Tuesday, December 6, 2011

Shoddy reporting by Bloomberg Blames the Fed and Lets Congress off the Hook

I would like to examine in some detail a recent report by Bloomberg about the actions of the Federal Reserve Bank during the depths of the 2008 financial crisis. Bloomberg, through a FOIA request, gained access to the records of the various facilities that the Federal Reserve created to inject liquidity into the banking system during the darkest hour of the financial crisis. At the time, the Fed disclosed the program in aggregate but did not identify specifically which firms were lent how much for how long. They argued that this was to avoid a stigma among the banks who might otherwise delay seeking liquidity for too long and thereby turn a liquidity problem into a solvency problem. For filing the request I think that Bloomberg should be congratulated because it sheds quite a bit of light on just how deep the freeze in short term lending markets became not merely among the banks but among corporates as well.

That said, the recent Bloomberg piece on the program which has stirred much controversy is a rather shoddy piece of sensationalist journalism designed to inflame rather than to inform. The over-arching narrative of the article, which came out on November 27th is that the Federal reserve liquidity facilities totaled $7.7 trillion dwarfing the Congressionally approved $700 billion TARP. The article asserts that, unlike the TARP, these funds were lent “with no strings attached” and that the fact that their recipients were not individually disclosed obscured just how serious the financial crisis was and therefore have hobbled the efforts of the legislature to reform the financial regulatory system as evidenced by the defeat of a bill to break up the top six banks or to reinstate Glass-Steagall.

The first things which draws the eye is the $7.7 trillion figure. They don't actually give too much detail as to what this comprises other than to say its what you get if you “add up guarantees and lending limits.” This number is highly suspicious because the total balance sheet of the Fed today, after two rounds of quantitative easing, stands at $2.8 trillion. How is it possible for the Fed to have lent a sum almost three times the size of its current balance sheet almost a trillion dollars larger than it was at the time? Well, it's not.What they are doing is counting all the loans made regardless of term which VASTLY overstates the extent of the amount of money at risk.

Here's how it works: let's say I lend you a million dollars over night and you pay me back the next day. Let's say we do this every day for 260 business days over the course of a year. Have I lent you $260 million over the course of a year? Yes. Was it ever possible for me to lose $260 million? No. the most I could lose was $1 million on any given day since if you don't pay me back you don't exist the next day for me to lend you another million. So to count all the loans over the entire time period in a single statement is to greatly inflate the sums involved. Which, of course, is precisely the objective of the Bloomberg article because it gets attention and with it clicks and reposts which you can see if you google “Federal Reserve $7.7 Trillion.”

That's the most egregious thing in the article and I almost forgive them because the click-based economics of internet journalism almost demand some kind of preposterous claim to encourage and diffusion of the article through social media. They do stick with that convention throughout the article which is unfortunate but they often refer to the days of maximum borrowing which give a better insight into the actual scale involved. What they don't do is provide any context as to what the relative importance of the Fed loans was to the overall capital structure of the firms nor do they compare the relative importance of the TARP and the Fed programs in order to support their claim that had the Congress known about the Fed program that much of the regulatory effort would be different. Luckily this perspective is actually pretty easy to come by, all that is required is a quick look at one of the larger recipients of both the Fed programs and the TARP. So let's have a look at JP Morgan. According to the documents that Bloomberg has acquired JP Morgan's borrowing peaked on February 28th 2009 at $45 billion. $45 billion? Whoa, sounds like a lot. They even point out in that this was larger than the cash holdings of JP Morgan. OK, let's have a closer look at the balance sheet from that era via the JPM 10-Q, here it is for your reading pleasure: 

OK, sure enough the cash holdings of JPM were $26 billion, less than the amount of the Fed loans. The Fed loans would be in the section under “Liabilities” entitled “Other Borrowings” which totals $112 billion. Wait a minute, it seems from the Bloomberg article that JPM was entirely dependent on the Fed for its borrowings, in fact the Fed was less than half of the short term loans that JPM was funding with at the time. Actually the more you look, the less important the Fed loans are. The balance sheet as a whole is $2,079 billion, so the Fed is meeting around 2% of the funding needs of JPM not a huge number but let's think about what would have happened had the Fed withdrawn its support. Well, given that the cash position of JPM was $26 billion, they could have self funded that bit and then come up with an additional $19 billion which they could have done by converting $19 billion of their $90 billion in deposits at other banks to cash. So it would not have been fatal to JPM after all.

So if it wouldn't have been fatal to the bank then why do it at all? Well the answer to that is also seen on the balance sheet, as is the need for secrecy. Notice what happened from December 2008 to March of 2009, the balance sheet shrank by about $100 billion in total, as you can see total deposits shrank by the same amount. In essence there was a general level of fear in the economy that was leading people to pull their money out of the banks. JPM could have done without the Fed's support but to do so it would have had to withdraw $10 billion or so from other banks, and those banks in turn would have had to withdraw their money from other banks as well. This is what the Fed was trying to prevent, a generalized withdrawal of liquidity from the banking system which would have halted lending altogether and withdrawn a lot of liquidity from the general economy as banks shrank their balance sheets.

The Fed was able to stabilize the banking system with relatively small amounts of capital relative to the balance sheets precisely because of the policy of secrecy of the program. It was entirely possible that if they had disclosed at the time that this or that bank was borrowing from the Feds liquidity facilities that already spooked depositors would accelerate their withdrawals and thus force the banks to withdraw more money from one another or else further shrink their balance sheets. It would have been possible for the Fed to grow the program in that event but the fact that no one knew which bank was borrowing how much when meant that it wasn't possible to panic about any individual bank though there remained a fair amount of fear in the system as a whole.

So the liquidity program of the Fed was very helpful in supporting the banking system as a whole but it was not vital to any individual bank. It might have become a more acute issue if the Fed at the time had not maintained the veil of secrecy around it. The relatively mild nature of the program despite its secrecy is one reason why I do not think that more general knowledge of it would have affected Congressional regulatory actions after the crisis. The other is that while the Federal Reserve liquidity facilities were helpful to the banking system as a whole, the truly decisive government program was the Congressionally funded and overseen TARP program without which it is far more likely that the banking system would have collapsed entirely.

When thinking about the relative importance of the Fed's facilities and the TARP is the nature of the problems they were designed to solve. The Fed was primarily concerned with liquidity, the TARP with solvency and solvency was BY FAR the more serious problem. Liquidity is a question of at what cost must the firm get the funds it needs to operate day to day. Solvency is a question of whether the assets on the balance sheet are worth more or less than the sum of the liabilities plus the equity and thus whether the firm in fact exists. At the time Congress was aware of the what if not the who of the efforts on the liquidity front but it had a front row seat for the efforts on the solvency front.

When discussing this it is important to remember what happened during the Lehman bankruptcy. The Friday night before the collapse Tim Geithner called the heads of the big New York banks and investment firms to a meeting and ordered them to come up with a private sector rescue for Lehman Brothers. This was by no means even remotely possible, which Geithner should have known, because at the time the markets for securitized mortgages, the most problematic items on the Lehman balance sheet, had ceased to function whatsoever and the securities which comprised it were so complex that it was not possible even to model them with any degree of certainty. Therefore any would be rescuer would have to take a leap into the abyss and given the fact that the Lehman balance sheet was $600 billion, it was well beyond the capacity of the other banks in the room to saddle their own shareholders with the potential losses.

Those fears proved extremely well founded. After the collapse of Lehman there was an auction to determine the settlement price for CDS on Lehman Brothers which resulted in valuing the recovery rate, that is what unsecured creditors of Lehman could expect, at 9 cents on the dollar meaning the size of the balance sheet hole was gargantuan (and incidentally if the banks had obeyed Geithner he would have destroyed the entire system.) The knowledge of how deep that hole was sent waves of panic through the markets are called into question the balance sheets of every bank which also engaged in mortgage securitization, which was all of them. This is important because if it were the case that the assets of the remaining banks were worth less than the liabilities and the equity the banks would be insolvent. Fear of this led people to being withdrawing their funds from banks exacerbating the liquidity crisis. It was entirely possible for that liquidity crisis to develop into a solvency crisis by its own momentum which is why Congress enacted the TARP.

