FOMC Rate Cut Will Not Change The Fundamentals

Monday, October 29, 2007

Who wants to be in the shoes of the Federal Open Market Committee (FOMC) on Wednesday? Escalating market pressure for a rate cut collides with a horrible inflation outlook as exploding oil prices start pushing commodities higher. Will there be enough hawks defending at least stable rates or will the doves led by Nanny Benny cave in to panicking markets and do the worst of all by cutting rates further? Chances are the FOMC will do nothing in a situation that would require a rate hike if fighting inflation is still a predominant concern which can be doubted in the face of the housing and mortgage bust.
Alan Greenspan once called gold a very reliable inflation indicator. A study that proves gold's high correlation with inflation can be found here. As the oldest currency in the world has jumped to $795 in Asian trading on Monday it appears the world is headed for markedly higher prices soon. Oil's ascent above $93 is poised to add to the spin of the inflation spiral that can be seen so clearly in basically all commodities. Been to your baker lately?
Americans are destined to get the worst of it all, thanks to a Federal Reserve dollar plunging to new record lows against the Euro on a daily basis.
Rollercoasting financial markets still indicate that the credit crunch - what happened to the "savings glut" of 2005? - is only worsening as banks hold back their funds in fear that their interbank counterparties go bust overnight. All attempts to prop up markets with SIVs should be seen as what they are: Vain efforts to pump up unsupportable prices. Where do all these billions come from? Certainly not out of the vaults of rich investors but created with Ben Bernanke's electronic printing press. Banks trying to play in the darkroom to hide the disaster run the risk of getting rimmed.
Cutting rates can be a very deceiving medicine that may work well in the short term. It will lessen the burden of debtors whose adjustable mortgages are set for a hike this fall. But it will not change the fundamentals that have been created by a 7-year streak of reckless deficit policies accompanied by a crumbling US infrastructure and major political and economic shifts on the globe.
The whole mess was created by too much credit. Extending it further will be monetary suicide resulting in sky high inflation.

ECB Drowns Markets In "Liquidity"

Wednesday, October 10, 2007

The European Central Bank (ECB) has added 55 billion Euros "liquidity" in its latest regular one-week tender on Wednesday. Bids for 218 billion Euros were accepted at a minimum rate of 4.12% and the weighted average rate came in at 4.16%, still above the reference rate of 4%. In so called "other operations" the ECB drained 24.5 billion Euros. As the ECB website information painstakingly avoids to list its money market operations in chronological order (as the Fed NY does) I am at a loss to explain where this was drained from. Single data points only are not exactly the kind of transparency Europe's high priests of ever expanding credit always like to praise so much.
It is ECB policy though. Only a day earlier ECB president Jean-Claude Trichet had told the European Parliament, Euro bankers should apply "verbal discipline." I would say, a sound policy would help more to calm markets which bid cash gold to a new 28-year high at $743.
In order to find out how much "liquidity" is currently chasing too few goods and services we will have to wait for the next weekly financial statement of the ECB.
The latest weekly statement shows a net gain of 2.5 billion Euros in "other assets" and a net drain of 150 million in gold and gold receivables, which was a result of central banks selling and one central bank again buying gold coin.
NOTE: Blogging hiatus until next Tuesday due to a shiny new (push)bike in the basement and perfect weather in Vienna. But a crash, which I expect to happen any day, could change all that. Times are simply way too interesting to leave my laptop behind.

