Connelly on Commerce

Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.

With all the focus on Freddie and Fannie (not to be confused with Brad and Angelina), we can lose sight of the bigger game — namely, that the economy is clearly not out of the woods, nor have the risks to the economy clearly receded, because the housing finance and financial institution crisis is neither contained, nor indeed over.

There will be renewed focus on inflation this week, to be sure. with the release of the latest PPI and CPI data, and this could again suggest that the Fed’s next move in interest rates will be up.
Certainly the usual band of hawks in and around the Reserve Board and on cable news will say so.

But the Fed must first finish the task of making sure the economy does not collapse into a deep and prolonged recession (which, of course, is one sure way to take care of the inflation problem — the monetary version of the “destroy this village to save it” strategy).

It may simply be the case that the broader economy, having been Fed (if you will) a diet of interest rates starting with a “1″ by the famed Dr. Greenspan, now requires a similar level of rates to begin to get well again. Thus keeping interest rates at a number starting with a “2″, even followed by a bunch of zero’s, just won’t do the trick, even if the level of rates is clearly “accommodative” or even “negative” to inflation as economists look at it.

Psychology has a role to play in consumer actions and sentiments, and in business strategy and investment decisions as well. If we needed one per cent interest rates to get well from the combination of the dot-com crash and 9/11, who is to say we don’t also need them to get well from the “perfect storm’ of unprecedented oil prices, the collapse of the hosuing market, and the credit and liquidity crisis that still prevails among financial institutions.

The Federal Government of course stepped in aggessively in both military and civil defense areas after 9/11, but it didn’t move to rescue the dot-com casualties — because their collapse posed no systemic threat to the whole financial system.

But Bear stearns and “Freddie and Fannie” did and do pose such a threat — although with the collapse of IndyMac, we now know that there is at least one financial institution that is not “too big to fail”. The question now, as one TV commentator cleverly put it this morning, is whether Freddie and Fannie are “too big to fix” — that is what the equity markets are now debating. The answer will affect the Federal Reserve’s August interest rate decision (near the first anniversay of the first of many Fed “about-faces” on rate policy in the past year).

Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.

Any “accommodative” Fed policy on interest rates will tend to risk
inflation to some degree; the question is what the balance of risks
are. The trio of Plosser, Poole and Lacker, when voting fed
governors, all opposed “accommodation” in the first place, so it is
hardly surprising that those who voted against Bernanke’s policy on
rates would now be urging a quick reversal of those policies.

The real question is whether Bernanke and the other Fed governors
who have been speaking out lately on the issue of inflationary
risks, as tied to the US dollar/commodity prices issue, are also
contemplating a quick reversal of the accommodative policy
themselves. I think the answer to that question, despite the views
showing up in the bond markets, is very much a “no”.

As the Fed has done in several recent past Springs — including
just as Bernanke took over two years ago before he “paused”
Greenspan’s quarter-point rate rise march at 17 straight — I
believe it is now trying to talk up the dollar with all these
warnings about its readiness to tame the inflation beast with rate
hikes, in order to forestall a currency crash that really could
send oil up to $150 and beyond.

Talk is, after all, cheap, or at least cheaper than a real rate
increase, up to the point when the markets realize it is just
talk. The equity markets simply don’t agree with Plosser, Poole and
Lacker that the risks to the economy have receded to the
considerable degree necessary for an end to “accommodation”.

There even remains a case that the Fed needs to make a further rate
cut to get the number down to having a “1″ at the front instead of
a “2″ — Greenspan having taught us that it takes 1 % rates to
spare us a serious post dot-com-crash, post- 9/11 recession (and
who’s to say the credit crunch plus oil bubble plus housing crash
isn’t even a worse, more systemic problem for the overall economy
than Greenspan had to deal with).

My sense is that Bernanke does not want to go down in history is
the man who killed any chance McCain may have in the election by
raising interest rates on top of gas and food prices, not to
mention tipping the stock market into another autumnal crash –
something the Fed really fears because it does have very little
ammunition left to respond to a share market collapse.

We have two months of key economic data on unemployment levels and
corporate earnings forecasts and housing performance, as well as
inflation and productivity, coming before the Fed’s August meeting;
let’s just go back to Bernanke’s earlier phraseology about being
“data dependent” and leave it at that for now!

Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.

