Banks – Page 3 – The Aleph Blog

Okay, Go Ahead, Sweat the Fed

Posted on 17 September 2015 by David Merkel

Photo Credit: Nate Steiner || There is always enough time to panic. ;) — Photo Credit: Nate Steiner || There is always enough time to panic. 😉

Today, I happened to stumble across an old article of mine: Easy In, Hard Out (Updated). ?It’s kind of long, but goes into the changes that have happened at the Fed since the crisis, and points out why tightening policy might be tough. ?Nothing has changed in the 2.4 years since I wrote it, so I am going to reprint the end of the article. ?Let me know what you think.

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In normal times, central banks buy only government debt, and keeps the assets relatively short, at longest attempting to mimic the existing supply of government debt.? Think of it this way, purchases/sales of longer debt injects/removes liquidity for longer periods of time.? Staying short maintains flexibility.

Yes, the Fed does not mark its securities or gold to market.? Under most scenarios, it is impossible for a central bank which can issue its own currency to go broke.? Rare exceptions ? home soil wars that fail, or political repudiation of the bank, where the government might create a new monetary standard, or closes the bank because of inflation.? (Hey, the central bank has been eliminated twice before.? It could happen again.)

The only real effect is on how much?seigniorage the Fed remits to the Treasury, or, if things go bad, how much the Treasury would have to lend/send to the central bank in order to avoid the bad optics of negative capital, perhaps via the Supplemental Financing Account.? This isn?t trivial; when people hear the central bank is ?broke,? they will do weird things.? To avoid that, the Fed?s gold will be revalued to market at minimum; hey maybe the Fed at that time will be the vanguard of market value accounting, and revalue everything.? Can you imagine what the replacement cost of the NY Fed building is?? The temple in DC?

Or, maybe the bank would be recapitalized by its member banks, if they are capable of doing so, with the reward being the preferred dividend they receive.

Back to the main point.? What effect will this abnormal monetary policy have in the future?

Scenarios

1) Growth strengthens and inflation remains low.? In this unusual combo, it will be easy?for the Fed to collapse its balance sheet, and raise rates.? This is the dream scenario; and I don?t think it is likely.? Look at the global economy; there is a lot of slack capacity.

2) Growth strengthens and inflation rises.? The Fed will likely raise the interest on reserves rate, but not sell bonds.? If they do sell bonds, the market will back up, and their losses will be horrible.? If don?t take the losses,?seigniorage could be considerably reduced, or even vanish, as the Fed funds rate rises, but because of the long duration asset portfolio, asset income rises slowly.? This is where the asset-liability mismatch bites.

If the Fed doesn?t raise the interest on reserves rate, I suspect banks would be willing to lend more, leaving fewer excess reserves at the Fed, which could stimulate more inflation. Now, there are some aspects of inflation that remain a mystery ? because sometimes inflationary conditions affect assets, rather than goods, I think depending on demographics.

3) Growth weakens and inflation remains low.? This would be the main scenario for QE4, QE5, etc.? We don?t care much about the Fed?s balance sheet until the Fed wants to raise rates, which is mainly a problem in Scenario 2.

4) Growth weakens and inflation rises, i.e. stagflation.? There?s no good set of policy options here. The Fed could engage in further financial repression, keeping short rates low, and let inflation reduce the nominal value of debts.? If it doesn?t run wild, it could play a role in reducing the indebtedness of the whole economy, though again, it will favor debtors over savers.? (As I?ve said before, in a situation like this, or like the Eurozone, all creditors want to be paid back at par on the bad loans that they have made, and it can?t be done.? The pains of bad debt have to go somewhere, where it goes is the argument.)

I?ve kept this deliberately simple, partially because with all of the flows going back and forth, and trying to think of the whole system, rather than effects on just one part, I know that I have glossed over a lot.? I accept that, and I could be dead wrong, as I sometimes am.? Comment as you like, with grace and dignity, and let us grow together in our knowledge.? I?ve been spending some time reading documents at the Fed, trying to understand their mechanisms, but I could always learn more.

