Saturday, November 17, 2007

Shadow Dancing

Investment Outlook: Shadow Dancing

By Bill Gross | 17 November 2007

When the music’s over, turn out the lights.
— Jim Morrison, The Doors 1967

Citigroup’s Chuck Prince was a dancer. Not by profession mind you, or even as an amateur Foxtrotter with the Stars on ABC. Prince danced with subprime mortgages and the financial conduits that contained them. "As long as the music is playing," he foreswore in early July, "you’ve got to get up and dance. We’re still dancing." Prince’s observation may not top that of Irving Fisher in 1929 who proclaimed a permanently higher plateau for the stock market, but it will suffice for a generation of modern day investors and their iconic leaders who should have known when to exit the floor. He— they— dance no more with their subprime partners. Still, someone had to be the last to know that the music was over and to be caught when Jim Morrison’s proverbial lights were dimming, if not flickering out. And, to be fair, there were millions of dancing investors still on that floor when the unraveling of Bear Stearns’ hedge funds gave the party its first hint that this was going to be the last dance.

A critic should also admit that the music had been playing for a long, long time— almost before Prince graduated from Cotillion. Subprimes were actually the last stanza in a song that described the financialization of the U.S. economy beginning way back in the 1970s. The delinking of the dollar from gold and the deregulation of banking and interest rates via the abolition of Regulation Q were necessary conditions in unleashing the potential for the hedge funds of the 21st millennium. What really provided the impetus however, were other expansive trends: global deregulation of capital [[and the no holds barred competition to keep the New York bankers and Wall Street foremost in the New World of Debt: normxxx]], computer technology, and the birth of potentially speculative instruments that could accommodate leverage and create credit outside the banking system [[and seperate risk from their assets: normxxx]]. Financial futures geared towards currencies, stocks, and bonds were followed by options, swaps, credit default securities and a host of anachronistic three-letter conduits that we now know as CDOs, SIVs, and— well, make up your own combination— it’s probably been marketed already.

Some would vehemently argue, although probably not the current Fed Chairman, that the pace of financialization was not matched by the steadying arm of regulation. The sorry state of mortgage origination with its "no docs" and "liar loans" is perhaps the most recent testament to that. In combination, the loose regulation and financial innovation of the past 35 years have spawned what PIMCO’s Paul McCulley has labeled a "shadow banking system" where credit is composed on a keyboard as opposed to a printing press. Economic historians marvel at the ability of the Weimar Republic in the late 1920s to have printed paper money so fast that workers would lower their afternoon wages in a basket to waiting wives in order to front run rampaging six-digit inflation. Surely they could not have imagined shadow investment bankers and their minions spawning financial derivatives in the hundreds of trillions, far beyond the reach of central bankers and Treasury officials alike. If old-fashioned banking’s pace could be described as a waltz, then their thoroughly modern shadow counterparts would resemble funk, hip-hop, grinding, and then some.

It is certainly true that the shadow system with its derivatives circling the globe have democratized credit. Subprimes are just another way to characterize mortgages assumed by less than blue-blooded homeowners. As benefits of cheaper credit became available to the many as opposed to the few, placating and calming waves of higher productivity and widespread diversification led to accelerating economic growth, incomes, and corporate profits. But trend reversal or momentum interruptus in the shadow as opposed to the regular banking system can offset many of the benefits. Since derivative creation and credit extension are dependent upon the animal spirits of capitalists as opposed to the interest rate metronome of central bankers, the ability to restart a stagnating or even recessionary economy is more problematic. Ask yourself how quickly individual investors will be willing to invest new money in hedge funds heralding the tarnished magic of subprime mortgages. Contemplate the future of asset-backed commercial paper. If these credit conduits contract, then a Federal Reserve seeking to resurrect a faltering economy with 25 basis point cuts in interest rates may confront the same unmanageable response from the private sector during an easing cycle, as it did during the past several years of steadily higher Fed funds.

