John Mauldin's Outside the Box : Ben Bernadke

All In

John Mauldin — Tue, 06 Jan 2009 19:34:42 GMT

There is an ongoing debate on the current nature of the economic environment and what should the response be by government. Today's Outside the Box by Paul McCulley takes up one view, arguing that we need a federal response and stimulus package to protect the overall economy and save capitalism from itself. Tomorrow, I am going to send yet another view arguing that by doing so we are hurting the prudent investor and businesses that did not over-leverage and behaved responsibly. Both are important to understand. And as I will argue on Friday in my 2009 Forecast Issue, both are right. And that is one of the great economic paradoxes that we are faced with today. Navigating through this period is particularly challenging, but I think it is critical that you understand what Paul says today and what Bennet Sedacca will say tomorrow. Understanding what is going to happen, whether or not we agree with the philosophy behind it should be our goal, as it will make us better able to respond with our own portfolio and business decisions.

By the way, Paul McCulley, the Managing Director of Pimco, always features a "conversation" he has with his pet rabbit at the end of each year. Not only is it instructive, but it can also be downright funny. I think you will enjoy this letter a lot. And sorry about the Outside the Box coming later this week. We lost power for the day yesterday due to a mild ice storm here in Dallas.

John Mauldin, Editor
Outside the Box

All In

Global Central Bank Focus
Paul McCulley | December 2008/January 2009

(A conversation with Bun Bun, the author's Netherlands Dwarf pet bunny
and early-morning debating partner.)

PMc: Good morning, Bun Bun. Ready for our end of year chin wag?

BB: Again? And the question is not whether I'm ready, but whether you're ready. You're looking haggard, man, like a horse rode hard and put up wet. I never see you anymore, where you been?

PMc: First off, I ain't a horse. But I do catch your drift. As to where I've been, I've told you before: either at work or at my little rental cottage down on the water. I rented it for a weekend getaway, and found the water so soothing to my soul that I essentially live there now. So you got this big house all to yourself, Precious.

Except when my son, Jonnie is home from college, of course. He likes this space more than down on the water, not the least because I'm rarely here, I suspect. But that's only a suspicion. You know anything about that?

BB: Don't act dumb, Mac. He's 19 years old and has more girlfriends than the Fed has special liquidity facilities. Enough said, except that I think he ought to be taxed one fresh head of romaine lettuce for me every time he shows me off to a date. Remember, I just get to live here in your study, while he has roam of the whole house.

PMc: Okay, Okay. I'll work on that for you. Meanwhile, how do you know about all the Fed's liquidity facilities?

BB: Simple. Jonnie explained them to me, telling me the Bank of Ben is now doing for the capital markets what the Bank of Dad does for him: liberal liquidity provisions against all sorts of collateral, including the mere promise to behave in a more socially acceptable and responsible way in the future.

PMc: That's not exactly right, Bun Bun. Well maybe it is with respect to the Bank of Dad, but it is not the case with the Bank of Ben. As a general rule, also called the law of the land, the Federal Reserve is not in the business of lending on a wing and a prayer, but rather good collateral.

BB: You mean like you giving money to Jonnie but taking his iPod and putting it in the desk drawer until he pays you back?

PMc: Sorta like that, but in the case of the Fed, they wouldn't give Jonnie the purchase price of his iPod, but some lesser amount against the re-sale value of his iPod, minus a haircut.

BB: You mean that Ben would make him get a haircut, maybe even a shave, before taking in his iPod as collateral against a loan?

PMc: No, even though that's not a bad idea. In the collateralized lending business, in which the Federal Reserve traffics, a haircut is the margin of safety the lender demands for a loan against the re-sale value of the collateral. In your example, if an iPod cost $200 new and has a secondary market value of $100, the Fed would not even lend $100 against it, but rather some haircutted amount, say $75.

BB: So Ben would take Jon's iPod and put it the drawer, give him 75 bucks, and if he didn't pay off the loan, Ben would sell it for anything greater than 75 bucks, even if it's quoted at 100 bucks today?

PMc: Yep, that's more or less the mechanics of the matter, though to the best of my knowledge, the Federal Reserve has never taken in iPods at its various lending facilities. Very much unlike the Bank of Dad, who is not really in the banking business but the welfare business.

BB: But Jonnie told me that the Fed really can be like you, Mac, lending to anybody against anything with no-recourse, if the Board of Governors declares an emergency. He said something about a section 33. Was Jonnie wrong? You are paying way too much tuition for that fancy college he goes to if they are teaching him stuff that is wrong.

PMc: Jon's answer is not so much wrong as incomplete, similar to his efforts to clean up his room. And it's not section 33; it's section 13(3) of the Federal Reserve Act of 1934 which allows the Fed to lend to anybody, but not against anything.

The Fed can do so only if (1) a super majority of the Board of Governors - not the Federal Open Market Committee, known as the FOMC - declares the need for such lending to be the consequence of "unusual and exigent" circumstances, and (2) such lending is done against collateral that is "indorsed or otherwise secured to the satisfaction" of the Fed's lending officers.

BB: Technical details, I say, Mac. Jonnie was essentially right: if the Fed declares that the stuff is hitting the oscillator, the law allows for the Fed to unplug the oscillator, just so long as it dutifully declares that said oscillator is indeed an oscillator that needs to be unplugged. Jonnie said that's what the Fed has been doing ever since some stern dude named Bear needed a loan against a bunch of iPods with the batteries stripped out of them. Is that true?

PMc: I think perhaps I need to have a conversation with Jon's economics professor, who needs to remember that you are supposed to teach students textbook economics before teaching them real-world economics. But yes, back in March, the Fed invoked Section 13(3), for the first time since it was passed into law in 1934, to make a big loan that it otherwise wouldn't have been permitted legally to make.

But it wasn't to a stern dude named Bear, but rather to a special purpose vehicle, known as an SPV and named Maiden Lane LLC, which was set up to lend against dodgy mortgages previously held by the investment bank named Bear Stearns. The Fed made this loan to facilitate the merger of Bear into a bank named JP Morgan, so that Bear Stearns didn't go bankrupt, blowing the financial system sky high.

BB: All technical details, no? Your boss Mr. Gross is right, you are far too wonkish sometimes. Jonnie had the essence of the transaction down, no? In that case, the Fed's lending principles were similar to those of the Bank of Dad, no?

PMc: What's with all the no's, Bun Bun? You are starting to sound like a lawyer, leading the witness. Jonnie hasn't started dating girls in law school has he?

BB: Not that I know of; he's only a sophomore in college, for goodness sake. Just yanking your chain, Mac. But the way Jonnie explained it to me, the Fed really did do something very novel when it dealt with that Bear oscillator. It put some $30 billion of Bear's dodgy assets into that Maiden Lane thingamabob, telling JP Morgan that it had to stand up for the first $1 billion of losses and that the Fed would stand up for the remaining $29 billion, no recourse to JP Morgan. Is that right?

PMc: Yes, that's right, it was indeed an unusual Fed loan, and the Fed declared that it was, so as to legally be able to make it.

BB: But didn't you say that the Fed must be "secured"? How could making JP Morgan stand up only for the first $1 billion of losses against a $30 billion portfolio of iPods without batteries be deemed a secure loan?

PMc: Enough, Bun Bun, enough. I like your inquisitiveness, but sometimes some things are just best accepted as the way the world works, not how some textbook says it is supposed to work.

You're triggering a memory that goes back some twenty-five years ago, when Paul Volcker was chairman of the Federal Reserve. That was before CNBC, so guys who do what I do, called Fedwatchers back then, had to literally travel to Washington, DC to hear Mr. Volcker deliver the Fed's semi-annual report to Congress.

Some Congressman, whose name I've long since forgotten, was really getting after Mr. Volcker, demanding that he detail something that Mr. Volcker didn't want to detail. So Mr. Volcker took a long draw on his cigar and blew a big fog of smoke and said: "Congressman, we did what we did and we didn't do what we didn't do." And that was that, no more explanation needed.

BB: Hold on here. This Volcker dude was smoking a cigar while testifying before Congress? Was the session held outside?

PMc: No, Princess, it was held in a stately Congressional hearing room. And I was sitting right behind him. Back then, it was not against the law to smoke a cigar indoors, though most considered it impolite.

Even I did, and I rarely begrudge a man a good smoke, because Mr. Volcker's cigars were so cheap that they smelled like burning car seats when he puffed them. But he didn't care. At least not back then. A few years later, he gave up cigars.

But that wasn't my point. While Congress is the legal boss of the Federal Reserve, Congress is a boss with 535 heads, and sometimes the Fed boss simply has to do what he has to do, blowing smoke, literally or metaphysically, after the fact.

BB: So is this what the Fed did in making that funky loan against Bear Stearns' funky assets?

PMc: No, Bun Bun. Well maybe, as the Fed didn't and hasn't disclosed all the details of just how funky the funky stuff was. But the Fed, and especially Chairman Ben Bernanke, made clear to everybody that would - or wouldn't - listen that the Fed was not happy about making that loan, and didn't want to have to ever make such a loan again.

