Release Date: January 30, 2008

For immediate release

The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 3 percent.

Financial markets remain under considerable stress, and credit has tightened further for some businesses and households.  Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets.

The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.

Today’s policy action, combined with those taken earlier, should help to promote moderate growth over time and to mitigate the risks to economic activity.  However, downside risks to growth remain.  The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh.  Voting against was Richard W. Fisher, who preferred no change in the target for the federal funds rate at this meeting.

In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 3-1/2 percent.  In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Philadelphia, Cleveland, Atlanta, Chicago, St. Louis, Kansas City, and San Francisco.

Like stopped clocks that are right twice a day, the Greek chorus of perennial economic pessimists is chortling. At last, their Cassandra-like chanting has moved to center stage, amplified by the megaphone of last week's Davos gabfest. Nouriel Roubini, a New York University economist, sees a recession that will be "ugly, deep and severe." From Morgan Stanley's Stephen Roach: a potential economic "Armageddon" (a 2004 warning). Even the esteemed George Soros calls the current situation "the worst market crisis in 60 years."

Worse than the early '80s, when wildly exuberant lending thrust a thousand savings and loans into insolvency, and some major U.S. bank stocks plunged to single digits? Worse than 1981, when the Federal Reserve drove its key interest rate to 19% in an effort to staunch inflation? Remember the 1970s, when our economy was mired in stagflation? More painful than the dot-com hangover — hardly a distant memory — when the Nasdaq fell by 78% amidst widespread corporate bankruptcies? Let's get real.

Make no mistake, the U.S. economy is weak and getting weaker. Recession odds have elevated to Condition Red. And hard experience confirms that detecting downturns is far easier through a rearview mirror than through the windshield. But the probability remains that what our economy faces is less a plunge into the dark ages than a cyclical purging of excesses — perhaps akin to the eight-month recession in 2001.

While the suddenness of the slowdown and extent of the turmoil in financial markets surprised many, the inevitability of a correction should have been evident. We've been aware for years that housing prices had soared well above their historic relationship to personal income. Americans were consuming beyond their means. Risk premiums — the extra amount that investors get paid for buying paper other than Treasuries — had fallen to record low levels that were clearly unsustainable. As those bubbles continued to inflate, we've known that the magnitude of the inevitable correction was growing.

It's easy to understand the fear that has enveloped our financial system, a fear grounded in the complexity and lack of transparency associated with the rise of increasingly esoteric derivatives with equally opaque names — credit default swaps, CDOs, RMBSs and the like. But remember that the same derivatives that are now terrifying even major financiers are what have increasingly allowed banks to spread risk in a way that was never before possible.

Some of that risk was exported. That's why financial institutions across the world and even small towns in Norway are feeling the pain of subprime losses in the U.S. while our banks remain solvent, able to absorb their portion of the write downs. Contrast that to the consequences of the bout of overeager lending two decades ago, when major institutions like the Bank of New England went bankrupt and still larger banks nearly toppled.

So pronouncing the demise of the world's most productive economy is surely premature. Count among our other blessings a flexibility that has kept inflation low and given the Federal Reserve the scope to reduce interest rates without triggering inflationary fears. Even as rates have been lowered by 1.75 percentage points since last summer, inflationary expectations, as measured by Treasury Inflation Protected Securities, have slid (from 2.7% in June to around 1.8% today).

Compare that to Europe, where a stubbornly higher inflation rate has tied the hands of the European Central Bank. Would we really prefer to trade our economy for that of old Europe?

Accompanying the cries of the Cassandras has been another (sometimes overlapping) chorus of diatribes aimed at policy makers working to soften the pain of the adjustment process. Many of those jeremiads have been aimed at the Federal Reserve for having acted either too quickly or too slowly and, of course, for having created the problem in the first place by keeping interest rates too low for too long.

Anyone can call plays from the bleachers. But just as we don't stand over doctors in an emergency room, we need to lay off the Federal Reserve and its chairman, Ben Bernanke. No doubt, history will find some fault with Mr. Bernanke's real-time decision making. But given the uncertain and fast changing dynamics, the Fed should be commended, not demeaned, for its actions thus far.

