PrefBlog

Econbrowser‘s James Hamilton has an interesting philosophical piece on the limits to the Fed’s ability to influence the economy, Asking too much of monetary policy:

I am certainly a believer in the potential real effects, sometimes for good, sometimes for ill, of monetary policy. But I just as certainly do not believe, nor should any reasonable person believe, that no matter what the economic problem might be, you can always solve it just by printing more money.
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I would nevertheless caution that we need to be open to the possibility that no matter how low the Fed brings its target rate, it may not arrest the unfolding financial disaster. Unless the intention is to go all the way with enough inflation to avert the defaults, that means we need an exit strategy– some point at which we all admit that further monetary stimulus is doing nothing more than generating inflation, and at which point we acknowledge that the goal for monetary policy is no longer the heroic objective of making bad loans become good, but instead the more modest but also more attainable objective of making sure that fluctuations in the purchasing power of a dollar are not themselves a separate destabilizing influence.

Indeed, with the Treasury curve virtually decoupled from the corporate curve, it doesn’t look like there’s anything more the Fed can do. Cutting rates again probably will not have any major effect on corporate yields, or on banks’ willingness to lend; I think that the only justification for such a move would be to help increase profit margins at the banks in order to assist their recapitalization, as was done in 1993 – the year of the steepest yield curve on record, which led to 1994 – the year of the worst government bond market on record.

At the moment, I don’t think there’s a lot of evidence that such drastic treatment is necessary. Below are some graphs available from the FDIC showing the recovery of the American banking system from 1990-94 … sorry they’re not too clear, click on them for a better version, or just go directly to the full report.

Some of this was due to Resolution Trust, to be sure, but a good chunk was due to a very steep yield curve that made it very profitable to borrow short and lend long.

It is interesting to note, from the FDIC report, that data for 4Q93 (the point at which the Fed said, “OK, play-time’s over, we’re going to start hiking now”) indicated that the 13,220 institutions reporting had $375-billion in capital backstopping $4,707-billion in total liabilities and capital, an equity leverage ratio of 12.61. The current FDIC report, 4Q07, shows 8,533 institutions with capital of $1,352-billion backstopping $13,039-billion, equity leverage of 9.6:1.

One may well quibble over the 4Q07 equity figure … perhaps there are massive unrecorded losses about to appear. And one may quibble even more about the relative quality of assets between then and now – subprime and perhaps credit card and auto debt coming up for kicking in The Great Leverage Unwinding of 2007-08. But all in all, as I’ve pointed out in posts on loss estimates and loss distribution, I’m having a hell of a time finding credible, sober analysis concluding that Armageddon is Now.

Anyway, what I’m trying to say is that I agree with Prof. Hamilton (subject to quibbles about loss estimates), when he states:

The problem then is many hundreds of billions of dollars in loans that are not going to be repaid, the prospect of whose default could completely freeze the market for credit.

That, it seems to me, is a problem you can’t solve by lowering the fed funds rate.

By me, the Fed is doing the right thing with the TSLF introduced yesterday. The problem is liquidity, and there are many players with indigestible lumps of sub-prime paper on their books. These are, I’ll bet a nickel, on their books at marked-to-disfunctional-market prices well below ultimate recovery, but so what? They can’t sell them to hot money – hot money’s got its own problems:

At least a dozen hedge funds have closed, sold assets or sought fresh capital in the past month as banks and securities firms tightened lending standards. The industry is reeling from its worst crisis because bankers — staggered by almost $190 billion of asset writedowns and credit losses caused by the collapse of the subprime-mortgage market — are raising borrowing rates and demanding extra collateral for loans.

They can’t sell them to real money – real money read in the paper just last week that it’s all worthless junk. So the paper has to sit on the books for a while and be financed in the interim.

Perhaps not entirely coincidentally, there’s an article on VoxEU titled Why Monetary Policy Cannot Stabilize Asset Prices. VoxEU is up to its old tricks … the page is blank. To read the article, you have to click “View|Source” on your browser, pick a section to copy/paste, save this extract as a .html file on your hard drive and then open this with a browser. The graph has to be viewed separately.

Mechanical difficulties aside, it seems that this will soon be a CEPR discussion paper; the authors state:

Figure 1 analyses the effects of a 100 basis points increase in interest rates. Note that after about 8 quarters, interest rates have declined but remain about 35 basis points above their initial level. After 12 quarters, they have fallen further to a level some 10 basis points above the starting point. Overall, the increase in interest rates will dissipate in about three years.