The surging price of oil — whether driven by pure speculation, Chinese demand, geopolitics, or long institutional futures bets — is driving a sea change in US economic calculations. And one can see from today’s release of the minutes from the April Federal Reserve meeting that Chairman Bernanke has reverted to what is becoming a traditional Spring ritual — using the minutes to jawbone the value of the US dollar upwards, or at least build a firebreak against further deterioration in its value.

Clearly enough, the Fed is worried about inflation especially in commodity prices stoked by the dollar’s fall as the Fed aggressively cut the funds rate in an atttempt (thus far technically successful) to ward off a recession.  (Who says the Fed cannnot try to deflate asset price bubbles?) But is the Fed sending an even more meaningful signal in today’s release (after all, they get three weeks to shape  the minutes to say exactly what they want them to say) that the Fed is quite willing to risk a recession in order to pre-emptively attack the risk of inflation. The stock market seemed to react as though this latter message was what it heard most loudly: and why not, when the minutes themselves  said even a “contraction” should not alter their new pause bias. And Board Member Warsh amplified today the same thoughts with his dismissal of calls for further rate cuts in the face of further economic deterioration as “reflexive”. (Of course, the Fed itself knows a little something about “reflexive” rate cuts, especially when threatened with a sharemarket meltdown.)

So we may be about to head back to the days of late last Summer and early Fall when the equity markets and the Fed engaged in a tussle over whether the risks of recession and inflation were in fact evenly balanced (as the Fed then said right through October despite the credit meltdown and housing crisis) or whether recession was a much greater threat — as the equity market perceived and attempted to signal by periodic bouts of swooning several hundred points down per day.

We can expect then more days of a a sort of stock market “Victorian fever” as institutions and individuals take the measure of the risks inherent  in the Fed’s new stance and attempt to again force the monetary authotities to “blink” as it has in the past) in the face of the potential for a stock market crash (just what the doctor ordered in an election year).  

Most worrisome to the markets is the prospect that a banking analyst at Oppenheimer (Meredith Whitney) is in fact more clued-in to the financial and credit market realities than the Fed is. Specifically, her predicted “other shoe” credit card rollover freeze-up in the face of new regulatory restrictions on issuer fees and flexibility which will, by her estimation, wipe out $2 trillion or more of consumer credit along about year end, and in turn trigger another round of massive defaults and bank receivables write-downs (not to mention the “negative feedback loop” in the overall economy that the Fed now wants us to think that IT THINKS is a diminished risk).

Perhaps the Fed’s willingness to again play at least a minutes game of ”chicken” with recession in order to flex its anti-inflation muscles will carry the day with the dollar and gradually take some air out of the oil bubble…for a while. But let’s also be a little “data dependent” ourselves and watch out for rising credit card defaults, May unemployment, more airline (not to mention personal) bankruptcies and rising mortage rates in the face of the inflationary expectations the Fed has now itself somewhat legitimatized by its own forecast. 

Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.

The vaunted removal of the phrase “downside risks to growth remain” from the Federal Reserve’s statement of April 30 accompanying its redtion in the benchmark Federal funds rate by 25 basis points is being overplayed by the media and commentators, and quite possibly the bond and stock markets, as a signal a new “pause bias” in the Fed’s thinking about rates.

It is entirely possible that, given the laundry list of concerns that the Fed specifically listed in its statement that it believes will “weigh on” economic growth going forward, they thought o remove the more generic downside risk statement simply because it was superfluous!

Thus mere correction of redundancy has been elevated to a notion  of bias change. It is insterad apparent that the votes just were no there for a specific “pause bias” statement. Indeed, when the Fed wants to make such a bias clear, it knows exactly what to say and how to say it. See for example its Otober 31, 2007, statement referring to the risks of recession and inflation being evenly balanced.

Of course, that just didn’t turn out to be the case — so perhaps six months later the Fed did not wish to declare victory against recession prematurely. As a “forward looking” statement, the April 30 message leaves little risk that the Fed will “miss its forecast” and hardly gives the markets much to go on — as Warren Buffett says, “all the speculation is just speculation”.

Rice is now getting as scarce as credit and almost as expensive; next week’s  meeting of the Federal Reserve may be the first on record to be affected by the travails of the Asian restaurants of San Francisco! (It’s a two-day meeting — do they order out for Chinese?)

