The good, the bad and the irrelevant

If I’m not mistaken, the Senate election last week was held not in Michigan, nor in Mississippi, but in Massachusetts: America’s highest-ranked state by health-insurance coverage and education, and the third-highest by per-capita income.

If I’m also not mistaken, the winning candidate lured voters not with his ruthless bank-bashing (on the contrary!), but by flagging himself as an “independent” with a (supposedly) fiscally conservative agenda.

Against this backdrop, the knee-jerk reaction that came out of the White House shortly after Tuesday’s results is not just bad (polarizing, desperate) politics; it’s also bad policy—irrelevant and potentially harmful policy.

Starting with irrelevant: The proposed “Volcker Rule”, which would prohibit banks “to own, invest or sponsor hedge funds [or] private equity funds” or engage in proprietary trading does exactly nada to address the causes of the financial crisis. These were:

(a) the inability of banks and their regulators to grasp, let alone contain, the level of systemic risk resulting from their highly leveraged operations;

(b) abundant liquidity, easy credit and the search for yield (call it greed if you like); and

(c) as a result of (a) and (b), too little capital to support the ballooning debt in the financial system and the real economy (esp. households).

Constructive initiatives to address systemic risk and capital adequacy are already underway, with high-level institutions like the Bank of International Settlements preparing proposals in these areas. These would include more effective and transparent rules for loss provisions, pro-cyclical capital buffers, a resolution framework for “too big to fail” institutions and stricter liquidity requirements.

What does the Volcker Rule add to this discussion? What… you said more protection to the taxpayer from the high risk takers?! Well, no.

Basically, the Volcker “rule” is grounded on an erroneous assumption: That only institutions that receive deposits from the man on the street are worth stabilizing with taxpayer money (e.g. through deposit guarantees) because of their special role in economic growth.

But this is clearly misplaced. Non-bank financial institutions such as money market funds, finance companies and securities lenders/dealers are absolutely instrumental for the flow of corporate finance and household credit. As such, they are very much “systemic” from an economic growth point of view. One can only recall the complete meltdown of the US and the global economy when Lehman was allowed to fail! Lehman was not a "bank"—yet it warranted an orderly resolution, which—at that stage—had to risk taxpayer money.

In light of this, the relevant policy response is not to --effectively-- force financial institutions to make a choice between their deposit-taking (ie banking) services and their "non-bank" activities. Instead, it is to recognize that what are seen as "non-bank" services are often very much "bank-like" and should be regulated approrpiately with the view of promoting sensible risk-taking across the balance sheet.

By "bank-like" I mean, first of all, maturity transformation. Take finance companies: They borrow short-term commercial paper to invest in instruments like mortgage-backed securities, which are backed by long-term assets. That's not far from plain vanilla banking. I also mean liquidity services: For example, securities dealers take deposits from their hedge fund customers, which are redeemable on demand, but then use the cash to fund their activities in credit market instruments whose liquidity can dry up instantly. This prompts funding uncertainties and a potential run on the dealers... and thus needs to be addressed.

Yet, rather than a targeted regulatory proposal, we get the Volcker rule--a waste of precious political capital and resources for a measure that is ultimately irrelevant!

Then you have the greed problem—and a problem it is! But containing it requires effective regulation, not populist one-off measures (which can backlash).

So what type of regulation can be effective in reining in greed in executive pay? Once again, some initiatives are already underway. The Federal Reserve for example has made a set of recommendations to better align incentive compensation with the risks undertaken by financial sector employees and also with their long-term performance.

But more may need to be done--if, for example, high executive pay turns out to be the by-product of an unduly monopolistic environment in the financial sector, which in turn leads to abnormally high earnings. Indeed, as I argued here back in November, a comprehensive assessment of the benefits and costs of the financial sector’s existing market structure and the identification of measures to improve it should be a top policy priority.

Yet, what we get is a bank tax! OK, may-be one can justify it by the extraordinary, government-backed recovery in financial markets and the, admittedly, business-as-usual attitude by some banks in the sphere of bonuses until it was too late. But it may also end up being harmful: If competition in the financial sector is limited, banks will have the market power to pass on the cost of business to their customers! And this can’t be good for lending nor for the economy more broadly.

Beyond the irrelevance of the proposals, what is far more disappointing is the new tone coming out of the leadership. Here you have the sober, Harvard-educated President, who excited many an independent voter with his intellectual approach to politics and policy back in 2008, employing an increasingly populist vocabulary.

Not only does this alienate independents further. It also raises the level of political risk for businesses and the markets, undermining the one visible achievement this Administration can claim credit for: The restoration of some sense of stability and order in financial markets and, with it, the recovery of a substantial amount of households’ financial wealth and confidence more broadly.

It would really be a shame if the (mis)reading of an electoral outcome ignited a policy agenda that is ill-focused, time-consuming and potentially unsettling. One can only hope it’s not too late to change tack.

The Good, and the Quick ‘n Dirty

You look at the key housing indicators and you’re probably thinking the government’s homeowner support plan has got to be working… mortgage rates at record lows, house prices stabilizing, inventories coming down, new home sales (begrudgingly) crawling upward.

Yet, it all depends on how you define “success”… there is "temporary feel good" success… "clean up now, pay later" success… "everything/everyone but the kitchen sink" success… and success as in "targeted help to the neediest" and "permanent solutions to the root problems."

I fear that only a teeny portion of taxpayer money has gone towards this latter type of success. To see why, one has to judge whether the government’s measures are geared towards tackling the root problems in the housing sector; whether they are cheaper compared to alternatives; and whether they target the neediest.

By "root problems" I mean the excessive supply of homes for sale, demonstrated by the record housing inventories back in 2007/08; and the excessive mortgage debt taken on by people who could not afford it.

By “neediest” I mean households at high risk of foreclosure with too few resources to either relocate or trade down. In turn, by “high risk” I mean households with negative equity and a meaningful cashflow problem (e.g. due to the loss of employment or the sudden increase in their monthly mortgage payments).

The "and" is critical for identifying the neediest: According to research by the Boston Fed (here and here), negative equity alone is not sufficient to prompt walk-outs, as many have argued/feared (unless it’s at egregious levels and the homeowner does not expect to return to positive equity within a reasonable horizon). A cashflow problem is also necessary.

So now let’s take a look at the government measures:

First, you have the Fed’s purchases of mortgage backed securities (MBS) (Cost: To be determined). The purchases have boosted MBS prices, allowing MBS investors to make nice profits. Higher MBS prices have also meant record-low mortgage rates, encouraging purchases of new homes or the refinancing of existing mortgages.

The scorecard? Mixed at best. For starts, the program fails to target the neediest. Those refinancing or purchasing new homes are people who can afford to do so. OK, you might say, but doesn’t this help clean up the large housing inventories? Perhaps… but inventories can also be reduced by letting house prices fall sufficiently, instead of propping them up with artificially low mortgage rates.

Indeed, I’d say that letting prices fall would be preferable, given the fiscal cost of the likely losses on the Fed’s MBS portfolio; the complications for the conduct of monetary policy; and the empirical evidence that lower house prices alone do not prompt walk-outs by the buckets, unless there is a also cashflow problem.