Turning to real property prices, we note that these start to fall in response to the tightening of monetary policy. After 16 quarters, they reach a bottom of about 2.6% below the initial level and then start to return gradually to their starting level. Overall, property prices react quite slowly to monetary policy actions.

Next we consider the responses of real GDP.³ The figure shows that it also reaches a trough after 16 quarters, when it is some 0.8% below its initial level.⁴ Thus, the responses of real GDP are almost exactly 1/3 of those of real property prices.⁵ This is an important finding. To see why, suppose that monetary policy makers come to believe that a real property price bubble of 15% has developed, and decide to tighten monetary policy in order to bring down asset prices. In doing so, the average central bank in the 17 countries we study should also expect to depress the level of real GDP by 5%, a truly massive amount.
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Whatever merits such a stabilisation policy has in theory, our research suggests that in practice, monetary policy is too blunt an instrument to be used to target asset prices – the effects on real property prices are too small, given the responses of real GDP, and they are too slow, given the responses of real equity prices. In particular, there is a risk that setting monetary policy in response to asset price movements will lead to large output losses that exceed by a wide margin those that would arise from a possible bubble burst.

In other news, Accrued Interest points out that It’s just a dead animal:

Now I’m not here to say whether Bear Stearns has liquidity problems or not. The recovery in both the stock and bond market for Bear paper would indicate that they probably don’t. But this kind of panicky trading is exactly why its hard to own financial bonds right now. I mean, anyone who had traded through bear markets knows that the rumor mill becomes very active. Right now everyone is nervous. The longs are nervous because they’ve been losing money and/or under performing their index for months now. I’m sure there are many portfolio managers and/or traders worried about losing their jobs over poor performance.

The shorts are nervous too. Right now corporate credit spreads are at all-time wides. That means that getting short a credit is expensive to begin with.
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So amidst all this nervousness, it seems that Wall Street starts giving more credence to rumors.

Sit tight, do your homework, turn off the TV and stare at financial statements until you’re crosseyed, that’s the path to success. The bond market is excitable and always will be … ignore it, keep your company-specific bets small, your leverage non-existant and have another look at them financial statements.

In other news, it looks like Barney Frank, Chairman of the House Financial Services Committee wants to start his own credit rating agency:

U.S. Representative Barney Frank gave ratings companies a month to fix “ridiculous” standards that they apply to local government debt, as his House committee opened a hearing today on how the firms evaluate municipal bonds.

“I am going to say to the rating agencies and to the insurers: they have about a month to fix this,” Frank, the Massachusetts Democrat who chairs the House Financial Services Committee, told reporters in Washington yesterday. “We’re going to tell them they have to straighten it out.”

California Treasurer Bill Lockyer and other state officials are calling for Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings to change a system they say costs taxpayers by exaggerating the risk that municipal issuers will default on their debts. Every state except Louisiana would be AAA if measured by the scale used for corporate borrowers, according to research by Moody’s.

“This notion of having a separate standard for the municipals because they would do too well on the other standard is ridiculous,” Frank said.

Cool! Credit ratings courtesy of the politicians! Doesn’t that make you feel safe? Sign me up!

Back on Earth, Berkshire Hathaway is worried that municipal bond insurance will return to ultra-cheap levels in a price-war:

The risk of guaranteeing municipal debt is increasing because the economy is slowing and some insurers may cut prices to regain lost business, said Ajit Jain, head of Berkshire Hathaway Inc.’s new bond insurer.

Fiscal stress in Vallejo, California, and Jefferson County, Alabama, may be the “tip of the iceberg” for municipal defaults, said Jain, who runs Warren Buffett’s Berkshire Hathaway Assurance Corp. He said downgrades of some insurers hurt the industry’s integrity and those firms may spark “pricing wars” if they regain their financial footing and seek to recoup lost business.
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Ambac and MBIA, the two largest bond insurers, may trigger a price war if they stabilize their AAA ratings and start backing municipal bonds again, Jain said.

“That will be unavoidable,” he said in his testimony. “Unless you continue to believe that this is zero-loss business, that conduct assures a bleak future for this business.”

Another light day for volume. Split-shares got hammered, particularly the BNA issues that have something of a penchant for volatility. PerpetualDiscounts were also weak.

There were eight other index-included $25-pv-equivalent issues trading over 10,000 shares today.

