Henry Kaufman Takes the Fed to the Woodshed

For those who may be too young to have been around in his heyday, Henry Kaufman, aka Dr. Doom, was one of the preeminent economists during the early to mid 1980s, when his firm, Salomon Brothers, ruled the bond markets. Kaufman had a particularly well honed ability to read interest rate trends, no mean skill when that was where the action was (during the Volcker-induced recession of 1980-1982, equities were seen as a has-been). He is also a particularly articulate speaker and writer.

Kaufman is still highly regarded. For example, after Bernanke’s October presentation at the Economics Club of New York, Kaufman asked him a question from the floor. Mere mortals don’t get to do that.

Today, in the Wall Street Journal, Kaufman criticizes the Fed on its policies towards transparency. He argues that the current mix, transparent monetary policy and opacity in financial markets, has not only helped fuel asset bubbles, but will also impede the return of stability.

Kaufman avoids polemics of any kind and goes to some length to be factual and dispassionate. Nevertheless, his article sets forth how a short-term focus took innovations that could have been salutary and instead rendered them toxic. In large measure, this happened because the inmates are running the asylum. Senior managers are hostage to mid-level producers, who could take their business to another firm or form a hedge fund.

And these internal entrepreneurs have every incentive to take huge risks. If they win, they get a handsome payout. And if they lose, even if they lost their job, Wall Street is remarkably forgiving. Many traders who have been responsible for noteworthy meltdowns (the poster child being former Salomon star and head of Long Term Capital Management John Meriwether) go on to successful second and third acts.

This is nevertheless a fundamental indictment of the incentive structures of the financial services industry. And it results primarily from the fact that these firms are now public.

In the old days of private partnerships, it wasn’t just senior management, but also the leaders of the revenue producing units, which were often quite narrow, who were owners. Profits were retained largely within the firm, creating long-term incentives. And while talented young performers were well paid, the big prize was joining the partnership, which enabled the partners to rein in current compensation.

Now with public shareholders, everyone is paid on a current basis (even executive option plans tend to operate in addition to rather than in lieu of bonuses) and there is no particular reason to be careful with the house’s money. Even though Morgan Stanley CEO John Mack decided to forgo a year-end bonus, the firm’s bonus pool was $10 billion. Note that it has also secured an agreement from China Investment Corp, to invest $5 billion, ostensibly to shore up Morgan Stanley’s capital base after a fourth-quarter loss of $3.6 billion.

Looks like Morgan Stanley sold equity so it could pay out bonuses, a move that would have been unthinkable 20 years ago.

Back to Kaufman. He discusses in detail how the Fed’s move towards greater transparency has in fact backfired in terms of helping it achieve its institutional goals. And he point out how the libertarian/free market ideology so dear to Greenspan and widely accepted in the American culture cannot readily be reconciled with the cold fact that there are institutions too big to fail, and the number that falls into that category has increased over time. More disclosure of their risk-taking is a minimum requirement, and although Kaufman does not say it here, more regulation is likely necessary as well.

From the Wall Street Journal:

Transparency is a hallmark of modern capitalism, and Federal Reserve Chairman Ben Bernanke has made transparency a hallmark of his new regime. Yet among our leading financial institutions, opacity, not financial transparency, has been on the rise

The combination — increasingly opaque financial markets and increasingly transparent monetary policy — has created a dangerous brew of financial excesses. Unless both trends are reversed, financial stability will remain elusive.

The explanation for increasingly opaque financial markets lies chiefly in securitization — the conversion of non-marketable assets into marketable obligations — which has accelerated dramatically in recent decades.

In theory, securitized markets are supposed to operate on the basis of accurate and readily available prices, the clear assessment of credit quality, and objective analyses of these obligations by rating agencies and those engaged in trading and underwriting them. These virtuous mechanisms presumably have been reinforced by a host of new credit instruments, especially financial derivatives that mitigate risk taking. Securitization also has been supported by a dazzling array of new quantitative analytical techniques that are capable, according to practitioners, of defining risk probability down to decimal point levels.

So what went wrong? In the broadest sense, the structural changes in the financial markets encouraged participants to become short-term oriented.

Financial intermediaries quickly recognized that the process of securitization held the potential for enormous profits — from underwriting, distributing and trading the newly commodified obligations, as well as from managing them for others. To many, the profit potential seemed virtually unlimited, because it stretched well beyond non-marketable assets (like a mortgage) and was global in scope. Thus securitization drove a massive wave of credit creation and helped lift the level of financial-market transactions to record levels.

