Thoughts on the Fed’s Actions

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4 responses to “Thoughts on the Fed’s Actions”

1. 

   AaronHorvitz

   March 13, 2008

   Unfortunately it seems that the Fed had to do some creative maneuvering recently…

   This is a fun site with great reads, and I’m interested to see what anyone else has to write as well. I’m no expert in economics but this is my take on it. Unfortunately it’s not focused and needs to read like a mini-story.

   I believe the Fed’s recent actions need to be taken in the context of recent economic events.

   Trade imbalances with the United States left foreign investors flush with US dollars. Foreigners needed to find investments they could purchase with their dollars that offered good returns. This is partially their fault since their currencies were pegged to the dollar in some form, forcing us to pay for their goods to what amounts to now as nothing more than Monopoly Money.

   This all started years ago when the ratings agencies were paid by the companies they rate, which is both tragic and hilarious. I think this boom and bust will be viewed in hindsight as about as absurd as the Dutch Tulip Mania of the 17the century.

   Insurance companies essentially paid ratings agencies like Fitch, Moody’s and S&P to rate them. With a pristine rating, they then offered to insure bonds and mortgage backed securities in the form of Collateralized Debt Obligations or structured debt (the nefarious CDO.) One has to ask, were these companies, armed with their new ratings, really in the business of insuring bonds? Or where they in the business of giving bonds and debt a complete fashion make over before they hit the market with their new AAA rating?

   Either way, once these newly minted AAA rated bonds hit the markets, they were sold like hot cakes to foreign investors hungry for security of principal and a good return. What they did not bank on was that eventually their returns were being paid for by you and me, every month as we write our checks to pay the mortgage on our home.

   As mortgage companies and banks were flush with cash they had to find people to loan this stuff too. The available funds to loan to the public for real estate soared. Thus cheap money from abroad provided the fuel in the form of cheap loans to help spark a buying spree in real estate. As demand outstripped supply, housing prices rose. The common sales pitch heard round the world from financial experts was that, “buying a house is better than renting because at least this way you are not throwing your money away.”

   This cacophony of experts forgot to mention that one must compare the costs of borrowing to pay for an inflated asset in a boom market. Then when the available supply of borrowers dried up, the only one’s left were sub-prime borrowers. Eventually those dried up, and the supply of available funds outstripped available borrowers. This happened about the time defaults and debt write downs occurred.

   It seems to me that paying someone to rate you is a lot like paying your high school teacher to send you home with a AAA rating on your report card. Then your parents trust you so much to take care of yourself without their assistance, they leave you with the house and take a thirty year vacation to Mars.

   Skip ahead and enter stage II. As home prices decline and defaults rise, US assets deflate in price. When this happens, net worth on balance sheets deflate, and by extension so does our ability to borrow and spend. Now we have a liquidity crisis. Banks might as well put up signs in their windows saying, “Please go elsewhere. All dollars have gone to China and we have no available funds to loan you.”

   The solution to our economic woes is obviously now a “helicopter drop” of money. The Fed responds by making more money available. The conundrum is that the more money the Fed makes available, the more the dollar devalues. Thus the larger supply of dollars the less they are worth. Here is the clincher. The available supply of oil stays exactly the same. At one barrel of oil, 80 dollars are available to purchase that barrel. We now have 100 dollars to purchase that exact same barrel just a few months later. A nice side affect is that commodities prices rise as well. (Compare the recent shock in the price of oil and it’s correlation to the sharp decline in the value of the dollar.)

   Enter stage III. In an attempt to be first out the door, everyone panics, sells their assets and stashes their cash. Banks are now flush with cash but are a little gun shy to loan because they just got burned. Basically the people that had their heads chopped off for losing the bank money were just replaced, and new management does not want the same fate. Not to mention financial institutions have difficulty evaluating how much collateral is needed for loans backed by assets sharply declining in value with no end in sight.

   In a vain attempt to predict a market bottom, financial houses big and small, proudly display their technicians on stage like soothsayers and astrologers predicting when the market decline will end. No one knows and a tarot deck is about as good as anyone’s best guess.

