Relevant and even prescient commentary on news, politics and the economy.

THE Reason for the Downgrade

Or, Barack Obama sucks at 11-dimensional chess.

On July 14, 2011, S&P was assuming that 2001 and 2003 tax fraud deferrals would expire at the end of 2012 [Update: link updated, via MG; PDF–see page 4].

It is no longer making that assumption, which is worth another $4T. Brad DeLong annotates/redlines the press release without comment on that part:

Compared with previous projections, our revised base case scenario now assumes that the 2001 and 2003 tax cuts, due to expire by the end of 2012, remain in place. We have changed our assumption on this because the majority of Republicans in Congress continue to resist any measure that would raise revenues, a position we believe Congress reinforced by passing the act.

English translation: even though extending the tax cuts would require an affirmative action of both houses of Congress and consent from President Obama (or veto override by vote of 2/3 of both houses), we don’t believe this will happen or we would have kept our innumerate mouths shut in the first place (or at least after Treasury called us on our McArdlesque calculations).

Our revised upside scenario–which, other things being equal, we view as consistent with the outlook on the ‘AA+’ long-term rating being revised to stable–retains these same macroeconomic assumptions. In addition, it incorporates $950 billion of new revenues on the assumption that the 2001 and 2003 tax cuts for high earners lapse from 2013 onwards, as the Administration is advocating. In this scenario, we project that the net general government debt would rise from an estimated 74% of GDP by the end of 2011 to 79% in 2015 and to 87% by 2021. to 77% in 2015 and to 78% by 2021. [redlining by BdL]

English translation: if we thought Barack Obama and his Administration both were serious and would be successful, we wouldn’t have left the U.S. on credit watch for possible downgrade. But we don’t, nyah, nyah, nyah.

As I noted earlier today, it’s not coincident that the twenty countries still rated AAA (with the possible exception of New Zealand) all either are tax havens, authoritarian “democracies” (Hong Kong and Singapore) or have Mandatory National Health Insurance.

If S&P on 14 July had said, “The U.S. needs to control its health care costs or we will downgrade it,” no one would have said a word of dissent. But the downgrade S&P presented is not based on the root issue; it is based on the belief that temporary blackmail does long-term damage.

It’s punditry, not analysis. Even Barack Obama deserves better.

At least until he fails 11-dimensional chess the way S&P believes he will.

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The "Standard" of The Price of Gold is This Century’s DeBoers

I’m writing a few long posts—you’ve been warned—but that machine doesn’t have Internet access right now.* So I’m just going to point to Kash, who writes about something else:

In looking at the data I was struck by how small (relatively) the worldwide market for gold really is. That means that relatively small inflows of funds into the market for gold could potentially have very large effects on the price of gold. And that in turn means that the price of gold could be very sensitive to a number of factors that have nothing to do with economic conditions or inflation….

[M]oving just 0.1% of the financial wealth of US households into gold could be enough to have a dramatic impact on the price of gold. Note that the same can not be said of other asset prices that we care about; it would be difficult to discern any price effects whatsoever of a move of an additional $50 billion more or less per year into the stock market (valued at over $50 trillion around the world), the bond market (also with a total value in the tens of trillions of dollars), or real estate.

[A] good advertising campaign by gold producers could be enough to move the price of gold. Imagine that an effective, sustained advertising campaign, targeted at wealthy, conservative individuals in the US, is able to persuade 25,000 of them per month to switch a portion of their financial assets into gold….Such an advertising campaign would have the effect of pushing $15 billion per year into the market for investment gold — very possibly enough to have a significant impact on the price of gold, given how small the overall market for gold is.

[A] very similar thing happened to the market for diamonds in the middle of the 20th century. The DeBeers diamond cartel used an incredibly successful advertising campaign in the 1950s to cement the idea of the diamond as the premier gemstone, and in so doing permanently changed the value of diamonds.

Whether or not you like that analogy, the central point here is a very simple one. Since the market for gold is so small, its price may be strongly affected by things that have nothing to do with the state of the economy.

