"The housing boom has raised concerns among some analysts about the possibility of a home price bubble and the specter of home prices suddenly collapsing. Rising levels of consumer and mortgage debt and a decline in the quality of that debt, also merit attention. What connects these areas of concern is the possibility that household credit quality could decline further if home prices were to fall precipitously."

"Housing Bubble Concerns and the Outlook for Mortgage Credit Quality"
FDIC Outlook
Spring 2004

"You know, there's none so blind as they that won't see."

In this issue of The Institutional Risk Analyst, we feature another contribution from members of the Herbert Gold Society regarding the role of the Federal Reserve System as "risk manager." Since the Obama Administration seems to think that the Fed should be responsible for managing "systemic risk," whatever that may be, it seems appropriate to ask how good a job the US central bank has done and is doing regarding plain vanilla risk management.

Before our feature, however, we need to comment on some developments in the financial sector.  Top of mind is the front-page report in Monday's Financial Times.  It seems that Goldman Sachs (NYSE:GS) and Barclays (NYSE:BARC) are now marketing "insurance" products that can help buyers dodge capital adequacy rules. You just can't make this stuff up.  The term that comes to mind is "impunity." 

Here's our question: When are regulators in the US and EU going to put an end to this nonsense?  Wasn't the collapse of AIG a sufficient example of the deliterious effects of using structured credit to window dress corporate balance sheets?   

As we told subscibers to The IRA Advisory Service earlier this week: "Goldman Sachs (NYSE:GS) is expected to report record Q2 results, proving that while the people who run GS may know how to manipulate politicians, they have no political common sense. If, as we now anticipate, the US economy continues to weaken and American International Group (NYSE:AIG) reports further losses, then GS and all of the other dealers who faced AIG prior to the rescue last year by Tim Geithner and the FRBNY may become political targets going into the election year."

Of interest, we have another missive on AIG in the works.  Our next comment will focus on the "rest of the story" at AIG, namely that the insurance units were so badly compromised by cross-guarantees and other bogus "risk-shifting" transactions -- just like the "insurance" being offered by GS and BARC, it seems -- that these once valuable assets are now essentially unsalable.  We also hear in the M&A channel that the advisors working diligently to sell AIG's remaining assets, after months of effort, are finding no takers at any price. 

Given that AIG raising cash through asset sales seems unlikely and also given the public disclosure by AIG that more losses are "possible" on the firm's remaining book of credit default swaps, the only question now seems when the next installment payment by the US Treasury will be required.  Just immagine how the Congress and American voters are going to react when Treasury Secretary Tim Geithner finally asks us to pour billions more in public funds into AIG -- this as American states and cities are facing the possibility of default in 2H 2009.  You know what we think the answer is for AIG:  bankruptcy.  And former AIG CEO Hank Greenberg agrees with us. 

By the way, if you have not yet seen it, read the article by UCLA Law Professor Lynn Stout on FinReg21, "How Deregulating Derivatives Led to Disaster, and Why Re-Regulating Them Can Prevent Another."   Also, we are working on responses to questions from the Senate Banking Committee on reforming the OTC derivatives markets.  When our response is complete, we will post the Q&A in a future issue of The IRA.  

Now to our feature.  The success of crisis and risk managers rests on their ability to identify sources of risk, and to conceptualize and implement disaster avoidance and recovery plans. As the global economy seemingly heads for a second downward shift in GDP and asset valuations this year and in 2010, below is a comment by members of the Herbert Gold Society that looks at what the Fed says about risk management and what it actually does in practice. 

The Fed as Risk Manager?

In November 2002 before the National Economists Club, then Fed governor Ben Bernanke gave a speech titled "Deflation: Making Sure "It" Doesn't Happen Here."  It is frequently referred to in the media as the "play book" by commentators and analysts when discussing the Fed's response to the financial crisis which broke in 2007.  In the speech, Bernanke argued "that the chance of significant deflation in the United States in the foreseeable future is extremely small".

