Photo Credit: Alcino || What is the sound of negative one hand clapping?

Photo Credit: Alcino || What is the sound of negative one hand clapping?

As with many of my articles, this one starts with a personal story from my insurance business career (skip down four paragraphs to the end of the story if you want):

25 years ago, when it was still uncommon, I wanted to go to an executive course at the Wharton School for actuaries that wanted to better understand investment math and markets.  I went to my boss at AIG (a notably tight-fisted firm on expenses) and asked if the company would pay for me to go… it was an exclusive course, and very expensive compared to any other conference that I would ever go to again in my life.  I tried not to get my hopes up.

Lo, and behold!  AIG went for it!

A month later, I was with a bunch of bright actuaries at the Wharton School.  The first thing I noticed was aside from the compound interest math, and maybe some bond knowledge, the actuaries were rather light on investment knowledge, and I would bet that all of them had passed the Society of Actuaries investment course.  The second thing I noticed were some of the odd investments described in the syllabus: it was probably my first taste of derivative instruments.  At the ripe old age of 29, I was learning a lot, and possibly more than the rest of my classmates, because I had spent a lot of time studying investments already, both on an academic and practical basis.

I had already studied the pricing of stock options in school, so I was familiar with Black-Scholes.  (Trivia note: an actuary developed the same formula for valuing optionally terminable reinsurance treaties six years ahead of Black, Scholes and Merton.  That doesn’t even take into account Bachelier, who derived it 73 years earlier, but no one knew about it, because it was written in French.)  At this point, the professor left, and a grad student came in to teach us about the pricing of bond options.  At the end of his lesson, it was time for the class to have a break.  I went down to make a comment, and it went like this:

Me: You said that we have to adjust for the fact that interest rates can’t go negative.

Grad student: Of course.

Me: But interest rates could go negative.

GS: That’s ridiculous!  Why would you ever lend money and accept back less than you gave them, and lose the time value of money?!

Me: Almost of the time, you wouldn’t.  But imagine a scenario where the demand for loanable funds leaves interest rates near zero, but the times are insecure and violent, leaving you uncertain that if you stored your cash privately, you would run too large of a risk of having it stolen.  You need your cash in the future for a given project.  In this case, you would pay the bank to store your money.

GS: That’s an absurd scenario!  That could never happen!

Me: It’s unlikely, I admit, but I wouldn’t say that you can never have negative interest rates.

GS: I will say it again: You can NEVER have negative interest rates.

Me: Thanks, I guess.

Well, so much for the distant past.  Here is why I am writing this: yesterday, a friend of mine wrote me the following note:

Good evening.  I trust you had a blessed Lord’s Day in the new building. 

Talking bonds today with my Econ class.  Here’s our question. Other than playing a currency angle why would anyone buy European debt with a negative yield?  The Swiss and at least one other county sold 10 year notes with a negative yield.  Can you explain that?  No interest and less principle [sic] at the end.

Now, I didn’t quite get it perfectly right with the grad student at Wharton, but most of it comes down to:

  • Low demand for loanable funds, with low measured inflation, and
  • Security and illiquidity of the funds invested

The first one everyone gets — inflation is low, and few want to borrow, so interest rates are very low.  But that doesn’t explain how it can go negative.

Things are different for middle class individuals and large financial institutions.  Someone in the middle class facing negative interest rates from a checking or savings account could say: “Forget it.  I’m taking most of my money out of the bank, and storing it at home.”  Leaving aside the inconvenience of currency transaction reports if the amount is over $10,000, and worries over theft, he could take his money home and store it.  Note that he does have to run a risk of theft, though, so bringing the money home is not costless.

The bank has the same problem, but far larger.  If you don’t invest the money, where would you store it?  Could you even get enough currency delivered to do it?  if you had a vault large enough to store it, could you trust the guards?  Why make yourself a target?  If you don’t have a vault large enough to store it, you’re in the same set of problems that exist for those that warehouse precious metals, but with a far more liquid commodity.

Thus in a weak economic environment like this, with low inflation, banks and other financial institutions that want certainty of payment in the future are willing to pay interest to get their money back later.

Part of the problem here is that the fiat currencies of the world exist only to be units of account, and not stores of value.  Thus in this unusual environment, they behave like any other commodity, where the prices for futures are often higher than the current spot price, which is known as backwardation.  (Corrected from initial posting — i.e. it costs more to receive a given cash flow in the future than today, thus backwardation, not contango.)  The rates can’t get too negative, though, or some institutions will bite the bullet and store as much cash as they can, just as other commodities get stored.

To use another analogy, a while ago, some market observers couldn’t get why anyone would accept a negative yield on Treasury Inflation Protected Securities [TIPS].  They did so because they had few other choices for transferring money to the future while still having inflation protection.  Some people argued that they were locking in a loss.  My comment at the time was, “They’re trying to avoid a larger loss.”

Thus the difficulty of managing cash outside of the bond/loan markets in a depressed economy leads to negative interest rates.  The financial institutions may lose money in the process, but they are losing less money than if they tried to store and protect the money, if that could even be done.

