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In William Shakespeare's Hamlet,
Lord Polonius advised that one should "neither a borrower nor
a lender be". It follows, then, that Polonius, a chief adviser
in the court of King Claudius, might be particularly piqued
at a phenomenon of today's finance capitalism where many banks,
brokerages and other financial institutions are simultaneously
both lenders and borrowers.
Julian Delasantellis in Asia Times
This week, Larry Kudlow and others strongly chastised Bernanke for his failure to read the writing on the wall and urged the Fed Chairman to quickly slash the Fed Funds rate. Methinks the pundits doth protest too much. For years, Kudlow, who practically coined the term “Goldilocks economy,” has dismissed with scorn suggestions that the American economy was anything less than ragingly healthy. If our economy is really so strong, why does he call so loudly for the artificial stimulus of a significant rate cut?...
...With the ugly truth laid bare, many now prod Bernanke and Bush for solutions. Unfortunately there are none. Based on absurd assumptions about real estate, we simply borrowed more money than we can ever hope to pay back. There is no magic elixir we can swallow to cure what ails us. The free market is the only force that can fix this mess. Unfortunately, the fix won't be pretty. Prudent lending standards will return, guaranteeing that real estate prices collapse. This is an important connection that very few have made. There is no way the average American can afford to buy the average house at today’s prices with a mortgage he can afford. Assuming that the lax standards of 2005-2006 do not return, the only way this can happen is if real estate prices collapse, which is exactly what is happening.
The financial institutions that are calling most loudly for a bailout claim the Government must act to protect homeowners. However, the most severe losses will not be born by homeowners but by those who loaned them the money. Therefore any bailouts will ultimately go to lenders not borrowers. Homeowners who offered no down payment and who have no equity in their homes will in reality lose nothing in foreclosure, except perhaps a debt burden on an overpriced house. In addition, even those homeowners who made down payments likely extracted larger sums in subsequent refinancings or home equity loans. With plenty of available foreclosed homes on the market to rent it is unlikely that these former homeowners will become homeless.
As a result, the only losses for most homeowners will be psychological, as their dreams of real estate riches vanish. For some paper millionaires, the sudden realization that they are flat broke will be somewhat disheartening. Also for those who thought retirement was simply a function of living in a home and allowing it to appreciate, the sudden realization that they will now have to finance their retirement the old fashioned way, by saving up, will be quite an eye opener. However, even if misguided government bailouts enable more borrowers to keep their homes the equity they thought they had will still be gone.
In the final analysis, though it was Wall Street that served the punch, it was the Greenspan Fed that spiked it in the first place. Just as Fed policy enabled Wall Street to flood the world with worthless dot.com stocks it enabled an encore performance with subprime mortgage-backed securities. My guess is the Fed’s bubble blowing days are over. Once the inebriates sober up this time, the hangover will be so severe that no one will drink a drop of Wall Street’s punch again, meaning any more inflation the Fed creates will go strait into consumer prices.
The gross domestic product, the broadest measure of economic health, expanded at an annual rate of 4 percent in the April-June quarter, significantly higher than the 3.4 percent rate the government had initially estimated a month ago, the Commerce Department reported Thursday.
Houses are today's tulip bulbs, and in California they are the equivalent of the 3,000 guilder tulip bulb. But instead of letting the bubble play itself out in order to create conditions for long-term economic stability, the Fed, under extreme political pressure from the power brokers and banks, seems determined to keep the bubble from bursting for as long as possible by continuing to lower interest rates and flood the market with liquidity, much as the Dutch banks did in 1624 to keep up the price of tulips. Such a short-sighted strategy will not only keep the price of homes beyond the reach of the average American, but will make the final and inevitable collapse that much more horrendous.
Gold and silver have been beneficiaries of the excess money creation this decade that has lifted the prices of all asset classes higher. As we enter into a period of tighter credit, asset prices will fall, as will gold and silver. The behavior of gold and especially silver over the past month is a testament to this, I believe.
Investment banks are set to cut 10-15 per cent of their staff across the board as turmoil in the markets takes its toll on revenues.
The bulk of cuts are expected in structured credit and leveraged finance, though recruitment experts said other investment banking areas could be affected.
Russ Gerson, chief executive of the Gerson Group, a Wall Street executive search firm, said: “Unlike previous cycles, all the financial institutions are inter-related because of the credit market, so there will be a major fall in activity across all areas, with the inevitable job cuts.”
Aug 24th, 2007.
I think that basically what we learned in the past three to five days is that holders of funds got frightened because they didn’t know what they owned and because they were losing money on certain portions of these investments. The Fed stepped in and is trying to take us over that period of stress. However, it still doesn’t solve the problem that somebody has to come up with the money to make the payments on these different forms of debt which are outstanding in the economy ..
