FOMC Holds Target Rate Near Zero With Explicit Inflation Targeting

On January 28, 2009 the US Federal Open Market Committee (FOMC) announced that it planed to keep the target rate between zero and ¼ %. The announcement comes in the wake of the continuous stream of weak economic news. The low rate is likely to persist well in to 2009 with the committee noting that it anticipated a slow turnaround with considerable downside risks. It appears the FOMC is concerned with the low inflationary environment, noting that inflation remains below the sufficient level for strong economic growth. The Fed is concerned that the US will enter a deflationary environment similar to that of Japan in the 1990’s.

The Fed is officially targeting an inflation range of 1.5-2.0% per the FOMC’s semiannual report to lawmakers. Ben Bernanke is a proponent of inflation targeting having co-authored the book “Inflation Targeting: Lessons from the International Experience.” The book highlights a few key benefits of inflation targeting, (1) countries achieve lower inflation rates and lower inflation expectations, (2) price shocks have a reduced impact on sustained inflation; (3) lower nominal interest rates as a result of lower expectations; (4) better transparency and public understanding of monetary policy; and (5) accountability for policy makers. Interestingly, Bernanke notes in his book that inflation targeting has become a popular tool for central banks as result of economists’ belief that monetary policy is not an effective tool for spurring the economy in the short-run.

The book presents three main reasons for the adoption of inflation targeting in the early 1990’s by a host of industrialized nations including New Zealand, Canada, and the United Kingdom. First, economists are less confident in monetary policies ability to alter short-run changes in the economy. Secondly, low stable inflation is required for sound economic growth and price stability is essential for imposing accountability on central banks. The book further points out a break-down in the trade-off between inflation and unemployment. If inflation inhibits economic growth, moderate-to-high rates of inflation may actual result in higher rather than lower unemployment rates.

Inflation targeting is a relatively new phenomenon, replacing former Fed Chairman Alan Greenspan’s FOMC tool of interest rate targeting informally re-enacted in mid-1980’s (potentially as early as October 1982). Interest rate targeting through the fed funds rate was the result of Greenspan’s assertion there was not a stable relationship between the borrowed reserves and the fund rate. The Fed now believes explicit inflation targeting is the best tool to mitigate the delicate balance between (1) a deflationary (Japan 1990s) economy and (2) an inflationary (US 1970s) economy. The Fed has aptly phrased the paradox as the Two-Headed Dragon.

No bailout for Blago

Rod Blagojevich, the Illinois Governor accused of attempting to sell President Barack Obama's vacated Senate seat, just can't catch a break. While the government is busy bailing out everyone in site, page 14 of the recently introduced bailout bill tells Blago exactly what Congress thinks of him:

1 SEC. 1112. ADDITIONAL ASSURANCE OF APPROPRIATE USE
2 OF FUNDS.
3 None of the funds provided by this Act may be made
4 available to the State of Illinois, or any agency of the
5 State, unless (1) the use of such funds by the State is
6 approved in legislation enacted by the State after the date
7 of the enactment of this Act, or (2) Rod R. Blagojevich
8 no longer holds the office of Governor of the State of Illi
9 nois. The preceding sentence shall not apply to any funds
10 provided directly to a unit of local government (1) by a
11 Federal department or agency, or (2) by an established
12 formula from the State.

The impeachment process is proceeding apace in Illinois, but can not conclude this sad debacle fast enough...

(Hat Tip: Sid Shenai for finding this text in the 647 page H.R. 1 document)

Revisiting the Securities that Caused the Meltdown

Now that the country is headed for, in the best case, a pretty terrible recession it is perhaps a good time to look back and reflect on the housing bubble that really perpetrated this current mess.

The origins are easy enough to understand: cheap credit and a society whose government which was pushing home ownership, even on to those who could not afford it. What is not as well understood is how these toxic assets, mortgages to less than credit worthy borrowers, spread their way through the financial system and past safeguards the government had put in place in order to protect the solvency of the banking and insurance system.

The main culprit in this story is the vehicle known as a Collateralized Debt Obligation, or CDO. Every loan, in addition to having a certain yield, also has a certain idiosyncratic probability of default. This, in turn, translates into a credit rating assigned by a rating agency, which are then relied upon by the constituents which make up the financial system in order to properly guage the risk of the assets on their balance sheets. A CDO is a pooling of these loans, designed to take advantage of the fact (assumption is perhaps more appropriate) that the defaults of these instruments are not correlated, and therefore a portion of these assets become more valuable than if they were owned individually.

Take a simple example: if there are two $1 bonds in a pool and each has a 50% probability of default, the expected value of the pool is $1. If the defaults are uncorrelated, there is actually only a 25% chance that (50% times 50%) that pool will be worth $0. Said another way, there is a 75% chance the pool will be worth at least $1. Is the first $1 of the pool not worth more than the second dollar of the pool? Is the first $1 of the pool not worth more than each of the underlying assets? That is the ultimate logic behind the CDO. Thus, the first $1 of the CDO would be sold to an investor as a highly rated instrument (a senior tranche), and the second $1 of the CDO would be sold as something rated closer to junk status (a junior tranche).