Summary

During older times, the end of a Fed loosening cycle would end with the Fed funds rate rising.? In this cycle, it will end with interest of reserves rising, and/or, the sale of bonds, which I find less likely (they will probably be held to maturity, absent some crisis that we can?t imagine, or non-inflationary growth).? But when the tightening cycle comes, the Fed will find that its actions will be far harder to take than when they made the ?policy accommodation.?? That has always been true, which is why the Fed during its better times limited the amount of stimulus that it would deliver, and would tighten sooner than it needed to.

Far better to be like McChesney Martin or Volcker, and be tough, letting recessions do their necessary work of eliminating bad debt.? Under Greenspan, and Bernanke to a lesser extent (though he persists in pushing the canard that the Fed was not too loose 2003-2004, ask John Taylor for more), there were many missed opportunities to stop the buildup of bad debts, but the promise of the ?Great Moderation? beguiled so many.

Removing policy accommodation is always tougher than imagined, and carries new risks, particularly when new tools have been used.? Bernanke can go to his carefully chosen venues and speak to his carefully chosen audiences, and try to exonerate the Fed from well-deserved blame for their looseness in the late 80s, 90s, and 2000s.? Please, Mr. Bernanke, take some blame there on behalf of the Fed ? the credit boom could never have happened without the Fed.? Painting the Fed as blameless is wrong; the ?Greenspan put? landed us in an overleveraged bust.

I?m not primarily blaming the Fed for its current conduct; we are still in the aftermath of a lending bust ? too much bad mortgage debt, with a government whose budget is out of balance.? (In the bust, there are no good solutions.)? I am blaming the Fed for loose policies 1984-2007, monetary policy should have been a lot tighter on average.? But now we live with the results of prior bad policy, and may the current Fed not compound it.

Postscript

The main difference between this time and the last time I wrote on this is QE3.? What has been the practical impact since then?? The Fed owns more MBS and long maturity Treasuries, financed by more reserve balances at the Fed.

Banks use this cheap funding to finance other assets.? But if they want to make money, the banks have to take credit risk (something the Fed is trying to stimulate), and/or interest rate rate risk (borrow short, lend long, negative convexity, etc).? The longer low rates go on through interest on reserves, the greater the tendency to build up imbalances in the banking system through credit and interest rate risks. 1992-1993 where Fed funds rates were held at 3%, was followed by the residential mortgage backed security market melting down in 1994, not to mention Mexico.? Sub-2% Fed funds rates from 2002 through mid-2004 led to massive overinvestment in residential housing, leading to the present crisis.

Fed tightening cycles often start with a small explosion where short-dated financing for thinly capitalized speculators evaporates, because of the anticipation of higher financing rates.? Fed tightening cycles often end with a large explosion, where a large levered asset class that was better financed, was not financed well-enough.? Think of commercial property in 1989, the stock market in 2000 (particularly the NASDAQ), or housing/banks in 2008.? And yet, that is part of what Fed policy is supposed to do: reveal parts of the economy that are running too hot, so that capital can flow from misallocated areas to areas that are more sound.? At present, my suspicion is that we still have more trouble to come in banking sector.? Here?s why:

We?ve just been through 4.5 years of Fed funds / Interest on reserves being below 0.5% ? this is a far greater period of loose policy than that of 1992-1993 and 2002 to mid-2004 together, and there is no apparent end in sight.? This is why I believe that any removal of policy accommodation will prove very difficult.? The greater the amount of policy accommodation, the greater the difficulties of removal.? Watch the fireworks, if/when they try to remove it.? And while you have the opportunity now, take some risk off the table.

The Incredible Chain of Lending

Posted on 19 August 201519 August 2015 by David Merkel

Photo Credit: Vinoth Chandar || Do you control the elephant, or does the elephant control you?

I’m currently reading a book about the life of Jesse Livermore. ?Part of the book describes how Livermore made a fortune shorting stocks just before the panic of 1907 hit. ?He had one key insight: the loans of lesser brokers were being funded by the large brokers, and the large brokers were losing confidence in the creditworthiness of the lesser brokers, and banks were now funding the borrowings by the lesser brokers.

What Livermore didn’t know was that the same set of affairs existed with the banks toward trust companies and smaller banks. ?Most financial players were playing with tight balance sheets that did not have a lot of incremental borrowing power, even considering the lax lending standards of the day, and the high level of the stock market. ?Remember, in those days, margin loans required only 10% initial equity, not the 50% required today. ?A modest move down in the stock market could create a self-reinforcing panic.

