Washington, DC -- (ReleaseWire) -- 12/28/2015 --DAWN BENNETT: Chris Whalen is a Senior Managing Director and Head of Kroll Bond Rating Agency. He is also the author of two books. The first one in 2010 titled Inflated: How Money and Debt Built the American Dream. And then the second book in 2014 was titled Financial Stability: Fraud, Confidence & the Wealth of Nations. As you can see, Chris has a particular expertise, which is why I have him here today. I want to know if we are heading into 2016 credit crunch, and if so, why the Fed hasn't fixed anything yet and why aren't they preemptively trying to manage this bad debt that everybody knows it's out there. Chris, welcome to Financial Myth Busting.
CHRIS WHALEN: Hey, good morning, Dawn.
BENNETT: So, the Federal Reserve operates with very few checks and balances. As a matter of fact, the 12 members of the Federal Open Market Committee determine monetary policy, but in real practice, the buck actually starts and stops with the head of the table, Janet Yellen. In your opinion, what could possibly go wrong with this approach?
WHALEN: Well, you're being kind. I think the staff of the Federal Reserve board actually runs things. I don't really think the governors have that much impact on policy. They vote on it, obviously. But you're right, the chairman controls the staff, and the staff is largely comprised of people you and I would describe as left of center. They have a largely European socialist world view; they don't really think about traditional American values. So there's a definite kind of big government, big bank slant to everything they do. That's how they approach the markets. And, you know, as your intro suggested, the Fed has been largely slanted towards subsidizing and supporting debtors at the expense of savers for the past seven, eight years, really, since the crisis. They've been running away from the problem of debt is what it comes down to, and now, as you noted, this year could be plenty interesting, 2016.
BENNETT: You know, the financial press, of course, went gaga for Janet Yellen this week, who I think they almost made out to be some type of hero when she finally raised rates, after seven long years at zero percent. What's your take on this, and was this the expertly executed move the media claims it was?
WHALEN: No, not really. You know, I don't view Janet Yellen as some malevolent figure. I think she's a reasonable, if somewhat liberal, economist, who looks at the world through the eyes of the Keynesian school, if you will, of economics. A lot of the policies they've followed since the crisis in 2008 are the same policies we had in place before, low interest rates. So to that extent, nothing really has changed, and Americans do tend to gravitate towards heroic narratives. We really want kings, even though we pretend to be a democracy, so we look at people like Yellen as our savior. And I would tell you that most of the policies the Fed has had in place since the crisis have not really helped. I mean, think about the money markets today, the Fed funds rate that everybody talks about in the media. The market doesn't exist, Dawn. There is no bilateral trading between banks and the New York market today; it all runs through the Fed.
BENNETT: It's odd that on Tuesday, the day before Yellen's rate hike, the S&P 500 index closed at 2,043. And then the day after the Fed announcement, when everybody cheered that everything was just simply fantastic and perfect, it almost was like it was dovishly Goldilocks, right?
WHALEN: Yes, precisely.
BENNETT: It was just very odd. And then of course, it all started to fall apart afterwards. Did the algorithms finally figure out precisely what was going on, namely that the market completely ignored what was actually a hawkish hike?
WHALEN: Well, these terms hawkish and dovish, I think, don't really tell us what's going on. The markets have been uncertain as to what the Fed was going to do. Obviously the equity markets wanted to see a rate hike because it implies that things are getting better. That's been what they've wanted for the past four years, really. We've been on again, off again. On the other hand, in the credit markets, the manipulation of asset prices by the Fed is starting to come home to roost. Think of, Dawn: how ridiculous is it to have a 2 percent inflation target, if our central bank is going to go out and manipulate asset prices for a while, and then have them collapse because we haven't seen a commensurate increase in income? You know, if asset prices like commercial real estate, residential real estate all go up, but we're not seeing GDP go up, we're not seeing personal income go up, what are we missing here, right? So you have this social engineering on the part of the Fed, and I don't think they fully appreciate just how much damage they're doing while they pretend to help us.
