So much for a no volatility world
Hard as it is to believe on a day like today, those who expressed concerns about the sustainability of the global expansion around this time last year were mocked as worry warts.
A FT headline from Davos 2007 read "Big risks to the global economy receding." Back then, more and more voices argued that global imbalances were a natural byproduct of dynamic globalization. Few warned that if the US couldn’t attract enough (net) private capital inflows to cover its deficit in good times, it would almost certainly fail to attract enough private capital inflows in bad times - and might need, for example, to sell off a large swath of corporate America to sovereign funds to “fund” its deficit.
The dominant debate - if memory serves - around the turn of last year centered on whether the equity markets had fully priced in the fall in macroeconomic volatility. Credit spreads were incredibly low at the time - but that too was thought to be more a reflection of limited macroeconomic volatility than a reflection of an (overly) exuberant credit market.
The US had, after all, managed to withstand the collapse of the .com bubble with only a mild recession. The seemingly inexorable rise in the price of oil had failed to put a dent in the US consumer or the US economy. Hedge funds had failed — Amaranth — without causing much stress in the market. The risks associated with the trade deficit never seemed to materialize. All was clear.
In an environment marked by little macroeconomic volatility, limited financial volatility, and low credit spreads, equities looked undervalued. There was no real risk to taking on more debt to reduce the amount of outstanding equity on a firms balance sheet and, in the process, increase the return on existing equity. Private equity firms had shown the way to arbitrage the difference between the pricing of debt and equity; all that remained was for everyone else to follow suit.
The same basic view marked the foreign exchange market. Low macroeconomic and financial volatility made carry trades attractive. The more leveraged, the better. There was little need to worry about the large resulting deficits in (some) high-carry countries that were the recipient of such inflows.
More somber voices had started to warn of building risks - whether from rising oil prices, speculative excesses in the housing market, low levels of household savings in the US, high levels of investment in the US or a global flow of capital that seemed the reverse of what conventional economic wisdom would expect - back in 2003 or 2004. They had been wrong for an extended period.
Being wrong meant leaving money on the table. Financial history is written by the winners. They are the ones, generally speaking, who can afford Davos.
The world looks incredibly different today. Just look at the posts over at Calculated Risk.
The equity market seems to have lost confidence that macroeconomic volatility has disappeared - and that existing corporate earnings should consequently be priced at a higher multiple. The private equity put disappeared in a world of hung bridge loans. The SWF put doesn’t seem quite as powerful as some hoped.
The bull market in credit is over.
And it turns out that credit risk wasn’t quite as dispersed as some thought. Sure, the Bank of China (BoC) had taken on some subprime exposure. But not near as much as Citi, Merill and Morgan Stanley. The really big pools of sovereign money - think China’s State Administration of Foreign Exchange and the Japanese Ministry of Finance - seems to have largely avoided the biggest subprime related excesses. The BoC’s $60-70b of bonds (If Goldman’s research on the Bank of China is right and the BoC’s total bond portfolio was $90b at the end of 2006, the Areddy/ Leow Journal article may slightly understate the BoC’s total bond exposure) pale relative to the PBoC’s $1400b or so of bonds.
It no longer seems clear that the global economy can decouple from a US recession. The world economy did, in my view, decouple from the US to a remarkable degree from a slowing US in 2006 and 2007. Non-oil US import growth has been slow for some time. But Europe picked up a lot of the slack, emerging as the number one destination for Chinese and Japanese exports. Now though it isn’t clear that Europe can continue to be a locomotive for global demand - and the world needs a non-American locomotive more than ever.
The only risk that doesn’t seem to have really materialized is risk that I have obsessed over for the past several years. The dollar’s decline so far has been fairly orderly. Setting the moves in the yen (especially v the kiwi) on a couple of days in August aside, the currency markets really haven’t moved like the equity markets did today. Low Treasury bond yields suggest that foreigners have retained an appetite for Treasury bonds.
Thank the world’s central banks.
Global reserve growth has never been faster, or put differently, the advanced economies have never been as dependent on financing from emerging market governments as they are now. My guess is that the extent of dollar asset accumulation in the world’s central banks (counting China’s now chastened state banks, who still manage funds for the central government) would truly shock if the sum were every to be transparently revealed. Many big central banks don’t report data to the IMF, and others have gotten more and more skilled at hiding their intervention.
But such reserve growth - and the associated pressures created by a rapidly growing net long position in dollars among the world’s governments - also has consequences. Think of Summers’ warnings about the balance of financial terror. The world’s central banks aren’t adding to their net long position in dollars because they want more dollars. Rather, they fear the consequences of stopping.
Maybe someone will reach the a simliar judgment about the monolines.
You’ve done a lot on global imbalances in terms of current accounts, central bank intervention, and capital flows. I’d love to see a single post on global imbalances in terms of an asymmetric risk distribution - i.e. low risk central bank assets (ex FX) and high risk domestic US assets. As a counterpoint, consider how the world might have looked even with the same global nominal imbalances, but with the portfolio allocations of surplus countries and their central banks/SWFs much more advanced in terms of risk diversification. The nominal imbalances developed at a pace that far exceeded the capability of central banks and their SWFs to manage these positions in a more orderly fashion. Hence, the SWF rear guard action moving into risk assets at this late stage.
Bottom line is that it’s a compound imbalance - nominal flows and stocks; and risk - a lethal combination.
Various US bubbles have resulted from risk that has been trapped within the US, due to the inability of the surplus nations to accept more risk more quickly in the profile of their invested surpluses.
