Friday, March 14, 2008

Secret is out: PWGFM has no mojo

I'll go back to the '60s, recharge my mojo, defeat Dr. Evil, and be back in time for tea. Austin Powers (wav)

Late in 2005, in response to an article by Bloomberg's Caroline Baum, I am not now, and have never been, a PPT member, I opined, it becomes quite clear that one of us will look the fool in the medium term. Our bone of contention was the notion that the President's Working Group on Financial Markets (PWGFM), or, as per Brett Fromson of the Washington Post called it, the Plunge Protection Team (PPT) "conspired" with major banks to shore up financial markets- a notion she thought preposterous.

Yesterday I learned that the PWGFM had been asked by the President, in August of 2007, to "review the underlying causes of developing financial market turmoil" (a.k.a. plunging markets) with the aim of "mitigating systemic risk, restoring investor confidence, and facilitating stable economic growth." The PWGFM, which includes the Treasury Department, the Federal Reserve, the Securities and Exchange Commission and the Commodity Futures Trading Commission working with the Office of the Comptroller of the Currency and the Federal Reserve Bank of New York- the lobbying group, if you will, for the major banks in NY, then discussed the problems the banks were facing to try and get the markets "back on track."

So, would this count as a "conspiracy?" It depends on how one defines that term. Leaning on my rusty Latin, to conspire is to breath, or whisper, together, denoting a degree of secrecy. To conspire is not to give orders. Those on the inside of a conspiracy know something those on the outside do not- in this specific case, that the group was meeting to "mitigate systemic risk, restore investor confidence, and facilitate stable economic growth." I think it shouldn't strain credulity to imagine that knowledge of the whispers might induce people to buy some of the plunging markets.

I suspect this may have happened a few times in the past; PWGFM gets called, they speak to the NYFed, who speaks to the banks, while the general public is unaware, and the next thing you know the plunging markets reverse. Note that, in my imagined scenario, nobody gives anyone orders, rather, the mere knowledge that a powerful group is working behind the scenes is enough to induce action.

While this might be a secret to Ms. Baum, it is not the secret to which the title of this post refers. It seems to me a far more interesting observation is that the PWGFM has lost its mojo- despite the "behind the scenes" action, plunging markets continue to plunge.

Before offering a few possible causes of this loss of mojo, let's check on the PWGFM's diagnosis of the problem:

The global market turmoil has not yet abated, so any diagnosis is necessarily incomplete. Nonetheless, it seems clear from experience to date that the principal underlying causes of the turmoil in financial markets were:

  • a breakdown in underwriting standards for subprime mortgages;
  • a significant erosion of market discipline by those involved in the securitization process, including originators, underwriters, credit rating agencies, and global investors, related in part to failures to provide or obtain adequate risk disclosures;
  • flaws in credit rating agencies. assessments of subprime residential mortgagebacked securities (RMBS) and other complex structured credit products, especially collateralized debt obligations (CDOs) that held RMBS and other assetbacked securities (CDOs of ABS);
  • risk management weaknesses at some large U.S. and European financial institutions; and
  • regulatory policies, including capital and disclosure. requirements, that failed to mitigate risk management weaknesses.

Their diagnosis also contains this sentence: Following many years of benign economic conditions and plentiful market liquidity, global investors had become quite complacent about risks, even in the case of new and increasingly complex financial instruments.

What seems missing from the diagnosis is the sense that the Fed and Treasury, by embracing the "free market" dogma, which included successfully lobbying for the termination of depression-era banking regulations, like Glass Steagle, tenaciously defending the "rights" of the major banks to grow their derivative exposure (i.e. the "new and increasingly complex financial instruments" referred to above) without any regulations, and habitually adding liquidity at any sign of significant market decline, may have fostered the environment which led us to this pass.

So now that the horses have bolted from the barn, they aver, let's close the door and make things right again.

So why has the PWGFM lost its mojo? Here's a few guesses. One, just as has occurred many times when official support becomes swamped by economic reality; remember, for example, the BoE and BoI attempts to keep the GBP and ITL within the ERM in 1992, the inevitably magnetic "pull" of intrinsic value cannot be ignored any longer. Two, there may be an, at this point, small, nagging sense among the major banks that the Fed and Treasury might, after yet another attempt of the same medicine, actually have to do what they should- better police the game, and stop adding liquidity which only serves, after years of habit, to put off the problem until tomorrow.

That is, the "conspiracy" worked to reverse market plunges so long as all members therein had the same goals, and the "pull" noted above hasn't begun to work its magic.

As an analogy, on the second point, a shift in focus by the official financial sector might, at this point, be akin to a corrupt police department that had decided to enforce the laws fairly. The once symbiotic relationship becomes antagonistic. This, in the inimitable words of Austin Powers leads to a situation wherein, I started to work my mojo, to counter their mojo; we got cross-mojulation, and their heads started exploding.

Who knows, maybe the PWGFM might actually act to liquidate a large, mismanaged financial institution instead of propping it up- the cops might do their job.

I'd write more, but I think I just saw a black helicopter outside my window.