Tuesday, December 14, 2010

EMU Ever-lasting Monetary System or not???

Europe's problems are not really about debt

‘OK’ is not necessarily ‘all-right’ - On the recent monthly numbers alone, the EMU is looking OK and maybe even like it is trying to right itself. But behind the scenes we know there are processes with long lags in operation undermining recovery. The markets are far from reassured. Ireland is a ticking time bomb. Spain and Portugal are trying to keep from being sucked into the debtors’ vortex. Some wonder about Italy-the country of the Treaty of Rome that began the move toward greater European integration. If Italy goes-all bets are off… or are they?

A brief history of which to be aware before you throw out the baby with the bathwater – The Treaty of Rome, signed in 1957, laid out a vision of a united Europe, it put the formation of the EEC in motion. The precursor to this plan had been launched in France with the initial ideas being promoted in 1950: the Iron and Steel Community. Its objectives were codified under the Treaty of Paris. Its objective was in part to keep French and German rivalry from boiling over by forming a more inclusive trading community. We see that same objective in the formation of the EU and of EMU in modern times. These plans to fuse Europe and diffuse rivalries have long-standing histories. Of course they were forged in different times with different fears in the fronts of peoples’ minds, not in the back or in some forgotten Alzheimer’s-ridden space. It is reasonable to ask if mere economic strains will break down what has been inexorable, if sometimes erratic and glacial, progress. This is a train that has been in motion for over 60-years in contrast to the relatively short life of EMU that many talk of when they speak of euro-unraveling and of a lack of commitment. Is there really a lack of commitment, or was EMU just poorly laid out? Was EMU just a bad idea that won’t work? Is it something to patched and fixed? Is it part of longer 60-year legacy with a real political will behind it that should not be short-changed despite its need to be fixed?

What are the REAL ties that bind Europe? When push comes to shove, is the geopolitical will in Europe stronger than the economic ties that bind? Is the real ‘will’ geopolitical or economic? That is the root question here. Economists that are forecasting the break-up of EMU see only the economic side and discount the political will.

The European legacy - In fact after the Iron and Steel Community was formed the Treaty of Rome’s EEC became the EC and then the EU and eventually EMU was formed out of part of the EU. Both EMU and EU stand today with the British in their familiar one-leg-in-and-one-leg-out stance. Italy is an important European and EMU nation with significant problems. But the train to European integration has been on a long ride. Will Italy, once the motivator of integration, send the Zone on a path toward disintegration? Can 60-years of progress be wrong? Is a ‘common currency’ just one ambitions step too-far for a people that 60-years ago dreamt of European integration? Is this all the farther it will go, or are they willing to go further to preserve their dream? To put another way, when Europeans dream, do they dream of being German, Italian, or French or of being European as it says on their passports? That will decide the fate of the EMU not Italy’s or Spain’s or Portugal’s debt problems.

As I said above, it’s not really about debt.

Friday, December 10, 2010

Clods and critics: Defending Bernanke

Get in with the in-crowd - More QE! really! The Fed missed. it never gets anything right! Aren't you tired of the same old criticism? I'll tell you one thing. The employment report for November was a real disappointment but bond prices FELL and STOCKs went UP after th release. markets acted as though it was good news. What that means for you is if you want to ride with a winner, it's time to get on the optimists' bandwagon and and off the pessimists bandwagon.

It is easy to be critical now. The Fed has lots of problems that it faces and few tools to attack them.

I found Bernanke's 60min performance about as good as one could expect.

It's complicated - As I am teaching Micro and Macro again at the Zicklin School of Business, I found Bernanke's comments on money quite illuminating. He is reminding us that the Fed NEVER prints money. And I'm not talking about the US mint either. The Fed provides markets with the raw material. Then banks use excess reserves to make loans; loan proceeds are deposited and the money creation process (money multiplier) is in gear. It is always in the hands of the banks. Always.

Putting the toothpaste back in the tube - Bernanke is trying to make the point that the massive injection of reserves is sitting there, just sitting there idle. When the Fed injects reserves it does TWO things (1) it pumps reserves into the banking market and (2) to accomplish that, it acquires assets. It is very complex to try and explain why the Fed is doing what it always does -and at the same time- why THIS TIME it thinks the cutting edge of policy different. This time it is the asset acquisition part of the operation not the reserve injection part. That is not the stuff for discourse on TV. Many economists do not seem to 'get' this. In any event, as long as banks sit on excess reserves, the Fed's reserve injections 'are not printing money'. They may be enabling the printing of money but since banks aren't doing it, how does enabling something that is not happening translate into doing it?

Since QE1 did not work banks have excess reserves on their books already.

Hand holding with the public- Bernanke is trying to reassure the public of two things: One, the Fed is not 'just' adding to that pile; it has another plan and, two, that all these reserves are not immediately inflationary. Until or unless they are lent they will not be an inflation factor. Banks hardly seem on the verge of doing' a 180' on lending. Hence his comment on money supply stands as correct.

Transitivity does not hold in economics or in football rankings- Michigan State University beat Wisconsin this year in football., Each team lost one game. yet it is Wisconsin is rated ahead of MSU. Because of that, Wisconsin gets to go to the Rose Bowl. How come if A>B then it is also true that A

Demand or supply? Money supply growth is picking up as the economy is picking up but that is not very well related to the enormous pile of excess reserves..Arguably the pick up is one of money demand not of supply.

Bernanke is trying to explain difficult, abstract, economic processes to a lay TV audience and I think he did a good a job with a complex subject.

Spokesperson not oracle - He is trying to bolster confidence which monetary policy needs to be effective. I think we can cut him some slack on being 'too certain'. Maybe saying that he is 100% certain that he can control this is not accurate... but can you imagine how everyone would have jumped down his throat had he used a number less than 100%.

Making policy effective - Getting support for his policies is a proper role for his public engagements. If you remember your early economics, it used to be call 'moral suasion.' Lying about policy effectiveness would not be right. But, here recognize that NY law allows businesses to 'boast' but not to engage in deceptive advertising.

Doesn't the Chairman get the same nuance?

Forget the facts it's Agenda City - I also think there is way too much negativism and that is what is hurting the economy. It is easy to be critical. There are different agendas here. Obama remained too negative far too long because he wanted to blame the Republicans for the economy and as a result he and the democrats did a worse job than they should have in promoting recovery. They paid in the polls. Wall Street wants QEII because it can make money off of it, whether it is a good idea or not. . Economists are afraid to stick their necks out on improved forecasts and bankers probably do not want a rosy outlook because they do not want to lend until the coast is clear. There are lots of agendas in the way of an 'objective' outlook.

Fearing Fear itself- All those economists fearful of the double dip did the economy a great disservice conjuring up risk when the economy did not dip again. Without all those fears don't you think the economy would have done better? I do.

Shame on all this negativism. Stop hiding under your bed.

Sunday, December 5, 2010

The markets play a new game as employment disappoints

Markets did not react as expected to the disappointing jobs report.