The money is there [to provide liquidity during the current crisis]. It exists. The problem is that the holders of funds have lost confidence in the system and therefore do not want to lend it. And what the Fed is attempting to do is break the logjam to allow people to use their money to put it back in the system. Once it’s achieved that result, then it has to start working, if it can — and I don’t think it can — on the real problem. Which is, how do you get enough income in the economy to actually meet the debt-service payments?
Bove also spoke with the LA Times on the same topic:
“The Fed is protecting these guys on the theory that they’re protecting the economy,” said Richard Bove, an analyst at Punk, Ziegel & Co. But “Wall Street deserves to bear the results of their actions — and to date, the results of their actions is that they’re worth $10 million or $20 million or $30 million and they have multimillion-dollar houses in the Hamptons.” ..
Bove of Punk Ziegel put it this way: “If you’re someone living in a run-down home in a questionable neighborhood and somebody calls you up and says, ‘I can put you in a $200,000 home in a fairly nice neighborhood and it won’t cost you any more than where you’re living now,’ you’d be a fool not to do it. I don’t think the man in the street has in any way stimulated this problem. The lenders have stimulated this problem.”
KAI RYSSDAL: I'll tell you what, I'll lay out the financial news of the past couple of days. You decide whether things are OK or maybe not. In no particular order, we have relative calm in the markets; no bombshells from mortgage lenders — today anyway; and the bond market's looking more stable.
On the other hand, the Federal Reserve is still pumping money into the financial sector to prevent a crisis. Countrywide CEO Angelo Mozilo, the man arguably at the center of the storm, says we're headed for a recession. And lots of people are still banking on the Fed to cut rates.
I don't know where you came down on whether the worst has passed or not, but we decided to call financial strategist Richard Bove at the investment bank Punk Ziegel for some guidance. Mr. Bove, thanks for being here.
RICHARD BOVE: My pleasure.
RYSSDAL: There's been a certain sense the past couple of days of Ahhhh ... that maybe we're sort of past the worst of whatever this crisis was. Do you think that's true?
BOVE: No, it's not even remotely close to being true. I think that basically what we learned in the past three to five days is that holders of funds got frightened because they didn't know what they owned and because they were losing money on certain portions of these investments. The Fed stepped in and is trying to take us over that period of stress. However, it still doesn't solve the problem that somebody has to come up with the money to make the payments on these different forms of debt which are outstanding in the economy.
RYSSDAL: Cast your mind forward now with me to the 18th of September when the Federal Open Market Committee talks about interest rates. What happens if they don't cut the Federal Funds Rate on that date?
BOVE: The real issue is that, you know, we need economic growth. And economic growth is gotta stimulate income growth, which is gotta solve the problem. On September 18th, I think the Fed is going to reduce the discount rate by another 50 basis points.
RYSSDAL: That is to say they'll cut the discount rate — the rate they cut last Friday — by another half a percent.
BOVE: Correct. And they won't touch the Federal Funds Rate. Now the reason why I'm saying that is because we had a very odd development in the market yesterday.
The Federal Reserve requested that the four largest banks in the United States borrow $500 million apiece at the discount window.
The reason why that was somewhat bizarre is because none of these banks needed that money. Why would the Fed do that?
The stated reason is because the Fed wants to create confidence among other banks that they should also borrow from the Federal Reserve discount window.
RYSSDAL: That all goes back, though, to the reason we called you up to begin with. Which is, the idea that what's happening as these very public moves are made is in some sense a confidence game in the most pejorative sense of the word.
BOVE: Yes, you're right. In other words, basically, the money is there. It exists.
The problem is that the holders of funds have lost confidence in the system and therefore do not want to lend it.
And what the Fed is attempting to do is break the logjam to allow people to use their money to put it back in the system.
Once it's achieved that result, then it has to start working, if it can — and I don't think it can — on the real problem. Which is, how do you get enough income in the economy to actually meet the debt-service payments?
uberbroker 24 Aug 2007, 01:36 PM EDT Msg. 241316 of 241461
(This msg. is a reply to 241149 by uberbroker.)
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hitch...I see you are on the board today
You declined the opportunity to back up your contention that my post regarding Greenspan, the Fed and the current credit crunch were "strawman" arguments. Instead, you chose to blindly bash Bush with no substantiation. How typical. I will give you a second chance. Here is a well written article that I read over the weekend while I was enjoying the rewards for my embrace of Capitalism...
