Yellen in Jackson Hole
Doug Nolan
“A resilient financial system is critical to a dynamic global economy -- the subject of this conference. A well-functioning financial system facilitates productive investment and new business formation and helps new and existing businesses weather the ups and downs of the business cycle.” Janet Yellen, “Financial Stability a Decade after the Onset of the Crisis,” August 25, 2017
I would add that a well-functioning financial system is critical to long-term social, political and geopolitical stability. Importantly, well-functioning finance would have mechanisms that promote adjustment and self-correction. This is fundamental to market-based systems. I would argue that this is also a basic premise of sound money and finance. Sound finance would neither suppress market volatility nor work to repeal business cycles - but would instead have inherent characteristics that counteract protracted market and economic excess.
For starters, I question whether a so-called “resilient financial system” is necessarily a sound one. As we have witnessed, obtrusive government measures can dictate “resilience” – in terms of extended sanguine backdrops free from volatility, risk aversion and crisis. Yet this type of resilience fosters excesses that can inevitably end with a financial and economic crash.
Ten years ago most would have argued forcefully that the system at the time was resilient.
I would add that a well-functioning financial system is critical to long-term social, political and geopolitical stability. Importantly, well-functioning finance would have mechanisms that promote adjustment and self-correction. This is fundamental to market-based systems. I would argue that this is also a basic premise of sound money and finance. Sound finance would neither suppress market volatility nor work to repeal business cycles - but would instead have inherent characteristics that counteract protracted market and economic excess.
For starters, I question whether a so-called “resilient financial system” is necessarily a sound one. As we have witnessed, obtrusive government measures can dictate “resilience” – in terms of extended sanguine backdrops free from volatility, risk aversion and crisis. Yet this type of resilience fosters excesses that can inevitably end with a financial and economic crash.
Ten years ago most would have argued forcefully that the system at the time was resilient.
Chair Yellen argues in her Jackson Hole paper that myriad regulatory changes have created a much more resilient financial system and economy. Her long speech highlights a laundry list of measures put in place since the crisis. Much to my liking, 22 footnotes include references to even Minsky, Kindleberger and Charles Mackay.
There was also footnote #2: “A contemporaneous perspective on subprime mortgage market developments at this time is provided in Ben S. Bernanke (2007), "The Subprime Mortgage Market," speech delivered… May 17 (2007).”
Looking back, chairman Bernanke presented a knowledgeable understanding of the subprime industry in 2007. His deeply flawed understanding of the macro backdrop was captured in a single sentence: “In general, mortgage credit quality has been very solid in recent years.”
Total mortgage Credit had doubled in less than seven years. Indicators of excess were everywhere. Inflation psychology had taken deep root throughout the nation’s housing markets, with California housing prices spiraling ever higher. The inflationary backdrop ensured a proliferation of new mortgage products that kept the game going with low monthly payments for prime and subprime borrower alike.
As someone who chronicled the mortgage finance Bubble in its entirety on a weekly basis, it was all too conspicuous. This was the most important market for finance (mortgages) and the real economy (housing and home-related) – that was dominated by the thinly capitalized GSE with their implied federal backing. It was a sophisticated financial scheme. Measures going back to the Greenspan era (bolstered by “helicopter Ben” musings) convinced the markets that the Fed would respond aggressively to avert market crisis. Surely, Washington would never allow a housing bust. It would simply be too devastating. In an irony of recent Bubbles, the greater they inflate the more convinced markets become that officials will not permit a bust.
What might explain Bernanke’s indifference to unprecedented mortgage and housing risks?
There was also footnote #2: “A contemporaneous perspective on subprime mortgage market developments at this time is provided in Ben S. Bernanke (2007), "The Subprime Mortgage Market," speech delivered… May 17 (2007).”
Looking back, chairman Bernanke presented a knowledgeable understanding of the subprime industry in 2007. His deeply flawed understanding of the macro backdrop was captured in a single sentence: “In general, mortgage credit quality has been very solid in recent years.”
Total mortgage Credit had doubled in less than seven years. Indicators of excess were everywhere. Inflation psychology had taken deep root throughout the nation’s housing markets, with California housing prices spiraling ever higher. The inflationary backdrop ensured a proliferation of new mortgage products that kept the game going with low monthly payments for prime and subprime borrower alike.
As someone who chronicled the mortgage finance Bubble in its entirety on a weekly basis, it was all too conspicuous. This was the most important market for finance (mortgages) and the real economy (housing and home-related) – that was dominated by the thinly capitalized GSE with their implied federal backing. It was a sophisticated financial scheme. Measures going back to the Greenspan era (bolstered by “helicopter Ben” musings) convinced the markets that the Fed would respond aggressively to avert market crisis. Surely, Washington would never allow a housing bust. It would simply be too devastating. In an irony of recent Bubbles, the greater they inflate the more convinced markets become that officials will not permit a bust.
