Christopher Whalen

Readers of this blog know that I am a long-time reader of The New York Review of Books. Sadly this love is not because of that great publication’s coverage of finance and economics, which I think is skewed to the neo-Keynesian, socialist end of the intellectual spectrum. George Soros does not count.

No, I read the NYRB because of contributors like physicist and author Freeman Dyson, who teach us about other ideas, people and worlds, both real and imagined. “Dyson has spent most of his life as a professor of physics at the Institute for Advanced Study in Princeton, taking time off to advise the US government and write books for the general public,” notes his bio on the NYRB web site.

This literate and considerate man of science has told the human history of the world of physics in his contributions to the New York Review, most recently through an essay on two new books about his teacher and Nobel Prize winner Richard Feynman: “Quantum Man: Richard Feynman’s Life in Science” by Lawrence M. Krauss and  “Feynman” by Jim Ottaviani.

Dyson’s essay on Feynman, “The ‘Dramatic Picture’ of Richard Feynman,” is important on many levels. It is a personal tribute and a professional history of a man Dyson argues is now a superstar of physics on a par with the likes of Albert Einstein and Stephen Hawking. It is also an important discussion of Feynman’s insights into the nature of organizations and society, particularly how we differentiate between reality and speculation when it comes to public policy.

Following the 1986 space shuttle Challenger disaster, Dyson reminds us, a fatally ill Feynman gave his final months of life to serving the people of the United States by participating in the official investigation and fighting political efforts to conceal the institutional causes of the accident:

Feynman wrote an account of the cultural situation as he saw it, with the fatal division of the NASA administration into two noncommunicating cultures, engineers and managers. The political dogma of the managers, declaring risks to be a thousand times smaller than the technical facts would indicate, was the cultural cause of the disaster. The political dogma arose from a long history of public statements by political leaders that the Shuttle was safe and reliable. Feynman ended his account with the famous declaration: “For a successful technology, reality must take precedence over public relations, for nature cannot be fooled.”

Sound familiar? The same statement could be made about Washington’s complicity in creating the housing bubble and the shameful evasion of responsibility for the subsequent financial collapse. In terms of the world of ratings and analytics in which my firm operates, the same juxtaposition could be described as the difference between guessing about the future performance of a bank or company versus focusing on the visible facts of today’s financial and operational results.

But the sacrifice of Feynman at the end of his life to argue the perspective of science in the aftermath of the Challenger tragedy was not his greatest legacy, particularly to the layman who cannot fully appreciate many scientific achievements. Dyson describes how Feynman used pictures to describe the laws of physics, eschewing the mathematical equations used by his peers for more simple conceptual descriptions that are accessible to the average person. “Feynman,” to that end, is laid out as a comic book. Buy this book for your children, but read it yourself.

Even more important, Dyson reminds us of the distinction between the classical layer of human experience — the things we can see, touch and measure — and the quantum layer of reality, that which is impossible to measure with complete accuracy and therefore remains speculative. “The primary difference between the classical layer and the quantum layer is that the classical layer deals with facts and the quantum layer deals with probabilities,” Dyson writes. For Feynman, he concludes, “the road to understanding is not to argue about philosophy but to continue exploring the facts of nature.”

This distinction between the world of observable facts and the speculative worlds of quantum physics — and also unscientific realms such as politics and economics — is an important concept for all of us to ponder. So much of our public discourse about financial markets and fiscal issues like raising the debt ceiling is really just speculation, obscured by the pronouncements of supposed experts and their political sponsors. The beautiful vignette of Richard Feynman which is the latest addition to the literary legacy of Freeman Dyson gives all of us living in the “real” world of finance and public policy much food for thought.

There are growing signs of unease bordering on desperation inside the Obama White House. Most of the O Team now understands that the real, private economy never got out of Dip Number One. The prospect of a permanent downward shift in “trend growth” to a lower track, and continued double digit unemployment, are driving a search for alternative measures that has even touched conservatives in the worlds of finance and economics.

The Obama Administration and the Fed have taken the position that the crisis affecting the U.S. economy and the financial sector is slowly ending. In fact, the largest banks remain profoundly troubled by bad assets on their books as well as claims against these same banks for assets sold to investors. By allowing banks to “muddle along” and heal these wounds using low interest rates provided by the Fed, the Obama Administration is embracing a policy of deflation that has horrible consequences for U.S. workers and households.

