Posts filed under “Think Tank”
Governor Daniel K. Tarullo
At the Exchequer Club, Washington, D.C.
October 21, 2009
The far-reaching financial crisis that has afflicted our country in the past two years has drawn attention to a raft of problems–from the concentration of commercial real estate exposures in some regional and community banks, to the risks associated with some forms of derivatives, to the need for more vigorous financial services consumer protection. Proposals for administrative and congressional responses are thus appropriately diverse. I would suggest, however, that the reform process cannot be judged a success unless it substantially reduces systemic risk generally and, in particular, the too-big-to-fail problem. This afternoon I will address my remarks specifically to the task of forging an effective response to this problem.1
The Current Form of the Too-Big-to-Fail Problem
The concern is hardly a new one. In one manifestation, too big to fail was an extension of the classic problem of bank runs and panics. If a large bank failed–whether because it was illiquid after a deposit run or insolvent after severe losses–the entire banking system might be endangered. In cases in which other banks held significant deposits in the distressed institution, the failure of a large bank might lead directly to the illiquidity or insolvency of other banks. The result could be a domino effect in the interbank lending market, with one bank’s failure toppling the next. Even where direct losses to other banks were thought manageable, the failure of a large bank might strike panic into depositors, especially uninsured depositors, of other large institutions. The result might be a far-reaching run on the entire banking system that could, in a worst case such as occurred in early 1933, freeze the financial system completely.
Faced with either variant of such a devastating impact on the system, government authorities often believe they have little choice but to intervene. The government may provide funds or guarantees to the bank in order to keep it functioning. Alternatively, the government may allow the bank to fail, but shield some or all of its depositors from loss, even those not covered by existing insurance programs. In 1984, for example, the Federal Deposit Insurance Corporation protected the uninsured depositors of Continental Illinois Bank, then the nation’s seventh largest depository institution, after a foreign depositor run that followed heavy losses.
As stocks and commodity prices move higher again in response to another move lower in the US$, at some point there will be some differentiation in stocks between those companies with a large % of overseas exposure (and don’t see a margin squeeze from rising commodity prices) that will benefit from the weak $ and…Read More
Investment letter – October 18, 2009
LONG TERM STABILITY OR INSTABILITY?
The twenty-five year period between 1982 and 2007 may be the best period in economic terms in our nation’s history. There were only two shallow recessions, each lasting just 8 months. This extended period of economic growth and stability provided a wonderful investment climate that lifted the DJIA from under 1,000 in 1982 to over 14,000 in 2007. In order to gain a better perspective and appreciation of this period of prosperity, one should stand back and view a long term chart of the DJIA from 1946, just after the end of World War II. What quickly becomes apparent is the extended rally in the DJIA from near 150 in 1949 to 1,000 in 1966 that was also accompanied by strong economic growth, stability, and very little social unrest. Sandwiched between these two wonderful windows of growth and stability is the period of 1966 and 1982. These 16 years were marked by instability that not only engulfed the economy, but also resulted in enormous social stress. As assassinations gave way to race riots, war demonstrations, runaway inflation, and mile long gas lines, it felt as if the foundations underpinning our society were shifting.
From a historical perspective, visualize a pendulum that oscillates between stability and instability, with each period reaching an extreme after 15 to 20 years. The period of stability that ended in 1966 was heralded with the political phrase “The Great Society”. The ensuing 16 years were many things, but few would describe it reflective of a Great Society. On July 15, 1979, near the end of this 16 year period of turmoil, President Carter gave a speech in which he said, “It is a crisis of confidence. It is a crisis that strikes at the very heart and soul and spirit of our national will. We can see this crisis in the growing doubt about the meaning of our own lives and in the loss of a unity of purpose for our nation.” Quite a change from the optimism and confidence in the proclamation of a Great Society at the peak of the prior period of stability. The period of stability, which began in 1981-1982, probably reached its extreme as investors embraced the ‘New Paradigm’ in 1999, and bid technology stocks to absurd valuations. In response to the bursting of the tech bubble, the Federal Reserve aggressively lowered interest rates to keep the economy from deflating. Ironically, the extended period of economic stability between 1982 and 2000 encouraged market participants to take on highly leveraged risks, even as the pendulum was already swinging away from stability toward instability. This new 15 to 20 year period of instability began in 2001 or 2007, but it did not end in March 2009.
As I discussed in last month’s letter, there are numerous cyclical and secular headwinds that could easily take another 5 to 7 years to work through. (The September letter is available at welshmoneymangement.com, click on Publications and this month’s letter.) The fundamental challenges facing our financial system and all levels of government are structural in nature, and the result of excesses that have built up since 1982. There are no easy solutions. During the 1966-1982 period of instability, the DJIA made its price low in December 1974. (Chart below.) Even though the period of instability had another 7 years to run, the DJIA never fell below 730. My hope (and prayer) is that the March 2009 low marks the price low in the stock market, even as the economy struggles and social unrest increases in coming years. If the March 9 low is broken, it would suggest that all the efforts and money spent to prevent a deeper economic contraction had failed.
