Labor(Capital) Day

Packed elbow to rib in a cacophonous six seat paint-can shaker implausibly airborne 800 feet above the ground, fighting for breath against senses of entitlement inflated to SUV size by a sham economy addicted to cheap debt, carrying a desperate need to out consume and out do rooted in a lifetime diet of spoon fed commercials and the easy calories of celebrity worship, mindless of nature's rigors or the rewards of patient cultivation of character or virtue, grimly wondering if their enemies below have surface-to-air or a surprise welcoming committee at the LZ - so begins the US holiday weekend for capitalism's winners according to Bloomberg News.

Fear not for m* however. For one thing, m* took the Rolls earlier in the week. (No shaking, forced intimacy, or cortisol floods and door to door, about the same). For another, while the clamoring masses of fake-tan attorneys, has-been movie stars, and assorted financial eel and remora are heading east, m*, ever the contrarian, will be heading back from whence they came to the wonderfully peaceful and empty late summer city.

While the holiday signals the official end to summer and the impending reality of m*'s packed fall agenda, idyllic thoughts of majestic mountain vistas, sparkling clear streams, sun drenched hikes, and yes, heated campfire discussions of monetary policy offer a temporary reprieve. m* is referring of course to the annual Kansas City Fed Symposium and central bankers' working holiday this weekend in Jackson Hole.

m* will not be attending of course, but in honor of the event and the final weekend of summer will be sitting down with two very recent papers from Michael Woodford, an occasional co-author with Chairman Bernanke and the esteemed intellectual godfather of inflation targeting and rule driven central bank decision-making now very much embedded in the thinking of current CB-ista. Why? Know thine enemy. It is Woodford of course who's work shows that monetary aggregates are largely irrelevant to the conduct of modern monetary policy, a viewpoint widely accepted among leading monetary economists today, implying of course that m* is not simply elusive but nonsensical too (and well, m* would have to agree!)

Of course, an effective inflation targeting policy requires an accurate and transparent measure of inflation. Dissenters to inflation targeting in the US frequently point to the vast discrepancy between government price indices and consumers' reported "sense" of inflation. No where is this more apparent than in the spread between the reality of rapidly rising home prices over the last ten years and the stagnant behavior of the much derided statistical construction, "owner equivalent rent."

As an illustration, consider the BOE. While the BOE follows an explicit inflations targeting mandate and thus adheres closely to many of the protocols expected in that regard, it also rather unusually includes direct asset prices (in particular home prices) into its price measures. The relevance of asset prices to measuring inflation is still open to debate in the academic world. But the BOE apparently believes that asset price levels do contain signaling information for inflation and an ability to influence the very important expectations component.

It may not be a coincidence then that Woodford believes the BOE comes closest to his idealized inflation targeting Central Bank. It is certainly no coincidence that the BOE has had m*'s vote for the hardest bank over the last three years - witness the performance of Sterling over that period. It will be interesting to see, now that inflation targeters are in charge in the US too and confronting a home finance crisis with larger potential ramifications, whether some greater recognition of the indicator that Greenspan pointedly ignored in price measures is warranted, particularly as popular sentiment views home price declines as analogous to a depressionary deflation. The announced theme of this weekend's symposium is housing, housing finance and monetary policy so this could be interesting.

Two papers by Woodford:

"How Important is Money in the Conduct of Monetary Policy?"

"Globalization and Monetary Control"

Meanwhile, Greg Ip in the WSJ "Bernanke Breaks Greenspan Mold" does a smashup job of burying former Fed Chairman Greenspan's crisis response approach of listening to the markets in relation to Chairman Bernanke's attempts to let the real economic data tell the story. Ip relates a quote from Greenspan during the deliberations on the 1998 LTCM crisis that shows dramatically how far apart the two philosophies for managing policy are.

"It would be wrong to say that the change in psychology is all ephemeral just because we have not seen it in the hard data yet," he told colleagues. "It is the change in value judgments that alters the real world."

In m*'s opinion, Greenspan saw his role as one of actively managing monetary policy, especially during times of crisis, through a forecast (using a very personal mosaic of indicators) of the animal spirits at work in the economy. Undoubtedly these forecasts were colored by his baptism in the 1987 crisis, and following this more intuitive policy, he fell back on the (appropriate) response to that crisis time and again. It is quite clear that in later crises, Greenspan gave the markets significant weight, really too much weight, in his assessments of future risk taking appetite in the economy and acted, erroneously, on those assessments.

It is the personal nature of those assessments, in the face of widespread evidence to the contrary (in particular the dramatic increases in mortgage debt and real estate values), the mistaken signals sent to the economy via inappropriate interest rate policy in response, and the long term consequences for the nation's standard of living as a result of the serial asset price bubbles, mal-investment and overconsumption, unprecedented explosion in debt, and inflation from a devalued dollar that incite Greenspan's critics, m* among them.

Bernanke, on the other hand and like Woodford, is an advocate of inflation targeting. Though he does not have that mandate at the US Central Bank, he has clearly discussed his desire to hew much more closely to the more mechanical adjustment mechanism such targeting espouses, with a healthy appreciation for expectations of course as befitting one of the foremost scholars on the Great Depression. Ironically, Greenspan's Vice Chairman, Alan Blinder, was also a proponent of for data-dependent incrementalist approach but he seems to have been less influential than one would have thought.