At the same time, monetary policy can't by itself provide the spark that the economy needs. For one thing, relying completely on lower interest rates jeopardizes the progress that's been made since last summer in convincing markets that, yes, bad investment decisions will lead to losses. For another, monetary policy, which operates through lower interest rates, aids some — but not all — corners of the economy.

That's why we need to get behind last week's remarkable agreement between the White House and Democratic lawmakers on a stimulus package of tax cuts and rebates. Instead of yet another round of carping, congratulations should be offered, particularly to Treasury Secretary Hank Paulson and House Speaker Nancy Pelosi, for bridging difficult partisan differences.

No doubt, anyone could find fault with aspects of the package. For my part, I'd happily part with the ineffective accelerated depreciation and add a dollop of extended unemployment benefits. But of all the stimulus measures that have been assembled in our Washington sausage factory in past decades, this may well be the best, and the Senate needs to get over its hurt feelings about being left out of the negotiations.

This package need not be the end of our efforts to address our economic challenges, particularly the plight of homeowners. While the proposed legislation offers some hope for easing the mortgage crunch, more should be done.

In particular, we should reach back to the Depression and consider resurrecting the Home Owners' Loan Corporation. Created in 1933, that long-forgotten agency bought defaulted mortgages from savings-and-loan institutions at discounts to face value and then negotiated new terms with stretched homeowners to avoid foreclosure. By the time it finally closed down in 1951, the HOLC had aided one in five mortgaged dwellings and had even turned a small profit for the government.

We also should reform the patchwork of government regulators overseeing our financial institutions, to provide more coherence. While Alan Greenspan's Fed shouldn't be blamed for keeping rates low for too long (would we really have wanted slower growth these last five years?), it did ignore its responsibilities to regulate predatory lending. (Too much Ayn Rand and not enough FDR.) Additionally, with the internalization of financial markets, attention should be paid to Mr. Soros's excellent suggestion of more globally coordinated regulation.

Ironically, America's most serious economic challenges are almost surely the ones currently receiving the least amount of attention. Let's not forget that income inequality has risen to record and unacceptable heights. Nor should we lose sight of vast unfunded future obligations — $50 trillion, by some government estimates — for social welfare programs, particularly Medicare. Finally, as presidential candidates on the campaign trail remind us regularly, we have important unmet needs, ranging from health care to infrastructure.

While further stresses are inevitable as the adjustment process continues, our economic bedrock remains fundamentally strong. We have the means to continue to prosper, as long as we don't panic just when we should be getting down to work.

Mr. Rattner is managing principal of the private investment firm Quadrangle Group LLC.

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Paul D. Deng
Department of Economics
Brandeis University
IBS, MS 032
Waltham, MA 02454
http://www.pauldeng.com

The Loss Where No One Looked

Jérôme Kerviel, the Société Générale employee who sparked the world's biggest-ever trading loss, was so low on the bank's totem pole that some didn't consider him a trader at all.

That may have been what allowed him to pull it off.

According to preliminary inquiries into the trading fraud that cost Société Générale €4.9 billion ($7.2 billion), Mr. Kerviel allegedly placed hundreds of thousands of unhedged real trades on stock-index futures markets. (Read the bank's statement¹.)

For months, Mr. Kerviel avoided detection because — even as he allegedly built up massive positions — he always managed to square his books as a low-level trader in the "Delta One" desk: never make a big profit or loss. When one trade caught the attention of a supervisor last week, and the system collapsed, myriad small losses compounded into a huge financial hole for the bank.

A prosecutor is due to decide today whether to put Mr. Kerviel, who was questioned by police this weekend, under formal investigation. Through his attorneys, Mr. Kerviel has denied wrongdoing.

Had Mr. Kerviel been one of the A-league traders in Société Générale's most prestigious perch — the desks that handle complex equity derivatives — his actions likely would have drawn more attention.

To run that section of its business, Société Générale spends a fortune luring talent from France's elite engineering schools to nab people who can develop "exotic" derivative products, using sophisticated computer models.