BENNETT: Junk bonds, of course, suffered a bruising wipe-out in the last couple of weeks, but the Fed never seemed to acknowledge it. Don't you find that a little off?
WHALEN: Well, there's schizophrenia on the part of the regulators. If you look at the banking side of the Fed, the controller's office, the FDIC, they've all been talking about leverage credit for years now, and rightly so. The Fed, on the other hand, in their Keynesian worldview, wants to see asset prices go up, because they want people to take more risks. The problem is at the same time that we were doing this, the Chinese decided to stop spending money. They're not borrowing anymore, so commodity prices collapsed. We're going to be working through the oil patch problems for the next year or two - they're going to be quite severe - and then you're going to see other problems in other commodities. In a way, the Chinese and their state-driven economy and the Fed, with low interest rates, were both part of the problem. And since they're both now taking a relatively restrained approach to the economies in these different countries, all of a sudden, demand is falling. I think you're going to see us perhaps even in a recession by middle to the end of the next year, simply because demand isn't growing.
BENNETT: Back in September, the Fed raised a few eyebrows out there when Janet Yellen actually opted against raising rates, despite having indicated to all of us earlier in the year she likely would. The thing is, our economy is weaker today than it was back in September. What exactly is going on? That can't be their basis for making this decision, so what is?
WHALEN: Right, that's exactly the issue. We're supposedly data dependent at the Federal Open Market Committee, yet clearly one of their key criteria, 2% inflation, is not going to happen. And you've noticed they've stopped talking about it. On the other hand, you're right; they should've probably raised rates three years ago, when credit and everything else bottomed out, especially for the banking industry. Now you're starting to see banks put aside reserves again; they're expecting to see losses, much of which will come out of the energy and commodity sector. So you've got to, I think, appreciate that the Fed is late coming to the party; if anything, they should be easing now. They're totally out of step with the other world central banks. I'm not saying they should coordinate necessarily, but you're right; GDP, if you look at most economists, they're looking for it to soften. We're even looking for housing to kind of level off and perhaps soften, in terms of lending volumes. So there aren't a lot of bullish indicators out there. That's the interesting thing. As I said, I think they're three years too late.
BENNETT: Do you think the Federal Reserve is blowing it again? Do you think this is going to turn out to be some big, bad policy error or even worse?
WHALEN: Well, the Fed has been the cause of much of our problems over the past two decades. I mean, the low rate regime in the early 2000s led us to the housing bubble. Now we've seen a swing away from housing, and you're seeing enormous growth on the bank balance sheets for things like commercial lending, C&I lending, commercial real estate, other asset classes that are running away from consumers, because the consumer is considered toxic in a regulatory sense. It's just too painful to make mortgage loans. And think about this, Dawn; the top banks who are currently let's say the top 10 mortgage lenders in this country, they're going to get out of residential real estate entirely, just because of the regulatory environment. Think about that; that's going to have a profound impact on the housing sector in this country.
BENNETT: Why do you think the media's not talking about this? A couple of weeks ago, Neil Cavuto, of all people, came out and said that we shouldn't second guess Janet Yellen, because she is so smart.. Take a listen to this:
NEIL CAVUTO: "And the growing betting is that the Federal Reserve is going to raise rates. I don't think that's going to happen, but again, she's brilliant. She is really a-- I mean, she has an IQ like genius level, it's like 300. So to me-- I'm just saying consider your sources, because my dad used to say, 'Neil, the idea with your college cumulative average is to put a number in front of the decimal point.' Having said that, I don't know. I think there are plenty of reasons to just hold back, to not do anything; what's the rush? Can you imagine, after all this imploring from Europe, she goes ahead and hikes rates? Can you imagine, just as the European Union is lowering rates again, and we're raising them? Can you imagine how that's going to go down? I'm just saying. That's all; I'm just saying. But she's very, very smart."
BENNETT: Is she's really, really smart?