What might explain Bernanke’s indifference to unprecedented mortgage and housing risks?
Well, his policy doctrine was at the heart of the problem: Dr. Bernanke had been a leading proponent for using mortgage finance to reflate the system after the bursting of the “tech” Bubble.
Yellen: “Repeating a familiar pattern, the ‘madness of crowds’ had contributed to a bubble, in which investors and households expected rapid appreciation in house prices. The long period of economic stability beginning in the 1980s had led to complacency about potential risks, and the buildup of risk was not widely recognized. …A self-reinforcing loop developed, …as investors sought ways to gain exposure to the rising prices of assets linked to housing and the financial sector. As a result, securitization and the development of complex derivatives products distributed risk across institutions in ways that were opaque and ultimately destabilizing. In response, policymakers around the world have put in place measures to limit a future buildup of similar vulnerabilities.”
As I’ve written in the past, I understand why officials did what they did back in the autumn of 2008. Clearly, they were not about to sit back and watch the system collapse. They would also not settle for mere stabilization. Their epic mistake was to push forward with aggressive reflationary policies – a global monetary inflation regime to which they remain entrapped nine years later. While post-“tech” Bubble reflation focused on mortgage Credit and housing, post-mortgage finance Bubble reflationary measures went much farther: reflate risk assets (equities, corporate debt and housing), collapse market yields and force savers out of the safety of deposits and money funds. It was the same flawed doctrine that had nurtured the “worst crisis since the Great Depression” – but on a much grander scale.
If there was the “madness of crowds” then, how about these days with Trillions flowing into passive ETFs, record corporate debt issuance, record securities and home prices, a proliferation of cryptocurrencies and a bubbling derivatives marketplace. So long as the Fed targets higher asset prices while repeatedly providing liquidity backstops, a culture of speculation becomes only more deeply entrenched.
Yellen’s speech makes repeated mention of “too big to fail” – and how policy measures have dealt with this leading element of the previous crisis. In reality, central bankers have ensured that “too big to fail” moral hazard has mushroomed from an issue with respect to large financial institutions to a critical facet afflicting global securities and derivatives market pricing.
Yellen’s speech, “Financial Stability a Decade after the Onset of the Crisis,” somehow doesn’t address the historic experiment with quantitative easing (QE). There’s no mention of the Fed (and global central banks) repeatedly responding to incipient market instability (with QE, an extension of monetary stimulus, or a postponement of “normalization”). The powerful doctrine of the Fed “pushing back against a tightening of financial conditions” is omitted from the discussion. The Fed chair largely avoids monetary policy altogether.
Bernanke had his “mortgage credit quality has been very solid…” For Yellen, it’s “evidence shows that reforms since the crisis have made the financial system substantially safer.” If the Yellen Fed believed as much, I doubt rates would be at 1.25% and their balance sheet would remain ballooned at $4.4 TN.
Yellen: “Investors have recognized the progress achieved toward ending too-big-to-fail… Credit default swaps for the large banks also suggest that market participants assign a low probability to the distress of a large U.S. banking firm.”
I would caution against calling out low bank CDS prices as evidence of progress toward ending too-big-to-fail. CDS is atypically low across the spectrum of corporate borrowers. Indeed, sovereign CDS pricing is unusually inexpensive around the globe despite a huge run up in debt loads (Italy 148bps!). And then there’s the historically low VIX that astute analysts argue has been disregarding risk. Low risk premiums across various asset classes - at home and abroad - are consistent with market perceptions that central bankers are committed to liquidity backstopping necessary to safeguard against another crisis. “Too big to fail” has never had such momentous market impacts.
Yellen: “Our more resilient financial system is better prepared to absorb, rather than amplify, adverse shocks, as has been illustrated during periods of market turbulence in recent years. Enhanced resilience supports the ability of banks and other financial institutions to lend, thereby supporting economic growth through good times and bad.”
Resilience over recent years has clearly been associated with concerted open-ended QE from all the world’s leading central banks. It would also appear that chair Yellen overly emphasizes traditional banking when referencing the “financial system.” “Banks are safer. The risk of runs owing to maturity transformation is reduced.”
