Saturday, October 18, 2008

Bernanke Defends the Liquidity Maginot Line with the Same Results

Anna Schwartz tells The Wall Street Journal that Bernanke is using the wrong tools to solve this problem. The hapless Fed Chairman defends his Maginot Line of Liquidity while the CDO Panzers outflank him through the forest of overleveraged balance sheets. Who is Ms. Schwartz? She is 92 years old and lived through the Great Depression. She co-authored with Milton Friedman "A Monetary History of the United States" in 1963, the leading treatise on how monetary policy "turned the stock market crash into the Great Depression". Since 1941, she has worked at National Bureau of Economic Research in New York. Her thoughts on the current crisis should be taken very seriously. Regular Readers of this blog will find her remarks sound very familiar.

"Ms. Schwartz thinks that our central bankers and our Treasury Department are getting it wrong again.
To understand why, one first has to understand the nature of the current "credit market disturbance," as Ms. Schwartz delicately calls it. We now hear almost every day that banks will not lend to each other, or will do so only at punitive interest rates. Credit spreads -- the difference between what it costs the government to borrow and what private-sector borrowers must pay -- are at historic highs.
This is not due to a lack of money available to lend, Ms. Schwartz says, but to a lack of faith in the ability of borrowers to repay their debts. "The Fed," she argues, "has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that [uncertainty] that the balance sheets of financial firms are credible."
So even though the Fed has flooded the credit markets with cash, spreads haven't budged because banks don't know who is still solvent and who is not. This uncertainty, says Ms. Schwartz, is "the basic problem in the credit market. Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them. So to assume that the whole problem is inadequate liquidity bypasses the real issue
.".....

Today, the banks have a problem on the asset side of their ledgers -- "all these exotic securities that the market does not know how to value."
"Why are they 'toxic'?" Ms. Schwartz asks. "They're toxic because you cannot sell them, you don't know what they're worth, your balance sheet is not credible and the whole market freezes up. We don't know whom to lend to because we don't know who is sound. So if you could get rid of them, that would be an improvement." The only way to "get rid of them" is to sell them, which is why Ms. Schwartz thought that Treasury Secretary Hank Paulson's original proposal to buy these assets from the banks was "a step in the right direction."
The problem with that idea was, and is, how to price "toxic" assets that nobody wants. And lurking beneath that problem is another, stickier problem: If they are priced at current market levels, selling them would be a recipe for instant insolvency at many institutions......

Today's crisis isn't a replay of the problem in the 1930s, but our central bankers have responded by using the tools they should have used then. They are fighting the last war. The result, she argues, has been failure. "I don't see that they've achieved what they should have been trying to achieve. So my verdict on this present Fed leadership is that they have not really done their job." http://online.wsj.com/article/SB122428279231046053.html

This is what Karl Denninger has been preaching on The Market Ticker and what he said on Kim Wade's show Monday. Most of the financial reporters don't have a clue or are using the wrong paradigm to analyze this problem. Its not liquidity, its not interest rates, its not the bailout and recapitalization. Its the transparency that is key. The freezing up of international shipping is merely a symptom although its a very serious one. The Fed and Treasury ostriches refuse to acknowledge they might have made a mistake in ignoring this issue. As Ms. Schwartz and others have stated, the problem is these CDO's were private deals and too often were kept off the balance sheets yet can very easily sink a company. Until these are acknowledged and valued properly (and how do you void mark to market if they were grossly overvalued in the first place?), banks will not lend to each other and the credit markets will stay frozen.

2 comments:

Anonymous said...

Bernanke may be struggling on the delivery of the Fed's part of the solution but I don't see the purpose in vilifying him. There are a cast of bad guys whose roles were far more central to this mess than the current Fed Chairman.

Schwartz seems to validate Paulson and Bernanke's original thrust of the government buying the toxic paper. The problem is now the execution and the length of time it will take to do it right -- meaning doing the job properly in order to provide the maximum amount of protection to taxpayers.

Pelosi and Reid should have the Congress in session right now working to pass emergency legislation that immediately forces all financial institutionds to completely divulge all salient details regarding any toxic paper they hold.

But, of course, if they did that it would crash the stocks of certain institutions the day after they were forced to report.

Kingfish said...

Greenspan bear partial responsibility for having rates too low for too long. He was more worried about fighting a recession when he should've only been worried about fighting inflation. As a result, the recession will probably be worse than the one he was fighting because of his error in judgement.

Bernanke was on the Greenspan team at the time and went along with it. Bernanke's whole program has been to throw money at the program and cut interest rates. Show me where he has demanded a cleaning up of the balance sheets? The buying up of toxic paper might have worked but only because it would've cleaned up the balance sheets if it did.

The bailout bill however, probably is a failure because there is still no way of knowing what is out there in these credit default swaps, who holds them, and what their effect will be. Unfortunately, Bernanke has been following what worked in 87 and shold've been done in 29: injecting liquidity, just as Japan also tried to do in the 1990's. He has yet to address the achilles heel which is transparency.

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