All the same, he was in the right place at the right time, and repeated the performance in 1929 (I’m not that far in the book yet). ?In both cases you had a mix of:

High leverage
Short lending terms with long-term assets (stocks) as collateral.
Chains of lending where party A lends to party B who lends to party C who lends to party D, etc., with each one trying to make some profit off the deal.
Inflated asset values on the stock collateral.
Inadequate loan underwriting standards at many trusts and banks
Inadequate solvency standards for regulated financials.
A culture of greed ruled the day.

Now, this is not much different than what happened to Japan in the late 1980s, the US in the mid-2000s, and China today. ?The assets vary, and so does the degree and nature of the lending chains, but the overleverage, inflated assets, etc. were similar.

In all of these cases, you had some institutions that were leaders in the nuttiness that went belly-up, or had significant problems in advance of the crisis, but they were dismissed as one-time events, or mere liquidity and not solvency problems — not something that was indicative of the system as a whole.

Those were the warnings — from the recent financial crisis we had Bear Stearns, the failures in short-term lending (SIVs, auction rate preferreds, ABCP, etc.), Bank of America, Citigroup, credit problems at subprime lenders, etc.

I’m not suggesting a credit crisis now, but it is useful to keep a list of areas where caution is being thrown to the wind — I can think of a few areas: student loans, agricultural loans, energy loans, lending to certain weak governments with large liabilities and no independent monetary policy… there may be more — can you think of any? ?Leave a comment.

Subprime lending is returning also, though not in housing yet…

Parting Thoughts

I’ve been toying with the idea that maybe there would be a way to create a crisis model off of the financial sector and its clients, working off of a “how much slack capital exists across the system” basis. ?Since risky?borrowers vary over time, and some lenders are more prudent than others, the model would have to reflect the different links, and dodgy borrowers in each era. ?There would be some art to this. ?A raw leverage ratio, or fixed charges ratio?in?the financial sector wouldn’t be a bad idea, but it probably wouldn’t be enough. ?The constraint that bind varies over time as well — regulators, rating agencies, general prudence, etc…)

In a highly leveraged situation with chains of lending, confidence becomes crucial. ?Indeed, at the time, you will hear the improvident squeal that they “don’t have a solvency crisis, but just a liquidity crisis! We just need to restore confidence!” ?The truth is that they put themselves in an unstable situation where a small change in cash flows and collateral values will be the difference between life and death. ?Confidence only deserves to exist among balance sheets that are conservative.

That’s all for now. ?Again, if you can think of other areas where debt has grown too quickly, or lending standards are poor, please e-mail me, or leave a message in the comments. Thanks.

Modeling Financial Liquidity and Solvency

Posted on 1 August 20152 August 2015 by David Merkel

Too often in debates regarding the recent financial crisis, the event was regarded as a surprise that no one could have anticipated, conveniently forgetting those who pointed out sloppy banking, lending and borrowing practices in advance of the crisis. ?There is a need for a well-developed model of how a financial crisis works, so that the wrong cures are not applied to the financial system.

All that said, any correct cure will bring about a predictable response from the banks and other lending institutions. ?They will argue that borrower choice is reduced, and that the flow of credit and liquidity to the financial system is also reduced. ?That is not a big problem in the boom?phase of the financial cycle, because those same measures help to avoid a loss of liquidity and credit availability in the bust phase of the cycle. ?Too much liquidity and credit is what fuels eventual financial crises.

To get to a place where we could have a decent model of the state of overall financial credit, we would have to have models that work like this:

