Category: Banks

The Yield Curve Can?t Invert With Fed Manipulation

The Yield Curve Can?t Invert With Fed Manipulation

Posted on by David Merkel

This piece should be short.? I have heard otherwise intelligent people say that the economy can?t go into a recession because the slope of the Treasury yield curve is too positive.

With the Fed trying to manipulate the yield curve for its own policy purposes, starving savers of income, the yield curve is not a useful measure.? To invert the Treasury yield curve when the Fed is holding short rates at zero, we would have to see the Fed engage in Quantitative Easing to the degree that Treasury Notes and Bonds can be issued at significant negative interest rates.

To argue that we can?t have a recession at present because of the Treasury yield curve essentially says that if the Fed holds short rates at zero, we can?t have a recession.

I?m sorry, but with an overindebted economy, we can have a structural, not cyclical recession, where the shape of the yield curve doesn?t matter much because of all the debt.? When large portions of the economy have no inclination to borrow, monetary policy, even unorthodox and evil monetary policy has little effect on the real economy, where ordinary people borrow money (excluding from the GSEs).

This is another reason why I think the Fed actions to twist the yield curve will fail. ?They can twist the curve, yeah, but it will do little to stimulate an overindebted economy where many mortgage loans are inverted.

The Fed may control the Treasury yield curve, but it does not control the free market yield curve where (aside from Fannie and Freddie and the FHA), ordinary people and firms borrow.

 

-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=

 

PS — I’m still without power.? Yeah, day 7, and I’m in the lucky 2%.? Still, we’re not doing badly, and this is a lesson from God, teaching us patience.

.? I thought I would have more to say on yesterday’s piece, but I don’t.? If anyone reading this has a copy of what a collateral swap agreement looks like, I would enjoy looking through it.

Financial Complexity, Part 1

Financial Complexity, Part 1

Posted on by David Merkel

FT Alphaville had an article recently where they featured an academic paper Complexity, Innovation and the Regulation of Modern Financial Markets by Dan Awrey.? It?s not a mathematically complex paper, though it deals with complex financial instruments and it is quite relevant to our present troubles.

Let me start by quoting the beginning of the abstract:

The intellectual origins of the global financial crisis (GFC) can be traced back to blind spots emanating from within conventional financial theory. These blind spots are distorted reflections of the perfect market assumptions underpinning the canonical theories of financial economics: modern portfolio theory; the Modigliani and Miller capital structure irrelevancy principle; the capital asset pricing model and, perhaps most importantly, the efficient market hypothesis. In the decades leading up to the GFC, these assumptions were transformed from empirically (con)testable propositions into the central articles of faith of the ideology of modern finance: the foundations of a widely held belief in the self-correcting nature of markets and their consequent optimality as mechanisms for the allocation of society?s resources. This ideology, in turn, exerted a profound influence on how we regulate financial markets and institutions.

I have consistently been a critic of modern portfolio theory, the Modigliani and Miller capital structure irrelevancy principle, the capital asset pricing model and, the efficient market hypothesis.? I have also criticized the idea that incomplete markets are a problem, and that derivatives are needed to complete markets.? Trying to make liquid markets out of assets that are naturally illiquid is a fool?s bargain.? I have also argued that derivatives should be regulated as insurance contracts, and subject to the doctrine of insurable interest.

Why don?t academic finance theories work?? Quoting again from the paper:

These theories share a common and highly stylized view of financial markets, one characterized by, inter alia, perfect information, the absence of transaction costs and rational market participants. Yet in reality financial markets ? and market participants ? rarely (if ever) strictly conform to these assumptions.? Information is costly and unevenly distributed; transaction costs are pervasive and often determinative, and market participants frequently exhibit cognitive biases and bounded rationality.

In short, men are not hyper-rational calculators, like the Vulcans of Star Trek.? Markets for goods and services might be efficient, but not those for assets, where values are not as easily estimated.

Asset markets are frequently reflexive.? As an intelligent former boss once said to me, ?When does a company look its best?? Immediately after receiving a loan.? That?s why we wait a few years before shorting a bad company that has just received a significant loan.?

The paper encourages study to understand how markets work in practice, rather than how they work ideally to neoclassical economists.? I heartily agree; I think that the more one studies the structure of asset markets, the more they will understand that there are many approaches to the market, and the popularity of strategies depends a lot on past success.

Quoting again:

Nevertheless, taking a broad look across the financial system, it is possible to identify at least six ? in many respects intertwined and overlapping ? sources of complexity: technology, opacity, interconnectedness, fragmentation, regulation and reflexivity.

Technology ? things move faster, but can people keep up with it.? More data can be gathered by connected players.? It is one reason that I am a low turnover investor.? There are too many playing the short duration game in the market.

Opacity ? few can truly understand the economics of most securitizations, or whether the subordination levels are right or not.? Investing in ?dark pools? is rarely wise.? And as for the credit guarantors that I have criticized, they could not understand the risks they were taking, because they assumed the credit boom was normal and perpetual.

