Janet Yellen’s Superb Speech

Ask and you shall receive. Here’s your double dose of Rosie for the evening. From today’s daily letter:

San Francisco Fed President Janet Yellen delivered a superb speech last night that really resonated with us — a true reality check for a stock market which has galloped ahead by 54% from the lows, purely on a record eight point expansion of the P/E multiple. The move in equity valuation suggests that stock market investors are anticipating 4% real GDP growth in the coming year. Janet Yellen has proven to be one of the more astute economic forecasters at the Federal Reserve and so we thought it prudent to re-print part of her sermon.

First, the good news

“I’m happy to report that the downturn has probably now run its course. This summer likely marked the end of the recession and the economy should expand in the second half of this year.”

A slow motion recovery lies ahead

“But I regret to say that I expect the recovery to be tepid. What’s more, the gradual expansion gathering steam will remain vulnerable to shocks. The financial system has improved but is not yet back to normal. It still holds hazards that could derail a fragile recovery. Even if the economy grows as I expect, things won’t feel very good for some time to come. In particular, the unemployment rate will remain elevated for a few more years, meaning hardship for millions of workers. Moreover, the slack in the economy, demonstrated by high unemployment and low utilization of industrial capacity, threatens to push inflation lower at a time when it is already below the level that, in the view of most members of the Federal Open Market Committee (FOMC) best promotes the Fed’s dual mandate for full employment and price stability.”

Sorry, but the credit crisis is not over

“Unfortunately, more credit losses are in store even as the economy improves and overall financial conditions ease. Certainly, households remain stressed. In the face of high and rising unemployment, delinquencies and foreclosures are showing no sign of turning around. The delinquency rate on adjustable-rate mortgages is now up to about 18 percent, and, on fixed-rate loans, it’s about 6 percent. Delinquencies on both types of loans have increased sharply over the past year and are still rising. This trend is consistent across other major loan categories, and is affecting high- and low-quality borrowers alike. Even recent-vintage loans are experiencing rising delinquency rates …

…As I said, financial conditions are better, but not back to normal. And the likelihood of continuing losses by financial institutions will add new fuel to the credit crunch. In particular, small and medium-size banks could experience damaging losses on commercial real estate loans. Thus far, the largest losses have been on loans for construction and land development. Going forward, however, rising loan losses on other commercial real estate lending is likely because property values are falling, office vacancy rates are rising, and credit remains tight or nonexistent for those many property owners that will need to refinance mortgages over the next few years. Financial contagion from this sector is one of the most important threats to recovery.”

Severe consumer headwinds

“The chances are slim for a robust rebound in consumer spending, which represents around 70 percent of economic activity. Of course, consumers are getting a boost from the fiscal stimulus package. But this program is temporary. Over the long term, consumers face daunting issues of their own. In fact, it’s easy to draw a comparison between the financial state of households and that of financial institutions. For years prior to the recession, households went on a spending spree. This occurred during a period that economists call the “Great Moderation,” about two decades when recessions were infrequent and mild, and inflation was low and stable. Credit became ever easier to get and consumers took advantage of this to borrow and buy. Stock and home prices rose year after year, giving households additional wherewithal to keep spending. In this culture of consumption, the personal saving rate fell from around 10 percent in the mid-1980s to 1½ percent or lower in recent years. At the same time, households took on larger proportions of debt. From 1960 to the mid-1980s, debt represented a manageable 65 percent of disposable income. Since then, it has risen steadily, with a notable acceleration in the last economic expansion. By 2008, it had doubled to about 130 percent of income.

It may well be that we are witnessing the start of a new era for consumers following the traumatic financial blows they have endured. The destruction of their nest eggs caused by falling house and stock prices is prompting them to rebuild savings. The personal saving rate is finally on the rise, averaging almost 4½ percent so far this year. While certainly sensible from the standpoint of individual households, this retreat from debt-fueled consumption could reduce the growth rate of consumer spending for years. An increase in saving should ultimately support the economy’s capacity to produce and grow by channeling resources from consumption to investment. And higher investment is the key to greater productivity and faster growth in living standards. But the transition could be painful if subpar growth in consumer spending holds back the pace of economic recovery.”

Read more »

Lehman And Meritocracy

Following on the Lehman thread (one year anniversary and all), here is Andy Kessler writing in Forbes:

Part of the charm of Wall Street, and what scares most reasonable people away, is that it is as close to a meritocracy as exists on this earth. It’s dog eat dog. It’s sink or swim. You do a trade and it makes money, then you’re a hero (for a moment anyway) and deserve a bonus. You bring in a deal, you get paid. You lasso more clients’ assets under your firm’s roof, you’re a hitter. I once discovered some good news on the stocks I followed before the rest of the Street, and mentioned it to the sales force at a morning meeting and moved markets in New York, Tokyo and London. I had the head of global equities pat my head on the elevator ride up the next morning. Pat my head! I was told he never does that.

