Wednesday, November 9, 2011

Repo Markets and Financial Instability

NYFed PriDealerRepo Jul 01 Nov 11

ICMA EurRepoSurvey Jun 01 Jun 11

BoE repo Dec 01 Jun 11

SIFMA global cdo issuance


SIFMA Eur Securitisation Issuance

The repo markets are fueling the fires again.

Repurchase agreements ("repos") are the sale of securities combined with an agreement for the seller to buy back the securities at a later date, or a cash financing transaction combined with a forward contract. The duration of the agreement can be overnight, term or open. They are heavily used by investment firms to obtain short-term financing that can be rolled over; common financing aims are for longer-maturity, higher-yielding securities to juice the yield spread. Collateral for repo trades include sovereign debt (e.g., Treasuries), agency debt (e.g., Fannie/Freddie or GSE debt), or mortgage-backed securities (MBS). The Federal Reserve also uses repos to inject or withdraw money into/from bank reserves and the money supply, with Treasuries serving as usual collateral.

As the curves above show, the repo market size just among U.S. Primary Dealers had grown geometrically in the last decade, until choking following the 2007-8 credit markets seizure. It is worthwhile to note that the growth and decline of these markets correlates with the growth and decline of collateralized debt obligation (CDO) issuance, the same asset and mortgage-backed derivative security that provided a significant contribution to the counterparty risks leading to the credit markets seizure. CDOs were a structured hodgepodge of good and bad mortgage and asset-backed debt, and given a AAA rating from credit rating agencies, making them eligible as collateral for repo transactions, and attractive for their yield. When default rates picked up in 2006-7, the values of CDOs plummeted, and triggered a margin call nightmare that eventually doomed both Bear Stearns and Lehman. The fallout also affected AIG, who sold cheap CDO insurance in the form of credit default swaps (CDS) to CDO buyers, without recognizing the risks should those CDOs implode. The repo markets made most of this "Ponzi finance" of CDOs possible.

It may not be a surprise then that the recent failure of yet another large brokerage firm and primary dealer (MF Global) involved a sizable ($7.6B in March 2011) repo trade with European sovereign debt as collateral. Though MF Global structured the trade such that the maturity of the repo equaled the duration of the European bonds pledged as collateral, thereby seemingly reducing its duration mismatch risk, the firm off-loaded the collateral from its balance sheet as part of the accounting for the repo sale, and in doing so summarily avoided capital cushions to cover shortfalls should that debt lose value until maturity. As the Euro debt crisis heated up this fall, MF Global started getting a barrage of margin calls, then credit downgrades, and then more margin calls. It failed to survive this liquidity thrashing, seeking bankruptcy protection on Halloween. Lehman succumbed to similar fate, and has been accused of employing repo transactions as accounting maneuvers to manipulate its financial reports and leverage, using the funds from repo sales to temporarily pay down debt before repurchasing the collateral ("Repo 105").

To be sure, many repo transactions are used responsibly and legitimately, just as firms responsibly and legitimately use interest rate swaps to hedge interest rate risk. The problem arises when the underlying collateral of the repo trade sharply loses value, and the seller counterparty doesn't have enough capital to survive margin calls and credit downgrades.

The financial instability caused by the exploitation of the repo markets to finance the debt market growth cannot be overlooked, though regulators (Federal Reserve, SEC, et al.) have consistently ignored this major weak point. The worst manifestation of this systemic problem is when such debt market growth leads to "Ponzi finance," a term coined by Hyman Minsky in his classification of financial instability. It is so defined: "expected income flows will not even cover interest cost, so the firm must borrow more or sell off assets simply to service its debt. The hope is that either the market value of assets or income will rise enough to pay off interest and principal." This is precisely what occurred to mortgage and asset-backed debt during the housing boom-turned-bust, as subprime lenders accelerated their loans to unworthy borrowers and sold such bad debt en masse to MBS and CDO packagers/issuers. Those CDOs turned out to contain enough bad debt to invalidate their AAA rating — a rating issued on the faulty basis that default risks were spread out when super-packaged with "good" debt into a structured CDO.

Banks and investment houses still rely too much on repo lines to fund their spread bets (i.e., a lousy business model that just keeps on kicking despite the "systemic risk" and Ponzi finance potential). When the underlying collateral starts to smell, the markets start to seize, and central bank swap lines start to swing. The Eurozone repo market in particular as reported by ICMA declined less than the U.S. repo market and remained elevated after 2008 - and sovereign government and RMBS issuances in Europe increased (see above curves). As already discussed, the growth in the U.S. repo market before 2008 was correlated to the increase in CDO and MBS/ABS issuances, many loaded with subprime "II" junk. Meanwhile global debt outstanding keeps increasing at a record pace.

The opacity of the repo financing markets is an issue that regulators and industry both have failed to address. In particular, the Federal Reserve (specifically the NY Fed) has failed to provide adequate transparency to the U.S. markets, even though it is increasingly charged with regulatory powers that would cover these markets. The Basel Committee on Banking Supervision recently provided a case to strengthen repo clearing and a liquidity/capital framework but certain elements in the system (namely large dealers who want to maintain market share and certain capital terms to draw business) are bucking any changes or improvements that would seek to avoid market seizures and instabilities. Jamie Dimon's rant over the Basel solution is such an example, and JP Morgan has among the largest U.S. market share of the tri-party repo market. Granted, the Basel solution may not be the panacea, but a sensible capital and margin framework and a push to standardized clearing would go a long way, as would market transparency. JPM's role in the MF Global failure ought to be reviewed, no doubt. Let's not forget that JPM was also the repo banker of Lehman and Bear.

The derivatives markets also have suffered from opacity, but in recent years coverage has dramatically improved of both cleared and over-the-counter (OTC) derivative statistics, thanks to the Bank of International Settlements (BIS), DTCC, Tri-Optima, SIFMA, ISDA and other organizations and industry warehouses. In the case of repos, no organization tracks this market with the same level of detail; even accurate market size is not available from existing data [1]. DTCC has started to track a proprietary metric that measures the weighted average interest rate paid each day on General Collateral Finance (GCF) Repos based on U.S. government securities HERE, but not based on other collateral such as EU sovereigns, which has caused much recent consternation and contributed to the failure of MF Global.

Regulators and regulations were not the answer to the repo financing/debt market growth financial instability weak point. Regulators missed Lehman and they missed MF Global. Time after time, financial participants look to arbitrage (avoid) regulatory requirements through creative use of financial products and accounting, and they will continue to do so as avenues are closed, and others opened through "financial innovation" (and sheer desperation for yield and return). I submit that there are three solutions to mitigate this:

  • For industry and regulators to provide as much transparency of the repo, debt and derivatives markets as possible, so market participants can gauge exuberant growth and start to correct it through markets before unstable levels are reached;
  • Letting firms that abuse financing lines to juice yields or manipulate leverage and capital ratios FAIL, even if they are listed as "systemically important" or "too big to fail" — this will reduce moral hazard and force firms to consider consequences should they ignore prudent risk management or engage in fraudulent accounting;
  • Remove the Fed's mandate to control and fix interest rates, which in itself is a source of financial instability, as it leads to excessive endogenous money creation and speculation [2] — the thriving repo markets are but one symptom of this endogenous money activity.