The models would have to have both a cash flow and a balance sheet component to them — it’s not enough to look at present measures of creditworthiness only, particularly if loans do not fully amortize debts at the current interest rate. ?Regulatory solvency tests should not automatically assume that borrowers will always be able to refinance.
The models should try to go loan-by-loan, and forecast the ability of each loan to service debts. ?Where updated financial data is available on borrowers, that should be included.
The models should try to forecast the fair market prices of assets/collateral, off of estimated future lending conditions, so that at the end of the loan, estimates can be made as to whether loans would be refinanced, extended, or default.
As asset prices?rise, there has to be a feedback effect into lowered ability to finance new loans, unless purchasing power is increasing as much or more than asset prices. ?It should be assumed that if loans are made at lower underwriting standards than a given threshold, there will be increasing levels of default.
A close eye would have to look for situations where if the property were rented out, it would not earn enough to pay for normalized interest, taxes and maintenance. ?When asset prices are that high, the system is out of whack, and invites future defaults. ?The margin of implied rents over?normalized interest, taxes and maintenance would be the key measure, and the regulators would have to have a function that attributes future losses off of the margin of that calculation.
The cash flows from the loans/mortgages would have to feed through the securitization vehicles, if any, and then to the regulated financial institutions, after which, how they would fund their future liabilities would?have to be estimated.
The models would have to include the repo markets, because when the prices of collateral get too high, runs on the repo market can happen. ?The same applies to portfolio margining agreements for derivatives, futures, and other types of wholesale lending.
There should be scenarios for ordinary recessions. ?There should also be some way of increasing the Ds at that time: death, disability, divorce, disaster, dis-employment, etc. ?They mysteriously?tend to increase in bad economic times.

What a monster. ?I’ve worked with stripped-down versions of this that analyze the Commercial Mortgage Backed Securities [CMBS] market, but the demands of a model like this would be considerable, and probably impossible. ?Getting the data, scrubbing it, running the cash flows, calculating the asset price functions, implied margin on borrowing, etc., would be pretty tough for angels to do, much less mere men.

Thus if I were watching over the banks, I would probably rely on analyzing:

what areas of credit have grown the quickest.
where have collateral prices risen the fastest.
where are underwriting standards declining.
what assets are being financed that do not fully amortize, including all repo markets, margin agreements, etc.

The one semi-practical thing i would strip out of this model would be for regulators to score loans using a model like point 5 suggests. ?Even that would be tough, but even getting that approximately right could highlight lending institutions that are taking undue chances with underwriting.

On a slightly different note, I would be skeptical of models that don’t try to at least mimic the approach of a cash flow based model with some adjustments for market-like pricing of collateral and loans. ?The degree of financing long assets with short liabilities is the key aspect of how financial crises develop. ?If models don’t reflect that, they aren’t realistic, and somehow, I expect that non-realistic models of lending risk will eventually be the rule, because it helps financial institutions make loans in the short run. ?After all, it is virtually impossible to fight loosening financial standards piece-by-piece, because the changes seem immaterial, and everyone favors a boom in the short-run. ?So it goes.

On Bond Market Illiquidity (and more) Redux

Posted on 13 June 201514 June 2015 by David Merkel

Photo Credit: Bowen Chin || What's more Illiquid than Frozen Tundra? — Photo Credit: Bowen Chin || What’s more Illiquid than Frozen Tundra?

My last piece on this topic, On Bond Market Illiquidity (and more), drew a few good comments. ?I would like to feature them and answer them. ?Here’s the first one:

Hello David,

One issue you don’t address in your post, which is excellent as usual, is the impact of what I’ll call “vaulted” high quality bonds. The explosion and manufacturing of fixed income derivatives has continued to explode while the menu of collateral has been steady or declining. A lot of paper is locked down for collateral reasons.

That’s a good point. ?When I was a bond manager, I often had to deal with bonds that were salted away in the vaults of insurance companies, which tend to be long-term holders of long-term bonds, as they should be. ?They need them in order to properly fund the promises that they make, while minimizing cash flow risk.

Also, as you mention, some bonds can’t be sold for collateral reasons. ?That can happen due to reinsurance treaties, collateralized debt obligations, accounting reasons (marked “held to maturity”),?and some?other reasons.

But if the bonds are technically?available for sale, it takes a certain talent to get an insurance company to sell some of those bonds without offering a?steamy?price. ?You can’t sound anxious, rushed, etc. My approach was, “I’d be interested in buying a million or two of XYZ (mention coupon rate and maturity) bonds in the right price context. ?No hurry, just get back to me with any interest.” ?I would entrust this to one mid-tier broker familiar with the deal, who had previously had some skill in prying bonds out of the accounts of long-term holders before. ?I might have two or three brokers doing this at a time, but all working on separate issues. ?No overlap allowed, or it looks like there is a lot of demand for what is likely a sleepy security. ?No sense in driving up the price.