Not that the Maiden Lane loan didn't need to be made at the time, to save the capitalist financial system from its debt-deflationary pathologies. But the loan should have been made by the fiscal authority, not the monetary authority, with express blessing from Congress, who have express blessing from the electorate to do such things. For you see, Bun Bun, if there is the equivalent of the Bank of Dad in Washington, DC, it is supposed to be the Treasury, not the central bank.

BB: All very interesting, very interesting. Is this why the Fed refused to make a loan to that Lee Man chap when he was teetering on the edge of bankruptcy, feeling remorse for having made a loan against that Bear dude's stinky stuff?

PMc: It's Lehman, not Lee Man. And I don't know about any remorse for the Bear loan, Princess. All I know is that the Fed was not happy about it. Thus, when it came time to decide whether to lend against Lehman's stinky stuff, the question became just how stinky it was versus the Bear dude's stuff. Ben and the NY Fed Chief Tim Geithner decided it was just too stinky and took a pass. Or, as Mr. Volcker might have said, they didn't do what they didn't do.

BB: In which case, why didn't the Treasury step up and make the loan? After all, you said the fiscal authority can legally do what the monetary authority can't. Why didn't the Treasury unplug the oscillator, rather than let Lehman go down, effectively turning the oscillator on high?

PMc: Again, we'll never know precisely, Bun. But most fundamentally, the Treasury didn't have the express authority from Congress to do so. At least that is what Treasury Secretary Paulson says, while pounding the table with his shoe, Khrushchev style.

Could he have found some way, say using the Foreign Exchange Stabilization Fund? It's a fund of near $50 billion that the Treasury has Congressional approval to spend, if such spending is deemed necessary to keep the dollar from going wonky. Mr. Paulson later used it to establish a guarantee program for Money Market Mutual Funds. So conceptually, he could have used it to keep Lehman out of bankruptcy. I wasn't there, so I don't know. I certainly would have, but that assertion ain't worth a cup of coffee unless you have 4 bucks to go with it.

BB: So Lehman went down, and as was feared when the decision was made to prevent Bear from going down, the financial system blew sky high?

PMc: I might have been using a bit of hyperbole earlier when I said that, Bun Bun. But your Ockham's Razor conclusion is essentially correct.

BB: Never heard of such a razor, Mac. I think Jonnie uses something called a Gillette when he shaves that scruffy beard off every six weeks. What's an Ockham's Razor and what does it have to do with you becoming a much older man in the 100 days or so since Lehman was consumed by the oscillator?

PMc: Ockham's Razor is not a device for removing whiskers, but rather a mode of logic from the 14th century, defined loosely as cutting away all non-essential arguments when trying to answer a question or solve a problem. Which you just did, wonderfully, Bun Bun, when you asserted that what happened after Lehman went down was exactly what policy makers feared when they prevented bankruptcy for Bear: a systemic lock up of the global financial system.

BB: And out of that lacuna was born the TARP (Troubled Assets Relief Program), which explicitly gives the Treasury the authority and the money to unplug oscillators that need to be unplugged, when the Fed lacks the power to do so?

PMc: Yea verily, I say unto thee, Princess. You are a rather smart rabbit. Lacuna, that's a nice word. I don't recall saying it in front of you before. Where did you learn it?

BB: Looked it up on the web myself, and it precisely defines living in this place, while you live in the cottage. Take a hint, dude.

PMc: Taken. Now back to the matter at hand. The TARP, which Congress fought intensely about, and is still fighting about, given how the Treasury has used it to date, does indeed fill a gap in the federal safety net against systemic risk. It allows the Treasury to go where the Fed can't, literally lending to anybody against anything, or simply injecting equity into anybody against nothing, if necessary to maintain the capitalist financial system as a going concern.

BB: So is it 21st century socialism or welfare? Or is that a difference without a distinction?

PM: Bun, how am I to answer your machine gun questions if you keep answering them yourself? But yes, you've called it what it is. For my taste, I prefer the word socialism, but it does have a kernel of welfare in it, too. Whatever you call it, the TARP is a huge new tool for the visible fist of Treasury to support the invisible hand of capitalism.

BB: A fist, you say? How about calling it the taxpayers providing a hand out?

PMc: Ain't going there, Bun. Wouldn't be prudent, as the current President's father used to say. It is what it is, as everybody seems to say these days, in defense of what is unpalatable, but also necessary.

BB: So, if there was a positive externality of Lehman's demise, it is that policymakers finally found their socialist mojo, putting in place the necessary laws for the government to lever up and risk up its balance sheet more than proportionate to the private sector's new-found proclivity to do just the opposite?

PMc: Nice way to put it, Bun, with the operative phrase being "more than proportionate". That is indeed what is needed to save capitalism from its inherent debt-deflation pathologies. The paradox of deleveraging and the paradox of thrift are beasts of burden that capitalism simply can't bear alone. Only the Minsky Solution can lift that load.

BB: Ah, Minsky. I knew you would get ‘round to him, it was only a question of how long you could restrain yourself. You and I recently talked a lot about Professor Minsky, complete with his Forward Journey, followed by his famous or infamous Moment, followed by his Reverse Journey. But I don't recall talking about his Solution. I know I'm going to regret this, but could you refresh my memory?

PMc: Thank you, Princess, for asking. I'm quite sure a number of those listening in on this conversation similarly share your reservation about letting me loose to pontificate on Minsky. So out of respect for both you and them, I'm going to act on the old cliché that a picture is worth a thousand words, maybe more. Here's a stylized graph, created by my colleague and friend Ramin Toloui, that captures all you need to know about Minsky right now.

BB: You are a kind man, Mac, spoiling me relentlessly. Looking at the graph, which I see starts in 2003, you have the Forward Minsky Journey unfolding, complete with the ever-risky steps from Hedge to Speculative to Ponzi Finance. The Shadow Banking System expands explosively. And then, you have the Minsky Moment in August 2007.

And then you have the Reverse Minsky Journey, as Ponzi Units evaporate, Speculative Units morph after the fact into Ponzi Units, and even Hedge Units take a beating, as the Shadow Banking System contracts implosively. And then the pain stops with this new thing called the Minsky Solution, followed by something called Reflation.

But I don't see a precise date on the graph for when this happens. Are we there yet? Is the pain going to stop? Like, now?

PMc: Nice framing and clearing of the graphic, Bun Bun. Have you been taking an on-line course from Communispond while I haven't been looking?

BB: Nope, I just look up cool words on the computer. You never take me out on the speaking circuit, so I don't need to learn how to dance the Communispond dance steps.

Stop dodging the question, Mac. I presume this Minsky Solution thing is that "more than proportionate" socialist response that we were talking about just a moment ago?

PMc: Precisely - if you weren't a bunny, Bun, I'd call you grasshopper! That is precisely the Minsky Solution: the government not only steps up to the risk-taking and spending that the private sector is shirking, but goes further, stepping up with even more vigor, providing a meaningful reflationary thrust to both private sector risk assets and aggregate demand for goods and services.

BB: Okay, I got it even though I hate the notion of being called a grasshopper. So answer my question, master: Are we there yet? And if so, doesn't that mean that it's now time for all good peoples, and bunnies, to sell their T-bills and canned green peas into cheap corporate bonds and stocks?

PMc: I didn't put a date on that box, Bun, precisely to avoid answering the question as to precise timing. All I can say is that the timing is ripening, with the Fed now committed to an all-in reflationary campaign. This includes not just expanding its lending facilities, but doing so in joint ventures with the Treasury, now armed with TARP money, which can serve as the equity in new SPVs that are essentially government-sponsored Shadow Banks.

The recently announced Term Asset-Backed Securities Loan Facility, known as the TALF, and scheduled to come on in February, is a perfect example of just such a joint venture, with the Treasury putting up $20 billion of equity and the Fed putting up $180 billion of loans senior to the Treasury.

The TALF will effectively step around the risk-adverse commercial banking system and provide warehouse financing directly for securitization of new consumer and business loans to Main Street. It's a really cool innovation, which is likely to be expanded or replicated. And most important, it is likely to get reflationary traction.

The Fed also stands ready to print $600 billion of money to buy directly $500 billion of Agency MBS (Mortgage-backed Securities) and $100 billion of Agency debentures, so as to pull down and hold down long-term mortgage rates. The buying of the debentures is already under way, and the buying of MBS is likely to start in a matter of weeks.

And if necessary, the Fed is openly willing to print money to buy longer dated Treasuries, providing a further downward gravitational force for long-term interest rates. As my friend Colin Negrych argues, and indeed forecast when the rest of the world thought he was nuts, there is nothing like a 2% handle on longer-term Treasuries yields - the credit risk-free benchmark - to make private sector assets more valuable.

BB: But where are Ben's helicopters tossing out money?

PMc: Bun, you know that I don't like references to Helicopter Ben. It's a cheap shot, absolutely a cheap shot, fired by people who haven't bothered to actually read his famous November 2002 speech, when he discussed an anti-deflation technique conceived by the great Milton Friedman - a money-financed tax cut.

That said, it is indeed a fact, a glorious fact, in my view, that the Fed does presently stand ready to print as much money as necessary to accommodate the financing of an all-in reflationary fiscal policy thrust, as promised by President-elect Obama. Through holes in the floor of heaven, Hyman Minsky weeps tears of joy.