As has been widely reported during the current crisis, Bernanke has said while he will of course take whatever action necessary to preserve stability, he is attempting to hold off policy adjustments that effect the real economy as much as possible until data show a policy change is required. Not said but also clearly implied is that Bernanke supports an unwind in the degree of leverage promoted under his predecessor provided it can be done without dramatic effect on the real economy. While this may seem unresponsive to a vocal sector of the financial markets, it is a view widely shared, it seems to m*, in the central banking community globally.

The likelihood of success of that de-levering, whether success is even possible, even the actual definition of success are to m* still very much open questions. The problem is that it may be just one crisis too late to take that harder line. With a global system as leveraged as the current one, it's highly doubtful there is much less they can do than the inevitable blunt rate stimulus.

Happy Capital Day.

Moralists unwound

So the New York Fed has "clarified" that it will accept ABCP with a credit wrapper from the borrowing member bank. This seems another reasoned step in a progression of maneuvers aimed at targeting the informational aspect of the sub-prime contagion. However, as addressed in this piece from VoxEu calling for just such a step prior to the move, it does open the door just a bit to that moral hazard issue very much on the mind of m* and perhaps readers too.

Why is that? What is this moral factor attached to our views on management of the economy?

It is not just m* or the narrow group of curmudgeons and crackpots that make up a small but consistently entertaining portion of the intellectual stew each week raising the moral stakes. Arguments for "tough love" on Fed policy and the economy seem to be appearing more frequently than in past financial rough patches. This week even The Economist, (admittedly advocates of the moralist view on US and UK home prices - less so on weapons of mass destruction and wars of choice), asks "Does America Need a Recession?"

Others go even further. A recent piece from Bernard Connolly that caught m*'s attention mentions with incredulity that "the Fed is wedded to the view that "normalization" without "liquidation" is possible." Liquidation is a very strong word for capital destruction on a large scale. As retribution for the excess of the explosive growth in credit over the last twenty five years, the correctness of a major recession, if not liquidation and depression, is an article of faith for holders of this view, many of them sympathetic to economic and political philosophies often collectively referred as the Austrian School.

Why is it that the financial landscape of this period and the Central Bank policies most associated with them (see Subprime crisis: Greenspan's Legacy for one exposition, or James Grant writing in the NYT for another - or, if those are too mild for you, this is as good a departure point as any), whether malicious, inept, or simply an error of "optimism about productivity," come in for such strong reprobation from this crowd?

Mark Thoma, an academic economist whose Economist's View is a frequent source, confronts what m* has taken to calling "the moralists" view in a straightforward piece that also asks "Do We Need a Recession?"

...Recessions, popped bubbles and the like do not have to be somebody's fault and, as such, we don't necessarily have to extract blood from anyone to avoid it happening again. Perfectly reasonable actions a priori - in the sense of responding to the economic incentives that are in place - can still lead to bad ex-post outcomes. The people acting in the economic environment didn't write the rules, they're simply maximizing given the rules that are in place, so why punish them?...

He refutes the Economist piece on three points: that the "creative destruction" at the heart of a dynamic economy is not dependent on recession, that over-investment in housing will be absorbed in time and so is a bringing forward of supply rather than wasted consumption, and lastly that arguing that the Fed should not attempt to stabilize because it would only encourage more speculation and greater moral hazard reflects a set of priorities that obviates the need for a Fed in the first place, (if m* got that part right).

Thoma also cites Paul Krugman (link from pkarchive.org) on "the hangover theory" which he calls "disastrously wrong headed."

"...Recessions are not necessary consequences of booms. They can and should be fought, not with austerity but with liberality--with policies that encourage people to spend more, not less. Nor is this merely an academic argument: The hangover theory can do real harm. Liquidationist views played an important role in the spread of the Great Depression--with Austrian theorists such as Friedrich von Hayek and Joseph Schumpeter strenuously arguing, in the very depths of that depression, against any attempt to restore "sham" prosperity by expanding credit and the money supply....

"... nobody has managed to explain why bad investments in the past require the unemployment of good workers in the present."

This is a thread m* will be returning to.

Just business

Not clear why m* gets worked up about mortgage "lender" versus "originator?" This story in the Sunday NYT by GM (who else?) on the nature of Countrywide's business ought to straighten things out. While the linguistic nuance m* argues for is lost on the Times' team, (they repeatedly call the firm a lender) the story documents a litany of unscrupulous practices demonstrating what has been obvious to everyone: Origination is a dirty business. Why? Because the incentives for originators are utterly divorced from the suitability of the debt for the financial resources and sophistication of the borrower.

From "Inside the Countrywide Lending Spree" by Gretchen Morgenson:

ON its way to becoming the nation’s largest mortgage lender, the Countrywide Financial Corporation encouraged its sales force to court customers over the telephone with a seductive pitch that seldom varied. “I want to be sure you are getting the best loan possible,” the sales representatives would say.

But providing “the best loan possible” to customers wasn’t always the bank’s main goal, say some former employees. Instead, potential borrowers were often led to high-cost and sometimes unfavorable loans that resulted in richer commissions for Countrywide’s smooth-talking sales force, outsize fees to company affiliates providing services on the loans, and a roaring stock price that made Countrywide executives among the highest paid in America.

Countrywide’s entire operation, from its computer system to its incentive pay structure and financing arrangements, is intended to wring maximum profits out of the mortgage lending boom no matter what it costs borrowers, according to interviews with former employees and brokers who worked in different units of the company and internal documents they provided...

...“In terms of being unresponsive to what was happening, to sticking it out the longest, and continuing to justify the garbage they were selling, Countrywide was the worst lender,” said Ira Rheingold, executive director of the National Association of Consumer Advocates. “And anytime states tried to pass responsible lending laws, Countrywide was fighting it tooth and nail.”

