Dollars and Jens
Saturday, December 27, 2008
moral hazard
Tyler Cowen suggest that the LTCM rescue sowed seeds for the recent financial crisis:
At the time, it may have seemed that regulators did the right thing. The bailout did not require upfront money from the government, and the world avoided an even bigger financial crisis. Today, however, that ad hoc intervention by the government no longer looks so wise. With the Long-Term Capital bailout as a precedent, creditors came to believe that their loans to unsound financial institutions would be made good by the Fed — as long as the collapse of those institutions would threaten the global credit system.
I've argued before that regulators should concern themselves far more with systemic risk than idiosyncratic risk of institutions; from that standpoint, it is exactly the worst behavior that is being encouraged by a "too large to fail" doctrine.
What would have happened without a Fed-organized bailout of Long-Term Capital? It remains an open question. An entirely private consortium led by Warren E. Buffett might have bought the fund, but capital markets might still have frozen because of the realization that bailouts were not guaranteed.

And Fed inaction might have had graver economic consequences, especially if a Buffett deal had fallen through. In that case, a rapid financial deleveraging would have followed, and the economy would have probably plunged into recession. That sounds bad, but it might have been better to have experienced a milder version of a downturn in 1998 than the more severe version of 10 years later.
Of course, even if it would have been better than what happened — better than the counterfactual counterfactual — regulators would surely have been criticized for the decision.

Wednesday, December 24, 2008
Christmas card

Tuesday, December 23, 2008
zero interest rates continued
Term: 4-Week
High Rate: 0.000%
Investment Rate*: 0.000%
Price: $100.000000
Allotted at High: 58.16%
Total Tendered**: $100,856,034
Total Accepted**: $25,783,169
Issue Date: 12/26/2008
Maturity Date: 01/22/2009
CUSIP: 912795J85

That means there were something like $44.33 billion in bids at 0%.

IV 04I 05II 05III 05IV 05I 06II 06III 06IV 06I 07II 07III 07IV 07I 08II 08III 08
Gross domestic product2.
Nondurable goods.
Durable goods.
Change in private inventories-.11.63-2.07-.191.56-.24.38-.11-1.41-
Fixed investment1.14.851.21.88.411.39-.40-.81-1.27-.57.47-.15-.97-.86-.25-.79
Net exports of goods and services-
Government spending-.35-.04.17.65-.

The "final" report. Nothing all that new. I might reduce the consumption detail again next time; I'm curious as to to what extent durable goods looks like investment.


Saturday, December 20, 2008
how finance is weird
In the mid-1980s, a long line in front of a Hong Kong pastry shop adjacent to a bank triggered a bank run. Depositors assumed that the line was headed into the bank; word spread rapidly; soon, the bank was mobbed.
From The Panic of 1907, by Bruner and Carr.

As I've indicated before, any financial institution has an illiquid, even insolvent (in at least some sense) equilibrium as a function of perceived risk, but for financial institutions with solvent equilibria, that is the socially optimum one. The trick with attempts to favor the solvent equilibrium is that, if there isn't one, those attempts can result in the destruction of economic resources that ought to be redeployed, in the same way that propping up any other inherently insolvent company does.

Thursday, December 18, 2008
Executive compensation
Managing directors at Credit Suisse will be getting bonuses ... sort of.
Credit Suisse Group AG’s investment bank has found a new way to reduce the risk of losses from about $5 billion of its most illiquid loans and bonds: using them to pay employees’ year-end bonuses.


The securities will be placed into a so-called Partner Asset Facility, and affected employees at the bank, Switzerland’s second biggest, will be given stakes in the facility as part of their pay. Bonuses will take the first hit should the securities decline further in value.

“It’s monstrously clever,” said Dirk Hoffman-Becking, an analyst at Sanford C. Bernstein Ltd. in London who has a “market perform” rating on Credit Suisse stock. “From a shareholders’ perspective it’s great because you’ve got rid of some of the assets and regulators will be pleased because you’ve organized a risk transfer.”

‘Better Than Nothing’

For employees, “there’s some upside in there and if the alternative is nothing, it’s a lot better than nothing,” Hoffman-Becking said.
I don't know about "a lot". Hopefully a lot. "Monstrously clever" I'll agree with, though.

Tuesday, December 16, 2008
Treasury bonds
Yields on two-, five-, 10- and 30-year U.S. government debt touched the lowest since the Treasury began regular sales of the securities.
From Bloomberg.

FOMC statement
The fed statement:
The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent.

Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined. Financial markets remain quite strained and credit conditions tight.

Overall, the outlook for economic activity has weakened further.

Meanwhile, inflationary pressures have diminished appreciably.

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 further in coming quarters.

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses.

The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Christine M. Cumming; 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 75-basis-point decrease in the discount rate to 1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Cleveland, Richmond, Atlanta, Minneapolis, and San Francisco. The Board also established interest rates on required and excess reserve balances of 1/4 percent.


Term lending facility
I'm going to note the 28-day term lending auction the Fed held, which resulted in a 28bp borrowing rate, which was the minimum permissible bid; the bid-to-cover ratio was .42, i.e. well below 1. The effective fed funds rate has been in the low teens lately, in spite of the supposed target of 100bp. This is worth remembering when the FOMC lowers the target later today; that "target" has been For Entertainment Purposes Only for the past couple months.

Term: 4-Week
High Rate: 0.000%
Investment Rate*: 0.000%
Price: $100.000000
Allotted at High: 64.37%
Total Tendered**: $97,690,248
Total Accepted**: $30,941,285
Issue Date: 12/18/2008
Maturity Date: 01/15/2009
CUSIP: 912795J77
A 52-week issue went at 59bp.

Monday, December 15, 2008
T-bill auctions
Term:                         13-Week
High Rate: 0.050%
Investment Rate*: 0.051%
Price: $99.987361
Allotted at High: 51.47%
Total Tendered**: $75,560,362
Total Accepted**: $27,000,010
Issue Date: 12/18/2008
Maturity Date: 03/19/2009
CUSIP: 912795K83
The 26-week went at 27bp.

Wednesday, December 10, 2008
4 week T-bill auction
Term: 4-Week
High Rate: 0.000%
Investment Rate*: 0.000%
Price: $100.000000
Allotted at High: 82.27%
Total Tendered**: $128,455,438
Total Accepted**: $32,420,952
Issue Date: 12/11/2008
Maturity Date: 01/08/2009
CUSIP: 912795J69


Big 3 labor costs
Some of the blogs I read were recently going back and forth on a figure of $73 per hour in compensation for the average Big 3 automaker, which people ultimately agreed was not actually an honest accounting of what it claimed to be measuring, but included benefits for retirees prorated over hours worked by workers. What that back-and-forth never produced was a breakdown of the actual labor costs of the big 3, which this NYTimes column does provide.
Add the two together, and you get the true hourly compensation of Detroit’s unionized work force: roughly $55 an hour. It’s a little more than twice as much as the typical American worker makes, benefits included. The more relevant comparison, though, is probably to Honda’s or Toyota’s (nonunionized) workers. They make in the neighborhood of $45 an hour, and most of the gap stems from their less generous benefits.
I'm always a bit suspicious of pension accounting, and this number should include a measure of pension benefits being earned now by current employees, though it should not include current payments on previously incurred obligations — but the indication is that this column is at least trying to get those numbers right, and includes pension charges in the $55. Including the other $15 or $18 or however much one adds in for current retirees is like taking the interest on debt the company has outstanding and dividing that by hours worked and throwing that on as well; the company's previously incurred debt and current expenses are completely separate. If an automaker were to shrink its operations, that denominator would go down, but the numerator remains fixed; the actual savings would be along the lines of the $55 per hour, and the fixed expenses would simply loom all the larger relative to the ongoing size of the company.

He goes on to indicate that that $10 per hour difference is worth about $800 a car, and writes
[L]abor costs, for all the attention they have been receiving, make up only about 10 percent of the cost of making a vehicle. An extra $800 per vehicle would certainly help Detroit, but the Big Three already often sell their cars for about $2,500 less than equivalent cars from Japanese companies, analysts at the International Motor Vehicle Program say.
This buttresses his assertion that the Big 3's bigger problem than labor costs is that people don't want to buy their cars. I would note that retirement benefits and debt service are a problem for them of comparable size; if you gave them $2500 per car, they could probably meet these costs.

The statistics are very useful, and it's nice to see them published, but there's a lot of shoddy economic analysis in the article as well, and I want to warn you off of that. (Page 1 has an odd assertion that "[t]he Big Three and the U.A.W. had the bad luck of helping to create the middle class", somehow as though it were required not only that the automakers take on the retirement planning services of their employees, but that they fail to fund them. He refers on page 2 to the cost of "keeping jobs" versus "creating jobs", which should be a red flag that someone doesn't know what he's talking about.) I'd also like to note that, in bankruptcy, other items in the cost structure — notably overly expansive dealership networks — could also be reined in; even without getting people to pay more for their cars, he has me thinking they might be viable if they went through bankruptcy, stripped down the fixed costs, pared the dealership networks, and reduced labor costs to those of their competitors. And, perhaps, if Ford and Chrysler merged and both remaining companies scaled back their operations to the ones that are most profitable. This is one of the biggest impediments the fixed costs create: if you scale back to where you maximize your ongoing profit, it will obviously not be enough to meet old obligations, so the companies stay too large, hoping that a bit of luck will enable them to survive, and exacerbating the losses when it doesn't.

Catastrophe bonds
A catastrophe bond — I presume one of my readers knows this, but the other may not — is a high yield bond, often issued by an insurance company, that can be repudiated in the event of a big insurable loss due to a single event. Of course, as obligations of a company, they are also subject to the credit risk of the company — if there is no qualifying catastrophe, but the company goes into bankruptcy, these bonds lose as much as any other obligation of the company — which is something that often gets ignored in normal times, as the risk of the catastrophe dwarfs the credit risk of the company.