Giving Credit Where Due
The search for scapegoats in the current leading mess
By THOMAS G. DONLAN
WHOM SHALL WE BLAME FOR the so-called credit crunch? Casting about for scapegoats has never been easier, because the herd includes dozens of famous people, thousands of obscure but important financiers and millions of impecunious borrowers.
Not in any special order, we blame:
Alan Greenspan and George Bush. The "maestro" of the Federal Reserve pounded the monetary gas to get the country out of recession in 2001, the "compassionate conservative" president pounded tax cuts and allowed the Republican Congress to boost spending as if they were Democrats. Either stimulus might have been enough; together they were too much.
Bill Clinton and his housing promoters at the Department of Housing and Urban Affairs, Henry Cisneros and Andrew Cuomo. It takes a long time to get a housing boom started, just as it will take a long time to cut back the inventory of new condos and houses that is pushing the market down.
William R. Fair and Earl J. Isaac, who started the eponymous credit analysis company. Fair Isaac analytics are used in three out of four U.S. mortgage originations, and the company sells 10 billion credit scores a year. Though the company has reduced the effect of prejudice and allowed lending to move more quickly, it has turned credit from a character judgment into a commodity. Commoditized loans, in turn, are turned into commodity packages of loans.
From AAA to DDD
The rating agencies, Standard & Poor's and Moody's, swallowed tonics compounded with financial alchemy that lead them to believe that over-collateralization could trump high leverage and poor quality in a package of loans. Or, if it was not an alchemical elixir, perhaps it was money. Issuers pay the rating agencies to bless their bits of paper.
Supposedly professional investors who rushed to put their funds' funds into Triple-A rated things they did not understand, ignoring the market's warning signal that risk premiums were nearly non-existent. Sometimes you get paid for buying junk, and sometimes you don't.
There's also room to blame predatory lenders and their phony appraisers and brokers. Their chief concern was that fees were paid up front. The worst of these made their living inducing old folks with free-and-clear homes to become speculators in real estate and credit. But the greatest blame attaches to people who borrowed imprudently, and who should have known better.
They are still around waiting to be fleeced again, to judge from the lower dregs of commerce.
Little Green Loans
An advertisement from "Lowermybills.com, an Experian Company" slipped through our office spam filter the other day. Headlined "Mortgage Rates Fall Again," it purported to offer a "$430,000 mortgage for under $1,299 a month," which seems to be a rate of 3.5% or less, depending on the amortization of principal, if any. It urged the would-be borrower, "Select your credit: Excellent, Good, Fair, Needs Improvement, Poor." We stopped following the lead when it asked for personal information. Experian, which likes to describe itself as "a global information solutions company," is not to be trifled with, since it runs one of the major credit-reporting bureaus.
People get this kind of junk mail all the time, but the odd thing was the corporate spokescreature: Instead of a gecko or a frog, the ad featured an animation of a little green alien, dancing what appeared to be the Macarena.
What were they trying to say, that Experian has investors on Mars who haven't heard about the problems with subprime mortgages?
In the snail-mail at our house the other day there appeared a come-on from an outfit called Crown Mortgage Corp., which may beat the little green alien.
"Start saving now with our 1.750% loan program," it said. "It's almost impossible not to qualify! And it's fast and easy."
No worries: "Borrow up to 100% of the value of your home and take cash out for any purpose. Use the cash for anything you want. Pay off high-interest debt or tax liens, take a vacation or finance your child's education. It's up to you."
Compared to companies like these, Countrywide Financial is as sound as the U.S. Treasury. Which may be true anyway.
The Last Trump
Henry Kaufman, who used to be known as "Dr. Doom" back a few financial crises ago, weighed in last week with the all-too-accurate assessment that financiers redefined liquidity over the past couple of decades. Liquidity used to mean cash, or assets that certainly could be converted to cash with the stroke of a pen.
"Firms and households today often blur the distinction between liquidity and credit availability," Kaufman said. "When thinking about liquid assets, present and future, it is now commonplace to think in terms of access to liabilities."
Personal liquidity recently has been defined as what you can borrow with the stroke of a pen. An individual adds up all the limits on the credit cards in his wallet, permissible overdrafts on his checking account, margin-loan limits on his brokerage account and home-equity loan checks in his desk. Maxing them out, he may command two years' salary, or more if he had worked at it when lenders were bullish.
Corporate liquidity is not much different. Companies maintain credit lines that would have constituted the mark of Cain many years ago, confident that they can borrow their way through any crisis.
When a person or a corporate treasurer writes a check on air to achieve liquidity, he should think of Owen Glendower, the Welsh magician who tries to impress Henry Hotspur in an early scene of Shakespeare's Henry IV, Part I. Glendower brags that he can "call spirits from the vast deep!" Hotspur gives him no credit: "Why, so can I; or so can any man. But will they come?"
