Wednesday, September 21, 2011

"The Twist:" Ben Bernanke channels his inner Vincent Vega

I ain't saying it's right. But you're saying a the twist don't mean nothing, and I'm saying it does. Now look, I'm giving 400 billion bonds 400 billion  duration shifts, and they all mean something. We act like they don't, but they do, and that's what's so fucking cool about them. There's a sensuous thing going on where you don't talk about it, but you know it, the Christine Lagarde knows it, fucking BofA shareholders know it, and Rick Perry should have fucking better known better. I mean, that's the  fucking term structure, man. I can't be expected to have a sense of humor about that shit. You know what I'm saying? -Ben Bernanke in the todays Fed announcement.

Quite an action packed day today was. Today we got a large stock market move lower, down about 3%. This was driven by three news items.

First of all this morning existing home sales were released and the numbers were better than economists expected: 5.03 million vs. an expectation of 4.75 million. Most of the data out of the housing market has been pretty abysmal lately so the markets took this with a grain of salt.

The second most important thing to happen today was that Wells Fargo and Bank of America both had their ratings cut by Moodys to below AA. Though something along these lines was expected it was still a big deal. The reason that its a big deal is that BofA and Wells Fargo are two of the four largest banks in the country. With the other large banks they have been struggling to recover from the near death experience that the financial system underwent in 2008. Yes they have paid back their TARP funds and have more or less returned to profitability but there remains a huge overhang of sketchy real estate loans on their balance sheets. There has been a lot of speculation as to what these balance sheets are worth and generally the markets have their doubts which is why the financial sector has taken a beating all summer.

There are only two ways for the balance sheet problem to be fixed, one is for the assets in question (US residential real estate) to recover significantly enough to remove the cloud of doubt as to what the true value of the balance sheets are. Today's ray of sunshine notwithstanding the markets are not too optimistic about this scenario. The other is to earn their way out, that is, if they earn enough money so that they can fill whatever balance sheet hole there is with their profits then they'll be fine. The problem with the downgrade is that it will seriously impair their ability to make money.

Remember all a bank does is borrow money from savers and lend it to borrowers. What money they don't borrow from depositors they borrow from other institutions at what is usually called LIBOR (The London Interbank Offered Rate. Believe it or not this was invented by the Soviet Union when they refused to hold their Marshall Plan Aid in US banks and so deposited it in London and the London banks had to figure out a generic interest rate to pay the Russians. Thus the offshore interest rate for US dollars was born and has been called LIBOR ever since.) This is the rate at which banks generally lend to each other and the credit rating for LIBOR is generally assumed the credit rating is AA. Now BofA can't borrow at LIBOR any more, it has to pay more. So therefore in the interbank lending market BofA's costs of funds are higher. Interest costs are the most important factor in bank profitability so losing their AA rating instantly means that they'll be less profitable and therefore it will take them longer to close the balance sheet hole.

Interestingly one of the reasons that Moodys lowered the rating was that they felt that the US government is less likely to bail out a troubled financial institution than it was in 2008 because there is less risk of contagion. Since these banks were, formerly, considered too big to fail they're correspondingly riskier. This is interesting considering the high adventure going on in the European banking system right now. If there is a Eurozone sovereign default then there will almost instantly be a MAJOR European banking crisis. This crisis will spread far and wide at high speed. I actually think that Moodys is correct that government assistance will not be forthcoming but not because there is less systemic risk. There is a large and powerful faction within the Congress that was willing to let the US sovereign default. Do you think they're willing to let Bank of America default? Sure are you're born.

Of course the most important news of the day was the Federal Reserve Statement. The Federal Reserve announced, after a two day meeting, that they would move $400 billion of their Treasury portfolio from short dated securities to longer dated ones (an operation called “the twist”) and they would reinvest their maturing mortgage securities into new mortgage securities rather than Treasuries as they had been doing. They also said that the economic outlook was increasingly gloomy and that downside risks were increasing.

So what does this all mean? First the easy part, during the financial crisis when there was a massive collapse in the mortgage market the Federal reserve stepped in and began buying mortgage backed securities. This was a controversial move because the Fed usually government securities, it was a departure from standard practice for the Fed to intervene in the private sector borrowing markets. Since the crisis, as the securities that the Fed bought have matured the Fed has bought treasuries with the proceeds, slowly getting out of the private sector mortgage markets and returning to its natural habitat of US government securities.