The new credit entrepreneurship paid off handsomely. For nearly a decade — up to mid 2007 — financial profits outpaced the growth of profits in the broader markets.

But the fervor for profits from securitization also ushered in a host of less apparent, and less cheery, institutional shifts. Senior managers at a growing number of leading financial institutions either lost control of risk management or became its captives. In some cases, this happened as managers struggled to understand the dazzling complexity and diversity of the risks assumed by their financial conglomerates. And every institution, of course, felt growing competitive pressure to take on risk in order to maintain market share.

The glamour and profit of risk-taking insured that the risk-takers themselves gained more and more power within the structure of financial institutions. With the eclipse of partnerships on Wall Street, investment banks and other financial institutions are now owned by absentee stockholders, the vast majority of whom lack the information and the analytical skills needed to judge the risk portfolios of their institutions. In any case, it is the rare shareholder who will voice displeasure during favorable markets.

Power and decision-making increasingly resided in the middle ranks of leading financial institutions. Unlike top managers, who are supposed to take the long view and think strategically, those in the middle ranks — traders, investment bankers and managers of proprietary activities — compete in arenas that are by nature focused on the near term. They are the rainmakers. They and their institutions thrive on profits from securitized markets and on ever-expanding asset markets. They are biased to pursue ever greater levels of risk.

Incentive systems within financial institutions offer few restraints. It is possible, though rare, for top managers to be removed from office. But even then, judging by recent events, compensation packages for the deposed are more than generous. Middle managers are sometimes dismissed, but they too typically received generous termination payments as part of their contractual arrangements. Such arrangements are net losses for employers, for there are no claw-back provisions to recoup any of the losses incurred by the former managers.

As financial markets have become opaque and risk-laden, the Federal Reserve has touted its own growing transparency. Yet the central bank has made no real effort to compel financial institutions to follow suit.

When the Fed failed to put into place new disclosure requirements or otherwise penetrate market opacity, market participants took note and devised new ways to camouflage risk and create additional excessive credit.

Some of the Special Investment Vehicles (SIVs) that contributed to the recent hemorrhaging of the money market were an off-balance-sheet activity of bank holding companies — and therefore subject to Federal Reserve supervision. But the Fed seemed satisfied to allow them, as long as it determined that the value-at-risk procedure employed by these holding companies fell within generally accepted parameters.

Rather than focus on the threat posed by the lack of transparency, the Fed has focused on mechanical deficiencies in the market. For instance, regulators tried to insure that the huge volume of trades would be cleared quickly and with correct documentation. This is worthwhile, but by itself cannot forestall credit abuses. By failing to acknowledge and attack risks posed by opaque financial practices, the Fed encouraged them.

Ironically, the Fed’s own transparency — as demonstrated by the new tenor of the central bank’s open market pronouncements in recent years — has tended to foster rather than dampen financial excesses. Perhaps nothing better illustrates the Fed’s lack of pre-emptive restraint than what has become known in the investment community as the “Greenspan Put.”

Briefly stated, this is the now-prevailing view that monetary authorities do not know when a full-blown credit bubble is upon us, but that they do know what to do once a bubble bursts. I have long argued this approach condones excessive credit growth. Massive infusion of new funds following a major market collapse can provide temporary relief, but it does not repair the long-term political, social and economic damage caused by the meltdown. How can this monetary approach not reduce market discipline before the collapse, or incite a quick return to speculative activities after the Fed rescue?

Consider another example of the Fed’s transparency policy that is likely to backfire. In November 2007, the Fed announced that it will “increase the frequency and content” of its economic projections released to the public. Rather than twice a year, the Fed will announce them quarterly; and it will extend the forecast horizon to three years from two.

At first blush, these might seem like moves in a positive direction. But will they actually diminish market opacity or restrain market activity within prudent bounds?

This is highly unlikely. That is the case, at least, for the Fed’s first, more-detailed economic pronouncement, which predicted moderate economic growth for the next three years, inflation to remain within acceptable bounds, and high resource utilization, as measured by the unemployment rate. In contrast, if the Fed were to project a significant escalation in the inflation rate or a sharp cyclical turn to a business recession, financial markets would recoil, and the central bank would be blamed for damaging the economy.