OK OK, but surely the profits to MBS investors can’t have hurt, given the dire state of the financial industry last year? Yeap, profits are nice, but… MBS (and other asset) prices would equally respond to measures tackling the root problem: Excessive leverage in the household and financial sectors. Financial-sector leverage was partly addressed by the capital increases dictated by the stress tests. In contrast, VERY little has been done to reduce household leverage.

Moving on to the measures by the Treasury:

First-time home buyer credit (Cost: $14 billion so far, per the CBO): Originally the scheme offered tax credits to new home buyers, but was recently expanded to also cover long-time homeowners and/or homebuyers with higher incomes! The scorecard? Thumbs down! Yet again, the measure does not target the neediest, fails to address the leverage problem and artificially props up house prices.

Support to Fannie and Freddie (Cost: $96bn of cash infusions and $43bn of subsidies in 2009 alone, per the CBO): The idea here is that Fannie and Freddie buy more mortgages from banks (thus allowing banks to extend more mortgages); and facilitate securitization and onward MBS sales to investors by providing guarantees that insulate MBS buyers from the risk of default.

The scorecard? Thumbs down… big time! The measure fails to benefit the neediest, fails to reduce household leverage and, on top of that, is aggravating the fiscal hemorrhage, since we have yet to see *a* plan for the institutional resolution of Fannie and Freddie.

The only program providing targeted help is the Home Affordable Modification Program (or HAMP). HAMP has allocated up to $75 billion to finance the modification of primary-residence mortgages owed by people in financial hardship. But progress has been painfully slow—the CBO estimates that only a tiny portion of HAMP resources have been spent this year. (The Treasury's latest progress report on HAMP shows 651,000 active trial and permanent modifications as of end-October 2009).

Part of the problem is that HAMP rests on the collaboration of mortgage servicers, which slows down the process, on top of limiting the amount of relief provided by the modification (e.g. due to “net present value rules” in the servicing agreement). The latter is crucial since, the lower the relief, the more likely a household will eventually fall back into arrears.

What I would have liked to see instead is true relief to low-income households with little home equity and a serious cashflow problem. If the hardship is due to employment loss, monthly grants would be offered to reduce a homeowner’s mortgage burden until s/he finds another job. If the cashflow problem is due to a jump in the monthly payment (e.g. due to an unaffordable ARM mortgage obtained through predatory lending), the relief should be permanent. But to avoid the risk of the homeowner pocketing the taxpayer money and then selling the home at a profit, help should take the form of monthly grants instead of one-off debt relief.

By my count, this relief would be targeted, tackle the leverage problem and would likely be swifter by avoiding the intermediation of mortgage servicers. It would be fiscally responsible by foregoing blank taxpayer checks to people with comfortable incomes. It’s also pretty obvious… which makes it all the more astounding why the government has chosen to bypass a good solution, opting instead for the quick ‘n dirty!

On Carry and Other Tales...

I’m amazed with the number of academics, journalists and “pundits” in my field who keep on talking about “the carry trade” as if it’s some sort of cult… “The end of carry as we know it”… “Carry-trade silence”… “Carry makes a comeback!”…

Since last week, the carry trade has also found a mother, a father and some heavyweight patrons (like the Fed) who, apparently, keep on feeding it to monstrous and potentially self-destructive proportions.

I want to use this post to respond to some of the points raised in these op-eds, notably with regard to the role of policy in feeding carry trades and, in turn, asset bubbles. But before I get there, let me deal with the cult notion first...

The carry trade is NOT a cult… “Carry trade” is another way of describing “risk-taking” in financial markets. Anyone who invests their money in anything riskier than a safe, cash-like asset (e.g. US Treasury bills or money market funds) is effectively a carry trader: They are short cash and long a risky asset such as a stock, a corporate bond, a foreign currency, etc.

Indeed, the term “carry” is a literal description of that risk-taking process: When you buy shares in Microsoft, for example, you decide to forego the safety of a US T-bill and instead “carry” the risks embedded in Microsoft’s stock: Risks related to the company’s management, its capital structure, the growth and/or regulatory outlook of the IT industry and so on. Similarly, investors in a foreign currency have to “carry” risks related to the foreign country’s external imbalances, inflation prospects, politics, etc.

Now, to be fair, what many refer to as “carry trades” in the press are leveraged investments. In the above examples, investors use their own capital to make the risky investment. But when they are leveraged, they borrow multiples of their capital short-term and invest the funds in higher-yielding products (e.g. asset-backed securities or currencies like the Brazilian real) to make the spread.

The principle is exactly the same as before—risk taking—only that the use of leverage helps multiply profits in good times (and totally destroy them in bad times!).

OK... now to 2009. Since March this year, most risky assets have seen stellar returns, be it global stocks, corporate bonds, emerging market assets, higher-yielding currencies, etc. How big a role has the “carry trade” played in driving this price action?

Let’s see… One important driver has been the positive surprises in some parts of the real economy (remember those “green shoots”?) As a result, investors revised upwards their baseline forecasts on the economy. In statistical terms, their distribution of expected returns shifted to the right (i.e. a higher mean).

A second driver was the Herculean backstop measures by governments and central banks the world over, aimed at eliminating extreme downside risks. These basically cut off the left (negative) tail of investors’ expected-return distribution.

Neither of these can be said to have encouraged “carry trades” in the leveraged sense. But by shifting the distribution of expected payoffs from risky assets in a favorable way, both factors encouraged (some) investors get out of safe assets and take on risk.

Then you have the Fed’s (and other major central banks’) low-for-long interest rate policy. Is that contributing to “carry trades” and/or to asset price bubbles? There are at least three ways in which the low-for-long interest rates can impact asset prices:

First, the policy “condemns” investors to earning near-zero return on their cash assets for an extended period. This, together with a restored confidence, helps push investors out of zero-yielding cash towards riskier assets.

Asset flow data are supportive of such shifts, but it is important to understand that the low interest rate is only one of the drivers: Factors that changed the mean and the shape of the expected return distribution were arguably more important—recall that in the midst of the panic of 2008, investors were willing to sit on US Treasuries with negative (but certain) yield!

Second, the low interest rates are helping asset prices by boosting the profitability of banks. Think about it: Banks borrow short-term (e.g. depositors’ money or in money markets) and invest in long-term, higher-interest-rate assets like corporate or mortgage loans.

By fixing their borrowing rates at near zero, the Fed is helping banks make profits even in a difficult lending environment. In turn, this helps prevent the negative feedback loop we saw last year, when financial institutions fire-sold their risky investments to preserve their capital, driving down asset prices.

Third, the low-for-long rate can arguably encourage the fresh build up of leveraged carry trades: Investors could borrow short-term at low rates and invest in riskier assets like equities.

Maybe… but… Evidence of such leverage is lacking: Flow of funds data show that the liabilities of the US financial system on aggregate actually declined in Q2 2009--even as new capital was raised. True, we don’t have data yet for Q3, when asset prices kept shooting higher. But then, please, show me data that point to an ongoing “highly leveraged carry trade”! I’d love to see them, along with many in the markets who try to assess systemic risk on a real-time basis!

Even (even) if leverage were indeed occurring, the point that “traders are borrowing at negative 20% rates to invest on a highly leveraged basis on a mass of risky global assets” is grossly unfair: The “minus 20%” is the ex post cost of borrowing in dollars to invest in a basket of major foreign currencies, following the dollar’s depreciation since March.