Photo Credit: DonkeyHotey

Photo Credit: DonkeyHotey

December 2014January 2015Comments
Information received since the Federal Open Market Committee met in October suggests that economic activity is expanding at a moderate pace.Information received since the Federal Open Market Committee met in December suggests that economic activity has been expanding at a solid pace.Shades GDP up. This is another overestimate by the FOMC.
Labor market conditions improved further, with solid job gains and a lower unemployment rate. On balance, a range of labor market indicators suggests that underutilization of labor resources continues to diminish.Labor market conditions have improved further, with strong job gains and a lower unemployment rate.  On balance, a range of labor market indicators suggests that underutilization of labor resources continues to diminish.Shades their view of labor use up a little.  More people working some amount of time, but many discouraged workers, part-time workers, lower paid positions, etc.
Household spending is rising moderately and business fixed investment is advancing, while the recovery in the housing sector remains slow.Household spending is rising moderately; recent declines in energy prices have boosted household purchasing power.  Business fixed investment is advancing, while the recovery in the housing sector remains slow.Interesting how falls in energy prices are treated as permanent by the FOMC, while rises are regarded as transient.

 

Inflation has continued to run below the Committee’s longer-run objective, partly reflecting declines in energy prices. Market-based measures of inflation compensation have declined somewhat further; survey-based measures of longer-term inflation expectations have remained stable.Inflation has declined further below the Committee’s longer-run objective, largely reflecting declines in energy prices.  Market-based measures of inflation compensation have declined substantially in recent months; survey-based measures of longer-term inflation expectations have remained stable.Shades their forward view of inflation down.  TIPS are showing slightly lower inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.03%, only down 0.04% from December.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators moving toward levels the Committee judges consistent with its dual mandate.The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate.No change. They are no longer certain that inflation will rise to the levels that they want.
The Committee sees the risks to the outlook for economic activity and the labor market as nearly balanced. The Committee expects inflation to rise gradually toward 2 percent as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate. The Committee continues to monitor inflation developments closely.The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced.  Inflation is anticipated to decline further in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate.  The Committee continues to monitor inflation developments closely.CPI is at 0.7% now, yoy.  They shade up their view down on inflation’s amount and persistence.

Okay, so here they regard the energy price declines as transitory.

To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate.  In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation.  This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.No change. Highly accommodative monetary policy is gone – but a super-low Fed funds rate remains.  Policy normalizes, sort of, but no real change.
Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy.Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy.No change.  In other words, we’re on hold until something goes “Boo!”
The Committee sees this guidance as consistent with its previous statement that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program in October, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.Sentence removed, but I doubt that it means much.
However, if incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.However, if incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated.  Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.Tells us what we already knew.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.  This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.No change.  Changing that would be a cheap way to effect a tightening.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.No change.
The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.No change.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.  The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.“Balanced” means they don’t know what they will do, and want flexibility.  They are not moving anytime soon.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Loretta J. Mester; Jerome H. Powell; and Daniel K. Tarullo.

Voting against the action were Richard W. Fisher, who believed that, while the Committee should be patient in beginning to normalize monetary policy, improvement in the U.S. economic performance since October has moved forward, further than the majority of the Committee envisions, the date when it will likely be appropriate to increase the federal funds rate; Narayana Kocherlakota, who believed that the Committee’s decision, in the context of ongoing low inflation and falling market-based measures of longer-term inflation expectations, created undue downside risk to the credibility of the 2 percent inflation target; and Charles I. Plosser, who believed that the statement should not stress the importance of the passage of time as a key element of its forward guidance and, given the improvement in economic conditions, should not emphasize the consistency of the current forward guidance with previous statements.

Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.A congress of doves for 2015.

Things will be boring as far as dissents go.

We need some people in the Fed and in the government who realize that balance sheets matter – for households, corporations, governments, and central banks.  Remove anyone who is a neoclassical economist – they missed the last crisis; they will miss the next one.

Comments

  • Pretty much a nothing-burger. Few significant changes.  The FOMC has a stronger view of GDP and Labor, and deems the weak global economy to be a reason to wait.
  • Despite lower unemployment levels, labor market conditions are still pretty punk. Much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.  Wage growth is weak also.
  • Forward inflation expectations have flattened out.
  • Has the FOMC seen how low the 30-year T-bond yield is?
  • Equities fall and long bonds rise. Commodity prices are flat.  The FOMC says that any future change to policy is contingent on almost everything.
  • Don’t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
  • The FOMC need to chop out more “dead wood” from its statement. Brief communication is clear communication.  If a sentence doesn’t change often, remove it.
  • In the past I have said, “When [holding down longer-term rates on the highest-quality debt] doesn’t work, what will they do? I have to imagine that they are wondering whether QE works at all, given the recent rise and fall in long rates.  The Fed is playing with forces bigger than themselves, and it isn’t dawning on them yet.
  • The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain’t moving rates up, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.\
  • We have a congress of doves for 2015 on the FOMC. Things will be boring as far as dissents go.  We need some people in the Fed and in the government who realize that balance sheets matter – for households, corporations, governments, and central banks.  Remove anyone who is a neoclassical economist – they missed the last crisis; they will miss the next one.

