Saturday, August 30, 2014

09/20/1999 Coin in the Fuse Box *

Transcript from a speech given at the Credit Bubble Symposium, Sept. 21, 1999

I have spent the past decade in a personal quest, striving to understand the workings of our financial system and economy. I am here today hoping to share a few insights. Part of the dilemma we all face is that we are so inundated with numbers and statistics that it is difficult to see the forest through the trees. Today, I hope to bring some clarity to the forest.

Recently, while pondering the state of the financial world, I recalled a childhood experience. If you will bear with me for a few minutes, I would like to share my story. I was in the fifth grade and my teacher was Mrs. Hill. For the school year, Mrs. Hill devised a novel plan to reward students for good behavior. For this, she created "Mrs. Hill dollars," and granted them to deserving students. At the end of the school year these dollars would then be exchanged at auction for items – games, radios, books and such. She introduced this "system" one day by rewarding one of my classmates a Mrs. Hill dollar for collecting trash from the hallway. Soon, Mrs. Hill dollars were being granted for a variety of achievements. The winner of the Spelling Bee received one Mrs. Hill dollar. If you entered the school’s science fair, you received a Mrs. Hill dollar. If you read a book and wrote a report, you received two Mrs. Hill dollars. Later, a few students began picking up trash during recess and were rewarded with a couple Mrs. Hill dollars. On Arbor Day, some students planted trees on school grounds and they were rewarded a few Mrs. Hill dollars. And so on.

After several months, it was obvious that Mrs. Hill’s monetary experiment was a raging success. Her class was planting trees, picking up trash, reading books, and winning the school science fair. This was recognized and appreciated by teachers throughout the school. Quite impressed, teachers were happy to donate items for our auction. If there would have been a contest for "teacher of the year," Mrs. Hill would have won hands down. A very interesting thing happened, however, two weeks before the end of the school year and just one week before the big auction. Mrs. Hill "let her guard down." Maybe it was because there were so many items that had been donated for the upcoming auction. In this regard, Mrs. Hill had certainly created prosperity. Possibly, with most of the money being held by a relatively small group of hardworking students, Mrs. Hill believed that it would be nice to allow the rest of us kids the means to bid for items. That seemed harmless enough.

It was one of those rainy Oregon Spring days, and the students were stuck indoors and rambunctious. So for our 30-minutes of recess, a jovial Mrs. Hill decided to demonstrate how to make paper hats by folding together newspapers. She then offered 10 Mrs. Hill dollars for each hat made. Well, this wasthe break I needed. I wasn’t much of a reader back then and I saw recesses as a time for playing football and basketball, and not for picking up trash. As such, I didn’t have many Mrs. Hill dollars. But at the end of that 30-minute recess I presented to her 30 folded up newspapers that resembled hats. Mrs. Hill did not look happy, but nonetheless quietly paid me 300 Mrs. Hill dollars. At that point, there were no protests from other students and no appearance that anything had changed. In fact, there was a general euphoria throughout the classroom as everyone was excited for the chance to make some quick Mrs. Hill dollars.

But the reality of the situation became perfectly clear the day of the big auction. For in my 30 minutes of slopping together newspapers, I was rewarded 2 to 3 times more Mrs. Hill dollars than the hardest working students had accumulated throughout the school year. As the best items came up for auction, I simply bid up the price and bought them. For good reason, the hard working kids were not pleased by this injustice. After working diligently for most of the school year, it took just 30-minutes for one big transfer of wealth to me for folding together newspapers. The point I would like to make is that Mrs. Hill, after doing all the right things for months, lost control of her monetary system for 30-minutes. But that was all it took. Importantly, in just 30 minutes she completely distorted the pricing mechanism – the reward system that had so effectively encouraged redeeming behavior. The outcome was, I will call it, one big "asset inflation" and redistribution of wealth. I also propose that this big "inflation," would have changed student behavior. I do not believe that students would have continued to spend their recesses picking up trash for a Mrs. Hill dollar. Instead, I think most would have believed it much more rational to make newspaper hats.

I am proposing today that the Federal Reserve, like Mrs. Hill, has lost control of the financial system. Here, I would like to stress a key point: Excessive credit creation distorts the market pricing mechanism. And with our financial system having experienced an unprecedented explosion of credit, particularly financial credit – or borrowings made to finance the holdings of securities – this has led to endemic distortions throughout both the financial asset markets and, importantly, the almost forgotten real economy. Massive credit inflation has impaired the ability of free markets to function properly. This has led to pricing distortions that have bred a massive misallocation of resources and a maligned economy - complete with an historic asset inflation, a subtle redistribution of wealth, over-borrowing by both the household and corporate sectors, and trade deficits that imperil the dollar and our standard of living.