Kash’s analysis—read the whole thing—should drive the final stake through the heart of the idea that, in the current economy, gold is anything more than what I quoted Warren Buffett as saying it is more than a year and one-half ago.

*In this context, does anyone know how to add the Windows Live Writer app to a Droid X?

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Liquidity, Markets, and Pricing: A Contemporary Example

A lot of trading in the Fixed Income (and especially FX) market is done for “liquidity” purposes. There is often an underlying goal involved (e.g., push prices higher with small lots, sell large ones at the elevated prices) and frequently such strategies are discussed as “algorithmic trading.” (Example: the algorithm estimates that you will need to buy 5 $100MM lots of JPY at incrementally higher rates to be able to sell $1B USD at the higher JPY level.)

The liquidity of the “markets” is facilitated by algorithmic trading: the seller for the first five trades in the above example doesn’t care about the purpose of the counterparty’s trade, just that the price bid is agreeable.

Then there are the times when algorithmic pricing goes terribly wrong:

Eisen began to keep track of the prices until he caught on to what was happening: The two sellers of that particular book — bordeebook and profnath — were adjusting their product prices algorithmically based on competitors:

Once a day profnath set their price to be 0.9983 times bordeebook’s price. The prices would remain close for several hours, until bordeebook “noticed” profnath’s change and elevated their price to 1.270589 times profnath’s higher price. The pattern continued perfectly for the next week.

The biologist continued to watch the prices grow higher and higher until they hit a peak price of $23,698,655.93 on April 19. On that day “profnath’s price dropped to $106.23, and bordeebook soon followed suit to the predictable $106.23 * 1.27059 = $134.97.” This means that someone must’ve noticed what was happening and manually adjusted the prices. [italics mine]

As a mathematical exercise, the shift from $106.23 to $23,000,000 and change is clear: one dealer must price their copy higher than the other dealer. (If both do so, you get to the same point or higher even quicker.) Similarly, if both dealers price at a fraction below 1.000 of the other, the price will converge toward $0.00 as the algorithm progresses.

Consider the implication for a potential third seller, though. Depending on when they check, they may believe they have a book that will make them (if and when sold) rich. But the “market” they see is two computers offering against each other—there is no bid-side shown, and pricing “to sell” (say, $850K when both of the others are offered at around $1.7MM) implies that the third potential seller is carrying that asset at an inflated value.

Market transactions do not require two entities to like each other, or even to understand what the other is trying to do. Indeed, if your alogirthm is buying at 85.3 JPY/USD and mine is selling at that level, neither of us necessarily cares why the other is transacting. And the rest of the market sees an actual trade against which they can adjust their pricing.

It’s only when the algorithms are trying to do the same thing that $23MM+ books are offered.

The implication for mark-to-market valuation seems obvious, and is left as an exercise to the reader.

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Markets and Liquidity, Part 1 of Many

I’ve been working on White Paper on Liquidity and the idea of a “market,” and plan to post some pieces of it here over the next week or so.

But this is too good to pass up, and I’m late to the game as is.

On 15 September, the CFTC and the SEC held a joint “public roundtable discussion” on Swap Execution Facilities (SEFs). Part 1 is here, Part 2 here.

What is most amazing, if you didn’t pay attention to the markets, is how few actual transactions occur in the “derivatives market”—at least according to people who work in the Industry and are discussants.

Take, for example, the Credit Swaps Market. According to ISDA, the Credit Default Swaps Market in 2009 declined to $38.6 trillion; that’s $38,600,000,000,000, give or take forty or fifty billion.

Sounds like a lot, no? Strangely, there’s virtually no liquidity associated with that $38.6T. According to the testimony in Part 1, the most frequently traded CDS—GE, presumably because they bring good things to life (or at least have DoD contracts)—trades around 15 times a day. That might be impressive for a penny stock, but it’s not exactly the type of thing that makes you think “Wow, that’s a market!”

The implications are clear: the bid-offer will be wide (think FX rates from your local bank, or gold prices from Goldline), the loss when one tries to get out of the trade makes “driving a new car off the lot” look like a blip, and any dispute will be resolved against your favor.