FOMC Says Data Has Limited Value

It appears that Jim Cramers infamous outburst on TV has led the Federal Reserve into a panic action at its latest Federal Open Market Committee (FOMC) meeting. According to the FOMC minutes published on Tuesday policymakers brushed away economic data and preferred to give markets a shot in the arm with its 50bp cut of the Fed Funds rate to 4.75%.
Here comes the lengthy explanation from the FOMC that tries to justify a rate cut I still consider most inappropriate in a time when surging commodities prices show that even a downturn in the USA will be offset by continuing strong demand from the economic powerhouses in the Eastern hemisphere.
From the FOMC minutes:
In the Committee's discussion of policy for the intermeeting period, all members favored an easing of the stance of monetary policy. Members emphasized that because of the recent sharp change in credit market conditions, the incoming data in many cases were of limited value in assessing the likely evolution of economic activity and prices, on which the Committee's policy decision must be based. Members judged that a lowering of the target funds rate was appropriate to help offset the effects of tighter financial conditions on the economic outlook. Without such policy action, members saw a risk that tightening credit conditions and an intensifying housing correction would lead to significant broader weakness in output and employment. Similarly, the impaired functioning of financial markets might persist for some time or possibly worsen, with negative implications for economic activity. In order to help forestall some of the adverse effects on the economy that might otherwise arise, all members agreed that a rate cut of 50 basis points at this meeting was the most prudent course of action.
If the FOMC calls this rate cut prudent I am inclined to change my brand name.
Market participants can learn a very important lesson from this decision. Don't worry about moral hazard. Just bet the house (what a pun in these days) and in case it goes wrong, cry for Nanny Benny. He will immediately fire up the Fed's helicopters and shower the burning house with "liquidity." And if the helicopters are not enough, he still has this (not so) secret weapon, called printing press. Welcome to the new world order of perma-inflation.
The Fed's excuses did not stop there. Here is a little more:
Such a measure should not interfere with an adjustment to more realistic pricing of risk or with the gains and losses that implied for participants in financial markets. With economic growth likely to run below its potential for a while and with incoming inflation data to the favorable side, the easing of policy seemed unlikely to affect adversely the outlook for inflation.
Don't despair yet. The minutes offer at least a real gem of information, telling us that the FOMC sits on wet bottoms.
There seems to have been an intense discussion of inflationary dangers. Remember, in August this was the predominant concern of the Fed.
Now they are backtracking with a rather inconsistent statement:
The Committee agreed that the statement to be released after the meeting should indicate that the outlook for economic growth had shifted appreciably since the Committee's last regular meeting but that the 50 basis point easing in policy should help to promote moderate growth over time. They also agreed that the inflation situation seemed to have improved slightly and judged that it was no longer appropriate to indicate that a sustained moderation in inflation pressures had yet to be shown. Nonetheless, all agreed that some inflation risks remained and that the statement should indicate that the Committee would continue to monitor inflation developments carefully.
Hu?

We Have No Idea
The next sentence sounds as if the FOMC hopes for understanding nods:
Given the heightened uncertainty about the economic outlook, the Committee decided to refrain from providing an explicit assessment of the balance of risks, as such a characterization could give the mistaken impression that the Committee was more certain about the economic outlook than was in fact the case.
Does anybody know what the captain of the Titanic said after the ship hit the iceberg?
In my interpretation we can expect that the Fed will sideline its fight inflation as soon as bankers will repeat their cry for Nanny Benny.
Looking back into history will let me find sleep tonight. Future investment strategies are not that difficult. Don't listen to any Sunday school talk that says there will be no bailout for gamblers as it will be only empty talk. Nanny Benny will stand guard at the helipad and keep the engines ready for more action.
Which reminds me of an old Wall Street rule: Money walks and bulls**t talks.
And the orchestra of the Titanic had been fiddling while first class passengers had been jumping into the lifeboats. Wall Street today offers the same perspective: There will be lifeboats for the privileged ones only who know that the ship is sinking. All others please enjoy the orchestra.
Sorry, I can't help my cynicism. I remember August too well. Just re-read my posts from August and you will understand it.

Does OPEC Mull Rejecting Federal Reserve Dollars?

