Kudlow Backtracks Posted by: Dale Franks
on Thursday, August 16, 2007
Well, isn't this interesting. A few days ago, I criticized a Larry Kudlow column that explained to us that this whole credit crunch deal was just a tempest ina teapot. Today, Mr. Kudlow is doing a little backpedaling.
Last Wednesday, August 8, T-bills traded at 4.49 percent. On Monday they dropped to 4.74. On Tuesday, 4.63. And yesterday they fell to 4 percent. This morning they dropped another 50 basis points to 3.52 percent. What’s this mean? It means the entire banking system has turned completely risk averse and is fleeing into the safest haven possible.
It is fear. It is hording cash. It is a mountainous tremor that has seized financial markets.
In terms of funding requirements — for big mortgage banks like Countrywide, or perhaps the major money-center banks and various hedge funds — it shows financial dysfunction.
Now, what to do?
The Federal Reserve must lower its target rate and pour new cash into the banking system. It should float the federal funds rate and let reserve and money-market forces determine the right rate level as it injects new liquidity into the system. A T-bill rate around 3.5 percent suggests a fed funds target rate of perhaps 3.75 percent, or somewhere thereabouts.
Right now, because of the fear and hording, cash demands inside the banking system are rising faster than cash reserve supplies injected by the Fed.
You don't say.
Well, I never...
Oh, wait a minute, I did.
And what do we call the result of people hoarding cash? Class? Class? Anyone?
So, now, Larry Kudlow is recommending that the Fed just blows off the target rate for the Fed Funds Rate and just let it stabilize at whatever point the market is comfortable with, dumping money into the system until everyone is satisfied.
You gotta love this recommendation, too:
[T]he Fed should expand its open-market purchases of collateral to include non-government mortgage-backed securities, jumbo mortgages, and asset-backed commercial paper, along with the more typical Treasury and government agency paper which includes Fannie and Freddie paper. This will help get the new cash into the places that need it the most. It’s a buck-shot approach, not a clean rifle hit. Unusual and cumbersome perhaps, but necessary I think at the present time.
Yeah. Huh. A week ago, everything was peachy. His recommendation then to the Fed was:
Federal Reserve officials believe we have a temporary liquidity issue, not a solvency crisis. So, at the prevailing interest-rate target, the Fed and other central banks are prudently injecting $131 billion of new cash to “facilitate the orderly functioning” of markets. Fed chairman Ben Bernanke has the story right.
So, in the space of a week, we've gone from a «prudent injection of cash to maintain the current Fed Funds Rate target», to «what's all this nonsense about maintaining a Fed Funds Rate target, then? we need liquidity now! And what the hell; buy mortgage-backed paper too! Buy it all!»
And he's only come to this conclusion because the T-Bill yield fell a full percent in one week? None of the warning signs that indicated such a flight to quality was in the offing crossed his desk last week?
I interviewed Mr. Kudlow a few times on my Money Radio show in LA, back when he was still the big econoboy at Bear Stearns. He seemed a little more prescient back then. I wonder if his political activities since retiring have clouded his judgment a little bit.
But now, apparently having the scales fall from his eyes by watching the yield on T-Bills drop by a full percent in less than a week, he seems to be...concerned.
So far, the economy looks fine. This is good. But the Fed must be the lender of last resort for the banking system. For my inflation-worrying friends out there, I say we can deal with that issue if it remerges sometime in the future. After financial stabilization, the new cash can be withdrawn and the fed funds target can be readjusted.
All I’m saying is first things first. That means stabilizing the banking system and accommodating the huge cash demands that have arisen. Right now, the system is virtually frozen...
Today the problem is deflation — more specifically, credit deflation...
This is a solvable problem. The economy is in relatively good shape. Stocks are still at a relatively high level. The unemployment rate is low. The vital economic signs are positive. But we need a credit fix. We need to restore banking confidence. Right now.
Translation: The economy is fine, but this credit deal threatens to strangle it if we don't do something fast.
In return, I say welcome on board, Larry. Finally.
Kudlow was always a wild optimist. He serves the roll as cheerleader for the WSJ/Forbes/Barrons people.
