The Float

Friday Reading

Here's to a safe and enjoyable Labor Day weekend for everyone...

• With all this talk about Fed policy, it's important to remember that however consequential a rate cut might be for market psychology and investor confidence, the real economic effects of monetary policy changes typically take quite a while to kick in.
• Jenny Anderson and Heather Timmons consider the past, present, and future of debt-related financial engineering in The New York Times.
• Slate's Daniel Gross riffs on the phenomenon of public companies shedding subsidiaries.
• Writing at MarketWatch, Mark Hulbert notes that corporate insiders appear plenty bullish these days.
• Barry Ritholtz wonders out loud about the timing of a certain White House announcement this morning.
• These are interesting and uncertain times at Fidelity.

Connecting the Credit Crunch and the Broader Economy

Market participants know the Bernanke Fed is concerned about the macroeconomic implications of recent turmoil in the credit markets. With this morning's PCE release, we see that consumer spending remained relatively strong--and inflation relatively modest--in July. Nevertheless, as Bernanke said this morning, these are truly backward-looking data:

The incoming data indicate that the economy continued to expand at a moderate pace into the summer, despite the sharp correction in the housing sector. However, in light of recent financial developments, economic data bearing on past months or quarters may be less useful than usual for our forecasts of economic activity and inflation. Consequently, we will pay particularly close attention to the timeliest indicators, as well as information gleaned from our business and banking contacts around the country.

So as we look ahead to the post-crunch data flow, it pays to think about the mechanisms by which credit-market troubles can translate into broader macroeconomic difficulties. And that's where two recent items from Minyanville come in handy:

1. A penetrating review of recent credit-market developments, Fed policy changes, bank balance sheets, the role of credit card issuers as "lenders of last resort," and more. Our advice here is simple: Read it. Then read it again.
2. Kevin Depew's thorough description of credit expansion and contraction. Read this too.

UPDATE: Depew continues with a post-speech analysis of what Bernanke said this morning and what it all means.

Sources

Joe Richter, "U.S. Economy: Consumer Spending, Incomes Increase," Bloomberg, August 31, 2007

Ben S. Bernanke, "Housing, Housing Finance, and Monetary Policy," August 31, 2007

Darrell Hassler, "Commercial Paper Extends Slump on Asset-Backed Woes," Bloomberg, August 30, 2007

Bernanke Stands and Delivers

It's early, but our immediate assessment of Ben Bernanke's Jackson Hole speech this morning is that the Fed Chairman gets it. Before reviewing a couple highlights of Bernanke's remarks, we were reminded of a passage from the August 16th Economist that captured our thinking on the Fed just about perfectly. Here it is:

The retreat to a new level of risk was never going to be orderly or free of casualties. Neither should it be. Bankers and investors need to suffer precisely because the methods of modern finance have been found wanting. It sounds Darwinian, but the brutal demonstration that you pay for your sins is what leads the system to evolve. Markets learn from their mistakes. Only fear will spur investors to price risks better and get them to put more effort into monitoring their counterparties.

If these lessons are to sink in, central bankers must stand back--as, by and large, they have done. Every intervention now will be taken as a sign of what the regulators will do next time. If they bail out banks that have mispriced risk, the mispricing will continue. And when the central banks do step in, it should not be to save the financiers. The cost of intervention is warranted only to save the rest of the economy from the financiers' folly. By that test, central banks were right to lend money to the banks in recent days, because it ensured that a liquidity crisis did not become a solvency crisis. They may yet have to take over a failed bank, though only if that is needed to stop a run. It is still far too soon to cut interest rates.

The point here is that the Fed's job is decidedly not to determine asset prices--and thus not to respond at the first sign of anxiety among so many CEOs and talking heads. Instead, the Fed's job is to preserve (and, when necessary, restore) the orderly functioning of markets so market participants can determine asset prices.