Traditionalists would point out that the regular banking system has its hands full without throwing in the complications of the modern day shadow. That is undeniable. Mortgage write-offs, credit card losses, and increasing defaults on small business loans will squeeze bank balance sheets and income statements for the next several years. That pressure in turn will result in more conservative lending practices, which will induce not a contraction in credit growth, but a noticeable slowdown. Regulators, the press, and politicians will do their part as well, characteristically closing the barn door after the subprime mortgage horse has escaped from the barn. There’s nothing like the strong arm of new laws and/or newspaper headlines to straighten the spine of a lender faster than you can pronounce "Barney Frank," or "Gretchen Morgenson." Ask Countrywide’s Angelo Mozilo how many marginal loans his company will be making now that he’s being publicly pilloried for personal stock sales that allegedly got him out before public shareholders. And too, observe the Chancellor of the Exchequer Alistair Darling’s plea for the private market to "return to old-fashioned banking." Better late than never I suppose, but the return journey will exact a cost in the form of more restrictive credit, inducing a danger of further asset deflation in housing and other markets.

So both old-fashioned banks and their derivative, conduit-fed shadow counterparts will be growing their balance sheets a lot more slowly in future months and quarters. That rather immediately translates into a slower economy and the need for government assistance in the form of lower interest rates or liquidity pushes like Treasury Secretary Paulson’s "Super SIV." Whether Paulson’s "Committee to Save the World— Part II" will succeed like Bob Rubin’s original during the Long Term Capital crisis is debatable. The idea, first of all, is counterproductive because it continues to hide subprime asset prices in the "shadows." Secondly, Rubin confronted no regulatory headwinds back in 1998, nor did he have to deal with today’s behemoth shadow banking system in the process of losing its brave face. Rubin in fact, along with his all-star committee featuring Alan Greenspan and Larry Summers, had a near hurricane force tailwind with 24 months more of dotcom IPOs yet to come. No wonder that Chairman Greenspan needed to cut short rates by only 75 basis points before stabilizing the economy nearly a decade ago.


The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Minsky: Neutral, Forward, Reverse

Global Central Bank Focus: Comments Before the Money Marketeers Club
Minsky and Neutral, Forward, and in Reverse

By Paul McCulley | 17 November 2007

    It is a great pleasure to be invited to speak before this group for the third time. It’s wonderful being among friends, many going back over 25 years. It is also humbling to be forced to go back and read what I said the last two times, in April 20041 and February 20062. I rarely write speeches, preferring to speak extemporaneously, but for this august group, I put fingers to keyboard, because you deserve carefully thought out analysis, as well as a speaker who must own his words.

    In preparing for tonight, re-reading my words was both instructive and humbling—
    good normative logic about policy, I re-learned, does not necessarily lead to good forecasts! Indeed, the older I get the more I regretfully conclude that too much thinking is probably counterproductive to good forecasting, particularly in the short run. The same holds for good portfolio management, my day job since leaving the Street back in 1999.

Financial objects in motion tend to stay in motion a lot longer than fundamental analysis suggests they should. Unless, of course, the fundamental analyst is a student, not just a student of Graham and Dodd, but also of the late great Hyman Minsky, who famously taught us— borrowing from the great John Maynard Keynes— that stability is ultimately destabilizing. More about that in a few minutes.

But first, let me review what I said here in 2004 and 2006, chronicling what I got right and what I got wrong, which will provide us a good basis, I think, for considering where we are right now and where we’re going. Not to hold you in suspense, the conclusion is that we’re in the midst of a Minsky Moment and have embarked on a Reverse Minsky Journey, as I wrote in my monthly essay posted on the PIMCO web site last month.3 And such a journey implies a parallel journey downward for the “neutral” real Fed funds rate— a long, long journey down!

Neutral is as Neutral Does (or Doesn’t)

    Back in April 2004, right before the Fed began its long, 17-step, 25-basis-points a step journey from 1% Fed funds to 5 ¼% Fed funds by June 2006, my axe to grind was that the “neutral” real Fed funds rate was a lot lower than most pundits— and policymakers— were touting. I argued:

    “As I have been writing ever since last fall4, I believe that
    the near universal assumption, as per Taylor’s Rule, that the ‘neutral’ real Fed funds rate is 2% is wrong. Put differently, I believe the notion that the real short rate should be just a touch below potential real GDP growth (assumed to be 2½% when Taylor came up with his Rule) is wrong.
    I believe ‘neutral’ is about one-half of one-percent.

