<blockquote>
'The misperception of mortgage Credit “moneyness” was the root cause of the crisis. The market perceived that Trillions of mortgage-related securities were a safe and liquid store of nominal value. This created the insatiable market demand for these debt securities that Wall Street so capably exploited. Supply and demand dynamics no longer applied, as Trillions of mortgage Credit was supplied at lower yields and easier terms. And greater mortgage Credit excess inflated home prices and economic output, further buttressing the perception that mortgage debt was Good Money. The markets’ fateful misconception – and a momentous breakdown in the market pricing mechanism - can be traced directly to Washington.
Going back to the 1994 bond market crisis, Fannie, Freddie and the FHLB had become the steadfast liquidity backstop for the mortgage/bond market in times of stress and speculator deleveraging. Especially during crisis periods, the GSEs enjoyed unlimited capacity to borrow cheap finance that they would then immediately redeploy to purchase mortgages, MBS, CMBS, ABS and other debt instruments (reliquefing markets). The implicit guarantee of federal government backing – a perilous market distortion tolerated by Houses of Congress, Administrations, financial regulators and Federal Reserve officials over the years – was instrumental in the GSEs amassing Trillions of debt. The long-standing U.S. national policy of promoting homeownership – and rising home prices – was fundamental to the perception of mortgage Credit “moneyness.”
Inflationism today dominates economic doctrine and policy - and has so for years. The view holds that the Federal Reserve’s manipulation of the general prices level moderately higher each year (say, a steady 2 to 3%) helps grease the economic wheels - while underpinning the value asset markets and system debt. Federal Reserve manipulation of interest rates and market interventions, as necessary, remains fundamental to ensuring requisite Credit system expansion and systemic stability. The Greenspan and Bernanke Federal Reserves convinced themselves that asset price inflation should be disregarded, as long as consumer prices remained well-contained. And their strategy for how they would deal with Credit system and asset price dislocations was communicated quite explicitly to the markets: “mopping up” would entail aggressively inflating system Credit as required to buttress asset prices, the general price level, and debt market stability. Deflation was THE scourge to be avoided at all cost.
The “inflationism” intellectual and policy doctrine was instrumental in forging a historic market distortion: the perception of mortgage Credit “moneyness.” Inflationism is the root cause of the recent crisis – and a rather lengthy list of debacles throughout history. Today, the same dangerous incongruity exits that throughout history has propped up inflationism when apparent failings should have led to this dogma’s collapse: Instead of inflationism being recognized as the problem – the force behind the boom and unavoidable bust - it is instead viewed as the solution. There is today virtually universal support for policies that would incite a rapid increase in stock market and real estate prices; rising employment, incomes and spending; and a brisk economic recovery. The common view today is that the greatest risk is to fail to inflate sufficiently.
...
...inflationism is really playing with fire.'</blockquote>
Money GoodBy Doug Noland
April 09, 2010
Source“I first recall learning of these super senior positions in the Fall of 2007… I learned that Citi’s exposure included $43 billion of super senior CDO tranches. The business and risk management personnel advised that these CDO tranches were rated AAA or above and had de minimis risk. My view, which I expressed, was that… these CDO transactions were not completed until the distribution was fully executed. That said, it is important to remember that the view that the securities could be retained was developed at a time when AAA securities had always been considered money good. Moreover, these losses occurred in the context of a massive decline in the home real estate market that almost no financial models contemplated, including the ratings agencies’ or Citi’s.” Robert Rubin, April 8, 2010, Financial Crisis Inquiry Commission (quoted by Reuters).
Mr. Rubin’s comment yesterday, “AAA securities had always been considered money good,” inspired my dive into a little money and Credit theory. Over the years, I’ve offered up the concepts of “moneyness of Credit” and “Wall Street Alchemy” as key factors nurturing the U.S. Credit Bubble. “Moneyness” is essential for a protracted Credit expansion. And Wall Street’s capacity to transform endless risky loans into trusted AAA securities was fundamental to the spectacular boom and bust.
