The Dollar and the Credit Crunch

By RONALD MCKINNON
March 31, 2008; Page A19

We are all too familiar with the problem of mortgage credit associated with the slump in home prices. The great unresolved puzzle in today’s financial crisis is why some other private credit markets are seizing up.

The financial press is full of stories about a shortage of the U.S. Treasury bonds necessary in the multitrillion-dollar interbank market as collateral for borrowing by illiquid banks. This shortage seems even stranger in the face of a large federal fiscal deficit ($237.5 billion in 2007) that continually increases the supply of new Treasurys.

This shortage of Treasurys, and the unexpected severity of the credit crunch, is linked to the flight from the dollar in the foreign exchanges.

The U.S. Federal Reserve has hastily cut short-term interest rates to just 2.25% in March 2008 from 5.25% in July 2007. Unsurprisingly, private capital inflows for financing the huge U.S. trade deficit have dried up. Hot money has flowed out of the U.S. into those countries (of which China is the most prominent) with currencies that are most likely to appreciate.

Foreign central banks (apart from those in Europe) are then induced to intervene, sometimes massively, to buy dollars in order to slow their currencies’ appreciations. In 2007, China had the biggest overall reserve buildup of $460 billion. Other central banks, from the Gulf oil-producing states to Russia, Brazil and some smaller Latin American and Asian countries, have also intervened to accumulate dollar reserves.

A substantial proportion of these official reserves is invested in U.S. Treasurys. The Federal Reserve’s Flow of Funds data (March 2008) show that in 2007 foreign central banks accumulated about $209 billion of U.S. Treasurys. Somewhat inconsistently, the Treasury’s own data show an accumulation of $250 billion.

Although acute in 2007 and more so going into 2008, this drain of Treasurys was also very large from 2003 to 2005. By early 2004, the federal funds rate had been cut to just 1%, which also triggered a flight from the dollar — at that time more into yen than renminbi. This previous episode of easy money and unduly low interest rates greatly aggravated both the U.S. housing bubble and the more general overleveraging of the American financial system from 2003 to 2006.

In 2007-08, the crash in housing and the implosion of over-leveraged hedge funds, special investment vehicles and so on, has increased counterparty risk in most financial transacting. Illiquid financial institutions cannot effectively bid for funds by putting up suspect private bonds or loans as collateral. Unsurprisingly, there is a “flight to quality” that increases the private domestic demand for Treasurys. But this is happening at a time when the flight from the dollar in the foreign exchanges has greatly reduced their supply.

This increased demand coupled with a fall in supply helps explains why, in the midst of a U.S. credit squeeze with higher interest rates on private financial instruments, nominal interest rates on U.S. Treasury bonds have fallen to surprisingly low levels. Despite substantial ongoing U.S. price inflation of 4.3% in the consumer price index and 6.4% in the producer price index, Treasury yields are less than 1% on a three-month bill, 1.32% on a two-year note, and 3.5% on the benchmark 10-year bonds. There are even reports of effectively negative nominal yields on certain very short-term Treasurys. The real yield on Treasury Inflation Protected Securities has turned negative. (See chart.)

So we have a paradox. Despite the financial turmoil in the U.S. and its government’s not-so-strong fiscal position, with huge contingent liabilities for guaranteeing private and public pensions as well as bailing out failing banks, its credit standing has strengthened. The fact that the U.S. government can market Treasury bonds at insultingly low interest rates at least provides an argument for using fiscal stimuli — such as the $160 billion tax rebate passed in February 2008 — to prop up the sagging U.S. economy.

Beginning on March 27, the Fed offered to lend banks and bond dealers as much as $200 billion of Treasurys from its own portfolio for up to 28 days, in return for a variety of collateral. The Fed was responding to complaints from dealers of a shortage of Treasurys in the interbank markets, but without recognizing that the root cause was the flight from the dollar in the foreign exchanges.