Markets acted as though jobs rose and unemployment fell or stayed steady. This tells us that the paradigm of a recovering economy is still locked into the market’s pricing mechanisms. Traders were not able to stampede buyers into the treasury market on a weak jobs report. The pessimists have been routed.

Even though the Fed is expected to continue its QE - especially with this report showing that the economy is still not building that long-expected head-of-steam- NO ONE seems to want to bet on lower rates even with the Fed program fully in gear.

Pretty interesting stuff, eh?

We know that the jobs report has some volatility but this week’s backtrack is really out of the blue. The ADP has been improving, jobless claims have notched down, the quit rate (a reverse indicator) has ticked up. The ISM employment gauges were good –especially for the non-MFG ISM which (fortunately) was released after the employment report or there may have been a more violent negative reaction to the actual release. The non-MFG ISM employment barometer rose to a reading of 52.7 to the 74th percentile of its rate since 1998, a very respectable position. In contrast non-MFG private sector jobs are only in their 63rd percentile over that period. The non-MFG ISM is much stronger than the jobs series it purports to track. Moreover, it was the strongest non-MFG ISM reading for jobs in this expansion –the strongest reading in 37 months, while the non-MFG job gain was the seventh strongest in 37months..

We have other instances of indicators being different from their true-data counterparts. Of course we care the most about the true-data, in this case, the jobs report and the unemployment rate, not the ISMs. But the ISMs are not alone in showing strength. Auto sales have picked up. Other consumer spending has picked up. Jobless claims, another true-data report, has been carving out new lows. Announced corporate lays offs are very low. Yet everything in the November jobs report was disappointing. Was it a massively bad seasonal adjustment problem, or were the strong reports (smaller firms) simply the late reporters and will there be a substantial upward revision next month?

In some sense it is the monthly employment report that is isolated. And we know that seasonal adjustment factors play a big role in this report. We also know the earlier months were on balance revised UP making the month’s weakness even harder to fathom at a time that most indicators other than those for housing are improving.

One additional report that improved and did not get the headlines it deserves is the NFIB employment survey. This is important since so many jobs are in small businesses. So will the monthly jobs report get revised up? We’ll see.

Tuesday, November 30, 2010

Ireland and beyond

Ireland is still in a fix it has not been fixed. In an effort to cut-off the belief in knock on effects a huge package has been given to Ireland that is so massive that Ireland probably will not be able to afford it. Irish banks are in trouble as is Ireland and as are all those banks that lent to them. And while all the Ireland bailout stories are about Ireland, Ireland is not the point. The Ireland and Irish credit default swaps are at issue as well as the not guaranteed loans. In other words the real worry here is not about Ireland but about the various kinds of knock-on effects. These range from the crises spreading to Spain and Portugal to an intensified concern about the banks that lent to these countries.

Europe ran some stress tests but those tests did not really imply much more than mild haircuts on sovereign debt. Everyone knows it was not a real test just as you know the difference between how people act in a fire drill is different compared when there is a real fire. With Ireland we shovel money in, tie Ireland’s hands and feet and pretend everything will be fine. How did this happen?

The e-zone was badly conceived as fiscal rules were too loose. Some of the nations in the Zone have run inflation rates that have further widened price level differences (exacerbating competitiveness issues) within the currency area, instead of narrowing them. This is a difficult and painful situation to remedy. Countries within the Zone cannot depreciate against one another; they are in a locked currency grid. Since December of 1998 German core HICP price level has fallen nearly 8% below the e-Zone average while Greece is 20% above that average, Spain is 12% above that average, Portugal and Ireland are nearly 9% above that average and Italy is 6% above that average. Those are huge shifts of competiveness to give away within a fixed exchange rate system. That list of higher-than-average inflation countries pretty much identifies the countries that are under pressure in the Zone, too. Putting that toothpaste back in the tube will be a huge job. It will take more than just financing or a little soaping down with some Irish Spring.

The current bail out of Ireland has shifted eyes to Portugal and to Spain, Spain being a much larger potential problem than the all the previous countries with difficulties combined. Spain is a large e-Zone nation. The Irish bail out has ratcheted Ireland’s already large deficit-to-GDP ratio from 12% to 32% and some seem to think it can deal with that. Such a burden from the bailout must be viewed with extreme suspicion. Ireland will now operate with a huge weight around its neck. However, any plan that would have given it debt relief would have impacted the international banking system which may still not be off the hook. As Ireland wavers in its task, the banks will remain nervous. On top of that, concerns continue to mount about who is next. Italy’s bonds’ spread to Germany bunds ratcheted to a historic high on Monday. That’s not exactly a vote of confidence in the steps that have been taken to calm frayed nerves.

The economic news shows progress; the burden for the future on some Zone economies is nonetheless huge. The challenge is for the ECB to make one monetary policy that can survive these sorts of strains; it is an extreme challenge, the ultimate reality show. With such a Bundesbank-influenced staff we know how the ECB will tilt its policy and that just brings us back to being skeptical about how this sort of a bailout can work, one that just mounds up the debt on a troubled economy. Have Europe’s banks been saved or are they standing on still-thin ice that continues to make strange cracking sounds? I guess it’s probably not a good time to do another round of stress tests on Europe’s banks, is it?

While the Zone has toted up some nice numbers for November in the EU Commission survey we know that there are termites actively munching on that wooden framework. Solid as it may seem it is under duress. Ireland’s debt load likely cannot be borne by Ireland. It cannot be reduced since that world harm banks or trigger credit default swap payments. We are back in familiar, though not very tasty, soup.

Getting competiveness back in line is a main challenge for the Zone. But how Ireland gets there from here with that load of debt is beyond me. There will have to be some sort of restructuring before long. Is Europe just hoping to forestall the issue until banks are healthier? Can we wait that long? More questions are raised than answered by this alleged bailout which is why we should not call it that. It is a bail-along like a sing-along and it will go on for some time with everybody joining in most of them off-key.

Tuesday, November 16, 2010

Catch QE-II Meets Operation Leap Frog

Catch QE-II Meets Operation Leap Frog

Joseph Heller did not write the script for the Fed’s latest move, but he might have. Ben Bernanke is pursuing a policy that can only work if people suspend disbelief. In Heller’s famous book, Catch-22, the pivotal idea was that while insanity could get you out of military service requesting discharge for the reason of insanity was proof that you were sane after all. That was ‘catch-22.’ In this case there is also a ‘catch’ but if the Fed can get you to stop thinking about the details and to suspend some logistical disbelief, its policy can be effective. Will it?

As the G-20 meet and about 19 out of the 20 members are hostile to the current US policy this is an ever-pressing question.

The problem, or ‘catch’, with QE-II is that mechanically it just is not working. The Fed already has tried reserve injections and banks still are sitting on billions of excess reserves. As any ‘Money and Banking 100’ student knows, if the reserves are not lent by banks (as loans to the public) then the money multiplier is thwarted. So the jump start ability of QE-II is dead in the water from the start since this process is not underway. To see this version QE-II work now, you must suspend disbelief.