Seriously; the price of rice and other foodstuffs may be to the current economic malaise what WorldCom was to financial scandals earlier this decade — the tipping point of the situation from an insiders market scandal matter to a broad market meltdown.  Enron was an elite player’s market nightmare — but WorldCom was one of the top five holdings of all US equity investors. After WorldCom revealed the extent of its fraud, it only took about a month of precipitous Dow downturns to turn Sarbanes-Oxley from a dead letter to the scourge of executive suites (not to mention the savior of the accounting industry as we know it).

So, too, today with the looming recession — likely to be confirmed the very morning of the Fed’s interest rate announcement — do you really believe the Fed will choose that same day to announce NO further rate reduction? (Now THAT would be a story.) The market’s focus will most likely be on the Fed’s forward-looking statement (and there is no “safe harbor” for the Fed as with corporate earnings projections, and hell to pay if the Fed misses its guidance ). But lately the Fed has been on a winning streak, especially with its decision to open a new “window” in its stately loan-office facade for the post-Glass-Steagall investment banks, bringing them into debtor parity with their not-so-distance commercial bank cousins, as well as its Bear Stearns crisis intervention (rather, its $30 billion insurance policy, with a $1 billion deductible, in favor of JP Morgan). These bold actions have enhanced Bernanke’s market credibilty simply because they seem to have worked at turning around around the financials  — at least their equity shares – and allowing  Hank Paulson to breath a very public sigh of relief — always a good move for a Treasury Secretary; like coming out for a “strong dollar”.  And Hank may get his chance to look good on that score soon, too  — see below, about 3 paragraphs.

And given its winning ways, surely it’s not the Fed’s fault that the vaunted Washington “stimulus package” of direct deposits and checks-in-the-mail that will begin flowing next week has morphed from currency coupons for a shopping binge at the local big-box retailer to the functional equivalent of middle class food stamps to counteract the emerging phenomenon of grocery gouging. Or is it?

It is apparent that the price of food is now the most potent “chicken coming home to roost” of the Fed’s policy of lowering interest rates precipitously to mitigate the coming recession, in turn caused by the credit crisis in part brought on by the Fed’s previous policy of lowering interest rates precipitously to mitigate the previous recession bought on by the dot-com collapse, which itself was brought on by the the Fed’s previous policy of…oh, well, you get the drift. Rates brought low in turn brought the dollar all-time lower against the Euro, and brought in turn higher prices for all commodities denominated in dollars, not the least of which oil and jet fuel, which in turn added to the tab for moving all those other commodities around the globe (like, say, rice), and in turn added a fair bundle of digits to the bar codes at our local supermarket.  

So, yes, the Fed’s to blame for your grocery bill – what’s more , it knows it. To put a floor under the dollar and maybe start it back up again, the Reserve Bank seems to have been in touch with its designated leaker this midweek leading to a very prominent story in Rupert Murdoch’s latest acquisition to the effect that the coming Fed meeting may indeed produce  the “one and done” signal on interest rate policy that the inflation hawks (read dollar bulls) have been waiting for. And the well-timed leak did the trick: dollar  up, gold down, and only a little popgun play with the Iranian version of McCale’s Navy (we don’t yet have McCain’s) kept oil from slinking back to the more decent levels –  say, $115, which passes for decency these days.  

So before the new backbones at the rating agencies put the US dollar on credit watch with negative inplications, watch for the Fed to send some signal that, having demonstrated their quick draw proficieny with interest rate cuts, the gun may be back in the holster a while because the credit markets seem to be turning peaceable and any more gunplay might just provoke a run on the US dollar bank, not to mention a worsening  case of rice hoarding. When Costco starts putting a limit on what you can truck out of the place, you know something is seriously amiss!

Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.

As the story unfolds of the Federal Reserve’s action in what appears to be a $30 billion insurance policy written in favor of JP Morgan (with no premium payment but with a $1 billion deductible), more pressure mounts on Congress and the Bush Administration to provide direct relief for the diffused but nonetheless “systemic” risk in the US-based (but globally impactful) mortgage market.

Indeed, there was no “bailout’ of Bear Stearns; rather, a burial, with a $10 eulogy. And there was no bailout of JP Morgan or Wall Street, either. But there was Federal aid, and plenty of it, because the financial hazard to the system was worse than the “moral” hazard of providing relief

The same treacherous conditions remain in the mortgage market. Not moving to aid distressed mortgagors with incentives for financial institutions to write down their mortgages to below the relevant homes values (no worse a travesty on the free market than, say, re-valuing stock options grants for executives that went under water with stock price declines) only defers further the needed restart of the securitization market for mortgage debt generally. The revival of the securitized secondary market, in turn, is a prerequisite to return the US housing market back to a growth path.

