THE BEAR'S LAIR Fed's misplaced fulcrum
By Martin Hutchinson
The investment bank Lehman Brothers spent last week teetering towards the sort
of bankruptcy which, like that of Bear Stearns, Fannie Mae and Freddie Mac,
looked is if it too might result in a "bailout" by the long-suffering US
taxpayer. All four of these institutions shared a common feature: they had far
too much leverage, that is, they had borrowed far too much money to be
compatible with their modest capital bases. Excessive leverage is currently a
characteristic of the US economy as a whole, and we are in the process of
paying the price for it.
Investment banks traditionally had a leverage limit (total assets to
shareholders' equity) of about 20 to 1. That limit was fudged to a certain
extent with subordinated debt, but fudging was limited by investors'
unwillingness to buy subordinated debt of such intrinsically unstable
institutions. However, while investment bank assets traditionally consisted of
commercial paper, bonds and
shares that trade every day and can be valued properly, they have now come to
include investment real estate, private equity stakes, hedge fund positions,
credit default swaps and other derivatives positions that do not even appear on
the balance sheet. Thus even 20 to 1 in modern market conditions is excessive.
Adding in subordinated debt, and claiming that say Lehman has an "11% capital
ratio" works fine in bull markets, but not when things get tough.
Scaling that 20 to 1 up to 30 to 1, as Lehman had at its November 2007
year-end, is asking for trouble. Even if the off-balance sheet credit default
swaps and other derivatives don't lead to problems, and there are no assets
parked in "vehicles" that have to be suddenly taken back on balance sheet, an
institution that is 30 to 1 levered needs to see a decline of only 3.3% in the
value of its assets before its capital is wiped out. Such a decline can happen
frighteningly quickly - it represents only a 10% decline in the value of a
third of the assets.
Lehman's leverage was not exceptional among Wall Street investment banks. At
the last quarterly balance sheet date (May or June), while Lehman's leverage
had been brought down to 23.3 times through asset sales, Morgan Stanley's was
still 30.0 times, Goldman Sachs's 24.3 times and Merrill Lynch's an astounding
44.1 times (or to be fair, 31.5 times at its December 2007 year-end, before new
losses appeared.)
The commercial banks are not as leveraged. At the latest quarter-end, Citigroup
was the most leveraged at 15.4 times, JP Morgan Chase 13.3 times, Wells Fargo
12.4 times, Wachovia 10.8 times and Bank of America 10.5 times. That more
modest leverage is the advantage of proper regulation. Even Fannie Mae and
Freddie Mac, which benefited from a quasi-state guarantee and were dubiously
regulated since they held a stick over their regulator in the form of the
congressional Democrat power structure, had leverage ratios of only 21.5 times
and 29.4 times respectively.
It is thus not surprising that investment banks have taken on the life
expectancy of second lieutenants on the Western Front. With Lehman now
effectively out of the way following its filing for bankruptcy, the speculative
spotlight was set to move to Merrill Lynch, whose share price fell by 12.6%
Friday - indeed with Merrill Lynch's leverage so much higher than its peers I
was surprised that it was still in business. Bank of America's purchase of the
bank over the weekend was a timely move.
Beyond determined a l'outrance resistance to the inevitable taxpayer
bailouts that will be demanded as the investment banks collapse into rubble,
it's not immediately clear what our reaction to the Gotterdammerung of the US
investment banks should be. On the one hand, the modest service-providers of
the 1950s and 1960s, resembling London merchant banks but less aggressive and
slightly smaller, have long gone and been replaced by these trading
conglomerates whose economic purpose beyond self-enrichment is to say the least
unclear.
In terms of long-term market benefit, the conglomerates will be little loss,
probably being replaced by a combination of very conservatively run "too big to
fail" institutions and aggressively entrepreneurial risk-taking boutiques, the
natural destination for those numerate top graduates of more aggression than
cognitive depth.
Nevertheless, the short-term turmoil and devastation will be huge; you can't
hold fire-sales of US$5 trillion of assets without prices collapsing. We are
gradually coming to see more clearly the drivers of the currently impending
downturn, likely to last the best part of a decade from its onset last summer;
there's no doubt that the collapse of Wall Street investment banking will be
one such driver. What has also become clear is that the problem of excessive
leverage is not confined to the investment banks, but operates over the US
economy as a whole.
That is not surprising; investment bankers (the good ones) are among the most
financially and economically sophisticated of mankind, so if they thought
excessive leverage was advantageous, that belief was naturally transmitted to
other less exalted and less wealthy beings:
There was the mortgage salesman who bought several rental properties, on the
assumption that his income was assured and negative cash flow from the
properties didn't matter in an environment of rising real estate prices.
