This from the Financial Times on the morning of Friday, November 20, 2009: “Short-term US interest rates turned negative on Thursday as banks frantically stockpiled government securities in order to polish their balance sheets for the end of the year.” (See: http://www.ft.com/cms/s/0/52e0f72c-d575-11de-81ee-00144feabdc0.html.)
“The development highlighted the continuing distortions in the financial system more than a year after Lehman Brothers’ failure triggered a global crisis.”
“With the Federal Reserve maintaining an overnight target rate of zero to 0.25 per cent, investors are demonstrating a willingness to completely forgo interest income—or even to take a small loss—to own securities that are seen as safe.”
Just how “safe” do these banks have to appear?
The way they are acting indicate that they are not very “safe” at all.
Total reserves at depository institutions for the two weeks ending November 18 averaged $1,106 billion of which $1,068 were reserve balances with Federal Reserve Banks and $38 billion was vault cash used to satisfy required reserves.
The Fed has pumped roughly $350 billion into the banking system over the past 13-weeks primarily through the purchase of open market securities.
The effective Federal Funds rate has fallen steadily through the fall from August and averaged 11 basis points toward the end of the latest banking week.
Putting this information together indicates, to me, a banking system that is still seriously threatened and desirous of all the spare cash that it can attain. This is not a situation of quantitative easing but of bankers that are overly concerned with their solvency. The Federal Reserve is supplying reserves “on demand.” They are not, at this time, initiating the supply.
And, why might this be so?
Well, take a look at some of the headlines of the past week: United States mortgage delinquencies reach a record high; bankruptcies continue to remain near record levels; commercial real estate to remain major problem for years; commercial real estate too complex for government to bail out; unemployment at 25-year high; credit card delinquencies remain at record levels; and bank failures will continue to average about 3 a week for the next 12 to 18 months.
President Obama is even talking about the possibility of a “double-dip” recession.
The distortions in the financial system continue to be enormous. Even given these attitudes within the banking system, as the Financial Times reports, “many” of the leading US banks are “sitting on big trading profits.”
And, why not? When they can borrow for less than 35 basis points and lend out at 350 basis points who cannot make profits. When they can engage in the “carry” trade and profit from the declining dollar as well as earn large spreads, who cannot make profits.
Stock markets have been living off of momentum trading. There are so many unknowns about the future of business and industry, let alone finance that the justification for the rise in stock prices since March can continue to be questioned.
The real problem that exists in the market right now is the huge overhang of uncertainty. Not only are there unknowns about the recovery of industry and finance right now, there are also unknowns related to the huge cloud of government budget deficits that hang over the financial markets for the future and the concern over the ability of the Federal Reserve to “exit” from all the reserves it has put into the banking system.
The risk that is incorporated in this environment shows itself from time-to-time. Of course, the massive rise in the price of gold has been one place that investors have flocked to this year. Another continues to be the world-wide demand for United States Treasury securities. And, like yesterday, enough bad news causes currency traders to move rapidly back into United States dollars for “reasons of safety.”
I know many measures of market risk have declined substantially over the past six months or so. One has to go back to November 2007 to see a spread between Aaa and Baa yields as low as they are now. Likewise, with spreads on high-yield securities. The VIX index has fallen, once again, around its 52-week low. My belief is that these measures are so low because of the Fed’s interest rate policy. Interest rates, in general, are lower than they would be if the Fed was not forcing low rates on the market, and interest rate spreads are low for the same reason.
Still, there is much to be wary of. The only certainty that exists right now is that the Federal Reserve, and other central banks around the world, will keep short term interest rates low for an “extended period.” But, at some point, these rates are going to have to rise. Until they do, the interest arbitrage opportunities will remain and large financial institutions will continue to take away large profits from the financial market. Furthermore, the carry trade will continue to prosper using funds from the United States.
The question here is, when will all the investors that are “making it” through government support and government guarantees head for the doors. It is only logical that when there is an indication that the Federal Reserve is going to start letting interest rates rise that there will be a rush to get out of the market or move to the other side of the market. In such a situation, the financial firms that are big in the trading area cannot afford to be second or third getting to the door to pull their own exit.
