Sunday, August 31, 2008

Once upon a time in Jackson Hole

I was secretly hoping this year’s symposium at Jackson Hole would evolve into a hot-blooded feud—you know, like in mafia movies, when all the different gangs get together in a room, in the name of harmony and reconciliation, and end up slaying each other to pieces.

The setting was perfect: A menacing mountain, a year-long financial crisis, powerful central bankers, Wall Street high-fliers, renowned academics, eager journalists, a few stuffed bears. I could so vividly see bankers opening fire on rating agencies, hedge funds firing at their brokers, academics shooting at the Fed, Ben running to hide behind a bear, Chuck Prince—still dancing—caught in the crossfire, the IMF (as usual) watching… And, as bodies fell one by one, everyone turning to chase the Chinese.

But oh no.. This was an economists’ conference after all, where even the most belligerent attacks (like the one by the “colorful” Dutchman Willem Buiter) are met by responses as impassioned as “I respectfully disagree.”

Still, hints of “you should have known better” were indeed made, in the form of academic papers alluding to the possibility that, maybe, had we kept our eyes open while at the wheel, we might have not missed the dazing headlights of a giant truck coming towards us. Among the papers discussed was one by Hyun Song Shin and Tobias Adrian, which argues its case in language readable enough even for those who save their weekends for Martha Stewart’s Living.

Mind the dealers: Accordingly, in their conduct of monetary policy and pursuit of financial stability, central banks seemed to have missed out on an important channel of monetary transmission: The broker/dealers. These are firms that act as both brokers (that is, they execute buy or sell orders on behalf of clients for a fee); and as dealers (trading securities for their own account).

Now, in the (brave?) new world of originate-to-distribute banking, broker/dealers have played a central role in facilitating the securitization of pools of loans, including mortgages. Namely, by underwriting issues of, say, mortgage-backed securities, or by trading such securities for their own account. As such, they have been critical drivers of the overall supply of credit, notably for housing.

Dealers are “special” for a couple of more reasons: First they mark their assets to market, meaning that they tend to value their assets at their current market price rather than at face value. In contrast, “traditional” commercial banks have not historically marked their assets to market. Second, like most financial institutions, broker/dealers are highly leveraged (borrowing at short maturities in money markets to lend at longer terms and for less liquid investments) and their leverage is “procyclical”—it moves in tandem with their size of their assets. In other words, if the value of their assets grows, broker/dealers will borrow more, while if it falls they will seek to reduce their borrowing—or deleverage.

These features combined can give rise to “special effects” such as asset price bubbles or credit booms and busts. How so? Say asset prices rise for whatever reason. Then, broker/dealers’ assets increase in value, prompting them to raise their leverage: They borrow more and use the money to buy more assets. Their demand helps raise asset prices further, inflating the value of their balance sheets more, leading them to borrow even more and so on. An asset bubble is born… I’ll leave it to your imagination to see what happens on the way down.

Complicit in leverage: Where does the Fed come into this? According to the authors, one key driver of the expansion or contraction of broker/dealers’ balance sheets is the Fed funds rate--the Fed’s main policy rate. So by lowering interest rates, the Fed effectively encourages more dealer borrowing, contributing to the credit boom.

Is this a big… deal? Perhaps. Turns out that the dealers’ balance-sheet growth today has an impact on demand tomorrow—particularly on durables consumption and housing investment, which are arguably more sensitive to the availability of credit. Moreover, the increase of housing investment in response to dealers’ asset growth seems to be large and persistent (around three years). The implication would be that broker/dealers’ asset growth should enter into the Fed’s considerations when assessing the outlook of growth and price stability and sets interest rates.

Offering solutions: True to economists’ reputation, the explanation of what happened and/or what the Fed got wrong is not accompanied by definitive policy proposals. Wisely so. Not only are there caveats in the authors’ estimation process (which they acknowledge). It is also difficult to see how to incorporate leverage and asset-growth considerations into an operational rule for monetary policy. How would a central bank decide what is the optimal or sustainable level of leverage? As the IMF’s John Lipsky remarked, “the historical evidence suggests that there is a large structural component to rising leverage [… and that] separating structural and cyclical trends would seem to be quite difficult.”

While hesitant about definitive recommendations, the authors did dare to slip in a mini-bombshell… the idea that transparency in central banks’ communication of monetary policy can be harmful! The reason? Clarity in communication reduces uncertainty about the path of future short-term interest rates and encourages broker/dealers to lever up more and more. Ergo... greater ambiguity might help?? Ouch! Talking about collateral damage when you try to fix one problem and, in the process, you reverse all the benefits of a more transparent monetary policy, e.g. for firms’ productive investment plans.

Finally, the Fed funds rate is declared as “the most potent tool in relieving aggregate financing constraints” during times of distress due to a sharp pullback in leverage. Fair enough: Lower short-term rates would increase the profitability of financial institutions that borrow at short maturities and lend at longer ones. But hey, is that an implicit endorsement of the Fed’s swift 325-basis-point cuts? I hope not... (at least not yet!) Because if it were, we should beg for an analysis that takes into account not only financial stability, but those other things the Fed targets, like inflation and unemployment. Especially since some of these broker/dealer guys, SIVs and their likes might actually deserve to go bust.

So there you go. Looks like the Fed missed out on the truck but gets a pat on the back for its crisis management after the truck hit—far, very far, from the shoot-out I was eagerly anticipating. I guess for that I’ll have to wait for “Once upon a time in Jackson Hole”—the movie.

Glossary: broker, dealer, leverage, mark-to-market, face value, Once upon a time in America.

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