenspan's Chairmanship
After becoming Federal Reserve chairman, Alan Greenspan could not fulfill Senator Proxmire's fears fast enough. (Proxmire had retired.)
In 1989, the Federal Reserve permitted J.P. Morgan, of which Greenspan had been director before becoming Fed chairman, to underwrite Xerox debt. This was the first such debt issue from a commercial bank since 1933, the year of the Glass-Steagall Act.
In 1990, the Federal Reserve permitted J.P. Morgan to underwrite stock. Time magazine called this "the widest breach of Glass-Steagall yet."
Greenspan was as permissive when it came to money printing as he was on mega-banking. He had to be. Americans were impatient and Greenspan did not want to disappoint: He loved to be liked. He would not wait for a proper recovery after the recession of 1990. He reduced the fed funds rate from 9-3/4% in 1989 to 3% in 1992. Banks and hedge funds leveraged up and refloated the economy.
This was the first time a recovery in the U.S. was driven by finance rather than production. Money and credit was concentrated more and more in the hands of "the slick and the clever" who had nearly unlimited access to "more and more financing." By now, the middle class was getting trounced.
From that point forward, every time the economy coughed, Greenspan cut rates and pumped up a bubble. Loose money attracts characters who should never deal in money.
The economy had become badly unbalanced. Federal Reserve Governor Larry Lindsey warned the Federal Reserve Open Market Committee (FOMC) of the growing income disparity, in every FOMC meeting from 1993 to 1996. The other Fed governors did not understand what he was talking about. For example, Lindsey spoke and Janet Yellen worried that Americans were saving too much, which would reduce the GDP. Not only was the underclass getting crushed, it was borrowing in a desperate attempt to keep up.
In what might be called his farewell address, Lindsey spoke at the September 1996 FOMC meeting:
MR. LINDSEY. Our luck is about to run out in the financial markets because of what I would consider a gambler's curse: We have won this long, let us keep the money on the table.... But the long-term costs of a bubble to the economy and society are potentially great. They include a reduction in the long-term saving rate, a seemingly random redistribution of wealth, and the diversion of scarce financial [and] human capital into the acquisition of wealth.... I think it is far better that we [burst the stock-market bubble] while the bubble still resembles surface froth and before the bubble carries the economy to stratospheric heights. Whenever we do it, it is going to be painful however.... If the optimists are wrong, then indeed not only our luck but that of the markets and of the economy has run out. Thank you.
CHAIRMAN GREENSPAN. On that note, we all can go for coffee.
Greenspan sat there and drank coffee for the next 10 years. He blew up the stock market, then the mortgage and credit markets while the sorts of characters who were reaching the top on Wall Street were of a persuasion that you wouldn't allow to fill your gas tank.
Part 10: Standards Keep Eroding
In 2001, David Tice testified before the House Financial Services Committee: "The most reckless fund managers, the most reckless auditors, the most reckless investment bankers, the most reckless corporate officers made the most money. So you had greater and greater incentives to promote the most reckless guys." Meanwhile "the most reckless CEOs hired the most reckless [chief financial officers.]"
That was in 2001 - a generation of CEOs before those who were promoted and reached the top ran us off the cliff, as such types could be expected to do.
But, the worst racketeers in the country have gravitated to the Federal Reserve Board. To prevent the economy from collapsing they rigged more markets than the Politburo.
The 2004 transcripts from the Federal Reserve Open Market committee - the FOMC - were just released.
At the March, 2004 meeting, Federal Reserve Governor Donald Kohn stated the FOMC's mission: "Policy accommodation - and the expectation that it will persist - is distorting asset prices. Most of the distortion is deliberate and a desirable effect of the stance of policy. We have attempted to lower interest rates below long-term equilibrium rates and to boost asset prices...."
In other words, Federal Reserve policy was to distort asset prices. Kohn also said this was deliberate and desirable. In other words, distorted asset prices were not an unfortunate consequence of such-and-such Fed policy. The Fed's goal was to distort asset prices.
Kohn went on: "It's hard to escape the suspicion that at least around the margin some prices and price relationships have gone beyond an economically justified response to easy policy. House prices fall into this category".
So note: the Fed was deliberately driving up the prices of houses.
I wrote about the 2004 transcripts last week on my blog. Having read all the transcripts from 1994, I can say this latest batch was of a different character. The Fed was now - in 2004 - holding long-term Treasury rates within a narrow band - for the benefit of the carry trade. The FOMC was now managing the size of the carry trade, and Greenspan was now asking whether hedge fund managers were properly delta hedging the extension of mortgage security duration due to changes in interest rates.
That was in 2004 - and we know how badly this central planning effort failed. Now in 2010, what in the world is the FOMC trying to manage to prevent an even larger blow up? [Those who own stocks: take note.
In retirement, Alan Greenspan claimed that he really didn't get it about subprime housing until late 2005.
He can be a particularly incurious fellow.
The center of the subprime universe was Irvine, California. Lincoln Savings and Loan was in Irvine, California. This was not a coincidence. Some of the same characters who had used their "combination of native cunning and access to leverage" in the 1980s were back.
In 2005, New Century ($35 billion), Option One ($29 billion) and Ameriquest ($19 billion) - all of Irvine - sold $83 billion of subprime loans in 2005. That is just subprime. In a single year.
All of America bought $161 billion worth of mortgages in 1992.]
And what is Fed policy today?
This policy was stated by Donald Kohn in the fall of 2009:
"Recently 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."
So, we have it:
One reason for the Fed's zero percent interest-rate policy, in the words of former Federal Reserve Board member Henry C. Wallich: "is [as] a means by which the strong can more effectively exploit the weak. The strategically positioned and well-organized can gain at the expense of the unorganized and aged."
The old can not live on zero percent, so the Fed has been able to chase them into riskier assets.
Part 11: Conclusion
In conclusion, Chairman Greenspan was a fiat chairman for a fiat age. His credentials were inflated to serve in a position of responsibility where he would justify that "special confidence" Wall Street executives had vouched for in 1983.
Americans were beguiled by this fixture on television, who gained more credibility simply because he was the central attraction on television. Americans were also taken in by corrupt economists, who were advertised as experts. They propelled a system that needed constant infusions of propaganda, convincing Americans they were getting richer even though they were getting poorer. By 2001, the "slick and the clever" had to be "the most reckless auditors [and] the most reckless investment bankers" since their dealings were divorced from any real, economic function. Thus "fundamental faith in the fairness of our institutions and our Government has deteriorated."
Hear Frederick Sheehan interviewed by Lisa Chase, "The Political Chick," on May 24, 2010, in "Interviews" on AuContrarian.com
Thursday, May 13, 2010
The 2004 Fed Transcripts: A Methodical, Diabolical Destruction of America's "Wealth"
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 Federal Reserve releases transcripts of the Federal Open Market Committee (FOMC) meetings with a five-year lag (as required by law, the Fed would like to burn them). Transcripts for 2004 meetings were released on April 30, 2010. The Dow Jones Industrial Average fell 998 points on May 6, 2010. The 2004 transcripts help explain why the Dow could have disappeared last week.