In the 1970s under the dollar standard, episodes of a weak and depreciating dollar led to monetary explosions in foreign trading partners, with world-wide inflationary consequences. Now, the inflation threat to the U.S. could be aggravated if foreign central banks intervene to prevent their currencies from appreciating too fast and overly expand their money supplies.

Stabilizing the dollar in the foreign exchanges and encouraging the return of flight capital to the U.S. will require two things. The first is to convince the U.S. Federal Reserve that continually cutting interest rates and expanding the U.S. monetary base is not the appropriate response to today’s credit crunch; rather it triggers a vicious cycle.

The Fed responds to the credit crunch by cutting interest rates, which would be the seemingly correct textbook strategy if the economy were closed and the foreign exchanges could be ignored. But the economy is open, and capital flies out of the country. Because of the unique position of the U.S. at the center of the world dollar standard, the drain of Treasurys — the prime collateral in impacted credit markets — exacerbates the credit crunch, and monetary expansion abroad worsens world-wide inflation. The Fed then further expands in response to the tightening of U.S. credit markets.

The second component of a strong dollar policy is more direct action on exchange rates. At the very least, China bashing as a means to force dollar depreciation against the renminbi should end. The U.S. government should also cooperate with central banks in Europe, Japan, Canada and elsewhere to stabilize the sinking dollar.

The best solution to the current crisis is to stop the flight from the dollar. This would be beneficial beyond relieving the drain of Treasurys and relaxing the crunch in American credit markets. Letting the dollar depreciate without any convincing action to secure its long-term value against other major currencies undermines confidence in the dollar’s long-term purchasing power. It also lets the inflation genie out of the bottle, and makes a return to 1970s-style stagflation look imminent.

Mr. McKinnon is a professor at Stanford University and a senior fellow at the Stanford Institution for Economic Policy Research.

See all of today’s op-eds and editorials, plus video commentary, on Opinion Journal.

And add your comments to the Opinion Journal Forum.

 

http://online.wsj.com/article/SB120692677175575901.html?mod=opinion_main_commentaries

http://online.wsj.com/article_print/SB120692261621575605.html The U.S. needs monetary policy that maintains a stable price level, bank supervision that recognizes mortgage losses and lets markets clear, and marginal rate tax cuts that boost incentives to work and invest. In short, the American policies of the 1980s, not those of Japan’s lost decade. March 31, 2008

