But fixed-income investors wanted an excuse to invest in riskier stuff that carried slightly higher yields

TO BE NOTED: From Naked Capitalism:

"Guest Post: Geither admits easy money did us in

Submitted by Rolfe Winkler, publisher of OptionARMageddon

In an interview with Charlie Rose on Tuesday, Tim Geithner admitted the bubble was caused by Greenspan's easy money policy. Unfortunately, Charlie didn't ask the obvious follow-up: "why will this time be different? Why will Bernanke's easy money policy lead to different results?" Here was the crucial exchange:

Rose: "Looking back, what are the mistakes and what should you have done more of? Where were your instincts right, but you didn't go far enough?"

...

Geithner: "...I would say there were three types of broad errors of policy and policy both here and around the world. One was that monetary policy around the world was too loose too long. And that created this just huge boom in asset prices, money chasing risk. People trying to get a higher return. That was just overwhelmingly powerful."

Rose: "It was too easy."

Geithner: "It was too easy, yes....

What makes Geithner's admission so frustrating is that the government is engaged in the same disastrous policy today, to fight the same bogeyman: deflation.

As Geithner makes plain, a huge side effect was that investors seeking meaningful returns inflated the bubble taking flyers on overpriced, risky securities. Toxic structured products are the obvious example. Credit rating agencies get lots of blame as enablers, rating trash "AAA." But fixed-income investors wanted an excuse to invest in riskier stuff that carried slightly higher yields; hell, artificially low interest rates meant many needed an excuse.*

Truly low risk securities like Treasurys and money market instruments were yielding so little, they were of no use to portfolio managers trying to match assets with liabilities.

But what happens when low-risk fixed-income securities yield 0% or close to that? Asset managers are more or less forced( NB DON ) to seek higher interest rates through riskier investments.

So what are the results of our latest experiment with rock-bottom rates? Investors are piling back into risky investments across the board. Taking just one example, FT noted this week that high-yield debt is skyrocketing. The "experts" cited in the article claim this is proof that we've come through the worst of the recession. In their brains, markets operate efficiently, so running bulls must reflect improving fundamentals.

First of all, efficient market theory doesn't apply to asset markets the way it applies to goods markets. But even if it did, how can folks pretend that any market with fixed prices is operating efficiently? With their stranglehold on interest rates via open market ops, central banks everywhere are engaged in a massive price fixing scheme that distorts investor incentives across all asset markets.

Geithner admits such a policy was a disaster before, that the "overwhelmingly powerful" force of low rates inflated the bubble. So how can he/Bernanke justify the same approach this time 'round? No doubt they'd argue they've no other choice: a ponzi system "relying on credit" needs credit to flow or else it will collapse. It doesn't occur to these guys that the system itself is flawed, that we need a gut renovation, not just another layer of paint.

No doubt de-leveraging would be quite violent if the Fed left rates higher. But de-leveraging is the only solution to the crisis. God forbid Bernanke's easy money policy actually "works;" God forbid he "rescues" the economy by reflating the credit bubble. De-leveraging is coming, whether we want it to or not. Better to rip the band-aid off quickly...

-----

*Not that CRAs are blameless. They deserve every ounce of criticism they've received. "

Me:

Don said...

"But fixed-income investors wanted an excuse to invest in riskier stuff that carried slightly higher yields; hell, artificially low interest rates meant many needed an excuse.*"

"Asset managers are more or less forced to seek higher interest rates through riskier investments."

I agree with you about the search for higher yields, but there is no such thing as "more or less forced". Actual human beings made decisions and gave advice that was either negligent or criminal, in many cases. Wanting to achieve higher returns with less risk is silly. Lower interest rates cannot "cause" any sentient being to do anything. An incentive is just that. It is not a command or irresistible urge. This is a mechanistic explanation of human behavior.

"to fight the same bogeyman: deflation"

Not only is it not a bogeyman, it is far worse than inflation. A Debt-deflationary Spiral has no natural stopping point. From my view, that's what Fisher's paper showed, and the current crisis validates Fisher's theory.