Tuesday, October 09, 2007

The Federal Reserve Dollar may be in for another big punch. Gulfnews banking editor Babu Das Augustine has raised the possibility that OPEC may switch from dollars to another currency, furthermore reducing the demand for the Dollar which gets shunned by more and more oil producing countries. Iran only accepts Euros or Yen and Venezuela dumped the greenback while countries in the gulf region move their funds away from it too.
According to Das Augustine,
"Asset diversification by the Gulf sovereign wealth funds and the possibility that the Organisation of Petroleum Exporting Countries (OPEC) will change the pricing of oil from the dollar to another currency could mean more trouble for the dollar."
Quatar and Vietnam announced only a few days ago that they were shifting away from the ailing currency that was never worth less than nowadays.
Analysts see the admission by Qatar as a signal that regional state-owned funds are moving away from the dollar.
Qatar has admitted that its investment fund has been diversifying their portfolios to compensate for the decline of the dollar. It would be naive to think that other Gulf funds are loyal to the dollar at the cost of heavy portfolio losses," said a Dubai-based investment banker.
During the past 12 months, companies, mainly state-owned investment arms and private equity firms from the GCC, have quietly acquired more than $50 billion in assets worldwide with Asia's and Europe's shares together accounting for more than 55 per cent.
The state-owned Kuwait Investment Authority, with assets of more than $150 billion, last year increased the Asian share of its portfolio to 20 per cent from 10 per cent.
Although gulf central banks have been discussing asset diversification in the past two years, there hasn't been any evidence of a major shift. The size of assets held by Gulf central banks are relatively small compared to the funds managed by the state-owned investment funds.
According to IMF estimates, global investment funds managed by governments control an estimated $2.5 trillion, outstripping hedge funds. Morgan Stanley estimates these assets could rise to $12 trillion by 2015, roughly the size of the US economy. Gulf countries account for a major share of these funds.
Currency market analysts believe that the gulf sovereign funds' gradual move away from the dollar is a precursor to OPEC opting for a different currency in which to price oil.
"If the dollar were to lose its lustre as a reserve currency this could prove disruptive to the global financial system," Merrill Lynch said in a research note.
"Pricing oil in dollars might have made sense when there was a paucity of other relatively stable currencies and when the Middle East imported more from the US - but not any-more," said an analyst.
I guess it is safe to say that the exodus from the first completely unbacked reserve currency in the world's history has begun - and will not stop. A strong reason for this is the fact that the USA has very little to offer in terms of sought-after export goods besides weapons, aircraft and gas guzzling oversize cars whose low MPG ratios can only be afforded by oil producing countries anymore.
Anybody counter my bet that another fiat currency experiment will be coming to an end in the next decade?
Before you lose your money; remember that ALL fiat currencies of the past 350 years have returned to their intrinsic value. Gold has NEVER lost its value in the past 3,500 years!
For some background about the role of the Federal Reserve Dollar in commodities markets click here.

US Congress Knows the Parallels Between 1929 and 2007

Monday, October 08, 2007

I cannot recollect to have seen this congressional testimony by Robert Kuttner (pdf) from October 2 being reported in the MSM.
It again confirms my view that shorting the financial sector and the Federal Reserve (not US!) Dollar as well as all US federal debt and using the profits to buy more precious metals is probably the most prudent investment strategy these days. I am most grateful for your other suggestions in comments.
Read Kuttner's testimony in full (all emphasis mine):

Testimony of Robert Kuttner
Before the Committee on Financial Services
U.S. House of Representatives
Washington, D.C.
October 2, 2007

