Monday, March 14, 2005

The Fed sees bubbles -- and keeps them secret

MSN Money

In public, the Federal Reserve says there's no housing bubble. But the Fed also said there was no stock market bubble in 1999. Behind closed doors, the governors knew there was.

By Bill Fleckenstein

Our Fed chairman has argued (most recently last October, in a speech to America’s Community Bankers Annual Convention) that for a variety of reasons, real estate cannot experience a bubble. Yet anyone with a pulse can see wild speculation taking place all around them.

At the height of the stock-market bubble in the first quarter of 2000, it was becoming progressively more difficult for me to adequately describe (in my daily column) the market action. So, in an attempt to capture the mood of the day, I began to share stories of insane behavior that were being e-mailed to me by regular readers. I dubbed this series "The Mania Chronicles," and you'll find excerpts from it in Chapter 3 of the Archives section of my Web site. (Readers of the Contrarian Chronicles can access the site for the next week by using the password/username: mania/mania.)

The kind of maniacal behavior that we saw then toward stocks and which we are seeing now in real estate tends to come at the end of a speculative mania. It is almost always coincident with rising supply, which helps to satiate the inflated demand.
Banks and insurers
check your credit.
So should you.

As I have pointed out, the true danger in the real-estate bubble is that folks are often speculating with more than 100% leverage. When it all ends (and though we don't have a timeline for exactly when that will be), the banking system and other financial entities will be left with the bad assets, which will severely impact the economy.

So, even though I offer up the following vignette in a somewhat lighthearted way, everyone should be aware that the current insanity it demonstrates is very dangerous. Each e-mail I have received reveals a variety of preposterous assumptions made by the people depicted, but what the vignettes share is:

* The belief that one can't lose.
* Incredible greed.
* The absence of any common sense.

"In Chicago this weekend, there was an apartment conversion to condos where 200 people slept out overnight for a chance to be one of the first people to have a chance at buying a condo. I personally knew five people who stayed out all night, and these people were only buying on spec, with the thought of flipping the property in the next year or so. They believe it is impossible to lose money on this deal. It reminded me of when everybody would line up at stock-quote machines to check all their winning stocks."

Truth outed by a Fed transcript
Today's housing bubble is a consequence of policies designed to ameliorate the effects of the bursting of the stock-market bubble. All long-term readers know that I place the blame for the stock and real-estate bubbles squarely on Alan Greenspan and his easy-money comrades at the Fed.

Consequently, it was with interest that I read "Fed Officials Worried in 1999 About Managing Stock 'Bubble'" in last Monday's Wall Street Journal. The article discusses the fact that in 1999, Fed officials were aware of the stock-market bubble, even though they claimed before and after not to have known.

Related news and commentary on MSN Money
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• Housing bubble is real, report says
• Don’t get trapped in a housing bubble
• Home prices still headed high in 2005
• Housing mania will end in tears
• The housing bubble doesn’t add up

Since those days, I have been waiting to see the contents of the 1999 minutes, which are released with a five-year lag, to learn what the Fed was really saying, as opposed to what it said in public. With the Journal story serving as a reminder, I went to the Federal Reserve's Web site to review the just-released December 1999 Federal Open Market Committee minutes. I was shocked by what I found.

Lone wolf amidst bull bankers
In an introductory presentation to the FOMC, Fed economist Mike Prell noted the lunacy as follows:

"I refer to the incredible run-up in 'tech' and e-commerce stocks, some which have entered the big-cap realm without ever earning a buck. To illustrate the speculative character of the market, let me cite an excerpt from a recent IPO prospectus:

'We incurred losses of $14.5 million in fiscal 1999, primarily due to expansion of our operations, and we had an accumulated deficit of $15 million as of July 31, 1999. We expect to continue to incur significant . . . expenses, particularly as a result of expanding our direct sales force. . . . We do not expect to generate sufficient revenues to achieve profitability and, therefore, we expect to continue to incur net losses for at least the foreseeable future. If we do achieve profitability, we may not be able to sustain it.'