What is shaking the markets is a refusal of the spirit of easy money to come from the vast deep. We are undergoing an agonizing reappraisal of the power and security of credit.
After a slow start in responding to the surge in money- market rates earlier this month as banks hoarding capital stopped lending to each other, the U.S. central bank has shown some nifty footwork in trying to dodge the rate-cut bullet.
It started by reducing the cost of emergency funds at its discount window. That borrowing source, though, has provided a weekly average of just $52 million this year when seasonal credit to small institutions in agriculture or tourism is excluded. The most it has been tapped for in the past five years is just $785 million, though almost $12 billion was drawn down following the Sept. 11 terrorist attacks.
So on Aug. 22, the four largest U.S. banks stepped up, with Citigroup Inc., Bank of America, JPMorgan Chase & Co. and Wachovia Corp. each taking $500 million of funds at 5.75 percent, well above the 4 percent rate that the overnight Fed funds rate closed at that day.
The implied message to the smaller finance houses is that there shouldn't be any stigma attached to borrowing at the penalty rate if you need to.
You can imagine the telephone conversation with the Fed that inspired such munificence; not dissimilar from the 1998 chat that brought about the rescue of Long-Term Capital Management LP. A cynic might also wonder whether Bank of America's $2 billion vote of confidence in the U.S. mortgage market by buying preferred stock in Countrywide was similarly Fed-inspired.
All of this is evidence that the Fed will keep pulling new tricks to avoid cutting its key overnight target rate of 5.25 percent, either before or at its Sept. 18 gathering -- and will rally U.S. financial institutions to its cause, marshaling the forces of capital by reminding them that their interests in maintaining market order are 100 percent aligned.
The Fed doesn't want to be bullied into changing course; it must also be acutely aware that a policy response would stoke concern the situation is even worse than it appears -- not to mention guaranteeing that Chairman Bernanke would be known as ``Helicopter Ben'' for the rest of his career.
The Working Group on Financial Markets (also, President's Working Group on Financial Markets or the Working Group) was created by Executive Order 12631, signed on March 18, 1988 by United States President Ronald Reagan.
The Group was established explicitly in response to events in the financial markets surrounding October 19, 1987 ("Black Monday") to give recommendations for legislative and private sector solutions for "enhancing the integrity, efficiency, orderliness, and competitiveness of [United States] financial markets and maintaining investor confidence".
As established by Executive Order 12631, the Working Group consists of:
- The Secretary of the Treasury, or his designee (as Chairman of the Working Group);
- The Chairman of the Board of Governors of the Federal Reserve System, or his designee;
- The Chairman of the Securities and Exchange Commission, or his designee; and
- The Chairman of the Commodity Futures Trading Commission, or her designee.
One theory regarding the Working Group refers to it as the Plunge Protection Team. This theory claims that the Working Group is a scheme to manipulate U.S. stock markets in the event of a market crash by using government funds to buy stocks, or other instruments such as stock index futures.
The term "Plunge Protection Team" was originally the headline for an article in The Washington Post by staff writer Brett D. Fromson, published on Sunday, February 23, 1997. It is commonly believed that he did not invent the term; that it was added later by a copy desk editor as a sensational nickname for the Working Group.
Half of America's Gain in Income Goes to Richest 0.25 Percent by David Cay Johnston
[Earners of over $1 million/year,] who constitute less than a quarter of 1 percent of all taxpayers, reaped almost 47 percent of the total income gains in 2005, compared with 2000.
People with incomes of more than a million dollars also received 62 percent of the savings from the reduced tax rates on long-term capital gains and dividends that President Bush signed into law in 2003...The group’s calculations showed that 28 percent of the investment tax cut savings went to just 11,433 of the 134 million taxpayers, those who made $10 million or more, saving them almost $1.9 million each. Over all, this small number of wealthy Americans saved $21.7 billion in taxes on their investment income as a result of the tax-cut law.
The nearly 90 percent of Americans who make less than $100,000 a year saved on average $318 each on their investments. They collected 5.3 percent of the total savings from reduced tax rates on investment income.
The I.R.S. data showed that the number of Americans making less than $25,000 a year shrank, down by 3.2 million, or 5.5 percent.
Nearly half of Americans reported incomes of less than $30,000, and two-thirds make less than $50,000.
The number of taxpayers making more than $100,000 grew by nearly 3.4 million and accounted for more than two-thirds of the growth in the number of returns filed in 2005 compared with those in 2000.
The fact that average incomes remained lower in 2005 than five years earlier helps explain why so many Americans report feeling economic stress despite overall growth in the economy. Many Americans are also paying a larger share of their health care costs and have had their retirement benefits reduced, adding to their out-of-pocket costs.
