It is somewhat of a fair criticism that playing armchair quarterback years after events unfolded amounts to lazy or devalued analysis. Picking apart assessments with the full benefit of hindsight is seemingly unfair to the participants and targets of any reproach. It also may appear to be irrelevant to spend so much time when current events demand more attention and intellectual rigor. In other words, what standing do I (and the disappointingly few others like me) have to damn the monetary apparatus so vigorously so long after the fact?
Again, those are valid concerns, but the FOMC is a special case. What they did in 2008 is entirely relevant to what is transpiring in 2014, not the least of which is that the regime crafted in 2008 is central to the 2014 condition. Further, and most importantly, that regime rests almost fully on the carefully crafted illusion that the FOMC capabilities contain both a high degree of understanding (far higher than the casual observer) and the ability to correctly discern programs that take advantage of that understanding to achieve stated purposes.
To offer a fuller accounting here, and to assert my own standing in this argument, I offer some contrast. In September 2008, the discussion of the Wachovia’s demise included what should be a startling admission:
ALVAREZ. Also, there was concern that, because Wachovia looked so strong on a capital basis and it would be somewhat surprising to some in the market when it closed, it would send a bad signal about similarly situated institutions.
Like almost everything else during that period, the economists that make up the Fed panel were shocked that such a “well capitalized” bank would be on the brink of a full bank run, pulling down the system with it – as if market participants solely concern themselves with audited financial statements. This group includes enormous resources at their collective disposal, including real-time monitoring of markets that we can’t really fathom. If any body in the world was as “plugged in” as the FOMC, particularly through the Open Market Desk (Bill Dudley), it was these people.
This is what I wrote with just an internet connection, some good knowledge of actual financial plumbing and enough familiarity with the math to be plausibly critical:
That strategy worked, at first. As the subprime mortgage mess became big news in February, valuations of CDO’s backed by them fell. The market value of them in the BSHGSCS [one of the Bear Stearns funds that collapsed] fell 14.4%. Just as the hedge was designed, the ABS index value also dropped and the funds saw 13.5% gain – not a full hedge but effective enough to limit losses. The BSHGSCSELH [the other Bear hedge fund] saw a 4.4% decline in market value but earned 5.3% on its hedging.
Then the wheels fell off exactly where the models cannot predict. Despite the falling valuation of subprime CDO’s the ABX index stabilized. It seemed that the subprime loans made before the middle of 2006 were performing within constraints – it was the loans made in the third and fourth quarters that were trouble. This distinction was the reason for the “all clear” signal that Wall Street and the Fed sent shortly after the New Century and Countrywide troubles were made public.
I wrote that on August 1, 2007, a full week before the eurodollar market froze. It was clear, to me at least, that there had already been a fuse lit, burning its way through not just specialized segments of finance, but the basis of the entire system as it existed at that time. What was most interesting about those two hedge funds was their ultimate disposition, as essentially all the major firms took losses – with no collateral seizures to offset them. It didn’t take much intellectual capacity to figure out why. Again, from August 1, 2007:
There is another side to the liquidity problem, another good reason for pushing the light of market pricing into the future. If recovery rates have fallen, default rates have risen, a correlation amongst and between both, then valuations across all CDO’s, not just subprime-backed securities, may have to be adjusted lower. Since hedge funds use so much leverage, even a small decrease in valuations would lead to a run of margin calls. The resulting run of asset sales, in that illiquid market, would force prices still lower. The lower recovery rates would pressure all those counterparty default swap agreements and strain banks and insurance companies. The resulting cascade could jeopardize the entire financial system, a financial Armageddon. Small wonder Bear, Merrill, JP Morgan and other not-yet named parties to the debacle have eaten their losses privately.
My original prognosis, economically speaking, in August 2007 was recession in early 2008 and recovery by the end of that year. At the time, the scale was not yet as evident, as it seemed there were mitigating factors, potentially, at play. By November 2007, however, I had significantly downgraded my outlook despite “emergency” Fed moves that, to me, appeared to be misunderstanding the real problems. From November 23, 2007:
The real lesson in the crisis [eurodollars] may be that a near panic resulted from limited information about the true nature of the credit derivative problem. Fear of losses in subprime-backed securities led to a near shutdown of the $2 trillion commercial paper market, which led to a near meltdown in the banking system as banks struggled to maintain liquidity in the face of ever-growing fears. It was a self-perpetuating cascade, the very cascade Wall Street has been having nightmares about, resulting from imperfect information. Nothing has changed since August in that regard.