Interconnectedness ? What could be more interconnected than the financial guarantors?? Or the banks who lent to one another, directly and indirectly?

Fragmentation ? Securitization makes it tough for owner to understand what is happening several links down the chain.? Guess what?? It?s a lot easier to have your own mortgage loan department, and watch over your own loans.

Regulation ? Financial regulation is fragmented, and often co-opted by those regulated.?? Because the US government does not get this, market players arbitrage regulators.? Another aspect of it was the moral hazard engendered by the Fed and other regulators, giving the impression that there would be rescues available in any real crisis.

Reflexivity ? I have talked about this above.

I would add a seventh source of complexity ? leverage.? People underestimate the effects of leverage on managements in managing assets.? When the possibility of bankruptcy arrives, the effects are discontinuous, violent.? This is especially true when debts are layered, where A owes B, who owes C, who owes D, on thin equity bases.? A?s failure to pay has ripple effects, leading to a cascading failure.

An eighth source of complexity is use of short-term debt to finance long term assets.? An early precursor to the crisis was the failure of off-balance sheet subsidiaries that were financed with short-term loans.? Similarly, firms that relied on repo funding to finance their inventory of assets had a rough time of it as repo haircuts rose rapidly, and in tandem.

A ninth source of complexity was similar: margin requirements in derivative agreements, where a credit downgrade could lead to a call on capital at the worst possible moment.? This happened with AIG.

A tenth source of complexity which enabled much of the above nine is one that many writers don?t want to talk about, because it exposes many of ?victims? to be enablers: yield-seeking.? Why be a lender to complex investment vehicles?? You get more yield.? None of them have blown up.? They are highly rated.? Why not go for the higher yield?? As I have said before, it takes failure to mature an asset class.? All new asset classes look pristine; nothing starts with failure.? Typically the best deals get done first ? best quality, best incremental yields.? Then competition drives down quality and yield spreads, but raises quantity.

Without the yield-seeking, many complex financial instruments would never get issued.? Someone had to buy the ?safe? tranches of CDOs, CDO-squareds, ABS CDOs, etc., in order to sell the deals.? Many European banks bought them because they didn?t have to put much capital against them for risk purposes, and the added yield helped them meet earnings targets, at a cost of greater illiquidity.

An eleventh source of complexity was the failure of accounting to properly account for these new instruments with volatile fair values.? Fair Value accounting, using market values and their approximations was a step in the right direction, and bitterly opposed by those who were financing illiquid, opaque, financial instruments, while their funding was short-dated with too little equity.

More will come in part 2, soon.? Still without power — a hard providence, be we are surviving it.

 

 

FT Alphaville had an article recently where they featured an academic paper Complexity, Innovation and the Regulation of Modern Financial Markets by Dan Awrey. It?s not a mathematically complex paper, though it deals with complex financial instruments and it is quite relevant to our present troubles.

 

Let me start by quoting the beginning of the abstract:

 

The intellectual origins of the global financial crisis (GFC) can be traced back to blind spots emanating from within conventional financial theory. These blind spots are distorted reflections of the perfect market assumptions underpinning the canonical theories of financial economics: modern portfolio theory; the Modigliani and Miller capital structure irrelevancy principle; the capital asset pricing model and, perhaps most importantly, the efficient market hypothesis. In the decades leading up to the GFC, these assumptions were transformed from empirically (con)testable propositions into the central articles of faith of the ideology of modern finance: the foundations of a widely held belief in the self-correcting nature of markets and their consequent optimality as mechanisms for the allocation of society?s resources. This ideology, in turn, exerted a profound influence on how we regulate financial markets and

institutions.

 

I have consistently been a critic of modern portfolio theory, the Modigliani and Miller capital structure irrelevancy principle, the capital asset pricing model and, the efficient market hypothesis. I have also criticized the idea that incomplete markets are a problem, and that derivatives are needed to complete markets. Trying to make liquid markets out of assets that are naturally illiquid is a fool?s bargain. I have also argued that derivatives should be regulated as insurance contracts, and subject to the doctrine of insurable interest.

 

Why don?t academic finance theories work? Quoting again from the paper:

 

These theories share a common and highly stylized view of financial markets, one characterized by, inter alia, perfect information, the absence of transaction costs and rational market participants. Yet in reality financial markets ? and market participants ? rarely (if ever) strictly conform to these assumptions. Information is costly and unevenly distributed; transaction costs are pervasive and often determinative, and market participants frequently exhibit cognitive biases and bounded rationality.

In short, men are not hyper-rational calculators, like Vulcans. Markets for goods and services might be efficient, but not those for assets, where values are not as easily estimated.

Asset markets are frequently reflexive. As an intelligent former boss once said to me, ?When does a company look its best? Immediately after receiving a loan. That?s why we wait a few years before shorting a bad company that has just received a significant loan.?