Their announcement today means that, going forward, they're going to be reinvesting back into mortgages. This will lower mortgage rates generally, or at least dampen any increases. The Fed is probably hoping that this gives a bump to the real estate markets and thereby help the banks with problems they have with all the residential real estate on their books. The real estate markets are indeed in serious trouble so any little bit helps but I doubt that this will have a significant impact.

The main event of course was “The Twist.” The repositioning of the government securities on the Fed's balance sheet from near term to long term. The nominal objective is to lower long term rates without affecting short term rates very much. They'll succeed in this because $400 billion isn't that much in the very deep and very liquid short term US government securities markets, but its really big in the long term markets. Thus they can have a lot of impact on long rates by buying but not too much impact on near term rates by selling. Keep in mind that because the transactions will be offsetting this is not Quantitative Easing, so Rick Perry can leave his shotgun on the gun-rack in his F-150.

What's behind this? Well, basically for the past few years banks have had a free ride. The Fed has crushed near term rates to zero which, if you have a bank account of any kind, means that banks can borrow money from their depositors at near zero interest rates. They could then buy ten year Treasuries at 3% or so and make that a risk free 3% per year and this is what they have been doing. Sure there has been some loan growth but why lend money into the real economy if you can make this nice juicy 3% risk free? Well, sheriff Bernanke has come to town and is calling that game over. What he's trying to do is force longer term interest rates so low that the banks are forced to move up the risk curve and start lending more money into the real economy.

Will it work? That is a really tough question. There are a lot of really good reasons to have your capital close to the vest right now if the banks hold back and stay where they are on the risk curve all the Fed has done is reduce the profitability of the banking sector. You could look at today as a one two punch for the banking system, the downgrades lower increase their costs and lower long term interest rates lower their revenues. On the other hand if they are forced out on the risk curve and at lower rates that might be helpful for the real economy. This of course assumes that the reason that loan demand has been so low is that businesses think that long term rates, already the lowest in over a decade, are still too high. This is not likely. Far more likely is that economic conditions are very uncertain and taxes on investment are scheduled to almost double by 2014.

In any case the markets were not a fan. The S&P, which opened the day lower, dropped like a stone into the close closing down 3% on the day. I think this is for three reasons. One, I think that though most market analysts correctly called the Fed action many market participants thought that Bernanke might do something more aggressive. There are serious problems in Europe and the US data is getting pretty bad. Bernanke has been very innovative and I think the markets thought he might have something else up his sleeve perhaps even QE3. The fact that gold also dropped like a stone and the dollar rallied seems to indicate that the markets had baked a bit more loosening into the market cake. Alas, no joy. The second reason I think is that the Fed remarks were very grim. At the same time, the relatively limited action of the Fed this time despite that grim data, and the relatively high number of dissenters is a further indication that the tools the Fed has at its disposal are limited. Finally, I think that the speculative attack in Europe may have been on hold until the Fed made its announcement. Now that the Eurozone bond vigilantes know where Bernanke stands, they're free to renew their assault on Fortress Europa. It should be interesting.  

Monday, September 12, 2011

I've come up with some ideas on how to create jobs. To pay for it I've decided to hire the guys who brought you the debt ceiling fiasco. Sound like a plan?

There's a lot going on in the world but I want to write something on Obama's speech last week.

I was interested for two reasons. First, I have been studiously avoiding the clown car demolition derby that is the GOP primary but I remain interested in the political contest, such as it is. Given that Obama's approval ratings are going over a cliff and polls show he would lose against a generic Republican, if not any of the actual Republican candidates, this was an important speech for him. Second, I was very interested to see what sorts of policy initiatives he would put forward. As you will see from my next series of posts I think that the trouble brewing in Europe is extremely dangerous to the global economy and anything the US can do to increase the rate of US growth would be very helpful at this stage of the game.