Call it good, very good: the monetary and fiscal authorities, separately yet together, going all in. And call me cautiously optimistic that Reflation will get traction.

BB: I hate that phrase, Mac, absolutely hate it. And you're the one that taught me to hate it. What is cautiously optimistic? Either you are or you aren't, no?

PMc: Touché, Bun, touché. With respect to the willingness of policy makers to do the right reflationary thing, we can drop the adverb cautiously. I'm flat out optimistic. But prudence demands that I at least acknowledge that even the best laid reflationary plans might go awry, at least in the short run.

BB: Well if that might happen, how can you call them the "right reflationary thing"? All in means all in, no?

PMc: Yes it does, Bun Bun. But it doesn't mean that all sectors and all companies have to flourish in response. The "right reflationary thing" is a macro concept, not necessarily a micro concept. It doesn't mean extending the soothing socialist hand to every square inch of the capitalist landscape.

The right reflationary thing to do is to systemically save capitalism from its inherent debt-deflationary pathologies, not to eliminate capitalism. Recall, capitalism at its micro core is a process called creative destruction, churning resources from yesterday's technologies and work methods to the more productive ones of tomorrow.

BB: Ok, that makes some sense. In my world, that's called the survival of the fittest. Wouldn't make sense for government to try to overrule that force of nature, I agree. But it would make sense for the government to put out a forest fire that threatened to consume all us creatures, right?

PMc: Nice way to put it, Princess. Very nice! It's a delicate balance.

BB: Thank you. In your world of investing, it seems the analog would be to go long the forest, because the government is going to keep the flames of deflation from burning it down, while taking a selective approach to going long particular creatures. Is that about right?

PMc: Yea verily, I say unto thee again. But with just a slightly finer point on the matter: In order to save the capitalist economic forest, there are certain creatures that the government must necessarily also save. The right investment strategy is to go long both the forest and those creatures.

BB: Fair enough. Now name them!

PMc: We have been publicly naming them for months here at PIMCO, Bun Bun. Well maybe not always particular names, but rather the attributes of those names. The most important is explicit government support, which is most notably the case with the debt issued by banks that get to drink a triple-thick socialist shake: Equity injections from the Treasury, debt guarantees from the FDIC, and access to the munificent liquidity facilities of the Federal Reserve.

BB: But isn't it time to get a little more daring than that? What would be wrong with starting to average into some funds in the major stock and bond indexes, as a play on your thesis that the American capitalist economy is a going concern? Yes, I know that means you would be indirectly going long some individual names that will be on the fatal end of the creative destruction process, but isn't that always the case?

PMc: I can't argue with you, Princess. Your suggested strategy is consistent with the all-in reflationary policy responses. Yet caution is still warranted. I'd tilt it toward corporate bonds over corporate stocks, however, as seemingly little known in the popular press, high grade corporate bonds have, on a risk- and volatility-adjusted basis, been beaten up even more than blue chips stocks this year.

BB: I'm glad you are finally seeing it my way, Mac. Sometimes, you can be so thick, letting the pursuit of the perfect become the enemy of grasping the good. Do some of my trade for the Morgan Le Fay Dreams Foundation portfolio, okay?

PMc: As you wish, Bun. And thank you for honoring her memory and wanting her portfolio to do well. Because by doing well, she can continue to do good, lots of good. With that lovely thought, let's end this chin wag with Morgan's favorite prayer of the season. You have the honors.

BB: Thank you, Paul.

May God bless you and keep you,
May God's face shine upon you
and be gracious to you,
May God lift up his countenance
upon you,
And give you peace.

Paul A. McCulley
Managing Director
December 23, 2008

The Six Lessons from Last Week's Action

John Mauldin — Mon, 01 Dec 2008 22:19:58 GMT

This week we look at a short but excellent summary of the state of the current economic crisis. I always enjoy reading David Rosenberg, the North American economist of Merrill Lynch. He has a no-nonsense style that is refreshing from most mainstream economists. The reality is that things continue to deteriorate. Today's stock market action shows that we are not of the bear market woods just yet. Rosenberg gives us a few reasons why.

John Mauldin, Editor
Outside the Box

The Six Lessons from Last Week's Action

By David Rosenberg, North American Economist,
Merrill Lynch

1) Expect the worst recession in the post-WWII era

First, this is going to be the worst recession in the post-World War II era, in our view. The ECRI leading indicator hit a record low for the fifth week in a row – down to - 29.2 as of the November 21st week versus -28.2 the week before. This index, which leads real GDP by two quarters with a 70% historical correlation, is getting further and further away from the prior all-time low of -19.8 that defined the worst recession of the post-WWII era and saw a six-quarter consumer recession coincide with a 45% peak-to-trough decline in the stock market. Perhaps the fact that this bear market is proving to be even more severe is symptomatic of an economic downturn that will also prove to be deeper and more prolonged. After the flurry of data released just before Thanksgiving, we are now tracking close to a 4.5% QoQ annualized fall in real GDP in 4Q. This would be the largest pullback since the 1982 recession, and we see a similar contraction in the first quarter of 2009.

2) Capex is in a steep decline

Second, capex is in a very steep decline right now. Durable goods orders dropped 6.2% in October, the third decline in a row. Over that time frame, orders have plunged at a 39% annual rate, which is unprecedented. The retrenchment has spread to the tech sector, where order books were expanding at a 7% annualized rate over the three months to June. Currently, that same three-month trend has swung to a negative 13% annualized rate.

3) Consumer spending down sharply; savings rate is soaring

Third, consumer spending fell 1% in October, which was a near-record decline. This, in fact, was the fourth straight monthly decline, which is unprecedented. The savings rate is soaring; it leapt to 2.4% from 1.0% in September, in a sign of heightened risk aversion and cash preservation, and is a shift that we believe should be seen as secular, not merely cyclical.

This was a conclusion that came through loud and clear in the Conference Board's Consumer Confidence Index, principally in the spending intention components of the survey. Auto buying plans dropped for the third month in a row to a record low in October while home-buying plans fell to their lowest level since the 1982 recession. Consumer plans to buy a major appliance fell to a 14-year low as well – down for three months in a row. During this four-month period of unprecedented consumer retrenchment from July to October, spending on discretionary items collapsed at an average annual rate of 18%. Even spending on groceries has declined 6%, toiletries are off by 6% and utilities are down 3%. So, even some of the classic staples are being curtailed.

The only areas that have posted increases in spending over this unprecedented four-month decline in spending have been pharmaceuticals (+7%), telecom services (+3%), medical care services (+5%) and mass transit (+26%) – all other forms of transportation, from rail to bus to air fell at a 19% annual rate.

4) Obama planning a $700 billion fiscal package

Fourth, we learned this week that President-elect Obama's economics team is planning a fiscal package as big as $700 billion over the next two years. We are going to wait for the details to see how this is going to impact our base case macro forecast. Suffice it to say that the cornerstone of the stimulus this time around will likely be infrastructure, not tax rebates. The key for investors is where these outlays will be concentrated, which, in turn, means identifying the areas of the capital stock that have been the most underinvested in recent years. After sifting through the data, we believe that the prime candidates will be hospitals, waste management services and passenger transit.

5) Housing market is not close to bottoming out

Fifth, we learned that the housing market is nowhere close to bottoming out. New home sales dropped 5.3% in November to a 433k annualized rate – the worst since the 1982 recession. Even though sales are now down 69% from the July 2005 bubble peak of 1.39 million units, we believe builders have not been aggressive enough in curbing production because the most critical variable of all, the unsold inventory backlog, rose to 11.1 months' supply from 10.9 in September.

Need to see inventory backlog drop to 8 months' supply

The reality is that even though single-family starts have dropped to 26-year lows of 531,000, they are still running 23% above the prevailing level of new home sales. The worst the inventory-sales ratio ever got in the early 1990s real estate meltdown was 9.4 months' supply. We are currently 18% above that level and almost 40% higher than the 8 months' supply we would need to see before calling an end to the housing deflation phase.

Another 15-20% decline in home prices likely from here

As we saw last week, the Case-Shiller index fell 1.85% MoM or at a 20% annual rate. All 20 cities were down both sequentially and YoY. Home prices are now down a remarkable 22% from the 2007 peaks. With the unsold inventory sitting at the third highest level of the past three decades and mortgage approvals for new home purchases falling to their lowest level in nine years, we believe the laws of supply and demand point to a further 15-20% decline from here. So, of all the things that happened last week in the market, retailing stocks up 17%, the bank stocks up 26%, tech up 9%, the one development that probably has the greatest chance of being reversed is the 60% surge we saw in the homebuilding group.

6) Fed has switched December meeting to a two-day affair

Sixth, we learned that the Fed is going to make the December FOMC meeting a two-day affair instead of one (December 15-16). The market is already sniffing out a 50 basis point rate cut. However, now that the Fed has de facto embarked on the process of quantitative easing, perhaps the need for a two day meeting is to iron out a more aggressive plan to revive the credit markets and the economy. The only areas that have posted increases in spending over this unprecedented four-month decline in spending have been pharmaceuticals (+7%), telecom services (+3%), medical care services (+5%) and mass transit (+26%) – all other forms of transportation, from rail to bus to air fell at a 19% annual rate.