REVIEW & OUTLOOK

Hillary’s Bad History March 31, 2008; Page A18 No, not sniper fire in Bosnia. We’re referring to Hillary Clinton’s lament last week that the U.S. is flirting with a 1990s Japan-style deflation. Perhaps it’s a good time to remind everyone what really happened in Japan, so Mrs. Clinton and the rest of Washington don’t make the same mistakes. “I don’t think we can work our way out of the problems we’re in in the broad-based economy with monetary policy alone,” Mrs. Clinton said in the interview with Journal reporters. “I think the Japanese tried that and tried and tried that.” She added Japan should have relied more on fiscal stimulus spending and aid to banks and homeowners, which is what she wants Washington to try now. The Senator needs a refresher in Japanese economic history. Far from easing monetary policy, the Bank of Japan kept money too tight for too long in the early 1990s. Japan’s stock market slide began in early 1990, but its central bank raised interest rates through most of that year and didn’t cut them until July 1991. While the Bank of Japan eventually chased interest rates down to zero, it was always too late to break the deflationary spiral. There’s little sign the U.S. is facing a similar danger today, given that the Federal Reserve has been dropping rates quickly as the economy has slowed. If anything, the problem is the opposite, with the Fed risking future inflation by putting rates into negative real territory and devaluing the dollar. (See Ronald McKinnon1 nearby.) Japan also made the mistake of refusing to make banks pay for the mistakes they made during their global lending spree in the late 1980s. As the world economy fell into recession in 1990, so did Japan. But rather than letting banks take their losses, the Liberal Democratic Party kept bailing them out. This merely delayed the day of reckoning, as insolvent banks were allowed to exist as “zombies,” alive in name but unable to lend. 2 The government also raised consumption taxes, burdening consumers at exactly the wrong time. Meanwhile, with encouragement from the Clinton Treasury, Tokyo launched a vast Keynesian spending program. Roads, bridges, trains — you name it, Japan built it. The nearby chart shows the impact this spending had on overall Japanese government debt, which exploded over the decade. The nearly annual spending programs led to several false recoveries with growth blips, but they never changed incentives enough to revive domestic risk-taking. Yet this is exactly the policy that Mrs. Clinton now wants the U.S. to emulate. Rather than let housing speculators and lenders take the hit for mispricing credit and allow the market to clear, she wants a 90-day freeze on foreclosures and a five-year freeze on mortgage resets. She also wants the feds to buy up mortgage-backed securities and guarantee troubled mortgages. Rather than let housing markets find a bottom where they can begin a recovery, she and her allies in both parties would prolong the agony. While some homeowners and banks would be saved from foreclosure or greater losses, the cost would be to lengthen the housing recession. A better model is the one the late Al Casey put into practice during the savings and loan crisis in the early 1990s. As president of the Resolution Trust Corp., Mr. Casey sold almost $400 billion of bankrupt assets as rapidly as he could. Declaring that his purpose was to “put the RTC out of business,” Mr. Casey let investors buy those assets even at “vulture” prices. The real estate market was able to find a bottom, and the recovery came so fast that Bill Clinton inherited an economy that grew by 3.3% in 1992. The Beltway class also now wants to indulge in the same Keynesian “stimulus” that failed in Japan. Mrs. Clinton’s “Rebuild America Plan” would invest $10 billion over 10 years in an “Emergency Repair Fund” — a plan she claims would create 48,000 jobs for every billion dollars spent, or close to half a million jobs. She would build ports, railroads, airports, public transit, tunnels and roads. Senate Democrats are proposing more than $35 billion in new spending — on top of their $168 billion in tax rebates. These may also lead to false recoveries, but they won’t ignite a new round of risk-taking and investment. Japan finally emerged from its funk earlier this decade after it realized its bank losses and caught the updraft from global monetary reflation. Still, its economic growth remains mediocre — a level that wouldn’t be tolerated in the U.S. and may not be enough even in Japan. Sluggish growth has already sunk one Prime Minister and could prove fatal to the current leader, Yasuo Fukuda, whose approval ratings are dropping fast. The way to revive U.S. growth is by learning from Japan’s mistakes, and doing the opposite. The U.S. needs monetary policy that maintains a stable price level, bank supervision that recognizes mortgage losses and lets markets clear, and marginal rate tax cuts that boost incentives to work and invest. In short, the American policies of the 1980s, not those of Japan’s lost decade. See all of today’s editorials and op-eds, plus video commentary, on Opinion Journal.3 And add your comments to the Opinion Journal Forum.4 URL for this article: http://online.wsj.com/article/SB120692261621575605.html Hyperlinks in this Article: (1) http://online.wsj.com/article/SB120692677175575901.html? mod=opinion_main_commentaries (2) http://online.wsj.com/article/SB120692261621575605.html (3) http://online.wsj.com/opinion (4) http://forums.wsj.com/viewtopic.php? t=1956

