The financial markets hate uncertainty. It is the unknown that creates uncertainty and unexpected new information often creates uncertainty because investors must not only absorb the new information but must also translate what they have learned into action!
This is what I tried to emphasize in my post of April 28, 2010, “Greece: The ‘Surprise’ That Breaks The Camel’s Back” (http://seekingalpha.com/article/201382-greece-the-surprise-that-breaks-the-camel-s-back). Recently we were given knowledge that the budget deficit of the Greek government was much worse than we had been told, and, as a result of this news, the rating on Greek bonds was lowered. Immediately, investors began to sell off these bonds.
The financial market unrest continued. Then the European Union and the International Monetary Fund came up with its bailout package of €110 billion “to save the euro by providing Greece with enough cash to meet its financial obligations over the next twelve months or so.” (http://seekingalpha.com/article/202754-greece-and-insolvency-finding-a-way-out)
The problem is, as I pointed out in this last post, that the response was aimed at preventing a liquidity crisis and not a solvency crisis. These two types of financial crises are different and a failure to understand the difference and react in the appropriate way can just exacerbate a problem and not solve it.
The Federal Reserve under Ben Bernanke has been guilty of this very thing and, as a consequence, has contributed to the lingering solvency problem in the “less than mammoth” banks in the United States banking system today. (I have discussed this in many other posts.)
A liquidity crisis is a short run phenomenon related to the disclosure that the price of a certain financial asset should be different from what it had recently been trading at. The buy side of the market disappears and the price of the financial asset drops, sometimes precipitously. In the classical case, the central bank comes into the market and makes sure that there is sufficient liquidity in the market so that the price of the asset in question stabilizes and trading can resume.
The prices of other similar assets may be caught up in this uncertainty but the response of the central bank is enough to stabilize the market.
A solvency crisis is different. In a solvency crisis the value of the assets must be written down, but the concern is over the ability of the institutions that own the assets to cover the value write down with the equity capital they possess. Of course, the value of the assets may go up at some time in the future but in general these institutions must “work off” these assets over time in a way that does not exhaust their capital base.
Otherwise, if the effected institutions have to write off these “underwater” assets immediately they may have to be closed.
A solvency crisis takes a much longer time to get over than does a liquidity crisis. That is why so many small- to medium-sized banks are still having so much difficulty even with massive amounts of liquidity available in the banking system.
The problem with the current situation in the European Union is that the situation is not one of liquidity, but one of solvency. There is a very real concern in the market for sovereign debt about whether or not certain nations within the EU can maintain their solvency given the debt load their governments have assumed and given the very weak nature of their economies.
There is a question about the ability of certain governments to be able to pay-off their debts. And, if these debts cannot be re-paid, what will happen to the solvency of the banks and other institutions that now hold this sovereign debt. Special concern exists about commercial banks in Germany and France. Some think that the real reason for the Greek bailout is to keep several major banks in Germany and France from failing. (See the second post mentioned above.)
Just providing Greece the ability to be able to roll over its debt in the next twelve months or so is an attempt to make Greek debt “liquid”. The hopes are that this will buy time for the Greek government to “right its ship” so that it will be able to meet its financial obligations and then go bravely forward. The financial markets have responded by saying that the Greek situation is not a problem of market liquidity but a problem of government solvency: the government, as it appears now, cannot pay its bills.
The concern over solvency has spread. If Greece lied to its debtors, maybe other countries have been doing so as well. Maybe these other countries are not as well off as was thought. Hence, a need to check other “undisciplined” countries out.
The credit ratings of Spain and Portugal were lowered (with Portugal facing additional review concerning its credit rating). Isn’t this evidence enough. But, of course, other countries are on the radar screen: countries that have been particularly profligate like Great Britain where the Labour Government outspent the rate of inflation since 1997 by 41%! But also Italy and Ireland.
What we seem to be seeing in the world is a realignment away from countries that have over-stayed their welcome in the credit markets. We see this especially in the currency markets. The value of the euro has plunged against the dollar and other major currencies. Today, May 6 it hit a 52-week low around 1.26. In other areas of the currency market the move seems to be away from the currencies of countries having “debt problems” to those that appear to be more secure.
The same thing has occurred in bond markets. The rush to United States Treasury bonds has been phenomenal over the past week. The two-year Treasury was yielding about 1.07% April 23 while the ten-year Treasury was yielding around 3.82%. These two yields have dropped to 0.79% and 3.39%, respectively, a major move!
When uncertainty increases, market volatility also increases. If we look at one index of market volatility, the CBOE’s VIX index, we see it peaking over 40 today, up from around 20 or so over the past week and in the 15-20 range before that. The market appears to be spooked and this means one might expect the volatility of the financial markets to remain high in the near future.
The major problem going forward is leadership: who can lead the eurozone and Great Britain out of this mess? The concern is captured in Landon Thomas’ article in the New York Times, “Bold Stroke May Be Beyond Europe’s Means,” (http://dealbook.blogs.nytimes.com/2010/05/06/bold-stroke-may-be-beyond-europes-means/?scp=5&sq=landon%20thomas%20jr.&st=cse). In the case of the eurozone, there is no leader. And, this has been a problem the detractors of this union have pointed to since before the euro was put into place. There is an economic union but no political union. It is like herding cats and given the cracks that are occurring in the structure, many are wondering if this economic union can last for more than two or three years more.
In Great Britain, there is going to be a “hung” Parliament. But, who really wants to rule in jolly ole England. Some are saying that if the new government (‘hung’ or not) really does what it needs to do with respect to the fiscal condition of the nation, these politicians will not be able to be re-elected for the next ten- to fifteen years because they will be so unpopular. Shades of Greece?
