Friday, January 25, 2008

Willem Buiter on the "Bernanke Rule"

(Naked Capitalism) Willem Buiter's immediate reaction to the Fed's emergency rate cut earlier this week was sharply negative, and upon reflection, his view has become even more critical. Buiter sees the reason for the cut as a "knee jerk" response to the prospect of a sharp fall in equity prices. He looks at the proximate causes of the fall – heightened worry about monoline downgrades, and the hasty unwinding of suddenly discovered trades at SocGen – and finds neither points to the sort of fundamental new information about the economy that might justify Fed action.

Note that the SocGen sales aren't the first occasion in recent weeks that sales by a big player has helped fuel a market decline. Cassandra in Tokyo pointed to a sharp down day in Tokyo last week in which the pattern of trading suggested forced sales out of a major portfolio, and similarly, efforts to reduce quant pain played a role in market volatility in August. The Fed should have considered the possibility of exceptional, one-off factors before pulling the trigger.

By happenstance, Cassandra today has learned of the existence of the Bernanke Rule, which is a new and improved version of the Taylor Rule:
The Bernanke Rule, by contrast, stipulates how much the Central Bank should change the nominal interest in response to nominal divergences of the stock market indices from levels that cause those that own lots of stocks - whether leveraged or unleveraged - to hoot, howl, cry-foul, (and this is most important distinction) irrespective of what these changes in interest rates will do to the actual rates of inflation, inflationary expectations, in comparison to any reasonable target rates of inflation.


She and Buiter should compare notes.

Half the reason for reading the post is Buiter's colorful phrase-making. For instance, he swiftly dispatches both the monoline business model and the adequacy (in dollar terms) of the rescue effort. He sees it as patently obvious that they are carrying far more risk than they can credibly handle. He is also, as we are, suspicious of the "rogue trader" explanation of the SocGen mess.

From Buiter:
Even with a few days worth of hindsight, the Fed’s out-of-sequence, out-of-hours 75 basis points cut in the target for the Federal Funds rate continues to look extraordinary and deeply misguided. Indeed, it looks less and less like a decisive pre-emptive move in response to unexpected bad news designed to meet the Fed’s triple mandate of maximum employment, stable prices and moderate long-term interest rates, than a knee-jerk panic reaction to a global stock market collapse.

Did the sharp global decline in stock values at the beginning of this week reflect a rational re-assessment of fundamentals? The only two candidate explanations I have heard are (a) that the collapse was probably triggered by concerns about the financial viability of the monolines and (b) that it was intensified by the unwinding by SocGen of the long equity positions taken by its employee of the year (not!). I find neither explanation convincing. If the collapse was a spurious, non-fundamental event, there is no reason for the Fed to react to it. The ability of the Fed to meet its fundamental objectives is seriously undermined if it is perceived as the poodle of the equity markets.

Monolines

Fear about the credit ratings or even the financial viability of some of the monolines is not a plausible driver of a fundamentals-based stock market retreat. The monolines insure default risk. They don’t diminish it, but only spread it. They therefore fulfil the same economic function as credit default swaps (CDS).

When a monoline insures credit risk, this has a number of consequences. First, if no default has occurred as yet, the debt instrument (a bond, say) that is insured now carries a lower risk premium, provided the probability of default of the monoline is lower than that of the original issuer of the bond and provided the default risk of the original issuer and of the monoline are not perfectly correlated. This is one reason why monolines without a AAA rating cannot get new business. Second, the original issuer (or the party offering the credit-risk-insurance-enhanced instrument) pays an insurance premium to the monoline. If markets are reasonably efficient, there should be no free lunch here: the cost of the default insurance should equal the reduction in borrowing costs permitted because of the insurance.

Third, when a default occurs, it redistributes the financial cost of the default from the holder of the debt instrument to the monoline.

Finally, if monolines are better able to bear the default risk than the issuers of the securities they insure, and if other credit risk insurance mechanisms (e.g. CDS) are not perfect substitutes, there will be an increase in economy-wide efficiency. This could, but need not, be reflected in an increase in aggregate stock market values (adding together the equity of the issuers of the debt and that of the monolines).

Monolines are few in number and small. They don’t have a lot of capital. It seems unlikely that, in an even vaguely rational world, their existence would make a huge different to the performance of the credit markets and, indirectly, the equity markets. It is clear that, while they may well offer credible protection against idiosyncratic default risk of individual borrowers, they will offer no protection against a significant economy-wide increase in defaults, such as may be associated with a recession. Monolines are unbelievably leveraged: last year the value of their outstanding guarantees was 150 times capital, with the notional value of the insured assets at around $ 3.3 trillion and capital of between $20 billion and $25 bn.

It does not take a wildly implausible increase in the level of the average default rate to wipe out this capital. I don’t understand a business model for default risk insurance which implies that your capital will be wiped out if less than 0.7 percent of your insured assets go belly-up. The efforts by New York state's Insurance Superintendent to get a posse of banks to put up between $ 5.0 bn and $15.0 billion to shore up the capital of the monolines, after one of the largest two (AMBAC) lost its AAA rating, seem modest compared to reasonable estimates of the expected losses of the monoline industry. Perhaps the decimal point should be moved one place to the right?

In addition, the monolines share a feature with one of the other villains of the securitisation crisis: the rating agencies. The rating agencies started out rating sovereign debt and large corporates – an activity that does not require more than an abacus and a modal IQ. They then expanded into the rating of complex structured products (ABS, CDOs etc.). They were revealed to be out of their depth in this business.