March 31, 2008

Law Firms Expect Rise In Bankruptcy Business By JACQUELINE PALANK March 31, 2008; Page A2 As the credit crisis deepens, law firms across the country are betting that bankruptcy work will be their most-promising avenue of growth, and are accelerating their recruitment of restructuring specialists. A survey of more than 300 attorneys from the country’s largest law firms found that a plurality — one out of every four — expects bankruptcy law to be the fastest area of growth in the next 12 months. That number exceeds the tally of attorneys who think litigation or corporate governance will be hot growth areas. “The number of bankruptcy proceedings is expected to increase in reaction to continued economic uncertainty,” said Charles Volkert, executive director of Robert Half Legal, which conducted the survey. The slump in U.S. housing prices over the past year triggered a financial crisis that some economists say is the country’s worst in at least 50 years. To ease the crisis, the Federal Reserve has cut interest rates and lent hundreds of billions of dollars to financial institutions on Wall Street. But the credit crunch persists, making it especially difficult for troubled companies to obtain loans. Last year, Chapter 11 bankruptcy filings hit a two-year high of 6,236, according to Jupiter eSources, an Oklahoma company that tracks the data. The pace of Chapter 11 filings has accelerated further this year. “We’ve just stayed extremely busy,” said Laura Davis Jones, managing partner of boutique bankruptcy firm Pachulski Stang Ziehl & Jones LLP’s Delaware office. “The way the market looks now, it doesn’t look like that will be changing anytime in the near future.” Skadden, Arps, Slate Meagher & Flom LLP added 17 attorneys to its corporate restructuring team last year and expects to add three more to the ranks over the next two months, according to J. Gregory Milmoe, the team’s co-leader in New York. Mr. Milmoe said the group’s attorneys billed 45% more hours in January and February of this year than they did in the same months a year earlier, thanks to a demand for the their services that “emphatically” increased. At Davis Polk & Wardwell, the firm’s “extremely busy” bankruptcy practice has looked internally to meet its need for more staff, according to Marshall Huebner, partner and co-head of the practice. The firm cross-trains attorneys in related practices, such as banking or litigation, so it may redistribute them based on demand. He said there are between 30 and 40 attorneys who are “actively working on restructuring,” whether or not that is their full-time focus. Of those, 15 are attorneys who wouldn’t have been working in the area a year ago but may have been focusing on banking or litigation. Mr. Volkert of Robert Half said the complex and fast-paced nature of bankruptcy leads most firms to seek attorneys who have at least three to five years of experience in the practice so they can hit the ground running. “Hands-on experience really matters. Legal professionals who are able to demonstrate a proven track record in that area are in demand,” he said. URL for this article: http://online.wsj.com/article/SB120692379488875669.html

http://blogs.wsj.com/deals/2008/03/31/

the-private-equity-fee-stream-dries-up/?mod=WSJBlog

March 31, 2008, 10:01 am

The Private Equity Fee Stream Dries Up

Posted by Deal Journal

Fees paid by two of the world’s biggest private-equity firms to investment banks have fallen to almost zero amid the collapse in their deal-making activity since the credit crisis began in June.

Blackstone Group and Goldman Sachs Capital Partners, usually lucrative sources of fees for investment bankers, paid less than $5 million for advice and financing in the first quarter of this quarter, according to data provider Dealogic.

That compares with the first three months of last year, when Goldman Sachs Capital Partners paid out $208 million and Blackstone spent $198 million, making them the second and third-biggest fee payers to investment banks world-wide after Texas Pacific Group, now TPG.

In the first quarter, Goldman didn’t feature in the top 100; Blackstone was ranked 67th. Dealogic didn’t specify how much each firm paid out.

The data are another sign that private equity deal making has been one of the biggest casualties of the credit crisis and has hit revenue at investment banks. Total fees paid by private-equity firms globally fell 79% to $1 billion in the first quarter, led by Apollo Management, which paid out $74 million.

Private-equity firms were one of the biggest and fastest-growing sources of revenue for investment banks until the start of the credit crisis in June. Instead of chasing private-equity business, banks now are reducing their exposure to the sector by selling leveraged loans or redeploying staff into other areas.

Fees earned by banks from private-equity firms accounted for 9.1% of global investment banking revenue in the first quarter, compared with 22% a year earlier.

–David Rothnie is investment banking editor in London for Financial News, a Dow Jones publication and a contributor to Deal Journal.