"Based on these prospects, the VA Linux IPO recorded a first-day price gain of about 700% and has a market cap of roughly $9 billion. Not bad for a company that some analysts say has no hold on any significant technology. The warning language I’ve just read is at least an improvement in disclosure compared to the classic prospectus of the South Sea Bubble era. . . .

"But, I wonder whether the spirit of the times isn't becoming similar to that of the earlier period. Among other things, it may be noteworthy that the tech stocks have done so well of late in the face of rising interest rates. Earlier this year, those stocks supposedly were damaged when rates rose, because, people said, quite logically, that the present values of their distant earnings were greatly affected by the rising discount factor. At this point, those same people are abandoning all efforts at fundamental analysis and talking about momentum as the only thing that matters (and that’s just like right now!).

"If this speculation were occurring on a scale that wasn't lifting the overall market, it might be of concern only for the distortions in resource allocation it might be causing. But it has, in fact, been giving rise to significant gains in household wealth and thereby contributing to the rapid growth of consumer demand -- something reflected in the internal and external saving imbalances that are much discussed in some circles. Whether our assumed 75 basis-point increase in the fed funds rate would be a sufficient shock to halt this financial locomotive is open to question." (The emphasis is mine.)

Failing to follow the bouncing bubble
One can quickly see that this particular Fed staffer understood what was going on, although without knowing more of his thoughts or talking to him, I'm not sure if even he comprehended just how misallocated capital was at the time. We must also remember that this was only December 1999, with another 50% rally in the Nasdaq Composite ($COMPX) yet to come.

In any case, one might have thought that after such a powerful introduction by Prell, some of the Fed governors might have had their curiosity piqued. But near as I could tell in going through the Q&A that followed his remarks, most of the governors were much more concerned about economic minutiae than the epic bubble they had blown. Y2K was supposedly a concern at the time, though I read with interest that "bankers around the (Philadelphia Fed) district reported that they believe that Y2K will be a non-event."

Given the concern by some Fed staff members that a bubble was brewing and that certain district reports thought Y2K might be a non-event, one might have thought that a sober band of concerned citizens might have tried to ensure that the liquidity the Fed was forcing into the economy wouldn't be used for more speculation.

But, of course, that was not the case. When Greenspan discussed the stock market in passing during the meeting, he said, "It is only a question of how much of a bubble there is in the process." In public, he repeatedly said the opposite. (Still denying it was possible to spot one, even after the blow-off of the first quarter of 2000, in a Q&A before Congress in April 2000, he stated: "That presupposes I know there is a bubble. I don't think we can know there is a bubble until after the fact.")

Considering how out-of-control the mania was in 1999, I was struck that this group of clueless buffoons spent nearly half the time (according to the transcript of this meeting) arguing about whether the post-séance communiqué should contain the language "asymmetric," "symmetric" or a little of both, etc., rather than spending any time discussing what their actions had wrought in the stock market and the economy.

Al was so pleased with himself in the lead-up to the voting that he opined: "Having said all that, my view on policy is, if I may reference Governor Kelley's comment about raising his hand and saying present, that I almost think the best way we could have gotten through this period would have been somehow to cancel this meeting. The reason is that markets, as far as I can see, seem to be pretty much where we as a Committee would like them to be." (The emphasis is mine.)

Bouncing from bubble to bubble
There you have it: The most incompetent and irresponsible Fed chairman in the history of the world thinks nothing of talking from both sides of his mouth about whether he can identify a bubble. He blows the biggest one in history, claims he didn't know it was happening. And then he bails it out with a housing bubble that he says can't exist because real estate can't experience a bubble.

What I'd like to know is, given not just Alan Greenspan's record but also what he says in public (and what we can now see he says behind the public's back), how can this menace to society have any credibility whatsoever? I certainly don't know. I encourage everyone to read through these minutes just to get a flavor for how completely untrustworthy and shallow these people are.


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