The Myth of the Slow Crash

[Finster]

Re: The Myth of the Slow Crash

with fed funds at 5.25, lower than inflation [in my books], normalization required all rates going up, with longer rates going up more. what happened mostly is that short riskless rates dropped sharply, while long risky rates went up only a bit. and whatever the absolute level of rates, spreads are still too low, reflecting a continued underpricing of risk.

I agree fed funds @ 5.25% was definitely, by far, lower than inflation for most of the past four or so years. But that changed very fast just in the past few weeks. We hit a deflationary cliff. If anything this highlights the non-utility of very slow, lagging inflation indicators favored by conventional econometricians.

The real financial markets, however, respond instantaneously. The new, lower natural level of interest fell through a cataract. So this normalization occurred, but rather than with respect to past inflation, it was with respect to a rapidly moving target.

With a big caveat, of course. The above does not take into account default risk, real or perceived. That is, it is limited to consideration of the risk-free interest rate. So it does not even attempt to address your contention that spreads are "still too low" …

i am not privy to details on the credit markets, but the impression i receive from my readings is that credit is tight even for traditionally creditworthy borrowers. i suspect we are heading into an overshoot.

i also suspect that there is value in some of the debt instruments that are currently unmarketable. one real underlying problem is the lack of transparency in these instruments. the abcp market is evaporating rapidly, for instance, because people don't know how to value the underlying collateral. that doesn't mean the collateral is worthless. so this [abcp unmarketability] is already an element of overshoot.

i realize that the last remark appears to contradict my assertion that spreads are too low. the variability of risk pricing is what is striking. i think the generic junk bond market is still underpricing risk, while there are pockets in which risk is being priced at infinity and more exotic paper can't be sold at all. these disparities will be resolved, i guess, by risk being priced into junk, not by risk being priced out of exotic junk.

This is hard to dispute, given the infamously low degree of transparency in credit exotica. But worse yet, we have the veracity of credit rating agencies having been called into question. That being the case, shouldn’t we view the ratings as the tail and the actual market pricing as the dog? In other words, if the market is pricing a certain issue at X default risk and the rating agencies are assigning it a Y default risk, the market’s opinion is arguably more valid. So we have little concrete basis upon which to criticize spreads as being "too narrow" or "too wide", just armchair arguments. We will only have such basis for arguing whether risk was being mispriced when we can look back with 20-20 hindsight and identify areas that were being priced for default risk where it turned out to be rare and vice versa. Just as we can do now with issues once given AAA blessings!

[GRG55]

Re: The Myth of the Slow Crash

This may be because the Fed knows the mess is one of its own creation. I’d love to hear Bernanke admit that; just come out and say he realizes that it remained (mostly under Greenspan) tooo accommodative tooo long in 2004-2006. Both in keeping Fed funds too low too long and in being too predictable (euphemism: "transparent") in bringing them back up, thus encouraging the very speculation, housing bubble, and - most of all - credit bubble that threatens the financial system and economy now. Such an admission would be very encouraging to hear because it would allow the Fed to pursue its cleanup effort more vigorously without creating as much fear that it will yet again commit a similar error in doing so.

But we’re not holding our breath…

Agree. The only time I can recall the Fed admitting any reponsibility for anything was when Bernanke told Milton Friedman, at his birthday party, that the Fed caused the 1930's Depression.

I don’t think it was deliberate, since the Fed obviously would have preferred a gradual adjustment, but we have already had at least one "sharp, short deflationary shock". Another such event would IMO be even less deliberate! But that doesn’t mean we won’t get one. Or two or more. But this is an inherent problem in allowing speculative credit excess to build up in the first place. Despite the Fed’s baby-step gradualism and "transparency" in trying to gradually reign in the excess, it just kept building until it collapsed of its own weight. That’s the way real markets work. As suggested above, the slow pace and predictability of the Fed’s "removal of accommodation" merely served to embolden speculation. If it had chosen instead to throw in a couple ad hoc inter-meeting 50 bp hikes back in 2005- 2006, it could have let off some of the steam before it blew out the boiler.

