Fed and Wall Street farther apart on the credit crunch
Fed and Wall Street farther apart on the credit crunch
By John Dizard
Copyright The Financial Times Limited 2007
Published: August 21 2007 03:00 | Last updated: August 21 2007 03:00
The disconnect between Washington and Wall Street thinking about the credit crunch has narrowed somewhat in the past few days. The Wall Streeters had been missing the point when they tried in recent weeks to get through to the fundamentalist Fed governors about the systemic risks of the credit seize-up. In the absence of strong leadership, the Federal Reserve staff and board have been driven by the dictates of academic-bureaucratic politics. That means that admissions of fallibility have been more of a problem for them than the consequences for the real economy of their sticking to inadequate econometric models.
Don't make the mistake of thinking this is anything but a bear market rally in risk. Investors still face a risk of spreading asset deflation. There are not yet enough cash-dispensing central bank helicopters.
At times such as this, it has been worthwhile to listen to the most fawning courtiers among opinion writers in the Washington newspapers. From them, unfiltered by any knowledge or judgment, you get what has been the straight Fed party line on the credit crunch. In an environment teetering on catastrophic asset deflation (look at the decline in the gold price), until the past
couple of days Fed people were still pushing a particular model of inflation-targeting as their guide, while behind-the-scenes factions squabble over the ideal level for the target. Now, I am told, the Washington Fed people know how bad things are. The question is what mechanisms they can use to react without unintentionally invoking other demons. It is not clear they have enough skilled former market operators in house to devise a good enough plan. Incredibly, the Bush administration has a competent team at the top of the Treasury. Henry Paulson, the Treasury secretary, for all his reassuring comments, does know what is going on. But even he cannot tell the governors what to do.
Chairman Ben Bernanke's quiver does have a usable back-up theory, which you can find in his academic work on the Depression. This is based, as we have noted before, on what he has termed the cost of credit intermediation, or the institutional barriers to liquidity, finding its way in a crisis to the right borrowers. Mr Bernanke is more an academic department chairman than a dictator and he has to create among colleagues a consensus on the appropriate theoretical construct.
"Wall Street", to the degree it has a consensus, does not want to create moral hazard by supporting the price of unsound assets or by ensuring that hedge fund managers and proprietary traders get their bonuses - or even keep their second houses. It does not want to accelerate inflation by monetising bad paper. But it does believe the deleveraging process could get out of hand quickly. The illiquidity developing in commercial paper is an ominous warning.
Many on the Street are assuming that Fannie Mae and Freddie Mac, two of the government-sponsored enterprises, and their regulators will abandon their prudential limits and rescue housing finance. Along with their allies on the congressional banking committees, they think that the problems could be managed if Fannie and Freddie's caps on lending were removed and "good" mortgages were bought in securitised, carload lots. The default risk posed by resets on adjustable rate mortgages would be avoided by F&F,inter alia, exchanging ARMs for fixed-rate mortgages and funding them out with the GSEs' government-supported paper.
The problem is that the Greenspan Fed and its allies in the government avoided what might have become a systemic crisis with the GSEs earlier this decade. They did that by imposing those funding caps, and limiting the GSEs' fixed-rate asset exposure. Otherwise, this crisis might have come a year or two ago in the form of a crunch in the interest rate swaptions market. This would have been caused by the enormous hedging requirements of the GSEs, driven by the need to keep the duration of assets and liabilities matched on thin capital bases. The Fed would probably have had to become the interest rate derivatives counterparty of last resort, a role for which it was ill-prepared.
The real issue has been the excess liquidity created by the central banks through a decade of ever-more ambitious crisis management. The risks created by those "solutions" were not identified, let alone measured, by their econometric models. Now they have to conduct a credit triage by supporting sound and essential borrowers, so we can get something closer to the mythical soft landing. The inflationary risks of massive liquidity provision later can only be reduced, not eliminated, by selective direct purchases of good paper, directly or indirectly, by the Fed. My bet would be that they do just that. Already, we've seen the discount rate cut as well as the preferential purchase of mortgage-backed agency paper over Treasuries in their open market operations. This is necessary but probably not sufficient. The question is how long the Fed delays taking more direct action and, therefore, how much more inflationary risk will be introduced.
