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Thursday Fed Chief Bernanke articulated both how and why investor confidence has been so severely shaken in the US financial markets—not just in the sub-prime mortgage market but also in the insured, high quality mortgage market as well as in money market funds. His speech was well-prepared and served as a sobering explanation of what has occurred and why this problem will take some time to resolve. The Fed Chairman acknowledged poor underwriting, fraud, exotica in lending, and importantly, told of the complex, structured, derivative, credit products which banks participated in and guaranteed to enhance credit ratings before being sold to investors around the world.

Accordingly the Fed Chief said legislators, "regulators, accounting boards, central banks and others who have responsibility for oversight of the financial system are hard at work distilling lessons to be learned from this experience." He concluded by disclosing details of recent Fed Policy actions to deal with the credit crisis by adding liquidity through the Discount window and by using Term Auction Facilities to permit a wider range of collateral for loans from banks. He discussed how the Fed viewed their role as both supporting growth and protecting the US economy. He then gave assurances that the Fed would vigilantly watch the unemployment and inflation data and implied that additional rate cutting may be necessary and forth coming as "monetary policy was the best tool available to accomplish sustainable employment levels and price stability."

The stock market responded favorably to what most have reported was a commitment to cut interest rates another 50 basis points (half percent) by the end of January. However a closer reading of the Chairman’s remarks combined with an understanding of the trade-offs of rate cuts alters this foregone conclusion. In the Fed's words:

However, any tendency of inflation expectations to become unmoored or for the Fed’s inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and reduce the central bank’s policy flexibility to counter shortfalls in growth in the future.

Translation: the Fed may have to forgo interest rate cuts or even raise rates if inflation, or the perception of the Fed’s policy with regard to inflation, deems it necessary. The Fed was acknowledging that while rate cuts stimulate employment, they also stimulate lower dollar levels and inflationary pressures-both unacceptable consequences. The FOMC is therefore focused on stabilizing the banking system by creating liquidity and focused on macroeconomics, but the Fed is also acknowledging that it can not eliminate the financial constraints to the broader economy arising from the devaluation of inflated home prices. That, rightly in the Fed’s opinion, is something that will take time in the marketplace to work itself out.

Excerpts of Bernanke's speech follow below:

Although poor underwriting and, in some cases, fraud, and abusive practices contributed to the high rates of delinquency that we are now seeing in the subprime ARM market, the more fundamental reason for the sharp deterioration in credit quality was the flawed premise on which much subprime ARM lending was based: that house prices would continue to rise rapidly. When house prices were increasing at double-digit rates, subprime ARM borrowers were able to build equity in their homes during the period in which they paid a (relatively) low introductory (or “teaser”) rate on their mortgages. Once sufficient equity had been accumulated, borrowers were often able to refinance, avoiding the increased payments associated with the reset in the rate on the original mortgages.

However, part of the explanation for the far-reaching financial impact of the subprime shock is that it has contributed to a considerable increase in investor uncertainty about the appropriate valuations of a broader range of financial assets, not just subprime mortgages. For example, subprime mortgages were often combined with other types of loans in so-called structured credit products. These investment products, sometimes packaged with various credit and liquidity guarantees obtained from banks or through derivative contracts, were divided into portions, or tranches, of varying seniority and credit quality. Thus, through financial engineering, a diverse combination of underlying credits became the raw material for a new set of financial assets, many of them garnering high ratings from credit agencies, which could be matched to the needs of ultimate investors.

The complexity of structured credit products, as well as the difficulty of determining the values of some of the underlying assets, led many investors to rely heavily on the evaluations of these products by credit-rating agencies. However, as subprime mortgage losses rose to levels that threatened even highly rated tranches, investors began to question the reliability of the credit ratings and became increasingly unwilling to hold these products. Similar concerns arose in the market for asset-backed commercial paper [ABCP]. In this market, various institutions established special-purpose vehicles to issue commercial paper to help fund a variety of assets, including some private-label mortgage-backed securities, mortgages warehoused for securitization, and other long-maturity assets. Investors had typically viewed the commercial paper backed by these assets as quite safe and liquid. But the concerns about mortgage-backed securities and structured credit products more generally (even those unrelated to mortgages) led to great reluctance on the part of investors to roll over ABCP, particularly at maturities of more than a few days, leaving the sponsors of the various investment vehicles scrambling for liquidity. Those who could not find new funding were forced to sell assets into a highly illiquid and unreceptive market.

Although structured credit products and special-purpose investment vehicles may be viewed as providing direct channels between the ultimate borrowers and the broader capital markets, thereby circumventing the need for traditional bank financing, banks nevertheless played important roles in this mode of finance. Large money-center banks and other major financial institutions (which I will call “banks,” for short) underwrote many of the loans and created many of the structured credit products that were sold into the market. Banks also supported the various investment vehicles in many ways, for example, by serving as advisers and by providing standby liquidity facilities and various credit enhancements. As the problems with these facilities multiplied, banks came under increasing pressure to rescue the investment vehicles they sponsored — either by providing liquidity or other support or, as has become increasingly the norm, by taking the assets of the off-balance-sheet vehicles onto their own balance sheets. Banks’ balance sheets were swelled further by non-conforming mortgages, leveraged loans, and other credits that the banks had extended but for which well-functioning secondary markets no longer existed. Even as their balance sheets expanded, banks began to report large losses, reflecting the sharp declines in the values of mortgages and other assets. Thus, banks too became subject to valuation uncertainty, as could be seen in their share prices and other market indicators such as quotes on credit default swaps.