Mr. Chairman and members of the Committee:
Thank you for this opportunity. My name is Robert Kuttner. I am an economics and
financial journalist, author of several books about the economy, a magazine editor, and former investigator for the Senate Banking Committee. I have a book appearing in a few weeks that addresses the systemic risks of financial innovation coupled with deregulation and the moral hazard of periodic bailouts.
In researching the book, I devoted a lot of effort to reviewing the abuses of the 1920s, the effort in the 1930s to create a financial system that would prevent repetition of those abuses, and the steady dismantling of the safeguards over the last three decades in the name of free markets and financial innovation.
The Senate Banking Committee, in the celebrated Pecora Hearings of 1933 and 1934,
laid the groundwork for the modern edifice of financial regulation. I suspect that they would be appalled at the parallels between the systemic risks of the 1920s and many of the modern practices that have been permitted to seep back in to our financial markets.
Although the particulars are different, my reading of financial history suggests that the abuses and risks are all too similar and enduring. When you strip them down to their essence, they are variations on a few hardy perennials - excessive leveraging, misrepresentation, insider conflicts of interest, non-transparency, and the triumph of engineered euphoria over evidence.
The most basic and alarming parallel is the creation of asset bubbles, in which the
purveyors of securities use very high leverage; the securities are sold to the public or to specialized funds with underlying collateral of uncertain value; and financial middlemen extract exorbitant returns at the expense of the real economy. This was the essence of the abuse of public utilities stock pyramids in the 1920s, where multi-layered holding companies allowed securities to be watered down, to the point where the real collateral was worth just a few cents on the dollar, and returns were diverted from operating companies and ratepayers. This only became exposed when the bubble burst. As Warren Buffett famously put it, you never know who is swimming naked until the tide goes out.
There is good evidence--and I will add to the record a paper on this subject by the Federal Reserve staff economists Dean Maki and Michael Palumbo--that even much of the boom of the late 1990s was built substantially on asset bubbles. ("Disentangling the Wealth Effect: a Cohort Analysis of Household Savings in the 1990s,")
A second parallel is what today we would call securitization of credit. Some people think this is a recent innovation, but in fact it was the core technique that made possible the dangerous practices of the 1920. Banks would originate and repackage highly speculative loans, market them as securities through their retail networks, using the prestigious brand name of the bank - e.g. Morgan or Chase - as a proxy for the soundness of the security.
It was this practice, and the ensuing collapse when so much of the paper went bad, that led Congress to enact the Glass-Steagall Act, requiring bankers to decide either to be commercial banks—part of the monetary system, closely supervised and subject to reserve requirements, given deposit insurance, and access to the Fed’s discount window; or investment banks that were not government guaranteed, but that were soon subjected to an extensive disclosure regime under the SEC.
Since repeal of Glass Steagall in 1999, after more than a decade of de facto inroads, super-banks have been able to re-enact the same kinds of structural conflicts of interestthat were endemic in the 1920s - lending to speculators, packaging and securitizing credits and then selling them off, wholesale or retail, and extracting fees at every step along the way. And, much of this paper is even more opaque to bank examiners than its counterparts were in the 1920s. Much of it isn't paper at all, and the whole process is supercharged by computers and automated formulas. An independent source of instability is that while these credit derivatives are said to increase liquidity and serve as shock absorbers, in fact their bets are often in the same direction - assuming perpetually rising asset prices - so in a credit crisis they can act as net de-stabilizers.
A third parallel is the excessive use of leverage. In the 1920s, not only were there pervasive stock-watering schemes, but there was no limit on margin. If you thought the market was just going up forever, you could borrow most of the cost of your investment, via loans conveniently provided by your stockbroker. It worked well on the upside. When it didn't work so well on the downside, Congress subsequently imposed margin limits.
But anybody who knows anything about derivatives or hedge funds knows that margin limits are for little people. High rollers, with credit derivatives, can use leverage at ratios of ten to one, or a hundred to one, limited only by their self confidence and taste for risk.
Private equity, which might be better named private debt, gets its astronomically high rate of return on equity capital, through the use of borrowed money. The equity is fairly small. As in the 1920s, the game continues only as long as asset prices continue to inflate; and all the leverage contributes to the asset inflation, conveniently creating higher priced collateral against which to borrow even more money.
The fourth parallel is the corruption of the gatekeepers. In the 1920s, the corrupted insiders were brokers running stock pools and bankers as purveyors of watered stock. (In the) 1990s, it was accountants, auditors and stock analysts, who were supposedly agents of investors, but who turned out to be confederates of corporate executives. You can give this an antiseptic academic term and call it a failure of agency, but a better phrase is conflicts of interest. In this decade, it remains to be seen whether the bond rating agencies were corrupted by conflicts of interest, or merely incompetent. The core structural conflict is that the rating agencies are paid by the firms that issue the bonds. Who gets the business - the rating agencies with tough standards or generous ones? Are ratings for sale? And what, really, is the technical basis for their ratings? All of this is opaque, and unregulated, and only now being investigated by Congress and the SEC.