The Setting
To refresh memories, the Fed had cut the fed funds rate to 1.00% in June 2003. America leveraged up on free money ("free," since inflation was higher). The mortgage boom etched itself on the national conscience. The 2004 FOMC meetings were filled with discussions of whether and when the Fed should tighten. ("Tighten," meaning, raise the funds rate from 1.00%. Raising the rate should tighten, or restrict, access to credit.) The result of FOMC talk was to increase the funds rate after each of the FOMC meetings, starting in June through the end of the year. Each time it was raised by 0.25%. In practice, this is the Fed's minimum rate change. The FOMC raised the funds rate to 1.25% in June 2004, to 1.50% in August, to 1.75% in September, to 2.00% in November, and to 2.25% in December. It would continue with a total of 17 consecutive 0.25% boosts, until the funds rate reached 5.25% in June 2006. This gave the impression the FOMC was walking on eggshells.
FOMC transcripts in 2004 confirm the Fed was afraid of markets. Its concerns about the economy were only a derivative function of how market volatility could disrupt consumer spending. (Over 100% of economic growth after the post-2001 recession had been consumer spending.) The Fed understood rising asset prices boosted consumer spending. As I discuss below, the FOMC was not simply fixing short-term interest rates. It was now interfering with long-term interest rates, the stock market, and the housing market. This distorted the entire structure of prices through the economy and we know how it ended - no better than the Politburo's central planning.
In 2004, the FOMC knew that when it raised the funds rate, financial markets might exhibit any number of unintended consequences. In June, Chairman Greenspan stated a policy change to avoid such turmoil: "By committee desire, we have been changing the funds rate only at meetings. That was not the case in the past." He wanted the markets to know it could rely on the Fed's constancy.
The FOMC seemed most concerned that higher rates might interfere with the carry trade. In the sad tale of The Financialization of the United States, the carry trade deserves a chapter. It received one in [Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession.] Chapter 10: "Restoring the Economy: Greenspan Underwrites the Carry Trade, 1990-1994," discusses the unique recovery from the 1990-1991 recession. Never before had the U.S. economy resurrected itself through finance rather than industry. To accomplish this amazing feat, finance flooded the banking system and hedge funds.
The Federal Reserve had cut the funds rate from 9.75% in 1989 to 3.0% in 1992. Quoting from Panderer to Power: "Speculators borrowed at a cheap rate - such as a Treasury bill, yielding 3%. They bought higher yielding securities, such as Japanese government bonds that yielded around 6%. They expected (or hoped) the borrowed asset would not rise in price. They leveraged the 3% spread at 10:1 or 100:1. Up to the present, the carry trade has funded fortunes in New York, London, Tokyo, and Shanghai."
By 2004, the carry trade was a mammoth enterprise of hedge funds and banks. The too-big-to-fail banks were, by now, leveraging their own internally managed hedge funds, managing their own proprietary trading desks, and also lending to highly leveraged hedge funds. Leverage, and, the belief that access to rising levels of credit would never end, pushed up asset values on bank balance sheets - whether real estate, bonds, stocks, or private-equity. This increased the banks' lending capacity which encouraged banks to lend more. Hedge funds and private-equity funds (that were leveraging their acquisitions into bankruptcy) could not, or would not, refuse free money. Rising asset prices boosted mortgage origination, refinancing, home-equity withdrawal, prices of mortgage securities and lines-of-credit from commercial and investment banks to unscrupulous mortgage lenders. Markets believed asset prices would only go up for many silly reasons. Belief in the Greenspan Put may have been the silliest but also the most influential. (The Bernanke Put today is even sillier.)
The FOMC's Manipulation of Asset Prices
Federal Reserve Governor Donald Kohn stated the FOMC's mission at the March, 2004 meeting: "Policy accommodation - and the expectation that it will persist - is distorting asset prices. Most of the distortion is deliberate and a desirable effect of the stance of policy. We have attempted to lower interest rates below long-term equilibrium rates and to boost asset prices...."
It is worth pausing here. Kohn told his confreres that Federal Reserve policy was to distort asset prices. He also said this was deliberate and desirable. In other words, distorted asset prices were not an unfortunate consequence of such-and-such Fed policy. The Fed's goal was to distort asset prices.
Kohn went on: "It's hard to escape the suspicion that at least around the margin some prices and price relationships have gone beyond an economically justified response to easy policy. House prices fall into this category [note: the Fed was deliberately overpricing houses], as do risk spreads in some markets and perhaps even the level of long-term rates themselves, which many in the market perceive as particularly depressed by the carry trade...." Summarizing, Kohn believed the Fed had deliberately set a policy that raised house and long-term bond prices beyond a "justifiable response" to the 1.00% fed funds rate. (One justifiable response to free money is a price of infinity, but Kohn was not of that persuasion.) Second, Kohn thought the carry trade was reducing yields on long-term Treasury bonds. (As follows: when a trader borrows $1 billion at 1% and buys $1 billion of 10-year Treasury bonds that yield 4%, prices of the 10-year bond go up as the yield goes down.)
At the January 27-28, 2004, FOMC meeting, Fed Governor Roger Ferguson voiced his own fears, about the state of financial markets: "During the intermeeting period [the prior meeting was on December 9, 2003], we saw quite a run-up in the prices of equities.... During the same period, interest rates dropped quite significantly. Risk spreads have come down.... This may indicate an underappreciation of the risks that may be imbedded. Frankly, to put it mildly, I think that the dollar carry trade has become extremely well entrenched and that the markets are looking to us perhaps more than they should be.... Perhaps we are anchoring the yield curve more than we'd like....I'm afraid the fixed income markets in particular are not in fact doing the appropriate job of pricing risks. We need in some sense to remove the anchor that we have placed on those markets."
Greenspan did not agree. At the same January meeting, Governor Kohn said he did not think the FOMC should "second-guess asset price levels." Kohn continued: "It's something we didn't do in the stock market run-up in the '90s and I was pretty comfortable with how we handled that. So I'd be a little cautious about using monetary policy to try to damp asset price movements." Greenspan replied to Kohn: "I certainly agree with that." It is not clear if the chairman was agreeing to this obsequious compliment of Greenspan's successful demolition of the stock market, but the chairman was affirming he wanted asset prices to move up and up and up.
As a more trivial matter, these conversations contradict Alan Greenspan's recent attempts to rehabilitate himself at the Brookings Institute in March 2010, and before the Financial Crisis Inquiry Commission (FCIC), on April 7, 2010. According to the old humbug, the Greenspan Fed does not bear an iota of blame for "by far the greatest financial crisis globally ever" (Greenspan's words). He claimed under oath before the FCIC that the Fed was blameless because the "house bubble, the most prominent global bubble in generations, was engendered by... long term mortgage rates" which "by 2002 and 2003... delinked from their historical tie to central bank overnight rates." The italics were Greenspan's. There are many pages in the 2004 FOMC transcripts where tactics to move or fix the 10-year Treasury yield are discussed. (For those who remember Greenspan's "conundrum" - his inability to understand why long-term rates weren't rising - this answers what most suspected. His protestations of bewilderment were a ruse.)
In 2004, the then-Fed chairman stated there was a direct link between Fed policy and long-term interest rates. At the September 2004 FOMC meeting, Greenspan said an issue on the table was "whether we should encourage lower ten-year interest rates...." He stated this would happen "if we do decide to pause later in the year, we will end up with lower long-term rates, higher bond prices, and presumably higher asset prices on the balance sheets of a number of financial institutions." (A "pause," in this case, would be to break from the established pattern of raising the funds rate at every meeting.) There was no question about it: "we will end up." Yet, he told the FCIC this linkage no longer existed after 2003.