History suggests that these extended periods of instability (1929-1949, 1966-1982), do not reward investors who buy and hold, or the institutions that disdain cash. As a kid growing up in the Midwest, during July and August, I always wore a t-shirt and shorts and wore a crew cut. In January and February, my hair was longer and I never went outside in shorts and a t-shirt. (Well maybe once on a dare.) If my parents had known, they would have rhetorically asked me if I was stupid. So here’s a worthwhile question. Why do investment professionals advise their clients to simply buy and hold, whether we are in a period of stability or instability?
Over the last two years, the Federal Reserve has responded with unprecedented programs to initially prevent a complete collapse of the financial system and subsequently to restore some measure of functionality to the credit markets. The Treasury Department launched a large bailout of banks deemed too big to fail, and Congress passed a huge stimulus package. Despite these extraordinary efforts, overall credit is still contracting, residential and commercial real estate prices are still deflating, and consumer incomes are shrinking. On the plus side, the stock market rally has recovered half of the bear market losses, and corporate bond prices have also rebounded significantly. The economy has stabilized and is rebounding, but at a price. Government income transfers amounted to 17% of total personal income in the first half of 2009. Federal fiscal stimulus dollars helped plug the gaping hole in state budget deficits, which enabled them to avoid deeper cuts in services. But the safety net provided by the federal government will produce trillion dollar deficits for years to come. At some point, the Federal Reserve will shrink monetary stimulus and end their market support programs. The Federal government will need to raise taxes and lower spending to rein in the Federal budget deficit in coming years. The removal of these economic life support measures must be timed and balanced against the numerous secular and cyclical headwinds that will suppress economic growth and tax revenue in coming years. This sounds like a prescription for years of instability. Unless you believe the Federal Reserve and Congress are capable of perfect execution.
Category: Think Tank
The looming expiration of the home buying tax credit is having a clear impact on mortgage applications. The MBA said purchases fell by 7.6%, down for the 3rd week in 4 and is now at a 10 week low. Refi’s fell 16.8% to a 5 week low as the average 30 yr mortgage rate rose…Read More
Brooksley Born finally gets to tell her story on national TV. Note the pathetic apology by Arthur Levitt below for being part of the Greenspan-Rubin-Summers gang that tried to ruin Ms. Born’s career in Washington in the name of making the world safe for OTC derivatives. And notice that this was one of the early good works of the President’s Working Group on financial services, an unconstitutional entity that should be outlawed. Fortunately there has been enough continuing interest in the media to get the story out. Chris
FRONTLINE INVESTIGATES THE ROOTS OF THE FINANCIAL CRISIS
Tuesday, October 20, 2009, at 9 P.M. ET on PBS
“We didn’t truly know the dangers of the market, because it was a dark market,” says Brooksley Born, the head of an obscure federal regulatory agency — the Commodity Futures Trading Commission (CFTC) — who not only warned of the potential for economic meltdown in the late 1990s, but also tried to convince the country’s key economic powerbrokers to take actions that could have helped avert the crisis. “They were totally opposed to it,” Born says. “That puzzled me. What was it that was in this market that had to be hidden?”
In The Warning, airing Tuesday, Oct. 20, 2009, at 9 P.M. ET on PBS (check local listings), veteran FRONTLINE producer Michael Kirk (Inside the Meltdown, Breaking the Bank) unearths the hidden history of the nation’s worst financial crisis since the Great Depression. At the center of it all he finds Brooksley Born, who speaks for the first time on television about her failed campaign to regulate the secretive, multitrillion-dollar derivatives market whose crash helped trigger the financial collapse in the fall of 2008.
“I didn’t know Brooksley Born,” says former SEC Chairman Arthur Levitt, a member of President Clinton’s powerful Working Group on Financial Markets. “I was told that she was irascible, difficult, stubborn, unreasonable.” Levitt explains how the other principals of the Working Group — former Fed Chairman Alan Greenspan and former Treasury Secretary Robert Rubin — convinced him that Born’s attempt to regulate the risky derivatives market could lead to financial turmoil, a conclusion he now believes was “clearly a mistake.”
Here is an update from my earnings and revenue cheat sheet and the trends still remain similar to Q2 in that most companies are beating eps estimates while slightly more than half are beating revenue forecasts. The relative positive though is the amount of the beats are exceeding what was seen in Q2. I have…Read More
From a major NY trading desk: European markets opened a few points above flat, fell by nearly -1%, and have since rallied back to the unchanged mark: DAX -0.1%; CAC -0.2%; FTSE -0.1%. Earnings season is now in full swing in the U.K. and on the continent. Dutch supermarket chain Ahold is modestly lower after…Read More
In contrast to the Reserve Bank of Australia, the Bank of Canada decided to keep rates at the historical low level of .25% and the strength of the Canadian $ seems to be the main motivation. The RBA spent more time focused on the possible imprudence of keeping rates at emergency levels when it was…Read More
Sept PPI fell a sharp .6% vs expectations of flat and the core also unexpectedly fell .1% vs a forecasted rise of .1%. The headline drop was led by a 2.4% fall in energy prices, especially in gasoline which was down by 5.4%. This will reverse though in Oct as gasoline prices are back up…Read More