Monday, March 31, 2008

Bill Gross weighs in on recent Fed actions

Bill Gross sees the business model of investment banks changing rather dramatically and their leverage and subsequent profits will better resemble those of conventional banks. He also thinks that recent actions of the Fed will increase inflation.

Investment banks' invitation to borrow at the Fed's discount window will ``come with a price tag,'' Gross wrote on Pimco's Web site today. ``There seems no way that current reserve requirements for banks will not in some nearly uniform way be imposed on investment banks. Leverage and gearing ratios of securities firms therefore, will in a few years resemble those of commercial banks themselves resulting in reduced profitability for major houses such as Goldman, Lehman and Merrill Lynch.''... This ``will be costly, and bond spreads as well as stock prices should begin to reflect it.''

The Fed's direct lending to investment banks will also increase inflation, Gross said in his commentary. ``Because of this lender-of-last-resort operation, subsequent inflationary trends may have been fertilized because the debts that caused the crisis are now primarily in another private portfolio and not liquidated,'' Gross said. ``These debts have to be validated by policy makers through attempts to increase cash flows in the finance-based economy, which is another way of saying they are trying to reflate, which is another way of forecasting an increasing probability of higher inflation.''

source: Fed Rules to Cut Wall Street Profits, Boost Costs, Gross Says

USD is still the main reserve currency

source: IMF

Today the IMF released its preliminary report on Currency Composition of Official Foreign Exchange Reserves (COFER) for 4Q07. To much surprise the amount of USD has not changed on a sequential basis and also not on year over year basis. At the end of last quarter 64% were allocated in USD that compares to 65.5% from a year ago. The amount of euros also changed slightly from 25% to 26% on a year over year basis. Although the report does not break down the currency composition of foreign reserves in different countries it breaks out the numbers for developing countries. The amount of USD in developing countries was 61% at the end of last year unchanged from a year ago. A possible explanation is that many central banks are still buying dollars in an effort to strengthen their own currencies, which helps exports in their mostly supply side economies.

It is interesting to note the rather strange move in the Eur/USD currency cross on the day COFER released its preliminary quarterly report. One could be tempted to speculate that the European central bank used this report as a cover for intervention in the markets. The appreciation in the euro is certainly something that gets a lot of attention and the calls for intervention are getting louder.

source: Currency Composition of Official Foreign Exchange Reserves (COFER)
IMF quarterly publication

The blame game is on

Increasingly municipal borrowers are starting to cry 'foul' when they see the cost of their loans going up. Their anger strikes me as odd considering their quiet indulgence while they were on the receiving end of the easy money binge. They should rather shut up and accept the new realities. It would be better for the people they represent if they would focus more on solutions how to get the heck outa there.

some examples:
Massachusetts Secretary of State William Galvin said March 28 he is probing Zurich-based UBS AG, Merrill Lynch & Co. in New York, Bank of America Corp. of Charlotte, North Carolina, and other dealers over how they marketed the securities. The same day, UBS cut the value of auction debt held by its customers by about 5 percent.

``It's outrageous,'' said Rory Burnett, finance director of Vernon, California's smallest incorporated city. Located four miles south of downtown Los Angeles, Vernon lost $7 million since mid-February on auction-rate bonds the industrial enclave sold to cut borrowing costs for power plants and natural gas contracts.

The cost to protect the bonds of Iceland's three biggest lenders from default rose after central bank Governor David Oddsson said ``unscrupulous dealers'' are trying to break the country's financial system. Oddsson called for an international investigation into attempts to drive Iceland's economy ``to its knees,'' in a speech on March 28.

Is SFAS 157 the real reason for forced sales? - B.R. says 'Yes'

I wanted to way in on a post from Barry Ritholtz', s blog the Big Picture:
SFAS 157: Market Prices Too Low? Just Ignore Them!
He caught a very interesting piece of information regarding SEC guidelines for banks to value level 3 assets:

Here's a honey of an idea that almost slipped by unnoticed last week. Thankfully, the NYT's sharp eyed business columnist, Floyd Norris, caught it. An SEC opinion letter advising companies how to deal with their Level 3 assets made a rather curious suggestion. They advised that if the prices of mark-to-model crappy paper are underwater, well then, declare it the result of forced liquidation -- and then you can simply ignore them. It truly boggles the mind.

This is the actual passage from SEC opinion letter that is in question here:

Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale. Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability.

B.R. argues that under this SEC rule (referring in particular to the part that is highlighted in red) banks would have an incentive to make the value of their assets appear as a result of margin calls and consequently move them into level 3, where they could be valued market to model rather than market to market. This would lead to "window dressing down" and for the banks "as to not have to come up with a legitimate value for tier 3 junk".

