Fed's Dilemma Continues

Market Comment






Fed's Dilemma Continues



Fri, Aug 31 2007, 06:25 GMT
by Comstock Partners TeamComstock Partners Inc.

While
most of the stock market discussion is revolving around subprime loans,
securitized mortgages, lack of transparency, the possibility of
contagion and potential Fed action, economists and strategists are
overlooking one basic fact. Even in more ordinary times before the
current housing boom and massive buildup in all sorts of credit
derivatives, major declines in home building have almost inevitably led
to recessions. In the last 50 years there have been only seven
occasions where housing starts were down 30% or more from a year
earlier and six have been associated with a recession. The current
instance is the eighth time, and the result is likely to be the same.
The lone exception was 1966 when a recession was narrowly averted and
the Dow plunged 25%. Historically the housing industry has served as
the conduit through which easy or tight money has been transferred to
the rest of the economy, and what is happening today is a result of the
previous tightened policy acting with its usual lag. Since the current
turmoil in the credit markets is particularly severe, it is hard for us
to believe that this would be only the second time a major downturn in
housing did not lead to a recession.
The Fed remains faced with a serious dilemma. Bernanke apparently
wants to stabilize the credit markets and prevent a recession, but in a
potential change of policy from the Greenspan-led Fed, is trying to
separate the two problems in order to avoid the perception that it is
creating a "moral hazard". This seems clear for a number of reasons. On
August 17 the Fed took the unusual step of using the discount rate
mechanism in an attempt to add confidence to the system without
lowering the fed funds rate. In addition, on the day before the cut St.
Louis Fed president Poole said the subprime crisis did not threaten
economic growth and only a "calamity" would justify an interest rate
cut and that the best course would be for officials to review the
economic data when they meet on September 18.
This view was reinforced by Richmond Fed president Lacker the day
after the discount rate cut. Lacker argued that a discount rate
reduction was a good thing to do because it can supply liquidity
without leading the market to misprice credit again. Hammering home his
point, he stated "Sound discount window policy, I believe, should aim
at supplying adequate liquidity without undermining the market’s
assessment of risk."
In addition the well-informed Greg Ip of the Wall Street Journal
reported that "Fed officials were looking for a maneuver dramatic
enough to shore up confidence while avoiding a cut in the Fed’s main
interest rate, the federal funds rate. Mr. Bernanke was still not
convinced that the economy needed a cut, and some Fed officials feared
it might encourage more of the sloppy lending that led to the crisis."
Ip added that Bernanke is making an effort to undo the "moral hazard"
perceptions created by Greenspan. Al Broadus, former head of the
Richmond Fed, said that he and some others were skeptical of the need
for action during the 1998 Long Term Capital crisis. We note that Ip is
a reporter, not an opinion columnist. He was likely given this
information on background.
Although it seems likely that Bernanke is making an effort to avoid
a cut in the fed funds rate at or before the September meeting, the
market may force his hand. First, continuing financial turmoil may make
holding the line untenable. Second, a large number of stock market
economists and strategists are screaming for a rate cut and the market
is long way toward pricing it in. If so, the FOMC may have to cut if
only to avoid a severe market collapse following the meeting. The
problem is that if a rate cut is already priced in prior to the
meeting, the result may still be greeted with disappointment.
In our view, no matter what the Fed does, a major growth slowdown
or recession is already baked in the cake as a result of the severe
housing decline. Even with today’s 2nd quarter GDP revision, annualized
GDP growth has averaged only 2.0% over the last five quarters, and this
was before the credit crisis snowballed. In addition 2nd quarter
consumer spending was up only 1.3% annualized while employment growth
has been tepid. We are therefore faced with a softening economy that
can only deteriorate further in the second half. We believe that the
stock market rally since the bottom is purely technical and that much
more decline is ahead.


Published on
Fri, Aug 31 2007, 06:22

The Freeway to Serfdom

"One
of the annoying things about believing in free will and individual
responsibility is the difficulty of finding somebody to blame your
problems on. And when you do find somebody, it's remarkable how often
his picture turns up on your driver's license." - P.J. O'Rourke



Friday, August 31, 2007






Bailing out credit crackheads with other people's money



NY Times: Bush Offers Relief for Some on Home Loans
<blockquote>
"It’s
not the government’s job to bail out speculators or those who made the
decision to buy a home they knew they could never afford," Mr. Bush
said. "Yet there are many American homeowners who can get through this
difficult time with a little flexibility from their lenders or little
help from their government."</blockquote>
So it is in fact
the government's job to bail out "speculators" and those who made the
decision to buy a home they knew they could never afford. Nice
headline, though. Is W. really reaching into his own retirement
portfolio to offer this relief? Wotta swell guy.