These aren't normal times.

Saturday, December 06, 2008
An article in the FT on microfinance.
In South Africa in late 2004, Karlan and Zinman persuaded an anonymous consumer finance company that we'll call "ZaFinCo" to participate in an experiment. Ordinarily, almost half of its borrowers would have been turned away as a bad credit risk. But for two months, ZaFinCo loan officers were instructed to identify applicants who had narrowly failed to pass credit checks. From this pool of near-customers, a computer selected almost half and requested that branch managers reconsider and offer a loan anyway.

This procedure emulated the randomised trials of new medicines - after all, a more typical, non-random comparison of borrowers versus non-borrowers would not be able to tell whether borrowers were doing well because they had access to loans, or because they were confident, entrepreneurial people.

Karlan and Zinman wanted to know what value there might be in expanding access to credit. ZaFinCo was no dewy-eyed social business, but a hard-nosed, profit-minded company, charging 11.75 per cent per month on a four-month loan, or 200 per cent APR, much more than Compartamos was generally judged to have been charging.

Despite the high rates, the results were astonishing. "We expected to see some good effects and some bad," explained Karlan, who checked in with the experiment's participants six to 12 months after they had filed their initial loan applications. "But we basically only saw good effects."

Most strikingly, those "treated" by the experiment - that is, those for whom the computer requested a second chance at a loan - were much more likely to have kept their jobs than the control group. They were also much less likely to have dropped below the poverty line or to have gone hungry. All these outcomes were recorded well after the loan had been taken out and (usually) repaid, so this was not measuring a temporary debt-funded binge.
Someone I respect was making fun several months ago of a "microfinance CDO" — I should probably dig up details on that — but the idea makes sense to me, insofar as you could expand money going into microfinance by giving the bulk of the participants a market return while the regular microfinance enthusiasts buy up the junior 10% or so, giving that money a 9 to 1 ratio over what it might otherwise have. I think it's great that we have people giving charity to microfinance organizations, and that we have investors seeking profits from microfinance organizations; I think there's room for more money to do good in microfinance than is being drawn, at this point, by both combined. And it's important to note another point from the article:
"If you're trying to make the world a better place but you're not, that's bad. If you're trying to make profits and don't care about people, but make them better off anyway, that's good[.]"


Friday, December 05, 2008
November Jobs report
You don't want to know.

Monday, December 01, 2008
Bernanke's speech
The Federal Reserve’s efforts in conjunction with other agencies to prevent the failure of systemically important firms have been controversial at times. One view holds that intervening to prevent the failure of a financial firm is counterproductive, because it leads to erosion of market discipline and creates moral hazard. As a general matter, I agree that preserving market discipline is extremely important, and, accordingly, the government should intervene in markets only in exceptional circumstances. However, in my view, the failure of a major financial institution at a time when financial markets are already quite fragile poses too great a threat to financial and economic stability to be ignored. In such cases, intervention is necessary to protect the public interest. The problems of moral hazard and the existence of institutions that are “too big to fail” must certainly be addressed, but the right way to do this is through regulatory changes, improvements in the financial infrastructure, and other measures that will prevent a situation like this from recurring. Going forward, reforming the system to enhance stability and to address the problem of “too big to fail” should be a top priority for lawmakers and regulators.
As has been noted before, regulation has focused too much on idiosyncratic risks, exactly the kind that should be left to market discipline.

On the topic of monetary policy:
In principle, our ability to pay interest on excess reserves at a rate equal to the funds rate target, as we have been doing, should keep the actual rate near the target, because banks should have no incentive to lend overnight funds at a rate lower than what they can receive from the Federal Reserve. In practice, however, several factors have served to depress the market rate below the target. One such factor is the presence in the market of large suppliers of funds, notably the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, which are not eligible to receive interest on reserves and are thus willing to lend overnight federal funds at rates below the target.

This is combined with the footnote that
Banks have an incentive to borrow from the GSEs and then redeposit the funds at the Federal Reserve; as a result, banks earn a sure profit equal to the difference between the rate they pay the GSEs and the rate they receive on excess reserves. However, thus far, this type of arbitrage has not been occurring on a sufficient scale, perhaps because banks have not yet fully adjusted their reserve-management practices to take advantage of this opportunity.

Getting more press is the next paragraph.
Although conventional interest rate policy is constrained by the fact that nominal interest rates cannot fall below zero, the second arrow in the Federal Reserve’s quiver–the provision of liquidity–remains effective. Indeed, there are several means by which the Fed could influence financial conditions through the use of its balance sheet, beyond expanding our lending to financial institutions. First, the Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities. This approach might influence the yields on these securities, thus helping to spur aggregate demand. Indeed, last week the Fed announced plans to purchase up to $100 billion in GSE debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters. It is encouraging that the announcement of that action was met by a fall in mortgage interest rates.
Looks like quantitative easing is coming.

The business cycle dating committee has called a top at December of last year. Last time they declared a recession it was ending as they finally called it; that is almost certainly not the case this time.

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