The Bernanke Put

December 2007 Malcolm Thomas and Dr. Hans Black

When Ben Bernanke and his counterpart at the US Treasury, Henry Paulson, took the helm of the two leading US financial policymaking institutions, many were looking for decisive changes. Mr. Bernanke, in particular, appeared keen to encourage more democracy within the Fed as well as less emphasis on intuitive “feel” while pushing for greater transparency in decision-making. Along similar lines, Mr. Paulson’s more active and informed assessment of several key issues involving staff input and extensive but careful negotiations – as with China – also marked a refreshing departure from his predecessor. And apart from some early contretemps, both individuals initially scored high marks for policy management, but those were relatively relaxed times marked by above-potential economic expansion, relatively low inflation, buoyant housing, a firm dollar and strong corporate profits. Yes, interest rates were rising along with household debt, and there were signs of excess leverage amidst an explosion in derivative activity, partly based on the housing boom itself. But thoughts of an asset implosion along the lines of the NASDAQ some six years earlier seemed barely conceivable.

Nevertheless, there was one nagging question: Although a major financial crisis was considered unlikely, how would the new leadership at the Fed and US Treasury react should one occur? Would it follow a Greenspan-type response of bailing out the offending sectors to save the economy from recession, thereby incurring moral hazard that could compromise future action? Alternatively, would the Schumpeter process of “creative destruction” be allowed to work again, ridding the economy of excesses and so providing a more solid base for another expansion?

Early this year, when the first major cracks in an overly leveraged US economy began to appear, the commitment to the alternative approach looked as strong as ever, with increased market volatility accepted as inevitable. Indeed, many G7 central bankers and finance ministers became unusually vocal in their belief that risk had been priced far too low, and would have to increase. By mid-summer, when the first serious credit attack began, Central Banks, in the US ands elsewhere, were thus happy to provide funding but were also reluctant to engage in an overt policy response other than (in the Fed’s case) making the cost of emergency lending less onerous. Even in September, the FOMC decision to reduce Fed Funds was said to be “intended to help forestall some of the adverse effects on the broader economy from the disruptions in financial markets.” The rate cut in October was justified along similar lines, that is as insurance.

So at the start of November, with a total of 0.75 percent in rapid-fire cuts under their belts, Fed officials unsurprisingly appeared satisfied that enough such “insurance” had been taken out to offset earlier unfavorable credit and economic developments and prevent recession. While housing was expected to remain in a downturn and consumer spending to slow, other sectors, it was argued, would keep the US economy expanding at an acceptable if slower rate over the next few quarters before returning to potential late next year. This would allow inflation to weaken as resource utilization eased, thus ushering in a period of relative stability. For although the minutes of the FOMC October 31st meeting painted a less encouraging picture, the actual policy statement noted that, with the latest 0.25 percent rate cut, “the upside risks to inflation roughly balance the downside risks to growth.” Subsequent remarks from some regional Fed presidents and even a governor (Randall Kroszner) seemed to emphasize the Fed’s inclination to at least pause for now, given the mixed flow of economic data, latent inflation risk and potential moral hazard issues. High market expectations of another rate cut thus contrasted sharply with Fed statements hinting that no further moves were likely soon. Instead, before deciding the next policy move, officials were clearly more inclined to await incoming data, and in terms of the mortgage situation, allow efforts to directly address key problems by both regulatory bodies and the US Treasury to take shape. Such efforts had begun during the summer but progress had been painfully slow until the increasingly dangerous environment around Structured Investment Vehicles (SIVs) had focused the Treasury Secretary’s attention on the issue. Yet even Mr. Paulson, as indicated by the lack of advance in establishing the Treasury-backed “SuperSiv” to prevent these vehicles from bankruptcy, seemed to be underplaying the severity of the situation.

But all this changed around November 19. Far from easing, the credit crisis actually took a major turn for the worse, intensifying as the reappraisal of risk spread to mortgage insurers and Federal agencies, as well as eliciting enormous asset write-downs in the financial sector. With global stability at risk and the once highly vaunted US bank capital of $800 billion challenged in the face of mortgage and related losses that the OECD considered could amount to over $300 billion, the Fed and the Treasury were obliged quickly to reassess the situation. Mr. Paulson moved to accelerate negotiations with mortgage lenders, hinting that the “rules” governing ARMs would be changed to prevent the next wave of home foreclosures, while both Mr. Bernanke and his vice-chairman Donald Kohn – in open contradiction to statements by other Fed colleagues only a few days earlier – suggested that policy would have to be “pragmatic and flexible” given renewed financial “turbulence”.

