liquidity driven story, not a fundamentals-based, or market price of risk/systematic risk-based story

TO BE NOTED: From the Streetwise Professor:

"So Speaketh Chairman Bernanke–to SWP

Filed under: Economics, Financial crisis, Politics — The Professor @ 10:10 pm

I am participating in the Atlanta Fed’s conference on Financial Crises and Innovation in Jekyll Island, GA. The keynote speaker tonite (the first evening of the conference) was Ben Bernanke, Chairman of the Fed.

Bernanke’s speech was about the stress tests. I thought he did a good job in explaining and defending the tests. He clarified a few things in my mind. Which is not to say he persuaded me that all is well. In other words, I’m not ready to help revive Tinker Bell just yet.

Three things he said about the stress tests gave me some disquiet.

First. He emphasized that they were a “confidence building exercise.” That seems like assuming the conclusion. I would like a fact finding exercise, with a clear statement of the findings, good or bad. Stating that the objective is to build confidence suggests a pre-ordained result–Kabuki Theater. It’s like saying that something is needed to build “self-esteem.” Success builds self-esteem, not the other way around. Similarly, success builds confidence; confidence building does not ensure success.

Second, he argued that the stress tests were based on models calibrated to extensive historical experience. Well, we are in uncharted territory here, which raises doubts about the probative value of historical experience. I can think of some ways to massage historical data that could be useful. But one of the problems I see is that the characteristics–the quality–of loans issued in the 2005-2007 period differed substantially from the quality of loans issued in prior years even holding measurable characteristics constant. What’s more, the unemployment and growth scenarios used in the stress tests differ substantially from anything in the historical data likely to have been employed. Thus, there are at least two reasons to believe that historical experience may be misleading.

Third, Bernanke stated something that I had conjectured in my previous post Tinkerbell Goes to Wall Street. Namely, that the stress tests are not intended to estimate the market value of bank assets under alternative scenarios, and are not intended to be solvency tests. Instead, they are based on a view that market prices are deeply discounted from fundamental values due to liquidity effects, and that as long term investors funded by deposits, banks can hold assets to maturity. As a result, when evaluating the capital banks need, expected losses (in the “physical measure” if you will) are the relevant measure, not mark-to-market losses.

This last is a view that Bernanke has maintained since early in the crisis; he testified to this effect in the days immediately following Lehman. Maybe. But this is essentially speculation. Indeed, although Bernanke cited one of the papers presented earlier in the day to support his view, the other paper (by Michael Brennan) supports a contrary view. Specifically, that by focusing on expected losses alone one ignores the states of the world in which the losses occur, and the systematic risk of those losses. Losses that occur in very bad economic times are discounted more heavily. The disparity between valuations based purely on expected losses and market prices may be due to liquidity effects, but it may be due to fundamental risk pricing issues–the shift from the physical to the pricing measure. By ignoring this possibility, the stress tests could seriously underestimate the amount of capital banks really need.

In sum, Bernanke took a particular view on why many asset prices are so heavily discounted. It is a liquidity driven story, not a fundamentals-based, or market price of risk/systematic risk-based story. If he is right, there is some justification for the stress test estimates of capital needs and the capital position of banks. If he is wrong . . .

Bernanke took questions afterwards. In response to his statement that the Fed was committed to price stability, I asked: “How does the Fed make its commitment to price stability credible in light of the extraordinary measures it has taken in the past year?”

Bernanke gave a very long answer–I’d guess it took 3-4 minutes. He looked me in the eye the entire time. His answer was, it seemed to me, well practiced. But it was not entirely reassuring. He said (and I paraphrase, obviously): we’re doing two things. First of all, all of the members of the Board of Governors and the Fed Open Market Committee are making public our views on what the “right” amount of inflation is–about 2 percent. Second, we are making clear that we have the tools–charging interest on reserves, reverse repos–to withdraw liquidity from the system without selling assets. That’s fine, to a point. I have no doubt he knows that inflation is costly and has the tools to fight it; the question, though, is whether he can credibly commit to use these tools.

He went on to say that he understands clearly the nature of the problem, and is getting heat from both sides–those that fear inflation if he doesn’t respond to a rebounding economy by withdrawing liquidity, and those who fear a prolonged recession/deflation if he withdraws liquidity too quickly. He suggested that this is nothing new–he said a couple of times that this is the kind of problem central bankers always face when an economy is at a turning point.

Fair enough. But as with my reservations about the use of historical data in the stress test, here I believe that we are in uncharted waters, and that although this problem may be of a kind that central bankers are quite familiar with, it is of a scale that none (at least none living) have had to navigate. The amount of liquidity overhang is so large; the severity of the recession is so much greater than any of recent memory, and as a result the political reaction to a “double dip” recession would be commensurately greater; the banking system is so much more fragile than during previous downturns; and the independence of the Fed has been called into question as a result of its extraordinary actions more than ever before. All of these factors make the Fed’s job of steering between the Scylla of deflation and the Charybdis of inflation very daunting indeed. And although Bernanke certainly was personally impressive and appealing, I still believe that there is a very serious inflationary risk going forward.

And for the record. I’m damn glad I don’t have his job."