How did this happen? In our view, the Federal Reserve allowed (and even nurtured) these credit excesses, yielding a financial system that has developed an extraordinary propensity for excess.

And this brings us to the title of this speech: "Putting a Coin in the Fuse Box." This was a phrase I stumbled across a few years back while reading Ayn Rand’s Objectivist magazines from the early 1960’s. "Putting a Coin in the Fuse Box" was ascribed to Alan Greenspan by a fellow Rand colleague who stated that Greenspan firmly placed responsibility for the depression on the Federal Reserve. According to the 1960’s Greenspan, the Fed had repeatedly circumvented market forces with liquidity injections and, by accommodating credit and speculative excesses, perpetuated the fateful bubble. That is, the Fed circumvented natural market circuit breakers – the adjustments necessary for cleansing the system of building excesses and distortions. Instead of shutting off the source fueling these excesses before they became a risk to the entire system, the Fed allowed them to escalate until the great crash.

Today’s Fed has repeated this catastrophic error. Like the Fed of the 1920s, the 1990s Fed has repeatedly put "Coins in the Fuse Box" over what I see as a "Persistent Financial Crisis" going back to the 1987 Stock market crash. I believe this post-crash accommodation helped foster the real estate bubbles in the NE and California, the junk bond fiasco, the S&L debacle and other excesses from the late 80s.

In the early 1990s, following the collapse of the Northeast real estate bubble, it was clear that California was the next shoe to drop, with potentially catastrophic ramifications for the California banks and the entire financial system. The government was in the midst of dealing with a series of bank failures and even the solvency of the money center banks was in question. At the same time, the government was trying to manage an S&L crisis spinning further out of control. The FDIC was tapped out and the cost of the S&L bailout was skyrocketing, adding to already alarming fiscal deficits.

The situation looked dire, and it appeared that there could not possibly be enough money to make these failed banks and S&L depositors whole. In hindsight, however, it is easy to see money was not at issue - it was all about credit. For example, let’s say we have Bank A that has failed with $1 billion in deposits. We also have troubled, but not yet failed, bank B. Here’s basically how these bailouts worked. The government would fund $1 billion to troubled bank B, as payment for accepting the $1 billion of deposit liabilities from failed bank A. Troubled bank B, now with $1 billion of funds to invest, would then buy government bonds, sending the liquidity right back to the government where it could then fund more bailouts.

As a result, it took very little money to "solve" the problem. Instead, funds just spun around between the government and the banking system, creating additional government debt. In short, the bank and S&L bailouts were simply monetized. Moreover, government debt purchased by the banks rose in value as interest rates declined. Here, of course, the Fed played its instrumental role cutting rates 23 straight times, with short rates falling to 3% by early 1992. In the process, a steep yield curve allowed troubled banks to repair themselves. Soon the banks were cured and the Fed became very confident in administering "coins to the fuse box"

But, this big "coin" allowed an incredible surge of power. And it was during the early 1990’s that the Greenspan Fed "let their guard down" and began to lose control of the financial system. First, the Fed’s aggressive move to bailout the bankers created a big moral hazard issue. Second, with short-term rates plummeting, an opportunistic Wall Street went into what I call "harvesting asset mode," inciting a major shift of funds from bank deposits to mutual funds, money market funds, and securities, thus sowing the seeds for today’s financial bubble. Third, by pushing Fed Funds to 3% and creating an unusually steep yield curve, the Fed incited unprecedented credit market speculation, thus playing a major role in the proliferation of both leveraged speculation and its close sibling, derivatives. After all, 3% Fed funds were a godsend for the hedge funds, Wall Street proprietary traders, and derivative players.

Fourth, ultra-easy money fostered leveraged speculation in high-yield emerging debt markets. And fifth, a very important but unappreciated factor, was the emergence of Wall Street inspired non-bank financial companies and the incredible growth of the asset-backed securities market. As an aside, it was in 1991, during the darkest days for the banks, that Fannie Mae and Freddie Mac began to aggressively expand their balance sheets. Yet, Greenspan acquiesced, apparently more focused on the "Strong Headwinds" of an impaired US banking system that he saw as restricting the US economic recovery. He was loose and Wall Street took full advantage. The explosion of non-bank financial credit had begun and the Fed was quickly losing control.