If this is correct it would mean that banks operate on two standards, one for the values of assets on their own books and another for assets they lend out to borrowers like HFs. The SEC opened an investigation into this problem as early as last August. How can banks reprice certain assets they hold as collateral for money they lend to investors in order to not reprice similar assets they are holding on their own books (moving them to level 3), and not anticipate to run into severe problems with regulators? It would need an elaborate scheme of fraud to make even Wall Street blush. I do not see this as an incentive for banks to force liquidations in order to clean up their books. While forced sales as a direct result of margin calls are an important part of the current crises it is repricing of risk that is the real incentive for the deleveraging process that is taking place. As the pendulum of easy money has turned around and is now swinging in the other direction it might well overshoot in the process of it.

source: SFAS 157: Market Prices Too Low? Just Ignore Them
Barry Ritholtz

source: S.E.C.

Friday, March 28, 2008

Forms of Federal Reserve Lending to Financial Institutions

source: Forms of Federal Reserve Lending to Financial Institutions
Federal Reserve bank of New York

Fisher on the economy

Dallas Fed president Fisher sees infaltionary pressures building.
"I don't think the financial system is at risk of being brought down".

click to start

source: Bloomberg

Barry Ritholtz's Secret Formula for Blogs

Barry ways in on his successful blog, The Big Picture

Greenspan's credo revisited

A Bloomberg article addresses the question of the Fed's role in averting and managing asset price bubbles. In the light of the recent developments or should one say the last ten years, which have seen more bubbles and fewer calm periods in between, the public's desire for more regulation is getting stronger. The tide seems to be turning. Minneapolis Fed Bank President Gary Stern in a recent speech said that it is possible "to build support" for practices "designed to prevent excesses." This is a remarkable development although it remains to be seen how far it goes. The achievement would have to be heroic in the light of Greenspan's credo that it can't be done , the deflation of asset bubbles that is. The honesty of the former chairman in this regard has to be questioned for two reasons. First, asset bubbles are created by easy monetary policy which favors investments over savings. The role of the government is substantial here as well. That leads directly to the second point, the issue of independence of the Fed, which can be questioned to say the least. The Fed's dual mandate of price stability and optimal growth is a bogus mandate and inevitably leads to a conflict of interest between government officials in Washington and the monetary policymakers at the Federal Reserve. It is for that reason that other central banks around the world have not adopted this approach. To change the shameful culture that has permeated into the halls of Wall Street and the Federal Reserve it certainly would take an effort of massive proportions. The focus of the Fed on its real mandate of price stability alone would be a first step in the right direction. The alternative of insufficient action or in the worst case doing nothing would be disastrous and the outcome of systemic financial failures a sure thing.

As a reminder the Greenspan credo:
For two decades, the ruling philosophy has been Greenspan's. ``It is far from obvious that bubbles, even if identified early, can be pre-empted at a lower cost than a substantial economic contraction and possible financial destabilization,'' Greenspan told the American Economic Association in 2004.

``I have always said if we could defuse a nascent asset bubble, I would be all for it,'' Greenspan, 82, said in an e- mailed response to a question yesterday. ``The reason I am against is that in my experience it cannot be done. I know of no occasion when such actions have been successful.''

Fed May Rethink Greenspan's Hands-Off Approach Towards Bubbles
By Craig Torres and Vivien Lou Chen

Continuing claims moving higher

This is a long term chart of continuing jobless claims in the US. Claims are moving higher but are still well below the alarming levels seen in the 70s, early 90s or during the 2001 recession.

from Bloomberg

Thursday, March 27, 2008

The central banks dilemma

UK inflation expectations are jumping higher in March. Two surveys show that Britons are becoming increasingly wary of their central banks ability to contain price stability. Consumer prices are expected to rise by 3.6 percent over the next 12 months, that is up from 3.1 in February. High energy and food prices are putting pressure on consumer sentiment. Inflation expectations in the US have also moved higher according to the Conference Board Sentiment index, which jumped 7 points in March to 6.1. In January 07 the same index stood at 4.7! Although not dramatic yet this developments point to an increasing dilemma at the Federal Reserve and other central banks. Easing monetary policy to stimulate growth seems increasingly at odds with price stability.