But any reserve injection process has two sides to its scissor. Asking which blade of the scissor cuts the paper misses the point. The ‘other blade’ in this case is the Fed’s asset purchase program which enables the reserve injection. But it is hard to believe that a $600bln asset purchase program could have the effect the Fed wants given the huge stock of treasury securities in the world. Again, to see this policy as effective, you must suspend disbelief, or play leap frog...

The Fed and Operation leap frog

Interestingly, the Fed’s policy is unnerving the foreign exchange market. Interestingly, the nations of the G-20 are worried about the impact. What the Fed appears to be successful in doing is in convincing markets that QE-II can leap frog over the broken mechanisms that give the policy teeth and affect market performance anyway. Its scissors are broken, but the Fed is talking with such conviction that its goal has become ‘credible.’ This is an amazing twist of logic and made more amazing since it seems to be working. Future historians looking back at this - if it works – will take it as evidence of cognitive dissonance on a grand scale (this can’t work…but it is working!).

Read the Fed’s last policy statement. It expunged from that statement nearly all forward-looking negative thoughts about the economy. No more forecast that growth will be ‘modest’ or inflation ‘too low.’ The Fed eliminated this sentence for its September 21 policy statement when it issued a new one in November:

With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.”

It also eliminated this one:

The Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be modest in the near term”

It is as though the Fed thinks that through the sheer force of its will and rhetoric it can get the results sought by QE by pretending that QE-II can work. Hence I call it Operation Leap Frog.

Interestingly, the Fed has left in its policy statement the reference to rates being kept low for an extended period of time. But there is no longer a low inflation or growth statement to support that tilt. The Fed is engaged in Open Mouth Operations instead of Open Market Operations to do its will. If it can project the force of its will onto the market and if the market believes that the Fed can have an impact on inflation expectations (raising them) then the Fed can make real interest seem lower than they really are and make current policy more stimulative to the economy.

This is a game. We know the important central role expectations have come to have in modern economics. But, of course, it takes credibility to alter expectations. It takes a ‘policy will’ and ‘mechanical ability’ to do achieve what that will is focused upon. The Fed seems to be succeeding with only one of the prerequisites in place. How is that possible?

Maybe the Fed’s timing is right. Like the Druid priest that warned his people that God will swallow the sun he has no power to make this happen but knows there is an eclipse coming. The Fed has timed its policy move to coincide with the economy actually doing better, and with the US elections that have been cathartic. People have a taste for change. For once they want to believe. They are acting even though it is illogical. Cognitive dissonance rears its helpful head. This is also like the period in the financial crisis when the bank ‘stress tests’ were run as mark-to-market rule were suspended. When banks stocks rebounded the Fed/Treasury argued it was the stress tests that convinced people that banks were safer, when in fact it was the suspension of mark to market rules that had been so destabilizing. Bait and switch can make good policy even if it’s devious. In this case the Fed seems to have channeled some careful timing and a delicate alignment of all the stars. To the G-20’s chagrin QE-II seems to be working. But maybe QE-II is a good thing for its members too.

Bernanke after pushing for $800 billion for TARP for another strangely esoteric ‘reverse auction’ rescue of banks in the depths of the financial crisis may have stumbled or craftily maneuvered (you decide) into anther esoteric rescue scheme. This one may work… but for all the wrong reasons. It will be interesting to see how history will judge him for his various innovations some of which worked some of which did not even get started. But this one will be his crowning achievement – if it works.

This is no ordinary QE.

Sunday, November 7, 2010

Beyond aliens and the trilateral commission

This past week markets again were dazzled by myriad events. The elections produced the expected results. QE was put in motion and defended by the Fed president himself in an unusual Op-Ed piece written after the Fed meeting. October jobs were stronger than expected and past job gains were revised to be stronger so that the trend is now firmer looking and backsliding should see a much more remote possibility.

There’s something about QE… The Fed chairman has defended QE as being not that far from the doings of normal monetary policy. He says that there is little deviation by the Fed from its normal policy. H also says that the Fed takes both sides of its mandate equally seriously. This alone is huge break from the past.

The economics profession has gone a long way in agreeing to what the Phillips curve really is. In the long run there is no unemployment –inflation tradeoff. So what is the Fed chairman doing apparently seeking more growth and more inflation? Well, the economy has lots of slack so there is plenty of room for stimulus to work some magic without creating inflation of the bottleneck sort. But what of inflation due to expectations and stronger money growth? Can’t we get that even with an output gap? There is a debate about that.

Benjamin’s choice: What the Fed has done this time that is different, is to take on the burden for growth in the short term, a burden that had been lifted from its shoulders. Under Paul Volcker the Fed had ‘resolved’ the apparent dichotomy between looking for maximum sustainable growth (MSG) and price stability by arguing that MSG is a long run property, not a short run property. It argued that by pursuing price stability it was freeing the economy to be all that it could be in the long run which is all that the Fed and monetary policy could be expected to do. It is not clear why Bernanke has ‘bought into’ the notion of the Fed having responsibility for short run growth especially with interest rates at zero. Isn’t that about all that the Fed can do? Why put yourself on the hook for more?

The trilateral commission, aliens, and smoke filled rooms - Some think it is because the Fed was under duress and pressure from its role in the financial crisis. While the Fed acted when no other agency did it also did some things that are controversial. On top of that, it made mistakes that helped to foster the crisis. The Fed eventually lobbied to get more power instead of to lose power in the re-regulation of the economic system, and it won its case but to do so did it have to strike a bargain ‘with the devil’ and is this it? Is taking responsibility for short run growth the Fed’s pay-back for retaining and acquiring more power? We may never know if this is some conspiracy theory allegation or if there is truth here. Whatever the reason, Bernanke’s choice puts the Fed in an odd spot.

So is this QE a Bad idea or not? The economics are complicated. But basically the idea is that banks have excess reserves, the raw material to make loans. They choose not to do that,however. They are also under pressure to raise capital and have been prohibited from dividend pay outs. They are being hounded by bank examiners. But they are being encouraged to lend! In any event, they are not lending so money supply is not expanding (or it has not been until recently). As long as we have excess reserves without loan growth the reserve growth is ineffective so why do more?

What it is - The answer here is complicated but it’s a lot of like this… Suppose you have a car and it is sound, except the starter is broken. As long as the starter won’t start it the car can’t run and it sits idle. But if you and some friends can push it down the street, and pop the clutch with the car in motion, the car just might start and be able to run and get to the garage where it could be fixed- problem solved. So there is a way, a bit of an unusual way, to get the car going with a broken starter. In some ways this is the Fed’s plan. The problem is that while it’s a work around it’s a work-around with risk. It’s like getting all the big guys to push that car and putting the lightest teenage pre-driver at the wheel. Once the car gets going can he control it? Can Bernanke? For all his protestation he is in uncharted waters and he is running the Fed on a completely different model since the Fed became successful in controlling inflation. In many ways we are back to the Arthur F Burns trust-me (I’m a central banker and expert) days of five monetary-aggregate monetary-monte. Only Bernanke’s shtick is the depression he means is bank reserves.