With that thought in mind, here are a few key passages from Bernanke's Jackson Hole remarks (emphasis added):

Although this episode appears to have been triggered largely by heightened concerns about subprime mortgages, global financial losses have far exceeded even the most pessimistic projections of credit losses on those loans. In part, these wider losses likely reflect concerns that weakness in U.S. housing will restrain overall economic growth. But other factors are also at work. Investor uncertainty has increased significantly, as the difficulty of evaluating the risks of structured products that can be opaque or have complex payoffs has become more evident. Also, as in many episodes of financial stress, uncertainty about possible forced sales by leveraged participants and a higher cost of risk capital seem to have made investors hesitant to take advantage of possible buying opportunities. More generally, investors may have become less willing to assume risk. Some increase in the premiums that investors require to take risk is probably a healthy development on the whole, as these premiums have been exceptionally low for some time. However, in this episode, the shift in risk attitudes has interacted with heightened concerns about credit risks and uncertainty about how to evaluate those risks to create significant market stress. On the positive side of the ledger, we should recognize that past efforts to strengthen capital positions and the financial infrastructure place the global financial system in a relatively strong position to work through this process.

...

Well-functioning financial markets are essential for a prosperous economy. As the nation's central bank, the Federal Reserve seeks to promote general financial stability and to help to ensure that financial markets function in an orderly manner.

...

It is not the responsibility of the Federal Reserve--nor would it be appropriate--to protect lenders and investors from the consequences of their financial decisions. But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy. In a statement issued simultaneously with the discount window announcement, the FOMC indicated that the deterioration in financial market conditions and the tightening of credit since its August 7 meeting had appreciably increased the downside risks to growth. In particular, the further tightening of credit conditions, if sustained, would increase the risk that the current weakness in housing could be deeper or more prolonged than previously expected, with possible adverse effects on consumer spending and the economy more generally.

The incoming data indicate that the economy continued to expand at a moderate pace into the summer, despite the sharp correction in the housing sector. However, in light of recent financial developments, economic data bearing on past months or quarters may be less useful than usual for our forecasts of economic activity and inflation. Consequently, we will pay particularly close attention to the timeliest indicators, as well as information gleaned from our business and banking contacts around the country. Inevitably, the uncertainty surrounding the outlook will be greater than normal, presenting a challenge to policymakers to manage the risks to their growth and price stability objectives. The Committee continues to monitor the situation and will act as needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets.

This speech is a tour de force, pitch-perfect in both tone and substance. The scholarly review of housing finance history is worthwhile too, but the opening third of the speech, in which Bernanke deals with current financial market conditions, is worth reading in full.

Source

"Surviving the Markets," The Economist, August 16, 2007

Daniel Gross, "The Punch Bowl Caucus," Slate, August 27, 2007

Ben S. Bernanke, "Housing, Housing Finance, and Monetary Policy,"August 31, 2007

The Bernanke Vision

In this morning's Wall Street Journal, Greg Ip describes the subtle but significant changes Ben Bernanke has ushered in at the Federal Reserve. Here's an extended excerpt that captures the essential points:

When Ben Bernanke was nominated to head the Federal Reserve in 2005, he promised to "maintain continuity with the policies and policy strategies established during the Greenspan years." But in handling his first financial crisis, Mr. Bernanke shows signs of a break with Alan Greenspan, the Fed's chairman from 1987 to 2006.

That shift is important in understanding why Mr. Bernanke hasn't cut the Fed's main interest rate yet, and it could alter investors' expectations of how the Bernanke Fed will function.

The Fed historically has had two major economic duties. Maintaining financial stability is one. Controlling inflation while preventing recession is the other.

To Mr. Greenspan, market confidence and the economy's growth prospects were so intertwined as to make the Fed's two duties almost inseparable. He cut rates after the 1987 stock-market crash and the near-collapse of hedge fund Long-Term Capital Management in 1998 to prevent investor reluctance to take risks from undermining the nation's economic growth.