Yet another parallel is the failure of regulation to keep up with financial innovation that is either far too risky to justify the benefit to the real economy, or just plain corrupt, or both. In the 1920s, many of these securities were utterly opaque. Ferdinand Pecora, in his 1939 memoirs describing the pyramid schemes of public utility holding companies, the most notorious of which was controlled by the Insull family, opined that the pyramid structure was not even fully understood by Mr. Insull. The same could be said of many of today’s derivatives on which technical traders make their fortunes.
By contrast, in the traditional banking system a bank examiner could look at a bank's loan portfolio, see that loans were backed by collateral and verify that they were performing. If they were not, the bank was made to increase its reserves. Today's examiner is not able to value a lot of the paper held by banks, and must rely on the banks' own models, which clearly failed to predict what happened in the case of sub-prime. The
largest banking conglomerates are subjected to consolidated regulation, but the jurisdiction is fragmented, and at best the regulatory agencies can only make educated guesses about whether balance sheets are strong enough to withstand pressures when novel and exotic instruments create market conditions that cannot be anticipated by models.
A last parallel is ideological - the nearly universal conviction, 80 years ago and today, that markets are so perfectly self-regulating that government's main job is to protect property rights, and otherwise just get out of the way.
We all know the history. The regulatory reforms of the New Deal saved capitalism from its own self-cannibalizing instincts, and a reliable, transparent and regulated financial economy went on to anchor an unprecedented boom in the real economy. Financial markets were restored to their appropriate role as servants of the real economy, rather than masters. Financial regulation was pro-efficiency. I want to repeat that, because it is so utterly unfashionable, but it is well documented by economic history. Financial regulation was pro-efficiency. America’s squeaky clean, transparent, reliable financial markets were the envy of the world. They undergirded the entrepreneurship and dynamism in the rest of the economy.
Beginning in the late 1970s, the beneficial effect of financial regulations has either beendeliberately weakened by public policy, or has been overwhelmed by innovations notanticipated by the New Deal regulatory schema. New-Deal-era has become a term ofabuse. Who needs New Deal protections in an Internet age?
Of course, there are some important differences between the economy of the 1920s, and the one that began in the deregulatory era that dates to the late 1970s. The economy did not crash in 1987 with the stock market, or in 2000-01. Among the reasons are the existence of federal breakwaters such as deposit insurance, and the stabilizing influence of public spending, now nearly one dollar in three counting federal, state, and local public outlay, which limits collapses of private demand.
But I will focus on just one difference - the most important one. In the 1920s and early
1930s, the Federal Reserve had neither the tools, nor the experience, nor the self-confidence to act decisively in a credit crisis. But today, whenever the speculative excesses lead to a crash, the Fed races to the rescue. No, it doesn't bail our every single speculator (though it did a pretty good job in the two Mexican rescues) but it bails out the speculative system, so that the next round of excess can proceed. And somehow, this is scored as trusting free markets, overlooking the plain fact that the Fed is part of the U.S. government.
When big banks lost many tens of billions on third world loans in the 1980s, the Fed and the Treasury collaborated on workouts, and desisted from requiring that the loans be marked to market, lest several money center banks be declared insolvent. When Citibank was under water in 1990, the president of the Federal Reserve Bank of New York personally undertook a secret mission to Riyadh to persuade a Saudi prince to pump in billions in capital and to agree to be a passive investor.
In 1998, the Fed convened a meeting of the big banks and all but ordered a bailout of Long Term Capital Management, an uninsured and unregulated hedge fund whose collapse was nonetheless putting the broad capital markets at risk. And even though Chairman Greenspan had expressed worry two years (and several thousand points) earlier that "irrational exuberance" was creating a stock market bubble, big losses in currency speculation in East Asia and Russia led Greenspan to keep cutting rates, despite his foreboding that cheaper money would just pump up markets and invite still more speculation.
And finally in the dot-com crash of 2000-01, the speculative abuses and insider conflicts of interest that fueled the stock bubble were very reminiscent of 1929. But a general depression was not triggered by the market collapse, because the Fed again came to the rescue with very cheap money.
So when things are booming, the financial engineers can advise government not to spoil the party. But when things go bust, they can count on the Fed to rescue them with emergency infusions of cash and cheaper interest rates.
I just read Chairman Greenspan's fascinating memoir, which confirms this rescue role. His memoir also confirms Mr. Greenspan's strong support for free markets and his deep antipathy to regulation. But I don't see how you can have it both ways. If you are a complete believer in the proposition that free markets are self-regulating and self-correcting, then you logically should let markets live with the consequences. On the other hand, if you are going to rescue markets from their excesses, on the very reasonable ground that a crash threatens the entire system, then you have an obligation to act pre-emptively, prophylactically, to head off highly risky speculative behavior. Otherwise, the Fed just invites moral hazards and more rounds of wildly irresponsible actions.
While the Fed and the European Central Bank were flooding markets with liquidity to
prevent a deeper crash in August and September, the Bank of England decided on a
sterner course. It would not reward speculators. The result was an old fashioned run on a large bank, and the Bank of England changed its tune.
So the point is not that the Fed should let the whole economy collapse in order to teach speculators a lesson. The point is that the Fed needs to remember its other role - as regulator.
One of the odd things about the press commentary about what the Fed should do is that it has been entirely along one dimension: a Hobson's choice: - either loosen money and invite more risky behavior, or refuse to enable asset bubbles and risk a more serious credit crunch - as if these were the only options and monetary policy were the only policy lever. But the other lever, one that has fallen into disrepair and disrepute, is preventive regulation.
