Wednesday, 28 May 2008

The Meaning of the "Bernanke Doctrine”

The New York Times informs us that there is a new doctrine in town. It is called the Bernanke Doctrine. The president of the New York Fed described it as “the overpowering use of monetary policies and lending to avert an economic collapse”.

On one level, what we have here is the ex post facto rationalization by Bernanke’s sycophant underlings of his actions in the past several months. But there is a subtext to the story.

Firefighters use an overpowering supply of water – as well as fire retardant and explosives, if need be – to fight fires, but they have no “doctrine” about the use of these measures because the need is self-evident and thus, sanctioned.

The Bernanke Doctrine, by contrast, involves policy actions that might violate the by-laws of the Federal Reserve Board. “Over a frantic weekend in mid-March, Ben S. Bernanke rewrote the rule book as chairman of the Federal Reserve,” we are informed.

The rule book of the Federal Reserve is a technical document. It does not lend itself to being “re-written” by one man – and that, in haste. But that is precisely what Bernanke did. That conduct is now being telegraphed as the standing modus operandi of the Federal Reserve: if the rules stand in the way of needful actions, they go. That is the gist of The Bernanke Doctrine, the “whatever it takes” of the cornered men bent on getting themselves out of a tight spot.

The Times gave a crisis-made-the-man spin to the story – how the mild-mannered academic rose to the occasion, etc. The paper quoted the president of the Dallas Federal Reserve who said about Bernanke: “He’s developed a serenity based on a growing understanding of the hardball ways the system actually works. You can see that it’s no longer an academic or theoretical exercise for him.”

That is the critical point of the article, the insinuation that the working of the “real world”, where men play hardball, is beyond the grasp of the theoretical bull that is the official finance and economics; Ben S. Bernanke finally grew up.

With regard to the medley of smatterings that is the official economics and finance, that assertion is certainly true. But is not true that the actions of Bernanke and his European counterparts at the ECB and the BOE are beyond the realm of comprehension and thus, must be conducted in an ad hoc and fly-by-the-seat-of-the-pants manner. Quite the contrary. As market grow more complicated, the need for a theory to explain what is happening, i.e., what is changing, becomes paramount; we have seen how little an ad hoc, gut-feeling approach, the monetary equivalent of a frightened soldier emptying round after round into the bushes hoping to hit a target, accomplishes.

If Bernanke is the contemplative economist that he is touted to be, he must know that the financial system at some point will outgrow his ability to influence the events. That, more than anything else, requires a theoretical understanding of the system, of the kind you will find in Speculative Capital and in entries in this blog. The Credit Woes series offered a glimpse of what a real theory could do.

Bernanke will of course learn no such thing. He could not. A defining characteristic of the systemic risk is its inevitability and the destruction that precedes it, be it of the U.S Constitution, Federal Reserve by-laws or the long held codes of conduct in the world of business.

Saturday, 17 May 2008

How're They Doing?

Ed Koch, a cutting edge lowlife who was made the mayor of New York City in the late 70s – once collapsed in a restaurant from overeating – had a catchphrase. He used to ask, addressing no one in particular, How'm I doing? Not that he gave a damn about the answer, but it was good p.r., this show of going to the rabble for feedback.

How should we respond if the central banks, specifically, the European Central Bank, the Bank of England and the Federal Reserve, ask the same question? How are they doing in handling the ongoing liquidity/credit crisis?

The Financial Times of May 16, under the heading “ECB liquidity scheme fears” gave the answer in black and pink. The highlights are in red:

The European Central Bank yesterday voiced its “high concern” at growing evidence that banks are exploiting its efforts to unlock the frozen funding markets by using its liquidity scheme to offload more risky assets than it envisaged. Yves Mersch, a governing council member ... was speaking amid sign of some banks creating low-rated assets specifically so they can be traded for treasuries at the European Central Banks.

Central banks have become important in providing funding for difficult to sell mortgages on what is intended to be a short-term basis while securitisation markets remain frozen.

The Bank of England recently created a facility for UK banks to access funding for mortgages and the Financial Times has learned that almost £90bn ($175bn) worth of bonds are being created to be placed there – almost twice the £50bn initially expected when the scheme was launched only three weeks ago.

Meanwhile, Macquarie Leasing, a unit of the Australian bank, has done a securitisation of Australian motor loans, which will have a euro-denominated slice so that the investors who buy the deal can use it at the ECB. Investment bankers who work in securitisation say that their main business is structuring bonds that are eligible for ECB liquidity operations. Some analysts have concerns about whether the bonds being created will ever be saleable if markets recoverAccording to debt market sources, the banks planning to use the scheme are the UK’s eight largest lenders.
Let us see.

As part of its liquidity operations where it exchanges treasuries for junk, the BOE has taken in $175 billion worth of junk – twice the amount it was expecting only three weeks ago.

There is a critical point here that must be understood. When you give your high-yield junk (that you can neither finance nor sell) to a central bank and receive treasuries in return, the transaction is considered a security lending. What it means is that the ownership of securities does not change. You still own the junk and the central bank owns the treasury, so you receive the high coupon rate of junk and pay the low rate of treasuries. This is precisely the sort of arbitrage that triggered the current crisis, only now a central bank is the party to the transaction instead of the jittery and cautious CP investors.

