May 12, 2022 |
In this issue of The Institutional Risk Analyst, our friend and co-author Fred Feldkamp talks about Paul Volcker, volatility, inflation and honesty. Fred is a retired Partner of Foley & Lardner in Detroit, where he spent decades advising clients in the world of secured finance. Fred is a veteran securities counsel who was "in the room" for the salvation of General Motors in the early 1990s and many other significant transactions. He acted as counsel for the first private securitization of residential mortgages in the early 1990s is responsible for helping to define the modern concept of true sale.
Many years ago, I spent a couple hours with former Fed Chairman Paul Volcker (1927-2019). I doubt he’d remember it. During the conversation, I explained how much I appreciated the path he chose to stop inflation in the late 1970s. He was surprised. Few people, it seems, had so openly thanked him.
During our conversation, I explained that the US was facing an accumulation of inflation pressures dating to the 1942 decision to spend “whatever it takes” to win WW II by producing materials under “cost plus” contracts with suppliers. That policy was correct. It led to victories over: (1) totalitarians in Germany, Japan and Italy and (2) deflation generated during the Great Depression.
What led to inflation was our national lack of willingness to “stop” when a “good” idea became stupid. Inflation arose by our unwillingness or inability to end the “sugar high” created by government expenditures, spending funded with borrowings rather than by the imposition of responsible taxation. As conditions worsened, those responsible refused to “come clean” and change course.
Volcker’s commitment to honesty forced recognition of our flaws. He refused to continue to “hide” nearly three decades of political failure and raised interest rates into double digits to force a change of course for an entire nation. I thanked him because raising interest rates forced homebuilders to create more efficient ways to fund home mortgages. The nation’s commitment to honesty weakened after Volcker retired. We went on a mortgage binge in the mid-2000s to give everyone a home while hiding the increased debt “off balance sheet.”
We spent “whatever it takes” to end the Great Recession that started when the US “subprime mortgage crisis” became a Global Financial Crisis. In 2001, George W. Bush committed to spend “whatever it takes” to fight terrorism, but refused to raise taxes to pay for that commitment. President Barack Obama deserves no flak for spending what W forced on him after missing all the pre-2008 signals of the impending crisis.
By 2007 (6 years into W’s admin), the best folks at FASB agreed with me that fraudulent accounting had accumulated more than $30 trillion of unreported systemic bank liabilities globally. During that time, I advocated a need to resolve that threat long before a collapse of capital would force stock markets over the “cliff” as in fact occurred in 2008.
Through the years of President Obama, American financed domestic spending and a global war on terror with debt. Political infighting again precluded responsible taxation to cover the accumulated costs. In 2017, President Donald Trump actually lowered taxes despite higher US expenditures at home and abroad. President Trump battled to close the door on immigration, this in a mistaken belief that immigrants “take jobs” from “us.” Incredibly, Trump would have us all believe that immigrants do not spend what they earn within the domestic economy.
In 2020, after Trump refused to listen when COVID could have been slowed by steps that have worked since the mid-1300s, he triggered an epidemic that required spending “whatever it takes” to prevent another depression. We added trillions more to the federal debt. In total, "W" and Trump borrowed and wasted more than $15 trillion of taxpayer money to finance domestic priorities and foreign wars.
GOP leaders now seek to blame President Joe Biden because he used roughly $1 trillion to rescue the nation from the disaster Trump left behind due to COVID. Benevolence, as Chris and I noted in our book "Financial Stability: Fraud Confidence and the Wealth of Nations," always gets you more bang for the economic buck than being miserable.
In the early 1980s, rising interest rates forced homebuilders to spend for the creation of stand- alone collateralized mortgage obligations (“CMOs”). Since 1983, that innovation has changed the world of finance. When the Global Financial Crisis hit in 2007-8, that model allowed the US bond market to create a system for financing all forms of investments without reliance on credit support from entities insured by the government. As a result, I told Mr. Volcker that his “honesty made my legal career.”
When I met with Mr. Volcker, we also discussed abusive derivatives of CMOs that were partly responsible for numerous crises after 1983. Most notable was the “Companion Class” CMO debacle that bankrupted Kidder Peabody and threatened General Electric (GE) in 1994. Fed Chairman Alan Greenspan replaced Paul Volcker in 1987. In 1994 he decided to raise rates to “discipline speculation” and almost caused a recession.
By the nature of their structure, Companion Class CMOs immediately extended in maturity and, of course, collapsed in value when the Fed raised interest rates. Any debt supported by the instruments collapsed in turn. Kidder Peabody had loaned holders of the securities a lot of money on security of pledged Companion Class instruments. The loans could not be collected and, within a year, most Kidder Peabody employees worked elsewhere and the firm’s name ceased to be used.
General Electric owned Kidder, but avoided reporting its loan losses by putting the impaired assets in an investment portfolio that was not “marked to market.” CMO technology is now applied to all sorts of markets around the world. That has eliminated a lot of “systemic risk” among insured depositories. But undisclosed losses are still losses. The Fed now has the same problem as faced Kidder Peabody decades ago.
By the impact of market losses by Rivian (RIVN), we are now seeing Ford (F) and Amazon (AMZN) being forced to recognize loss on those investments. Does that mean market losses of the past week will be reported as further write-downs among firms that invested in the firms that suffered loss? If so, could this trend generate a chain reaction of still more losses as past investment losses are reported? Not if we remember the rule of benevolence.
Investors and advisors should support a measured approach to taming today’s inflation, as recommended to Fed Chairman Jerome Powell by this Sunday NY Times editorial.
Chairman Powell has made clear that the FOMC is not entirely sure how to wind down the extraordinary accommodation of recent years. If honesty of valuation increases the volatility of markets, the losses may accelerate a reversal of inflation expectations. Inflation is a very significant problem today, and better disclosure and higher risk spreads may “self correct” inflation pressures. The best course for the Fed to pursue today would seem to be a measured pace that allows for change and adjustment.