The TARP injected $250 billion onto the balance sheets of the banking system at the preferred stock level thereby adding an essential additional layer to the capital structure of the firm. Equity is the key element in this because the firm is solvent as long as the uncertainty around the balance sheet is less than the equity because it means all the unsecured lenders will recover all their funds in the event of a liquidation. This is why the TARP was structured in the way that it was and why it was crucial for the survival of the system as a whole, far more so than the Fed programs. At the time of the peak borrowing from the Fed the common stock of JPM was worth about $65 billion and the firm had $35 billion of preferred stock including $25 billion of TARP funds. So while the Fed was providing about 2.5% of the borrowings of JPM the taxpayer was providing 25% of the equity. So for Bloomberg to claim that the decisive aspect of the bailouts was the Fed liquidity facility is to do violence to the facts.

The Fed programs have largely been unwound and resulted in no losses to the Fed. The TARP still has billions outstanding and will result in losses to the taxpayers of about $30 billion. So of the two programs, by far the more crucial and the more painful for the taxpayers was the TARP rather than the Feds liquidity programs. Thus it is quite disingenuous for Bloomberg to claim that had there been more knowledge of the specific borrowers from the Fed that there would have been more effective regulation of the banking system in the Dodd-Frank Act. It is quite true that there are serious flaws in the Dodd-Frank Act and there has been a very effective campaign against implementation of some of the more useful features but to claim that this is because of a lack of knowledge of the Fed program is to provide a smoke screen for the real issues behind the failures of Dodd-Frank and to let Congress off the hook.  

Wednesday, October 5, 2011

My Suggestion for Occupy Wall Street Demands

So, though the market action has been highly interesting lately and the drama in the Eurozone is extremely compelling I would like to take some time today to lend a hand to the marginally important though highly amusing Occupy Wall Street movement. The movement is emotive if incoherent not unlike the Tea Party. There has been some concern lately that while they are unhappy about a great many things they have little in the way of concrete solutions or even demands. A website affiliated with them did publish a draft of potential demands but it obviously cannot be taken seriously because, like the movement itself, it has virtually no understanding of how the world actually works and therefore cannot address itself to the root causes of the problems which vex them so.

So I have decided to publish what I consider to be a more reasonable list of demands that I think would actually go a long way toward resolving many of the issues which face them. My views on the solutions to the economic ills facing the country are so counter to the thoughts of the OccupyWallStreet crowd that they require a separate post. However, fundamentally I agree with the protestors that the influence of well financed special interests has totally undermined the Democratic process and largely captured the state.  

First I will list some assumptions:

  1. Corporations and people respond to incentives, the key element in controlling behavior is not to simply enact rules but to enact rules and laws which consider second order effects, that is the ways in which individuals and groups will respond to them. The key is to focus on final outcomes, not initial rules.

  2. Money in politics is here to stay. If you are going to tax and regulate business, business is going to seek to influence those taxes and regulations. If you make it illegal to donate to campaigns then you'll move to a revolving door regime such as we have with regulators and administration officials or corporations will find some other means to influence policy. The rewards to it are simply too great. The key therefore is not to eliminate money from the political system but to alter the political system in such a way as to minimize the influence that money can buy.

    So with that in mind, here are my suggestions:

  1. Quadruple the number of members of House of Representatives. 

    The average member of the house current represents about 650,000 people. This is such a large number that the only way for Congressmen to communicate with the voters is through mass media. Mass media is expensive. If you lowered the number of people that Congressmen had to win over in an election to a more manageable number then you would diminish the necessity of mass media buying and you would therefore also minimize the influence of money in elections.

    As a second order effect, instead of having to pay off 435 Congressmen, large well financed special interests would have to pay off 1740. You would be raising the total cost of influencing national policy but simultaneously lowering the costs for any individual citizen to actually run for office. This would have a substantially dilutive effect on the role of money in elections and would make Congressmen as in touch with their constituents as the mayor of a medium sized city.
  1. Double the number of Senators

    Same reasoning as the above.

  2. Change the term of a house member to five years and a Senator to fifteen.

    When the Constitution was originally written life expectancy in the US was about 40 years of age. Therefore a two year congressional term would constitute about 5% of the life span of the average person living in the country at the time. It was therefore a very serious time commitment and few people thought they would run more than a few times. Now that people live much much longer, most politicians plan on running for election several times. This is extremely expensive and makes fundraising a virtually constant demand on the time and attention of all public servants. The moment they are elected they have to be thinking about raising money for the next election. Why not take the pressure off, by making the term of office a similar life commitment to what it was in when the Constitution was first framed. Think about it, for several years, while there was no imminent election, it would be extremely difficult to influence the political system with money.

  3. Implement non-partisan redistricting

    This is absolutely essential. Today many Congressional districts are drawn up by partisan committees which basically divide up the districts so that many of them are “safe” for one party or the other. Basically the parties largely decide between them what their proportion of seats in Congress will be. This has some very pernicious effects on governance. The most important is that in “safe” districts the candidate really only has to win the primary. Imagine a Congressional district with 650,000 residents. Of these lets say 300,000 are registered voters. Of these 150,000 will vote in the general election. Lets say that 85,000 of them are Democrats, and 65,000 of them are Republicans because this was designated a “safe” Democratic seat through partisan redistricting. Let's say that 20,000 of the most hard-core Democrats are going to vote in the primary to choose which Democrat actually gets to run against the Republican who is almost certain to lose. First of all, the Rep has to only appeal to the most committed of that 20,000 in order to “represent” them and the other 630,000. Keep in mind, the people who vote in primaries tend to be VERY committed to their ideology which is why they pay attention to the primary.

    This kind of thing has a HUGE influence on policy. Imagine you are a Tea Party Republican. You may think its reasonable to include some tax increases in some kind of compromise. Of the 650,000 people in your district about 400,000 probably agree with you. But, only 20,000 voters actually count because if you don't win the primary you're out of the game before it starts. Let me assure you than on the Republican side those 20,000 guys don't want to hear ANYTHING about raising taxes. So you're sure as hell not going to raise them.

    Non-partisan redistricting is not perfect but it would go a long way toward breaking the stranglehold of the extremes on the right and the left over the political process and would return power to the more pragmatic and centrist elements of the political system.

So, that's my suggestion for a platform for the Occupy Wall Street crowd. You can't get the money out of politics but you can dilute its effect and refocus our elected representatives on serving the needs of the entire public rather than their special interests and ideological masters. 

Wednesday, September 21, 2011

"The Twist:" Ben Bernanke channels his inner Vincent Vega

I ain't saying it's right. But you're saying a the twist don't mean nothing, and I'm saying it does. Now look, I'm giving 400 billion bonds 400 billion  duration shifts, and they all mean something. We act like they don't, but they do, and that's what's so fucking cool about them. There's a sensuous thing going on where you don't talk about it, but you know it, the Christine Lagarde knows it, fucking BofA shareholders know it, and Rick Perry should have fucking better known better. I mean, that's the  fucking term structure, man. I can't be expected to have a sense of humor about that shit. You know what I'm saying? -Ben Bernanke in the todays Fed announcement.

Quite an action packed day today was. Today we got a large stock market move lower, down about 3%. This was driven by three news items.

First of all this morning existing home sales were released and the numbers were better than economists expected: 5.03 million vs. an expectation of 4.75 million. Most of the data out of the housing market has been pretty abysmal lately so the markets took this with a grain of salt.

The second most important thing to happen today was that Wells Fargo and Bank of America both had their ratings cut by Moodys to below AA. Though something along these lines was expected it was still a big deal. The reason that its a big deal is that BofA and Wells Fargo are two of the four largest banks in the country. With the other large banks they have been struggling to recover from the near death experience that the financial system underwent in 2008. Yes they have paid back their TARP funds and have more or less returned to profitability but there remains a huge overhang of sketchy real estate loans on their balance sheets. There has been a lot of speculation as to what these balance sheets are worth and generally the markets have their doubts which is why the financial sector has taken a beating all summer.

There are only two ways for the balance sheet problem to be fixed, one is for the assets in question (US residential real estate) to recover significantly enough to remove the cloud of doubt as to what the true value of the balance sheets are. Today's ray of sunshine notwithstanding the markets are not too optimistic about this scenario. The other is to earn their way out, that is, if they earn enough money so that they can fill whatever balance sheet hole there is with their profits then they'll be fine. The problem with the downgrade is that it will seriously impair their ability to make money.

