Currencies – Page 12 – The Aleph Blog

The March FOMC Statement

Posted on 19 March 2009 by David Merkel

Below you will see my summary of the FOMC Statement and how it changed.? Before I give you that, let me summarize what I think the changes are, the market impact, and whether I think it will work.

The Changes

The Fed will expand its balance sheet massively, buying another $750 billion of agency mortgage-backed securities, $300 billion of long Treasuries, another $100 billion of Agencies, and expand eligible collateral for the TALF to include who knows what.
The crisis involves the real economy in a big way now, not just the financial economy.
The crisis is definitely global.
They have ceased to forecast when it will end.
They are pursuing recovery, not growth now.

The Market Impact

The Dollar fell roughly 2-3%.? Gold rallied 4%+.
The ten-year sector of the nominal Treasury curve fell the most in yield terms, around 50 basis points. Biggest rally since 1962.? The long end fell 30 basis points. Agencies outperformed Treasuries.? Mortgages lagged.
TIPS outperformed nominal bonds with the long end falling 40 basis points, and the 10-year 55 basis points, leading inflation expectations to rise.

Will this work?

I?m skeptical.? This is just a bigger shift of financial obligations from the balance sheet of financials to the Fed, at prices unfavorable to the Fed, because their own statements will make them buy dearly.? When they unwind these trades, they will take significant losses, eliminating seniorage income to the US Treasury.

Lowering Treasury, Agency and conforming mortgage rates, assuming that it can be done in the long run (not likely), will not help consumers or corporations.? Forcing a small spectrum of interest rates down does little for collateral values.? People are inverted on their debts, and this does not solve that.? You might get a few refinances out of that, but that?s all.? Credit card, auto, and other debts are unaffected, and the TALF is still pie-in-the-sky.? Can it work?? Corporate bonds, bank debt, Commercial real estate loans, etc. ? there is no effect.? It only makes life better for the US Government, Fannie, Freddie, the FHLB, and those seeking conforming mortgage loans.

There is no real debt reduction here, and debt levels are the cause of this crisis, not interest rates on the debt.? I don?t think this will work, but this is another case where ?the beatings will continue until morale improves.?? Ben Bernanke is too certain of what is the correct move, given his Ph.D. studies.? It would be better and simpler to follow an inflationary course that hits at the root causes of debt by giving every adult a $5,000 voucher good to pay off a debt to any regulated financial institution.? Consumers win, banks win, and foreign creditors lose.

Current Recommendation

I don?t think this rally will hold, so when upward momentum fails, sell long duration fixed income positions.

Fed Statements Compared

(I reordered the January Statement to make the compare better.)

January 2009 Information received since the Committee met in December suggests that the economy has weakened further.	March 2009 Information received since the Federal Open Market Committee met in January indicates that the economy continues to contract.	My Thoughts Basically the same.
Industrial production, housing starts, and employment have continued to decline steeply, as consumers and businesses have cut back spending.	Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending.	There is a hint of deepening of the crisis, especially how falling asset values and diminishing credit affect behavior.
Conditions in some financial markets have improved, in part reflecting government efforts to provide liquidity and strengthen financial institutions; nevertheless, credit conditions for households and firms remain extremely tight.	Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment.	No hint of improving credit now. Lack of credit having real effects on business activity.
Furthermore, global demand appears to be slowing significantly.	U.S. exports have slumped as a number of major trading partners have also fallen into recession.	Recession abroad, not merely slowing.
The Committee anticipates that a gradual recovery in economic activity will begin later this year, but the downside risks to that outlook are significant.	Although the near term economic outlook is weak, the Committee anticipates that policy actions to stabilize financial markets and institutions, together with fiscal and monetary stimulus, will contribute to a gradual resumption of sustainable economic growth.	No longer forecasting a recovery this year. Near term outlook is weak.
In light of the declines in the prices of energy and other commodities in recent months and the prospects for considerable economic slack, the Committee expects that inflation pressures will remain subdued in coming quarters.	In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued.	Weakness is widespread and not contained by country or sector. Economic slack is here now, and not prospective.
Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.	Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.	Same
The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability.	In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability.	No longer are they pursuing growth, but recovery.
The Federal Open Market Committee decided today to keep its target range for the federal funds rate at 0 to 1/4 percent. The Committee continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.	The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.	The Fed funds rate, now irrelevant, will stay irrelevant for a long time.
The focus of the Committee’s policy is to support the functioning of financial markets and stimulate the economy through open market operations and other measures that are likely to keep the size of the Federal Reserve’s balance sheet at a high level. The Federal Reserve continues to purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand the quantity of such purchases and the duration of the purchase program as conditions warrant. The Committee also is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets.	To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.	What was a possibility now is coming. If all of it is executed, the Fed?s balance sheet will grow from $1.9 to $3.0 Trillion. Credit easing, the attempt to manipulate key market interest rates using Fed credit, will be the majority of Fed policy now.
The Federal Reserve will be implementing the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses.	The Federal Reserve has launched the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses and anticipates that the range of eligible collateral for this facility is likely to be expanded to include other financial assets.	TALF, should it get off the ground, will include rasty stuff that we never imagined the Fed would buy.
The Committee will continue to monitor carefully the size and composition of the Federal Reserve’s balance sheet in light of evolving financial market developments and to assess whether expansions of or modifications to lending facilities would serve to further support credit markets and economic activity and help to preserve price stability.	The Committee will continue to carefully monitor the size and composition of the Federal Reserve’s balance sheet in light of evolving financial and economic developments.	This isn?t just a financial markets crisis anymore. It is now affecting almost every part of the business world.