Because it is difficult to get the actual cash bonds, it is tempting for some managers to buy synthetic versions of those bonds, or synthetic collateralized debt obligations of them instead. ?Aside from counterparty risk, the derivatives exist as “side bets” in the credit of the underlying securities, and don’t provide any additional liquidity to the market.

My point here would be that these conditions have existed before, and I think what we have here is a repeat of bull market conditions in bond credit. ?This isn’t that unusual, and it will eventually change when the bull market ends.

Here’s the next comment:

Hi David,

I hope you?re doing well.? I?ve been reading your blog for about a year now and really appreciate your perspective and original content.? Just wanted to ask a quick question regarding your most recent post on bond market liquidity.?

Our investment committee often talk about the idea of bond liquidity (and discusses it with every bond manager who walks in our doors), and specifically how there are systematic issues now which limit liquidity and considerably push the burden onto money managers to make markets vs. the past, when banks themselves were free to make more of a market with their own balance sheets.

My (limited) understanding is that legislation since 2008 has changed the way that investment banks are permitted to trade on their own books, and this is a big part of the significantly decreased liquidity which has thus far been a relative non-issue but which could rear its head quickly in the face of a sharp correction in bonds.

Do you have any thoughts about this newer paradigm of limited market-making at the big banks?? You didn?t seem to mention it at all in your article and I?m wondering if my thoughts here are either inaccurate or not impactful to the bottom line of the liquidity conversation.

I?m sure you?re a busy guy so I won?t presume upon a direct response but it may be worthwhile to post an update if you think these questions are pertinent.

Another very good comment. ?I thought about adding this to the first piece, but in my experience, the large investment banks only kept some of the highest liquidity corporates in inventory, and the dregs of mortgage- and asset-backed bonds that they could not otherwise sell. ?The smaller investment banks would keep little-to-no-inventory. ?Many salesmen might have liked the flexibility of their bank to hold positions overnight, or buying bonds to “reposition” them, but the experiences of their risk control desks put the kibosh on that.

As a result, I think that the willingness of investment banks to make a market rely on:

The natural liquidity of the securities (which comes from the size of the issue, market knowledge of the issue, and composition of the ownership base), and
How much capital the investment bank has to put against the position.

The second is a much smaller factor. ?Insurance companies have to deal with variations in capital charges in the bonds that they hold, and that is not a decisive factor in whether they hold a bond or not. ?It is a factor in who will hold a bond and what yield spread the bond will trade at. ?Bonds tend to gravitate to the holders that:

Like the issuer
Like the cash flow profile
Have low costs for holding the bonds

Yes, the changed laws and regulations have raised the costs for investment banks to hold bonds in inventory. ?They are not a preferred habitat for most bonds. ?Therefore, if an investment bank buys a bond in order to sell it (or vice-versa) in the present environment, the bid-ask spread must be wider to compensate for the incremental costs, thus reducing liquidity.

To close this evening, one more letter on bonds from a reader:

First off, thank you for taking the time to share your knowledge via your blog.? It is much appreciated.

Now for a bond question from someone learning the fixed income ropes…

What is the advantage/reasoning behind a company co-issuing notes with a finance subsidiary?? Even with reading the prospectus/indenture I can’t understand why a finance sub (essentially just set up to be a co-issuer of debt) would be necessary especially since the company is an issuer anyway and they also may have?other subs guarantee the debt also.? I’m probably missing something obvious.

The answer here can vary.? Some companies guarantee their finance subsidiaries, and some don?t.? Those that don?t are willing to pay more to borrow, while bondholders live with the risk that in a crisis, the company might step away from its lending subsidiary.? They would never let the subsidiary fail, right?

Well, that depends on how easy it is to get financing alternatives, and how easy it might be for the parent company to borrow, post-subsidiary default.

If things go well, perhaps the subsidiary could be spun off as a separate company, or sold to another finance company for a gain.? After all, it has had separate accounting done for a number of years.

Beyond that, it can be useful to manage lending separately from sales.? They are different businesses, and require different skills.? Granted, it could be done as two divisions in the same company, but doing it in separate companies would force separate accountability if done right.

There may be other reasons, but they aren?t coming to my mind right now.? If you think of one, please note it in the comments.

