As you know, I believe that setting for a central bank policy goals, other than providing sound money and stabilization against systemic risk, (providing last-resort lending) is a dangerous delusion. In particular, I find Paul Krugman's article at http://web.mit.edu/krugman/www/triangle.html as one of best descriptions of why one can't have a cake and eat it too. You won't hear anything like that from a practical politician, because, in democracy, the the essence of successful politics is promising everything to everybody, in order to get as many votes as possible. Some issues, however, are necessarily divisive, and serious analysis can't just ignore them.
In any case, I wouldn't be so sure that financial disintermediation has weakened the FED. The regulated banking system is not disconnected from the securitized debt and, more generally, the capital markets: liquidity injected in the first percolates in the second, because nobody borrows at higher rates if they can do it at lower rates. Disintermediation may have made more difficult to tighten the monetary policy, but not to ease it. In the worst case, just print money. Of course, moral hazard emerges when a relatively unregulated sector like the capital markets can enjoy the same safety as the regulated banking sector. However, the Savings and Loans were regulated, and we have all seen what happened...
Anyway, I'm puzzled by the plight taken by REIT's. I'm not familiar with them, but I thought that they worked like open-ended funds, reflecting in their NAV the value of the underlying assets (real estate, in their case). Any light shed will be welcome.
Cheers --
Enzo
-----Original Message----- From: Henry C.K. Liu <hliu at mindspring.com> To: lbo-talk at lists.panix.com <lbo-talk at lists.panix.com> Date: Sunday, November 22, 1998 6:20 AM Subject: Re: Mr. Charles "Please come home for Christmas" Brown
Tom, it would be a real breath of fresh air if someone in Washington would admit to the same dilemma.
In theory, the Chairman of the Fed has the power to maange the economy by addressing the interest rates and liquidity components as tools of US monetary Policy to achieve the stated of objective of the Federal Reserve Act of 1913, as modified by Humphrey-Hawkins. The Federal Reserve Act of 1913 mandates that "the Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates." Humphery-Hawkins, as we know, accepts full employment as 4% unemployed, below which is considered as economically "inconsistent" with inflation targets.
In practice, the widespread of the securitization of debt, which allows borrowers to bypass banks to directly tap capital markets for debt rather than for equity, has in effect weakened the power of the Fed. Such developments remove the levers of control from government fiat and place them in the market where the lawful goals of the FR Act have no bearing (creeping illegality and unconstitionality?). We are witnessing a massive leakage of the speicalized gas inside of the monetary balloon into the general atmmosphere of the open market. Some economists think this is positive and some think negative, depending on their individual vision of economic purpose in society. Some economists may even think bubbles, like vacination, are good, because they purify/strengthen the post-bubble economy. In theory, the view is arguable, except for those who happen to be among the innocent victims. The evolution of advance human systems makes it increasingly difficult to justify the sacrifice of individual cells (persons) for the good of the total social system (the economy), especially when the system celebrates mal-distribution as a merit.
At any rate, Greenspan can no longer directly interfere with liquidity without paying the increasingly high costs of unintended and unwanted systemic consequences, such as excess deflation or inflation, unemployment, capital flight, runaway risk and above all, their political impacts.
The fast emerging credit crunch is not just a bank liquidity problem any longer. Lowering interest rates by the Fed, a classic monetary tool, will not solve the liquidity problem. The 3rd cut (November 17) since September 29 was greeting with a half-hearted applause from both the stock and bond markets, because since last summer, investors have fled risky markets for the safe haven of US Treasuries, causing the bond market to lead the Fed on interest rate policy, trading at levels that predicted even further drops in key rates. The good news, according to market analysts, was that there will NOT be any more cuts before the end of 1998. Greenspan is pushing on the credit string instead of pulling on it.
For the last decade, debt securitization has incresingly shifted borrowing from banks to capital markets. Unlike bank loans which stay at par until there is an actual default, high yield bonds and securities are subject to daily market volatility. Institutional investors' share of the high leverage borrower market has grown from 1.7% to 19%, at the expense of banks. Private debt jumped from 3% of GDP in 1991 during the downturn, to 14 % in 1998. While consumer debt peaked at an annual growth rate of 15% in 1995 and falls to 4% in 1998, business borrowing keeps growing at 14% annual rate. The credit crunch is a sign of more serious economic problems to come. Junk bond default rate remain at around 3%, yet the spread between 30 year Treasury and high yield bond increased because of the extra risk premium the market demanded.
This was the major cause of the demise of LTCM.
The tumult in the debt markets makes new construction loans and acquisition financing harder to come by for private real-estate investment trusts (REITs). REITs are byproducts the previous real-estate credit crunches. Lenders, burnt by mortgage defaults in the beginning of the decade, were reluctant to lend when rents were low and properties were cheap. REITs filled the vacuum by selling stock instead of borrowing to finance their acquisitions, an innovative approach. As occupancy and rents rise in recent years, the US$200 billion REIT market delivered high returns: 35% in 1996, 20% in 1997, which in turn caused REIT share prices to rise and allowed the conservative debt level of 50% of asset value to arise in dollar terms, fueling a boom (bubble). By the third quarter of 1998, REIT share prices have fallen 25% as a result of the plunge in the stock market, cutting off access to new equity sources, despite of good real-estate fundamentals (high rentals and low supply). A wave of REIT bankruptcies have started in recent weeks.
The entire financial sector is bracing for massive losses to be followed by a long credit drought.
In six months, Greenspan will give another speech, or testimony before Congress, explaining the phenomenon, as if belated understanding can ease the damage. There is not much he can do, because he knows that he is boxed into a corner where the cure can be worse than the ailment.
IN ALLAN WE TRUST, except that there are increasing signs that Allan is dead.
One more factor to take into consideration is "creative" corporate accounting procedures. With a view towards the importance the market assigns to corporate earnings, distortive excessive write-offs to trade off for phantom future earnings improvements have become widespread gimmicks. The SEC has recently launched a study headed by Messr. Milstein and Whitehead (a lawyer and an retired investment banker respectively) to address this problem, which suggests that the impacts are systemic. This abusive manipulation of the earnings picture, while legal, contributes to the making of a bubble in asset value.
Another equally serious problem is the systemic socialization of risk through structured finance. The widespread use of derivatives to unbundle risks so that hedging against dis-aggregated risks can be priced at the highest level to serve those with targeted specific needs, creates the false impression of individual safety through extensive risk management. This tends to cushion the downside (through risk management complacency) and inflate the upside (through ballooned efficiency expectations). Yet in fact the same degree of risks remains, because individual risks are only passed on to systemic risks, but the nature of the risk has become more serious, and added economic value comes mainly from accounting creativity. The counterparty of every hedge is a speculator, and in some blazen cases, the lack of regulation and transparency has permitted the counterparties to be the same entity, as in the case of LTCM. Further more, when efficiency is defined as achievable via a reduction of caution, a higher peak then requires a lower valley. The defining characteristic of a bubble is that everyone inside the bubble crashes at the same time. Structured finance has made that prospect more likely and less preventable.
What is RCP website address?
Henry C.K. Liu
uswatl at ibm.net wrote: [...]