On The Ron Smith Show Today

Posted on 12 March 200912 March 2009 by David Merkel

The invite came late today, but in the 4PM (Eastern) hour, I will be on The Ron Smith Show.? For those in the Baltimore area, that’s 1090 on the AM dial.? For those over the internet, go here, and click the “Listen Live” button.

What will we be talking about?? Alan Greenspan’s editorial that I replied to here, and which FT Alphaville picked up on twice.? (Incidentally, here is where my “Blame Game? (one, two) series is located.

Also, we will be discussing the WSJ article, Obama, Geithner Get Low Grades From Economists.? Now economists have enough egg on their faces from the current crisis, so maybe their ability to judge should be weighed in the balance as well.? I’m not crazy about the actions of the Fed or the Treasury during either the Bush, Jr. or Obama Administrations.? As with my Blame Game series — there is more than enough blame to go around.? The real question is whether policymakers aren’t digging us into a deeper eventual hole, which I think they are.

And then we’ll talk about whatever else the callers want to talk about.? It’s fun and fast — the hour just blows by.? More to come later — I have pieces on AIG, Berky, and a few other things in the hopper.

Oh, one more thing, from jck at Alea: U.S. Household Net Worth: Down $11.5 Trillion in 2008. I definitely questioned the growth in national net worth when I was writing for RealMoney.? My main argument was that incurring debt to buy the assets was artificially inflating their vale, and when debt levels normalized, net worth would drop as well.

Ten Aspects of Our Current Market Troubles

Posted on 18 February 2009 by David Merkel

1) One of the unwritten rules of the corporate bond market is avoid the sector that has been the biggest issuer lately.? Underwriting and credit quality get sloppy in any sector that issues a lot of debt.? It would be a salutary warning for telecom bonds in 2000 and financials in the mid-2000s.? Even though they are not? corporates, the same would apply to mortgage bonds near the end of the real estate boom.? The little bit of extra spread would not be worth it.

Well, what if a sector is expanding rapidly, and there is no incremental spread?? Again, not a corporate sector, but that describes our dear Government today.? We talked about “crowding out” in early 80s, but it never truly materialized.? It is probably not happening now either.? Most corporations that want to borrow can’t, and those that can don’t want to.

All the same, outside of TIPS, I don’t see a lot of value in Treasuries at present.

2) Note to the Fed: if you want to keep mortgage rates low, buy mortgage bonds, not Treasuries.? The cost of that is that the Fed would bear some risk if Fannie of Freddie went down.? But Fannie, Freddie, and the Fed have one unified balance sheet given that the Federal Government is behind all of them.

3) But, is it desirable that banks lend at this point?? It might be better for them to restore their balance sheets, battered from the sloppy underwriting of the boom years.? Then they could once again lend soundly.

It makes little sense to try to force debt onto the US consumer who is largely overleveraged.? So why try to prompt banks to lend?? This applies to my mutual bank idea as well.? Do we really need more aggregate lending when the economy as a whole remains overlevered?

4) ?We hate you guys. Once you start issuing $1 trillion-$2 trillion [$1,000bn-$2,000bn] . . .we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.?

So said Mr. Luo, a director-general at the China Banking Regulatory Commission.? I’ve been saying for a long time that China is stuck, and that we are their problem, and not vice-versa.? There may come a point where they stop buying US Dollar-denominated debt, and let existing debt mature, but that will come after a shift in their own economy where they are no longer driven bythe promotion of their exports.? There aren’t many large good alternatives to US debt for parking the proceeds from exporting aggressively.

5) In a downdraft, pockets of hidden leverage get revealed.? Consider the states of the US.? With the declining economy, revenues from real estate taxes decline, as do capital gains and wage taxes.? Budgets of 46 of the states are facing significant deficits.? Governments got to used to capital gains taxes, rising wages, rising property assessments, and high turnover of property.? Now those are gone. ? Rainy day funds were not established at necessary levels and were drained too early.

6) In a downdraft, pockets of hidden leverage get revealed.? Consider the Ponzi schemes that have come to light: Madoff, Stanford (it seems), and a small number of smaller Ponzis.? Why revealed now?? During a boom period liquidity is superadequate; most investors don’t face a need to call for cash.? Investors are happy to receive highish stable rates of return that come with seeming safety.? During the bust period many need cash, and the frauds are revealed for what they are.? Ponzi schemes are mini-bubbles; they pop when the call on cash is too great, if aren’t discovered as frauds during their growth phase.