As Chairman Bernanke suggested in several speeches he gave back in 2002 and 2003, one of the deflation-fighting strategies would likely involve Fed action to nurture lower rates at the longer end of the yield curve. Perhaps this prospect is behind the rally in the 10-year note yield and long bond to cycle lows. This would fit in very well with our ongoing strategy of focusing on equity sectors that have income-generating characteristics like utilities, health care and telecom services; these sectors also screen very well in a negative nominal GDP growth environment.

Banking Crises Around The World

John Mauldin — Wed, 01 Oct 2008 16:45:11 GMT

Do government bailouts in times of banking crises work? Philippa Dunne & Doug Henwood of The Liscio Report highlight a major study of 42 fairly recent banking crises around the world. Result? Some types of government intervention works and some don't. One characteristic that is needed though is speed. Dithering, a la Japan, is a recipe for disaster. This is a brief summary of the report (to which they provide a link) and their conclusions as to the basic outlines of what the US should do. Given that Europe is already in the throws of its own bank crisis, and the rest of the world could experience problems, this should be useful reading. They also provide graphs of banking crises and comparisons with developed countries and the resulting market experience.

One major point? This is like the old Fram oil filter commercial line "Pay me now or pay me later." As this study points out, the tax payers and citizens of the US (and the world) are going to pay for this crisis in one way or another. Either a major recession (with high and persistent unemployment), reduced incomes and tax collections or a collective efforts to stabilize the banking system. The costs of inaction are much higher. It is not a matter of cost or no cost. We are going to have to pay in one form or another.

We cannot avoid the costs given where we are today. The time to avoid cost was years ago reigning in Freddie and Fannie and proper oversight of the mortgage industry. We (Congress) missed that opportunity. (Sadly, we are going to re-elect the very leadership to both parties largely responsible for the neglect. There is plenty of blame to go around. No amount of partisan finger pointing by Speaker Pelosi shifts that blame.) However, we can choose the form of the cost will be paid in. Personally, I prefer collective efforts to 10% or more unemployment and the risk of an extended recession and its costs. I know this is not pure free market theory, and sticks in the craw of many of my readers, but when many of my neighbors and friends will be unemployed and businesses are suffering theory will not make a very good meal. Congress must act now. This report is a good reminder of what has worked in the past.

My thanks to Philippa and Doug for allowing me to send this as a Special Outside the Box. You can see their work and blog at http://www.theliscioreport.com.

John Mauldin, Editor
Outside the Box

Banking Crises Around The World

The Liscio Report On the Economy
October 1, 2008

Having rejected Henry Paulson's rescue plan, it's not clear what Congress --or those in the broad population opposed to a "bailout"-- propose to do to keep the financial system from imploding. But a database of systemic banking crises recently assembled by IMF economists Luc Laevan and Fabian Valencia (www.imf.org/external/pubs/cat/longres.cfm?sk=22345.0) provides a useful map of how crises play out and what does and doesn't work.

Laevan and Valencia identify 124 systemic banking crises between 1970 and 2007, and assemble detailed information on 42 of them, representing 37 countries. (Some countries, like Argentina, appear multiple times.)

In almost every case, governments took active measures to mitigate the crisis, so there is no real test of whether rescue schemes actually work; no politician seems willing to face the consequences of letting the chips fall where they may. But the work of Laevan and Valencia does offer some guidance as to what works best.

Dithering Costs

One crucial lesson stands out: speed matters. This is obvious to anyone who followed Japan's dithering in the 1990s; standing aside and hoping the problem goes away is not a good idea. Relatedly, "forbearance" --regulatory indulgence, such as permitting insolvent banks to continue in business-- does not work, as has been established in earlier research. As the authors say, "The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred in the absence of forbearance." This suggests that suspending mark-to-market requirements is not a good idea.

Since forbearance does not work, some sort of systemic restructuring is a key component of almost every banking crisis, meaning forced closures, mergers, and nationalizations. Shareholders frequently lose money in systemic restructuring, often lots of it, and are even forced to inject fresh capital. The creation of asset management companies to handle distressed assets is a frequent feature of restructurings, but they do not appear to be terribly successful. More successful are recapitalizations using public money (which can often be partly or even fully recouped through privatization after the crisis passes); recaps seem to result in smaller hits to GDP. But they're not cheap: they average 6% of GDP, which for the U.S. would be about $850 billion.

Total fiscal costs, net of eventual asset recoveries, average 13% of GDP (over $1.8 trillion for the U.S.); the average recovery of public outlays is around 18% of the gross outlay.

But those who don't want to spend that kind of taxpayer money should consider this: Laevan and Valencia find that "[t]here appears to be a negative correlation between output losses and fiscal costs, suggesting that the cost of a crisis is paid either through fiscal costs or larger output losses." And if the economy goes into the tank, government revenues take a big hit, so what's saved on the expenditure side could well be lost on the revenue side.

Oh, and about half the countries that have experienced crises have had some form of deposit insurance. So merely expanding the FDIC's coverage is not likely to do the trick --and, in any case, it's going to be hard to escape the huge expense of a systemic recapitalization, though using the FDIC might simplify the politics of the rescue.

(A note on the politics of the rescue: an ABC poll shows the public to be far more worried about the economic consequences of the bailout's defeat than Congress seems to be. There's not a lot of enthusiasm for what's seen as handing money over to Wall Street --but if properly structured and sold, say with more cost recovery prospects for the government, more relief for debtors, a rescue is not as unpopular as some would have it.)

Relevant Examples

Most of the countries in the Laevan/Valencia database are in the developing world, and are of questionable relevance to the U.S. But TLR has taken a closer look at four countries that offer more relevant models: Japan, Korea, Norway, and Sweden. Some major stats for the four and the U.S. are in the table at the end of the newsletter, and graphs of some important indicators are there as well.

Sweden, now widely seen as a model of swift, bold action, kept its ultimate fiscal costs relatively low --3.6% of GDP at first, almost all of which was recovered through stock and asset sales-- but was unable to avoid a deep recession. At the other end of the spectrum, Japan, the model of foot-dragging half-measures, saved no money through its procrastination; its fiscal outlay was 24% of GDP, almost none of which was recovered. And it was unable to avoid recession.

Note, though, that some of the worried talk surrounding the financial market impact of bank bailouts looks misplaced, at least on these models. Three years after the outbreak of crisis, inflation was lower and stock prices higher in all four countries, and government bond yields were lower in all but Japan. It's likely that the deflationary effects of a credit crunch outweigh the inflationary effects of debt finance.

Although the U.S. in 2007 had a lot in common with other countries on the brink of a banking crisis, one thing stands out: the depth of the current account deficit. Of the four comparison countries, only Korea comes close to the U.S. level of red ink. The unweighted average current account deficit of the 42 countries in the Laevan/Valencia database was 3.9% of GDP --compared with 6.2% for the U.S. That suggests that the U.S. has more to deal with than just resolving a banking crisis.

A Better Bailout

So, with the modified Paulson plan dead for now, what might a better bailout scheme look like in light of the Laevan/Valencia historical database?

First, it must be adopted quickly. Perhaps operating through the FDIC would be a way to accomplish that, though the FDIC will almost certainly need to have its coffers copiously refilled.

Second, forbearance would be a bad idea; it does no one any good not to face reality.

Third, purchasing bad assets and turning them over to an asset management corporation is not a promising strategy.

Fourth, recapitalizing the banks should be the heart of any policy; as the authors say, it should be selective, meaning supporting those institutions with hope of revival, and letting the terminal go down.

And fifth, targeted relief for distressed debtors, supported with public funds, has also shown success in earlier banking crises, and should be part of any rescue scheme in the U.S. as well.

Crises like this are manageable. They're expensive and painful to resolve, but even more expensive and painful when left to fester.

-- Philippa Dunne & Doug Henwood

Bailout Stats And Graphs

Haste Makes Waste

John Mauldin — Mon, 29 Sep 2008 21:48:06 GMT

The purpose of Outside the Box is to present views which cause us to think through our basic assumptions. This week our old friend Michael Lewitt of Hegemony Capital Management gives us a view as to why the bailout bill going down may not be as bad as I think it might. There is much we agree on, however. And part of our agreement is that a deeper recession is in our future. Let me be clear. Muddle Through is now at risk.

I have talked with my publisher, and for the next few weeks of The continuing Crisis, we are going to send more than one OTB per week, and I may also add some short commentary. These are extraordinary times, and I know a lot of you (as I can tell from phone and emails) are worried and are interested in analysis that is not biased with either a perma-bull or perma-bear stance. I will call it as I see it, as always, and forward you material from my best sources.

That being said, we will get through this, one way or another. Sanity and clarity will return, as it always does after times of crisis. I wish you the best in your situation.

