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Minyan Mailbag: The "Activist" Fed


The more debt there is, the more income is needed to service that credit, the less effective the Fed is in cajoling the market into taking it.

Profs. Succo and Reamer,

We are now at the point where "everyone" finally recognizes that lending in real estate got way too sloppy.

What I am curious about now is how an activist Fed responds to the unwinding of excesses. I believe that one can reasonably deduce from Greenspan's commentary over the years that the Fed believes that the U.S. private sector can adjust and recover from virtually any problem that develops as long as a sharp correction or crash is avoided.

PIMCO is suggesting that the real estate lending excesses will continue to bear on the markets/economy for the next two years. That is the period over which most of the aggressive lending will reset. There should be very little new problem lending entering the pipeline because of currently tightening lending standards. My question is, what do you think the probability is that an activist Fed will seek to spread the consequences over a significantly longer time period?

I am seeing headlines like, "Citigroup (C), Bank of America (BAC) to aid subprime victims." Could we see some limited below-market lending coupled with extensively restructuring troubled ARMs that avoid substantially higher current resets but still have a day-of-reckoning that is pushed further into the future? (With the hope of a milder correction and then higher future real estate values and better access to credit.) Is the Fed cheerleading large institutions to be creative (LTCM style) in spreading the lending crisis over a much longer period of time in order to avoid a "snowballing" of the problem? (Foreclosures increase housing supply, credit tightens further, depresses prices, increases foreclosures, increases supply...) Were Freddie Mac (FRE) and Fannie Mae (FNM) encouraged by the Fed to intervene as owners/overseers of problem loans so that they can be restructured rather than foreclosed?

Do we really have a much more "activist" Fed, or am I reading too much between the lines? (Please tell me if I've become a conspiracy theorist lunatic.)

Lastly, if some of what I've hypothesized is really possible, what are some not-broadly-considered potential ramifications that I should be thinking about for the markets and the economy?

Minyan Jeff


If the Fed had the ability, they would of course insulate the banking system and markets from the pain of this credit write down for as long as they could – by spreading it out over time. On that there is no debate: since 1987 the Fed has increasingly addressed the fact that when the "market" wanted to tighten because of excess debt and or speculation, the Fed steps in and creates the credit where the market does not. This has led over time to massive mis-allocation of capital and larger and larger debt levels.

The real debate is whether or not the Fed can do that. After all, the Fed itself can monetize anything and keep rates low (at the expense of the currency), but the only thing that matters really is will the market want the credit? The more debt there is, the more income is needed to service that credit, the less effective the Fed is in cajoling the market into taking it. That is, the bankers become less inclined to lend and borrowers become less able to borrow.

In Japan from 1990 to 2003, the BOJ kept rates at virtually zero but during that entire time the Japanese consumer and corporation did not want to borrow (having suffered asset price write downs and thus hits to their capital bases) and the Japanese banks themselves did not want to lend (having themselves suffered the same capital write-downs from their holdings (direct on their balance sheets and indirect via loans to consumers/corporations). Thus what the BOJ wanted was moot - they wanted to shield the Japanese banking system from the negative effects of the property and stock busts but were unable to at all. Huge debt levels create the circumstances above: where consumers and corporations cannot suffer even small capital declines (stock or property) before their appetite for credit diminishes massively.

The fact that total US bank lending y/y is now about 8% y/y vs. 13.5% or so as early as last summer (growth rate is coming down pretty rapidly) speaks to this idea: the US is already seeing declines in total bank lending that have in 1990, 1996, and 2000 led to credit cycle 'busts' of some degree. And obviously the amount of debt outstanding now dwarfs all of those periods; so a decline in the willingness of bankers to lend (and thus support the ability of debtors to service their debts and simultaneously support debtor's capital bases) bodes ill indeed for the US' debt laden consumer economy.

Most of the LBO deals we have seen will eventually suffer greatly because of leverage: one little problem in margins will cause a catastrophe to earnings. This is what leverage does. The more levered a company is the more stable its margins must be.

Given the massive amounts of credit that are now being created outside of the traditionally controlled "Fed channels" (Stephanie Pomboy puts the number at 75% of total credit creation), one must ask the additional question of if the Fed can impact marginal credit demand (by lowering its price or monetizing it outright). Recall that while the Fed was increasing rates 17 times in 2004/05, the housing bubble – and the 'creative' financing that fed it - was reaching manic proportions. Thus, from that experience, you could conclude that the Fed is less in control of credit supply (and as well credit demand) as they would like to admit.

Who is in control? The People's Bank of China, the Bank of Japan, pension and hedge funds, and the broader capital markets: all have a stake in keeping the liquidity cycle going (and thus the credit creation cycle cycling). But those are fickle friends: the Olympics, the carry trade, the aging of the G7 populations, and the 2%/20% model of hedge funds are feeding the frenzy now but any one of those factors could change and cause any of those factors to turn tail and end the game of musical chairs, causing the deflationary credit bust we think is an inevitability with a system as heavily indebted as the US'.

From the Fed's own flow of funds we see just how ineffective the Fed has become: in 1980 it took $1 of new debt to create $1 of GDP (debt levels were much lower and capital usage was much tighter so new credit found its way into production), whereas today it takes $7 to $8 of new debt to create $1 of GDP.

No matter what the Fed 'wants,' no matter what they are able to get FNM, FRE, BAC, WM, C and the gang to do, and no matter who (PBOC, BOJ, TIAA-CREF, or PIMCO) gets the last chair, there is one verity in macroeconomics:

All credit cycles cycle.

John Succo and Scott Reamer
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