But this ex-post analysis completely ignores the tremendous amount of uncertainty surrounding investors’ forecasts back then. No offence to my female cohorts in the industry, but it took gigantic balls to re-enter that market, especially when a LOT of asset managers were already deep underwater and capital preservation was the ultimate priority.

So to recap—low interest rates are just a small part of a broader set of policies and real-economy data that have helped boost asset prices since March. Importantly, based on available data, leverage has yet to manifest itself as the key driver of the price action.

Now, this doesn’t mean that systemic risk is not rising. In fact, IF that were so, the Fed should take notice. But is that so?

Some cite as evidence of systemic risk the high correlation between different risk assets recently (equities, commodities, EMs, etc). I’m not convinced: Since everything collapsed in tandem last year, the recovery in risk appetite should make everything recover in tandem. In other words, the high correlation is not necessarily a cause of alarm at this juncture.

Still.. high correlation means that, if there is a negative surprise, risk assets will all move down in tandem again. Which would be pretty bad! But here is the real crux of the debate: Have the prices of risky assets already moved “too much, too soon, too fast”? Are we already in bubble territory and, hence, at risk of a sharp correction as soon as “reality” strikes?

Well, it depends on your outlook of “reality” in the coming months/years, and on your framework for translating that outlook into a forecast for asset prices. It could indeed turn out that the world is in much worse shape than the average investor thinks (/hopes!)

But let’s get this straight: It is one thing to claim that current valuations reflect forecasts that are overly optimistic given the “true” state of the economy; and it’s another thing to say that the Fed’s low-for-long interest rates are feeding highly leveraged carry trades, which are in turn feeding asset bubbles.

I personally see the Fed’s promise of low interest rates for an extended period (or the ECB’s term lending at low fixed rates) as a plea to investors to take on risk. The idea is to help assets reflate; support consumption through positive wealth effects; and help lending to the real economy through positive valuation effects on collateral.

Investors are slowly heeding, taking on more risk, some even levering up—but still in an environment of heightened uncertainty about the future. We’ll find out “the truth” about the future when it happens. And some will get the chance to say “I told you so!”. But given the scale of today’s uncertainty, nobody can credibly claim that investors (or “carry traders”) are taking on risk for free!

PS My apologies to those who have recently received some of my old posts, looks like Blogger has gone about recylcing old ideas, please ignore them if they recur, I seem to have no control over this!

The plain vanilla option for bank reform

I’m taking a quick break from my blog break to throw in some food for thought re. the bank-reform debate, which has been simmering in earnest.

I also feel pretty energized after a mind-blowing trip to Asia, which has forced me to rethink the definition of “construction boom”, “shopping mall” and... “exotic cuisine”!

Anyway, at the crux of the reform debate are measures to prevent banks from engaging in the risk-taking behavior that led to, yeap, “the worst financial crisis since the Great Depression.” Proposals have targeted, inter alia, bankers’ pay, with the view of curtailing greed and short-termism; and bank capital requirements, to basically make banks’ risky activities more expensive and less procyclical.

Personally, I’m against the former, and not because I have any particular affinity for bankers (unless they are economists!). I just happen to think that, per Econ 101, employee compensation, together with the return to shareholders, should be both derived from a firm’s profit-maximization exercise—provided this exercise also internalizes the systemic implications of the bank’s own risk-taking behavior.

Put differently, if we can make financial institutions pay explicitly for what is now an implicit, unpaid-for insurance provided by the taxpayer against a systemic banking crisis, I see no reason why banks cannot distribute any left-over profits to their workers and capital owners as they please.

For this same reason, while I partly see the logic of the second proposal—to introduce counter-cyclical capital requirements—, I don’t think it’s enough to do “the job”: Yes, it might well discourage banks from engaging in “excessive” risk-taking behavior in good times; but it still does not make banks pay in advance for the next financial bailout which, believe me, will happen again at some point.

Against this backdrop, one idea for making banks pay for systemic-risk insurance was put forward in a paper presented at the 2009 Jackson Hole symposium by MIT economists Ricardo Caballero and Pablo Kurlat.

Accordingly, banks would pay a fee to the Fed in exchange for potential access to insurance, which would be triggered if systemic risk exceeded a certain threshold. This access to insurance would take the form of "TICs" (or Tradable Insurance Credits)—securities that would be issued by the Fed to the fee-paying bank, providing access to Fed guarantees on a pre-specified pool of the bank’s assets.

The paper has some interesting insights and, actually, a somewhat different tilt than the issue I’m raising in this piece (Their point is, in part, that there is a need for a new policy tool to help remove market uncertainty about the depth of bank losses during a systemic financial crisis). So I recommend that you read the whole thing.

Insights aside, I think this type of proposal suffers from a number of flaws, some of which are fundamental. On top of that, it is far more complicated than what I think is a more straightforward solution, which could not only help generate a less procyclical risk-taking behavior, but also address the need to make the now implicit insurance explicit. Let me explain:

Flaw number one in the Caballero-Kurlat approach is the fact that the guarantees would cover a financial institution’s assets (instead of its liabilities).

Why is that a problem? It is, because it would make extremely difficult the failure of any too-big-to-fail financial institution, even if such an institution “deserved” to fail. This would unduly protect the owners of such an institution, despite what might have been excessive risk-taking, lack of oversight and/or sheer incompetence on their side.

As an example, rewind to March 2008, when a (clearly systemic) financial institution in the name of Bear Stearns is at the brink of going bust. Now, an eventuality of that nature is bound to trigger a TIC-like guarantee by the Fed to every financial institution holding TICs, including Bear Stearns.

This is despite the fact that Bear Stearns may be actually insolvent and thus “deserving” to fail (yes, we can debate this, but in a separate forum). The distinction between a liquidity and a solvency crisis is practically irrelevant in the TIC framework.

So this is how it would go… Bear Stearns is about to fail, systemic risk rises unexpectedly, Fed guarantees are triggered, Bear Stearns is saved, systemic risk subsides and all ends well… only that the principle of efficient resource allocation has been wildly damaged: The most short-sighted, over-levered and incompetent bankers on Wall Street are still allowed to roam around, feeling good and getting ready to go back into the game.

To be sure, the Fed (or the relevant supervising institution) might still decide to declare Bear Stearns bankrupt and wind it up, while providing guarantees to the remaining financial institutions. But that would trigger follow-up complications:

E.g. how would we (and the Fed) know ex ante that, urrrh, Lehmans or AIG, say, are soundly-managed institutions deserving to survive, courtesy of the Fed’s guarantees? Or, if the Fed were to trigger its guarantees on a selective basis, what would that do to market uncertainty—the very problem the TIC proposal was meant to address?

But let me go to the second fundamental flaw of the Caballero/Kurlat proposal: Which is that it confuses the roles of the fiscal and monetary authorities in a crisis resolution framework. Contrary to what they suggest, the provision (and, ultimately, the cost) of any guarantees on any financial institution should be the role of the fiscal authority (ie the Treasury), NOT the Fed.

True, the Fed did provide backstops against certain assets or liabilities of financial (and non-financial) institutions during the 2008 crisis, as the crisis escalated. But that was due to (a) the absence of a systematic framework for crisis resolution; and (b) the inability of Treasury and Congress to respond proactively to the dramatic events that unfolded. Yet, what we need is not the Fed taking the lead in what is essentially a fiscal activity; but a solution that would help avoid the need for the Fed to get financially involved, for the sake of its financial and political independence.

