Why Greenspan's Defense is Wrong

Greenspan launched another defense of himself in the WSJ today.

The meat of his argument is below and here is the full article.

The second, and far more credible, explanation agrees that it was indeed lower interest rates that spawned the speculative euphoria. However, the interest rate that mattered was not the federal-funds rate, but the rate on long-term, fixed-rate mortgages. Between 2002 and 2005, home mortgage rates led U.S. home price change by 11 months. This correlation between home prices and mortgage rates was highly significant, and a far better indicator of rising home prices than the fed-funds rate.

This should not come as a surprise. After all, the prices of long-lived assets have always been determined by discounting the flow of income (or imputed services) by interest rates of the same maturities as the life of the asset. No one, to my knowledge, employs overnight interest rates -- such as the fed-funds rate -- to determine the capitalization rate of real estate, whether it be an office building or a single-family residence.

The Federal Reserve became acutely aware of the disconnect between monetary policy and mortgage rates when the latter failed to respond as expected to the Fed tightening in mid-2004. Moreover, the data show that home mortgage rates had become gradually decoupled from monetary policy even earlier -- in the wake of the emergence, beginning around the turn of this century, of a well arbitraged global market for long-term debt instruments.

U.S. mortgage rates' linkage to short-term U.S. rates had been close for decades. Between 1971 and 2002, the fed-funds rate and the mortgage rate moved in lockstep. The correlation between them was a tight 0.85. Between 2002 and 2005, however, the correlation diminished to insignificance.

This is disingenuous. First look at these two charts (fed fund rates and housing price index).

From FinancialSense.com So here is what really happened:

a) we had a huge asset bubble in the largest sector of the consumer economy

b) because the Greenspan Fed did not believe in targeting asset bubbles and because the way CPI measures housing is insane and because of deflationary effect of Chinese manufacturing

c) Greenspan was able to keep Fed Funds at historical lows for years, while pretending inflation was tame, which of course it was not - all the easy money inflation was pouring into housing

Greenspan says:

Fed funds and mortgage rates de-correlated because of global liquidity fueling the securitization chain so there was nothing we could do about it

Why this is silly, in reverse order of importance

a) They could have clamped down on lending by both depository and non-depository institutions that were fueling the bubble with idiotic or fraudulent products

b) i suspect the reason that the correlation between short and long-term rates disappeared is because short-term rates were trading in such a small and low range. If you take short-term rates to 5 or 6% they were in the 1990s, the 4-6% long-term mortgages are obviously going to disappear.

But Greenspan never felt he needed to do that because we had reached some new golden economic paradise where easy money does not cause inflation.

c) most important:

What exactly does Dr. Greenspan think was fueling the massive liquidity and chasing for yield from all the institutional investors that held down long-term rates, except the amazingly low fed fund rates. Given the savings glut and very low yields, financial "innovation" was inevitable.

None of these excuses the various parties (homeowners, originators, securitizers, buyers) from the varied and sundry stupid or fraudulent things that they did, but for the Chairman of the Fed, who is supposed to take the punch bowl away when party gets going, to say that there was nothing he could have done, well, that is plain ridiculous.

Thanks to Josh for bringing the article to my attention and Larry for noting that nobody gets a free pass in this debacle.

Berkshire Hathaway 2008

The most lucid annual reading in business has just come out. This was Buffett's worst year (down 9.6%), but he still crushed the S&P by over 27 points.

Page 1:

Our decrease in net worth during 2008 was $11.5 billion, which reduced the per-share book value of both our Class A and Class B stock by 9.6%. Over the last 44 years (that is, since present management took over) book value has grown from $19 to $70,530, a rate of 20.3% compounded annually.*

The table on the preceding page, recording both the 44-year performance of Berkshire’s book value and the S&P 500 index, shows that 2008 was the worst year for each. The period was devastating as well for corporate and municipal bonds, real estate and commodities. By yearend, investors of all stripes were bloodied and confused, much as if they were small birds that had strayed into a badminton game.