John Mauldin, Editor
Outside the Box

Haste Makes Waste

by Michael E. Lewitt

"Examining the record of past research from the vantage of contemporary historiography, the historian of science may be tempted to exclaim that when paradigms change, the world itself changes with them. Led by a new paradigm, scientists adopt new instruments and look in new places. Even more important, during revolutions scientists see new and different things when looking with familiar instruments in places they have looked before. It is rather as if the professional community had been suddenly transported to another planet where familiar objects are seen in a different light and are joined by unfamiliar ones as well. Of course, nothing of quite that sort does occur: there is no geographical transplantation; outside the laboratory everyday affairs usually continue as before. Nevertheless, paradigm changes do cause scientists to see the world of their research-engagement differently. In so far as their only recourse to that world is through what they see and do, we may want to say that after a revolution scientists are responding to a different world."

Thomas S. Kuhn¹

The problem with trying to legislate in the middle of a revolution is that you aren't sure whether you are governing the world that is being destroyed or the one that is coming into being. There can be little question that the Wall Street that existed at the beginning of this year is no longer the industry that Congress is seeking to rescue from its own excesses. The financial world has been permanently altered by the collapse of the debt bubble that inexorably built up over the past three decades. Now Congress is trying to design a rescue plan for a world whose shape is highly contingent and unstable. Such an undertaking requires more than two weeks of work. Conventional thinking tells us that the government must do something to stabilize the markets immediately, and that doing something is better than doing nothing. Once again, conventional thinking is wrong. Congress would be much better advised to take the extra few days or week it would take to structure a plan that the world is going to have to live with for a very long time. As we were completing this newsletter, the House of Representatives voted down the emergency package and the financial markets are panicking. Such panic is unwarranted. The world should take a deep breath and consider whether defeat of a deeply flawed bill should be treated as a catastrophe or a rallying cry to develop a better plan that addressed the underlying issues that need to be fixed.

The Paulson Plan

HCM has been warning for years that all of the king's horses and all of the king's men wouldn't be able to put this mess back together again. It is now time for America to take the pain and figure out how to move forward. Any plan that is adopted must include a sufficient dose of strong medicine to prevent the culture of self-delusion and moral hazard that created the current crisis from further perpetuating itself. The purpose of the Paulson Plan has to be to rebuild confidence in the financial system. The manner in which the plan was presented and debated rendered that more difficult but hopefully not impossible. For any plan that fails to bring confidence back to the market will not work.

The great economic historian Charles Kindleberger wrote in his seminal study of financial crises, Manias, Panics, and Crashes, that, "[f]or historians each event is unique. Economics, however, maintains that forces in society and nature behave in repetitive ways. History is particular; economics is general."² This is a very important observation. While each financial crisis is unique in terms of its causes and the types of assets that it engulfs, the conditions that led to it are always driven by human irrationality and hubris. Financial busts are preceded by financial bubbles. The current bust was preceded by a debt bubble whose unique manifestations were debt securitization and credit derivatives. Underlying these novel debt structures were the human emotions of greed and fear that led to abuses by even the most sophisticated individuals and most highly respected institutions in the market. While these human attributes are the most difficult to legislate, their ability to wreak havoc is clear evidence that they must be regulated in a thoughtful way.

Recently, former New York Federal Reserve Governor Gerald Corrigan led a group of market experts that released a report entitled Containing Market Risk: The Road to Reform, The Report of CRMPG III (Corrigan III) (August 6, 2008). In that report, Mr. Corrigan and his colleagues wrote the following very wise words:

"The fact that financial excesses fundamentally grow out of human behavior is a sobering reality especially in an environment of intense competition between large integrated financial intermediaries which, on the upside of the cycle, fosters risk taking and on the downside, fosters risk aversion. It is this sobering reality that has, for centuries, given rise to universal recognition that finance and financial institutions must be subject to a higher degree of official oversight and regulation than is deemed necessary for virtually all other forms of commercial enterprise."

What is lacking from the public debate is a serious understanding of the difference between treating the symptoms of the crisis and trying to cure the disease. The disease is a total loss of confidence in the American model of debt-engorged free enterprise, and American economic and political leadership. The cure is regaining that confidence.

In his new book, economic consultant David M. Smick writes,

"the survival of the world financial system depends on an elaborate confidence game. The size of the financial markets, relative to the governments, has become so monstrously huge there is no other means of maintaining stability than to establish a psychology of confidence. The governments themselves cannot by edict restore order. They can only project to the markets a sense that they know what they're doing."³

What Henry Paulson and Ben Bernanke are desperately trying to explain to Congress is that America's leadership must immediately restore the world's confidence in American economic and political leadership. But the Paulson Plan was generated under impossible conditions. Were it to succeed, the best that could be expected at this point is a slow revival of the credit system. To hope for more is sheer folly. It is a certainty that America, and then the rest of the world behind it, is going to experience a severe recession the likes of which it hasn't seen for decades. Frankly, HCM can't see any way that such a slowdown can be avoided, although HCM has some ideas on how to begin to work out of it. Moreover, if by some miracle it were to be avoided, it would merely delay the inevitable purging of the psychological and financial excesses that have been piling up in our economic system over the past thirty years. One of the problems plaguing America is that we have become so frightened of short-term pain that we are willing to risk incalculable long-term suffering. Any plan that treats the symptom (the loss of confidence) and not the disease (the underlying problems that caused the loss of confidence) will not solve the real problem.

At one point during the bailout negotiations, Henry Paulson was seen genuflecting at the feet of House Speaker Nancy Pelosi, a fitting emblem of just how far the credibility of the Bush Administration has fallen.⁴ Earlier policy blunders are now haunting a lame-duck Administration. The Paulson Plan is being pushed with the same kind of urgency that pushed the U.S. to invade Iraq, and the President has no more weapons of mass destruction to sell. There are legitimate fears that anything approaching the Paulson Plan, like the Iraq War, will get quickly bogged down in the complexities and contingencies that will be encountered on the battlefield. Despite the cries of pain from the credit markets, HCM has never believed that the world would spin off its axis if a deal is not rushed to completion in the next few days. A bad deal would be worse than no deal at all.

There is one practical problem that will plague the Paulson Plan and any plan that involves the government purchasing distressed assets from financial institutions. These assets are NOT(!!!) accurately valued on the books of financial institutions.⁵ Accordingly, these institutions are not in a position to sell them to the government at current fair market value. Any sales at current market value would inflict huge losses on these institutions. The alternative is for the government to grossly overpay for these assets, which would constitute a disguised capital infusion into these firms that would short-change the American taxpayer. This flaw in the plan is why members of Congress from both sides of the aisle insisted on some kind of profit-sharing structure that would compensate taxpayers in the event the government pays above-market prices for assets. HCM fears that very little of the $700 billion is going to be spent in the near future because of the reluctance of banks to part with assets at anywhere near their current value, and the government's reluctance to overpay for these assets.

HCM views the Paulson Plan as a matter of form over substance. The details of how the plan will work are ultimately less important than whether the plan succeeds in rebuilding market confidence. In order to be successful, the Paulson Plan needs to be followed up by comprehensive regulatory reform that accomplishes the goals of convincing the public that the financial system will be fairer in the future than it has been in the past (i.e. that the gains will be spread more equitably and that failure will not be rewarded) and that strong steps will be taken to prevent the oversights that led to the current instability from being repeated.

An Alternative Bailout Plan

A successful plan must address the following elements:

Confidence: It must restore market confidence by convincing both Wall Street and Main Street that the government will stand behind the mortgage obligations that are the weakest part of the financial system.
Time: It must provide time for financial institutions to earn profits that can be used to absorb future losses on bad mortgage paper. The primary way financial institutions make money is by borrowing money at one rate and lending it out at a higher rate. The cost of money for financial institutions must be lowered immediately.
Prevention: It must convince both the American people and the global community that the regulatory lapses that allowed this disaster to occur will not happen again, and that the system will be fairer in the future. This is closely tied to the issue of restoring confidence in the markets as well as in American economic and political leadership.

The government's plan must restore market confidence, give companies the time to heal their balance sheets, and prevent a recurrence of the most abject series of regulatory lapses in the history of Western financial markets. For the sake of contributing to the public debate, which will continue even after the initial plan is adopted by Congress, HCM suggests that the government move ahead with the following measures in an effort to restore order and stability to the global credit and financial markets:

The HCM Bailout Plan

The government should announce that it will effectively stand behind the U.S. financial system against failure through some sort of guarantee or insurance program. The government has already done this with respect to money market assets.
Mark-to-market accounting for financial institutions should be suspended for an indefinite period. Since nobody knows what these assets are worth, we should not drive the system into insolvency trying to place a value on assets that nobody is willing to purchase at the current time.
The Federal Reserve should reduce the overnight interest rate by 75 basis points immediately. This will allow financial institutions to begin to earn more on their assets, which will begin the process of rebuilding their balance sheets.
The Securities and Exchange Commission should announce the formation of a study group that will report back no later than December 31, 2008 on a comprehensive regime for regulating the credit default swap market.

As noted above, HCM is concerned that the plan to purchase mortgage assets from financial institutions will not produce the intended results because of the difficulty of reaching agreement on price without inflicting too much further damage on the sellers' balance sheets. That is why we favor a guarantee or insurance program rather than the Paulson proposal.

Will The Paulson Plan Work?