<blockquote>Administration
officials said in advance of Mr. Bush’s appearance that the goal would
be to change its federal mortgage insurance program in a way that would
let an additional 80,000 homeowners with spotty credit records sign up,
beyond the 160,000 likely to use it this year and next.</blockquote>
Moral hazard to the front desk, please. Moral hazard to the front desk. As TJIC notes:

<blockquote>Brilliant.

Small cans of gasoline are exploding, and spreading a fire.

Bush’s plan is to put another 80,000 cans of gasoline in the path of the flames. </blockquote>

From sub-primes to anarchy: it isn’t such a leap


August 31st, 2007 · 2 Comments



“Bernanke
maintained that it is not the Fed’s responsibility to bail out
borrowers who took on risky loans or the financial institutions that
made them, saying that it would not be ‘appropriate…to protect lenders
and investors from the consequences of their financial decisions.’
“Nonetheless, he did say that ‘developments in financial markets can
have broad economic effects felt by many outside the markets, and the
Federal Reserve must take those effects into account when determining
policy.’” (Source: “Fed Ready to Act”)
I’ve been waiting two years for the sub-prime meltdown to come into
common parlance, and it has arrived. I’ve watched, fascinated,
wondering whether the models in the animated ads on Yahoo! were going
to jump out their windows when their $510,000 ARMs at $1,200 a month
bumped up. But the resilient models now have gigs on insurance ads.
Other people aren’t so resilient, but rely on Helicopter Ben to save
them– without directly paying off their homes–that of course, would be
“moral hazard,” and encourage reckless investing.
Greenspan warned of investors’ “irrational exuberance” in the
previous decade, but heck, their exuberance was perfectly rational. Why
not invest if the Fed will practically guarantee controlled losses?
What I don’t see anyone calling this is anarchy. The A-word just
isn’t coming up. But what else is it if the least responsible people
are essentially making policy?
The Fed is operating as clean-up crew, while irresponsible borrowers
and investors are setting policy by behavior. The Fed is simply
reacting, invoking situational policy because it deems the damage too
big not to.
The Fed’s safety net protects everyone from the consequences of
inherent market risks, so the booty really goes to those driving up the
consequences–the least responsible. The Fed is mopping the bloody
streets with a bloody sponge so no one gets hurt. It’s soft anarchy.
Just because incredibly foolish lending opportunities are presented
doesn’t mean people should buy over their heads. But they do, and they
have been, and now we are seeing the fruits of their unfunded
opportunism and correctly referring to the crash as a crisis. What was
behind their optimism?
Moral hazard, of course. Moral hazard in this case means the
reduction of risk based on sure rescue response by the government.
Greenspan sounded the moral hazard alarm, warning of the recklessness
that bailouts would encourage. But when things got too tough for too
many, well, that’s the hazard–they got help. The help becomes a factor
in future behavior–there will always be help, so why be responsible?
Investors, borrowers, and lenders had seen it before. The Fed would
cushion their fall.
The Fed’s predictable behavior is an established factor in general
public optimism. Individuals may not perceive this directly, but they
are swung by the trend pushed by those who do. They go for the gold as
though nothing could happen. Who can blame them?
So what Bernanke is saying here is that it’s bad for business if the
Fed bails people out. But if business gets too bad for too many, the
Fed needs to bail people out. Again, this places the least responsible
people in the economy’s cockpit. The people live to spend; the Fed
lives to save. The situation, not principle, pilots the whole economy
to doom, and the Fed throws the people’s money back at it. Then
everyone replays the same roles.
Help is coming. Borrowers who would not have qualified for FHA loans
before and were driven to sub-primes, now suddenly do, under a new Bush plan.
This is not a bailout, we are assured; no, a bailout would “only
aggravate the problem.” This is an opportunity to refinance, for people
who were formerly unqualified. Nothing has changed but the rules.
Imagine kids trashing a house as a party activity, and the parents
just appear and clean up and go back to reading the paper upstairs. Or
imagine a casino that gives you money when you’ve lost everything, to
enable you to keep playing. Replaying moral hazard, and then doing
clean-up duty anyway because the damage is “too big and too broad not
to” is anarchy because no one’s in charge.
The economy still looks free because everyone is free to fail. But
failure is mitigated by the knowledge that the government will respond
and refill investors’ tills, in one way or another. Where failure is
mitigated, freedom is mitigated.