Dino Kos, Manager of the Fed's System Open Market Account (at the New York Fed, which fixes the fed funds rate by trading with dealers), made an interesting observation at the March meeting: "If we talk to people who are active in, say, Treasuries, we hear a lot about the carry trade and about an expansion of risk and leverage." It is not clear from reading the transcript, if Kos, or others, considered this to be good or bad. Speculative risk and leverage in the banking system would not normally be welcomed by the nation's leading bank regulator (Greenspan), but neither was it desirable to slow down the mortgage carry trade. Such developments as Interest-Only and Negative-Amortization mortgages may have remained a niche market if not for speculators who were asking for more assets to buy with the money they had borrowed. (Dino Kos at the June 29-30, 2004 FOMC meeting: "Banks and hedge funds are still holding on to large positions in mortgage-backed securities.") By 2004, Wall Street was funding and even buying subprime mortgage lenders to accelerate the flow of mortgage securities they sold, such as CDOs. In 2004, Lehman Brothers was the 11th largest subprime lender in the U.S. and the top issuer of subprime mortgage securities.
Greenspan: "We Created the Carry Trade"
At the September FOMC meeting, Federal Reserve Governor Susan Bies commented: "The whole process of reserve management has changed. This is a profit center in a bank...."
The Fed worked closely with the banks to help maximize these profits. According to Bies, this has "gotten a lot of credibility in the market and we need to be careful what we do..." Chairman Greenspan chimed in, drawing an analogy to another cooperative effort in which the Fed maximized profits of commercial banks: "For the same reasons we've created the carry trade, because if you lock in with some permanence one leg of it, that reduces the risk."
There was never doubt that the Fed was aware, and possibly complicit, in the restructuring of America into a financial economy. It is noteworthy to discover that the Fed is so much more; such entrepreneurial spirit is unusual within government bureaucracies. Who guessed the pivotal role Alan Greenspan played in turning investment banks into proprietary trading desks; that the Fed created the carry trade? Certainly not the author of Panderer to Power. No wonder the man still commands six-figure fees for speaking engagements sponsored by banks and attended by hedge fund managers.
It is also interesting to read that this Public-Private Partnership "lock[s] in with some permanence one leg of [the carry trade], that reduces the risk." This evolution of the Federal Reserve's responsibility has escaped legislative approval. It does not seem sporting to eliminate risk to speculators who can make $100 million a year when the trade works. (Long-Term Capital Management is an example of 100-to-1 leverage that failed.) Rather than an investment, this looks more like a racket.
Greenspan's motives are always a quagmire of probabilities. It is better to operate from certainties and, in this case, it is certain he was caught in a trap with no good way out. He entered a pact with the devil when he created the carry trade in the early 1990s. By not allowing nature to take its course, the "real" economy could not heal. Finance drove steel piles into the ground and established a new foundation for the financial economy. The real economy slowly rusted while finance rose to the sky. Greenspan perverted the nation's economic discussion during the second half of the 1990s with his productivity fantasy. Wall Street spread the Greenspan gospel and made fortunes from the Internet bubble.
The stock market collapsed in 2000 and 2001, which is the inevitable conclusion of such hallucinations. The girders of the real economy were wobbly by then - manufacturing jobs were disappearing at the fastest rate since the Great Depression. From March 2001, the official starting date of the recession, through the end of 2004, employment in the private economy fell by 1,200,000. Greenspan looked for a financial solution - the housing bubble. It was, in the larger sense, a credit splurge. This Godzilla had to be much bigger than the stock market fiasco, and it was. (The farther the economy deviated from its traditional foundation, the more credit needed to be created to forestall a collapse.)
At the 2004 meetings Greenspan - and the FOMC - were setting Federal Reserve policy not only by fixing short-term interest rates, but also by calibrating the carry trade. Conversations show the Committee understood the danger of expanding the trade: if it grew too large, a financial earthquake would crash the rising skyscraper to the ground. At the January 2004 meeting, Dino Kos talked about "the already rather steep yield curve [nirvana to the carry trade], the 3 percent differential between the funds rate and the yield on the ten-year bond is historically wide, and further steepening probably would bring in new investors to take advantage of the carry." The tone of Kos' comment (measured by the direction of the meeting and questions being asked) seems to be that the 3% spread was about right. Less, and credit arteries might harden. More, and the Fed might not be able to contain the carry trade. The FOMC, interpreting Kos' statement, should work towards holding the spread at 3%.
This was the same meeting at which Governor Ferguson had worried that "we are anchoring the yield curve more than we'd like." The anchor was the short-term borrowing rate, the 3% spread to the long-term rate was the profit, after it was leveraged.
The FOMC was also tugging on long-term interest rates for reasons Chairman Greenspan discussed at the September meeting. He asked the question: "[Should] we should encourage lower ten-year interest rates, given how close they are to levels that would prompt a lot of mortgage financings and a significant drop in duration in the mortgage market...?" His interest in mortgage refinacings was to boost consumer spending.
Consumer spending exceeded consumer income. This had to continue. Greenspan described the importance of rising asset prices in fooling the consumer at the November FOMC meeting: "We have a very significant problem with private saving. The household saving rate has come down dramatically and now is close to zero....The idea of having a negative savings rate is not out of line with the way the world works. Remember...the average household looks at the market value ...of its equity holdings.... We can have a negative saving rate with a significant part of the population believing that they are saving at a fairly pronounced rate."
This strategy of fixing asset prices at an artificially high rate to fool the American people into spending money they did not have was diabolical. It was even more so, given what Greenspan told the public. Before Congress on July 15, 2003, he claimed: "The prospects for a resumption of strong economic growth have been enhanced by steps taken in the private sector over the past couple of years to restructure and strengthen balance sheets....Nowhere has this process of balance sheet adjustment been more evident than in the household sector." The man will say anything.
Conclusion
The Federal Reserve releases transcripts of the Federal Open Market Committee (FOMC) meetings with a five-year lag (as required by law, the Fed would like to burn them). Transcripts for 2004 meetings were released on April 30, 2010. The Dow Jones Industrial Average fell 998 points on May 6, 2010. The 2004 transcripts help explain why the Dow could have disappeared last week.
To refresh memories, the Fed had cut the fed funds rate to 1.00% in June 2003. America leveraged up on free money ("free," since inflation was higher). The mortgage boom etched itself on the national conscience. The 2004 FOMC meetings were filled with discussions of whether and when the Fed should tighten. ("Tighten," meaning, raise the funds rate from 1.00%. Raising the rate should tighten, or restrict, access to credit.) The result of FOMC talk was to increase the funds rate after each of the FOMC meetings, starting in June through the end of the year. Each time it was raised by 0.25%. In practice, this is the Fed's minimum rate change. The FOMC raised the funds rate to 1.25% in June 2004, to 1.50% in August, to 1.75% in September, to 2.00% in November, and to 2.25% in December. It would continue with a total of 17 consecutive 0.25% boosts, until the funds rate reached 5.25% in June 2006. This gave the impression the FOMC was walking on eggshells.
FOMC transcripts in 2004 confirm the Fed was afraid of markets. Its concerns about the economy were only a derivative function of how market volatility could disrupt consumer spending. (Over 100% of economic growth after the post-2001 recession had been consumer spending.) The Fed understood rising asset prices boosted consumer spending. As I discuss below, the FOMC was not simply fixing short-term interest rates. It was now interfering with long-term interest rates, the stock market, and the housing market. This distorted the entire structure of prices through the economy and we know how it ended - no better than the Politburo's central planning.
In 2004, the FOMC knew that when it raised the funds rate, financial markets might exhibit any number of unintended consequences. In June, Chairman Greenspan stated a policy change to avoid such turmoil: "By committee desire, we have been changing the funds rate only at meetings. That was not the case in the past." He wanted the markets to know it could rely on the Fed's constancy.
