Ben Bernanke and his Fed cohorts will get cheap money flowing with a series of interest-rate cuts. But that won't fix the credit crunch.
By Jon Markman 8.23.07
In a country whose populist heroes are kick-ass rebels Jack Bauer, Jason Bourne and Bart Simpson, it is perhaps only fitting that our latest would-be real-world savior is an economist and banker whose monkish beard makes him look almost countercultural.
Unlike his fictional counterparts who always save the day with a snappy remark or a chop to the throat, Federal Reserve chief Ben Bernanke is working from a terrible script that is doomed. He seems like such a nice man that it's a pity he could go down in history as the first one-term Fed chief in decades, not to mention the accidental steward of one of the world economic system's darkest periods.
It's going to take me a few moments to explain, so bear with me. Here's the problem: Last Friday, Bernanke earned a round of applause from the media by bowing to White House and Wall Street pressure and slashing the rate that the Fed charges the nation's least-creditworthy commercial banks for loans from the public till. He also allowed these sketchy banks to put up their worst loans as collateral and radically lengthened the time that they are permitted to hold onto these borrowings from the standard single day to a month or more.
In doing so, the common belief is that Bernanke provided a much-needed shot of adrenaline to the financial system. Yet this medical metaphor, which seems so apt, really misses the point. What the Fed really did was perform an imperfect version of the Heimlich maneuver on the credit markets, dislodging a blockage in one section of its windpipe only to allow the chicken bone to embed itself more firmly elsewhere.
The Fed is now about to embark on a long series of interest-rate cuts in the face of a global economic slowdown, but it has no proof that cheaper money can, by itself, unwind the worldwide credit crunch.
It could work if Bernanke and other U.S. financial officials are able to persuade the biggest institutional investors here and overseas that it will work. Or it could end up lighting an inflationary brush fire that combines with a recession to create the perfect storm of unending investor pain.
All I can tell you is that the last time this was tried in a pre-contraction environment, it failed miserably. From January 2001 to June 2003, the federal funds rate fell from 6.5% to 1% even as the S&P 500 ($INX) fell by 26%, from 1,320 to 976. The lesson: An earnings collapse beats low interest rates every time.
Bring on the pain
Some veteran market observers have remarked that if the Fed had not cut the rate it charges at its "discount window" to 5.75% from 6.25%, providing the illusion of more liquidity, the Dow Jones Industrial Average ($INDU) could have crashed 1,000 points on Friday or Monday.
Well, this may sound harsh, but in the fullness of time we may pine for the crash. Because instead of a short-term crisis that would have wiped out a few overleveraged hedge funds, brokerages and individuals -- causing terrible pain to innocents as well, no doubt -- we may instead wind up with a debt debacle that stretches on for years and years and harms many more.
The plain fact of the matter is that every few decades since the dawn of paper money, long periods of outstanding economic growth have led complacent noblemen, companies, governments and private citizens to borrow large sums amid boundless optimism that that they will pay the principal and interest back on time. Inevitably, reality has caught up with these sponges at the worst possible moment, and they have been forced to surrender their collateral and pride.
Talk back: Time to bring back debtors prison?
In ancient times, creditors were often permitted to torture debtors, and up to the mid-1800s debtors prison was the destination for irresponsible borrowers.
Exploding packages
Today the situation is quite different in a fascinating way. Blame for bad risk-taking is so spread out, and collateral so ephemeral, it's hard to know whom to punish and what to seize. Even as recently as the 1980s, thrifts took real balance-sheet risk by providing mortgages to individuals.
There were loan officers whose jobs were on the line if they made bad loans, and regulators scrutinized the process. In the last housing bust, several S&L chiefs went to jail for their roles in fraud and mismanagement.
Oh, for the good old days -- a much simpler time before financial engineers figured out, with evil genius, how to distribute risk more widely. In the mid-2000s, when money became super-cheap under former Fed Chairman Alan Greenspan, S&L officers were replaced by mortgage "originators" who were paid merely on volume and were not graded by the after-sale performance of their loans.
Continued: A global game of hot potato
These loans were then distributed to banks such as Wells Fargo (WFC, news, msgs), which in turn sold them to be bundled into securities by brokerages like Bear Stearns (BSC, news, msgs), which in turn repackaged those bundles -- called mortgage-backed securities -- into a new class of financial instruments known as "structured finance" vehicles. These instruments, in some cases known as "collateralized debt obligations," or CDOs, basically smooshed thousands of very high and very low credit risks into a single new income-producing package that could be dolled up enough with marketing, duct tape and pixie dust to earn high marks from credit-rating agencies like Moody's (MCO, news, msgs).
