This Crisis Is Not Over
John Mauldin's Outside the Box

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What a momentous weekend. I was pounding the table about the need to move quickly on Fannie and Freddie in my last few letters, and especially this last letter. And then they did it. There are a lot of details that have yet to come out, and it is likely to be far more expensive the Savings and Loan crisis was for the US taxpayer, but it did get done. Hopefully, we can get some real regulation for part of our costs, as well as get rid of the implicit guarantees by US taxpayers so that something like this never happens again. The fact that it did was the fault of the regulatory environment and Congress. They fired the heads of Fannie and Freddie (with multi-million dollar parting gifts), but sadly, the truly responsible parties will be re-elected to perpetrate yet more frauds.

This week in Outside the Box we will look at two essays, one by Paul McCulley, Managing Director of PIMCO ( The second is a quick shot by Michael Lewitt of Hegemony Capital Management on the Freddie and Fannie nationalization ( They both make points that there is a lot of work still to be done by the authorities. This crisis is not over...

And on that note, I agree with this paragraph from Greg Weldon:

"There is talk that yesterday's 'event' signals an end to the credit crisis ... nothing could be further from the truth. The take over of Fannie and Freddie implies that the credit contraction continues to INTENSIFY, as the government will likely NOT ... EXPAND ... the balance sheets of these two entities. More importantly, the take-over does NOTHING in terms of bank lending standards, which continue to tighten. Nor does it do anything for Ma and Pa Kettle, as it relates to their ability to continue to take on more debt, which continues to worsen in line with intensifying erosion in the housing market and the labor market as was WELL EVIDENCED by ALL the macro-data released last week ... and the horrific labor market report. Indeed, today's markets move might provide the best "FADE" opportunity of the year!!!"

And Now, on to the essays by Paul and Michael.

In the Fullness of Time

By Paul McCulley, Managing Director, PIMCO

This was my third year attending the Kansas City Fed's annual Jackson Hole Symposium. As always, I was honored to be invited and found the event, both the formal meetings and the informal discussions, to be engaging. But, quite frankly, I found this year's confab to be the least intellectually satisfying of the three I've attended. Why? Policy makers, and even more so academics, just don't seem to collectively "get it" when it comes to understanding what is unfolding in the capital markets right now, and the implication for a whole array of policies, not just monetary policy.

Note I said "collectively." Many policy makers, led by Chairman Bernanke, do "get it" - perhaps he more than any other, as both a student of the Great Depression as well as a theoretician on the transmission mechanism of monetary policy, notably the "credit channel" with its associated "accelerator." But regrettably, there has yet to be a collective recognition of what is unfolding. As evidence, only two of the five papers presented even had the name Minsky in them and even in those cases, only in passing or in a footnote. I'll come back to that in a few paragraphs.

Neutral Is as Neutral Does
But first, let me touch on the most obvious source of cognitive dissonance: the hawks vs. the doves regarding inflation. The hawks scream that the Fed must tighten sooner rather than later, so as to burnish the Fed's anti-inflation credibility, but do so without any discussion whatsoever of the monetary policy transmission mechanism; they simply look at the negative prevailing real Fed funds rate and say it's too damn low and should be raised.

Really, that is essentially their entire story. The only good thing about their story is that it is so easy to refute using standard macroeconomic and finance theory. But unfortunately, not even that seems to get them to shut up.

All sensible discussion of the "right" real Fed funds rate logically must begin with the proposition that the putative "neutral" equilibrium real Fed funds rate is not constant, but rather time varying, a function of financial conditions, notably whether levered financial intermediaries - conventional banks, as well as shadow banks, a term I coined last year at Jackson Hole - are ramping up or ramping down their leverage. The former will lift the "neutral" real rate while the latter will reduce it. Thus, a high Fed funds rate may not be restrictive at all while a low Fed funds rate might not be stimulative at all.

This should be a self-evident truth, but somehow, it hasn't penetrated the gray matter of the inflation nutters, who view a negative real Fed funds rate as prima facie evidence of monetary laxity at best, and moral bankruptcy at worst. It is not. The whole concept of "neutral" is best defined by the famous economist Forrest Gump: neutral is as neutral does.

And right now, a 2% Fed funds rate is not doing much at all to stimulate aggregate demand relative to aggregate supply, reducing resource slack in the economy, engendering increased pricing power by capital or labor, or both. To the contrary, resource slack is going the other way, notably in the labor market, with the unemployment rate up over a full percentage point since its cyclical low. Thus, if anything, a 2% Fed funds rate is restrictive, not stimulative.

And the reason is simple: the economy is caught in the paradox of deleveraging, as I detailed in this space two months ago. Terms and conditions for private sector credit creation, the fuel for private sector aggregate demand growth, are tighter, much tighter than when the Fed funds rate was 5 1/4% a year ago. Thus, the current 2% Fed funds rate is not providing any tinder whatsoever for an inflationary fire.