Inflation expectations outside comfort zone, Thursday Jan10, 2008
UK inflation expectations jump higher in March - YouGov/Citigroup

Wednesday, March 26, 2008

Iceland's emergency rate hike

In an emergency move the central bank of Iceland has raised interest rates to 15pc this week. Iceland's currency krona has depreciated 18pc since mid-March as a reaction to carry trade liquidations. In good times investors borrow from the lower yielding yen and invest in higher yielding emerging market currencies like the krona. Iceland is one of the premier beneficiaries of this trade. As the spigot of easy credit has been turned of it is feared that flight from emerging markets might spread to other currencies and jeopardize the fragile financial system in these countries. Turkish companies reportedly have difficulties to raise $48bn of fresh loans needed to stay afloat. It is noteworthy though that yen carry trade reacts primarily to interest rate differentials and is not so much dependent on specific conditions in the the credit market. In my opinion this will continue as long as world economies do not go into a tailspin.

Ambrose Evans-Pritchard, international Business Editor, disagrees and submits to The Daily Telegraph:

Iceland contagion may spread far and wide

This spigot of easy credit has now been turned off. The spreads on Icelandic bank debt have risen above 800 basis points, near levels seen in Bear Stearns' debt before the Federal Reserve's rescue. Which raises a thorny question: Is the Icelandic government - which presides over an economy the size of Bristol - big enough to underpin its encephalitic banks if push ever comes to shove?

"There are clearly limits to what the government can do," said Paul Rawkins, an Iceland expert at Fitch Ratings. "If the government tried to raise billions in the markets it would damage its own credit worthiness. In any case, these debts are in foreign currencies. The central bank has just $2bn (£1bn) in reserves," he said.

The banks insist they are well capitalised, with enough liquidity to tide them through to 2009. If the credit crunch subsides, the issue will never be put the test.

Fitch said countries that run current account deficits above 10pc of GDP for any length time almost always come to grief. East Asia's debt crisis in 1997 erupted before any state reached double digits. Iceland's deficit is now 16pc of GDP. Latvia is at 25pc, Bulgaria 19pc, Georgia 18pc, Estonia 16pc, Lithuania 14pc, Romania 14pc and Serbia 13pc. The region will need $337bn in foreign loans this year.

source: Iceland contagion may spread far and wide
Ambrose Evans-Pritchard, The Daily Telegraph

Loans to small businesses decline

These days credit availability is in anybody's mind. A recent NYT article addresses this problem for small businesses. Credit restriction could have severe implications for employment and the economy. The number of business loans has declined in the beginning of this year according to the Small Business Administration.

The NYT article: Small Firms Find Credit is Tightening

The Small Business Administration has not said publicly that it is worried about a credit squeeze even though the number of business loans made through its main program, called 7 (a), has declined so far this fiscal year by more than 15 percent compared with the period last year. And the dollar value of the loans declined by more than 7 percent. The agency guaranteed some $20.6 billion in such loans in the last fiscal year.

According to S.B.A. data, more than $1 billion in 7 (a) loans — the most basic and most used loan type — were delinquent on Dec. 31, 2007, compared with about $673 million a year earlier.

To set the record straight

from WSJ - Stocks tarnished by Lost Decade:

Over the past 200 years, the stock market's steady upward march occasionally has been disrupted for long stretches, most recently during the Great Depression and the inflation-plagued 1970s. The current market turmoil suggests that we may be in another lost decade.

The stock market is trading right where it was nine years ago. Stocks, long touted as the best investment for the long term, have been one of the worst investments over the nine-year period, trounced even by lowly Treasury bonds.

Hot money inflates China's currencey reserves

Problems are brewing in the Far East with hot implications for the rest of the World. Michael Pettis, professor at Peking University's Guanghua School of Management, writes in his blog that Chinese foreign exchange reserves rose by a surprising $57.3 billion over the month of February. In his opinion $30 billion of that increase comes from hot money inflows that are accelerating in recent months due to RMB appreciation. Pettis argues in favor of a maxi-revaluation of the currency.

Since at least 2002-2003 China has been caught in a monetary trap. By tying the value of the RMB to the dollar, and especially by setting it too low, the Chinese authorities ran the risk that in a time of excess global liquidity they would find themselves in the position of excess money inflows leading to excess domestic money expansion, which would be reinforced as domestic money expansion funded rising industrial production, which would cause an increase in the trade surplus and so increase money flows further.

Because of the self-reinforcing nature of this system, this process must necessarily go on until a very sharp adjustment stops it. The adjustment could come in the form, as it has in the past to China and other countries, of sharply rising domestic investment (“good” version: massive infrastructure spending; “bad” version: forced corporate investment via rising inventories), rapid debt deflation, a collapse of the banking system into bad debts, a breakdown of sovereign external or domestic credit (from excess fiscal expansion), or out-of-control inflation (which is, of course, one way that the currency can adjust), or it could come as a combination of these factors. It is possible but unlikely that the adjustment will be benign, and the longer we wait the less likely it is. This last statement is hard to prove but seems reasonable largely because of historical precedents......The only useful way to address capital inflows is to adjust the currency....The main argument in favor of a maxi-revaluation, however, is not that it will be painless. The main argument is that the alternatives are much more painful.

