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John Hussman: Imagine

The latest from John Hussman

June 20, 2016 | About:

Imagine the collapse of an extended speculative tech bubble, resulting in a broad economic recession. Imagine if the Federal Reserve had persistently slashed short-term interest rates during the downturn, to no avail, leaving rates at just 1% by the time the Standard & Poor's 500 had lost half of its value and the Nasdaq 100 collapsed by 83%. Imagine that the Fed kept rates suppressed, in the initially well-meaning hope of encouraging lending, growth and employment. Imagine that the depressed level of interest rates made investors feel starved for yield and drove them to look for safe alternatives to Treasury bills.

Imagine that investors found the higher yields they sought in mortgage securities, which had historically always been safe, and that Fed policy inadvertently created voracious demand for more of that debt. Imagine Wall Street had weak enough requirements on capital and underwriting standards that financial institutions had an incentive to create more “product” by lending to borrowers with lower and lower creditworthiness. Imagine that by the magic of “financial engineering” and lax oversight of credit ratings, Wall Street could pass these mortgages off to investors either directly by bundling, slicing and dicing them into mortgage-backed securities or by piggy-backing on the good faith and credit of the government by transferring them to Fannie Mae (FNMA) and Freddie Mac (FMCC) in return for funds obtained from investors in these “agency” securities.

Imagine that this Fed-induced yield-seeking speculation changed the dynamics of the housing market, and produced a bubble in home prices, coupled with overbuilding and malinvestment. Imagine that the Federal Reserve, focused exclusively on exploiting the very weak links between monetary policy and its “mandates” of employment and price stability, ignored the phrase “long run” in those mandates and wholly disregarded the speculative effects of its actions, which any thoughtful central banker should have viewed as a significant risk to the long-run economic health of the nation. Imagine that the then-head of the San Francisco Federal Reserve, Janet Yellen, answered questions about 1) whether speculative risks existed, 2) whether the Fed had any role in addressing them and 3) whether there was any doubt that the Fed could halt a resulting economic downturn if it occurred, responding with a dismissive “No, no and no.”

Imagine that this second speculative bubble collapsed anyway, producing the worst economic downturn since the Great Depression, and that persistent easing by the Fed failed to stop any of it, just as it failed to do so during the preceding collapse. Imagine that the Fed violated the existing provisions of section 13.3 of the Federal Reserve Act (later rewritten by Congress to spell it out like a children’s book) and created off-balance sheet shell companies called “Maiden Lane” to take bad assets off the ledgers of certain financial institutions in order to protect the bondholders of those companies and facilitate their acquisition by purchasers. Imagine that the crisis continued, and that what actually ended the crisis was a change in FASB accounting rules in the second week of March 2009, which relieved the need for financial institutions to mark their distressed assets to market value, and instead allowed them “significant judgment” in valuing those assets, instantly removing the specter of widespread financial insolvencies with the stroke of a pen. Imagine that legislation following the crisis was heavy on paper regulation, signed assurances and living wills but was light on capital requirements and contained provisions that essentially tied the hands of the FDIC and instead gave veto power to the Treasury and the best friend of the banking system, the Federal Reserve Board itself, in deciding whether a “too-big-to-fail” bank would actually go into receivership (where bondholders often lose money, but depositors are protected) if it was to become insolvent.

Imagine that in response to the collapse of a yield-seeking mortgage bubble, a resulting global financial crisis, and a 55% collapse in the S&P 500, the Federal Reserve insisted on pursuing more of what created the bubble in the first place: refusing to admit the weak cause-and-effect relationship between monetary easing and the real economy, pushing interest rates to zero and expanding the monetary base to the point where $4 trillion of zero-interest hot potatoes constantly had to be held by someone in the financial markets. Imagine that, despite pursuing this experimentation for years, the response of the real economy was no different than could have been predicted using prior values of nonmonetary variables alone. Imagine that the main effect of this unprecedented intervention was to drive the most reliable measures of stock market valuation (those best correlated across history with actual subsequent 10- to 12-year market returns) well beyond double their historical norms, and that it prompted massive issuance of low-grade, “covenant lite” debt, in much the same way yield-seeking speculation encouraged the issuance of low-grade mortgage debt in the preceding bubble.

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Domi99domi - 4 years ago    Report SPAM

Who does still listen to this perma Bear?

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