A footnote on additional US financial risk - fast approaching on the horizon is a potential financial system catastrophe, which is the effective bankruptcy of the entire bond insurance industry. In the event, this means horrific additional losses for the US banking system, due to the billions in underwater CDO and CDS positions that are currently supposed to be hedged or ‘insured’ by that bucket-shop industry.
More than one commentator has suggested that a full US government bailout of this industry will be essential in order to prevent such catastrophe.
I’m guessing you will be writing about the failure and/or bailout of this entire industry in due course, in order to plumb all of the pieces of the global puzzle.
anon1 — good points. a counterfactual with less Cbank demand for safe bonds and more Cbank/ SWF demand for risk earlier would be interesting.
Like the rest of the world, i am scrambling to learn about the bond insurance industry. It isn’t a part of the financial world that I have any experience with. Like the rest of the US financial system, it sure looks to be undercapitalized.
and it also increasingly looks like the bond insurers could be too systematically important to fail –
the obvious bailout in this case would come from the bond insurers counterparties in the financial system. but they themselves are in trouble.
Hank Paulson may be working on more than just a fiscal stimulus soon.
What a mess.
“Financial history is written by the winners”.
This is my opinion about the financial future :
For the first time in history,a lot of people know the truth about our economic system.
Is it a critical mass ?
We will find out very soon.
Best regards,
Duric Aljosa
Crom Alternative Money Payment System
What a mess, indeed.
How can a credit strapped goverment bail out something of that magnitude?
The only hope may be that every country knows it will be deeply affected and will, therefore, help to straighten the mess out.
I would expect all central banks to now be in a deep huddle for the next play.
Its the sheer complexity of this system that makes a bailout so difficult. It nowhere near as easy as it was 20 years ago. Increased correlation and interconnection has its downside
Let’s hope the FDIC has an army of accountants ready to move in and take over all those soon to be insolvent banks.
How do you bailout the entire globe?
Brad-
I greatly enjoy your blog and style of analysis. With respect to the under capitalized bond insurers the real issue is that hedged CDS books are in fact flying without principal protection anymore. Same thing goes for anyone who was writing the protection side of the swap.
I suspect that once the monolines realized they were in trouble they had an increased need for fees (ditto hedge funds and banks facing losses) and wrote even more protection on what they knew to be increasingly likely defaults (deals circa ‘06 and ‘07).
The sheer size of these guarantees with little or no underlying capital is mind boggling. I fear no regulator fully yet comprehends the potential damage once the inevitable defaults come. What do you get pressing claims against a counterparty who is insolvent?
This whole man-made leverage disaster forgot Bill Gross’s quip years ago that the plankton have to live. Ponzi is smiling in his grave no doubt. He had/still has disciples in-spite of overwhelming evidence to the contrary!
What an incredible lack of common sense… if only there was basic underwriting.
Coming up you will see (from my brief queries on trips to FL and CA) incredible tails of fraud as well. One: Foreigners doing NINJA loans with cashback of 10pc on a 1mm mortgage and flying immediately after closing back home without even making the first payment (think Miami and San Diego). I’m not even sure there was collusion between the mortgage broker and the ‘borrower’; that would require some intelligence.
Yep, volatility is back and the emperor has no clothes.
pressing claims against an insolvent counterparty is a bit like litigating to get payments from an insolvent sovereign. you ain’t gonna get much, and you won’t get it quickly.
i have long worried that credit risk had morphed into counterparty risk via the CDS market (then again, i worry about a lot of things). but i was looking for risk in the wrong places — i had assumed that hedge funds looking for a bit of income had been writing a lot of credit insurance.
I never really considered the possibility that a lot of structures had an embedded from of insurance from a weak counterparty - I guess that is the risk of not knowing the particularities of a new market. those on the outside learn only when things go wrong.
Brad or whomever: Given the market’s general run from risk assets, and despite the big build up in fx reserves, anyone have any good candidates for countries likely to suffer some form of currency/debt crisis? I’m thinking eastern europe is a good place to start looking. Perhaps look at who has a large chunk of 08 and 09 financing still tbd.
Again I remind you, Brad, that the fundamental problem is political, not financial. For a hundred billion or so, we could prevent the majority of defaults. The only reasons this is such a mess are (a) the complexity of unraveling the CDOs, and (b) the unwillingness to give money to people who aren’t rich.
Yes, we should let the speculators and those who committed fraud take their hits. But that can happen while keeping the world economy from crashing. Alas, the $100B will be given precisely to those most culpable for the crisis, through deficit spending on tax giveaways and by the Fed socializing risk.
anonymous — eastern europe (especially the baltics and south-eastern europe) certainly has its share of vulnerabilities. large deficits there were one of the risks i highlighted in my beginning of 08 post. i linked to an imf paper that lays out the risks in southeastern europe quite clearly. danske bank has highlighted the risks in the baltics.
You and Nouriel have superlatively covered this down cycle. Please don’t fall into the media trap of covering today’s events, as they do the Presidential election, as a horse race. The business media tend to focus on dissecting the previous tick and forecasting the next tick. Trivia.
What’s the next major event in this cycle? How will this cycle end? What will the world look like when we enter the next expansion?
“Anonymous ibid” makes an interesting point. The mtg losses to date — and probably thru 2009 — are tiny compared to the trillion-plus cost of our Middle Eastern expeditions.
Brad,
I recommend reading the Big Picture every day for a while. He’s ahead of the pack right now.
So is Dr. Peter Morici. It’s a shame you never mention him (to my knowledge). He’s well ahead of the pack, including you. And that’s saying something.