In a post over the weekend on ZeroHedge –  “Bernanke Fed Drives Deflation With Zero Rate Policy” — I described the negative effects of the Fed’s low interest rate policy on bank earnings, as well as consumer and corporate spending and saving. When interest rates are low, savers move their preference for liquidity to infinity, especially after the past several years of market breakdown. Retirees spend less because the interest earned on bonds and savings has plummeted.  Here’s an excerpt:

When the Fed buys securities through QE, it is removing duration from the markets, pushing down yields and volatility. For a while this boosts the net interest margin (NIM) of leveraged investors such as banks, who are able to borrow at lower rates to fund current assets. As assets re-price to the low rates maintained by the Fed, however, NIM begins to disappear. Over the medium to longer term, think of duration and NIM as being linked, so obviously a sustained period of QE is bad for NIM. This is why NIM in the U.S. banking sector is starting to fall.

Just as the earnings of leveraged investors like banks are starting to suffer due to zero rate policy, so too the spending by all manner of savers, from retirees to companies and not-for-profits to municipalities, is falling too. Fed Chairman Bernanke and the other members of the FOMC are killing the real economy to save the banks — but none of the benefit flowing to the banks is reaching U.S. households. In fact, the Obama Administration has been providing political cover for the Fed to conduct a massive, reverse Robin Hood scheme, moving trillions of dollars in resources from savers and consumers to the big banks and their share and bond holders.

The first priority is to make clear to the largest banks, especially the top four institutions — JPMorganChase (JPM), Bank of America (BAC), Wells Fargo (WFC) and Citigroup (C), that the party is over when it comes to providing credit to the real economy. Until President Obama and Fed Chairman Bernanke recognize that six institutions — FNM, FRE, BAC, C, JPM and Wells Fargo — have broken the mechanism which makes interest rate easing work, we will make little progress fixing the economy.

“In every Fed easing event during my career in finance (1986, 1992, 1998, 2002), it was the wave of refinancing of debt after the Fed eased interest rates that put permanent disposable income into the hands of households,” notes a former Fed official who worked in the banking industry for decades. “In this last easing, however, FNM, FRE and the TBTF banks have conspired to break the transmission mechanism for monetary policy and are now strangling the U.S. economy to save themselves from past errors.”

Rules changes made by FNM and FRE since the Treasury’s conservatorship began in 2008 have prevented millions of American consumers and business from refinancing their mortgage debts. The Bernanke Fed will attempt to compensate for this de facto freeze on refinancing with QE II, but this will fail.

So what should President Obama do?

First, the Obama Administration should use the power provided in the Dodd-Frank legislation to force an accelerated cleanup of bad assets and to mandate refinancing and principal reductions for performing loans with viable borrowers. If any banks resist, the Treasury should use the power under current federal law to remove recalcitrant officers and directors of these same banks.

Second, President Obama also needs to focus on the growing competitive problem in the U.S. mortgage sector. The mortgage banking industry suffered significant consolidation since 2007. In particular, the competitive, third part origination players went out of business via bankruptcy or by being taken over. The industry is now dominated by a cozy oligopoly of Too Big To Fail banks (TBTF).

The top three banks control 55% of all mortgage originations. The top 10 banks control 95%. The top five run the only surviving channels to sell loans to Fannie Mae (FNM) and Freddie Mac (FRE), and force their pricing upon the entire banking industry. Small banks give up half the economics of a typical loan to sell a loan to FNM or FRE indirectly, through WFC or JPM. Why is there no antitrust investigation of the top banks by the Department of Justice?

The Obama Administration should move to restructure FNM and FRE now, not in 2011. The Treasury should use its existing authority under the conservatorship to force FNM and FRE to make rules changes to allow for the refinancing of all existing residential mortgages, if only to reduce the current cost of the debt and increase disposable income for households.

By moving on reforming FNM and FRE, the Obama Administration can provide relief to home owners and also send a strong message to Wall Street and global investors that the practice of “too big to fail” is at an end. We should always remember that the model of the government sponsored enterprises (GSEs) goes back to fascist Italy and Germany of the 1920s. The very public demise of these GSEs is an important part of ending TBTF for the large banks — but only part of the story.

President Obama should make some political hay over the fact that loan origination margins for the top four banks have gone from ½ point to over 4 points in the last two years. This is the subsidy for Wall Street above and beyond the zero interest rate policy of the Fed. The Obama Administrations needs to require changes in the way in which FNM and FRE do business with the banking sector and with mortgage holders, and use these changes to reform the mortgage market in preparation for legislation from the Congress.

By reducing barriers to refinancing by FNM and FRE, and aggressively forcing private banks to mark mortgages to market and accept principal write-downs or short sales to clear the backlog of bad debt, the Obama Administration can restore balance to the economy and create a healthy basis for new growth.