So enough of the purist posturing about not rewarding speculators with government financial props — we do that in the oil drilling market every day of the week and twice on Sundays!  

Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.

Is this the week that the Fed destroyed the bear stearns village in order to savbe it  — or vice versa? 

On Tuesday, the Federal Reserve announced a new, unprecedented arrangement to provide credit in the form of Treasury securities against discounted mortgage-backed collateral  of up to $200 billion that would be available to broker-dealers,  as distinct from lending to banks through the Reserve Bank’s “discount window” and previously announced and executed special auctions also limited to commercial bank participants.

In retrospect after Friday’s emergency action to provide a loan of undisclosed size to Bear Stearns to keep the firm temporarily afloat through the intermediary of J P Morgan,  it seems apparent that the Tuesday plan was designed to help one particular broker-dealer — namely Bear Stearns —  to deal with the seriously adverse balance sheet consequences of hedge-fund positioning gone awry in terms of the rapidly-widening spreads between Treasury securities and mortgage-backed issues: ie, it seems that it was the Bear that was holding the bag! 

But what if some discerning market participants didn’t really need to wait until Friday to figure that out? And what if these participants, understanding that the first availability of the credit facility announced by the Fed on Tuesday was not to come until the end of this month, smelled enough Bear Stearns blood in the water — as a result of the Fed’s own announcement — to call in their credit lines to that firm in such a fashion that Thursday night’s funding crisis for Bear was the result?

If that is the case, then the Fed woke up Friday to an emergency that it had perhaps itself unwittingly abetted with an all too obviously telegraphed pass that sent a message to Bears’ creditors to “get out while the getting’s good”?

As for Bear Stearns, it now looks like putting a couple billion of the firm’s albeit modest capital into their hedge funds caught in the subprime squeeze last July might have been a cheap price to pay to live to trade another day.

Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.

The Chairman of the Federal Reserve spoke truth to Paulson this week. Acknowledging the depth of the housing finance crisis (and, like his predecessor, acknowledging the limitations of Fed rate cuts in terms of solving the problem),  he directly countradicted Bush Administration policy and urged bankers to accept the reality that they are better off haircutting the principal of underwater mortgages than triggering foreclosures of those mortgages.

The banks would thus not be forced into steep write-offs immediately but only the more minor haircuts involving the excess of mortgage amount over current house price value, and could also move to secure a first-in-line claim on any subsequent price appreciation to claw back the haircuts at a time of later sale

Bernanke was in effect saying that the moral hazard involved in bailing-out the balance sheets of both improvident mortgagors and mortgagees in this manner is less damaging to the economy as a whole than a period of steeper write-downs in the banking industry, a collapse of mortgage credit altogether, and a resultant severe economic contraction that even lower Fed funds rates will be too late to stop. His is neither a Japanese solution to a real estate meltdown (leave the sorry loans on the books too long) or the doctored accounting solution that propped-up the S&L industry in the US in the 80’s well-past its “use-by”‘ dates. His suggestion involves real pain, but more controlled pain — tiring to the body perhaps like targeted radiation, but not sickening altogether like the chemotherapy of excessive rate cuts that also debase the currency and trigger further commodity inflation  (at least until that boom is busted by the realities of recession).

Yes, he is making a policy suggestion that to some degree would takes pressure off the Fed  –not to mention the declining US dollar, which could firm if the Government acted to facilitate Bernanke’s barber-shop move. But the Government shows no sign of doing so — especially by authorizing more Federal agency  mortgage purchases and guarantees.

It is therefore quite possible that the inter-meeting rate cut device employed in January to stave off a capital markets rout will be back on the table — maybe as early as this Friday or Monday morning. There is just too much panic in the US capital markets since Bernanke called the question on the underwater mortgage mess, further illustrated by this week’s figures on increased foreclosures and home equity value deterioration. One thing the economy cannot stand is a stock market crash on top of a credit crunch.  

Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.

If you want to understand why the meltdown of the credit securitization market is so central to everything that is going on with the economy in the US today, imagine this: All the cellphone towers in the world simultaneously go off. Sure, many of us could get by reverting to landlines and payphones (if there are any left on a corner or two). But those on the fringes who connect with the rest of the world only by their mobile phones would be totally left out. And the pace of commerce generally would be radically curtailed.