It’s worth recalling that traditional bank runs were not much of an issue during the previous crisis. Traditional old Market Panic was. As they will do, long periods of market greed erupted into fear and panic. The acute issue was “repo” financing of large institutions financing MBS holdings – along with what a Wall Street liquidity crisis meant for the pricing of mortgage-related finance and the functioning of derivatives more generally. Investor panic was sparked by the loss of faith in the safety and liquidity of repo “money.” Yet the overriding issue remained the mispricing of Trillions of MBS and mortgage-related securities and derivatives. I’ve always argued that a repricing of mortgage debt – and risk more generally – was inevitable, and that major financial and economic repercussions were unavoidable. Bubbles are not forever.
There is no doubt in my mind that today’s issue of securities mispricing dwarfs the mortgage finance Bubble period. I also believe latent derivatives market-related instability (i.e. market “insurance”) also likely exceeds pre-2008 crisis levels. Less clear is where an acute liquidity episode could initially manifest. Lehman and the cadre of leveraged speculators borrowing in the short-term repo market to finance long duration mortgage securities was rather egregious.
Financial crisis typically erupts in the “money” markets. This is where risk is perceived to be minimal, yet it is at the same time the domain of aggressive risk intermediation that works to distort overall market dynamics. Throughout the mortgage finance Bubble period, “Wall Street Alchemy” transformed progressively riskier mortgages into endless perceived safe and liquid “money”-like instruments – “The Moneyness of Credit,” with the “repo” market at the epicenter of perilous risk distortions.
I have argued that unparalleled Fed and global central bank inflationary measures molded the “Moneyness of Risk Assets”. In particular, central bank backing ensured that inflating markets in equities and corporate Credit came to be perceived as low-risk stores of value. And with the proliferation of (perceived liquid) fund choices available in the marketplace (ETFs in particular), central banks coupled with Wall Street Alchemy achieved the incredible: the transformation of high-risk securities - with ever-rising prices - into perceived “money”-like instruments.
Returning to the above opening paragraph extracted from Yellen’s speech, I believe it is important to contemplate whether market resilience has been due to sound financial system structure or instead because of central bank-induced market distortions and liquidity backstops. If the latter, it is critical to appreciate that this extended period of “resiliency” has ensured cumulative financial distortions and Bubble Economy Maladjustment – on an unparalleled global scale. With tens of Trillions of mispriced securities globally, a painful bout of repricing is unavoidable.
We’ll see how resilient “the financial system” proves to be come the unmasking of risk market liquidity and safety misperceptions. It’s a curious discussion of “Financial Stability a Decade after the Onset of the Crisis,” that glosses over near zero rates, unending QE, Trillions of global debt securities trading with negative yields and the extraordinary expansion of the ETF complex. It recalls Alan Greenspan’s speeches - the reasoned analysis along with the intrigue of what went unsaid. For me, it’s disingenuous and lacks credibility.
Yellen: “Repeating a familiar pattern, the ‘madness of crowds’ had contributed to a bubble, in which investors and households expected rapid appreciation in house prices. The long period of economic stability beginning in the 1980s had led to complacency about potential risks, and the buildup of risk was not widely recognized. …A self-reinforcing loop developed, …as investors sought ways to gain exposure to the rising prices of assets linked to housing and the financial sector. As a result, securitization and the development of complex derivatives products distributed risk across institutions in ways that were opaque and ultimately destabilizing. In response, policymakers around the world have put in place measures to limit a future buildup of similar vulnerabilities.”
As I’ve written in the past, I understand why officials did what they did back in the autumn of 2008. Clearly, they were not about to sit back and watch the system collapse. They would also not settle for mere stabilization. Their epic mistake was to push forward with aggressive reflationary policies – a global monetary inflation regime to which they remain entrapped nine years later. While post-“tech” Bubble reflation focused on mortgage Credit and housing, post-mortgage finance Bubble reflationary measures went much farther: reflate risk assets (equities, corporate debt and housing), collapse market yields and force savers out of the safety of deposits and money funds. It was the same flawed doctrine that had nurtured the “worst crisis since the Great Depression” – but on a much grander scale.
If there was the “madness of crowds” then, how about these days with Trillions flowing into passive ETFs, record corporate debt issuance, record securities and home prices, a proliferation of cryptocurrencies and a bubbling derivatives marketplace. So long as the Fed targets higher asset prices while repeatedly providing liquidity backstops, a culture of speculation becomes only more deeply entrenched.
Yellen’s speech makes repeated mention of “too big to fail” – and how policy measures have dealt with this leading element of the previous crisis. In reality, central bankers have ensured that “too big to fail” moral hazard has mushroomed from an issue with respect to large financial institutions to a critical facet afflicting global securities and derivatives market pricing.
Yellen’s speech, “Financial Stability a Decade after the Onset of the Crisis,” somehow doesn’t address the historic experiment with quantitative easing (QE). There’s no mention of the Fed (and global central banks) repeatedly responding to incipient market instability (with QE, an extension of monetary stimulus, or a postponement of “normalization”). The powerful doctrine of the Fed “pushing back against a tightening of financial conditions” is omitted from the discussion. The Fed chair largely avoids monetary policy altogether.