By contrast, Mr. Bernanke distinguishes between the central bank's two functions. So, on Aug. 17, the Fed cut the interest rate and lengthened the term on loans to banks from its little-used discount window in hopes banks would use the window -- or at least the knowledge it was available -- to lend to solid borrowers having trouble getting credit amidst the market turmoil. The action was aimed at restoring the normal functioning of disrupted credit markets, not primarily at boosting growth.

Fascinating stuff here on two competing visions of the central bank's duties and functions. We're temperamentally and intellecutally sympathetic to the Bernanke model, but it's getting a pretty good stress test these days. (One caveat: Though we weren't caught up in the epic short squeeze on August 17th, we still think that timing was too interventionist by half.)

We think market participants are expecting a bit too much out of Bernanke's remarks at the Jackson Hole Symposium tomorrow. Then again, we'll be watching!

Sources

Greg Ip, "Bernanke Breaks Greenspan Mold," Wall Street Journal, August 30, 2007 (subscription required)

Scott Lanman and John Fraher, "Bernanke May Hear Call for Fed Activism on Regulation," Bloomberg, August 30, 2007

Conventional Wisdom

We've long held BlackRock's Chief Investment Officer Bob Doll in high regard. And in no way does the following observation change that; in fact, he may well be right. But if there's such a thing as conventional wisdom among equity managers these days, Doll seems to have distilled it into its purest form in a recent commentary. Here's the essence of that CW, courtesy MarketBeat:

"In general, we have been favoring large-cap over smaller-cap companies, multinational companies in favor of those with a predominantly U.S. focus, and growth companies over value."

We think we've seen and heard an inordinately large number of market participants express those preferences in recent weeks, which raises the timeless question: If everyone's saying it, does that mean the trade is already crowded and played out? Or is it still early enough in the trend to participate in its potential upside?

This dilemma reflects the dynamics of a "Keynesian beauty contest," in which market participants value assets not just on the basis of their own estimates, but their estimates of others' estimates, in a multi-stage process of convergence that ultimately produces market prices.

More on Market Sentiment

Back in July, we posted a pair of items on the role of market sentiment in gauging the near-term outlook for equities. The first one, posted just before the July top, is here; the second, posted a week and a half later, is here.

In those posts, we looked at the CBOE's put-call ratio. This morning, we ran across mid-July data from a Reuters/Zogby poll concerning individual investors' market expectations. Remember...this poll was in the field just before the broad market averages topped out. Here are the key findings:

Meanwhile, few fear a dramatic pullback in stocks after their recent record charges.

The survey was conducted just as the Dow Jones industrial average was making headlines with its biggest daily point gain since October 2002 and the broader Standard & Poor's 500 index was regaining record highs after seven years.

Tuesday, the Dow crossed the 14,000 mark for the first time.

Most polled saw the current rise in stocks as sustainable.

About 42 percent of the respondents said stock prices over the next three months will "stay about the same" and about 30 percent said prices could "increase a little," the survey found.

Just 2.4 percent of the respondents said stock prices will "drop dramatically."

Though definitions of the pollster's terms--increase a little, drop dramatically, &c.--are to some extent in the eye (and ear) of the beholder, there's little mistaking these results for what they are: extremely low levels of anxiety among self-identified members of the "investor class."

Alongside the unusually low levels in the equity put-call ratio we flagged in mid-July, these polling data should have sent shivers up the spine of every self-respecting contrarian.

Source

"Investors upbeat on economy, stock prices," Reuters, July 18, 2007

Wednesday Reading

In the spirit of the Hamptons, a lazy summer reading list...

• We hadn't seen this Reuters piece when we posted yesterday's item on the Fed, but it adds a little more texture to the uncertain implications of a September rate cut.
• As we noted just before this late-Summer correction began in July, trends in the debt and equity markets foreshadowed one of three outcomes: (1) lower premiums for takeout targets, (2) lower returns for private equity players, and/or (3) reduced private equity activity. Bloomberg's Jason Kelly argues that lower returns are a new fact of life and (at the Wall Street Journal, subscription required) BreakingViews analysts see the same handwriting on the wall.
• Problems in the world of conduits and structured investment vehicles--see relevant news items here and here--bear watching in the coming days and weeks.
• On Monday, we noted the rising risk of trouble in the world of revolving consumer credit (i.e., credit cards). Today Barry Ritholtz excerpts a Financial Times story that adds more unsettling detail.
• Why so much anxiety about the economy? Our CEOs are doing great!