    Essentially, my thesis is that
    overnight money, carrying zero price risk, zero credit risk and zero liquidity risk should not yield a real, after-tax return. A 50-basis-point real rate in the context of a 2% inflation rate— my definition of ‘effective price stability’— would translate to a zero real rate on money: a 2½% nominal rate, with 50 basis points going to Uncle Sam for taxes (assuming an average marginal tax rate of about 20% in this country) and 200 basis points making the holder of money whole for inflation.

    In contrast to my axe to grind with Taylor (and everybody else, it seems!) about the
    ‘neutral’ real short rate, I have zero problem with using potential GDP growth as a rough cap for the ‘equilibrium’ real long-term rate for high-grade private sector obligations. Common sense, the most powerful tool in portfolio management, as Bill Gross has pounded into me, says that over the long run, the return on financing GDP cannot be above the internal rate of return of GDP.

    Thus, I think that the long-term private rate is now probably about 3½%, my rough guess as to potential GDP growth. Subtract a long-term swap rate, and that implies a real long-term Treasury rate in a range of 3% - 3½%.

    The contrast between my assessment of the real short-term rate and the real long-term rate implies a market segmentation view of the yield curve, of course.
    It also implies a very, very steep real yield curve.
    And I have no problem with that:real returns should be connected to the longevity of risk that an investor is underwriting.

    A market-segmentation view of the yield curve is, I acknowledge, in conflict with an expectations-driven view of the yield curve, which states that the yield curve is a forward curve on the Fed-controlled Fed funds rate, plus a risk premium for uncertainty about the forward Fed funds rate. Yes, my market-segmentation view implies a structural reward for levering up into the carry trade. And, indeed, that was definitionally the case during the era of Regulation Q, when banking was about borrowing short at 3%, lending long at 6%, and hitting the golf course at 3 pm. 3-6-3 banking it was called.

    Thus, if the Fed were to enforce my view of the real short rate, the Fed and other financial regulators would need to also enforce quantitative rules on growth in levered players’ balance sheets, so as to prevent unbridled growth in credit creation via the carry trade.
    And indeed, that’s precisely what is on the table for the maestros of the carry trade, the housing finance agencies. Thus, in a world of effective price stability, in which there is no justification for the Fed to richly reward the holders of money with a hefty return for taking no risk, I anticipate that regulatory tools, rather than the interest rate tool, will become the dominant governor against excess credit creation.”

In retrospect, the Fed did not give a hoot about my estimate of the "neutral" short rate, driving the nominal Fed funds rate to 5¼%, which translated to about 3% in real terms (before taxes), depending upon your preferred inflation measure. And the reason, besides conventional wisdom? The housing and mortgage markets proved remarkably inelastic to a rising real Fed funds rate with both inflating into bubbles!

The Shadow Grows: IS-LM Implications

I fully recognized this risk back in 2004, but downplayed it because I explicitly thought that the Fed and other financial regulators would "enforce quantitative rules on growth in levered players’ balance sheets, to prevent unbridled growth in credit creation via the carry trade." How could I have been more wrong?

Financial regulators, with the Fed’s full support, did, to be sure, restrain the growth of Fannie and Freddie’s balance sheets. [[just barely! : normxxx]] But the Fed went the exact opposite direction away from those institutions, cheerleading an explosion of growth in the levered balance sheets of what I’ve dubbed the shadow banking system— the whole alphabet soup of levered non-bank intermediates. They funded themselves not with insured deposits, but asset-backed commercial paper and reverse repo, with no access to the Fed’s discount window in the event of a drying up of such funding (also known as a run), only access to (less-than-complete) back-up lines of credit with conventional banks.

Former Fed Chairman Greenspan would, no doubt, argue that he was not a cheerleader for the explosive growth of the shadow banking system, merely a cheerleader for Adam Smith’s invisible hand of markets, which birthed and nurtured non-bank levered intermediaries. I could counter that he doth protest a bit too loudly, but it would be a useless exchange; Alan believes what he believes, just as I do, and I respect him for that.

