Kurt Brouwer March 20th, 2008
Source: Bloomberg
Three headlines from Bloomberg News:
Gold Falls, Capping Biggest Weekly Drop Since 1990 as the Dollar Rallied
Crude Oil Drops Below $100 on Concern U.S. Slowdown May Limit Fuel Demand
Copper Falls, Capping Biggest Weekly Drop in 10 Months, as Demand May Slow
Kurt Brouwer March 18th, 2008
In a piece written for the Financial Times, former Fed Chairman Alan Greenspan admitted that the Fed does not always know what is going on. And, he acknowledged that ultimately the markets have to deal with financial problems such as the subprime lending mess.
Mr. Greenspan also tacitly acknowledged that he did not have a perfect — or even a good — model of risk in the housing markets. This then is probably the closest we will come to a mea culpa from the former Fed chairman [emphasis added]:
We Will Never Have a Perfect Model of Risk (Financial Times, March 16, 2008, Alan Greenspan)
The current financial crisis in the US is likely to be judged in retrospect as the most wrenching since the end of the second world war. It will end eventually when home prices stabilise and with them the value of equity in homes supporting troubled mortgage securities.
Home price stabilisation will restore much-needed clarity to the marketplace because losses will be realised rather than prospective. The major source of contagion will be removed. Financial institutions will then recapitalise or go out of business. Trust in the solvency of remaining counterparties will be gradually restored and issuance of loans and securities will slowly return to normal. Although inventories of vacant single-family homes – those belonging to builders and investors – have recently peaked, until liquidation of these inventories proceeds in earnest, the level at which home prices will stabilise remains problematic.
…The problems, at least in the early stages of this crisis, were most pronounced among banks whose regulatory oversight has been elaborate for years.
…The essential problem is that our models – both risk models and econometric models – as complex as they have become, are still too simple to capture the full array of governing variables that drive global economic reality.
I believe he meant something like this: the models we were using failed because the information that went in was of limited value so the output was not reliable. In computer programming, I believe the phrase is GIGO — garbage in/garbage out.
Kurt Brouwer March 18th, 2008
As expected, the Federal Reserve again cut its key Fed funds’ rate. Some on Wall Street were expecting a larger cut, but this was still a substantial move. In fact, I think we may be reaching the end point in the effectiveness of further rate cuts. Now, it’s really a matter of waiting to see what impact these interest rate cuts as well as the other Fed moves (see The Federal Reserve’s Historic Innovation) are having.
Fed Cuts Funds Rate to Three-Year-Low (Associated Press, March 18, 2008, Martin Crutsinger)
The Federal Reserve on Tuesday slashed a key interest rate by three-fourths of a percentage point, moving aggressively to contain a credit crisis threatening to push the country into a severe recession.
The latest action brought the federal funds rate — the interest that banks charge each other — down to 2.25 percent, the lowest point since late 2004. It marked the second back-to-back cuts of three-fourths of a percentage point.
Fed Chairman Ben Bernanke and his colleages have now cut the funds rate six times since last September, with the reductions becoming more aggressive since January as the central bank has faced growing turmoil in global financial markets.
In Jacksonville, Fla., Tuesday, President Bush said the government will take further action — if necessary — to help the sagging economy.
The rate cut Tuesday caps an unprecedented period of Fed actions aimed at trying to stabilize financial markets and ward off a recession or at least keep it from being too severe.
While the cut was larger than the Fed’s normal quarter-point moves, markets dropped sharply in the moments after the announcement, with investors disappointed that the central bank did not cut rates by a full percentage point…
I hope the Fed takes a breather at this point and allows the economy and the financial markets to go for a while without further intervention unless there is another shock such as the Bear Stearns situation (JP Morgan, Fed Move To Bail Out Bear Stearns).
Kurt Brouwer March 14th, 2008
It appears that Bear Stearns’ attempts to stem the tide of capital fleeing the venerable investment bank may have failed. As in other recents cases such as Thornburg Mortgage, this appears to be driven more by liquidity needs than anything else. The investment bank apparently borrowed short-term and invested or lent over the long-term.
Now, its creditors are calling in their loans and the company is scrambling to find other sources of capital. JP Morgan apparently is stepping in with guarantees of some sort from the Feds [emphasis added below]:
JP Morgan, Fed Move To Bail Out Bear Stearns (New York Times, March 14, 2008, Landon Thomas Jr.)
Bear Stearns, facing a grave liquidity crisis, reached out to JPMorgan on Friday for a short-term financial lifeline and now faces the prospect of the end of its 85-year run as an independent investment bank.
With the support of the Federal Reserve Bank of New York, JPMorgan said in a statement that it had “agreed to provide secured funding to Bear Stearns, as necessary, for an initial period of up to 28 days.”
For the next month, JPMorgan will work with Bear Stearns to reach a solution for its financing crisis. Options could include organizing permanent financing or, according to people briefed on the discussions, buying the bank for a discounted price.
“JPMorgan Chase is working closely with Bear Stearns on securing permanent financing or other alternatives for the company,” JPMorgan said in its statement.
This is not the outcome Bear Stearns shareholders would seek, but it is an example of the creative destruction of capitalism (see Paul Krugman — Capitalism’s Mysterious Triumph). Though they are different types of companies, this type of lack of liquidity led to the sale of Countrywide Mortgage (see Bank of America Snaps Up Countrywide) and no doubt it will happen again.
Kurt Brouwer March 14th, 2008
Martin Feldstein is a distinguished economist who has studied business cycles for many years. This statement indicates his deep concern over the credit crunch that is the primary cause of our current economic slowdown [emphasis added].
US Faces Severe Recession, Feldstein Says (CNBC / Reuters, March 14, 2008)
The United States has entered a recession that could be “substantially more severe” than recent ones, former National Bureau of Economic Research President Martin Feldstein said
“The situation is very bad, the situation is getting worse, and the risks are that it could get very bad,” Feldstein said in a speech at the Futures Industry Association meeting in Boca Raton, Florida.
NBER is a private sector group that is considered the arbiter of U.S. business cycles.
Feldstein said the federal funds rate is headed for 2 percent from the current 3 percent.
This point is no great mystery. Most observers believe the Federal Reserve is going to continue lowering short-term interest rates for a while.
His next point is one that we have discussed as have others. This economic slowdown is not a typical recession, but rather it is more of a financial panic or credit crunch brought on by the subprime lending mess. Therefore, reductions in the Fed Funds rate will not necessarily have the same effect they would have in a more normal economic slowdown.
He added that lower short-term rates from the Federal Reserve would not have the same impact in the current downturn, in terms of reviving economic activity.
“There isn’t much traction in monetary policy these days, I’m afraid, because of a lack of liquidity in the credit markets,” he said.
The Fed’s new credit facility, announced on Tuesday, “can help in a rather small way … but the underlying risks will remain with the institutions that borrow from the Fed, and this does nothing to change their capital,” Feldstein noted…”
Apparently, Mr. Feldstein believes this recession will be unlike the two most recent recessions — 1990-91 and 2001. Other observers think this economic slowdown has many similarities to that of 1990-91, which was also driven by a sharp reduction in real estate prices.
Today’s announcement of a ‘run on the bank’ at Bear Stearns bears out the last point he made (see JP Morgan, Fed Move To Bail Out Bear Stearns). The financial markets are struggling to sort out the risk level of financial institutions and this uncertainty breeds nervousness in the viability of our financial institutions because no one is exactly sure what is going on.