Policy Matters

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Bernanke: Transparency x10

Bernanke’s most recent speech is pretty straightforward — he wants the market to understand what the Fed is doing. If forward guidance is based on “economic objectives,” then that’s what it means. 

I wonder if he’s saving “it is what it is” for the finale? Transparency x10:

1. “…one of my priorities was to make the Federal Reserve more transparent…”

2. “…to make monetary policy as transparent and open as reasonably possible.”

3. “…transparency in monetary policy enhances public understanding and confidence, promotes informed discussion of policy options.” 

4. “…the deepest recession since the Great Depression has required a more prominent role for communication and transparency in monetary policy than ever before.”

5. “…I will discuss how the Federal Reserve’s communications have evolved in recent years and how enhanced transparency is increasing the effectiveness of monetary policy.”

6. “… I believe that policy transparency remains an essential element of the Federal Reserve’s strategy for meeting its economic objectives.”

7. “Experience demonstrates that a useful approach to managing expectations—one that dovetails well with basic principles of transparency—involves policymakers stating clear objectives as well as their plans for attaining those objectives.”

8. “…numerical inflation goals have helped increase the transparency and predictability of policy in a number of economies.”

9. “This increased transparency about the framework of policy has aided the public in forming policy expectations, reduced uncertainty, and made policy more effective.”

10. “I began my time as Chairman with the goal of increasing the transparency of the Federal Reserve, and of monetary policy in particular.”

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Geithner goes in through the out door

He took the a-typical path for someone fascinated with finance. It wasn’t the most lucrative, but it was an intellectual roller-coaster. He devoted himself to public institutions and the functioning of global markets, ran the world’s largest portfolio, and after 25 years he’s going to work in global private equity where he can apply what he learned in a different way. 

Is that a bad thing? Evidently, some people think so. And evidently, whether we want to crap another man’s private decision to make a living boils down to our view of such things:

Is Scheiber right? That whether you think Geithner’s decision is respectable or not is based on your world-view? Yes, I think so.

However, this tweet gets more to the point than Scheiber’s article does, which is that his beef with Geithner is nothing more than him expressing his feelings about the financial industry, not Geithner himself. 

Call me crazy, but perhaps Scheiber should write about whether he thinks America is over-financed (fellow TNR’er Robert Solow does). Or better, what careers he thinks Geithner should be doing to better serve the public good; if that’s his world-view.

One more thought — What if Geithner went to run a health-care company or a university? Noah Smith says these positions might be equally ”bullshit jobs”. Even more reason to write about what Geithner should be doing! 

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Remember that $83 billion dollar subsidy?

In August, Moody’s Investor Services stated that they were reviewing the credit ratings of large banks in order “to reflect the impact of US bank resolution policies.” Moody’s competitor S&P has already made these changes.

This past week, Moody’s finished their review by downgrading the likelihood of government support, stating, “Today’s rating actions reflect strengthened US bank resolution tools, prompted by the Dodd-Frank Act, which affect Moody’s assumptions about US government support.” 

While financial markets already priced in regulatory changes associated with Dodd-Frank – changes that make bank failure less likely and failure less messy – critics often pointed to credit ratings to state that big banks were receiving an implicit subsidy (valued at $83 billion), in a large part because this was the only methodology that stated there was one.

With these changes, no matter what methodology one uses, no “implicit TBTF subsidy” exists. 

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Lend Freely At A Penalty Rate, Or Something

Walter Badgehot summarized the lender of last resort function by saying: “Lend freely at a high rate, on good collateral.” This is often translated: “Lend freely, but at a penalty rate.”

Based on analyses of the programs, the Fed did lend at a penalty rate, although, similar to “high rates,” the definition of a penalty changes as market conditions change. The fact that the market wound down the programs before the Fed actually closed them is a perfect example of why they did lend at a penalty. As the financial system stabilized, why did the market stop relying on the Fed if it wasn’t at a penalty rate? 

Here’s the New York Fed in a 2010 study on the pricing structure of the CPFF:

"The CPFF’s pricing structure and other program requirements helped ensure that the facility played a constructive role in restoring stability to the market. At the same time, they also served to: 1) prevent artificial inflation of issuance beyond what may be absorbed by investor demand under normal conditions, 2) ensure that the facility was used as a backstop in times of stress while also providing a disincentive to issue to the facility under more liquid market conditions, and 3) mitigate the credit risk associated with adverse selection to minimize the Federal Reserve’s exposure to loss relative to its accumulated capital from program fees.”