Remember all a bank does is borrow money from savers and lend it to borrowers. What money they don't borrow from depositors they borrow from other institutions at what is usually called LIBOR (The London Interbank Offered Rate. Believe it or not this was invented by the Soviet Union when they refused to hold their Marshall Plan Aid in US banks and so deposited it in London and the London banks had to figure out a generic interest rate to pay the Russians. Thus the offshore interest rate for US dollars was born and has been called LIBOR ever since.) This is the rate at which banks generally lend to each other and the credit rating for LIBOR is generally assumed the credit rating is AA. Now BofA can't borrow at LIBOR any more, it has to pay more. So therefore in the interbank lending market BofA's costs of funds are higher. Interest costs are the most important factor in bank profitability so losing their AA rating instantly means that they'll be less profitable and therefore it will take them longer to close the balance sheet hole.

Interestingly one of the reasons that Moodys lowered the rating was that they felt that the US government is less likely to bail out a troubled financial institution than it was in 2008 because there is less risk of contagion. Since these banks were, formerly, considered too big to fail they're correspondingly riskier. This is interesting considering the high adventure going on in the European banking system right now. If there is a Eurozone sovereign default then there will almost instantly be a MAJOR European banking crisis. This crisis will spread far and wide at high speed. I actually think that Moodys is correct that government assistance will not be forthcoming but not because there is less systemic risk. There is a large and powerful faction within the Congress that was willing to let the US sovereign default. Do you think they're willing to let Bank of America default? Sure are you're born.

Of course the most important news of the day was the Federal Reserve Statement. The Federal Reserve announced, after a two day meeting, that they would move $400 billion of their Treasury portfolio from short dated securities to longer dated ones (an operation called “the twist”) and they would reinvest their maturing mortgage securities into new mortgage securities rather than Treasuries as they had been doing. They also said that the economic outlook was increasingly gloomy and that downside risks were increasing.

So what does this all mean? First the easy part, during the financial crisis when there was a massive collapse in the mortgage market the Federal reserve stepped in and began buying mortgage backed securities. This was a controversial move because the Fed usually government securities, it was a departure from standard practice for the Fed to intervene in the private sector borrowing markets. Since the crisis, as the securities that the Fed bought have matured the Fed has bought treasuries with the proceeds, slowly getting out of the private sector mortgage markets and returning to its natural habitat of US government securities.

Their announcement today means that, going forward, they're going to be reinvesting back into mortgages. This will lower mortgage rates generally, or at least dampen any increases. The Fed is probably hoping that this gives a bump to the real estate markets and thereby help the banks with problems they have with all the residential real estate on their books. The real estate markets are indeed in serious trouble so any little bit helps but I doubt that this will have a significant impact.

The main event of course was “The Twist.” The repositioning of the government securities on the Fed's balance sheet from near term to long term. The nominal objective is to lower long term rates without affecting short term rates very much. They'll succeed in this because $400 billion isn't that much in the very deep and very liquid short term US government securities markets, but its really big in the long term markets. Thus they can have a lot of impact on long rates by buying but not too much impact on near term rates by selling. Keep in mind that because the transactions will be offsetting this is not Quantitative Easing, so Rick Perry can leave his shotgun on the gun-rack in his F-150.

What's behind this? Well, basically for the past few years banks have had a free ride. The Fed has crushed near term rates to zero which, if you have a bank account of any kind, means that banks can borrow money from their depositors at near zero interest rates. They could then buy ten year Treasuries at 3% or so and make that a risk free 3% per year and this is what they have been doing. Sure there has been some loan growth but why lend money into the real economy if you can make this nice juicy 3% risk free? Well, sheriff Bernanke has come to town and is calling that game over. What he's trying to do is force longer term interest rates so low that the banks are forced to move up the risk curve and start lending more money into the real economy.

Will it work? That is a really tough question. There are a lot of really good reasons to have your capital close to the vest right now if the banks hold back and stay where they are on the risk curve all the Fed has done is reduce the profitability of the banking sector. You could look at today as a one two punch for the banking system, the downgrades lower increase their costs and lower long term interest rates lower their revenues. On the other hand if they are forced out on the risk curve and at lower rates that might be helpful for the real economy. This of course assumes that the reason that loan demand has been so low is that businesses think that long term rates, already the lowest in over a decade, are still too high. This is not likely. Far more likely is that economic conditions are very uncertain and taxes on investment are scheduled to almost double by 2014.

In any case the markets were not a fan. The S&P, which opened the day lower, dropped like a stone into the close closing down 3% on the day. I think this is for three reasons. One, I think that though most market analysts correctly called the Fed action many market participants thought that Bernanke might do something more aggressive. There are serious problems in Europe and the US data is getting pretty bad. Bernanke has been very innovative and I think the markets thought he might have something else up his sleeve perhaps even QE3. The fact that gold also dropped like a stone and the dollar rallied seems to indicate that the markets had baked a bit more loosening into the market cake. Alas, no joy. The second reason I think is that the Fed remarks were very grim. At the same time, the relatively limited action of the Fed this time despite that grim data, and the relatively high number of dissenters is a further indication that the tools the Fed has at its disposal are limited. Finally, I think that the speculative attack in Europe may have been on hold until the Fed made its announcement. Now that the Eurozone bond vigilantes know where Bernanke stands, they're free to renew their assault on Fortress Europa. It should be interesting.  

Monday, September 12, 2011

I've come up with some ideas on how to create jobs. To pay for it I've decided to hire the guys who brought you the debt ceiling fiasco. Sound like a plan?

There's a lot going on in the world but I want to write something on Obama's speech last week.

I was interested for two reasons. First, I have been studiously avoiding the clown car demolition derby that is the GOP primary but I remain interested in the political contest, such as it is. Given that Obama's approval ratings are going over a cliff and polls show he would lose against a generic Republican, if not any of the actual Republican candidates, this was an important speech for him. Second, I was very interested to see what sorts of policy initiatives he would put forward. As you will see from my next series of posts I think that the trouble brewing in Europe is extremely dangerous to the global economy and anything the US can do to increase the rate of US growth would be very helpful at this stage of the game.

In the end, the speech was far more interesting from the political angle than from the economic angle. From a policy perspective the “American Jobs Act” contains a few new tweaks of the mechanics of unemployment insurance but otherwise is more or less a $550 billion extension of the American Recovery and Reinvestment Act (ARRA or “the stimulus.”) It contains some infrastructure spending, extensions of unemployment benefits, transfers to states to pay public employees, an extension of the payroll tax cut, and accelerated depreciation. I found this pretty disappointing. If $1.6 trillion of these initiatives failed to revive employment then why should another $550 billion do the job? To be sure the ARRA has its defenders though I am not one of them. I was doubtful that the President would bring something new to the table but I wanted to be surprised. In the end, my doubts were confirmed. 

I should mention that in the 2008 elections I supported Obama. I donated the legal maximum to his campaign both in the Democratic primary and in the general election. I had many reasons for doing this a short list would be that I was disgusted with the job the Republicans had done running the country, horror at the prospect of Sarah Palin in any position of responsibility whatsoever, and I'll admit, I was captured by the rhetoric. I thought his speech after the Jeremiah Wright controversy was brilliant. Given that it was clear that the country was in for some serious trouble as the financial crisis gathered strength I felt the country needed some inspirational leadership and I thought Obama might provide it. In the back of my mind I was aware that his resume was remarkably thin but he seemed so much brighter than most other politicians I felt that perhaps he would grow into the role and I hoped that perhaps he might be a transformational character. Having admitted this I'll also have to admit that I have been disappointed with his policies generally. I'm to the left of Obama on healthcare and pretty far to the right of him on economic policy. Thus I was not surprised by the lack of policy initiatives that I thought might be effective. I was surprised by the political nature of the speech.