7) In a downdraft, pockets of hidden leverage get revealed. Prime brokerage is very profitable to investment banks, but even they have to do risk control in a tough environment.? Hedge funds with better risk control get more leverage, those with worse risk control get less.? As I have said before, hedge funds aren’t the most stable vehicles in a downdraft.? They are reliant on the good graces of their prime brokers and the patience of their limited partners.

8 ) In a downdraft, pockets of hidden leverage get revealed. While housing prices kept rising, aided by increasing buying power facilitated by poorly underwritten loans, the mortgage insurers happily clipped profits; their greatest worry was the banks eating their business through second lien loans.? Most of the banks that did a lot of that financing have gotten whacked.? The mortagage insurers had somewhat more flexibility in their balance sheets, but if present loss rates continue for the next two years, many of their operating insurance subsidiaries will need to file a plan to remedy their impaired balance sheets.

9) In a downdraft, pockets of hidden leverage get revealed. (Sorry, last one.)? Just as Iceland was a harbinger of global weakness, and especially to the UK, might Eastern Europe prove to be that for Western Europe, and particularly Austria?? (Also here and here.)? Many Western European banks are exposed to Eastern European creditworthiness.? Some individual borrowers in Eastern Europe have mortgages denominated in Swiss Francs or Euros.

I’ve seen situations like that before, and sometimes I call it a currency vise.? It works well for a time during the boom phase, but then weaker currencies get trashed during the bust phase.? It simultaneously makes it more difficult to service the debt in the newly expensive hard currency, and the lender isn’t better off either — he now faces credit problems.

10) I’ve done many pieces on hidden credit problems inside ETFs and ETNs.? After my last piece, a reader asked if I would do a survey article on the problems.? Sorry, no survey article, but I can summarize them all for you here.

Exchange Traded Notes [ETNs] carry the risk that their sponsor will default.? They are unsecured obligations of a bank, but they have done some sort of hedge to provide the ETN buyer with a certain return so long as their bank is solvent.? For the bank, it is a sweet deal, because to them it is cheap funding.
Leveraged funds carry two risks.? The first is that any swap counterparties that the fund deals with goes bust.? The second is the money market instruments / cash equivalents behind the derivatives in these funds don’t prove good.? Granted, it is hard to lose in the money markets, but choose your credits with care.? Lehman went down pretty quickly.
Then there is the risk that a counterparty could go bust in a currency fund, as in the last article that I wrote.

ETFs and ETNs are great new? products that increase the scope that an investor can pursue.? Just be aware that in some funds there can be credit risk — with currencies, commodities, leveraged funds, and ETNs.

The Humility of Realism — II

Posted on 30 January 200930 January 2009 by David Merkel

This post is supposed to be a kind of “catch up” post, where I write about a number of small things that I thought were interesting, but weren’t worth a full post.

1) The government can’t fund everybody. The recent backup in the US treasury note market is a great example of that.? As the demands for funds now in exchange for funds later has increased, Treasury interest rates have risen.

I have several biases, but one of them is that the Government can’t unilaterally create prosperity.? It can create conditions that encourage economic activity, through predictable and fair laws, but it can’t make us immediately better off through deficit spending, or tax-and-spending.? The Government does not know what is needed to a better degree than its citizens do individually.

But let the government fund or guarantee everybody.? When they do that, there is just one overleveraged credit that matters, and it will fail, taking us with them.

2) Equity Private is one clever lady.? Fair value accounting primarily exists to deal with investments that are as volatile as equities. How are publicly traded equities valued?? At market.? How about volatile assets where the value is derivable from market prices?? They should be valued at pseudo-market.? If we were back in the old days, and all of our assets were bonds, we wouldn’t need fair value accounting.? Even if we did it, the values wiould not vary much. ? But when you slice and dice the various pieces of bonds, the volatile bits jump around a lot.? To value them at their initial value is ridiculous, the value is too volatile.

3) Felix is right.? There needs to be more of a debate over bank nationalization. I’ve written my pieces there, influenced by the better regulations of the insurance industry, and how they deal with insolvencies.? Mark assets to market.? Do the triage.? Send insolvent institutions to RTC 2, and take stakes in some marginal institutions.? That is where the money will do the most good.

4) “We have to buy up assets that are selling at fire sale prices.? We will even make money for the taxpayers.” So go the arguments of those that want to create a “bad bank”.? Oh, please.? Profits are rare in bailouts.? They happen by happy accidents, a la Chrysler (80s, not now), which possibly could have made it without a bailout.

Assets are at fire sale prices because there is not enough balance sheet capacity to buy and hold them over a period where the realization of value is likely.? I’ve seen structured assets rated AAA where the collateral is okay, and the likely realization of value is in the 90s, if you can hold it for 5 years.? Where does it trade?? Around $60.? Another asset, which would likely be worth $35 if it could be held for 15 years, where does it trade?? It doesn’t trade, but you could get rid of it to a broker for zero.

