RealMoney Silver - Profit From Government's Response to Crisis

Profit From Government's Response to Crisis
By Jeff Miller
RealMoney.com Contributor
8/23/2007 5:54 AM EDT

There is value in seeing things from different viewpoints, especially if one wants to make winning trades, and active traders and fund managers have a very different perspective than government policymakers do.

It is easy for those of us managing money to drift into a mode in which we believe that we see the future more clearly than policymakers and that we know exactly what they should do.

The most-important government decision makers are generalists, and many are elected or appointed by elected officials. If we had their jobs, we would probably behave as they do. Elected policymakers consider ideology, the consequences for their political base, and their own electoral chances. Many also think about the overall good of the country. They want to look good while going through this process. They often make strong statements as an initial position, while prepared to compromise and negotiate.

It is a process of building consensus. It is how our democracy works. It often seems too slow, and sometimes it is too slow. But the astute investor may well benefit from stepping out of his or her own traditional role and attempting to view the problem from a different perspective.

The Trader Perspective

Here are a few characteristics that reflect the market mind-set of active traders (a term I will use to include all of us who are fund managers, investment advisors and active individual traders). The elements of the mind-set are drawn both from conversations and written reports.

Narrow trading range: Before the last few weeks, we had become accustomed to a rather narrow trading range, with modest corrections. Volatility has been low by historical measures. Despite this, it has usually been right to fade small moves and sell option premium. Our notion of what constitutes a crisis is conditioned by this focus.

Large and leveraged positions: In an effort to generate above-market returns in this multiyear environment, many traders have taken on positions that are too large and too leveraged. The recent risk/reward differed from the historical risk/reward. Highly leveraged hedge funds and aggressive selling of puts are two examples.

Expectations about government: Many of us have grown to expect, despite our underlying confidence in markets, that problems will generate an instant government response. Some call it the "Greenspan put," but it really goes beyond Fed policy.

Dismissing outside messengers: There is a lot of information about how others are viewing current problems. It is tempting, if we disagree with the conclusions, to dismiss these messengers as wrong-headed, misguided or failing to see reality. Recent examples include the following:

Ben Stein trying to place mortgage problems in perspective
Treasury Secretary Paulson's interview on the economy and policy options
George Will's column about the Fed and moral hazard.

The Policymaker Perspective

Right or wrong, policymakers take a far different perspective than those intimately involved with the markets. There are several important distinctions.

Problem recognition: Policymakers do not see a 10% market decline in the same way that money managers might. Many view it as normal. Others expect that the market will resolve any problems. Even when focused on the impacts for homeowners, borrowers and corporations, it is not automatically a problem unless there is a failure of free markets. In general, this is the perspective we should hope them to take. Usually, it is correct.

Different time frames: Those of us managing trading accounts make quick decisions. We look at information and make a trade. Some may alter overall positions many times a day. For us, a period of a few weeks is an eternity.

For policymakers, the time frame is completely different. Nothing happens quickly. The government is fastest in dealing with problems such as natural disasters. When a bridge collapses, there is an obvious need and a standard solution. When the issue is more complex, problem recognition is slower. Many key decision makers are asking whether the current credit issues involve a normal market correction or constitute evidence of a systemic problem.

The president, to take the most important example, has a watch that includes scores of issues. Many of them may seem more important than the issues that occupy our days, and some of them really are.

Agreement about the Problem

Action requires agreement about the nature of the problem.

While the answer to this question may seem obvious to us, pretend for a moment that you are a member of Congress. Your focus might well include homeowners, businesses and investors. You might need some education about why credit markets are not functioning properly and what alternatives are possible. This process usually includes committee hearings and testimony from experts.

Government policymakers rely on government data. They set the rules for how things are measured. They believe that decisions made from these data are strong and logical and also defensible in the political arena. While many of us may find fault with various government statistics, we should recognize that policymakers do not agree.

In particular, the Fed has stated that its decisions about interest rates are data-dependent. Fed members are cognizant of the foibles of any specific report but attentive to trends in actual data. They augment this with plenty of conversations and anecdotal evidence.