First of all was the setting. He did not address the nation from the Oval Office but instead called a joint session of Congress and initially tried to schedule it to upstage the GOP debate. The speech itself was not so much an address to the American people as a harangue of Congress, specifically the recently elected Republican freshmen who have been taking the President apart over the budget. Indeed, the speech was delivered directly to them, the President said “Pass this bill, pass it now” or derivatives thereof ten times in the course of the speech. What references there were to the actual citizens were stage whispered asides about how the government works for the people and the people are unhappy with the government. So, why would you get up in front of Congress, present them a bill whose merits you claim are self evident, and then demand ten times that they pass it in front of a television audience of the voters? It seems like an odd set up to me but there you have it.

The speech itself had some interesting moments. My favorite was when he mentioned Lincoln's support for the trans-continental railroad as an example of a Republican going ahead and putting public funds to good use. The speechwriter was probably not too familiar with the corporate history of the Union Pacific. It was at the center of what was probably the largest corruption scandal in the history of the federal government. The authorization bill was so badly written the Union Pacific was in litigation for nearly a century, including nearly a dozen Supreme Court cases, over what precisely the terms of its obligations back to the government were. Of course, several private transcontinentals were also built in the years following the Civil War. The UP was however an outstanding source of campaign contributions to Congressmen, judges and state legislatures, particularly when it was in the hands of Jay Gould who tried unsuccessfully to resolve the legal disputes through mass bribery. So at least from the perspective of the legislators on the receiving end of this largesse it was a major success. Not the kind of thing I would put in a speech though.

I also liked how Obama could in one sentence frame his opposition as on the side of “millionaires and billionaires” and himself on the side of “teachers” and “our kids” and then in the next sentence say “this is not class warfare.” It's me and the teachers against the Republicans and the billionaires? If that's not a reference to class strife then I don't know what is. Still, it was artfully done and I think the Republicans have done an atrocious job of explaining their position. I also thought that he might have wanted to do some more research around his rejection of "the idea that we have to strip away collective bargaining rights to compete in a global economy." Surely the Democratic Party, the annual recipient of hundreds of millions of dollars in campaign contributions from unions, must have noticed that the only places where unions continue to thrive are in services and the public sector. Of course service employees and the public sector are not subject to global competition. Union membership in the traded goods segment has been totally obliterated in the last 30 years. Obama himself presided over the most spectacular example of this when US automakers with their UAW workers had to be rescued by the state while the non-union automakers in the South kept right on going. 

In any case, the main event of the speech for me was the rhetorical bait and switch around how the AJA will be paid for. He led strong with “Everything in this bill will be paid for. And here's how.” At this I was on the edge of my seat. The hard part of leadership and governing is not giving away tax breaks and entitlements but figuring out how to pay for them, and now Obama, the responsible leader, is going to do just that. Thank God, but then.... “The agreement we passed in July will cut government spending by about $1 trillion over the next 10 years. It also charges this Congress to come up with an additional $1.5 trillion in savings by Christmas. Tonight, I am asking you to increase that amount so that it covers the full cost of the American Jobs Act. The agreement we passed in July will cut government spending by about $1 trillion over the next 10 years. It also charges this Congress to come up with an additional $1.5 trillion in savings by Christmas. Tonight, I am asking you to increase that amount so that it covers the full cost of the American Jobs Act.”

What? Wait a minute. So his big idea for how to pay for it is to ask the Congress to figure it out for him? Hold on a second, didn't he do that back in February when he decided not to implement any of the recommendations of his own deficit cutting committee and sent Biden to the Congressional negotiations for the first three months thereby ceding the initiative to Congressional Republicans? Yes, he sure as hell did. How did that work out? Hmmm.... let me think..... Oh, now I remember the freshmen GOP Congressmen crucified him with the debt ceiling fiasco, nearly put the country into default and in so doing got the credit of the country downgraded. What's more that fiasco was only averted by the eleventh hour deal the President refers to but whose terms he wants to change. So at best he's reneging on the original agreement for $2.5 trillion and upping it to $3 trillion and at worst he's totally abdicating responsibility and putting it on the very people who almost drove us over a cliff in the first place. What about all that talk about how the GOP in Congress were a bunch of irresponsible kids and the finances of the country need to be handled by “grownups.” So, here Obama gets a chance to take some responsibility and what does he do? He puts the ball right back in the court of the kiddies. Seriously, what's behind all this? I mean, the person who knows best what will happen to the AJA in congress is Obama himself. If the last time he punted fiscal responsibility to Congress the result was a total legislative fiasco why would he do it again?

I hate to say it but I think the answer is that he knows full well that it will be a fiasco, and that he wins to a Congressional Republican fiasco. It seems pretty clear that there's little chance that the economy improves significantly before 2012. Obama knows that as bad as he looked during the debt ceiling debate the Republicans looked worse. His plan seems to be to go on TV, and in front of the cameras demand that Congress pass his jobs bill. Never mind that the AJA is just a diet version of the ARRA. Never mind that the ARRA was not a stellar success. Never mind that it still required $1.6 trillion of debt finance. These things supply the only coherence the Tea Party possesses, so Obama is trying to use them to his advantage.

Rather than actually formulate how to pay for the AJA he's decided to lay that part of it at the feet of the very people who almost put the government into default rather than borrow more money or raise taxes which he knows full well will be necessary if we're going to extend the ARRA for another 3% of GDP. He also knows that the Republican base will not stand for those tax increases or additional borrowing and will hold the GOPs feet to the fire to prevent it. So he knows that the AJA will struggle in congress, in fact I think he hopes it does. He may even wish for it to go down in flames. Then when indeed the economy does not recover by 2012 he can say that if only the Republicans had passed his jobs bill all would be well. And after Thursday the video editors for his campaign ads have ten shots too choose from of him telling Congress to do what he knows they have a minimal chance of actually doing. No one will remember that the original stimulus was extremely expensive but not very effective. They won't remember that by adding another $550 billion to the $2.5 trillion he's reneging on the original deal further eroding his capacity to negotiate with Congress anyway. No, they'll remember Obama telling Congress to pass the jobs bill and then congress, ie Republicans, screwed it all up. For Obama, mission accomplished. For the unemployed, not so much.

It makes all that gooey nonsense at the end of the speech about the expectations of the American people sound like a sneer, as if the people in the audience are too stupid to notice that he is doing exactly the opposite of what we sent him there to do: taking responsibility and making hard decisions. Instead, he's handing the responsibility over to people who have already played chicken with the economic security of the country just so that he can blame put them when he's running for office next year. Great. 

I recognize that my criticism of the ARRA and the political rather than economic nature of this post obligates me to step up and discuss the economics behind this in more detail, more to come. 

Wednesday, August 31, 2011

Bernanke's silence provokes market thunder, Lagardes thunder provokes market silence.

My mother used to tell me that if you can't say anything nice then don't say anything at all. I wonder if that aphorism might not have been going through the mind of Ben Bernanke as he wrote the speech which he delivered in Jackson Hole on Friday. In his much anticipated speech Bernanke did not announce any new policy measures. Indeed, he was at pains to point out the limits of monetary policy. In his public statement Bernanke is always extremely cautious about getting involved in policy debates, particularly policy debates which are the responsibility of the US Congress. In his most recent testimony, which happened to be during the recent bitter budget debate, each side tried to corner him into supporting their position and he simply refused to take a side. His actual words were: “I'm not going to tell you what to do, that's your job to decide. That's why you get paid the big bucks.” I love this guy. So for a man so careful not to get into the business of Congress the closest he can get to taking a shot at them is to simply describe the limits of his own power which was the main point of his speech.

He did point out that the recovery was very weak and that there are serious problems in the real economy that need to be addressed with long term policy. Precisely the kind of policy which Congress seems totally incapable of producing. When the markets read this part of the speech, they dove. But then, interestingly for a speech which was primarily about how little the Fed can do, Bernanke also mentioned that the next Fed meeting would last an extra day. Wait a minute? An extra day? Why whatever for, you've just got done telling us that there is little the Fed can do to address the long term structural problems facing the economy. Hmmm.... Perhaps that means you're going to be thinking extra hard about what policy options you have RIGHT NOW while we wait for Congress to sort itself out. Then the conventional wisdom became that the Fed would take some kind of action and the markets have been screaming higher ever since.