[1] Sizing the vast repo markets is a challenge. The first step is to recognize who participates in these markets and what type of repo agreement those participants enter into. The participants include Fed-approved Primary Dealers (MF Global was one), the Fed itself, and non-Primary Dealers (bank holding companies, insurance companies, etc.). Agreements fall into two general categories: tri-party and bilateral. Tri-party agreements are mediated by a custodian bank or international clearing organization, which act as agents. In the U.S., JPM and Bank of NY Mellon are the major tri-party agents. Bilateral agreements are direct between the repo buyer and seller. The NY Fed provides data on repos between Primary Dealers, which includes its own repo activity HERE, the same as the data plotted at the top. The Fed's publicly available repo activity is broken out in the Fed's H.4.1 statistical release on factors affecting reserve balances, and is a fraction of the reported Primary Dealer activity. The M3 money supply metric, which the Fed used to publish but has discontinued, included its repo activity as well as interbank repo activity. The NY Fed has started to track tri-party repo activity HERE; this data includes both Primary Dealer and non-Primary Dealer participants. When I asked the NY Fed whether their tri-party data could be broken out into PD and non-PD buckets, they told me that this granularity was not available. I also asked the NY Fed for any data they had on repos between non-PD participants, most specifically bank holding companies. They told me that an aggregate was not publicly available through them, and indicated that they do not track such data. Instead they sent me a link to a website they maintain that contains thousands of quarterly reports on bank holding companies HERE, the National Information Center (NIC). When I asked the help desk at the NIC to advise on how to access aggregate data through this site, they responded that the NIC public website did not provide this service and advised me to "check with the Freedom of Information Act (FOIA) at" WOW. If our U.S. regulators are this lousy about tracking and releasing aggregate data, they are indeed impotent to prevent any financial instability! The reader may note that a true market size would include Primary Dealer and non-Primary Dealer, for both tri-party and bilateral agreements. A 2008 BIS report "Development in Repo Markets During Financial Turmoil" does publish data it was able to obtain on repo activity among some 1000 bank holding companies, and that market size is nearly 30% of the huge U.S. Primary Dealer repo market. Eurozone (non-UK) repo markets are tracked by ICMA HERE, and the Bank of England tracks UK repo markets HERE. To the regulators and industry: market participants and researchers are still waiting for a clean transparent total size of the repo markets. A breakdown of collateral, rates and maturities would also be (obviously) useful to track.

[2] See "Federal Reserve Capital Management," which includes a primer on endogenous money.

Thursday, October 20, 2011

Federal Reserve Capital Management

Is the Federal Reserve essentially a giant hedge fund? Can it fail?

Check out this new essay (Click Here), which explores the Fed's role within the context of financial stability/instability in markets. Included are primers on endogenous money and chaos theory vs. neoclassical models in quantitative finance.

Monday, October 10, 2011

Private Domestic Investment and Real Economic Growth: Why the Dearth?

RealGDP Jun 11

RealPrivInvest Jun 11

Those connected with econometric data are all too aware of the first chart. Less attention and focus goes to the components of real gross domestic product (GDP) and their trends, particularly private domestic investment (PDI), which historically leads to real economic growth and job creation. The correlation for this comes from looking at the change in real GDP, which responds to changes in PDI [1].

The historical trend for PDI has been relatively weak and muted, despite its multiplier effects on real growth and jobs. The period of the greatest compounded annual growth rate (CAGR) in PDI since 1947 occurred from June 1992 to June 2000 (9.3%; $985B to $2.01T). At the same time, growth in government expenditures was relatively flat (1.4%). Speaking to our trade deficit crisis, net exports (exports-imports) increased negatively at a CAGR of -36.6% (-$36B to -$439B). Personal consumption grew steadily (4.2%) with real GDP growth (4.0%), confirming the moniker "consumer-driven economy."

Since the "prolific" 1992-2000 period, the trend has reversed on PDI. From June 2000 to June 2011, PDI shrank with a negative CAGR of -1.1%, and the current value is stuck at around 2001 levels. While it is true that real GDP and the components kept growing until the 2006-7 pop in the mortgage bubble, PDI has not robustly recovered since the 2008 plunge. A large contributor came from the plunge in residential fixed investment, which we may classify as synonymous with personal consumption, given the hefty progression of homebuyers and speculators that took on mortgage debt and refinancings to finance further consumption. But what about nonresidential fixed investment? Why is it not showing healthy robust growth? Embarrassingly, government expenditures have outpaced at a 1.6% CAGR, and real GDP and employment remain flat to down.

What are the plausible causes of the dearth in PDI, specifically the contributions coming from nonresidential fixed investment? I provide a list below, which is by no means complete:

  • Government regulations are too many, too costly, without justifiable cost benefits
    • EPA, Labor Dept (employment regulations), Sarbanes-Oxley, Dodd-Frank, ...
  • Monetary and tax policies support/induce consumption/speculation, not investment (nonresidential PDI) that leads to solid job creation
    • Zero interest rate policy (ZIRP) and quantitative easing (QE) induce speculation and malinvestment, distorting risk-reward
    • Significant overseas profits remain unavailable for domestic investment due to punitive corporate tax policy
    • Tax code growth has coincided with providing vote-buying tax subsides linked to consumption; increasing complexity and uncertainty in the code represent a fundamental drag on business growth
  • Government expenditures crowd out PDI, and may have as damaging an effect in the future as mortgage debt consumption did in the recent past
    • Government stimuli (including subsides), social "entitlements" and welfare ($9T+ marketable Treasury debt, $5T+ non-marketable debt, $100T+ off-balance-sheet liabilities)
    • False safety in Treasuries and the sovereign credit rating

The bottom line is that unless we address the inhibitors to PDI, specifically nonresidential fixed investment, we risk stagnant growth (or worse) for the foreseeable future.

[1] The charts showing the correlated trend between real GDP and PDI, and total non-farm payroll and real GDP, are shown below:

ChangeRealGDP Jun 11

ChangeRealGDPvsPDI Jun 11ChangeNFPayrollvsRealGDP Jun 11

Tuesday, October 4, 2011

Credit Market Redux, Copper and China

TED Oct4 11 1yrMarkit iTraxx Europe Oct4 11

Markit CDX Oct4 11

Markit iTraxx Asia Oct4 11

China 5yr CDS Oct4 11

FCX Oct4 11VWO Oct4 11

GLD Oct4 11XOM Oct4 11

The credit markets are rumbling again, as measured by the TED (LIBOR-OIS) spread and widening credit default swap (CDS) spreads. Though the latter have been intensely worse for European debt indices over the last 3-4 months from the play-out over Greece and faltering European banks holding PIIGS sovereign debt, increasing spreads are seen across global CDS indices (Europe, NA, Asia - see Markit curves above), a potential precursor to a global slowdown.