The American taxpayer is going to suffer economically whether the Paulson Plan, or some variation on it, is passed or not. HCM does not believe for a second that taxpayers will profit from this bailout as some prominent commentators are arguing. The assets that are clogging bank balance sheets are highly complex and illiquid, and the time required for them to return to any reasonable value will consume their recovery value in present value terms. Nonetheless, voices considered wiser than ours are touting the plan as a good deal for the American taxpayer.

Bill Gross of PIMCO, for example, has argued that taxpayers could profit from the $700 billion plan put forth by the Bush Administration. According to Barron's, Mr. Gross "estimates that the average price of distressed mortgage debt that will pass from troubled financial institutions to Treasury will be about 65 cents on the dollar, representing about a one third loss for the seller from face amount. Financed at 3% to 4% by the sale of Treasury debt, Treasury will be in a position to earn a positive carry, or yield spread, of at least 7% to 8% on the purchases, even after taking into account severe assumptions of default rates and foreclosure recoveries."⁶ Mr. Gross to his great credit has offered PIMCO's services to the government gratis in this endeavor (provided his competitors do the same). In PIMCO's hands, he argues, the government will get a fair deal for the assets it buys. "'The prices that Treasury will get will be somewhere between par, which of course might screw the taxpayer, and a fire sale price of, say, 20 cents on the dollar, which would likely bankrupt some weak institutions and defeat the purpose of the bailout.'"

We think Mr. Gross is unduly optimistic from a couple of standpoints. First, he appears to be assuming that virtually all of the assets that the government will be purchasing will be AAA-rated mortgage securities, since these are the only mortgage securities trading remotely close to 65 cents on the dollar today. Unfortunately, many of the securities that are weighing down the balance sheets of financial institutions carry lower ratings, and many AAA-rated tranches are trading at well below 65 cents on the dollar today. (We would note that the Federal Reserve had already agreed to take onto its balance sheet much lower rated collateral, including equities, in order to support these same financial institutions.) Current trading prices may be unduly depressed by speculative shorting of the ABX indices as well as crisis conditions in the marketplace, but by all accounts AAA-rated tranches of 2006 and 2007 vintage collateralized mortgage obligations are deeply distressed due to inordinately high levels of defaults in the underlying pools of mortgages. While current prices may reflect unrealistically pessimistic projections of future mortgage defaults, the fact remains today's prices are today's prices. If the government pays more for these securities, it will be giving the seller a windfall. Mr. Gross's scenario glosses over this dilemma, which lies at the heart of why the Paulson Plan is unlikely to yield rapid progress in moving troubled assets off bank balance sheets.

Second, we have yet to see the non-financial economy bear the full brunt of the collapse of the financial economy. Main Street is only starting to pay for the sins of Wall Street. The stock market remains in deep denial about the scope and depth of the economic slowdown this country is about to face. As the consequences of tighter credit seep into the mainstream of the American economy, there is every reason to expect that mortgage default rates will rise and home prices will continue to fall, further depressing the value of the mortgage securities that the government is supposed to be purchasing under the Paulson Plan. We wish we could share Mr. Gross's optimism, but we question whether deep in his heart he isn't trying to use his bully pulpit to talk up the market.

Japan Redux?

One of the tough questions that deserve to be asked in the wake of the U.S. government's bailout of the U.S. finance industry is whether American prosperity of the 1990s and 2000s was as illusory as Japanese prosperity of the 1980s? Just as Japan's prosperity was based on a rigged economic system constructed out of a cheap currency, cross-ownership of institutions and a nonmark-to-market accounting system, America's recent prosperity was also built on a cheap dollar, a non-mark-to-market accounting system, and an addiction to debt. While this comparison can be debated endlessly, and will likely be the subject of many scholarly articles and books, the real question is whether the United States will suffer anything like the "lost decade" that haunted Japan (actually, it has been almost two "lost decades"). There are significant differences between Japan and the United States (the most troubling, perhaps, being that Americans do not possess nearly the savings that the Japanese did entering their difficulties), but the question will gain more attention in the coming months.

While it is too soon to make any judgments that far into the future, America is certain to see very slow economic growth in the immediate future. The world's only superpower may see its first trillion dollar deficit within the next couple of years, although Washington will try to dress up the number to keep it under thirteen figures (an unlucky number in too many ways to count). That alone should be sufficient to knock down American hegemony a further peg or two. Such a deficit will contribute to a further debasement of the U.S. dollar against Asian currencies and the Swiss franc.

The primary reason why economic growth is going to be sluggish is that credit is going to be strictly rationed for the foreseeable future, which means that only the most creditworthy borrowers will be able to access capital at a reasonable cost. Companies that need capital will be the ones that find capital most difficult and expensive to access. This means that many companies will have to pay exorbitant rates to borrow, and many highly leveraged companies that have to borrow will be forced into bankruptcy or capital restructurings in order to do so. Many leveraged companies are already drawing down their revolving credit lines before their banks withdraw them. General Motors was the most prominent company to have done this recently, but HCM is seeing this occur throughout the corporate credit market.

American Oligarchy

One of the most discouraging parts of the debate over the Paulson Plan was the discussion about limiting executive compensation for those firms that might benefit from the plan. While trying to help rebuild confidence in American capitalism, Mssrs. Paulson and Bernanke tried to convince Congress that bank executives would prevent their institutions from participating in the bailout if it meant that their compensation would be capped. One would think, as the financial system teeters on the brink of collapse, that the Secretary of the Treasury and the Chairman of the Federal Reserve could make a more persuasive argument than one that poses the likelihood that corporate executives would knowingly violate their fiduciary duty and refuse to participate in a plan to rescue the financial system because it might limit their compensation. If troubled financial institutions are going to be run by individuals who would conduct themselves in such a manner, there isn't much hope that any plan is going to work. The mentality that led two of our best and brightest public officials to attempt to defend the kind of avaricious conduct that played a central role in the current crisis is something that must be changed if we are to avoid future market crises.⁷

This brings HCM to two related areas that need to be legislated immediately: financial institution leverage; and the taxation of highly compensated financial executives. There is a point when free enterprise tips over into a degree of economic and social inequality that is politically unacceptable, and the United States has reached that point. HCM is well aware that its views on this topic genuinely anger many of its readers, but this is an issue that must be addressed as an essential component of any program that will return confidence to the financial system. Free market economic policies, in particular tax policies, have led to the creation of an American oligarchy whose wealth and power is excessive. While not as pernicious as the oligarchy that rose from the ruins of the Soviet Union and now lords over Russia and spends its money garishly over the world, an American oligarchy has unduly benefitted from ill-advised tax and economic policies and must be reigned in as a sign to Main Street that the game will no longer be rigged against it.

We do not believe it is presumptuous to state that the debate over whether Wall Street firms were too leveraged is over. The decision by Goldman Sachs and Morgan Stanley has decidedly ended the leveraged investment banking model that brought down Bear Stearns, Lehman Brothers and Merrill Lynch. The profits that Wall Street generated over the past few years were not the result of some new-found genius in the executive suites, but were merely the product of adding unprecedented amounts of leverage to balance sheets. Unfortunately, compensation schemes did not take into account the fact that adding leverage is far different than adding value (i.e. compensation schemes were not properly risk-adjusted). As a result, compensation structures for these executives were largely asymmetrical, particularly with respect to the portion of their pay that was distributed in cash. Multimillion dollar cash payments for profits earned in a single year were not subject to being repaid if losses in later years wiped out those earlier profits. Too much cash exited these firms each year in the form of compensation, significantly weakening their capital bases. Fortunately, a significant amount of compensation was also paid in stock, which did not weaken these firms' balance sheets but still failed to instill sufficient caution in management when it came to assuming balance sheet risk.

In addition to the gargantuan amounts of compensation being paid out, the taxes paid on these amounts continued to drop over recent years. This is a result not only of reduced taxes on capital gains and dividends, which are only good economic policy up to a point, but on tax deferral schemes and other aggressive tax stances taken by corporate, private equity and hedge fund executives to reduce their taxes to unconscionably low levels.⁸ Private equity managers, for example, are able to treat their "carried interests" as capital gains and pay taxes at only a 15% rate. Yet these earnings are no less the product of their labor than a teacher's or a policeman's earnings are a result of his or hers. Last year, several private equity billionaires actually had the gall to lobby on Capitol Hill to retain the 15 percent tax rate on their "carried earnings." These individuals argued that if their taxes were raised, they would no longer be willing to take the kinds of business risks that lead to new job formation and economic growth. Attempts to require these over-indulged [fill in the blank]⁹ to pay the same taxes on their income as ordinary Americans were derailed in what must go down as one of the most cynical lobbying efforts in history. It would be one thing if private equity firms were funding innovation and job creation, but in the last few years they have done little more than use cheap financing to engage in speculative transactions that generate fees for themselves and what are going to turn out to be at best mediocre returns for their investors.

