...Archive for November 2007

The Fed’s policy space is not one-dimensional

It’s easy right now to view the Fed as trapped. If the Fed fails to lower rates, asset prices will continue to collapse, the housing crisis will worsen, and the broad economy will suffer. If the Fed does lower rates, capital flight from the US will continue, gold, commodities, and foriegn currencies will surge, and weakness of the dollar will eventually translate into a dangerous inflation. The Fed is damned if it lowers, damned if it raises, and damned if it does nothing at all. In the usual cliché, the Fed is “in a box”.

But the Fed has more options than “raise or lower”. Let’s go back to Bernanke’s famous 2002 speech about deflation. Note that the root of the current crisis is deflation, though of a particular kind, a deflation in the value of certain financial assets. If all the terrible paper Wall Street has been producing over the past few years really had been as solid as their boosters and the rating agencies claimed, we’d have no crisis today to fuss about. A collapse in the value of supposedly “ultrasafe” assets held by parties with little capacity to take risk or bear losses is at the heart of the today’s financial mayhem. Whatever its deeper roots, the proximate cause of the crisis is a deflation.

Here’s Dr. Bernanke:

[T]hat deflation is always reversible under a fiat money system follows from basic economic reasoning… [T]he U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services… Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys.

Unlike some central banks, and barring changes to current law, the Fed is relatively restricted in its ability to buy private securities directly. However, the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window. Therefore a second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral. For example, the Fed might make 90-day or 180-day zero-interest loans to banks, taking corporate commercial paper of the same maturity as collateral. Pursued aggressively, such a program could significantly reduce liquidity and term premiums on the assets used as collateral.

The first thing to note here is the candor and prescience of Dr. Bernanke’s remarks. The future Fed chairman is describing very unconventional monetary policy options, and discussing how the central bank could, in a time of crisis, circumvent regulatory obstacles designed to constrain bank behavior. And obviously, these turned out to be more than mere musings. Bernanke’s first response to the present crisis was to try to lend indirectly to holders of struggling collateral via the discount window.

Suppose that the Fed were not restricted in the sorts of assets it could buy. What might the Fed do about the present crisis? Consider the obvious. The Fed could bail out holders of the compromised paper. It could determine a “fair long-term value” for all those struggling RMBSs and CDOs, something less than par but much higher than the market bid, and purchase securities outright with freshly printed money. You might think that a cash bail-out would be inflationary, and “ceteris paribus”, it certainly would be. But “ceteris paribus” doesn’t hold here. By strategically choosing which assets to buy, the Fed could mitigate the harm that higher interest rates would otherwise do to the financial sector. Becoming the “bagholder of last resort”, the Fed would purchase the freedom to raise interest rates without provoking a “nonlinearity” (knzn‘s delightful euphemism for a meltdown). The Fed would have its cake and eat it too. It would promote full employment by stopping a dangerous financial crisis in its tracks. It would promote price stability by hiking interest rates to support the purchasing power (and FX value, and commodity value) of the dollar.

There would be some danger that, even with the banks bailed out, interest rate hikes would slow the economy. But that hazard is unusually small now, because the binding constraint on lending is not the Fed-set interest rate, but concerns about creditworthiness and quality of collateral. The larger the credit spread is, the less of an effect changes in core rates have upon behavior. Raising rates certainly won’t help homeowners struggling with their mortgages, for example. But it won’t hurt homeowners who have no hope of refinancing affordably anyway. There will always be someone caught at the margin. But in macro terms, a bad situation would be made very little worse by a moderate rate hike, if the financial sector could withstand it.

In reality, the Fed is not permitted to buy up dodgy CDOs outright. But as Bernanke has suggested, lending on sufficiently easy terms can approximate a purchase. Bernanke’s initial try at using the discount window to fight the structured-credit deflation didn’t work. But it was not a very radical attempt. So long as there is a “penalty spread” between the federal funds rate and the discount rate, any use of the discount window signals a lack of confidence by other banks and is reputationally costly. Suppose the Fed were to offer to lend against specific sorts of collateral at a negative spread to Federal Funds. Then all banks would have a clear financial incentive to take advantage, regardless of the quality of their own portfolio. Banks holding the privileged collateral might claim their assets are performing beautifully, but that it would be foolish not to take advantage of the Fed’s subsidy. Lining up at the discount window would suddenly become shrewd rather than shameful.

Of course, this might not work. Markets might be spooked rather than reassured, a l&agrave the Northern Rock fiasco. And even if it would work, I don’t advocate any of it. I don’t mean to be a “liquidationist“. But piling moral hazard on top of moral hazard, making ever lighter the consequences of poor choices by people whose choices are consequential for all the rest of us, strikes me as a bad way to encourage quality decision-making.