Sound familiar? Received any phone calls from stock brokers lately? The securities industry is heavily regulated and securities brokers are registered, fingerprinted, and licensed in large part to prevent such abuses. The mortgage industry and its brokers are very lightly regulated and then on a state by state basis, (ie: weaker and more ah, impressionable, legislators). This is not news.

However, Wall Street had its hand deeply in the pie too. From looking the other way while continuing to buy the securities backed by pools of junk mortgages to investing directly in the originators that created them. This is not news either.

From the WSJ story "How Wall Street Stoked The Mortgage Meltdown" by Michael Hudson:

Twelve years ago, Lehman Brothers Holdings Inc. sent a vice president to California to check out First Alliance Mortgage Co. Lehman was thinking about tapping into First Alliance's lucrative business of making "subprime" home loans to consumers with sketchy credit.

The vice president, Eric Hibbert, wrote a memo describing First Alliance as a financial "sweat shop" specializing in "high pressure sales for people who are in a weak state." At First Alliance, he said, employees leave their "ethics at the door."

The big Wall Street investment bank decided First Alliance wasn't breaking any laws. Lehman went on to lend the mortgage company roughly $500 million and helped sell more than $700 million in bonds backed by First Alliance customers' loans. But First Alliance later collapsed. Lehman landed in court, where a federal jury found the firm helped First Alliance defraud customers.

That hardly stopped them of course as they later acquired several originators to feed one of the Street's largest mortgage security underwriting and trading businesses. They had plenty of company too. Lehman shut down one of their mortgage origination firms this week but still maintains a presence in the business.

Loathe though m* would be to have anything in common with the current crop of politicos clamoring for socialization of the problem, m* suggests that if one insists on using "lender," do the right thing and precede it with "predatory."

Cheerios rising

This caught m*'s attention.

Wheat hits record price as bad weather prompts inflation fears

By Javier Blas, Commodities Correspondent

Published: August 24 2007 03:00 | Last updated: August 24 2007 03:00

Wheat prices jumped to an all-time high yesterday as panicked buyers rushed into the market amid extremely tight supplies, raising fears of a global food inflation spike.

Canada, the world's second-largest wheat exporter, warned output might be almost 20 per cent below last year as adverse weather damaged the crop as it had done in Europe and Australia.

Japan and Taiwan, which depend on foreign wheat supplies, bought new cargoes in the international market while India launched a large tender to boost its inventories ahead of its peak demand season.

Gavin Maguire, analyst at Iowa Grain in Chicago, said the combination of disappointing production levels and strong demand was pushing up prices. "Wheat buyers are beginning to panic."

In Chicago, wheat for December delivery surged to an all-time high of $7.54 a bushel. Prices have jumped 110 per cent in the past 12 months and have risen threefold since 2000.

Food industry executives warned that meat, poultry and dairy prices would climb in the short term as farmers and processors passed on higher feed costs to consumers.

Alex Waugh, director-general of the UK Flour Milling Association, said the cost of wheat was at an unprecedented level: "Wheat costs for flour millers in the UK now stand some £500m higher than last year. This has yet to come through in wholesale or consumer prices."

The International Grains Council cut its estimate for the 2007-08 wheat crop to 607m tonnes while forecasting demand would reach 614m tonnes, resulting in a further stock drawdown. It said global wheat inventories were at their lowest since 1979.

James Gutman, of Goldman Sachs in London, said: "Buyers are scraping the bottom of the bushel of the inventories."

Additional reporting by Chris Flood in London

Copyright The Financial Times Limited 2007

Quant factor

After a bit of shadenfruede shared with a colleague and occasional quant manager earlier this week, m* finally got around to reading the investor letters of several quant funds, as neatly collected and summarized in numerous articles of late. Collectively, they sound like no one so much as the homebuilder ceo’s, blaming other companies for building too many homes and saying things will improve just as soon as the other guy leaves the business. m* thinks these guys are missing a factor or two.

Their strategy, also called statistical arbitrage, exploits various market inefficiencies well known in academic circles. Returns to small size, value, the January effect, momentum, and mean reversion form the theoretical basis for these strategies. However it was only with the onset of electronic trading systems and large commercial databases of regressions of stock returns on various risk factors that these strategies could be implemented on an efficient scale. The low cost of electronic trading made possible vast numbers of transactions, most earning mere pennies or fractions of pennies. The risk factor regressions made it possible to create long-short portfolios positioned to exploit the inefficiencies while remaining statistically neutral to a myriad of macroeconomic, industry, and company characteristic factors. The product has expanded into global equity markets and even into markets for currencies and interest rates.

Pre-2002 let’s say, before the serious explosion in hedge fund assets, and the no-volatility-four-year-without-so-much-as-one-10%-pullback-bull-market (have you been feeling very smart in your investing until recently?), quant funds were on the whole rather small, an under the radar presence, and far from being dominant participants in equity markets relative to large mutual funds and institutional investors. However they were very successful at generating consistent returns and this, along with the intrigue stemming from the intense secrecy that shrouded their intellectual property, made them must-have investments for asset allocators.

Of course success breeds imitators and with the basic principles in the public domain, there was little to stop two guys in a garage from programming up their own systems, proving it in backtesting, and raising investor capital, often from an existing hedge fund eager to expand into the space. Moreover, as the original operations matured, more and more employees with the requisite knowledge left to start their own firms which also found ready investors. The amount of capital employed in quant strategies mushroomed from a few billion to likely in excess of $100bn in equity capital today, levered 3x to 6x, and with their high frequency transactions magnifying their influence, a daily volume estimated to be more than half the overall equity market.