WHALEN: Look, I think all of our colleagues at the Fed are very smart people. That doesn't mean they understand finance and that doesn't mean they understand economics in a comprehensive way. So for example, most of the Keynesian school - which dominates the Fed, in terms of research and the people that they employ - thinks about lowered interest rates causing credit expansion, causing consumption and consumer activity to rise, right? That's clearly not happened in this cycle. All of those relationships have broken down. So you have to wonder, does Chairman Yellen have the intellectual honesty to realize that most of us every day, Dawn, fight against what I call the cognitive illusion, that we think we know what we're doing, but we're not really fully aware that we're facing a dynamic problem - it's a moving target - and every day the economy changes? That's why when people talk about the business cycle, I laugh. There is no such thing as the business cycle. If you go back and read Irving Fisher's great essay from 1933 about that deflation, he skewers that boar very effectively. And yet, most economists today pretend that there is a regularized, observable business cycle that you can use to set policy, which is clearly wrong. The variables are always changing and their relationship to one another is always changing. So that's why it's impossible to do top-down economic management, yet that's what the Fed tries to do. And they do so much damage as they go along that I think the media, to your question, they just don't understand this. Even people who are really focused on economics, they're really more cheerleaders than analysts, and they all have a very strong equity market bias. They don't think about credit and they don't think about what the bond market or credit conditions are going to do the economy in the future.
BENNETT: I think this is the big question. They raised rates last week; after that hike, do you think that they're going to un-hike and potentially launch QE4, or whatever they're going to call it, in 2016?
WHALEN: Well, that's a very good question. If the economy slows appreciably - and certainly the global economy is slowing now; you can see it in the data - there will be pressure on the Fed and also the ECB, European Central Bank, to do more market manipulation. I hope, though, that they're going to not do that, because at the end of the day, the problems we're seeing in the capital markets that you referred to, with leverage debt, a high yield market, which really crashed back in August when the Chinese economy visibly slowed - or at least when they admitted that it slowed - these are things that market manipulation's not going to address. We really need to start looking at bad debt, at reducing bad debt. And they're starting to do this in Europe, ironically. Look at Italy; Italy is on the verge of creating a bad bank that's going to take about a trillion dollars' worth of non-performing loans from Italian banks, because they're all crippled. They can't even support the economy, much less support expansion right now.
BENNETT: When you say they're going to take them, they're going to somehow pay them off, or are they going to take them and then file bankruptcy?
WHALEN: No, they're going to keep the banks afloat, but they're going to take the bad assets off their books and work them out; that's what a bad bank is. You separate the solvent institutions from bad assets. You have to fund it, though, and there's a big fight in Europe, because they don't like state support. Well, when your banks are insolvent, when they have a lack of capital, somebody's got to put money on the table, and that's what they've been unable to do, because none of the European economies are really growing. They have big fiscal constraints. In this country, we largely worked through the banking system, in terms of resolving bad debt, but we still have an awful lot of bad mortgage debt, especially in the north east. When you look at New Jersey, New York, Connecticut, Massachusetts, that's where the bad loans still are that haven't been worked out, in some cases bad mortgages that go back four and five years, Dawn. That's not helping these economies. That's not helping the real estate market in New Jersey and New York, for example. And yet, because of the consumer protection laws and the other impediments to clearing out this mess, we're still talking about it. In California, on the other hand, a very hot market, most of the bad loans were cleared two and three years ago. So there's still some structural problems in the U.S., when it comes to bad debt. And now we've accumulated all of this new debt in sectors like energy and other areas, which I think will be problematic in the next couple of years. But the politicians don't want to deal with it; it's a difficult thing to talk about.
BENNETT: Another questions I have is about Puerto Rico, which is currently pleading with Washington to help it stave off its credit default, which is major. And of course, backing up into that, there was a press conference last week, and House Minority Leader, Nancy Pelosi, said that we should help Puerto Rico, because she said passing a law would enable Puerto Rico to restructure its debt, and it wouldn't cost taxpayers one thin dime, 'Not one thin dime,' is what she said. I want you to take a listen.
NANCY PELOSI: "We're concerned about the ignoring of the urgency of the situation in Puerto Rico, where American citizens are really in a situation that we must address. It won't cost American people one thin dime to enable-- to allow Puerto Rico to restructure their debt and declare bankruptcy, not one thin dime to the American people."
