One of the things that bothers me about all the talk concerning the re-regulation of banks and other financial institutions is that it is “framed” within the context of the Great Depression and the Glass-Steagall Act, the Banking Act of 1933.
Get real people, times have changed!
We are not back in the age of the manufacturing, we are in the information age. We are not early in the 20th century, we are at the beginning of the 21st century. And, while no person commands my respect in the same way that Paul Volcker does, we do not need regulation that is in the mold of Glass-Steagall.
Finance is information. This dollar bill can be exchanged for that dollar bill. These dollars can be exchanged for so many Euros. Even more so, my set of 0s and 1s can be traded for your set of 0s and 1s: your checking account, my debit card, and her credit card.
Even individuals don’t trade in anything more than 0s and 1s these days. Finance, even at the most elemental level is just about information. And the more sophisticated that one gets, the more esoteric the information flow can become. And, that is the issue.
But, the post-World War II transformation in the financial industry began in earnest in the 1960s. The commercial banks were constrained by the Glass-Steagall Act and by geographic constraints. Yet, the world was growing. And, the banks, in order to be competitive in the world needed to become bigger and more geographically dispersed.
Three financial innovations were in place by the end of the 1960s that began to change of everything: the creation of the Bank Holding Company; the invention of the large denomination negotiable Certificate of Deposit; and the Eurodollar account.
The Bank Holding Company gave banks a freedom that they did not have when their charters limited their activity to just being a deposit taking bank. The large denomination negotiable Certificate of Deposit was an innovation that indicated that just about any financial instrument could become marketable. The development of the Eurodollar market showed that banks could raise funds worldwide and in different forms.
These three changes, when combined, turned large banks into liability managers and not asset managers. In essence, the invention of the large CD and the Eurodollar put an end to any constraints on the size of a financial institution. These instruments allowed banks to buy or sell all the funds they wanted at the going market interest rate. For all intents and purposes, by the start of the 1970s all interstate constraints on bank operations were history. And, except for capital requirements, all constraints on the size of financial institutions were history. The ability to manage liabilities ended these boundaries.
Other developments took place during this time. I will just discuss two of them. The first is the mortgage-backed security. In the 1960s politicians decided that if more housing got into the hands of the middle income classes that there would be a greater chance that they could get re-elected. They considered the mortgage, a long term asset. Then they looked at pension funds and insurance companies and saw that these institutions held long term assets. Mortgages were not quite what the pension funds or insurance companies wanted: mortgages came in sizes less than $100,000 in value when they wanted assets in the millions of dollars; also mortgages paid principal and interest whereas these funds and companies just wanted interest payments. So there were some hurdles to overcome.
As people worked with the idea, they saw that the mortgages generated and held by depository institutions could be bundled up into another form of security in order to get the size of asset needed. They also worked with the idea that the cash flow streams from the initial mortgages could be cut up in different ways so as to make individual streams of cash flows that were more desirable to the pension funds and insurance companies. Eventually they saw that securities could even be created that paid just interest (Interest Only securities or IOs) or that just made principal payments (Principal Only or P0s).
Bottom line, cash flows could be cut up (or in current terms ‘sliced and diced’) in any way that could sell! And, what is the abstract view of this? Cash flows are just 0s and 1s and 0s and 1s can be put in any form that anyone wants. These cash flow 0s and 1s could have assets behind them like houses, autos, or credit cards, or they could just be cash flows. What difference did it really make?
Of course, it could make a lot of difference. (I can’t be too ironic in what I write!)
If cash flows could just be created, why not asset values? Hence the idea of “notional” values.
Take an interest rate swap, for example. No money changes hands, the whole transaction is based on ‘notional’ values. Thus, a swap of a fixed interest payment arrangement for a variable interest payment arrangement could be achieved. Both parties are ‘better off’ and there is no real exchange of liabilities.
I could go on, but I don’t think I need to. By now you can see where I am going. Finance, today, is just 0s and 1s and people, individuals as well as institutions, don’t need real assets on which to base cash flows and cash flows can be ‘sliced and diced’ in any way imaginable so as to meet the needs and desires of those that want to acquire them. In essence, everything, all information, can be computerized and treated as interchangeable.
At least in the machines: at least ‘on paper’. But, this is the modern world of finance. That is why mathematicians, statisticians, physicists, and other “Quants” can play with this stuff. The modern world of finance is just information and information is just 0s and 1s. At the highest level, it is not people and assets and things. It is just 0s and 1s.
And, if you are concerned with this then you need to be aware of what is coming. This is the world of the future. There is a vibrant area of study that deals with information markets. The idea is that everything, and I mean everything, can be transformed into information and a market can be created for it. Robert Shiller, the behavioral economist of “Irrational Exuberance” is one of the leaders of this field.
Modern day finance is the model with the idea that this model can be extended to anything and everything. So get ready!
The fundamental point I want to make today is that the world of finance in the Age of Information is entirely different than the world of finance in the Age of Manufacturing. The 1930s are not directly transferrable into the 2010s! The rules and regulation of the modern world are not the same as the rules and regulations that needed to be applied to the world of the thirties. And the way to regulate the world of the 2010s is the subject of my next post.
Let me just close by saying that even Paul Volcker missed the point when he said that the only banking innovation of the last 50 years that was significant was the ATM machine, that all the other financial innovation contributed nothing to the age. The ATM is an ‘information age’ machine and is a part of the innovation that took place in the Age of Information. If one really understands this age then one cannot make the distinction between the ATM and all the other financial innovations that took place during this time period. Volcker has missed the point!