The natural question to ask of course is how much alpha is available to these strategies? At what point do they go from exploiting the over trading noise of other traders in the market to being the market themselves?

The answer, the quants would say, is in the results. When the strategy stops working, then you will know the point has been reached. Except of course, if you fail to account for the influence of your collective behavior on your results, you may not appreciate having reached that point until you are in fact well beyond it.

That is exactly what happened. When you have the CFO of Goldman Sachs talking about multiple 25 standard-deviation events and hedgefund managers publicly dissecting their daily performance data like FAA crash investigators while saying things like “a perfect storm of negative events” m* is pretty certain they lack (publicly anyway) an understanding of the true distributions or their true risk, not to mention any semblance of personal accountability or embarrassment.

They seem to have mistaken the collective reinforcing effect of their own behavior on the trend for continued success of the strategy. Over time, as capital flowed in the funds poured more money into the same long and short value strategies while actively dampening volatility with the mean reversion strategies, in effect self-validating their models from the past even while the real situation had changed.

In short this most sophisticated group of investors became just another group of levered momentum traders, creating their own temporary low volatility trend. Their alpha capture became beta follow, and they were none the wiser until the infinitely creative market disrupted their somnolence with levered losses that appeared in a flash accompanied by the insight “Oh, we’re trend followers and we’re short vol!”

Except of course that not one of the letters from these managers mentions that insight, nor any explanation that demonstrates an understanding and acceptance of the true nature of the fund's risk. m* finds this amusing because in all the writhing gymnastics blaming the other guy, the market, the universe, or those darn frustrating statistics, (anything to avoid taking responsibility), a simple declarative “Yes, well, the strategy is inherently short volatility, a bit of a trend formed, and these event do occur from time to time,” would be the most exculpatory and truthful explanation.

What now for these funds and the prognosis for the strategy? Beyond this week’s easily foreseeable rebound (as they lever up again and GS puts $3bn more to work on the small cap buy list) a double whammy of diminished single digit returns and higher returns volatility is in store. How so? Lower leverage. The true alpha here is vanishingly small hence the intense focus on transaction cost and the need for considerable leverage to earn returns. Higher exogenous volatility in the marketplace, from the turmoil in credit for example, necessitates running lower leverage. In addition, as the mean reversion strategies were essentially providing liquidity to the market, acting as market makers in effect, a reduction of leverage there will lead to still higher volatility. Finally, the recent sharp losses are the clearest and loudest signal possible to investors that the strategies may not work as expected from here on out. Expect inflows and self reinforcing trends to diminish and volatility of returns to increase accordingly.

The missing quant factor is an awareness of themselves.

Bullets over bridges

Senator John Warner's public statements to start bringing troops back from Iraq seems to, m*, an event of note in the painful travesty this Administration's unnecessary war of choice has become.

Leaving aside the immense human toll for the moment, the roughly $500bn spent per year, or roughly $2 trillion already spent, represents the entire budget laid out by the American Society of Civil Engineers for bringing the crumbling US infrastructure up to acceptable levels.

In the panalopy of possible BHAG's available to the Administration five years ago, the focus on the foreign over the domestic now seems not only woefully unsuited for the times, but a tremendous missed opportunity for the Republicans, their friends in business, and the nation. As a welcome fiscal stimulus after the 2001 capital spending recession, an investment in the future productivity of the nation, and a way to keep Halliburton's coffers full with nice safe work at home, a China-scale infrastructure rebuild would have been a political triple play.

Isn't it ironic then that after five years and $2 trillion consumed in a useless war funded by debt sold to Asian Central Banks, the only way we'll see more repairs of repairs of repairs is with the help of this guy. How do you say EZPass in Chinese?

Loan terms

In times of heightened emotion, uncertainty, and fear, it often helps to be particularly mindful of the power of language to frame an issue. With respect to the changed (tighter) conditions in the mortgage market for risky borrowers and jumbo mortgages, the unseemly and anti-capitalist clamor for Federal intervention of a fiscal or monetary nature by self-interested politicians of western states with significant housing overbuild, patrician presidential candidates running hopelessly behind southern populist (and wealthy!) trial attorney presidential candidates, ceo's of distressed manufacturing companies utterly dependent on the power of cheap financing to suck yet more future demand into the present, and fabulously wealthy left coast bond managers and their rabbit chatting sidekicks with a perverse fetish for deflationary fearmongering, has been aided and abetted by sloppy and sensational use of language in the "popular" (as they are anything but) press and tv.

m* offers the following clarification in terms.

Mortgage Lender: a profit seeking institution whose business is to earn the difference between its cost of funds (liabilities) and the return on mortgages held (assets) for investment.

Mortgage Originator: a profit seeking institution whose business is to collect fees for originating mortgages for mortgage lenders.

With the rise of asset backed securitization, note that mortgage lenders can now include pension and insurance funds, hedge funds, publicly traded mortgage reits, as well as banks, and via Fannie and Freddie and an implicit claim on the Federal government's power to tax its citizens, every one of you and m* too.

The key feature uniting these lenders is that their participation is rooted in a calculation of the loan eventually being repaid. In this their interests are aligned, at least somewhat, more closely with the borrowers than the interests of an originator are.