   Also Buffet is making a fortune gobbling up value companies before everyone comes to their senses…..Check that out!

   As policy makers scratch their heads in wonder, it seems the Fed has come to the rescue with a more creative scheme which makes more sense this time. Ben Bernanke essentially said, “Let’s hock these old falsely rated AAA rated report cards my way. I know they should have received an F+ on their report card, but we will use those as collateral for AAA rated US securities sold to you at a discount.” It’s kind of like robbing Peter to pay Paul, but Paul is not allowed to graduate high school now until he proves that he can get A’s in class. He’s required to stay inside at detention until headmaster Ben says it’s okay to go outside again or graduate. In the mean time, the neighborhood kid just took Paul’s seat in the classroom and gets to advance a few grades. The neighborhood kid is your US backed treasury. The affect is an exchange of bad for good for a small rate of interest. They are doing this to the tune of $200 Billion!

   The reality is that the only way this will sort itself out is when people get tired of selling.
   At some point the value of assets in the United States just can’t get any lower. It’s the only way to be sure that prices are within a margin of safety to what they should be “rated.”

   The bottom line is that the credit rating agencies will have a hard time salvaging their reputations. Who in their right mind is going to trust them now? They are making new mathematical models however and employing new technicians. We’ll see.

   Now we are passing through stage IV, which is the post merchandizing stage. This includes rubbing salt in the wound and conspiracy theories which will sell like crazy to the general public in search of answers.

   What else can the Fed do? Again this is both tragic and hilarious at the same time.

   Now the brilliance of the merchandizing phase of this boom is that the same cacophony of experts that told us to buy real estate in the first place are claiming to be on the look out for the worst economic downturn since the Great Depression. This will help them sell new editions and updates to their books necessary to guide their flocks through the next phase of the economic down turn.

   Please feel free to browse the business/ investment section of your local bookstore and read books by “experts” that discuss investment riches, real estate riches, beating the market, the upcoming dollar crisis, how to make money in the upcoming dollar crisis, how to make money in the next stock market boom/ crash, how to make money flipping homes, how to make money with rental property, or how to create your own business and strike it rich in a down economy. In fact a few of these books sell in series, and they sell well. They are also written at the fifth grade level and are quite motivational.

   A final justification for their doom saying is that by accurately pointing out that we have not had a depression in such a so long time, we are bound to have one now. I have not won the lottery in a long time, so I think I’m bound to win one right now too. Maybe I should line up to pay taxes at my local gas station by buying up the lottery ticket supply. I may have better luck at the slot machine that has not paid out in a while.

   The best part is that even the presidential candidates are answering the clarion call to stave off the economic crisis and have become quite adept at using fear mongering to their advantage. One candidate accused the government of turning a blind eye to, “predatory lending practices,” and proclaimed that this never would have happened during, “my administration.” The other big one is that “NAFTA has lost Americans jobs.” All of this of course spells doom and gloom for the American economy. Since when is tossing hundreds of thousands of dollars at people that can’t pay you back predatory? It’s stupid, not predatory. Also, unemployment has gone down not up. No one needs a Yale education to add and subtract. It’s actually that simple.

   Bottom line is that the market could use a dose of Milton Friedman’s “A Monetary History of the United States” This proved that once we got off the gold standard, our economy is highly unlikely to have a repeat of the Great Depression. Further, we erased over one trillion dollars worth of debt in 2000. We bounced back quite nicely then and we will now. Today’s losses now are not nearly as severe.

   All the Fed did recently was just hock the bad notes for good. This should provide some sort of bottom and margin of safety for the market to work with. What other choice did Headmaster Ben or the Board of Governors have?

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2. 

   booproo

   March 19, 2008

   I cant write long comments, but one thing i can tell for sure is..the U.S economy is in crisis and the only thing that FED has to do to solve this problem of worst crisis is start cutting the interest rates for the best and bright future of U.S. It should consider all the areas but then it should atleast make a point cut so that the U.S dollar will not be in slumping side.

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