So here is an idea: Extend the FDIC’s deposit-insurance framework to the entire financial sector. In other words, get financial institutions (i.e. not just commercial banks) to pay a fee to a dedicated FDIC-like fund, which would be financial subsumed to the Treasury. This fund would be available to cover the liabilities of a financial institution (i.e. its creditors, up to a given amount and level of seniority), if that institution failed.

If you think this provides too nice a treatment to the creditors covered, think again: These guys would now be getting paid much less for their lending to the bank, since the default risk would now be minimal thanks to the explicit insurance the bank is paying to the government.

Importantly, the scheme could be so designed to address the need to discourage excessive risk-taking as well as a heavily procyclical behavior on the part of financial institutions: For example, the fee could be a function on an institution’s leverage, appropriately defined; and it could also be time-varying, in tune with the business cycle, to discourage heavily procyclical behavior.

What are the advantages of this approach?

* First, it allows for the failure of insolvent, poorly-managed institutions, inlcuding systemically important ones.
* Second, it makes financial institutions explicitly pay for the insurance that taxpayers have been implicitly providing to them.
* Third, it can be designed to be countercyclical and incentive-compatible.
* Fourth, it provides provides a more predictable framework for crisis resolution than the status quo, notably with regard to the treatment of the different parts of the capital structure, if it were to fail. Uncertainty about the treatment of shareholders and creditors of different seniorities was a major driver of the market volatility that prevailed in 2008 and early 2009.
* Finally, it makes it clear that any net costs from the resolution of a failed financial institution will be borne by the fiscal authority instead of the Fed.

So here you go, my first wonkish piece for the first official day of Fall. Pretty plain vanilla, dare I say, compared to some of the alternatives out there. And, believe me, after weeks of heated policy debates over silk-worm skewers, bamboo fungus appetizers and live squid entrees, plain vanilla sounds good to me!

Time to ditch the PPIP

You know the world has changed when you go out for a drink with a banker (from the “legendary 19”) and he orders “anything without government in it”! Out of curiosity I seconded the order, and we both received a commiserating look and a vodka tonic.

Anyway, the topic du jour is the PPIP… Revisited after several rounds of thinking, as well as conversations I had with a (small) sample of eligible buyers and sellers. And I am convinced more than ever that the scheme has become useless.

I mean, literally. First of all, in the post-stress test era, I’m having trouble to understand why we need to subsidize investors with taxpayer money to bid up the prices of the banks’ legacy assets.

Think about it… IF (big IF) we were to take the results of the stress tests at face value, banks are fine (we are told), provided they can raise the amount of capital they were instructed to, privately or otherwise. This is because the stress tests have already taken into account the expected losses on banks’ assets (over 2 years), including the “legacy” ones, even under an extremely bad scenario.

But if that’s so, banks shouldn’t need additional help in the form of artificially high bids for their legacy assets. At best, they could sell them to the private market and fetch prices consistent with the government’s own analysis. At worst, they could keep them in their books for a couple of years, possibly more, and still be comfortably capitalized and ready to lend to businesses, mortgage borrowers, you and me. So, why PPIP?

One reason could be that the stress test results are a joke. But let’s not be so harsh… Even if the stress tests results are sound, the PPIP might still be useful if it could facilitate the process of “price discovery” for the legacy assets. But this is not the case.

The whole point of providing private investors with cheap government money is to encourage them to bid up the prices and help bridge the gap between what sellers would love to receive and what buyers would be prepared to pay in the current market conditions. (The idea is to avoid having sellers incur massive losses that could force the government to acquire unacceptably high equity stakes in banks and be accused of the N-word.)

But this is not “price discovery”. It’s a subsidized purchase. As such, it will do little to catalyze market activity in banks’ illiquid assets more broadly, since buyers will not risk bidding high for assets that are not covered by the government’s funding. It is even questionable whether investors would be willing to take the risk to buy securities with maturities longer than the government’s funding.

Ironically, price discovery is happening already in private markets, at least for some “legacy” assets. I am not in this field so what follows is anecdotal, but I understand that at least some “legacy” securities and even loans are being sold and bought as we speak.

Indeed, if you want to see price discovery, you might not have to go further than the sales of loans and securities conducted by the FDIC itself! These are asset sales on behalf of the numerous banks that have been going bust every other Friday or so and that the FDIC (shhh!!) nationalizes before turning them around and re-selling them to new private owners.

True, the prices fetched may not be prices that the FDIC (or the taxpayer, for that matter) likes. But the merit is a swift turnaround of the failed banks, which can then be run by new (better) owners and start lending again. At the same time, the “legacy” loans are passed on to investors with better expertise in distressed assets, loan work-outs and the like, who should be able to maximize the value of these assets (sure, for their own benefit, but also at their own risk!)

Then you also have the problem with the sellers. I mean, what’s in it for a seller? Oh, really? Higher prices? But take a look at the cost…

First, per my fellow drinker’s quote, eligible sellers loathe the idea of having anything with “government” in it. So that’s the starting point. The question is, is there anything that can incentivize them to participate anyway?

Well, one could be the government’s stick. But how strong is that stick? Post-stress tests (and related recapitalization), the government’s case for forcing banks to sell their illiquid assets has become weaker.

Beyond that, the incentives are few to none, especially in the absence of forced collective action. The reason is a big free-rider problem: An individual bank has every incentive not to sell anything, and wait (hope) instead that the participation of the other banks in the PPIP will improve financial market stability and lift asset prices more broadly. At which point, it will go ahead with its own sales, benefiting from the PPIP without having to bear the brunt of Congressional oversight or the public’s wrath for its taste for private jets.

So is there a solution?

Frankly, my preference has been, since time immemorial, for a fully government-owned vehicle to take over banks’ illiquid assets swiftly, at close to “market” prices (or at least prices consistent with a given probability distribution of economic scenaria).

The government could then manage these assets to maximize shareholder (taxpayer) value. Management would include, of course, selling these assets in an orderly fashion to private investors—only that taxpayers have all the upside (and the risk, of course, but they bear most of the risk now anyway).

This never happened because of concerns about heavy writedowns and concomitant bank nationalizations. Fine. But post stress-tests, the landscape has changed: The government’s case for a taxpayer subsidy to banks and investors is weak, especially as banks have been raising capital in private markets and trying to issue debt free of FDIC guarantees.

So maybe it's time to ditch the PPIP and let buyers and sellers sort things out privately, including bank recapitalization. If the latter becomes forbidding for some banks, the taxpayer can step in, with all the strings attached to maximize taxpayer value but also with the due arms-length approach to bank management that allows that value to flourish (something that is not happening right now in some cases).

Ultimately, you can't satisfy buyers, sellers and taxpayers all at once--something has to give. In my world, sellers are forced to take action (as in writedowns), but with the promise of a predictable, reliable and prosperous field ahead for private enterpreneurship (and bonuses!).

Because if there is anything all three groups agree on is the following: Nobody likes to have the government meddling in their affairs!

Ben's Shakespearean dilemma

Inflation or deflation? That is the question.