The market rocketship got even more fuel when the minutes of the Fed meeting were released on Tuesday. If you recall at the last Fed meeting the policy announcement was that the Fed would keep interest rates at the current low levels until mid 2013, that is they put a date to their “extended period” language. When the Fed releases its decision it also discloses how many of them agreed with the policy and how many dissented. It does not, however, say WHY they dissented until the minutes are released. At the time, I thought the dissenters were more Hawkish about inflation and therefore thought that the easing was unnecessary. I could not have been more wrong. One of the dissenters did not like the nature of the signaling. He felt that the The other dissenters dissented not because they thought monetary stimulus was unnecessary but that the structural factors in the economy were so severe that it might not even do any good and but would contribute to inflation. It was pretty grim.

Strangely this has put the markets in an unusual position. Since mid-summer the markets have come off quite a lot. The decline has been driven by concerns about Europe, the budget debate, the and the downgrade. It has also been driven by negative economic data. The markets are now at a level where the news has a sort of goldilocks aspect to it. If the data shows the economy is strengthening then the markets will think earnings will be better and the stocks should be higher. If the data is bad then the Fed will be painted into a corner by the time of its two day meeting in September and will likely easy monetary policy further in some creative way. Thus the markets have the same response to good news and bad: they go up. So, Bernanke did not say too much but the markets have heard plenty.

At the same time they seem to be ignoring something else, in particular a quite shocking speech given by Christine Lagarde the new head of the IMF. The speech was especially shocking to be because of an argument I got into a few years ago at a University of Chicago alumni event. The event was a talk by a noted Chicago alum about the financial crisis and the role of the state in it. It was an enlightening talk and the Q&A session led to a lively debate. The debate turned to the subject of what the government could have done to forestall the crisis. A man in the front of the room who was extremely critical of the government generally and the Fed in particular said that obviously the thing to have done was to have the Fed order the banks to raise capital in the summer of 2008. The problem by then was clearly one of solvency, not liquidity, that is to say the the problem was not a short term cash crunch but that the banks did not have enough capital to absorb the losses they would take when the sub-prime writedowns had to be taken.

I could see why the man felt this was a good idea but I thought it was totally impractical. I stood up and argued that if the Federal Government announced to the world that the US banking system was in such deep trouble, and indeed it was not possible at the time to know precisely how deep, that it needed a massive infusion of capital that the capital would not be forthcoming. I felt this way because I remember working in the middle east at the time and watching as a parade of US banks sought out capital infusions from wealthy Arabs and sovereign wealth funds. By the summer of 2008, investor appetite for additional bank capital infusions had waned substantially. My argument was that while it would have been desirable for the banks to recapitalize, no one in their right mind would have put their money into a bank if the banks own regulators were so concerned about its solvency that it was being forced to raise capital.

The man at the front of the room turned around and gave me a look of death, he was obviously not someone used to being argued with, and said “Well, they did all raise capital eventually didn't they.” Smug smile. To which I replied: “Yes, from the taxpayers! And the taxpayers only contributed to it because you go to jail if you don't pay your taxes!”

Well this story has two surprise endings. First the man at the front of the room was Cliff Assness the billionaire founder of hedge fund AQR. For the record, I am not a billionaire. The second is that this past weekend, Christine Lagarde, the head of the IMF called for the European banks to be forced to raise capital. In my opinion this is by far the most important thing to come out of the Jackson Hole conference. Far more important than the non-comments by Bernanke. I would even go so far as to say, that, if the speculative attack on the Eurozone is renewed and is successful, people will be talking about this speech for years to come and Christine Lagarde will become a very important historical figure for being ahead of the curve. The response of the ECB and the EU was to deny that this was necessary and the markets have been listening far more to what Bernanke has not said than to what Lagarde did say.

They should listen more closely. More than anything else what has driven the markets lower this summer is the fear that a major fiscal problem is brewing. The US downgrade is part of this but while this is embarrassing for the US it is potentially fatal for Europe. What the markets are afraid of is that the once the ECB is done with its bond purchases, the speculative attack will resume and it will ultimately succeed in bringing down a European sovereign. If this happens there is going to be an ABSOLUTELY MASSIVE banking crisis in Europe. This is because the Eurozone has created a continental market for banks but, because the ECB is has no taxing power, any attempt at a TARP like bank rescue would have to be funded by individual countries. The problem here is that because they operate across the entire Eurozone the banks are MUCH MUCH larger than the countries which would have to rescue them.

In the US the balance sheets of the top 3 banks are about 60% of US GDP. In France, the balance sheets of the top three banks are 600% of GDP. That's right, the top three banks have assets outstanding equal to six times the size of the French GDP. Remember the TARP? That was 5% of US GDP. It was a big number but the US could borrow it. Now imagine a world in which Spain has gone bankrupt and the French banking system is on the verge of collapse so France decides to implement its own TARP, it would have to be 50% of GDP, or put another way, France would have to instantly borrow as much money as it has in the past fifteen years combined. Do you think there is any chance that this would actually happen? No there is not. What would happen is that those banks would fail and would therefore wipe out the savings of their depositors as well as damage any banks to which they owed money. Keep in mind this is not just France, this is the case in every country. So if there is a major sovereign default the European banking system cannot be saved.

Christine Lagarde's idea is to get in front of this and force the European banks to raise more capital from private sources before the storm breaks so that they have a better chance of weathering it. I take my hat off to her for raising it. That said, as was the case with Cliff Asness, I don't think it can be done though for different reasons. The reason that in 2008 the banks could not be recapitalized in practice was that though there was enough money to do it, no one knew what precisely the scale of the problem was. In this case, we do know what the scale of the problem is but not only is there not enough money in practice to do it, there's not enough money even in theory.

Thursday, August 25, 2011

Do you think Ron Paul, Michelle Bachmann, and Rick Perry are idiots? Would you like to bet on it? Tomorrow is your lucky day.

Since my last post there has been quite a bit of excitement in the markets. The S&P 500 has had about a 10% range and has been moving at least a percent a day, often much more. Given these massive moves its hard to ascribe a lot of meaning to the market action on any given day. That said I think fundamentally three things are at work. One, is that the markets are still getting used to the idea that there is no risk free rate. This is a complicated fact for the markets to absorb given how much portfolio theory and how many pricing models rely on this assumption. That said, its a very subtle impact and the markets seem to have adjusted by fleeing relatively risky assets and piling into relatively less risky ones.

The second story is the Eurozone crisis. Though the ECB has, for the time being, successfully pushed back a speculative attack on Italy and the attack on France in light of the US downgrade has also receded most investors are aware that there remain very deep and vexing problems in the Eurozone. Though many of the consequences of a sovereign default of a major country are unknown they would almost certainly lead to a major banking crisis which would be nearly impossible to contain. Though the markets don't know what the probability of this is they know the consequences are very very bad and this fact is weighing heavily on the markets. More on this in subsequent posts.

What optimism there is stems from two things. One is the hope that though the economy is slowing down the market reaction has been overdone and that the economy and with it the markets will pick up, of on their own in the second half. The other reason, and according to some pundits, by far the stronger, is the idea that the Federal Reserve is going to ride to the rescue. This is because Ben Bernanke is set to give a speech in Jackson Hole at the Kansas City Fed conference of Central Bankers on Friday. It was at this conference a year ago that Ben Bernanke announced that he was embarking on a second round of quantitative easing, or as it has been affectionately called: QE2.

Now the Quantitative Easing policy has been controversial to say the least. Where you stand on this controversy will say a lot about whether you think Bernanke will announce further easing on Friday. Virtually all of the Republican Presidential candidates have come out against Quantitative Easing. Just last week Rick Perry called the policy “treasonous.” Ron Paul, who has made himself heard on this subject repeatedly not only opposes Quantitative Easing but the entire Federal Reserve System and, for good measure, the whole concept of fiat money. Naturally someone who believes that we should return to the gold standard is not going to be a fan of creating reserves in the banking system and using them to purchase Treasury bonds with them. Michelle Bachman has also come out against Quantitative Easing though, if you ask me, not with a particularly coherent objection. It may be silly to call a monetary policy tool “treasonous” but at least you know where the guy stands even if his reasoning can best be called “obscure.”