In the initial throes of the credit market induced selloff in October 2008, certain asset classes sold off quickly with sharp declines: Emerging Market (EM) equities and debt, commodities (especially copper, gold and oil). During the month of September 2011, we've seen a similar sharp selloff in these asset classes, minus commensurate participation from oil (so far). The declines in copper have come with speculation that China and other major copper holders are dumping copper onto the open market, creating selling pressure, in anticipation of a slowdown in Chinese housing and manufacturing growth.

If these selloffs are a true reflection of a coming global slowdown, then we may anticipate lower lows in copper (a futures curve asymptote to $2 and the equity proxy FCX below $20) as well as EM equities (VWO proxy $20 range). Though oil has not participated for a variety of reasons, it too could follow, leading to sharp declines in the majors and the commodity. Gold may be the exception again this time — it reached a relative low October 24, 2008, and rebounded from there, never looking back.

The flip side is that what we are seeing is a head fake, created by selling pressure from hedging activity.

The question then becomes: what are the catalysts to sharp market reversals to the upside with a sustained rise? European debt restructuring is a foregone conclusion, and may not lead to significant sustenance, given the debt levels involved and the uncertainty and disorder within the EU in general. Another quantitative easing binge by monetary authorities may give a lift, but as we've seen, the result leads to an uptick in commodity inflation mixed with stale real growth, while promoting continued debt accumulation and preventing debt deleveraging. Negative real interest rates and economic uncertainty from regulatory, tax and fiscal policies are hampering private investment.

Given this outlook, continued volatility is the most likely outcome. Hiding out in the Treasury and muni markets may not be a panacea, given the negative real returns and the latent risks. As commodities, equity majors and proxies reach lower lows, their attractiveness to acquire and hold rises, given the probability of continued inflation growth. Disinflation from debt deleveraging (while it is allowed to occur!) provides significant opportunities.

Thursday, September 22, 2011

Valuing Gold From Inflation and Money Supply Growth Rates


How much is gold worth? Is gold in a bubble? Is it undervalued, even at $1900/oz? Is the current selloff providing a buying opportunity or a reason to sell? How can we tell?

One way to value gold is to look at long-term compounded annual growth rates (CAGRs) in inflation and money supply metrics, and use those rates to calculate the future value (FV) of gold from some traded price level in the past. Since I have not seen this type of analysis anywhere, it seemed germane and useful, as gold demand in terms of traded price level responds to both inflation and money supply growth, among other factors. Not surprisingly, inflation and money supply metrics grow at different rates over different time periods, due to ebbs and flows of economic activity and Federal Reserve (Fed) monetary policy.

The table above lists CAGRs of two inflation metrics, the consumer price index (CPI) levels reported by the Bureau of Labor Statistics (BLS) and the pre-1983 BLS CPI reported by ("SGS CPI") [1]. Also shown are CAGRs for five broad money supply metrics, M2, M3 (and M3b, which is M3 calculated by other sources [2] after the Fed discontinued its M3 series in early 2006), M3c [2], MZM, and TMS [3].

The results: Gold's Aug 2011 FV based on inflation rates range from $209-$5840, and based on broad money supply growth rates range from $539-$7141. Taking a closer look, the lows of these ranges stem from a relative market low price level at the start of the compounded period, namely 1970, when gold was artificially kept at a $35 peg (the market trading price level was slightly higher, $36), and 2000, which represented a decades market low for numerous commodities such as oil and gold, due to an exceptionally stronger dollar from a short-covering rally. The consistently low FVs based on the BLS CPI CAGR, $209-$1673, can probably be thrown out, given the specious definition for the metric after 1983 [1]. That leaves a FV range of $539-$7141. The averages over all of the FVs from this set span from $1709-$2757.

As one might expect, the wider ranges for gold FVs come from the money supply metrics, especially M3c, which contains the significant effects from recent Fed monetary stimuli programs, 2007-present. M3c ~ $17.32Trillion as of Aug 2011 [2], well exceeding nominal GDP ~$14.5T. Perhaps most telling is the FV range from long-term gold price appreciation since 1925: $3174-$7141. The lower bracket here is provided by the FV from the SGS CPI inflation rate, $945.

A few notes on the growth rates. The highest rates come from SGS CPI growth from 2000-2011 and 1995-2011 (yet we were told by the gov't and the Fed that inflation was exceedingly low over these periods!), M3c from 1995-2011 (thanks to "special" Fed monetary stimulus programs), and TMS from 2000-2011. Growth in the latter, TMS, is interesting, as TMS differs from the other metrics through its inclusion of Fed special memorandum data in its monetary aggregates database that many argue should be construed as money substitutes, while it excludes less liquid substitutes that have shown downside volatility from financial instability.

This analysis provides a realization that if gold buyers specify demand through price based on historical inflation and money supply growth, gold FV price levels can easily exceed where it is currently trading, and we have a concrete series of FV price levels to measure from.

Gold buyers should keep in mind that as we have gold sell off sharply on days such as today, Sept 22, 2011, that the selloff is driven largely by margin calls as all price levels fall in a volatile trading session in the broader commodities futures and equities markets, i.e., there is sharp deleveraging leading to forced selling. If gold's long-term trend is motivated by inflation and money supply growth rates that we have outlined here, that provides a floor for the traded gold price, as the expectation is that the Fed will continue its monetary stimulus measures as the dollar strengthens and the commodity and equity markets wane.

Author's Note, 9/23/2011: As the metals market continues sharp declines on a second day of volatile trading, gold closes at ~$1643, some 13.3% below the average high close of $1895 on 9/6/2011. Gold would have to go down to ~$1335 from this average high close to equal the peak-to-trough decline experienced in 2008 (~29.5%: $1011 on 3/17/2008 down to $712.50 on 10/24/2008), a recent period of comparative selling. On a longer scale, gold selloffs exceeding the 2008 decline occurred between 1980-1982 (~65.1%: $850 on 1/21/1980 down to $297 on 6/18/1982) and 1983-1985 (~44.2%: $509 on 2/15/1993 down to $284 on 2/25/1985). A 65% decline from $1900 is $663, below the lowest low of the FVs based on the SGS CPI CAGR shown in the above table. The 2008 and 1980-82 declines resulted in sharp reversals, while the 1983-1985 decline didn't yield any significant price appreciation until gold hit a multi-decade low in July 1999 ($252) after meandering around a average price of $355 (sigma ~ $52) between 1985-2004, before taking off in 2005.