Sunday, January 24, 2010
Saturday, January 23, 2010
Politics and Regulation
I would like to recommend two more articles on the growing move to greater regulation. Both appeared this Saturday morning. The first by John Authers, “Politicians look to enter another Faustian pact,” appeared in the Financial Times (http://www.ft.com/cms/s/0/b1379f2a-07bf-11df-915f-00144feabdc0.html). The second by Jason Zweig, “Will New Rules Tame the Wall Street Tiger?” appeared in the Wall Street Journal (http://online.wsj.com/article/SB20001424052748703822404575019423049886674.html#mod=todays_us_section_b).
Both articles discuss the unfolding drama in Washington, D. C. concerning the direction events are taking and both authors make some suggestion as to the direction regulation should take.
The important take-away from each article, however, is that politicians often enact laws, rules, and regulations that either miss the point or provide impediments to competition that banks and other financial institutions spend millions of dollars to get around, eventually succeeding.
Zweig argues in his piece that “the bad behavior on Wall Street in the 1920s wasn’t really caused by the blurring of commercial and investment banking”. The bad behavior he lists include “collusion among firms to jack up prices, sweetheart deals for favored clients, shoddy due diligence, too little disclosure of risk, too much trading on borrowed money, betting that securities would go down while telling the public they would go up.”
However, Zweig presents the argument that “there is a strain in the American psyche that has always worried about concentration of financial power.” Drawing upon this populist concern, Senator Carter Glass and Representative Henry Steagall were able to pass legislation fondly remembered as the Banking Act of 1933.
[Disclosure: I was born in the state of Missouri, formally a Unit Banking state, and my grandfather was a Missouri banker. My hand was photographed in the check copying machine in the latter part of the 1940s. Missouri bankers were paranoid about the “concentration of financial power!"]
Zweig’s conclusion is that “the Obama proposals are politically shrewd, because they tap into the same populist anger that motivated the Glass-Steagall legislation in 1933.”
Authers also compares the present time with that of the 1930s. He prefaces his discussion of the 1930s by stating that “Tighter regulation involves a Faustian bargain, of accepting greater stability in return for limiting ‘upside’, or potential growth.” The Glass-Steagall Act, the Faustian bargain, “worked” as “Bank runs, endemic for decades before the 1930s, disappeared in the US after this package of reforms. Growth in both markets and the economy was relatively stable.”
“Over the years, financial ingenuity and regulatory changes found a way around most of the repressive 1930s rules.” By 1998, there was basically nothing left and the rules were finally buried.
“The White House’s proposal on Thursday can loosely be called an attempt to apply the spirit of Glass-Steagall for the new era.”
The end result of the process will be up to Congress.
And what hope do we have?
Authers’ conclusion: “It is not clear that as a deliberative body it (the Congress) is capable of making a coherent decision.”
“It looks as though US and European political institutions are about to go through much the same test that they failed in the autumn of 2008. It is the risk that they fail again that worries the market.”
‘Nuff said!
See my position on this point: “Bracing for the New Banking Regulations” (http://seekingalpha.com/article/183203-bracing-for-new-banking-regulations).
Both articles discuss the unfolding drama in Washington, D. C. concerning the direction events are taking and both authors make some suggestion as to the direction regulation should take.
The important take-away from each article, however, is that politicians often enact laws, rules, and regulations that either miss the point or provide impediments to competition that banks and other financial institutions spend millions of dollars to get around, eventually succeeding.
Zweig argues in his piece that “the bad behavior on Wall Street in the 1920s wasn’t really caused by the blurring of commercial and investment banking”. The bad behavior he lists include “collusion among firms to jack up prices, sweetheart deals for favored clients, shoddy due diligence, too little disclosure of risk, too much trading on borrowed money, betting that securities would go down while telling the public they would go up.”
However, Zweig presents the argument that “there is a strain in the American psyche that has always worried about concentration of financial power.” Drawing upon this populist concern, Senator Carter Glass and Representative Henry Steagall were able to pass legislation fondly remembered as the Banking Act of 1933.
[Disclosure: I was born in the state of Missouri, formally a Unit Banking state, and my grandfather was a Missouri banker. My hand was photographed in the check copying machine in the latter part of the 1940s. Missouri bankers were paranoid about the “concentration of financial power!"]
Zweig’s conclusion is that “the Obama proposals are politically shrewd, because they tap into the same populist anger that motivated the Glass-Steagall legislation in 1933.”
Authers also compares the present time with that of the 1930s. He prefaces his discussion of the 1930s by stating that “Tighter regulation involves a Faustian bargain, of accepting greater stability in return for limiting ‘upside’, or potential growth.” The Glass-Steagall Act, the Faustian bargain, “worked” as “Bank runs, endemic for decades before the 1930s, disappeared in the US after this package of reforms. Growth in both markets and the economy was relatively stable.”
“Over the years, financial ingenuity and regulatory changes found a way around most of the repressive 1930s rules.” By 1998, there was basically nothing left and the rules were finally buried.
“The White House’s proposal on Thursday can loosely be called an attempt to apply the spirit of Glass-Steagall for the new era.”
The end result of the process will be up to Congress.
And what hope do we have?
Authers’ conclusion: “It is not clear that as a deliberative body it (the Congress) is capable of making a coherent decision.”
“It looks as though US and European political institutions are about to go through much the same test that they failed in the autumn of 2008. It is the risk that they fail again that worries the market.”
‘Nuff said!
See my position on this point: “Bracing for the New Banking Regulations” (http://seekingalpha.com/article/183203-bracing-for-new-banking-regulations).