The flip side, of course, is what makes Wall Street so dangerous. You lose money for the firm and you’re a heel. Do it again and you don’t get paid that year. Do it a third time and you’re out of a job. Just like that. Gone. I’ve seen it happen to friends and acquaintances at just about every firm up and down Wall Street. There is no tenure on Wall Street, no job security, no long-term guarantees. Ten- and 20-year careers end in a flash. Happens all the time, and everybody who works in the business knows this.

…But the crude reality is that Lehman Brothers is a classic Wall Street story. Inside and outside, it was a meritocracy. They wanted to one up on Goldman Sachs, generate as good a return on equity and earnings growth so they could win the meritocracy game and get paid in spades. How dare Bear Stearns’ CEO make more than ours! Let’s lever this sucker up with mortgage-backeds and create a trillion-dollar balance sheet. If not us, who? And by the way, very few people at Lehman really understood how upper management was playing this meritocracy game with the rest of Wall Street with the rank and files’ careers.

Read the full article here

Andy Kessler: Running Money: Hedge Fund Honchos, Monster Markets and My Hunt for the Big Score

Why a Lehman Deal Would Not Have Saved Us

Niall Ferguson writing in the Financial Times:

All would not have been for the best in the best of all possible worlds if only Lehman Brothers had been saved. On the contrary, a decision to bail out Mr Fuld would almost certainly have had worse consequences than letting him and his company go under.

…Lehman’s chief executive persistently over-played his hand, overvaluing the property assets on the bank’s balance sheet by as much as $25bn-30bn. Mr Fuld was adamant: “As long as I am alive this firm will never be sold. And if it is sold after I die, I will reach back from the grave and prevent it.”

…But there was a reason why no buyer could be found in this universe. Lehman was a firm in its death throes. It had lost $6.7bn in the space of six months. It had debts in excess of $600bn. Its assets were collapsing in value. Even when a deal with Barclays seemed within reach, the British Financial Services Authority vetoed it. Alistair Darling, the chancellor of the exchequer, made it clear: “We are not going to import your cancer.”

…Not everything in history is inevitable; contingencies abound. Sometimes it is therefore right to say “if only”. But an imagined rescue of Lehman Brothers is the wrong counterfactual. The right one goes like this. If only Lehman’s failure and the passage of Tarp had been followed – not immediately, but after six months – by a clear statement to the surviving banks that none of them was henceforth too big to fail, then we might actually have learnt something from this crisis.

The real tragedy is that the failure of Lehman has left Wall Street’s survivors both bigger in relative terms and more secure politically. As long as the big banks feel confident that they can count on the government to bail them out – for who would now risk “another Lehman”? – they can more or less ignore calls for lower leverage and saner compensation.

If only we had learnt from Lehman that no bank should be “too big to fail”, we might still have a real capitalist system, instead of the state-guaranteed monstrosity that is the real legacy of last year’s crisis. If only.

Read the full article here

Niall Ferguson: The Ascent of Money: A Financial History of the World

Rosenberg: A Vote for Bonds Over U.S. Stocks

This is from an interview with Rosie in Barron’s:

The equity market is de facto priced for 4% real GDP growth. The corporate-bond market is priced for 2% real GDP growth. So in terms of asset mix, it’s pretty clear that you have more downside protection in corporate bonds right now than you have in equities. And if you can tolerate the risk, you can pick up a 12% coupon in the high-yield market. But if you are a more cautious investor, you have an array of solid investment-grade securities in the A-rated universe where you can pick up a 6% yield. With a negative 2% inflation backdrop, that equates to an 8% real yield — a very juicy rate of return. In the equity market, you have a 4% earnings yield plus a 2% dividend yield, and you are in a riskier part of the capital structure. Corporate bonds are priced for the sort of recovery I have in my forecast.

We are in a post-bubble credit-collapse environment, and what is critical is capital preservation and income. Asset mix is extremely important. We at Gluskin Sheff have a cautious view toward U.S. equities. We’re more positive on Canadian equities, given that the banks are stable and the commodity market is in a bull phase. We’ve been big fans of corporate bonds, though, admittedly, a good part of the low-hanging fruit is behind us. But they will be relative outperformers.

The rally in the U.S. equity market has been so pronounced that it is no longer just pricing in the end of the recession. It is pricing in two years of recovery. At this stage, there is a little too much risk. If the S&P 500 were to correct back to around 840 or 850, versus 1025 recently, I would be much more interested.

Read the full interview here

Myths of the Collapse

Barry Ritholtz of The Big Picture provides a quick overview of the key points many folks seem to be getting wrong about the credit crises:

• The Crisis was a confluence of rare events, a “Perfect Storm”:  To the contrary, the crisis was inevitable. It was the end result of too much liquidity, bad central banking, special legislation, regulatory exemptions, too much risk, misaligned compensation systems, regulatory capture, and a unwavering belief that markets are efficient and humans are rational.