[1] The SGS CPI mimics the inflation metric reported by the BLS before 1983. Starting in 1983, the BLS CPI was changed to de-emphasize food and energy inflation and allow for hedonic adjustments and substitutions, among other changes. The SGS CPI tracks the original definition, which maintains a measure of the cost of living needed to maintain a constant standard of living. HERE is a great article discussing just how misleading the current BLS CPI is. 
[2] M3b is estimated by HERE. M3c is essentially M3b on steroids: it includes the money supply growth estimated from the Fed's various special liquidity and monetary easing programs since 2007, namely TAF, PDCF & TSLF, QE,... .
[3] TMS is "true money supply," which is M2 minus small time deposits and retail/institutional money funds, plus demand and time/savings deposits due to foreign banks/institutions, U.S. gov't demand/note balances at banks and depositories, and U.S. gov't general account balances at the Fed. TMS seeks to track standard money plus money substitutes ("perfectly secure and immediately convertible, par value claims to standard money"). Up-to-date TMS is tracked HERE. Whether TMS is better and more accurate than M2 or M3 or MZM at tracking broad money supply will be discussed in a later article.


Thursday, September 15, 2011

Global Debt Watch: $95T and Counting

TotalMktDebt BIS Dec 89 Dec 10

As of Dec 2010, worldwide marketable/tradable debt outstanding neared some USD$95Trillion, according to the Bank of International Settlements (BIS). The historical data above indicates that debt markets have more than doubled from Dec 2002 to Dec 2010, with the largest increases stemming from domestic issuances, at first (2002-2007) from mortgage and asset-backed security issuances, and then more recently (since 2008), from sovereign government issuances. The United States maintains the largest debt market, at some $32.5T, ~35% of the worldwide total market [1].

Gauging and tracking marketable/tradable debt is key to understanding global capital market stability. Though total debt levels can also contain "nonmarketable" debt, such as nonmarketable sovereign government debt, it is the marketable debt that has the greater systemic influence across debt, equity and derivatives markets, since market participants price and trade that debt; however, the influence of nonmarketable debt levels should not be understated. I have started to maintain a "Global Debt Watch" page HERE, with the intent of providing historical trends and data analysis at regular intervals from a variety of international sources.

The fantastic growth in the debt markets has been assisted by three primary factors: (a) the reduced borrowing costs made possible by central bank monetary easing policies worldwide; (b) the aggressive use of short-term funding markets, such as the repurchase agreement (repo) and commercial paper (CP) markets, to borrow cash short and buy longer-dated, higher-yielding debt; (c) government policies that promote debt issuance, and government-sponsored entities (GSEs) that "back" such issuances. Government sanctioned credit rating agencies have also been a factor in the growth of debt markets.

The growth and decline of the repo and CP markets in the last decade coincide with that of the growth and decline of mortgage and asset-backed securities (MBS/ABS) and collateralized debt obligations (CDOs), structured pools of MBS/ABS. The total repo market size between the two largest markets, U.S. and Europe, stood at approximately $12.6T Dec 2010, after falling from a 2008 high of $17.5T [2]. Unlike the CP markets, the repo markets are not reported in the BIS debt data above; repo markets are (usually) very fluid, with the majority of transactions composed of overnight or very short-term maturities. The relative opacity of repo markets, plus their vulnerability to liquidity issues due to collateral quality, counterparty risk and capital cushions, make tracking these markets imperative to gauging stability and "systemic risk." Conceivably, the more transparency in the repo markets, the better able the system would be to handling (greater) market liquidity dislocations, such as that experienced from the credit crisis of 2007/8. However, such transparency does not solve the problem of debt accumulation sponsored by central bank monetary and sovereign government fiscal policies.

[1] The Securities Industry and Financial Markets Assoc. (SIFMA) estimates U.S. debt markets at $35.5T, ~37% of the total worldwide market. SIFMA includes offshore centers and CDOs issued in USD.
[2] I assembled these estimates from two sources, the NY Federal Reserve (Fed) and the International Capital Market Association (ICMA). The NY Fed data only reports primary dealer repos, from a survey of Fed primary dealers, and does not count private OTC repos handled by bank holding companies. That may likely increase the U.S. total by some 30%, according to BIS.


Global Derivatives Watch: Netting, Collateral and Capital Cushions Matter

DerivMkt BIS Dec 87 Dec 10

In an attempt to demystify the derivatives markets, which have endured an abundancy of malign from both somewhat credible and uninformed critics, I have started to maintain a "Global Derivatives Watch" page HERE, with the intent of providing historical trends of these complex markets along with data analysis at regular intervals. Not only do I trade these markets (namely the options, futures and forex markets), but I see enormous value in derivatives to (a) hedge risks with a defined loss and (b) place bets with a defined loss, when structured properly and controlled with defendable margins and prudent capital controls.

The first fallacy that pervaded the derivatives markets, only to lead to the road to ruin for certain participants in these markets, was that there was ever such a construct as "risk free." Let me assure you that there is nothing of the sort. The second fallacy was that due diligence was not necessary on the derivatives counterparties with which a participant executes a trade, particularly of the sort that includes high leverage or risky collateral, and also particularly on custom over-the-counter (OTC) contracts that don't trade through a clearinghouse or on an exchange. Most equity, futures and forex options and forwards trade on exchanges and have benefitted from the transparency and liquidity. Nearly half of all interest rate swaps (IRS), the largest derivatives market by almost an order of magnitude over all the others in terms of gross market exposure, are cleared through a central clearinghouse, where netting and collateral control can be verified. To be sure, there are many specialized, one-off OTC derivatives that will still be executed between parties directly or through a dealer, but that doesn't minimize the importance in netting, monitoring of underlying or backing collateral quality and value, and capital cushions should a trade go south. (The poster child for failure to execute these tenants is AIG, which should have never been bailed out for its incompetence and risk mismanagement.)

As I like to say, derivatives don't bankrupt people, people bankrupt people. (Sound familiar?)

As the chart above shows, the derivatives markets have grown exponentially over the last two decades, signifying the demand for the ability to hedge and define risks. Much of this demand is due to heightened risks in markets that result from uncertainties in macroeconomic factors, such as interest rate risk, foreign exchange rate risk, systemic default/credit risk, and futures curve (commodity price) risk. Though the credit default swaps (CDS) markets have taken the brunt of the criticisms from an array of punditry, and have spawned one too many sensational bestsellers filled with overblown rhetoric, these instruments do serve a purpose in hedging both macro and microeconomic risks, particularly specific to securities, indexes of securities, companies, institutions and governments.

Just so I don't come off as a rep for one of the industry or lobby groups for derivatives, I will provide my own criticisms of the derivatives markets thus: not everything is known about these markets to gauge systemic stability in the event of gross risk shocks (dislocations) that in turn might bring about market liquidity issues (i.e., selling panic) and lead to serious market degradation and inadvertent losses. Of particular interest is the study of interest rate swaps when rates correct markedly higher or experience extreme volatility, as a result of market panic and inviting more market panic. Understanding the vulnerabilities in markets (not just derivatives, but also equity and debt/bond markets) is valuable and the role of market transparency, disclosure and visibility critical to the task.


