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Stop It & Mop It

If you can't spot a bubble when it's expanding, how can you clean up after it bursts...?

CLICK!

   That's the sound of a light coming on at the Fed. The one at the end of the hallway. In the supplies closet, writes Rob Peebles of Prudent Bear.

   There, the Assistant Vice President of Containment rummages for the legal-sized copier paper. His flow chart titled Stop It & Mop It Disaster Recovery Plan requires the extra length.

   "There it was on the bottom shelf," the AVP told the board members eight years later,

   "The asset bubble of 1999. Sure, we all thought it existed, but until then, none of us had seen it. It was beautiful - encrusted with strange symbols like KOOP and WBVN. It was pumped so tight it seemed it would burst at the slightest touch."

   He went on: "Yes, I saw it with my own eyes. But when I returned to the closet to show the others, it was gone. I didn't see it again until Greenspan rushed into the conference room with it, months and months later. By then, it was shriveled and deflated.

   "The Maestro cradled it in his arms like it was an injured kitten. 'We've got to do something about this,' he wailed. 'And we will'..."

   What else could explain the Fed's about-face on former Fed chairman Greenspan's policy of not looking for bubbles until they grab you by the assets? Greenspan, of course, claimed it was impossible to spot a bubble while it was inflating. Rather than battle futility, he argued, the Fed should stand at the ready, blinders in place, with mops poised to clean things up after they got messy.

   Current Fed chairman Bernanke affirmed Greenspan's Avert-Thy-Eyes Policy back in 2002. But last week, the Financial Times told us that the Federal Reserve is re-thinking its no-thinking approach to asset bubbles. Eight years after the internet blow-up and several months into the housing meltdown, the Financial Times says that some at the Fed "are open" to the idea that asset bubbles – unlike the Yeti – can be readily identified.

   Exactly what weapons the Fed would wield apparently remains under discussion.

   The basic idea – that asset bubbles are somehow encased in military composite materials, thus defying detection – seems especially silly given another FT piece, this one an editorial by Roger Altman. He reminds us of the following items that sprang from the bubble after the bubble:

  • Credit Default Swap insurance spiked from $5 trillion in 2005 to $50 trillion two years later – 10 times the value of all insurable bonds;
  • Securities companies ratcheted up borrowing to a record 32 times their capital;
  • Junk bond spreads were cut in half;
  • Record ratio of financial assets to GDP;
  • Bank regulators ignored off-balance sheet risk.

   The above of course was in addition to the Great Mortgage Funding Race and the transformation of millions of otherwise sane Americans into leveraged real estate speculators.

   Back in April 2000, Paul McCulley of giant-bond fund group Pimco was addressing Congress on Greenspan's Close the Barn Door After the Horses Exit policy. He thought it puzzling that, even though Greenspan himself equated the absurd valuations of internet stocks with lottery tickets, the Fed chairman actually argued against raising margin requirements.

   Rather than play the dorm mother who quashes the midnight shenanigans, Greenspan saw himself as the cavalry, arriving just in time to avert disaster.

   Or maybe Greenspan really believed there was less risk in ignoring a bubble than deciding what to do with it once you caught it. But surely doing something beats picking up pom-poms and high kicking over technology's productivity miracles, or counseling first-time home buyers to buy adjustable-rate mortgages when long-term fixed rates stood near all-time record lows.

   Besides, the risks of doing the wrong thing at the wrong time aren't just limited to the bubbly phase. Former Fed super-chair Paul Volcker warned last month that actions taken after an asset bubble bursts have risks of their own.

   The Great Volcker was particularly concerned that the Fed's independence can be called into question when – with disaster upon them – the Fed tries novel tactics to save the day.

   "If we lose confidence in the ability and the willingness of the Federal Reserve to deal with inflationary pressures...we will be in real trouble," Volcker said.

   According to the Bloomberg story covering Volcker's comments to Congress, the old warrior remains concerned about the implications of recent unconventional tactics, including the Bear Stearns rescue package and the Fed's willingness to accept mortgage bonds from bond dealers.

   Now that has seen how messy mopping up can be, they may decide that limiting the size of the spill is not such a bad idea.

Rob Peebles CFA was formerly managing editor of the excellent Prudent Bear website published by David W.Tice & Associates LLC.

See the full archive of Rob Peebles articles.
 

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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