In short, there is—and should be—very little retail demand for these products, for very good reason. Paul Volcker’s description of the ATM as the only financial innovation in the past 25 years that helped people has never seemed so true.

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Economists = Idiots? Part 1829

It was their idea, so it’s no surprise they like paying interest on reserves, even excess reserves:

For quite a while, the Fed was quite happy to have that money on its books. Indeed, the power to pay interest on reserves was considered a key tool to keep control over all the liquidity the Fed pumped into the system during the financial crisis. The Fed wanted to see bank lending increase, but in a controlled fashion, so as not to fan the flames of an inflation surge.

But as worries about the outlook have risen, the game has changed. Some see a move to drive all those reserves into the economy as a key way to produce better economic growth. Markets got to thinking Fed Chairman Ben Bernanke would indicate this as a possible path when he testifies before the Senate Wednesday and the House of Representatives Thursday on the economic and monetary policy outlook.

Economists, however, think ending the interest on reserves policy would be a bad idea.

Right, because the $2,534,722.22 a year paid in interest on $1 Billion in excess reserves is a drop in the bucket for the U.S. Federal deficit.

And because the risk-free rate of return that features in so many economic models should be different for intermediaries (financial institutions) than wealth-creators (businesses).

And because “excess reserves” are money issued by the government which is inflationary because of the multiplier effect of money—which, of course, assumes the money is being invested. (As this money is, in taxing our tax dollars and giving them to Vikram Pandit, Ken Lewis, Lloyd Blankfein, and Jamie Dimon [in descending order of theft; YMMV].)

And, of course, because that $1 Billion that is not being used in the economy would only produce about $5-8 Billion in GDP, which is roughly, what, 50,000 to 80,000 new jobs?

But, of course, banks have better use for the money than potential workers.

[Barclays Capital’s Joseph Abate] noted much of the money that constitutes this giant pile of reserves is “precautionary liquidity.” If banks didn’t get interest from the Fed they would shift those funds into short-term, low-risk markets such as the repo, Treasury bill and agency discount note markets, where the funds are readily accessible in case of need. Put another way, Abate doesn’t see this money getting tied up in bank loans or the other activities that would help increase credit, in turn boosting overall economic momentum. [emphasis mine]

Oh, well, since they’re not going to lend the money anyway, we should have no trouble paying them interest on it. What is The Fed other than a mattress stuffed by tax dollars?

The key phrase is “precautionary liquidity.” If you assume that the recovery started in June or July of last year,* then you would expect “excess reserves” held for “precautionary liquidity” to have declined over time, as the need for “precautions” is reduced as the economy becomes safer. But that hasn’t been the case.

Choose one (or both) from: (1) the banks don’t believe the economy is recovering or (2) the banks are holding assets on their books at higher levels than they know they are worth, and are therefore using “excess reserves” to cover real losses until they can’t any more.

It is unclear whether Abate sees the banks’s unwillingness to be intermediaries as a feature. But at least he knows not everyone is doing it.

Abate buttressed his argument that banks really just want to stay liquid by noting who is holding reserves at the Fed. He said the 25 largest U.S. banks account for just over half of aggregate reserve levels, with three by themselves making up 21% of the reserves.

So the biggest of the Too Big to Fail banks have decided not to act as financial intermediaries, preferring instead to continue feeding from the taxpayer trough (where the $25MM in interest really is a drop in the bucket) and/or pretend that they are more solvent than they really are.

And, according to the Wall Street Journal, economists believe we should continue to pay those banks for misvaluing their assets and refusing to perform their economic function.

The economic theory I learned is that capital is paid its marginal product. The marginal product of those excess reserves is zero, while the required reserves are intended to explicitly provide “precautionary liquidity.”

Unless the TBTF banks are arguing that the Fed’s current Reserve Requirements are too low—a possibility, perhaps, though the FT cites evidence contrariwise—the basis of all economic and financial theory indicates that they should receive no interest on those reserves.

An “economist” who says otherwise is either lying or selling something.

*I would argue—see yesterday’s post—that June 2009 is rather eliminated by the non-recovery of more than half the states’s job markets a full year later.