Today’s big news was the expansion of the Term Securities Lending Facility:

The Federal Reserve announced today an expansion of its securities lending program.  Under this new Term Securities Lending Facility (TSLF), the Federal Reserve will lend up to $200 billion of Treasury securities to primary dealers secured for a term of 28 days (rather than overnight, as in the existing program) by a pledge of other securities, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS.  The TSLF is intended to promote liquidity in the financing markets for Treasury and other collateral and thus to foster the functioning of financial markets more generally.  As is the case with the current securities lending program, securities will be made available through an auction process.  Auctions will be held on a weekly basis, beginning on March 27, 2008.  The Federal Reserve will consult with primary dealers on technical design features of the TSLF.

The kerfuffle over Bear Stearns yesterday shows that the market is prepared to believe anything, as long as it’s bad. Yes, times are tough. But they actually managed to scrape out a profit last year (Nov. 30 year end) and have $18-billion cash on the balance sheet thanks to a vigorous term issuance programme in which they haven’t been afraid to pay up for five year money. They’re not going to disappear overnight. Though mind you, as Naked Capitalism points out, they’re very highly levered:

With this in mind, why were Bear and Lehman so highly geared? Lehman is levered 40 to 1, Bear is geared 34:1 (by contrast, Carlyie is levered 32:1). Trading firms should know better.

In deteriorating debt markets, the last thing you want to be carrying is a big balance sheet. Perhaps the banks in question assumed that the Fed’s interest rate cuts would produce enough gains in value (due to lower prevailing rates) to make deleveraging less urgent.

But now Bear and Lehman (and no doubt their peers as well) are delevearging out of necessity, as mark-to-market losses force them to write down assets, leading to hits to equity, and then putting them at gearing levels that are untenable. So shrink they must.

And, mind you, if I was thinking about buying their stock, I wouldn’t be counting on a return to pre-2007 earnings anytime soon. Neither would Punk Ziegel.

“The key problem is not the write-offs and losses that the company must take in the just-ended first fiscal quarter. The key issue is building a new business model,” Bove said. “Bear Stearns must adjust and it is probably going to be forced to find a merger partner,” he added.

Find a partner? Maybe they have!

Joseph Lewis, the second-largest shareholder in Bear Stearns Cos., may add to his holdings after the stock fell on speculation the company lacks sufficient access to capital, a person close to him said.

Times are tough, did I say above? Econbrowser‘s James Hamilton won’t quarrel if you say a recession has begun and his partner Menzie Chinn takes a certain amount of Democrat glee in the prospects for a two recession Bush presidency:

So, I’ll echo Jim’s assessment: too soon to be sure, but chances are pretty darn good that we that we’re into the second recession of the G.W. Bush presidency.

It seems to me the next question of interest is whether the recession is likely to be short or long. I keep on seeing predictions of a short V-shaped recession [3], [4], [5]. Most macro forecasts do predict a resurgence in 2008H2 (just as CEA Chair Lazear alluded to in his last press conference). For instance, today’s Deutsche Bank forecast is for (-0.5%) and (-0.3%) in Q1 and Q2, respectively, with growth spiking in Q3 at 2.6% before settling at 0.9% in Q4. Still, with oil and ag commodity prices stubbornly high, the extent of the financial system turmoil uncertain, and the less-than optimally constructed fiscal stimulus limited to only one percent of GDP, I’m don’t think the 2008H2 acceleration will be a sustained one.

Well … I’m not an economist and I have a high degree of skepticism towards any macro-forecast anyway … but if I had to bet a nickel I’d bet on a long grinding recession that squeezes every last bit of leverage out of the system. The credit markets are thoroughly disfunctional, borrowers are extending term to stay alive (Bear Stearns, CIT, …) rather than to expand and these funds are staying on the balance sheet as cash at a negative carry (Bear Stearns, CIT, …). I don’t know what will happen tomorrow, but I can say it looks pretty ugly out there today!

As usual, Accrued Interest has some sensible remarks regarding what will bring an end to the credit market:

What would bring an end to this bear market? Simple. Bear markets end when the market runs out of sellers.

I would prefer to phrase it … ‘Bear markets end when prices stop going down’, but this is a mere quibble.

Naked Capitalism has an interesting piece on the Credit Rating Agencies’ alleged reluctance to cut the ratings on AAA sub-prime paper:

The Bloomberg story confirms our cynicism about the S&P’s and Moody’s. It reports that the rating agencies have held back from downgrading AAA subprime related securities.