The bottom line: governments have lived beyond their means. Certain ‘brands of economics’ have argued that this is possible because people don’t really take into account future tax liabilities or future inflation. They are very ‘current minded.’ It just seems possible that this philosophy has run its course!
Showing posts with label financial bailouts. Show all posts
Showing posts with label financial bailouts. Show all posts
Thursday, May 6, 2010
Tuesday, May 4, 2010
Greece and Insolvency
A financial crisis that is a result of the potential insolvency of a borrower is connected with the “true” value of the underlying assets held by the lender. In the case of the Greece bailout, the European Union (EU) and the International Monetary Fund (IMF) are working to keep the value of Greek bonds at 100% of face value.
Thus, the €110 billion (or $145 billion) package put together over the weekend is an effort to save the Euro by providing Greece with enough cash to meet its financial obligations over the next twelve months or so. Hopefully, at the end of this time Greece will be welcomed back into the capital markets so that it can raise its own cash, something it needs lots of.
Then, as is usually the assumption in insolvency situations like this, the debtor will grow out of its difficulties so that its debt will return to 100% of face value in the financial markets. The problem with this is that Greece is expected, at best, to return to the level of real GDP it achieved in 2009 in or around 2017. The austerity moves required by the IMF of the Greek government is not expected to contribute to a strong rebound in its economy.
Many analysts are contending that the bailout is really to protect the banks in Germany and France. The commercial banks in these two countries hold a massive amount of Greek debt. If one gives the Greek debt a haircut of 40% to 50%, several banks in these two countries will fail and require government support to keep the banking systems functioning. If this were to happen both nations would find themselves in deep economic trouble, threatening the recovery of all Europe.
But, note…”The European Central Bank (ECB) agreed to continue accepting as collateral any current or future Greek government bonds, no matter how much debt-rating companies downgraded them.” (See http://online.wsj.com/article/SB20001424052748703612804575222331434882588.html#mod=todays_us_page_one.)
By doing this, the ECB is attempting to prevent a liquidity crisis at Greek banks, because these banks can use the new collateral rule to get cash from the ECB by pledging their Greek bonds as collateral. Also, this rule will benefit euro-zone banks because it will mean that these banks can also get money from the ECB by pledging their Greek bonds as collateral.
There seems to be a special effort on the part of EU and IMF officials to take all discussions of losses on Greek debt “off-the-table.” The emphasis is upon ensuring that the banks that hold Greek debt and the financial markets that everyone will be “paid-in-full” over the next year or two. Anyone that talks differently will have his or her hand slapped!
The ultimate mechanism for insuring that debt is covered over the longer run is to produce an inflationary environment. And, in a severe financial crisis, the concern of the policy makers is to err on the side of providing too much liquidity. The policy makers do not want people, at some time in the future, to accuse them of not providing enough liquidity to the system which resulted in an even greater financial crisis.
Jean-Claude Trichet, the President of the European Central Bank certainly is adhering to this principle in the current situation. Trichet, the stern defender of central bank fight against inflation in 2007 and 2008, now seems to be putty in the hands of current circumstances.
Trichet, however, still seems to be a amateur when compared with his counterpart Ben Bernanke at the Board of Governors of the United States’ Federal Reserve System. When it comes to “throwing stuff against the wall to see if it sticks” Bernanke is the poster-child.
Inflation may be the ultimate tool that Europe uses to save the Euro and the European Union. The reason for this is the other nations that are on the brink of financial disaster: Spain, Portugal, Italy, and Ireland. Also, there is the U. K. sitting across the channel showing us the very real possibility of having a “hung” Parliament which would find it very difficult to do what it needs to do to get its own act in order. There may just be too much to do in the current state of affairs to overcome the lack of national discipline that has been exhibited in this the European region in the recent past.
The factor that might set this all off is the reaction of the government employees and the working classes in these nations to the austerity programs that are being forced down the throats of the governments in question. Europe has a long and proud history of labor movements and working class unrest. These movements have been relatively quiet in recent years. In Greece we are seeing a resurgence of protest that could fuel further unrest in other countries, especially in Italy.
It was fear of such unrest in Europe in the 1920s and 1930s that led to a philosophy of government policies that supported the creation of an inflationary environment to keep people employed with ever increasing wages. These policies were implemented in many countries once the disruptions created by World War II subsided. The history of labor movements in Europe in the twentieth century is long and rich. It is unlikely that the austerity programs will be easily accepted by the people being impacted by them.
Again, the problem we are seeing is that there are no attractive options to governments or governmental bodies after a long period in which financial discipline has been absent. As Carmen Reinhart and Ken Rogoff have shown in their book “This Time is Different”, every time that governments (or people, or, businesses) lose their fiscal discipline the time is never different.
The Piper eventually has to be paid.
The effort to prevent too much pain, however, is to bail out governments (and people, and, businesses) and then stimulate the economy to put businesses, and, people, and, governments, back where they were before the crisis began. This is done by inflating the economy through extensions of liquidity and programs to maintain asset prices. The goal: to get the economy back to where it was before the crisis began.
This is what the European Union, with the help of the International Monetary Fund, is attempting to do. Unfortunately, the underlying problem has not been solved. There are major amounts of assets on the books of financial institutions and other organizations that are substantially over valued. The question that lingers in an insolvency crisis relates to how long these financial institutions and other organizations can continue to hold onto the assets without marking them to a more realistic value or working the losses off through charges against other earnings?
Thus, the €110 billion (or $145 billion) package put together over the weekend is an effort to save the Euro by providing Greece with enough cash to meet its financial obligations over the next twelve months or so. Hopefully, at the end of this time Greece will be welcomed back into the capital markets so that it can raise its own cash, something it needs lots of.