There’s a Reason for Risk Premiums

Posted on 3 June 2015 by David Merkel

Recently I ran across an academic journal article where they posited one dozen or so risk premiums that were durable, could be taken advantage of in the markets. ?In the past, if you had done so, you could have earned incredible returns.

What were some of the risk premiums? ?I don’t have the article in front of me but I’ll toss out a few.

Many were Credit-oriented. ?Lend and make money.
Some were volatility-oriented. ?Sell options on high volatility assets and make money.
Some were currency-oriented. ?Buy government bonds where they yield more, and short those that yield less.
Some had you act like a bank. ?Borrow short, lend long.
Some were like value investors. ?Buy cheap assets and hold.
Some were akin to arbitrage. ?Take illiquidity risk or deal/credit risk.
Others were akin to momentum investing. ?Ride the fastest pony you can find.

After I glanced through the paper, I said a few things to myself:

Someone will start a hedge fund off this.
Many of these are correlated; with enough leverage behind it, the hedge fund?could leave a very large hole when it blows up.
Yes, who wouldn’t want to be a bank without regulations?
What an exercise in data-mining and overfitting. ?The data only existed for a short time, and most of these are well-recognized now, but few do all of them, and no one does them all well.
Hubris, and not sufficiently skeptical of the limits of quantitative finance.

Risk premiums aren’t free money — eggs from a chicken, a cow to be milked, etc. ?(Even those are not truly free; animals have to be fed and cared for.) ?They exist because there comes a point in each risk cycle when bad investments are revealed to not be “money good,” and even good investments are revealed to be overpriced.

Risk premiums exist to compensate good investors for bearing risk on “money good” investments through the risk cycle, and occasionally taking a loss on an investment that proves to not be “money good.”

(Note: “money good” is a bond market term for a bond that?pays all of its interest and principal. ?Usage: “Is it ‘money good?'” ?”Yes, it is ‘money good.'”)

In general, it is best to take advantage of wide risk premiums during times of panic, if you have the free cash or a strong balance sheet behind you. ?There are a few problems though:

Typically, few have free cash at that time, because people make bad investment commitments near the end of booms.
Many come late to the party, when risk premiums dwindle, because the past performance looks so good, and they would like some “free money.”

These are the same problems experienced by almost all institutional investors in one form or another. ?What bank wouldn’t want to sell off their highest risk loan book prior to the end of the credit cycle? ?What insurance company wouldn’t want to sell off its junk bonds at that time as well? ?And what lemmings will buy then, and run over the cliff?

This is just a more sophisticated form of market timing. ?Also, like many quantitative studies, I’m not sure it takes into account the market impact of trying to move into and out of the risk premiums, which could be significant, and change the nature of the markets.

One more note: I have seen a number of investment books take these approaches — the track records look phenomenal, but implementation will be more difficult than the books make it out to be. ?Just be wary, as an intelligent businessman should, ask what could go wrong, and how risk could be mitigated, if at all.

On Risk-Based Liquidity and Systemic Risk

Posted on 8 May 2015 by David Merkel

I can’t help but think after the financial crisis that we have drawn some wrong conclusions about systemic risk. Systemic risk is when the financial system as a whole threatens to fail, such that short-term obligations can’t be paid out in full. ?It is not a situation where only big entities fail — the critical factor is whether?it creates a run on liquidity across the system as a whole.

Why does a bank fail? ?It can’t pay in full when there was a demand for liquidity in the short run. ?Typically, there is an asset-liability mismatch, with a lot of payments payable now, and assets that cannot be easily liquidated for what their stated value reported to?the regulators.

Imagine the largest bank failing, and no one else. ?Yes, it would be a mess for the FDIC to clean up, but it could be done. ? Stockholders?and?preferred stockholders get wiped out. Bondholders, junior bondholders, and large depositors take a haircut. ?Future deposit insurance premiums might have to rise, but there would be enough time to do that, with banks adjusting their prices so that they could afford it.

But banks don’t fail one at a time, except perhaps in good times with a really incompetently managed bank. ?Why do some banks tend to fail at the same time?

They own many of the same debt securities, or same types of loans where the underlying asset values are falling.
They own securities of other banks, or other deposit-taking institutions.
Generalized panic.