Strong balance sheets can’t be created out of thin air, though.? Remember how formidable Fannie and Freddie used to be, or many of the FHLBs?? Strong balance sheets only exist through investments where the cash flows will not be needed for decades, like pension and endowment plans.

5) Some commentators complain that the current crisis destroys the concept of efficient markets, because a trust in markets led us to failure. Oh please.? First, all of our markets were by no means free from government mismanagement, and many of the distortions came from poor regulation.? Our dear government had many lending programs pre-crisis, and even more post-crisis.? They further encouraged the increase in debt through the tax code.

Why is debt finance tax deductible, and equity finance not?? What might the system have been like if interest payments could not be deducted on taxable income, but dividends could be?? Leverage would have been a lot lower, and the system would be a lot more stable.

Market efficiency means many things.? In the short run, it means that no one can do better than the current situation. In the intermediate-to-long term, markets are efficient in a different way.? They reveal problems that need to be solved.? Some might call those market failures but they aren’t.? In the present crisis, the invisible hand is saying to us: reduce debt levels; your economic system in too inflexible.? The visible hand, the government, says: “Have some more of the hair of the dog that bit you.? We need lower mortgage rates.? We need more consumer lending.? We’re going to borrow more than ever before in an effort to create prosperity.”? Caroline Baum takes a similar view, and as usual, she expresses it well.

Market efficiency does not mean things are trouble-free, but it gives us sharper incentives to solve our problems.? Some things become revealed as truly public goods that the government needs to regulate.? But that is not the majority of human actions.

6) AIG is one black hole for cash.? Selling or IPO-ing units during the bust phase, when valuations are compressed does not seem to be an optimal strategy here.? If all of the assets were sold, would there be enough for the junior debt or preferred shareholders to get paid?? (Forget the common.)? So, in the face of it, do they IPO partial stakes in enterprises, with an eventual end of IPO-ing or selling the whole thing later?? If so, there is little free cash flow being generated to pay down debt.

What this implies to me is that the huge loans that the government made to AIG will likely hang out there for a long time.? Is this the best use of the government’s credit?? I think not.? If there are still systemic risk issues, wall those off separately, and send the rest of AIG into liquidation.? The insurance units are intact; let others buy and manage them.? Speculating on a future boom in asset prices is not a reaonable government policy.? Hope is not a strategy.

7) It is simple to blame the US for the current global crisis.? Simple and wrong. The US deserves blame, true, but not even the majority of the blame, just a slightly larger than proportionate amount for its size.

But when China blames the US, it goes too far.? In the era of neo-mercantilism, China had political goals to achieve.? Industrialize the country.? Get surplus workers off of the farms and into the cities.? Keep the currency undervalued to support export-led growth.? Force savings through restrictions on imports.? As a result, suck in developed country debts and companies where strategically desirable and possible.? Do these deals in their currencies because of the need to keep the Yuan cheap.

China made its bed, let it sleep in it.? They knew that they were lending to the US in its own currency; it was a necessary part of the bargain to achieve their own goals.? Just as the mercantilists sucked in gold, and then found it to be less valuable than they imagined when they had to draw on it, so it will be when nations want to draw on the US dollar assets that they have hoarded.

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My phrase, “the humility of realism” is meant to get us thinking about the system as a whole, and about the long-term consequences of societal actions, whether by the government or private parties.? Humility says that sometimes we have to say, “No, we can’t.”? It also says that we should think carefully about major policy actions, and not let ourselves get bullied by those who rush, shouting “crisis, crisis,” while quietly angling for their favored pet projects to get swept in while no one is looking.? Realism sometimes means the government has no good solutions, so it should inform the public that they aren’t omnipotent, and humbly say the crisis must be borne with grace.

The problems generated by the short-termism of the past three decades will not get solved by more short-term thinking.? The present rush to assure prosperity will not end well, in my opinion.

Spot the Three Currency Regimes

Posted on 24 January 2009 by David Merkel

I’ve had an interest in the Yuan since the revaluation in 2005. To start this off, two RealMoney CC posts:

		David Merkel
		Yuan Musings
		8/10/2005 10:46 AM EDT

Today, the People’s Bank of China, in a speech given by central bank governor Zhou Xiaochuan, announced the currencies that are in the basket against which it sets the value of the yuan. They are the currencies from the following nations, excerpted from the speech:

China’s major trading partners are the United States, the Euro land, Japan, Korea, etc., and naturally, U.S. dollar, euro, Japanese yen and Korean won become major currencies of the basket. In addition, China also trades significantly with Singapore, U.K., Malaysia, Russia, Australia, Thailand, and Canada, currencies of these countries are also important in determining China’s RMB exchange rate.

Nice. But the weights and whether the weights are fixed were not given either. I’ve run a constrained regression model using data from the last 15 trading days (which only gives me 4+ degrees of freedom), constraining the lesser currencies to a 10% weight at most. What I end up with is that the U.S. dollar is in the high-80% range in terms of weight in the basket. If true, it means that the change in the yuan peg accomplished little, as I suggested at the time.