Then, as is usually the assumption in insolvency situations like this, the debtor will grow out of its difficulties so that its debt will return to 100% of face value in the financial markets. The problem with this is that Greece is expected, at best, to return to the level of real GDP it achieved in 2009 in or around 2017. The austerity moves required by the IMF of the Greek government is not expected to contribute to a strong rebound in its economy.
Many analysts are contending that the bailout is really to protect the banks in Germany and France. The commercial banks in these two countries hold a massive amount of Greek debt. If one gives the Greek debt a haircut of 40% to 50%, several banks in these two countries will fail and require government support to keep the banking systems functioning. If this were to happen both nations would find themselves in deep economic trouble, threatening the recovery of all Europe.
But, note…”The European Central Bank (ECB) agreed to continue accepting as collateral any current or future Greek government bonds, no matter how much debt-rating companies downgraded them.” (See http://online.wsj.com/article/SB20001424052748703612804575222331434882588.html#mod=todays_us_page_one.)
By doing this, the ECB is attempting to prevent a liquidity crisis at Greek banks, because these banks can use the new collateral rule to get cash from the ECB by pledging their Greek bonds as collateral. Also, this rule will benefit euro-zone banks because it will mean that these banks can also get money from the ECB by pledging their Greek bonds as collateral.
There seems to be a special effort on the part of EU and IMF officials to take all discussions of losses on Greek debt “off-the-table.” The emphasis is upon ensuring that the banks that hold Greek debt and the financial markets that everyone will be “paid-in-full” over the next year or two. Anyone that talks differently will have his or her hand slapped!
The ultimate mechanism for insuring that debt is covered over the longer run is to produce an inflationary environment. And, in a severe financial crisis, the concern of the policy makers is to err on the side of providing too much liquidity. The policy makers do not want people, at some time in the future, to accuse them of not providing enough liquidity to the system which resulted in an even greater financial crisis.
Jean-Claude Trichet, the President of the European Central Bank certainly is adhering to this principle in the current situation. Trichet, the stern defender of central bank fight against inflation in 2007 and 2008, now seems to be putty in the hands of current circumstances.
Trichet, however, still seems to be a amateur when compared with his counterpart Ben Bernanke at the Board of Governors of the United States’ Federal Reserve System. When it comes to “throwing stuff against the wall to see if it sticks” Bernanke is the poster-child.
Inflation may be the ultimate tool that Europe uses to save the Euro and the European Union. The reason for this is the other nations that are on the brink of financial disaster: Spain, Portugal, Italy, and Ireland. Also, there is the U. K. sitting across the channel showing us the very real possibility of having a “hung” Parliament which would find it very difficult to do what it needs to do to get its own act in order. There may just be too much to do in the current state of affairs to overcome the lack of national discipline that has been exhibited in this the European region in the recent past.
The factor that might set this all off is the reaction of the government employees and the working classes in these nations to the austerity programs that are being forced down the throats of the governments in question. Europe has a long and proud history of labor movements and working class unrest. These movements have been relatively quiet in recent years. In Greece we are seeing a resurgence of protest that could fuel further unrest in other countries, especially in Italy.
It was fear of such unrest in Europe in the 1920s and 1930s that led to a philosophy of government policies that supported the creation of an inflationary environment to keep people employed with ever increasing wages. These policies were implemented in many countries once the disruptions created by World War II subsided. The history of labor movements in Europe in the twentieth century is long and rich. It is unlikely that the austerity programs will be easily accepted by the people being impacted by them.
Again, the problem we are seeing is that there are no attractive options to governments or governmental bodies after a long period in which financial discipline has been absent. As Carmen Reinhart and Ken Rogoff have shown in their book “This Time is Different”, every time that governments (or people, or, businesses) lose their fiscal discipline the time is never different.
The Piper eventually has to be paid.
The effort to prevent too much pain, however, is to bail out governments (and people, and, businesses) and then stimulate the economy to put businesses, and, people, and, governments, back where they were before the crisis began. This is done by inflating the economy through extensions of liquidity and programs to maintain asset prices. The goal: to get the economy back to where it was before the crisis began.
This is what the European Union, with the help of the International Monetary Fund, is attempting to do. Unfortunately, the underlying problem has not been solved. There are major amounts of assets on the books of financial institutions and other organizations that are substantially over valued. The question that lingers in an insolvency crisis relates to how long these financial institutions and other organizations can continue to hold onto the assets without marking them to a more realistic value or working the losses off through charges against other earnings?
Monday, February 23, 2009
It's All A Matter Of Incentives
Cerberus Capital Management has asked for a bailout! Who would have thought that a private equity fund would be seeking the help of the Federal Government to provide it with bailout funds?
The United States government is the largest creator of incentives in the world. Whatever it does it sets up incentives that people respond to in order to gain whatever edge they can obtain. And, the competition can sometimes become extremely fierce.
Incentives can either be positive or negative. They can either encourage us to do something…like pursue an education…or they can discourage us from doing something…like quitting smoking. They can work to make the society better…like improving the environment…or they can cause criminal behavior…like prohibition resulted in an underground business boom.
Whatever it is that the government does…it sets up incentives that people respond to. And, making lots and lots of funds available to people creates a huge incentive for those individuals to line up…with their hands out.
We saw this earlier with TARP. I thought that this effort supposedly had something to do with the “toxic assets” that were on the balance sheets of banks. But, as soon as it was passed…all of a sudden mayors and governors had their hands out for some of the money. Somewhere I missed their inclusion in the bill passed by Congress.