Is that a good thing? Aren’t we already depressed?

The really good news and new news last week was the jobs report. For chapter and verse on that see our weekly PowerPoint on the subject.

Let’s Boogie with the Boogieman- For our purposes here, let’s just hit some of the highlights: 159K jobs reported in Oct. combined with upward revisions to past months means that the level of jobs rose by 240K in Oct. We now have more momentum. The work week expanded so its jobs and hours-worked in demand. The NFIB (small business) survey showed less resistance to hiring among small firms. The productivity report showed productivity gains waning from having workers whipped and cajoled and threatened and coerced. The thrill of overtime and fear of unpaid hours worked are gone. There is no more gas in that tank. Firms will now have to HIRE to get more output and spending is picking up. All that is good for job growth prospects. Best of all, however, spending on services is picking up, since that is both the low productivity sector and the sector where jobs are created - that is good news indeed. It’s about time. So those are the main reasons to be really optimistic and to spank any pessimist you see. Double dip is a risk that is gone. It never was that big; those rumor mongers will continue to talk about it until they can put it to rest without harming their own credibility. These are the same people that keep their children from sleeping by telling them the boogieman is under their bed. He isn’t but they don’t know that, so they worry all night about something that isn’t there. It’s a case of how something you ‘know’ that’s really wrong that can hurt you. So forget those fears don’t waste time worrying about what ain’t there. Time to boogie with that boogie man.

Tuesday, November 2, 2010

Back to the future with the Fed?

Back to the future with the Fed

The Federal Reserve is at it again. We now know another round of ‘QE’ (quantitative easing) is in the pipeline even though the FOMC and Board of Governors have not met to approve it. Apparently it is a done-deal and the ‘stimulus’ will be parceled out in batches instead of in one giant slug. What is its objective? How is it supposed to work? What are the risks? Sadly, the Fed has told us little about these things and it will suffer for those omissions.

Too-much is not enough? The Fed has done QE before in this cycle and now we are to have more of the same. Banks already have many billions of dollars in excess reserves and the Fed leaves unexplained how more are supposed to stimulate the economy. I guess this is a case of too-much not being enough. Perhaps the real idea is not what is happening on the reserve injection side but what is happening on the ‘other side’ of this transaction that enables reserve injections, the asset purchase side. To inject reserves the Fed must buy (or accumulate) assets. If that is the case we could argue that this action is more like fiscal policy in disguise than like a monetary policy action. Altering the stocks of assets in the economy is playing with fire. Traditionally the main impact of a central bank’s action has been its operations in the reserve market or in the interest rate market. Traditionally, the main concern with asset stocks has been that they be liquid enough to permit reserve injections or drains without disturbing markets. The Fed policy seems to have turned this upside down- a position many homeowners with mortgages can readily appreciate.

Don’t capital flows trump reserves? If the Fed’s idea is that asset purchases can make a difference, then why not just wait? One of the biggest asset purchase programs of all is already in force. Here I refer to the huge US current account gap. Each month billions of dollars of capital flows surge into the US. That capital needs to go somewhere. These are not funds swimming around in some ‘reserve pool’ locked away by banks, earning a return paid by the Fed and held in ‘excess.’ These are real monies being invested in the active economy. If these can’t stimulate the economy how will the Fed’s behind the curtain flows do it when reserves already are being hoarded to such a degree?

Playing a new game or not? The new reserve injections planned for QEII do not really matter. They do not change the game. If the economy (banking system) reverts to normal times the reserves currently in excess are plenty of kindling to start a fire under the economy –in fact one that would be too hot. The real objective of QEII is to play with this fire and to reduced the stocks of certain assets in the economy to gain some policy traction. The Fed’s idea is to convince market participants that the Fed is playing a new game. But, this game is a chameleon. The Fed calls it ‘end deflation now’ but it is more famously known as ‘start real inflation now’ and it spawned another game years ago called ‘whip inflation now’. The Fed uses only one of these names, but it’s the same game-board. QE is such a crude tool the Fed cannot fine-tune it and assure us that game-one won’t morph into game-two. Yet, the Fed wants to convince us that it is being responsible and that its plan will ‘work,’ ignoring this very important complication. Doesn’t that undermine Fed credibility?

Consuming credibility – Credibility is not a consumption good for a central bank; when it becomes so, it is in especially short-supply. I find these Fed actions surrounding plans for QEII inconsistent with the Fed’s promise of conduct; these actions have become a drain on Fed credibility itself. The Fed’s ’mandates,’ to which it very oddly referred in its last public policy statement, are not the issue. The issue is the Fed’s own conduct measured against its promise to us about how it would act. The Fed no longer is transparent. Its policy is opaque. Policy decisions are being spoon-fed to us by journalists instead of after FOMC meetings or in speeches after a decision is made. We are now informed by leaks or ‘scoops’. The Fed’s policy tilt is being announced to us by consulting economists with inside access before the policy has been formally announced to the public! The Fed is losing credibility as it is no longer truthful. It is not being candid about the risks of QEII and instead is overpromising its results; hubris is not an excuse for overpromising (and ‘overpromising’ a nice word for ‘deception’).

Shooting at a target or itself in the foot? In truth the Fed has no inflation target but it is playing fast and loose with the ‘forecasts’ the FOMC generates in calling inflation ‘too low’. These Fed forecasts (actually FOMC expectations which are presented in a range format) are not policy targets, they are forecasts. Even a long-run desired result can’t be the basis for short run policy although some Fed members have argued this in public. This sort of argumentation leads to more confusion about Fed policy and the role of its public ‘forecasts’. Early in his first term, Ben Bernanke and the Fed considered inflation targeting but could not get agreement, as Congress stood in the way. But the Fed spoke of an inflation cap like other central banks have of 2%. So how does 1% become too low? If 2% is/was the top of a desired range then zero is the bottom and 1% is the middle. How is 1% too low and how has 2% become the new minimum? How did it happen? What was the process? The Fed ‘forecasts’ do not help us here. Without targets the Fed cannot articulate its policy with precision. These sorts of changes appear as chaos. Is this another game of bait and switch using benchmarks that do not even have normal policy standing?

Shell Game? I see the Fed as engaged in another shell game of policy options like the one it pursued under Arthur F Burns with the many-money targets. Only the Fed knows why it is doing what it is doing. We no longer have intermediate targets like money supply growth ranges; we do not have inflation targets or ceilings like other central banks. We do have the occasional Fed ‘forecast’. The Fed’s credibility is its only credibility, if you will pardon that redundancy. But it is true. There is no process from which the Fed can draw credibility. That fact has become another big problem. Even if the Fed extracts us from this mess where does it leave us in terms of being able to trust our central bank? I ‘d say back in the 1970s.