Why is this important? In most deals, roughly 80% is of the value of the transaction was in the AAA tranches. These are far and away the most important in terms of economic value. But, not surprisingly, many of the buyers of this paper did so because they had portfolio constraints or capital requirements that made top-rated instruments particularly desirable. Thus in many cases, downgrades of this paper would have a pronounced impact, leading in many cases to sales, depressing prices.
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The ratings methods balance estimated losses against so-called credit support, a measure of how likely it is that owners of each piece of the bond will incur losses. For AAA rated debt, credit support needs to be five times the expected losses, according to Sylvain Raynes, author of The Analysis of Structured Securities, a college textbook.

All but six of the 80 AAA ABX bonds failed an S&P test for investment-grade status, which requires credit support to be twice the percentage of troubled collateral. The guideline was one of four tests used by S&P, and a failure to meet the standard wouldn’t have automatically resulted in a downgrade. The other companies used similar metrics to grade bonds, Raynes said. Investment grade refers to all bonds rated above BBB- by S&P and Baa3 by Moody’s….

On a $118 million Washington Mutual bond issued in 2007, WMHE 2007-HE2 2A4, 5.6 percent of its loans are in foreclosure and its safety margin, or the debt available to absorb losses, is less than the combined total of its loans at risk. Both S&P and Moody’s rate it AAA.

Fitch rates that bond B, five levels below investment grade and 15 levels less than its rivals….

The full Bloomberg story explains the Fitch discrepency a little better:

“We have built in 20 percent more home price declines from the end of ’07,” said Glenn Costello, managing director for residential mortgage-backed securities at Fitch. “When you build in that much home price decline, I feel good when I pick up the paper and I see that home prices are only down another 3 percent. My ratings are still good.”

Fitch is a good shop. I like Fitch.

In yet another sign of the cavalier sloppiness that was epidemic at the height of the bubble, there are indications that CDO deal documents are not clear:

These bad decisions, in turn, have resulted in the collapse of many investment vehicles: more than 100 collateralised debt obligations (CDOs) and structured investment vehicles (SIVs) have already entered the murky post-event of default (EOD) state. This number will grow in the coming weeks.

Unfortunately, the legal documents that govern these transactions are so poorly written – full of ambiguities, inconsistencies, “circular references” and worse, contradictions – that many investors, trustees and respective legal advisors do not know how to interpret them.

The lawyers will feast!

Speaking of lawyers and their feasting, I was asked recently about BCE’s bonds following their triumph over the bondholders. It was one of Markit’s “CDS Deteriorators” on March 10, with 5-Year CDS yields increasing 73bp to 646bp. According to Markit’s CDS commentary for March 10:

BCE’s spreads widened on expectations that the company’s LBO will go ahead. A Quebec Court threw out a bondholder lawsuit that alleged the takeover of the Canadian telecoms company by an investment consortium was unlawful.

Volume returned to the preferred market today and was actually relatively heavy – the first time that’s happened in a while! I don’t know quite what to make of the price and volume activity in the PWF/GWO issues … there’s no news that I can see – it may just be a single manager re-jigging his portfolio. Or random chance!

There were thirty-three other index-included $25-pv-equivalent issues trading over 10,000 shares today.

Bloomberg has a story headlined TIPS’ Yields Show Fed Has Lost Control of Inflation::

“The way TIPS are trading now, investors believe headline inflation will stay lofty and are willing to give up the real yield for that,” said Brian Brennan, a money manager who helps oversee $11 billion in fixed-income assets at T. Rowe Price Group Inc. based in Baltimore. Prices for the securities indicate “a real concern of a recession and high headline inflation,” he said.

This is the type of boneheaded analysis that is rife now that the smiley-boy salesmen have taken over the industry completely. If the driver of these real yields is inflation, then why is the 30-year Treasury bond yielding less than 4.5%?

As Accrued Interest points out, Treasury yields are being driven by fear, with investors piling into government guaranteed debt for the simple reason that they want to protect their capital. TIPS are simply maintaining a spread to nominals – an increasing spread, to be sure; inflation fears are part of the picture as I have previously discussed, but to ascribe the entire move to this is … boneheaded. Sorry folks, I just can’t think of any other word.

PerpetualDiscounts got smacked again today, on extremely light volume – all eyes, yet again, were on the equity markets and wondering if the music would stop with EVERYBODY holding the hot potato. BCE issues did very well – it appears that there are some who took the unsuccessful bondholders’ lawsuit a lot more seriously than I did.

There were three other index-included $25-pv-equivalent issues trading over 10,000 shares today.