Where there can be no room for argument, however, is that if the marginal creditor of credit— the shadow banking system— is systematically relaxing loan underwriting standards (with the blessing of the credit rating agencies, critical to the shadow’s ability to float asset-backed commercial paper on comparable terms to conventional banks), then it is tautologically the case that both the demand and supply of credit will become less elastic to changes in the Fed funds rate.

Or, for those of you, like me, who are still fond of the old IS-LM model of our college youth, wanton and rakish degradation in loan underwriting standards by loan originators, supported by shadow bank buyers of such originations in securitized form, both shifts the IS curve to the right and makes it steeper. Put more simply for those who hated playing with the IS-LM model, such a journey to the credit cesspool both increases the volume of credit creation while also making it less sensitive to changes in the Fed funds rate.

A Loan or Calls and Puts?

Indeed, I’ve taken to calling the 2004 - 2006 vintages of limited or no document, no down payment, negative amortization (pay-option) subprime ARM loans as not loans at all, but rather free, at-the-money call and put options on property prices. Not exactly free, to be sure, as the putative borrower was obligated to pay something in cash interest, even if not the full amount, with the unpaid amount being added to the principal.

But as a practical matter, the options were essentially free. If home prices went up [[as they certainly did in the early years: normxxx]], the putative "borrower" would stay current, as the "call" went into the money, refinancing before the ARM reset, essentially re-striking the option exercise price higher. Simply stated, the borrower wouldn’t default, as logical people do not walk away from in-the-money call options.

And they didn’t, until about a year ago. As a consequence, default rates on pools of such subprime loans came in amazingly low, soothing rating agencies’ nerves and re-enforcing the shadow banking system’s appetite for securitized pools of them.

But if house prices didn’t rise, the call option would fall out of the money, and the put option— the right to default on the full principal value of the loan— would go into the money. Indeed, house prices didn’t have to fall, but simply not rise for this outcome to unfold, given negative amortization. In which case, the putative borrower would no longer have any incentive to stay current: Why throw good money after bad for an at-the-money call option that you got for free, which has gone out of the money?

    And so it came to pass about a year ago, when early-payment defaults became a new phrase in our collective lexicon. The home price bubble popped, the at-the-money call options went out of the money, the at-the-money put options went into the money, and the holders of them remembered the wisdom of Paul Simon’s 1975 treatise on 50 ways to leave a bad situation:

    You just slip out the back, Jack
    Make a new plan, Stan
    You don’t need to be coy, Roy
    Just get yourself free
    Hop on the bus, Gus
    You don’t need to discuss much
    Just drop off the key, Lee
    And get yourself free

And with Jack, Stan, Roy, Gus and Lee setting themselves free, the shadow banking system was revealed to be caught between the longing for love and the struggle for the legal tender, living life as Jackson Browne’s Pretender, ships bearing their dreams sailing out of sight, with the junkman pounding their fenders. To wit, a run on the asset backed commercial paper market!

My 2004 forecast of a cyclical peak for Fed funds of 2½% was spectacularly wrong. I own that. I also own the very rational reason why: the Fed chose not to use its regulatory powers to police the mortgage loan originator sharks feeding the levered yield appetites of the shadow banking system. I thought they both should and would, and I was wrong.

Too Much Success is Unsuccessful

Which brings me to my February 2006 address before this group. Having had my head handed to me with my April 2004 forecast, my axe to grind 21 months ago was that the Fed’s implicit 1% - 2% target for the core PCE deflator was too low, even as I applauded new Chairman Bernanke’s push to move toward an explicit inflation objective, which he had earlier dubbed the Optimal Long-term Inflation Rate, or OLIR.

I actually grounded my thesis with a flashback to Chairman Greenspan’s valedictory address at Jackson Hole the prior August, and follow-up remarks he made a month later. Specifically, at Jackson Hole, Alan said:

    "The lower risk premiums— the apparent consequence of a long period of economic stability— coupled with greater productivity have propelled asset prices higher."

He went on to say:

    "Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums."

And then a few weeks later, on September 27, Mr. Greenspan upped his Jackson Hole ante on himself and declared:

    "In perhaps what must be the greatest irony of economic policymaking, success at stabilization carries its own risks. Monetary policy— in fact, all economic policy— to the extent that it is successful over a prolonged period, will reduce economic variability and, hence, perceived credit risk and interest rate term premiums.

