Bill Gross. chief investment officer of bond investment giant Pimco, uses his monthly newsletter to tackle the question of whether the Fed and the Treasury really understand what they are up against. Although he reaches no definitive conconclusion, he suggests they have a bank-centric, and therefore badly outmoded, view of the world.
We’ve raised this issue repeatedly in the past, back in the days when members of the Fed were cheerfully extolling the virtues of risk diversification and the role of derivatives. (And to be clear about our view, we’re not opposed to the techniques of modern finance. What bothers us is that regulators have ceded not merely control, but even oversight and reporting of these activities. As a result, due to competitive pressures among money managers, you have institutional investors using instruments they don’t understand fully, and sometimes have not been tested in adverse markets. That behavior is risky and arguably speculation ras opposed to investing, yet it is all too common).
To illustrate, consider this excerpt from a March post on a speech by the president of the New York Fed:
Compared to other Fed governors, Timothy Geithner is straightforward and more than usually willing to talk about bad things. So when he gives a speech that is comparatively upbeat, as he did earlier this week (“Credit Markets Innovations and Their Implications“) it should be reassuring.
So why did this speech bother me? It wasn’t as if Geithner was overselling his case. He described both the risks (more credit issuance outside the banking system; more debt held by institutions with a propensity to trade rather than buy and hold) and the benefits (greater range of product, better pricing of risk, more diversified portfolios among investors) and thus deemed financial innovation to be a plus.
Perhaps I have an eye for problems, but I saw in Geithner’s straight-up-the-center description plenty of cause for worry. First, banks, the financial institutions that are most closely regulated, hold only 15% of the “nonfarm nonfinancial” debt outstanding (remember financial institutions do lend to each other, so that is excluded). By contrast, hedge funds are becoming increasingly important players, and their investing operations are unregulated, unsupervised, and largely unreported. So while the Fed has good information about what its banks are doing, and can send in extra examiners when warranted, it has no idea what is up with the biggest players in the credit markets.
Second is that the variety and complexity of instruments has exploded. Geithner believes this is a plus, giving issuers and investors more choice, and investors greater ability to diversify and fine tune their risks. Yet we’ve been told that one of the effects is that very complex and risky instruments have wound up held by weak institutions that really don’t understand them. This is not a pretty picture.
Third, Geithner indicates that while disintermediation (borrowers going directly to investors rather than via banks) has been around for some time, new instruments and vehicles have proliferated. He indicates that the Fed has taken steps to assure that mechanisms are in place to make sure that operational as well as credit risks are managed. Yet look at the first concern above. Most of this activity is taking place outside the Fed’s purview. All it has to work with is moral suasion, not regulatory authority. That is not a position of strength.
Finally, Geithner has no objective foundation for his rosy view. He has essentially admitted the Fed and other regulators lack a complete, or even good, picture of what is happening. We’ve had money supply growth well in excess of GDP growth, and loose monetary conditions can obscure underlying weaknesses. His argument boils down to,”Our current structure and distribution of risks is outside the bounds of anything in financial history. We can muster some arguments as to why this should be OK, and so far, it has been OK.” I don’t find that terribly convincing. And I find one quote particularly troubling:
….these broad changes in financial markets may have contributed to a system where the probability of a major crisis seems likely to be lower, but the losses associated with such a crisis may be greater or harder to mitigate.
Back to Gross. While he approves of and lobbied for the Fed’s 50 basis point cut in September, he points out multiple elements of the Fed’s conundrum. While a fall in housing prices will have a much greater impact on the economy than a stock market decline, it’s not clear a Fed rate cut will do much to shore up that market. And he didn’t even mention the real dead body in the room, namely, the dollar.
In addition, he observes that the target for a Fed easing cycle is real short rates of 1% or less. If you assume inflation is 2 1/2%, that means the Fed’s goal is around 3.75% ish, which means they don’t have much room for further cuts. And if you believe, as many do, that inflation is higher than the “core” inflation stats indicate, the Fed effectively had pretty much done all it can do without debasing the currency. The rate increase on the long end of the yield curve says the markets are already of that view.
The 200 point rally in the Dow today shows that a lot of people don’t agree with Gross, but that’s why he’s a bond man.
From Gross, who starts with a riff on the contrast between the permabull of one generation, the debonair, knowing, and bemused Louis Rukeyser, versus the histrionic Jim Cramer:
As Cramer was railing, I and other PIMCO professionals were attempting to describe to high-ranking Treasury and Fed officials the near-frozen commercial-paper markets and the draining confidence of bond and stock investors worldwide. It was Thursday, August 16. Stocks had closed down 210 points and were expected to open hundreds of points lower on Friday. The country’s largest mortgage originator, Countrywide Financial, was rumored to be in liquidation mode (it survived that crisis). This was to be Ben Bernanke’s first test, an opportunity to prove that he and his board of governors knew “something” as opposed to “nothing.” Pass the test he did, cutting the discount rate the next morning and calming markets in ensuing weeks. When Bernanke’s Fed met officially on September 18, it acted again and joined a convoy of global central bankers maneuvering to restore a semblance of normalcy to credit and equity markets. So far, so good.