This is a very tentative conclusion, because I need more data. Two weeks from now, I will be able to shed more light on this.

As an aside, I have a model for the Singapore dollar, where the basket weights aren’t given, and it’s very predictable and normal-looking. They clearly have fixed weights. Within two months, I should be able to determine whether the same is true of the Chinese yuan.

None

		David Merkel
		China’s Rigged Currency
		9/30/2005 4:10 PM EDT

Please pardon a brief Friday rant on China’s currency. I have a model that attempts to figure out the weights on their non-disclosed currency basket. Given the multicollinearity problems of my model, here is what I think I know:

The hypothetical basket is composed 75% of US dollars. Probably some of that weight belongs to currencies highly correlated with the US dollar, but the model picks the US dollar.

The yuan has been artificially appreciated versus the basket Over the past month and a half by 0.5%. If all of the currencies in the basket were revalued equally, the dollar would be 8.133 yuan, as compared to 8.092 today. (Wouldn’t Washington squawk if the exchange rate actually fell below the initial devalued level?)

This may explain the recent move by China to change the currency bands for all currencies except the US dollar. It was getting too hard to do a controlled appreciation of the yuan versus the dollar while staying within their currency bands for the other currencies; it’s impossible to have more than one set of cross rates globally.

My guess here is that China is trying to please Washington in a slow way, but retain the benefits (to the government, and those connected with it) of a managed currency. Investment implication: business as usual in China; neo-mercantilism continues for now.

Position: none

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For those that missed my logic at the time of the devaluation, China kept its currency fixed to the US Dollar until mid-2005, then appreciated it in a dirty float until mid-2008.? Since then it has returned to a dirty fixed rate versus the US Dollar.? Note that the last regime shift fits with when things really began to turn down in the global economy.

Make no mistake, China’s currency has been managed since 2005.? Timothy Geithner was correct when he said in his written responses to the Senate:

President Obama – backed by the conclusions of a broad range of economists ? believes that China is manipulating its currency. President Obama has pledged as President to use aggressively all the diplomatic avenues open to him to seek change in China’s currency practices.

Now, it was a mistake and impolitic to say that.? Given all the money that China has loaned the US in US Dollars, you don’t want to let the sucker know how badly he has lost money bite the hand that feeds you.? We need to send economic policymakers to media school so that they can know how their statements affect markets and foreign relations.? Learning on the job wears on us all.

I don’t have a big point here, except to say:

China’s currency policy changed in mid-2008.
China never let its currency float, even against a basket.
Timothy Geithner needs to consider his words more carefully.
We need to consider what a pseudo-fixed exchange rate implies for economic matters.

Personally, I don’t think that China keeping its currency artificially cheap can work in the intermediate-term.? But the Chinese Government does not think in terms other than what benefits their long-term control over China.? Other things can and will be sacrificed.? But maintaining control over domestic affairs matters greatly to the Chinese Government, and all foreign affaqirs must bow to that.

The pseudo-fixed exchange rate will require increased purchases of US assets, relative to? an appreciating Yuan regime.? Perhaps we should be grateful for that.? If so, we haven’t seen any benefits, and neither hasw China.

I wish I could give a crunchier conclusion here, but I can’t.? In our deflationary world, the temptations toward protectionism, even through currency policy, are significant.? It is no surprise that we are seeing this change now.

Against Bank Nationalization

Posted on 23 January 2009 by David Merkel

With options, we often talk about them being in, out or at the money. When options are in the money, there is a high probability of receiving a payoff.? When options are out of the money, there is a low probability of receiving a payoff.? When options are at the money, it could go either way.

The same is true of banks.? There are some banks that were cautious during the boom era, and their underwriting stayed conservative.? There are others that were so aggressive that once the results of their sloppy underwriting/investing begin to be realized, it will be obvious that they are deeply insolvent.? Then there are those banks that hang in the balance.? Which way will they fall?? Will they survive or not?

I’m not in favor of blanket nationalization of banks.? My best example is the stupid move by Hank Paulson where he forced bailout money on a bunch of big banks, with no attention to whether they needed the money or not.

Who could use the capital?? The banks that have big holes in their balance sheets can’t use the capital, because it will just plug holes, and maybe it will not be enough.? Those that are healthy don’t need the money, and there is a public policy reason why the government should not forcibly buy stakes in solvent companies.? But those that are on the brink could really benefit from a capital injection.? Anything to remove the uncertainty, and the high cost of incremental capital due to uncertainty over survival.

My point is that our dear Government, should it decide to intervene in the banks at all, should aim its capital injections toward banks that are on the cusp of creditworthiness.? (On the cusp assuming that assets and liabilities are fairly valued).? Those that will likely eventually be dead should be declared dead, the assets absorbed by RTC 2 (in concert with the FDIC), and the liabilities absorbed by other local banks.? Those banks that are healthy should continue on.? Giving them more capital in order to lend more is a cute idea, but really, why should the government get involved if there is no crisis?? Many solvent banks are looking for quality borrowers now, and finding few of them.

