The Fed Vs. The ECB

The talk started last week in the media, only to be ramped up today with the equity market down and the economic news weaker. Look what the ECB (and a few others) are doing! They're out throwing gobs and gobs of liquidity at the markets in the hope that something beautiful will grow. The Fed, on the other hand, is performing more surgical strikes, trying to get at the root cause of the problem, the stagnation of the money markets. The pundits here are screaming up and down, "Why can't the Fed be more like the ECB?" My answer would be, "Why should they be?"

The ECB's policy of flooding the market with short-term liquidity is uninspired and, for all intents and purposes, ineffective. The ECB is like an army with only one weapon. It's not entirely their fault; the problem derives from the EU's inherent political weakness. Different growth rates and differing political agendas among the EU's member states makes the ECB's job (whatever it might be) difficult. Their policy is akin to city looking to solve its crime problem by calling in a carpet-bombing air strike. Sure, the crime problem is solved but no one is around to benefit. The problem with throwing liquidity at the situation is that it is not targeted at the areas in trouble, it has a diminishing marginal return, and the markets become dependent on its continual occurrence. The end goal is to create a smoothly functioning market, not a socialist welfare state for the banking system.

The Fed's goal seems to be to nudge the money markets back to normal function. They have made moves toward that end, being as minimalist as possible. Listening to some, you would think it is 1932 and that the New Deal needs to be recreated immediately. Take a look around, it is not that bad. Let the excesses wring themselves out of the market and let's see what happens.

Pardon the language, but the throwing of shit on the wall to see what sticks isn't the answer here. Smooth out the money markets, remove the excesses, and restore market confidence will go a long way to putting us back on track.

Merry Christmas and Happy New Year

I know it isn't PC, but Merry Christmas and Happy New Year!

The Fed Weighs In On Changes To Reg Z

I debated today whether to write about Goldman Sachs' remarkable quarter/year or about the Fed's proposed rule changes. On the former topic, for all those analysts out there that were blind to fact that credit markets were way overvalued for sometime, Goldman's results prove that at least one group out there knew what was coming, had the right controls in place and executed a successful strategy in very difficult markets.

Let's move on to the Fed, shall we? I have stated many times in this forum that the blame in this situation (if blame is the appropriate word) needs to be spread around to all parties involved, not just the mortgage originators/sellers. The Fed's pronouncements today don't really help out on that front. Deceptive and illegal practices should, without saying, be addressed by authorities. If these practices were so rampant, why was there no clamor to change/investigate them six months ago or a year ago? It has been tacit policy of every Administration over the past 60 years to increase the level home ownership in the United States. It has been the desire of most Americans to own a home for long before that. Over the years, home financing has become more creative and complex to accomodate more and more buyers. This market is no different than any other speculative market situation over the past 500 years. Loans were made to people and/or against properties that should not have been made. Due diligence had fallen by the wayside. When home values ceased rising, the whole scheme unwound.

Most of the attempts on the Federal level to remediate the current situation will, in my opinion, lengthen the time will take the market to resolve this mess. Loans need to default or restructure, homes need to foreclose, housing prices need to fall to a market clearing level, whatever that happens to be on a local basis. Some owners will revert to being renters, most likely people that shouldn't have been lent money to buy a house in the first place. Lenders will go out of business, or, more likely, be taken over by strong/opportunistic players.

The Fed's actions on Reg Z today, if implemented, will effectively shut down the sub prime mortgage market, at least until someone finds a way around the new rules. I don't think that should be the answer. For a price, people and companies should be allow to accept those risks, on both sides. Otherwise, what is being said is that this market shouldn't have existed in the first place. That's OK by me, but let's have the Fed, the Treasury, and Congress come out and state they were wrong to allow this to develop. That's not going to happen, nor should it as some, on both sides of the homeownership coin, benefitted from the existence of a sub prime mortgage market.

Do The Right Thing

Vikram Pandit made a bold move last week, particularly in light of short tenure on the job. Taking the approximately $50 billion of SIVs and placing them on Citi's balance sheet is the right thing to do. It recognizes the seriousness of the festering credibility issue that the credit markets find themselves. For months now, market experts have been chiding the US Government and the Fed to take some action, primarily in the form of a lower Fed Funds rate. The Fed has obliged with 100 bp (so far), with little effect on the problem at hand (as predicted in this and other learned forums). They have, however, propped up the stock market. The reason why a lower Fed Funds rate isn't helping the credit markets is that rates weren't too high to create tight lending conditions. Fear, uncertainty, and the re-realization of the existence of credit risk put the market into its present state, something that even a 1% Fed Funds rate would ameliorate significantly. The way to move forward is recognize the problem, and Mr. Pandit's move goes a long way for Citi. On balance sheet makes the SIV mess more quantifiable for the rest of the investing world, which, in turn, makes it easier for the investing world to evaluate the risk. This is what the market is all about, evaluating and taking risks, with the potential for being rewarded for that risk.