Photo Credit: Chris Piascik

Photo Credit: Chris Piascik

Most formal statements on financial risk are useless to their users. Why?

  • They are written in a language that average people and many regulators don’t speak.
  • They often don’t define what they are trying to avoid in any significant way.
  • They don’t give the time horizon(s) associated with their assessments.
  • They don’t consider the second-order behavior of parties that are managing assets in areas related to their areas.
  • They don’t consider whether history might be a poor guide for their estimates.
  • They don’t consider the conflicting interests and incentives of the parties that direct the asset managers, and how their own institutional risks affect their willingness to manage the risks that other parties deem important.
  • They are sometimes based off of a regulatory view of what can/must be stated, rather than an economic view of what should be stated.
  • Occasionally, approximations are used where better calculations could be used.  It’s amazing how long some calculations designed for the pencil and paper age hang on when we have computers.
  • Also, material contract provisions that are hard to model/explain often get ignored, or get some brief mention in a footnote (or its equivalent).
  • Where complex math is used, there is no simple language to explain the economic sense of it.
  • They are unwilling to consider how volatile financial processes are, believing that the Great Depression, the German Hyperinflation, or something as severe, could never happen again.

(An aside to readers; this was supposed to be a “little piece” when I started, but the more I wrote, the more I realized it would have to be more comprehensive.)

Let me start with a brief story.  I used to work as an officer of the Pension Division of Provident Mutual, which was the only place I ever worked where analysis of risks came first, and was core to everything else that we did.  The mathematical modeling that I did in there was some of the best in the industry for that era, and my models helped keep us out of trouble that many other firms fell into.  It shaped my view of how to manage a financial business to minimize risks first, and then make money.

But what made us proudest of our efforts was a 40-page document written in plain English that ran through the risks that we faced as a division of our company, and how we dealt with them.  The initial target audience was regulators analyzing the solvency of Provident Mutual, but we used it to demonstrate the quality of what we were doing to clients, wholesalers, internal auditors, rating agencies, credit analysts, and related parties inside Provident Mutual.  You can’t believe how many people came to us saying, “I get it.”  Regulators came to us, saying: “We’ve read hundreds of these; this is the first one that was easy to understand.”

The 40-pager was the brainchild of my boss, who was the most intuitive actuary that I have ever known.  Me? I was maybe the third lead investment risk modeler he had employed, and I learned more than I probably improved matters.

What we did was required by law, but the way we did it, and how we used it was not.  It combined the best of both rules and principles, going well beyond the minimum of what was required.  Rather than considering risk control to be something we did at the end to finagle credit analysts, regulators, etc., we took the economic core of the idea and made it the way we did business.

What I am saying in this piece is that the same ideas should be more actively and fully applied to:

  • Investment prospectuses and reports, and all investment and insurance marketing literature
  • Solvency documents provided to regulators, credit raters, and the general public by banks, insurers, derivative counterparties, etc.
  • Risk disclosures by financial companies, and perhaps non-financials as well, to the degree that financial markets affect their real results.
  • The reports that sell-side analysts write
  • The analyses that those that provide asset allocation advice put out
  • Consumer lending documents, in order to warn people what can happen to them if they aren’t careful
  • Private pension and employee benefit plans, and their evil twins that governments create.

Looks like this will be a mini-series at Aleph Blog, so stay tuned for part two, where I will begin going through what needs to be corrected, and then how it needs to be applied.

Bad-Paper-Chasing-Debt-from-Wall-Street-to-the-Underworld-Book-Online

This book has two significant types of insights: on people and on market failure.  It does well with both of them, but spends most of its time on the former, because it is more interesting.  That said, the second set is more important, and is buried in a few places in the second half of the book.

With people, this book answers the following questions:

  • Why does this book largely take place in Buffalo, NY? Because entrepreneurs got started there, and found it easy to acquire talent there.
  • Why does the industry employ a lot of ex-convicts? There are some crossover benefits to having been through the rough-and-tumble of street life that gives an edge in dealing with desperate people who have bad debts.
  • Is there an ethical code for debt collectors? Well, yes, sort of.  Kind of like “the code” from the movie Repo Man – don’t tell debtors they are in legal trouble, don’t threaten, treat them with kindness, don’t buy debt where you don’t have a clear chain of title, don’t sell lists of debts to collect where the debtors have already been verbally flogged.
  • Do all debt collectors follow the code? Well, no, and that is one place where the book gets interesting, as various debt collectors look for edges so that they can make money off of debts that creditors have given up on.  There *is* honor among thieves, and be careful if you cross anyone powerful or desperate enough.
  • Can’t you use the legal system to try to recover money on the debts? Well, only at the end, and even then it is difficult, because if the debtor asks for evidence on the debt that is being collected, the debt collector usually doesn’t have it, and the case will be dismissed.  It is best for collectors to come to settlements out of court.