The monolines started life in the 1970s as insurers of American municipal bonds. In recent years, they have expanded on a large scale into the insurance of complex structured products, such as ABS and CDOs. While there appears to have been little exposure of the monolines to thesubprime market, it would seem to this outsider that they either grossly underestimated the default risk on the bonds they insured, or grossly underpriced it. (They were of course not alone in this during the years of global underestimation/underpricing of credit risk and all other forms of risk from 2003 till 2007). With the reassessment and repricing of risk now under way, it is inevitable that the monolines would take a massive hit and that new underwriting business would be on much more stringent terms. The entry of new, and one hopes better capitalized, firms, such as the venture created by Berkshire Hathaway, into the monoline industry is therefore very welcome.

But the magnitude of the stock market declines stands in no proportion to the fundamental importance of the monolines, even in aggregate. With their ludicrously high leverage, they were never able to provide any kind of cushion against even a small increase in aggregate as opposed to idiosyncratic, default risk.

Société Générale

The fraud at Société Générale, resulting in a € 5bn loss will provide bloggers and columnists everywhere with material for weeks to come. It raises serious issues for regulators and supervisors of banks and other financial institutions. But it is not a macroeconomically significant event. Like all theft, the fraud itself merely redistributed wealth, without any obvious effects on aggregate demand. To make a loss of €5bn, there probably was an exposure of between €50 and €70bn. Société Générale closed all these positions in a hurry starting Monday. This may have contributed to the stock market decline in Europe, but the rout was already under way in Europe (and earlier in Asia), before Société Générale did its bit for the bears. I assume the Fed must have been informed of the Société Générale debacle by the French regulator (the Banque de France) before it decided on its rate cut (Monday evening US time).

The stock market sometimes loses its nerve. Left to its own devices, it will recover it. There is no monetary policy mandate to protect those who lose their nerve against those who don’t. So it looks as though the Fed, like the stock market, simply lost its nerve.

As an aside, I am usually a believer in the screw-up theory of history rather than the conspiracy theory of history, but in the case of Société Générale I am not so sure. How could one man, a junior trader, even if he is a wizz at Solitaire, carry a € 50 billion to € 70 billion position day after day without anyone else noticing? He is supposed to have been long equity. That cannot have been a long outright position, because this would have been noticed in the cash markets. It cannot have been in the equity futures markets either, because that requires margin payments whenever stocks fall. The perp would have been caught a long time ago. So how did he do it? Did he sell equity puts? Could he have done this on his own? Unlikely, I would say. He has also, conveniently, disappeared. If he is found hanging from a bridge somewhere, my suspicions that there is more to this than has thus far met the eye will have been confirmed.

Conclusion

The stock market giveth - the stock market taketh away; and then the stock market giveth again etc. Most of the high frequency movement in stock prices is fluff – noise that policy makers ought to ignore.

Many commentators talk as if a recession in the US is a done deal, with a recession in the UK not far behind and significant weakening in Euroland coming up fast in the outside lane. I am not so sure.

A recession in the US is possible, but not in my view the most likely outcome. Employment appears to be holding up better than would be consistent with the economy already being in recession or about to enter it. Clearly, the housing sector and the financial sector in the US have over-expanded in the latest credit boom and will have to contract painfully. Profits, capital and employment in these two sectors will all fall. But outside these two sectors there has not been any significant degree of excessive capital formation in the US economy. The same holds for the UK. In Euroland the situation is even better, because there the housing sector has only expanded excessively in a few cases (Spain and Ireland), while the financial sector appears to have expanded excessively only in the Netherlands, Germany, Spain and Ireland.

The contraction of the financial sector will have repercussions for the non-financial economy, especially for the household sector, which is more highly leveraged than the non-financial corporate sector. But as yet there is no sign of a major across-the-board decline in activity even in the US, let alone in the UK and in Euroland.

Both the housing sector and the financial sector are among the most vocal sectors in the economy. The amount of attention paid to these sectors by politicians, policy makers and the media is quite disproportionate, when compared to their fundamental economic significance. When regulatory capture extends to the central bank, the quality of monetary policy making is bound to suffer. We have seen this in the US since Greenspan took over from Volcker as Chairman of the Fed. And it continues today.

We will see a slowdown in global growth, with the most severe slowdown likely in the US and the UK. But even there I don’t understand how those yielding the R-word can be as confident as they pretend to be.

2 comments:

Anonymous said...

I'm not sure that there is a majority of credible commentators out there readily wielding the "R" word. I do think that Buiter is being pretty unfair to the FOMC and seems fundamentally opposed to its full employment mandate. I don't think that a fast acting Fed and a strong policy response by Congress is a bad thing in times of liquidity crunch, rising mortgage defaults and potential slowdown or worse, although Buiter has devoted his last two posts to an open mockery of the Fed which lowers his credibility and makes him sound more like a Eurocrat than an economist to me.
If the policy response works and the US dodges a recession, Buiter, the FT, and the Economist magazine will go back to emphasising "global economic imbalances", "asset bubbles", and "over-accommodative monetary policy" like the have been for the last 7 years (or 15 years depending on who you quote). The thing is economic growth has actually been relatively steady since sometime in the 1980s (compared to prior periods), and there have been particularly remarkable breakthroughs in the US economy (productivity gains spring to mind, but they're not the only ones). I would have much preferred to live and work in the US over the last 15 years than in Europe or the UK (having lived in all three places for significant time periods). Buiter and his tribe sometimes seem to me like a bunch of guys who have an idea of how the world "ought" to be economically, and who are dismayed that it isn't so. Perhaps one day they'll be proved right, and, as his colleague Wolf says, the "Anglo-Saxon financial system" will finally collapse under the weight of these "imbalances". But does anyone ever hold these guys to account for getting it wrong as much as they do?

Cormick Grimshaw said...

I suppose even a broken clock is correct once a day. I'm just pissed off because I've been carrying a structural short position for years, and every time it looks to pay off, in comes the Fed put!