At its peak in January 2009, the CPFF held more than 20 percent of all outstanding commercial paper. By the time it expired on February 1, 2010, the facility represented only 1 percent of market issuance. The self-liquidating feature of the CPFF is illustrated by the steady decline in the amount of outstanding commercial paper throughout 2009.” 

Their Liberty Street Blog says something similar about the PDCF program:

The terms of the PDCF were designed to make the facility’s usage unattractive in normally functioning markets, so that it would be used only as last-resort funding…In particular, the Fed extended loans at the discount rate, which was set above the fed funds rate (at the same level as the primary discount rate). Because rates in the repo market generally fall below the fed funds rate, borrowing through the PDCF would ordinarily be more expensive than borrowing in the private market. Moreover, the Fed implemented an escalating usage fee, which was imposed on borrowers that used the facility for more than forty-five days. In addition, the haircuts imposed on pledged collateral were monitored and updated to achieve a balance between preventing losses, which required higher haircuts, and helping restore greater liquidity, which required lower haircuts.” 

Douglas Elliot of Brookings also offers good insight on this issue in his response to the latest GAO study on Fed lending programs: 

“Completely unsurprisingly, the government support was more favorable than market terms. There is no point in intervening by offering the same terms as the market under crisis conditions. Financial crises cause prices to be distorted. Credit spreads shoot up to unreasonable levels and stock prices collapse temporarily. Offering the same terms as the market provides no help in fighting these distortions and stabilizing the system.

Central banks like our Federal Reserve have dealt with this issue for years, in the context of their role as “lender of last resort”. It is well accepted that lending by central banks under crisis conditions should be on more favorable terms than the market, even though the costs generally still represent a penalty rate compared to more normal conditions.

The GAO figures are interesting and of historical significance, but do not contradict the fact that government support during the financial crisis was essential and that taxpayers escaped with remarkably little direct cost from that support, actually making money on most of the programs. The indirect costs of the crisis, which triggered the Great Recession, were much larger. However, these societal costs were reduced, not increased, by the government’s bold actions in stepping up to provide the necessary support to the financial sector.”

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Break up the banks “…so I can replace them.”

Yesterday on CNBC, Citadel’s Ken Griffin opined on whether we should break-up the banks: “…We don’t have a good legal justification for breaking up the banking system, but if I could wave a magic wand, I’d break up the banking system.”

Aside from not having good legal justification (anti-competitive), there are many reasons why a bank break-up is a bad idea; however, in order to understand why people like Griffin would say this, one needs to understand his bias. The best response to this comes from Noah Smith, well-known financial blogger and economics professor, in his tweet to Jim Pethokoukis (Jimmy P happens to agree with Griffin):

Simply, in event of a break-up, the services that large banks provide can only be provided by other large foreign or non-bank financial institutions (call them the shadow banking sector). They will be the ones to replace them. 

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In response to Cam Fine at ICBA

Also posted in American Banker http://www.americanbanker.com/bankthink/wall-street-funding-advantage-is-all-too-real-1063257-1.html#comments


Only looking at credit ratings in attempt to value a too-big-to-fail (TBTF) subsidy does not pass academic rigor. Also, one should analyze the market as it changes, accounting for the significant impact of Dodd-Frank reform. Only by looking at the issue from multiple perspectives and testing new assumptions will we ultimately arrive at the best solution.

Summary analysis on the TBTF subsidy issue was recently released by Chicago Booth’s Randall Kroszner. He sources nearly 100 different studies where the subsidy issue is discussed or is directly related to the research. In his paper, he simply asks, do changes in credit ratings reflect changes in debt-pricing? If they do not, then using credit ratings to calculate a TBTF subsidy “…would not provide a reliable or accurate way to determine funding cost differentials. In fact, it would significantly overstate the advantage.” Kroszner concluded that credit ratings and bond pricing did not move in tandem, accordingly, “…the CDS markets were not pricing in any “uplift” in their assessment of the likelihood of default by the large banks. These data do not support the assumption that a ratings “uplift” automatically translates into lower borrowing costs, and hence calls into question the use of the “uplift” as a measure of funding cost differentials.” (Kroszner, “A Review Of Bank Funding Cost Differentials,” Booth School of Business, October 2013).