The FOMC seemed most concerned that higher rates might interfere with the carry trade. In the sad tale of The Financialization of the United States, the carry trade deserves a chapter. It received one in [Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession.] Chapter 10: "Restoring the Economy: Greenspan Underwrites the Carry Trade, 1990-1994," discusses the unique recovery from the 1990-1991 recession. Never before had the U.S. economy resurrected itself through finance rather than industry. To accomplish this amazing feat, finance flooded the banking system and hedge funds.
The Federal Reserve had cut the funds rate from 9.75% in 1989 to 3.0% in 1992. Quoting from Panderer to Power: "Speculators borrowed at a cheap rate - such as a Treasury bill, yielding 3%. They bought higher yielding securities, such as Japanese government bonds that yielded around 6%. They expected (or hoped) the borrowed asset would not rise in price. They leveraged the 3% spread at 10:1 or 100:1. Up to the present, the carry trade has funded fortunes in New York, London, Tokyo, and Shanghai."
By 2004, the carry trade was a mammoth enterprise of hedge funds and banks. The too-big-to-fail banks were, by now, leveraging their own internally managed hedge funds, managing their own proprietary trading desks, and also lending to highly leveraged hedge funds. Leverage, and, the belief that access to rising levels of credit would never end, pushed up asset values on bank balance sheets - whether real estate, bonds, stocks, or private-equity. This increased the banks' lending capacity which encouraged banks to lend more. Hedge funds and private-equity funds (that were leveraging their acquisitions into bankruptcy) could not, or would not, refuse free money. Rising asset prices boosted mortgage origination, refinancing, home-equity withdrawal, prices of mortgage securities and lines-of-credit from commercial and investment banks to unscrupulous mortgage lenders. Markets believed asset prices would only go up for many silly reasons. Belief in the Greenspan Put may have been the silliest but also the most influential. (The Bernanke Put today is even sillier.)
The FOMC's Manipulation of Asset Prices
Federal Reserve Governor Donald Kohn stated the FOMC's mission at the March, 2004 meeting: "Policy accommodation - and the expectation that it will persist - is distorting asset prices. Most of the distortion is deliberate and a desirable effect of the stance of policy. We have attempted to lower interest rates below long-term equilibrium rates and to boost asset prices...."
It is worth pausing here. Kohn told his confreres that Federal Reserve policy was to distort asset prices. He also said this was deliberate and desirable. In other words, distorted asset prices were not an unfortunate consequence of such-and-such Fed policy. The Fed's goal was to distort asset prices.
Kohn went on: "It's hard to escape the suspicion that at least around the margin some prices and price relationships have gone beyond an economically justified response to easy policy. House prices fall into this category [note: the Fed was deliberately overpricing houses], as do risk spreads in some markets and perhaps even the level of long-term rates themselves, which many in the market perceive as particularly depressed by the carry trade...." Summarizing, Kohn believed the Fed had deliberately set a policy that raised house and long-term bond prices beyond a "justifiable response" to the 1.00% fed funds rate. (One justifiable response to free money is a price of infinity, but Kohn was not of that persuasion.) Second, Kohn thought the carry trade was reducing yields on long-term Treasury bonds. (As follows: when a trader borrows $1 billion at 1% and buys $1 billion of 10-year Treasury bonds that yield 4%, prices of the 10-year bond go up as the yield goes down.)
At the January 27-28, 2004, FOMC meeting, Fed Governor Roger Ferguson voiced his own fears, about the state of financial markets: "During the intermeeting period [the prior meeting was on December 9, 2003], we saw quite a run-up in the prices of equities.... During the same period, interest rates dropped quite significantly. Risk spreads have come down.... This may indicate an underappreciation of the risks that may be imbedded. Frankly, to put it mildly, I think that the dollar carry trade has become extremely well entrenched and that the markets are looking to us perhaps more than they should be.... Perhaps we are anchoring the yield curve more than we'd like....I'm afraid the fixed income markets in particular are not in fact doing the appropriate job of pricing risks. We need in some sense to remove the anchor that we have placed on those markets."
Greenspan did not agree. At the same January meeting, Governor Kohn said he did not think the FOMC should "second-guess asset price levels." Kohn continued: "It's something we didn't do in the stock market run-up in the '90s and I was pretty comfortable with how we handled that. So I'd be a little cautious about using monetary policy to try to damp asset price movements." Greenspan replied to Kohn: "I certainly agree with that." It is not clear if the chairman was agreeing to this obsequious compliment of Greenspan's successful demolition of the stock market, but the chairman was affirming he wanted asset prices to move up and up and up.
As a more trivial matter, these conversations contradict Alan Greenspan's recent attempts to rehabilitate himself at the Brookings Institute in March 2010, and before the Financial Crisis Inquiry Commission (FCIC), on April 7, 2010. According to the old humbug, the Greenspan Fed does not bear an iota of blame for "by far the greatest financial crisis globally ever" (Greenspan's words). He claimed under oath before the FCIC that the Fed was blameless because the "house bubble, the most prominent global bubble in generations, was engendered by... long term mortgage rates" which "by 2002 and 2003... delinked from their historical tie to central bank overnight rates." The italics were Greenspan's. There are many pages in the 2004 FOMC transcripts where tactics to move or fix the 10-year Treasury yield are discussed. (For those who remember Greenspan's "conundrum" - his inability to understand why long-term rates weren't rising - this answers what most suspected. His protestations of bewilderment were a ruse.)
In 2004, the then-Fed chairman stated there was a direct link between Fed policy and long-term interest rates. At the September 2004 FOMC meeting, Greenspan said an issue on the table was "whether we should encourage lower ten-year interest rates...." He stated this would happen "if we do decide to pause later in the year, we will end up with lower long-term rates, higher bond prices, and presumably higher asset prices on the balance sheets of a number of financial institutions." (A "pause," in this case, would be to break from the established pattern of raising the funds rate at every meeting.) There was no question about it: "we will end up." Yet, he told the FCIC this linkage no longer existed after 2003.
Dino Kos, Manager of the Fed's System Open Market Account (at the New York Fed, which fixes the fed funds rate by trading with dealers), made an interesting observation at the March meeting: "If we talk to people who are active in, say, Treasuries, we hear a lot about the carry trade and about an expansion of risk and leverage." It is not clear from reading the transcript, if Kos, or others, considered this to be good or bad. Speculative risk and leverage in the banking system would not normally be welcomed by the nation's leading bank regulator (Greenspan), but neither was it desirable to slow down the mortgage carry trade. Such developments as Interest-Only and Negative-Amortization mortgages may have remained a niche market if not for speculators who were asking for more assets to buy with the money they had borrowed. (Dino Kos at the June 29-30, 2004 FOMC meeting: "Banks and hedge funds are still holding on to large positions in mortgage-backed securities.") By 2004, Wall Street was funding and even buying subprime mortgage lenders to accelerate the flow of mortgage securities they sold, such as CDOs. In 2004, Lehman Brothers was the 11th largest subprime lender in the U.S. and the top issuer of subprime mortgage securities.
Greenspan: "We Created the Carry Trade"
At the September FOMC meeting, Federal Reserve Governor Susan Bies commented: "The whole process of reserve management has changed. This is a profit center in a bank...."
