Showing posts with label banking. Show all posts
Showing posts with label banking. Show all posts
Wednesday, May 13, 2009
Friday, May 08, 2009
When Bad News Looks Good
As predicted, unemployment has indeed increased. The latest number from the Bureau of Labor Statistics is 8.9%, bringing the total number of people unemployed to 13.7 million.
The ranks of the marginally attached (those who want work and have looked in the recent past, but have given up and haven't been looking in the last 4 weeks) has been sharply increasing during the recession, and now stands at 2.1 million.
This is pretty bad news, but Wall Street seems to be giving it a positive spin; as the Wall Street Journal reports, job losses are "decelerating". Unfortunately, the slowing growth of job losses doesn't really count as good news, as much of the reason for the
lessening slack is new hiring by the government. Given the fiscal realities that the various levels of government are facing, it seems unlikely that government can pick up the slack for long.
The second piece of bad news is that the stress tests results are in: the Federal Reserve reckons that bank losses may be as high as $599 billion. It almost sounds like a sale, doesn't it? Act now, bank losses only $599, that's right, $599 billion!
The WSJ also has a poll, asking readers: Do the stress tests results paint an accurate picture of the financial services industry? When I checked the results, 88% had said no.
The table is from the Fed's report; it gives some of the assumptions that led to their results about the extent of bank losses.
The interesting thing about these numbers is how big they are. Under the baseline view, loss rates in subprime mortgages of 15-20%! That's the optimistic scenario! And 12-17% for credit cards - unreal. So given these huge loss rates, why didn't banks see it coming? Why did they make these loans? And why should they now rush in to lend more, with these kind of loss rates?
Monday, April 27, 2009
Repo Fee
The Treasury reports that as of Friday, a new fee will be levied on participants in the Repo market of 3%. This is an interesting development; it's pretty unusual for the government to place any kind of punitive fee on any financial market. Why are they doing it?
A "repo" or "sale and repurchase agreement" is a kind of fixed rate short-term lending that uses debt or equity as collateral. A common form of debt to use is US Treasury debt.
An example of a repo transaction would go like this. Say I'm a bank with $10 mil in Treasury debt, and say I'd like to make an investment, but I also want to keep the Treasuries on my balance sheet. I can use a repo to sell the Treasuries to another bank, agreeing to repurchase the Treasuries some time later, for a set amount. Let's say I agree to repurchase the debt 100 days later for $10,0136,986.30. (This would imply that the yearly rate is 5%) I pay $136,986.30 to the lender for giving up my illiquid Treasury debt but knowing I could buy it back later at a fixed price. Why would I do it? Perhaps I have an idea in mind for an investment which would have a higher yield, but I need money to do it, not Treasury debt. Why not simply sell the Treasuries in the bond market and buy them back later? If I did that, there would be no entry in my balance sheet, and say I need to keep the Treasuries on my balance sheet because they are my reserves, and I must keep a certain ratio of reserves to deposits.
Repos are in fact commonly used by banks to have their cake and eat it, too. Banks can lend their reserves at a proft (thereby reducing their reserve ratio, which banks always want to do) and they can keep the Treasuries on their books as if they own the Treasuries, when in fact the bank no longer owns the Treasuries (at least for the term of the repo). The implied interest rate on repos (called the "repo rate") is usually a bit below the federal funds rate, currently at zero.
The unusual thing that began to happen on a large scale during the credit crunch of the fall of 2008 is that many of the buyers of repos (the lenders) did not return the Treasury debt on time. In fact, the total of all the late repos added up to $5 tril (there's a good discussion on the Naked Capitalism blog). There's no real penalty for this, but one question we might ask is: why?
Are the lenders unable to come up with the Treasuries? What did they do with them? Could they have done a repo on the Treasuries they just bought?
The Treasury will place a fee of 3% on the late repos. Because rates are so low, this will probably push the repo rate into negative territory. (Hey, just what Greg Mankiw wanted!) So if the repo rate is negative 3%, the math on my $10 mil repo changes. I now buy back my $10 mil in Treasury debt for only$ 9,917,808.72. Wow, free money! I get to make my investment (hope that works out) and I get to make an easy profit of over $82 grand!