In the end, the speech was far more interesting from the political angle than from the economic angle. From a policy perspective the “American Jobs Act” contains a few new tweaks of the mechanics of unemployment insurance but otherwise is more or less a $550 billion extension of the American Recovery and Reinvestment Act (ARRA or “the stimulus.”) It contains some infrastructure spending, extensions of unemployment benefits, transfers to states to pay public employees, an extension of the payroll tax cut, and accelerated depreciation. I found this pretty disappointing. If $1.6 trillion of these initiatives failed to revive employment then why should another $550 billion do the job? To be sure the ARRA has its defenders though I am not one of them. I was doubtful that the President would bring something new to the table but I wanted to be surprised. In the end, my doubts were confirmed. 

I should mention that in the 2008 elections I supported Obama. I donated the legal maximum to his campaign both in the Democratic primary and in the general election. I had many reasons for doing this a short list would be that I was disgusted with the job the Republicans had done running the country, horror at the prospect of Sarah Palin in any position of responsibility whatsoever, and I'll admit, I was captured by the rhetoric. I thought his speech after the Jeremiah Wright controversy was brilliant. Given that it was clear that the country was in for some serious trouble as the financial crisis gathered strength I felt the country needed some inspirational leadership and I thought Obama might provide it. In the back of my mind I was aware that his resume was remarkably thin but he seemed so much brighter than most other politicians I felt that perhaps he would grow into the role and I hoped that perhaps he might be a transformational character. Having admitted this I'll also have to admit that I have been disappointed with his policies generally. I'm to the left of Obama on healthcare and pretty far to the right of him on economic policy. Thus I was not surprised by the lack of policy initiatives that I thought might be effective. I was surprised by the political nature of the speech.

First of all was the setting. He did not address the nation from the Oval Office but instead called a joint session of Congress and initially tried to schedule it to upstage the GOP debate. The speech itself was not so much an address to the American people as a harangue of Congress, specifically the recently elected Republican freshmen who have been taking the President apart over the budget. Indeed, the speech was delivered directly to them, the President said “Pass this bill, pass it now” or derivatives thereof ten times in the course of the speech. What references there were to the actual citizens were stage whispered asides about how the government works for the people and the people are unhappy with the government. So, why would you get up in front of Congress, present them a bill whose merits you claim are self evident, and then demand ten times that they pass it in front of a television audience of the voters? It seems like an odd set up to me but there you have it.

The speech itself had some interesting moments. My favorite was when he mentioned Lincoln's support for the trans-continental railroad as an example of a Republican going ahead and putting public funds to good use. The speechwriter was probably not too familiar with the corporate history of the Union Pacific. It was at the center of what was probably the largest corruption scandal in the history of the federal government. The authorization bill was so badly written the Union Pacific was in litigation for nearly a century, including nearly a dozen Supreme Court cases, over what precisely the terms of its obligations back to the government were. Of course, several private transcontinentals were also built in the years following the Civil War. The UP was however an outstanding source of campaign contributions to Congressmen, judges and state legislatures, particularly when it was in the hands of Jay Gould who tried unsuccessfully to resolve the legal disputes through mass bribery. So at least from the perspective of the legislators on the receiving end of this largesse it was a major success. Not the kind of thing I would put in a speech though.

I also liked how Obama could in one sentence frame his opposition as on the side of “millionaires and billionaires” and himself on the side of “teachers” and “our kids” and then in the next sentence say “this is not class warfare.” It's me and the teachers against the Republicans and the billionaires? If that's not a reference to class strife then I don't know what is. Still, it was artfully done and I think the Republicans have done an atrocious job of explaining their position. I also thought that he might have wanted to do some more research around his rejection of "the idea that we have to strip away collective bargaining rights to compete in a global economy." Surely the Democratic Party, the annual recipient of hundreds of millions of dollars in campaign contributions from unions, must have noticed that the only places where unions continue to thrive are in services and the public sector. Of course service employees and the public sector are not subject to global competition. Union membership in the traded goods segment has been totally obliterated in the last 30 years. Obama himself presided over the most spectacular example of this when US automakers with their UAW workers had to be rescued by the state while the non-union automakers in the South kept right on going. 