It is worth taking a look at the arguments that these men and other opponents of QE make because, whether you agree with them generally or not, there are indeed good arguments to be made against it. Opponents of QE have two main objections. The first is that QE is an enabler of government profligacy. That is to say that the fact that the Federal Reserve is creating reserves (printing money) in the banking system and using those reserves to purchase US government securities is creating artificial demand for those securities and as a result is lowering the cost of borrowing for the government. This of course just encourages the government to borrow more than it would otherwise. While it is true that QE does marginally lower the rates at which the government borrows it is not clear to me that it follows that this creates more borrowing. The level of government borrowing is a function of the budget process which is well in the hands of congress and I don't think that the level of interest rates has been of much concern to Congress with regard to those decisions for at least a decade. In any case, even without QE interest rates are at a level which would be unlikely to deter borrowing anyway so I think this is a weak argument.

A more compelling argument is that money creation is well known to be inflationary. Historically countries which have found themselves creating money in order to finance public spending often fall into an inflationary spiral which often has devastating consequences for the country. This is because the artificial creation of money in the hands of the state tends to devalue all the real goods and services in the economy in terms of that currency. That the more money there is the lower its value in terms of actual goods and services and therefore the price of everything goes up. This erodes the savings of the thrifty and devalues the debts of the levered. It also causes massive dislocations in the economy generally. Latin America is littered with examples of this and the recent example of Zimbabwe going over the hyperinflation cliff has once again served as a warning to the world. Of course the most politically momentous monetization of government obligations occurred in Germany in 1922. The subsequent hyperinflation obliterated and then radicalized the German middle class and laid the groundwork for the capture of the state by the Nazi party. So to say the least, the historical record for debt monetization (printing money to finance government spending) is not great.

So the Tea Party guys are not crazy to raise objections to quantitative easing. Given that they think the primary motivation behind it is to facilitate additional government stimulus when the economy slows down it is not hard to imagine why they might think that a fresh wave of it is on the way. GDP growth has been much slower than planned, consumer sentiment is weakening and many economic indicators have come in much weaker than expected or hoped. A few weeks back the Fed revealed that its outlook for the economy has darkened significantly and announced that it would maintain its extremely low interest rate policy through 2013. Given this, it is easy to see why many people expect some kind of announcement of further policy action by the Fed come this Friday and since they hate the idea they are up in arms. On the other hand, stocks are priced in dollars and so, in the event that the Fed announces QE3, their prices are likely to rise which is why many think we have come off the bottom despite continuously grim economic data.

Personally I have a different view of this. While I am not a fan of printing money generally and I am very aware of the historical record I think that, at least in the hands of Ben Bernanke, Quantitative Easing is not to be feared. The reason is that Bernanke had a very specific reason for engaging in QE last year that had nothing to do with a desire to fund the US Treasury more cheaply. The thing to remember is that just as money can be created it can also be destroyed and what Bernanke was doing was making up for monetary destruction.

As mentioned the Federal Reserve Bank creates money through quantitative easing but because the US banking system is a “fractional reserve” banking system the commercial banks are able to create money as well in the course of taking in deposits and making loans. This is because they are only required to hold some of their deposits in reserve (ergo “fractional reserve.”) This is why banks are able to operate with such extraordinary leverage. Banks are also required to have an adequate equity capital cushion in the event of losses so that the equity holders take the losses before the depositors do.

The trouble is when banks take a large losses over a short span of time as they did during 2008 they erode that equity cushion and this means. Since the equity cushion has to be repaired before banks can engage in new money creation large losses shrink the money supply. This is why the Fed embarked on QE1. So the collapse in housing prices has forced the banks to take recognize huge losses on their balance sheets but, as large as those losses are, the markets believe (and are probably right) that there are still far more losses yet to be taken. A year ago this fear and the weakening of the US economy led people to believe that there would be so much monetary destruction that there in the future not only would we not have inflation, we would have its opposite, deflation. Now, as bad as Ron Paul and Rick Perry think inflation is, the thing that scares the hell out of Ben Bernanke is deflation.

This is a little counterintuitive. It's easy to see why inflation is bad, if you want to buy something and the prices are always going up and going up fast its easy to see how this harms you. On the surface it seems that a world in which the prices of everything were always going down would be good, everything is always cheaper so one can buy more of it with the same funds, everybody wins no? No. The thing about deflation is that it doesn't so much function as a permanent sale but as a permanent deterrent to every buying anything. Imagine if everything in the world was always getting cheaper, then you would only buy the things you absolutely needed right now and you would defer all other purchases. Deflation is a HUGE buzz-kill for economic activity. Not to mention that it has the effect of obliterating the solvency of large debtors and the US government is the largest debtor on Earth.

So, seeing deflation on the way last year Ben Bernanke warmed up the printing presses and launched QE2. This sent the stock market higher and whipped cured the deflation problem well and proper. So here we are in the future and not only is there no expectation of deflation, people are concerned about inflation. If the Fed were to engage in Quantitative Easing right now the fears of Ron Paul and Rick Perry and the hopes of the stock market would be fulfilled. This is what gives you an opportunity to bet against Ron Paul and Rick Perry. If you think Ben Bernanke is just part of a nefarious plot to load up the country with debt then you'll probably think he'll embark on QE3 tomorrow and if you do think that you should buy the markets with both hands. If you think that Paul and Perry are all wet and there's no way that Bernanke will do any such thing then you might want to be short going into Bernanke's speech tomorrow. Well, Bernanke speaks at 10AM New York time tomorrow so you'll have 30 minutes to place your bets.

Wednesday, August 10, 2011

What do Rowan Atkinson's MacLaren F1 and Bernanke's Equity Rally have in common? I'll give you one guess.

Whoa, I guess I was more right than I thought with my article about how yesterdays rally might be short lived. This was on account of a renewed speculative attack in the Eurozone this time focused on France. I hope to publish on this sometime before midnight tonight. Sorry for the brevity, this is an interim post.

Forthcoming Post: The Return of the Bond Vigilantes

Thank you friend reader for your unseen but ever-felt presence.


Before I talk about yesterday's action I want to tell you a story.

Back in September of 2007 I was the Global Head of Business Development for what I will call “a large foreign bank.” It sounds impressive but in essence I was “Mr. Fixit” for the guy who ran equities. The thing that needed fixing most at the time was the DIFX, a stock exchange in Dubai owned by one of the largest shareholders in the firm I worked for. MENA was covered by the Emerging Markets group and so whenever I was in London or New York I hung out with the EM guys. We were in the middle of what we knew was likely to be the best bonus year in the history of Wall Street. 2006 had been outstanding and 2007 was blowing it away. Given the events of 2008, it's easy to think of the summer of 2007 as a kind of idyllic past, like June of 1914 or August 1939 and in truth, it was. Of course it didn't seem that way at the time. The trouble in the real estate markets had already begun. Though people were still thinking of how to spend their bonuses, I was contemplating a certain watch at the time, people were getting the sense that the gig was up.

I like to think that the financial crisis officially began on my birthday. On June 7th, 2007 Bear Stearns halted redemption from its High-Grade Structured Credit Strategies Enhanced Leverage Fund. That fund would be wiped out entirely in less than six weeks and in the first week of July S&P put 600 subprime ABS on negative watch. Then in August American Home went bust, and in September the Bank of England halted a run on Northern Rock, the first bank run in England in over a century. People were starting to freak out and the markets started to sell off. The S&P 500 fell from about about 1550 to an intraday low of 1370 in a week and a half, which given recent events, may not seem like much, but considering that it took the market the whole of 2006 to go up 140 points it felt like a big scary move at the time. People were scared, a friend of mine in New York called me at 3AM Dubai time and told me about a meeting he had with our firms asset backed credit traders about the default cascade that could be initiated by the seizing up of the credit markets that caused me to ring up my parents and suggest they move their retirement savings to cash. It was that kind of scary.

Then as now, all eyes were on the government especially after the Northern Rock fiasco in the UK. The Fed had come out and said it would ensure the liquidity of the banking system (back then it still seemed like a liquidity issue rather than a solvency issue) but took no action. Then on September 18th, the Federal Reserve cut the Fed Funds rate from 5.25% to 4.75%. Whoa! 50 basis points in a day? Hallelujha! Daddy Bernanke is home he's gonna make it all right. The markets positively screamed. The S&P jumped 50 points in a single day, think about it, six months of price action in 2006 in a day! Woo Hoo! Happy days are here again, we're all going to get paid after all. Pop the champagne!