An aside: Why are we giving money to bank holding companies? If there is trouble in the regulated subsidiaries there might be a reason to help there directly, after cutting off the subsidiaries’ ability to dividend back to the holding company (and watching transfer payments — a good transfer pricing accountant is worth his weight in gold.)? Let the unregulated subsidiaries die, and the holding companies too.? If there are excess assets of these entities let them be distributed through chapters 11 or 7 of the bankruptcy code.? I understand exceptions for systemic risk reasons, but if the operating regulated banks are firewalled, that shouldn’t be as big of a problem.

I’ve been a critic of the industry that I grew up in for a long time, but the state insurance regulators have a better handle on their companies than the banking regulators do from a solvency standpoint.? The insurance risk models work better, even though the companies are more complex.? Imperfect as the insurance risk-based capital models are, they captured much of the action.? The banking regulators did not get as much data, and did not see the damages that could occur in a real credit bust, because many were obscured by securitization and derivatives.

There is no need to nationalize the banking system.? Set up RTC 2.? Let the regulators look at the banks on an asset-by-asset basis, and analyze what the hard-to-value assets are worth.? Compare values across companies to make fair comparisons.? Do triage then.? Send the insolvent to RTC 2.? Pump some money into the operating banks that are marginal, after cutting off dividends to the holding companies.? Let the healthy banks look for opportunities on their own.

Our existing legal framework can deal with operating bank solvency problems.? We did not need something as big as TARP 1 to solve issues at the operating banks… but if we are profligate in handing out money to bank holding companies, then even TARP 2 might not be enough to deal with all of the mess.

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One more note: there have been times in insurance regulation where the regulators looked the other way and said to themselves, “Meh, the company is insolvent if we marked it to market today, but if I just give them a few years, operating profits will bail them out.? We didn’t pay close enough attention to the issues involved in the new assets they bought or new liabilities they issued, so I will be embarrassed in front of the Governor, legislators and media if this company goes down.? I will forbear for now.”

And, about half of the time, that strategy worked.? Half of the time it didn’t, leading to a deeper hole and deeper embarrassment.? In more than a few cases where it worked in the short run, in the long run, the management culture of a firm that survived did not learn the lessons of undue risk taking, and blew it up again.? Part of fixing the system is weeding out bad management teams.

So, when I see arguments that say, “Let the banks in trouble borrow at low rates.? The positive carry will bail out their balance sheets over a period of years,” I say, “Been there.? Done that.? Got the T-shirt, and a Polaroid of them drinking the Kool-aid.”

Why provide a subsidy in such a haphazard way?? Manay banks have spent a great deal of time and effort developing low-cost deposit bases, and rotten managements should now receive a low funding cost?? If banks know that the regulators will forbear, and even subsidize their incompetence, why shouldn’t they take the free option, and continue to speculate?? Let the RTC 2 deal with the problem, and let them borrow at Treasury rates.

Part of the need to collapse bad banks is a need to eliminate bad management teams.? Without that, the system will not reset properly as bad debts get cleared.? They will get cleared eventually, but what will the nation look like when it is done?? Will we still have the same level of property rights and the rule of law?? Will we have a currency that is worth anything?? If the last century changed the value of a dollar from a dollar to a few cents, what will happen with this century?

It is Good to be the World’s Reserve Currency

Posted on 21 January 2009 by David Merkel

I decided to write this piece because of a short post at Alea; rather than comment there, I thought I would post something slightly longer here.? Consider the similarities between the US and Britain in the current crisis:

Accommodative monetary policies.
Generally free-ish with respect to financial regulation and credit.
Overleveraged housing markets after a bubble.
Banks that felt they could hedge risks and enhance returns through structured finance and derivatives.
Aggressive approaches to bail out financial institutions.

There’s probably more, but now I want to highlight one difference: the US Dollar is the global reserve currency and the British Pound is not.? Thus Britain, as it tries to reflate, runs up against borrowing constraints faster than the US does.? Those limits aren’t showing up in their interest rates yet, but it is showing up in the currency, which has been falling rapidly of late.

With the creation of so much liquidity out of thin air, the surprise is not that the British Pound is weak, but that the US Dollar is strong, and still regarded as a safe haven.? Then again, what are the alternatives?

The Yen?? Japan has its own problems, and their economy is not large enough to deal with all of the financial flows entailed.

The Yuan? Banking system too immature.

The Euro? Too young.? Tha current danger of the Euro is not that it will be weak, but that it might be too strong, leading to hard adjustments in Ireland, Spain, Greece, Portugal, and tangential European economies with weak fiscal policy positions.? I’ve said it before; I’ll say it again: the Euro is a noble experiment, but currency unions that are not political unions don’t typically work.? Then again, most fiat currencies eventually fail.

External commodity-based currencies?? None that I know of; few governments want to limit their power by tying their hands on monetary policy.