    A decline in perceived risk is often self-reinforcing in that it encourages presumptions of prolonged stability and thus a willingness to reach over an ever-more-extended time period. But, because people are inherently risk averse,
    risk premiums cannot decline indefinitely.

    Whatever the reason for narrowing credit spreads, and they differ from episode to episode,
    history cautions that extended periods of low concern about credit risk have invariably been followed by reversal, with an attendant fall in the prices of risky assets. Such developments apparently reflect not only market dynamics but also the all-too-evident alternating and infectious bouts of human euphoria and distress and the instability they engender."

Irony, indeed, I proclaimed: "The Fed can be too successful in cyclically fine-tuning inflation, if such success breeds irrationally thin risk premiums, the aftermath of which history has not dealt kindly!"

Thus, I argued, the Fed faced a dilemma (not a conundrum): if it set the inflation target too low and achieved it, asset bubbles would be the inevitable consequence, the eventual bursting of which would create fat-tailed deflation risk. Thus, ironically, the best prospects for achieving secular price stability would involve, I theorized, more, not less cyclical volatility in inflation, in a wider and higher band than 1% - 2%. I suggested 1½% to 3%.

But that was just a suggestion. My key point, which I had made public in September 20055, was the irony of too much success for too long in maintaining very low and very stable goods and services prices; it was a prescription for asset price bubbles followed by a debt-deflation fat tail.

Bottom Line

Which brings us to the here and now: we are living in a debt-deflation fat tail, also known as a Minsky Moment. Well actually, as I wrote last month, the Moment has passed and we are now embarked on a Reverse Minsky Journey where "instability will, in the fullness of time, restore stability, as Ponzi Debt Units are destroyed, Speculative Debt Units are severely disciplined, and Hedge Debt Units make a serious comeback (remember, in Minsky terms, Hedge Units are the good guys!)."

The shadow banking system is being turned into a shrunken shadow of itself, as my partner Bill Gross articulately explained just a few weeks ago in his monthly essay, "Shadow Dancing6." Most important, from an investment perspective, a Reverse Minsky Journey will have the precise opposite, probably more violent, effect on the ‘neutral’ real Fed funds as the Forward Minsky Journey of 2004 – 2006. A Reverse Minsky Journey will lower it dramatically, as the implosion of the double bubbles of housing prices and the shadow banking system renders the demand for credit very interest rate inelastic to Fed easing.

Might we get back to a 2½% Fed funds rate, as I forecast would be the peak, way back in 2004? I honestly don’t know. What I do know, or at least think I know, is that the slower the Fed is in lowering the Fed funds rate, the greater will be the cumulative decline in the Fed funds rate. Debt deflation is a nasty beast and will not be tamed with a gentle monetary policy response.

Or, in the famous words of John Maynard Keynes:

    "For whilst the weakening of credit is sufficient to bring about a collapse, its strengthening, though a necessary condition of recovery, is not a sufficient condition."

The sufficient condition will be a combination of house price deflation and lower interest rates that re-ignites animal spirits towards housing as an asset class. Which means not fair, but cheap. So cheap, perhaps, that I, who’ve never owned more than one house, might decide that a second one might not just be a fun idea, but a good speculative put.

But we ain’t there yet. And, to borrow a Fed phrase, I don’t anticipate being there for a considerable period. Perhaps by the time I’m blessed to be invited to speak before this group yet again.

Meanwhile, let me thank you, from the heart, for inviting me here today for the third time. I understand this puts me in a small club, for which I’m deeply honored, as the Money Marketeers is a club of great history and distinction.

1 "A Brave New World," Fed Focus, April 2004.
2 "Musings on Inflation Targeting," Fed Focus, February 2006.
3 "A Reverse Minsky Journey," Global Central Bank Focus, October 2007.
4 "Needed: Central Bankers With Far Away Eyes," Fed Focus,
August 2003.
5 "Pyrrhic Victory," Fed Focus, September 2005.
6 "Shadow Dancing," Investment Outlook, November 2007.


The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.