 

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March 31, 2008, 11:20 am

Winners and Losers in Paulson’s New Regulation Plan

Posted by Heidi Moore

Treasury Secretary Hank Paulson’s as-yet-unnamed new plan for financial regulation likely will spark the kind of overwhelming, take-no-prisoners financial war that passive-aggressive Washington politicians and regulators usually tread delicately around, and it brings to mind the old difference between Washington and Wall Street: on Wall Street, they stab you in the front. So, were Paulson’s plan to be enacted in toto, here are some likely winners and losers:

Winners
Hank Paulson: The proposed plan neatly puts Paulson (left) in the role of top cop for the entire financial system. This is a responsibility the Department of the Treasury already claims, but you wouldn’t know that from the tenures of Paulson’s predecessors, some of whom spent their time warring with the Bush administration. Paulson also is increasing the influence of the Treasury Secretary’s office by expanding the role of the The President’s Working Group on the Financial Markets. This shadowy group , will “evaluate these issues and their implications for regulation of bank and non-bank financial institutions.” The group is, of course, headed by the Treasury Secretary.

The Federal Reserve: Until now, the Federal Reserve hasn’t considered itself the “cop on the beat,” a role usually played by the Securities and Exchange Commission. Under Paulson’s plan, the Fed would be the “market stability” sheriff. The Fed’s most prominent current job–watching over the nation’s banking system–would go to a new entity. There might be some dissatisfaction with this at the Fed, as our WSJ colleagues write in the article linked to above: “A roving oversight role would ultimately leave the Fed as sole supervisor of nothing while being potentially liable for everything.” If that is the case, the Fed should be careful what it asks for: in seeking to protect the nation’s financial system by forcing the J.P. Morgan Chase-Bear Stearns deal, the Fed donned its Superman cape. It is a hard uniform to take off.

Wall Street: Wall Street regulation already is down to only two agencies: the Securities and Exchange Commission and the Financial Industry Regulatory Authority, which resulted from the merger of the National Association of Securities Dealers and the enforcement arm of the New York Stock Exchange. The new plan likely signals the death of the SEC. And so many people read the plan as a move toward lighter regulation. In the short term, SEC staff is likely to be caught up in defending their jobs rather than devoting their already overburdened staff to more investigations, which leaves Wall Street some breathing room this year.

Losers
Christopher Cox: This SEC chairman (right), despite his friendliness to Wall Street’s interests, could be the last. Paulson’s plan calls for the SEC to be merged with the Commodity Futures Trading Commission and, given the equally strong personalities at both regulators, it will be a political steel cage match to see who takes over control. Besides that, there always is poignancy–and some blame–associated with being the last man to run a dying institution.

The Office of Thrift Supervision: This agency would be merged out of existence, prompting a memo from Office of Thrift Supervision Director John Reich to employees saying the time isn’t right for rule chances. In fact, the OTS, Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency have been competing to be seen as the “good” regulator that banks will want to deal with. But it isn’t clear where their responsibilities may overlap. The OCC, for instance, is usually quiet but, to the chagrin of some, is deeply involved in Blackstone Group’s proposed buyout of Alliance Data Systems.

Congress and the Presidential candidates: By taking the reins in his own hands, Paulson may be putting the pin back into one of the big grenades in an election year. Election-year power plays typically involve politicians dragging disgraced Wall Street executives to televised hearings. While there have been some of those already, Paulson’s plan shows who really is calling the shots. Perennial Congressional hearing-holder Barney Frank, a Democrat Representative from Massachusetts, already has complained that these changes come too close to an election year. The Presidential candidates, as well, face being stuck with the bill for regulation they likely may not understand and may not agree with. current Barack Obama already said he opposes Paulson’s plan.

State insurance regulators: State insurance regulators have been all-powerful grandees. Under Paulson’s plan they would be scrapped in favor of a single federal regulator. This bodes particularly badly for New York State Superintendent of Insurance Eric Dinallo, who attempted to save the bond insurance industry. Any state regulators who still harbored hopes of crafting an Eliot Spitzer-like career (sans disgrace, of course) has now had their hopes smashed. Paulson’s plan doesn’t allow for interlopers.

There also is the open question of whether this plan will do everything it needs to do. Everyone in the financial markets knows cycles come and go; regulation can’t fight that destiny. As Paulson himself told the WSJ in this Q&A: “I don’t mean to imply that we aren’t going to keep having these periods every five to 10 years. I don’t think any regulatory system is going to change that.”

 

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