The book follows around debt collectors and those associated with them, a colorful bunch, who see their see their opportunities flow and ebb as the financial crisis first produces a lot of bad debts to work on, and they mine that ore until the yields get poor.  Some of these people you will gain sympathy for, as they are trying to make a buck ethically.  Others will turn you off with their conduct.

As for market failure issues, you might wonder why the credit card companies and other creditors don’t pursue the debtors themselves.  Why do they sell the right to collect on unsecured debts at such deep discounts to the face value of the debts? [Pennies on the dollar, or less…]

The creditors don’t want to make the effort to dig up the necessary data to make the case in court a slam-dunk.  It would not pay for them to do so in most cases given the large number of cases to pursue, and the relatively small amounts that would be recovered.  That’s why the debts are sold at a discount.

Some debts don’t get removed from databases when payments are made to close them out, and as such some debt collectors try to collect on debts that were once in default, but paid off in a compromise.  This could be remedied if there were a comprehensive database of all debts, but the costs of creating and updating such a database would likely be prohibitive.

Finally, you might ask where the regulators are in all of this.  Between the States and the Feds, they try to clip the worst aspects of debt collection, but they are stretched thin.  This means that for many people, the optimal strategy is not to pay on defaulted unsecured debts, and challenge them if they take you to court.

Quibbles

Lots of foul language, but you’re dealing with the lowest rungs of society, so what do you expect?

Summary / Who Would Benefit from this Book

This is a good book if you want to understand the unsecured debt collection business.  If you have friends who are troubled by debt collectors, it might be worth a purchase, and lend the book to them.  If you still want to buy it, you can buy it here: Bad Paper: Chasing Debt from Wall Street to the Underworld.

Full disclosure: I received a copy from the author’s PR flack.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Photo Credit: DonkeyHotey

Photo Credit: DonkeyHotey

September 2014October 2014Comments
Information received since the Federal Open Market Committee met in July suggests that economic activity is expanding at a moderate pace.Information received since the Federal Open Market Committee met in September suggests that economic activity is expanding at a moderate pace.No change. This is another overestimate by the FOMC.
On balance, labor market conditions improved somewhat further; however, the unemployment rate is little changed and a range of labor market indicators suggests that there remains significant underutilization of labor resources.Labor market conditions improved somewhat further, with solid job gains and a lower unemployment rate. On balance, a range of labor market indicators suggests that underutilization of labor resources is gradually diminishing.Shades their view of labor use up.  More people working some amount of time, but many discouraged workers, part-time workers, lower paid positions, etc.
Household spending appears to be rising moderately and business fixed investment is advancing, while the recovery in the housing sector remains slow.Household spending is rising moderately and business fixed investment is advancing, while the recovery in the housing sector remains slow.Shades up household spending a little.

 

Fiscal policy is restraining economic growth, although the extent of restraint is diminishing.Finally dropped this bogus statement.
Inflation has been running below the Committee’s longer-run objective. Longer-term inflation expectations have remained stable.Inflation has continued to run below the Committee’s longer-run objective. Market-based measures of inflation compensation have declined somewhat; survey-based measures of longer-term inflation expectations have remained stable.Shades their forward view of inflation down.  TIPS are showing slightly lower inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.35%, down 0.18% from September.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators and inflation moving toward levels the Committee judges consistent with its dual mandate.The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators and inflation moving toward levels the Committee judges consistent with its dual mandate.No change.  They can’t truly affect the labor markets in any effective way.
The Committee sees the risks to the outlook for economic activity and the labor market as nearly balanced and judges that the likelihood of inflation running persistently below 2 percent has diminished somewhat since early this year.The Committee sees the risks to the outlook for economic activity and the labor market as nearly balanced. Although inflation in the near term will likely be held down by lower energy prices and other factors, the Committee judges that the likelihood of inflation running persistently below 2 percent has diminished somewhat since early this year.CPI is at 1.7% now, yoy.  They shade up their view down on inflation’s amount and persistence.
The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions.The Committee judges that there has been a substantial improvement in the outlook for the labor market since the inception of its current asset purchase program.No change.
In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in October, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $5 billion per month rather than $10 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $10 billion per month rather than $15 billion per month. Moreover, the Committee continues to see sufficient underlying strength in the broader economy to support ongoing progress toward maximum employment in a context of price stability. Accordingly, the Committee decided to conclude its asset purchase program this month. Finally ends QE, for now.

