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Five Things You Need to Know: Digging Ourselves a Deep Jackson Hole


What you need to know... and what it means!


Minyanville's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:

1. What Did Bernanke Say?

Speaking at the Kansas City Fed's annual symposium in Jackson Hole, Wyoming, Federal Reserve Chairman Ben Bernanke reassured financial markets that the Bernanke Put remains in place, ready to limit damage to consumer spending and economic growth from a deepening housing recession.

  • Before going further, please read the full text of Chairman Bernanke's speech here.

2. What is the Primary Concern?

Having done that, here are some important takeaways that we see.

  • First, remember all that stuff about subprime mortgage issues being "well contained"? Well, that was wrong.
  • "The financial turbulence we have seen had its immediate origins in the problems in the subprime mortgage market, but the effects have been felt in the broader mortgage market and in financial markets more generally, with potential consequences for the performance of the overall economy," Bernanke said.
  • What happens when risk aversion grows?
  • The velocity of money slows.
  • In other words, the key engine of our economic growth begins to sputter.
  • "More generally, investors may have become less willing to assume risk," Bernanke noted.
  • Of course, the role of the Federal Reserve as it is seen from within, is to push risk assumption without letting it get too carried away.
  • "Some increase in the premiums that investors require to take risk is probably a healthy development on the whole, as these premiums have been exceptionally low for some time," Bernanke acknowledged. "However, in this episode, the shift in risk attitudes has interacted with heightened concerns about credit risks and uncertainty about how to evaluate those risks to create significant market stress."
  • In other words, risk aversion has spilled over into credit markets generally, which threatens the whole ball of wax.

3. The Bernanke Put Clarified

In the Fed Chairman's speech today we actually learn quite a bit more about the Bernanke Put.

  • Let's take a brief step back, what is the Bernanke Put?
  • Back in May, (Only One Thing You Need to Know: The Bernanke Put) we noted that in prepared remarks before a conference on bank structure at the Chicago Fed, Chairman Bernanke essentially absolved the Fed of playing any role whatsoever in the subprime loan debacle, declared the subprime problem "isolated" from "responsible lending" and then waved around a gigantic put option just to let everyone know that, regardless, the Fed will step in and clean up whatever mess is left over.
  • But first, what is a "put"?
  • The purchase of a put option gives one the right, but not the obligation, to sell a specified amount of something at a specified price within a specified time frame.
  • What does that mean? Ask your insurance agent. Seriously.
  • Think about your car for a moment. Most states require you to buy some type of insurance on your car. That insurance requirement? That's basically a put option.
  • How does it work? Well, in simplest terms, when you go to an insurance agent and take out a policy on your car, you are buying the right, should something bad happen to your car, to "put" (sell) it to the insurance company in return for an agreed upon amount over a specified time.
  • If you buy the most expensive insurance policy available, then you cover the total cost of replacing your vehicle.
  • If you buy the most inexpensive insurance policy available, then you may be just covering the cost you would have to pay if your vehicle injures someone else.
  • The Bernanke Put falls somewhere in between a full coverage insurance policy and the most basic liability insurance policy.
  • How so? Let's go back to his speech today.
  • "It is not the responsibility of the Federal Reserve--nor would it be appropriate--to protect lenders and investors from the consequences of their financial decisions."
  • In other words, the comprehensive policy is out of the question.
  • So what is covered by the Fed's insurance policy?
  • "But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy," Bernanke added.
  • So that's slightly better than a basic liability policy.
  • Remember the velocity of money issue we discussed in Number Two?
  • The Bernanke Put means the Fed will essentially do whatever is necessary to maintain a certain velocity of money.
  • "The further tightening of credit conditions, if sustained, would increase the risk that the current weakness in housing could be deeper or more prolonged than previously expected, with possible adverse effects on consumer spending and the economy more generally," Bernanke said.
  • Yes, velocity of money, acceleration of credit demand and consumer spending must be maintained.

4. Anti-Deflation Round 1: Coordinated Fiscal and Monetary Response

As we noted in yesterday's Five Things (What Does "Credit Crunch" Mean? Number 5), the tools for halting a credit crunch will include monetary stimulus from the Federal Reserve as well as a Fiscal response. Today we are seeing just the first of what will be a 15 round bout against deflation.

  • This morning President Bush just concluded a speech announcing the first stage of Federal help for subprime borrowers.
  • This is not a "bail out" of borrowers and speculators President Bush said.
  • Indeed it is not.
  • Bush will "let" the Federal Housing Administration guarantee loans for subprime borrowers, allowing them the avoid foreclosure and refinance at more favorable rates, but as with all things there is a price.
  • In other words, the move is to help guarantee payments to lenders.
  • The irony?
  • The fiscal response illustrates what is really going on behind the guise of "bad" subprime lending.
  • Nobody wants these homes because they aren't worth what was paid for them.
  • The borrowers would rather walk away than service the outrageous debt to value ratio.
  • And the last thing the lenders want are homes that they are unable to sell.

5. It's a Series of Events, Not a Process

What about financial markets? Shouldn't they go down if we are really on our way toward a full scale deflationary credit crisis?

  • Remember, the end of this credit cycle is a series of events, not a defined process. What do we mean by that?
  • If we do fall into a full-scale deflation, it will eventually look like this: Stocks decline, interest rates move lower, bonds move higher, yet the dollar goes up.
  • Only dollars can pay down debt, so they become more valuable.
  • That is why the dollar can go up if deflation is at hand even though the central bank will be trying to fight it by lowering the cost of borrowing money.
  • But by that time, deflation will be front page news and, almost by definition, any fiscal and monetary response will be too little and too late.
  • But this is a long-term series of events, not a domino process, and we are just now entering the first round of policy actions.
  • That makes it difficult to understand why markets may continue to go up for a while.
  • Narratives are linear by design.
  • Scenes are set, characters identified and defined, actions unfold over time in steps that lead toward a resolution.
  • Unfortunately, while narrative is convenient in helping us understand things, it is useless in predicting how things unfold. Why?
  • Because history does not unfold in a linear manner.
  • Man, in retrospect, it all seems so clear. Have you ever thought that? I have.
  • But why? Why does everything seem so clear in retrospect?
  • Because we are hardwired to recount events in linear narrative fashion... even events that do not unfold in a linear manner!
  • In other words, our need for linear narrative colors our perception of history.
  • Linear narratives unfold in steps, the output proportionate to the input.
  • The Federal Reserve Chairman lowers interest rates, the first a surprise 50 basis point cut, for example.
  • The stock market rallies.
  • Money is less expensive, so people borrow and put that money back into the stock market, or in houses.
  • It certainly seems that way.
  • However in reality, in non-linear systems, the output is not directly proportional to the input.
  • So it's not the case that if, say, the Fed does X, a proportional outcome will follow, or if the Fed and politicans implement Y, a series of proportionate outcomes will follow.
  • On the one hand, this is why it is so very easy to sit back and laugh at the predictions of economists and market strategists.
  • Hoho, the one prediction that is sure to be guaranteed proven correct?
  • That their predictions will most likely be wrong.
  • But this is not about "predicting" deflation.
  • It's about discussing the most probable outcome of central banks continuing policies of attempting to maintain continued credit expansion.
  • As long as credit expansion and demand for credit continues at an accelerating pace, the appearance of prosperity continues as asset prices increase.
  • The one thing we do know, is that this credit expansion has a price.
  • It must one day be repaid.
  • How that day arrives is anyone's guess.
  • But the longer it is delayed, the more painful it will ultimately be.
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