First, a few definitions:
Credit: The creation of new liabilities/IOUs/financial claims that introduce additional purchasing power into the financial and economic systems.
Money: A “precious” financial claim; the very best Credit, perceived as a safe and liquid store of nominal value. “Money” is inherently dangerous because virtually insatiable demand creates a propensity for over-issuance.
Inflation: Increasing the quantity of money and Credit (not CPI)
Inflationism: The doctrine that a reliably moderate rise in the “general price level” promotes economic dynamism and financial stability. And, importantly, it is believed that any potential debt and post-bubble predicament can be rectified by additional government-supported credit expansion and resulting higher price level.
In yesterday’s testimony, Mr. Rubin stated that Citigroup’s AAA rated CDO securities did not garner attention at the company board level because they were viewed as safe – “money good.” Mr. Prince even defended the traders operating in these instruments, explaining that they – and everyone else – believed they were holding safe securities. Citigroup’s risk managers also avoided culpability, as their models at the time foresaw an extremely low probability of default with these mortgage securities (Mr. Rubin quoted a ratio “one in 10,000”). The regulators relied on similar models. Everyone’s models failed miserably.
From my vantage point, the Financial Crisis Inquiry Commission is making little headway when it comes to understanding the crucial factors that led to financial breakdown. The defensive Alan Greenspan certainly didn’t provide enlightened testimony. I would like to suggest an alternate approach. How about a few days of hearings examining issues specific to total mortgage Credit having almost doubled in just six years, to end 2007 at $14.5 TN. More specifically, how was it possible that the vast majority of this Credit was perceived - in the marketplace; by the rating agencies; by the regulators - as “money good”? A more conceptual analytic focus would get us much closer to appreciating key Credit system dynamics than a piecemeal grilling of policymakers and executives from Citi, AIG, Lehman, Bear Stearns, the GSEs and the like.
Mr. Greenspan and others have eagerly pointed fingers directly at the rating agencies. They remain an easy target. But how could their – and Wall Street’s - risk models have failed so spectacularly? Well, it’s because there was nothing fed into these models over the past couple decades that would have suggested acute systemic vulnerability. Not since the Great Depression had there been the degree of home price collapse that would significantly impair the structure of U.S. mortgage finance (Clearly our adept policymakers would never allow another depression). For decades, national home prices rose only higher and higher. And, repeatedly, the occasional bout of financial tumult would lead predictably to aggressive Fed rate cuts and resulting lower mortgage rates, renewed housing inflation and economic expansion.
The misperception of mortgage Credit “moneyness” was the root cause of the crisis. The market perceived that Trillions of mortgage-related securities were a safe and liquid store of nominal value. This created the insatiable market demand for these debt securities that Wall Street so capably exploited. Supply and demand dynamics no longer applied, as Trillions of mortgage Credit was supplied at lower yields and easier terms. And greater mortgage Credit excess inflated home prices and economic output, further buttressing the perception that mortgage debt was Good Money. The markets’ fateful misconception – and a momentous breakdown in the market pricing mechanism - can be traced directly to Washington.
Going back to the 1994 bond market crisis, Fannie, Freddie and the FHLB had become the steadfast liquidity backstop for the mortgage/bond market in times of stress and speculator deleveraging. Especially during crisis periods, the GSEs enjoyed unlimited capacity to borrow cheap finance that they would then immediately redeploy to purchase mortgages, MBS, CMBS, ABS and other debt instruments (reliquefing markets). The implicit guarantee of federal government backing – a perilous market distortion tolerated by Houses of Congress, Administrations, financial regulators and Federal Reserve officials over the years – was instrumental in the GSEs amassing Trillions of debt. The long-standing U.S. national policy of promoting homeownership – and rising home prices – was fundamental to the perception of mortgage Credit “moneyness.”
