Kids say the darndest things...and so do central bankers.
In a recent sit-down with Yahoo Finance's editorial team, San Francisco Fed President John Williams was asked about the risks of a bubble in the tech sector generally, and the Bay Area specifically. After saying he wasn't particularly concerned about a bubble in the SF Fed's district, Williams added: "On the West Coast we invent things without leverage, and on the East Coast you create [mostly] leverage."
The implication, of course, is that while Wall Street titans are busy inventing derivatives and other such speculative financial tools that depend on leverage, California’s innovators are creating useful, tangible things that serve consumers and corporations – without the need for massive amounts of debt.
Williams didn't quite go that far but he also didn't back away from the comment in a follow-up conversation.
"I was being a little facetious saying that all innovation comes from the West Coast," he said. "But financial companies arguably do relatively little innovation in matters of productivity and run with huge amounts of leverage that have been at times a threat to the financial system."
Notably, Williams referenced a 2009 speech in which former Fed Chair Paul Volcker suggested the ATM was "the most important financial innovation" of the past 20 years and openly questioned whether the financial sector really deserved such a high percentage of the nation's profits. "Is that a reflection of all your financial innovation or is it just a reflection of how much you pay?" Volcker wondered.
The San Francisco Fed president further noted "thoughtful research literature" by academics such as Stanford's Anad Admati that "highlights incentives to create these [derivative] instruments beyond their social value. There's a positive side to [finance] but also a negative side."
Williams demurred when I asked if Volcker's perspective represented the prevailing outlook at the Fed, saying, "I can only speak for myself."
But in doing so, he offered a refreshingly candid window into how some policymakers view the world, albeit one subject to interpretation.
'Masters of the Universe' No More
"[Williams'] comment reflects a growing feeling among policymakers that preference within the national economic policy matrix should be given to firms that produce real goods as opposed to derivatives," says Joe Brusuelas, chief economist at McGladrey. "His comment is indicative that the preferred place of finance over the past 35 years has come to an end."
On the other hand, "the business of the Fed is the 'real economy,'" says David Kotok, who oversees roughly $2.3 billion in assets as chairman and CIO of Cumberland Advisors. The central bank "is of necessity in the financial market business too: They get distracted by the financial economy because of its behavior whether it's 'irrational exuberance' or a CDO that blows up."
The real meaning of Williams' comment, according to Kotok, is that the Fed's zero interest rate policy invites leverage -- and its a bicoastal problem. "The most enduring quality of asset pricing is the discounting mechanism of interest rates," he says. "And if the interest rate being used to discount is zero or near it, it makes the price of any asset - real estate, stocks, art -- infinite in potential price levels. That's what he's really saying."
A spokesperson for New York Fed President William Dudley, who might be inclined to defend Wall Street, did not respond to a request for comment.
Here are some replies from other sources with whom I shared Williams' quote:
- "I think that's actually a really interesting point - if you aren't a forced seller because of debt being called, you can make long-term investments that don't have to crash. The problem is that everyone has figured that out. Also, the Fed is a shadow lender to the Valley whether they realize it or not. [Venture capital] is just as much a part of the chase for returns as every other asset class." -- Josh Brown, The Reformed Broker, Ritholtz Wealth
- "Many U.S. stocks are expensive and even overpriced perhaps, but there is not a bubble yet – except the one in government bonds." -- Jim Rogers, chairman Rogers Holdings.
- "I find it a little ironic to hear John Williams, successor to Janet Yellen, sounding a little like an Ayn Rand superhero, talking about how his guys are doing the roll-up-your-sleeves, sweat equity work, while the effete East Coast guys are pushing paper around and making profits by leveraging up. The abundance of money to fund all those venture capital investments in Silicon Valley didn’t materialize out of the desert, but rather was fathered by the same central bank policy that engendered all the leverage at which Williams apparently scoffed. So I see them as offspring of the same misguided policy." -- Scott Frew, general partner, Rockingham Capital Partners LP
- "Great quote. But that's insane. Real estate in SF is silly as is traffic and so you can't just use the word bubble on either side loosely. The long tail of this boom could be messy. Each coast has massive inflation and all these guys have NIMBY vision and bias. That's dangerous." -- Howard Lindzon, chairman StockTwits.
