Five Things You Need to Know: Home Prices Fall; Nervously Confident; A Strange and Terrible Comment on Potential Systemic Risk; Back On Target; Where Did the "Helicopter" Come From Anyway?
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. Home Prices Fall
Home prices fell by a record in the second quarter according to a report by S&P/Cash-Shiller.
- Year-over-year home values declined 3.2% in the three months through June, the report said.
- The report also showed that prices in June in 20 U.S. metropolitan areas fell 3.5% from a year before.
- The June index covering housing transactions in 20 metropolitan areas showed that home prices declined 0.4% in June compared to May, after falling 0.3& from April to May.
- "The pullback in the U.S. residential real estate market is showing no signs of slowing down," Robert J. Shiller, Chief Economist at MacroMarkets LLC, said in a release accompanying the price index.
- "The year-over-year decline reported in the 2nd quarter of 2007 for the National Home Price Index is the lowest point in its reported history, which dates back to January 1987," he added.
- On the bright side, five of 20 cities showed year-over-year price gains: Atlanta, Charlotte, Dallas, Portland and Seattle.
- Of course, since for many of us a home is our largest asset, and regardless of whether we're selling it anytime soon, the value of it feeds directly into confidence and sentiment... and this leads us to today's Number Two...
2. Nervously Confident
The Conference Board's index of confidence declined to 105 from 111.9 in July, the largest drop since the aftermath of Hurricane Katrina, according to Bloomberg.
- To put the overall decline in perspective, however, we're coming off a six-year high, and overall confidence averaged 105.9 in 2006.
- Apparently, while we're still nervously "OK" in the present.
- The Conference Board's measure of present conditions fell to 130.3 from 138.3 in July.
- But the gauge of expectations for the next six months dropped further, to 88.2 from 94.4.
3. A Strange and Terrible Comment on Potential Systemic Risk
A little over a week ago the Federal Reserve suspended the limit on the percentage of capital that Citigroup (C) and Bank of America (BAC) can lend to their affiliated brokerage firms. What does that mean, and why should we care?
- The exemptions are from section 23A of the Federal Reserve Act and the Board's Regulation W.
- Section 23A and Regulation W limit the amount of "covered transaction" between a bank and any single affiliate to 10% of the bank's capital stock and surplus, and limit the amount of covered transactions between a bank and all affiliates to 20% of the bank's capital stock and surplus.
- Both Citigroup and Bank of America petitioned the Federal Reserve for the exemptions in order to extend short-term liquidity (in excess of these caps) to finance "certain mortgage loans" and related assets.
- Well, hey, that's' well within the Fed's mandate, right? After all, they are to provide liquidity and help ensure the stability of markets, right?
- Sure, after all the Fed must have some leeway in determining when to grant section 23A and Regulation W exemptions in order to fulfill those objectives.
- In researching this we stumbled across a Chicago Federal Reserve comment paper on Regulation W that discusses, among other things, , .
- The comment paper offers some helpful suggestions on Reg W exemptions, among them this important paragraph:
"Broker/dealers actively use matrix pricing to validate the price of a fixed-income securities portfolio for SEC reporting and capital allocation purposes. In fact, matrix pricing is an accepted pricing convention for most fixed-income securities. Perhaps a distinction needs to be made between matrix pricing and idiosyncratic internal pricing models. In its simplest form, matrix pricing involves comparison of a security to other securities of similar credit risk profile and tenor to determine an appropriate spread to a reference Treasury security. Simple non-complex bond math is then applied to calculate a price. These spreads are tracked and disseminated through a number of widely used independent pricing sources (Bloomberg, Reuters, etc.). In contrast, internal models are used to price more complex instruments that often involve imbedded optionality, contingent cash flows, or other subjective pricing assumptions. As a result, common sense warrants limiting matrix pricing
for the (d)(6) exemption to relatively "plain vanilla" transactions such as investment-grade corporate bonds and commercial paper. This would effectively exclude most structured notes and mortgage-backed securities where the ultimate price is highly dependent on prepayment and rate volatility assumptions."