But as you suggest, whether we see $50 oil and $500 gold is very much in the Fed’s hands. Remember it has been on an avowed inflation-fighting mission. This latest market event is the first tangible evidence of success. If it is as gradual and "transparent" in cutting rates as it was in raising them, then it will have won that fight and we could well see your $50 oil and $500 gold. But that would also mean a genuine consumer-led recession. If instead it is determined to try and prevent such recession, then we will not likely see a five-handle on either one ever again.

Unless it’s with another zero at the end…

I am not saying the Fed WILL deliberately try a sharp, short deflationary shock treatment on the patient; but IMO it's within the range of reasonable possibilities. Recognising it would take Fed courage (not an abundant character trait), in no particular order here's some reasons why they might try such a stunt, prior to the inevitable massive re-flationary actions (critique of the soundness of this line of reasoning welcomed):

• period of pain much shorter than the slow drip Japan deflation experience - assuming they don't screw it up;
• forces and concentrates the asset devaluation and debt write offs in the most egregiously inflated sectors (structured credit, real estate, finance sector equities);
• reduces risk of deflationary bleed-through into other parts of the economy by time-function quarantining the really sick part of the economy (the FIRE economy part);
• the more accumulated debt burden that can be euthanized in a deflation event, the less the Fed has to inflate away later, and the greater its future capacity to expand credit to goose the economy without creating excessive inflation;
• magic of securitization has stuffed every foreign pocket with US asset backed credit risk; Volker once pointed out that the Fed is not responsible for the effect of its policies on foreign economies, its only accountable for what happens in the USA.
• driving a wooden stake through the heart of the structured finance mania restores some future control over credit creation that the Fed lost in recent years.
• finally, it would cement Bernanke's reputation (genius if it works, goat if it doesn't) as the man who caused the Greenspan Put to expire and didn't cave in to Wall St's clamour for an immediate rate cut.

However, if they decide their mission is to act aggressively to prevent a recession then you are correct - a 5 handle is unlikely.

[GRG55]

Re: The Myth of the Slow Crash

JK,

you have missed the third and, perhaps the most important reason for a tightening credit spiral, fear. I well remember during 1992 here in the UK that National Westminster Bank was paying big fat bonuses to their staff for the amount of funds they could get back by calling in overdrafts and had put a complete stop on sale of any loans to anyone.

Fear of a complete collapse and thus that, as the collapse spiralled downwards, their own fundamentals for the underlying capitalisation of the bank was driving total fear.

It is fear of what will happen if the collapse continues that has the most dramatic effect upon access to credit. A bank profits from the sale of loans, yes, but survives disaster by calling in everything it can lay its hands on when times get rough.

There were reports that continental European banks were so desperate to raise cash some were calling borrowers during the week of August 13-17, trying to persuade them to make their mortgage payments a few days earlier than contractually required...

[GRG55]

Re: The Myth of the Slow Crash

...i am not privy to details on the credit markets, but the impression i receive from my readings is that credit is tight even for traditionally creditworthy borrowers. i suspect we are heading into an overshoot.

i also suspect that there is value in some of the debt instruments that are currently unmarketable. one real underlying problem is the lack of transparency in these instruments. the abcp market is evaporating rapidly, for instance, because people don't know how to value the underlying collateral. that doesn't mean the collateral is worthless. so this [abcp unmarketability] is already an element of overshoot.

i realize that the last remark appears to contradict my assertion that spreads are too low. the variability of risk pricing is what is striking. i think the generic junk bond market is still underpricing risk, while there are pockets in which risk is being priced at infinity and more exotic paper can't be sold at all. these disparities will be resolved, i guess, by risk being priced into junk, not by risk being priced out of exotic junk.

The vulture funds seem to be cashing up. Goldman, Blackstone, all da boyz are waiting to pounce. I would guess they are 1. waiting to see what the Fed and the Govt plan to do; 2. still raising their war chests; 3. waiting for someone else to be first mover; 4. trying to figure out how to value some of this stuff (yo, we need to build another model...). I would guess either they, or some Govt RTC-style entity, or both, will be the catalyst to get transactions underway again.