Mr. Chairman, you have had a series of hearings on the sub-prime collapse, which has now been revealed as a textbook case of regulatory failure. About half of these loans were originated by non-federally regulated mortgage companies. However even those sub-prime loans should have had their underwriting standards policed by the Federal Reserve or its designee under the authority of the 1994 Home Equity and Ownership Protection Act. And by the same token, the SEC should have more closely monitored the so called counterparties - the investment and commercial banks - that were supplying the credit. However, the Fed and the SEC essentially concluded that since the paper was being sold off to investors who presumably were cognizant of the risks, they did not need to pay attention to the deplorable underwriting standards.
In the 1994 legislation, Congress not only gave the Fed the authority, but directed the Fed to clamp down on dangerous and predatory lending practices, including on otherwise unregulated entities such as sub-prime mortgage originators. However, for 13 years the Fed stonewalled and declined to use the authority that Congress gave it to police sub-prime lending. Even as recently as last spring, when you could not pick up a newspaper's financial pages without reading about the worsening sub-prime disaster, the Fed did not act - until this Committee made an issue of it.
Financial markets have responded to the 50 basis-point rate-cut, by bidding up stock prices, as if this crisis were over. Indeed, the financial pages have reported that as the softness in housing markets is expected to worsen, traders on Wall Street have inferred that the Fed will need to cut rates again, which has to be good for stock prices.
Mr. Chairman, we are living on borrowed time. And the vulnerability goes far beyond the spillover effects of the sub-prime debacle.
We need to step back and consider the purpose of regulation. Financial regulation is too often understood as merely protecting consumers and investors. The New Deal model is actually a relatively indirect one, since it relies more on mandated disclosures, and less on prohibited practices. The enormous loopholes in financial regulation - the hedge fund loophole, the private equity loophole, are justified on the premise that consenting adults of substantial means do not need the help of the nanny state, thank you very much. But of course investor protection is only one purpose of regulation. The other purpose is to protect the system from moral hazard and catastrophic risk of financial collapse. It is this latter function that has been seriously compromised.
HOEPA was understood mainly as consumer protection legislation, but it was also systemic risk legislation.
Sarbanes-Oxley has been attacked in some quarters as harmful to the efficiency of financial markets. One good thing about the sub-prime calamity is that we haven't heard a lot of that argument lately. Yet there is still a general bias in the administration and the financial community against regulation.
Mr. Chairman, I commend you and this committee for looking beyond the immediate
problem of the sub-prime collapse. I would urge every member of the committee to spendsome time reading the Pecora hearings, and you will be startled by the sense of deja vu.
I'd like to close with an observation and a recommendation.
My perception as a financial journalist is that regulation is so out of fashion these days that it narrows the legislative imagination, since politics necessarily is the art of the possible and your immediate task is to find remedies that actually stand a chance of enactment. There is a vicious circle - a self-fulfilling prophecy - in which remedies that currently are legislatively unthinkable are not given serious thought. Mr. Chairman, you are performing an immense public service by broadening the scope of inquiry beyond the immediate crisis and immediate legislation.
Three decades ago, a group of economists inspired by the work of the late Milton Friedman created a shadow Federal Open Market Committee, to develop and recommend contrarian policies in the spirit of Professor Friedman’s recommendation that monetary policy essentially be put on automatic pilot. The committee had great intellectual and political influence, and its very existence helped people think through dissenting ideas. In the same way, the national security agencies often create Team B exercises to challenge the dominant thinking on a defense issue.
In the coming months, I hope the committee hears from a wide circle of experts - academics, former state and federal regulators, financial historians, people who spent time on Wall Street - who are willing to look beyond today's intellectual premises and legislative limitations, and have ideas about what needs to be re-regulated.
Here are some of the questions that require further exploration:
First, which kinds innovations of financial engineering actually enhance economic efficiency, and which ones mainly enrich middlemen, strip assets, appropriate wealth, and increase systemic risk? It no longer works to assert that all innovations, by definition, are good for markets or markets wouldn’t invent them. We just tested that proposition in the sub-prime crisis, and it failed. But which forms of credit derivatives, for example, truly make markets more liquid and better able to withstand shocks, and which add to the system's vulnerability. We can't just settle that question by the all purpose assumption that market forces invariably enhance efficiency. We have to get down to cases.
The story of the economic growth in the 1990s and in this decade is mainly a story of technology, increased productivity growth, macro-economic stimulation, and occasionally of asset bubbles. There is little evidence that the growth rates of the past decade and a half - better than the 1970s and '80s, worse than the 40's, 50's and '60s - required or benefited from new techniques of financial engineering.
I once did some calculations on what benefits securitization of mortgage credit had actually had. By the time you net out the fee income taken out by all of the middlemen - the mortgage broker, the mortgage banker, the investment banker, the bond-rating agency - it's not clear that the borrower benefits at all. What does increase, however, are the fees and the systemic risks. More research on this question would be useful. What would be the result of the secondary mortgage market were far more tightly subjected to standards?
It is telling that the mortgages that best survived the meltdown were those that met the underwriting criteria of the GSE's.