The Fed worked closely with the banks to help maximize these profits. According to Bies, this has "gotten a lot of credibility in the market and we need to be careful what we do..." Chairman Greenspan chimed in, drawing an analogy to another cooperative effort in which the Fed maximized profits of commercial banks: "For the same reasons we've created the carry trade, because if you lock in with some permanence one leg of it, that reduces the risk."
There was never doubt that the Fed was aware, and possibly complicit, in the restructuring of America into a financial economy. It is noteworthy to discover that the Fed is so much more; such entrepreneurial spirit is unusual within government bureaucracies. Who guessed the pivotal role Alan Greenspan played in turning investment banks into proprietary trading desks; that the Fed created the carry trade? Certainly not the author of Panderer to Power. No wonder the man still commands six-figure fees for speaking engagements sponsored by banks and attended by hedge fund managers.
It is also interesting to read that this Public-Private Partnership "lock[s] in with some permanence one leg of [the carry trade], that reduces the risk." This evolution of the Federal Reserve's responsibility has escaped legislative approval. It does not seem sporting to eliminate risk to speculators who can make $100 million a year when the trade works. (Long-Term Capital Management is an example of 100-to-1 leverage that failed.) Rather than an investment, this looks more like a racket.
Greenspan's motives are always a quagmire of probabilities. It is better to operate from certainties and, in this case, it is certain he was caught in a trap with no good way out. He entered a pact with the devil when he created the carry trade in the early 1990s. By not allowing nature to take its course, the "real" economy could not heal. Finance drove steel piles into the ground and established a new foundation for the financial economy. The real economy slowly rusted while finance rose to the sky. Greenspan perverted the nation's economic discussion during the second half of the 1990s with his productivity fantasy. Wall Street spread the Greenspan gospel and made fortunes from the Internet bubble.
The stock market collapsed in 2000 and 2001, which is the inevitable conclusion of such hallucinations. The girders of the real economy were wobbly by then - manufacturing jobs were disappearing at the fastest rate since the Great Depression. From March 2001, the official starting date of the recession, through the end of 2004, employment in the private economy fell by 1,200,000. Greenspan looked for a financial solution - the housing bubble. It was, in the larger sense, a credit splurge. This Godzilla had to be much bigger than the stock market fiasco, and it was. (The farther the economy deviated from its traditional foundation, the more credit needed to be created to forestall a collapse.)
At the 2004 meetings Greenspan - and the FOMC - were setting Federal Reserve policy not only by fixing short-term interest rates, but also by calibrating the carry trade. Conversations show the Committee understood the danger of expanding the trade: if it grew too large, a financial earthquake would crash the rising skyscraper to the ground. At the January 2004 meeting, Dino Kos talked about "the already rather steep yield curve [nirvana to the carry trade], the 3 percent differential between the funds rate and the yield on the ten-year bond is historically wide, and further steepening probably would bring in new investors to take advantage of the carry." The tone of Kos' comment (measured by the direction of the meeting and questions being asked) seems to be that the 3% spread was about right. Less, and credit arteries might harden. More, and the Fed might not be able to contain the carry trade. The FOMC, interpreting Kos' statement, should work towards holding the spread at 3%.
This was the same meeting at which Governor Ferguson had worried that "we are anchoring the yield curve more than we'd like." The anchor was the short-term borrowing rate, the 3% spread to the long-term rate was the profit, after it was leveraged.
The FOMC was also tugging on long-term interest rates for reasons Chairman Greenspan discussed at the September meeting. He asked the question: "[Should] we should encourage lower ten-year interest rates, given how close they are to levels that would prompt a lot of mortgage financings and a significant drop in duration in the mortgage market...?" His interest in mortgage refinacings was to boost consumer spending.
Consumer spending exceeded consumer income. This had to continue. Greenspan described the importance of rising asset prices in fooling the consumer at the November FOMC meeting: "We have a very significant problem with private saving. The household saving rate has come down dramatically and now is close to zero....The idea of having a negative savings rate is not out of line with the way the world works. Remember...the average household looks at the market value ...of its equity holdings.... We can have a negative saving rate with a significant part of the population believing that they are saving at a fairly pronounced rate."
This strategy of fixing asset prices at an artificially high rate to fool the American people into spending money they did not have was diabolical. It was even more so, given what Greenspan told the public. Before Congress on July 15, 2003, he claimed: "The prospects for a resumption of strong economic growth have been enhanced by steps taken in the private sector over the past couple of years to restructure and strengthen balance sheets....Nowhere has this process of balance sheet adjustment been more evident than in the household sector." The man will say anything.
Conclusion
Greenspan is gone and his successor is also a man not to be trusted filling your gas tank. In 2004, when then-Federal Reserve Governor Ben S. Bernanke was still an underling to Greenspan, he demonstrated the lack of truth, common sense, and intelligence needed to be selected Fed chairman: "Increases in home values, together with a stock-market recovery that began in 2003, have [aided]...the expansion of U.S. housing wealth, much of it easily accessible to households through cash-out refinancings and home-equity lines of credit." This is not "wealth," but it was a sales pitch that may have convinced a perplexed audience to buy houses. That was in public. At the December 2004 FOMC meeting, Simple Ben showed an appreciation for why he was bamboozling the public: "As a result of rising stock and house prices, over the past year U.S. net wealth... has increased about $3.3 trillion, or around 30% of GDP. That's a number which, incidentally, goes some way to explaining the continued strength of consumer spending."
He consistently misunderstands the current situation. On November 16, 2009, he told an audience: "It's not obvious to me in any case that there's any large misalignments currently in the U.S. financial system." How on earth can anyone think an economy run on a zero-percent interest rate - a fantastical plan never before attempted in recorded history - is A-Okay?
The manipulation of markets and of the American people has grown worse under Bernanke's chairmanship. In the fall of 2009, Governor Kohn spoke at a Federal Reserve conference. He made it clear that the Fed still wants to fool the people into a state of poverty: "Recently 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."
On March 27, 2010, former Federal Reserve Chairman Alan Greenspan told Bloomberg TV if not for the stock market recovery, the economy would be shrinking faster than Zimbabwe's. That is an exaggeration, but he was drifting in that direction. From the horse's mouth: "Ordinarily, we think of the economy affecting stock prices. I think we miss a very crucial connection here in that this whole economic recovery, as best as I can judge, is to a very large extent, the consequence of the market's bottoming last March, and coming all the way back-up. It is affecting the whole structure of the economy, as well as creating the usual wealth effect impact."
The 998 point drop in the Dow on May 6 was a warning to those who still invest in and trust markets. The government has permitted sophisticated strategies among a handful of operations to run the stock market. Program trading, high-frequency trading, and investment bank proprietary trading have replaced the buy-low, sell-high investor. At the August, 2004 meeting, Dino Kos reported: "In the past several months, quite a few traders have bemoaned the low level of volatility across a range of asset markets and the absence of perceived trading opportunities." It would take a strong imagination to not believe the FOMC is just as solicitous and equally willing to anchor the risk of institutional traders today.
The Financial Times reported in January 2010 that only 3% of trading is retail. The traditional relationships by which common stocks are measured such as price-to-earnings ratios are not that relevant anymore. IBM's price is more likely a reflection of a computer programmed to trade the stock because of a phrase spoken on CNBC. It is difficult to retain the pretense of markets reflecting the distilled knowledge of a company's value. Caveat Emptor.
More importantly to those with money invested in public markets is the possibility of a 5,000 point drop in the Dow that does not recover, but converges on zero. Traditional diversification strategies such as separating stocks among small, large, domestic and foreign companies neglect protection. The Bernanke Put will fail and with it the greatest bubble of all will crash. This is the reason investors need to devise a personal put strategy.