Bernanke had his “mortgage credit quality has been very solid…” For Yellen, it’s “evidence shows that reforms since the crisis have made the financial system substantially safer.” If the Yellen Fed believed as much, I doubt rates would be at 1.25% and their balance sheet would remain ballooned at $4.4 TN.
Yellen: “Investors have recognized the progress achieved toward ending too-big-to-fail… Credit default swaps for the large banks also suggest that market participants assign a low probability to the distress of a large U.S. banking firm.”
I would caution against calling out low bank CDS prices as evidence of progress toward ending too-big-to-fail. CDS is atypically low across the spectrum of corporate borrowers. Indeed, sovereign CDS pricing is unusually inexpensive around the globe despite a huge run up in debt loads (Italy 148bps!). And then there’s the historically low VIX that astute analysts argue has been disregarding risk. Low risk premiums across various asset classes - at home and abroad - are consistent with market perceptions that central bankers are committed to liquidity backstopping necessary to safeguard against another crisis. “Too big to fail” has never had such momentous market impacts.
Yellen: “Our more resilient financial system is better prepared to absorb, rather than amplify, adverse shocks, as has been illustrated during periods of market turbulence in recent years. Enhanced resilience supports the ability of banks and other financial institutions to lend, thereby supporting economic growth through good times and bad.”
Resilience over recent years has clearly been associated with concerted open-ended QE from all the world’s leading central banks. It would also appear that chair Yellen overly emphasizes traditional banking when referencing the “financial system.” “Banks are safer. The risk of runs owing to maturity transformation is reduced.”
It’s worth recalling that traditional bank runs were not much of an issue during the previous crisis. Traditional old Market Panic was. As they will do, long periods of market greed erupted into fear and panic. The acute issue was “repo” financing of large institutions financing MBS holdings – along with what a Wall Street liquidity crisis meant for the pricing of mortgage-related finance and the functioning of derivatives more generally. Investor panic was sparked by the loss of faith in the safety and liquidity of repo “money.” Yet the overriding issue remained the mispricing of Trillions of MBS and mortgage-related securities and derivatives. I’ve always argued that a repricing of mortgage debt – and risk more generally – was inevitable, and that major financial and economic repercussions were unavoidable. Bubbles are not forever.
There is no doubt in my mind that today’s issue of securities mispricing dwarfs the mortgage finance Bubble period. I also believe latent derivatives market-related instability (i.e. market “insurance”) also likely exceeds pre-2008 crisis levels. Less clear is where an acute liquidity episode could initially manifest. Lehman and the cadre of leveraged speculators borrowing in the short-term repo market to finance long duration mortgage securities was rather egregious.
Financial crisis typically erupts in the “money” markets. This is where risk is perceived to be minimal, yet it is at the same time the domain of aggressive risk intermediation that works to distort overall market dynamics. Throughout the mortgage finance Bubble period, “Wall Street Alchemy” transformed progressively riskier mortgages into endless perceived safe and liquid “money”-like instruments – “The Moneyness of Credit,” with the “repo” market at the epicenter of perilous risk distortions.
I have argued that unparalleled Fed and global central bank inflationary measures molded the “Moneyness of Risk Assets”. In particular, central bank backing ensured that inflating markets in equities and corporate Credit came to be perceived as low-risk stores of value. And with the proliferation of (perceived liquid) fund choices available in the marketplace (ETFs in particular), central banks coupled with Wall Street Alchemy achieved the incredible: the transformation of high-risk securities - with ever-rising prices - into perceived “money”-like instruments.
Returning to the above opening paragraph extracted from Yellen’s speech, I believe it is important to contemplate whether market resilience has been due to sound financial system structure or instead because of central bank-induced market distortions and liquidity backstops. If the latter, it is critical to appreciate that this extended period of “resiliency” has ensured cumulative financial distortions and Bubble Economy Maladjustment – on an unparalleled global scale. With tens of Trillions of mispriced securities globally, a painful bout of repricing is unavoidable.
We’ll see how resilient “the financial system” proves to be come the unmasking of risk market liquidity and safety misperceptions. It’s a curious discussion of “Financial Stability a Decade after the Onset of the Crisis,” that glosses over near zero rates, unending QE, Trillions of global debt securities trading with negative yields and the extraordinary expansion of the ETF complex. It recalls Alan Greenspan’s speeches - the reasoned analysis along with the intrigue of what went unsaid. For me, it’s disingenuous and lacks credibility.
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