Mozilo (chief executive of Countrywide Financial Corp), speaking on CNBC television, said the housing market was "certainly not getting better" and could push the economy into a recession. He also said the commercial paper market isn't improving.
Adding to the negative tone was a Financial Times report that a private equity-led buyout of home improvement retailer Home Depot Inc's (HD.N: Quote, Profile, Research) wholesale supply division could be in trouble.
... When the Fed cut its discount rate on August 17th, it admitted for the first time that the credit crunch could hurt the economy. The markets are betting it will soon cut its main federal funds rate. Economists are arguing vigorously about how much damage falling house prices and the subprime mortgage crisis will do. But there is one question that is rarely asked: even if a downturn is in the offing, should the Fed try to prevent it?
Most people think the question smacks of madness. According to received wisdom, the Fed should not cut interest rates to bail out lenders and investors, because this creates moral hazard and encourages greater risk-taking; but if financial troubles harm spending and jobs the Fed should immediately ease policy so long as inflation remains modest. Central bankers should be guided by the “Taylor rule”—and set interest rates in response to deviations in both output and inflation from desired levels.
A necessary evil
But should a central bank always try to avoid recessions? Some economists argue that this could create a much wider form of moral hazard. If long periods of uninterrupted expansions lead people to believe that the Fed can prevent any future recession, consumers, firms, investors and borrowers will be encouraged to take bigger risks, borrowing more and saving less. During the past quarter century the American economy has been in recession for only 5% of the time, compared with 22% of the previous 25 years. Partly this is due to welcome structural changes that have made the economy more stable. But what if it is due to repeated injections of adrenaline every time the economy slows?
Many of America's current financial troubles can be blamed on the mildness of the 2001 recession after the dotcom bubble burst. After its longest unbroken expansion in history, GDP did not even fall for two consecutive quarters, the traditional definition of a recession. It is popularly argued that the tameness of the downturn was the benign result of the American economy's increased flexibility, better inventory control and the Fed's firmer grip on inflation. But the economy also received the biggest monetary and fiscal boost in its history. By slashing interest rates (by more than the Taylor rule prescribed), the Fed encouraged a house-price boom which offset equity losses and allowed households to take out bigger mortgages to prop up their spending. And by sheer luck, tax cuts, planned when the economy was still strong, inflated demand at exactly the right time.
Many hope that the Fed will now repeat the trick. Slashing interest rates would help to prop up house prices and encourage households to keep borrowing and spending. But after such a long binge, might the economy not benefit from a cold shower? Contrary to popular wisdom, it is not a central bank's job to prevent recession at any cost. Its task is to keep inflation down (helping smooth out the economic cycle), to protect the financial system, and to prevent a recession turning into a deep slump.
The economic and social costs of recession are painful: unemployment, lower wages and profits, and bankruptcy. These cannot be dismissed lightly. But there are also some purported benefits. Some economists believe that recessions are a necessary feature of economic growth. Joseph Schumpeter argued that recessions are a process of creative destruction in which inefficient firms are weeded out. Only by allowing the “winds of creative destruction” to blow freely could capital be released from dying firms to new industries. Some evidence from cross-country studies suggests that economies with higher output volatility tend to have slightly faster productivity growth. Japan's zero interest rates allowed “zombie” companies to survive in the 1990s. This depressed Japan's productivity growth, and the excess capacity undercut the profits of other firms.
Another “benefit” of a recession is that it purges the excesses of the previous boom, leaving the economy in a healthier state. The Fed's massive easing after the dotcom bubble burst delayed this cleansing process and simply replaced one bubble with another, leaving America's imbalances (inadequate saving, excessive debt and a huge current-account deficit) in place. A recession now would reduce America's trade gap as consumers would at last be forced to trim their spending. Delaying the correction of past excesses by pumping in more money and encouraging more borrowing is likely to make the eventual correction more painful. The policy dilemma facing the Fed may not be a choice of recession or no recession. It may be a choice between a mild recession now and a nastier one later.
This does not mean that the Fed should follow the advice of Andrew Mellon, the treasury secretary, after the 1929 crash: “liquidate labour, liquidate stocks, liquidate the farmers, and liquidate real estate...It will purge the rottenness out of the system.” America's output fell by 30% as the Fed sat on its hands. As a scholar of the Great Depression, Ben Bernanke, the Fed's chairman, will not make that mistake. Central banks must stop recessions from turning into deep depressions. But it may be wrong to prevent them altogether.
Of course, even if a recession were in America's long-term economic interest, it would be political suicide. A central banker who mentioned the idea might soon be out of a job. But that should not stop undiplomatic economists asking whether a recession once in a while might actually be a good thing.