Academics Balasubramanian and Cyree looked at senior bond spreads at banks pre and post Dodd-Frank. They concluded that whatever advantage large banks had in the past, it has been eliminated. Now large banks are funding operations with debt priced at a premium. According to the paper, “Markets charge a premium of 33 basis points for the TBTF banks after the DFA…default risk sensitivity of several variables improves and changes in risk are perceptible in the changes in yield spreads.” (Balasubramanian and Cyree, “The End Of Too-Big-to-Fail? Evidence From Senior Bank Bond Yield Spreads Around The Dodd-Frank Act,” SSRN, 06/23/2012).

Steve Strongin, Head of the Global Investment Research (GIR) Division at Goldman Sachs, offered a different perspective – although he came to a similar conclusion as Balasubramanian and Cyree – he looked at bond-pricing not only between banks, but other industries throughout our economy, such as retail, tourism, and more. He found that debt-funding advantages were present in all industries, and that the spread is far wider for industries outside of banking. According to Strongin, “The benefits of size are seen in industries beyond banking, making it necessary to consider the question of advantageous funding rates for the largest banks in a broader market context.”  (Strongin, “Measuring The TBTF Effect On Bond Pricing,” Goldman Sachs Global Markets Institute, May 2013).  

Another approach is event studies. Looking at natural experiments around the world, Schafer, Schnabel, and Weder Di Mauro find that “reforms seem to have reduced bail-out expectations, especially for systemic bank,” with the strongest effects coming from Dodd-Frank. “Has anything happened in financial regulation after the crisis? Have the various structural reforms enacted in countries hosting major financial centers been registered in equity valuations and credit default spreads of their banks? The good news is that the answer is yes. In all cases, the reforms seem to have reduced bail-out expectations, especially for systemic banks, and lowered equity returns in many cases. We find the strongest results for the Dodd-Frank Act and, in particular, the Volcker rule, which led to a significant decrease in equity prices and an increase in CDS spreads, especially for investment banks and systemic banks.” (Alexander Schafer, Isabel Schnabel, And Beatrice Weder Di Mauro, Financial Sector Reform After The Crisis: Has Anything Happened?” SSRN, 5/24/13)

Kroszner states that “Sound empirical analyses are crucial for policy makers to be able to assess the magnitude of concerns…then to be able to weigh the costs and benefits of alternative reform proposals.” This cannot be emphasized enough.

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BlackRock’s Fink on U.S. confidence, default, and the debt-cieling

In the FT today 

"Confidence in America derives not just from our sustained economic growth over the past century but also from our ability to reconcile the nation’s diverse political views. This is now in jeopardy…

The short-term damage has been done; the next round of budget discussions needs to show that the American political system still works. If our leaders can return to the standards of good faith, civil deliberation and mutual respect that have always provided the foundation of our global economic leadership, we can restore the confidence of all Americans – as well as business leaders, investors and markets worldwide – and with that the potential for a long-term US economic resurgence.”

- Larry Fink, CEO, Blackrock

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Do The GSEs Need To Be Reformed?

Lost in much of the debate over how to reform the GSEs is whether reform is necessary. Let’s be clear, the entities should not return to their pre-crisis ways. The reason the government owns them today is because they got away from their core-function of purchasing conforming loans and went belly-up when their bets went sour.

However, they are now different entities with different standards under FHFA. They now have tighter credit limits and are liquidating their portfolios in order to reduce their long-term credit risk. 

At the same time, the market is performing well. Housing prices have stabilized and are no longer acting as a drag on the economy. Yes, the private-label securitization (PLS) market has yet to return, but I think that’s more of a matter of rebuilding trust between issuers and investors more than anything else.

But getting back to it, as far as completely winding-down the entities, I really don’t see the logic in that. We need a government backstop that’s explicit or we’ll be left holding the bag again if there’s another crisis — and there will be another crisis. 

Further, it can be argued that the response to the financial crisis — whether we’re talking GSE conservatorship, TARP, Fed liquidity programs, etc — was overall good policy (good not great). It was countercyclical, responsible and highly effective in keeping the economy from tanking.