Thursday, May 6, 2010
Let Goldman Sachs Interrogate the SEC
Since April 16, 2010, when the Securities and Exchange Commission (SEC) indicted Goldman Sachs on fraud charges, the bank must approach each day wishing it could stay in bed. New charges and rumors of lawsuits swirl around the firm. Goldman will have its day (or, years) in court, but the government agency that rolled the snowball down the mountain should also sit in the dock.
The SEC aided and abetted the credit bubble in several instances, one of which will be discussed here.
The Securities and Exchange Commission removed the 12:1 leverage limit on broker/dealers in 2004. (The 12:1 limit is a rough figure calculated from SEC Final Rule, 17 CFR Parts 200 and 240, "Alternative Net Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities.") When Wall Street collapsed in 2008, Goldman Sachs, Lehman Brothers, Merrill Lynch, Bear Stearns, and Morgan Stanley were leveraged at 30:1, and sometimes at over 60:1 between their quarterly financial reports.
In the whirlpool of bank reform discussion, the extent to which banks were leveraged before the deluge is underappreciated. (Nor, is current leverage appreciated, either.) Economists, for instance, did not - and do not - pay attention to leverage, and since the country is run by these specimens of constricted imagination, their holy models did not capture the inevitability of Wall Street's collapse (or, of the one to come.)
What follows is an exercise that turns the tables. Goldman Sachs is given the opportunity to interrogate its regulator. Goldman's legal counsel might recommend, if the firm were given such an opportunity, that the bank's line of questioning be more diplomatic. There is no need for that here:
"Why did you remove limits to our leverage when the whole economy was already operating as a highly leveraged carry trade? Houses, for instance, were being sold on terms that no bank in its right mind would offer - unless they could dump mortgages in our lap. Chairman Greenspan even gave a speech imploring Americans to buy adjustable-rate loans in February 2004.
"Our economists scratched their heads at the time: why did he need to do that? In the state with the most speculative housing market, California, the percentage of adjustable-rate mortgages (ARMs) had already risen from 2% in 2002 to 47% in when he spoke. Median house prices in California had shot up from $237,060 in 2000 to $443,148 at the time Greenspan made his plea. Median incomes had been falling, so more mortgages were being written with no money down. Nevertheless, ARMs jumped to 61% of California mortgages by the spring of 2005, and prices reached $542,720.
"You knew that Goldman Sachs and other brokers were securitizing these mortgages that the banks and mortgage brokers would not hold. Yet, you blew open our leverage constraints. You were practically ensuring we would increase the volume of securitization. What was left to securitize other than loans to borrowers with little chance of paying off their debt? Our more fevered participation inevitably raised the volume and prices of house sales.
"What else did you think we would do with this new freedom? Putting our investment banking hat on, what were we going to finance? Productive companies couldn't get out of the country fast enough. Manufacturing profits had fallen from $144 billion in 2000 to $96 billion in 2003. Corporate financing was being channeled into the [irresponsible, highly leveraged, destructive - Goldman legal counsel: leave this out!!!!] private equity market.
"The Bush administration wanted more jobs and housing was making them. In 2003, we found that over the previous two years 750,000 high-tech jobs had been lost and 125,000 Americans became real-estate agents. By 2006, at least 600,000 people were selling mortgages in California. Goldman Sachs was building a more employed, although highly distorted, America. Why did you encourage us to turn the United States into an ancient Egyptian pyramid-building empire?
"We will tell you why we thought at the time, and still think now, that you removed the leverage limit: you wanted us to securitize mortgages at a faster pace. Maybe this was not the SEC's goal, but you do what you're told in the political arena. The United States could no longer fund its trade deficit without shipping boatloads of mortgages overseas. In 2000, the U.S. imported about $400 billion more goods and services than it exported. By 2006, this doubled to $800 billion. How could Americans - with falling median incomes - spend at such an accelerating rate and how could foreigners finance our lifestyles?
"We will abbreviate the answers to these questions with two simple examples.
"In 2005, Americans withdrew $800 billion of home equity from the rising values of their houses, about half of this was spent on consumer purchases. We will add that if it were not for our highly innovative mortgage securities that had evolved from the simple asset-backed derivatives to CDOs, to synthetic CDOs, to CPDOs, to Russian-doll CDOs, [each innovation even more profitable to us, since they were more inscrutable to the hapless buyer - Goldman legal counsel - stop this!!!!!], we could not have attracted the wider customer base necessary to unload this garbage. [Goldman legal counsel - OK, the sloppiness is so obviously true and gives the impression of sincerity].
"In 2005, foreigners bought 53% more Fannie Mae and Freddie Mac securities than they had in 2004. They had to buy them if they wanted America to buy all their junk. (Given the poor quality of imported socks that ripped the first time we put them on, the poor quality of our exported subprime CDOs did not cost us much sleep.) Americans couldn't buy the debt securities we issued since we were spending at such a furious rate. Foreigners had pulled back from the U.S. stock market after the Internet bubble burst. The Treasury could not issue enough securities, so we had to unload subprime loans on them.
"In conclusion is Exhibit A. This is from Goldman Sachs Global Investment Research, 2007 Issues & Outlook, published on December 10, 2006. Your decision - or, indecision - to permit brokerage debt to keep spiraling upward is unforgivable. And, don't say we didn't warn you:
The world is flooded with too much capital. It is virtually impossible to find any asset class that offers attractive value to investors. When the little black dress that Audrey Hepburn wore back in 1961 as Holly Golightly in 'Breakfast at Tiffany's' sells at auction for $917,000, or the 1907 Gustav Klimt painting Adele Bloch-Bauer sells for $135 million, or a fully-occupied office building on 48th and Park Avenue in New York City with no leases expiring for ten years changes hands for $1.2 billion at a cash yield of 4% (Treasuries less 0.50% !) before deferred maintenance reserve, or the financial markets believe for a day that a major national retailer is about to receive a $100 billion LBO offer, then the touchstones and benchmarks of what represents value seem [like] anachronisms of a time long ago.
The SEC aided and abetted the credit bubble in several instances, one of which will be discussed here.
The Securities and Exchange Commission removed the 12:1 leverage limit on broker/dealers in 2004. (The 12:1 limit is a rough figure calculated from SEC Final Rule, 17 CFR Parts 200 and 240, "Alternative Net Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities.") When Wall Street collapsed in 2008, Goldman Sachs, Lehman Brothers, Merrill Lynch, Bear Stearns, and Morgan Stanley were leveraged at 30:1, and sometimes at over 60:1 between their quarterly financial reports.
In the whirlpool of bank reform discussion, the extent to which banks were leveraged before the deluge is underappreciated. (Nor, is current leverage appreciated, either.) Economists, for instance, did not - and do not - pay attention to leverage, and since the country is run by these specimens of constricted imagination, their holy models did not capture the inevitability of Wall Street's collapse (or, of the one to come.)
What follows is an exercise that turns the tables. Goldman Sachs is given the opportunity to interrogate its regulator. Goldman's legal counsel might recommend, if the firm were given such an opportunity, that the bank's line of questioning be more diplomatic. There is no need for that here:
"Why did you remove limits to our leverage when the whole economy was already operating as a highly leveraged carry trade? Houses, for instance, were being sold on terms that no bank in its right mind would offer - unless they could dump mortgages in our lap. Chairman Greenspan even gave a speech imploring Americans to buy adjustable-rate loans in February 2004.