For all the increase in unemployment and excess capacity that this recession has brought (arguably, the perfect incubator for DEflation), there are people out there raising the INflation alarm.

Me thinks it’s the Fed’s fault. Not because of its aggressive expansion of (base) money. The usual monetarist argument that a large-scale expansion of money supply leads to inflation appears naïve at present, as it assumes a stable demand for money. But this has clearly not been the case: The financial crisis led to a sudden surge in the demand for money, as institutions and individuals fled riskier/less liquid assets in favor of liquid alternatives.

The problem has been communication. The Fed, with its actions, has created confusion about its priorities and objectives. Let me explain.

The “positives” first… Since September 2008, right before the “fireworks” began, the Fed’s balance sheet has expanded by $1.2 trillion. But almost half of that is the result of lending facilities (the TAF, CPFF, PDCF and ABCPMMMF) established to fill the funding gap that financial institutions faced, as counterparty risk skyrocketed and banks lost their traditional sources of funding. The corresponding expansion in money supply is therefore a response to a surge in the demand for liquid assets and, as such, it’s inflation-innocuous. Moreover, by design, these facilities are short-term and set to expire once the need for them is eliminated.

Secondly, in his communications Ben has been careful to subsume every single unconventional measure the Fed has taken under the “credit easing” sphere instead of “quantitative easing” (QE). In other words, the arch objective of these measures, we are told, is to help improve conditions in private credit markets (rather than to help create inflation, which was the case in Japan during 2001-06).

Very importantly, Ben has been talking time and again about the Fed’s menu of exit strategies, presumably with the view of addressing fears about inflation once financial conditions normalize.

But that’s where the clarity ends. Then come the (other) deeds.

Beginning with the Fed’s decision to purchase longer-term Treasuries. Not only are there theoretical reasons why they are likely to be ineffective in lowering long-term yields (I promise a post on this). Not only is there empirical evidence from Japan’s own QE suggesting that the so-called portfolio rebalancing channel through which it’s supposed to work had a small impact at best. Not only have long-term yields here in the US actually increased since the Fed’s announcement that it will start buying Treasuries on March 18th…

…Basically, not only are Treasury purchases a waste of money from a “credit easing” perspective; they are also a mistake, in so far as they breed concerns that the Fed is monetizing the government deficit and/or has inflation as an implicit objective.

This is not paranoia. We are in a world where the menu of unconventional central bank policies that Ben talked about in his famous “Deflation speech” are handicapped: The banking system is broke and thus incapable of fulfilling its role in the monetary transmission process (e.g. by lending out the cheap money the Fed is providing). Household and financial sector leverage is high, which means that, even if rates came down, the room for additional borrowing is limited. Importantly, the economy is in recession and the government is engaging in a massive fiscal expansion which, per CBO’s projections, would raise the government debt by a shocking 30% of GDP by 2012.

In other words, the Fed’s Treasury purchases were announced at a time when the Fed’s tools are impaired by a broke banking sector; and when high household debt and a huge fiscal deficit are creating strong incentives for inflating our way out. I mean, sorry, but this is the perfect setting for a “helicopter drop” of money—a measure proposed by Ben himself in that same “Deflation” speech. Combined with the dubious theoretical and empirical case for them, Treasury purchases can only confuse as to the Fed’s policy priorities and objectives.

Priorities, objectives… So here is a second source of confusion. The Fed has a LOT of objectives at the moment. Take a look at the March 18th FOMC statement:

The Fed “will employ all available tools to promote economic recovery and to preserve price stability.” The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities [..] and to increase its purchases of agency debt this year [..] to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months. The Federal Reserve has launched the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses […].”

Everything but the kitchen sink! I should add of course the objective (me now) “to prevent a financial sector meltdown”, which has seen the Fed acting as lender of last resort to Bear Stearns, Citi and AIG; or (coming shortly) “to promote the orderly deleveraging of greedy financial institutions” through the Fed’s participation in the PPIP.

Luckily for Ben, for the moment all his objectives—stirring economic activity, credit easing and “price stability”—point in the same direction. That’s because “price stability” in this environment means avoiding deflation. But what happens if this alignment is broken? What would he do if the objectives become conflicting?

The answer looks unclear right now. On one hand, for the Fed to effectively bring long-term rates down, in the hope of stimulating aggregate demand, it has to credibly guide the private sector to expect that short-term rates will stay near-zero for a long time, even after economic recovery picks up. The Fed has indeed tried to do so, per the FOMC statement above (“conditions are likely to warrant [...] for an extended period”). Upward price stability would be a secondary objective, under this line of thinking.

On the other hand, Ben’s talk about exit strategies suggests that the Fed is very alert to the inflationary implications of the its current policies and stands ready to fight. Sounds reassuring but, if that’s so, it undermines the credibility of the Fed’s “promise” to keep rates low “for an extended period”.

There is no simple solution, obviously. But my preference would be (a) do away with the “try everything and see what happens” approach to policy-making; (b) do away with (or, at this point, contain) Treasury purchases; and (c) clarify that upward price stability will be *the* priority, if the environment warrants it, even if such clarity comes at the cost of a smaller “expectation effect” on the yield curve from the commitment to keep rates low for some time.

Ben is trudging through tough territory, I admit. But by dispelling “the question” about inflation once and for all, he might find he will not have to “suffer the slings and arrows of outrageous fortune”!

Sayonara Japan, Hello America!

After Geithner’s earnest declaration that “we are not Sweden” I felt compelled to go back and read through the details of past banking crises just to see what makes us so different. Following which, I fear our Treasury Secretary will have to make a bit more effort to convince me how we are going to avoid becoming Japan.

The parallels have been drawn many a time, including in a fairly recent NBER paper, whose eerie timeline of Japan's steps to resurrect the financial sector left me wondering: Is it short memory, self-denial, inflated egos or what, that’s driving our own policymakers into trying to reinvent the wheel?

I’m not going to go through Japan’s measures one by one (I strongly recommend reading the NBER paper for that). I want to focus instead on how to avoid repeating Japan’s mistakes in dealing with banks' undercapitalization problem. So here we go:

What to aim for: Let’s start with a vision… One of the most interesting parts of the paper (for me) is its discussion of the Japanese authorities’ disregard of evidence of “overbanking” and a need for consolidation in the sector.

“Instead, the only objective that was pursued forcefully as part of the recapitalization was that banks were required to increase their lending, especially to small and medium firms. The recapitalized banks were required to report the amount of loans to small and medium firms every six months.”

The parallel with the US is clear: The US approach up till now has lacked a vision with regard to the desirable size and structure of the banking system. If anything, the authorities plan to make it bigger by providing subsidized leverage to what would effectively be new “banks,” while “old” banks unload their burdens so that they can go ahead and… lend more.

Some have countered that before you get to repair the Titanic, you have to prevent it from sinking. Maybe. But to take the analogy further, to me it looks like we are wasting our efforts unloading our “family gold” into the ocean, instead of employing some of our limited resources to plug the holes.

Put it differently, (and as in Japan), the rescue efforts have been (and are being) applied to all institutions indiscriminately, without careful auditing to assess each financial institution’s health or the outlook of its future viability.