How will this leave the banks that are written about in the Financial Times? If these banks, generally the smaller ones, have “stockpiled” government securities, how will they handle the decline in the prices of these securities once interest rates begin to rise? If they are concerned about their solvency now, what will their condition look like under this kind of scenario?
If there is a rush to get out of bonds, will the Federal Reserve back off its exit strategy?
Uncertainty continues to rule the markets. And, on top of the basic market insecurity, there seems to be a growing insecurity about our governmental leaders (Geithner and Bernanke to start with), and about the institutions of our government (see House attack on secrecy in the Federal Reserve). Uncertainty is bad enough but if people have little or no confidence in our leaders and our institutions where are they to turn?
Showing posts with label financial risk. Show all posts
Showing posts with label financial risk. Show all posts
Friday, November 20, 2009
Thursday, November 12, 2009
Discipline is Needed for Real Economic Performance
There is an interesting article inside the Wall Street Journal this morning comparing the fortunes of Brazil and Argentina. (See “Argentina Falters as Old Rival Rises,” http://online.wsj.com/article/SB125798960525944513.html#mod=todays_us_page_one.) In the article a research paper published in Argentina is quoted: “Since the middle of the last century, Argentina’s economy has endured a notable decline relative to the rest of the region, falling into ‘insignificance in the international context.’”
During this time period the government of Argentina followed a very undisciplined approach to economic policy while it kept itself in power and suppressed dissent. In 2001, Argentina declared the largest sovereign debt default in history. Things have not gotten much better since.
Brazil’s government, on the other hand, after years of self-serving activity started to get its act in order about 15 years ago under the leadership of former President Fernando Henrique Cardoso. Runaway inflation was brought under control and more orthodox and conservative economic policies were put into place. The current president, Luiz Inảcio Lula da Silva, has maintained these policies. (See ”Olympic Accolade Sets Seal on Progress” in Financial Times: http://www.ft.com/cms/s/0/d16a27a6-c8d9-11de-8f9d-00144feabdc0.html.)
The central bank in Brazil is treated as independent and the stability that has been created has brought about lower interest rates and a growing mortgage market that has stimulated a construction boom. An emerging middle class has emerged and has supported the effort to obtain the Olympics and other international initiatives that will lead to a vast expansion of the Brazilian infrastructure in upcoming years.
Over and over again we see examples of the benefits of discipline in economic and financial affairs. We also see that the loss of discipline does nothing but eventually lead the undisciplined into undesirable situations in which all of the alternative options that are available to correct the condition are undesirable. In other words, there are no good choices to get one out of the difficulty in which one finds oneself.
Inflation represents a loss of discipline that always ends up hurting a large number of people. Furthermore, the consequences of inflation can leave a wreckage in which policymakers are left with no good alternative policies to follow. Often, the path of least resistance in such situations is to reflate.
Historically, governments have always excelled in spending more than they could bring in through taxes and other levies. Thus, going into debt is a normal governmental activity. Other than outright default on debt, governments got very good at inflating themselves out of excessive amounts of debt. And, the ability to inflate was helped in the twentieth century by developments in information technology: so governments got better and better at inflating their economies. (See “This Time is Different” by Reinhart and Rogoff: http://seekingalpha.com/article/171610-crisis-in-context-this-time-is-different-eight-centuries-of-financial-folly-by-carmen-m-reinhart-and-kenneth-s-rogoff.)
Philosophically, this bias toward inflation was supported by Keynesian economics as the argument was made that twentieth century governments could not allow wages and prices to fall. (See http://seekingalpha.com/article/167893-john-maynard-keynes-and-international-relations-economic-paths-to-war-and-peace-by-donald-markwell.) (Also see op-ed piece in Wall Street Journal “The Fed’s Woody Allen Policy”: http://online.wsj.com/article/SB10001424052748704402404574529510954803156.html.) So the twentieth century saw not only an improved technology to inflate but also a respected philosophy that supported a government policy that had a bias toward inflation.
The point is that inflation creates an incentive for economic units to grow and to take on greater and greater amounts of risk. This is, of course, because inflation favors debtors versus creditors. It pays individuals and businesses to take on more and more debt. And, this policy is particularly successful, at least in the early stages, when the central bank forces interest rates to stay excessively low.