If markets can meltdown over speculation of losses, what is its fate if such losses become known? The definitive conclusion from this episode is that investor confidence is severely shaken. That confidence has not in any way been restored. The next shoe to drop may be a true panic that overwhelms some institutions and forces the Fed into really hard choices.
Using just SEC filings and assorted anecdotes, I uncovered the hornet’s nest. Again, November 23, 2007:
The scope of the problem is huge, and it is not easily pinned down. But somewhere on Wall Street these six firms [JPM, C, BAC, BSC, MER, GS] have an idea of how bad things can get. Just perusing six balance sheets we have pieced together an estimate. The amount of these assets that are off balance sheets is enough to cause a panic…
As the losses continue liquidity again becomes a problem. The potential for another bank run [unlike most commentary of the age, I referred to the August 2007 eurodollar freeze as a bank run, which I still believe is the correct designation] is there as banks absorb greater losses and get pulled into the CDO mess even further. Investor confidence, already shaken, may take the next panic to another level. We see money market funds as perhaps being the catalyst – the next shoe.
Knowing the Fed all too well, I could see where this was going in terms of policy (still November 23, 2007):
We argued in August that a recession would result from the credit derivative crisis. We now have a much clearer picture into the mechanism for contraction. At this point we cannot see how to avoid a recession. The Fed will be torn between its two conflicting purposes and even if it were to lower interest rates to near zero that will not stoke economic growth in the context of the banking crisis. Lowering short-term interest rates in the hope of increasing growth can only work if banks are functioning normally.
But banks are busy managing risks in loans they have already made, packaged and sold, and are now forced to take back. New loans to consumers and businesses are forced to the back burner regardless of the interest rate environment. The only interest rates banks will be paying attention to are the commercial paper rates they depend on to fund their day-to-day operations.
I think that is a stark enough contrast in predictive capacity from what I wrote well in advance, in 2007, and how badly the FOMC botched affairs all the way to the panic of 2008. By no means was I correct on everything, including my own expectations for inflation and that I actually defended the Federal Reserve in some respects to that point, but it was apparent that these were fatal flaws, not minor disruptions. That should establish for me at least some minimum credentials for continued assault on the capabilities of the modern monetary practitioners – especially considering the vast disparity in resources between myself and the whole array of the Federal Reserve System (including the banks themselves, as they engaged in continuous and close consultation – too close at times).
Mr. Alvarez’ September 2008 contention that Wachovia’s failure would represent a surprise to the “markets” is more than interesting. It was surprising only to the FOMC committee as apparently they took Wachovia’s word and accounting statements at face value. In other words, they did no independent research on their own, despite the power of regulation and inside positioning as well as impressive resources, and blindly followed their bland ideology.
Adherence to orthodoxy overwhelmed, and it wasn’t close, basic human curiosity that perhaps a dynamic world may have changed since the Fed machinery was put in place in the 1980’s. The FOMC talked about money supply in the ancient terms of M1 and M2, meanwhile commercial paper and repos, not to mention the entire eurodollar apparatus that supported all global finance, had ceased to function already by September 2007. Derivatives markets were spreading contagion, and the FOMC sputtered on about subprime as if it were something to be addressed by FICO score alterations. They patted themselves on the backs for bravely cutting the federal funds target by 50 bps (September 2007), fully believing in the magic of interest rate “stimulus” to counter everything and anything. Meanwhile, the unsecured lending markets, the very mechanism in which their interest rate target mysticism channels, had already stopped being a primary avenue of marginal funding altogether.
A little research and observation would have served them far better than sclerotic dedication to orthodox pieties. There is no excuse.
To this day, unsecured interbank lending remains a dream of that less sophisticated age where economists really believed all they had to do was change one interest rate number to effortlessly engineer “moderation.” Worse, they still claim the exact same mantle of competence and power, which makes this exhaustive and exhausting examination of hindsight more than fair game.
Click here to sign up for our free weekly e-newsletter.
“Wealth preservation and accumulation through thoughtful investing.”
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, contact us at: firstname.lastname@example.org