Think of the Treasury’s Capital Assistance Program, which applied to the “selected” institutions on a mandatory basis, needed or not; or the PPIP which is designed to benefit whichever bank has assets for sale, regardless of whether some banks may eventually have to fail. Not to mention the billions already wasted on AIG.

If the current course of action were to continue, the outcome would look like this: A recapitalization that is too small to solve the problem; yet too large by any standard of social equity and fairness. A banking sector that is too large to be sustainable without meaningful consolidation. And a bunch of carcasses left in banks’ books, as banks eagerly wait for a turnaround in the markets to lift asset prices and help them close their (true) capital hole. Japan all over.

Here is a better approach, building on the Japanese experience:

Step 1: “In Japan the recovery started with the toughening of the regulatory audits.”

Frankly, I don’t see (the substance of) why the authorities have been resisting conducting an evaluation of banks’ health on a mark-to-market basis. The taxpayer is in with his wallet either way, whether it’s in the form of new bank capital or of subsidized funding to private participants in the PPIP, TALF, etc.

But still. The point is that we need a consistent and transparent process to estimate the size of the capital gap in each bank. If mark-to-market is a non-starter, the estimates could be based on the valuations of the so-called “Third Party Valuation Firms”, i.e. the entities used by the Treasury to assign preliminary prices for the pools of assets banks put for sale under the PPIP.

(Incidentally, I don't think the stress tests can do the job, and you can see here why. Neither will the PPIP, but I’ll have to discuss why in another post).

Step 2: “[..] the 1999 recapitalization, together with the introduction of a scheme for orderly closure of systemically important banks through nationalization in 1998, ended the acute phase of the banking crisis.” (my emphasis)

Just to clarify, this is not (necessarily) a call for nationalization, but… For me, one of the most positive developments coming out of the Treasury has been the government’s request for authority to take over systemically important financial institutions at the brink of default (see here). If granted, it could be a powerful tool in helping execute the government’s vision (to the extent they develop one) as to the desirable/feasible size of the banking system, by allowing the (orderly) wind-downs of weak institutions, including systemic ones.

Step 3: “One important ingredient were the changes initiated in late 2002 and early 2003 at the behest of Heizo Takenaka, who […] called for (1) more rigorous evaluation of bank assets, (2) increasing bank capital, and (3) strengthening governance for recapitalized banks” (my emphasis)

The Administration’s attitude towards bank governance has been gentle at best; yet it should be a core element of a comprehensive bank strategy. I continue the quote:

“In August 2003, the FSA also issued business improvement orders to fifteen recapitalized banks and financial groups, including five major ones (Mizuho, UFJ, Mitsui Sumitomo, Mitsui Trust, and Sumitomo Trust) for failing to meet their profit goals for March 2003. They were required to file business improvement plans and report their progress each quarter to the FSA.

UFJ Holdings was found to have failed to comply with its revised plan in March 2004 and received another business improvement order. The CEOs of UFJ Holdings, UFJ Bank, and UFJ Trust were forced to resign, and the salaries for the new top management were suspended. The dividend payments (including those on preferred shares) were stopped. Salaries for the other directors were cut by 50%, their bonus had already been suspended, and the retirement contributions for the management were also suspended. The number of regular employees was reduced and their bonuses were cut by 80%.”

I am personally encouraged by the Administration’s decision to take a tougher line on GM and I can only hope that it adopts a similar approach towards banks—involving changes in banks’ management and the requirement for business restructuring and viability plans.

As a concluding note, here is another quote from the paper:

“The main problem with the Japanese approach was that the banks were kept in business for far too long with insufficient capital. This limited the banks willingness to recognize losses and they took extraordinary steps to cover up their condition and in doing so retarded growth in Japan. The U.S. policymakers seem to appreciate that this was extremely costly and appear to be trying to avoid it.”

Let’s hope that America's efforts to avoid Japan's mistakes go beyond “appearances,” because the similarities are too scary to allow us to imagine a different outcome.

We are all Keynesians now

I don’t know when it was exactly that Pimco’s Bill Gross took his SAT exam but it must have been a long time ago. And that’s not a judgment on his looks, which brim with So Cal youthfulness. Rather, it’s a judgment based on his latest call for the US Treasury to step in to buy (on behalf of taxpayers) the numerous acronym-of-securities that are being dumped into the market by troubled financial institutions.

Cynics of course could rush to read this as a frantic plea to the government to… “for god’s sake…! Save our as*&*&s,..! We were wrong… Got in too early… failed to see how massive a deleveraging would be needed to correct the excesses of recent years.. (excesses we invariably disparaged, by the way, and take credit for avoiding).. So we used our pile of cash to buy, you know, those “bargains” that emerged from the ashes early on.. the Citigroups of this world, Fannie & Freddie MBS.. and so on.. but prices keep on falling.. it hurts!”

I won’t go there. And that’s because, apart from billions of assets “hurting,” Gross and his Pimco buddies have (high-quality) brains. And they seem to have used them in this case to offer an economic rationale for their call. So let’s see if that one works.

The paradox of deleveraging: The idea of Treasury intervention goes back to an earlier article by Pimco’s “spokesman” par excellence, Paul McCulley. McCulley argues that it is one thing for a single bank to shed assets in order to reduce its leverage to more acceptable levels; but it’s another thing if every bank does so at the same time.

The reason is that collective asset-shedding drives asset prices down, creating losses for all those who own them (including the banks), which in turn reduces banks’ equity. Lower equity means leverage goes back up—which makes the whole deleveraging effort counterproductive. That’s what McCulley calls “the paradox of deleveraging.”

The solution? Bring in the Treasury! Have them buy enough dumped assets to stop their prices from falling… so that all those who need to deleverage can do so in peace (and those with cash can buy some of the dumped stuff without worrying about further price declines).

Makes sense? Well, it makes as much sense as another paradox that McCulley uses as an analogy, Keynes’ paradox of thrift: That’s the thesis that if everyone, collectively, save more, aggregate consumption will fall, and so will incomes. And, since people save less when they earn less, aggregate savings will fall—once again, beating the purpose of saving in the first place. So savings is bad for growth??! Sounds like it, and the way to stop this is to have the government step in and spend more!...

...Right, only that economic thought has advanced since then (a little bit). Indeed, I hear that even big Keynes fans like Nobel-prize winner Paul Samuelson dropped references to the thrift paradox in more recent versions of their economic textbooks (evidently after McCulley and Gross’ time!)

The reason is that the “paradox” ignores a few basic points: First, lower consumption should drive prices down—eventually by enough to spur new consumption. Moreover, the “paradox” confuses “savings” with cash hoarding: When people save, they don’t actually keep their cash in their drawers. They put it in stocks, a new home or other investments or, alternatively, in banks, which go on to lend to the productive sector. That’s good for growth! Finally, when the supply of savings increases, interest rates should fall, spurring higher investment—again, good for growth.

Back to deleveraging: Never mind the paradox of thrift. But what about the paradox of deleveraging? Hmmm… The argument rests on the assumption that current asset prices don't make sense.. that they are falling way below what is justified by fundamentals—say, historic default and recovery rates on mortgages.

But hey, if that’s so obvious, why isn’t the “buy-side” stepping in? Why is Gross warning (/threatening?) that “We, as well as our Sovereign Wealth Fund (SWF) and central bank counterparts, are reluctant to make additional commitments”? If anything, some of the “bargains” they bought in January are even better bargains now! Gross of course can defend himself: Ongoing deleveraging will keep on lowering prices. So why buy now instead of waiting until prices are cheaper?.. and cheaper?.. even cheaper?

