It's The Distributor Cap, Stupid!

The Federal Reserve Bank yesterday lowered the Fed Funds rate to 0% to 0.25%, in an effort to get the economy going. I, like all of you, am hopeful that this move by the Federal Reserve Bank will help jump start the economy and get everyone back to work that wants to work.

I have little if anything to say about Mr. Madoff. I did not know Mr. Madoff and to the best of my knowledge do not recall ever meeting Mr. Madoff. I think that everyone that has read about Mr. Madoff and what he did to so many people and foundations, losing their money to the tune of $50 billion, that the argument for better and more regulations, oversight and enforcement at this point should be a no brainer. The SEC means nothing if it is not going to do its job, and that means equal enforcement of the laws. Just because you know a few important people should not mean that you are not held accountable to the same laws and regulations as the rest of us. Why was Mr. Madoff given a pass when it came to review and accountability?

Now let us get back to the Federal Reserve Bank, interest rates and the economy. It just so happens that with the American auto makers in the news as well, that I attempt to explain this economy in terms of an internal combustion engine, a gasoline driven engine. With gas in the tank and all the parts working perfectly, a gas engine will not turn over and run without a small piece of equipment found under the hood of the car. This small piece is part of a larger small piece, but without it, nothing moves. This small piece of equipment is called the distributor, and the even smaller piece is called the distributor cap, if the distributor cap is missing, it is enough to keep a 2,000 + pound car from moving one inch. No spark to the spark plugs and the pistons do not move. Everything else can be ready to go, and without this small piece of the equation, the car stands still. Our economy, unfortunately has more than one piece of the equation missing or broken. Let me explain.

The ratings of bonds and debt obligations is the distributor cap of the financial sector of our economic engine, in my opinion. In this case, it is not just missing, it is broken. Perhaps, it is time for Paulson and Bernanke to roll up their sleeves and get under the hood of the economic engine and get their hands dirty.

Back in the mid 1970’s, after New York City defaulted on their general obligation (GO) notes, several of the institutional bond departments brought together their own analysts to produce their own municipal bond research in a booklet form on a weekly basis. I remember this well because I received these pieces of research from several of the municipal bond departments of the large institutional brokerage firms in New York, and which no longer even exist. I read the research each week and paid particular attention to those large new issues of municipal debt that I might consider buying for the tax free common trust fund that I managed. Each brokerage firm had their own distinct texture and color nine by twelve paper envelope. I used to save the envelopes to draw on and take into boring meetings with me so I would not fall asleep. I believe I even designed the storm windows I made out of redwood for my old house (1901) on these large envelopes. Well, what is my point? My point is this. When the rating agencies let the bond investor down by not sticking with their downgrade of New York City G.O.’s in the early 1970’s, there were brokerage firms that put out their own research. Today that is impossible. Even if the firms were prepared to do this, no one would place any faith in their ratings because they are behind the securitization of asset-backed bonds.

Believe it or not, asset-backed bonds in and of themselves is not the problem. The problem is in the lack of faith in the rating agencies that give the bond rating to the asset-backed bonds like mortgage bonds. Without the mortgage lenders having the ability to sell their mortgages to the underwriters of mortgage-backed bonds, there will be little if any movement in the recovery of the housing market. Recovery of the housing market is essential to the full recovery of the economy. It all fits together Mr. Paulson and Mr. Bernanke, you just have to open the hood and get your hands dirty.

Take the rating responsibility of asset-backed debt away from the rating companies. The investing public has no confidence in the rating agencies. Without creditable bond ratings, bonds do not get underwritten and without bond underwritings, there will be little if any real movement in the financing of homes. The sale of cars is also tied to the asset-backed bond market in that car loans are also bundled and packaged and rated as asset-backed debt. Without the distributor cap nothing moves.

There must be some strong political opposition to my idea of the Federal Government taking over the responsibility of debt ratings. Confidence drives the bond market, and until there is confidence in bond ratings the investing public will continue to place their confidence in U.S. Treasury obligations. This is why interest rates are so low for U.S. Treasuries, the whole world is seeking the safest form of debt obligations, and U.S. Treasuries fill the bill. Until there is creditability in the rating of asset-backed debt obligations, spell that mortgage and car loan bonds, the economy will continue to misfire.

Stay tuned.