Second, what techniques and strategies of regulation are appropriate to damp down the systemic risks produced by the financial innovation? As I observed, when you strip it all down, at the heart of the recent financial crises are three basic abuses: lack of transparency; excessive leverage; and conflicts of interest. Those in turn suggest remedies: greater disclosure either to regulators or to the public. Requirement of increased reserves in direct proportion to how opaque and difficult to value are the assets held by banks. Some restoration of the walls against conflicts of interest once provided by Glass Steagall. Tax policies to discourage dangerously high leverage ratios, in whatever form.
Maybe we should just close the loophole in the 1940 Act and require of hedge funds and private equity firms the same kinds of disclosures required of others who sell shares to the public, which in effect is what hedge funds and private equity increasingly do. The industry will say that this kind of disclosure impinges on trade secrets. To the extent that this concern is valid, the disclosure of positions and strategies can be to the SEC. This is what is required of large hedge funds by the Financial Services Authority in the UK, not a nation noted for hostility to hedge funds. Indeed, Warren Buffet's Berkshire Hathaway, which might have chosen to operate as private equity, makes the same disclosures as any other publicly listed firm. It doesn't seem to hurt Buffett at all.
To the extent that some private equity firms and strategies strip assets, while others add capital and improve management, maybe we need a windfall profits tax on short term extraction of assets and on excess transaction fees. If private equity has a constructive role to play - and I think it can - we need public policies to reward good practices and discourage bad ones. Industry codes, of the sort being organized by the administration and the industry itself, are far too weak.
Why not have tighter regulation both of derivatives that are publicly traded and those that are currently regulated - rather weakly - by the CFTC: more disclosure, limits on leverage and on positions. And why not make OTC and special purpose derivatives that are not ordinarily traded (and that are black holes in terms of asset valuation), also subject to the CFTC?
A third big question to be addressed is the relationship of financial engineering to problems of corporate governance. Ever since the classic insight of A.A. Berle and Gardiner Means in 1933, it has been conventional to point out that corporate management is not adequately responsible to shareholders, and by extension to society, because of the separation of ownership from effective control. The problem, if anything, is more serious today than when Berle and Means wrote in 1933, because of the increased access of insiders to financial engineering. We have seen the fruits of that access in management buyouts, at the expense of both other shareholders, workers, and other stakeholders. This is pure conflict of interest.
Since the first leveraged buyout boom, advocates of hostile takeovers have proposed a radically libertarian solution to the Berle-Means problem. Let a market for corporate control hold managers accountable by buying, selling, and recombining entire companies via LBOs that tax deductible money collateralized by the target’s own assets. It is astonishing that this is even legal, let alone rewarded by tax preferences, even more so when managers with a fiduciary responsibility to shareholders are on both sides of the bargain.
The first boom in hostile takeovers crashed and burned. The second boom ended with the stock market collapse of 2000-01. The latest one is rife with conflicts of interest, it depends heavily on the perception that stock prices are going to continue to rise at multiples that far outstrip the rate of economic growth, and on the borrowed money to finance these deals that puts banks increasingly at risk.
So we need a careful examination of better ways of holding managers accountable - through more power for shareholders and other stakeholders such as employees, proxy rules not tilted to incumbent management, and rules that reward mutual funds for serving as the agents of shareholders, and not just of the profit maximization of the fund sponsor.
John Bogle, a pioneer in the modern mutual fund industry, has written eloquently on this.
Interestingly, the intellectual fathers of the leveraged buyout movement as a supposed source of better corporate governance, have lately been having serious second thoughts.
Michael Jensen, one of the original theorists of efficient market theory and the so called market for corporate control and an advocate of compensation incentives for corporate CEOs has now written a book calling for greater control of CEOs and less cronyism on corporate boards. That cronyism, however, is in part a reflection of Jensen's earlier conception of the ideal corporation.
I don't have all the answers on regulatory remedies, but people smarter than I need to systematically ask these questions, even if they are beyond the pale legislatively for now.
And there are scholars of financial markets, former state and federal regulators, economic historians, and even people who did time on Wall Street, who all have the same concerns that I do as well as more technical expertise, and who I am sure would be happy to find company and to serve.
One last parallel: I am chilled, as I’m sure you are, every time I hear a high public official or a Wall Street eminence utter the reassuring words, "The economic fundamentals are sound." Those same words were used by President Hoover and the captains of finance, in the deepening chill of the winter of 1929-1930. They didn’t restore confidence, or revive the asset bubbles.
The fact is that the economic fundamentals are sound - if you look at the real economy of factories and farms, and internet entrepreneurs, and retailing innovation and scientific research laboratories. It is the financial economy that is dangerously unsound. And as every student of economic history knows, depressions, ever since the South Sea bubble, originate in excesses in the financial economy, and go on to ruin the real economy.
It remains to be seen whether we have dodged the bullet for now. If markets do calm down, and lower interest bail out excesses once again, then we have bought precious time. The worst thing of all would be to conclude that markets self corrected once again, and let the bubble economy continue to fester. Congress has a window in which restore prudential regulation, and we should use that window before the next crisis turns out to be a mortal one.