Thursday, January 21, 2010
Obama's Push for Bank Reform
“President Obama on Thursday will publicly propose giving bank regulators the power to limit the size of the nation’s largest banks and the scope of their risk-taking activities.” This from the New York Times (http://www.nytimes.com/2010/01/21/business/21volcker.html?hp) and from the Wall Street Journal (http://online.wsj.com/article/SB10001424052748704320104575015910344117800.html?mod=WSJ_hps_LEFTWhatsNews).
After the Tuesday victory of Scott Brown in the Massachusetts Senate race, the Obama administration seems to be going “populist” and taking on Wall Street and the bankers seems to be the way to go!
Simon Johnson, a professor at MIT, published this advice on the New Republic website this morning: “Run hard now, against the big banks. If they oppose the administration, this will make their power more blatant--and just strengthen the case for breaking them up. And if the biggest banks stay quiet, so much the better--go for even more sensible reform to constrain reckless risk-taking in the financial sector.” (See http://www.tnr.com/blog/simon-johnson/trap-their-own-design.)
This, I believe, is the wrong direction for the Obama administration to take. First of all, I believe it is incorrect. See for example my post from yesterday, “Blame the Central Bankers” (http://seekingalpha.com/article/183429-blame-the-central-bankers). Also see my post from Wednesday “Bracing for New Banking Regulations” (http://seekingalpha.com/article/183203-bracing-for-new-banking-regulations).
Secondly, there is strong evidence that you cannot win on a “populist” platform. Arguing from the “populist” approach can vote someone out of office, but it doesn’t seem to be able to elect anyone to office.
I still believe that Al Gore had the 2000 election wrapped up until he took on the “populist” mantel during the election campaign. I can still see him overlooking the Mississippi River in Mark Twain’s childhood home town of Hannibal, Missouri. Then I heard him starting to expound on the world as a “populist” politician would. My comment to others at that time: if Gore keeps heading in this direction he has lost the election!
The same advice also comes from one of the most astute political families in America: the Clinton family. In Robert Rubin’s book “In an Uncertain World: Tough Choices from Wall Street to Washington,” Rubin presents a discussion he had with Hillary Clinton. He wanted to take a public approach to an issue that was couched in “populist” language. Rubin states that Hillary responded strongly to his ideas with the comment that one could not win elections relying on a “populist” message. Rubin, consequently, backed off this approach to presenting the matter.
And, he succeeded in getting what he was after, politically.
I believe that the approach the President is taking toward banking reform should be strongly rejected. Not only do I believe that it will not help him to get re-elected, I believe that it would be a disaster for the American financial system!
After the Tuesday victory of Scott Brown in the Massachusetts Senate race, the Obama administration seems to be going “populist” and taking on Wall Street and the bankers seems to be the way to go!
Simon Johnson, a professor at MIT, published this advice on the New Republic website this morning: “Run hard now, against the big banks. If they oppose the administration, this will make their power more blatant--and just strengthen the case for breaking them up. And if the biggest banks stay quiet, so much the better--go for even more sensible reform to constrain reckless risk-taking in the financial sector.” (See http://www.tnr.com/blog/simon-johnson/trap-their-own-design.)
This, I believe, is the wrong direction for the Obama administration to take. First of all, I believe it is incorrect. See for example my post from yesterday, “Blame the Central Bankers” (http://seekingalpha.com/article/183429-blame-the-central-bankers). Also see my post from Wednesday “Bracing for New Banking Regulations” (http://seekingalpha.com/article/183203-bracing-for-new-banking-regulations).
Secondly, there is strong evidence that you cannot win on a “populist” platform. Arguing from the “populist” approach can vote someone out of office, but it doesn’t seem to be able to elect anyone to office.
I still believe that Al Gore had the 2000 election wrapped up until he took on the “populist” mantel during the election campaign. I can still see him overlooking the Mississippi River in Mark Twain’s childhood home town of Hannibal, Missouri. Then I heard him starting to expound on the world as a “populist” politician would. My comment to others at that time: if Gore keeps heading in this direction he has lost the election!
The same advice also comes from one of the most astute political families in America: the Clinton family. In Robert Rubin’s book “In an Uncertain World: Tough Choices from Wall Street to Washington,” Rubin presents a discussion he had with Hillary Clinton. He wanted to take a public approach to an issue that was couched in “populist” language. Rubin states that Hillary responded strongly to his ideas with the comment that one could not win elections relying on a “populist” message. Rubin, consequently, backed off this approach to presenting the matter.
And, he succeeded in getting what he was after, politically.
I believe that the approach the President is taking toward banking reform should be strongly rejected. Not only do I believe that it will not help him to get re-elected, I believe that it would be a disaster for the American financial system!
Wednesday, January 20, 2010
Blame the Central Bankers more than the Private Bankers
“I cannot help thinking that the central bankers are escaping very lightly in the post-crisis dust-up. For while incentive structures in banking exacerbated the credit bubble, they were a much less potent cause of trouble than central bank behavior across the world.”
So writes John Plender in the Financial Times this morning (See “Blame the Central Bankers more than the Private Bankers”: http://www.ft.com/cms/s/0/58aa12a8-0575-11df-a85e-00144feabdc0.html.)
This article should be read!
One point that Plender makes is that maybe we need fewer academic central bankers and “more private sector bankers with a practical understanding of markets.” You mean heading up the Economics Department at Princeton is not enough to be the head of a central bank?
“The academics who dominate modern central banking were ideologically committed to the notion of efficient markets and to exclusive reliance on inflation targeting regardless of imbalances arising from easy credit and soaring asset prices.”
The consequence? An asymmetrical approach to monetary policy: “Interest rates were reduced when asset prices fell, but were not raised in response to wildly overheating markets.”