The paper encourages study to understand how markets work in practice, rather than how they work ideally to neoclassical economists. I heartily agree; I think that the more one studies the structure of asset markets, the more they will understand that there are many approaches to the market, and the popularity of strategies depends a lot on past success.

Quoting again:

Nevertheless, taking a broad look across the financial system, it is possible to identify at least six ? in many respects intertwined and overlapping ? sources of complexity: technology, opacity, interconnectedness, fragmentation, regulation and reflexivity.

Technology ? things move faster, but can people keep up with it. More data can be gathered by connected players. It is one reason that I am a low turnover investor. There are too many playing the short duration game in the market.

Opacity ? few can truly understand the economics of most securitizations, or whether the subordination levels are right or not. Investing in ?dark pools? is rarely wise. And as for the credit guarantors that I have criticized, they could not understand the risks they were taking, because they assumed the credit boom was normal and perpetual.

Interconnectedness ? What could be more interconnected than the financial guarantors?

Fragmentation ? Securitization makes it tough for owner to understand what is happening several links down the chain. Guess what? It?s a lot easier to have your own mortgage loan department, and watch over your own loans.

Regulation ? Financial regulation is fragmented, and often co-opted by those regulated. Because the US government does not get this, market players arbitrage regulators.

Reflexivity ? I have talked about this above.

I would add a seventh source of complexity ? leverage. People underestimate the effects of leverage on managements in managing assets. When the possibility of bankruptcy arrives, the effects are discontinuous, violent. This is especially true when debts are layered, where A owes B, who owes C, who owes D, on thin equity bases. A?s failure to pay has ripple effects, leading to a cascading failure.

An eighth source of complexity is use of short-term debt to finance long term assets. An early precursor to the crisis was the failure of off-balance sheet subsidiaries that were financed with short-term loans. Similarly, firms that relied on repo funding to finance their inventory of assets had a rough time of it as repo haircuts rose rapidly, and in tandem.

A ninth source of complexity was similar: margin requirements in derivative agreements, where a credit downgrade could lead to a call on capital at the worst possible moment. This happened with AIG.

A tenth source of complexity which enabled much of the above nine is one that many writers don?t want to talk about, because it exposes many of ?victims? to be enablers: yield-seeking. Why be a lender to complex investment vehicles? You get more yield. None of them have blown up. They are highly rated. Why not go for the higher yield? As I have said before, it takes failure to mature an asset class. All new asset classes look pristine; nothing starts with failure. Typically the best deals get done first ? best quality, best incremental yields. Then competition drives down quality and yield spreads, but raises quantity.

Without the yield-seeking, many complex financial instruments would never get issued. Someone had to buy the ?safe? tranches of CDOs, CDO-squareds, ABS CDOs, etc., in order to sell the deals. Many European banks bought them because they didn?t have to put much capital against them for risk purposes, and the added yield helped them meet earnings targets, at a cost of greater illiquidity.

More will come in part 2, soon.

Missed Opportunities

Missed Opportunities

Posted on by David Merkel

Even Hayek said something to the effect that there are no good solutions in the bust phase of the market.? Opportunities to avoid the bust come in the bull phase of the market.? How?

  • Fiscal authorities could lessen the advantages of financing with debt, leading to a decrease in debt employed.
  • Monetary authorities could keep monetary policy tight for longer, allowing bad debts to fail, rather than refinancing them with lower interest rates.? Let recessions do their real work of eliminating marginal economic concepts.

The Fed is supposed to take away the punch bowl when the party is getting too wild.? Greenspan (and to a lesser extent Bernanke, because he inherited Greenspan?s profligacy) did the opposite.

Instead of letting markets find their own level in a panic, they aided in the refinance of dud assets.? This led to a buildup of personal debts, particularly those financing housing.

But let?s consider the individual situations.? Start with 1987.? Alan Greenspan, new Fed Chairman reacts to the crash in October by promising loans to back up the market.? Wrong.? Let some market players fail, revealing the bad risks they had taken.? But no, this is the beginning of the Greenspan Put, and all of the malarkey that allowed risk-taking to extend? to every market because it seemed the Fed would rescue every crisis.

The stock market should not be an interest of monetary policy.? Focus on banks, and have them cut their links to the stock market.? Bonds are fine, that is lending.? Banks should not engage in speculation, if their deposits are guaranteed by the FDIC.

Then we come to the Commercial real estate crisis of the early 90s.? More projects needed to fail, but the Fed lowered rates to what were then unprecented levels, and enough marginal projects that should have failed survived.? The recession should have gone longer, and reduced overall debt levels.? But no, we end up with more debt and a reduced marginal productivity of capital.

In 1994, the residential mortgage market imploded because of perverse bets on the volatility of residential mortgage prices.? The rout led to a self reinforcing rise in interest rates, and then the Fed loosened too soon, once again.

By this time aggregate debt levels had risen dramatically since 1984.? With lower interest rates, the interest burden was lower, but the principal burden was higher, because people refinanced, and began to take money out.