A role for the government then? Perhaps. But not the one Gross and McCulley call for. IF prices are "fair" (or way below fair), the problem seems to be one of (failure of) coordination: Pimco doesn’t get in because, alone, it will get hurt. But suppose Paulson organized a luxury weekend retreat for the Pimcos and Blackrocks and Wellingtons of this world… and brought in the Chinese too, and a few SWFs from the Gulf states. I mean, some of these guys are flush with cash. Together, they should be able to garner an impressive demand for all the acronymed "bargains" floating out there—and entice smaller players in the process. Not a penny of taxpayer money—the government is just the coordinator.

Problem is, the “fairness” of current prices remains a trillion-dollar question. Especially as the economy weakens further and unemployment keeps climbing. And even more so since the prices of many of these securities were extremely dubious to begin with—to the point that Gross himself labeled some of them as “garbage” only a few months back.

So that's it, the government is called to buy the garbage... Or could I be reading this wrongly? Maybe it’s just called to buy the “good”, truly undervalued, stuff? (You know, those bargains that that Pimco and others bought early on?) But if one were to stop the spiraling impact of deleveraging on prices one should not discriminate, right?

Internalizing the externality: But could a government intervention be justified by the existence of a market failure, like an externality? You know, when you have some agents (read “undercapitalized banks”) deleveraging and, in the process, cause collateral damage (read “falling asset prices”) on good guys (read “Pimco & co”)? Even here, the government’s role is not obvious. The market-based solution would have the “bad” guys “internalize” the cost of their actions.

Of course, it’s unrealistic to ask Merrill, Citi & co. to compensate investors for the losses they have inflicted on them. But maybe they should start paying a bigger price. There are more than one ways for banks to deleverage—shed assets, which hurts everyone, or raise capital, which hurts them, as new capital is becoming more and more expensive. What? Did I hear Lehmans was having trouble raising money from the Koreans because it didn’t like the price??! It’s about time banks swallow it. Needless to say, that would be good news for Pimco & co, who should be able to participate in the recapitalization process at much more attractive rates.

Ultimately, the excesses of the past few years are turning out to have been too gigantic for even the wildest of imaginations. But asking the government (taxpayer) to assume a liability of still-unknown proportions is clearly wrong—a massive wealth transfer from (greedy) borrowers to (prudent) savers. Yet, this is what we are seeing, with July’s housing bill and the latest government plan to bail out Fannie and Freddie.

We are all Keynesians now.


Glossary: deleveraging, paradox of thrift, externality, Keynesian economics

Bill Gross: Government must buy assets to prevent “tsunami”

Government takes control of Fannie and Freddie

Once upon a time in Jackson Hole

I was secretly hoping this year’s symposium at Jackson Hole would evolve into a hot-blooded feud—you know, like in mafia movies, when all the different gangs get together in a room, in the name of harmony and reconciliation, and end up slaying each other to pieces.

The setting was perfect: A menacing mountain, a year-long financial crisis, powerful central bankers, Wall Street high-fliers, renowned academics, eager journalists, a few stuffed bears. I could so vividly see bankers opening fire on rating agencies, hedge funds firing at their brokers, academics shooting at the Fed, Ben running to hide behind a bear, Chuck Prince—still dancing—caught in the crossfire, the IMF (as usual) watching… And, as bodies fell one by one, everyone turning to chase the Chinese.

But oh no.. This was an economists’ conference after all, where even the most belligerent attacks (like the one by the “colorful” Dutchman Willem Buiter) are met by responses as impassioned as “I respectfully disagree.”

Still, hints of “you should have known better” were indeed made, in the form of academic papers alluding to the possibility that, maybe, had we kept our eyes open while at the wheel, we might have not missed the dazing headlights of a giant truck coming towards us. Among the papers discussed was one by Hyun Song Shin and Tobias Adrian, which argues its case in language readable enough even for those who save their weekends for Martha Stewart’s Living.

Mind the dealers: Accordingly, in their conduct of monetary policy and pursuit of financial stability, central banks seemed to have missed out on an important channel of monetary transmission: The broker/dealers. These are firms that act as both brokers (that is, they execute buy or sell orders on behalf of clients for a fee); and as dealers (trading securities for their own account).

Now, in the (brave?) new world of originate-to-distribute banking, broker/dealers have played a central role in facilitating the securitization of pools of loans, including mortgages. Namely, by underwriting issues of, say, mortgage-backed securities, or by trading such securities for their own account. As such, they have been critical drivers of the overall supply of credit, notably for housing.

Dealers are “special” for a couple of more reasons: First they mark their assets to market, meaning that they tend to value their assets at their current market price rather than at face value. In contrast, “traditional” commercial banks have not historically marked their assets to market. Second, like most financial institutions, broker/dealers are highly leveraged (borrowing at short maturities in money markets to lend at longer terms and for less liquid investments) and their leverage is “procyclical”—it moves in tandem with their size of their assets. In other words, if the value of their assets grows, broker/dealers will borrow more, while if it falls they will seek to reduce their borrowing—or deleverage.

These features combined can give rise to “special effects” such as asset price bubbles or credit booms and busts. How so? Say asset prices rise for whatever reason. Then, broker/dealers’ assets increase in value, prompting them to raise their leverage: They borrow more and use the money to buy more assets. Their demand helps raise asset prices further, inflating the value of their balance sheets more, leading them to borrow even more and so on. An asset bubble is born… I’ll leave it to your imagination to see what happens on the way down.

Complicit in leverage: Where does the Fed come into this? According to the authors, one key driver of the expansion or contraction of broker/dealers’ balance sheets is the Fed funds rate--the Fed’s main policy rate. So by lowering interest rates, the Fed effectively encourages more dealer borrowing, contributing to the credit boom.

Is this a big… deal? Perhaps. Turns out that the dealers’ balance-sheet growth today has an impact on demand tomorrow—particularly on durables consumption and housing investment, which are arguably more sensitive to the availability of credit. Moreover, the increase of housing investment in response to dealers’ asset growth seems to be large and persistent (around three years). The implication would be that broker/dealers’ asset growth should enter into the Fed’s considerations when assessing the outlook of growth and price stability and sets interest rates.

Offering solutions: True to economists’ reputation, the explanation of what happened and/or what the Fed got wrong is not accompanied by definitive policy proposals. Wisely so. Not only are there caveats in the authors’ estimation process (which they acknowledge). It is also difficult to see how to incorporate leverage and asset-growth considerations into an operational rule for monetary policy. How would a central bank decide what is the optimal or sustainable level of leverage? As the IMF’s John Lipsky remarked, “the historical evidence suggests that there is a large structural component to rising leverage [… and that] separating structural and cyclical trends would seem to be quite difficult.”

While hesitant about definitive recommendations, the authors did dare to slip in a mini-bombshell… the idea that transparency in central banks’ communication of monetary policy can be harmful! The reason? Clarity in communication reduces uncertainty about the path of future short-term interest rates and encourages broker/dealers to lever up more and more. Ergo... greater ambiguity might help?? Ouch! Talking about collateral damage when you try to fix one problem and, in the process, you reverse all the benefits of a more transparent monetary policy, e.g. for firms’ productive investment plans.