Hedge fund managers play their own games. The most popular tax reduction technique among this crowd is the formation of offshore trusts that enable them to defer their management and performance fees for periods as long as ten years. A ten year deferral of taxes reduces the effective tax rate paid on these managers' already huge earnings to virtually zero on a present value basis while they continue to enjoy the ability to profit from investments in America's (once) free markets. This tax deferral scheme, which comes in a number of variations, further separates the interests of those hedge fund investors who are paying taxes on their income from those of managers who are not. (Of course, investors don't mind as long as they are making money. Investors never mind as long as they are making money. That's the problem.) As one memorable television commercial put it, "it's not what you earn, it's what you keep." And hedge fund managers have figured out how to keep virtually everything for themselves. Now that the bloom has come off the rose for many hedge fund strategies, investors are going to discover just how one-sided was the deal they made with their managers. Redemption requests from hedge funds are expected to reach epic levels this year, yet many investors are going to be greeted with the unhappy news that they can't get their money back right now (or anytime soon) because it is stuck in illiquid, hard-to-value investments. Others will be told that it would be unwise for their funds to liquidate positions to meet redemptions in the middle of a financial crisis, failing to be informed of the likelihood that many of these securities will most likely be worth less in the future.

Fairly taxing the upper 1/10 of 1 percent isn't going to plug the gaping U.S. budget deficit, but it will go a long way to returning a sense of fairness to a system that has lost its moral compass.

Footnotes:

1 Thomas S. Kuhn, The Structure of Scientific Revolutions (Chicago: University of Chicago Press, 1962), p. 111.

2 Charles Kindleberger, Manias, Panics and Crashes A History of Financial Crises (New York: Basic Books, 1989), p. 16. This book should be required reading in Congress.

3 David M. Smick, The World Is Curved (New York: Penguin Group (USA) Inc., 2008), p. 23. Not that we need more things to worry about, but Mr. Smick also makes a compelling case for why we should be concerned about China's future economic stability in the near future.

4 According to The New York Times, September 26, 2008 ("Day of Chaos Grips Washington; Fate of Bailout Plan Unresolved", p. A1)"n the Roosevelt Room after the session, the Treasury secretary, Henry M. Paulsen, Jr., literally bent on one knee as he pleaded with Nancy Pelosi, the House speaker, not to withdraw her party's support for the package over what Ms. Pelosi derided as a Republican betrayal." Nothing else has worked, so why not try this?

5 Although in fairness all the blame for this can't be placed on these institutions. There is currently no market for many of these assets and placing a value on them would be an arbitrary exercise. This is why mark-to-market accounting should be suspended for an indefinite period of time.

6 Barron's, September 29, 2008, "Making A Mint," p. 30.

7 There were unconfirmed media reports late last week that certain Wall Street firms were marketing products to hedge funds that were designed to avoid the restrictions on short selling that were imposed by the Securities and Exchange Commission. Whatever one thinks of the short-selling restrictions, which were far from optimal, the prospect of financial institutions trying to circumvent them suggests that even the biggest financial crisis since the Depression has been insufficient to instill good judgment into some of those in positions of responsibility on Wall Street. Anti-fraud rules are designed, among other things, to prevent individuals from doing indirectly what they can't do directly. Gaming the short-selling restrictions would be a perfect opportunity to teach somebody a lesson that there are things more important in this life than making money.

8 It would not seem unreasonable, particularly during a period when the government is going to be starved for revenue, to impose a higher capital gains tax of 20% or 25% at significantly higher levels of gain, so that a taxpayer would pay 15% on the first $1 or $2 million of gain and the higher rate on gains over that amount. In general, however, lower capital gains rates stimulate economic growth and should be maintained. Dividend tax rates should be maintained at very low levels since these earnings are already taxed once at the corporate level.

9 HCM always likes to identify cultural images that capture the spirit of the times. There is currently an exhibition of modern sculpture called "Beyond the Limits" being held in the gardens of Chatsworth House, home to the Duke and Duchess of Devonshire, in England. One of the works on display is entitled "Planet" by Marc Quinn; it is a giant white sculpture of a baby lying/floating on its side. "Planet," which belongs more to the category of stunt or spectacle than art, seems to be a perfect emblem of these private equity chieftains groveling for tax relief from our elected officials (although the baby is not sucking its thumb). To view "Planet" on-line, see www.chatsworth.org.

This Crisis Is Not Over

John Mauldin — Tue, 09 Sep 2008 01:32:47 GMT

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 (www.pimco.com). The second is a quick shot by Michael Lewitt of Hegemony Capital Management on the Freddie and Fannie nationalization (www.hcmmarketletter.com). 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.

Macroprudential
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

The Paradox of Deleveraging

John Mauldin — Mon, 28 Jul 2008 18:57:16 GMT

I have often commented about the problem of personal savings. We worry about the lack of savings here in the US, but many do not understand that if everyone started to save 5% of there income immediately that it would seriously impact consumer spending, pushing the US into a recession. It is a paradox, as Paul McCulley points out, that what may be good for the individual may not be good for the collective country.

And in this week's Outside the Box, good friend and this week's Maine fishing buddy Paul McCulley writes about another paradox called the Paradox of Deleveraging. This Paradox is at the heart of the credit crisis. Many of you will not like his conclusions, as it calls for the government to step into the breach created by the problem he describes. But as I often point out, the purpose of Outside the Box is to make us think about ideas which may not be in our usual sources of information. Paul is the Managing Director at PIMCO, the world's largest bond manager. (www.pimco.com for more information.)

John Mauldin, Editor
Outside the Box

The Paradox of Deleveraging

By Paul McCulley

Back in college, most of us took microeconomics before we took macroeconomics. In fact, at Grinnell College where I went, microeconomics was a prerequisite for macroeconomics. The reason was simple: microeconomics begins with the concepts of supply and demand, an essential starting point for the study of macroeconomics. But you only know you've mastered both when you intuitively grasp that macroeconomics is not just the summation of microeconomic outcomes, but rather the interaction of microeconomic outcomes.

For me, a simple concept brought this realization: the paradox of thrift. For those of you who might not recall, the paradox of thrift posits that if we all individually cut our spending in an attempt to increase individual savings, then our collective savings will paradoxically fall because one person's spending is another's income – the fountain from which savings flow.

This principle is part of a whole range of macroeconomic concepts under the label of the paradox of aggregation: what holds for the individual doesn't necessarily hold for the community of individuals. Understanding this paradox is absolutely vital to understanding macroeconomics and even more so to understanding what is presently unfolding in global financial markets.

Double Bubbles Bust

Once the double bubbles in housing valuation and housing debt burst a little over a year ago, everybody, and in particular, every levered financial institution – banks and shadow banks alike – decided individually that it was time to delever their balance sheets. At the individual level, that made perfect sense.

At the collective level, however, it has given us the paradox of deleveraging: when we all try to do it at the same time, we actually do less of it, because we collectively create deflation in the assets from which leverage is being removed. Put differently, not all levered lenders can shed assets and the associated debt at the same time without driving down asset prices, which has the paradoxical impact of increasing leverage by driving down lenders' net worth.

This process is sometimes called, especially by Fed officials, a negative feedback loop. And it is, though I prefer calling it the paradox of deleveraging, because the very term cries out for both a monetary and fiscal policy response, not just a monetary one. Lower short-term interest rates via Fed easing are, to be sure, useful in mitigating deflating asset prices, particularly if they serve to pull down long-term rates, which are the discount rates for valuing assets with long-dated cash flows.

But monetary easing is of limited value in breaking the paradox of deleveraging if levered lenders are collectively destroying their collective net worth. What is needed instead is for somebody to lever up and take on the assets being shed by those deleveraging. It really is that simple.

Time to Lever Up Uncle Sam's Balance Sheet

As Keynes taught us long ago, that somebody is the same somebody that needs to step up spending to break the paradox of thrift: the federal government, which needs to lever up its balance sheet to absorb assets being shed through private sector delevering, so as to avoid pernicious asset deflation. That's a fiscal policy operation and, fortunately or unfortunately, fiscal policy is not made by a few learned technocrats above the political fray of the democratic process, but is squarely in the hands of the legislative branch, consisting of 535 politicians, with far more lawyers than economists among them.

Yes, I know that Congress passed a properly Keynesian stimulus package earlier this year, the benefit of which we are feeling now, sending over $100 billion in rebates to the citizenry, borrowing the money to do so and levering up the Treasury's balance sheet with debt in an equal amount. So, yes, I may be too harsh when I challenge the economic literacy of Congress: they do understand that Uncle Sam should borrow and spend, directly or indirectly through tax rebates to citizen spenders, to truncate the paradox of thrift (even if they don't know what that is).

But levering up Uncle Sam's balance sheet, to buy assets to break asset deflation resulting from the paradox of deleveraging still seems to be a foreign, if not a sinful proposition. This need not be, and should not be. Yet we hear endlessly that any levering up of Uncle Sam's balance sheet to buy assets must be done in a way that "protects tax payers." By definition, levering Uncle Sam's balance sheet to buy or guarantee assets to temper asset deflation will put the taxpayer at risk – but will do so for their own collective good!

This was defacto what the Federal Reserve did when it put up $29 billion on nonrecourse terms to buy assets so as to facilitate the merger of Bear Stearns into JPMorgan. As I said at the time, and wrote about two months ago, this was a fiscal policy operation, conducted by the Fed. Logically, it should have been conducted by the Treasury using appropriated spending power from Congress. But alas, that "right" solution was not legally available to the Treasury, whereas the Fed did have the power to act: Section 13(3) of the Federal Reserve Act of 1932 gave the Fed the power to lend to essentially anybody against any collateral, so long as it declares it is necessary to do so because of "unusual and exigent circumstances."

