The Fed's Failure
by Michael S. Rozeff
by Michael S. Rozeff
The first and most important rule of speculation is to cut your losses quickly, while they are still small. In poker, this means folding when you don't have good cards. In research and development, it means halting investment when the initial results are unpromising. In stock speculation, it means selling a purchase when it falls by 7—8 percent below a well-chosen entry level.
The first loss is the smallest, the saying goes. The Fed is violating that rule, and it is encouraging banks to violate that rule. It is doubling down on a bad hand. It is buying more stock as it falls, instead of selling out. How is it doing this? The Fed is lending more and more of its liquid government securities to client banks. In return, it is accepting their questionable and risky collateral.
The Fed is making three kinds of bad loans. First, the Fed is lending to banks that are in bad shape and need the funds badly. They are simply bad risks. If the Fed were a profit-maximizing banker, it would not make such loans, throwing good money after bad. The Fed is simply gambling (not wisely speculating) that in time these banks will recover. The gamble is huge; the amounts it is lending are a huge portion of its assets.
Second, the Fed is lending to banks that have agreed to take over some other failing financial institution, like JP Morgan Chase taking over Bear Stearns and Bank of America taking over Merrill Lynch. These buyouts and these loans are hastily arranged affairs. The buying bank doesn't really know what liabilities it is absorbing, and neither does the Fed. More often than not, mergers do not work out at all well. The costs of bringing two organizations together often are far greater than the buyers imagined.
These mergers will end up weakening the stronger bank as it absorbs the corpse of the weaker bank. No prudent banker would make such large loans on such short notice. The Fed is not a prudent banker.
Third, the Fed is lending to banks that have themselves agreed (under Fed pressure) to make loans to such failing giants as AIG. The Fed then has an indirect stake in making loans to a very risky enterprise like AIG. Again, both the lending banks and the Fed weaken themselves by making these loans that are supposed to shore up and save a failing institution.
We have a series of Titanics in these failing financial businesses, and their rescuers are not in much better off condition. They all employed too much leverage. They all made unsound investments. They are all sinking. Now, the Fed attempts to keep them going and/or prevent their outright bankruptcy by lending out its own high-grade securities. And the banks it is lending to have problems all their own to boot!
The losses do not disappear by these maneuvers. Perhaps they are submerged for a time within watered down balance sheets, but they will bob up and surface later.
The Fed is prolonging the credit bust. It is also weakening itself by making such questionable loans to risky deals upon collateral whose value is probably only a fraction of par.
What is going through the minds of the Fed's governors? Fed Chairman Bernanke says of recent steps that they "are intended to mitigate the potential risks and disruptions to markets."
In other words, the Fed is trying to lessen the price declines in asset markets. And its preferred method is itself to make loans and have its client banks make loans to failing banks and other financial institutions.
There are a number of cogent reasons why the Fed will fail in this attempt to stem price declines in such markets as stock markets, preferred stock markets, and corporate bond markets.
First off, the Fed is speculating against the market. If Merrill Lynch stock is worth $10 a share and not $60, it is because the cash flows of Merrill that come from its assets can only produce a cash return that justifies a $10 price. The assets are able to produce a cash flow such that, after paying a return to the bondholders, the stock's price is only worth $10 in view of that net cash flow.
Lending Merrill more money will not create value for the stockholders unless that money can be put to use by buying assets that earn returns in excess of the required return on Merrill's capital. But if Merrill actually possessed such good investment projects, it would be able to borrow money or issue stock and get capital based on the merits of those investments. The fact that the stock has sold off drastically is because it does not have such projects. It is a sign that investors do not want to provide Merrill with more capital.
In making its loans, the Fed is basically pitting its judgments of value against the market's. The evidence of such past attempts, such as in currency markets, is one-sided. Central bankers do not know more about valuation than markets know. If that is so, then no matter how much the Fed lends to a Merrill or a bank whose stock has declined greatly, the loans cannot shore up the stock price. They can only keep the patient alive and substitute the Fed's ownership for the ownership of investors in the market.
Secondly, the Fed is only one player in the market. The markets are in the aggregate much larger than any single player, including a large one like the Fed.
There was a time when J.P. Morgan could place a bid under U.S. Steel and stem a stock market decline. At that time, people knew that Morgan was risking his own capital, and so they interpreted his buying as a positive signal. But even then, speculators understood that perhaps Mr. Morgan was liquidating other issues under cover of strength in Steel.
The Fed has no such credibility when it makes loans. The Fed governors are not risking their own money, and they have a backup which is an open checkbook to create high-powered money.
When the Fed steps up to bail out a failing bank, it is taken, not as a sign that the bank is worth more than what the market thinks, but as a sign that the Fed is afraid that prices will fall further; for that is exactly what Bernanke has himself said. Indeed, one institutional investor said of the Fed's moves: "There is little doubt that the Fed believes systemic risk is coming closer to really landing on shore."
Each time that the Fed makes a move to shore up the system or keep it "orderly," it has the opposite effect of what a Morgan could do. It is interpreted as a sign of the Fed's negative expectations.
Each time that the Fed raises the ante, it communicates more and more desperation. In this latest Lehman episode, the Fed will for the first time in its history accept stocks as collateral. The Fed in all likelihood has already accepted a good deal of very low-grade mortgage collateral. From that viewpoint, accepting stock collateral is not a big stretch. But there is an important difference. The stock collateral has quoted markets. Will the Fed now follow the rules and require maintenance margins and issue margin calls if the stocks decline in price?
In past bear markets, institutions that are pressed often sell stocks to raise liquid capital. If stocks are held off the market, will this stem their price declines? They will not, because the stock prices are determined by the cash returns that the assets can produce. If the stocks are locked up in the Fed vaults rather than traded, the main effect may be to make markets less liquid.
The day is coming closer when the Fed is out of securities to lend. At that point, its only tool will be to print money if it wants to bet against the financial markets. Helicopter Ben will have to gas up and learn how to fly. But since the Fed's paper is not real capital, this will do nothing to augment value in the capital markets.
Value creation induces the creation of credit when lenders believe that a value-creator has or can create assets that have returns that warrant loans, but credit creation itself does not create value. The Fed cannot create value. Causation runs from sound assets to sound credit. Causation does not run from credit creation to sound assets.
Judging from price declines that have already occurred, many more bank failures lie ahead. More large banks and important regional banks will fail. The Federal Deposit Insurance Fund will quickly be depleted. The Fed will be helpless to address the problems. Its moves to date already show how ineffectual it is.
As with Fannie Mae and Freddie Mac, so with the rising tide of failures to come. The Congress and the Treasury will be directly involved in their resolution. This prospect is a fearful one. There is no telling what schemes legislators will propose and pass in the face of widespread bank and financial institution failures.
September 17, 2008
Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.
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