But the Delta One desk on the seventh floor of the bank's headquarters in western Paris deals with the boring corner of the equities derivatives market: It's a low-risk division where Société Générale and its clients can place basic bets on whether a stock market index will rise or fall. Profits are generated through the sheer volume of transactions.

"We all lived in fear that something within the exotic products would blow up in our face. It never came to our mind that we might have a problem with Delta One," said a top Société Générale official.

Arrival at Delta One

Though even within Société Générale, traders held little regard for the Delta One desk, for Mr. Kerviel, just getting there had been an achievement. For his first five years at the bank, beginning in 2000, he toiled away at a back office of the prestigious equity-derivatives desk, a place that other traders derisively refer to as "the mine."

In 2005, Mr. Kerviel was promoted to the Delta One desk. There, his job was to invest in portfolios that took opposite bets on the direction of the markets. The bets essentially were supposed to offset each other in what is typically a low-risk way to make a small profit.

Mr. Kerviel was given an annual target: earn between €10 million and €15 million for the bank. And he was given a small margin to play with: the net value of his almost perfectly balanced portfolio of bets should be kept roughly under €500,000.

But while there, Mr. Kerviel found a way to rack up a potential liability of €50 billion via a simple scheme: Making bold trades in one portfolio and then covering up those positions with a fictitious, second portfolio. That led to a neutral trading account that wouldn't draw attention.

Scattered Trades

In addition, the trades were scattered on several separate balance sheets, and drawn into the massive flow of daily transactions, so the bank never realized Mr. Kerviel was vastly exceeding his risk limit.

The fake trades in the second portfolio were fake trades with actual banks or clients. Rather than betting on futures with an exchange — a move that would trigger money flow and would have left trails — Mr. Kerviel used forward transactions, which often don't require actual cash to exchange hands.

With this type of over-the-counter transaction, clients didn't know that they had been used to make a fake trade.

Books Check Out

When the bank checked Mr. Kerviel's books, the real and fictitious trades balanced out within the trader's risk limit and everything looked normal.

Several times, Mr. Kerviel's supervisors spotted mistakes in the trader's books. But Mr. Kerviel would claim it was a mistake and fix it, said Jean-Pierre Mustier, head of Société Générale's investment-banking arm.

"Société Générale got caught just like someone who would have installed a highly sophisticated alarm … and gets robbed because he forgot to shut the window," said the Société Générale manager.

Much of Mr. Kerviel's real trading was in making bets on the future prices of big European indexes, including the Dow Jones Euro Stoxx 50, the DAX index in Germany and the CAC-40 in France.

Total Exposure

As of Jan. 18 — the day Mr. Kerviel's ruse went astray — Société Générale had €18 billion of exposure to the DAX, €30 billion exposure to the DJ Euro Stoxx 50 and €2 billion to the FTSE 100 Index in London, according to Mr. Mustier. All of these exposures were established this year in a short period of time, he said.

As he traded, Mr. Kerviel had to circumvent rules on how much one portfolio gain or loss could exceed a mirroring set of trades. For example, if Mr. Kerviel hypothetically bet that an index would rise in value €10, he would need to make a counter trade to cover that amount.

To balance the books, Mr. Kerviel began using the fake trades in a second portfolio, bank officials say.

For example, in his real trade, Mr. Kerviel was betting that indexes would rise at a certain point in the future. To offset that real risk, Mr. Kerviel made fake trades to show he had taken positions for a drop in the indexes, bank officials say. He forged trade documents on these trades, they add.

Covering Tracks

Once Mr. Kerviel had offset his real trading positions with fake ones, he still needed to cover his tracks. So he would erase his fake trades just before his books were checked, bank officials say. Once the threat had passed, he quickly would re-enter the trades to balance his positions. The temporary imbalance, apparent for just a few minutes, failed to set off alarms.