Rather, the ongoing deleveraging of levered credit creators is fueling asset price deflation in a vicious downward spiral, known in central bank circles as a "negative feedback loop." And as long as that loop is looping, it would be a colossal policy mistake to get wrapped 'round the axle about the fact that the real Fed funds rate is negative. It is, as it should be.

Unless, of course, as Goldman Sachs Chief Economist Jan Hatzius pointed out in this morning's New York Times, you somehow believe that the United States economy is not throwing enough people out of work and/or not throwing them out of work quickly enough. I don't. And neither does the intellectual center of the Federal Open Market Committee, I can assure you. Yes, headline inflation is presently higher than the Fed would prefer. It's higher than I would prefer.

But it's also the consequence of a negative real terms of trade shock, which the Fed can do nothing about in real time. I've been to the Fed's headquarters in Washington and believe me, there are no oil derricks on the property. Sometimes, you just have to live with things that you don't like because trying to fix them will give you something you like even less. It's time for the inflation nutters to understand and accept that.

In turn, it is also time for those who ignore the Minsky framework for understanding current financial turmoil to quit ignoring his work, getting over their visceral disdain for the man who declared financial capitalism to be inherently unstable. Minsky pointed the corrective finger at high church believers in the efficiency of markets and the rationality of market expectations. And they simply don't like it, even though Professor Minsky passed away over a decade ago.

An important subplot to the Jackson Hole discussions this year was that somehow, the Fed urgently needs to restore a separation between its monetary policy mission and its financial stability mission. In contrast, I'm increasingly convinced that while the two missions can be viewed intellectually as distinctly different, they are in reality forever joined.

Not as much as at present, I certainly hope, but not nearly so separated as many in the Tetons advocated, including some card carrying members of the financial conditions-driven intellectual center. Yes, I'm an equal opportunity chop-buster, not just a critic of the easy-mark inflation nutters. Fortunately, Chairman Bernanke's opening address, a powerful forward looking commentary, not just a retrospective on the last year, suggests that I should exempt him from any chop-busting.

Therefore, I do. Specifically, Mr. Bernanke put squarely on the table the need for "macroprudential" regulatory arrangements, designed to temper the inherent pro-cyclicality of existing regulatory/capital requirement arrangements. If established and successful in implementation, a macroprudential approach would temper the Minsky-esque boom-bust tendencies of banking and the capital markets.
Such an outcome would, in turn, have direct implications for monetary policy. More specifically, if the transmission mechanism between the Fed funds rate, financial conditions and aggregate demand could be made more tightly bound, it would reduce the overall cyclical range the Fed would need to pursue for the Fed funds rate.

Thus, an effective macroprudential supervisory/regulatory approach would tighten the relationship between the Fed's traditional monetary policy mission and its financial stability mission. This outcome would be counter to the consensus view at Jackson Hole, that the two missions should be kept as far apart as possible.

Specifically, here's what Chairman Bernanke said:

"A systemwide focus for financial regulation would also increase attention to how the incentives and constraints created by regulations affect behavior, especially risk-taking, through the credit cycle. During a period of economic weakness, for example, a prudential supervisor concerned only with the safety and soundness of a particular institution will tend to push for very conservative lending policies.

In contrast, the macroprudential supervisor would recognize that, for the system as a whole, excessively conservative lending policies could prove counterproductive if they contribute to a weaker economic and credit environment. Similarly, risk concentrations that might be acceptable at a single institution in a period of economic expansion could be dangerous if they existed at a large number of institutions simultaneously.

I do not have the time today to do justice to the question of the procyclicality of, say, capital regulations and accounting rules. This topic has received a great deal of attention elsewhere and has also engaged the attention of regulators; in particular, the framers of the Basel II capital accord have made significant efforts to measure regulatory capital needs 'through the cycle' to mitigate procyclicality.

However, as we consider ways to strengthen the system for the future in light of what we have learned over the past year, we should critically examine capital regulations, provisioning policies, and other rules applied to financial institutions to determine whether, collectively, they increase the procyclicality of credit extension beyond the point that is best for the system as a whole."

That, my friends, was beautiful music to my Minsky-tuned ears! I've long believed that asset price cycles should have a much greater role in Fed policy than has been the case. Note, I said "asset price cycles," not asset prices. Chairman Bernanke has long advocated that the Fed eschew "targeting" asset prices. I have felt less strongly about that than he has. But with his new advocacy of macroprudential policies aimed at enhancing financial stability, I think we've reached the point where our differences are but noise.

Regulatory arrangements - notably restrictions on leverage, liquidity and capital restrictions - that procyclically turbo-charge asset price cycles are an anachronism that need to be not just re-examined, but fixed. Ben Bernanke just told us that he will be the presiding physician. And I have no doubt that the spirit of Hyman Minsky will be in the re-examination room.

Bottom Line
Jackson Hole is a very special place. And the Kansas City Fed's annual symposium in Jackson Hole is a very special gathering. The Tetons are good for the soul, especially when soul searching for the answers to the critical economic questions of our time. This year, there was no table-pounding consensus as to how to right all that is wrong with the world. Humility, except perhaps for the inflation nutters, was very much on display.