Also in 1994, speculators on Mexican Cetes were partially rescued by the US Government through a set of loans to the Mexican Government.? This led to a greater sense that the US Government would back up speculators if they were big enough group.

In 1998, the Fed could have let investment banks sweat over Long Term Capital Management and Russia, but no, they forced them to cooperate while injecting a lot more liquidity into the system.

As a result, bad loans persisted and the marginal efficiency of capital fell, as companies and people refinanced.

In 2000, the Fed had its last chance to right the system in the midst of the tech bubble.? Instead of leaving rates high, because the general economy was not under that much threat, the Fed loosened down to unimaginable levels, mainly to force a bubble in US Housing, which would lead the economy out of the recession, which it did and then some.

In doing so, the Fed pushed debt levels relative to GDP far higher than they were during the Great Depression.? Because overall debt levels create depressions, I sometimes wonder that the supposed scholar Bernanke, and the toady Greenspan did not consider that they were setting up the seeds of destruction.

By 2007, the situation is too far gone, as the Fed tightens, it reveals systemic weaknesses as debt is too high relative to GDP, and we find ourselves in a structural depression, as opposed to a cyclical recession.

In 2008, if the Fed had not loosened, maybe things would have been worse in the short-to-intermediate run.? I expect that if deposits were protected, and losses of senior unsecured capped at 25%, the system would have survived.

But no, the Fed acted to increase leverage more, again.? In this new era, since 1984, that?s all it can do.

When does the day of reckoning come?? I trust the masses more than the elites.? Where is the bailout for the masses?? The elites got more than their share recently.? Is the helicopter of happiness going to fly over the homes of average people anytime soon?

If Bernanke ever believed in Milton Friedman?s view of the economy, it does not show here.? There is no increase in inflation, at least in the assets that need it.? There is only inflation in the prices of assets that are healthy, and little in those that are sick.

There should be no surprise here; it is impossible to reinflate a dud asset, except at high cost.

My point is this: who pushed for greater austerity when it would not have hurt our republic?? Few.

Instead, the debt grew exponentially as the Fed created the Great Moderation, which in other terms would be eventually be called a liquidity trap.

Though the US government is guilty for its deficits, and fostering a culture favoring debt over equity, the Fed is more guilty for not keeping interest rates higher, letting moderate recessions do their good work of eliminating malinvestment.? That might have prevented this current crisis.

There are no good solutions now.? Bail out this, bail out that.

Eventually there will be a fail of some sort.? I just don?t know what, when or how.

Leverage Isn’t Free

Leverage Isn’t Free

Posted on by David Merkel

I’ve been running across an idea that outperformance is possible with safe assets, so why not take those assets and lever them up until their volatility is equal to common equities, and earn more at the same level of volatility?? That was my only significant disagreement with the book Expected Returns.

I think this is a stupid idea.? (I don’t favor the CAPM either.)? When you borrow money to buy some asset, the distribution of possible returns changes.

Let me give you some analogies.?? First, securitization.? Those that invest in non-senior loan tranches get an enhanced yield, but they face a different risk profile than most corporate bond investors.? Corporate bond investors have a high expectation of full payment, but when default occurs, they lose 60-80%.? Investors in securitized bonds rarely get recoveries.? They usually get paid in full or lose it all.

Second, think of banks or REITs.? They lever up safe assets, and they blow up with a higher frequency than do industrial corporate bonds.

Leverage changes the nature of the distribution of possible returns in three ways:

  1. The cost of borrowing decreases the return.
  2. The returns are levered by the amount of borrowing.
  3. To the degree that others do the same thing, the strategy is no longer undiscovered, and superior returns should not be expected.? In a crisis, the borrowed money leads to overshoots as panicked investors bail out en masse.

Personally. I wish we could get rid of the writings of academic economists and finance writers that don’t actively invest.? They don’t get the dynamics of investing, and assume a simple world that does not resemble our world.

My main point is that trying to buy the asset class with the highest return after equalizing volatilities is a fool’s bargain.? Adding leverage changes the nature of decisionmaking, and what tests in the lab will not likely work in real life.? Paper trading does not always translate to real world profits.

Debt Junkies

Debt Junkies

Posted on by David Merkel

Our problems today stem from too much debt, both personal and governmental.? When enough of the populace is overindebted, they become conservative in spending.? When corporations see that, they become conservative as well, and cut back on production.? The same is true with governments.? As governments get more indebted, people begin to think they won’t spend as much in the future, which is a reasonable assumption.

But what do the pundits suggest?? Borrow more.? If you only would borrow more, and allocate the money to our favored projects, things would improve.? But that is more of the “hair of the dog that bit you” reasoning.? More debt does not solve the problem of too much debt.

In general, the more of the economy that we hand off to the government, economic growth will be less.? The government rarely grows anything, except itself.

I realize in the short-run that reductions in the growth of debt, much less reductions in debt will be viewed negatively by many.? The question becomes whether you want a solution, or you want to continue the disease, and hope for a miracle.