The major criteria now for getting money from the Obama stimulus plan just passed by Congress is “shovel ready.” Wow…I didn’t know that so many governmental bodies in the United States had so many proposals ready to begin putting the shovel into the ground next Monday!
Most incentives in an economy evolve out of the workings of the economic and social system that exists within a country. One could say these incentives are “endogenous” to the system…that is, they are created through the normal functioning of daily life. One could say that these incentives arise naturally.
Governments and some large organizations can create incentives “exogenously”…that is, they can impose incentives on a society from outside the system…say, because they think that certain incentives create “right” behavior. A church, for example, is one such system. A government can create incentives that will raise the nation to fight a war…and the incentives must be strong enough to get the nation to pay for that war by paying taxes to support the war.
One of the problems with these “exogenous” incentives is that they may ultimately be harmful to the people that they were trying to help. This problem is observed quite often in economics because most changes in incentives take a substantial time period to work themselves out. Consequently it is difficult to attach the “consequence” of a government policy with the underlying “cause” of the result. Especially since modern society and its sources of information…television, newspapers, and radio…tend to focus on the current and the dramatic “consequences” without any recognition of what might have started off the whole chain of events leading to this end.
This leaves us with an uncomfortable situation in which we must deal with the existing problem and with the emotions and psychology of current events isolated from what got us into the mess we are in.
Last Friday, we saw an announcer on public television ranting and raving about how the people that have followed the rules and responsibly sheparded their resources now have to dig into their pockets and cover those that have not behaved in such a sensible manner and now are experiencing financial and economic difficulties. And, this tirade has gained national attention by both sides of the argument.
The auto industry “big-guys” are down on their knees begging for some “bread and water” so as to keep their positions of power and control. Yet, these are the people that have been protected for years by the same state and national politicians they are now seeking mercy from.
And, the bankers…what a bad lot they are…those greedy “b……s”! Of course, bankers are always an easy bunch to pick on…and this picking goes back centuries. The auto-guys are just wimps in comparison to bankers when it comes to taking criticism.
The question that goes unanswered is “What was the environment created by government that set up the incentives that resulted in the results just described?” I have already answered this for the auto industry. But, who wouldn’t go to the government and get protection of their industry when it was so possible to do so?
Who wouldn’t support the Federal Reserve keeping interest rates so low for an extended period of time…of course, real interest costs were negative…so that business could be continued at a furious pace? Who wouldn’t be in favor of substantial tax cuts for the wealthy…especially if you happen to be wealthy? Who wouldn’t support going after that bad dictator who had those…what was it now? Oh, yes…weapons of mass destruction.
The obvious point to this discussion is that government got us into the mess we are in through the incentives it created eight or so years ago…and now we are faced with a situation in which it appears that government must set up a new set of incentives in order to make up for the mess that resulted from the incentives set up from an earlier time.
Yes, we have to take some money from those that did not over play their fiscal hand and transfer it to some that did. Yes, we have to help those financial institutions that responded in too extreme a form to the perceived opportunities that existed for them. Yes, we may need to do more for the auto industry…and for other industries.
But, where does it stop? Is everyone entitled to a bailout? (Well, as a matter of fact…I think I need a billion or two to get me through the next several years! I’m sure you are deserving of a bailout as well!) And, what are the consequences down-the-road a piece for the people and the society that are getting the bailouts?
Does Cerberus Capital Management really deserve a bailout? I thought private equity firms were risk takers and that is why they got the big bucks? Maybe Cerberus should face a "stress test" like the commercial banks.
What kind of a society are we creating through the incentives that are being developed today? What mess is the government going to have to bail us out of in two or three, or, five or six years from now…the mess that we are now creating…but we don’t know what mess that will be?
Of course, the final question is…how are you going to respond to the incentives now being created? Is it wise for certain Republican governors to turn down the bailout money because of…what was that…because of their principles?
The United States government is the largest creator of incentives in the world. Whatever it does it sets up incentives that people respond to in order to gain whatever edge they can obtain. And, the competition can sometimes become extremely fierce.
Incentives can either be positive or negative. They can either encourage us to do something…like pursue an education…or they can discourage us from doing something…like quitting smoking. They can work to make the society better…like improving the environment…or they can cause criminal behavior…like prohibition resulted in an underground business boom.
Whatever it is that the government does…it sets up incentives that people respond to. And, making lots and lots of funds available to people creates a huge incentive for those individuals to line up…with their hands out.
We saw this earlier with TARP. I thought that this effort supposedly had something to do with the “toxic assets” that were on the balance sheets of banks. But, as soon as it was passed…all of a sudden mayors and governors had their hands out for some of the money. Somewhere I missed their inclusion in the bill passed by Congress.
The major criteria now for getting money from the Obama stimulus plan just passed by Congress is “shovel ready.” Wow…I didn’t know that so many governmental bodies in the United States had so many proposals ready to begin putting the shovel into the ground next Monday!
Most incentives in an economy evolve out of the workings of the economic and social system that exists within a country. One could say these incentives are “endogenous” to the system…that is, they are created through the normal functioning of daily life. One could say that these incentives arise naturally.
Governments and some large organizations can create incentives “exogenously”…that is, they can impose incentives on a society from outside the system…say, because they think that certain incentives create “right” behavior. A church, for example, is one such system. A government can create incentives that will raise the nation to fight a war…and the incentives must be strong enough to get the nation to pay for that war by paying taxes to support the war.
One of the problems with these “exogenous” incentives is that they may ultimately be harmful to the people that they were trying to help. This problem is observed quite often in economics because most changes in incentives take a substantial time period to work themselves out. Consequently it is difficult to attach the “consequence” of a government policy with the underlying “cause” of the result. Especially since modern society and its sources of information…television, newspapers, and radio…tend to focus on the current and the dramatic “consequences” without any recognition of what might have started off the whole chain of events leading to this end.