Thursday, October 21, 2010

The eight hundred pound gorilla meets the weight of evidence

The eight hundred pound gorilla meets the weight of evidence

As we see it the Fed is overly fixated on the risk of deflation. Partly the Fed argues that deflation is such a terrible thing, policy needs to ensure it does not take hold. But what is deflation? Is it having the CPI drop for one month? Is it a drop in the headline or in the core? How long or severe does the drop in some key price index need to be for it to be construed as deflation instead of just low inflation with some normal volatility? It’s not as though having some CPI measure negative for one month is going to inject the economy with some fatal disease. I wish the Fed would specify its fear. It has drawn a line on inflation as have other central banks then gone above it. But what about deflation and the number zero? Is it inviolable? What is the trip-wire for the deflation trap?

We know the fear: Japan. But is this ‘Japan’? Is our currency being pushed up accentuating the deflation as it was with Japan? Are stock prices super high and are P/E ratios on the moon? Is all of real estate so wildly overvalued that a long period of adjustment lies ahead? Are residential house prices so high that we need multi-generational mortgages to make buying them at current prices feasible for families? During its most troubled times Japan also had a high debt to GDP ratio. And while we are beginning to worry about our debt ratio, it is nothing like Japan’s. The dollar is weak, not strong. Houses are very affordable, not too-expensive. Stocks are reasonably priced. The parallels with Japan are not strong at all. Still, there is more than one way to enter deflation. Are we just going through a different door?

Disconnect number one: Indeed, the most consistently negative aspect of the US economy has been the amazing tendency for policymakers to see bad news everywhere. These are people with a vested interest in telling you that things are BETTER THAN THEY SEEM! We know the importance of expectations in economics. So why was the President so late in seeing recovery? Why did he deny it after the first good GDP number which, as it turns out, did herald the start of recovery? We know why. It was to gain political advantage and blame the Republicans as long as possible. Political infighting is one main reason why we are not in a better recovery right now. Being pessimistic is seen as being prudent. How did that happen?

And what of the Fed? It seems to be overly concerned about a very mild drop off of core inflation. With the dollar falling and commodity prices so high, is that fear rational?

Disconnect number 2: Interestingly - at least it seems to me - conservatives have become the bulls and liberals the bears on the economy. The liberals (Democrats) want the Fed to do more. The conservatives (Republicans and free market types) do not want the Fed to do more. Politicians of both stripes want the Fed to do something because they do not want to do anything! In taking steps, they risk the ire of the electorate that is worried about the build-up in debt, making new fiscal stimulus tough to get without alienating voters. So our ‘leaders’ have stepped forward by taking a step back –and for that they want to be re-elected?

The sparking short-circuit - The 800 pound gorilla in the room that everyone is ignoring is the fact that if the Fed stimulates an economy that does not need it and if recovery comes, and subsequently overheats, the signals in place from commodity prices gold and money growth will make the Fed’s error look especially foolish. Free-market economists line up, looking at these traditional inflation indicators, wanting the Fed to stay on the sidelines while these signals are flashing. Keynesian economists look in another direction, at the huge GDP gap (short-fall of actual GDP from potential), and feel it will be an inevitable source of further deflationary pressures. So, are we all Keynesians now? Or are we just afraid of being Japanese? And do either of these fears have merit?

The graphs above (graphs are in the blog version of this report email me if want to see them, regrets) look at the core inflation rate and the services sector less the controversial rent of shelter portion and less energy. What we see are broadly mild trends.There are volatile herky-jerky moves on 3-mo growth rates but for the two main components of the core (goods and services) the picture shows infation is still mostly steady and moving sideways even over 3-Mo. For a central bank that talks of inflation being capped at 2% (and 2% is the cap rate that other inflation-targetting central banks use and its one that the Fed had talked about- it has no formal ‘target’) these previaling 3-Mo rates are inflation rates closer to the middle of the range (2% to zero %). The special service category with the rate of change compressed to its three-month horizon shows more distress but also more volatility. We insert that one to stack the deck in the Fed’s favor.And even that one is not compelling. Sure you can wring your hands about this, but is this really creeping deflation?

The upshot is that the parallels with Japan are not as strong as the fears and mutterings of the pundits. The politicians – pick your party, any party- are spineless wimps. They are dumping the case for action in a lap where it does not belong- the Fed’s. The Fed is not as powerful OR as independent as it was once. It was severely criticized for its role in the financial crisis and had to lobby Congress to retain its powers. It is more dependent on Congress and this administration than ever before. And, yes, it has made mistakes but it also acted when the politicians moved to the sidelines in the crises. The Fed bore a load then that it probably should not have; making it bear this one is wrong too.

More monetary stimulus is not the answer. Jobs are the problem. The links from monetary policy to job growth when you have a liquidity trap, as we seem to have, are as strong as a third grader’s construction paper and glue chain link project. The employment problem needs a different fiscal solution. Helicopter Ben can’t solve it. And the ‘threat of deflation’ does not need the Fed’s hand.

It’s not that banks don’t have problems or that the Fed has no role. The new foreclosure imbroglio could be another swat to the backside of the banks. Some think the new push for QE has this risk as its motivator and believe that the Fed will buy up more mortgages to ‘paper over’ the issue. Banks are facing stiffer regulation. And then there is the fact that lower rates do not make them want to lend more, so how is that a solution? Banks are being told that they have to hold more capital and so they want to risk less but everyone is being urged to see MORE risk in this economy. What a comedy of errors! Lending early in a recovery is supposed to be safer since the economy is expanding. Instead, of lending on the expected recovery trajectory banks are not-lending because of the continued risk ‘of deflation,’ slow growth, the potential for backsliding and the large GDP GAP. Is the belief in Keynesian economics holding us back?

From ‘the Big Picture’ to the ‘Bigger Picture’

Is the economy gaining a toe-hold and moving ahead? Is there anything to this fear of backsliding? How did this great economy lose its mojo? We have gone from a nation of rugged individualists to a pampered group of government-aided stay-at-home shut-ins with leaders that urge the over-burdened central bank to carry more of their load instead of making tough decisions themselves. No wonder people are placing bets on China this millennium. If this is an example of what we have become, we are doomed. It’s no wonder either that the Madhatter is spreading his tea party.

Do we still have a spark of entrepreneurship? Are there, not just risk-takers, but any who are not afraid of their own shadow? Can anyone see how dysfunctional our political system has become? Who would bell this cat? How can we get rid of a thing like the electoral college that gives Republicans and Democrats a tight grip on national politics? Why is it popular for our nation to bail out our banks but not to help our people? In comparison concerns about monetary policy-making this cycle pale in importance. Still…

Is Bernanke blinded from seeing the real risk and is he going to be caught in the clutches of the 800 pound gorilla because he is looking at the risks in his rear view mirror, risks that he has studied for so long? And if he makes the BIG MISTAKE all of the above problems will probably be made worse.

Cross roads or double-cross roads? You can almost sense that America is at a cross roads. As at other times in her past this crossroads has come with a huge influx of immigrants, some legal, some not. We are facing a new appraisal of our values. What will government provide for its people? If we have hit the debt limit (debt-to-GDP?) it means we have hit the peak of redistributive policy unless an even more redistributive tax policy is put in place. We are only beginning to see what happens when you increase burdens on the most productive.