That leaves the imperfect US Dollar.? For now, lending to the US remains open, despite the many problems, and the paltry compensation for lending to the US Government and those that they guarantee to varying degrees.

If you live in the US, it’s a small reason for optimism that we don’t deserve, but it allows our government to borrow more.? Now, whether they will use it wisely is dubious, but things could be worse.? Ask Britain.

Book Review: Lombard Street

Posted on 20 December 2008 by David Merkel

This is a wonky book, and not for everyone.? It details the actions of monetary policy in the United Kingdom for much of the 19th Century.? In Great Britain, that was a century of incredible growth, and yet stability of the overall price level.? The Gold Standard worked, and the UK Government di not try to cheat on it, as it did in the early 20th century before the Great Depression.

One of Bagehot’s main ideas was that during a crisis, central banks should lend at a penalty rate without limit, and that would re-liquefy the marginal banks in the system that just needed a little to get by.? Bad banks would fail; good banks would not need to borrow.? We can contrast that with present policy of the Fed to lend against marginal collateral at favorable rates.? Ain’t no chance of us getting out of the problem that way.? All we do is create a new class of arbitageurs to extract money from the taxpayers, or Treasury note buyers.

The mangement of a good central bank is very conservative, and keeps a reserve large enough to avoid all disasters.? This again is the diametric opposite of the Federal Reserve, which was not in a conservative posture, and believes it can solve all of the credit problems through the wanton expansion of its balance sheet.

For a classic understanding of central banking, do not read Ben Bernanke.? Instead, read Walter Bagehot.? If you want to buy it, you can find it here: Lombard Street: a description of the money market.? Or, you can get it for free here.

PS ? Remember, I don?t have a tip jar, but I do do book reviews.? If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don?t pay anything extra.? I?m not out to sell things to you, so much as provide a service.? Not all books are good, and not every book is right for everyone, and I try to make that clear, rather than only giving positive book reviews on new books.? I review old books that have dropped of the radar as well, like this one, because they are often more valuable than what you can find on the shelves at your local bookstore.

Twenty Comments on the Current Economic Scene

Posted on 18 December 2008 by David Merkel

1) There are firsts for everything.? Americans paid down debt for the first time, according to a Federal Reserve Study that started in 1952.? America has always been a pro-debt and pro-debtor nation.? It goes all the way back to the Pilgrims, who paid back the merchant adventurers who funded them at a rate of nearly 40%/yr over a 15-20 year period.? But, the Pilgrims did extinguish the debt.? Us, well, I’m amazed at the decrease, but we need more of that to restore normalcy to financial institutions.

2) Dropping to 45%, though, is the amount of aggregate home value funded by equity.? With the decline in housing values, the fall in the ratio was inevitable.? The low ratio puts downward pressure on home prices, because it means that more homes are underwater.? Perverse, huh?

3) It’s a long interview, but Eric Hovde (my former boss) has a lot of important things to say regarding the financial sector.? Few hedge funds focused on financials remained bearish on the sector, but Hovde’s funds survived to 2007-2008 where his bets paid off.

4) Is there a Treasury bubble?? Yes, but it may persist for a while because of panic, central bank buying, buying from pension funds and endowments, mortgage hedging, and more.

5) Now these same low yields whack Treasury money funds. How many will close?? How many will cut fees?? How many will break the buck, and credit negative interest?? An unintended consequence of monetary policy.? Another unintended consequence reduces liquidity in the repo markets.? Yet another unintended consequence is the reduction in investment from Japan and other nations that don’t want to hold dollars at low rates.

6) Brave Ben Bernanke is fighting the Depression.? If his theories are right (and mine wrong), if he succeeds, he will face a difficult challenge in collapsing the Fed’s balance sheet as inflation re-emerges, without taking the wind out of the economy.? But if I’m right (or London Banker, or Tim Duy, or Stephanie Pomboy) things could be considerably ugly as the situation proves too big for the Fed and the US Government to handle.

7) Inflation is the lesser evil at this point.? It would raise the value of collateral over the value of the loans, dealing purchasing power losses to those that made the bad loans, but not nominal losses.

8 ) I have said before that the Fed and Treasury are making it up as they go, and Elizabeth Warren now confirms it for the Treasury.? My Dad (turned 79 yesterday) used to say, “The hurrier I go, the behinder I get.”? So it is for the TARP bailout.? Policy made hastily rarely works.? Spend more time, get it right.? The market won’t die as you work it out.

9) But will AIG die, or the automakers?

Sales are slow for assets at AIG.? (no surprise valuations are crushed, and all likely buyers face lower P/Es and higher debt costs.)
And who knows where the writeoffs end?? As I said long before the failure of AIG, don’t trust the financial statements.? The palce was too complex, and the culture of fear inhibited objective financial reporting.
GM’s suppliers are seeking cash. Just one of the costs of financial stress.
Suppliers worry over a lack of demand if the automakers fail. They should retool for Japanese and European automakers.
From Credit Slips, the important idea is that without a good business plan the automakers are toast anyway.? I predict they will be back hat in hand in half a year even with a bailout.
A GM bankruptcy would take a long time, and a prepack would not get done before the cash runs out.? Maybe, but I would still take it through bankruptcy, with the US Government as the DIP lender.

