I have been noodling over a blog published by Mark Shuttleworth on economic oversteering. The basic coverage is prompted by the drop in interest the FED did last week as the markets were coming unglued, first in Europe then in the US. I am also an avid reader of a more pure-economics blog called "Naked Capitalism" and the author, Yves Smith, also usually takes the road of castigating the FED on its over reaction.
Blame the FED, cheap credit is bad okay?
The article echoes a lot of the economic coverage of the blogosphere that I read of late. Namely that, to use Mark's words, the cut was like giving crack to a crack addict. After all, everyone concurs to blame Greenspan and the low rates of the early 00's, which created a negative real rates, once you factor in inflation. This according to many led to the creation of the housing bubble. Most of the coverage usually goes further with notions of "moral hazard". The banking industry, surprise, is rotten and the salaries structures encourage reckless behavior. Namely because money managers are paid on a yearly return basis, they have all interest in investing YOUR money at high risk and getting high returns and high bonuses. By the time the risk profile you have taken on hits your portfolio they have long cashed their bonuses, they gain, you lose. Going overboard on risk is therefore a systemic problem that starts with compensation structure. That the FED encouraged this behavior by making credit cheaply available just fueled that fire. Another angle attacking the banking industry is that essentially profits are private while losses are socialized, governments are rushing to the rescue of the financial system as we speak, furthering the reckless tendency to take risks.
The credit crisis is still going furiously
Nowadays the focus and all the rage is on the ratings agency that estimate risk defaults. I was reading this morning that about $300 billion of securities were losing their AAA ratings still following the sub-prime debacle. This will of course have rippling consequences as investment that cannot hold anything under "investment grade securities" will start dumping these. The new debacle is in the insurance companies that insure against defaults on credit. They are going under big time.
I was also reading in the FT this morning that against all predictions, americans were defaulting on their houses before they defaulted on their credit cards or their cars, further deepening the housing slump. Common theory held that people would default on everything but their houses, let the car go, get the kids out of school, sell the dog, default on the credit card, but keep the house. An explanation advanced by the FT is that with declining prices, homeowners find themselves with no equity and paying a mortgage based on a value that is higher than the actual value of the house. In essence they are paying a 20% mortgage (7% mortgage + 13% price house fall). So they better move and take a new house with a new price or renegotiate their mortgages but the banks already paid 100 so they take the loss anyway. It is plausible but if that was the case I would think we would see a large volume of buying as well since people would need to relocate. I don't think we are seeing that in the market as volume is dropping. An alternative explanation I would offer is that many of these houses were actually investments and not primary residences but rather secondary or even third houses that people bought in the hope to "flip". When the markets went south it was easy and economically sound for an investor to just default on the property rather than pay their mortgage and since these were not primary residences it was an easy thing to do, just a financial decision, and a sound one, rather than relocating the kids, the missus and the dog. How do I know? I have seen it done on a million dollar home in front of my parents retirement home in the keys. It is funny how people associate "subprime" with "innercity poor" but in reality "subprime lives in a neighborhood of the Florida keys. This guy bought the house in front for a cool $1M (it is worth maybe 750) as a 3rd property and was going to flip it. He defaulted within 3 month as soon as economic hardship hit his income stream, THAT is subprime.
Credit in and on itself is not a bad thing. Credit is just a way for you to pay for things over time. Bank gives you money now, you pay for the goods, and you repay the bank over time. Or you do that directly with the car sales guy as "financing". Either way, from your pocketbook standpoint all you are doing is paying over time for a good you may not have the capital for upfront. At most what credit does is create an illusion of "growth" from a goods sold standpoint because you lower the barrier to entry to buying those goods. The problem here is that credit has been overextended and repayment is not happening, in other words, some of the earnings growth, fueled by credit will not be a repeatable on-going item for corporations. With the credit backlash happening, there is the risk of contracting further the buying ability and creating an earnings impact. All of this is worrying investors greatly.
The FED's limited monetary leverage
Which leads me to the point I wanted to make. Amid all this complicated background, brought about by some of my classmates at Polytechnique who are traders and price derivatives and structured products :) what is the FED to do? the FED controls one thing really, interest rates on Treasuries. That is a blunt instrument. Furthermore inflationary signals seemed mixed. Signs coming from Europe and China are inflationary , but deflationary forces are built in a credit crunch since if credit is not available, demand goes down and so do prices. So the FED choose to salvage the markets from their own panicky reactions.
Could the SocGen debacle have brought down the financial markets?