[Finster]

Re: The Myth of the Slow Crash

Agree. The only time I can recall the Fed admitting any reponsibility for anything was when Bernanke told Milton Friedman, at his birthday party, that the Fed caused the 1930's Depression.

You are more familiar with this anecdote than I am, GRG55. But Bernanke writings have suggested that the blame lay in the Fed’s having been too slow to ease when the bubble popped, rather than for in its role in inflating it in the first place. This is in contrast to Greenspan, who in a (pre-Fed) incarnation identified the Fed’s blunder with the first cause. Gold and Economic Freedom Greenspan was right.

I am not saying the Fed WILL deliberately try a sharp, short deflationary shock treatment on the patient; but IMO it's within the range of reasonable possibilities. Recognising it would take Fed courage (not an abundant character trait), in no particular order here's some reasons why they might try such a stunt, prior to the inevitable massive re-flationary actions (critique of the soundness of this line of reasoning welcomed):

• period of pain much shorter than the slow drip Japan deflation experience - assuming they don't screw it up;
• forces and concentrates the asset devaluation and debt write offs in the most egregiously inflated sectors (structured credit, real estate, finance sector equities);
• reduces risk of deflationary bleed-through into other parts of the economy by time-function quarantining the really sick part of the economy (the FIRE economy part);
• the more accumulated debt burden that can be euthanized in a deflation event, the less the Fed has to inflate away later, and the greater its future capacity to expand credit to goose the economy without creating excessive inflation;
• magic of securitization has stuffed every foreign pocket with US asset backed credit risk; Volker once pointed out that the Fed is not responsible for the effect of its policies on foreign economies, its only accountable for what happens in the USA.
• driving a wooden stake through the heart of the structured finance mania restores some future control over credit creation that the Fed lost in recent years.
• finally, it would cement Bernanke's reputation (genius if it works, goat if it doesn't) as the man who caused the Greenspan Put to expire and didn't cave in to Wall St's clamour for an immediate rate cut.

However, if they decide their mission is to act aggressively to prevent a recession then you are correct - a 5 handle is unlikely.

If Bernanke is a Volcker, then your scenario is well within the realm of possibility. There’s no denying the positive features of the getting-it-over-with-sooner-rather-than-later argument. But if he (as discussed above) believes the Depression was caused not by excessive Fed ease, but by too much Fed restraint …

[GRG55]

Re: The Myth of the Slow Crash

...Again, we have the phenomenon of abnormally loose credit returning to a more normal state. If we were to call lack of credit availability for uncreditworthy borrowers "tight" credit conditions, we may as well stand atop Everest and call the entire rest of the world a valley.

From the lofty heights of Wall St., with its breathtaking compensation, the entire rest of the world does look like a valley. Now that they are in danger of sliding off the peak, the chorus is calling for an alternate means of escape..."Somebody call Ben to send the helicopter. We need a "flight to safety..."

[GRG55]

Re: The Myth of the Slow Crash

You are more familiar with this anecdote than I am, GRG55. But Bernanke writings have suggested that the blame lay in the Fed’s having been too slow to ease when the bubble popped, rather than for in its role in inflating it in the first place. This is in contrast to Greenspan, who in a (pre-Fed) incarnation identified the Fed’s blunder with the first cause. Gold and Economic Freedom Greenspan was right.

Good catch! You are correct. That'll teach me for taking on the Shadow Fed Chairman...

If Bernanke is a Volcker, then your scenario is well within the realm of possibility. There’s no denying the positive features of the getting-it-over-with-sooner-rather-than-later argument. But if he (as discussed above) believes the Depression was caused not by excessive Fed ease, but by too much Fed restraint …

Volcker is lionized for his actions in the early 1980's, but weren't the conditions for the loss of confidence that led to the 1987 market crash created on his watch?

[Finster]

Re: The Myth of the Slow Crash

Good catch! You are correct. That'll teach me for taking on the Shadow Fed Chairman...

Not trying to 'catch' you at all, GR. ;) In reading your posts, it looks like we are much in accord. If we differ on something here, it's well into in the nit zone ...