Mr. Kerviel also had to cancel the fake trades before confirmations of those trades were sent to the alleged counterparties such as banks. Bank officials say he used computer access codes to enter the bank's system and cancel the trades. He then created more fake trades to keep his books balanced. Mr. Kerviel's trading in 2007 essentially was flat in terms of profits and losses. But his 2008 trading yielded actual losses and trades.

The juggling act ended Friday, Jan. 18 when a counterparty trade exceeded a certain financial threshold. That then led to the discovery of a suspicious trade confirmation email.

At 10 p.m. that Friday, Mr. Mustier received a phone call that something had gone wrong.

I believe the monoline insurance companies like Ambac and MBIA are in worse shape than most realize, the counter-party risk in the $45 trillion Credit Default Swap market is much worse than we realize, and the exposure by various banks to their problems is much larger than currently understood. The Fed understands this, and realizes that they have been behind the curve but need to catch up. Let's go back and look at this quote from my letter just last week:

 

"If you are a bank or regulated entity, and you have mortgage-backed securities that have been written by a AAA monocline company, you can carry that debt on your books as AAA. But as the companies get downgraded, you have to write down the potential loss. Quoting from a recent note from Michael Lewitt:

 

" 'MBIA's total exposure to bonds backed by mortgages and CDOs was disclosed to be $30.6 billion, including $8.14 billion of holdings of CDO-squareds (CDOs that own other CDOs, or mortgages piled on top of mortgages, or, to quote Jeff Goldblum's character in Jurassic Park again, 'a big pile of s&*^'). MBIA was being priced as a weak CCC-rated credit when it issued its bonds last week; it is now being priced for a bankruptcy. MBIA's stock, which traded just under $68 per share last October, dropped another $3.50 this morning to under $10.00 per share.

 

" 'The bond insurers' business model is irreparably broken. In HCM's view, it will be all but impossible for these companies to raise capital at economic levels for the foreseeable future and certainly in enough time to work out of their current difficulties. The performance of MBIA's 14 percent bond issue will prove to have been the death knell for this business. The market needs to come to the realization that the so-called insurance that these companies were offering is not going to be there if it is needed. The fact that these companies were rated AAA in the first place will remain one of the great puzzles of modern finance for years to come.'

 

"You can bet that the $8 billion in CDO-squareds is gone. It is a matter of time. MBIA's market cap is about $1 billion [it is now at $1.74]. Current shareholders will be lucky if they only get diluted 75%."

 

Think this through. MBIA is still rated AAA. Ratings downgrades are just a matter of time. Banks that raised $72 billion to shore up capital depleted by subprime-related losses may require another $143 billion should credit rating firms downgrade bond insurers, according to analysts at Barclays Capital.

 

Banks will need at least $22 billion if bonds covered by insurers, led by MBIA Inc. and Ambac Assurance Corp., are cut one level from AAA, and six times more than that for downgrades by four steps to A, as Paul Fenner-Leitao wrote in a Barclays report published today. Barclays' estimates are based on banks holding as much as 75% of the $820 billion of structured securities guaranteed by bond insurers. (Source: Bloomberg)

 

The stocks of MBIA and Ambac have risen on speculation of take-overs or a rescue. But MBIA is going to have to cover that $8 billion of CDO squareds. With what cash? MBIA makes about $5 billion a year. It will take almost two years' earnings just to deal with the losses from CDO squareds. Not to mention the subprime mortgage exposure.

 

But what if the above-mentioned monolines are downgraded to junk, as was ACA when it could not raise capital? As the downgrades on various mortgage assets and the CDOs continue to increase, the ability of the monolines to deal with the problems is going to come under increasing question. The losses at major banks could be much worse than $122 billion if they are downgraded to the same junk level that ACA was.

 

And that is just the credit default swaps (CDSs) from the monolines. What about the trillions that are guaranteed by banks and hedge funds? There are a total of $45 trillion CDSs outstanding.

 

No one is really sure who owes what and to whom, and what is the risk that there may be no one to pay that CDS when it comes due? The entire mess is going to have to be unwound in the coming quarters. It may take a year or more.