It has been easy for politicians to spend more and to dole out benefits when no one paid anything but more interest on the national debt. Now if they have to fund redistribution in real time with real money the tensions will become more acute. We will have our class warfare. If government pulls back on benefits like social security and medical care, as seems inevitable, tensions and vitriol will rise. And as government considers these options we see how poorly the economy operates when these public policies and burdens are shunted off onto private enterprise as we ‘pretend’ that we do not have to pay for them. All polices have costs. Chinese companies offer no health care to their employees. American firms compete with them. US firms have a relatively recently raised minimum wage. China does not have one. And so on.

So we draw the line. But where? And on which side of it will you stand? Most important of all, who will draw it?

Friday, September 17, 2010

Bernanke Obama and Yo’ Mama

Bernanke Obama and Yo’ Mama

This recovery has been very iffy. When times are hard you naturally ask what can the Fed do? What can government do? What about my family? (hence, the title Bernanke, Obama and yo’ Mama).

Out of options? In this cycle I think the Fed is tapped out. The government has fumbled the ball and then, to mix the metaphor, painted itself into a corner. Now it proposes an alternative to a Republican idea, an alternative that even after some thought seems pretty lame. No wonder confidence is slow in forming. It seems pretty clear when all is said and done that policy is dueling it out on a political battlefield not on an economic one. That means the economy is sure to lose out... again.

Why is confidence dropping? Ask yourself this: after everything the Fed and the Administration have done, why is sentiment sinking even as current conditions are improving? Therein lies a story of government that has lost its way and lost control and of a central bank with too much on its plate.

Obama hits rock bottom with Summers:

I recently saw Larry Summers on TV. It’s a bad sign, since Mr Summers is no pitchman. He stood there telling us, or trying to tell us, how much better investment expensing would be than making the Republican tax cuts stick for 10 years when they would send $750bln to the richest of Americans.

Republicans bad! Well, that’s one way to tell the story. But when Larry is talking we know to check our back pockets for our wallets. As usual he has presented us with a glaring and biased view of the trade-offs. Where has intellectual honesty gone? Is anybody stupid enough to believe what he said and take it at face value? I think even partisan Democrats must have choked as they chortled and listened to Larry.

The real deal - In the first place what most people seem to have put on the table is extending the Bush tax cuts for a couple of years not for the ten year period Summers used to inflate the cost. The idea is to extend the cuts until the economy gets on its feet.

The ‘why’ behind extending tax benefits - The reason for this idea is to shield small business from tax hikes. Many small businesses are not incorporated so their owners pay the personal tax rate. This means that if the personal tax rate goes up, the tax on business goes up and that will restrict activity. Congress has known about this for some time and has done nothing to solve the problem. It’s back! A tax hike on high wage earners is one thing; a tax on business is something else. That is what is really at stake and Mr Summers wants to hide that and prefers to sell policy on the basis of ideas rooted in class warfare which can never be good but do get the blood flowing. Summers is a much better economist than political spin-meister but his foray into politics via economics makes him look foolish.

Behind the tax deal - What’s worse is the idea that Summers proposes which is to make all investment spending tax deductible immediately. That would provide tax breaks for investment that responds to a tax incentive plan as well to all the investment that would have occurred anyway. That is a big giveaway. If the plan stimulates a 10% increase in investment spending then 90% of the break is a giveaway. But I guess giving money to big business is more palatable than giving it to ‘rich Americans’ even if some of them are small business owners. When it comes down to it I guess Summers likes capital better than labor. Did capital vote for Obama?

Small help for small business- This investment plan will not help small businesses since they do not invest to get tax breaks if they don’t have business. Large businesses can and do take advantage of such things. In addition there is the problem that a lot of capital investment is labor saving. So what Summers is doing is subsidizing the implementation of capital investment that will substitute for labor. That does not sound very helpful in creating jobs. Moreover, capital equipment is usually very capital intensive in its production. So even if capital goods output is stimulated it will not spur much hiring. The more you look into Summers’ idea, the less attractive it gets.

THE REAL TRADE-OFF- It comes down to this: Give money to rich firms to invest in high-end capital equipment and hope for a trickle of stimulus that will dominate the negative impact of this tax break, or give the tax break to the ‘rich’ knowing some of them are business owners and that a lower tax rate will impact how they manage their firm and deal with issues of economic expansion and hiring.

Different strokes for different folks - Stimulus plans for large well capitalized, well-lawyered up, and fully bureaucratized corporations Vs those for small business are very different things. The Administration does not seem to understand that after all this time. Small business will go with the flow. Large incorporated firms can swim against the current.

Interest rate distortion - Look at Microsoft. This week it announced a bond offering. Why? This firm is loaded with capital, and in the form of extra cash, too. Yet, it has a bond offering. It finds money so cheap it just had to stockpile more. It has no good use for it, but if money is almost free I may as well get some- that’s what they think at Microsoft. If a corporation is huge it can do stock buy backs or something else. At this cost large firms will find some use for the cheap money. A small business never would do that. Not all the corporate borrowing will stimulate jobs some will just dress up the balance sheet.

Rate incentives - More to the point, this behavior shifts our focus to monetary policy. Microsoft, certainly, is not the only firm that finds long term rates very low and very attractive. So if you are on the other side of that trade, say a bank, are you very eager to lend at these rates? I’d say no. It’s one of the reasons I think the Fed is tapped out on policy. Rates are already so low bankers probably do not really want to pile on any more long term fixed rate assets.

Rate disincentives - If a banker makes a 30-Yr loan at a 30-yr fixed rate two ‘bad’ things can happen. The loan can default causing the bank to incur loss. Or, the loan can remain on its books for 30-Yrs causing its investments to underperform. Few expect long term rates to stay this low. All this makes a mockery of the economic theory of the determination of long term interest rates. Banks are dragging their feet in mortgage lending precisely because they are skeptical that rates can stay here for very long. They are being picky about documentation and are setting high standards in terms of credit scores for access to the best rates for mortgage borrowers. In short, they act like they really do not want to do this business. They don’t.

The Truth - Rates that are ‘too low’ will not stimulate the economy, to the extent that demand increases supply pulls back. Low rates may have the opposite impact form what’s intended. As for the Fed’s quantitative easing, if it does not work through interest rates, how does it work? Do we really want another round of the Fed sloshing in reserves hoping they will have some impact on market rates or market spreads? Worsening the excess reserve situation will only make unwinding the process all the harder. If the idea is to stimulate the economy by shifting expectations to see more inflation I’m not sure that is a good route to go. Indeed, at some point too much bloating of the Fed’s balance sheet is not good for the Fed’s reputation or for the dollar. We do not want to flirt with that route. That would be the biggest mistake of all. We did not have such a thing to worry about in the Great Depression Bernanke studied. The dollar is now the principle international reserve asset; it changes the game.