So much for transparency, democracy and less of intuitive feel: as with other recent episodes, policymakers’ pain threshold has proved limited in the face of a possible major systemic threat. Or was it that, in a spectacular instance of denial, the Fed leadership had believed the crisis in the mortgage market, which had been bubbling all year and was producing an exponential surge in home foreclosures, was actually past its worst, and were shocked to see that such was not true. This despite the fact that the sub prime problems had clearly spread from asset-backed instruments and related derivatives to structured investment vehicles and beyond, and were now assuming a much more global aspect – as illustrated by events in Europe. In this case, the likelihood of the Fed refusing a bailout would always be tested to breaking point, with the real issue reduced to how low asset prices might have to fall.

While the market appears to have won in forcing the Fed’s (and the Treasury’s) hand, the positive reaction has been immediate though probably temporary. This is because we estimate the size of the credit problem to be far greater than anticipated by either the Fed or the Treasury, though the frantic about-face suggests that officials are finally starting to appreciate the overall picture. In terms of securities at risk — those backed by US subprime and Alt-A mortgages as well as leveraged commercial construction loans — we reckon there are some $2 trillion outstanding. Unless Mr. Paulson can achieve a watertight agreement, we suspect around 30 percent of these will go bad (in a recent Boston Fed study, a 20 percent foreclosure rate is assumed on the basis of post-war experience, but the leverage and exposure is far greater now than before). This means total losses to holders could be some $600 billion, so the Bernanke put may end up being more than even Ben can arrange, helicopters and all. MT

As my dear friend and colleague has indicated in the above essay, we continue to be deeply troubled by what can only be called the early stages of the great financial panic of 2007-2008 (2009?). The key question for us at this point is whether this entire sorry episode will play out over a period of one to three years, such as was the case during the S&L crisis of the late 1980s and early 1990s, or will it resemble the scenario that Japan experienced for over a decade following the stock market collapse of 1989? Clients of this firm as well as long-term readers of these pages will remember the Japanese ordeal as being characterized by repeated denials and repeated half measures to rectify problems that became more evident every day.

If we examine the opening salvos of this crisis nearly a year ago, it is clear we are still in the early stages of the unwinding process, and as Mr. Christian Noyer, governor of the Bank of France and board member of the European Central Bank, indicated recently, it is the unwinding of a credit bubble. Although not a surprise to some, there appear to be many politicians and Wall Streeters in a state of denial, immobilized in the headlights of the approaching train. Even we are surprised by how quickly this has spread beyond the banks, investment banks and other institutions, to engulf mortgage brokers, mortgage insurance companies and, in the most recent episode, U.S. government sponsored enterprises, Fannie Mae and Freddie Mac. The inclusion of Fannie Mae, in particular, is a clear warning of just how rotten the state of credit had become.

Furthermore, it is interesting to see how consumer confidence, not only in Europe but also in Japan and of course North America, has slumped in remarkable unison. Politicians in Asia, notably in Japan and in Singapore, have gone out of their way to tell their citizens they are not involved with the subprime problems. Little do they realize that it is no longer all about the subprime problems but rather about the growing and vastly complicated web of derivatives that have been spun so artfully together by financial institutions in recent years. From credit default swaps to interest rate swaps and countless other versions of modern financial engineering, we are only now learning how difficult some of these instruments are to unwind. Further complicating this entire mess is what we detect is a gradual withdrawal of the confidence that is so fragile in our financial system. One indication is the so-called TED spread (the spread between Treasury bill yields and short-term euro dollar yields) which has been widening steadily, to the point that, as this is being written, it is over 200 basis points, which is very rare in recent years. The key concern, of course, remains the banks and exactly how they will find their way out of these current difficulties.

For now we are content not to be directly involved in these problems. We do not own shares of banking institutions, investment banks, and especially housing stocks in our portfolios. We are troubled, however, by a seemingly flippant comment made by a recently retired central banker we happen to know, who reminded us that occasionally the so-called chickens that come home to roost can land unexpectedly in the backyard of the innocent. We shall endeavor to be vigilant and to use opportunities and cash judiciously. HB