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Liquidity

“Liquidity” is another magic word. I like it rather less than “friction.” In the debate on financial regulatory reform opponents of tight regulations use the word liquidity as a magic spell which, they hope, will make all inconvenient evidence and arguments go away (no links my claim is like saying the Sun emits light). The word is used with different meanings. Sometimes it refers to something which is definitely good, sometimes it refers to the effects of structured finance. This is an equivocation.

It wasn’t always this way. Like “friction,” “liquidity” has been used for purposes other than special pleading and obfuscation. I don’t know the history of the word, so I will start with a definition (which may not be the oldest definition) and explain how the word lost all useful meaning through over use. As with “friction” I think a good practical rule is to demand that anyone who makes an argument including the word “liquidity” be asked to rephrase it without using that word.

Long long post after the jump.

First money is liquid. Money is any asset which can be used to buy anything or pay and debt right now. Other assets are more or less liquid depending on how quickly they can be converted into money and how much that operation costs. One definition of liquidity (the only one which I accept) is the cost of a round trip money to the asset to money divided by the price of the asset.

When we describe the liquidity of an asset as a property of the asset, we are making a very strong totally false assumption. We assume that the proportional cost of the round trip is constant and does not depend on the amount of the asset purchased then sold. Of course this is nonsense. For extremely small purchases, the cost of a round trip is very high. Much more importantly the round trip costs of extremely large purchases can be much higher than the round trip costs of medium size purchases. An extremely large buy order drives prices up and an extremely large sell order drives prices down. It is this problem and no other which is being discussed basically every time a financier uses the word liquidity. They call an asset liquid when huge positions can be taken and unwound with low round trip costs. This sort of liquidity – large transaction liquidity – is not directly valuable to me or to 99.9% of people.

The main point of this post is to object to the equation of round trip costs for medium size round trips and huge round trips. However, the abuse of language is much worse. A third meaning of liquidity is the money supply. This is the sense in which Central banks are said to inject and remove liquidity via open market operations. Here “liquidity” means “liquid assets.” I don’t think this abuse of English is dangerous. It is just very mildly irritating.

However, and much more importantly, “liquidity” is also used to mean free cash flow. It is in this sense that people distinguish between an illiquid firm (which can be profitably rescued with a loan) and an insolvent firm (which can’t). The claim is that the problem for an illiquid firm is that its assets can’t be converted into money.

This is clearly a false statement. Nowadays all assets can be sold. Even in the past, firms could issue new shares. The problem for an illiquid firm (with this 4th meaning of liquidity) is that no one wants to buy its assets. The claim of the manager that her firm is illiquid is a claim that the asset prices are different from fundamental values.

The assets can be sold (as shares of the firm if need be) but people would not pay enough to cover the firm’s liabilities. This is not because the instrument called the public offering of shares doesn’t exist. It is because they don’t believe the assets are worth that much. The claim of illiquidity not insolvency always is the claim that investors are wrong about fundamental values. It hasn’t been a statement about available financial instruments since the invention of the joint stock limited liability company.

It doesn’t matter if the firm’s effort to liquidate its assets would drive prices down or if prices are already low. What matters is that the firm can’t get enough money for its assets to pay its debts.

For the purposes of this post, the point is that, other things equal, we would like firms to have a huge free cash flow. Using “liquidity” to refer to free cash flow gives the word positive connotations. The implicit suggestion is that market institutions such that huge round trips have low proportional costs will improve the cash flow of all firms. This suggestion comes close to being an explicit argument when the same person describes the recent crisis as a liquidity crisis and says that tighter regulations will reduce liquidity.

A fifth meaning of “liquidity” is “market thickness” or “trading volume.” I’m fairly sure the word originally described assets. Now it is often used to modify markets so thick markets are called “liquid markets.” This is actually fairly important, since market thickness is key to making the round trip costs of taking and unwinding a large position low. If I own 100 shares of IBM, the amount of money I can get for them depends almost not at all on trading volume the day I sell. A minuscule fraction of current market volume would be enough that I don’t drive the price down by dumping 100 shares.