By John Dizard
Copyright The Financial Times Limited 2007
Published: August 21 2007 03:00 | Last updated: August 21 2007 03:00
The disconnect between Washington and Wall Street thinking about the credit crunch has narrowed somewhat in the past few days. The Wall Streeters had been missing the point when they tried in recent weeks to get through to the fundamentalist Fed governors about the systemic risks of the credit seize-up. In the absence of strong leadership, the Federal Reserve staff and board have been driven by the dictates of academic-bureaucratic politics. That means that admissions of fallibility have been more of a problem for them than the consequences for the real economy of their sticking to inadequate econometric models.
Don't make the mistake of thinking this is anything but a bear market rally in risk. Investors still face a risk of spreading asset deflation. There are not yet enough cash-dispensing central bank helicopters.
At times such as this, it has been worthwhile to listen to the most fawning courtiers among opinion writers in the Washington newspapers. From them, unfiltered by any knowledge or judgment, you get what has been the straight Fed party line on the credit crunch. In an environment teetering on catastrophic asset deflation (look at the decline in the gold price), until the past
couple of days Fed people were still pushing a particular model of inflation-targeting as their guide, while behind-the-scenes factions squabble over the ideal level for the target. Now, I am told, the Washington Fed people know how bad things are. The question is what mechanisms they can use to react without unintentionally invoking other demons. It is not clear they have enough skilled former market operators in house to devise a good enough plan. Incredibly, the Bush administration has a competent team at the top of the Treasury. Henry Paulson, the Treasury secretary, for all his reassuring comments, does know what is going on. But even he cannot tell the governors what to do.
Chairman Ben Bernanke's quiver does have a usable back-up theory, which you can find in his academic work on the Depression. This is based, as we have noted before, on what he has termed the cost of credit intermediation, or the institutional barriers to liquidity, finding its way in a crisis to the right borrowers. Mr Bernanke is more an academic department chairman than a dictator and he has to create among colleagues a consensus on the appropriate theoretical construct.
"Wall Street", to the degree it has a consensus, does not want to create moral hazard by supporting the price of unsound assets or by ensuring that hedge fund managers and proprietary traders get their bonuses - or even keep their second houses. It does not want to accelerate inflation by monetising bad paper. But it does believe the deleveraging process could get out of hand quickly. The illiquidity developing in commercial paper is an ominous warning.
Many on the Street are assuming that Fannie Mae and Freddie Mac, two of the government-sponsored enterprises, and their regulators will abandon their prudential limits and rescue housing finance. Along with their allies on the congressional banking committees, they think that the problems could be managed if Fannie and Freddie's caps on lending were removed and "good" mortgages were bought in securitised, carload lots. The default risk posed by resets on adjustable rate mortgages would be avoided by F&F,inter alia, exchanging ARMs for fixed-rate mortgages and funding them out with the GSEs' government-supported paper.
The problem is that the Greenspan Fed and its allies in the government avoided what might have become a systemic crisis with the GSEs earlier this decade. They did that by imposing those funding caps, and limiting the GSEs' fixed-rate asset exposure. Otherwise, this crisis might have come a year or two ago in the form of a crunch in the interest rate swaptions market. This would have been caused by the enormous hedging requirements of the GSEs, driven by the need to keep the duration of assets and liabilities matched on thin capital bases. The Fed would probably have had to become the interest rate derivatives counterparty of last resort, a role for which it was ill-prepared.
The real issue has been the excess liquidity created by the central banks through a decade of ever-more ambitious crisis management. The risks created by those "solutions" were not identified, let alone measured, by their econometric models. Now they have to conduct a credit triage by supporting sound and essential borrowers, so we can get something closer to the mythical soft landing. The inflationary risks of massive liquidity provision later can only be reduced, not eliminated, by selective direct purchases of good paper, directly or indirectly, by the Fed. My bet would be that they do just that. Already, we've seen the discount rate cut as well as the preferential purchase of mortgage-backed agency paper over Treasuries in their open market operations. This is necessary but probably not sufficient. The question is how long the Fed delays taking more direct action and, therefore, how much more inflationary risk will be introduced.
posted by Carlos T Mock at 9:24 AM
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