 

The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.No change
The Committee’s sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate.This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.Maintains reinvestment of long-term securities, which does little to hold interest rates down, assuming that is a desirable goal.
The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.Finally ends a useless paragraph.
If incoming information broadly supports the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will end its current program of asset purchases at its next meeting.Deletes sentence
However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.Deletes sentence
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate.  In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.Highly accommodative monetary policy is gone – but a super-low Fed funds rate remains.  Policy normalizes, sort of, but no real change.
The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.The Committee anticipates, based on its current assessment, that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program this month, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.No change.  Its standards for raising Fed funds are arbitrary.
However, if incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.Tells us what we already knew.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.No change.
The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.No change.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Narayana Kocherlakota; Loretta J. Mester; Jerome H. Powell; and Daniel K. Tarullo.Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Richard W. Fisher; Loretta J. Mester; Charles I. Plosser; Jerome H. Powell; and Daniel K. Tarullo.Fisher and Plosser dissent.  Finally some with a little courage.
Voting against the action were Richard W. Fisher and Charles I. Plosser. President Fisher believed that the continued strengthening of the real economy, improved outlook for labor utilization and for general price stability, and continued signs of financial market excess, will likely warrant an earlier reduction in monetary accommodation than is suggested by the Committee’s stated forward guidance. President Plosser objected to the guidance indicating that it likely will be appropriate to maintain the current target range for the federal funds rate for “a considerable time after the asset purchase program ends,” because such language is time dependent and does not reflect the considerable economic progress that has been made toward the Committee’s goals.Voting against the action was Narayana Kocherlakota, who believed that, in light of continued sluggishness in the inflation outlook and the recent slide in market-based measures of longer-term inflation expectations, the Committee should commit to keeping the current target range for the federal funds rate at least until the one-to-two-year ahead inflation outlook has returned to 2 percent and should continue the asset purchase program at its current level.Send Mr. Kocherlakota a chill pill, and ask him to review how badly the FOMC forecasts, and how little effectiveness monetary policy has had for the good in the US.  He just wants to create another bubble, along with the rest of the doves.

 

Comments

  • Pretty much a nothing-burger. Few significant changes, if any.  Yes, QE ends, but who didn’t expect that?
  • Despite lower unemployment levels, labor market conditions are still pretty punk. Much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.  Wage growth is weak also.
  • Equities flat and long bonds rise. Commodity prices are down.  The FOMC says that any future change to policy is contingent on almost everything.
  • Don’t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
  • The FOMC chops some “dead wood” out of its statement. Brief communication is clear communication.  If a sentence doesn’t change often, remove it.
  • In the past I have said, “When [holding down longer-term rates on the highest-quality debt] doesn’t work, what will they do? I have to imagine that they are wondering whether QE works at all, given the recent rise and fall in long rates.  The Fed is playing with forces bigger than themselves, and it isn’t dawning on them yet.
  • The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain’t moving rates up, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.

Photo Credit: whologwhy || Danger: Butterfly at work!

Photo Credit: whologwhy || Danger: Butterfly at work!

There’s a phenomenon called the Butterfly Effect.  One common quotation is “It has been said that something as small as the flutter of a butterfly’s wing can ultimately cause a typhoon halfway around the world.”

Today I am here to tell you that for that to be true, the entire world would have to be engineered to allow the butterfly to do that.  The original insight regarding how small changes to complex systems occurred as a result of changing a parameter by a little less than one ten-thousandth.  Well, the force of a butterfly and that of a large storm are different by a much larger margin, and the distances around the world contain many effects that dampen any action — even if the wind travels predominantly one direction for a time, there are often moments where it reverses.  For the butterfly flapping its wings to accomplish so much, the system/machine would have to be perfectly designed to amplify the force and transmit it across very long distances without interruption.

I have three analogies for this: the first one is arrays of dominoes.  Many of us have seen large arrays of dominoes set up for a show, and it only takes a tiny effort of knocking down the first one to knock down the rest.  There is a big effect from a small initial action.  The only way that can happen, though, is if people spend a lot of time setting up an unstable system to amplify the initial action.  For anyone that has ever set up arrays of dominoes, you know that you have to leave out dominoes regularly while you are building, because accidents will happen, and you don’t want the whole system to fall as a result.  At the end, you come back and fill in the missing pieces before showtime.

The second example is a forest fire.  Dry conditions and the buildup of lower level brush allow for a large fire to take place after some small action like a badly tended campfire, a cigarette, or a lightning strike starts the blaze.  In this case, it can be human inaction (not creating firebreaks), or action (fighting fires allows the dry brush to build up) that helps encourage the accidentally started fire to be a huge one, not merely a big one.

My last example is markets.  We have infrequently seen volatile markets where the destruction is huge.  A person with a modest knowledge of statistics will say something like, “We have just witnessed a 15-standard deviation event!”  Trouble is, the economic world is more volatile than a normal distribution because of one complicating factor: people.  Every now and then, we engineer crises that are astounding, where the beginning of the disaster seems disproportionate to the end.

There are many actors that take there places on stage for the biggest economic disasters.  Here is a partial list:

  • People need to pursue speculation-based and/or debt-based prosperity, and do it as a group.  Collectively, they need to take action such that the prices of the assets that they pursue rise significantly above the equilibrium levels that ordinary cash flow could prudently finance.
  • Lenders have to be willing to make loans on inflated values, and ignore older limits on borrowing versus likely income.
  • Regulators have to turn a blind eye to the weakened lending processes, which isn’t hard to do, because who dares oppose a boom?  Politicians will play a role, and label prudent regulations as “business killers.”
  • Central bankers have to act like hyperactive forest rangers, providing liquidity for the most trivial of financial crises, thus allowing the dry tinder of bad debts to build up as bankers use cheap funding to make loans they never dreamed that they could.
  • It helps if you have parties interested in perpetuating the situation, suggesting that the momentum is unstoppable, and that many people are fools to be passing up the “free money.”  Don’t you know that “Everybody ought to be rich?” [DM: then who will deliver the pizza?  Are you really rich if you can’t get a pizza delivered?]  These parties can be salesmen, journalists, authors, etc. whipping up a frenzy of speculation.  They also help marginalize as “cranks” the wise critics who point out that the folly eventually will have to end.