Risk is minimized because inflation creates a situation of moral hazard by “bailing out” people who take on large amounts of exposure to risk. For example, one rule of thumb that floats around the banking world from time-to-time is that “In a time of inflation, anyone can become a contractor for building houses. One only learns who is bad at it is when inflation slows down or stops.” The idea can be expanded to say that in inflationary times, anyone can appear to be successful. As Citigroup’s CEO Charles O. Prince III blithely stated: “As long as the music is still playing, we are all still dancing…” Risk takes a back seat.
Second, size becomes all important! Since inflation reduces the real value of debt it becomes silly for individuals or businesses not to leverage up. What is it to create $30 of debt for $1 of equity you have? And, why not $35…or, $40? Using such leverage magnifies performance! Using such leverage magnifies bonuses! Using such leverage allows us to reach a size where we become “Too Big to Fail”!
Finally, inflation allows individuals and businesses to forget about producing good quality goods and services and diverts attention to “speculative trading” and “financial games”. Since outsize rewards and bonuses go to areas that prosper during inflationary times, more and more “talent” moves into areas connected with finance or with trading. Less and less emphasis is placed upon production and quality because rising prices contribute more to profits than does improvements in what goods and services are offered. As a consequence, the composition of the nation’s workforce becomes tilted toward finance and the financial industries.
In effect, inflation destroys discipline. And, once discipline is reduced, problems occur and until discipline is renewed the problems just cumulate and re-enforce one another. This happens in families, in businesses, and in governments.
But, as is usual in economics, the consequences associated with destructive incentives are not always easy to identify. (See “Feakonomics” or “Superfreakonomics”: http://seekingalpha.com/article/166993-the-power-of-unintended-consequences-superfreakonomics-by-steven-d-levitt-and-stephen-j-dubner.) It is so much easier to blame executive greed for the troubles we have been experiencing. This explanation covers so much territory: the growth of finance in the economy relative to “productive” jobs; the taking on of more and more leverage; the taking on of more and more risky deals; the emphasis on speculative trading rather than productive producing; and the payment of excessive salaries and bonuses.
In fact, it is often hard to identify the benefits of greater discipline unless examples of that discipline are placed alongside examples of a lack of discipline. This is why the Argentina/Brazil contrast caught my attention.
Such stories, however, cause one to worry about whether the United States will once again be able to regain its economic discipline. The fear is that as long as governmental policies contain an inflationary bias, the solution to the problems caused by this inflationary bias will continue to be re-flation. If this is so, discipline will continue to be lacking in this country, both personally and corporately. Maybe it is not so surprising that Brazil won the voting for the Olympics over the United States!
During this time period the government of Argentina followed a very undisciplined approach to economic policy while it kept itself in power and suppressed dissent. In 2001, Argentina declared the largest sovereign debt default in history. Things have not gotten much better since.
Brazil’s government, on the other hand, after years of self-serving activity started to get its act in order about 15 years ago under the leadership of former President Fernando Henrique Cardoso. Runaway inflation was brought under control and more orthodox and conservative economic policies were put into place. The current president, Luiz Inảcio Lula da Silva, has maintained these policies. (See ”Olympic Accolade Sets Seal on Progress” in Financial Times: http://www.ft.com/cms/s/0/d16a27a6-c8d9-11de-8f9d-00144feabdc0.html.)
The central bank in Brazil is treated as independent and the stability that has been created has brought about lower interest rates and a growing mortgage market that has stimulated a construction boom. An emerging middle class has emerged and has supported the effort to obtain the Olympics and other international initiatives that will lead to a vast expansion of the Brazilian infrastructure in upcoming years.
Over and over again we see examples of the benefits of discipline in economic and financial affairs. We also see that the loss of discipline does nothing but eventually lead the undisciplined into undesirable situations in which all of the alternative options that are available to correct the condition are undesirable. In other words, there are no good choices to get one out of the difficulty in which one finds oneself.
Inflation represents a loss of discipline that always ends up hurting a large number of people. Furthermore, the consequences of inflation can leave a wreckage in which policymakers are left with no good alternative policies to follow. Often, the path of least resistance in such situations is to reflate.