Will the negative repo rate spur banks to make more repos, and hence to make more loans? Perhaps that's the goal of this policy change. My guess is that there will be unforeseen consequences. Who will rush to take the money-losing side of the repo? If there is no counterparty, then the repo market could be diminished, which may have the effect of raising reserve ratios, further contracting the money supply. Most economists these days are against a contraction in the money supply during a recession, especially "The Great Recession".
Thursday, January 22, 2009
What Caused the Stock Market Crash of 2008-2009?
[Written for the Borsen-Kurier]
What caused the US stock market to spectacularly crash in 2008 is intimately connected to what caused the market to boom from 1980 to 2007. In broad terms, the long market boom, which took the Dow from 875 to over 14,000 at its peak in the fall of 2007, was the result of two interconnected forces: money creation and redistribution.
Economically, the great puzzle to solve is not why the market crashed, but why it performed so far above the rate of economic growth for so long. Why should the stock market, which is composed of nothing more than a broad section of corporations, on average perform any better than the overall rate of economic growth, upon which it surely rests?
Consider the following graph of the stock market and M3, the Federal Reserve’s broadest measure of money creation (M3 was discontinued in 2006, but the series is kept up by several different private economists). Notice that the performance of the stock market (as measured by the Dow) is far above the rate of productivity growth or the rate of real economic growth.
The fractional reserve nature of most modern banking systems means that money creation takes place in a decentralized manner; during this period, much of that money found its way into financial markets, in the form of leveraged buyouts, stock buybacks, and the effects of increasing leverage on the part of investment banks and the explosive growth of the highly-leveraged hedge fund industry. Much of this borrowing went to purchase equities, bidding up prices dramatically.
At the same time, the shifting balance of power between labor and capital made it possible for corporations to hold down wage growth, resulting in an unprecedented 20 year period of falling real wages in the US. This caused corporate profits to increase, along with share prices, as stockholders re-evaluated the new distribution of income between labor and capital.
The problem, of course, is that neither of these forces are sustainable. The share of income going to labor can fall, allowing the share that goes to profits to rise, but labor’s share cannot fall far without producing resistance. In the US, that resistance was weak, in part because of a new innovation: leverage for consumers. Unfortunately, the new kinds of consumer credit that were invented and eagerly used by US consumers were rarely used for any kind of investment, so debts mounted without an increase in income to pay them back.
As for money creation, it must eventually lead to inflation. No one can truly create wealth out of thin air, so when money is created far in excess of economic growth it must cause rising prices somewhere. If it causes rising consumer prices, we notice it and demand a solution, but if it causes rising stock prices, we celebrate it. But the money is not real, and the prices cannot last. At this point, it seems likely that the Dow will fall to 5500, which would give the Dow a traditional bear market dividend yield of 6%. Given the extent of money creation thus far, a strong possibility is that the Dow shows strong growth, perhaps rising above 10,000, or even above its record heights. While this may reassure investors, such an outcome would simply be the first manifestation of inflation that will not be confined to financial markets this time around.
What caused the US stock market to spectacularly crash in 2008 is intimately connected to what caused the market to boom from 1980 to 2007. In broad terms, the long market boom, which took the Dow from 875 to over 14,000 at its peak in the fall of 2007, was the result of two interconnected forces: money creation and redistribution.
Economically, the great puzzle to solve is not why the market crashed, but why it performed so far above the rate of economic growth for so long. Why should the stock market, which is composed of nothing more than a broad section of corporations, on average perform any better than the overall rate of economic growth, upon which it surely rests?
Consider the following graph of the stock market and M3, the Federal Reserve’s broadest measure of money creation (M3 was discontinued in 2006, but the series is kept up by several different private economists). Notice that the performance of the stock market (as measured by the Dow) is far above the rate of productivity growth or the rate of real economic growth.
The fractional reserve nature of most modern banking systems means that money creation takes place in a decentralized manner; during this period, much of that money found its way into financial markets, in the form of leveraged buyouts, stock buybacks, and the effects of increasing leverage on the part of investment banks and the explosive growth of the highly-leveraged hedge fund industry. Much of this borrowing went to purchase equities, bidding up prices dramatically.
At the same time, the shifting balance of power between labor and capital made it possible for corporations to hold down wage growth, resulting in an unprecedented 20 year period of falling real wages in the US. This caused corporate profits to increase, along with share prices, as stockholders re-evaluated the new distribution of income between labor and capital.