The combination of larger balance sheets and unexpected losses also resulted in a decline in the capital ratios of a number of institutions. Several have chosen to raise new capital in response, and the banking system retains substantial levels of capital. However, on balance, these developments have prompted banks to become protective of their liquidity and balance sheet capacity and thus to become less willing to provide funding to other market participants, including other banks. As a result, both overnight and term interbank funding markets have periodically come under considerable pressure, with spreads on interbank lending rates over various benchmark rates rising notably. We also see considerable evidence that banks have become more restrictive in their lending to firms and households. More-expensive and less-available credit seems likely to impose a measure of financial restraint on economic growth.

Broadly, the Federal Reserve’s response has followed two tracks: efforts to support market liquidity and functioning and the pursuit of our macroeconomic objectives through monetary policy.

To help address the significant strains in short-term money markets, the Federal Reserve has taken a range of steps. Notably, on August 17, the Federal Reserve Board cut the discount rate — the rate at which it lends directly to banks — by 50 basis points, or 1/2 percentage point, and it has since maintained the spread between the federal funds rate and the discount rate at 50 basis points, rather than the customary 100 basis points. The Fed also adjusted its usual practices to facilitate the provision of discount window financing for as long as 30 days, renewable at the request of the borrower. Loans through the discount window differ from conventional open market operations in that the loans can be made directly to individual banks. In contrast, open market operations are arranged with a limited set of dealers of government securities. In addition, whereas open market operations involve lending against government and agency securities, loans through the discount window can be made against a much wider range of collateral.

The changes to the discount window were designed to assure banks of the availability of a backstop source of liquidity. Although banks borrowed only moderate amounts at the discount window, they substantially increased the amount of collateral they placed with Reserve Banks.

To address the limitations of the discount window, the Federal Reserve recently introduced a term auction facility, or TAF, through which pre-specified amounts of discount window credit can be auctioned to eligible borrowers…

In December, the Fed successfully auctioned $40 billion through this facility and, as part of a coordinated operation, the European Central Bank and the Swiss National Bank lent an additional $24 billion. These two central banks obtained the dollars from the Federal Reserve through currency swaps (essentially, two-way lines of credit in which each central bank agrees to lend the other up to a fixed amount in its own currency). As part of the same coordinated action, the central banks of the United Kingdom and Canada conducted similar operations in their own currencies. On January 4, the Federal Reserve announced that we will auction an additional $60 billion in twenty-eight-day credit through the TAF, to be spread across two auctions that will be held later this month. With these actions and the passage of the year end, term premiums in the interbank market and some other measures of strains in funding markets have eased significantly, though they remain well above levels prevailing before August last year.

Although the TAF and other liquidity-related actions appear to have had some positive effects, such measures alone cannot fully address fundamental concerns about credit quality and valuation, nor do these actions relax the balance sheet constraints on financial institutions. Hence, they cannot eliminate the financial restraints affecting the broader economy. Monetary policy (that is, the management of the short-term interest rate) is the Fed’s best tool for pursuing our macroeconomic objectives, namely to promote maximum sustainable employment and price stability.

Financial conditions continue to pose a downside risk to the outlook for growth. Market participants still express considerable uncertainty about the appropriate valuation of complex financial assets and about the extent of additional losses that may be disclosed in the future. On the whole, despite improvements in some areas, the financial situation remains fragile, and many funding markets remain impaired. Adverse economic or financial news has the potential to increase financial strains and to lead to further constraints on the supply of credit to households and businesses. I expect that financial-market participants — and, of course, the committee — will be paying particular attention to developments in the housing market, in part because of the potential for spill-overs from housing to other sectors of the economy.

Even as the outlook for real activity has weakened, there have been some important developments on the inflation front. Most notably, the same increase in oil prices that may be a negative influence on growth is also lifting overall consumer prices and probably putting some upward pressure on core inflation measures as well. Last year, food prices also increased exceptionally rapidly by recent standards, further boosting overall consumer price inflation. Thus far, inflation expectations appear to have remained reasonably well anchored, and pressures on resource utilization have diminished a bit. However, any tendency of inflation expectations to become unmoored or for the Fed’s inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and reduce the central bank’s policy flexibility to counter shortfalls in growth in the future. Accordingly, in the months ahead we will be closely monitoring the inflation situation, particularly as regards inflation expectations.

Monetary policy has responded proactively to evolving conditions… The Committee will, of course, be carefully evaluating incoming information bearing on the economic outlook. Based on that evaluation, and consistent with our dual mandate, we stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks.

So we now have a more transparent view of the circumstances that led to the credit crisis now routing the American economy. What remains unknown is what final effect the mass of leveraged Derivative contracts will have on the US economy, and indeed the US financial system. Will sovereign governments like China, make demands that the US Treasury honor loans guaranteed by its banks? Will the US government pledge additional foreign aid to nations like Israel and payback on their mortgage-backed write-offs (Bank Hapoalim)? Will the US open up its market to foreign purchases of US banks? What conclusions will sovereign governments finally make and will they eventually seek redress in a court of international law?

We hope that Chairman Bernanke is hard at work calculating the probable, net Derivative risk exposures to US banks and will be proactive in facilitating necessary banking mergers (Countrywide, Washington Mutual?). Likewise this author prays that someone in the Justice Department’s financial crimes department is being proactive both in prosecuting banking fraud and in limiting damage while building a legal defense for Treasury, FDIC, and the GAO who may find themselves party to international lawsuits for failure to regulate and breach of fiduciary duty pursuant to securities fraud.

And while clearly this Fed Chief inherited a Greenspan Nightmare not of his making, one thing is clear and that is that this story is still being written. America must continue to seek the truth and make full disclosure to restore confidence in its financial markets. Unfortunately what has transpired has far-reaching consequences and international ramifications of immense proportion. We must remove uncertainty and engage the natural, human reluctance not to disclose our worst findings. Chairman Bernanke is the right man, at the right time. God Bless him for I would not want his job.

Disclosure: Author is long DIA, SPY and FXI.