His argument had two dimensions:  "The first is the resilience and structural stability of the U.S. economy itself."  In support of that premise, Bernanke said:  "A particularly important protective factor in the current environment is the strength of our financial system…our banking system remains healthy and well-regulated,…"

Moreover, Chairman Bernanke went on to argue that the Fed, in conjunction with other parts of government, was in a position to respond if the probability of a deflationary episode increases:

"The second bulwark against deflation in the United States, and the one that will be the focus of my remarks today, is the Federal Reserve System itself…. I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States and, moreover, that the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief."

Amidst, the fallout from the financial and real bubbles that started to deflate in 2007, Bernanke's arguments appear empty and the assumed safety net nearly non-existent. The policy responses by the Fed suggest that policymakers view the US economy as anything but resilient and stable. The idea that our financial system is strong and that the banking system was up until 2007 healthy and well regulated is, sad to say, laughable.  When Treasury Secretary Tim Geithner made such statements in China earlier this year, audiences laughed openly -- an enormous insult in any Asian society.

The idea that the Fed would be aided by other agencies of the US Government also rings hollow. Which agencies could Bernanke have been referring to?  The SEC?  Fannie and Freddie?  Treasury?  The scramble for new tools and the pleas from the Fed regarding the lack of legal authority to save Lehman Brothers suggests that Fed did not have all the policy and instruments that it might have found useful.

Perhaps the criticism is unfair?  Perhaps the economy was stable and resilient in 2002?  Perhaps the banking system was well-regulated in 2002?  Perhaps.

However, a speech by Raguram G. Rajan, "Has Financial Development Made the World Riskier?"  and a response by Fed Vice Chairman Donald Kohn at the Jackson Hole Conference of 2005, allows us to get a read of Fed views on the condition of economy and financial system much closer to the bursting of the bubbles. These speeches were delivered well after some economists had already sounded alarms re: the housing sector (e.g. Gramlich, Schiller), the financial sector (e.g.Rajan), and international imbalances (e.g. Roach). In opening paragraphs, Rajan argued that that the transformation of the financial sector had made it more efficient, but at the expense of increased tail risk:

"The expansion in a variety of intermediates and financial transactions has major benefits... However, it has potential downsides, I which I will explore.  … the incentive structures of investment mangers today differ from the incentive structures of bank managers in the past in two important ways. First... managers have a greater incentive to take risk. Second, their performance relative to other managers matters.  The knowledge that managers are being evaluated against other managers can induce superior performance, but also perverse behavior.

One is the incentive to take risk that is concealed from investors-since risk and return are related, the manger then looks as if he outperforms peers.. typically the kind of risks that can be concealed most easily… are known as tail risks.  Both behaviors can reinforce each other during an asset price boom…An environment of low interest rates following a period of high rates is particularly problematic, for not only does the incentive of some participants to "search for yield" go up, but asset prices are given the initial impetus which can lead to an upward spiral, creating conditions for a sharp messy realignment….. the most important concern is whether banks will be able to provide liquidity to financial markets so that if tail risk does materialize, financial positions can be unwound and….the real consequences to the real economy minimized."

The balance of the Rajan paper was a succinct development of these ideas along with the presentation of a considerable amount of supporting evidence.  He referenced over 50 plus scholarly papers, some of which Fed official presumably have read.  Rajan never forecasted or predicted the financial crises which were to follow.  However, he concluded:

"A risk management approach to financial regulation will be important to attempt to stave off such states through the judicious operation of monetary policy through macro-prudential measures. I argue some thought also should be given to attempting to influence incentives of financial institutions mangers lightly, but directly."