Wednesday, August 24, 2011

A Tale of Two "Safe Havens"


As gold sells off sharply today after hitting a nominal intraday high of $1911.46 yesterday, a reminder of the global fiscal and monetary events that powered gold up into this point is useful. The attached chart shows the path of gold compared to another "safe haven," the US 10-year Treasury note (normalized price, inverse yield). Both have a story to tell, and both reflect market uncertainty on issues of inflation, deflation, debt loads and economic growth.

During the fall 2008 market turmoil created by the credit and housing market crises, investors and traders piled into Treasuries and the dollar, while gold sold off in a technical basing pattern. As markets recovered in 2009 due to massive Federal Reserve injections of monetary liquidity (including "QE1"), gold climbed above its previous high of $1011.30 hit March 17, 2008 (the day Bear Stearns died). Fed liquidity drove a selloff of Treasuries and the dollar, with money flowing into equities, commodities and gold.

The late April 2010 flare up of the European sovereign debt crisis from fears of defaults from Greece, Portugal and Ireland sparked a "safe haven" trade into US Treasuries from May-August. In the same period, gold rose less steadily, but put in what market trading technicians call an important "base" by weeding out short-term sellers from the long-term buyers. Gold resumed its climb briskly from $1200-$1400 on inflation expectations following Bernanke's Jackson Hole speech, where he announced Fed plans for more monetary liquidity injections.

Like gold today, the 10-year Treasury has had its woes, namely a brisk selloff after the Fed embarked on its "second" round of quantitative easing last year (QE2). [By highlighting "second" I mean to dispel the idea that this was really a "second" round — the Fed engages in quantitative easing continuously through its permanent open market operations (POMO).] When inflation expectations heat up, the prospect of negative real yields prompts a selloff of lower yielding Treasuries into commodities and higher yielding equities and bonds, as evidenced by market action between September 2010-April 2011. Markets were also expecting real economic growth, but an alternate reality has since crept into market psyche.

As the European debt crisis flared again alongside US debt concerns in April-June 2011, investors chose both Treasuries and gold as "safe havens," and they have been remarkably correlated ever since. The acceleration of the trend throughout the US debt ceiling blowoff, S&P US credit downgrade and the Fed's declaration of a 2-year moratorium on zero target interest rates (ZIRP) should give observers pause. Is this a rational market or an irrational search for economic sanity?

Sunday, August 21, 2011

National Debts, Debt Monetization and Inflation

U.S. Natl Debt and Money Supply vs. CPI

This last week marked the 40th anniversary of Nixon's move to break up the international gold standard, set by the Bretton Woods Agreement among 44 nations in 1944. The move represented a post WWII culmination of a U.S. balance of payments crisis, including a run on U.S. gold reserves that would trigger an insolvency event:

"Recently the markets had panicked. Great Britain had tried to redeem $3 billion for American gold. So large were the official dollar debts in the hands of foreign authorities that America's gold stock would be insufficient to meet the swelling official demand for American gold at the convertibility price of $35 per ounce." [1]

This insolvency event was chiefly driven by the unbalanced fiscal spending of the Johnson administration (e.g. the "Great Society" welfare state and other profligate spending), Nixon's inability to deal with rising deficits, and the growing shift of the U.S. from a creditor to a debtor nation, with a trade deficit that would likewise increase in coming years.

While Bretton Woods was a flawed international monetary system in many respects - imposing currency pegs and encouraging intervention by monetary "authorities" such as the IMF - the decision to make the dollar the reserve currency backed by gold was among the positive aspects that supported the growth of the U.S. as a net creditor nation.

It is worthwhile to review what has happened since Nixon declared a fiat end to the gold standard, allowing the dollar to float. By removing the restrictions of a dollar-to-gold conversion, debt monetization by monetary authorities (in particular the Federal Reserve) could ensue without check, under pretense of the "full faith and credit" of the sovereign.

The figure at the top depicts the geometric growth of the U.S. national debt, the broad M3 money supply metric, and price inflation as represented by the original Consumer Price Index (CPI) calculated before 1984 [2,3], resulting in an 82% decline in the purchasing power of the dollar. Such national debt growth does not take into account the 'unfunded' liabilities faced by the U.S. government through Medicare, Medicaid and Social Security programs, which exceed $100T.

Keynesians and Post-Keynesians have misguidedly supported deficit financing and debt monetization to stimulate aggregate demand and to prevent deflationary or disinflationary relief during debt deleveraging cycles. When will they wake up to the damage caused by such fiscal and monetary policies, chief among them financial instabilities that occur due to the unsustainability of perilously high debt loads, the understated risks due to artificially low interest rates, and the growing lack of confidence in the dollar?

[1] "The Nixon Shock Heard 'Round the World," Lewis E. Lehrman, WSJ, August 15, 2011.
[2] Graph is taken from "Modern Monetary Madness and King George III," May 8, 2011
[3] The pre-1984 CPI is tracked by HERE.

Saturday, August 13, 2011

Vintage Greenspan and the Lessons of LTCM

"There are some who would argue that the role of the bank supervisor is to minimize or even eliminate bank failure; but this view is mistaken, in my judgment. The willingness to take risk is essential to the growth of a free market economy...[I]f all savers and their financial intermediaries invested only in risk-free assets, the potential for business growth would never be realized." –Alan Greenspan, November 1994 [1]

In reviewing these words from "the maestro," one gets an insight into the mind of Federal Reserve (Fed) actions from 1994 to 2008, in particular the dichotomies that promoted risk-taking and investment-driven growth, yet allowed for the rise of moral hazard. In driving an environment of increasingly low interest rates through easy monetary policy, Greenspan manipulated market driven risk-reward and ignited a series of rallies and crashes in the bond and stock markets that distorted normal capital market function.

The private hedge fund Long Term Capital Management (LTCM), one of the first major casualties of the 1998 global bond and stock market swoons, had bet a near 100-to-1 leverage on a risky portfolio mix of directional trades, bond arbitrages, swaps and equity volatility shorts [2]. Though LTCM thought it was "diversified" and "hedged" according to its academic models, it was anything but, placing large bets in markets that became distorted by its very presence and dislocated when the selling started; it didn't help that instead of an early divestiture of a portion of its holdings and a decrease in leverage, LTCM doubled down, falling for the Casanova's Martingale, a betting scheme that provides an eventual win as long as there is enough capital to keep doubling the stake.