- So much for that suggestion.
4. Back On Target
The New York Federal Reserve publishes statistics on overnight trading in the federal funds market on a daily basis here. Yesterday, for the first time since August 9, the fed funds actual rate traded at the Fed's target level of 5.25%. Note that on August 14 it's level was 4.54, nearly 75 basis points below the target.
- The interesting thing about this table is it shows how, under normal circumstances, the Federal Reserve maintains an illusion of "control" over short-term interest rates.
- Some even maintain the Fed has the ability to "set" long-term rates by adjusting the Federal Funds target rate, or using some of their other mechanisms. (See today's Number Three, for example.)
- However, as we have seen first hand, the Fed's "illusion of control" can be broken by any number of factors.
- The reality is that the mechanisms for maintaining the constant inflation of money and asset prices necessary to keep our scheme running are entirely dependent on a steady appetite and desire for credit.
- No matter what we call the Fed's tools - repos, open market operations, adjusting the fed funds rate, the discount rate, suspension of lending restrictions, lowering capital requirements - they all depend on there being an increasing appetite for credit.
- Even a steady appetite for credit is not enough to continue to grow a finance-based economy.
- And a declining appetite for credit is at the root of how deflationary credit contractions are triggered.
5. Where Did the "Helicopter" Come From Anyway?
Federal Reserve Chairman Ben Bernanke is frequently referred to in a derogatory manner as "Helicopter Ben." But where did the nickname come from?
- In a speech he delivered in November 2002 on "Deflation: Making Sure "It" Doesn't Happen," then-Fed Governor Ben Bernanke referred to a "helicopter drop of money."
- And since that time this much-misunderstood reference to a "helicopter drop of money" has stuck with him, most often believed to be an allusion to taking whatever steps are necessary to prevent or cure deflation.
- But let's look at what he really said, and what he really meant:
"A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money."
- Yes, in fact, it was Milton Friedman who "invented" the helicopter drop of money analogy, but his invention was actually based on John Maynard Keynes theory of the Liquidity Trap.
- A Liquidity Trap occurs in a low-interest rate environment with stagnant economic conditions and high savings.
- During this environment monetary policy becomes ineffective.
- Because people believe (psychology at work) that they will not receive an adequate return for the risk assumed in owning other financial assets, even bonds, they prefer to keep cash in short-term bank accounts. In other words, they hoard cash.
- The most frequently misunderstood aspect of the "helicopter drop of money" analogy (from Keyenes to Friedman to Bernanke) is that it refers to actions on the part of a central bank, but this is not true.
- Bernanke used the phrase in his speech in a section explicitly discussing Fiscal Policy:
"Each of the policy options I have discussed so far involves the Fed's acting on its own. In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money."
- This may be true, but note he says "almost certainly," and that it presumes that the credit appetite for households will increase - a faulty assumption.
- The only thing a central bank can do is make credit available - and the Federal Reserve has certainly been doing this.
- Whether that credit availability is received or rejected will determine whether, and how long, a deflationary credit contraction will last.
- Of course, there is one last tool - the Fed and Fiscal Policy could come together to help foster a continuation of the game, as Bernanke says:
"[I]n lieu of tax cuts or increases in transfers the government could increase spending on current goods and services or even acquire existing real or financial assets. If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets."
- Yes, that would help... but the costs are not mentioned, and here we are not referring to the "dollar costs," but something more severe; a steeper price - the nationalization of financial markets.
- In plain English, that paragraph is saying that, if all else fails, a government can issue public debt, financed by the Federal Reserve, to purchase private assets.
- At that point the very question of whether capitalism survives becomes irrelevant, because a government, by issuing debt to buy private assets, will have effectively concluded it.
- Is that frightening?
- It should be, for when is the last time in all of human history that anything, once controlled by any government, was returned to the people?
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