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Christopher Mahoney
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I spent eight years at Bank of America in New York (1978-86) covering Wall Street, then moved to Moody's Investors Service where I worked for 22 years, covering banks, sovereigns and corporates. I chaired the Credit Policy Committee for four years. I retired in 2007 as vice chairman. PLEASE... More
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Capitalism and Freeedom
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  • Bank Bailouts Are Healthy And Necessary

    As readers know, I am a Tea Party libertarian, at least up to a point. I get off the bus when it comes to monetary and financial policy. I like having central bank, a lender of last resort, and a financial safety net. Why? Because I don't want the American people to experience another Depression.

    There is strong sentiment on the Right (and the Left) to break up the big banks, and to prohibit future bank bailouts. Indeed, there is a push for a Constitutional Amendment to outlaw future financial bailouts (I haven't seen the wording). The view is that, had Paulson and Bernanke allowed Wall Street go bankrupt in October of 2008, excesses would have been squeezed out, and market discipline would have been restored. That, of course, is Mellonism.

    Please note that the Great Recession was not caused by the existence of the financial safety net: it was cause by Paulson's inexplicable withdrawal of the net under Lehman. The past five years would have been quite different if the safety net did not have a Lehman-sized hole in it.

    Breaking up the big banks is a stupid idea that goes in the wrong direction. Most countries have a few very large banks that are TBTF. The US is unique in that, because of prairie populism, it has thousands of small regional banks that are not TBTF, and a handful of big banks that need to be TBTF. The best run banking systems (Canada, Australia) consist of a few, well-regulated national banks that are subject to strict regulation and which are not permitted to default upon their senior debt or uninsured deposits. That is called "financial stability", which is a predicate for prosperity. (Note also that the "securities firm" is also a dangerous American invention.)

    The US experimented with a fragmented banking system with no safety net for 150 years until 1934. Financial stability was not a hallmark of those 15 decades. There were decennial banking panics and decennial depressions, culminating in the Big One. Go back and read an account of the mid-1890s; it wasn't pretty unless you were rich.

    Financial capitalism is prone to cycles and panics, as Hyman Minsky has shown. There is a constant repeating of the credit cycle: prosperity, overconfidence, overleverage, panic, collapse, depression, recovery. This cycle may be prophylactic in some Darwinian sense, but it creates a lot of unnecessary suffering, as well as undesirable political consequences. It cannot be legislated out of existence, and it cannot be prevented by repetition.

    Market discipline doesn't work because the credit markets have a memory of at most two years. Markets do not learn. How many traders at Goldman have read Friedman's monetary history of the US? How about none. How many traders at Goldman remember LTCM? A handful at most. The Masters of the Universe tend to be about 30 years old and are lucky to remember who Bill Clinton was.

    The credit market in general and the banking system in particular need to be protected from themselves. That requires three pillars:

    1. High capital requirements for the systemically-significant.

    2. Intrusive prudential regulation with an emphasis on risk management and risk tolerance. (London Whales should be punished.)

    3. A reliable safety net, such that panics do not occur. That means no more Lehmans, not no more bailouts. It means financial stability.

    Let's not relearn the lessons of the 1930s.

    Sep 30 3:15 PM | Link | Comment!
  • QE Verdict After Five Years: A Failure Of Nerve
    It is now five years since the Lehman crash and the commencement of the Fed's bond-buying policy known as QE. Since Lehman, the Fed has bought $2.8T trillion of bonds from banks, quadrupling its balance sheet from $800B to $3.6T. Today's topic is: How successful has QE been in delivering strong money growth, sustained economic growth, full employment, and 2.0-2.5% inflation? Answer: unsuccesful. Today, the Fed has zero credibility when it comes to market confidence in its ability and commitment to fulfill its twin mandates. Here is the current data (percent change from year ago):


    M1: 7.0%

    M2: 6.6%

    M3: 4.5%

    M4: 3.6%

    Core inflation: 1.2%

    Nominal GDP: 3.1%

    Real GDP: 1.6%

    Unemployment rate: 7.3%

    We are looking at an economy that has been stuck in second gear for four years, and employment indices that have yet to return to precrash levels. Five years after Lehman, millions of people are unnecessarily out of work and out of the workforce.

    This is because the Fed has not pursued a consistent policy of monetary expansion since 2008. The trillions that the Fed has supposedly "pumped into the economy" are nowhere to be found; they are sitting on deposit at the Fed as sterile and useless excess reserves. They are not "in the economy" and they have had no impact on money growth, inflation expectations or economic growth.