To borrow a line from Spike Lee, it is time for the rest of Street to do the right thing. Citi maybe the biggest single player, but there needs to be some follow through from other big players for this credit situation can come to a resolution.

As a final note, let us not forget that, in the aggregate, markets are generally positive as compared to the start of 2007. There are certainly market sectors that are down for the year, but all the major averages are higher. The rate cuts in the pipeline plus a presidential election will go a long way to helping out the market in 2008, unless we get more inflation numbers like we saw last week.

Here We Go Again...

The Fed shouldn't ease at this point. The equity market has become addicted to rate cuts. It is time to stop. The same pundits that are crying for a rate cut today are also saying that the real problem is in the money markets. They are correct on that count, that is where the real problem is. Seventy-five basis points worth of Fed Funds rate cuts haven't helped there; further cuts are unlikely to do anything on that front. If the Fed cuts rates back down to 1% and LIBOR trades at 3.5%, would these pundits consider that a success? At 250 bps spread, I would consider it a failure. The Fed need to deploy other weapons, specifically discount rate cuts combined with encouraging language to allow for use of the discount window. Here's a idea: Let the Fed cut the discount rate 75bp today and leave funds where they are. Then, we will see it that has an effect on the money markets. The Fed Funds cuts will have no effect, other than an artificial boost to stocks, leaving the markets in the same situation as we have been in since August. Lending needs to free up on the most basic level, overnight and short-term between banks, in order to open up markets and stimulate the economy on a more macro scale. This being said, I'm sure that Bernanke and Co. will not listen to me and go with the path of least resistance

Trust Your Government Redux

I think the best thing I can say about this plan to freeze rates for some mortgages is that, for the time being, Congress isn't sticking its head in this mess. It seems to be a huge leap, and a blind one at that, to thing that this will stabilize home prices. It remains to be seen whether this helps anyone. Many of these loans were on houses where the buyer's equity investment was zero to start. Freezing the rates on loans on properties where there is a negative equity situation may keep the payments manageable, but why as a borrower would you want to do so? The best thing would be A) restructure and refinance the loans to reflect reality and B) streamline the foreclosure process to allow property values to adjust to the appropriate (read: lower) level more quickly to the country and markets can move beyond this crisis. I understand the political expediencies behind this move, but, in the long term, the borrowers won't be helped. Using history as a guide, these homeowners will be stuck in their houses for an extended period, waiting for the time when their home equity will turn positive. Look at the late Eighties. If you bought a house in 1986, you would have had to wait until at least 1996, on a nationwide average, to get back to the 1986 (absolute, not inflation adjusted) level. People at the margin, the sub prime borrower in trouble, are just locking themselves into a situation they probably shouldn't have bought into in the first place. The Band-Aid approach is better. It hurts a lot to rip it off, but it's over with quickly.

Followed By the UK

In all fairness, the BOE has legitimate reasons for cutting rates.

Canada Caves First

The Bank of Canada (BoC) this morning cut its overnight rate 25 bps to 4.25%. This was in response not to a slowing economy (au contraire) or rising unemployment (it is at a 30+ year low), but rather to a hue and cry of Canada's manufacturing sector and the provincial premiers. The BoC used for cover the idea that future inflation will be lower; present inflation however is still pretty high. Canada was the first to cut rates to prop up exports, but they won't be the last. I don't blame them; Canada is acting in its national self-interest, ostensibly. However, the world, including many Americans, need to stop treating the United States and the rest of the world with a double standard. Let the rest of the world become more competitive rather than relying on the crutch of currency devaluation. Everyone and their brother is touting the success of the Brazilian economy. However, most of these touters either have too short of experience there or have chosen to ignore the fact that Brazil got to this point by devaluing its currency, which was one of the contributing factors to Argentina's bankruptcy. The Brazil real is still significantly weaker versus the US dollar than in was in 1999, even after the big run up this year.

I have said here many times that the risk of lower rates is higher inflation. If the reason for the Fed lowering rates was to prop up exports, I would be vehemently opposed to them. As it is now, I don't think a lower Fed Funds rate is justified, but at least a credible case can be made. Other countries, even those with independent central banks, lower rates all time in order to make exports competitive. My point is that these same countries shouldn't complain when a consequence of lower US rates is stronger US exports. However, no one people are as altruistic as Americans are. Maybe it is time to be more selective in our altruism.