I remember September 18th 2007 very clearly. At the time I was commuting between London, New York and Dubai and I had been spending the past week and a half in London putting things together for an IPO we were doing in Dubai so I was sitting in my desk on the EM trading desk. Even though I was a management person I always felt more comfortable on a trading desk. I'm sure it annoyed all the actual traders to have an ex-trader management guy on the dest but nostalgia is a powerful drug, sitting on the desk allowed me to relive my youth. At the time I considered myself an old salt, having traded through the Russian default crisis, the LTCM collapse, the internet boom and bust, September 11th. In a young mans business at 34 I was a seasoned veteran. The guys on the desk were on edge because the VIX, an index of volatility, had popped from 18 to 36 in a day. I could remember a time when it stayed above 40 for months at a time. Yep, I had seen it all (rueful smile.)

All that summer I had been telling people that things felt a lot like they did in 1998 during the Russian Default Crisis and the LTCM debacle. The internet collapse was different, everyone knew it had to happen they just didn't know how far it would fall. In the summer of 2007, unexpected things were happening all the time and people were generally worried. They knew there was a problem and though they did not know how big it was, they knew they did not know. Then on September 18th, something that seemed normal happened, the Fed jumped in with an aggressive rate cut and language saying they would supply all the liquidity necessary and the markets absolutely screamed higher. I stayed in the office through the New York close, 9PM in London watching the markets rally. My eyes were popping out of my head. At the end of it the guys and I were just staring at the screens dumbfounded. Knowing what we knew about how deep a mess the markets were in, we simply could not believe the size of the rally but there it was, mocking our “knowledge.”

After the bell rang in the US I stood up and shouted to the trading desk, “Boy, what a relief! I'm sure glad the crisis is over.” The desk erupted in laughter because, in our heart of hearts and no matter what the screens said, we knew it had just begun. Indeed, two weeks later the S&P touched 1575, its all time high and then things came apart at high speed from then on.

I tell this story not to compare recent events in the markets and the Great Crash of 2008. There are a lot of comparisons between the two being made now but I think it best to defer to the principle of Heraclitus: a man never crosses the same river twice because the river is different, and so is the man.

Instead I tell it as a warning of how difficult it is to interpret market moves, especially extremely violent one as we have had these past two days. Monday was had an extremely violent crash that got relentlessly more violent with every bit of news that came out culminating in a vertiginous plunge that began during Obama's remarks. This seemed to present a straightforward vote of no confidence by the markets ini risk assets generally and in the will of the American political system to address itself to the most serious challenge that the Republic has faced in a long while.

Yesterday, the day began with a relief rally that gathered steam until about noon and then lost steam, trading back down to flat into the moments before the Federal Reserve Statement. The Fed Statement was, in a word, grim. First of all, it acknowledged that the economy was slowing appreciably which is most certainly is. It also acknowledged that the slowness is not merely the result of supply chain disruptions from the Japanese earthquake and pressure on consumer spending driven by commodity spikes which are traceable to political events in the Middle East and therefore temporary. It also mentioned that though long term inflation expectations were stable short term inflation had indeed risen from the beginning of the year. This is key because the markets have been cheering for a resumption of Quantitative Easing, something which cannot happen unless long term inflation expectations diminish substantially.

Instead of announcing QE3 then the Fed announced went a bit further in the direction of defining what precisely it meant by “an extended period.” The Fed has been using that phrase for some time to describe how long they plan to maintain their easing stance. They do this to try to give reassurance and yet provide some ambiguity within which the markets can adjust. Yesterday they said that they intended to maintain the current stance until mid 2013. In economic terms that's a REALLY long time. Interestingly there were also 3 dissensions from the policy statement. Meaning that almost half the Board did not agree with the statement. We don't know why they objected, they might have been against the continued easing or simply against the idea of the Fed telegraphing its intentions for so far in advance.

Personally I read this as the Fed being seriously concerned that the economy is slowing, that fiscal stimulus had not only failed but, given the deficit issues the country faces, unlikely to be attempted at least unless and until the 2012 elections provide a meaningful mandate one way or the other. The Fed also recognizes that in the current environment commodity prices have been high for a persistent period and are therefore beginning to be priced into final products and being transmitted into core inflation. This is a major challenge for them because it means they cannot engage in Quantitative Easing without seriously stoking inflation. So they're making the best of a bad position and telling people that though the Fed won't be growing its balance sheet, it also won't be shrinking it any time soon either and you don't have to worry about increases in interest rates for years. As I said, it was grim.

It was actually pretty hard for the markets to digest. The first thing they did was to read the economic prognosis and note the lack of QE and the high level of dissent and dive for the deck. The S&P dropped about 20 points to 1100 or so, down 50 points form the high of the day. Treasuries rallied hard and gold, which was already higher on the day jumped another $30. Actually I think I should just stop commenting on gold, just assume that whatever happens, gold is up $30. OK?

Then something interesting happened. The market turned on a dime and leapt higher by 4%, hung out near the highs of the morning, and then in the last 30 minutes of the day screamed higher by another 3% giving the day almost an 8% range. I think would be fair to call what happened an “Up-Crash.” Do not pass go, do not collect $200 go straight to the moon, the devil take the hindmost and for good measure let's crush the hell out of any lingering short sellers who will panic and get out because they know Asia will follow this rally. The rally was so strong it basically brought us back to where the equity markets opened before the S&P conference call and the Obama statement of the day before. It was as if none of the bad news ever happened.

As an observer its actually pretty hard to know what exactly happened in the last hour of trading. Maybe the markets thought that keeping the balance sheet high and maintaining Fed Funds at Zero through 2013 was likely to provide a similar level of monetary stimulus to QE and so they jammed higher on a sense of renewed monetary easing. Maybe but if that's what happened then its pretty hard to explain why in the last hour of trading gold dropped $40 in the same period of time. At the same time US Treasuries fell out of bed as well.

Yes, it is extremely hard to explain which is why I draw your attention to the rally in September of 2007. Yesterday was an up-crash: a panic rout of buying just as frenzied as the panic rout of selling the day before. It is extremely hard to discern what this means about the future direction of markets. It does speak volumes about the level of uncertainty in the markets that they from day to day they cannot agree as to what the total value of US productive capacity is to the nearest trillion. In the final analysis, the important thing is not what I can tell you about what happened between 3:30 and 4PM yesterday. It's what I can tell you did not happen: in the last 60 minutes of trading on Tuesday the entire global financial system did not rationally think though the implications of the S&P 500 downgrade and decide that it did not matter after all. It does matter and it will take more than two days for all of the implications to be fully explored by the markets.

Things are interesting and they are going to stay interesting.

Tuesday, August 9, 2011

Gotterdamerung: S&P pours fuel on the fire, world leaders struggle to put it out

Sorry for the delay. I hosted a dinner party last night so I could not get straight to writing. I'll just go over the market action yesterday and the major news that drove it.

Of course the top story was Friday's downgrade. As I mentioned in my Sunday night post I did not think that the markets had absorbed the possibility of a US downgrade and it would seem that they had not. So Sunday night the markets in Asia started us off with a respectable sell off and, once the CME overnight trading portal (GLOBEX) opened, T-bonds sold off as well and the Euro rallied though both of these moves had reversed themselves by the London open.

The ECB Counter Attack

So, as I mentioned in my post of last Friday, after the European close on Friday the Italians announced that they had negotiated a package of reforms with the European Central Bank that would push forward thier fiscal consolidation, would free up the labor markets and amend the Italian Constitution to balance the budget. This, it was theorized, would enable the ECB to add Italy to its program of bond buying. Indeed, yesterday morning the ECB leapt into the European bond markets with guns blazing.

Buying Spanish and Italian government bonds in $50 million clips the ECB was able to jam the yields on both of them to around 5.5%, well under the 6% danger zone that most investors consider unsustainable and where they have recently been. This encouraged markets in the European morning and they actually rallied off the Asian lows. London actually opened higher but the joy was short lived. While it was true that the ECB was able to jam Spanish and Italian bonds below a 6% yield, German bonds remained remarkably well bid.