Tuesday, March 25, 2008

Will the recession last years?

Mort Zuckerman sees "worst economic downturn in his lifetime"

Bottom fishing

One argument against jumping into financials comes from Diane Garnick of Invesco, which has over $500 billion of assets under management:

"The ability to borrow against assets is still pretty low"

Monday, March 24, 2008

Flagged by Barry Ritholtz

Barry Ritholtz in his excellent blog "The Big Picture" posts following question in his latest post: Investing in a Post-Fact Society (a/k/a, Were the Good Times a Mirage?)

Are we stuck with these fantasists? Has
Truthiness replaced Truth? Are we going to be saddled forever with these damaging, hallucinatory hacks?

I replied, unfortunately my comment was blocked from publishing. Barry does not like my input. How sad is that?

My comment:
This is an excellent question. I think the answer is 'yes' we are stuck with truthiness for quite a while, as long as the stakes in this poker game are so high (JPM 91T USD in counterparty risks, that is almoust 2x world GDP). Its time for regulating Wall Street pundits and Washington hacks and put on the breaks to change course.

A reversal of fortune?

Recession in U.S. Sows Slower Growth, Weaker Dollar
source Bloomberg

"We're going to have 4 to 5 percent inflation,'' says Kenneth Rogoff , former chief economist for the International Monetary Fund who's now at Harvard University. "The dollar will continue to drop and stay down for years. And we're going to end up with more regulation.''

Sunday, March 23, 2008

The clear and present danger of the shadow banking system.

What created this Monster?
here is the link to the article in the Times

from NYT

I feel sorry for Mr. Gross having to set his timer at 2:30 am. every day in the morning to get to work as the world's biggest bond fund manager with nearly a trillion dollar in assets. He has to do this in a time of financial crises, probably the worst since the Great Depression. Mr. Gross says his firm has set aside $50 billion in case trading partners suddenly demanded payment, and he has done so because he knows a thing or two about our financial system. Back in August last year when the Fed was still concerned with inflation Mr. Gross much like an athlete swimming against a strong current saw the tide turning and predicted Fed easing what he called to a three handle. Turns out he was too optimistic. The current Fed Funds rate is at 2.25 percent.

Mr. Gross is one of those who point towards a very dark corner, the "shadow banking system", as the main reason for the current panic that engulfs Wall Street. The outstanding value of credit default swaps or CDS has been bloated to more than 45.5 trillion dollar in 2007 , up from only 900 billion in 2001. An attempt to regulate this out of control market has failed so far, although many maintain that this will change in the future because of today's problems. Mr. Geithner, the head of the New York Fed, in a series of meetings in 2005 and 2006 pushed for changes in credit derivatives trading in investment banks, but was blocked by this powerful institutions with the help of politicians in Washington. The prevailing notion at the time about the benefits of derivatives was their ability to differentiate and allocate risk.

Alan Greenspan, the long term chairman of the Federal Reserve, opposed new regulations at a time when he could have made a difference.

Speaking in Boca Raton, Fla., in March 1999, Alan Greenspan, then the Fed chairman, told the Futures Industry Association, a Wall Street trade group, that “these instruments enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it.” Although Mr. Greenspan acknowledged that the “possibility of increased systemic risk does appear to be an issue that requires fuller understanding,” he argued that new regulations “would be a major mistake.” “Regulatory risk measurement schemes,” he added, “are simpler and much less accurate than banks’ risk measurement models.”

In the meantime financial institutions have written down their balance sheets by almost 200 billion dollar, credit markets have repeatedly frozen and the Federal reserve has resorted to actions not seen since the Great Depression. The developments came to a climax last week with the demise of Bear Stearns, one of Wall Street's most distinguished firms. They should have listened to Warren Buffett, who in 2003 said derivatives were potential "weapons of mass destruction."

Saturday, March 22, 2008

Partying Like It’s 1929

An interesting article in the Times by Paul Krugman:

The financial crisis currently under way is basically an updated version of the wave of bank runs that swept the nation three generations ago. People aren’t pulling cash out of banks to put it in their mattresses — but they’re doing the modern equivalent, pulling their money out of the shadow banking system and putting it into Treasury bills. And the result, now as then, is a vicious circle of financial contraction.