Volcker is lionized for his actions in the early 1980's, but weren't the conditions for the loss of confidence that led to the 1987 market crash created on his watch?

You bet. On the other hand, the 1987 crash was less of an economic event and more of a market event. Despite the worry that a depression would follow, it turned out to be of little consequence to other than folks who were levered up into the crash or sold stocks immediately afterward.

Even Greenspan would have to get good marks when he took the helm. His post-crash liquifaction was benign, as inflation continued to abate for several more years. It was sometime around the beginning of 1995 that things started to go really haywire. Reserve requirements were cut, the Boskin Commission dumbed down the CPI, we had the "Mexican Peso Crisis" bailout, and the Fed underwrote a 1920's stock market bubble redux.

[GRG55]

Re: The Myth of the Slow Crash

...You bet. On the other hand, the 1987 crash was less of an economic event and more of a market event. Despite the worry that a depression would follow, it turned out to be of little consequence to other than folks who were levered up into the crash or sold stocks immediately afterward.

Even Greenspan would have to get good marks when he took the helm. His post-crash liquifaction was benign, as inflation continued to abate for several more years. It was sometime around the beginning of 1995 that things started to go really haywire. Reserve requirements were cut, the Boskin Commission dumbed down the CPI, we had the "Mexican Peso Crisis" bailout, and the Fed underwrote a 1920's stock market bubble redux.

Given it was more market event than economic event can we infer Greenspan's motives for his liquidity injection response?

1. There was evidence that the market event was infecting the economy? Or...
2. There was no evidence of any impact on the economy, but Greenspan decided to pre-empt any chance of that? Or...
3. The Greenspan Fed saw protecting/supporting the equity market as within its mandate and an important responsibility?

I wonder if the current financial community view that the Fed "should" protect the stock market, and today's accompanying Pavlovian chorus of "cut the rate, cut the rate...", had it's genesis way back in 1987? Just a thought...

[Chris Coles]

Re: The Myth of the Slow Crash

Multiply your own diverse scenarios by the number of players, world wide, and you get total chaos with no single player certain of anything other than that no one knows who holds the biggest loss and has to make an immediate move to try and avoid total collapse. Perhaps the best advice is indeed to wait for someone else to make the first move.

If EJ is correct, (was correct), to re-start itulip, then the best strategy is to wait for several months at least until you can be certain that the dust has settled. Time is definitely not of the Essence here. The patient war chest will win the best bargains. Buying half way down will only serve to waste resources.

[Finster]

Re: The Myth of the Slow Crash

Given it was more market event than economic event can we infer Greenspan's motives for his liquidity injection response?

1. There was evidence that the market event was infecting the economy? Or...
2. There was no evidence of any impact on the economy, but Greenspan decided to pre-empt any chance of that? Or...
3. The Greenspan Fed saw protecting/supporting the equity market as within its mandate and an important responsibility?

I wonder if the current financial community view that the Fed "should" protect the stock market, and today's accompanying Pavlovian chorus of "cut the rate, cut the rate...", had it's genesis way back in 1987? Just a thought...

As a good a thought as any! We have no inside track on Greenspan's inner motives in 1987. I just view that response as benign in light of later policy actions. In 1987, the market had not become nearly so overvalued. In 2000, it had actually doubled after Greenspan's own famous 1996 musings on "irrational exuberance". Inflation did not skyrocket after 1987. After the 2000-2002 bear market, Greenspan's response produced phenomenal inflation, with commodity prices tripling, house prices going through the roof, and the most out-of-this world speculative credit bubble since 1720. With the repercussions we are seeing now.

All with no visible justification. By 2004-2005, the stock market was zooming skyward again, GDP data were robust, unemployment low, and inflation accelerating to the highest levels in decades, yet the easy money just wouldn’t go away. Greenspan was ever-so-grudging in "removing accommodation" in baby steps, and further incited speculation by being so predictable about it.