After a Fed-orchestrated bailout of LTCM by a plethora of Wall Street firms that had lent LTCM money, had been its counterparty or investment partner, a Fed official issued a telling statement that was ignored by the banking establishment, the Fed and regulators as a whole thereafter:

"LTCM appears to have received very generous credit terms even though it took an exceptional degree of risk...Counterparties obtained information from LTCM that indicated that it had securities and derivative positions that were very large relative to its capital. However, few, if any, seem to have really understood LTCM's risk profile, especially its very large positions in certain illiquid markets. Instead, they appear to have made credit decisions primarily on the basis of LTCM's past performance and the reputation of its partners. LTCM's counterparties...required little or no collateral to cover the potential for future increases in exposures from changes in market values...[and] appear to have significantly underestimated those potential future exposures. Their estimates simply did not make adequate allowance for the extreme volatility and illiquidity of financial markets that surfaced in August and September [1998]. Furthermore, they failed to take into account the potential for credit exposures to increase dramatically if LTCM had defaulted and they and other counterparties had attempted to liquidate collateral and replace derivatives contracts in amounts that in some instances would have been very large relative to the liquidity of the markets in which the transactions would have been executed. Because the counterparties did not take these risks into account, they granted LTCM huge trading lines in a variety of products, and LTCM took advantage of those lines to achieve its exceptional degree of leverage." [3]

The December 1998 testimony in [3] goes on to offer numerous recommendations on risk management and prudential oversight, and in particular on OTC derivatives. Yet this working group and its findings were largely ignored, LTCM bailed out, and the easy credit-moral hazard derby in play.

In bailing out LTCM, major Wall Street firms (Goldman, J.P. Morgan, Merrill, Chase, Salomon, Lehman, plus a number of foreign creditors) agreed to a settlement that would provide in excess of some $4B to cover LTCM's losses, in large part to cover counterparty exposure and to prevent further losses among the counterparties that lent LTCM money or invested with LTCM. On the seemingly positive side, it was the Street and not the Fed that would provide the bailout, but this is not entirely true. After LTCM's failure, the Fed embarked on a series of interest rate cuts to ease jittered markets affected by LTCM's failing positions and hit with the contagion fear of LTCM's fate. The Fed was now catering to the idea of staunching what it thought was systemic risk with monetary intervention, and thereby providing a market-wide bailout.

A decade later, Bear Stearns (LTCM's clearing broker) would experience a more massive failure fate from subsisting on repurchase agreements (repos) and additional short-term funding obtained on favorable credit terms from JPM and other lenders to double down on mortgage debt and derivatives. Bear, like LTCM, thought it was diversified and hedged, when it was anything but, and instead of reducing leverage and positions it too doubled down, especially on securitized mortgage debt (CDOs, or collateralized debt obligations) that it thought could recover in value. When Bear could not sell such illiquid CDOs in an increasingly hostile market, and when its capital positions withered along with its credit lines, Bear received a Fed-orchestrated bailout by JPM, except this time taxpayers received exposure via a $30B backstop from the Fed of increasingly toxic mortgage debt instruments.

Within 6 months, AIG would receive a direct $85B bailout (and later over $100B more) from the Fed, for much the same serial infraction of risk taking as LTCM and Bear. AIG would extend CDO insurance (in the form of credit default swaps or CDSs) to Société Générale, Goldman, Merrill, Deutsche Bank, and many other firms that invested long in the CDO market, without anywhere near the proper capital to cover losses from CDO defaults, should they occur (and they did, en masse, in tail risk fashion). Lehman, like Bear, relied on repo lines and the commercial paper markets to fund its Martingales on CDOs and off-balance-sheet entities such as structured investment vehicles (SIVs) that in turn invested in CDOs to get around regulated capital requirements. Though Lehman succumbed to bankruptcy fate instead of a Fed/Street bailout, Citigroup and Merrill would receive large infusions from the Fed and Treasury, with Merrill taken over by Bank of America.

Many financial pundits today blame the November 1999 repeal of the Glass-Steagall (G-S) Act as the cause of exploding risk taking and moral hazard stemming from systemic risk among large financial institutions. I disagree. In parsing the history of LTCM's failure (which occurred well before G-S was repealed) and the Fed's summary monetary policy response, we didn't need a repeal of G-S to set the stage for exploding risk and moral hazard. The Fed provided plenty of fuel in its cheap money policy for firms to borrow short on cheap terms and invest leveraged long in highly risky assets for their carry interest. Regulation and regulators are obviously not the panacea here. Government needs to quit rewarding moral hazard, to allow firms to fail, and to not intervene with monetary policy bailouts to markets. Financial firms will then get the idea that risk taking does indeed require prudential management and oversight. Business investors in the main who are willing to take on the calculated risks that Greenspan called "essential to the growth of a free market, capitalist economy" know, accept and manage such risks, otherwise they are out of business.

[1] "The New Risk Management Tools in Banking," Alan Greenspan, Address to the Garn Institute of Finance, University of Utah, November 20, 1994. Everyone should read this address, which contains some very persuasive arguments. The tragedy is the actual history that followed, negating Greenspan's credibility. 
[2] Two outstanding books that have documented the rise and fall of LTCM are of note: (a) "When Genius Failed," Roger Lowenstein, c.2000; (b) "Inventing Money," Nicolas Dunbar, c.2000. 
[3] Testimony of Patrick M. Parkinson, Associate Director, Division of Research and Statistics of the Federal Reserve Board, Progress report by the President's Working Group on Financial Markets, Before the Committee on Agriculture, Nutrition, and Forestry, U.S. Senate, December 16, 1998.


Sunday, June 19, 2011

Who Will Buy the Debt?

"Who will buy Treasuries when the Fed doesn’t?" is a question asked by major bond fund manager Bill Gross of PIMCO in his March 2011 Investment Outlook. Gross has come under considerable scrutiny for daring to divest his flagship Total Return bond fund of Treasury holdings post the late August QE2 announcement by the Fed/Bernanke, and in some timeframes thereafter apparently took short positions against Treasuries.

Despite the significant rally in Treasuries from mid-April, with a near 18%/10% decrease in the 10-yr/30-yr yields (leading to ~6-7% price appreciation on the market), Gross has essentially maintained his low-to-no position on Treasuries, with a 35% holding in cash equivalents, 21% mortgage debt, 18% high-grade corporate debt, and 20% equally split between emerging and developed market (mostly government) debt, shying away from municipal debt in a similar manner to Treasuries. Gross maintains he has "no regrets" over missing the recent Treasury rally, and recommends that bond investors should shift their weights to corporate or government debt issued by companies and sovereigns with far better balance sheets than the U.S. government (and also by implication, municipalities).

I submit the larger, more general question at this point should be: "Who will buy the debt?" Though debt-holders have continued (or have been forced) to de-lever from the credit market excesses that eclipsed in 2007/8, record debt issuance continues in the corporate markets and from the U.S. Treasury [1], thanks to historically low rates led by the Fed's zero interest rate policy (ZIRP) and ongoing permanent open market operations (POMO, or debt monetization).

Low yields mean investors may not be adequately compensated for the aggregate risks they are taking by buying the issued debt. Those risks include default, interest rate and inflation risks. The latter is already an issue: the real rate on the 5-yr Treasury note is currently negative [2]. Though default risks are in real terms lower for many high-grade corporates vs. our own sovereign debt, the current talk of sovereign default from Greece to the U.S. increases this risk span, yet rating agencies still rate Treasuries as AAA and the corporate-to-Treasury spreads are increasing as Treasuries rally. Interest rate risk (the risk that interest rates shoot significantly higher, sending bond prices sharply lower) is a real possibility that could lead to a broad market "event" not dissimilar to the Black Swan-type swoon we saw in 2008/9, except this time Treasuries may lack the "flight-to-quality" status that investors then sought for sanctuary while the stock, commodity, and non-government bond/debt markets all got pummeled. In this scenario, investors and traders may choose to dump some or all of their debt holdings (including Treasuries and munis), preferring not to get caught as prices fall, and therefore may trigger a cascade of selling and even sharper declines in prices.