This leaves us with an uncomfortable situation in which we must deal with the existing problem and with the emotions and psychology of current events isolated from what got us into the mess we are in.
Last Friday, we saw an announcer on public television ranting and raving about how the people that have followed the rules and responsibly sheparded their resources now have to dig into their pockets and cover those that have not behaved in such a sensible manner and now are experiencing financial and economic difficulties. And, this tirade has gained national attention by both sides of the argument.
The auto industry “big-guys” are down on their knees begging for some “bread and water” so as to keep their positions of power and control. Yet, these are the people that have been protected for years by the same state and national politicians they are now seeking mercy from.
And, the bankers…what a bad lot they are…those greedy “b……s”! Of course, bankers are always an easy bunch to pick on…and this picking goes back centuries. The auto-guys are just wimps in comparison to bankers when it comes to taking criticism.
The question that goes unanswered is “What was the environment created by government that set up the incentives that resulted in the results just described?” I have already answered this for the auto industry. But, who wouldn’t go to the government and get protection of their industry when it was so possible to do so?
Who wouldn’t support the Federal Reserve keeping interest rates so low for an extended period of time…of course, real interest costs were negative…so that business could be continued at a furious pace? Who wouldn’t be in favor of substantial tax cuts for the wealthy…especially if you happen to be wealthy? Who wouldn’t support going after that bad dictator who had those…what was it now? Oh, yes…weapons of mass destruction.
The obvious point to this discussion is that government got us into the mess we are in through the incentives it created eight or so years ago…and now we are faced with a situation in which it appears that government must set up a new set of incentives in order to make up for the mess that resulted from the incentives set up from an earlier time.
Yes, we have to take some money from those that did not over play their fiscal hand and transfer it to some that did. Yes, we have to help those financial institutions that responded in too extreme a form to the perceived opportunities that existed for them. Yes, we may need to do more for the auto industry…and for other industries.
But, where does it stop? Is everyone entitled to a bailout? (Well, as a matter of fact…I think I need a billion or two to get me through the next several years! I’m sure you are deserving of a bailout as well!) And, what are the consequences down-the-road a piece for the people and the society that are getting the bailouts?
Does Cerberus Capital Management really deserve a bailout? I thought private equity firms were risk takers and that is why they got the big bucks? Maybe Cerberus should face a "stress test" like the commercial banks.
What kind of a society are we creating through the incentives that are being developed today? What mess is the government going to have to bail us out of in two or three, or, five or six years from now…the mess that we are now creating…but we don’t know what mess that will be?
Of course, the final question is…how are you going to respond to the incentives now being created? Is it wise for certain Republican governors to turn down the bailout money because of…what was that…because of their principles?
Wednesday, January 21, 2009
Where Will the Federal Reserve Go?
The Federal Reserve evolved over the years to perform three major tasks: to supply liquidity to commercial banks and the financial markets (specifically as the “lender of last resort”); to manage the monetary system so as to encourage economic growth, yet contain inflation; and to oversee the health of the banks who were members of the Federal Reserve System through regulation, examination, and supervision.
Whereas the Federal Reserve System is supposed to fight a liquidity crisis, a very short term phenomenon, it was not set up to resolve a solvency crisis, a longer term situation. The problem faced in a liquidity crisis is that, for one reason or another, an institution or a few institutions want to sell quickly some kind of a financial asset but there are few, if any, buyers. The responsibility of the Federal Reserve is to supply liquidity to the market on a short term basis so that the market will stabilize and buyers of these financial assets will return to the market.
We have gone through our liquidity crises this time around. Liquidity crises are surprises…we are not prepared for them…and this is why the response has to be quick and decisive. I say that we have gone through our liquidity crises this time around because investors are very wary about ALL asset classes now and the surprises that come to light on a regular basis are how deep the losses on assets continue to be…not that there are losses.
The Federal Reserve is not set up to solve a solvency crisis. The solvency crisis is a capital adequacy problem. It is a problem related to how large the losses are related to the book value of the assets. Yes, there are liquidity issues related to these troubled assets…they may not be able to be sold…or they cannot be sold. If this is the case the question becomes whether or not the problems related to these assets can be worked out and if so how much of the asset value will be retained…if any of it can be retained. And, the solvency crisis is of a longer term nature than the liquidity crisis.
The Federal Reserve, over the past 13 months has drastically changed the way it operates in an effort to provide liquidity to financial markets. Attention has been directed to the expansion of the asset portfolio of the Federal Reserve System. In the last 13 months, the line item labeled “Total Factors Supplying Reserve Funds” that appears on the Federal Reserve Statistical Release, H.4.1, “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks,” has increased by approximately $1.2 trillion. The increase is from $0.9 trillion on Wednesday November 28, 2007 to $2.1 trillion on Wednesday January 14, 2009. All of this increase has come since Wednesday September 3, 2008 when the balance totaled $0.94 trillion.
I include December 2007 in this calculation for it was in this month that we first got the innovation called the Term Auction Credit Facility introduced to the Fed’s tools of operation. And, as they say, the rest is history.
The major changes include a decline in the “Securities Held Outright” of $275 billion, the account that includes Treasury securities the instrument that the Federal Reserve has traditionally used to conduct monetary policy. But even this figure is misleading because this category now includes “Federal Agency Debt Securities” and “Mortgage-backed Securities”. These two accounts have gone up by about $23 billion over the past 13 months, so that the decline in Treasury securities held by the Fed has actually declined by about $300 billion.