Promises, promises.  And all too good to be true, but it all looks reasonable in the short run, so the game continues.  The speculation can take many forms: houses, speculative companies like dot-coms or railroads, even stocks themselves on sufficient margin debt.  And, dare I say it, it can even apply to old age security schemes, but we haven’t seen the endgame for that one yet.

At the end, the disaster appears out of nowhere.  The weak link in the chain breaks — vendor financing, repo financing, a run on bank deposits, margin loans, subprime loans — that which was relied on for financing becomes recognized as a short-term obligation that must be met, and financing terms change dramatically, leading the entire system to recognize that many assets are overpriced, and many borrowers are inverted.

Congratulations, folks, we created a black swan.  A very different event appears than what many were counting on, and a bad self-reinforcing cycle ensues.  And, the proximate cause is unclear, though the causes were many in society pursuing an asset boom, and borrowing and speculating as if there is no tomorrow.  Every individual action might be justifiable, but the actions as a group lead to a crisis.

In closing, though I see some bad lending reappearing, and a variety of assets at modestly speculative prices, there is no obvious crisis facing us in the short-run, unless it stems from a foreign problem like Chinese banks.  That said, the pension promises made to those older in most developed countries are not sustainable.  That one will approach slowly, but it will eventually bite, and when it does, many will say, “No one could have predicted this disaster!”

Photo Credit: Michael Daddino

Photo Credit: Michael Daddino

I am mystified at why people might be outraged or surprised that the Federal Reserve does a poor job of overseeing banks.  The Fed is an overstaffed bureaucracy.  Overstaffed bureaucracies always tend toward consensus and non-confrontation.

I know this from my days of working as an actuary inside an overstaffed life insurance company, and applying for work in other such companies.  I did not fit the paradigm, because I had strong views of right and wrong, and strong views on how to run a business well, which was more aggressive than the company that I worked for was generally willing to do.  Note that only one such company was willing to hire me, and I nearly got fired a couple of times for proposing ideas that were non-consensus.

This shouldn’t be too surprising, given the past behavior of the Fed.  In 2006, the Fed made a few theoretical noises about residential real estate loan quality, but took no action that would make the lesser regulators do anything.  It’s not as if they didn’t have the power to do it.  One of the great canards of financial reform is that regulators did not have enough power to stop the bad lending.  They most certainly did have enough power; they just didn’t use it because it is political suicide to oppose a boom.  (Slide deck here.)

As a result, I would not have enacted Dodd-Frank, because I like my laws simple.  Instead, I would have fired enough of the regulators to make a point that they did not do their jobs.  How many financial regulators were fired in 2008-2009?  Do you hear the crickets?  This is the #1 reason why you should assume that it is business as usual in banking regulation.

You won’t get assiduous regulation unless regulators are dismissed for undue leniency.  I have heard many say in this recent episode with Goldman Sachs, the New York Fed, and Carmen Segarra that those working for the Fed are bright and hard-working.  I’ll give them the benefit of the doubt; my own dealings with those that work for the Fed is that most of them, aside from bosses, are quiet, so you can’t tell.

Being quiet, and favoring the powerful, whether it is bosses, politicians, or big companies that you regulate is the optimal strategy for advancement at the Fed over the last 30 years.  It doesn’t matter much how bright you are, or how hard you work, if it doesn’t have much impact on the organization’s actions.

I try to be an optimistic kind of guy, but I don’t see how this situation can be changed without firing a lot of people, including most of the most powerful people at the Fed, lesser banking regulators, and US Treasury.

And if we did change things, would we like it?  Credit would be less available.  I think that would be an exceptionally good thing, but most of our politicians are wedded to the idea that increasing the availability of credit is an unmitigated good.  They think that because they don’t get tagged for the errors.  They take credit for the bull market in credit, and blame everyone except themselves and voters for the inevitable bear market.

Also, if we did fire so many people, where would we find our next crop of regulators?  Personally, I would hand banking regulation back to the states, and end interstate branching, breaking up the banks in the process.

Remember, the insurance industry, regulated by the states, is much better regulated than the banking industry.  State regulators are much less willing to be innovative, and far more willing to say no.  State regulation is simple/dumb regulation, which is typically good regulation.

But whether you agree with my policy prescription or not, you should be aware that things are unlikely to change in banking regulation, because it is not a failure of laws and regulations, but a failure of will, and we have the same sorts of people in place as were there prior to the financial crisis.