And that is all to the good, I think. Finding the right answers sometimes requires conceding that yesterday's answers were actually wrong. In the money management business, I live with this reality every day. It was good to see those who don't feel similar pains to the wallet to at least feel them to the ego.

The most important conclusion, at least to me, was Chairman Bernanke's open call for a shift to macroprudential regulatory arrangements, not to supplant microprudential regulation, but to enhance it, notably by reducing its procyclical character. The time for such a shift is long, long overdue, as surely Hyman Minsky would agree.

In the fullness of time there does come a time when time is full.

Now is such a time.

The Fannie/Freddie Bailout:
The End of the Beginning of the End

By Michael E. Lewitt

Equity markets are rallying around the world this morning in the aftermath of the U.S. government's seizure of Fannie Mae and Freddie Mac. The rationale for this rally is that the government's open-ended commitment to support these two entities eliminates a huge cloud of uncertainty that was hanging over the markets. Naturally, HCM completely disagrees and believes this bailout is a sign of severe distress in the U.S. and global financial sector. While it provides short-term stability for the mortgage market, the bailout plan requires Freddie and Fannie to severely reduce their mortgage holdings in the future, removing two of the main liquidity engines from the housing market. Markets detest uncertainty, but this bailout leaves huge unanswered questions about how American home ownership will be supported in the future. HCM still expects the Dow Jones Industrial Average to drop below 10,000 and potentially hit 9,000 before the full impact of this credit crisis is felt (i.e. most likely before mid- 2009). The Freddie/Fannie bailout is no reason to become a buyer of stocks except on a very short-term trading basis. This rally will be short-lived. Investors should use it to reduce exposure to financial stocks. Financial institutions' balance sheets are still significantly impaired. A significant part of today's buying will be related to short-covering by hedge funds that have been continually wrong-footed by the direction of the markets this year.

The seizure of Freddie and Fannie is another step on the way to unwinding the biggest credit bubble in history. The liquidation of the Mount Everest of mortgage debt, leveraged loans and other asset-backed securities that are weighing down the balance sheet of paralyzed financial institutions around the world has barely begun. While many of these institutions have reported some of their losses, that is a very different matter than selling these securities. The markets have yet to see the rubber meet the road, so to speak, in terms of buyers and sellers agreeing on clearing prices for these hundreds of billions/trillions of dollars of securities. That is the next step that has to begin to happen for this crisis to begin to work itself out. The American model of debt-engorged free market capitalism is coming full circle and straining under its own weight. Fannie Mae and Freddie Mac were the epitome of the capitalism for-the-poor, socialism-for-the-rich policies that have been pursued by financial authorities in this country. Developed as a public-private partnership, these beasts were neither fish nor fowl.

While their equity was left in private hands and their stock-option incented management teams engaged in accounting fraud, they were able to fund themselves at below-market rates based on an implicit government guarantee of their debt. The U.S. government, particularly Congress, was fully complicit in permitting these companies and their managements to enrich themselves while abusing their unique charters. Apparently the final straw that led to the current conservatorship (translation: nationalization) was the "discovery" by the Treasury's financial advisor, Morgan Stanley, that both agencies were not marking their books properly. The government was shocked, simply shocked to learn that these institutions were gaming the system by overstating the value of their mortgage holdings and delaying the recognition of losses and were in reality insolvent. As Christopher Wood wrote this morning, one of "the long-term consequences of the US Treasury's forced action is to lead to further decline in the moral authority of the US to lecture others on economic matters." The United States has become one big glass house, and it can no longer cast stones at others.

And indeed that is the point that HCM has been making over the past several months. The credit collapse can be laid directly at Wall Street's door. We do not say this because we like sounding churlish, but because what has occurred has real, negative long-term economic and political consequences. The cost of our unwise and corrupt policies has already been very high and it will continue to rise unless we act now to do better. Confidence in the American model of capitalism has been shaken with good reason. Despite the rally of the dollar (mostly against the Euro, another compromised currency), the U.S. currency has been battered largely due to a loss of confidence in American economic policies and leadership. We continue to shift hundreds of billions of dollars out of our own coffers into those of countries that do not share our beliefs because we have moved too slowly to develop sound energy policies. In large part this is because our politicians remain indebted to an automobile industry that is on the verge of insolvency and to an energy industry that places its own interests ahead of the country's and the world's. We have allowed our derivative markets - specifically those related to credit (i.e. credit default swaps) - to grow in a completely unregulated manner to the point where everybody is basically holding their breath and praying that a financial accident won't occur. This has occurred largely because it has been in Wall Street's interest to limit regulation of derivatives. But the time has come to stop allowing the fox to patrol the chicken coop. Just as it was completely foreseeable that Freddie and Fannie would fail, it is a certainty that we will face future crises if we continue to avoid difficult and unpopular choices or refuse to speak truth to power. How many wake-up calls do we need?

Your knowing we are not of the woods by a long-shot analyst,

John Mauldin


John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

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Posted 09-08-2008 8:32 PM by John Mauldin