In any case, the main event of the speech for me was the rhetorical bait and switch around how the AJA will be paid for. He led strong with “Everything in this bill will be paid for. And here's how.” At this I was on the edge of my seat. The hard part of leadership and governing is not giving away tax breaks and entitlements but figuring out how to pay for them, and now Obama, the responsible leader, is going to do just that. Thank God, but then.... “The agreement we passed in July will cut government spending by about $1 trillion over the next 10 years. It also charges this Congress to come up with an additional $1.5 trillion in savings by Christmas. Tonight, I am asking you to increase that amount so that it covers the full cost of the American Jobs Act. The agreement we passed in July will cut government spending by about $1 trillion over the next 10 years. It also charges this Congress to come up with an additional $1.5 trillion in savings by Christmas. Tonight, I am asking you to increase that amount so that it covers the full cost of the American Jobs Act.”

What? Wait a minute. So his big idea for how to pay for it is to ask the Congress to figure it out for him? Hold on a second, didn't he do that back in February when he decided not to implement any of the recommendations of his own deficit cutting committee and sent Biden to the Congressional negotiations for the first three months thereby ceding the initiative to Congressional Republicans? Yes, he sure as hell did. How did that work out? Hmmm.... let me think..... Oh, now I remember the freshmen GOP Congressmen crucified him with the debt ceiling fiasco, nearly put the country into default and in so doing got the credit of the country downgraded. What's more that fiasco was only averted by the eleventh hour deal the President refers to but whose terms he wants to change. So at best he's reneging on the original agreement for $2.5 trillion and upping it to $3 trillion and at worst he's totally abdicating responsibility and putting it on the very people who almost drove us over a cliff in the first place. What about all that talk about how the GOP in Congress were a bunch of irresponsible kids and the finances of the country need to be handled by “grownups.” So, here Obama gets a chance to take some responsibility and what does he do? He puts the ball right back in the court of the kiddies. Seriously, what's behind all this? I mean, the person who knows best what will happen to the AJA in congress is Obama himself. If the last time he punted fiscal responsibility to Congress the result was a total legislative fiasco why would he do it again?

I hate to say it but I think the answer is that he knows full well that it will be a fiasco, and that he wins to a Congressional Republican fiasco. It seems pretty clear that there's little chance that the economy improves significantly before 2012. Obama knows that as bad as he looked during the debt ceiling debate the Republicans looked worse. His plan seems to be to go on TV, and in front of the cameras demand that Congress pass his jobs bill. Never mind that the AJA is just a diet version of the ARRA. Never mind that the ARRA was not a stellar success. Never mind that it still required $1.6 trillion of debt finance. These things supply the only coherence the Tea Party possesses, so Obama is trying to use them to his advantage.

Rather than actually formulate how to pay for the AJA he's decided to lay that part of it at the feet of the very people who almost put the government into default rather than borrow more money or raise taxes which he knows full well will be necessary if we're going to extend the ARRA for another 3% of GDP. He also knows that the Republican base will not stand for those tax increases or additional borrowing and will hold the GOPs feet to the fire to prevent it. So he knows that the AJA will struggle in congress, in fact I think he hopes it does. He may even wish for it to go down in flames. Then when indeed the economy does not recover by 2012 he can say that if only the Republicans had passed his jobs bill all would be well. And after Thursday the video editors for his campaign ads have ten shots too choose from of him telling Congress to do what he knows they have a minimal chance of actually doing. No one will remember that the original stimulus was extremely expensive but not very effective. They won't remember that by adding another $550 billion to the $2.5 trillion he's reneging on the original deal further eroding his capacity to negotiate with Congress anyway. No, they'll remember Obama telling Congress to pass the jobs bill and then congress, ie Republicans, screwed it all up. For Obama, mission accomplished. For the unemployed, not so much.

It makes all that gooey nonsense at the end of the speech about the expectations of the American people sound like a sneer, as if the people in the audience are too stupid to notice that he is doing exactly the opposite of what we sent him there to do: taking responsibility and making hard decisions. Instead, he's handing the responsibility over to people who have already played chicken with the economic security of the country just so that he can blame put them when he's running for office next year. Great. 

I recognize that my criticism of the ARRA and the political rather than economic nature of this post obligates me to step up and discuss the economics behind this in more detail, more to come.