Every crisis begets finger-pointing, and the blame now is falling on the rating agencies that helped structure these exotic instruments. The European Commission is understood to be reviewing why rating agencies failed to move more quickly in response to the growing crisis in subprime mortgages. Currently, they are guided by a voluntary code that aims to tackle potential conflicts of interest. The biggest is that the agencies are paid by the firms they rate. Rating CDOs was a profitable business.
To understand why so much blame is being heaped on the rating agencies, consider how CDOs and collateralised-loan obligations (CLOs) came into vogue. In the mid-1990s individual loans looked appealing to investors, but their ratings (often below investment grade) made them too risky for conservative types. So whole forests of asset-backed securities were put together into a single CDO. These were structured so that the first losses would be taken by whoever had bought the riskiest, highest-yielding piece of the package. That piece had a low rating. But the piece at the top, which would take the last losses, was rated AAA—a reflection of how unlikely it was that all the loans in the CDO would default at once.
Rather than standing back and observing this from the sidelines, the rating agencies got involved in structuring these products. Like schoolgirls asking for help with their homework, the banks would go to the agencies and ask how the different slices of the CDOs they were putting together would score. The agencies would suggest improvements based on their models. And lo, the senior tranches were given the ratings required to market them to banks, which liked the security the triple-A ratings conferred, especially because their yields were higher than those of American Treasuries.
If these securities are now downgraded, the same banks could be forced to offload lots of illiquid instruments into a falling market—one of the fastest ways to lose money yet devised. But if there are no buyers, banks may have to sell something else to shore up their balance sheets.
... ... ...
At the end of Old Maid as banks used to play it, the loser would take a big write-off and then everyone could start playing again. In the new version, the use of leverage means the game is being played with hundreds of packs of cards and by thousands of different players. “Securitisation,” says Avinash Persaud of Intelligence Capital, a financial adviser, “has meant that credit risks have moved from knowledgeable, long-term hands, to fast hands, where the principal risk-management strategy is to sell before prices fall more”. Working out who has won and who has lost in this round will take a long time.
In this case, the complex models that drive them were upended by the extreme market volatility. Four building-blocks of such models are stock valuations, quality, price momentum and earnings momentum. These usually offset each other, but when they all started suffering, the models went awry. Some of the world's biggest hedge funds all began selling the same things at the same time. “You had the proverbial camel trying to get through the eye of the needle,” an analyst says.
Although the pain was not confined to hedge funds—some long-only mutual funds were also hurt—the use of ample leverage (a staple in the hedge-fund world) meant they were hardest hit. One big investment bank is said to have offered leverage of 20-to-one to hedge funds investing in subprime mortgages just months ago.
In a conference call on August 13th, Goldman Sachs said its leading global equity fund—which relies on a quantitative trading model—had lost more than 30% of its value within a week. The bank waived fees to attract investors to the fund after it lost about $1.4 billion in assets.
Understandably, given the opacity of the investment banks' exposure to credit markets, not least subprime mortgages, investors decided to sell first and ask questions later, walloping the shares of Wall Street firms, especially Bear Stearns, Lehman Brothers and Merrill Lynch. Then came the reappraisal of risk.
Liquidity fears were the biggest hurdle. The evaporation of funding possibilities ultimately drove Drexel Burnham Lambert, a high-flying investment bank, into bankruptcy in the 1980s and threatened Wall Street banks after the implosion of Long-Term Capital Management (LTCM), a gargantuan hedge fund, in 1998.
... ... ...
But like its peers it continues to keep details of its subprime and other credit exposures to itself. Investors will take a lot of convincing that it is fully seaworthy, having looked so tattered just days ago. Says Eileen Fahey of Fitch, “It is a trust issue more than a liquidity issue.” And if trust goes, liquidity usually follows.
August 23 2007 | FORTUNE Magazine
The Fed may well end up slashing interest rates, but the Greenspan era of pumping up market bubbles with repeated cuts is over, predicts Fortune's Peter Eavis.
NEW YORK (Fortune) -- It may be the most important development to emerge from the recent market turbulence: The Federal Reserve, under Chairman Ben Bernanke, is going back to being a central bank.
Judging by its cautious and finely-calibrated responses through a very ugly August, the Fed appears keen to put the Alan Greenspan years firmly in the past and take a much more orthodox approach to monetary policy. While the Fed will probably cut interest rates as early as next month, its behavior in August strongly suggests that Bernanke will avoid using interest rates to deliberately spark big increases in lending, the high risk strategy pursued by Greenspan from 2001 to 2004.