As total outstanding debt continues to grow and yields are kept artificially suppressed, investors must ask why they should risk buying any debt if there is market volatility risk attached that could stem from default and/or interest rate risks. "Who will buy the debt" is the hazard for debt oversupply in any market, with markets increasingly correlated due to leverage and other factors.

[1] Total outstanding U.S. bond market debt as of Q1/2011 stands at some $35.5T, composed of $9.1T Treasury debt (26%), $7.6T corporate debt (22%), $8.5T mortgage debt (24%), $2.9T muni debt (8%), $2.9T money market debt (commercial paper, etc.)(8%), $2.5T federal agency debt (Fannie/Freddie, etc.)(7%), and $2T asset-backed debt (auto, credit card, home equity, student loan, etc.)(5%). The trend of this data since 2007 has clearly shown an increase of Treasury and corporate debt, and a leveling-out or decrease of all other types of debt, from the credit market deleveraging process. This data was sourced HERE from the Securities Industry and Financial Markets Assoc. (SIFMA). U.S. bond market debt is some ~39% of the total world-wide market debt estimated at ~$92T using Bank of International Settlements (BIS) data HERE. Note that these stats are total outstanding "market" or marketable/tradable debt, and not total outstanding market+non-market debt. I will discuss and source the latter in a future commentary, but the obvious example is the non-marketable U.S. Treasury debt that includes social security obligations, state and local government series bonds and savings bonds. 
[2] The U.S. Treasury has a nifty interactive yield curve flash app HERE, showing nominal vs. real rates and a historical rate comparison tool.

Beware of 'Peg the Dollar to the Euro' Proposals

In a cure for what is being forecast as a recession after the end of the Federal Reserve's latest targeted quantitative easing binge (QE2), Nobel Laureate Robert Mundell has proposed that the Treasury fix the exchange rate of the dollar to the euro. Mundell believes that a sure sharp rise in the dollar post-QE2 will lead to deflation in the U.S., and then recession. His prescription for this scenario is to stabilize currency exchange rates, given his view that exchange rates transmit inflation or deflation into economies by raising or lowering prices for imported items and commodities. By targeting a peg of the dollar to the euro, the world's two leading currencies, greater economic stability will be achieved.

I say that this is an absurd idea. Fixing the exchange rate of the dollar to the euro does not equate to currency stability. I also take issue with the dynamics that Mundell may be using in his argument: commodities don't always correlate with the eurodollar, so fixing the dollar to the euro won't necessarily affect commodity speculation and hot money flows across borders and back. The problem is with mismatched credit expansions and interest rate policies between borders - causing money to flow preferentially to the highest yielding opportunities at that moment. We have a very fluid and liquid global system now, and swing trading based on these mismatches in policies is quite obvious. We live in the realm of the carry trade, wherever it can be found.

Would an international gold standard help? Not if it isn't supported by a commitment to maintaining its stability, and I doubt that commitment exists at present. For one, it would mean credit could not expand or contract too drastically, and I do believe there are some highly placed who want such a turbulent environment. The other issue is interest rates, which are already monopolistically fixed by sovereign central banks - this is another control not likely to be easily ceded. A stable international gold (or hard money) standard and "free banking" are ideals for the distant future, and the benefits are worth continued extolment.

Sunday, June 12, 2011

Failed Fed Auction an Early Warning?

Not widely reported except by Bloomberg, the Federal Reserve (Fed) had a rare failed auction last week of mortgage-backed securities (MBS) "purchased" by the Fed from AIG during its $182.5B bailout in 2008/9. The Fed bought a total of $52.5B of MBS from AIG as part of the bailout package, forming the "Maiden Lane II" portfolio of distressed crisis assets on its balance sheet. Why should investors and traders care about this event? Keep reading.

In a June 8 dutch auction, investors only bought $1.9B of $3.8B of debt offered, causing market spectators to question the quality of MBS assets that AIG dumped on the Fed (or that the Fed overpaid for). The byline is that the Fed ended up selling the assets into a weak(ening) market, a casualty of bad timing. The irony is that the Fed was offered $15.7B from the rescued-and-lingering AIG for repurchase of the remaining $31B Maiden Lane II portfolio in March. Perhaps the Fed saw such a discount repurchase (reverse repo, actually) as a giveaway that would get too much press attention as a taxpayer loss, and decided that selling into the open market was a more tenable option. Credit markets in February-March were at a 2-year "high" of health, but have since deteriorated somewhat, with both MBS and corporate high-yield (junk) debt spreads increasing along with the price of credit default swaps for major banks and bond insurers.

So why should investors and traders care about this event? First, failed Fed auctions are a rarity. Second, the Fed has some $2.8T of "crisis assets" on its balance sheet [1], with ~$2T collected since fall 2008. Yes, the majority of those assets are Treasuries bought via quantitative easing asset swaps, and are AAA-rated, of the very highest quality debt (for now). Likely, the Fed won't be unwinding its balance sheet anytime soon, given some show of recent economic weakness and calls for even more quantitative easing from some quarters. The questions that arise are: Is selling into a weak market a destabilizer for credit/debt markets, and what is the risk of more failed auctions as the perception of quality deteriorates? Could those failed auctions ever be mint-Treasury auctions by the Treasury [2], forcing the Fed to continue loading its balance sheet and monetizing debt? And then there's always the question of all that muni-debt...

Note I am not just another "chicken little" on the issue of failed auctions and bond market turmoil, as the quality of debt has always been, and always will be, the paramount concern. If the 2008 crisis taught us anything, an oversupply of debt in the market can have destabilizing consequences, especially if quality of that debt declines. Investors and traders need to be vigilant of any signs of worsening conditions.

[1] Public view of the Fed's balance sheet can be found HERE.
[2] Newly-issued Treasury auctions can be tracked HERE.

Thursday, June 9, 2011

Japan's Downgrade is Bearish For U.S. Treasuries

The recent rally in U.S. Treasuries has many of us wondering when the trend is going to end. One party disruptor may be Japan, a major foreign creditor holding some $900B of U.S. Treasury debt, second only to China, who holds ~ $1.15T. Japan may yet decide to liquidate some of its holdings to divert capital to post-tsunami rebuilding efforts or to invest in higher yielding debt or other investments elsewhere.

Japan's recent sovereign credit rating downgrades are perhaps warranted, but a tad nonsensical in comparison with a lack of an actual downgrade of U.S. sovereign credit. Though Japan's government debt/GDP approaches ~220% of GDP, the U.S. debt/GDP at ~100% of GDP is growing at a much faster rate and does not account for unfunded obligations that will easily exceed projected tax revenues.