The problem, of course, is that neither of these forces are sustainable. The share of income going to labor can fall, allowing the share that goes to profits to rise, but labor’s share cannot fall far without producing resistance. In the US, that resistance was weak, in part because of a new innovation: leverage for consumers. Unfortunately, the new kinds of consumer credit that were invented and eagerly used by US consumers were rarely used for any kind of investment, so debts mounted without an increase in income to pay them back.
As for money creation, it must eventually lead to inflation. No one can truly create wealth out of thin air, so when money is created far in excess of economic growth it must cause rising prices somewhere. If it causes rising consumer prices, we notice it and demand a solution, but if it causes rising stock prices, we celebrate it. But the money is not real, and the prices cannot last. At this point, it seems likely that the Dow will fall to 5500, which would give the Dow a traditional bear market dividend yield of 6%. Given the extent of money creation thus far, a strong possibility is that the Dow shows strong growth, perhaps rising above 10,000, or even above its record heights. While this may reassure investors, such an outcome would simply be the first manifestation of inflation that will not be confined to financial markets this time around.
Sunday, November 30, 2008
Solving the US Banking Crisis
[Written for the Borsen-Kurier]
Most efforts proposed these days go exactly the wrong direction: back toward unsustainable economic activity like debt-funded consumer spending, home buying, and government spending, or away from the transparency that markets need to reach equilibrium (for example, the recent proposal at the G-20 meeting that accounting standards be ‘temporarily’ loosened—as if we could escape our problems through denial).
Here is an economic plan that would work immediately; it would stabilize the banking sector instantly, preventing the crisis in the stock market from reducing business investment in the real economy, thus preventing a major contraction of GDP.
The catch? It will involve some short-term economic pain.
The reason that banks are fragile is that they have only a fraction of their deposits on hand at any given time. Because banks are currently scrambling to increase their reserves, they have restricted lending by $100 bil from October 29th to November 19th. Granted, this is a small decrease when the total volume of loans is over $7,000 bil, but any decrease in lending tends to be pro-cyclical, resulting in the contraction of the money supply at precisely the wrong time. In theory, a money multiplier of 10 would imply that a $100 bil restriction in lending would lead to money destruction of $1,000 bil. Additionally, because of decreased consumption and investment spending, there is a falling velocity of money, meaning fewer transactions per week. This exacerbates the effect of a contraction in the money supply. As of November 28th, 2008, the total money supply (M2) was $7,854 bil. Bank reserves have skyrocketed from $44 bil in August to $652 bil in October, while bank deposits have stayed constant at about $7,000 bil.
Here’s the plan, in two parts.
Part 1: the total cash and coin in the US is less than $800 bil. Print an additional $7,000 bil, and give it to banks in exact proportion to their deposits. Then make sure that bank reserves always equal bank deposits, creating a 100% reserve system. This would cause no net change in the money supply, for we’d simply have printed money to back up bank deposits, money that was already in use. We’d merely replace checkbook-money with paper money. No problem so far. There would be no inflationary pressure, and the cost would be minimal - the cost of printing and distributing the money.
Part 2: Define the dollar as a portion of gold. This is where the sacrifice begins, for it involves a substantial devaluation of the dollar. The US holds 8.133 bil grams of gold, and the IMF has another 3.217 bil grams; if we divide the total money supply M2 by the total US and IMF gold reserves, we get about $700 per gram, meaning a dollar is worth 1/700th of a gram. Now the tough part: we keep this ratio in good times and bad, at all times allowing anyone to trade $700 for a gram of gold. Since the current market price of gold is about $26 per gram, this plan would entail that the dollar must fall to 3.7% of its current value. (The drop would probably be less severe, as this plan would pull gold out of private gold stocks and into service as money).
Without access to deficit spending, cuts in government spending will add to the economic contraction, but the plan will prevent future pain, for the current strategy of massive money creation and fiscal deficits will surely devalue the dollar, without the benefit of ever leading to a sound medium of exchange.
The financial crisis is first and foremost a debt-deflation crisis, which was produced by banks’ wanton money creation during the expansion of the 1990s and early 2000s (an expansion supervised by the Federal Reserve). If we give the market a medium of exchange that can be trusted to hold its value, the extraordinary ingenuity and entrepreneurship that is America’s greatest asset will be unleashed, and we will soon be enjoying prosperous times again.