This problem is not limited to the US.? It extends to the Eurozone and China, and indirectly to the rest of the developed and semi-developed world.? In the Eurozone, the ECB and EFSF buy the debts of the weakest nations in order to back the Euro.? Imagine the Fed buying Puerto Rican and Californian bonds.? Ugly, and I hope the Fed does not become more imaginative.? It is too speculative already.

The Eurozone is transforming what was a fringe problem into a core problem and CDS spreads of Germany and France are greater than those of the UK, which has its own currency.? If the Eurozone were a nation, it would be in roughly the same shape as the US, which means not good.

As for China, the government forces loans that are not economic on the banks.? There are many projects that seem to have no economic purpose, but might have political purpose.? Why build ghost cities?? Why build a highway to Xingjang, and plan a model city there?? For the latter it is to control the Uighurs; for the former, I am not sure, aside from distorting GDP statistics.

China also has its issues with owning US debt.? They have to own US debt to keep their currency cheap for exporting.? This is just another way that China discriminates against their consumers in favor of exporters who are political cronies.

Coming back to the US, the Fed encouraged more debt todayby saying that financing rates would remain low for two years.? That may push up asset prices, and allow the highest quality borrowers to borrow more, but is useless in stimulating the economy, because credit spreads do not respond to the Fed when the economy as a whole is overlevered.

The world is led by debt junkies who think that debt doesn’t matter.? They are leading us to a greater crisis where the only thing that does matter is debt, and for political reasons, some governments will not be willing to pay in full.

Redacted Version of the August 2011 FOMC Statement

Redacted Version of the August 2011 FOMC Statement

Posted on by David Merkel
June 2011 August 2011 Comments
Information received since the Federal Open Market Committee met in April indicates that the economic recovery is continuing at a moderate pace, though somewhat more slowly than the Committee had expected. Information received since the Federal Open Market Committee met in June indicates that economic growth so far this year has been considerably slower than the Committee had expected. Shades down their view of GDP again.? I think they need to hire better modelers.
Also, recent labor market indicators have been weaker than anticipated.? The slower pace of the recovery reflects in part factors that are likely to be temporary, including the damping effect of higher food and energy prices on consumer purchasing power and spending as well as supply chain disruptions associated with the tragic events in Japan. Indicators suggest a deterioration in overall labor market conditions in recent months, and the unemployment rate has moved up. Shades down their view of employment further.? Wishful thinking regarding transitory factors disappears? Japan does not have that big of an impact on US employment, nor do food and energy prices, which have been going up for some time.

(See 2 boxes below.)
Household spending and business investment in equipment and software continue to expand.? However, investment in nonresidential structures is still weak, and the housing sector continues to be depressed. Household spending has flattened out, investment in nonresidential structures is still weak, and the housing sector remains depressed. ?However, business investment in equipment and software continues to expand. Shades down their view of household spending, otherwise similar.
  Temporary factors, including the damping effect of higher food and energy prices on consumer purchasing power and spending as well as supply chain disruptions associated with the tragic events in Japan, appear to account for only some of the recent weakness in economic activity. New sentence that takes back part of their wishful argument from last month.? They were grasping at straws.
Inflation has picked up in recent months, mainly reflecting higher prices for some commodities and imported goods, as well as the recent supply chain disruptions. Inflation picked up earlier in the year, mainly reflecting higher prices for some commodities and imported goods, as well as the supply chain disruptions. Basically the same.
  More recently, inflation has moderated as prices of energy and some commodities have declined from their earlier peaks. What evidence do they have that overall inflation is declining?? I don?t see it; this is more grasping at straws.
However, longer-term inflation expectations have remained stable. Longer-term inflation expectations have remained stable. Basically the same.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.? The unemployment rate remains elevated; however, the Committee expects the pace of recovery to pick up over coming quarters and the unemployment rate to resume its gradual decline toward levels that the Committee judges to be consistent with its dual mandate. Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. ?The Committee now expects a somewhat slower pace of recovery over coming quarters than it did at the time of the previous meeting and anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Shades down their view of the recovery overall.? The misplaced optimism is declining.
Inflation has moved up recently, but the Committee anticipates that inflation will subside to levels at or below those consistent with the Committee’s dual mandate as the effects of past energy and other commodity price increases dissipate. ?However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.