ECB, BoE Leave Rates Unchanged Despite Inflationary Dangers

Friday, October 05, 2007

Central banks in the Eurozone and Great Britain have left key interest rates unchanged in their meetings on Thursday.
ECB president Jean-Claude Trichet delivered this key paragraph in his introductory statement at a press conference held in Vienna.
To sum up, a cross-check of the information identified under the economic analysis with the outcome of the monetary analysis has confirmed the existence of upside risks to price stability over the medium term, against the background of good economic fundamentals in the euro area. Accordingly, and with money and credit growth vigorous in the euro area, our monetary policy stands ready to counter upside risks to price stability, as required by our primary objective. At the same time, given the heightened level of uncertainty, additional information is needed before further conclusions for monetary policy can be drawn. Consequently, the Governing Council will monitor very closely all developments. On the basis of our assessment, and by acting in a firm and timely manner, we will ensure that risks to price stability over the medium term do not materialise and that medium and long-term inflation expectations remain firmly anchored in line with price stability, which is all the more important in the current context. As regards the financial markets, we will continue to pay great attention to developments over the period to come.
Eurozone inflation accelerated above the 2% target rate in August and stands now at 2.1%.
According to Trichet recent money supply record figures may be overstating actual M3 growth as a result from the flattening yield curve and recent market volatility.

Data Shows Monetary Policy Still Accommodative
The ECB has dropped the phrase about an "accommodative monetary policy" stance for the first time since October 2005. Dropped words are one thing - and the hard data in the most recent weekly financial statement of the Eurosystem shows the opposite. The ECB's longer term refinancing transactions now stand with 265 billion Euros at almost double the former pre-summer average of 150 billion Euros.

First Gold PURCHASES by a Central Bank

I also cannot forego a light chuckle when seeing that gold reserves have been revalued to the tune of 8.4% at the end of Q3 2007.
According to the ECB last week saw also the first gold coin purchases by a central bank from the Eurozone since its inception. Gold is the best performing asset of the Eurozone's reserves but has been dumped over the last 8 years when central banks began to prefer yield carrying investments.
I doubt that these investments have really delivered more profits than leaving the bars in the vaults. Not that this would have been of any interest to the press corps in attendance...

My Inflation Is a Lot Higher
Having relocated to Vienna again (and still suffering from jet lag) I am experiencing acute and severe sticker shock. Following are some price raises since April.
  • City parking fees rose 50%.
  • Public local transport rose 13.3%.
  • Bread costs now 3 Euros for half a kilo, roughly 1,200% more than when I started monitoring bread prices 35 years ago (and 10plus percent only in 2007.)
  • Pizza in my favourite place rose 14.9%.
  • Gasoline costs about 20% more.
  • Milk and milk products rose around 15%.
  • Butter rose 25%.
Family members extend this list with more food items, electricity and natural gas which all rose markedly, they say.
As these figures will probably not add up to the official inflation rate of 2.1% but result in significantly higher personal outlays I conclude one more time: Consumer price indices have nothing to do with reality and are kept artificially low as governments have to pay inflationary increases in many index linked contracts.
How much longer will consumers accept this betrayal?

Wikinvest Wire