• Lehman should have been saved:  This was not a yes/no decision. The best option would have been a more Bear Stearns approach (w/o the Fed $29B) — a prepackaged, orderly bankruptcy sale/liquidation.

• Regulation was the cause of the collapse: It was not regulation, but specific exemptions from regulation that allowed bankers to run wild. Glass Steagall repeal, CFMA, Net Cap exemptions, ignoring the lack of non-bank lending standards, excess stock option comp, all contributed to the collapse.

• Lehman’s collapse us what killed AIG:  The same riptide that drowned Lehman also swept AIG out to sea: Too much leverage, too much exposure to subprime loans, too many derivatives, too little risk management, with costs borne by shareholders and taxpayers. A classic correlation/causation error.

• Housing’s special status caused the collapse: Housing has long had a special status in America. But the mortgage interest rate deduction has been around for a century. It did not cause the collapse — the abdication of lending standards is at the heart of this crisis.

I also highly recommend reading his book, Bailout Nation, which has a greatly expanded version of this list.

Simon Johnson: Economic Donkeys

This is a great follow up to my previous post. Simon Johnson and Peter Boone discuss the Wall Street-Washington connection, or as Tyler Cowen termed it, the politicization of the economy.

The real problem with our financial system is that our economic and political system work together to encourage excessive risk, and this risk in turn leads to cycles of prosperity and collapse.  In 1998, a much smaller Lehman Brothers was placed in financial peril by the aftermath of the Asian financial crisis and failure of Long Term Capital Management, a major hedge fund.  The Federal Reserve responded by lowering interest rates and other central banks followed suit.   This reduced the cost of obtaining funds, effectively bailing out Lehman and other institutions in trouble.

As markets have grown to recognize how quick the Federal Reserve is to bail out institutions (and executives) in trouble, they naturally respond.  In the 1990s, people talked about the “Greenspan Put” a term which derisively suggests that it is always safe to invest in risky assets, because the Federal Reserve is ready to bail out investors (a put is effectively a promise to buy an asset at a fixed price if you are unable to sell it to someone else at a higher price – this is a way to lock-in profits or limit losses on investments).  However, in months following the collapse of Lehman, we learned that the “Bernanke Put” is even more valuable since Chairman Bernanke, alongside the Bank of England, the European Central Bank, and central banks in much of the rest of the world, is prepared to take drastic measures to prevent asset prices from falling when there are risks of global collapse.

This policy of responding to the aftermath of bubbles, rather than addressing them before they get going, through tighter regulation, has become the mantra of most central banks.  It is usually combined with fiscal policy stimulus and other measures to support the economy.  Each time banks fail, by bailing the system out again, we teach our finance sector a lesson:  you can safely take too much risk because, when you lose, the taxpayer will pick up the bill.  We also send a simple message to creditors:  it is safe to lend to Goldman Sachs, or Barclays Bank, because taxpayers and our nations’ savers are standing by to cover your losses.  Rational bank executives and creditors respond as any person would: creditors lend to banks at low interest rates, and our banks gamble heavily hoping to make large profits.  Such a system is destined to fail, but the party can run for a long time.

A government implicit (now explicit) guarantee absolutely encourages excessive risk taking. FDIC and government implicit guarantees helped lead to the financial crisis by encouraging reckless risk taking, and then the government bailed out the companies. I’m not sure how much of a free market proponent Simon Johnson is, but for the record, what I just described is not how the free market operates. It’s also not capitalism, but once again, the mixed economy at work.

NYT: Where Politics Don’t Belong

Tyler Cowen has an interesting piece in today’s NYT titled “Where Politics Don’t Belong“:

FOR years now, many businesses and individuals in the United States have been relying on the power of government, rather than competition in the marketplace, to increase their wealth. This is politicization of the economy. It made the financial crisis much worse, and the trend is accelerating.

Well before the financial crisis erupted, policy makers treated homeowners as a protected political class and gave mortgage-backed securities privileged regulatory treatment. Furthermore, they allowed and encouraged high leverage and the expectation of bailouts for creditors, which had been practiced numerous times, including the precedent of Long-Term Capital Management in 1998. Without these mistakes, the economy would not have been so invested in leverage and real estate and the financial crisis would have been much milder.

But we are now injecting politics ever more deeply into the American economy, whether it be in finance or in sectors like health care. Not only have we failed to learn from our mistakes, but also we’re repeating them on an ever-larger scale.