This focus gave us the ridiculously low interest rates in the United States from 2002 through to 2004 and the subsequent asset (housing) bubble which accompanied them. This conclusion comes even after and “In spite of the bizarre recent assertion by Ben Bernanke…that the Fed was largely innocent in the matter of bubble creation.”
This mindset, Plender argues, is still around and is present in some of the approaches to fight systemic risk and to provide “macro-prudential” regulation and supervision. The mix of policy that these “academic” officials are proposing “suffers from the single disadvantage that it will not work.”
What Mr. Plender really asks for is central bankers that have less experience with the academic study of banking and financial markets and that have more practical experience in these markets.
The particular approach followed by central bankers, Plender continues, led to the rise in bank leverage which was “a far more important factor” in the crisis than was financial innovation.
How could this be?
Well, the incentive structures in banking placed emphasis on current bank earnings. And, the surest way to increase performance during the 1990s and 2000s was to leverage up the portfolio so as to earn a few more basis points. This behavior had to continue because competitors kept doing it. As “Chuck” Prince, the Chairman and CEO of Citigroup, so eloquently put it, if the music is still playing you must continue to dance. Competition demanded more basis points to keep in the dance for investor’s money.
And, the continued increases in leverage were underwritten by the monetary authorities who followed the philosophy of central banking described above. When the bubble burst, the leverage, of course, worked in the opposite direction.
I would highly recommend reading Plender’s article.
So writes John Plender in the Financial Times this morning (See “Blame the Central Bankers more than the Private Bankers”: http://www.ft.com/cms/s/0/58aa12a8-0575-11df-a85e-00144feabdc0.html.)
This article should be read!
One point that Plender makes is that maybe we need fewer academic central bankers and “more private sector bankers with a practical understanding of markets.” You mean heading up the Economics Department at Princeton is not enough to be the head of a central bank?
“The academics who dominate modern central banking were ideologically committed to the notion of efficient markets and to exclusive reliance on inflation targeting regardless of imbalances arising from easy credit and soaring asset prices.”
The consequence? An asymmetrical approach to monetary policy: “Interest rates were reduced when asset prices fell, but were not raised in response to wildly overheating markets.”
This focus gave us the ridiculously low interest rates in the United States from 2002 through to 2004 and the subsequent asset (housing) bubble which accompanied them. This conclusion comes even after and “In spite of the bizarre recent assertion by Ben Bernanke…that the Fed was largely innocent in the matter of bubble creation.”
This mindset, Plender argues, is still around and is present in some of the approaches to fight systemic risk and to provide “macro-prudential” regulation and supervision. The mix of policy that these “academic” officials are proposing “suffers from the single disadvantage that it will not work.”
What Mr. Plender really asks for is central bankers that have less experience with the academic study of banking and financial markets and that have more practical experience in these markets.
The particular approach followed by central bankers, Plender continues, led to the rise in bank leverage which was “a far more important factor” in the crisis than was financial innovation.
How could this be?
Well, the incentive structures in banking placed emphasis on current bank earnings. And, the surest way to increase performance during the 1990s and 2000s was to leverage up the portfolio so as to earn a few more basis points. This behavior had to continue because competitors kept doing it. As “Chuck” Prince, the Chairman and CEO of Citigroup, so eloquently put it, if the music is still playing you must continue to dance. Competition demanded more basis points to keep in the dance for investor’s money.
And, the continued increases in leverage were underwritten by the monetary authorities who followed the philosophy of central banking described above. When the bubble burst, the leverage, of course, worked in the opposite direction.
I would highly recommend reading Plender’s article.
Tuesday, January 19, 2010
The Move Toward More Regulation
The air is heating up when it comes to the subject of banking regulation. The only advice I can offer those considering changes in the regulatory environment is “be careful.”
The main reason for this caution?
John Bogle, the founder and former chief executive of the Vanguard Group, wrote it very succinctly in the Wall Street Journal this morning: “There are few regulations that smart, motivated, targets cannot evade.” (See “Restoring Faith in Financial Markets: http://online.wsj.com/article/SB20001424052748703436504574640523013840290.html#mod=todays_us_opinion.)
Another reason for this caution comes from Mervyn King, governor of the Bank of England: “The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion.” Andrew Ross Sorkin provided this quote in the New York Times this morning. (See “Big, in Banks, is in the Eye of the Beholder”: http://www.nytimes.com/2010/01/19/business/19sorkin.html?ref=business.)
According to these two individuals, banks cannot be prevented from engaging in the types of activities that they really want to be engaged in and there is little that supervision can do to keep them from failing due to speculative activities.
In other words, bankers cannot be protected from themselves.
Why is this?
There are two very good reasons. First, in this Information Age, almost anything can be done with cash flows and risk, and regulators will always be behind the curve in trying to catch up with what is going on in the financial sector. After the financial crisis of 2008, this type of behavior has began again in the bigger banking organizations and I would argue that the regulators are already at least three- to six-months behind what these institutions are now doing.
Second, the financial community is truly global now and the flow of money (information) is very fluid. If something cannot be done somewhere it can always move elsewhere. Discussions about what the BRICs are doing (see the week long series of articles on Brazil, Russia, India, and China in the Financial Times this week) present one picture of how the world is continuing to shrink, financially. Another picture of the flow of funds throughout the world is captured in a recent research paper by MIT’s Ricardo Caballero which is quoted in the recent article in Time magazine: “Did Foreigners Cause America’s Financial Crisis?” by Stephen Gandel. (See http://www.time.com/time/business/article/0,8599,1954240,00.html.)
I would like to make one other point: many people continue to assume that behind active governmental policy and regulation are government officials and bureaucrats that are either more perceptive and talented than their private sector counterparts, or, are less self-serving than their private sector counterparts, or, are better placed to observe how the world works than are their private sector counterparts.