What has accounted, therefore, for the $1.5 trillion increase? (The $1.5 trillion comes from the $1.2 trillion increase in Factors Supplying Reserves and the decline of $0.3 trillion of Treasury Securities held.) “Term Auction Credit” injections accounted for almost $0.4 trillion, “Other Federal Reserve Assets” rose by almost $0.6 trillion and “Net portfolio holdings of Commercial Paper Funding Facility LLC” rose by a little over $0.3 trillion. The other roughly $0.2 trillion came from minor accounts like the increase in primary borrowings from the discount window, primary dealer and other broker-dealer credit, credit extended to AIG, the assets connected with the Bear Stearns bailout, and Asset-backed Commercial Paper Money Market Mutual Fund Liquidity Facility.
And, what is the point of listing all of these different sources of funds? The point is to highlight that most of the funds were injected into the market in order to provide liquidity to different sectors of the financial markets in an effort to “unfreeze” lending. The securities provided to the Federal Reserve to serve as collateral for these “loans” are supposedly of the highest credit quality. The rest of the funds…really a minor part of them…only about $113 billion…is to hold assets connected with the bailouts of AIG and Bear Stearns. That is, almost all of the funds were supplied to the market for liquidity reasons…not for solvency reasons. Thus, the Fed is sticking to one of its primary functions and not entering into the area of “capital adequacy” problems.
The capital adequacy problem should not be an issue that the Federal Reserve takes up. To do so would cause a major conflict with its primary responsibility…to conduct monetary policy.
To me, this is an issue primarily for the Treasury Department because it is very closely related to ownership...and when we start talking about ownership we start thinking of “nationalization”…and I believe that a lot of people have trouble walking down this road. However, given the depth of the problems of the banking industry, the issue of nationalization is going to come up and must be thoroughly discussed and debated. This is a major step for any nation to take…and most nations around the world that are looking at this problem in the face are treating the issue very gently. Even those nations who have governments that look to more governmental involvement in the economy at being very careful.
Fed Chairman Bernanke has stated that the United States cannot just rely on the Obama stimulus plan to get the economy going…and he is right. But, the Federal Reserve has supplied a lot of liquidity to financial markets…and, they will stand ready to supply more liquidity if it is needed. However, the Fed cannot do much more at this time. I hope it does not have many more tricks up its sleeve to surprise us with as it did this past year. In this respect, I think the Fed needs to be careful going forward and not get impatient and do something way off the wall.
As you may remember, I am not a great fan of Bernanke and I had hoped that he would offer to step down so that President Obama could select a Chairman of the Fed that would be more capable. I believe that Bernanke panicked last September (See “The ‘Bailout Plan: Did Bernanke Panic?” on Seeking Alpha, http://seekingalpha.com/author/john-m-mason/articles/latest, November 16, 2008.) Paulson was over whelmed, Bush 43 was absent without leave, and there was no one else in the administration with the intellectual quality to counter Bernanke’s arguments. As a result we got the mess labeled TARP…which was ill-planned, ill-debated, and mismanaged from the start…which has turned into its own source of disaster.
Frankly, I am concerned about where the Fed is headed. There are certainly stronger intellects around in the Obama administration…Larry Summers particularly comes to mind. However, the Fed has a certain independence that forces one to worry when you do not have confidence in its leadership.
Where will the Fed go? One should not be surprised by the central bank. A central bank needs to be steady and secure at the helm. A central bank needs to provide confidence to markets and institutions. I do not sense that participants in the financial markets feel this way at this time about the current Federal Reserve System.
Whereas the Federal Reserve System is supposed to fight a liquidity crisis, a very short term phenomenon, it was not set up to resolve a solvency crisis, a longer term situation. The problem faced in a liquidity crisis is that, for one reason or another, an institution or a few institutions want to sell quickly some kind of a financial asset but there are few, if any, buyers. The responsibility of the Federal Reserve is to supply liquidity to the market on a short term basis so that the market will stabilize and buyers of these financial assets will return to the market.
We have gone through our liquidity crises this time around. Liquidity crises are surprises…we are not prepared for them…and this is why the response has to be quick and decisive. I say that we have gone through our liquidity crises this time around because investors are very wary about ALL asset classes now and the surprises that come to light on a regular basis are how deep the losses on assets continue to be…not that there are losses.
The Federal Reserve is not set up to solve a solvency crisis. The solvency crisis is a capital adequacy problem. It is a problem related to how large the losses are related to the book value of the assets. Yes, there are liquidity issues related to these troubled assets…they may not be able to be sold…or they cannot be sold. If this is the case the question becomes whether or not the problems related to these assets can be worked out and if so how much of the asset value will be retained…if any of it can be retained. And, the solvency crisis is of a longer term nature than the liquidity crisis.
The Federal Reserve, over the past 13 months has drastically changed the way it operates in an effort to provide liquidity to financial markets. Attention has been directed to the expansion of the asset portfolio of the Federal Reserve System. In the last 13 months, the line item labeled “Total Factors Supplying Reserve Funds” that appears on the Federal Reserve Statistical Release, H.4.1, “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks,” has increased by approximately $1.2 trillion. The increase is from $0.9 trillion on Wednesday November 28, 2007 to $2.1 trillion on Wednesday January 14, 2009. All of this increase has come since Wednesday September 3, 2008 when the balance totaled $0.94 trillion.
I include December 2007 in this calculation for it was in this month that we first got the innovation called the Term Auction Credit Facility introduced to the Fed’s tools of operation. And, as they say, the rest is history.
The major changes include a decline in the “Securities Held Outright” of $275 billion, the account that includes Treasury securities the instrument that the Federal Reserve has traditionally used to conduct monetary policy. But even this figure is misleading because this category now includes “Federal Agency Debt Securities” and “Mortgage-backed Securities”. These two accounts have gone up by about $23 billion over the past 13 months, so that the decline in Treasury securities held by the Fed has actually declined by about $300 billion.
