When Fed ignorance isn't bliss
The machinery for creating credit has gotten so complicated and powerful in recent years that not even the Fed may know what it's doing, writes bond expert Bill Gross in Fortune.
(Fortune Magazine) -- If you're struggling to find something that symbolizes the transition from the old-fashioned markets of yesteryear to the seemingly inexplicable wildness of today's derivative-driven, conduit-imploding financial complex, you need look no further than the contrast between old television's Louis Rukeyser and thoroughly modern Jim Cramer.
Calm, stately, with deep-throated baritone certainty, Rukeyser was the spokesman for aging boomers who wanted assurance that a nostril-snorting bull market would reign supreme.
No less a cheerleader, but with soprano-inflected importuning decibels louder than any rival on the flat screen, Cramer, in recent weeks at least, has been willing to recognize that the momentum could turn in favor of the visiting bears.
At a moment when Treasury, Fed, and White House officials were trying to calm investors with an "all clear" story line, Cramer screamed at the CNBC camera, "They know nothing, they know nothing!"
Just who "they" were was left to the imagination, but it was clear that in Cramer's world Rukeyserian bullishness was not the order of the day.
Indeed, it was not. As Cramer was railing, I and other Pimco professionals were attempting to describe to high-ranking Treasury and Fed officials the near-frozen commercial-paper markets and the draining confidence of bond and stock investors worldwide.
It was Thursday, Aug. 14. Stocks had closed down 210 points and were expected to open hundreds of points lower on Friday. The country's largest mortgage originator, Countrywide Financial (Charts, Fortune 500), was rumored to be in liquidation mode (it survived that crisis). This was to be Ben Bernanke's first test, an opportunity to prove that he and his board of governors knew "something" as opposed to "nothing."
Pass the test he did, cutting the discount rate the next morning and calming markets in ensuing weeks. When Bernanke's Fed met officially on Sept. 18, it acted again and joined a convoy of global central bankers maneuvering to restore a semblance of normalcy to credit and equity markets. So far, so good.
Yet the validity of Cramer's rant remains to be disproved. The modern financial complex has morphed into something unrecognizable to many astute market veterans and academics.
Bernanke's fellow governors and Hank Paulson's staff at Treasury spread their roots during an era in which traditional banking activity - lending out deposits backed by a certain level of reserves - was the accepted vehicle for liquidity creation.
Remember those old economics textbooks that told you how a $1 deposit at your neighborhood bank could be multiplied by five or six times in a magical act of reserve banking? It still can, but financial innovation has done an end run around the banks.
Derivatives and structures with three- and four-letter abbreviations - CDOs, CLOs, ABCP, CPDOs, SIVs (the world awaits investment banking's next creation, perhaps IOU?) - can now take a "depositor's" dollar and multiply it ten or 20 times. Reserve banking, and the Federal Reserve that regulates the system, appear anemic in comparison.
I'm sure that Bernanke, Paulson, and their cohorts understand this, but it isn't yet clear how much they appreciate it. Alan Greenspan admits in his newly published book that he didn't appreciate until recently the impact adjustable-rate mortgages and their subprime character, accompanied in some cases by fraud, would have on the housing market.
If the Fed was so slow to grasp the role that subprime mortgages played in the housing boom, do the Fed and the Treasury of today totally comprehend what happens when the nonbanking private system suddenly stops flooding the market with credit? Do they recognize that such a shutdown puts spending for housing and business investment at risk, and job growth as well?
The Fed will have to adapt its monetary policy, and the Bush administration, led by the Treasury Department, will have to adjust its fiscal policy to this brazen new world dominated more and more by private rather than public policies and proclivities.
To overcome private-market caution, the Fed may need to put on a bold face marked by even more decisive cuts in short-term rates. To prevent a housing-market slump from metastasizing into a cancerous, self-feeding tumor, Treasury Secretary Paulson will have to coordinate policies that lend a helping hand to homeowners in distress.