What can stop?a bank from failing? ?Adequate short-term cash flow from assets. ?Why don’t banks make sure that they always have more cash coming in than going out? ?That would be a lower profitability way of running a bank. ?It is almost always more profitable to borrow short and lend long, and make money on the natural term spread that exists — but that creates the very conditions that makes some banks run out of liquidity in a panic.

You will hear the banks say, “We are solvent, we just aren’t liquid.” That statement is always hogwash. ?That means that the bank did not adequately plan to have enough liquidity under all circumstances.

Thus, planning to avoid systemic risk across an economy as a whole should focus on looking for the entities that make a lot of promises where payment can be demanded in the short run with no adjustments for market conditions versus assets available to make payments. ?Typically, that means banks and things like banks that take deposits, including money market funds. ?What does it not include?

Life insurers, unless they write a lot of unusual annuities that can get called for immediate payment, as happened to General American and ARM Financial in 1999. ?The liability structure of life insurance companies is so long that there can never be a run on the bank. ?That doesn’t mean they can’t go insolvent, but it does mean they won’t be part of a systemic panic.
Property & Casualty and Health insurers do not have liabilities that can run from them. ?They can write bad business and lose money in the short-run, but that doesn’t lead to systemic panic.
Investment companies do not have liabilities that can run from them, aside from money-market funds. ?Since the liabilities are denominated in the same terms as the assets managed, there can’t be a “run on the bank.” ?Even if assets are illiquid, the rules for valuing illiquid assets for liquidation are flexible enough that an investment firm can lower the net asset value of the payouts, while liquidating other assets in the short run.
Even any large corporation that has financed itself with too much short-term debt is not a threat to systemic panic. ?The failure would be unique when it could not roll over its debts. ?Further, it would take some effort to actually do that, because the rating agencies and lenders would have to allow a non-financial firm to take obvious risks that non-financial firms don’t take.

What might it include?

Money market funds are different because of the potential to “break the buck.”
Any financial institution that relies on a?repurchase [repo] market for financing is subject to systemic risk because of the borrow short to finance a long-dated asset mismatch inherent in the market.
Watch any entity that has to be able to post additional margin in order maintain leveraged asset finance.

How then to Avoid Systemic Risk?

Regulate banks, money market funds and other depositary financials tightly.
Don’t let them invest in one another.
Make sure that they have more than enough liquid assets to meet any conceivable liquidity withdrawal scenario.
Regulate repurchase markets tightly.
Raise the amount of money that has to be deposited for margin agreements, until those are no longer a threat.
Perhaps break up banks by ending interstate branching. ?State regulation is good regulation.

But aside from that, there is nothing to do. ?There are no systemic risks from investment companies or those that manage them, because there can’t be a self-reinforcing “run on the bank.” ?Insurance companies are similar, and their solvency is regulated far better than any bank.

Thus, there shouldn’t be any lists of systematically important financial institutions that contain investment managers or insurance companies. ?Bigness is not enough to create a systemic threat. ?Even GE Capital could have failed, and it would not have had significant effects on the solvency of other financials.

I think it is incumbent on those that would?call such enterprises systemically important to show one historical example of where such enterprises ever played a significant role in a financial crisis like the ones that happened in the 1870s, 1900s, 1930s, or 2000s. ?They won’t be able to do it, and it should tell them that they are wasting effort, and should focus on the short-tailed liabilities of financial companies.

Redacted Version of the April 2015 FOMC Statement

Posted on 29 April 2015 by David Merkel

Photo credit: jonesylife || Oh look, there are twelve doves flying!

Comments

With this FOMC statement, people should conclude that they have no idea of when the FOMC will tighten policy, if ever. This is the sort of statement they issue when things are ?steady as you go.?? There is no hint of imminent policy change.
The FOMC has a weaker view of GDP, labor use, household spending, business fixed investment and exports.
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 reversed direction and are rising, and the twitchy FOMC did not note it.
Equities rise and long bonds rise. Commodity prices fall and the dollar rises.? 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 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.

On Negative Interest Rates

Posted on 21 April 201521 April 2015 by David Merkel

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.

Redacted Version of the January 2015 FOMC Statement

Posted on 29 January 2015 by David Merkel

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.

On Financial Risk Statements, Part 1

Posted on 13 December 2014 by David Merkel

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.