What has accounted, therefore, for the $1.5 trillion increase? (The $1.5 trillion comes from the $1.2 trillion increase in Factors Supplying Reserves and the decline of $0.3 trillion of Treasury Securities held.) “Term Auction Credit” injections accounted for almost $0.4 trillion, “Other Federal Reserve Assets” rose by almost $0.6 trillion and “Net portfolio holdings of Commercial Paper Funding Facility LLC” rose by a little over $0.3 trillion. The other roughly $0.2 trillion came from minor accounts like the increase in primary borrowings from the discount window, primary dealer and other broker-dealer credit, credit extended to AIG, the assets connected with the Bear Stearns bailout, and Asset-backed Commercial Paper Money Market Mutual Fund Liquidity Facility.
And, what is the point of listing all of these different sources of funds? The point is to highlight that most of the funds were injected into the market in order to provide liquidity to different sectors of the financial markets in an effort to “unfreeze” lending. The securities provided to the Federal Reserve to serve as collateral for these “loans” are supposedly of the highest credit quality. The rest of the funds…really a minor part of them…only about $113 billion…is to hold assets connected with the bailouts of AIG and Bear Stearns. That is, almost all of the funds were supplied to the market for liquidity reasons…not for solvency reasons. Thus, the Fed is sticking to one of its primary functions and not entering into the area of “capital adequacy” problems.
The capital adequacy problem should not be an issue that the Federal Reserve takes up. To do so would cause a major conflict with its primary responsibility…to conduct monetary policy.
To me, this is an issue primarily for the Treasury Department because it is very closely related to ownership...and when we start talking about ownership we start thinking of “nationalization”…and I believe that a lot of people have trouble walking down this road. However, given the depth of the problems of the banking industry, the issue of nationalization is going to come up and must be thoroughly discussed and debated. This is a major step for any nation to take…and most nations around the world that are looking at this problem in the face are treating the issue very gently. Even those nations who have governments that look to more governmental involvement in the economy at being very careful.
Fed Chairman Bernanke has stated that the United States cannot just rely on the Obama stimulus plan to get the economy going…and he is right. But, the Federal Reserve has supplied a lot of liquidity to financial markets…and, they will stand ready to supply more liquidity if it is needed. However, the Fed cannot do much more at this time. I hope it does not have many more tricks up its sleeve to surprise us with as it did this past year. In this respect, I think the Fed needs to be careful going forward and not get impatient and do something way off the wall.
As you may remember, I am not a great fan of Bernanke and I had hoped that he would offer to step down so that President Obama could select a Chairman of the Fed that would be more capable. I believe that Bernanke panicked last September (See “The ‘Bailout Plan: Did Bernanke Panic?” on Seeking Alpha, http://seekingalpha.com/author/john-m-mason/articles/latest, November 16, 2008.) Paulson was over whelmed, Bush 43 was absent without leave, and there was no one else in the administration with the intellectual quality to counter Bernanke’s arguments. As a result we got the mess labeled TARP…which was ill-planned, ill-debated, and mismanaged from the start…which has turned into its own source of disaster.
Frankly, I am concerned about where the Fed is headed. There are certainly stronger intellects around in the Obama administration…Larry Summers particularly comes to mind. However, the Fed has a certain independence that forces one to worry when you do not have confidence in its leadership.
Where will the Fed go? One should not be surprised by the central bank. A central bank needs to be steady and secure at the helm. A central bank needs to provide confidence to markets and institutions. I do not sense that participants in the financial markets feel this way at this time about the current Federal Reserve System.
Thursday, September 18, 2008
It' One World Now!
The headlines this morning…The Federal Reserve, the European Central Bank, the Bank of Japan and other counterparts entered into a coordinated effort to provide liquidity to world markets so as to revive confidence in international financial markets and, hopefully avoid a melt-down. Now, almost $250 billion of dollars can be auctioned off around the world via swap lines within the world central banking network. Almost one quarter of a trillion dollars of liquidity is now available!
To my mind, the tipping point has been reached. The era of go-it-alone, unilateral, cowboy nation behavior has collapsed. It should be very, very difficult for a nation to act independently in its own interest in the future.
This has been coming for many years now, but, as usual, it takes a crisis to pull it off. Four major books in recent years have given us a picture of this world and the lessons of these books should be taken to heart. These books should be “must” reading:
Mohamed El-Erian—“When Markets Collide”;
Thomas Friedman—The World is Flat”;
David Smick—“The World is Curved”;
Fareed Zakaria—“The Post-American World”.
None of these books contends that America will lose its premier position in the world. What all of these authors imply, however, is that the United States must become a partner with other countries rather than the arbiter of world behavior. Not only has the world become more connected and interdependent, the world has also become more uncertain. The only way nations can function within such a world is to cooperate with one another and seek solutions together because the problems and difficulties they face are huge and affect everyone.
Historically, I would place George W. Bush alongside François Mitterrand in terms of country leaders that got caught up in an ideological dead end. In the 1980s, Mitterrand, who was the president of France and a Socialist ideologue, attempted to “go-it-alone” and introduce a very socialist program which included substantial budget deficits underwritten by the French central bank, capital controls and a possible government take-over of industries. Capital fight followed and private business investment dried up. Finally, in March 1983, Mitterrand, after many fierce battles, gave in to world financial markets, gave up his ideological stance and moved to tighten up the budget, make the French central bank independent, and fight inflation. This whole experience “was a brutal warning to all political leaders that the regime of global capital made it much harder for any government, whatever its democratic political mandate, to go its own way.” (This quote comes from Steven Solomon, “The Confidence Game: How Unelected Central Bankers Are Governing the Changed World Economy,” pgs. 286-287.)