"I think Greenspan would have cut rates already. So I do think things are beginning to look different at the Fed," says Paul Kasriel, economist at Northern Trust.
A change at the Fed would have far-reaching consequences for the U.S. economy and the stock market. Initially, a much less accommodating Fed will be perceived as a reason for bearishness. But, over the longer term, market players may well see a less dysfunctional central bank as a good thing that could begin the process of cutting borrowing levels in the U.S., something that has to happen if the American economy is not going to seize up every time interest rates rise.
So what is the actual evidence that Bernanke, who helped formulate monetary policy under Greenspan, is not following the same approach as his predecessor? One huge change: Bernanke's actions have made it clear that he won't be panicked into cutting its key interest rate - the Federal funds target rate - when markets get mauled.
True, Greenspan often said that a central bank should cut rates chiefly in response to weakness on Main Street, not Wall Street -- the same message that is coming out of the Fed at the moment. But from 1998 onward, Greenspan's actions were very much at odds with that position. In that year, the Fed slashed rates in response to market turbulence sparked by the collapse of a large hedge fund and devaluation of the Russian ruble.
Current market conditions are worse than in 1998 and this Fed has cut only the discount rate, a move designed to get healthy financial institutions trading with, and lending to, each other. Critically, Bernanke's Fed hasn't yet reduced the Fed funds rate, which does have a big impact on the economy. And it has not officially commented on what its next moves might be with that rate.
And if it does lower the Federal funds rate next month, it's hard to see it rushing to further cuts, as happened in 1998. Why? Because there seems to be a recognition at the Fed that lending got out of hand in the past five years, and it's important now for markets to attach new, lower values to many loans and bonds.
In a June speech, Bernanke commented on the shake-out in subprime mortgages in a conspicuously neutral way, suggesting the Fed was monitoring housing problems, but was not unduly concerned by adjustments taking place in it. "I think the Fed is happy to see that risk aversion is increasing," says Kasriel.
Indeed, Jeffrey Lacker, president of the Richmond Federal Reserve Bank, made that point exactly in a speech Tuesday. While Lacker is not currently a member of the Fed committee that makes monetary policy, his views are almost certainly shared by some members of the committee. In an obvious nod to the cut the discount rate last week, Lacker argued that a reduction in a discount rate is a good thing to do because it can supply liquidity without leading the market to misprice credit once again. "Sound discount window policy, I believe, should aim at supplying adequate liquidity without undermining the market's assessment of risk," he stated.
While Treasury secretary Henry Paulson is not a Fed member, it was more than interesting to see him making the same point, also on Tuesday, when he said: "As the Fed addresses liquidity this makes it possible, this makes it easier, for the market to focus on risk and pricing risk."
What seems so different under Bernanke is a genuine recognition that interest rate cuts could spark another bubble, and thus must be enacted carefully. This appears to have been a big factor in the Fed's decision-making last week. In a blow-by-blow account Monday of the Fed's internal discussions surrounding the cut in the discount rate, The Wall Street Journal wrote about this fear: "The [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 the economy needed a cut, and some Fed officials feared it might encourage more of the sloppy lending that led to the crisis."
The stand-back strategy of Bernanke's Fed was in many ways vindicated by news Wednesday night that Bank of America is making a $2 billion investment in Countrywide, the large mortgage company that is suffering a liquidity squeeze. It shows that stronger firms are capable of becoming part of the market adjustment by making investments in weaker companies during this crisis. This happened without a cut in the Fed funds rate.
But if credit markets are in seizure, where might the next bubble be? Once markets settle down, a big drop in the Fed funds rate could, for example, spark a lending splurge by credit card and auto-finance companies, which currently have healthier balance sheets than mortgage lenders.
To be sure, more evidence is needed to make an open-and-shut case that the Fed has changed its spots. If weakness starts to show up in the real economy, the Fed could revert to the laxity of the Greenspan years in a flash. Bernanke is no Paul Volcker, whose anti-inflation bias led him to hike rates to recession-causing levels in the 1980s. However, Northern Trust's Kasriel does think the Fed would tolerate some economic sluggishness if it brings some stability back into the economy. "I don't think the Fed would welcome a recession, but I think it would be okay with some below potential growth," he says.
After nearly 20 years at the helm of the Fed, Greenspan left the U.S. economy more vulnerable to credit shocks than it has ever been. It will take Bernanke 20 years to undo that mess. And there's a good chance the clean up began last week.
At first the unemployed searched eagerly and diligently for alternative sources of work. But if four months or so passed without successful reemployment, the unemployed tended to become discouraged and distraught.
After eight months of continuous unemployment, the typical unemployed worker still searches for a job, but in a desultory fashion and without much hope.