Movie Guy
>>>
Recession? Are you quite sure? Meltdown? Of what? The dicers at the club grill haven’t said word one about it, I can assure you. Some are in finance’, too, in a way - they’re in bonds, I suppose. There’s one pushing sort of fellow who seems to have purchased a lot of his furniture, but he’s never given me any reason to think that he can’t live on his interest. I wonder what he would have to say.
@Shrek,
“How do you bailout the entire globe?”
CBs buy all outstanding bonds. Don´t need to tell you what that is going to do to the currency.
Does anybody have any insight on the rumour that Citi is about to file Chapter 11?
Anonymous: For a hundred billion or so, we could prevent the majority of defaults.
Yup. The trouble is who do you give the hundred billion to…….
Anonymous: The only reasons this is such a mess are (a) the complexity of unraveling the CDOs, and (b) the unwillingness to give money to people who aren’t rich.
b) isn’t quite the problem. Suppose you give hundred billion dollars to people so that they are going to be able to repay their mortgages. They immediately will go and repay the money to the banks. So what happens is that you get a bank bailout, and the money ends up in the hands of rich people. Hedge funds that bought CDO’s at deep discounts are going to be making a huge amount of money, and I’m sure Goldman-Sachs is going to find some way of coming up on top.
Getting money in the hands of poor people in a way that it doesn’t end up in the hands of rich people is less easy than it seems.
b) Yes, we should let the speculators and those who committed fraud take their hits.
This is the problem. The economy is so tightly intertwined that its difficult to make sure that the money goes to widows and orphans.
b) Alas, the $100B will be given precisely to those most culpable for the crisis, through deficit spending on tax giveaways and by the Fed socializing risk.
Yes, and all of the investment banks that invested heavily in CDO’s and subprime are now making huge amounts of money right now….. Not…. If you look at who is doing well on Wall Street right now and who is doing badly, the firms that are doing less badly are those that had some common sense a two years ago.
It’s fun and easy to go populist and talk about bailing out the little guy and railing against Wall Street fat cats. Trouble is that people are linked to each other. You give a $100 billion to someone so that they don’t default on their mortgage, and that money is going to instantly end up in the pockets of people that made stupid business decisions. That’s not too much of a problem. The problem is the next $100b, and the next, and the next, and the next…. You let a major bank fail. Then immediately, thousands of businesses start folding and people lose their jobs. That’s bad, but it gets even worse if you end up with a domino effect….
http://www.atimes.com/atimes/Global_Economy/JA23Dj01.html
Lack of consumer demand has not been the problem in the US economy since 1995, quite the opposite. Grossly excessive consumer demand, caused by an over-expansionary monetary policy over a period of 12 years, has produced record balance of payments deficits, a negative savings rate and the transfer to Asia and the Middle East of one of America’s most important comparative advantages: readily available capital at low cost.
At this point, the long-term need is for a radical upward re-orientation of interest rates, to a level that provides savers with at least a 3% real return over and above the current inflation rate of nominally 4%. That would reduce US consumer demand, close the payments deficit, increase US consumer saving and bring the US economy as a whole back into balance. It would also reduce the excessive US investment in housing and financial services, both of which sectors are in the early stages of a very unpleasant downsizing of their current bloated and carbuncular state.
A major rise in interest rates would also have the useful side effect of preventing a resurgence of inflation. Having remained quiescent over the past decade, in spite of excessive money creation in the US and worldwide, inflation is now making a comeback. Even by the heavily massaged numbers of the Bureau of Labor Statistics, US inflation is above 4% and likely to remain there.
However, a major rise in interest rates we are not going to get, quite the opposite. Instead the Fed, seeking as usual since 1995 to provide short-term palliatives to Wall Street at the expense of the long term health of the economy, clearly intends to cut the Federal Funds rate further at its meeting January 30th, probably by 0.50% to 3.75%
Thus the Fed and the administration are indeed working together on an economic policy. Unfortunately, they are working on an economic policy that will produce double digit inflation and trillion dollar federal deficits as far as the eye can see. However, that is not their worry. Bush leaves office next January and will have maximized the slim probability of electing a Republican successor. And the Fed will no doubt succeed, as it has so often in the past, in blaming somebody else for its mistaken policies.
ISDA Sees Default Swaps Losses at $15 Billion, Not $250 Billion
By John Glover and Hamish Risk
Jan. 22 (Bloomberg) — The International Swaps and Derivatives Association said global losses on credit-default swaps will be nearer $15 billion than the $250 billion forecast by Pacific Investment Management Co.’s Bill Gross.
let’s hope ISDA is right, but $15b seems incredibly small relative to the size of the CDS market. what is the embedded set of assumptions in their analysis?
movie guy — i do read big picture.
ISDA is fuzzy on assumptions, at least as reported by Bloomberg. It does seem incredibly small.
At the same time, Gross’ analysis is also very misleading. While he calculates aggregate losses on CDS according to reasonable default/recovery assumptions, he treats the $ 250 billion total as if it were an aggregate addition to the risk inherent in subprime mortgages and other primary credit instruments.
It isn’t. This is double counting (or triple, or n-tuple).
If $ 400 billion in expected subprime losses represents risk that has been intermediated through CDOs and thence through CDS hedges, for example, the aggregate risk remains at $ 400 billion.
If the CDS hedge on the CDO works, the CDS writer absorbs the loss.
If the CDS writer fails as counterparty risk, the loss boomerangs back to the CDO holder.