Postscript

I would commend the articles cited by Matt Levine of Bloomberg regarding this whole brouhaha:

A bit more on Carmen Segarra.

Apparently the place to discuss regulatory capture is on Medium. Here is Dan Davies:

Regulated institutions generally have better contacts and relationships with the top central bankers than their supervisors do. And for whatever reason, top central bankers never developed the necessary knee-jerk aggressive response to any attempts to make use of these relationships to affect the behaviour of supervisors.
So banks never need to listen to their line-level regulators because they can always get those regulators’ bosses’ bosses’ bosses to overrule them. Here is Felix Salmon, mostly agreeing. And here is Alexis Goldstein with a litany of Fed enabling of banks. Elsewhere, Martien Lubberink explains the transaction that got so much attention in the Fed tapes, in which Goldman agreed to hang on to some Santander Brasil stock for a year before delivering it to Qatar. He thinks it was pretty vanilla. And Adam Ozimek has a good point:

This American Life ep should lower avg est corruption belief. Goldman and NY Fed secretly taped & all u get is in non-confrontational nerds?

 

Photo Credit: Matt Cavanagh

Photo Credit: Matt Cavanagh

There is a saying in the markets that volatility is not risk. In general this is true, and helps to explain why measures like beta and standard deviation of returns do not measure risk, and are not priced by the market. After all, risk is the probability of losing money, and the severity thereof.

It’s not all that different from the way that insurance underwriters think of risk, or any rational businessman for that matter. But just to keep things interesting, I’d like to give you one place where volatility is risk.

When overall economic conditions are serene, many people draw the conclusion that it will stay that way for a long time. That’s a mistake, but that’s human nature. As a result, those concluding that economic conditions will remain serene for a long time decide to take advantage of the situation and borrow money.

When volatility is low, typically credit spreads are low. Why not take advantage of cheap capital? Well, I would simply argue that interest rates are for a time, and if you don’t overdo it, paying interest can be managed. But what happens if you have to refinance the principal of the loan at an inopportune time?

When volatility and interest spreads are low for you, they are low for a lot of other people also. Debt builds up not just for you, but for society as a whole. This can have the impact of pushing up prices of the assets purchased using debt. In some cases, the rising asset prices can attract momentum buyers who also borrow money in order to own the rising assets.

This game can continue until the economic yield of the assets is less than the yield on the debt used to finance the assets. Asset bubbles reach their breaking point when people have to feed cash to the asset beyond the ordinary financing cost in order to hold onto it.

In a situation like this, volatility becomes risk. Too many people have entered into too many fixed commitments and paid too much for a group of assets. This is one reason why debt crises seem to appear out of the blue. The group of assets with too much debt looks like they are in good shape if one views it through the rearview mirror. The loan-to-value ratios on recent loans based on current asset values look healthy.

But with little volatility in some subsegment of the overly levered assets, all of a sudden a small group of the assets gets their solvency called into question. Because of the increasing level of cash flows necessary to service the debt relative to the economic yield on the assets, it doesn’t take much fluctuation to make the most marginal borrowers question whether they can hold onto the assets.

Using an example from the recent financial crisis, you might recall how many economists, Fed governors, etc. commented on how subprime lending was a trivial part of the market, was well-contained, and did not need to be worried about. Indeed, if subprime mortgages were the only weak financing in the market, it would’ve been self-contained. But many people borrowed too much chasing inflated values of residential housing.  As asset values fell, more and more people lost willingness to pay for the depreciating assets.

We’ve had other situations like this in our markets. Here are some examples:

  • Commercial mortgage loans went through a similar set of issues in the late 80s.
  • Lending to lesser developed countries went through similar set of issues in the early 80s.
  • The collateralized debt obligation markets seem to have their little panics every now and then. (late 90s, early 2000s, mid 2000s, late 2000s)
  • During the dot-com bubble, too much trade finance was extended to marginal companies that were burning cash rapidly.
  • The roaring 20s were that way in part due to increased debt finance for corporations and individuals.

At the peak some say, “Nobody rings a bell.” This is true. But think of the market peak as being like the place where the avalanche happened 10 minutes before it happened. What set off the avalanche? Was it the little kid at the bottom of the valley who decided to yodel? Maybe, but the result was disproportionate to the final cause. The far more amazing thing was the development of the snow into the configuration that could allow for the avalanche.

This is the way things are in a heavily indebted financial system. At its end, it is unstable, and at its initial unwinding the proximate cause of trouble seems incapable of doing much harm. But to give you another analogy ask yourself this: what is more amazing, the kid who knocks over the first domino, or the team of people spending all day lining up the huge field of dominoes? It is the latter, and so it is amazing to watch large groups of people engaging in synchronized speculation not realizing that they are heading for a significant disaster.

As for today, I don’t see the same debt buildup has we had growing from 2003 to 2007. The exceptions maybe student loans, parts of the energy sector, parts of the financial sector, and governments. That doesn’t mean that there is a debt crisis forming, but it does mean we should keep our eyes open.