Hey, Wall Street: Be Careful What You Wish For

Though expectations of a September cut in the fed funds rate have come in a bit over the last few days, Wall Street's desire for such a cut continues to run hot. But we think the Street should think twice about just how badly it wants the Fed to make it rain again.

First, there's the simple Daniel Gross argument:

College students don't alleviate the after-effects of an evening spent at the punch bowl by returning to lap up the dregs. Just so, finance types should know that cheap money, credit on demand, and endless leverage aren't the cure for a hangover caused by too much cheap money, leverage, and credit on demand.

Then there's the stern Jim Grant argument:

Now comes the bill for that binge and, with it, cries for even greater federal oversight and protection. Ben S. Bernanke, Mr. Greenspan’s successor at the Fed (and his loyal supporter during the antideflation hysteria), is said to be resisting the demand for broadly lower interest rates. Maybe he is seeing the light that capitalism without financial failure is not capitalism at all, but a kind of socialism for the rich.

And the subtle Peter Coy argument:

Simply put, the Federal Reserve did not--and cannot--fix the problem at the root of the market crisis. That problem is a lack of crucial information.

Lenders know there are billions of dollars of weak assets out there, such as securities backed by foolish or fraudulent mortgages. What they don't know is who holds those weak assets. So when borrowers come to them offering suspect securities as collateral for a loan, the safest thing to say is no. When everyone says no at once, the result is a credit crunch that, if unabated, could cause a recession.

That's the key point: Financial and economic conditions sufficiently bad to compel a cut in the fed funds rate may be bad enough to swamp the effects of such a cut.

Which leads us to the historical John Hussman argument:

[I]t's not clear that investors should really be cheering for an environment in which the Fed would be prompted to cut rates because of recession risk. Recall that the '98 cuts were largely due to illiquidity problems from the LTCM crisis, not because of more general economic risks. In contrast (with a nod to Michael Belkin), below are a few instances when the FOMC successively cut the Fed Funds rate in attempts to avoid recession: 2000-2002 and 1981-1982. Those cuts certainly didn't prevent deep market losses. Speculators hoping for a "Bernanke put" to save their assets are likely to discover--too late--that the strike price is way out of the money.

Here are Hussman's charts, which can't be terribly reassuring to Dan Gross's Punch Bowl Caucus:

Because we think the Fed should welcome the re-pricing of financial risk from historically and unjustifiably low levels, the best case scenario is a flow of economic data just strong enough to keep the Fed marking time, an orderly unwinding of the leverage attached to weak and weakening assets, and a gradual reduction in market volatility.

Weak consumer confidence and falling home prices don't bode especially well, but we think the key data point of the week will be Friday's real consumer spending release, which will trump what consumers are feeling with what they're actually doing.

Sources

Daniel Gross, "The Punch Bowl Caucus," Slate, August 27, 2007

Jim Grant, "The Fed's Subprime Solution," New York Times, August 26, 2007

Peter Coy, "It's Out of Bernanke's Reach," BusinessWeek, September 3, 2007

John Hussman, "Knowing What Ain't True," Hussman Funds Weekly Market Comment, August 27, 2007

Bob Willis, "U.S. Consumer Confidence Falls by Most Since 2005," Bloomberg, August 28, 2007

Courtney Schlisserman, "U.S. Home Prices Fell by Record in Second Quarter," August 28, 2007

The Fed, Recession Risks, and Recession...Benefits?