The identification of round trip costs for huge and medium round trips leads many people to consider high trading volume socially desirable. Just try to imagine an explanation of why high trading volume is useful to someone who buys corporate bonds to save for her retirement or pay her children’s college tuition or buy a house. It is just assumed that market participants frequently take and unwind huge positions. The implicit assumption is that we should regulate so that the properties of the market please active traders. Most people do not believe that active traders are socially useful. The ambiguity of the word liquidity enables them to argue that the market should be designed for their convenience without their having to defend their claim to be socially useful.

Now an analogy – poker. The thing that smart professional poker players want most is not so smart poker players (fish, suckers etc). They want people who bet incorrectly so that they can take our money (they haven’t gotten any from me). Now, what about the smart traders who want liquid markets? Their view of the way markets should be is that, when they decide that an asset is underpriced, they can buy a whole lot of it at that too low price and, when they decide that an asset is overpriced, they can sell a whole lot of it at that too high price. I can see why they think this is good for them (I think they are often wrong, because they don’t have rational expectations). I can’t see why we should feel obliged to supply them with plenty of fish.

OK an example. “The RMBS based CDO market became very illiquid in 2008.” This sounds like a safe claim. The fact is that the volume of trading of RMBS CDOs collapsed so the market became thin. A market can be thin if everyone agrees on the fundamental value of assets and is pleased with their current portfolio. This was not the case in 2008. Many firms were very eager to get the CDOs off their books and no one had a clue what they were worth. A market can be thin as it is perceived to be very risky so everyone likes to hold zero of the asset. This was not the case in 2008. Net holdings of RMBS base CDOs were not zero. Many firms and individuals owned them and felt that they were bearing risk. They would have liked to reduce their holdings.

I think it is clear why the market was thin. The market clearing price was much lower than it had recently been. Very few wanted to buy at any price higher than this market clearing price, but the owners of the CDOs weren’t willing to sell at the market price, because then they would have had to book the losses. The market seized up, because it was necessary for it to seize up to neutralize mark to market accounting. Here as in the case of the allegedly illiquid firm the problem isn’t that the assets were illiquid, the problem was that their market price was so low that firms couldn’t cover their liabilities by selling the assets.

Having no respect at all for the efficient markets hypothesis, I am perfectly prepared to believe that this was an irrational panic and that many firms could profitably be saved by an emergency loan. It is not very bold to type that now, but at the time, I thought that the cost of a well designed TARP to the Treasury would be huge and negative – that the US Treasury had a huge gigantic profit opportunity.

This opportunity was largely wasted. My understanding is that the Treasury now guesses that it plus the Fed will make money saving banks (I count making good AIG fp obligations part of saving the banks). Not enough to cover the losses from saving GM Chrystler, Fannie Mae and Freddie Mac but quite enough to make it impossible for any semi-sane person to take the EMH seriously (of course I think no semi-sane person ever took the EMH seriously and I strongly suspect that Eugene Fama is semi-sane).

Well here we are finally at the end of an overlong post. My conclusion is that the debate on financial reform is seriously endangered because of a gross equivocation. It is insinuated that so long as trading volume is high, all firms will have an excellent cash flow. It is almost stated that extremely high trading volume is useful to savers and small investors. It is assumed that the problem in 2008 was that markets stopped working in a way pleasing to active traders who think that they can beat the market.

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Catch-Up Links

I have been a Bad Blogger this week. (As opposed to my usual practice, which seems to be described as Blogging Badly.)

While I intend to continue the New Tradition (think of me as Waylon, without the speed), following are Snow Day Links:

D-Squared was on fire on Wednesday: both Bank Lending Channel and The Foundations of Mathematics and the Roots of Finance are essential.

For all those of you—looking straight at you, o six-footed one—who believe TARP was the right idea to save the economy, here’s another data point: “Overall bank lending in the US economy shrank 7.4% in 2009 — the sharpest drop since 1942.”

James Hamilton looks at Those Other Programs that support the banks without providing any funds to the rest of the economy (though I don’t think he put it that way).