 

 Moreover, downside risks to the economic outlook have increased. The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee’s dual mandate as the effects of past energy and other commodity price increases dissipate further.? However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations. Shades down their views on inflation, but for little good reason.
To promote the ongoing economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent. To promote the ongoing economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent. No change.
The Committee continues to anticipate that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate for an extended period. The Committee currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013. Defines the ?extended period to be 2 years.
The Committee will complete its purchases of $600 billion of longer-term Treasury securities by the end of this month and will maintain its existing policy of reinvesting principal payments from its securities holdings. The Committee also will maintain its existing policy of reinvesting principal payments from its securities holdings. No real change.
The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate. No change
The Committee will monitor the economic outlook and financial developments and will act as needed to best foster maximum employment and price stability. The Committee discussed the range of policy tools available to promote a stronger economic recovery in a context of price stability. It will continue to assess the economic outlook in light of incoming information and is prepared to employ these tools as appropriate. The Fed doesn?t have any good tools left.? All they can work with are the bad tools, and work they will.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Richard W. Fisher; Narayana Kocherlakota; Charles I. Plosser; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen. Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen. Note dissenters below.
  Voting against the action were: Richard W. Fisher, Narayana Kocherlakota, and Charles I. Plosser, who would have preferred to continue to describe economic conditions as likely to warrant exceptionally low levels for the federal funds rate for an extended period. They would have preferred the old language not specifying how long the extended period would be at minimum.? This is a pretty weak dissent; there is a lot more to be objected to in our monetary policy.

Comments

  • The FOMC defines the ?extended period to be 2 years.? Short-intermediate part of the Treasury curve flattens.? Long end goes on a speculative tear.? Hope the FOMC likes that, but it will only allow high quality borrowers to borrow more cheaply, not average people and small businesses. The Fed?s policy can?t bring down credit spreads, not that it should.
  • Still engages in wishful thinking regarding inflation, thinking that it is declining.? Points at energy and commodities, but that?s not the largest part of what drives inflation.
  • Finally shades down its views on GDP and employment growth.
  • The Fed ends much of its wishful thinking regarding transitory employment factors? Japan does not have that big of an impact on US employment, nor do food and energy prices, which have been going up for some time.
  • The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.? As a result, the FOMC ain?t moving rates up, absent increases in employment, or a US Dollar crisis.? Labor employment is the key metric.
  • The hawks finally flew with a weak dissent, objecting to specifying how long the extended period would be at minimum.
  • The Fed is not shrinking its balance sheet anytime soon.
  • The Fed is out of good policy tools, so it will use bad policy tools instead.

Questions for Dr. Bernanke:

  • How big is the effect on employment from higher food and energy prices on consumer purchasing power and spending as well as supply chain disruptions associated with the tragic events in Japan?
  • Couldn?t increased unemployment be structural, after all, there is a lot more competition from labor in emerging markets?
  • Isn?t stagflation a possibility here?? I mean, no one expected it in the ?70s either.
  • Could we end up with another debt bubble from keeping short rates so low?
  • If the Fed ever does shrink its balance sheet, what effect will it have on the banks?
  • Is it possible that you don?t really know what would have worked to solve the Great Depression, and you are just committing an entirely new error that will result in a larger problem for us later?
How Would You Run a Rating Agency?

How Would You Run a Rating Agency?

Posted on by David Merkel

Rating agencies grew up rating corporate credit risk.? The nice thing about corporate credit risk is the failures happen at least every seven years.? There was a sideline on municipal credit risk, but since munis rarely defaulted, it was not very relevant.

Guess what?? Moody’s, S&P, and Fitch are very good at predicting corporate default.? Some new players are better still, but their ratings change more rapidly, which has pluses and minuses.? They are faster to identify failing entities, but they also have more “false positives” where they signal failure, and it does not happen.

GICs

Go back to the late ’80s.? The rating agencies were trying to evaluate the newly popular 401(k) investment Guaranteed Investment Contracts [GICs].? Guess what?? No GICs had ever failed.? What’s the right rating for all the companies offering them?? If the history is so positive shouldn’t everyone be AAA?

Though some of the larger companies had corporate debt that traded, GICs were not obligations of the holding company, but of the insurance subsidiary.? Not only that, unlike bonds, GICs (in most states) were policyholder obligations, not debt per se.? GICs were often super-senior obligations of subsidiaries of the company.

So, how to rate them?? Since there were few historical losses, and the rating agencies lacked a forward-looking view of what might happen, they rated most GICs AAA or AA.

After a few GIC-issuing companies went into insolvency, those ratings changed rapidly over the next seven years, leading to many exits by marginal players who did not default, a few defaults (with almost no losses), and a much smaller GIC industry dominated by synthetic GICs that relied upon insurance company derivatives.

Securitization

Because the regulators required ratings, the rating agencies were willingly drawn in to rating structured products.? With the GSEs it was easy — there is no credit risk, so they are AAA.? With the non-guaranteed whole loans, it was tougher — no GSE guarantee.? How to rate?? This was a new product, a new risk, and so the rating agencies looked at resident mortgage default rates in the past.

Very much like the error of health insurers in the ’60s, where they tried to calculate utilization of healthcare services from the non-insured and apply that to the insured, mortgages retained by originators defaulted less frequently than those that were sold to third parties.

The rating agencies could get the math right on securitization, but could not get the parameters right.? All of their loss data came from an era where lenders held onto their loans.? Selling loans, and having servicing as a separable function was totally unknown to the past.

Much as those who implemented securitization were relatively farsighted, they did not take into account the agency problems involved in “selling to securitize.”