Interest rate cuts and stimulus packages are well and good for building a fire break against recession, although the timing is a bit “last minute”. This economy now just needs a pacemaker, but if one doesn’t get implanted soon enough, it will need the paddles! But even more central is a restoration of market trust in the securitization process.

And restoration of trust cannot come until bond insurer financial footings are stabilized to the point where we do not have a ratings downgrade that sets in motion a chain reaction spreading through the municipal bond market and all the investment classes and state and local budgets that depend on their stability.

This risk is even more pronounced as the rating agencies themselves seek to regain their lost honor (due to the subprime ratings fiasco). The agencies may be tempted to re-assert their “independence” by ending their forebearance on the bond insurers’ ratings while regulators and financiers struggle to find a formula to fix the elemental problem caused by the insurers themselves investing way too much in the very dicey securities they were supposed to be insuring!

The financial markets will only stabilize and turn upwards when there is clear and convincing evidence that Central Banks across the globe are fundamentally in poliy alignment with respect to the global implications of the credit crisis especially in securitization. (They need not all have the same interest rate policies or levels, of course; they just need to show they recognize how serious the risk is, as Josef Ackerman of Deutche Bank observed just today.)

In addition, markets need a sense that those concerned have their arms around the bond insurance mess and see a way forward independent of what may or may not be the investment decisions of Warren Buffett and Wilbur Ross (not that there’s anything wrong with their investment decisions…it’s just that it’s not their job to save the economy).

Then and only then, slowly but surely, can the capital markets begin to resuscitate, issue by issue, the securitization process that served us all so well for the past three decades since the S & L crisis (a pre-globalization matter, thank goodness) and that only recently were systemically corrupted by rampant greed.

Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.

Thank you Microsoft for rescuing us all from a downer of a January jobs report last Friday, giving us time to reflect on the fact that the main thing we really know about that jobs report, like the 4th quarter 2007 GDP estimate released a couple days earlier, is that it is probably materially wrong, if recent history is any guide.

Indeed, the same news release corrected the modest 18,000 net job additions count first announced for December to over 80,000 (about 400% outside what the political polsters call the “margin of error”)!

Funny how we have much tougher standards for political pols than supposedly useful government data, on release of which we are prepared to make and lose billions in market value. Imagine how the markets would have reacted earlier in January to  a December jobs report showing an 80,000 gain; would we have started the year with the same sharemarket swoon? So let’s see next what the update in late February will bring to the aenemic GDP estimate. Remember that most actual data for December was not referenced in the .6% positive figure.

But back to the Microsoft bid for Yahoo to challenge Google’s search and ad dominance — or, as this event is otherwise known around these parts, the Stanford intramurals! It has been raining a bit much in Silicon Valley lately, and we can use some good indoor games. (As intrmurals go, this one could be the Super Bowl!)

Now of course it’s a great time for MSFT to bid a 60%+ premium for YHOO with its share price dangling in the teens at the possible onset of a recession. YHOO can’t really blame its problems on the subprime mortgage crisis, but maybe the bid does signal something of a bottom in terms of big-cap technology and interet share prices, which have suffered in the recent market sell-offs linked to the mortgage and credit mess.

In the short run, there are serious competitive disruptions inherent in a hostile bid which, while even at a big premium, really provides only a quiet exit for those folks unlucky enough to enter the YHOO picture at around $28-30 per share not so very long ago. More thrilling indeed would be the prospect of a competing bid or two, but who has MSFT’s cash and market leverage to compete? But also YHOO turned down an approach at around $40per share not so very long ago, and may be anxious to seek out other courses than simply owning up to a blown call.

Enter Google: not likely as a direct bidder, as they might have more trouble with the Justice Department than MSFT will face. (Indeed, the MSFT offer’s timing suggests an effort to get antitrust scrutiny out of the way before the risk of a change in party controlling the Justice Department’s merger philophy come November.) But Google has much to gain from a protracted seize-up of both MSFT’s and YHOO’s creative juices in a proxy battle and tender offer contest. Meanwhile, GOOG may be able  structure a relationship with YHOO and certain of its offshore interests that could bring equivalent or better  value for patient YHOO shareholders.

The question of whether that patience will be forthcoming may hinge on geography: this bid is very much a “road game” for Microsoft in terms of Silicon Valley — and we notice that Stanford’s men’s basketball team beat both Washington and Washington State this weekend — on the road!