Either way, the risk is only that generated by the subprime mortgage and then intermediated through various structured finance arrangements.
There’s a lot of inflated aggregation going on in the riskosphere.
And I’ll add - kind of analogous to assuming that international bank inflows are a big source of private capital financing for the US, until somebody like yourself notices the comparable bank outflows
And n-tuple counting of credit risk works well for Gross’ book.
http://www.prudentbear.com/index.php/CreditBubbleBulletinHome
The financial crisis took another giant leap this week. Credit insurer (”financial guarantor”) Ambac lost its AAA rating (from Fitch), in what will mark the onset of a devastating run of downgrades for the likes of Ambac, MBIA and the entire industry. The “monoline” insurance business, as we’ve known it, is done and the value of the insurance they’ve written is evaporating by the day. The market is now desperate to determine which financial institutions (and there are many) have purchased large amounts of (now suspect) insurance for hedging purposes, as well as other financial companies that have in one way or another participated in the Credit “reinsurance” market.
Virtually all the major financial players are embroiled in this Systemic Credit Fiasco. Importantly, the mind-blowing demise of the “financial guarantors” is fomenting a crisis of confidence in Credit insurance in all its various forms (certainly including the Credit default swap (CDS) and MBS guarantee markets). According to Bloomberg news, $2.4 trillion of securities are at risk to the financial guarantor industry downgrades.
The Credit system is today an incredible mess. Literally Trillions of securities, previously valued in the marketplace based upon confidence in the underlying financial guarantees, are now suspect. This has severely impacted marketplace liquidity. And perhaps tens of Trillions of Credit and other derivative contracts are now subject to very serious counterparty issues. Many players throughout the Credit market are now severely impaired and have lost the capacity to hedge against/mitigate further losses.
US is maxing out its exorbitant privilege card
Again: the G7 and Europe are clearly coupled and I don’t see how they can decouple. But I don’t see how the converse isn’t true for the BWII reserve accumulators.
Sure. China sells consumer goods to the US. How much will the US political system allow US consumer demand to drop - as measured strictly by the “nominal” dollar volume of consumer spending? 5%? 10%?
Let’s say it’s the latter. In that case, the Chinese government can completely decouple by:
(a) letting the RMB return to its value of - what? 2 years ago?
(b) using its gazillion-dollar reserves to apply a -10% export tariff.
(c) probably five or six other relatively straightforward maneuvers.
In this case, the number of dollars flowing into China is precisely the same. If trade with the West affects China in any other way than to supply dollars in exchange for exported goods, the effect is trivial. For example, a recession might change the mix of goods that China exports, but hold the number of dollars it receives constant. This might favor one region of China over another. But it is hardly a big deal.
China may not even have to decouple. It may not want to take any action in response to the Western recession. After all, the Chinese leadership is fighting hard against pervasive price increases. It dilutes its currency at 15 or 20% a year. It does so not because it thinks monetary dilution is wonderful, but because the PRC is an oligarchy based on a very complicated and intricate network of personal influence. When it chooses dilution, it always does so as the least bad scenario.
Perhaps an external event that is not anyone’s fault will be the PRC leadership’s excuse for spraying a bit of cold water on China’s extremely heated financial markets. On the other hand, since so many Western writers are worried that China will decouple, and the PRC certainly cannot afford a recession, I would expect the PRC to play it safe, and at least stop crawling their peg. I would certainly be very, very surprised if I saw them go in the other direction, and move toward ending their purchases of dollars. However, just because the PRC buys dollars does not mean it has to send them directly to the United States, like Rueff’s marbles.
Moldbug, China’s economy is much less dependent on exports to the US than a decade ago. An US Recession will have a slight impact by trimming China’s economic growth rate by a couple of percent, from the current 11% to perhaps 9%. At this juncture in time, Chinese exports to the US are merely icing on the cake.
http://afp.google.com/article/ALeqM5gScb_gUfdBykN0V1vi5kCOuluk2A
“Will the falls hit economic growth? I think that’s very marginal,” Pierre Gave, an analyst at Hong Kong-based consultancy GaveKal, told AFP.
“It will affect sentiment, but shopping malls here in Hong Kong are still pretty full, the hotels are fully booked and I can’t really see growth all of a sudden slowing down,” he said.
Even if exports to the United States slow down, Asia’s huge foreign exchange reserves can fund massive infrastructure spending programmes to keep growth going, while cash-rich governments can cut taxes.
Booming China alone accounts for more than 1.5 trillion dollars of those reserves — and experts say it could help buffer Asia from the worst of the fallout from the United States by driving regional trade.
“China’s economy is still very, very strong,” said former Morgan Stanley economist Andy Xie, who is based in Shanghai.
DC - how do you square your assertion that the Chinese economy will whether a US slowdown just fine with your usual line that many low margin Chinese exporters will go out of business if the RMB appreciates against the dollar. Aren’t those statements contradictory?
Brad, definitely agreed on risks outside the US. But southeastern Europe is a drop in the world economy. If the US mortgage crisis were to be resolved, the rest of the world’s economy will return to normal.
Twofish asks, “The trouble is who do you give the hundred billion to……. ”
Trickle up works much better than trickle down, Twofish. Although you are correct that money given to mortgage holders will then go to pay the banks, the first hands it passes through will not be JPM, C, or GS. It will be smaller banks. They will unwind any unwise positions they have. That will cause the values of CDOs to rise and facilitate writing off the genuinely bad assets. As the bad assets are written off and transparency returns, confidence will rise.