Moreover, after years and years of advertising from the likes of Fannie and Freddie, (especially Fannie), we have become conditioned to viewing lenders as good guys, as facilitators of the American Dream. And every time an originator is referred to as a lender, that sense of all-American-Mom's-apple-pie clouds our perception of the true nature of their business.

In our history, lenders were not always good guys of course. In the Great Depression and the agricultural poverty of the Great Plains droughts in the early part of the last century, mortgage holders, banks, lenders of all stripes were the enemy of the common man, the cruel hand of heartless capitalism at the root of the country's troubles.

It should be apparent that the entities that fall under the second definition are asset light middlemen, (think, um, call centers) whose comings and goings represent barely a ripple in the greater economy and whose demise presents no significant impediment to the realization of "the American Dream." The next time you hear or read about mortgage "lenders" in trouble, ask yourself if the subject of conversation is not in fact an "originator."

In the case of Countrywide, to take one example, for the six months ended June 30th, the company's income statement reported the following:

Gain on sale of loans 2.7 bn
Interest income 1.4 bn
less Bad loan provision (0.4) bn
Net interest income 1.0 bn

Loan servicing fees 2.8 bn
less actual srvc fees (1.9) bn
Change in value scrv rights 1.5 bn
Impaired scrv rights (0.7) bn
Srvc Hedges (1.5) bn

Insurance premiums 0.7 bn
Other 0.3 bn

Countrywide's gain on sale income, loan servicing business, and even "insurance + other" business is on par or far exceeds its interest income. Keep in mind also that while Gain on sale income is largely inclusive of net interest income that would have been earned over time had loans been retained at the firm, Countrywide does not have significant access to long term funding of the kind that would enable it to retain those assets.

In fact, their limited access to long term funding makes that well nigh impossible, and the inability to sell it's current originations and thus roll over its short term funding is what precipitated the fears of drastically reduced income as well as possible insolvency that led to them tapping credit lines and selling a stake to BoA. So what you have is a company acting very much like a bank, without a bank's capital base.

Is there something wrong with the banking system that companies like Countrywide need to exist for homebuyers to access mortgage loans? Hardly. But the firm has been extremely successful in marketing itself over time and as a result commands significant attention in the public eye. BTW Countrywide does have a recently acquired bank subsidiary, however the continued reliance by the firm as whole on short term financing for its primary business and the treatment of the firm's equity in the current turmoil points to its relative insignificance.

Quotable

Does anyone read the mutual fund stories in the WSJ? Of course not. You are too busy running to yet another story about some egomaniacal activist hedgefund manager acquiring exactly 1.042% of some ridiculous foreign company probably run by foreign gangsters that makes some hot sauce the gangsters like in that foreign country, whatever country that might be. Nonetheless, the most recent "what are they buying now, those who pretty much only buy?" report contained some real gems for the Quotable Manager Prizes. Consider this a snack before the heavy stuff.

"A lot of investors have been wanting safety -- call it the flight to quality or liquidity -- but when you can go counter to that, you have opportunities," says Edward Perks, manager of the $60 billion Franklin Income Fund. "Investment-grade mortgages have gotten sucked down with sub-prime," he says. "We think the market is treating it in too broad a brush."

$60 billion under management needs a new investment phrasebook, hopefully in time for that call from GM at the NYT.

Gone Fishing

Well that's one possibility to explain m*'s whereabouts this week. Meanwhile, on Tuesday the WSJ offered a brief interview, "The Market Whisperer," with a senior former voice of reason, Peter Fisher, ex head of the Markets Group in the Greenspan Fed, and undersecretary for domestic finance in the Treasury Department under Larry Summers. In his description of some of the current turmoil, he supports an argument m* has made that this market has simply not appreciated the hardness of the new Bernanke Fed and acknowledges what is now widely appreciated as a principle cause, that Fed policy was too loose during 2003-4:

WSJ: What do you think explains the timing of this seizing up in the credit market?

Mr. Fisher: In June the markets finally woke up to the idea that the Fed wouldn't be easing any time soon -- which is what Chairman Ben Bernanke had been saying for some time. Back in January the expected path of monetary policy was thought to be extremely benign. Market participants were convinced that a Fed easing was right around the corner. By the time we got to June, background monetary conditions in Europe were much firmer and, at the same time, the market finally had to confront the fact that Bernanke meant what he said. This started the process.

WSJ: And because there was so much easy money, there was so much borrowing. In retrospect, were interest rates too low for too long?

Mr. Fisher: It is hard to escape that conclusion. Did we create too much leverage? Was our credit capacity based on false assumptions about how low monetary conditions could be? I think so. We have the benefit of hindsight now but rates were too low for too long and now we are going to squeeze out the excessive levels of leverage that built up.

WSJ: For so long, we have been hearing that the banks don't matter much and the capital markets are all that matters. Yet suddenly we are discovering how much the banks do matter.

Mr. Fisher: A great deal of activity has shifted to the capital markets but banks still matter. Banks -- both commercial and investment banks -- play a pivotal role as asset originators for the capital markets, underwriting both consumer and business credit before it gets distributed to investors in the capital markets. With the rapid changes in prices and rise in volatility, the capital markets are less willing to buy these assets and they are piling up on the banks' balance sheets. To restart the process we need the banks to provide the grease. The Fed move Friday was to signal that it is still about the banks and their willingness to finance.