I’ve written about this before, but if the FSOC wants to prove that they don’t know what they are doing, they should define a large life insurer to be a systemic threat.

It is rich, really rich, to look at the rantings of a bunch of bureaucrats and banking regulators who could not properly regulate banks for solvency from 2003-2008, and have them suggest solvency regulation for a class of businesses that they understand even less.

And, this is regarding an industry that posed little systemic threat during the financial crisis.  Yes, there were the life subsidiaries of AIG that were rescued by the Fed, and a few medium-large life insurers like Hartford and Lincoln National that took TARP money that they didn’t need.  Even if all of these companies failed, it would have had little impact on the industry as a whole, much less the financial sector of the US.

Life insurance companies have much longer liability structures than banks.  They don’t have to refresh their financing frequently to stay solvent.  It is difficult to have a “run on the company” during a time of financial weakness.  Existing solvency regulation done by actuaries and filed with the state regulators considers risks that the banks often do not do in their asset-liability analyses.

Systemic risk comes from short-dated financing of long-dated assets, which is often done by banks, but rarely by life insurers.  I’ve written about this many times, and here are two of the better ones:

MetLife and other insurers should not have to live with the folly of “Big == Systemic Risk.”  Rather, let the FSOC focus on all lending financials that borrow short and lend long, particularly those that use the repurchase markets, or fund their asset inventories via short-term lending agreements.  That is the threat — let them regulate banks and pseudo-banks right before they dare to regulate something they clearly do not understand.

9142514184_9c85b423ae_z Starting again with another letter from a reader, but I will just post his questions in response to this article:

1) How much emphasis do you put on the credit cycle? I guess given your background rather a great deal, although as a fundamentals guy, I imagine you don’t try and make macro calls.

2)  What sources do you look at to make estimates of the credit cycle? Do you look at individual issues, personal models, or are there people like Grant’s you follow?

3) Do you expect the next credit meltdown to come from within the US (as your article suggests is possible) or externally?

4) How do you position yourself to avoid loss / gain from a credit cycle turn? Do you put more emphasis on avoiding loss or looking for profitable speculation (shorts or quality)

1) I put a lot of emphasis on the credit cycle.  I think it is the governing cycle in the overall economic cycle.  When some sector of the economy finds itself under credit stress, it has a large impact on stocks in that sector and related areas.

The problem is magnified when that sector is banks, S&Ls and other lending enterprises.  When that happens, all of the lending-dependent areas of the economy tend to slump, especially those that have had the greatest percentage increase in debt.

There’s a saying among bond managers to avoid the area with the greatest increase in debt.  That would have kept you out of autos in the early 2000s, Telecoms after that, and Banks/Finance heading into the Financial Crisis.  Some suggest that it is telling us to avoid the junior energy names now — those taking on a lot of debt to do fracking… but that’s too small to be a significant crisis.  Question to readers: where do you see debt rising?  I would add the US Government, other governments, and student loans, but where else?

2) I just read.  I look for elements of bad underwriting: loosening credit standards, poor collateral, financial entities focused on growth at all costs.  I try to look at credit spread relationships relative to risks undertaken.  I try to find risks that are under- and over-priced.  If I can’t find any underpriced risks, that tells me that we are in trouble… but it doesn’t tell me when the trouble will hit.

I also try to think through what the Fed is doing, and think what might be harmed in the next tightening cycle.  This is only a guess, but I suspect that emerging markets will get hit again, just not immediately once the FOMC starts tightening.  It may take six months before the pain is felt.  Think of nations that have to float short-term debt to keep things going, particularly if it is dollar-denominated.

I would read Grant’s… I love his writing, but it costs too much for me.  I would rather sit down with my software and try to ferret out what industries are financing with too much debt (putting it on my project list…).

3) At present, I think that an emerging markets crisis is closer than a US-centered crisis.  Maybe the EU, Japan, or China will have a crisis first… the debt levels have certainly been increasing in each of those places.  I think the US is the “least dirty shirt,” but I don’t hold that view strongly, and am willing to be challenged on that.

That last piece on the US was written about the point of the start of the last “bitty panic,” as I called it.  For a full-fledged crisis in US corporates, we need the current high issuance of  corporates to mature for 2-3 years, such that the cash is gone, but the debts remain, which will be hard amid high profit margins.  Unless profit margins fall, a crisis in US corporates will be remote.

4) My goal is not to make money off of the bear phase of the credit cycle, but to lose less.  I do this because this is very hard to time, and I am not good with Tactical Asset Allocation or shorting.  There are a lot of people that wait a long time for the cycle to turn, and lose quite a bit in the process.

Thus, I tend to shift to higher quality companies that can easily survive the credit cycle.  I also avoid industries that have recently taken on a lot of debt.  I also raise cash to a small degree — on stock portfolios, no more than 20%.  On bond portfolios, stay short- to intermediate-term, and high to medium high quality.

In short, that’s how I view the situation, and what I would do.  I am always open to suggestions, particularly in a confusing environment like this.  If you’re not puzzled about the current environment, you’re not thinking hard enough. ;)

Till next time.