Monday, November 10, 2008

Changing The Field of Play

Change the dimensions of the field the game is played on, causes a change in the strategy in which the game is played. The markets react to change in much the same way.

The Federal Reserve Bank’s strategy of keeping interest rates low to help our economy to continue to grow over the last several years may have held the seeds of the economy’s eventual meltdown. Let me try and explain.

With interest rates low, investors needed to “reach” for yield if they were to remain competitive with their competition in the world of professional money management. This “reaching” for yield itself created a strong demand for riskier bonds and the game was on.

Mortgage and other asset-backed bonds are a relatively new animal on the investment scene. The plain vanilla bond that has existed for centuries has been improved upon because of the technological advancements of the computer. Taking a stack of mortgages and turning them into an investment security such as a mortgage bond created a whole new strategy and changed the field on which the game was played. Now, add to this the creation of synthetic bonds and credit default swaps on top of the creation of this whole class of debt known as asset-backed bonds, and you have the making of an entirely new, complex and unregulated ball game.

Keeping interest rates low for the purpose of encouraging economic growth has unfortunately a flip side to this story. I often refer to this as the knife cuts both ways. In economics, like many things, the knife has a double edge. Be careful on the back stroke.

In the Sunday New York Times Business section were several articles written by college professors of economics. Now there is nothing wrong with having college professors of economics writing articles for the Sunday Business section of the New York Times, except if you really want to know what needs to be done to help the economy, you need to talk with the players on the field, not the fans. Economists, for the most part, are good at studying past economic events, running numbers, drawing graphs and writing boring commentaries. As a group, they do not know much about the markets and the present. If the New York Times wants to know what can be done in the future when President Obama takes office in January, then they need to talk with the people in the street and on the trading desks. The vast majority of economists are historians of past economic events. They run numbers and write papers. Bond traders trade bonds, they do not write papers.

I still think the responsibility for the rating of all debt instruments, I mean all bonds and notes, needs to be placed in the authority of the Federal Government. The era of for profit companies giving ratings to debt paper is past. It has been a terrible failure and will continue to hold back the economic recovery. In a card game the values of the cards dealt need to remain constant or else you do not have a card game. In the bond market the bond’s rating may not be able to be held constant, but the initial rating has to be worth the paper it is written on.

Stay tuned.

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