A natural follow up question went unasked unfortunately :

m*: "If banks still matter, presumably what happens at the intersection of banks and capital markets with respect to credit provision in the economy should be of concern to those charged with protecting the safe functioning of the banking system. To what extent did the Fed have a role in examining and potentially regulating the explosive and unregulated growth in credit extension outside the banking system? "

Some possible and wholly inadequate answers come to mind. "We relied on the rating agencies like everyone else." "We did not see a role interfering with the capital markets." "Non bank credit originators are regulated by the states." And m*'s personal favorite, "We did not fully grasp the nature of the problem." Astute and creative readers that you are, you no doubt will have ideas for your own.

In the event, none of this is likely to matter one whit to Mr. Fisher now as he is safely ensconced at Blackrock, while his first former boss is writing his memoirs in the bathtub, and his second got kicked out of school. Incidentally, his successor, Dino Kos, is now drumming up business from Asian SWF's for Morgan Stanley.

Deft dodge (for now)

As everyone knows by now, the Bernanke Fed resurrected the discount rate lever from obscurity on Friday, lowering the rate at which members of the Fed system can borrow against collateral from the Central Bank.

As a practical matter, lowering the discount window "penalty" rate is a red herring. Members of the Federal Reserve banking system can borrow short term from each other at a Fed Funds rate which is lower and devoid of the stigma attached to the discount window as financing of last resort. And extending the financing period from overnight out to 30 days is also not by itself going to relieve the credit conditions in the middle tiers of the commercial paper market that seemed to be a main area of concern.

However, in m*'s view this slight maneuver shows the Fed is clear about what it wants to do and in the short run deftly accomplishes several of its policy goals. Friday's action allows the Fed to demonstrate that it is in tune with the markets and Main Street to "do something", thus remaining relevant to the crisis and on the right side of public pressure. Its promise of unlimited liquidity at the discount window directly addresses the fear and uncertainty in the markets while sidestepping the moral hazard attached to a Fed Funds rate cut that would undoubtedly boost support for speculative positions. Lastly, it does not contradict the Fed's inflation policy stance despite uninformed commentary to the contrary now hitting the tape.

m* reminds readers that these analysts have gotten this Fed wrong since Bernanke took over. While the Fed is quite correctly concerned about the potential vulnerability of the economy to credit tightness (and addressing that tightness via the discount rate), it is not yet addressing the fact of a weakening economy (with Fed Funds) that the bulk of the vested (long) analyst and housing and automotive CEO community is so vocal about.

In short, this is the reasoned, measured, and pragmatic type of Central Banking that was missing from the Greenspan Fed and shares much with the Mervyn King led BOE, who's response thus far has been to remind people that his discount window is also open, albeit at 100bp premium to interbank rates. ECB has approached its informational deficit on this issue somewhat differently, giving away free beer in order to estimate total beer demand in effect, but its philosophical view about how and where to intervene is more or less similarly aligned.

What m* also suspects though is that this Fed wants de-levering to occur and is very reluctant to interfere in what it views as a long overdue cleansing of the system. What if, with his tenure on the board nearly up, "Calamity" Poole feels free to say just what he thinks, but also what the others are not free to say? That the Fed is "behind the curve" these analysts will readily attest. That the Fed may not even be in their corner and has not been since this business got started is perhaps only slowly dawning.

Nevertheless, when the economy does begin to exhibit more dramatic signs of a slowdown, perhaps this year into the back to school season, perhaps further along into next year, pressure will mount anew for rate cuts, and the Fed will most likely oblige. By then however, asset prices will have more than just fear and uncertainty to cope with. They'll have real economic weakness coming into play too and what de-levering is postponed now will likely begin again in earnest.

Pretty simple

Morgan Stanley's Serhan Cevik, left to his own devices and thinking big picture while the senior strategists are on vacation, comes up with a polite one paragraph worth reading in "the Limits of Engineering" on the MS-GEF page. Wonder what Dick Berner and the amenable gang will say when they get back!

Middle East/North Africa
Limits of Engineering
August 16, 2007

By Serhan Cevik | London

...The abundance of ‘market’ liquidity turned out to be a self-reinforcing phenomenon.Central banks’ coordinated attempt to flood money markets with cash may ease the immediate pain, but would not really address systemic threats. This is why we need to dig deeper and identify underlying fragilities in the global financial system. It seems that the ‘original sin’ was the extreme monetary easing campaign that ended up lowering the average short-term interest rate in the world from 4.8% in 2000 to 1.6% in 2003. Of course, with real interest rates declining from 4.3% to 0.8% over this period, it was not surprising to witness the emergence of a global liquidity wave and greater appetite of risk-taking among investors. However, the abundance of ‘market’ liquidity turned out to be a self-reinforcing phenomenon and kept expanding even as central banks tightened the policy stance to 3.7% last year and 4.4% of late. In other words, despite higher (real) interest rates bringing an end to the expansion of monetary liquidity, financial market liquidity increased (with occasional moments of pause) and fuelled the search for higher returns in riskier assets. But what is (or possibly was) behind the disconnection between monetary and market liquidity? We think that a couple of factors have made the most significant contribution to the pool of global liquidity. First, the recycling of current account surpluses has helped to de-link financial conditions from the behaviour of short-term interest rates. Second, financial innovation and the rise of new investors have become far more important in determining market liquidity. As one would have expected, these new financial trends depressed volatility and set the stage for greater risk-taking through highly leveraged derivative-based instruments. However, this type of liquidity is partly a function of confidence and thereby vulnerable to sudden changes in sentiment (see The Curse of Alpha, November 16, 2006). Hence, while structural factors are likely to keep the ‘excess savings’ channel intact, the ‘high-tech market liquidity’ channel is fragile and can quickly disappear when an unexpected shock occurs...