What would be more helpful is what is currently missing from the Fed’s current repertoire: the central bank’s assessment of financial developments for the next three years, and the specific interest rate range needed if the Fed is to achieve its economic targets.

At the heart of the Federal Reserve’s diminished influence as a positive economic influence is its ambivalent core philosophy. During his long tenure as Fed chairman, Alan Greenspan ostensibly was an economic libertarian. This means not only that the market knows best, but that the market should decide winners and losers.

I say “ostensibly,” because, like Mr. Greenspan and the central bank that continues in the shadow of his legacy, most Americans applaud competition while being uncomfortable with certain kinds of personal and institutional failure. There is no better example than our attitudes about the failure of large financial institutions.

With huge liabilities resting on a thin capital base, they are vulnerable giants. Yet they are the custodians of the public’s temporary funds, savings and investments. They cannot be allowed to fail. The costs — financially and economically, socially and politically, domestically and internationally — are unacceptable.

So many economic libertarians such as Alan Greenspan live uncomfortably with the doctrine of too-big-to-fail. Nevertheless, one cannot be a true advocate of the philosophy by adhering to it when monetary ease is the order of the day, and abandoning it when market discipline punishes those who have committed financial excesses.

Even out of office, Mr. Greenspan continues to want it both ways. His best-selling memoir reasserts his laissez-faire philosophy, but in a recent pronouncement he advocated giving funds directly to needy subprime mortgage borrowers to permit them to meet their contractual mortgage obligations.

This would have three consequences. It would alleviate the immediate pain of the borrowers (who should not have been allowed to borrow in the first place). It would keep the façade of the financial system in place without disciplining excessive lending practices. And it would socialize the cost of the problem by raising the government’s budget deficit.

Today, a shrinking number of huge, integrated financial conglomerates dominate markets. They offer a full range of financial services — commercial banking, investment banking, insurance, credit cards, asset management, mutual funds, pension funds and so on. But annual reports, 10-K reports and other currently required reporting tools give us little idea of the true extent of their risk-taking activities.

My own preliminary efforts to calculate, for a book in progress, the proportion of risk exposure to tangible financial assets within these institutions suggests a ratio of dozens of dollars at risk for each one in hand. Our economy would be better off if the Federal Reserve focused its campaign for greater transparency on those leveraged giants, rather than making the kinds of pronouncements that encourage them to take on even more risk.

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  1. Anonymous

    To describe a central banker of a fiat currency as an economic libertarian is to employ a contradiction in terms.

  2. Anonymous

    It would be more accurate to describe Alan Greenspan as a Bloomsbury socialist rathter than a libertarian. In this he is entirerly conventional.

  3. s

    The entire system assumes the cutrrent debt capacities are sustainable and servicable. they are not. some of the lumbering giants are already insolovent by any definition. Now without the help of financial leverage to help the bottom line, it will beinteresting to watch the bleeding spill over to the corporate sector.

  4. NC Jim

    Twenty-five years ago we were told that:

    1) Government was the problem and,

    2) Deficits don’t matter.

    Rather than religious (little r) truths these statements were ,in fact, class warfare stratagems which were successfully executed leading to:

    1) Corruption and the enrichment of the few.

    2) Socialization of corporate costs (ex. The occupation of Iraq includes the cost of procuring oil reserves).

    The past cannot be undone however the first step to repairing the damage is to recognize and crush the false economic “truths” embedded in the “Reagan revolution” which was nothing but centuries old class warfare with ruddy cheeks.


  5. flow5

    I remember Volcker (the worst Fed Chairman in history) and Kaufman (and his broken record) in the 80’s. Transparency? Only if you understand Money & Central Banking which Kaufman doesn’t.

  6. Gavin

    flow5, Volcker was the last Fed chairman who enforced the independence of the Fed by not kowtowing to the whims of investment banks. If that’s incompetence, throw me in that briar patch.

    yves, you linked to the story about kaufman.. from another part of that article, do you have any update on your position re the Fed’s competence? Given their shockingly massive under-estimation of losses from this credit implosion, I’m probably going to “throw my vote away” by picking Ron Paul to see if we as a nation can be freed of the uselessness called the Fed.

  7. Anonymous

    Republican leaders say one reason economic fears have risen in the past year is that Democratic plans to raise taxes, increase government regulation and boost spending have prompted businesses to cut back on expansion plans. On Wednesday, the GOP leadership released a 58-page report titled “Death by a Thousand Cuts: Democrats’ War on American Jobs.’’ It characterized the majority’s legislative proposals on a host of issues as “weapons of economic havoc.’’