In my estimation, government officials and bureaucrats are not more capable or talented than their private sector counterparts and they are certainly not less self-interested. Furthermore, in my experience in government, they are not better placed or better informed about what is going on in the world. This latter point is one that the economist Friedrich Hayek made over and over again.
There is no research that I have seen that indicates that those that work for government perform any better than those that work in the private sector. If anything, the argument goes the other way: government cannot hire or attract people of the same quality that work in the private sector. Furthermore, there is no evidence to prove, in my mind, that people that work in government service are any less greedy for advancement or personal gain than are people that work in the private sector.
Finally, in their attempt to protect the society from “bad outcomes” the government has tended to err on the side of creating an environment for greater and greater private sector risk-taking. This has come in several forms. The obvious case currently is the “Greenspan put” or the bank bailouts that have created moral hazard and greater and greater amounts of risk taking. (See the article by Peter Boone and Simon Johnson in today’s Financial Times, “A Bank Levy will not stop the Doomsday Cycle”: http://www.ft.com/cms/s/0/e118fcc2-0461-11df-8603-00144feabdc0.html.)
Another case relates to the underlying emphasis on trying to maintain low levels of unemployment. This has created an environment that encourages risk taking in terms of increased financial leverage, maturity mismatching, and financial innovation. I have referred to the whole period from 1960 to the present as one in which the government underwrote an environment of credit inflation.
Furthermore, this continual effort to stimulate the economy has tended to put people back to work in jobs that were outdated or in industries that needed change. In order to protect the worker, the easiest and best approach was to put workers back into their old jobs. We see the consequence of this policy in the problems experienced in the auto industry, the steel industry, and many other areas that formerly represented the industrial base of America.
Last, special interest programs, such as housing, although designed with good intent, have ended up with several government agencies serving as the residual lender and insurer of mortgages. Over the past several years we have focused on Fannie Mae and Freddie Mac, but it is now obvious that we cannot ignore the FHA. (See the article by Nick Timiraos in today’s Wall Street Journal, “Souring Mortgages, Weak Market Put Loan Agency on a Tightrope”: http://online.wsj.com/article/SB20001424052748704586504574654710172000646.html#mod=todays_us_page_one.) This effort has resulted in the federal government becoming biggest player in the housing market, by a long shot!
To me, regulation of the banking sector should focus on two things. The first relates to capital requirements. They should be raised.
Second, there needs to be greater transparency and openness in transactions, deals, and balance sheets.
Almost every other kind of regulation that can be put on the books, in the words of John Bogle, can be evaded. We cannot protect the bankers from themselves. But, we can attempt to protect investors and other wealth holders by giving them more information about those institutions they want to invest in. But, like the bankers, ultimately we cannot protect these investors and other wealth holders from themselves.
The main reason for this caution?
John Bogle, the founder and former chief executive of the Vanguard Group, wrote it very succinctly in the Wall Street Journal this morning: “There are few regulations that smart, motivated, targets cannot evade.” (See “Restoring Faith in Financial Markets: http://online.wsj.com/article/SB20001424052748703436504574640523013840290.html#mod=todays_us_opinion.)
Another reason for this caution comes from Mervyn King, governor of the Bank of England: “The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion.” Andrew Ross Sorkin provided this quote in the New York Times this morning. (See “Big, in Banks, is in the Eye of the Beholder”: http://www.nytimes.com/2010/01/19/business/19sorkin.html?ref=business.)
According to these two individuals, banks cannot be prevented from engaging in the types of activities that they really want to be engaged in and there is little that supervision can do to keep them from failing due to speculative activities.
In other words, bankers cannot be protected from themselves.
Why is this?
There are two very good reasons. First, in this Information Age, almost anything can be done with cash flows and risk, and regulators will always be behind the curve in trying to catch up with what is going on in the financial sector. After the financial crisis of 2008, this type of behavior has began again in the bigger banking organizations and I would argue that the regulators are already at least three- to six-months behind what these institutions are now doing.
Second, the financial community is truly global now and the flow of money (information) is very fluid. If something cannot be done somewhere it can always move elsewhere. Discussions about what the BRICs are doing (see the week long series of articles on Brazil, Russia, India, and China in the Financial Times this week) present one picture of how the world is continuing to shrink, financially. Another picture of the flow of funds throughout the world is captured in a recent research paper by MIT’s Ricardo Caballero which is quoted in the recent article in Time magazine: “Did Foreigners Cause America’s Financial Crisis?” by Stephen Gandel. (See http://www.time.com/time/business/article/0,8599,1954240,00.html.)
I would like to make one other point: many people continue to assume that behind active governmental policy and regulation are government officials and bureaucrats that are either more perceptive and talented than their private sector counterparts, or, are less self-serving than their private sector counterparts, or, are better placed to observe how the world works than are their private sector counterparts.
In my estimation, government officials and bureaucrats are not more capable or talented than their private sector counterparts and they are certainly not less self-interested. Furthermore, in my experience in government, they are not better placed or better informed about what is going on in the world. This latter point is one that the economist Friedrich Hayek made over and over again.
There is no research that I have seen that indicates that those that work for government perform any better than those that work in the private sector. If anything, the argument goes the other way: government cannot hire or attract people of the same quality that work in the private sector. Furthermore, there is no evidence to prove, in my mind, that people that work in government service are any less greedy for advancement or personal gain than are people that work in the private sector.