"Our economists scratched their heads at the time: why did he need to do that? In the state with the most speculative housing market, California, the percentage of adjustable-rate mortgages (ARMs) had already risen from 2% in 2002 to 47% in when he spoke. Median house prices in California had shot up from $237,060 in 2000 to $443,148 at the time Greenspan made his plea. Median incomes had been falling, so more mortgages were being written with no money down. Nevertheless, ARMs jumped to 61% of California mortgages by the spring of 2005, and prices reached $542,720.
"You knew that Goldman Sachs and other brokers were securitizing these mortgages that the banks and mortgage brokers would not hold. Yet, you blew open our leverage constraints. You were practically ensuring we would increase the volume of securitization. What was left to securitize other than loans to borrowers with little chance of paying off their debt? Our more fevered participation inevitably raised the volume and prices of house sales.
"What else did you think we would do with this new freedom? Putting our investment banking hat on, what were we going to finance? Productive companies couldn't get out of the country fast enough. Manufacturing profits had fallen from $144 billion in 2000 to $96 billion in 2003. Corporate financing was being channeled into the [irresponsible, highly leveraged, destructive - Goldman legal counsel: leave this out!!!!] private equity market.
"The Bush administration wanted more jobs and housing was making them. In 2003, we found that over the previous two years 750,000 high-tech jobs had been lost and 125,000 Americans became real-estate agents. By 2006, at least 600,000 people were selling mortgages in California. Goldman Sachs was building a more employed, although highly distorted, America. Why did you encourage us to turn the United States into an ancient Egyptian pyramid-building empire?
"We will tell you why we thought at the time, and still think now, that you removed the leverage limit: you wanted us to securitize mortgages at a faster pace. Maybe this was not the SEC's goal, but you do what you're told in the political arena. The United States could no longer fund its trade deficit without shipping boatloads of mortgages overseas. In 2000, the U.S. imported about $400 billion more goods and services than it exported. By 2006, this doubled to $800 billion. How could Americans - with falling median incomes - spend at such an accelerating rate and how could foreigners finance our lifestyles?
"We will abbreviate the answers to these questions with two simple examples.
"In 2005, Americans withdrew $800 billion of home equity from the rising values of their houses, about half of this was spent on consumer purchases. We will add that if it were not for our highly innovative mortgage securities that had evolved from the simple asset-backed derivatives to CDOs, to synthetic CDOs, to CPDOs, to Russian-doll CDOs, [each innovation even more profitable to us, since they were more inscrutable to the hapless buyer - Goldman legal counsel - stop this!!!!!], we could not have attracted the wider customer base necessary to unload this garbage. [Goldman legal counsel - OK, the sloppiness is so obviously true and gives the impression of sincerity].
"In 2005, foreigners bought 53% more Fannie Mae and Freddie Mac securities than they had in 2004. They had to buy them if they wanted America to buy all their junk. (Given the poor quality of imported socks that ripped the first time we put them on, the poor quality of our exported subprime CDOs did not cost us much sleep.) Americans couldn't buy the debt securities we issued since we were spending at such a furious rate. Foreigners had pulled back from the U.S. stock market after the Internet bubble burst. The Treasury could not issue enough securities, so we had to unload subprime loans on them.
"In conclusion is Exhibit A. This is from Goldman Sachs Global Investment Research, 2007 Issues & Outlook, published on December 10, 2006. Your decision - or, indecision - to permit brokerage debt to keep spiraling upward is unforgivable. And, don't say we didn't warn you:
The world is flooded with too much capital. It is virtually impossible to find any asset class that offers attractive value to investors. When the little black dress that Audrey Hepburn wore back in 1961 as Holly Golightly in 'Breakfast at Tiffany's' sells at auction for $917,000, or the 1907 Gustav Klimt painting Adele Bloch-Bauer sells for $135 million, or a fully-occupied office building on 48th and Park Avenue in New York City with no leases expiring for ten years changes hands for $1.2 billion at a cash yield of 4% (Treasuries less 0.50% !) before deferred maintenance reserve, or the financial markets believe for a day that a major national retailer is about to receive a $100 billion LBO offer, then the touchstones and benchmarks of what represents value seem [like] anachronisms of a time long ago.
Tuesday, April 27, 2010
Possible Misunderstandings about Municipalities and their Bonds
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).
Problems of state and municipal finance worsen. Governors announce new spending cuts at press conferences but inspire little confidence. The fury of emergency announcements leaves the listener (as well as the governors) in a daze. Research reports offer broad explanations but have left bondholders, as well as employees and local residents, unprepared for discontinuities. In other words, there will be instances when these constituencies will find themselves marched to the slaughterhouse without warning.
Following are corrections to the more common misunderstandings.
Claim #1: "General Obligation bonds do not default." Financial planners sometimes reassure retail clients with this claim. Following is a case study that shows how a truth may stumble into a half-truth. A half-truth is often more dangerous than a lie.
From a credit agency report: "Even in the event of default on [General Obligation] bonds, investors are likely to enjoy a full recovery of principal and interest because municipalities are required to levy additional taxes to repay debt backed by the general obligation pledge." The most significant word in that sentence is "likely." [Note: General obligation (GO) bonds are debt instruments issued by states and local governments to raise funds for public works. In contrast, revenue bonds are repaid from the revenue generated by the specific project that the bonds are issued to fund. Only GO bonds are addressed here.]
From a brokerage firm report: "General obligation debt is backed by a state municipal pledge to raise taxes to service debt if necessary." This is also true, but not the whole truth.
Courts have rebutted this pledge. A 1990 Missouri court ruled that "tax caps in effect when municipal debt was incurred cannot be overridden even if necessary to pay off the debt." (Kevin A. Kordana, "Tax Increases in Municipal Bankruptcy," Virginia Law Review) The court admonished the litigating bondholders: "[E]very purchaser of a municipal bond is chargeable with notice of the statute under which the bond is issued." (Missouri had a statutory tax rate cap.) In words the judge might have used: "Stop whining and wasting my time. Next time, read the bond offering."
Aside from a legal interpretation, raising taxes is often impractical. "At a certain point, raising taxes ceases to raise tax revenues." (McConnell and Picker, "When Cities Go Broke," University of Chicago Law Review).
The City of Vallejo, California may be an important precedent. It filed for bankruptcy in 2008. Both bondholders and city employees agreed to receive less money. The decision is before an appeals court.
Claim #2: "General Obligation default rate is 0.01%." This calculation is used to prove Claim #1. From a brokerage firm report: "The default rate on general obligation municipal bonds since 1970 is 0.01%." The calculation is correct. The brokerage firm used the default rate of Moodys-rated GO bonds since 1970.
Although true, this is misleading. It seems like yesterday when all - and it was all - the certified experts bellowed: "House prices never go down nationally." Just as mortgage payments had risen to uncollectible heights, municipal costs have risen to unsustainable levels. This is a different world than the period addressed by the Moodys study.
Even though money rained on municipalities during the salad days (sales tax revenue increased 46% between 2003 and 2007), it was only by playing games with the books and issuing a record amount of bonds that municipal spending grew so extravagantly over the past decade. States and municipalities issued $442 billion of bonds over the five years from 1998-2002. They issued $804 billion over the next five years, 2003-2007. The growth rate was not quite as steep, but, not dissimilar to mortgage securitizations and private-equity LBOs. The downward slope may not look that different, either.
Claim #3: "Most states are required by law to balance their budgets." This implies the restriction on revenues diverging from spending reduces the possibility of default. Municipal finance is often a shell game, shifting capital-project funds to meet today's burgeoning payrolls and benefits. [See Miami's Municipal Woes (Again): Exiting Before the Tide Goes Out].