Then, in February of 1994, the Fed raised rates 25 basis points and our financial system soon fell back in crisis. It became a near panic, especially for the leveraged speculators, many of whom were forced to unwind the infamous "carry trade." This led to a crushing bond bear market, huge losses for the leveraged speculating community, and major derivative problems. Among the casualties was Orange County, California. Its leveraged positions in structured notes from the aggressive Government related Agencies ultimately resulted in bankruptcy. Down south in Mexico, the Wall Street-inspired boom came crashing down with the rush to reverse leveraged speculations. The result: panic, capital flight and virtual financial collapse. In response, the Treasury and Fed moved aggressively to bailout Mexico and reliquefy our financial system. Another "Coin" was firmly inserted into the "Fuse Box." Wall Street was emboldened and almost overnight, "Hot money" began to circulate like never before.

Post bailout, the leveraged speculators and derivative players immediately had their sights on SE Asia. All of this hot money, however, only created a devastating boom and bust. When the Thai baht broke in the summer of 1997, this speculative house of cards came tumbling down. To this day, the full story has not been told as to the role that all the leveraged speculation and derivatives played in this meltdown. I don’t remember reading the word derivative once in Paul Krugman’s book, Depression Economics.

I am of the opinion that derivatives have played a critical role in the ongoing global crisis. Importantly, the proliferation of derivatives has come to radically distort financial markets. As such, I see derivatives as a very close partner to credit excess. Both work to distort market-pricing mechanisms. It is certainly my contention that derivatives affect risk perceptions and change behavior. In this regard, when discussing derivatives I like to use a flood insurance analogy. Say we have a homeowner who would like to build his dream home along the river. Yet, if this homeowner lacks access to affordable flood insurance, the risk of building is likely to be perceived as too great. If, however, inexpensive flood insurance is readily available, the perceived risk of building on the river is acceptable and building begins.

Now, taking this analogy one step further, let’s say that there has been a very long drought, which has led to a stampede of companies writing flood insurance. Why not? Premiums in this environment are as close as it gets to "free money." Here, insurance only gets cheaper, encouraging more exuberant homeowners to build dream homes on the river. Despite the appearance of prosperity, risk grows for the entire system. Importantly, the proliferation of cheap insurance fosters a change in behavior – encouraging a building boom along the river and the acceptance of greater risk by individual homeowners and the insurance companies. So come the inevitable flood, there will be more homes destroyed, the solvency of the insurance companies will be in jeopardy, and the risk of failure for the entire system will be much greater than if the building boom had never occurred.

Importantly, if a few homeowners purchase insurance and build on the river, flood insurance works fine. If everyone builds on the river and there is a flood, there is a big problem.

All the same, a very strong consensus led by Greenspan and Wall Street argues that derivatives reduce risk. I disagree. Derivatives simply shift risk from one party to another. Sure, an individual market participant can use derivatives to transfer risk. But if much of the market moves to transfer risk, there will simply be no one to take the other side of the trade. Entire markets can not hedge themselves. Indeed, for the system, the proliferation of derivatives significantly increases the risk of both market distortions and dislocations. This was undoubtedly the case throughout SE Asia, where derivatives fed financial boom and then meltdown. The Russian debacle was a more straightforward example, with the Russian banks major writers of derivative market insurance. Confidence and liquidity in this market instantly disappeared and the Russian banking system was wiped out with widespread counterparty defaults.

This river analogy now brings us to Fannie Mae and Freddie Mac that, by the way, have accumulated about $500 billion in interest rate derivative insurance, purchased mainly from Wall Street and the large money center banks. I do not believe one can overstate the dominant role these two institutions have come to play in both our financial system and economy. After beginning the decade with combined assets of about $160 billion, the assets of these two institutions are rapidly approaching $1 trillion. In 1991 they expanded assets by about $5 billion per quarter. Last year, these institutions increased assets by an astonishing $55 billion per quarter. During last year’s historic second half, Fannie&Freddie combined to grow their balance sheets by $147 billion. This was in the midst of financial crisis, with our leveraged credit system faltering in illiquidity after the Russian debacle and the collapse of Long Term Capital Management.