There are ways here to rinse and repeat. One can imagine a scenario where there have been several hundred or even several thousand CDOs created in this manner, all with more assets and more tranches than the simple example above. Is it not possible to take junior tranches from a set of these uncorrelated CDOs, pool them together, and then engage in the same process as above? In fact, this is what the investment banks did when they created Collateralized Mortgage Obligations, or CMOs. Obviously, the supply did not exist in a vacuum. In an easy credit environment, yields were at all-time lows, and many institutions were clamoring to find new assets which were highly rated (to satisfy internal or external risk management) and promised better yields than those that were traditionally available.

So what went wrong? Let's revisit our assumptions. It turns out that the mortgages that made up the underlying asset pool were correlated. Most of the speculative home buying (which provided the supply of assets) were actually taking place in three major geographies: California, the Southwest, and Florida. Additionally, in the face of a severe economic event (see financial crisis, or asset bubbles bursting) most assets are correlated. One observes this phenomenon where asset prices everywhere more or less mirror the US equity market in severe negative events. Furthermore, many of the mortgages themselves may not have been priced properly due to lax origination standards and outright fraud. If one takes the simple CDO above, perfect correlation means that both tranches are actually worth exactly the same. In some sense, the "AAA" rated structured credit instruments are nowhere near investment grade status, while the lowest tranches of those same instruments may have actually been priced fairly attractively.

Thus, by the time everything was said and done, the market for purchasing these AAA rated securities had dried up, and the underwriting investment banks ended up holding these as assets on their own balance sheets. These securities were marked to market one fated day last fall, and the rest, as they say, is history.

For a more in-depth read, refer to this working paper by Joshua Coval, Jakub Jurek, and Erik Stafford. Josh and Eric are on the faculty of the Harvard Business School, and Jakub is on the faculty of Princeton University.

Ranking State Recession Risk

The unending drumbeat of comparisons between today’s crisis and the Great Depression has helped to foster a sense of shared apocalypse, a constant reminder that we are all chained to the oars of the same sinking ship. While it is true that a devastating economic depression would eventually sink the entire country, the unfortunate reality is that one part of the boat would go under first.

Last Thursday the Wall Street Journal published an article that broke out TARP handouts (née “investments”) on a state-by-state basis. Not surprisingly, the states that play host to the headquarters of large banks were the biggest winners. New York led all states with roughly $80 billion in TARP receipts, nearly $30 billion more than the next two states combined (North Carolina and California). As lawmakers begin drafting legislation to hand out more than a trillion dollars to other troubled industries, many questions remain unanswered. How should recipient industries be chosen and compared against each other? How should the disbursements be structured? What kinds of demands can/should the government make?

Perhaps most importantly, what is the metric by which the success of this stimulus package should be judged? One might be tempted to throw out macroeconomic measurements like U.S. GDP growth, the unemployment rate or even the stock market. But a 1% growth in GDP will not constitute success if it results from the average of 3% growth in the Southwest and a 2% decline in the Midwest, nor will surging employment in Houston offset the socio-political impact of emptying Detroit. Success will be measured on how the stimulus package helps those regions, states and communities that are bearing the brunt of this recession.

So which states are on the sinking end of the boat? One approach is to look at state GDP by industry, and stack rank the economic risk based on composition. Starting with the industry classifications provided by the Bureau of Economic Analysis these industries can be further grouped into three buckets based on their level of economic risk in the current global environment:

At Risk: Each recession has its particular victims and this one is no different. The Real Estate, Construction, Financial Services and Automotive sectors have been the hardest hit so far. State and Local government spending has also suffered mightily, as elected leaders try to cope with a collapse in property tax rolls and a frozen market for public debt. As in any recession, General Manufacturing has severely retracted, as has the Travel and Entertainment industry.

Neutral: A number of industries are bound/cursed to follow the general direction of the economy, even if they aren’t leading the way into a recession. These include Media, Professional Services, Technology/Software, Publishing, Transportation/Warehousing. This high beta-ness applies to general retail sales as well. Given the confluence of this crisis and the turnover in the national government, consumers are still holding their breath, and will closely follow the recovery of at risk sectors.

Safe: While nearly every industry eventually feels the negative effects of a recession, some industries are relatively insulated by nature. These include utilities, education, health care, mining, oil/gas production and last but certainly not least….federal spending. In a stark contrast to the dustbowl Great Depression, the agricultural sector remains remarkably stable.

Using these classifications, one can create a “Recession Risk Index” to apply to each state based on their industry mix. This Index measures the proportion of a state’s economic output comprised of at risk industries, adjusted for the cushion provided by safe or countercyclical industries. The calculation is straightforward:

(% of GDP made up of “At Risk” industries) – (% of GDP made up of “Safe” industries)

For full data results, click here

The results, displayed on the map below, serve as a directional if not scientific approach for disbursing bailout funds. EVERY state will be dragged down into the abyss of a protracted recession, but those states in red and yellow will sink first and fastest. They have greatest exposure to industry risk and the least amount of protection provided by diversification. If the bailout package is truly meant to be preventative, the approach above might be one worth considering.

As a brief aside on electoral politics, try comparing this map with that of the 2008 presidential election. Economic anxiety can be a powerful political lubricant for squeezing incumbents out the door.

High Risk: > 85th percentile

Moderate Risk: 50-80th percentile

Low Risk: 15-50th percentile

Very Low risk: <15th>