Finally, the Fed funds rate is declared as “the most potent tool in relieving aggregate financing constraints” during times of distress due to a sharp pullback in leverage. Fair enough: Lower short-term rates would increase the profitability of financial institutions that borrow at short maturities and lend at longer ones. But hey, is that an implicit endorsement of the Fed’s swift 325-basis-point cuts? I hope not... (at least not yet!) Because if it were, we should beg for an analysis that takes into account not only financial stability, but those other things the Fed targets, like inflation and unemployment. Especially since some of these broker/dealer guys, SIVs and their likes might actually deserve to go bust.

So there you go. Looks like the Fed missed out on the truck but gets a pat on the back for its crisis management after the truck hit—far, very far, from the shoot-out I was eagerly anticipating. I guess for that I’ll have to wait for “Once upon a time in Jackson Hole”—the movie.

Glossary: broker, dealer, leverage, mark-to-market, face value, Once upon a time in America.

Sorry, I missed your call...

Some market players are becoming a bit “antisocial” these days. The latest one to breach the market etiquette was Carlyle Capital, a multi-billion-dollar investment fund and offshoot of the powerful private equity group, Carlyle Group. Apparently, Carlyle’s bankers had been calling for days and, after days of silence, the company came out last week to simply say “Sorry… I missed your calls!”

Now these are not any calls. They’re margin calls, and missing them is a pretty serious matter! Indeed, the news added fuel to the fire that has been burning in credit markets for months, sending risk premia to scary new heights as investors began to wonder who else might join Carlyle’s in its antisocial behavior! And sure enough, later on Friday, another company, Thornbug, a provider of “jumbo” (large) mortgages said it couldn’t meet its margin calls, putting its survival in doubt.

So what are margin calls? I mean, who’s calling? And are Carlyle & co. being plain rude?

Telling the tale: Let’s say we’re back in July 2007. You take a look at the latest economic data releases—rising mortgage delinquencies, falling house prices and all—and somehow decide that, nonetheless, it’s still a fabulous time to invest in mortgage-related securities. So you go to your broker and say:

“Hey, I see some high quality stuff out there.. but I only have one thousand dollars to invest. Why don’t you lend me another couple of thousand? I can make more money this way! And if it makes you feel better, I can give you collateral for the loan. Some good, low-risk bonds I own, maybe some cash…Deal?”

Now that’s smart! So now you have two thousand dollars to invest, which means that you can make much more money. How?

Working out the multiples: Say you only had your own $1,000 and the price of your chosen investments went 20% up. You gain—20% (or $200). But now you have $3,000 invested so a 20% price increase translates into a $600 profit. So you take your $3,600, pay back the $2,000 you owe to your broker (with some interest) and you are left with $1,600—a hefty 60% gain on your initial investment!

Of course that’s all great if the market goes up. If it goes down, yes, you guessed it… You’re SCR#($@D! And if you bother to do the calculation, you will note that, the more money you borrow to invest (or the more “levered” you are), the more multiply scr#($@d you are in a downturn!

The collateral you deposited with your broker is the “margin.” Brokers ask for margins because they know the downside can get pretty ugly in Dow-Land. And they want to be comforted that, even if your market acumen were misplaced, and your investments went downhill, they can still get their money back.

Reasonable deals: But let’s go back to last July. So you borrowed $2,000, added it to your own $1,000 and invested all of it in securities that are linked to the performance of residential mortgages. But you didn’t pick any mortgages. You knew that something was fishy in the subprime sector, so you said “I’ll only go for the safe stuff, triple-A-rated securities linked to mortgages issued by Fannie (Mae) and Freddie (Mac).” “These can’t possibly go bad,” you thought. “Not only are they good quality, but Fannie and Freddie are government-sponsored agencies. And the government can’t possibly let them join the fallen.”

“Sounds reasonable,” said your broker. So he lent you the money, but under the following conditions: That at any point in time, you maintain collateral in your account that is at least 15 percent of the market value of your assets. This is the maintenance margin. And that, if your “equity (or the value of your investments minus your debt) fell below the maintenance margin, you would need to find extra collateral and deposit it in your margin account. Otherwise, he reserved the right to start selling part of your existing collateral and use the cash to repay part of your debt, so that your equity goes back up again to acceptable levels.

Now I made up the 15% but, generally, the level of the maintenance margin depends on a number of factors. These include government regulations, brokers’ discretion, the level of competition among brokers to get your business, your overall creditworthiness and how risky the investments you want to make with the borrowed money are.

So, for example, you would expect that when many brokers compete for your business, they might be a bit more lax in the restrictions they place on you, and be happy with a 10% maintenance margin (provided it still lies within the government’s regulatory limits). Similarly, if a certain type of investment is very volatile, your broker will want a bigger cushion since the value can go down very rapidly.

When margins hit the fan: Come August 2007. Markets are getting nervous, as a series of land-mines explode in the credit world—mortgage delinquencies, bankrupt hedge funds, defaulting “SIVs”, major banks under threat. Your investments begin to shake. Your equity is still in positive territory but it’s getting dangerously close to the maintenance margin level. Indeed, as the crisis continues through November, ooops, the equity drops below the margin. And… you receive a call!

“Hello?” (It’s your broker!) You panic… and don’t pick it up! He leaves you a, message, a kind reminder that you need to replenish your margin account, else…

Shoot! Markets are cash-strapped and there is little hope you will find any investor willing to fund you. What to do? You call your mother!

“Hey mom, how are ya, not sure you’ve been following the news… but my investments are in a bit of a strain these days. And I’m short of cash. So when I heard Carlyle Capital managed to get a $150 million credit line from its own mother, Calryle Group, I got inspired and thought you might be able to lend me a few hundred bucks.”

Your mom is upset. “I can’t believe you refused your broker’s calls! What the hell will he think of me??” “I spent years teaching you manners, helping you build your reputation, and now this!” So she sends you the cash, together with a sweet, motherly note saying that this is your last chance.

But the credit-market carnage continues and is spilling over even to “safer” securities, the Fannies and Freddies of this world. This time it’s very serious. Not only are your investments going down. Not only is there more volatility in the market. Not only are you short of cash. But so is your broker, which makes him more nervous about his clients potentially going bust. So as soon as your equity falls below the margin, he calls again… and again and again. And as you “miss” his calls, he leaves you a message notifying you that he just took over your collateral, sold it for cash and used it to reduce your debt. And that, in light of the abysmal market conditions, you’re likely to get more calls soon.

That’s the Carlyle story.. kind of. One important difference being that Carlyle was not two, but thirty times leveraged, so start doing the math to see by which multiple it’s getting scr#^$%d.

But there is a bigger issue.. bigger than Carlyle, Thornbug & co. The more companies are facing margin calls, the more “fire sales” you would expect either by themselves (to reduce their exposure to risky assets with plummeting value) or by their brokers (as they want to recoup at least part of the cash they lent). This is driving prices down to obscenely low levels, even for securities that (in "normal" circumstances) would be safe.

So fasten your seatbelts, because the next few weeks will be bumpy. And, unlike most circumstances, calling your mother won’t help.


Glossary: Maintenance margins, equity, leverage, margin calls, etiquette