I’ve made the point to my friends before that we do not (and have not for quite some time) live in a capitalistic society. We live in a mixed economy: one part capitalism and one part government owned. Mr. Cowen’s article brings back memories of Enron. Enron was totally government supported. Both Democrats and Republicans had their hands in the cookie jar. Enron would not have become what it did without the government’s support. If a business uses the government to gain power, cronyism runs rampant. Do you believe a truly free market would allow this? Let me know.

VF: Good Billions After Bad

Vanity Fair has a long article on TARP that I’m sure will be widely discussed. And for good reason. There are some truly startling revelations in the article. Here are a couple of the highlights:

But once the money left the building, the government lost all track of it. The Treasury Department knew where it had sent the money, but nothing about what was done with it. Did the money aid the recovery? Was it spent for the purposes Congress intended? Did it save banks from collapse? Paulson’s Treasury Department had no idea, and didn’t seem to care. It never required the banks to explain what they did with this unprecedented infusion of capital.

There were no internal controls to gauge success or failure. The goal was simply to dispense as much money as possible, as fast as possible. When Treasury began giving billions to the banks, the department had no policies in place to ensure that the banks were using the money in ways that met the purposes of the program, however defined. One main purpose, as noted, was to free up credit, but there was no incentive to lend and nothing to stop a bank from simply sitting on the money, bolstering its balance sheet and investing in Treasury bills. Indeed, Treasury’s plan was expressly not to ask the banks what they did with the money. As the Government Accountability Office later learned, “the standard agreement between Treasury and the participating institutions does not require that these institutions track or report how they plan to use, or do use, their capital investments.” When the G.A.O. asked Treasury if it intended to ask all tarp recipients to provide such an accounting, Treasury said it did not—and would not. “There’s not a bank in this country that would lend money under [these] terms,” Elizabeth Warren, the chair of a Congressional Oversight Panel that was eventually charged by Congress with overseeing tarp activities, would tell a Senate committee.

There wasn’t even anyone within the tarp office to keep track of the money as it was being disbursed. tarp gave that job—along with a $20 million fee—to a private contractor, Bank of New York Mellon, which also happened to be one of the Big 9. So here was a case of a beneficiary helping to oversee a process in which it was a direct participant. Most of the tarp contracts—for everything from legal services to accounting—were awarded under an expedited procedure that government watchdogs regard as “high-risk,” because it lacks a wide array of routine safeguards. In its first three months of operation, the Office of Financial Stability awarded 15 contracts worth tens of millions of dollars to law firms, fiscal agents, management consultants, and providers of various other services. There was enormous potential for conflicts of interest, and no procedure to deal with them. When the possibility of conflict of interest was raised, two of the contractors voiced vague promises to maintain an “open dialog” and “work in good faith” with Treasury, and left it at that.

The real issue is tarp itself, one of the most questionable ventures the U.S. government has ever pursued. Adopted as a plan to buy up toxic assets—one that was quickly deemed impractical even by those who first proposed it—it evolved into something more closely resembling an all-purpose slush fund flowing out to hundreds of institutions with their own interests and goals, and no incentive to deploy the money toward any clearly defined public purpose.

By and large, the cash that went to the Big 9 simply became part of their capital base, and most of the big banks declined to indicate where the money actually went. Because of the sheer size of these institutions, it’s simply impossible to trace. Bank of America no doubt used a portion of its $25 billion in tarp funds to help it absorb Merrill Lynch. Citigroup revealed in its first quarterly report after receiving $45 billion in tarp funds that it had used $36.5 billion to buy up mortgages and to make new loans, including home loans.

A.I.G., the largest single tarp beneficiary, wasn’t even a bank. The insurance company used its $70 billion in tarp funds to pay off a previous government infusion from the Federal Reserve. The original bailout money had flowed through A.I.G. to Wall Street firms and foreign banks that had incurred big losses on credit-default swaps and other exotic obligations. These were basically the casino-style wagers made by A.I.G. and the counterparties—wagers they lost. The government justified the help by saying it was necessary to prevent disruption to the economy that would be caused by a “disorderly wind-down” of A.I.G. The collapse of Lehman Brothers had occurred just days before the Fed took action, and the shock waves on Wall Street from yet another implosion might have been catastrophic. Bankruptcy court, where troubled corporations routinely wind down their disorderly affairs, would have been another option, though that prospect might not have quickly enough addressed the gathering sense of urgency and doom. We’ll never know. Certainly bankruptcy court would not have allowed A.I.G.’s clients to get full value for their bad investments.

If your blood is already boiling, then you may want to read no further. There are a lot more of “WTF were they thinking” moments in the article. You can read the full thing here.

Why Some Economists Could See the Crisis Coming

Dirk Bezemer discusses his interesting new paper in the Financial Times. The paper presents evidence that accounting (or flow-of-fund) macroeconomic models helped anticipate the credit crisis and economic recession.

You can read the paper here.

Below is an excerpt from the Financial Times article: