Dollars and Jens
Thursday, October 30, 2008
The "advance" report:
4.8% -.2% .9%2.8%-0.3%
Consumption 1.44  .67  .61 0.87-2.25
Inventories .69 -.96 -.02-1.50.56
Fixed investment-.15 -.97 -.86 -.25-.83
Net Exports2.03.94.772.931.13
Government Spending.
The headline number isn't quite as bad as I thought it might be, though in part that's due to government spending, and of course it's negative. It's actually within the normal revision range of zero, but I wouldn't hold my breath expecting it to be revised into positive territory next month. Fixed investments are still significantly weighed down by continued decreases in housing construction, though even without that real fixed investment would have been down slightly this quarter due to a drop in transportation equipment. Note that oil prices topped in the third quarter; I wonder how much high oil prices affected these numbers.


Wednesday, October 29, 2008
The U.S. government's $160 billion handout to banks from Niagara Falls to Beverly Hills is going mostly to lenders that need it least, putting weaker rivals at risk of being shut down or taken over, analysts say.
Good to hear it. Insofar as the government is solidifying banks that are fundamentally sound to assuage unfounded fears, it is more likely to generate positive returns on its (our) investments and is less likely to create long-term distortions in the financial system. It is good, especially in the short-to-intermediate term, for fundamentally sound financial institutions to stay around while the unsound get culled. I was afraid there would be too much political pressure on the treasury to prop up zombie banks, and I'm quite excited to see the suggestion that I might have been wrong.


FOMC statement
The FOMC has unanimously cut the federal funds target by 50bp to 1%.
The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 1 percent.

The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures. Business equipment spending and industrial production have weakened in recent months, and slowing economic activity in many foreign economies is damping the prospects for U.S. exports. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit.

In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate in coming quarters to levels consistent with price stability.

Recent policy actions, including today’s rate reduction, coordinated interest rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth. Nevertheless, downside risks to growth remain. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh.

In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 1-1/4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Cleveland, and San Francisco.
It's worth noting that the effective fed funds rate has been around or below that rate for the last 3 weeks anyway.


Tuesday, October 28, 2008
If you're following the recent Volkswagen saga, you might want also to read up about the Northern Pacific Corner of 1901 if you don't know about it.

Update: This might be a better link for recent Volkswagen issues.

Update: Apparently, something similar happened in 1920 with the Stutz Motor Car Company.Hempton)

Friday, October 24, 2008
stocks fall
S&P futures dropped the maximum the CME allows before the market opened, though things look a little bit less gruesome than this implies an hour into the trading day.

Incidentally, I commented somewhere, possibly including here, that I'm cautiously optimistic that we've past the very worst of the crisis. By this I mean the credit crisis; by no means was I suggesting that the stock market, a year from now, would be higher than, say, two thirds of its current level. Though I'm certainly not predicting that it will be lower than it is today, either. Anyway, treasury bills are certainly rallying this morning, but I don't see general indicators of especially grim credit indicators, at least not by standards of the past month.


Tuesday, October 21, 2008
bank solvency, mark-to-market, and capital requirements
A lot of people have complained that mark-to-market accounting has contributed to bank solvency problems, forcing them to write down assets. Most of the time "mark-to-market" is going to be a much more reliable gauge to the value of an asset than is "mark-to-whatever-the-market-was-at-when-I-acquired-this-asset", or "mark-to-wishful-thinking" for that matter. Sometimes markets are inefficient, and it may well be that right now some assets for which markets exist are putting unduly low prices on assets that, with a more sober assessment of likely future outcomes, would make banks solvent that are currently, based on market prices, insolvent. As a general principle, though, I don't like the idea of encouraging banks to sit on those assets that are overvalued on their books when all evidence suggests that they have lost value. I think many people who come from a trading quant background feel the same way — mark-to-market is just obviously the right thing to do, and anything else is an attempt to ignore reality.

It's worth noting, though, that the fact that a company's assets are lower than its liabilities does not mean the company, as a going concern, is worthless; when Pepsico spun off Tricon (now "YUM brands", viz. Pizza Hut, Taco Bell, and KFC), it gave the new company more debt than assets, and the shares had a negative book value for a year or two. Operating profits were healthy, and the company's debt never had wide spreads, because bondholders knew they had nothing to fear; profits were high enough to make interest payments as they came due and to pay down some of the debt, and after a while the company had a positive net worth. It could well have paid a small dividend to shareholders, even with a negative book value, without ever imperiling the bondholders.

The term "solvency" can mean different things in different contexts; the uniform fraudulent transfer act renders certain transfers "constructively fraudulent" based on a definition of solvency as having assets worth more than liabilities. (Perhaps this explains why Tricon didn't pay its shareholders a dividend.) This is the usual definition, when a clear definition is needed; it is also the definition used by Chapter 9 of the bankruptcy code, which requires that a municipality be insolvent in order to file for bankruptcy. No other chapter makes that requirement, though; a company looking to effect an orderly liquidation can file for bankruptcy if it simply makes it easier (perhaps more transparent) to wind things down that way, or a company with a large contingent liability that would, if realized, make the company insolvent might well find it preferable to seek bankruptcy protection even if the accountants
don't deem it insolvent yet. On the other hand, a company that is "solvent" on paper can be pushed into bankruptcy if it can't make a debt payment, perhaps because its assets are illiquid (e.g. factories). When we distinguish between a company having a liquidity problem versus a solvency problem, we typically intend "solvent" to mean that a company would be able to pay off all of its debts if it were able to obtain credit at some reasonable rate for some finite period of time. In this sense, Tricon was viewed as solvent all along.

I've argued before — I think I've said this here, but maybe not — that I think the big financial institutions that haven't failed yet are all solvent in that last sense of the word, and I think any investment the government makes that returns a higher rate than the relevant treasury note is likely to result in a profit to the government if it leads the markets to believe that the company is both solvent and liquid. Any financial company without access to credit on reasonable terms is doomed, regardless of its actual solvency, at which point it's left in bankruptcy marking its assets to market, possibly straining those markets at the same time. This can lead to self-fulfilling "runs" — you don't want to be the last person to lend money to a bank, even if it would be viable, if it isn't viable — and conceivably even to speculative attacks, though I expect those are far less common than is popularly imagined. Of course, if you give more money to any institution that is not, in the long-run, solvent, you're throwing good money after bad, and (perhaps not disinterested) bankruptcy lawyers believe that, in general, most bankruptcy filers file much later than they should rather than sooner.

Washington Mutual, though, to hear some reports, was making $8 billion a year on its retail operations, and, if it had to mark its assets to market right away, would have been, making the absolute worst assumptions, $40 billion in the hole. It was in part hoping that those worst assumptions would not come to pass, but was also trying to delay write-downs as long as it could, in the hope that it could stretch out realizing its losses over a couple of years, and thereby never technically be insolvent. The company was by no means as solid as Tricon, but it may have been in a qualitatively similar situation, in which by a market reckoning it had negative equity, but would not have been unable to dig itself out without asking anyone to make an unprofitable investment.

The problem for Washington Mutual, taking this story as correct, is that it had regulatory (and even covenant) obligations that required that it remain solvent in the UFTA/Chapter 9 sense. Whether the assets were maturing soon or not — and thus, under any alternative to mark-to-market, would have had to be recognized — doesn't seem terribly salient to this fundamental element of the story. It may well be that regulators want to err in the direction of crude measures that are sometimes overly cautious and will prevent financial firms in holes from digging themselves, and the financial system and even taxpayer, in deeper; a company that wrote more than $40 billion in bad assets is not on the top of the list of companies you might expect to produce salutary results in the future, and there's something to be said for capping the size of the potential problem. Still, I wonder, if the possibility of being seized by regulators hadn't been in play, whether a WaMu might have had other options available to it.

One of the triggers for my thinking about all of this, over the last month or two, has been Arnold Kling's call for reduced capital requirements, at one point suggesting that one of the reasons for having significant capital requirements during good times is so that banks have funds that they would be able to lend — if capital requirements were lowered — when things look bad. This would be a bad idea from a cut-our-losses standpoint, but I agree with his proposal; solvent banks right now are unlikely to seek risky new loans, and a small change in capital requirements would do more to give room to healthy banks to make new loans than it would to increase the size of potential losses from zombie banks. On the other hand, I'm not sure "capital requirements", in terms of a straight-up look at a bank's balance sheet, is the best proxy for "how likely is this bank to cause how big a problem?" in the first place.

Some speakers at the Fed's conference at Jackson Hole in August noted that the Basel II international model banking regulations are too focused on making banks keep down the day-to-day volatility of their assets, rather than on tail-risk, systemic-type concerns, and I'm sure I agree; idiosyncratic risk, and especially day-to-day volatility, is the sort of thing that should be left to conventional market discipline. While we're looking at rethinking the way we do bank regulation, though, I think looking at balance sheets, whether with or without mark-to-market, without any attention to sources of future cash flows that aren't discounted and included as assets, is myopic, and might be amenable to improvement.

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Monday, October 20, 2008
Term: 13-WeekHigh Rate: 1.250%
Investment Rate*: 1.271%
Price: $99.684028
Allotted at High: 58.29%
Total Tendered**: $62,279,144
Total Accepted**: $25,000,081
Issue Date: 10/23/2008
Maturity Date: 01/22/2009
CUSIP: 912795J85
TED below 300bp.

NB, "TED at 300bp" would have been alarming as recently as two months ago. The credit system isn't what one would call "healthy", only the most so in a month. I'm cautiously optimistic that things will continue to improve, but we'll probably be on edge through the bottom of housing prices and the economic cycle at the end of next year.


Friday, October 17, 2008
Lehman CDS
It looks pretty clear now that the vast majority of cash due on Lehman CDS settlement is going to be paid.

Incidentally, TED is down to 359bp. I keep hearing "the worst isn't over yet", which I think means these people are either pessimists or insouciant toward the English language; in any case, there's a reasonable chance that the very worst is behind us, but I wouldn't count on things being a lot better really soon.

Wednesday, October 15, 2008
It's surely an indicator of some sort that, when I first saw that we had a drop today that was the biggest (in percentage terms) since 1987, it didn't look particularly big to me.


Lehman Brothers
This is interesting; Bernanke has just asserted, in answer to a question about "allowing Lehman to fail", that the Fed didn't have the legal power to do anything to prevent it; they couldn't lend to Lehman as they did in the Bear Stearns case because there wasn't any collateral to lend against. This is the first time I've heard any suggestion that it wasn't a voluntary decision to let Lehman go.

(Incidentally, I read a couple weeks ago where some automakers were suggesting that they would like the same discount-window access as has been broadened to non-bank financial institutions. My immediate thought was "how much discount-window--accepted collateral do car companies have?" I'm not sure some of the people realize that this is all secured credit the fed is giving out; the AIG assistance has in fact involved creative ways of bending in new directions to collateralize the quantities of credit AIG needs to keep functioning.)

Update: A transcript of that comment, and more.

Friday, October 10, 2008
Lehman Brothers CDS
ISDA is doing an auction of Lehman bonds today to determine the price at which Lehman default swaps will settle for cash. The initial indications give a recovery value of 9.75% on Lehman Brothers' bonds. That's lower than I think most people expected; it's a lot lower than is usual. (I wouldn't be surprised if Washington Mutual ends up in similar territory, though.)

The final results of the auction will be announced at 2PM eastern time, and most Lehman default swaps will settle shortly after that.

Update: Apparently PIMCO is one of the big writers of protection here. I hope they're good for it. There's been a lot of talk that AIG was writing a lot of credit protection; I haven't heard anything as to whether they currently have a lot of Lehman exposure. If there's a big default today because someone wrote more Lehman protection than they could handle (and still hasn't recognized it), things could in fact get worse. If not, the resolution of this could pacify things somewhat.

Update: The price will be established today, but actual settlement is still primarily two weeks out.

Update: 8.625% recovery value set. CDS writers will need to pay 913/8% of par value.

War, Pestilence, Famine, and
A VIX over 70.


Thursday, October 09, 2008
The Dow
1September 29, 2008 10,365.45 −777.68 −6.98%
2September 17, 2001 8,920.70 −684.81 −7.13%
3 October 9, 2008 8,579.19 −678.91 −7.33%
4 April 14, 2000 10,305.78 −617.77 −5.66%
5 October 27, 1997 7,161.14 −554.26 −7.18%
6 August 31, 1998 7,539.06 −512.62 −6.37%
7 October 7, 2008 9,447.11 −508.39 −5.11%
8 October 19, 1987 1,738.74 −508.00 −22.61%
9 September 15, 2008 10,917.51 −504.48 −4.42%
10 September 17, 2008 10,609.66 −449.36 −4.06%
From wikipedia, though today's figures are confirmed against google finance. Only two of the recent drops crack the top twenty in percentage terms, and neither of those the top ten.


Monday, October 06, 2008
End of the world XVIII
Corn, soybeans drop maximum allowed at CBOT, about 7% each.


End of the world XIIb
The VIX has broken 50 for the first time ever.


End of the world XVII
What does today have in common with November 14, 1972? The Dow Jones Industrial Average has four digits.

Update Nine years ago.


Fed to pay interest on bank reserves
I had suggested some time ago that the Fed pay interest on excess bank reserves as a way to set a floor on the fed funds rate, not realizing until a week or two ago that they actually didn't have the statutory authority to do so. They acquired that statutory authority when the President signed that bill last Friday, and announced today that they will be paying 125bp on excess reserves and 190bp on required reserves.

I had not included, in my plan, paying interest on required reserves, mostly because of the fiscal impact, and because it shouldn't have an effect on bank behavior — they should have the same quantity of required reserves regardless of interest received thereon because they're, you know, required. It seems a little odd to me to be paying substantially more than they do on excess reserves. Anyway, the overnight fed funds rate over the last two weeks, except for last Friday for which I don't have a data point yet, was 1.32%, with a significant variance; it may well start to show up at 1.25 consistently this week. Unless, of course, the rates get cut, which they could well do.

Saturday, October 04, 2008
End of the World XVI
The markets' modal prediction for the fed funds target at the end of the month is 100bp lower than the current target.


Friday, October 03, 2008
End of the world XV
California, among other states, can't borrow money:
California Gov. Arnold Schwarzenegger, alarmed by the ongoing national financial crisis, warned Treasury Secretary Henry M. Paulson on Thursday that the state might need an emergency loan of as much as $7 billion from the federal government within weeks.

The warning comes as California is close to running out of cash to fund day-to-day government operations and is unable to access routine short-term loans that it typically relies on to remain solvent.


Plans by several state and local governments to borrow in recent days have been upended by the credit freeze. New Mexico was forced to put off a $500-million bond sale, Massachusetts had to pull the plug halfway into a $400-million offering, and Maine is considering canceling road projects that were to be funded with bonds.


Thursday, October 02, 2008
End of the world XIV
AT&T, the American telecoms giant, has admitted it was forced to rely on ultra-short-term financing for its regular treasury operations as a result of the broader global crisis in the money markets.

Randall Stephenson, chairman and chief executive, said his company had last week been unable to sell any commercial paper for terms longer than overnight.

“It’s loosened up a bit, but it’s day-to-day right now. I mean literally it’s day-to-day in terms of what our access to the capital markets looks like,’’ he said.


monetary policy
The Economic Organization of a POW camp:
Machine-made cigarettes were always universally acceptable, both for what they would buy and for themselves. It was this intrinsic value which gave rise to their principal disadvantage as currency, a disadvantage which exists, but to a far smaller extent, in the case of metallic currency; that is, a strong demand for non-monetary purposes. Consequently our economy was repeatedly subject to deflation and to periods of monetary stringency. While the Red Cross issue of 50 or 25 cigarettes per man per week came in regularly and while there were fair stocks held, the cigarette currency suited its purpose admirably. But when the issue was interrupted, stocks soon ran out, prices fell, trading declined in volume and became increasingly a matter of barter. This deflationary tendency was periodically offset by the sudden injection of new currency. Private cigarette parcels arrived in a trickle throughout the year, but the big numbers came in quarterly when the Red Cross received its allocation of transport. Several hundred thousand cigarettes might arrive in the space of a fortnight. Prices soared, and then began to fall, slowly at first but with increasing rapidity as stocks ran out, until the next big delivery. Most of our economic troubles could be attributed to this fundamental instability.

net worth certificates
A different proposal for government assistance to banks, one that was used twenty years ago:
The FDIC purchased net worth certificates (subordinated debentures, a commonly used form of capital in banks) in troubled banks that the agency determined could be viable if they were given more time. Banks entering the program had to agree to strict supervision from the FDIC, including oversight of compensation of top executives and removal of poor management.

The FDIC paid for the net worth certificates by issuing FDIC senior notes to the banks; there was no cash outlay. The interest rate on the net worth certificates and the FDIC notes was identical, so there was no subsidy.
Insofar as the FDIC doesn't perfectly know who's going to remain solvent and who isn't, this still represents a subsidy in an expected value sense: the FDIC is essentially providing a partial guarantee to creditors in exchange solely for some additional oversight. Still, if John Hempton is right, and the problem is ultimately one of creditor faith in the reasonable safety of banks and willingness to lend to them — and I'm increasingly buying that — then this seems like a better way to go about it than anything else I've seen, at least provided the FDIC can do a decent job of discerning who's solvent and maintaining the political will to let insolvent banks go.

Recapitalization of banks is important for the real economy, but recapitalization of banks that are insolvent is not a long-term good use of resources, and once the financial markets are confident in solvent banks, they will be able to recapitalize themselves through those markets. It doesn't make sense to me for the government to do anything to try to promote recapitalization except for helping the markets figure out what's worth recapitalizing.

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