They have their own views about what information is forward-looking, and those views differ quite dramatically from many market pundits'. The data they see has shown a strong economy and somewhat resistant inflationary pressures. Many of my colleagues on RealMoney find fault with each and every report. Well and good, but they are not on the Federal Open Market Committee.

If you are trying to predict what will really happen, feel free to speculate. You might end up a big winner. If you are trying to predict what the Fed will do, it is better to look at reported data. Put yourself in the chair of a Fed governor at the meeting.

Available Alternatives

There are two fast fixes. One is for the Fed to cut interest rates. The Fed members are well aware of the arguments. They understand about adding liquidity on both a permanent and a temporary basis. They also grasp the idea that adding liquidity may not restore active trading in the most-relevant markets. The Fed is advised by over 300 economists, and they follow the markets.

The second fix is to allow current government-sponsored entities, or GSEs, to expand their balance sheets and (perhaps) to raise the limit on conforming loans above the current $417,000.

The expansion of overall lending limits is actually the fastest and easiest method to restore a bid to certain mortgage paper and help many of those seeking loans. The loan-size adjustment requires Congressional action. Traditional GOP resistance to the GSEs and reaction to their accounting problems have stalled this option. Even the private companies whose stocks have been under pressure, such as Thornburg Mortgage (TMA) , oppose raising the conforming loan cap for GNMA and Freddie Mac (FRE) loans.

When participants have so much disagreement, it is unreasonable to expect policymakers to reach a quick consensus.

Building Consensus

Even when leaders have a clear vision, the governmental process requires consensus-building. We are accustomed to seeing unanimous or near-unanimous votes from the Fed. When Paul Volcker lost the consensus, his power was reaching an end. The unanimity comes from a behind-the-scenes process of building agreement. It takes discussion, evidence and time.

Changing policies at the legislative level takes even more time.

Legislative leaders look to their own constituencies. These are more likely to be homeowners than big investors. They are doing what they should do in a representative democracy. If you or I were in their position, we would be listening to constituents and their concerns.

We should expect to see the introduction of various measures, including new rules for lenders, provisions permitting "workouts" of existing loans, temporary halts to foreclosures and emergency funding. Some of this may happen at the state level, since not all states have the same problems. Policymakers will also consider stronger regulation of future lending.

These ideas might be stopgap or misguided, but that is not the point. This is the way government addresses problems, often starting with the current symptoms. Government subsidizes flood insurance, for example, encouraging building in flood plains, while simultaneously offering relief efforts to victims.

Many ideas that are not really serious solutions will be advanced because they demonstrate attention to the problem. Every presidential candidate can be expected to do this, as will many members of Congress.

It is good strategy to show concern, even if the measure has no chance of passage. Once again, it does not mean that the representatives are stupid. They have a different job, and that is how the work is done. It is part of the explanation for why people hold Congress as an institution in low regard while giving high ratings to their own representatives.

Policymakers Matter

My general conclusion is that we should all be cognizant of the policymaker perspective in making trading decisions. Do not expect policymakers to see problems and react to them on the same time frame, evidence or policy bias that we might have. They read and think about Ben Stein, George Will and academic experts. To them, it is not all about the market.

The Fed is mostly concerned about inflation expectations, economic growth and the stability of the financial system. We infer much more attention to "asset bubbles" than the books about Fed behavior actually reveal.

I began writing this piece before Friday's Fed action, lowering the discount rate and extending the borrowing period, as one of the policy options. The Fed is trying to address the specific problem: illiquidity in certain credit markets. The action taken has important symbolic value in demonstrating awareness of the economic risks if the problem is not addressed. The change may be designed to stimulate private lenders to re-establish bids for mortgage securities involving loans without high foreclosure rates.

Some analysts even called it a "trial balloon" for a cut in the fed funds rate, with many economists joining in. It removes the inflation bias portion of the last FOMC statement.

Complicating the interpretation of this move is the lack of precedent. The full percentage-point difference between fed funds and the discount rate is a recent development. Returning temporarily to the historic difference of 50 basis points sends a message, but what is it?