    In the 1981-82 recession, Volcker grew M2 by double-digits for a year, and got things moving. Greenspan did the same thing during the 2001-02 recession, and again got things moving. Bernanke did the same thing in in 2009 and again 2011, but stopped in mid-2012, allowing money growth to fall to its current anemic levels.

    Five years on, we have persistently high unemployment and very weak growth. Nominal growth at 3.1% is far too low to bring down unemployment, and risks another recession. A deflationary recession at this point in the cycle would be disastrous, and would require heroic policies to reverse.

    Bernanke's half-hearted policies have failed to raise inflation expectations. The fact that expectations remain "anchored" at a low level is a sign of failure, not success. The real funds rate needs to be substantially lower than the current minus 1%. The best way to raise inflation expectations is to explicitly target and deliver 3-4% inflation.

    The Fed's talk of tapering QE was a major policy mistake. Not because QE has worked, but because tapering signals a surrender in terms of the Fed's commitment to fulfilling its mandate. It signals that the FOMC is OK with high unemployment and low inflation, and that that the Fed's mandates are aspirational "goals", which it doesn't really need to achieve.

    The failure of QE necessitates a bolder policy, not a more timid one. Wars are not won by retreat. The Fed needs to decisively change its focus from inputs (buying $X amount of bonds each month) to economic results: money growth, inflation and nominal growth. This will require a program of shock-and awe in order to make a decisive break in inflation expectations and market behavior:

    1. Target 10% money growth, 3-4% inflation, and 6-7% nominal growth.

    2. Stop paying interest on excess reserves in order to encourage banks to put them to use in the economy.

    3. Double the size of QE and make it open-ended until unemployment returns to a normal level, say 5%.

    3. Add to the QE buy-list a trade-weighted basket of foreign government bonds, and physical gold.

    4. Commit to raise the price of gold if M2 proves sticky.

    5. Permanently redefine "price stability" as 3-4% inflation.

    The Fed needs to restore its credibility by meeting its mandates, instead of half-heartedly trying to meet its mandates. There are no points for effort in this exercise. This is a very serious business, given the current level of unemployment and the dismal job prospects for young people.

    Sep 24 8:52 PM | Link | Comment!
  • The Next Black Swan Is: France

    Everyone is now looking under his bed for the next bubble or black swan. Some pundits are pointing to the revival of the market for risky corporate bonds. They worry what will happen when there are defaults. Well I can tell you what will happen when there are defaults: credit spreads will widen and speculators (the people who buy speculative-grade bonds) will suffer MTM losses. Big deal; this happens all the time. No one dies from it. And yes, speculative-grade bonds are speculative.

    What people die from is huge positions in low-risk instruments that overnight become toxic. That's what happened in the subprime fiasco. Here are the criteria for such an event:

    Before the event:

    1. The security is seen as low risk. It is rated investment grade and is thus eligible for fiduciaries to buy.

    2. The security attracts a low capital coefficient under the bank capital regime.

    3. The accounting treatment is to carry the security at par.

    4. Systemic exposure to the security is massive.

    The event:

    1. The security is downgraded to speculative grade, forcing fiduciaries to sell.

    2. The bank capital regime now requires a higher capital coefficient.

    3. The accounting treatment changes from cost to market (MTM).

    4. Large MTM losses result, rendering the most exposed players insolvent.

    What asset class meets these criteria: Club Med government bonds. In declining order of risk:

    1. Spain (Baa3/Negative outlook)

    2. Italy (Baa2/Negative outlook)

    3. France (Aa1/Negative outlook)

    I include France because it has the furthest to fall, like super-senior CDOs. Today French government bonds are a risk-free security. High ratings, zero capital coefficient, carried at par. Imagine if those factors should change: a lower rating, a higher capital coefficient, marked to market. Spain may be the next Lehman, but France could be the next WW1. If French bonds begin to decline in value, there is almost nothing anyone can do about it (besides fiddle with the accounting). It would rip a huge hole in the European banking system which would be impossible to fill without high inflation.

    So while we know that Spain is on a bad trajectory, we should worry that France may be too. Spain may be Lehman; but France is civilization as we know it. The next black swans are visible.

    Tags: france, spain, italy
    Sep 17 12:10 PM | Link | Comment!
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