I think the concern that there is the potential for a much worse credit crisis than we are currently experiencing is what is driving the Fed. They are looking at the problem from the inside, and realize that they simply have to engineer a much steeper yield curve to allow the banks to make enough profits so that they might be able to grow their way out of the crisis over time.

If I am wrong and the Fed was responding to the stock market, then we will likely not see a cut this next week. But if we get another 50-basis-point cut, as I think we will, then it means the Fed is responding to concerns about the credit crisis. And we will get another cut the next meeting and the next until we get down to 2% or below.

 

A 50-basis-point cut takes the rate to 3%. It they had cut the rate by 1.25% next week, the market would have collapsed. Better to do it in two leaps is what I think they are thinking. We will see. And it is not just the Fed that is concerned.

Paying for 'Goldman Envy'

Why did some banks and brokerage firms get so badly scorched by the subprime debacle and others come through relatively untouched? What's the difference between Citigroup and J.P. Morgan Chase? Morgan Stanley and Goldman Sachs? UBS and Deutsche Bank? Merrill Lynch and Lehman Brothers?

On the face of things, these companies may look quite similar to those they're paired with. But Citi, Morgan Stanley, UBS and Merrill have among them written off $65 billion so far because of the credit crisis. Meanwhile, J.P. Morgan Chase, Goldman, Deutsche and Lehman have racked up write-downs totaling around $9 billion. The average share-price performance of the first quartet was minus 36% last year. The latter group was down 5.3%.

There are several reasons for this. One is luck. But something else explains a lot of the difference. The losers were infected by what one could call Goldman envy. The winners were more immune to the malady.

Goldman envy started to become a serious problem after the turn of the millennium, when that Wall Street firm started to pull away from the investment-banking pack. Its profits per employee rose sharply as it deployed more of its own capital to big and sometimes complex bets — whether it was trading securities on its own account or investing in private equity.

Of course, it wasn't just Goldman that had competitors turning green. They also were agog over the burgeoning hedge funds and private-equity groups that have been raking it in over the past few years and making ordinary investment bankers seem like poor relations. And many yearned for the juicy returns of Lehman Brothers' mortgage business.

One common response among those lagging behind has been to try to emulate the alpha males of the banking world — in particular by increasing their bets in the once-booming fixed-income market.

Former Merrill boss Stan O'Neal would frequently berate his subordinates for not delivering Goldman-like results. Morgan Stanley's ex-second-in-command Zoe Cruz was constantly using Goldman as the yardstick for her firm's performance. And Citi executives described the megabank as a growth stock until just recently, putting its businesses under pressure to show commensurate earnings growth.

The snag is that mere desire doesn't turn a chimpanzee into a gorilla. Building successful operations takes time. Part of Goldman's success comes from the fact that its risk-taking approach — and the accompanying discipline of risk management — derives in part from betting its employees' money.

But desire can drive reckless growth. Take Citi and Merrill. Five years ago, neither was a big player in underwriting subprime-mortgage bonds and collateralized debt obligations, or loans often tied to risky mortgages, that were repackaged into different levels of risk. But by 2006, they were at or near the top of the league tables for both markets.

The snag is that a bank is unlikely to manage things well when it's expanding rapidly and doesn't have experience. It may put the wrong people in place, not institute the right controls and implement the wrong incentive schemes.

The banks and brokers with the biggest problems seem to have made such mistakes. UBS, for example, quickly ramped up its residential-mortgage business. But not because there was any strategic value in being in that market. Rather, it decided it wanted to bulk up in the hot securitization business, and trading and underwriting residential mortgages and CDOs was the easiest part of the market to enter.

So why were others relatively immune to Goldman envy? Well, Lehman had a big, lucrative mortgage-lending and structuring business, so it didn't need to engage in a breakneck game of catch-up. Deutsche arguably also had a more ingrained risk-taking culture. Meanwhile, J.P. Morgan had more market-savvy leadership in James Dimon than, say, Citi had in Charles Prince.

All this suggests two lessons. If you are a chimp, don't try to kid yourself that you're a gorilla. And, if you see a chimp pumping itself frantically with steroids, sell its stock.