Policy will reveal the Fed’s preferences - What the Fed chooses to do will tell us a lot about what it really thinks. When times get tough, when it is hard to do what is best, it is often best to avoid doing what’s worst. This is the mini-max approach. The aim under this doctrine is to take the path which, if it is wrong, will do the least damage. So what will the Fed do? That will tell us what it really fears. The Fed claims to see the economy doing better. It has cut its outlook but it still sees growth. If the Fed engages in another round of Q-easing we can only conclude that it sees a slippage into a double dip as the most severe risk. If it avoids a second Q–easing we can conclude it believes its own forecast for growth and sees excessive stimulus as the biggest risk. Ironically the more aggressively the Fed behaves the more pessimistic it should make us feel. Since the Fed’s ability to stimulate with quantitative easing is so suspect, it should be reticent about doing something that will trigger negative feedback.

What transparency does - Basically the Fed is stuck making policy in a fish bowl. We can all see what it is doing. We also can assess the impact of what it is doing. When the feedback effect might dominate the stimulus effect, something I believe is true, the Fed should very wary of adopting a new round of stimulus.

Summing up - To sum up, the economy is in recovery. The Fed has cut its view of recovery. Private sector economists have just cut their outlook. Yet, recent economic data have just been showing a bit more upside. We do not know what the Fed thinks will happen or how seriously it fears what ‘might happen.’ But we can infer these thoughts from the Fed’s next move.

The Fork in the road - We do know that there is a deep schism within the Fed. Some members feel their view has been ridden over roughshod. Bernanke keeps testifying that the Fed can do more and is not out of bullets. This is exactly what he should do/say if the Fed is out of bullets and cannot do any more. But at some point we will leave this world of posturing and the Fed will do something. Will it do more stimulus? Or will it try to convince us that it believes the economy really is on the road to recovery? It can’t have it both ways. Its forecast of recovery is undermined by its actions if we get a new Q-easing plan. Withholding a new plan gives the Fed’s forecast of continued growth more credibility. The Fed has reached the fork in the road. It’s time for it to take it.

But which one Yogi?

Tuesday, April 27, 2010

Goldman Again - a post to please no-one

As I watch the senators grill the Goldman folk I have to say that I am both impressed with the way they have gotten up to speed on the industry and yet displeased about how much they seem yet not to understand. Their lack of understanding is their undoing. I have been listening to this testimony today for over nine hours and I would not describe the questions as targeting the key issues like a laser.

Levin is compulsive about Goldman's large - HUGE short (the absolute size of the short); he is also compulsive about the idea that Goldman 'should' be an advocate of the assets Goldman sells to customers. These are two misguided positions by Senator Levin. Sorry, Carl, my fellow Michigander.

If the raw size of Goldman's 'short' in the mortgage market is an issue because it can impact the whole market then the issue should be one of governing market positions in instruments:instrument by instrument. Goldman had a huge short FOR THE PURPOSE OF hedging its huge 'long' in a weak and declining market. I don't think that is/was Carl's point. I don;t think Carl ever really made a damaging point on this subject. Testimonies began at 10AM and this point emerged early on; Yet it took us until Blankfein's commentary late in the day for it to be explained to Levin that the act of being a principle necessarily puts the dealer and his customer on different sides of the trade and with completely opposite risks, at least initially.

If a dealer is selling to a customer in a rising market or buying securities from customers in a falling market both circumstances put the dealer firm at great risk to 'service' the desires of his customer. These risks or interests cannot be 'aligned'. But that IS the business of the securities firm. Hedging that risk and managing it is the crux of the business. If firms sought out clients with the same market views it had, it would never do business with them!

As for transparency, a friend of mine who has been a trader on Wall Street for a long time says the best skill l to being a trader is to play poker. If you played poker would you want your opponent to know what you held in your hand? Of course not. Dealers can't (read that as meaning 'ought not be required to'...) disclose their positions. Some of their customers are very sophisticated and would use that information against a dealer. Senators need to know that. Markets are adversarial. Each transactor needs to look after his or her own interests. Buyer beware! At the same time there are rules to promote fair play. That is the complication of markets; that the point the Senators are missing. 'Caveat emptor', yes, but seller be fair.

There are other business in in which firms undertake a true fiduciary responsibility for their clients. And Goldman is in some of those businesses. But those businesses are not about the deals the that the senators were taking about today.

Now all of this is very different from the charge that Goldman did not just trade securities but it created a security for a client that wanted the price of that security to fall. Now let's point out that while that is peculiar and seems reprehensible, if the deal is properly described there is nothing 'wrong' with it (it's not illegal).

Abacus 2007-AC1 (maybe they should have called it 'Icarus')
Goldman is accused in this one deal (Abacus) of not making a material disclosure related to the deal. Two aspects of this have emerged. Not only does Goldman argue that the role of Paulson need not be revealed- it was material. It was also said by Blankfein today said that he thinks ACA knew what Paulson was doing. We have earlier testimony that points out that Paulson was not in the end listed as being in the equity part of the deal something ACA would have known as it underwrote a good portion of the deal for which it had the responsibility for asset selection and which it insured. Even though there are allegations that Paulson had been originally represented as being an equity player in the end he was not there. Most of the discussion today has not been about that at all.

This Abacus structure is allegedly a security formed with the objective of having it fall in value. This conclusion about the intended performance of the security follows from the fact that the deal was being designed for a Goldman client who wanted to bet against the housing market. A Goldman committee described the deal as being like Goldman 'working an order' for their client, Paulson. The telling aspect of that phrase is that we know the client wanted to short the housing market and that when Goldman works an order it does so without putting it's capital at risk. So Goldman wanted to sell it all.

Yet Goldman operatives deny that the deal was designed to produce a weak security that would fail, although Goldman operatives admit that the firm did not plan to own any of it- it did get stuck with a piece it could not sell. That fact does not allow Goldman to say it was blameless.

When Goldman put Abacus together, the developing information from todays testimonies suggests, it sought a novice firm to insure the deal and to pick the securities, a firm that may have felt 'honored' to have been chosen to do a deal with Goldman. The real client, the Paulson-run hedge fund , the intended short-seller who wanted the deal to fail, was put in meetings with the asset insurer who wanted the deal to succeed. Germane to the case, we have seen documents leading us to believe that the Insurer for Abacus, ACA, thought Goldman's customer, Paulson had a equity position - not that he was a short-seller. Though Goldman puts this allegation in dispute.

We now have for the first time in today's testimony an allegation by the 'Fabulous Fab' that he told ACA that Paulson would be short. We also, interestingly have had a case of the 'fab fab' making errors in statements possibly because of his less-than-stellar grasp of English. He also has described some of his emails as inaccurate because he was in a hurry and being less than completely 'accurate' in his haste. These are two possible lines of defense he can use later on.

Various background documents produced, have quoted Goldman operatives as saying that Goldman did not want to do more business with sophisticated customers but that it wanted to transact more with others since the sophisticated customers were more likely to be on the same side of the trade as what Goldman wanted. That's a nice revelation.