Legion of doom

The goldbugs arrived today. m* received the latest "Greed and Fear" from the inimitable Christopher Wood of CLSA and immediately checked the stock of canned food in the cupboards. If ever m* thought about dipping into those REITS down 25% or doubted for a minute those decoupling skeptics and declaimers of fiat money, this latest cured all weakness.

And Bernard Connolly at AIG, the walking Wikipedia of economic theory classification, sends his best as well. Only 18 pages but the usual tasty seminar in history of economic thought, replete with footnotes taking up entire pages, awaits.

These latest missives on "The Crisis" and policy perspective are almost too good to share, and almost too scary not to. Unfortunately these are not yet in the public domain, as m* understands it anyway.

However, as an altogether safer (you can put the ammunition away), and possibly more sane option, m* offers a recent note from two prominent macro-economists on the question "what do we want from our central banks in this situation?"

The note is a response to Martin Wolf's appropriately titled scare-mongering FT column "Fear Makes a Welcome Return." Incidentally m* has noticed a clear pattern of commentary in the FT of late strongly advocating what m* calls the moralist case, (first described as such in notes from the folks at Toqueville - yep more goldbugs), which deems a puritanical cleansing of credit excess only fitting and stealthily argues for "free banking" ie: permitting bank failures, thus re-introducing the natural counterweight to animal spirits, moral hazard, back into the system. That is revolutionary stuff from our Socialist cousins across the pond.

This however is not. It is not even sensational. It is so sane as to be boring. Maybe we could use some of that right about now. Thank you, gentlemen.

Ricardo Caballero and Arvind Krishnamurthy: A liquidity crisis is taking place where investors, banks, and funds are scrambling for liquidity. Several hedge funds run by prominent investment banks in the US and abroad have liquidated or have suspended convertibility.

Paradoxically, when viewed as a whole there is sufficient liquidity in the financial system. Banks are well capitalised and flush with liquidity. Just a few weeks ago stock markets were soaring, investors were optimistic, and the VIX hit 13, not far from its 9.5 all time low. Yes, the residential real estate market in the US was declining and creating a mess in the subprime market.

But it was generally understood that the scale of these subprime losses was small in relation to the US and world economy. Even if all subprime mortgages and related CDOs were to lose all value, this would amount to just 2.5 per cent of US wealth. A more realistic, yet still pessimistic scenario puts the potential losses at $400bn, less than 1 per cent of US wealth. These losses could hardly have reversed the liquidity position of the financial sector. Hence, many pundits used the word "contained" in describing the subprime losses. Yet, it is clear that there is a liquidity crisis unfolding before our eyes.

Why? The reason is a rise in uncertainty - that is, a rise in unknown and immeasurable risk rather than the measurable risk that the financial sector specialises in managing. The financial instruments and derivative structures underpinning the recent growth in credit markets are complex. Market participants cannot refer to a historical record to measure how these financial structures will behave during a time of stress. Thus, today there is considerable uncertainty about who will and will not lose money in the credit market turmoil.

To understand how uncertainty can move an economy from excess liquidity to a liquidity crunch, an analogy might be useful. In the children’s game of musical chairs, when the music stops, only one child will be left without a seat. However if the children are confused about the rules and each is convinced that they will be the one left without a seat, chaos may erupt. Kids may start grabbing on to chairs, running backwards, etc.

In the same way, in today’s market uncertainty is leading every player to make decisions based on imagined worst-case scenarios. Market players that have the liquidity stay out of markets or pull back dramatically. But the financial markets need participants and their liquidity in order to function. When much of the market disengages due to uncertainty, the effective supply of liquidity in the financial system contracts. Those that need liquidity are unable to get it and financial markets turn illiquid.

What should central banks do in this case? They must find a way to re-engage the private sector's liquidity. Understanding that uncertainty is the cause of the disengagement is the start of finding the solution. A first step in reducing agents' uncertainty is for the central bank to clarify how it will act if agents’ worst case scenarios come to pass.

The central bank’s mission is to stabilise the economy as a whole and not individual participants. When viewed as a whole, the worst case scenarios that guide the behaviour of each market participant cannot simultaneously occur. Like musical chairs, when the music stops, only one child will be left without a seat, not every child.

The subprime shock at the end of the day is a small shock; it is only the actions of panicked investors that make it appear large. A central bank that understands this point will convincingly promise large liquidity injections in the event of a meltdown. The likelihood of having to deliver on the promise is minimal, but the reduced anxiety fostered by such a commitment restarts private liquidity circulation and helps restore normalcy.

It is important to understand that this is all about information and not about real liquidity additions. We do not have a true liquidity shortage on our hands; we only have one because of the reactions of an anxious private sector. Talking and providing information and certainty can go a long way to reducing uncertainty. A rate cut may be the right tool, but it is important not for its direct liquid addition, and instead for what it conveys about the central bank's readiness to act if things do get worse.

Will the Fed and other central banks around the world act appropriately? The early reactions are positive. The ECB was first to act, injecting more than $214bn in the last two days. The Fed followed with a more modest $38bn on Friday, and the rest of the central banks of the world did their share, lending over $73bn to the market.

It may also be that some of investors’ uncertainty stems from not knowing how Fed chairman Bernanke will react in case of a meltdown. Is he too much of an inflation targeter and oblivious to the workings of financial market? Not likely. From his extensive academic work on these matters, it is apparent that he is quite aware of the importance of credit markets to the functioning of the economy and the cost of the central bank failing to identify a liquidity event in time. It may well be time to start buying put options on the VIX.