Reestablishing trust between issuers and investors is paramount and the ultimate goal, however, I don’t think raising G-fees to the point of pricing out the market is good policy, nor does it get us closer to our goal. 

Perhaps the reason we’re even talking about a mass revamp of the GSEs is purely political. As far as I can tell, the economic case simply does not exist. 

Sen. Harry Reid looks to be the first politician to come out against the majority and say GSE elimination isn’t necessary. Maybe all those waiting to take a side will switch over. It may not be the most political savvy place to be at this time, but it’s definitely the smartest.

More on this from a recent BAML report (sorry, no link) - 

Evidence is accumulating that the current model works  

Under control of the government with its tight limits on credit risk-taking and mandated shrinking portfolios, earnings remain strong. In addition, Fannie and Freddie have completed a large number of loan modifications, repayment plans, forbearance agreements and short sales – all of which have helped homeowners avoid foreclosure. These results provide two key takeaways: the GSEs function well as government-run entities and, the infrastructure of mortgage finance is not in need of major reform. 

GSE reform has become a hot topic in Washington 

High-profile GSE reform bills have been introduced this year by Senator Robert Corker and Representative Jeb Hensarling, while President Obama’s Better Bargain campaign kicked off last week with a speech in Phoenix also calling for GSE reform. All reform suggestions – including the president’s – call for a complete wind down of Fannie and Freddie. This is seen as pro-markets by the right and as anti-bailout by the left. The proposed bills call for an eventual receivership – or complete termination – of Fannie and Freddie, which would include an end to Fannie/Freddie debt and MBS markets, and in their place some new MBS markets would presumably arise. 

Time to separate useful reform from unnecessary reform 

Designing and implementing GSE reform is neither costless nor riskless. The resources now devoted to GSE reform are substantial and include multiple layers of staff at Treasury, FHFA, Congress, White House, HUD, and a multitude of policy advisory firms and industry participants. Change comes with risk, however, ranging from a significant decline in home prices to a sharp pullback in the availability and affordability of mortgage credit. Yet these costs and risks come with questionable benefits. We believe that reform for reform’s sake might soon begin to give way to a sober analysis of what’s best for the economy, borrowers and taxpayers.  

Senator Reid fires the first shot against major change 

This week Senate Majority Leader Harry Reid said in an interview that he thinks it is unwise to get rid of Fannie and Freddie entirely and that the current model provides a desirable level of home ownership and affordability. While he supports reform of certain aspects, he views the current infrastructure as effective. We think his statements represent the beginning of a countermovement to large-scale reform, and we expect to see growing support for smaller and smarter changes rather than a complete scrapping of the existing system in favor of something new. We think such a development would be good for agency debt spreads.  

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Can The Right Ever Respect Bernanke Like They Do Friedman?

I’ve often wondered what Bernanke will be like after his stint as Fed Chairman ends. 

As a tenured-again professor at Princeton, I imagine he’ll keep a very low profile. Sure he’ll give lectures, and may even be paid to speak, but the spotlight is simply not his style.

But what if it became his style? What if Bernanke, like Friedman (similar monetary schools), began voicing his opinion about policy outside of the monetary spectrum? What if every-day Bernanke was like the Bernanke we saw in Congressional hearings when he told Sen. Corker, “None Of The Things You’ve Said Is Accurate,” but took those opinions outside of central banking? Surely he has them.

Providing his thoughts on Friedman’s legacy, Noah Smith says that once an economist gets involved in public debates, that’s how he or she will be remembered; publicly at least. Your academic work will only be remembered in academia. 

This is a big reason why Rand Paul recently said his second choice for Fed Chairman, outside of Hayek, would be Friedman. Rand does not agree with Friedman’s monetary views, and Bernanke’s are arguably identical, so why would he choose Friedman?  

It must mean that either (1) Rand doesn’t know Friedman’s monetary views, as O’Brien writes, or (2) he’s willing to look past them because he pretty much agrees with everything else Friedman had to say.

The latter falls in line with how his father views Friedman, when he said, “Friedman’s very, very libertarian—except on monetary issues.” 

I’ll enjoy listening and reading Bernanke as an ex-central banker, but I don’t think he’ll get involved in non-monetary policy debates. For that reason, many people will never be able to look past his monetary views like they do for Friedman. Even if they are/were correct.