The rating agencies did the best that they could in a competitive environment, with little relevant loss data to guide them.

I suspect that they will do better before the next cycle of failures transpires.

=–==-=–==–==–=-=-=-==–=-==-=-=–==–==-=–==-=–==-

In short, my point is this: the rating agencies, blundered with ratings on securitization.? They will be better in the future, because they finally have real data to work with.? They are trying to be more forward looking on sovereign issuers, with some degree of pushback.? My view is that those that object more should be downgraded further, within reason.? I differ from the rating agencies, because I am more skeptical, and imaginative.

“Figures don’t lie, but liars will figure.” Issuers are not objective with respect to their own debts.? Rating agencies should ignore the issuers, and work off? of publicly available data, lest they be subverted by the issuers, as has happened.

=–===–=-=-==–=-==-=–==-=-=-=-=-=–=-=-==-=-=-=-=-=-=-=-

I don’t fault the rating agencies much with respect to sovereign ratings.? They seem mostly rational to me, though? there is little real default data to guide them.

That’s the crux of the issue here — they don’t have many sovereign fiat currency defaults to guide them.? Does that mean the odds are low?? By no means.? A larger model, including political motivations, and using game theory would indicate that there are possibilities where no coalition governs that debts will be paid.

I hate the simplistic models of the Keynesians and their bastard progeny.? One has to think more broadly, and consider the wide range of what might happen, because (surprise!) people/institutions aren’t always rational as economists view them.

-=-==-=-=–==-=–=-=-==-=-=-=–==-=-=-=-=-=-=-=-=-=-=-=-=-=-=-

I leave you with this: imagine that you run a rating agency, and your clients ask you to rate debts that you don’t have a good model to use.? You have competitors, and they are seeking advantage as well.? Add into the mix that the issuers can choose who they want.? How do you react to a new class of credit?? The question is a hard one.

=–==–==-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=–==-=-=-=-=-=-=-=-=-

And thus, to those who trash the rating agencies because of bad past decisions, I say, “Could you have done better, you have the benefit of hindsight?”

The rating agencies are flawed but are mostly honest dealers who used bad models on structured credit, because no one knew better.? They took the risk and put forth some bad ratings.

For this reason I say to the fools who argue against the S&P downgrade of the US, “How do you know?”? For once a rating agency is trying to be proactive, and they get a lot of abuse.? Watch the trading in the market, it will tell you a lot more than the downgrade.

On the S&P Downgrade

On the S&P Downgrade

Posted on by David Merkel

So S&P downgraded the US.? Big deal.? It should have happened long ago, and many other sovereigns deserve to be downgraded as well.? Now if you want my summary views, positive and negative one the rating agencies, they can be found here:

I have another set of writings as the financial guarantors were downgraded.? I was one of the early callers that the guarantors were nor AAA.? I made the same call on the GSEs.

My point is that the initial downgrades of a AAA entity come hard, but once they come, they come with vigor and speed.? S&P has cleared the way for Moody’s and Fitch to downgrade as well.? The cost for them to downgrade is a lot lower now, and they can go lower than Aa1/AA+ if they choose.? Without significant change, the ratings of the US go lower from here.

Now, some will say that there are no limits to what amount of debt a nation that controls its own currency could issue.? Typically, these are radical Keynesian economists, that like Keynes, have a simplistic model, but no sense of human nature or politics.? What could happen:

  • A blocking coalition against inflation elects a congress against additional borrowing, forcing a crisis versus demanded spending.
  • A constitutional convention removes the Fed, and/or repudiates external debts.
  • We could have another situation like the last one, and this time it doesn’t resolve, and we have a technical default.

The thing is, politics matters.? If we have a fiat currency, then it is politically driven.? If our politics with respect to debt repayment are unstable, then we don’t deserve a AAA.

But much as I don’t like the t-party, I do not blame them for this outcome.? I blame Obama, Bush, Clinton, Bush, Reagan, Carter, Nixon, Johnson, Kennedy, Eisenhower and CONGRESS.? They have overspent. They have created many useless programs.? They have created burdensome programs, they have turned medical care into a zoo of red tape. THEY HAVE NOT CARED FOR THE FUTURE OF THE NATION, BUT ONLY THE PRESENT!!

They have engaged us in wars that we have no business fighting.? I have not been in favor of any war we have fought since my birth in 1960.? Shrink the Defense department, please, and all the contractors that parasitically suck on it.? Shrink entitlements as well, we will not be able to afford Medicare.

It is amusing to see certain “wonks” who are not, trumpet Obama plundering Medicare to claim that he eliminated expenses there.? Do the liberals care that he is eliminating care to the elderly, because fewer doctors, and no quality doctors will serve them?

Most of the changes made in the recent agreement were an illusion. Few specific cuts were made, and a deficit commission would find changes, or else across-the-board cuts would happen.?? But given the polarization in politics, who thinks that there will be easy compromise in the future?? I don’t.