This is no mere 20-20 hindsight analysis. Plenty of analysts commented in awe on the credit bubble. The housing bubble was being tracked right here on iTulip. Even in officialdom, talk of a "world awash in liquidity" was becoming routine. Greenspan himself even cited "excessive risk-taking" as a potential danger, all while conducting policy that encouraged it.

In contrast, the 1987 post-crash response was … well … benign.

[GRG55]

Re: The Myth of the Slow Crash

Multiply your own diverse scenarios by the number of players, world wide, and you get total chaos with no single player certain of anything other than that no one knows who holds the biggest loss and has to make an immediate move to try and avoid total collapse. Perhaps the best advice is indeed to wait for someone else to make the first move.

If EJ is correct, (was correct), to re-start itulip, then the best strategy is to wait for several months at least until you can be certain that the dust has settled. Time is definitely not of the Essence here. The patient war chest will win the best bargains. Buying half way down will only serve to waste resources.

Chris: Agree fully that one doesn't want to act prematurely. For me, iTulip sharpens the ability to anticipate, in a world where most investors react. This thread is getting long, but I appreciate that you, Finster and j.k. have hung in there and I value the dialogue. Finster's expectations might come true reading the following about Jackson Hole. Clips from the Sept 3 Independent out of the UK, edited for brevity (emphasis mine):

"The Federal Reserve heard a plea for a full percentage point cut in US interest rates in order to forestall a recession, as central bankers debated the fall-out from the housing market slowdown.
The Harvard University economist Marty Feldstein…arrived at Jackson Hole to deliver a warning that sharp declines in house prices in many areas of the country could trigger a much broader recession, if the Fed did not act.
Lower rates may trigger a period of high inflation, which would have to be dealt with over time, but this was the "lesser of two evils", said Mr Feldstein, whose National Bureau of Economic Research is the recognised arbiter of whether the US

..."What we need to do as central banks, and we are clearly doing that, is to help them in the deleveraging process," said Axel Weber, president of the German Bundesbank and a member of the European Central Bank's governing council, who spoke in Wyoming. "There is no underlying problem of solvency, it's one of liquidity. So swift action is needed."...
..."Addressing one of the underlying issues of the conference, Mr Mishkin (Fed Governor Frederic Mishkin) said the Fed should not use interest rate policy to prevent or prick bubbles in the housing market, but simply use its regulatory powers to ensure responsible lending and use rate changes to manage the wider economic consequences."

So here we have Finster's worst nightmare being advocated as sound policy. My reaction: To Feldstein - Maybe he should start a renominate "The Maestro" movement. To Weber - More than a few former hedge fund managers, foreclosed homeowners and economists (like Roubini) might disagree re: solvency problem. However, given CB's limited toolset, I suppose every problem must be defined as one of liquidity, with a monetary policy remedy, or CBs may appear impotent. To Mishkin - The Bernanke Fed is increasingly indistinguishable from the serial bubble-blower Greenspan Fed.

Clearly the visible political pressure on the Fed & ECB is rising very rapidly; one wonders just how much heat is being applied behind the scenes. Yikes! :eek:

[Chris Coles]

Re: The Myth of the Slow Crash

The underlying problem is not the potential for any action by the FED, but the lack of a free marketplace for capital. At grass roots the industrial inventor is unable to access capital at any cost because he has no access to a free marketplace to obtain it. The same applies to a whole host of micro businesses that as a consequence, never get started at all. Just one example is the demise of the Mom and Pop businesses throughout the western world, not just the USA. So what happened instead is the rules for access to capital became much more onerous and complex and that left all the capital of the nation in the hands of the savings institutions and they in turn had to find somewhere to invest. That led to the numerous different financial vehicles that we see today.

When my grandfather, Francis George Coles was a Jobber on the London Stock Exchange, all he ever dealt with were shares in companies that were being set up to trade in some way or other. Some were risky ventures, others very sound businesses. But all the capital was available to use for trade. Working capital was readily available as long term 25 year bonds at about 4%.

Today, nothing could be further from the truth and most of the capital is mired in an illusion of trading between the financial institutions and governments, many of whom now hold major holdings in the trading companies of other nations.