Historically, governments have always excelled in spending more than they could bring in through taxes and other levies. Thus, going into debt is a normal governmental activity. Other than outright default on debt, governments got very good at inflating themselves out of excessive amounts of debt. And, the ability to inflate was helped in the twentieth century by developments in information technology: so governments got better and better at inflating their economies. (See “This Time is Different” by Reinhart and Rogoff: http://seekingalpha.com/article/171610-crisis-in-context-this-time-is-different-eight-centuries-of-financial-folly-by-carmen-m-reinhart-and-kenneth-s-rogoff.)
Philosophically, this bias toward inflation was supported by Keynesian economics as the argument was made that twentieth century governments could not allow wages and prices to fall. (See http://seekingalpha.com/article/167893-john-maynard-keynes-and-international-relations-economic-paths-to-war-and-peace-by-donald-markwell.) (Also see op-ed piece in Wall Street Journal “The Fed’s Woody Allen Policy”: http://online.wsj.com/article/SB10001424052748704402404574529510954803156.html.) So the twentieth century saw not only an improved technology to inflate but also a respected philosophy that supported a government policy that had a bias toward inflation.
The point is that inflation creates an incentive for economic units to grow and to take on greater and greater amounts of risk. This is, of course, because inflation favors debtors versus creditors. It pays individuals and businesses to take on more and more debt. And, this policy is particularly successful, at least in the early stages, when the central bank forces interest rates to stay excessively low.
Risk is minimized because inflation creates a situation of moral hazard by “bailing out” people who take on large amounts of exposure to risk. For example, one rule of thumb that floats around the banking world from time-to-time is that “In a time of inflation, anyone can become a contractor for building houses. One only learns who is bad at it is when inflation slows down or stops.” The idea can be expanded to say that in inflationary times, anyone can appear to be successful. As Citigroup’s CEO Charles O. Prince III blithely stated: “As long as the music is still playing, we are all still dancing…” Risk takes a back seat.
Second, size becomes all important! Since inflation reduces the real value of debt it becomes silly for individuals or businesses not to leverage up. What is it to create $30 of debt for $1 of equity you have? And, why not $35…or, $40? Using such leverage magnifies performance! Using such leverage magnifies bonuses! Using such leverage allows us to reach a size where we become “Too Big to Fail”!
Finally, inflation allows individuals and businesses to forget about producing good quality goods and services and diverts attention to “speculative trading” and “financial games”. Since outsize rewards and bonuses go to areas that prosper during inflationary times, more and more “talent” moves into areas connected with finance or with trading. Less and less emphasis is placed upon production and quality because rising prices contribute more to profits than does improvements in what goods and services are offered. As a consequence, the composition of the nation’s workforce becomes tilted toward finance and the financial industries.
In effect, inflation destroys discipline. And, once discipline is reduced, problems occur and until discipline is renewed the problems just cumulate and re-enforce one another. This happens in families, in businesses, and in governments.
But, as is usual in economics, the consequences associated with destructive incentives are not always easy to identify. (See “Feakonomics” or “Superfreakonomics”: http://seekingalpha.com/article/166993-the-power-of-unintended-consequences-superfreakonomics-by-steven-d-levitt-and-stephen-j-dubner.) It is so much easier to blame executive greed for the troubles we have been experiencing. This explanation covers so much territory: the growth of finance in the economy relative to “productive” jobs; the taking on of more and more leverage; the taking on of more and more risky deals; the emphasis on speculative trading rather than productive producing; and the payment of excessive salaries and bonuses.
In fact, it is often hard to identify the benefits of greater discipline unless examples of that discipline are placed alongside examples of a lack of discipline. This is why the Argentina/Brazil contrast caught my attention.
Such stories, however, cause one to worry about whether the United States will once again be able to regain its economic discipline. The fear is that as long as governmental policies contain an inflationary bias, the solution to the problems caused by this inflationary bias will continue to be re-flation. If this is so, discipline will continue to be lacking in this country, both personally and corporately. Maybe it is not so surprising that Brazil won the voting for the Olympics over the United States!
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