    “Democrats seem to be determined to make matters worse,’’ said House Minority Leader John A. Boehner , R-Ohio. “This job-killing agenda is the worst possible news at the worst possible time for American families and small businesses.’’

    The Republican critique was met with incredulity from House Financial Services Chairman Barney Frank , D-Mass., who has brought forward several bills (HR 3915, HR 1852 and HR 1427) to try to ease the pain of the subprime mortgage crisis. The mortgage losses, and the resulting tightening of lending standards and multibillion-dollar write-offs by major banks in several countries, are a major reason for heightened economic fears.

    “Even by the Republican standards, that is extraordinarily stupid,’’ Frank said. “No one believes that Democrats are responsible’’ for the economy, he said. “No one in the business community believes that.’’

    Frank added that “Republicans are desperate to escape the blame.’’

  8. Anonymous

    Re: I’m probably going to “throw my vote away” by picking Ron Paul

    That will happen a lot next year IMHO, but, its better to be counted in terms of the super majority, so its really not a wasted vote! Its a great vote!

  9. Yves Smith


    I wish I could give a short and tidy answer to your question.

    Remember, the Fed has two sets of responsibilities. The first is its regulatory function, to assure the safety and soundness of the banking system. The second is its monetary role which (I’m not looking at the statute. so this is my rough recollection) calls for the Fed to promote stable prices and employment.

    The complicating factor is that the Fed (according to Willem Buiter) is the second least independent central bank in the world (only the Bank of Japan is more hamstrung).

    However, I think most of the failings of the Fed are due to Greenspan, but even a more aggressive chairman might have had a hard time taking a tougher line (Theodore Levitt, SEC Chairman during the Clinton Administration, tried taking a more pro-consumer stand and was frequently opposed by Congress, which could cut his budget if he crossed them. Joe Lieberman was his fiercest opponent).

    The problems with the current Fed are that it has dropped the ball on oversight. It has taken the “let a thousand flowers bloom” approach to risk management. The only methodology its examiners understand is value at risk, and that has plenty of flaws. So they can engage in only a very limited way with the big institutions on what they are up to.

    This fit the ideology of the times, and also fit Greenspan’s personal views.

    Note that the Fed’s mandate does not cover consumer protection. However, it can be faulted (in my view) for blocking state efforts in that area.

    On the monetary front, the Fed has completely abandoned the idea of managing money supply in the Friedmanesque sense (setting monetary targets) and instead use inflation targets (not formally stated, as the EU has done). There are arguments against the use of money supply, the biggie being that with the proliferation of all the forms of near money and changes in the velocity of money, money supply isn’t terribly meaningful.

    To me, that’s the wrong way to formulate the problem. That says to me the Fed should have been trying hard to understand what all these new forms of near money (what now is part of the so-called shadow banking system) implied for monetary policy. But all central bankers and academics have dropped the ball on this one.

    Instead, Greenspan took interest in the stock market, and seemed to regard rising stock prices as a validation of his policies. That is horrible. The stock market is not the Fed’s job.

    Bernanke inherited a mess. Not only had Greenspan created serial asset bubbles (which central bankers don’t have a mandate to deflate) but our lack of savings has led to big current account deficits, which puts pressure on the dollar. The Fed has no good options at this point, policy-wise. It can cut rates to salvage the financial system (which has the effect of rewarding behavior that ranged from incompetent to venal), tank the dollar, and leave the US with big-time inflation (which will erode the value of the debt overhang) or try to hold the line on rates, which will lead to a nasty, unpopular recession but will leave the dollar somewhat intact . If you subscribe to Schumpeter, recessions are necessary to clear out excesses.

    The latter is the better course of action, in terms of the long-term health of the economy, but I doubt Bernanke has the nerve to implement it. Academic economists are easily bullied by market professionals.

    As to your bigger point, I don’t see how we can do without a Fed or equivalent. The fact is that we do have institutions who are too big to fail. When they screw up in a major way, the losses are socialized. That in turn means they need to be regulated to reduce the likelihood they get themselves in deep shit. This is a basic conundrum of modern finance and there is no simple way around it.

  10. Independent Accountant

    I remember Kaufman from 25 years ago. For my money, he’s one of the few people on Wall Street who understands money. I read his article and agreed with it.

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