In my humble opinion, nothing the FED can do will change the underlying problem, other than to force the imposition of free markets, and I mean totally free markets, on capital. And I do not believe that will even enter their minds until the whole edifice has completely crashed as their boss, the government itself, has such a vested interest in the ongoing success of the present system.

[GRG55]

Re: The Myth of the Slow Crash

The Economist Intelligence Unit has published a report titled "Heading for the Rocks - will financial turmoil sink the world economy?" It contains some scenarios for the major economic regions. The link below...

http://a330.g.akamai.net/7/330/25828...he%20rocks.pdf

[Finster]

Re: The Myth of the Slow Crash

Chris: Agree fully that one doesn't want to act prematurely. For me, iTulip sharpens the ability to anticipate, in a world where most investors react. This thread is getting long, but I appreciate that you, Finster and j.k. have hung in there and I value the dialogue. Finster's expectations might come true reading the following about Jackson Hole. Clips from the Sept 3 Independent out of the UK, edited for brevity (emphasis mine):

"The Federal Reserve heard a plea for a full percentage point cut in US interest rates in order to forestall a recession, as central bankers debated the fall-out from the housing market slowdown.
The Harvard University economist Marty Feldstein…arrived at Jackson Hole to deliver a warning that sharp declines in house prices in many areas of the country could trigger a much broader recession, if the Fed did not act.
Lower rates may trigger a period of high inflation, which would have to be dealt with over time, but this was the "lesser of two evils", said Mr Feldstein, whose National Bureau of Economic Research is the recognised arbiter of whether the US

..."What we need to do as central banks, and we are clearly doing that, is to help them in the deleveraging process," said Axel Weber, president of the German Bundesbank and a member of the European Central Bank's governing council, who spoke in Wyoming. "There is no underlying problem of solvency, it's one of liquidity. So swift action is needed."...
..."Addressing one of the underlying issues of the conference, Mr Mishkin (Fed Governor Frederic Mishkin) said the Fed should not use interest rate policy to prevent or prick bubbles in the housing market, but simply use its regulatory powers to ensure responsible lending and use rate changes to manage the wider economic consequences."

So here we have Finster's worst nightmare being advocated as sound policy. My reaction: To Feldstein - Maybe he should start a renominate "The Maestro" movement. To Weber - More than a few former hedge fund managers, foreclosed homeowners and economists (like Roubini) might disagree re: solvency problem. However, given CB's limited toolset, I suppose every problem must be defined as one of liquidity, with a monetary policy remedy, or CBs may appear impotent. To Mishkin - The Bernanke Fed is increasingly indistinguishable from the serial bubble-blower Greenspan Fed.

Clearly the visible political pressure on the Fed & ECB is rising very rapidly; one wonders just how much heat is being applied behind the scenes. Yikes! :eek:

Funny you should mention the Jackson Hole criticism. Just this morning there was a piece on Bloomberg, Fed, Blamed for Asset-Price Inaction, Is Told `Tide Is Turning':

Federal Reserve officials, wrestling with a housing recession that jeopardizes U.S. growth, got an earful from critics at a weekend retreat arguing they should use regulation and interest rates to prevent asset-price bubbles.

Otmar Issing, former chief economist at the European Central Bank, and Stanley Fischer, head of the Bank of Israel, were among guests at the Fed's summer symposium in Jackson Hole, Wyoming, to challenge the hands-off approach. ... ``The position that `this isn't an issue for central banks' has lost some support,'' Issing said in an interview at the gathering, which ran from Aug. 30 to Sept. 1. ``The tide is turning.''

By cutting rates to a four-decade low in 2003, the Fed inflated property values, Ed Leamer, head of an economic forecasting group at the University of California at Los Angeles, said at the conference. The ensuing housing slump, the worst since 1991, and the credit-market turmoil that followed, threaten to undo the six-year economic expansion.

``Central banks, probably on more occasions than they would like to admit, should respond to asset-price bubbles,'' said Fischer...

Bernanke first appeared at Jackson Hole in 1999 with a paper arguing that central banks shouldn't target asset prices except when they affect the economy.

Ahhh, but asset prices are the canary in the inflation mine...