The Yen carry trade that financed arbitrage-fancy T-bond purchases is not as lucrative as it once was, given the persistent strengthening of the Yen (USD/JPY is now trading again below 80). Given the U.S. debt profile, sitting on long-term U.S. debt has growing risks unless hedged. The Bank of Japan could see a sale of Treasuries and a purchase of higher yielding debt from other countries with stronger currencies as a prudent move as Treasuries continue to push higher on what I call a technical rally.

(Major foreign holders of Treasury securities are tracked by the Treasury here:

James Grant on Bernanke

Bernanke is the anti-Benjamin Graham, Graham being the great value investor. For Benjamin Graham, value was everything, price was a way of getting at value. For Bernanke, price is everything, value is an annoyance, value is what holds prices down. I think that investors should keep an extra margin of cash to exploit the opportunities that may well come from an unscripted rise of inflation that sets off a chain reaction in interest rates and brings values back down to earth. Nothing is sweeter than buying cheap stocks, and they do get cheap from time to time.

–James Grant, Value Investor and Publisher of Grant's Interest Rate Observer, March 31, 2011 on Kudlow & Co., CNBC

Japan's New Inflation

A few weeks ago Japan reported rising inflation, with the CPI gaining 0.3% and 0.6% YoY in March and April, after years of negative monthly CPI data. The headlines from major news outlets were indeed amusing: "Japan beats deflation for the first time in two years (BBC)," "Japan Ends 25 Months of Deflation in Victory Marred by Quake-Led Recession (Bloomberg)," and my personal favorite, "Why inflation is great news for Japan." Oh wait - that latter title is recycled from a myriad of similar news reports when inflation last surfaced in Japan in 2007/2008.

According to business/economic news media and Keynesians alike, inflation for Japan is good, while deflation is an anathema. Inflation means rising consumption, demand, loan growth and ultimately output, while deflation means falling consumption, demand, credit contraction and deleveraging, and ultimately falling output. Except the dynamics aren't that simple and settled.

Japan's persistent YoY deflation since 1995 is arguably the result of years of debt deleveraging from the '80s real estate and stock market boom-then-bust, but it is also the result of rising production and productivity [1], which has a positive effect on lowering overall consumer price levels, even when demand is increasing. One might call this "good deflation." Also overlooked is the fact that Japan's deflation was "low and stable," especially during the period 1998-2007, when the average annual YoY CPI deflation was -0.23% with a standard deviation of 0.49%. I find it contradictory that the bulk of economists (especially those residing at central banks) think that low and stable inflation is good (the "Great Moderation"), while apparently low and stable deflation is bad.

What Japan's experience with inflation proves is that rising prices can happen with falling output and productivity, or stagflation, a dirty word to garden-variety Keynesians. With the Yen recently strengthening against most major currencies, the Bank of Japan is limited in what it can do to weaken its currency, which in the past has been achieved though a plethora of quantitative easing measures. Japan has little choice but to continue to delever and fight off any potentially persistent high rates of inflation, should it arise.

[1] Japanese industrial production and labor productivity rose steadily from 1998-2007, aside from a break in the increase during the 2001 recession. CPI and production/productivity data for Japan were sourced from HERE.


Money Market Funds and Risk

Money funds carry risk, and taxpayers should not be expected to bail out poorly managed funds.

Are money market funds safe investments? With yields at historic lows the question is a good one to ask, especially if the risks outweigh the yields. The highest current yields may only be slightly over 1%, with the bulk of funds yielding far less than 1%. At such low yields, some consider these funds not as an investment, but as a place to reserve or "park" cash. Money market funds typically peg their net asset value (NAV) to $1/share to "guarantee" against principal loss, though in reality there is no inherent guarantee, and these funds are distinctly different from bank savings accounts.

Regulators, such as the SEC, are reportedly working on (you guessed it) more regulation of money funds, with possible reclassification as banks, and perhaps even the charter of a new FDIC-like entity to buy securities from the funds in liquidity, flight of capital, or quality of capital crises. The industry's trade group is even lobbying the SEC and the Federal Reserve to set up a "liquidity bank," one that would have access to the Fed's discount window.

A history lesson is useful here. The money funds that had trouble in Fall 2007 had bought short-term commercial paper from structured investment vehicles (SIVs), which in turn used this funding to buy risky/toxic collateralized debt obligations (CDOs) and mortgage backed securities (MBSs) - In effect to circumvent regulatory capital rules that restricted debt. The value of these SIVs plunged with CDO/MBS prices, imperiling the value of that paper. There were about a dozen money funds in this timeframe that suffered from potential losses and "breaking the buck," and some of them were names that would later succumb to essential failure or takeover (e.g. Wachovia). The problem funds simply replenished their capital to avoid further market turmoil.

In Fall 2008, the problem resurged, with one fund, the Reserve, the flashpoint - for holding some 1.2% of their assets in paper (debt) from Lehman after the bankruptcy. The irony with the Reserve fund is that it was started by the so-called creator of money funds, Bruce Bent, who in 1972 opened the first money fund to "invest in a diversified group of short-term credit instruments." Bent promoted the idea of maintaining the $1 NAV to attract investors interested in total preservation of capital. The irony is that Bent was also a staunch advocate "against the dangers of reaching for higher yield by stooping to inferior credits...denouncing commercial paper as overly risky." A run on the Reserve immediately following the Lehman bankruptcy (savvy investors noted the 1.2% interest in Lehman paper on the fund's websites) prompted Reserve management to "frantically seek help from the Fed." [Source for historical info: R. Lowenstein, "The End of Wall Street," c.2010.]

The Reserve Primary fund has since liquidated all assets after an SEC-ordered pro-rata distribution, with shareholders getting back ~0.9875 cents on the dollar.

My commentary: Does anyone read prospectuses and keep track of fund investment holdings? Money funds may promise a $1 NAV, but in practice many not be able to keep it, especially if they buy commercial paper secured by faulty collateral or credit. The same goes for any other poor-quality short-term debt. Money funds carry risk - and it rewards investors to seek funds that are conservative compared to others.

Not all commercial paper is "bad;" what matters is the collateral behind it. If it is a diversified set of solid businesses with solid balance sheets, great - but if it is Ponzi finance, such as SIVs seeking short-term funding to buy suspect MBSs to juice the yield spread, then something is wrong.

Money fund investors need a dose of caveat emptor, even with the perceived safety of more regulation, which may also mean even lower yields due to increased regulatory costs.

As for the idea of a liquidity bank, it's a fine one, and investors who have a perceived need for such a service or insurance should elect to pay for it. Allowing money funds to access the Fed's discount window in times of stress is akin to a taxpayer subsidy, given the discount rate charged for any liquidity.


Saturday, June 4, 2011

About The Econ Ideal

The Econ Ideal was created to provide frequent commentary (and some analysis) on current economics, finance, trading and investing subjects. Stay tuned for new posts. The peer site for this blog is For more information about me, the author, see

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