That’s the real goal here: confidence. But to get confidence, you have to solve the underlying problem, which is mass foreclosure.
BTW, I don’t know why populism has such a bad name among investment types. At root, it is the desire for the whole nation to rise together as quickly as possible. The alternative– a few getting rich at the expense of the many– tends to work very badly. Haiti is a model for laissez faire capitalism. It’s a nightmare.
“low margin Chinese exporters will go out of business if the RMB appreciates against the dollar”.
The Chinese export to alot more countries than just the United States. Over 45% of Chinese trade is inter-regional Pacific Rim trade. Europe is now the largest trading partner for China replacing the United States. Yangzhou City of East China’s Jiangsu Province exclusively caters to Middle East customers. A significant appreciation of the China yuan would severely damage labor-intensive Chinese to other price sensitive developing world markets under the existing global US Dollar hegemony regime. The US needs to purge its own economic excesses instead of scapegoating others.
“low margin Chinese exporters will go out of business if the RMB appreciates against the dollar”.
The Chinese export to alot more countries than just the United States. Over 45% of Chinese trade is inter-regional Pacific Rim trade. Europe is now the largest trading partner for China replacing the United States. Yangzhou City of East China’s Jiangsu Province exclusively caters to Middle East customers. A significant appreciation of the China yuan would severely damage labor-intensive Chinese exports to other price sensitive developing world markets under the existing global US Dollar hegemony regime. The US needs to purge its own economic excesses instead of scapegoating others.
PS:
Frankly, the US exports of AAA rated subprime paper by Wall Street to foreign investors represents the shoddiest and most deceptive product in world history. Bernanke’s bailout of Wall Street investment banks with irresponsible interest rate cuts merely postpones the day of reckoning. Fed induced rising-Inflation transfers “real” economic wealth from US middle class savers to heavily leveraged but politically connected Hedge Funds. Even after today’s absolutely irresponsible 0.75 percent cut, Bernanke indicates that he plans additional interest rate cuts at the upcoming Fed meeting on Jan 31st. Surely, a 1 percent interest rate on a money market account doesn’t adequately compensate the saver given current rising inflation levels. We should all take Jim Rogers advice, take all of your money out from the US Dollar and invest the proceeds in a country with a Central Bank that still believes in “sound money”.
If Ben Bernanke were sitting in front of me, I would spit in his face for his irresponsible and reckless US monetary policies that is destroying the monetary value of the US dollar.
DC — the first point you make (foreigners don’t like buying poor-quality financial “products” any more than buying poor-quality goods) is an important one.
the last sentence you wrote tho is absolutely inappropriate for this forum.
Off topic:
I just called the RGM-support line in NYC, because I can^t get access to NRs-blog even though I registered. What they said is that effective February first one needs to subscribe to both blogs NRs and Brad Setsers. As a I am not an economist but a medical doctor in “real life” and thus do not have a company or academic institution to support a subscription, I guess that will be it. It is a pity though as I have very much enjoyed to follow the discussions on both blogs (as have many other active contributers/ silent followers without beeing trained economists I could imagine).
Or does anybody sees an alternative?
P.S. Thank you Dr. Setser, you8r blog was very illuminating for a “bear with very little brain”.
BMH
let me talk to the sales team. my understanding is that my blog will remain open to the public, pending its shift to the cfr site. i cannot do an rge blog for subscribers only.
Brad,
Pardon my expression of disapproval of the Bernanke Fed monetray policy. However, simply stated, the primary responsibility of the Federal Reserve should be maintaining monetary stability with a “sound money” policy at all costs. It is almost laughable that the Bernanke Federal Reserve operates as if the board tunes daily into CNBC Jim Cramer’s TV show for clues to operating the nation’s monetary policy. Almost on cue, everytime the market pundits on CNBC led by Jim Cramer demand interest rate cuts, Bernanke always jumps into action. The recent correction in the stock market is not a justification for even more “cheap money” to appease Wall Street with excess US Dollar liquidity. It is totally irresponsible for the Bernanke Federal Reserve to pander exclusively to the narrow special interests of Robert Rubin’s Citicorp for a subprime banking bailout with a “cheap money” monetary policy. Moral hazard be damned. The monetary value of the US Dollar be damned.
Hallo
UBS (WMR, 21.1.08):
“Tracking the subprime credit crisis - Update2″
1. Estimated write-downs (no change)
-a. subprime an Alt-A: 275bn (total maket 2200bn)
b. LBOs : 25bn (total market 250bn)
c. ABCP (not included in a.): 42bn (total market 700bn)
d. CMBS: 20bn (total market 1000bn)
==> estimated writedowns:
total: 471bn (total market 4′150bn)
part for banks: 225bn
part for non-banks: 246
2. announced write-downs (only banks):
141bn = 60% of 225bn; (per 21.1.08); up from 101bn per 14.1.08
(source UBS)
3. not included (calculation from nakedlunch?):
- CDS: 175bn
- counterparty default of CDS: 150bn
- decline in credit quality: 40bn
==> 365bn
TOTAL:~840bn
globumedes
DC,
Isn’t the danger of moral hazard best handled by letting those fools who bought AAA rated subprime paper, whether inside or outside the US, bear their losses (especially when the alternative is that someone else bears them)? I am sick of hearing tales of woe about people not understanding what they bought, not knowing where risk is etc. It is high time that people learned: “don’t buy what you don’t understand”.
globumedes — could you send the ubs report to me at my cfr email (it can be found easily by googling brad setser council on foreign relations) thanks
DC: However, simply stated, the primary responsibility of the Federal Reserve should be maintaining monetary stability with a “sound money” policy at all costs.