Tags: RON PAUL · Economy · Politics

Central Bankers, Monetary Policy and Moral Hazard



DK Matai - August 31, 2007


The eyes of financial centres across the world are now turning
to Jackson Hole in anticipation of a speech by Federal Reserve Chairman
Benjamin Bernanke. The Federal Reserve has held an end-of-summer
symposium for central bankers, officials and academics for the past 31
years, 26 of which have been in Jackson Hole, Wyoming.




This invitation-only weekend event not only provides the opportunity
for carefully prepared written papers but also frank and off-the-record
interaction among the world's most powerful central bankers.

This year's theme - housing markets and monetary policy - lies at
the heart of the unfolding crisis in global markets. All of the central
bankers at this gathering, including those from the Federal Reserve,
the ECB, the Bank of England and the Bank of Japan, will have the
opportunity to talk to each other informally about what they have
learned from their own market contacts and how they now perceive the
scope and depth of financial turmoil and the potential impact on the
economic outlook.

[... continues...]

Although some central bankers had said just a few weeks ago that the
subprime mortgage crisis would be "contained," it is now generally
recognized that broad swathes of the credit markets have seized up. At
Jackson Hole it is likely that a common diagnosis will emerge that a
severe credit crunch is under way, even if the central banks continue
to use different tools in response to this credit crunch.

At essentially the same time that this rapid deterioration in the
market for complex debt obligations has been developing, central
bankers and other regulators had been pressuring bankers to cut back
the fast and loose leveraging of hedge fund investors. Now, growing
margin calls have been forcing many funds to sell off good assets when
confronted with the collapse of demand for their holdings of
securitized debt and other risky assets. Deleveraging is certainly a
contributing factor in vanishing credit market liquidity.

[... continues...]

For Fed Chairman Bernanke, this is "prime time." He is on stage in
the midst of the biggest credit market crisis in some years - some
bankers say it is the biggest crisis in decades. Fed Chairman Bernanke
faces a daunting challenge in trying to explain on Friday what he
believes to be happening and what he considers the appropriate
responses. Virtually anything he says runs the risk of spooking
markets: If he says bold action is needed, that will be interpreted as
newfound pessimism about the potential for economic slump or recession.
He could instead say that minor, incremental monetary measures are the
right stuff, and that he does not want to use indiscriminate interest
rate cuts to ease pain for the bankers and traders who were responsible
for the bursting of a bubble. If the market doesn't hear that Bernanke
will cut the target rate any time soon, there would likely be a market
swoon and a tide of criticism that Bernanke is out of touch with
reality.

Bernanke starts from a clearly different stance than the stance
taken by Chairman Greenspan in the past when confronted with credit
market turmoil. Greenspan believed the Fed should simply keep credit
markets from freezing up with rate cuts and rate hikes, while letting
markets work out the details. It is evident that Bernanke strongly
prefers a more cautious approach, using surgical tools to deal directly
with identifiable "glitches" in credit markets, while valiantly trying
to avoid generating increased moral hazard. This kind of response was
evident in the Fed's surprise cut in the discount rate combined with a
highly innovative reinterpretation of how the discount window
functions. Bernanke gained some public applause for his cleverness, but
much quiet criticism that the new discount window tool could only work
effectively if the cut in the discount rate was much deeper than the 50
basis points cut made by the FOMC.

Fundamentally, Bernanke believes that even in times of financial
turbulence, decisions on interest rates should be based on a
forward-looking economic forecast and a balance of risks around that
forecast. Bernanke is clearly still worried about inflation. At least
until now, he has not foreseen economic slump or recession that might
melt away the threat of inflation. Instead he has been worrying about
such problems as rising rental costs as households turn from buying to
renting - the cost of home rentals is a surprisingly large component of
the rate of inflation about which the Fed worries. Bernanke and his
colleagues are worried about the potential weakening of the dollar if
the Fed cuts its target rate boldly, because a sharply weaker dollar
would pump up the inflation rate.

[... continues...]

The full range of articles published on this complex crisis are available from here.