Fed Vice Chairman Kohn was a discussant for Rajan's paper at Jackson Hole in 2005, but his prepared response was not a discussion or rebuttal of the Rajan theses.  Rather, Kohn joined the chorus of voices chanting the mantra that was a pledge of allegiance to the Greenpan doctrine. Kohn's comments were an explicit reaffirmation of his and presumably the Fed's belief that the greater dispersion of financial risk away from banks and into non-bank vehicles via the unregulated OTC markets implies lower levels of systemic risk. There was no discussion of the implication of the changes in incentive structures or herding behavior.  Said Kohn:

"My perspective on this interesting paper by Ragu Rajan has been very much influenced by observing Alan Greenspan's approach to the development of the financial systems and their regulation over the past 18 years.  I believe that the Greenspan doctrine, if I may call it that, has reflected the chairman's analysis and deeply held belief that private interest and technological  change, interacting in a stable macroeconomic environment, will advance the general welfare."

The Kohn response to the Rajan paper seems to reflect a Fed decision to reject out of hand objections and questions about financial developments.  This is very troubling.  Academic credentials aside, Kohn's dismissal of alternatives as opportunities to test their working hypotheses was rather anti-intellectual and constituted a sin of omission that contributed to the scale, if not existence, of the current crisis. The degree to which economic and financial developments caught the Fed by surprise suggests that the probability that the Rajan theses would actually occur were never seriously explored within the Fed.

And Rajan was hardly the only voice raising questions. His thesis was really no more than "the 'innovations' that were driving growth were nothing more than market-based fundingof the banking sector, and overreliance on market-based funding in commercial banks is risky," although even Rajan seemingly did not have the depth of understanding of financial market developments to state that more clearly.  More direct was the warning by Edward Gramlich, who in 2004 said: "Increased subprime lending has been associated with higher levels of delinquency, foreclosure and, in some cases, abusive lending practices."

The underlying premise in risk management/control disciplines is the acknowledgement of the trade-off between risk and return, as mentioned by Rajan. In general, increased expected return (more upside) must be paid for in part by accepting more downside risk.  Former Fed Chairman Alan Greenspan acknowledged this trade-off when he said something to the effect that if the new paradigm that low interest rates were helping to finance turned out to be a speculative bubble, then the Fed would cushion the downside.  Greenspan, Kohn (who was then a Fed staffer and Chairman Greenspan's closest monetary policy advisor), the Fed, and the global economy took the risk.  When the tech bubble burst earlier in this decade, the Fed eased dramatically as part of an effort to avoid a deflationary spiral.  More recently, the Fed pursued stimulative interest rate policies -- this despite evidence of unsustainable bubbles in the housing and financial sectors. 

Where was the Fed's risk management? 

The Greenspan and Bernanke Feds both exposed the US economy to increased downside risk as they pursued more rapid growth. The low interest rate stances were sold as "risk management," reducing the probability of a high cost but still remote event-deflationary spirals.  There is only one problem: the policy stance had absolutely nothing to do with risk management or risk control as it is understood or imposed by the Fed.

In fact, the tech crisis and the more recent collapse occurred because the Fed failed to practice rudimentary risk management. In general, risk management systems operate by limiting the level of risk, i.e. they give up some expected return in order to maintain or reduce the downside to an acceptable level. Risk control and risk management operate when the risk is put on.  Damage control efforts initiated only when the bets go south are just that -- damage control -- not risk management

By not managing risk, both the Greenspan and Bernanke Feds exposed the US economy to greater risks.  In both cases, the extreme downside risks were realized.  Consequently, to identify the subsequent cuts in interest rates as "risk management," when they were in actuality political exercises in damage control necessitated by the absence of true risk controls, transcends mere Washington spin.  The Fed's stated position on its role in the crisis is the economic policy equivalent of Orwell's Ministry of Truth:

The Ministry of Truth - Minitru in Newspeak - was startlingly different from any other object in sight.  It was an enormous pyramidal structure of glittering white concrete, soaring up, terrace after terrace, 300 feet into the air.  From where Winston stood it was just possible to read, picked out on its white face in elegant lettering, the three slogans of the Party:

War is Peace
Freedom is Slavery
Ignorance is Strength

George Orwell
1984

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