And within a year of becoming unemployed the worker is out of the labor market for all practical purposes: a job must arrive at his or her door, grab him or her by the scruff of the neck, and through him or her back into the nine-to-five routine if he or she is to be employed again.
August 3, 2007 | www.dailyreckoning.com
...Treasury Secretary Paulson says the subprime mess will not affect the rest of the economy. He must have had a lot of practice lying at Goldman Sachs (NYSE:GS)…or else it just comes naturally to him. Affecting the rest of the economy is precisely what the subprime credit debacle is doing - just as you'd expect.
...On the rare occasions when we actually worry about the future…we wonder what will happen when these poor lumpenhouseholders realize what has happened to them, for they are the big losers of this economic era. Jobs and wages are moving to Asia - leaving them behind. And they actually helped finance…they helped to speed up…the process - by buying more from Asia than they could rightly afford. Now, they are the most indebted people in the world…with the most expensive lifestyles to support…and with the slowest income growth outside of Africa. While the foreigners have gotten richer and more competitive…America's middle and lower-middle classes have merely gone deeper into debt…and added to their monthly expenses. They have bigger houses to heat and cool. They have more cars. They have more gadgets and second homes. And in the years ahead, they'll find themselves competing with these dynamic foreigners for jobs…for earnings…for fuel…even for food - while trying to avoid bankruptcy.
Liquidity is, of course, econospeak for just plain old money; "wave of liquidity", in its simplest terms, just means that there's a whole lot of money sloshing around the world. I tell my students that in a free economy it's as if the quantity of money and prices of assets are on either side of an apothecary scale; if the quantity of money goes up that platform gets weighed down, driving the value of the physical assets on the other side up. Hence the tremendous run in global equity markets over the past few years.
There are ever-changing attempts to explain how the wave of liquidity was created. Some credit or, depending on your perspective, blame the US Federal Reserve; in response to the bursting of the dot-com boom in 2000-01 it reduced its key short-term lending rate from 6.5% in 2001 to 1% in 2003-04, before raising them back to the current 5.25%.
With rates this low it meant that banks were practically giving loans away; as that money circulated through the economy, from lender to borrower, from producer to consumer, over and over again, that began the wave of money. Low Japanese interest rates also get part of the credit/blame. Interest rates in Japan have been on the decline since the pricking of Japan's Nikkei stock index bubble in the late 1980s.
Japanese interest rates have been 1% or lower since 1995; from 2001 until recently, the Bank of Japan held its official discount rate at around 0.1%, making it virtually cost-free for international currency speculators to borrow funds in yen, convert them into other, higher-yielding currencies (this is what's referred to as the "carry trade"), thus increasing these countries' money supply, their "wave of liquidity".
But both the Bank of Japan's and the US Federal Reserve's interest-rate policies are basically on hold; they don't explain what happened in world equities in the past couple of weeks.
In William Shakespeare's Hamlet, Lord Polonius advised that one should "neither a borrower nor a lender be". It follows, then, that Polonius, a chief adviser in the court of King Claudius, might be particularly piqued at a phenomenon of today's finance capitalism where many banks, brokerages and other financial institutions are simultaneously both lenders and borrowers
American economist and historian Edward Luttwak calls the new globalized economy turbo-capitalism; applied to finance, it means an essential blurring between the distinction between borrower and lender. Where once the distinction was very clear (the lender lends, the borrower pays back with interest), these days a borrower might turn around and lend the money he just borrowed from the lender to another borrower, who just might be doing the same with another borrower further down the line.
Every successive round of borrowing and lending acts to increase the global money supply; the tops of the "wave of liquidity" grow ever higher.
July 30, 2007
Valuations are Sound
But the purveyors of doom and gloom are wrong. It's true that over the past few years the interest rate spreads between the high and low-rated became extremely low by historical standards. Then tremors developed last February when the sub-prime mortgage crisis surfaced. These tremors turned into an earthquake last week when the private equity firms and banks wanting to acquire Chrysler and Alliance Boots failed to attract the lenders needed to finance their $20 billion buyout. All of a sudden, the bears emerged from hibernation to yelp "I told you so!"
But the bull market in equities did not depend on these low spreads or on the rising tide of leveraged buyouts. Despite the fizz in a few stocks, the overall level of the stock market never became overpriced relative to the most fundamental metric of firm value - corporate earnings.
Based on the S&P 500 Index, which constitutes 80% of the total market value of U.S. stocks, these stocks are now selling at 16.5 times a conservative estimate of 2007 earnings. In a world where government rates are below 5% and inflation is below 3%, stocks are not only reasonably priced, but cheap on a historical basis.
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