In the past Greenspan had a more or less monetarist approach and avoided wild swings in reserve rates. It remains to be seen how Bernanke will react. I hope it is just to provide liquidity and not do anything rash.
Doubtless, Kudlow wrote this bit at the lowpoint of today’s sessions where the markets were off a little over three hundred points. one wonders if his position is changed by the end of the day, with the market recovering all but a little.
Doubtless, Kudlow wrote this bit at the lowpoint of today’s sessions where the markets were off a little over three hundred points.
I think a volatile day in the stock market is irrelevant to the point that he is making today, and Dale made yesterday, the flight to safety in Treasury instruments. This is a real live credit crunch, and it’s going to be a precarious bit of management to find a rate that relieves the crunch without stoking inflation fears. But considering the how little equity is left for consumers to borrow against, even with easy credit and great rates, I don’t think there is a big likelihood that they can overheat the market.
But they have to be careful not to appear to be taking crisis measures, which means we’ll have to wait 3 months to see action, and there may be a bit fear out there until then.
In hindsight, (always 20/20), the Fed perhaps should have dropped the Fed Funds a tiny bit, just to show they were not averse to such a move.
Oh well, managing an economy is about 10X harder than predicting one, so good luck with that.
Here’s what the Fed said last week when the decided to hold steady...
Although the downside risks to growth have increased somewhat, the committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected," the central bank said.
"Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing," it said.
"Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy," the Fed said.
Where’s downside risk compared to inflation risk now?
I think a volatile day in the stock market is irrelevant to the point that he is making today, and Dale made yesterday, the flight to safety in Treasury instruments.
Probably. Then again, there’s an awful lot of action going on the markets these days , that is supposedly in reaction to credit issues, that really has nothing to do with the fundamentals of thing. At the moment, it’s all perception. Which was precisely my point, of course, for bringing it up in the first place.
And again, I note that that particular molehill mountain showed up on the leading edge of an election cycle. Since we appear to be talking about, in this case, a managed perception , to discount the connection to the political, and thereby the idea that there isn’t a whole bunch of ’there’ there, seems illogical.
DALE RESPONDS: You really don’t understand anything I’ve written on this subject, do you?
I was wrong about the Fed, they DID take crisis action and lower the Fed Funds rate by a half point today, a month before the next scheduled review. This appears to have stimulated the equity markets, but I would be concerned that it shows the precariousness of our current situation and could backfire. We’ll see. But I expect we may see small drops in the Fed Funds rate for the next few quarters, and this may alleviate the worst of the sub-prime crisis. Their customers CAN pay at lower levels, it’s just the higher levels that were going to create the foreclosure crisis.
Perception is an issue, but it is fundamentals as well. What we are seeing is perception moving down to where the fundamentals truly are, they were not before. That is what Dale and I have been referring to with risk spreads. Fundamentally, the risk premium, depending on the asset, was very low, or in fact negative in many cases. For that to change (which it most certainly doesn’t have to anytime soon) prices have to go down.
Now you do have a point about perception. The short term crisis in liquidity is that in the short term even fundamentally sound credit has no buyers. We can say it is worth the same, but if there are no buyers it has no value to mark to market. So, with redemptions flooding in (with everybody redeeming we see why we have no buyers) many funds and institutions cannot honor redemption requests because they have no way to value what they own!
So, how do they determine what to give the investors asking to redeem their shares? Too much and they get sued by remaining shareholders. Too little and the fleeing investor gets his lawyers. If they try to sell the shares they see no bid, so they keep asking until someone picks it up. Usually a well heeled investor figuring to buy at 20 cents on the dollar. It is analogous to a bank run in some respects. If everybody heads for the exits at once nobody gets anything.
That is where the fed comes in. They allow banks to put up high quality securities as collateral for loans so that they can meet redemption and withdrawal requests until they can get things orderly. That helps perception, and can keep some people from going under just because if they mark things to market they look like they are facing huge losses despite maybe having no exposure to subprime. The Fed wants to stop the run.
The problem is that past that pure panic affect is that a lot of this paper may be worth more than the subprime stuff, but fundamentally it isn’t worth what it was priced at just recently. In addition, lenders do need to reprice and reconsider the risk they face in typical non investment grade debt, and investment grade as well. That means lower prices and higher interest rates. Fundamentals are reasserting themselves, not being ignored.