Finally, in their attempt to protect the society from “bad outcomes” the government has tended to err on the side of creating an environment for greater and greater private sector risk-taking. This has come in several forms. The obvious case currently is the “Greenspan put” or the bank bailouts that have created moral hazard and greater and greater amounts of risk taking. (See the article by Peter Boone and Simon Johnson in today’s Financial Times, “A Bank Levy will not stop the Doomsday Cycle”: http://www.ft.com/cms/s/0/e118fcc2-0461-11df-8603-00144feabdc0.html.)
Another case relates to the underlying emphasis on trying to maintain low levels of unemployment. This has created an environment that encourages risk taking in terms of increased financial leverage, maturity mismatching, and financial innovation. I have referred to the whole period from 1960 to the present as one in which the government underwrote an environment of credit inflation.
Furthermore, this continual effort to stimulate the economy has tended to put people back to work in jobs that were outdated or in industries that needed change. In order to protect the worker, the easiest and best approach was to put workers back into their old jobs. We see the consequence of this policy in the problems experienced in the auto industry, the steel industry, and many other areas that formerly represented the industrial base of America.
Last, special interest programs, such as housing, although designed with good intent, have ended up with several government agencies serving as the residual lender and insurer of mortgages. Over the past several years we have focused on Fannie Mae and Freddie Mac, but it is now obvious that we cannot ignore the FHA. (See the article by Nick Timiraos in today’s Wall Street Journal, “Souring Mortgages, Weak Market Put Loan Agency on a Tightrope”: http://online.wsj.com/article/SB20001424052748704586504574654710172000646.html#mod=todays_us_page_one.) This effort has resulted in the federal government becoming biggest player in the housing market, by a long shot!
To me, regulation of the banking sector should focus on two things. The first relates to capital requirements. They should be raised.
Second, there needs to be greater transparency and openness in transactions, deals, and balance sheets.
Almost every other kind of regulation that can be put on the books, in the words of John Bogle, can be evaded. We cannot protect the bankers from themselves. But, we can attempt to protect investors and other wealth holders by giving them more information about those institutions they want to invest in. But, like the bankers, ultimately we cannot protect these investors and other wealth holders from themselves.
Monday, January 18, 2010
A Look At The Monetary Aggregates
The growth of the monetary aggregates has slowed significantly in recent months. This, of course, does not mean that the significant concerns over the $1.0 trillion in excess reserves in the banking system have evaporated. By no means!
Looking at the monetary aggregates does provide us with vital information about what economic units are doing with their assets. We took a look at this in an earlier post last November: http://seekingalpha.com/article/175766-how-people-are-using-their-money-and-what-it-says-about-the-economy. At that earlier time, it was obvious that people were moving their assets into transaction accounts and shorter maturity deposits. Also, people were moving money from thrift institutions into commercial banks.
This general movement of wealth can be called “bearish”. That is, when people lack confidence in the economy and in the future, they move into cash and other very liquid assets.
The December year-over-year rate of increase of the currency held outside the banking system stands at 5.7%. This is right in line with the growth rate of M1, the narrow measure of the money stock, which was 5.9% in December.
These growth rates are the lowest to be achieved in 2009. As I shall argue, this is not a sign that “bearishness” is over, just that it lessened throughout the year.
The August year-over-year growth rate for currency was 10.5% and for October 8.3%. The similar measures for the M1 measure of the money stock were 18.5% and 13.4%, respectively. Thus, the move into these assets have slowed, measurably.
There is still strong information that economic units are moving funds from time and savings accounts into transaction accounts. The December year-over-year growth rate of non-M1 accounts, primarily time and savings deposits, was 2.4%, substantially below the growth rate of Demand Deposits and other Checkable Deposits which stood at 6.3%.
The movement here also indicates that the movement from thrift institutions to commercial banks remained strong. For example, the year-over-year rate of growth of Thrift Deposits was 1.7% and this included an increase of Checkable Deposits at thrift institutions of 13.1%. The thrift industry is still really suffering.
Add to this the fact that the 1.7% figure includes deposits at Credit Unions, which are rising significantly, strengthens the argument that the traditional thrift industry continues to suffer badly!
Additional evidence of the move into very liquid assets is the fact that the amount of money placed in Retail Money Funds dropped almost 26%, year-over-year, and the money placed in Institutional Money Funds fell by 8.0%, year-over-year.
People continue to be afraid of the future, and, as a consequence they remain very bearish in terms of how they are managing their assets.
This leads to the conclusion that the basic positive movements in financial markets, in the stock market and in the bond market, almost all come from institutional trading. And, this “good” performance is coming from the interest rate subsidy that the Federal Reserve is providing to the banking system and the financial markets.
The increase in transaction accounts in the banking system has meant that the required reserves of the banking system have increased. The December year-over-year rate of increase of required reserves in the banking system was 18.5%.
To cover this, the Federal Reserve, continuing to err on the side of providing too many reserves, increased the monetary base by 22.0% over the same period of time. As a result, excess reserves rose by 40%.
The banking system still tells us a lot about what is happening within the economy. It tells us what the banks, themselves, are doing. It tells us how people are allocating their assets. It provides us with a gauge about the bullishness or bearishness of economic units. It also gives us some information on how the different sectors of the banking industry, big banks, small- and medium-sized banks, and thrift institutions are doing.
Looking at the monetary aggregates does provide us with vital information about what economic units are doing with their assets. We took a look at this in an earlier post last November: http://seekingalpha.com/article/175766-how-people-are-using-their-money-and-what-it-says-about-the-economy. At that earlier time, it was obvious that people were moving their assets into transaction accounts and shorter maturity deposits. Also, people were moving money from thrift institutions into commercial banks.
This general movement of wealth can be called “bearish”. That is, when people lack confidence in the economy and in the future, they move into cash and other very liquid assets.