George W. Bush, upon election to the U. S. presidency, established a “go-it-alone” effort, only in his case, the ideology was tilted to the Reaganomics of the 1980s…cutting taxes was the true test of his conservatism, everything else be damned. (It was a remarkable experience to listen in the primaries to ALL of the Republican candidates running to become their Party’s presidential nominee. They ALL bent over backwards attempting to convince people that they were the true heir of Ronald Reagan because they were going to provide the most tax cuts to Americans when they were elected President.)
Bush 43 got his tax cuts…and the Federal Reserve supported the tax cuts by keeping real interest rates negative just like a good member of the administration should…and now, like Mitterrand, Bush 43 is getting his market response. The only difference is that Bush 43 is not repenting and not changing his administration’s policies. He doesn’t have to…he’s a lame duck.
Another world leader facing his “Mitterrand moment” is Vladimir Putin, Prime Minister of Russia. Putin is finding out that even a Russian oligarch cannot “go-it-alone” and escape unscathed in terms of the opinion of world financial markets. Since the invasion of Georgia, the Russian stock market has fallen 55% and capital seems to be fleeing the country. The Russian stock market was closed on Wednesday and Thursday to stop the decline and the Russian government pledged the equivalent of almost $20 billion to shore up market confidence.
Bottom line—world leaders must decide on one of two choices going forward with respect to globalization. Either they can pull in the carpet through a national catering to populism, protectionism, and withdrawal from free-trade agreements or they can work with other nations to build a coordinated, cooperative world economic order that is composed of equal partners and not prima donnas.
To me, this is no choice at all. True leadership is going to come from those that realize the need of world partnerships and don’t pander to a national populist frenzy. True leadership is going to come from those that subscribe to the basic fundamentals of economics and finance (as discussed in my posts of September 15 and September 17). And true leadership is going to come from those that do not believe that their nation can just “go-it-alone”.
To my mind, the tipping point has been reached. The era of go-it-alone, unilateral, cowboy nation behavior has collapsed. It should be very, very difficult for a nation to act independently in its own interest in the future.
This has been coming for many years now, but, as usual, it takes a crisis to pull it off. Four major books in recent years have given us a picture of this world and the lessons of these books should be taken to heart. These books should be “must” reading:
Mohamed El-Erian—“When Markets Collide”;
Thomas Friedman—The World is Flat”;
David Smick—“The World is Curved”;
Fareed Zakaria—“The Post-American World”.
None of these books contends that America will lose its premier position in the world. What all of these authors imply, however, is that the United States must become a partner with other countries rather than the arbiter of world behavior. Not only has the world become more connected and interdependent, the world has also become more uncertain. The only way nations can function within such a world is to cooperate with one another and seek solutions together because the problems and difficulties they face are huge and affect everyone.
Historically, I would place George W. Bush alongside François Mitterrand in terms of country leaders that got caught up in an ideological dead end. In the 1980s, Mitterrand, who was the president of France and a Socialist ideologue, attempted to “go-it-alone” and introduce a very socialist program which included substantial budget deficits underwritten by the French central bank, capital controls and a possible government take-over of industries. Capital fight followed and private business investment dried up. Finally, in March 1983, Mitterrand, after many fierce battles, gave in to world financial markets, gave up his ideological stance and moved to tighten up the budget, make the French central bank independent, and fight inflation. This whole experience “was a brutal warning to all political leaders that the regime of global capital made it much harder for any government, whatever its democratic political mandate, to go its own way.” (This quote comes from Steven Solomon, “The Confidence Game: How Unelected Central Bankers Are Governing the Changed World Economy,” pgs. 286-287.)
George W. Bush, upon election to the U. S. presidency, established a “go-it-alone” effort, only in his case, the ideology was tilted to the Reaganomics of the 1980s…cutting taxes was the true test of his conservatism, everything else be damned. (It was a remarkable experience to listen in the primaries to ALL of the Republican candidates running to become their Party’s presidential nominee. They ALL bent over backwards attempting to convince people that they were the true heir of Ronald Reagan because they were going to provide the most tax cuts to Americans when they were elected President.)
Bush 43 got his tax cuts…and the Federal Reserve supported the tax cuts by keeping real interest rates negative just like a good member of the administration should…and now, like Mitterrand, Bush 43 is getting his market response. The only difference is that Bush 43 is not repenting and not changing his administration’s policies. He doesn’t have to…he’s a lame duck.
Another world leader facing his “Mitterrand moment” is Vladimir Putin, Prime Minister of Russia. Putin is finding out that even a Russian oligarch cannot “go-it-alone” and escape unscathed in terms of the opinion of world financial markets. Since the invasion of Georgia, the Russian stock market has fallen 55% and capital seems to be fleeing the country. The Russian stock market was closed on Wednesday and Thursday to stop the decline and the Russian government pledged the equivalent of almost $20 billion to shore up market confidence.
Bottom line—world leaders must decide on one of two choices going forward with respect to globalization. Either they can pull in the carpet through a national catering to populism, protectionism, and withdrawal from free-trade agreements or they can work with other nations to build a coordinated, cooperative world economic order that is composed of equal partners and not prima donnas.
To me, this is no choice at all. True leadership is going to come from those that realize the need of world partnerships and don’t pander to a national populist frenzy. True leadership is going to come from those that subscribe to the basic fundamentals of economics and finance (as discussed in my posts of September 15 and September 17). And true leadership is going to come from those that do not believe that their nation can just “go-it-alone”.
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