No this isn’t true. Under the Humphrey-Hawkins Act, Federal Reserve is also tasked with maintaining full employment. Under Graham-Leach-Binney, the Federal Reserve is tasked with maintaining the stability of the banking system.
Having the Fed required by law to do three things that contradict each other is an amusing quirk of law, but there is no legal requirement that the Fed uphold a stable dollar above everything else, and such a requirement would be political unfeasible.
This is the basic long term problem with China (and the rest of the world) pegging currency to the US dollar, since the Federal Reserve both by law and in practice is tasked with maintaining a monetary policy that is in the best interest of the United States without any care about how it may impact the rest of the world.
Right now the fed wants to maintain a loose monetary policy for the United States while China wants to maintain a tight monetary policy for China. The peg is going to break.
Anonymous: Twofish. Although you are correct that money given to mortgage holders will then go to pay the banks, the first hands it passes through will not be JPM, C, or GS. It will be smaller banks. They will unwind any unwise positions they have.
No it won’t. All of the small banks have already resold their mortgages to the big investment banks. Basically there are no real small banks in the United States any more. Your neighborhood bank either got bought out by a big bank in the 1990’s, or else is basically just a retail front end that brokers mortgages and immediately resells them on the bond market.
Anonymous: That’s the real goal here: confidence. But to get confidence, you have to solve the underlying problem, which is mass foreclosure.
The underlying problem is that banks wrote out loans to people with bad credit, backed with nothing except for the inflated value of the houses. Someone is going to have to eat the loss, and it makes more sense to have the losses end up on the plates of shareholders of the big banks than anyone else.
I really don’t have any objection to having the owners of these houses work out some payment plan, but one essential part of the refinancing is that the money *doesn’t* go to the people that made the idiot loans in the first plan. One thing that really worries me about a lot of the plans to “avoid foreclosure” is that I’m worried what is going to happen is that someone with bad credit is going to have their loans extended which will leave them in debt forever, and be much worse off than if they just default and declare bankruptcy.
Everything depends on the individual situation and the problem is that people who are most vulnerable in society are the people that get the least amount of unbiased advice. It’s not in the bank’s interest to have someone default, but it is in their interest to have them in permanent debt, with just enough income so that they keep paying, but not enough income so that they can actually start saving.
I worry about this because these are the people that are going to be the foot soldiers for Lou Dobbs when he tries to run for President in 2016. If you screw someone over enough times, they’ll come back at you with pitchforks and rope.
Anonymous: BTW, I don’t know why populism has such a bad name among investment types.
It actually doesn’t. Most people on Wall Street are Rubin Democrats, and people here know too much about how markets work and don’t work in order to put too much trust in them. I don’t think I’ve ever met a laissez-faire capitalist in an investment bank. People have been too close to the sausage factory.
My objection with what you are suggesting is that it rewards the wrong people. There were people on Wall Street that made smart bets, and people who made stupid ones. If you reward the people that made stupid bets, then the people that made smart bets are going to be annoyed.
If you look at the big investment banks, some of them made huge bets on the mortgage market, and are shaking the tin cup looking for handouts from SWF’s and those handouts are going to come with strings attached. Others didn’t make such big bets, and they’ll keep doing what they were doing.
2fish — you need to spend a bit more time on the street. there are plenty of folks out there (more tho in the equity than other markets in my experience) who think there is nothing wrong with the us economy that another big tax cut wouldn’t fix, and that tax cut should targeted at those who pay the most tax. and there are others who truly think the biggest threat to civilization as we know it is the end of the tax break for carried interest.
@ RebelEconomist — “Isn’t the danger of moral hazard best handled by letting those fools who bought AAA rated subprime paper… bear their losses…? I am sick of hearing tales of woe about people not understanding what they bought…”
Well, I’m not sick of it. Rather the opposite. I’m getting sick of hearing the new slogan in American society, “Let the buyer beware.” AAA rated subprime? What’s that? USDA stamped prime beef with horsemeat in it? America’s business strength and economic growth were built on the trust of a contract society, where even a man’s handshake or word was as good as a written contract,
We must bring back that contract society — where contract represents an understanding for all parties. America cannot continue her future as an advanced economy using one-sided contracts. In my opinion, sellers who knowingly packaged and sold toxic risk under the AAA label owe retribution to the buyers who rightly relied on that label, i.e. Goldman Sachs is liable for the packaged toxic waste it knowingly sold AAA and shorted. Without force of law and justice in our contract system, we will overnight become a tin pot banana republic.
Writes Ream Heakal in “What Is a Corporate Credit rating, “for Fitch IBCA, a “AAA” rating signifies the highest investment grade and means that there is very low credit risk. “AA” represents very high credit quality; “A” means high credit quality, and “BBB” is good credit quality…
“A credit rating is a useful tool not only for the investor, but also for the entities looking for investors. An investment grade rating can put a security, company or country on the global radar, attracting foreign money and boosting a nation’s economy. Indeed, for emerging market economies, the credit rating is key to showing their worthiness of money from foreign investors.
“And because the credit rating acts to facilitate investments, many countries and companies will strive to maintain and improve their ratings, hence ensuring a stable political environment and a more transparent capital market.”
America needs a house cleaning in her markets and government. She has lost her credit rating.
Twofish: “Getting money in the hands of poor people in a way that it doesn’t end up in the hands of rich people is less easy than it seems.”
Correct. Everyone should be thinking of ways to solve this difficult problem of ensuring government money goes to poor people.
Twofish: “This is the problem. The economy is so tightly intertwined that its difficult to make sure that the money goes to widows and orphans.”
You are letting Wall St off too easy. The economy is not so much “intertwined” as it is rigged by Wall St. They want you to think what is in their interest is also what is good for the country. It is not.
What happened in the credit markets: CDO’s with inflated ratings, sham insurance with undercapitalized monoliners, off-balance sheet manipulations with SIVs etc is criminal profiteering by Wall St at the expense of essentially everyone else. Let us not forget that once this crisis is taken care of.
Twofish: “Yes, and all of the investment banks that invested heavily in CDO’s and subprime are now making huge amounts of money right now….. Not….”
Who exactly is “doing badly” on Wall St now? Merrill and Citi lost billions but so what? All it means this year’s bonus pool for its traders will not be as rich as 2006. Worst case some may lose their jobs. Big deal. The fat bonuses from 2004-2006 should keep them plenty warm for a few months. This is called hardship?
Brad,
When the FOMC hits 2 percent, what’s the next move? They could be down another .75 percent very quickly according to some analysts. Won’t take long to hit 2 percent thereafter.
If they’re attempting to bottom at 2.25 or 2.5 percent, they’re throwing everything into the fire rather quickly in my judgment.
I’m not questioning the FOMC, rather I’m trying to understand potential courses of action at or near the 2 percent level. The housing card is DOA. What will the FOMC and Treasury run up the success flagpole this time?
MG
Fed is now walking on thin ice..simple Taylor’s tells me that they are at minimum..assuming inflation at 2.5% and unemployment at 5%..Fed Rates at 3.5% seems to be the floor.
So far, I have been reading articles screaming about recession recession recession, what happened to stagflation?
It seems all rather amusing to me. I strongly don’t think US will plunge into a recession now, immediately, instantaneously, comeon guys have we forgotten about the elections,SWFs,monetary easing(5.25-3.50) that we are simply blinded by a bunch of figures that were relised 6 months ago and only brought onto the balance sheets now?
America is too big to fail, and I mean it. The banks are too big to fail, it doesn’t do anyone anywhere any good to see her fail now and disappear into thin air.
Twofish says that all mortgages have been re-sold.
I’m aware of the leveraging up that happened with CDOs. So, ultimately, you’re correct that the mortgages have been re-bundled. But who got left with mortgage servicing? Tanta did a nice post here in which she points out that mortgage originators retain substantial skin in the game. Who are the originators? Well, it’s a complex mix of institutions– banks, Countrywide, financial services corporations– but it’s not the investment banks.
Twofish says, “The underlying problem is that banks wrote out loans to people with bad credit, backed with nothing except for the inflated value of the houses.”
It’s not that simple, as I think you recognize. There was fraud by both lenders and borrowers. There were mortgages that looked good until someone lost a job or got sick. There were honest mistakes. Each situation needs a different response. But most important, we have to keep it straight that we– people like you and me– are in this to avoid losing money, not to be instructors of morals. For fraud, the laws provide penalties. For all other cases, we need to protect our economy and thereby our incomes.
As for bankruptcy, it is much worse than being deep in debt. The bankruptcy laws have changed, so that you have to pay off your debt anyway. So, you get all the disadvantages of being in debt and, in addition, you can’t book a hotel or an airline ticket or do many normal things that are necessary for most jobs. It’s total horror.
Twofish says, “If you reward the people that made stupid bets, then the people that made smart bets are going to be annoyed.”
There’s a big difference between “rewarding” someone and writing down 30% of their debt. The investment banks should pay for their adventures. So should buyers who fudged loan applications, originators who misrepresented mortgages on re-sale, and bond rating agencies who exaggerated the quality of repackaged paper. But they should not be made to pay at the expense of destroying the economy you and I rely on.
The reality is that the system is geared up to protect big institutions. By lowering Fed rates, Bernanke is giving the investment banks an outright cash gift. By accepting MBS at the discount window, he’s allowing them to offload dicey assets. Mortgages are getting stuffed into Fannie Mae, where they will acquire federal insurance they probably don’t deserve. And doubtless Bush will demand more corporate tax cuts as the price for the stimulus package. Ordinary people ought to be pushing for any payouts to go to homeowners, not to speculators or investment banks.
Guest on 2008-01-22 19:50:43,
Investors who are sufficiently large to buy debt securities ought to understand what a credit rating actually means. It is not a measure of price risk. An S&P credit rating measures default risk, while Moody’s measures expected loss through default. In other words, a credit rating describes only one particular feature of the return probability distribution. There is no single measure which can fully describe risk. Moreover, credit ratings are supposed to represent an average through the economic cycle. If investors, plan sponsors and even regulators (Basle II) find it convenient to treat credit ratings as risk measures, they are going to make poor decisions. Furthermore, the finance “industry” is going to produce securities which deliberately exploit investment rules based on credit ratings (I suspect that is what CPDOs do/did).
Guest: Goldman Sachs is liable for the packaged toxic waste it knowingly sold AAA and shorted. Without force of law and justice in our contract system, we will overnight become a tin pot banana republic.
Next to every credit rating there is a long bit of legal boilerplate wording that saying that the ratings are not guaranteed and if you rely on them and something goes wrong, it’s your own fault. It also discloses all of the conflicts of interests for the ratings issuer. This wording is not hidden. It’s on the first page and on the back cover.