In a global game of hot potato, these income-generating time bombs were then sold to hundreds of hedge-, pension- and money-market-fund managers in Asia, Europe, the Middle East and the United States who had vast pools of money to invest and wanted more yield than they could get from Treasury bills.
I know it sounds crazy, but these CDOs were bought by supposedly sophisticated customers who thought they knew what they were getting, but really had no bloody clue. It didn't really matter for the longest time, when U.S. home prices and incomes were rising and everyone could pay their mortgages. But now that foreclosure rates in parts of California, Florida, Ohio and Michigan are double last year's, home buyers are walking away from their investments. Money has stopped flowing into the humble mortgages underlying so many of these supposedly bulletproof instruments -- undermining the whole house of cards.
Last week, the crisis that led the Fed to act came from the trillion-dollar market for a type of short-term debt known as commercial paper. Buyers of these instruments had suddenly determined that toxic CDOs were being used as collateral in supposedly safe CP, and collectively backed away from the table in a stunning rebuke of issuers.
Said veteran banking analyst Richard Bove in a note to his institutional clients at Punk, Ziegel: The lenders realized "how unbelievably foolish they had been in throwing money after deals that they did not understand; instruments that they had not underwritten; and securities that provided no interest-rate protection against risk."
Cranking up the printing presses
The world cannot run without free-flowing commercial paper, so in order to prevent total worldwide economic collapse, European central banks and the Fed printed an astonishing amount of money -- almost half a trillion bucks -- to flood the zone. Then Bernanke topped it off with the discount-rate cut.
What's wrong with this? It perpetuates the cycle of blamelessness and only prolongs an inevitable splat. As Bove points out, homeowners years ago learned to roll over credit card debt into home-equity loans. Then the rise of negative-amortization home loans allowed people to buy homes with no down payments. Next came "evergreen" loans in which borrowers pay interest but little principal. Then came loans in which lenders actually funded interest costs. More recently have come so-called "covenant light" loans in which borrowers are often allowed to meet their obligations by automatically receiving new loans for the amount of the payment.
Continued: Potential for disaster
Bove notes that the financial system has essentially regressed from one in which borrowers were expected to pay back their debt, to one in which principal was forgotten so long as the interest payments were made, to one in which even interest payments are being refinanced. Now Bernanke has institutionalized this practice by bailing out errant commercial paper holders.
With the growth in total U.S. financial debt outpacing GDP growth, 8.7% to 1.5%, Bove concludes, our economy is not capable of generating the income necessary to meet the debt-repayment requirements. The potential for disaster is mind-blowing, and any steps taken to paper this over are only prolonging the unavoidable wipeout.
My guess is that the Fed will try to inject liquidity into the system many more times over the next few months with scant success. It will take years to unwind this mess, which is probably not a problem that monetary policy, by itself, can solve. On the other hand, who knows? Bernanke could catch a break and pull off a miracle recovery.
So play it like this: The S&P 500 Index is already below its 200-day moving average, which tends to distinguish bullish phases from bearish phases. But the really important uptrend line that traders are watching extends up from 2003 through the 2004 and 2006 lows. So long as the S&P 500 remains above that level, which is 1,370, all is well. A weekly break below that level will lead to cries of the end of the five-year bull market, and they're likely to be correct. So if that occurs, close out your long positions, buy government bonds or government bond exchange-traded funds, and save your physical and mental capital for better times.
If you want to buy something, consider regional banks, which will see their borrowing costs lowered by the Fed at a time when their payouts to customers via passbook savings accounts and CDs will also fall. These were among the few winners in the 2001 rout, so they could work again. You can participate by buying one of the industry's exchange-traded funds: the iShares Dow Jones U.S. Regional Banks (IAT, news, msgs); KBW Regional Banking Index (KRE, news, msgs); or Bank Regional Holders (RKH, news, msgs).
Or you can buy an individual regional bank such as First Busey (BUSE, news, msgs), Virginia Commerce Bancorp (VCBI, news, msgs) or Smithtown Bancorp (SMTB, news, msgs) that have solid long-term records.
Fine Print
To learn more about the Federal Reserve system, visit its Web site. To learn more about structured finance, visit Securitization.net. Learn about the many forms of collateralized debt obligations at Risk Glossary. . . .
To learn more about a debtors prison, check out this page at a Virginia preservation site. Charles Dickens' father was jailed in a debtors prison and the young author was forced to go to work at age 12 in terrible conditions to support his family. This hardship led in part to his literary work.
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