There is also a small events driven theory running around. I am sure many of you have read about Mr Kerviel, the french rogue trader that lost $7Bn for the Societe Generale last week. The kid, a junior trader, was supposed to take market neutral position and do arbitrage on derivatives. To play derivatives in a market neutral way you need massive amounts of capital since everything is covered. But the kid, a back-office IT specialist (blame IT!) knew how to cover his long positions with phantom shorts. In other words he never really covered $50BN long, that cracks me up. Of course the kid was returning massive returns this way but the moment the market went south so did his long position. However the real kicker is that management at SocGen decided on the Sunday night they discovered the fraud to unwind this position, thereby realizing the losses. They dug their own hole and roiled the world markets. Markets were closed in the US for MLK, further thinning volume and magnifying the selling pressure from the SocGen unwinding. Most people credit the SocGen unwinding for the nose-dive that happened last monday. Management created the loses at the WORSE possible time and created a market panic worldwide. But follow this: rumor has it that SocGen had notified the European Central Bank (ECB) and the ECB notified the FED on Sunday night.
The FED save the day
Come Tuesday the market implode with nose dive in the first 20 minutes. But the FED intervened, if the rumor is true that the FED knew of the Kerviel scandal, which was disclosed to the public on Friday, it means THEY WERE READY ON WEDNESDAY! They were ready and pounced with a rate cut that effectively stabilized the markets. The markets are still stable a week later and in fact have recovered the lost ground. The credit crisis is far from over (see above) but it is unwinding bit by bit. Keeping her steady as she goes is of paramount importance.
This is where I believe Bernanke et al to be the men of the hour with a TIMELY, APPROPRIATE AND AGGRESSIVE response. It is easy to sit in back and analyse the current movements only through the rigorous lens of strict economic theory, and nothing in what Mark says is wrong, technically speaking. But as I read somewhere, economic theory assumes humans are "rational automatas" and we are not. Optimism is an important component of market dynamics.
Behavioral black holes
These markets, i have learned to appreciate, are fraught with what I call black holes. Once irrational fear kicks in, it becomes RATIONAL to unwind positions. Market crashes aren't irrational. Many of the steps taken in the markets in the past day find grounding in reason and logic once the context of fear and uncertainty is set. Letting economic theory reign supreme can lead to absurd results. Markets sometimes needs to be saved from themselves. It is an unfortunate fact, but that is the way it is.
I believe the role of government agencies like the FED is to ensure stability, rational course and avoid these black holes of irrational horizon feeding on their own perverse logic. Human behavior feeds these markets. It is easy to set the course on a boat when the weather is clear. Everyone wants to be on deck and stir the boat. But when the storm hits you want someone that can stir "a vue" or "on sight" that reacts fast accurately and decisively. Rather than dismissing Mr Bernanke, saying he blinked and he has been a stool of the markets, I believe he has shown an amazing amount of gusto, courage, intuition, stoicness and decisiveness in dealing "a vue" with the unfolding crisis.
It ain't over till the fat lady sings, demographics as the culprit
Of course time will tell, but so far, you have to feel sorry for the guy that is finding himself thrown in the middle of this crisis and has to deal with it with the blunt instrument of monetary policy. I won't comment on the on-going debate of supplementing monetary policy with fiscal policies (what is going on in the US) because I don't understand what is going on there yet.
Also, I believe we are seeing the first shock wave of the demographic tsunami that is the retiring baby boomers. The demographics curve is not increasing any more. Like a baby being born, when the head comes out it is terribly painful, but once the head is out, expansion is done and the rest just slips out. I think that is what we are going through. Be it the real estate boom, spurred by boomers at maximum earning capacity, or the amount of savings and spending, I believe that the US economy needs to land softly in the spasms of a vertical demographic tree. THAT is the main driver, demographics. Multiply the number of people by productivity and you roughly have output and earnings. Income, which is related to output, can be leveraged by credit but at constant credit (which we are going to see) you either increase people or productivity. Many believe productivity increases are tapped out, the boomer curve certainly is, we are replacing generations but not increasing dramatically.
This phenomena will take years to flush itself out, in the meantime, avoiding panic behavior, maintaining order and to some degree OPTIMISM in the economic future of our societies is the role of the FED. Japan went through the same phenomena, to some extent, of a flat demographic tree (no expansion) and asset bubbles that exploded. Economic analysis of the "lost decade" says the problem was that banks were slow to recognize losses and move on and so the crisis lasted a decade. In the US the crisis originates in real-estate. Real-estate is traditionally REALLY slow in moving because unlike stocks that will drop in price overnight, real-estate moves on glacier times compared to the equity markets. This phenomena may be offset by the news related above that an increasing number of households default on their properties and the banks will hopefully move quicker. But still, there is a trickle of news of write-down by large banks and it doesn't seem clear at all that transparency and a correct accounting of losses is here today, still we do not know where most of these losses are... this will take some time.
In the meantime, Mr Bernanke is refilling his prescription of Xanax, Lexapro and Lorazepam, give the man a break, imho he is doing just peachy giving the downright hostile sea he is navigating.
Oben wan Bernanke, you are our only hope!