What follows has the inevitability of night following day: Banks – including UK’s eight largest lenders – are specifically creating low rated assets (i.e., junk) so they can take them to the European Central Bank in return for treasuries. In fact, they have investment bankers whose “main business” is structuring bonds that are eligible for ECB liquidity operations.

And the news has spread to the far-flung corners of the “globalized” world. “Macquarie Leasing of Australia is adding a euro denominated slice to its auto loans so investors who buy the deal can swap it for treasuries”. From mortgages in the US to auto loans in Australia in ten months; it is a small world after all.

There is one more thing that must be understood. What do you suppose the banks do with the treasuries that they get from the central banks?

You guessed it. They pledge the treasuries, get cash and, if they are smart banker, buy high-yielding junk so they could take them to central banks for treasuries ... You get the idea.

There seems to be madness in the method. Certainly the central banks’ position that the program was intended to be a short-term exchange invites ridicule. They offer the banks and broker/dealers the risk-free opportunity to launder their junk and in the process earn about 3% spread and then expect them to say “enough” after an appropriate short time.

What we have, however, is neither naiveté nor madness. It is lack of options. With their backs against the wall, central banks had no choice but to do precisely what they have done for the past several months. Now all they can do is hope for the best.

The most outstanding characteristic of the systemic risk is its inevitability, a characteristic that is formed through the elimination of policy options.

Thursday, 8 May 2008

US Financials and Fair Value Accounting

A few days ago, AIG reported first-quarter losses of $7.8 billion resulting from the sharp drop in the value of its mortgage securities and credit derivatives. If you were paying attention, you knew that something was in the offing. For some time now, the company’s CEO had been railing against the idea fair value accounting. As reported by Financial Times in March 14:

American International Group is urging regulators to change controversial accounting rules on asset valuation … Under AIG’s proposal, which has been presented to regulators and policymakers, companies and their auditors would estimate the maximum losses they were likely to incur and only recognise these in their profits … Martin Sullivan, AIG’s chief executive, told FT that “mark-to-market” rules forces companies to recognise losses even when they had no intention of selling assets at current prices.

First, note the word "controversial." That is FT's characterization. The paper's editors know where their sympathies must lie.

Why is fair value accounting controversial? It is a generally accepted accounting practice that purports to record and report securities at their fair market value. What could be foul about that?

In the fair value accounting, you have to mark the prices to market, i.e., take note of the changed price of a security and recognize the difference as either profit and loss, depending on your purchase price. Suppose you buy a security for $100. If the next day the price increases to $110, you'd have to report $10 profit; if the price drops to $90, $10 loss. That is how AIG was forced to report approximately $8 billion in losses. Hence, the unhappiness of the company’s CEO with the fair value accounting. His selfless proposal: to disregard the prices in the market and let the CEOs tell us what they think a security should be worth.

It is tempting to dismiss this as the nonsensical utterance of an embarrassed executive. But the idea is being seconded by others and might gain traction. If so, it would lead to less transparency and more misinformation.

There is more.

The concept of fair value accounting is improbably philosophical. It logically arises from the social nature of value and price and the transformation of one to another. It touches upon the question of the turnover of capital and the frequency and the speed of the circulation of its various components (within the same sphere of production) that gives rise, by turn, to money markets and capital markets.

The pressure to do away with it is the antithesis of the inner coherence of the financial system that has been maintained, however tenuously, since the collapse of the Bretton Woods regime of fixed exchange rates. It is made of the same cloth that makes Libor value questionable and pushes the authority of the Federal Reserve to its edge. It is, in short, the rise of yet another contradiction that is the hallmark of when things begin to fall apart and the center cannot hold.

These are the subject of Vols. 4 and 5 of Speculative Capital.

Monday, 5 May 2008

On Junk Bonds, Mike Milken and the Current Crisis

Martin Lipton, an old time Wall Street operative and a founding member of Wachtell Lipton recently blamed Drexel Burnham and, by implication, Michael Milken and his junk bond enterprise, for the current credit/liquidity crisis. “The financial crisis we’re in today stems from the invention by Drexel Burnham Lambert of the junk bond,” he was quoted in the New York Times. “You can draw a straight line from Drexel Burnham to the financial world today.”

No single firm, especially a firm that collapsed almost two decades ago, can be the “source” of crisis of the magnitude we are witnessing. What Lipton is looking at, but cannot articulate because he does not comprehend, is the role of speculative capital.

What oiled the machinery of arbitrage was the U.S. Treasury market which the massive borrowing of the government in the 1980s institutionalized. The Treasuries provided a convenient and practical tool for simulating borrowing and lending. All one had to do was to go short or long. In a “reverse hedge,” the arbitrageur did not have to find a borrower because the largest borrower was always on the stand by, ready to provide the IOU on request. This catalytic function of the Treasury market transformed it into a critical component of the global capital markets. The debt itself became of secondary importance. In that regard, Ronald Reagan was as instrumental in the rise of speculative capital as the junk bond trader Michael Milken. Both were products of their time.
That is what I wrote in The Enigma of Options. You can check it out.