Nevertheless, I liked your post, because you made plain the assumptions you are working under, which allow me to understand your argument and why you believe it. Many differences come from different assumptions.

Don the libertarian Democrat

Investors' bets that have fueled the recent rally in corporate bonds and other riskier markets have been made mostly without the excessive borrowing

TO BE NOTED: From Reuters:

"U.S. corporate bond rally unfazed by lack of leverage

Wed May 13, 2009 6:48pm EDT

By Tom Ryan and John Parry - Analysis

NEW YORK (Reuters) - Investors' bets that have fueled the recent rally in corporate bonds and other riskier markets have been made mostly without the excessive borrowing of the boom years that preceded the Panic of 2008.

The huge amounts of leverage provided to "hot money" investors, or hedge funds, in the bull market heyday has been unwound and the recent rally in corporate bonds marks a return of more traditional investors, analysts say.

De-leveraging of trillions of dollars in borrowed money lies at the heart of the global credit crisis. But corporate bonds' recovery, courtesy of more traditional investors like pension funds and insurers, is an early sign that securities markets can function without hefty amounts of borrowed money.

Hedge funds "were primarily credit driven and the more you listen to the shrinkage of the hedge fund community, the more you realize there is less and less leverage being used," said Tom Sowanick, chief investment officer at Clearbrook Financial LLC in Princeton, New Jersey.

The decimation of hedge funds is one reflection of the heavy price that investors who borrowed excessive amounts had to pay when the global financial crisis cut a swathe through riskier asset markets.

Such speculative investors' exposure was magnified by hefty borrowing, or "leverage." For example, before the global credit crisis erupted in summer 2007, some speculative investors borrowed about $30 for every $1 bet.

When those bets went badly awry in everything from mortgage-backed securities to other complex financial structures, that "leverage" had to be quickly paid back.

During the third quarter of 2008, when Lehman Brothers collapsed, the financial system went into cardiac arrest and leverage -- the lifeblood of hedge funds -- dried up.

As leverage was withdrawn, the hedge fund industry suffered over $100 billion in redemptions in the first quarter of 2009 alone, according to Hedge Fund Research, Inc, a Chicago-based research firm. That was on top of the quarterly record $152 billion in redemptions during the fourth quarter of 2008 and a huge acceleration from negligible redemptions in the previous three quarters.

Traditional buyers such as pension funds and insurers, who are restrained by regulators from borrowing large amounts to make market bets, have propelled corporate bonds to a stellar rally so far this year.

Since late March, U.S. investment-grade corporate bond yield spreads over comparable Treasuries have rallied 158 basis points tighter to 442 basis points, according to Merrill Lynch data as of Tuesday.

While hedge funds will always have a presence in the corporate bond market, they won't reach the same level they did before the financial meltdown, said Sabur Moini, high yield portfolio manager at asset management firm Payden & Rygel in Los Angeles.

"They were the marginal buyers that were being provided tremendous and cheap leverage by the Street" and "all that has been washed out of the system," he said.

"The world going forward is going to be different; we're just not going to have the sort of leverage and cheap financing" seen prior to the financial meltdown, Moini said.

With the once-championed Wall Street broker-dealer model extinct and stricter oversight on the remaining depository institutions, it is hard to see how the huge amounts of leverage once offered to hedge funds could ever return, analysts say.

"In the same vein, the prime brokers aren't extending the same amount of credit and there are fewer of them" than before the global financial crisis started, Clearbrook Financial's Sowanick said.

"Where the big change comes from is the brokers, who were (leveraged) between 30 and 40 times. But because brokers are now banks, their leverage has been cut significantly," to about 10 times, he said.

One example is Merrill Lynch, which had been leveraged at between 30 and 35 times. Its leverage is likely about 10 times since Bank of America bought it in late September, Sowanick said.

(Reporting by Tom Ryan and John Parry; Editing by Dan Grebler)"