This is important because German bonds in Europe are considered the local safe haven. In order for things to return to “normal” it is not enough for Spanish and Italian yields to drop, money has to come out of Germany and into the riskier economies. The stubbornly low German yields indicate that investors are not selling out of Germany and are therefore not following the ECB into Spanish and Italian paper. Even more disconcerting was the divergence of France from Germany. France and Germany are considered “Core” Europe. Those crazy sun addled Mediterraneans and the Guinness besotted Irish may indulge in absurdist levels of debt to GDP but France and Germany are viewed as above the fray. Well, once the US went over the AAA cliff on Friday, investors have been taking a hard look at France and do not like what they see. So while the ECB counterattack against the speculators in Spanish and Italian bonds was a major tactical success, at the strategic level things remained touch and go. Not a good sign.

The S&P Conference Call

Yesterday morning S&P held a conference call to discuss the US downgrade from Friday. S&P has come under some criticism for its downgrade. The US remains the most solid credit on Earth. This could be seen by the fact that within a few hours of the GLOBEX open USTs had reversed their decline and were headed higher. There is also the widely reported “$2 trillion error.” On the face of it, it's not hard to laugh at S&P's assertion that the error is not material because well, 2,000,000,000,000 is not a small number. The really depressing fact is that when thinking about US indebtedness it actually is a small number. The difference turned out to be whether the US would have a 86% or 92% debt to GDP ratio in 2022. As it turns out, either number is high enough to cast serious doubt on the long term credibility of the US and would easily justify the ratings cut so S&P is actually right in this case.

Even so, they were VERY aggressive on their conference call. Yesterday they downgraded several thousand other borrowers who are dependent on the US Treasury for income including Fannie Mae and Freddie Mac, the real estate holding companies backed by the Feds. They also downgraded Israel because, believe it or not, the US guarantees Israeli sovereign debt. This would have been grim enough news on its own but they went further than that. They said that they were many other AAA and AA+ credit in the world with a view to reorienting the worlds risks given the lower rating they assigned to the US. They did this with particular reference to US States, specifically US states which are heavily dependent on federal spending and transfers. There was a Q&A session in which many of those on the call attacked the S&P methodology. S&P was dismissive of it's critics and very assertive about its decision to downgrade the US, to keep it on negative watch and to look deeply into all its other ratings in light of the US downgrade.

This is of course a fiasco for two very specific sets of borrowers: European countries and US states. To have the ratings agencies reconsider all Europe in light of the US downgrade in the middle of a speculative attack is a serious blow. The idea that no European country at the AAA or AA+ has a safe rating is a shot across the bow of “core” Europe. Remember the mechanics of the EFSF, it functions essentially as a wealth transfer from the “Core” European countries to the periphery but calls on ALL European states for contributions. It in effect blurs the balance sheets of all the European countries and many of the commitments are so large that, if fully drawn down, they would significantly worsen the debt to GDP ratios of all Eurozone states. In addition to this, the level of cooperation that will be necessary at the EU level in order to fully fund or amend the functioning of the EFSF will be so fraught it will make the US debt ceiling debate look like the instant consensus of philosopher kings in comparison. This is likely to make the respite bought by the ECB counterattack remarkably brief.

In addition they put the US states on notice. This is a pretty serious problem. It is well known that the pension obligations of the US states are absolutely massive and that generally the financial position of many US states is extremely precarious. This is very interesting because, unlike municipalities, there is no bankruptcy code for states. In the event that a state went into default it would have to negotiate with its creditors almost as a sovereign but within the confines of federal law. Congress considered writing such a law but decided against it because it thought a significant number of states would file for bankruptcy immediately if such a law existed and this would raise borrowing costs for all states.

S&P downgrading a state on the back of the US downgrade would have immediate and serious consequences. The US sovereign has had its borrowing costs lowered because it is still the safest borrower on Earth and so has benefitted from a quasi-paradoxical flight to quality in the light of the downgrade. Will the same effect occur if California or New York are downgraded? Hell no. Their borrowing costs go up immediately which would have the effect of widening the fiscal gaps which drove the downgrades in the first place. What's more is that the states are, like Europe, looking at multiple simultaneous downgrades. This means that investors will not be able to switch from one state to another with confidence and may simply flee the municipal bond market entirely selling the safe and the risky, raising the funding costs for all.

In the event that there is a downgrade cascade that leads to a default cascade the US will be plunged into a VERY interesting but also VERY serious political crisis. It is widely assumed that the Federal government would step in to rescue the states in the same way that it did the banking system. I think this is unlikely to happen and that, if it comes to it, the State defaults will be extremely messy. This is because such a bail out would be extremely politicized. First of all the fiscal gaps the states are facing over time as their pension and health obligations increase with the retirement of the baby boomers are, across all the states, on the order of hundreds of billions of dollars. Trillions if you go out far enough in your calculations. Given the massive battle that just went on you can imagine the appetite in Washington for taking on more debt from the states is nil. Then you have to consider the opportunity that a cascade of state bankruptcies would present the Republican party.

The largest expense of any state is the salaries and benefits of its public employees. These employees are, by and large, unionized. Therefore they collect dues and use them to finance political campaigns of pro-union politicians, that is to say, Democrats. Public sector unions contribute over $100 million a year to the Democratic party at the federal level and several times that at the local level. A cascade of state bankruptcies which forced the states to seek funds from a federal government in which the House of Representatives are controlled extremely financially conservative Republicans presents an incredible opportunity to destroy a major source of Democratic campaign finance. Do I think the GOP is willing to play politics with this? Given that they were willing to put the country into default over much less, there's not a doubt in my mind.

Obama's speech

Naturally the United Sates can't take the downgrade lying down so Barak Obama planned to make a statement at 1PM. This was delayed until 1:30. It's a sign of how rapidly the markets are moving that the S&P 500 dropped a percent and a half during the delay. In the event the markets were not comforted by Obama's remarks.

Obama said that the US is still a AAA country and he quoted Warren Buffet as saying that there should be a AAAA rating and the US should have that. He then said that the main issue was not whether the US could pay or whether there were ideas about how to cope with the deficit but that the main issue was the political infighting. He said that all that was necessary was to make minor adjustment to medicare and to make the wealthy pay their fair share. He then called for unity and said that America would get through this and then made a reference to the deaths of the Navy Seals over the weekend in Afghanistan. The moment he said the words “Tax reform that will ask those who can afford it to pay their fair share and modest adjustments to health care programs like Medicare” the markets started dropping and plunged two more percent, had a last gasp rally and then closed on their lows.

When interpreting something like this it is very hard to speak for the markets without actually speaking for yourself. At this point I should admit that my market analysis is heavily formed by my own views. I think the markets sensed that Obama does not understand the depth of the problem he is facing. The markets are now fully alive to the scale of the US debt crisis and it is massive. Under the optimistic CBO projections which include the repeal of the Bush tax cuts and the end of the wars in Afghanistan and Iraq the federal debt grows by $10 trillion in the next ten years. If you look out over the next 30 the fiscal gap is in the high tens of trillions. This can not be solved by “asking those who can afford it to pay their fair share” or making “minor” adjustments to medicare. Think of it this way, this year the deficit is $1.6 trillion. The US collected around $1.1 trillion in income taxes, $650 billion of this came from the top 10%. So if you DOUBLED the taxes on the top 10% of income earners, which by the way not even the Democrats are actually suggesting, you close only a third of the deficit. That is to say, the problem is vastly greater than the simple solution of raising taxes on the rich.

Do you notice how in the debates no one ever actually refers to the data? They prefer comfortable sounding phrases like “make the wealthy pay their fair share.” That is, yes Mr. & Mrs. John Q. Public, there is going to be some pain but it won't be borne by you. The markets no longer buy it. To actually solve this problem is going to require very real pain across the whole of society. The debt ceiling debate showed how difficult it is to get a trivial amount of deficit reduction passed. In my opinion Obama's insistence that there isn't really a problem with the rating, and that what problem there is can be solved relatively painlessly if people agree to cooperate doesn't hold water. The reason people cannot cooperate is that the pain that will have to be borne is very real and they don't want to bear it. Until the politicians admit this to themselves and then to the voters we are going to continue to struggle.

And though we may get a relief rally today I don't think the fallout from the US is over by a long shot and my next few posts will describe what think will unfold in the coming weeks.