BENNETT: Absent some kind of last minute bailout, do you think what's happening in Puerto Rico will impact bond markets at a larger level? Is this type of thing contagious? And will it cost us at least one thin dime, here in the United States, the rest of us taxpayers?
WHALEN: Well, it's hard to say. Puerto Rico's a funny situation. My colleagues at Kroll follow it very closely, because of our work in the municipal bond market. But you think of Puerto Rico as a bigger version of the District of Columbia. It's not a state, it's not an independent nation; it's a protectorate. And it has some pretty fundamental economic problems, because the island was built up based on subsidies. You had a lot of pharmaceutical companies that used to operate there, and they're all gone, because the tax breaks were taken away, the labor issues, others, have made the island relatively attractive. There's also some governance issues, because the financials of the state and the power company and the other issuers are not particularly transparent. They did just make a debt payment that apparently they didn't have the cash to make, so the question is where did the cash come from? And the government is essentially managing cash on an aggregate basis. It doesn't give people in my business a lot of confidence in the published information that we get from the various actors on the island. I don't know if the U.S. is going to be able to simply pass a law and say, 'Okay, restructure your debts,' without doing something more to help the island. Because I'm not sure, as an entity - both in economic terms and political terms - the island is really viable, unless we do something else to help them.
BENNETT: Have you been buying Puerto Rico muni bonds?
WHALEN: No, no. We rate them; we don't buy them. We're not allowed to buy them. What I can tell you is this; apparently there's a movement towards a debt restructuring with the power companies. That was the latest news we saw last week; that's good. Overall, I think there's going to have to be a restructuring of most of the island's obligations. But then the question comes; how do we go forward? How do we generate growth on the island? How do we make it an attractive place to live again? That's, to me, the bigger issue.
BENNETT: What's your outlook, Chris, for 2016, and how do you think it being a presidential year will impact monetary policy, if at all?
WHALEN: Well, I think we're going to see the U.S. economy slow. The rest of the global economy is slowing. We've had a couple of good developments, in terms of lower energy prices for consumers. But at the same time, lower energy prices are hurting companies in industries that were focused on that sector. I mean, think about it; the value of collateral that most oil companies have has been cut in half, and oil's trading down in the 30s now; it was over $100 a year ago. So I think that we're still seeing the fallout from this, and my guess is we go into the election, we're going to have a soft economy, and I suspect that eventually the candidates are going to have to talk about it. They haven't been talking about it at all during the debates. But I think the first candidate that can get up there and really effectively talk about the lack of growth in income, jobs, that sort of thing is going to get a lot of traction with the electorate.
BENNETT: Do you think that Trump has a chance here?
WHALEN: Well, I don't pick individuals, because I work for a rating agency. But I think that he's a fascinating figure. He reminds me a lot of Silvio Berlusconi in Italy. All I can tell you is when I saw Vladimir Putin embracing him and saying nice things about him, that's all you need to hear.
BENNETT: One last thing. The Federal Reserve doesn't seem to want to let the scales balance out. In other words, it doesn't want the free market to come back in the markets. Do you think that might happen in '16?
WHALEN: No, you're absolutely right. The Fed is a largely statused and big government kind of organization. They are not concerned about the private sector. In fact, they've been attacking the private sector at every opportunity, which I think is unfortunate.
BENNETT: I do, too. Chris Whalen, thank you so much.
WHALEN: Thank you.
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About Dawn Bennett
Dawn Bennett is CEO and Founder of Bennett Group Financial Services. She hosts a national radio program called Financial Myth Busting http://www.financialmythbusting.com.
She discusses educational topics and events in the financial news, along with her thoughts on the economy, financial markets, investments, and more with her live guests, who have included rock legend Ted Nugent, as well as Steve Forbes and Grover Norquist. Listeners can call 855-884-DAWN a as well as take podcasts on the road and forums for interaction.
She can be reached on Twitter @DawnBennettFMB or on Facebook Financial Myth Busting with Dawn Bennett.