With all the talk of Liquidity needs and Greek bonds, jck at Alea posts an essential chart.

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The Drug War Saved the System?

Charlie Stross talks about liquidity:

What we’ve just seen, hidden in the euphemism here, is a confession that drug cartels and other organized criminals have gone on a $352Bn asset-buying spree — and the banks and regulators, world-wide, turned a blind eye to this because the alternative was to allow the banks to collapse. And the corollary is that these investments are now in the system, laundered, whitewashed, and legit. These narcodollars aren’t neatly bundled up inside the mattress any more; they’re in the system, doing their owners’ bidding.

A third of a trillion dollars is a lot of money; it’s enough to fund the US military invading another country halfway around the world, or a manned Mars exploration program. Obviously, there’s no single Mr Big here, no Blofeld investing SPECTREs ill-gotten billions in an ambitious bid to go legit.

But one wonders whether the “organised criminals” have been investing in anything innovative. (Politicians, if they’re smart.) And what the long-term consequences are going to be …

It won’t be Stross’s next novel, but it might be Ben Bernanke’s. Or Larry Summers, whose latest foray into fiction is here.

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Draining liquidity from the banking system

by Rebecca
(cross posted at Newsneconomics)

Prof. Jim Hamilton at Econbrowser (thanks Mark Thoma for the link) addresses one of the Fed’s standard methods of draining liquidity from the banking system: reverse repurchase agreements. Basically, the Fed will transfer some of its assets to the banking system via short-term loans taken out with its Primary Dealers, presumably offering standard (Treasuries) and less standard (MBS or agency bonds) assets as collateral.

Reverse repurchase agreements simply slosh around the assets (MBS, agencies, and Treasuries) between the Fed and the Primary Dealers, rather than removing the assets from the Fed’s balance sheet permanently. Eventually, though, the Fed must sell the securities outright onto the open market – we are far, far from that!

This is all hot air for now. How can the Fed soak up the expansionary liquidity, let alone unwind $1 trillion in assets, when the banking system is still shedding pounds?

The Fed is considering another route, too: conducting the same repurchase agreements with the money-market mutual fund industry in tandem. An excerpt from the FT:

The Federal Reserve is looking to team up with the money-market mutual fund industry as part of its strategy to ensure that its unconventional policies to stimulate the economy do not produce a bout of post-crisis inflation.

The central bank envisages eventually draining liquidity from the financial system by engaging in trades called “reverse repos” with the deep-pocketed money-market funds. In these, the Fed would pledge mortgage-backed securities and Treasuries acquired during the crisis as collateral for short-term loans from the funds.

The obvious counterparties for reverse repo deals are the Wall Street primary dealers. However, the Fed thinks they would only have balance sheet capacity to refinance about $100bn of assets. By contrast, the money-market funds have $2,500bn in assets, which means they could plausibly refinance as much as $500bn in Fed assets. Officials think there would be appetite on the part of the funds, which are under pressure from regulators and investors to stick to low-risk liquid investments.

The Fed is solely attempting to assuage inflation angst at this time; it’s still very premature to talk about an exit of expansionary policies when credit markets still crimp the stimulus that the Fed so desperately wants to get into the open market (much of the base, roughly $855 billion on September 23, 2009 and up from $2 billion in August 2008, remains on balance with the Fed in the form of “excess reserves). Just look at the crunch in the consumer credit space (chart to left).

As Prof. Hamilton suggests, the mechanisms of the reverse repos should successfully sterilize the base before it starts to become inflationary (with either the Primary Dealers and/or the Mutual Funds industry). However, one of the programs through which the Fed utilized previously to sterilize its liquidity, and to which Prof. Hamilton refers, – the Supplementary Financing Program – is unlikely to be an avenue for removing liquidity.

In fact, it’s quite the opposite. The Treasury already announced its imminent plan to liquidate the bulk of its $200 billion account with the Fed. There’s another $200 billion in excess reserves with which the Fed must contend (see my previous post here).

It’s easy to get the liquidity into the financial system. But getting it out without collapsing the economy or allowing inflation pressures to build? Well, that’s a different story.

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