Reference: R Caballero and A Krishnamurthy, "Collective Risk Management in a Flight to Quality Episode", forthcoming in The Journal of Finance

Dead dogs addendum

For the wonks among you, some weekend candy. VoxEU has a detailed explanation of the Fed and ECB repo operations last week.

The week that was

Of course the week has one day to go. And actually it has been a lot longer than a week for many participants, since the walls of "containment" proved somewhat more porous than officialdom cares to admit. But today had that definite "end of the beginning" vibe to it that leads m* to believe we can call this week in the bag now. m*'s mailbox is suddenly full of old colleagues clamoring to commiserate, and research galore from the bevy of moralists, perma-bears, and anti-carry-trade misanthropes, for whom there is always a warm place in m*'s heart. When m* is tapped to help run the new world financial system they will all be invited over for self-congratulatory tea and biscuits. However, while m* wholly believes (and fears) they will all be right if not rich, in the long run, in the short run, as with global warming, there is a large difference between one's circle of concern and one's circle of influence.

In that more immediate short run, long yen and long bonds, as mentioned here nearly three weeks ago, have been more than safe haven in a crisis while gold has been the deadweight m* expected and will likely continue to be until levered owners are thoroughly out or rate cuts take place. For all the commotion in US equities, with the VIX breezing through 25 like a bird in flight (volatility theme song ) the SP500 is off 10% to 1400, probably right about where a natural pull back ought to be. So automatic did that level seem that having spent the entire morning in meetings, m* was more than a bit puzzled to hear that stocks were down another 2%, and missed a golden opportunity to put some pieces in the pot on the way to yet more meetings.

It is probably a sign of the "baby with the bathwater" times that an analyst's sideways mention of Countrywide's possible bankruptcy (and of course that was always possible - why is the nation's "premier" home mortgage "lender", um, marketer, totally dependent on short term wholesale financing? Because if it were not, it would be a real lender, ie: a highly regulated high cost low p/e bank - that's why) was the main news of the day. What m* found amusing was that the analyst behind the report had a buy rating on the company only two days prior. From buy to using the word "bankruptcy" in two days is quite a switch. One can only imagine the kind of discussion that went on internally at ML (and how many lawyers were involved) to initially prop up and then expediently jettison their banking relationship with Countrywide. But then this is the same firm that rushed to seize collateral (and then on reflection, not) from those now kaput Bear sub-prime funds. How to explain? Then again, that's an awfully cheeky way of smashing bids for the collateral and the business if you plan buy it up later. Nonetheless, if even big slow-thinking Merrill can turn on you when you need them, it simply begs the question what arguments against arranging more permanent capital CFC's owner-manager with 30+ years of experience believed in.

Dead dogs repo

On the heels of yesterday's always entertaining moralizing about the current situation we have a more in depth look at what practical steps are available to policy makers facing a crisis, and a suggestion for a new (somewhat) approach.

"A credit crunch and liquidity squeeze is instead the time for central banks to get their hands dirty..." argues a new article The Central Bank as the Market Maker of last Resort at the excellent Vox EU.

The writers, economists Buiter and Sibert, make a point that where Central Banks were "lenders of last resort" in the old bank-centric credit system, they now ought to be "market makers of last resort" in the new markets based credit system. In particular, they argue that CB's should wade deeply into markets like the current situation with bids and offers to all market participants, hedge funds and institutional investors included, for the most illiquid securities.

This goes against the grain of previous Central Bank crisis management as a more targeted way of alleviating pressure on the asset based credit system. In effect where prior interventions sought to lift the tide for all boats, benefiting the biggest and most seaworthy disproportionately, this approach would target the leaky vessels already taking on water. In light of the Fed's encouragement to banks to repo highly rated mortgage paper in last Friday's injection, raising the issue of how broadly the definition of acceptable collateral may be is a timely point to raise.

The authors go on to say that current practice limiting repo collateral to highly liquid, high quality assets is more tradition than rule. In fact, they state the key Central Banks are legally free to accept almost whatever they may deem acceptable, the subject of a crude attention grabbing headline included. They go further and attribute the blunt instruments of rate cuts and blanket infusions of cash for government debt in prior crises with blame for the drastically distorted credit markets that got us here in the first place.

When it comes to socializing the bad choices of imprudent market participants speculating with other people's money, m* is all for a more targeted approach. (How do we leave out Cramer for example?). However, as described here, the authors posit an understanding of asset valuation that Central Banks are simply unprepared and ill-equipped to manage. More practical perhaps, is an "orchestrated" bailout where larger institutions join together to underwrite a consortium that bids for distressed assets en masse and at a discount before serious due diligence can take place. With prime brokers able to force the sale of these "assets" (to themselves in effect) this is highly possible.

Otherwise, as Tim Bond of Barclays writes in a recent piece on the Central Bank policy debate,"The Money Post," the complexity of the assets in question and the discrediting of the analysis underpinning them is likely to ensure that a secondary market forms only slowly as the mortgages underlying them season, dragging out the de-levering process, and turning a series of Central Bank substitutions of liquidity into permanent additions of liquidity. That is of course inflationary any way one looks at it and is least of what Central Banks need right now.

Central Banks: Butt out!

Andy Xie, for a time one of the most entertaining and outspoken economists on Wall Street, calls it like he sees it in today's FT. His message? Time for a bit of truth and consequences.
Andy Xie in the FT.