Most efforts proposed these days go exactly the wrong direction: back toward unsustainable economic activity like debt-funded consumer spending, home buying, and government spending, or away from the transparency that markets need to reach equilibrium (for example, the recent proposal at the G-20 meeting that accounting standards be ‘temporarily’ loosened—as if we could escape our problems through denial).
Here is an economic plan that would work immediately; it would stabilize the banking sector instantly, preventing the crisis in the stock market from reducing business investment in the real economy, thus preventing a major contraction of GDP.
The catch? It will involve some short-term economic pain.
The reason that banks are fragile is that they have only a fraction of their deposits on hand at any given time. Because banks are currently scrambling to increase their reserves, they have restricted lending by $100 bil from October 29th to November 19th. Granted, this is a small decrease when the total volume of loans is over $7,000 bil, but any decrease in lending tends to be pro-cyclical, resulting in the contraction of the money supply at precisely the wrong time. In theory, a money multiplier of 10 would imply that a $100 bil restriction in lending would lead to money destruction of $1,000 bil. Additionally, because of decreased consumption and investment spending, there is a falling velocity of money, meaning fewer transactions per week. This exacerbates the effect of a contraction in the money supply. As of November 28th, 2008, the total money supply (M2) was $7,854 bil. Bank reserves have skyrocketed from $44 bil in August to $652 bil in October, while bank deposits have stayed constant at about $7,000 bil.
Here’s the plan, in two parts.
Part 1: the total cash and coin in the US is less than $800 bil. Print an additional $7,000 bil, and give it to banks in exact proportion to their deposits. Then make sure that bank reserves always equal bank deposits, creating a 100% reserve system. This would cause no net change in the money supply, for we’d simply have printed money to back up bank deposits, money that was already in use. We’d merely replace checkbook-money with paper money. No problem so far. There would be no inflationary pressure, and the cost would be minimal - the cost of printing and distributing the money.
Part 2: Define the dollar as a portion of gold. This is where the sacrifice begins, for it involves a substantial devaluation of the dollar. The US holds 8.133 bil grams of gold, and the IMF has another 3.217 bil grams; if we divide the total money supply M2 by the total US and IMF gold reserves, we get about $700 per gram, meaning a dollar is worth 1/700th of a gram. Now the tough part: we keep this ratio in good times and bad, at all times allowing anyone to trade $700 for a gram of gold. Since the current market price of gold is about $26 per gram, this plan would entail that the dollar must fall to 3.7% of its current value. (The drop would probably be less severe, as this plan would pull gold out of private gold stocks and into service as money).
The sacrifice would begin when all imported goods immediately rise in price dramatically (an imported good that costs $1 may rise to $25). International trade flows would change as markets reach equilibrium. This would certainly cause some dislocation. But we’d skip the lasting pain of a sequel to the Great Depression because the main damage to the economy would be avoided. The money supply would not contract due to banks rational fear of collapsing during the financial crisis. Banks would be on a solid basis, and they could immediately begin lending (from savings accounts only; these would have to be set aside specifically for investment purposes, and would no longer be available on demand).
Sacrifices would continue as the US could no longer maintain a current account deficit without draining US gold reserves. The federal government would not be able to borrow billions or trillions to finance deficit spending. The depreciation of the dollar would mean foreign bond holders would immediately lose money, and large-scale selling of bonds would ensue. While it is unfortunate to break the trust of those who bought US bonds, it is simply unavoidable. The US has too much debt to pay it back. The US government will repudiate its debt, either simply and honestly, as in this plan, or covertly, through inflation.
Without access to deficit spending, cuts in government spending will add to the economic contraction, but the plan will prevent future pain, for the current strategy of massive money creation and fiscal deficits will surely devalue the dollar, without the benefit of ever leading to a sound medium of exchange.
The financial crisis is first and foremost a debt-deflation crisis, which was produced by banks’ wanton money creation during the expansion of the 1990s and early 2000s (an expansion supervised by the Federal Reserve). If we give the market a medium of exchange that can be trusted to hold its value, the extraordinary ingenuity and entrepreneurship that is America’s greatest asset will be unleashed, and we will soon be enjoying prosperous times again.
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