- "It’d be hard to quantify, since so much of the West Coast funding is in private markets. The concept, however, is pretty solid, and IMO worth explaining to readers: tech investments are almost entirely equity financed. And unleveraged. Absence of leverage puts a huge dampener on ripple effects. No need for forced selling. The stuff [central bankers] worry about are levered fixed-income positions that, under pressure, guys would be forced to sell, exacerbating the undershoot and causing collateral damage to those who provided the leverage. This is why the 2008 unwind was so much more damaging than 2000. I don’t think they believe these risks are currently high, but they do want to make sure they stay out in front of them so as to minimize taper tantrums. I call it the Fed’s Avalanche Patrol strategy." -- Mark Dow, Behavioral Macro blogger, former hedge fund manager, former staff economist at Fed and Treasury.
- "Looks like some sectional chauvinism with one's tongue firmly in one's cheek." -- Arthur Cashin, director of floor operations, UBS.
- "The tech sector doesn't use leverage because nobody would lend to 'em. They're only equity funded because they have no collateral. And West Coast real estate has much higher leverage than anywhere in country because of demand and the constrain on supply." -- Chris Whalen, senior managing director at Kroll Bond Rating Agency.
- "He is totally right. In fact, the innovation is happening so quickly here that it will have a massive deflationary effect across all of society. This is both a problem and a benefit to Americans." -- James Altucher, author, entrepreneur, blogger.
- "That is a very good observation, with some caveats. The biggest one is that the failure rate on the West Coast is much higher at an individual investment level. In many ways San Francisco never stopped being a gold rush town. Lots of people stake a claim, but most of them amount to nothing. A few get rich. Same with gold mines, same with venture capital. Then there is some history... Back in the late 1990s, there was plenty of leverage on technology, in the form of margin debt supporting equity valuations of ultimately worthless companies. To bypass that simple lesson of history seems odd." -- Nicholas Colas, chief market strategist, Convergex
'A Gigantic Realignment of Monetary Policy'
Beyond that, a few sources agreed that regulatory changes in the financial sector have resulted in less liquidity in the real economy. This is "reflective of the structural transformation in finance and the broader economy to Dodd-Frank and regulatory policies pursued by the Treasury and at the Fed," Bruseulas says.
"The reason the 1990s were so good is because it was the golden age of nonbank financing," says Chris Whalen, senior managing director at Kroll Bond Rating Agency. But after the collapse of Long Term Capital Management in 1998, the Securities and Exchange Commission "changed the rules on short-term paper issuance so only banks could do it."
Homebuilders used to issue collateralized mortgage obligations (CMOs) and sell them to money market funds, Whalen says, recalling the growth of GE Capital during that era. "After 1998, all financing got channeled into banks," he says. "Now everybody is interested in the real economy and the biggest constraint on economic growth is the fact [that] we have created this monopoly on finance for real companies with respect to banks. Non-banks have a hard time raising money."
The SEC made further changes to Rule 2A-7 in the wake of the 2008 financial crisis, putting further restrictions on the kind of short-term instruments that could be sold to money markets in order to avoid a fund "breaking the buck," as the Reserve Primary Fund did in September 2008.
Since the financial crisis in 2008, government regulators have introduced policies meant to make markets safer by limiting risk-taking, Whalen writes. "While all of these changes are, in theory, intended to help the global economy recover and make markets safer, [Kroll] believes that the consequence of these changes has been reduced liquidity in financial markets and increased systemic risk, all to the detriment of investors and market stability."
Asked to respond, Williams didn't (or couldn't) refute the idea that post-crisis regulations have put limitations on what firms and institutions can do, especially in the realm of short-term financing. "The great thing about capitalism is companies will work within that and reprice appropriately," he says.
Finally, Kotok put Williams' comment in the context of "the next chapter in the Fed's massive monetary experiment" -- and one that goes far beyond the media's hyper focus on the timing of the first Fed rate hike since 2006.
Raising the federal funds rate is just one part of what Kotok calls "a gigantic realignment of the working tools of monetary policy implementation," which also includes raising the rate the Fed pays banks on so-called excess reserves, as well as changes to the overnight reverse repo rate (RRP) program for money market funds and government-sponsored enterprises. The Fed started testing the RRP in 2013 and it's currently scheduled to wind down in January 2016.
The ultimate goal here is to create a "clearing mechanism" for overnight financing to get the front-end of the yield curve functioning again. "Today, it's totally dysfunctional," Kotok says. "Until we get to that, he's right to say the leverage is distorted... but this is the same John Williams who worries about what will happen if we raise rates. He's as schizophrenic as his statement."
What do you think? Is Williams' comment crazy, brilliant or insignificant?