The December year-over-year rate of increase of the currency held outside the banking system stands at 5.7%. This is right in line with the growth rate of M1, the narrow measure of the money stock, which was 5.9% in December.
These growth rates are the lowest to be achieved in 2009. As I shall argue, this is not a sign that “bearishness” is over, just that it lessened throughout the year.
The August year-over-year growth rate for currency was 10.5% and for October 8.3%. The similar measures for the M1 measure of the money stock were 18.5% and 13.4%, respectively. Thus, the move into these assets have slowed, measurably.
There is still strong information that economic units are moving funds from time and savings accounts into transaction accounts. The December year-over-year growth rate of non-M1 accounts, primarily time and savings deposits, was 2.4%, substantially below the growth rate of Demand Deposits and other Checkable Deposits which stood at 6.3%.
The movement here also indicates that the movement from thrift institutions to commercial banks remained strong. For example, the year-over-year rate of growth of Thrift Deposits was 1.7% and this included an increase of Checkable Deposits at thrift institutions of 13.1%. The thrift industry is still really suffering.
Add to this the fact that the 1.7% figure includes deposits at Credit Unions, which are rising significantly, strengthens the argument that the traditional thrift industry continues to suffer badly!
Additional evidence of the move into very liquid assets is the fact that the amount of money placed in Retail Money Funds dropped almost 26%, year-over-year, and the money placed in Institutional Money Funds fell by 8.0%, year-over-year.
People continue to be afraid of the future, and, as a consequence they remain very bearish in terms of how they are managing their assets.
This leads to the conclusion that the basic positive movements in financial markets, in the stock market and in the bond market, almost all come from institutional trading. And, this “good” performance is coming from the interest rate subsidy that the Federal Reserve is providing to the banking system and the financial markets.
The increase in transaction accounts in the banking system has meant that the required reserves of the banking system have increased. The December year-over-year rate of increase of required reserves in the banking system was 18.5%.
To cover this, the Federal Reserve, continuing to err on the side of providing too many reserves, increased the monetary base by 22.0% over the same period of time. As a result, excess reserves rose by 40%.
The banking system still tells us a lot about what is happening within the economy. It tells us what the banks, themselves, are doing. It tells us how people are allocating their assets. It provides us with a gauge about the bullishness or bearishness of economic units. It also gives us some information on how the different sectors of the banking industry, big banks, small- and medium-sized banks, and thrift institutions are doing.
The scorecard:
- People are still moving their money from savings accounts to transaction accounts;
- Commercial banks, in general, are not lending;
- Economic units are, by-and-large, still very bearish;
- Big banks are doing very, very well;
- Small- and medium-sized banks are still on the edge;
- And, thrift institutions are really suffering.
One doesn’t see much of a recovery captured in these results.
Sunday, January 17, 2010
Federal Reserve Exit Watch: Part 6
Debate seems to be picking up about the Federal Reserve exiting its current policy stance. Last week Thomas Hoenig, President of the Federal Reserve Bank of Kansas City, and Charles Plosser, President of the Federal Reserve Bank of Philadelphia, spoke last week of the forthcoming need to wind down the Fed’s position. Hoenig said that the Fed should end its purchase program of mortgage-backed securities and Plosser talked about the recovery being sustainable even as existing fiscal and monetary stimulus programs recede.
Still, economists are pessimistic about when the Fed will begin to raise its target for the Federal Funds rate. The effective Federal Funds rate in recent months has averaged about 12 basis points. Bloomberg News conducted a survey of economists’ expectations and the median forecast was for the target rate to remain unchanged through September 2010 and then rise by a half of a point in December 2010.
Since the Federal Reserve finally realized in 2008 that there was a financial crisis and began to combat the unfolding chaos, the basic policy of the Fed has been to throw whatever it can at the wall so that a sufficient amount of what is thrown will stick so that a financial collapse can be avoided.
Can people who devised such a policy really be expected to move its target rate up until it is far past the time that a rise is needed? And, the Fed will then face a situation in which rising interest rates will put many holders of Treasury securities and mortgage-backed bonds underwater and the question will then be, “Can the Fed afford to raise interest rates too swiftly because of all the losses it will create?”
Right now, the Fed is subsidizing the profits of the large banks (and not the small- and medium-sized banks) by its interest rate policy (of course, the Obama administration has threatened to tax away a good deal of the profits). It is just amazing the contradictions in monetary and fiscal policy that are coming out of Washington, D. C. these days. Confusion reigns!
It is no wonder that businesses and banks don’t want to do much of anything these days. They don’t know what the economic policy and regulatory environment will be in three years, let alone three months.
Anyway, the Federal Reserve continues to add reserve balances to the banking system. In the past 13-week period ending Wednesday, January 13, 2010, the Fed has added about $84 billion in reserves to the banking system.
Remember in August 2008 when the total reserves of the whole banking system were only about $44 billion!
Of this $84 billion, $62 billion was put into the banking system in the latest 4-week period.
The major contributor to this increase was security purchases by the Federal Reserve in the open market. In the latest 4-week period, the Fed added almost $71 billion to its securities portfolio bringing the total new purchases for the last 13 weeks up to $233 billion.
A large portion of this increase went to offset the decline in several of the special facilities set up to handle the financial crisis. For example, the amount of funds supplied the banking system through the Term Auction Credit facility fell by about $80 billion over the 13-week period, by $10 billion over the last 4 weeks.
The swap facility with foreign central banks also continued to decline dramatically, falling by almost $38 billion in the latest 13-week period and by about $9 billion in the last four weeks.
In total, it appears as if the funds supplied the banking system through special financial crisis facilities fell by $42 billion over the past 13 weeks and by only $2 billion over the last two.