But make no mistake, it was a fiscal policy action demonstrated by (1) the fact that the Fed sold a similar amount of Treasuries from its portfolio, increasing the supply of Treasuries in the market by the same amount, and (2) the fact that any losses the Fed experiences on that $29 billion will reduce dollar-for-dollar the amount of seigniorage profits that the Fed remits to the Treasury. At the end of the day, there are $29 billion more Treasuries on the open market than otherwise would be the case, and the Treasury is, one small step removed, on the hook for any losses the Fed experiences on the $29 billion of non-Treasury assets it now de facto owns.

Yes, that $29 billion is actually a loan to a Limited Liability Corporation (LLC) set up to hold the Bear assets, with JP Morgan providing a $1 billion subordinated loan (sometimes called the "first loss" tranche) to the LLC. But that is merely a technical detail – the bottom line is that we the taxpayers bought $29 billion of Bear's assets.

To their credit, legislators did figure that out – albeit after the fact. And they were none too happy about it, despite accepting the Fed's and Treasury's logic that it simply had to be done, for the greater good of the citizenry. Legislators rationally guard their constitutional powers over the federal purse.

And Now to Freddie and Fannie

Which brings us to Mr. Paulson's request to Congress to give him – and his successor – the power to spend unlimited amounts of taxpayers' funds to buy the debt or equity of Fannie Mae and Freddie Mac. I confidently predict that he's not going to get unlimited authority; it will most likely be checked by counting any such deficit-financed injections into Fannie and Freddie against the Treasury's statutory borrowing limit, which can be lifted only by Congress. But Mr. Paulson is going to get most of what he wants, if only because legislators are too fearful of the consequences if they stiff arm him.

Between now and then, the Federal Reserve stands ready to lend to Fannie and Freddie, again using Section 13(3) as its enabling authority. But unlike the case with the $29 billion spent for Bear's assets, any Fed lending to Fannie and Freddie is explicitly being billed as a "bridge" to Treasury lending or investing in the agencies. This is the way it should be: bailouts and backstops with taxpayer funds should be legislated by Congress and placed on the Treasury's, not the Fed's, balance sheet.

In fact, I envision that legislation will explicitly direct the Treasury to "buy out" any lending that the Fed does to Fannie and Freddie. Indeed, in what might be a bit of wishful thinking, I believe it would be highly appropriate for Congress to authorize the Treasury to buy out the Fed's $29 billion loan to the LLC holding Bear's assets, putting it on the Treasury's balance sheet, where it belongs.

Section 13(3) should be used only when it is absolutely necessary to avoid systemic financial turmoil. That's not to say that the Fed shouldn't be cooperative in any necessary bailouts or backstops. The fact of the matter is that the Fed is the only entity in Washington able to spend money without prior Congressional approval. Thus, when the stuff is truly hitting the systemic oscillator, the Fed has to unplug it.

But Section 13(3) should be considered sacred, used only in extremis, so as to ensure the Fed's operational monetary policy independence in the pursuit of sturdy growth and low inflation. It's never been a good idea to have the monetary authority and the fiscal authority housed under the same decision-making roof.

That's not to suggest that there is no room for coordination between the monetary and fiscal authorities. This is particularly the case when the economy is experiencing asset deflation, begetting debt deflation and deleveraging. Indeed, none other than Chairman Bernanke made this case when he was Governor, first in November 2002 in his famous speech titled "Deflation: Making Sure 'It' Doesn't Happen Here", and then in May 2003, in a speech titled "Some Thoughts on Monetary Policy in Japan".

In the first speech, the economic menace at hand was the risk of goods and services price deflation in the United States; in the second speech, the menace was the reality of goods and services price deflation in Japan. Currently, in the United States, asset price deflation is the menace at hand, not goods and services price deflation.

But make no mistake, asset price deflation can be every bit as nefarious as goods and services deflation. Indeed, asset price deflation in the context of deleveraging is, in my view, much more nefarious than modest goods and services price deflation, since asset price deflation undermines the capital base of levered financial intermediaries, begetting yet more deleveraging and further asset price deflation.

Harkening back to those two speeches from Mr. Bernanke, it is very clear that he sees the role of the central bank as different in deflationary times than inflationary times. Specifically, in the speech on Japan, he said (my emphasis):

The Bank of Japan became fully independent only in 1998, and it has guarded its independence carefully, as is appropriate. Economically, however, it is important to recognize that the role of an independent central bank is different in inflationary and deflationary environments. In the face of inflation, which is often associated with excessive monetization of government debt, the virtue of an independent central bank is its ability to say "no" to the government. With protracted deflation, however, excessive money creation is unlikely to be the problem, and a more cooperative stance on the part of the central bank may be called for. Under the current circumstances, greater cooperation for a time between the Bank of Japan and the fiscal authorities is in no way inconsistent with the independence of the central bank, any more than cooperation between two independent nations in pursuit of a common objective is inconsistent with the principle of national sovereignty.

Again, I'm aware that he was speaking in the context of both goods and services price deflation and asset price deflation in Japan, not just asset price deflation. So the parallel is not complete with current circumstances in America, which involves elevated goods and services inflation in the context of asset price deflation.

In fact, I believe the Fed faces a more daunting challenge now than the Bank of Japan did back then, in that the Fed has to balance the risks of both goods and services inflation and asset price deflation, whereas the Bank of Japan did not have to do so. Put differently, Japan faced both the paradox of thrift and the paradox of deleveraging, screaming for the Bank of Japan to subordinate itself for some time to the fiscal authority. This is not the case now in the United States, which is experiencing only the paradox of deleveraging, not the paradox of thrift, though the latter malady is certainly a fat tail risk if the former malady is not ameliorated, notably in house prices.

Bottom Line

Conventional wisdom holds that when an economy faces a paradox of private thrift, it is appropriate for the sovereign to go the other way, borrowing money to spend directly or to cut taxes, taking up the aggregate demand slack. Indeed, that is precisely what Congress did earlier this year, sending out $100+ billion of rebate checks, funded with increased issuance of Treasury debt. Good ole fashioned Keynesian stuff!

Concurrently, conventional wisdom is struggling mightily with the notion that when the financial system is suffering from a paradox of deleveraging, the sovereign should lever up to buy or backstop deflating assets. But analytically, there is no difference: both the paradox of thrift and the paradox of deleveraging can be broken only by the sovereign going the other way.

Fortunately, Congress is finally grappling with this reality, as it moves towards passage of Mr. Paulson's plan for backstopping Fannie and Freddie with taxpayer funds. It's not a fun thing to do, particularly following the use of $29 billion of taxpayer funds to facilitate the merger of Bear Stearns into JPMorgan. But it is the right thing to do. And it is further the right thing that Congress is doing it, not the Fed under Section 13(3), except as a possible bridge to Treasury authority.

Words From The Wise

John Mauldin — Mon, 21 Jan 2008 22:13:23 GMT

This week we do something a little different in our Outside the Box. Every weekend I get a very information-filled blog called Investment Postcards from Cape Town ( http://www.investmentpostcards.com ) by Dr. Prieur du Plessis. In it he highlights what...(read more)

The Next Dominos: Junk Bond And Counterparty Risk

John Mauldin — Mon, 26 Nov 2007 21:49:00 GMT

The subprime problem, we were told, would not spread to other markets. It would be "contained." And it has, according to Jim Grant. He quipped last week that it has been contained on planet Earth. The risks coming from rising defaults in the...(read more)

Yield Curve Conundrum

John Mauldin — Tue, 14 Feb 2006 03:55:00 GMT

Introduction Every month I read the outstanding commentary by Bill Gross, Paul McCulley and others at PIMCO. This month they have comments by Chris P. Dialynas, Managing Director, Portfolio Manager and Senior Member of PIMCO's Investment Strategy...(read more)

John Mauldin's Outside the Box : Ben Bernadke

All In

All In

The Six Lessons from Last Week's Action

The Six Lessons from Last Week's Action

1) Expect the worst recession in the post-WWII era

2) Capex is in a steep decline

3) Consumer spending down sharply; savings rate is soaring

4) Obama planning a $700 billion fiscal package

5) Housing market is not close to bottoming out

6) Fed has switched December meeting to a two-day affair

Banking Crises Around The World

Banking Crises Around The World

Dithering Costs

Relevant Examples

A Better Bailout

Bailout Stats And Graphs

Haste Makes Waste

Haste Makes Waste

The Paulson Plan

An Alternative Bailout Plan

The HCM Bailout Plan

Will The Paulson Plan Work?

Japan Redux?

American Oligarchy

This Crisis Is Not Over

In the Fullness of Time

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

The Paradox of Deleveraging

The Paradox of Deleveraging

Double Bubbles Bust

Time to Lever Up Uncle Sam's Balance Sheet

And Now to Freddie and Fannie

Bottom Line

Words From The Wise

The Next Dominos: Junk Bond And Counterparty Risk

Yield Curve Conundrum

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