THE BEAR´S LAIR : GET ON WITH IT ! / PRUDENTBEAR.COM

The Bear's Lair: Get on with it!

September 22, 2014

 

by Martin Hutchinson

The Federal Reserve last Wednesday did not even remove the "considerable period" from its language about when it might start raising interest rates, thus delaying the likely start of rate rises even further than expected. This repeats its mistake of 2004-06, when it raised the federal funds rate at only one-quarter of a percent per meeting, undertaking 17 such tiny rate increases over a two-year period.
 

The cost of this dilatoriness can be easily calculated: moving twice as fast would have killed the housing finance bubble a year earlier, removing some $2.5 trillion of malinvestment from the system and making the 2008-09 recession (probably occurring in 2007-08) correspondingly less severe. The AIG bailout and TARP would not have been necessary, and Lehman Brothers and Bear Stearns (though probably not Countrywide) would still be with us.

You can calculate quite easily the amount by which a faster Fed tightening would have reduced the amount of bad assets in the system. The Federal Open Market Committee began raising federal funds interest rates from the low of 1 percent at its meeting in June 2004 and raised them by a quarter percent at each of its eight annual meetings for the next two years, reaching a peak rate of 5.25% at the second anniversary of the first tightening, in June 2006. 

It took the Fed until early 2006 to achieve positive real interest rates, since 12-month consumer price inflation was running around 4% at that time. It is not 20-20 hindsight to criticize the dilatory nature of the Fed's interest rate rises in 2004-06; this column did so on several occasions at the time. 

The housing finance market peaked in 2005 with mortgage origination volume of $2.76 trillion, according to New York Fed statistics. By the first part of 2006, with real interest rates positive, it was already beginning to slow—volume for 2006 down somewhat at $2.52 trillion. Thus, as you would expect, the rise in interest rates began to kill off the housing market once real interest rates turned positive, with the Case-Shiller 20-city index of house prices peaking in July 2006.

 Now consider if the Fed had doubled the speed at which it raised interest rates, with half-percent increments at each meeting instead of quarter. By the end of 2004, the federal funds rate would already have stood at 3.5%, following five such interest-rate increases.

With inflation in early 2005 running at around 3%, real interest rates would already have been positive. By the time the Fed stopped its rate increase program at 5% in late April 2005 or at 5.5% in June 2005, the housing finance market would have been in full retreat and house prices would have peaked. The housing bubble would have been popped a full year earlier than in real life. 

Roughly, 2005's housing finance market would have resembled 2006's, and 2006's housing finance market would have resembled 2007's, with prices in full retreat. Since roughly $2.5 trillion of housing finance paper would never have come into existence, and house prices would have had less far to fall (the Case-Shiller 20-city index rose by 7.2% in the year to July 2006, and its 15.1% rise in the year to July 2005 would also have been slowed with rates rising rapidly) the bottom would have been reached somewhat more than a year earlier, perhaps around June 2007 rather than September 2008. The 2008-09 recession would have become a 2007-08 recession, less severe in depth than actually occurred.

The most important change would have been that much of the worst speculative activity, which took place around the top of the market, would never have occurred because such activity would have been choked off a year earlier. Fabrice "Fabulous Fab" Tourre's synthetic CDO activity, for example, which by creating artificial loss-making securities with which to stuff German banks amplified the downturn's losses, occurred almost entirely in 2006-07, with the notorious "Abacus 2007-AC-1" deal taking place in early 2007. By bursting the bubble a year earlier and cutting off the Abacus series of deals, the Fed would have reduced Fabulous Fab to Mediocre Fab, making him miserable in the short run but greatly improving his life prospects long-term.

Cutting off the bubble a year earlier would also have eliminated most of the bankruptcies that made 2008 such a dreadful year. Lehman Brothers, for example, increased its balance sheet total from $410 billion to $691 billion between 2005 and 2007. Without the last phase of the housing finance mania we can assume that this balance sheet bloat would not have happened and that Lehman would have avoided bankruptcy. 

Bear Stearns similarly increased its balance sheet total from $293 billion to $395 billion between November 2005 and 2007. Its survival must be less assured than that of Lehman, but without the final increase in leverage must be odds-on. It must be remembered that the disastrous SEC deregulation removing the limits on investment bank leverage occurred only in 2004, so a boom that stopped a year earlier would have markedly reduced those institutions' ability to get in trouble.

As for AIG, the wild expansion of its credit default swap operations began after the ouster of Maurice Greenberg as CEO in January 2005. By September 2008 it had $440 billion of CDS outstanding on mortgage backed securities, mostly subprime. With the housing market peaking in July 2005, much of this activity would have been avoided and no AIG bailout would have been necessary.

That's not to say the recession would have seen no defaults. Angelo Mozilo of Countrywide was already expressing alarm about its company's product range, such as the "80/20 subprime loan" in April 2006, and attempting to rein in the company's operations. The fact that he was forced to sell at a fire sale price as early as January 2008 to Bank of America, which has since incurred some $50 billion of additional costs as a result of its foolish purchase, is sufficient indication that even with the bubble bursting a year earlier Countrywide would have been unlikely to survive through the entire recession. 

However, without the Lehman and AIG defaults, there would have been no need for Congress to vote a $700 billion TARP bank bailout in October 2008, no public obloquy of bankers in the following years and no tsunami of regulation with the Dodd-Frank act. Furthermore, with no major financial crisis to trigger it through misapplication of Walter Bagehot's dictum of "lend freely, but at penalty rates," there would, even with Ben Bernanke at the Fed, have been no toxic monetary policy of six years of zero short-term interest rates. It's also most unlikely that the U.S. budget deficit would have reached even half the $1.4 trillion at which it peaked in fiscal 2009. 

The economic recovery would have been more normal in shape, without the massive distortions caused by government activity, although since Barack Obama would presumably still have won the presidency in 2008 there would still have been a productivity sluggishness caused by excessive regulation and economic meddling. Markets would not today be in bubble mode, and there would be no further mountain of malinvestment waiting to cause another financial crisis and more years of misery.

The $2.5 trillion figure of 2006 home mortgage lending at which I had initially estimated the cost of the Fed's appalling dilatoriness in raising interest rates in 2004-06 is thus undoubtedly an underestimate. When you add in the costs of the financial crisis and the output lost through the excessive depth and length of the 2008-09 recession, the total cost of that Fed bungle must come to many further trillions. Truly, central banks are the ultimate destructive force of our time.

It also follows that the Fed's current sluggishness in beginning to raise interest rates, together with the very prolonged and reluctant trajectory by which it means to raise them when it begins, is likely to be a huge mistake, possibly even more costly than the error of 2004-06. Now that unemployment is reduced to a tolerable level, the U.S. economy is at least chugging forward and markets are in a state of overvaluation resembling that of 1999 (mainly through the bloating of corporate earnings), the Fed should raise interest rates immediately by a substantial amount, perhaps to 2%, still around zero in real terms, and then institute a moderate program of further rises. 

Of course, the stock market and other overextended asset prices would tank, but their bubble would have been burst earlier than it might otherwise have been The Fed would be blamed for the bursting, but as William McChesney Martin said over a half-century ago, to end the party before exhibitions of financial drunkenness cause real damage is the principal function of a soundly managed central bank.

Since Alan Greenspan began to pump up the money supply in 1995, the Fed chairman has been almost universally popular. That is a sign of utter failure in his (or now, her) most important duties.