-=-=-==-=-=-==–=-=-=-=-=-==-=–=-==-=-

Now as a bond manager, I tell you there should be little change from the change in ratings. Why?

  • The rating of the US is still AAA, which is the average of Aaa/AA+/AAA
  • Downgrades of bonds rarely result in price changes on average.
  • Whenever major sovereign downgrades occur, covenants, collateral haircuts, investment guidelines, risk-based capital charges, etc. all get changed to make sure that nothing happens as a result.? Why? Ratings are an opinion, nothing more.? No one wants actions to occur on a sovereign because of a downgrade.

There are a lot of naive people speaking and writing about the downgrade as if it means something big, and they have never managed bonds in their lives.? I am not the be-all or end-all on this topic, but I would encourage people to read the opinions of those active in the bond markets before making definitive statements that have no reality behind them.

Events like this have happened before, and the US is still AAA for now. Prudent fiduciaries will make adjustments to reflect that AAA is not the standard for making investments, capital charges, etc.? There is no crisis here.? Don’t act like there is one, because there is none.

http://alephblog.com/2011/07/16/us-vs-moodys-sp-and-fitch/ 

US vs Moody?s, S&P and Fitch

Book Review: Lords of Finance

Book Review: Lords of Finance

Posted on by David Merkel

 

I really enjoyed this book.? It taught me a lot regarding the four main central bankers and the problems that they faced between WWI and WWII.? Add in Lord Keynes and you have real party.

WWI Reparations were too large for the Germans to afford.? But worse, France and England relied on those repayments so that they could repay America on their loans.? That made the squabble over reparations far worse.

What is more fascinating is how WWI with reparations helped lead to WWII.? The resentment of the Germans to occupation, reparations, etc., led to a fighting spirit, combined with antisemitism because of hatred of bankers, and you have a lot of what drove the war.

You will learn a lot if you read this book.? It is long, but valuable.? I recommend the book highly, subject to my disagreements.

Quibbles

Crises do not come as a result of a gold standard but from overly levered banking where liabilities are short and assets are long.? The book showed minimal understanding of basic principles of banking.

As a result, don’t listen to Keynes as much as Fisher.? Fisher understood the real cause of the Depression: too much debt.? Once debt came back to normal levels in 1941, the economy normalized.? WWII did not get us out of the depression, rather, it prolonged the suffering for those at home.

Who would benefit from this book:

Those wanting a good historical understanding of the financial facts between the First and Second World Wars will get it here.? You will understand the players and their motivations.

If you want to, you can buy it here: Lords of Finance: The Bankers Who Broke the World.

Full disclosure: I asked the publisher for the book and he sent me a copy.

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.

Don’t Play Near the Cliff

Don’t Play Near the Cliff

Posted on by David Merkel

As a nation or a corporation moves from being a safe credit [borrower] to being an unsafe credit, often the transition is more rapid than one would expect.? Success has many fathers, and people are reluctant to change their views rapidly.? But once the views change, it is very difficult to change them back.

Part of that is due to the construction of the markets.? Relatively little money is “go anywhere” in bonds.? There is significant segmentation.? Bond investors divide into safe and aggressive, with not a lot that can bridge the gap.? The same applies to banks, which have limits on what they can lend to corporate non-investment grade clients.

This problem gets worse with companies, quasi-governments and governments that are “confidence names.”? I never, ever, fully bought into the ratings agencies views on financial guarantors, mortgage guarantors, and the GSEs.? There was always a significant amount of hand-waving, suggesting that:

  • Disaster scenarios were impossible, and
  • There would be support from the government (for the GSEs).
  • Governments can easily raise taxes to pay off bonds.

The group of credits most in question today are governments.? There are a number of stages in-between health and default.

  1. Government has little debt, budget is largely in balance.
  2. Government has moderate debt, budget is slightly inbalanced, but not so much that the interest rate on the debt exceeds the GDP growth rate.
  3. Government has significant debt, budget is in significant deficit, but the interest rate on the debt does not exceed the GDP growth rate, because creditors expect the situation to be transitory.
  4. Government has significant debt, budget is in significant deficit, but the interest rate on the debt exceeds the GDP growth rate, because creditors expect the situation to be permanent.
  5. Default. Forced Exchange. Etc.

Note that the difference between phases 3 and 4 are only in the way a government gets viewed by creditors.? That shift often happens rapidly, and the ratings agencies tend to be lagging indicators.

My counsel to borrowers would be simple: don’t play near the cliff.? Once you move into phase 4, it is very difficult to move back into phase 3.

Now with governments that can print their own currency they might say that they have more flexibility. They do, economically.? They don’t, politically.? There are major constituencies against inflation that would rather force a government into default than tolerate inflation that disproportionately hurts them.

So be wary when lending to entities depending on lender confidence.? That confidence can disappear in an instant, leaving you to hold a depreciated loan with uncertainty as to whether it will be paid off.

 

Theme: Overlay by Kaira.