Scanning through Bloomberg's look-ahead to Ben Bernanke's Jackson Hole remarks this Friday, we ran across this observation from Lehman Brothers Chief Economist Ethan Harris (emphasis added):

"Monetary policy is very much about confidence,'' says Harris, a former New York Fed official who'll be in the audience when Bernanke speaks. "If the Fed doesn't unfreeze the markets, we'll have a recession, but also reputationally it's important'' for Bernanke.

A recession if the Fed doesn't rescue the markets? Perhaps, and the notion reminds us of a heretical question asked in last week's Economist:

When the Fed cut its discount rate on August 17th, it admitted for the first time that the credit crunch could hurt the economy. The markets are betting it will soon cut its main federal funds rate. Economists are arguing vigorously about how much damage falling house prices and the subprime mortgage crisis will do. But there is one question that is rarely asked: even if a downturn is in the offing, should the Fed try to prevent it?

Here's the essence of the argument that sooner and shallower may be better than later, longer, and deeper:

The economic and social costs of recession are painful: unemployment, lower wages and profits, and bankruptcy. These cannot be dismissed lightly. But there are also some purported benefits. Some economists believe that recessions are a necessary feature of economic growth. Joseph Schumpeter argued that recessions are a process of creative destruction in which inefficient firms are weeded out. Only by allowing the “winds of creative destruction” to blow freely could capital be released from dying firms to new industries. Some evidence from cross-country studies suggests that economies with higher output volatility tend to have slightly faster productivity growth. Japan's zero interest rates allowed “zombie” companies to survive in the 1990s. This depressed Japan's productivity growth, and the excess capacity undercut the profits of other firms.

Another “benefit” of a recession is that it purges the excesses of the previous boom, leaving the economy in a healthier state. The Fed's massive easing after the dotcom bubble burst delayed this cleansing process and simply replaced one bubble with another, leaving America's imbalances (inadequate saving, excessive debt and a huge current-account deficit) in place. A recession now would reduce America's trade gap as consumers would at last be forced to trim their spending. Delaying the correction of past excesses by pumping in more money and encouraging more borrowing is likely to make the eventual correction more painful. The policy dilemma facing the Fed may not be a choice of recession or no recession. It may be a choice between a mild recession now and a nastier one later.

Food for thought.

Sources

Scott Lanman, "As Bernanke Retreats to Wyoming, Critics Ask Is He Prime Time," Bloomberg, August 27, 2007

"Does America Need a Recession," The Economist, August 23, 2007

About That Condo Market...

In Saturday's Wall Street Journal, Alex Frangos offered up the latest in an ongoing series of "other shoe to drop" narratives, this one concerning the wildly overbuilt condo market (with the obvious caveat that details vary widely from locale to locale). Here are two key excerpts: 

Typically, condo developers are required to pay off construction loans shortly after construction is completed. But with sales stalled, more developers are defaulting, creating headaches for banks and real-estate funds that financed the projects.

The percentage of bank construction loans overall that are in default has risen to 2.3% in the second quarter of 2007 from 1.0% at the end of 2005 . "Condos are a significant share of defaults and delinquencies going on," says Matthew Anderson of Foresight Analytics, an Oakland, Calif., research firm. His analysis shows condo lending ballooned to $31.3 billion in 2006 from $8.4 billion in 2003. These figures don't include the large amounts flowing into condos from hedge funds and investment banks.

...

Underlying the defaults was a loosening of lending standards. In the past, wary of the high risks posed by condo sales, lenders such as commercial banks would give money to condo projects with the understanding that if the condos didn't sell, the developer could rent them and still repay the loan. That would limit the amount banks would lend, because the cash from renting units is slow and steady and can cover a smaller amount of debt than the amount generated by selling all units within a year of completion, as most condo projects aim to do.

But in the latest boom, a host of nonbank lenders began throwing cash at condo projects, allowing developers to pay prices for land and buildings such that they could pay back the loans only if the units sold at high prices.

A loosening of lending standards...that pretty well defines this multi-year credit binge, doesn't it?

Source

Alex Frangos, "Condo Troubles Further Squeeze Property Lenders," Wall Street Journal, August 25, 2007 (subscription required)