With another crisis, time came for another "coin in the fuse box." Here, two important factors combined for a dramatic rescue. First, of course, the Federal Reserve cut rates 75 basis points. Second, in the midst of financial crisis and dislocation in the mortgage securities market, mortgage rates dropped dramatically as Fannie&Freddie incited an historic refinancing boom. Fannie&Freddie, with their implied government debt guarantees, were able to borrow easily, largely from the money markets, and ballooned their balance sheets with new mortgages. The holders of the old mortgages, including the leveraged speculators, received desperately needed liquidity as households refinanced and Fannie&Freddie bought these new mortgages as well as other debt securities in the open market. During the final three months of 1998, Fannie, Freddie and the Federal Home Loan Bank System together expanded borrowings by almost $130 billion.

Admittedly, this had both the look and feel of a true miracle, but in reality this was one of history’s greatest episodes of credit excess. Some may argue, of course, that Fannie and Freddie are not banks and do not create credit. I disagree and see this is a critical analytical misconception. Actually, I see Fannie&Freddie as the greatest instigators of credit excess in history. I even go one step further and believe they also create "money". Consider - as these institutions borrow aggressively from money market funds, that are components of M2 and M3, they exchange their short-term IOUs for existing money stock. This borrowed "money" is then instantly used to purchase financial assets. Importantly, this "money" remains within the financial system where Fannie and Freddie can borrow it again and again, repeatedly replacing it with additional IOUs, thus increasing total money market assets. The money just spins around the system as the amount of debt multiplies. Actually, this mechanism works much like the old bank multiplier effect from econ 101, except for one crucial difference. Since Fannie and Freddie liabilities are not subject to reserve requirements, these institutions can virtually create an "infinite multiplier effect."

Importantly, this is not unlike my earlier example of money spinning around between the banks and the government, with government debt growth "monetizing" bank and S&L losses. This works even better with Fannie&Freddie. Importantly, the larger they grow their balance sheets, the more liquidity is pumped into the system, fueling the US bubble. With the leveraged speculators and our highly leveraged financial system at the brink last fall, problematic leverage was shifted to Fannie&Freddie with money spinning around the system, increasing Fannie&Freddie debt in what worked much like one massive monetization. However, with this explosion of credit, the Fed really lost control.

This massive credit creation provided excessive liquidity that quickly manifested into asset inflation as wild speculation drove the historic Internet mania, as well as a doubling of technology and NASDAQ indices. Egregious credit excesses have clearly distorted the market pricing mechanism. And with our over-zealous financial sector creating all this money and credit, there appears absolutely no need for households to save. Especially, with Fannie and Freddie pouring gas on an overheated residential real estate sector, and the resulting real estate inflation.

Importantly, since last year we have added about $2 trillion of additional debt on an already over-leveraged system, much of this new credit simply financing higher asset prices, stock buybacks, mergers, and many uneconomic ventures. Over the past year, the household and corporate sectors have engaged in an historic borrowing binge. Within our financial system, an unending explosion of financial credit provides the perception of unlimited capital. This illusion only fuels devastating distortions to our economy. And with an asset bubble creating the perception of endless wealth, it is forgotten that real economic wealth is created only through saving and sound investment – not by borrowing and consuming, not by massive credit creation and not by asset inflation. Today, credit excesses have fueled overheated domestic demand, with an historic consumption binge feeding both malinvestment and ballooning trade deficits that imperil the dollar.

That’s how we see it today…a highly unstable and acutely vulnerable financial system with a maladjusted economy. Years of putting "coins in fuseboxes" has fostered a financial system hopelessly distorted by endemic over-leveraging and speculating, and an economy addicted to credit excesses and rising asset prices, not to mention our dependence on a flood of imports to sustain our standard of living. Our system has created too much paper, of increasingly poor quality, while incorporating unfathomable leverage. To make this worse, much of this leverage is a mountain of accumulated debt owed to our foreign creditors. This is truly a "house of cards." Immediately, I see this situation creating an acutely vulnerable dollar. I also see potential dislocation in the interest rate derivative area that has ballooned along with financial credit.

I see our highly leveraged financial sector as one massive interest-rate arbitrage made possible largely because the Federal Reserve pegs short term interest rates, and this massive arb is today quite fragile. In fact, I believe we are in the midst of what I refer to as a "hot money" crisis, not unlike the "hot money" crises that led to capital flight, faltering currencies and financial collapse throughout SE Asia, Russia, and elsewhere. I wish I could offer a solution, but I can not. I subscribe to Dr. Richebacher’s premise that the only cure for a bubble is to not let it develop. Here, the Fed has clearly shirked its responsibility. Yet, the medicine certain to be prescribed - simply creating additional money and credit - is destined to create only catastrophe. Besides, inflating out of financial difficulties is an injustice to those that have worked hard, saved and played both prudently and by the rules. "