Five Things You Need to Know: The Winter of Our Fed Dissent
Did anyone honestly expect the Federal Reserve to roll over and allow deflation to take root?
Kevin Depew's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:
1. Fed Post Mortem
First, a quick note on what happened yesterday with the Federal Reserve Open Market Committee's 50 basis point Federal Funds and Discount Rate cuts. Looking at the FOMC statement, there are two things to note:
1) The Fed believes the housing contraction is "deepening.'
2) the Fed believes credit markets remain under "considerable stress."
This is not a surprise. If there is a surprise, it's in the hysteria coming from market pundits over the Fed's actions. Did anyone honestly expect the Federal Reserve to roll over and allow deflation to take root without using all means at the central bank's disposal to try and stave it off? Read Fed Chairman Ben Bernanke's "Deflation: Making Sure "It" Doesn't Happen Here" speech again. Or, better yet, read the details of the Bernanke Put we outlined last May.
The issue is not "whether" the central bank will act to fight deflation, but how aggressive they will be? After 125 basis points in eight days, I think we have the answer to that question at least.
The issue markets have not yet fully solved is will the Fed be successful in stopping deflation, or if it will, at what cost? Chairman Bernanke has been very clear in why he believes the Fed can successfully stop deflation. As he explained back in 2001, "[U]nder a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero."
2. The Winter of Our Fed Dissent
Federal Reserve Chairman Ben Bernanke has not just the market to convince of his deflation-fighting prowess, but apparently members of the Federal Reserve Open Market Committee as well. Going back through past Fed statements, since September 18 there has not been a single FOMC meeting that didn't have at least one dissenting member. Not one.
Compared to former Fed Chairman Alan Greenspan's velvet hammer, and given the context of the dire situation faced by credit markets since the summer, that's somewhat astonishing. Correction: Earlier we noted the weirdness in William Poole's dissent in the January 22 meeting, but not in yesterday's meeting. The answer is that he was not in the meeting yesterday. As Minyan richard Moody noted, "The St. Louis Fed is not in the FOMC's voting rotation this year, but was in 2007. The voting rotation changes each year – the Presidents of five of the regional Fed banks join the seven full time FOMC members in DC to comprise the 12 voting members. But, the rotation does not change until the first regularly scheduled meeting of the year and, since the January 22 rate cut was an inter-meeting move, the 2007 voting rotation – including Mr. Poole – was still in effect. And, going back to his dissent on 1/22, Mr. Poole stated he did not favor a move before the regularly scheduled meeting (i.e., this week's meeting). As such, we can't really be sure how he would have voted yesterday had he still been in the rotation."
3. Bristol-Myers' Squib Kick
This morning Bristol-Myers Squibb (BMY) announced a loss of $275 million due to "impairment of some short-term investments." Specifically, the company lost money on auction rate securities.
What are "auction rate securities"? In general they are debt securities issued by municipalities and corporations with maturities ranging from 20-30 years. However, the interest rates on the securities are reset at short-term intervals (every 7, 28 or 35 days) through auctions.
Now it's important to understand that BMY wasn't out in the marketplace looking to invest in weird securities willy nilly. The company has maintained a portfolio of auction rate securities for nearly a decade. In fact, the market for auction rate securities is (was) considered highly liquid (the market exceeds $200 billion in size) and generally safe; the vast majority of the securities in the market, more than 90%, are rated AAA.
While the vast majority of the auction rate securities have long-term maturities, they began being treated as short-term investments by many corporations several years ago due to the fact they're ordinarily very liquid and can be sold off at monthly auctions. Most audit firms in late 2004 began advising corporate clients to classify their auction rate securities as short-term, as opposed to cash or cash equivalents. More on this in a moment.
The incentive for corporations to invest in auction rate securities is obvious - with tons of cash on their balance sheets, many corporate treasurers began looking for ways to increase the return on that cash. That's actually a prudent strategy... as long as the market for auction rate securities is functioning. But the issue here (one that the SEC even investigated a few years ago) is that the market, although large in nominal dollar volume, is quite thin, controlled often by one dealer. Under ordinary circumstances, if there are too few bids the dealer will prop up the market by entering to place a final "clearing" bid. That practice of "propping up" the market is what the SEC probed a few years ago.
As BMY explained in the conference call, some of the short-term securities they invested in were unable to be sold at auction and the sponsoring brokers refused to make a market in the securities, or in this case refused to "prop it up," exactly what many feared would happen if liquidity issues developed.
BMY maintains there will be no impact on overall financial flexibility going forward, but the company, like many many others still has a sizable auction rate securities portfolio. Unable to liquidate these "short-term securities" as needed, remember this is supposed to be a cash management tool, the company could be forced to take additional impairment charges if credit market conditions continue to deteriorate. The alternative to the impairment charges? Suddenly owning long-term debt with maturities of 20-30 years. In other words, a bad trade just became an investment.
4. MasterCard's "Good" News Bad... for Everyone Else
When is bad consumer news good news? When you receive a slice of the credit card transaction pie without sharing any responsibility for debt load racked up on the other side. Welcome to MasterCard's (MA) enviable position.
This morning the company posted strong results that exceeded most estimates, led by the secular trend toward increased credit card usage. We understand the long-term secular trend toward cashless transactions. MA said that even if economic conditions in the U.S. slow the company's domestic growth rate, consumers will continue to transact. What was interesting to hear, however, was the company's detail on those consumer transactions.
CEO Robert Selander said, "Over the past several months, consumers have moved away from discretionary items such as jewelry, full service restaurants and home furnishings towards everyday purchases including gasoline, grocery and personal healthcare items." That's good for MA because "the shift in spending pattern translated into higher fourth quarter growth rates in U.S. volume when compared to the third quarter of 2007." Sweet. But that's not exactly good news for anyone else.
5. Feedback On The Crisis of the Real
Gotta admit we were rather surprised by the volume of comments on yesterday's Five Things: The Crisis of the Real. The feedback was so strong, however, we wanted to share a couple of responses with those who may not yet be members of the free Minyanville Exchange.
Stuart notes: "Mr. Depew has detected the phenomenon Max Weber (Essays in Sociology) identified as, "...the socio-psychotic tendency of capitalist societies to displace reality through errant simulation." Mr. Depew does not, however, fully realize the perniciousness of this recurrent pandemic.
In his example "4," he cites the transmogrification of "home" from signifier of stability to wealth indicator. In fact, the term "home" supplanted "house" as post WWII attempt to do just the opposite; to turn a transitory corruptible structure (believe me, I own one) into a signifier of stability. Thus, it was the initial transmogrification of house-to-home that attempted to transform the corruptible into the incorruptible: Turnabout, fair play."
Joon writes: "As I was reading this I remembered my mother lamenting/questioning the advent of designer jeans...she's a tailor, and she was commenting "you know, jeans became popular because they were tough and they lasted a long time under rough conditions. Today, they take a perfectly fine pair of jeans and run them through a machine that deliberately wears them out, and then people pay 200$ for them. What is going on with this world?"
As an aside, thinking about the simulacrum gives the Matrix a whole new twist. What is real?"
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