Point / Counterpoint


March 02, 2010
Joe Morgan and Jim Anderson (two pillars of our ISO commentaries) are actually pretty different. Joe grew up in Mississippi and Texas listening to Hank Williams and eating fried food. (Joe assures us you can "chicken fry" anything.) Jim spent his formative years in California as an aspiring leftist revolutionary getting "fried" at the beach (pre-SPF) and immersed in the melodies of Frank Zappa and Jimi Hendrix. Joe is at least a half foot taller than Jim. Jim has more gray hair (okay, more hair in general) although Joe is rapidly catching up on the silver-toned score.

They tend to agree on many political and economic issues, and, in the past, they've debated topics across the bond desk. More recently, however (since Jim's off the desk), their exchanges have become less frequent — relegated to e-mail banter or the occasional hallway encounter. At the request of loyal ISO readers, we decided to match up Joe and Jim and take a recent debate into the public domain.

Today's Topic: When and how fast should the Fed increase interest rates and why?

How Bernanke's Fed Lost Its Way
By Jim Anderson, Silicon Valley Bank

When the crisis hit, the Fed pulled every lever on their control panel to prevent a complete meltdown. Picture Homer Simpson in full panic at the controls of his nuclear power plant pulling every lever, pushing all the buttons and turning each dial as the sirens sound and red lights flash that the core is going critical. Like Simpson, Bernanke's Fed pulled a lot of levers that had never been touched before and some that many of us never knew existed. Now that the crisis has been averted, how can we tell which actions were important and which were extraneous or even misguided?

It is a long and bizarre list. The Fed guaranteed bad loans to facilitate a merger between a commercial bank and an investment bank. It quickly (over a weekend) approved banking charters for two huge investment banks. It guaranteed the quality of commercial paper and even committed to buy it in support of money market mutual funds. It bought over $1 trillion in assets from insolvent, government-sponsored financial entities (Fannie, Freddie et al). It put up $50 billion to support the government takeover of a failing insurance company. It entered into $600 billion in currency swaps to help finance struggling foreign banks. It doubled the amount of the money supply. It put so much cash into the banking system that free reserves have expanded one hundred times to over $1 trillion. Combined, these actions amounted to more than $8 trillion in cash, credit and guarantees.

Oh yes, and one more thing. The Fed dropped interest rates to zero.

So which policy actions were useful and important? Underlying that question is some understanding of the nature of the crisis. Was it a credit crisis, a liquidity crisis or a crisis of confidence? We contend that it all began with bad mortgage paper coursing through the veins of the global financial system and spreading disease. This dodgy mortgage paper created the crisis of confidence. Banks could not believe the quality of the balance sheets of their trading counterparties, in part because they had no confidence in the value of their own assets. The extended derivatives market, including credit default swaps, simply acted as an accelerant to the infection. Liquidity dried up because credit quality was suspect.

Interest rates were not a factor as we saw when Libor became unhinged from its traditional relationship with fed funds. You cannot turn a bad credit into a good one with lower interest rates. This we know for certain as mortgages restructured under assorted government programs have an alarming re-default rate (60 days past due after 90 days) of 18.7 percent. That means the defaulted borrower was able to make only one payment after their new loan closed.

So who is benefiting from the Fed's zero-rate policy? Not U.S. households. Mortgage rates have declined only modestly as the Fed went to zero. Credit card rates are still elevated because the risk is off the charts. Credit card charge-offs hit 14.5 percent at Bank of America late last year.

What about businesses? There is benefit as those with access to the bond market gain some advantage despite the record steepness of the yield curve. It is important to understand that these are refinancing benefits as very little new investment is taking place in such an uncertain environment. For most industrial companies a difference in rates of 100 or even 200 basis points is not going to make or break a decision to build a new plant or make an acquisition. The investments are long-term, whereas the interest rate situation is ephemeral. The risk and the returns on the investment are embedded in the quality of the project, not the cost of the financing.