Claim #4: "States cannot declare bankruptcy." This is a conclusion drawn by statements such as the following from a brokerage firm report: "The state is not permitted to file for Chapter 9 bankruptcy. Such filings are permitted only for 'municipalities' (e.g., levels of government below the state) under certain conditions." This is true. Bankruptcy law in the United States does not address the states. This does not mean states will not default. They might be in limbo according to the bankruptcy code, but still bankrupt according to the dictionary: "Any person unable to pay his creditors in full." Bondholders should take heed of the dictionary instead of waiting for the law to codify state bankruptcy.
Claim #5: "There has never been greater demand for municipal bonds." This is a sales pitch that implies "buy now, or you'll regret it later." Evidence for this claim is the willingness of retail investors to buy California municipal debt that yields 2% (for debt maturing in 2012; 5.8% for debt maturing in 2030). Another "get 'em while they're hot" argument is an initiative in Congress that would end the tax deductibility on interest from municipal bonds issued in 2011 and after.
First, the possibility of Congress passing such legislation is remote. Second, the "safe" asset classification by financial advisers is the real energy propelling retail investors into municipal issues. It was only two years ago when money market funds were thought of as "safe." They were often classified as "risk-free." (Beware of investment categories and classifications. Labels are often applied after their characteristics have been deemed predictable. By the time the predictable has been awarded a classification, the category has probably attracted too much attention and mindless buying.) After panic selling in September 2008, the federal government guaranteed the net asset value of money market funds.
Municipal appetite is also strong because Federal Reserve Chairman Ben Bernanke has chased savers out of short-term investments. His monetary policy (zero percent fed funds rate) is designed to refloat too-big-to-fail banks (that invest at zero percent and buy 3% Treasury notes) while leaving savers in the poor house. Municipal bonds produce some income, so are the new "cash" option.
Individuals are the only remaining net buyers. In 1975, commercial banks, savings banks, life insurers, and casualty insurers were municipal bond buyers. Only the individual is left today. This is a lonely outpost.
Problems of state and municipal finance worsen. Governors announce new spending cuts at press conferences but inspire little confidence. The fury of emergency announcements leaves the listener (as well as the governors) in a daze. Research reports offer broad explanations but have left bondholders, as well as employees and local residents, unprepared for discontinuities. In other words, there will be instances when these constituencies will find themselves marched to the slaughterhouse without warning.
Following are corrections to the more common misunderstandings.
Claim #1: "General Obligation bonds do not default." Financial planners sometimes reassure retail clients with this claim. Following is a case study that shows how a truth may stumble into a half-truth. A half-truth is often more dangerous than a lie.
From a credit agency report: "Even in the event of default on [General Obligation] bonds, investors are likely to enjoy a full recovery of principal and interest because municipalities are required to levy additional taxes to repay debt backed by the general obligation pledge." The most significant word in that sentence is "likely." [Note: General obligation (GO) bonds are debt instruments issued by states and local governments to raise funds for public works. In contrast, revenue bonds are repaid from the revenue generated by the specific project that the bonds are issued to fund. Only GO bonds are addressed here.]
From a brokerage firm report: "General obligation debt is backed by a state municipal pledge to raise taxes to service debt if necessary." This is also true, but not the whole truth.
Courts have rebutted this pledge. A 1990 Missouri court ruled that "tax caps in effect when municipal debt was incurred cannot be overridden even if necessary to pay off the debt." (Kevin A. Kordana, "Tax Increases in Municipal Bankruptcy," Virginia Law Review) The court admonished the litigating bondholders: "[E]very purchaser of a municipal bond is chargeable with notice of the statute under which the bond is issued." (Missouri had a statutory tax rate cap.) In words the judge might have used: "Stop whining and wasting my time. Next time, read the bond offering."
Aside from a legal interpretation, raising taxes is often impractical. "At a certain point, raising taxes ceases to raise tax revenues." (McConnell and Picker, "When Cities Go Broke," University of Chicago Law Review).
The City of Vallejo, California may be an important precedent. It filed for bankruptcy in 2008. Both bondholders and city employees agreed to receive less money. The decision is before an appeals court.
Claim #2: "General Obligation default rate is 0.01%." This calculation is used to prove Claim #1. From a brokerage firm report: "The default rate on general obligation municipal bonds since 1970 is 0.01%." The calculation is correct. The brokerage firm used the default rate of Moodys-rated GO bonds since 1970.
Although true, this is misleading. It seems like yesterday when all - and it was all - the certified experts bellowed: "House prices never go down nationally." Just as mortgage payments had risen to uncollectible heights, municipal costs have risen to unsustainable levels. This is a different world than the period addressed by the Moodys study.
Even though money rained on municipalities during the salad days (sales tax revenue increased 46% between 2003 and 2007), it was only by playing games with the books and issuing a record amount of bonds that municipal spending grew so extravagantly over the past decade. States and municipalities issued $442 billion of bonds over the five years from 1998-2002. They issued $804 billion over the next five years, 2003-2007. The growth rate was not quite as steep, but, not dissimilar to mortgage securitizations and private-equity LBOs. The downward slope may not look that different, either.
Claim #3: "Most states are required by law to balance their budgets." This implies the restriction on revenues diverging from spending reduces the possibility of default. Municipal finance is often a shell game, shifting capital-project funds to meet today's burgeoning payrolls and benefits. [See Miami's Municipal Woes (Again): Exiting Before the Tide Goes Out].
Claim #4: "States cannot declare bankruptcy." This is a conclusion drawn by statements such as the following from a brokerage firm report: "The state is not permitted to file for Chapter 9 bankruptcy. Such filings are permitted only for 'municipalities' (e.g., levels of government below the state) under certain conditions." This is true. Bankruptcy law in the United States does not address the states. This does not mean states will not default. They might be in limbo according to the bankruptcy code, but still bankrupt according to the dictionary: "Any person unable to pay his creditors in full." Bondholders should take heed of the dictionary instead of waiting for the law to codify state bankruptcy.
Claim #5: "There has never been greater demand for municipal bonds." This is a sales pitch that implies "buy now, or you'll regret it later." Evidence for this claim is the willingness of retail investors to buy California municipal debt that yields 2% (for debt maturing in 2012; 5.8% for debt maturing in 2030). Another "get 'em while they're hot" argument is an initiative in Congress that would end the tax deductibility on interest from municipal bonds issued in 2011 and after.
First, the possibility of Congress passing such legislation is remote. Second, the "safe" asset classification by financial advisers is the real energy propelling retail investors into municipal issues. It was only two years ago when money market funds were thought of as "safe." They were often classified as "risk-free." (Beware of investment categories and classifications. Labels are often applied after their characteristics have been deemed predictable. By the time the predictable has been awarded a classification, the category has probably attracted too much attention and mindless buying.) After panic selling in September 2008, the federal government guaranteed the net asset value of money market funds.
Municipal appetite is also strong because Federal Reserve Chairman Ben Bernanke has chased savers out of short-term investments. His monetary policy (zero percent fed funds rate) is designed to refloat too-big-to-fail banks (that invest at zero percent and buy 3% Treasury notes) while leaving savers in the poor house. Municipal bonds produce some income, so are the new "cash" option.
Individuals are the only remaining net buyers. In 1975, commercial banks, savings banks, life insurers, and casualty insurers were municipal bond buyers. Only the individual is left today. This is a lonely outpost.
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