There was the yuppie anxious to impress his friends and attract the opposite
sex, who bought a flashy and mechanically unreliable car on a long-term
automobile loan.
There was the two-income professional couple, who thought that by buying a
McMansion the size of Chatsworth mansion in England, their social status would
turn into that of the Duke of Devonshire.
There was the laid-off manufacturing worker, who thought it didn't matter that
he could find no job paying more than half his old union pay scale because
credit cards would allow his family to live the good life.
There was the low-skill immigrant, legal or illegal, who found the wages he
could earn were totally insufficient to fulfill his dreams of life in the
bountiful United States, but thought that through liberal use of credit cards
and maybe a subprime mortgage, affluence might be forthcoming.
There was the corporate CEO, who understood that buying back stock in his
unexciting company and financing the purchase by junk bonds would increase the
value of his stock options, but failed to realize that it made long-term
corporate survival unlikely to impossible.
Finally, there was the president of the United States, who thought he could
pursue an expensive if unsuccessful foreign policy, allow his congressional
colleagues to be thoroughly sloppy on public spending and introduce new social
programs that pleased his wife, all without raising taxes.
One has some sympathy with all of these hard cases, but it should be recognized
that together they probably form close to a majority of the country, so the
idea of imposing additional taxes on the thrifty minority (or on their children
through excessive budget deficits) in order to bail them out is both morally
abhorrent and fiscally impossible.
Once we recognize that attitudes to borrowing in the US economy have been
pathological for the last decade or more, the true culprit for our coming
troubles becomes clear. The Federal Reserve, by expanding the money supply at a
4% faster annual rate than output for the 13 years since 1995, has made
borrowing both excessively cheap and excessively easy to obtain. Not surprising
therefore that the US savings rate has dropped to less than zero. Fairly
unsurprising also that the epidemic of loose money after 2000 spread to the
globe as a whole, so that borrowers in Bangalore and Beijing are today as
overleveraged and vulnerable as those in Boston.
This isn't a failure of capitalism; the Fed isn't a capitalist institution, and
the United States hasn't had a capitalist financial system since it abandoned
the link to gold in 1933. It is instead a failure of government, which
established the Fed without adequate instructions as to its proper policy.
In a period when, because of the explosive increase in international
communication capability, money supply could be increased excessively without
producing an immediate inflationary backlash, the Fed under Alan Greenspan
succumbed to the temptation of easy popularity and admiring editorials in both
the New York Times and the Wall Street Journal. President George W Bush, not a
man to adhere to Republican "sound money" dogma if he could find a more
populist alternative, chose the most dedicated inflationist he could find as
Greenspan's successor, and the result was history followed by disaster.
The solution is not a return to the gold standard (impossibly deflationary,
given global population growth and economic expansion) but a revised charter
for the Fed. Its mandate must no longer be the dual one of quelling inflation
and fostering employment; the pressures on the Fed from Wall Street and
politicians to expand the money supply are already far too strong. Instead, it
must have the sole mandate of ensuring price stability, where prices are
defined so as to include asset prices as well as consumer prices. Of course,
the Fed cannot govern the world oil market, let alone the US stock market.
Nevertheless it must react to signs of "irrational exuberance" in the stock
market or excessive affluence in the world oil market (that is in country
members of the Organization of Petroleum Exporting Countries) by tightening
money forthwith, unless consumer prices themselves are in sharp deflation.
Warning signals of imbalance abounded for an institution whose job had been to
look for them. The excessive and unwontedly smooth stock market ascent after
1995 was one. The behavior of house prices in and after the 2001 recession was
another. The ability of economically illiterate dictators such as Russia's
Vladimir Putin and Venezuela's Hugo Chavez to sustain themselves in power was a
third signal that the global economy was out of kilter. The sustained US
payments deficit and savings dearth was a fourth.
Tools abound for the Fed to do its job properly. However it needs statutory
authority to do so without excessive interference from Congress and a mandate
that forces it to take broad monetary aggregates seriously, not sweeping them
under the rug as the Fed did with its disgraceful March 2006 abandonment of M3
reporting.
By far the best Fed chairman since the institution appeared in 1913 was Paul
Volcker, whose moral courage overcame opposition from congress and much of Wall
Street to wring inflation out of the system in 1979-87. We can't produce Paul
Volckers on demand; hence the Fed's revised statutes must force the ordinary
slippery and fallible mortals who serve as the Fed's chairmen to pursue a
Volckerian policy.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-07 David W Tice & Associates.)
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