So if households and businesses are not benefiting, who is? Entities that borrow a lot — banks and governments — are the key beneficiaries. A good portion of the giant leap in profits in the banking system has come from the carry trade of borrowing at zero and lending to Uncle Sam at 3 percent. Cash and Treasuries now equal over 30 percent of bank assets according to Barron's. While we certainly appreciate the need for the banks to make money and pay back TARP, this recapitalization process is probably complete.

So it is clear that the Fed's interest rate policy has been misguided. Today it is doing actual damage that is retarding the recovery. If at some level you believe that excessive leverage was a factor in the current financial dislocation, then households and business need to delever. (So do governments, but that is another story). Current market actions prove that households and businesses agree with this view. Why not help them along?

The Fed's current policy specifically punishes those attempting to get their financial house in order. Savers are paid zero. Worse, borrowers are encouraged to continue with the behaviors that brought us here in the first place. The policy impact benefits the biggest borrowers (governments) and punishes households and businesses who are struggling to put their balance sheets back on sound footing.

What should the Fed do now? They should immediately increase the fed funds rate to one percent and then begin a program of 25 basis point increases every meeting until they reach a decent positive after inflation return for savers — probably around 4 percent. In addition to helping savers, this would send very positive signals to the market.

Increasing rates would tell the world that the Fed has confidence in the eventual recovery of the U.S. economy. Higher rates would also tell those with U.S. dollar assets (notably China and Japan) that Chairman Bernanke is serious about keeping inflation at bay. Finally, it would increase the interest costs and the tax burden of the burgeoning federal deficit to the point that the emerging taxpayer revolt will carry a good portion of our 535 esteemed but innumerate public servants back to private life. We need to replace them with men and women in possession of some common sense.

Duck...Duck...Goose!
By Joe Morgan, SVB Asset Management


The Fed should begin raising interest rates in earnest in early 2011, once consumers have some vision of and confidence in both their wealth and job prospects. At that point, the Fed should aggressively raise rates more than one 75 basis point hike.

Last week, the Obama administration, along with Barney Frank, made it clear there will be no substantive reform of our mortgage market until much later this year or perhaps next.

First, Chairman Frank indefinitely delayed scheduled hearings on mortgage market reform that were specifically designed to discuss restructuring mortgage giants and wards of the state, Fannie Mae and Freddie Mac. The next day, Tim Geithner appearing before the House Budget Committee said the administration will delay release of its restructuring plan until 2011.

Putting off solutions only makes problems worse and I'm afraid the effect of the decimation of this market will only weigh more heavily on the consumer as we move forward through 2010.

Today, nine out of ten new mortgages involve some kind of government support and the U.S. government — through the Treasury, the Fed, Fannie and Freddie — owns the equivalent of about four in ten mortgages across the country. Seventeen months ago, the U.S. government owned nearly zero mortgages.

Given our desire for home prices to stay elevated to maintain mortgage demand, only a thriving private sector mortgage market in which capital is allocated based on free-market supply and demand factors will allow for housing prices to bottom. A government that allocates capital to potential borrowers in the housing sector will necessarily be based on short-term political goals, creating an unstable, unreliable and insufficient marketplace for home mortgages.

Consumers will see this volatility of debt support as a significant risk to their largest value asset — their houses — and will be forced to the sidelines. In an economy that is some 70 percent consumption, Bernanke should have no fear of potential inflationary pressures until the consumer can regain some confidence in their future wealth.

Until the government gets serious about handing the mortgage market back to the public sector, the Fed should remain on the sidelines holding rates at abnormally low levels to help offset these effects. However, once it becomes clear a consumer recovery is on the horizon, the Fed should act aggressively to raise interest rates and even "overshoot" to the high side for a time.

Considering a "glass half-full" approach, look for the Fed to raise interest rates aggressively in the first half of 2011, heading toward 5 percent or higher in 2012. If, however, we continue to delay dealing with our problem children, we could stay another full year in zero-land.


Investment Strategy Outlook
is published each week to highlight issues we hope you find relevant and topical. The views expressed in this newsletter are solely those of its authors and do not reflect the views of SVB Asset Management, Silicon Valley Bank, or any of its affiliates.