Yet the validity of Cramer’s rant remains to be disproved. The modern financial complex has morphed into something unrecognizable to many astute market veterans and academics. Bernanke’s fellow governors and Hank Paulson’s staff at the Treasury spread their roots during an era in which traditional banking activity – lending out deposits backed by a certain level of reserves – was the accepted vehicle for liquidity creation. Remember those old economics textbooks that told you how a $1 deposit at your neighborhood bank could be multiplied by five or six times in a magical act of reserve banking? It still can, but financial innovation has done an end run around the banks. Derivatives and structures with three- and four-letter abbreviations – CDOs, CLOs, ABCP, CPDOs, SIVs (the world awaits investment banking’s next creation; perhaps IOU?) – can now take a “depositor’s” dollar and multiply it ten or 20 times. Reserve banking, and the Federal Reserve that regulates the system, appear anemic in comparison.
I’m sure that Bernanke, Paulson, and their cohorts understand this, but it isn’t yet clear how much they appreciate it. Alan Greenspan admits in his newly published book that he didn’t appreciate until recently the impact adjustable-rate mortgages and their subprime character, accompanied in some cases by outright fraud, would have on the housing market. If the Fed was so slow to grasp the role that subprime mortgages played in the housing boom and bust, do the Fed and the Treasury of today totally comprehend what happens when the nonbanking private system suddenly stops flooding the market with credit? Do they recognize that such a shutdown puts spending for housing and business investment at risk, and job growth as well? The Fed will have to adapt its monetary policy, and the Bush Treasury will have to adjust its fiscal policy to this brazen new world dominated more and more by private rather than public policies and proclivities. To overcome private-market caution, the Fed may need to put on a bold face marked by even more decisive cuts in short-term rates. To prevent a housing-market slump from metastasizing into a cancerous self-feeding tumor, Treasury Secretary Paulson will have to coordinate policies that lend a helping hand to homeowners in distress.
But Paulson’s attempt to assist ailing homeowners will be complicated by the free-market laissez-faire policies of Republican orthodoxy. In addition, the rescue effort will be hampered by an uncomprehending press and public who appear to be more focused on revenge and “just desserts” as opposed to the ultimate negatives ahead for housing prices, employment, and economic growth. To use the old saw in updated form, a recession is when home prices in a neighboring state go down – a depression will be when the price of your home does. Well, if that be the definition of modern depression, then 70 million American homeowners will soon be residing in Bush, not Hoovervilles.
But if Paulson cannot prevent expected declines of 10-15% in national home prices over the next several years, it is problematic as to whether Bernanke can substantially cushion them either. First of all, the aforementioned lack of “appreciation” of a modern-day shadow banking system has put the Fed far behind the 8-ball in its reflexive duty to lower interest rates in an anticipatory fashion. Mortgage credit has been contracting on the ground level for all of 2007 with individual, small, and then national mortgage brokers and originators closing their doors. Legal threats and regulatory pressures have compounded the credit implosion. As a result, home prices, as shown in Chart 1, have been declining for nearly 12 months and only now is the Fed responding to an unfolding crisis.
Bernanke’s Fed may be as opposed to targeting asset prices as was Greenspan’s, but housing and stock market bubbles are birds of entirely different feather. 1987’s equity crash and its negligible effect on economic growth as well as Nasdaq’s fall from 5000 to 1500 in recent years, which led to a very mild investment led-recession, cannot be the textbook examples for Fed asset price policy today. Wall Street, despite its increasing influence in America’s finance-based economy, is not Main Street; and stock prices do not dominate the spending habits and confidence of its consumers in the same degree as do home prices. So Fed policy must, as governor Don Kohn mentioned recently, be as asymmetric as asset prices – emulating an escalator on the way up (25 basis point increases) and an elevator on the way down (50 basis point reductions).
Bernanke, however, may face a problem with this elevator-based ease in monetary policy. As I have pointed out in prior pages and Outlooks, globalization and financial innovation have enormously complicated the job of central bankers. Whereas in prior decades a “one size fits all” policy rate move has coincidentally and democratically affected households and corporations alike, the 21st century has ushered in an innovation revolution favoring corporations with global investment opportunities as opposed to individuals with daily bills to pay. The same 4¾% rate is not and cannot be “neutral” for both sides in today’s U.S. economy. Whereas current yields are not restrictive for investment grade corporations with global opportunities, they are far too high for homeowner Jane Doe and two million of her neighbors facing higher and higher monthly payments on adjustable rate mortgages. Should Bernanke put on a brave face and freeze the elevator and rates in mid-descent, he risks exacerbating a housing crisis in the making. Yet, should he favor the homeowner over the corporation, he risks reigniting speculative equity market behavior, and – in addition – a run on the dollar.
PIMCO’s view is that a U.S. Fed easing cycle historically has required a destination of 1% real short rates or lower. Under a conservative assumption of 2½% inflation, that implies Fed Funds at 3¾% or so over the next 6-12 months. Actually that’s only two, 50 basis point reductions, something that could, but probably won’t, be accomplished by year-end. Don Kohn’s asymmetric elevator will likely be interrupted by false hopes of a housing bottom, fears of a dollar crisis, or misinterpreted one month’s signs of employment gains and faux economic strength. The downward path of home prices, however, will dominate Fed policy over the next several years as will the lingering unwind of related financial structures and derivatives that have yet to be discovered by the public, and marked to market by their conduit holders.
Know nothing? Perhaps they now know more than I or Jim Cramer gave them credit for on that raucous day in August. If they do, however, their options are limited by Republican political orthodoxy, the receding willingness of the private sector to extend credit, and a still exuberant global economy. What do they know? I suspect at the very least they know they’re in a pickle, and a sour one at that.