10) Even VCs are looking at the survivability of their portfolio holdings.? Who can survive and become cash-flow positive in a tough environment.? Who needs little additional funds?

11) Leveraged loans are attractive, but it is a situation of too many loans with too few native buyers.? Watch the loan covenants, so that you can get good recoveries in a default.? If you are an institutional investor, this is a place to play now that will deliver reliable returns net of defaults.? For retail investors, the closed end funds typically employ too much leverage — it is possible that one could collapse before this crisis is over.

12) Residential mortgages continue to weaken along with property prices.? Two examples: Alt-A loans and second mortgages.

13) I have a lot of respect for Dan Fuss.? This is a tough time for anyone taking credit risk.? That said, it could be a good time to take on credit risk now, if you have fresh money to deploy.

14) Two views of the crisis: one that focuses on structured finance, particularly CDOs, and one that focuses on macroeconomics.? I favor the latter, but both have good things to say.

15) Michael Pettis is one of my favorite bloggers.? He notes the weakness in China, and notes that the current economic situation is ripe for trade disputes.

16) You can give the banks funds, but you can’t make them lend.? Would you lend if you didn’t have a lot of creditworthy borrowers?

17) The export boom is dead, for now.? Fortunately, imports are falling faster, so the current account deficit is falling.

18) I blinked when I saw this Wall Street Journal Op-Ed.? Sorry, but the secret to changing the residential real estate market is not lowering interest rates, but writing-off? portions of loan balances.? Most delinquents can’t make even reduced payments, half re-default, and can’t refinance because the property is underwater.? Yes, I know that the government is pressing to have Fannie and Freddie suck down more losses by letting underwater loans refinance, but if you’re going to do that, why not be more explicit and let the losses be realized today by resetting the loan’s principal balance to 80% of the property value, and giving the GSE a property appreciation right on any growth in the home value on sale, of say 150% of the amount written down?

19) On commercial property, when do you extend on a loan vs foreclosing?? In CMBS, if the special servicer has no bias, or if a healthy insurer/bank holds the loan on balance sheet, you extend when you are optimistic that this is just a short-term difficulty with the property, and you think that the property owner just needs a little more time in order to refinance the loan.? More cynically, extensions can occur in CMBS because the juniormost surviving class directs the special servicer to extend because it maximizes the value that they will get out of their investment, because a foreclosure will wipe out a portion of their interests, since they are in the first loss position.? With a less than healthy bank or insurer, the same procedure can happen if they feel they can’t take the loss now.? (I know that in a extension/modification there should be some sort of writedown, but some financial entities find ways to avoid that.)

20) Time to go bungee jumping with the US Dollar?? As Bespoke pointed out, the Dollar Index has just come off its biggest 6-day loss ever.? Should we expect more as the US heads into a ZIRP [zero interest rate policy], with aggressive expansion of the Fed’s balance sheet, much of which might be eventually monetized?? The best thing that can be said for the US Dollar is that it is already in ZIRP-land, and much of the rest of the rest of the world is being dragged there kicking and screaming.? As the interest rate differentials narrow in real terms, the US Dollar should improve.

But, there are complicating factors.? Future growth or shrinkage of the demand for capital will have an impact, as will future inflation rates.? Even if the whole world is in a global ZIRP, there will still be differences in the degree of easing, and how much easing the central bank allows to leak into the money supply.

This is a mess, and over the next few years, expect to see a whole new set of metrics develop in order to evaluate monetary policies and currencies.? For now, put your macroeconomics books on the shelf, because they won’t be useful for some time.

The Fed Funds Target Rate is an Exercise in Futility (II)

Posted on 16 December 2008 by David Merkel

Time again for another underwhelming FOMC meeting.? As I said before the last FOMC meeting, in The Fed Funds Target Rate is an Exercise in Futility, we are so close to the zero bound that further easing will do little.? Here’s a graph of effective Fed funds:

That is not to say that the Fed is out of options, but the FOMC and what it has to say, matters less and less.? The various lending programs of the Fed are where the action is, where they monopolize liquidity for the markets they deem worthy of service, while starving everything else of liquidity.

As others have commented, and I can’t remember where, the low Fed funds rate reduces the powers of the regional Federal Reserve banks, and raises the power of the NY Fed and the Board of Governors, because the regional Federal Reserve banks don’t have much play in the new lending programs.

The low fed funds rate affects high credit quality money market funds, many of which will close to new investments (and/or reduce fees).? Otherwise, the low rates may cause them to “break the buck.”? As it is, rates will be near the zero bound for a long-ish time, unless we get a spate of inflation due to dollar depreciation.

I’ll be back with a redacted version of the FOMC Statement after it is issued.