Inflationism today dominates economic doctrine and policy - and has so for years. The view holds that the Federal Reserve’s manipulation of the general prices level moderately higher each year (say, a steady 2 to 3%) helps grease the economic wheels - while underpinning the value asset markets and system debt. Federal Reserve manipulation of interest rates and market interventions, as necessary, remains fundamental to ensuring requisite Credit system expansion and systemic stability. The Greenspan and Bernanke Federal Reserves convinced themselves that asset price inflation should be disregarded, as long as consumer prices remained well-contained. And their strategy for how they would deal with Credit system and asset price dislocations was communicated quite explicitly to the markets: “mopping up” would entail aggressively inflating system Credit as required to buttress asset prices, the general price level, and debt market stability. Deflation was THE scourge to be avoided at all cost.
The “inflationism” intellectual and policy doctrine was instrumental in forging a historic market distortion: the perception of mortgage Credit “moneyness.” Inflationism is the root cause of the recent crisis – and a rather lengthy list of debacles throughout history. Today, the same dangerous incongruity exits that throughout history has propped up inflationism when apparent failings should have led to this dogma’s collapse: Instead of inflationism being recognized as the problem – the force behind the boom and unavoidable bust - it is instead viewed as the solution. There is today virtually universal support for policies that would incite a rapid increase in stock market and real estate prices; rising employment, incomes and spending; and a brisk economic recovery. The common view today is that the greatest risk is to fail to inflate sufficiently.
It’s fine that the Financial Crisis Inquiry Commission is holding scores of hearings. But it is battling the last war. AIG, the Wall Street firms and the banks will not be the instigators of the next crisis. Today’s excesses and makret distortions are not conjoined with “Wall Street Alchemy” or the “moneyness” of private-sector Credit. Inflationism and its market distortions are not these days promoting ridiculous behavior by our financial sector executives. Today’s abuses and market distortions go to the heart of “money.”
The greatest danger posed by the Wall Street/mortgage finance Bubble was that its bursting would incite a policymaker response with the potential to destroy the Creditworthiness of our entire Credit system. Gross lending and speculating excesses destroyed the “moneyness” of private-sector Credit. Now, aggressive “mopping up” policies that inflate of Trillions of government debt securities, obligations and guarantees nurture new market distortions and Bubble Dynamics.
Despite alarming financial vulnerability, state and local governments continue to pile on debt at incredibly attractive terms. In spite of underlying financial and economic fragility, junk debt issuance is running at record pace. Inflows continue to inundate bond funds - at home and abroad. Estimates now put hedge fund asset as high as $2 Trillion by the end of the year. Retail stocks are not far away from record highs. Risk premiums are narrow throughout.
The massive issuance of government “money” has always been inflationism’s trump card. It’s now in play, and this latest round of inflationism is again profoundly distorting market perceptions. “Too big to fail” has broadened from large financial institutions to encompass the entire system. Today, GSE obligations and municipal debt enjoy “moneyness” only because of the markets’ belief that Washington will not tolerate disruptions in these key markets. Risk premiums throughout the corporate debt market have collapsed on the back of the view that massive stimulus ensures economic growth and strong company balance sheets. Throughout the risk markets, prices are bouyed by confidence that the Fed will restart monetization operations in the event of any market liquidity disruption. Hedge funds and other speculators are thriving once again as they successfully exploite Washington’s inflationary policymaking. Washington is there with ongoing massive fiscal stimulus, ultra-low interest rates, and a liquidity backstop.
I noted above that “‘Money’ is inherently dangerous because virtually insatiable demand creates a propensity for over-issuance.” There is a second fundamental danger inherent in “money:” A loss of confidence immediately incites a very disruptive systemic dislocation. If you can’t trust money, what can you trust? No trust – no functioning Credit system or stable economy. Indeed, you really don’t want to mess with “money.”
Importantly, you don’t want to allow distortions in money perceptions to establish a foothold. Such distortions are always and everywhere the lifeblood of Bubbles. Above all, you certainly don’t want to finance a massive inflation of non-productive debt with “money.” This only ensures a problematic widening gulf between perceptions of safety and liquidity and the actual deteriorating underlying soundness of these financial claims. And when the inflation of this money is also distorting market perceptions for Credit and asset prices throughout the entire system, inflationism is really playing with fire. Money Not Good.