Nevertheless, if financials and asset prices continue to struggle, while commodities spike and the dollar falls, expect the unexpected from the Federal Reserve. Ben Bernanke has devoted his career to thinking about how a central bank might forestall financial catastrophe. He will not confine his options to “quarter point or half a point, up or down”.

Update History:
  • 11-Nov-2007, 2:00 p.m. EST: Removed an excess “but”. Changed “expected the unexpected” to “expect the unexpected”. Oops.

GM — Holy negative accounting equity, Batman!

Apparently GM is going to take a $39 billion dollar writedown of deferred tax assets this quarter. Wow.

The phrase “deferred tax assets” is one of many powerful hexes the accounting profession has invented over the years. Recitation of the words before ordinary mortals causes eyes to glaze and specks of spittle to appear at corners of the mouth. For an explanation, see the end of this post.

Anyway, as all the overnight press on the matter is careful to emphasize, these are non-cash charges, and they could be reversed if GM becomes profitable soon. Nothing to look at here, just move along. It’s an accounting thing, you wouldn’t understand.

But here’s an accounting thing for you. Check out GM’s top-level balance sheet last quarter (the quarter ending Jun-07). Look at the line called “Total stockholder equity”. Yes, it really does say negative 3.5 billion dollars.

Suppose GM offsets the writedown of tax assets with $9B of gains elsewhere, so that the net charge is, um, only $30B. (For example, they’re expected to report a gain of $5B on their sale of Allison Transmission.) A $30B net charge would bring GM’s accounting equity down to negative 33 billion dollars.

Is that a record? What’s the maximum negative accounting equity ever reported by a going concern? Or, consider this: GM is not a penny stock. The market imputes a lot of real value to those claims worth negative dollars on its balance sheet. GM’s market cap as of yesterday was about $20.5B. That’s a positive number. GM’s stock price fell after-hours on announcement of the charge by about 3%. So, incorporating (at least partially) the new information, the market imputes about positive $19.9B of value to roughly negative 30 billion dollars worth of book assets. There’s a nice fifty-billion dollar spread between market and book value. If GM could keep that spread, but bring its book value up to positive a billion, it would look like an incredible growth company, with a market to book ratio of 50 times! Google looks cheap by comparison.

Now, there are serious problems with accounting equity as a measure of value. GM is an old company. Perhaps it owns a lot of real assets that were purchased decades ago and are still valued on its books at 1940s cost. Could be. But it takes a lot of adjustments to get out of a hole $30B deep.

An interesting factoid from the WSJ. GM’s total net income for 1996 through 2004 totaled $34 billion dollars, less than is disappearing in tomorrow’s accounting “poof”.

Here’s a question: What percentage of GM’s market valuation do you think is based on a market-perceived “too big to fail” guarantee by the US government?

For those who want to know, “deferred tax assets” arise when firms recognize expenses before they are allowed to take a tax deduction for those expenses. Let’s say a large New York bank decides some of its assets are worth 10B less than originally thought, and writes those assets down on its balance sheet. If the bank pays a 35% tax rate, 3.5B of that “loss” should eventually be absorbed by the government in the form of reduced tax payments. But companies don’t get to pay fewer taxes whenever they change their estimate of the value of an asset. The bank gets a cash write-off on its taxes only when the assets are actually sold and the firm realizes a loss. In the meantime, the firm recognizes a 3.5B “tax asset”, the value of the future tax savings it expects. This is all perfectly legitimate — writing down the assets without recognizing the expected tax-savings would badly overstate costs. But sometimes a firm’s estimate of future tax savings turns out to be wrong. Say the bank is forced to sell the impaired assets when it is already losing money. Then there is no immediate tax savings, because the bank wouldn’t have paid taxes that year anyway. The firm may still be able to “carryforward” the loss, and recover some of the tax savings. Or it may not. Tax laws are complicated.

GM had previously estimated that it had $39B in future tax write-offs coming to it. Its accountants now think the company might never get the chance to use them. Though this is not a cash charge, it is not a good omen either. Firms realize tax assets when they are profitable enough to have a large tax bill to take deductions from. GM is basically announcing that it’s unsure it will earn enough money to be able to take advantage of its pent-up tax offsets before they expire. Tax asset writedowns are insult-to-injury kind of events. Firms get hit with the accounting charge when, and precisely because, they can’t make enough money to have a tax liability to escape from.

Tax asset writedowns might also be a signal of distress, indicating that a firm lacks the flexibility to time its loss realizations advantageously. Tax laws are complicated, and sometimes tax benefits expire regardless of what a firm does. One mustn’t draw conclusions. Still, it does make you wonder.

FD: I have no direct position in GM, but I am short the Dow.

Update History:
  • 07-Nov-2007, 11:33 a.m. EST: Changed “tax asset write-offs” to “tax asset writedowns”, since I use “tax write-offs” and the mix is confusing. Changes “to big to fail” to “too big to fail”.