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Sunday, 2 September 2007

Why Bernanke’s Critics Have it All Wrong

by Jeremy Siegel, Ph.D.

The recent financial meltdown has brought a torrent of criticism onto our central bank officials. "Rookie Mistake," cried Bloomberg News. "Flawed Forecast," proclaimed The New York Times. "They're nuts! They know nothing!" screamed Jim Cramer on CNBC in a now-famous tirade that has received millions of hits on YouTube.

But if you look at the evidence, you will find that Ben Bernanke, chairman of the Fed, made the right moves at the right time. He skillfully balanced the forces that called for an immediate lowering of interest rates with those that warned that bailing out these sub-prime lenders would encourage financial irresponsibility in the future.

Under Bernanke's leadership, we will recover from this crisis, but the financial landscape will be permanently changed. The proliferation of "asset-backed" securities that spurred so much lending in the last few years will end. Plain vanilla bank loans and old-fashioned commercial paper backed by the general credit of the corporation will be back in vogue. And believe it or not, one of the biggest beneficiaries will be the stock market.

Path to a Crisis

We need to go back several years to understand the origin of today's crisis. In response to the recession, the terrorist attacks, and the collapse of the technology bubble, Alan Greenspan pushed short-term interest rates down to 1% in 2003, the lowest rate in more than 50 years, and kept them there for a year. Other countries, also experiencing economic slowdowns and falling inflation, lowered short-term rates dramatically.

As interest rates sank, lenders became hungry for higher yields and borrowers eyed a real opportunity. One way of making risky loans more attractive were backing the loans by "assets" such as account receivables, inventory, and especially real estate. Since home prices were soaring, many borrowers - including some rating agencies - felt there was little risk in these new mortgage-backed securities.

But they were wrong. There was substantial risk if the security was backed by real estate that was sold at an inflated price with no equity cushion.

The first problems with these "sub-prime mortgages" surfaced in February when several mortgage lenders, such as American Home Mortgage and New Century admitted a high delinquency rate. In July, more mortgage woes surfaced and the credit markets tightened.

Nevertheless, when the Fed met on August 8, it had no evidence that loan defaults were rising outside the housing industry or that the real economy was being hurt. Indeed, GDP growth in the second quarter was running at a healthy 4%. In its August policy statement, the Fed acknowledged the disturbances in the security markets by stating, "Financial markets have been volatile and credit conditions are tightening" and recognized that the "downside risks to the economy had increased."

Although some market observers were disappointed that the Fed did not go to a "neutral stance," by stating the economic weakness was as great a risk as inflation, most were pleased to see the Fed was aware of deteriorating credit conditions. In fact, the stock market ended the day at the same level reached before the 2:15 p.m. announcement. Had investors been disappointed in the statement, stocks would have certainly sold off.

Problems Spread Internationally

But more troubles soon surfaced. On the very next day, BNP Paribas, France's largest bank, barred withdrawals from three of its hedge funds that held subprime loans. All of a sudden the crisis took on international proportions. Investors was asking, "Who owned what, how much, and what was it really worth?"

At this point a worldwide panic spread through the commercial banking systems. The overnight lending rate rose as banks feared for the safety of their loans to other banks.

It was exactly this sort of crisis that the central banks were ready for and they acted accordingly. The European Central Bank (ECB) moved first by lending over $100 billion in the overnight market to push the rate bank back down to the official target. A few hours later, when the US markets opened, the Federal Reserve did the same thing.

Central banks can supply unlimited funds to banks by buying securities in the open market and crediting the selling banks with reserves. This increase in the supply of reserves pushes down the price of reserves in the overnight market (called the "Fed funds rate" in the US and the "overnight repo rate" in Europe) and enabled the ECB and Fed to achieve their targets.

Although these actions temporarily quieted the market, they weren't enough. The following week stocks went into a tailspin as rumors erupted that more hedge funds and buyout firms were encountering serious difficulties. From noon Wednesday to noon Thursday the Dow plunged almost 600 points before staging a late-day rally.

To stem the rout, early Friday morning, August 17, the Fed announced that it was lowering the discount rate from 6 ¼% to 5 ¾% and issued a statement acknowledging that the tightening of the credit markets tipped the risk in the economy towards economic weakness and away from inflation. With the Fed recognizing the seriousness of the situation and taking positive action, markets rallied.

Why Didn't the Fed Act Earlier?

But questions were immediately raised. Why didn't the Fed realize on August 8 that the markets were heading for trouble? One simple answer is that the spread of fear and panic is impossible to predict. On August 8, borrowers with good credit could get loans. But by August 17, even credit market for which there was no evidence of rising defaults began to seize up as lenders froze in fear.

Furthermore, had the Fed taken emergency action in the August 8 meeting, it would have been accused of "jumping the gun," and bailing out the greedy lenders, the investment banks, and the super-rich hedge funds. Indeed, some are criticizing the Fed for this in spite of its careful lending to only qualified borrowers.

Finally, it must be remembered that all central bankers must establish their anti-inflation credibility. Bernanke had been accused of harboring a philosophy that was too soft on inflation and too eager to flood the financial system with liquidity at the first sign of trouble. Jimmy Rogers, the inveterate commodity market booster, toured the world warning about "Helicopter Ben," a reference to a Bernanke speech in 2002 in which he indicated that if deflation was a threat the Fed could always rain money down on the public from helicopters to increase buying power.

The upshot is that to have shifted policy on August 7 would have been too early. But by August 17, the markets were sufficiently disrupted that action had to be taken. Although the Fed does not want to bail out any impaired asset where poor lending standards were responsible, they also did not want the interest rate on sound loans to rise and choke the economy.

Post Mortem

I think the Fed made the right moves at the right time. But the fallout from this crisis will be with us for a long time. Stocks are thought to be riskier than bonds and much riskier than mortgage bonds. Those that believed they could automatically make junk bonds safe by "backing" them with assets, be they homes or railroad cars, have been proven wrong. It turns out that the best credits are general obligation bonds based on all the firm's income and assets, not debts backed by dubious assets.

In the long run, all this is a good development for the stock market. In the last decade, more than one trillion dollars has migrated to hedge funds and untold billions to complicated debt and derivative securities. Who will buy those assets in the future? I believe quite a few investors will return to stocks and general obligation bonds - assets that they can buy and sell at any time they want.

Wall Street has rediscovered liquidity and transparency. Stocks and old-fashioned bonds have them; new-fangled collateralized debt obligations and hedge funds do not. A return to basics will be good for both the economy and the financial markets.

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