Beyond Abacus
Goldman is confusing the issues in the case and so are the senators by not getting to the facts of the deal that has prompted this investigation and the charges by the SEC about Goldman's wrong-doing. The Senators are going beyond this deal and getting tripped up by confusing Goldman's role in this transaction with the idea of what a dealer does. There is no fiduciary responsibility for a dealer per-se, but there are securities laws. Goldman only has fiduciary responsibility when its firm undertakes that in some of the roles it does play apart from its role as dealer. But in the role of dealer it does not have its client's interests at heart. It is trying to trade and make money, but it still has rules it must follow. On the other hand when it underwrites or originates securities its participation is controlled by other securities laws. Being a dealer is not a license to engage in a free-for-all. The rules depend on whether the firm is trading listed securities or originating new paper or being an investment advisor, and so on.

Goldman is a complicated firm-as are most securities firms. Securities laws are complex. Derivative products are a rat's nest of troubles. Goldman had a number of emails whose contents once disclosed reflected badly on it. Some of this is just the stuff of securities markets and people who are under pressure and letting their guard down, blowing off steam, more than being underhanded. The talk about Goldman selling 'crap' is talk you'll find in every shop in Wall Street, as well as in used car lots and elsewhere. And... one man's crap is another man's fertilizer. It's hard to tell in these emails what is truth and what is just blowing off steam.

No trader thinks he is holding crap but he might call a security that after he sells it, especially if it falls in price. 'Crap' is often made obvious only after the fact. Salesman often have views that differ from that of the firm. Salesmen often think a company has underwritten or has created a security his customers don't want to buy and as a consequence, he does not want to be pushed to sell them. Sometimes the salesmen are right. Sometimes they are not.

The question is - in the case of Abacus - not was there 'pro and con' chatter nor 'did Goldman salesmen ever call it 'crap' (or a more vulgar term),' but was something illegal done? The senators lost their way. Michael Lewis's "Liar's Poker" would be a good book for the senators to read to get some perspective on how salesman work with customers and how they talk. I have worked on the assembly lines in Detroit and on Wall Street at a bank and at a securities firm as well as at the central bank, the Fed. I find the language used in on Wall Street as well as on Detroit's assembly lines has a lot in common.

The key here should be for the senators to pursue those charges that have to do with securities law violations or that have real moral character problems. They seem to have lost their way although they did score some points today.

One of the keys here is to poke through the complications to get at the real issues. The more we get into the complications of the industry, complications of the securities and complications of 'the deal' the more likely it is that Goldman wins. Complication works in Goldman's favor. When things are complex other things go wrong and sometimes that is seen as a result of the complication itself instead of being viewed as being the fault of those who were the transactors or deal architects who may have well understood the complex structure and used it to do no good and shield themselves.

Most disturbing to me is that Blankfein said he heard nothing today that makes him think that Goldman did anything wrong- really? Was he listening to the same stuff I was listening to? Or does he just have lower standards?


Tuesday, April 20, 2010


Several disparate and conflicting thoughts come to mind over he the SEC allegations against Goldman Sachs.

First, is this the best that the SEC could do? After all this time is this their flagship prosecution? It is essentially a case about improper disclosure.

Second, While Goldman makes a number of statements about how it did nothing wrong and that shielding the counter party identities is par for the course, this is the sort of partial-truth blather that makes them seem more culpable, at least to me.

Third, what it is: What Goldman did, as far as I know, is a first in markets. It set out to design a security that would fall in value almost from Day One and it got investors to buy it. We have seen high-risk initial securities offerings before (interestingly, Michael Milken pioneered original issue junk bonds), but in the past the risk was fully disclosed and was reflected in a higher yield and/or an initially discounted issue price. How do you sell such a thing that is not discounted? Goldman apparently intended to make the issue viable by mining the fact that market participants had vastly different views of the market's path and by not making that facet clear. Goldman's internal meeting describes this deal as accommodating a trade for hedge fund investor, Paulson (aspiring short-seller). An internal memo says that Goldman was effectively working an order for Paulson to buy protection on specific layers of the deal's capital structure.

Red badge of innocence, isn't -- While Goldman lost money in the deal, something it now wears as a red badge of innocence, the wound was self inflicted. Goldman seems to have been bearish on housing at the time it arranged the deal. It may have used securities it already had on its books it wanted to hedge or it just may have been caught holding the deal it could not sell. None of that adds to its 'innocence.' Some old expression about playing with fire comes to mind.

Goldman selected ACA, the credit expert company with a low credit rating itself (the smallest and weakest in its country) to be the independent analyst and selector of assets for the deal. ACA was a self-described expert that seems to have lacked a strong market profile despite describing itself as 'expert.' Arguably Goldman picked a weak 'expert' that could be pushed around. ACA would also insure the $909mln of the deal. But ACA collaborated on asset selection, nonetheless, with Paulson for whom the deal was arranged and intended as a short. ACA did not know that. The trader who arranged the ACA Paulson meeting left the meeting between the two calling it 'surreal.' IKB Deutsche industriebank AG bought a $150 mln slice of the deal it said it would only buy if an independent body picked the assets for it. So ACA's participation and control was crucial, at least to IKB. But due to ACA's weakness when the deal went sour its backing was insufficient as a backstop. Only Paulson seems to have gotten what he wanted, despite being described as being not the party with the authority to pick the assets. No wonder the young Goldman trader Fabbrice Tourre described the ACA-Paulson meeting as 'surreal'. One wonders what else that meeting could have been, given the very different objectives of these two participants one of whom did not know that the other was the enemy.

What ever really happened, whatever people were told or not told, it is pretty clear that Goldman put two adversaries together and did not disclose that to one of them. Two of the main parties to the transaction that worked on it together had very different interests in the design of this product and even though 'only one' had the mandate to select assets, as the other would be involved, it's possible that that ACA felt that some accommodation was called for to placate the other, Paulson. It was a sort of kabuki in which nothing was at it seemed.

One thing seems clear, this was not a normal above the board deal. There was a a lot of surreptitiousness here. While Goldman may have buried everyone with technical details on the securities involved and may wish to wash its hands of any further obligation, there seems to have been an underlying objective that was hidden from some of the key participants that Goldman herded together and some had mis-information about the goals of the others. The case in a legal sense will turn on the issue of, was there a material omission or not.

This deal is very tangled. As we learn more, it may not become that much clearer. One thing we know is the that the very complicated structure of theses deals, from the complex roles of the various counter parties, to the math that defines the security itself, gives all participants some degree of cover. But this is hardly the kind of deal we'd expect an expert market maker like Goldman to have championed. One could have looked at theses participants and at this deal and seen that this was not going to turn out well right from the start. But Wall Street is about doing the deal and raking in the commission. At the end of the day that is what Goldman did. What it took to get them there -guilty verdict, plea bargain, or 'vindication'- it does not matter, it has damaged the Goldman reputation. One thing Goldman has been very good at has been protecting itself. That skill is about to be tested.