Wednesday, March 19, 2008

Greenspan and the wealth of a nation

Greenspan submits to the FT:
We will never have a perfect model of risk

The crisis will leave many casualties. Particularly hard hit will be much of today’s financial risk-valuation system, significant parts of which failed under stress. Those of us who look to the self-interest of lending institutions to protect shareholder equity have to be in a state of shocked disbelief. But I hope that one of the casualties will not be reliance on counterparty surveillance, and more generally financial self-regulation, as the fundamental balance mechanism for global finance...Risk management systems – and the models at their core – were supposed to guard against outsized losses. How did we go so wrong?...If we could adequately model each phase of the cycle separately and divine the signals that tell us when the shift in regimes is about to occur, risk management systems would be improved significantly. One difficult problem is that much of the dubious financial-market behaviour that chronically emerges during the expansion phase is the result not of ignorance of badly underpriced risk, but of the concern that unless firms participate in a current euphoria, they will irretrievably lose market share....Paradoxically, to the extent risk management succeeds in identifying such episodes, it can prolong and enlarge the period of euphoria. But risk management can never reach perfection. It will eventually fail and a disturbing reality will be laid bare, prompting an unexpected and sharp discontinuous response.

Now it is official. Greenspan speaks out: "The crisis will leave many casualties", and risk management or the lack of it is to blame for it. What he willfully leaves out is his responsibility. As the chairman of the Federal Reserve he should have shown the way to a sound and strong financial system. Instead he choose to bail out Wall Street whenever need be, infusing into the managers of the firms that proper risk management is not necessary if only their balance sheet is big enough. Greenspan with his laissez-faire aaproach towards financial institutions has created a monster of counterparty risks over his years as the chairman of the most important central bank in the world. So if he submits an article that gets published for good money in the FT perhaps somebody else should point out that if this goes south history will not be as kind to him as he was to his buddies on Wall Street and in Washington. I have made up my mind. This man was an evil man with inferior qualifications and superior power. There exists a picture of him that shows him together with his powerful friends in the White House. He lies on the floor stretching his aching back. He looks like a poodle who wants to be scratched on his belly. I am not his biographer, I take a guess, but maybe that is what he was an underdog aching for acceptance among the big shots in this country. He sold out the wealth of a nation in order to satisfy his ambitions.

Tuesday, March 18, 2008

The real reason for the panic on Wall Street

Thanks to Mish's Global Economic Trend Analysis blog

This excellent table is in the heart of Wall Street's problems. For the Ben Stein's out there who think that market to markit is a mistake, and losses will be recovered, look carefully at this numbers. The current problem is not about subprime and it is not about foreclosure rates. This was just the spark that ignited the bush fire. This numbers show that Wall Street is a big poker table where success and defeat are dependent on confidence or lack of it. Confidence cannot be restored in an environment where Gold trades above a thousand dollar, oil above a hundred, a housing correction that is still ongoing and the dollar is being devalued by Central bank action. Maybe it was that inside that led Andrew Mellon to suggest to pres. Hoover "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.... That will purge the rottenness out of the system."

Warren Buffett in his latest letter to his shareholders:

Last year I told you that Berkshire had 62 derivative contracts that I manage. (We also have a few left in the General Re runoff book.) Today, we have 94 of these, and they fall into two categories. First, we have written 54 contracts that require us to make payments if certain bonds that are included in various high-yield indices default. These contracts expire at various times from 2009 to 2013. The second category of contracts involves various put options we have sold on four stock indices (the S&P 500 plus three foreign indices). These puts had original terms of either 15 or 20 years and were struck at the market. all cases we hold the money, which means that we have no counterparty risk.

No matter what happens to the eventual payout of Buffett's derivative contracts no counter party in risk of default owes Berkshire money. I bet that any CEO of any Wall Street firm has no idea of their risk exposure to counter parties. Perhaps proper risk management is impossible with JPM's 91T USD outstanding. Today Wall Street firms know in troubling times the Fed and the government will bail them out, if their balance sheet and their exposure to counter parties is big enough. Proper risk management is not necessary. Now we might understand when we caution about moral hazards in the context of bailouts for Wall Street firms. Larry Kudlow shifted the blame to the Fed for not opening the discount window to IBs, in light of the recent developments with BSC. To LK I would suggest the following: Why not nationalizing all of Wall Street and let the Fed and the Treasury with its printing presses do the accounting for them. In that way we can eliminate all the risk and make sure that the CEOs and managers can continue buying a piece of dirt in the Hamptons for 200M, or after one's company and shareholders go bust buy an apartment in Manhattan's Plaza for 60M. I don't know is it just me or is this starting to stink like a dead fish in the sun.