Which compounds a fundamental problem that affects the underlying panic, leverage. A lot of people in a lot of places used leverage (debt) to purchase a lot of this debt. Very profitable if things are stable. However, a small 2-5% change in the value of the underlying bonds can wipe out many funds which are levered quite highly (as are banks) and they can’t run to the fed like a bank can. These are not mere liquidity squeezes, these guys blowup, which feeds the panic. The people who lent to them to do this (banks) are now left holding the bag. That is a pretty big fundamental.
That doesn’t even take account of all those people borrowing in yen to buy this debt. Fine as long as the Yen remains stable. Unfortunately, as people abandon their trades the yen has started to rise, which really throws a wrench into the plans of those operating on those narrow spreads, so they flee, which leads to the yen rising even more and .... well you can see where this is going. One thing feeds on another and all those leveraged bets are getting killed.
There is more, as Dale and I have discussed there are fundamental affects the housing market will have on the economy that just can’t be papered over (though the fed may try;^)
Let’s be clear...I am by no means suggesting that there isn’t at all a "there" there. What I am suggesting is that the perception is far worse than the reality, at the moment. The numbers I provided in the comments of other thread, would seem to back this up rather well.
It also strikes me as interesting, the timing of this change in perception, the timing of all of this information suddenly coming to the fore. As I say, I suspect the proximity to the election is a driving factor, here. The economy is without question the best it’s been in several years. Decades, in fact. Lower flashing, low unemployment, stocks comparatively through the ceiling even with the up’s and down’s, and so on. If you’re going to run against the current president, as the democrats have announced they are going to do, what better way to do that, then to create the impression that the economy is in the crapper? The such complaints, after all, after a while of steamrolling become the fulfillment of their own prophecy. In this case, the fulfillment would end up being what , six to eight months away from the general election November next? You couldn’t ask for better timing.
In addition, lenders do need to reprice and reconsider the risk they face in typical non investment grade debt, and investment grade as well. That means lower prices and higher interest rates
No argument, here, at all. You (and Dale) do point out the overall symptoms, rather well. I would, however, look at the source of the problem rather than the symptom. How much of this subprime debt was induced by government policy? Subprime loans, after all, our mortgage is granted to home buyers with for credit or who don’t have enough cash to make a significant down payment. This by definition, involves "the poor". This by definition involves borrowers whom equal opportunity lenders statutes were intended to ’help’... as in "I’m from the government and I’m here to help you".
Look at the specifics that John Edwards laid out, as regards the residence of the delta region, where Katrina came through a few years ago. The economic disaster that was Katrina is now being felt in the banking sector, because so many were overextended. Well, why were they overextended? Because banks thought it was cheaper for them to provide such loans, then it was to pay legal fees for charges of race based lending... Particularly, when the weight of government was going to be involved in the lynching of any bank not willing to extend themselves thus. . Again, perceptions.
Of course, now we find out that Edwards was among those who profited greatly by the existence of such loans . But, thereby hangs a different tale, I suppose.
But, (and here’s the point of the other comment...) even with all that included, we are still talking about an exceedingly small percentage of loans.
How much of this subprime debt was induced by government policy?
That is a very good point, and one I plan on addressing soon at my place.
we are still talking about an exceedingly small percentage of loans
Yes, but almost all loans are (were) priced too aggressively. They won’t default, but losses due to a repricing are still losses. Loans passed on because of the repricing still matter a great deal to corporations and private equity.
The underlying problem, collapsing real estate, which affects everybody, still exists whether we have a credit crisis or not, though that likely will make it worse. The extent that real estate and housing accounted for economic growth over the last few years was astounding, not even including the mortgage equity ATM. How quickly the economy adjusts to that change is a big question. Perception and politics cannot account for that. I am not working for Bush, but I am certainly not trying to fan the flames for the Democrats either. This is a serious situation, one I have been disturbed about for quite a while. Asset bubbles the like of what we saw the last few years in housing rarely end up as soft landings. By rarely, I mean never in the case of housing, and this bubble has been several times any previous example in our history, but maybe this will be the exception. I don’t think the fed can do much about the fundamental issues, though they may be able to ameliorate the credit crunch.