Thus, the Federal Reserve continues to let these special facilities wind down, replacing them in the banking system through open market purchases.
In terms of preparing for the Fed’s exit, there has recently been trading in reverse repurchase agreements with dealers, but there was no “practice” activity in the past four weeks presumably because of the seasonal Thanksgiving/Christmas churning in the banking system.
As of Wednesday, January 13, 2010, the Federal Reserve held $969 billion in mortgage-backed securities in its portfolio. The central bank has authorized purchases of up to $1.25 trillion going into March of this year. As mentioned earlier, there seems to be substantial debate within the Fed as to whether or not this program should reach the maximum total. We shall see.
The Fed now holds $777 billion in Treasury securities and $161 in the securities of Federal Agencies.
So, the Fed Exit watch continues. So far, the Federal Reserve has honored the path that it started out on: purchasing securities to add to its portfolio thereby replacing the funds draining away from the special facilities created to combat the financial crisis.
Obviously, the real test has not begun. Within the next month or two, if the recovery continues, the Fed is going to come under more and more pressure to start raising its target rate of interest. Until then, big banks will continue to arbitrage the Treasury market and the carry trade will continue to prosper. This behavior is based on the assumption that the Fed is not going to let short term rates rise for a while.
When this assumption is broken, expectations will have to be reset and there will be a re-adjustment in the financial markets as investors exit their arbitrage positions.
What the Fed does then remains to be seen.
However, by maintaining its current policy stance, if the economy doesn’t recover or goes into a double dip recession, the Federal Reserve cannot be accused of aborting the upswing by raising its target interest rate too soon.
Still, economists are pessimistic about when the Fed will begin to raise its target for the Federal Funds rate. The effective Federal Funds rate in recent months has averaged about 12 basis points. Bloomberg News conducted a survey of economists’ expectations and the median forecast was for the target rate to remain unchanged through September 2010 and then rise by a half of a point in December 2010.
Since the Federal Reserve finally realized in 2008 that there was a financial crisis and began to combat the unfolding chaos, the basic policy of the Fed has been to throw whatever it can at the wall so that a sufficient amount of what is thrown will stick so that a financial collapse can be avoided.
Can people who devised such a policy really be expected to move its target rate up until it is far past the time that a rise is needed? And, the Fed will then face a situation in which rising interest rates will put many holders of Treasury securities and mortgage-backed bonds underwater and the question will then be, “Can the Fed afford to raise interest rates too swiftly because of all the losses it will create?”
Right now, the Fed is subsidizing the profits of the large banks (and not the small- and medium-sized banks) by its interest rate policy (of course, the Obama administration has threatened to tax away a good deal of the profits). It is just amazing the contradictions in monetary and fiscal policy that are coming out of Washington, D. C. these days. Confusion reigns!
It is no wonder that businesses and banks don’t want to do much of anything these days. They don’t know what the economic policy and regulatory environment will be in three years, let alone three months.
Anyway, the Federal Reserve continues to add reserve balances to the banking system. In the past 13-week period ending Wednesday, January 13, 2010, the Fed has added about $84 billion in reserves to the banking system.
Remember in August 2008 when the total reserves of the whole banking system were only about $44 billion!
Of this $84 billion, $62 billion was put into the banking system in the latest 4-week period.
The major contributor to this increase was security purchases by the Federal Reserve in the open market. In the latest 4-week period, the Fed added almost $71 billion to its securities portfolio bringing the total new purchases for the last 13 weeks up to $233 billion.
A large portion of this increase went to offset the decline in several of the special facilities set up to handle the financial crisis. For example, the amount of funds supplied the banking system through the Term Auction Credit facility fell by about $80 billion over the 13-week period, by $10 billion over the last 4 weeks.
The swap facility with foreign central banks also continued to decline dramatically, falling by almost $38 billion in the latest 13-week period and by about $9 billion in the last four weeks.
In total, it appears as if the funds supplied the banking system through special financial crisis facilities fell by $42 billion over the past 13 weeks and by only $2 billion over the last two.
Thus, the Federal Reserve continues to let these special facilities wind down, replacing them in the banking system through open market purchases.
In terms of preparing for the Fed’s exit, there has recently been trading in reverse repurchase agreements with dealers, but there was no “practice” activity in the past four weeks presumably because of the seasonal Thanksgiving/Christmas churning in the banking system.
As of Wednesday, January 13, 2010, the Federal Reserve held $969 billion in mortgage-backed securities in its portfolio. The central bank has authorized purchases of up to $1.25 trillion going into March of this year. As mentioned earlier, there seems to be substantial debate within the Fed as to whether or not this program should reach the maximum total. We shall see.
The Fed now holds $777 billion in Treasury securities and $161 in the securities of Federal Agencies.
So, the Fed Exit watch continues. So far, the Federal Reserve has honored the path that it started out on: purchasing securities to add to its portfolio thereby replacing the funds draining away from the special facilities created to combat the financial crisis.
Obviously, the real test has not begun. Within the next month or two, if the recovery continues, the Fed is going to come under more and more pressure to start raising its target rate of interest. Until then, big banks will continue to arbitrage the Treasury market and the carry trade will continue to prosper. This behavior is based on the assumption that the Fed is not going to let short term rates rise for a while.
When this assumption is broken, expectations will have to be reset and there will be a re-adjustment in the financial markets as investors exit their arbitrage positions.
What the Fed does then remains to be seen.
However, by maintaining its current policy stance, if the economy doesn’t recover or goes into a double dip recession, the Federal Reserve cannot be accused of aborting the upswing by raising its target interest rate too soon.
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