As the year progressed, a series of life-threatening problems within many of the world’s great financial institutions was unveiled. This led to a dysfunctional credit market that in important respects soon turned non-functional. The watchword throughout the country became the creed I saw on restaurant walls when I was young: “In God we trust; all others pay cash.”

By the fourth quarter, the credit crisis, coupled with tumbling home and stock prices, had produced a paralyzing fear that engulfed the country. A freefall in business activity ensued, accelerating at a pace that I have never before witnessed. The U.S. – and much of the world – became trapped in a vicious negative-feedback cycle. Fear led to business contraction, and that in turn led to even greater fear.

This debilitating spiral has spurred our government to take massive action. In poker terms, the Treasury and the Fed have gone “all in.” Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation.

Moreover, major industries have become dependent on Federal assistance, and they will be followed by cities and states bearing mind-boggling requests. Weaning these entities from the public teat will be a political challenge. They won’t leave willingly.

Whatever the downsides may be, strong and immediate action by government was essential last year if the financial system was to avoid a total breakdown. Had that occurred, the consequences for every area of our economy would have been cataclysmic. Like it or not, the inhabitants of Wall Street, Main Street and the various Side Streets of America were all in the same boat.

Amid this bad news, however, never forget that our country has faced far worse travails in the past. In the 20th Century alone, we dealt with two great wars (one of which we initially appeared to be losing); a dozen or so panics and recessions; virulent inflation that led to a 211?2% prime rate in 1980; and the Great Depression of the 1930s, when unemployment ranged between 15% and 25% for many years. America has had no shortage of challenges.

Without fail, however, we’ve overcome them. In the face of those obstacles – and many others – the real standard of living for Americans improved nearly seven-fold during the 1900s, while the Dow Jones Industrials rose from 66 to 11,497. Compare the record of this period with the dozens of centuries during which humans secured only tiny gains, if any, in how they lived. Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America’s best days lie ahead

Full report here in PDF format:

2008 Berkshire Hathway Annual Report

30+ years of great reading at BerkshireHathaway.com

Range Rovers vs. Equity

The best investment story of 2008 relates to a banker who had a modest shareholding in his employer – a storied investment bank. Upon being transferred to London, he sold the stock to finance a Range Rover. As business in London turned down, the banker was transferred to Dubai. When selling his Range Rover, he suffered a loss of around 50% of the price he paid barely six month ago. The interesting thing was that the proceeds from the sale of the car (despite the 50% loss) would have allowed the banker to purchase five times the number of shares he sold to finance the car. 2008 is perhaps the only year on record in which a distressed price for a Range Rover outperformed equities.

From Satyajit Das

BoA Bailout

Reeling from previously undisclosed losses from its Merrill Lynch & Co. acquisition, Bank of America Corp. received an emergency capital injection of $20 billion from the Treasury, which will also backstop about $118 billion of assets at the bank, said people familiar with the plan.

Reports of the unexpected Merrill losses sent Bank of America shares to their lowest levels since 1991, and set off a new round of debate in Congress about the scope and mission of the Treasury's financial-system bailouts. Thursday's 18% stock-market drop gives the Charlotte, N.C., bank a market value of $41.8 billion, a sum below the $46 billion in shares it originally offered for Merrill.

From WSJ

As taxpayers are forced to digest the latest Wall Street-Treasury outrage--a secret bailout of Bank of America to the tune of $15 billion of capital and $120 billion of trash-asset guarantees--it's clear that, this time, someone has to be held responsible. And that someone is Bank of America CEO Ken Lewis.

....

Let's walk through the possibilities:

* If it didn't occur to Ken Lewis that Merrill might be forced to take additional "monstrous" writedowns (as he now reportedly describes them), he should be fired. * If it did occur to him and he didn't check this out during the due diligence process, he should be fired. * If he didn't think the global debt markets could continue to deteriorate to a level that required such writedowns, he should be fired. * If he fully expected the writedowns and just didn't realize what they would do to Bank of America's own stock price, he should be fired.

From Silicon Valley Insider