Now there are lots of people that will guarantee payment for defaults on AAA bonds, and if you really want a guarantee then you need to pay your own money and buy a credit default swap. The interesting thing about these credit default swaps was that the insurance premium for AAA CDO’s was much higher than for AAA corporate bonds, which should have told you something right there any then.
I dunno, Rebel Economist. You’re asking that investors understand quite a lot. It’s not like one can look this up from the Yahoo home page. Furthermore, in this case, of the many factors contributing to price risk in simple MBS, default risk is probably primary in an environment in which risk appetite and interest rate risk are modest. In CDOs, the major default risk was hidden: it was that the guys doing the calculations would guess wrong.
Anonymous: Well, it’s a complex mix of institutions– banks, Countrywide, financial services corporations– but it’s not the investment banks.
Many of the larger mortgage servicers are parts of financial conglomerates that own investment banks. In any case, a mortgage servicer gets 0.25%, the holder of the repackaged security will get 5.0%.
Anonymous: As for bankruptcy, it is much worse than being deep in debt. The bankruptcy laws have changed, so that you have to pay off your debt anyway.
The cynic in me thinks that the idea that bankruptcy is worse than deep unrecoverable debt is the result of marketing by financial institutions that win if someone is in deep debt, but lose big if they declare bankruptcy. In any case, threatening to declare bankruptcy and have the bank foreclose on worthless property is a ***huge*** amount of leverage that someone deep in debt has over a bank. Whatever problems you end up with bankruptcy, they will be over in seven years. The alternatives could leave you in debt for a lot longer than that.
Anonymous: The reality is that the system is geared up to protect big institutions. By lowering Fed rates, Bernanke is giving the investment banks an outright cash gift.
And that gift rewards investment banks that didn’t invest in mortgages as well as those that did. If you give money direct to home owners to repay their debts, the money is going to end up in the investment banks that made bad decisions, and not the ones that avoided touching this mess.
Anonymous: Ordinary people ought to be pushing for any payouts to go to homeowners, not to speculators or investment banks.
I don’t disagree that social justice says that any payouts go to the most vulnerable people in society. My argument is that giving money to people near default so that they can pay their mortgages just doesn’t do that. The money is going to just end up in the hands of the banks.
If you want fiscal stimulus, do something about social security taxes, and if you really want stimulus more social spending on health and education can be useful.
Anonymous: I dunno, Rebel Economist. You’re asking that investors understand quite a lot.
An individual investor can’t go out to their stock broker and buy a CDO. They have to do so through a fund and while an individual investor shouldn’t be expected to understand the details, the highly paid fund manager certainly should.
50 Cent: You are letting Wall St off too easy. The economy is not so much “intertwined” as it is rigged by Wall St.
If it was rigged you wouldn’t be seeing layoffs right now, and bonuses at the banks would be a lot more than they have been this year.
50 Cent: They want you to think what is in their interest is also what is good for the country. It is not.
It works the opposite way. In general, what is good for the economy is good for Wall Street. When lots of people have money, there is need for money managers. When people don’t have money, there is no need for people to manage money.
This is something very important to remember because what seems like a good idea in the short term, may not be a good idea in the middle or long term.
I should point out that it isn’t *they*.
50 Cent: What happened in the credit markets: CDO’s with inflated ratings, sham insurance with undercapitalized monoliners, off-balance sheet manipulations with SIVs etc is criminal profiteering by Wall St at the expense of essentially everyone else.
And companies that did this, got hurt, Companies that didn’t do this are doing better off. Also Wall Street doesn’t consist of social parasites. The social use of Wall Street is that it moves and stores money in much the same way that furniture movers move and store furniture.
50 Cent: Who exactly is “doing badly” on Wall St now? Merrill and Citi lost billions but so what?
So you get a new group of people running things that will do things differently than the old group of people.
50 Cent: All it means this year’s bonus pool for its traders will not be as rich as 2006. Worst case some may lose their jobs. Big deal. The fat bonuses from 2004-2006 should keep them plenty warm for a few months. This is called hardship?
Depends on your point of view. Of course a managing director of an investment bank is going to find being unemployed better than a high school dropout which is why whatever handouts go out need to be targeted at high school dropouts. I don’t disagree that this should be the policy goal. I do disagree about whether doing things like helping people pay their mortgages actually does do this……
bsetser: 2fish — you need to spend a bit more time on the street. there are plenty of folks out there (more tho in the equity than other markets in my experience) who think there is nothing wrong with the us economy that another big tax cut wouldn’t fix
Perhaps, but I don’t work with any of them. Maybe Wall Street is teeming with laissez-faire capitalists, but I haven’t run into any of them. The thing about laissez-faire capitalists is that they do well when everything is going well, but historically they do tend to destroy themselves.
There are some in hedge funds in Connecticut, but most of the libertarians I know work in private equity and that is something that Wall Street isn’t very good at.
Guest on 2008-01-22 19:50:43
Credit ratings from the agencies have been proven to be as reliable as the recommendations of sell side analysts on stocks - and for the same reason - a broken business model due to conflict of interest.
Twofish, I think you’re mistaken about how servicing works. Countrywide is one of the largest mortgage servicers. Like other servicers, it is a relatively small fish in the financial system. Therefore, when mortgages are stabilized, money flows first to the small fish like servicers and bond insurers, and only later to the bigger fish, i.e. investment banks. Last of all it reaches the the predators atop the whole system: hedge funds and arbitrageurs.
As for bankruptcy, I suggest getting acquainted with the work of Elizabeth Warren. There are a lot of myths about bankruptcy and Warren’s work clears those up very nicely.