At least London is affordable again
When the pound falls more in a week than it did during the week of Black Wednesday, the week when Soros famously “broke the Bank of England,” you know big changes are afoot. Bloomberg reports:
Today’s drop in the pound brought the decline this week to 10.1 percent, the most since at least 1971 …. The currency lost 9.8 percent in the week when U.K. Prime Minister John Major pulled the pound out of the Exchange Rate Mechanism on Sept. 16, 1992 in what became known as Black Wednesday.
“These moves are absolutely without precedent,” said David Watt, a Toronto-based currency strategist at Royal Bank of Canada Ltd. “The 1970s are pretty much the extent of the data you’re going to get because currencies didn’t even float that far back.”
The dollar is rising against everything except the yen — which just hit a 13 year high against the dollar. The Indian rupee hit a new low against the dollar — which implies that the yen has really shot up against say the rupee, and pretty much everything else.
That tells you all that you need to know. This is much more of an unwinding of carry trades than a flight to quality — though there is an aspect of that too. Some Russians for example, seem to have rediscovered the joy of holdings dollars rather than rubles.
The dollar’s rally has a silver lining. It has pulled the RMB up too — and the RMB needed to appreciate against most European and emerging market currencies. The real appreciation of the RMB over the last few days and weeks has been far larger than the real appreciation associated with the RMB’s 20% nominal appreciation against the dollar.
That is good. China is the major oil-importing economy with the fastest growth, the biggest current account surplus and the lowest fiscal deficit (a surplus actually) going into the current crisis. It has the most capacity to use counter-cyclical fiscal policy to support its growth. Its currency should be appreciating in real terms right now.
It is harder to see the fundamental case for dollar appreciation though.
The dollar clearly was a “funding” currency for a lot of bets on the emerging world — the dollar not only had fairly low interest rates, but it was tending to depreciate over time v. many emerging market currencies. Companies in the emerging world — and high octane leveraged investors in the advanced economies — bet that this trend would continue. Those bets have gone sour fast.
But the US still has a significant trade and current account deficit — and setting the dollar aside, the currencies of most countries with trade and current account deficits have depreciated not appreciated recently. The dollar’s recent appreciation certainly won’t help to close the trade deficit. The US trades a lot with Korea, Mexico and Europe. If the current trend is sustained, US export growth will slow — perhaps sharply. That cuts into one of the current bright spots in the US economy.
The fall in oil prices and fall in domestic demand will tend to reduce the deficit — but the benign adjustment scenario, one driven by rising global demand for US goods and services seems off the table for the moment.
The net effect, I suspect, is that the US will still run a significant — though smaller — deficit. And once the deleveraging process is over and the US deficit cannot be financed by the sale of US foreign assets, China’s government will continue to finance a large share of the US deficit.
The dollar block will be in balance: The oil exporters that peg to the dollar will be in rough current account balance, and the US deficit will roughly match China’s surplus.
That at least is my best current guess.
It is hard enough to guess what the global financial system will look like next week, let alone next year. The only safe bet is that the IMF, the US Treasury, the Fed, and nearly every other government will be very busy.
Very interesting that the dollar block can be in balance (or even surplus) while the US economy is in a current account deficit. This suggests that the wealth drainage from the US may continue or even accelerate.
In my opinion, the net benefits of trade (and financial) surpluses clearly exceed the benefits of a strong currency. But since in aggregate trade must balance, the surpluses will go to those countries who want them most. If the US doesn’t insist on balanced trade, no one is going to stop the wealth drainage from the US for them.
volumes are really light, brown goes out as scares the sh** out of people with full blown recession statements, what else is to be expected from the pound?
any insights from other readers if london based hedgies sell their fund shares in dollars,euro,sterling? if in USD the dollar rally would be connected with redemptions and asset liquidations.
i read this morning in WSJ that 10% of china’s GDP is residential real estate buinding to house the 20-30 million migrants into urban areas each year. if the export engine stalls, the migration will decelerate or even stop 10% of china’s GDP could easily disappear on top of the exports contraction.
i would say run away from all countries running non commodity trade surpluses, they will suffer most from the oncoming adjustments.
and there is of course the posibility for a shock appreciation of the yen and rmb to adjust the trade imbalances. but this will leave china in even weaker state: having subsidized growth in the USA, holding lots of its debt and seeing its repayment possible only through goods imports. scarry indeed.
From Michael Whitney,
http://www.counterpunch.com/
“The dollar’s rise since July is part of a reversal in longstanding investment trends that prevailed during years of plentiful borrowing, strong growth and low financial-market volatility. Essentially, every large trade that built up a head of steam in the go-go years has blown up or is in the process of blowing up,” wrote Alan Ruskin, chief international strategist at RBS Greenwich Capital, in a report to clients. “That goes for almost every asset class.”
The recent surge in US Treasurys is also misleading, much of it having to do with terrified investors that are dumping their shares in stocks, mutual funds and hedge funds for the percieved safety of US debt. Foreign investors, however, seem to be losing their enthusiasm for Treasurys as America’s future continues to darken.
The net foreign purchases of long term securities in August was a mere $14 billion following an even more dismal $8.6 billion in July; not nearly enough to meet $55 billion per month the US needs to balance its consumption of foreign goods. Even worse, the purchases of long-term US securities “went negative” by for foreign private investors (by $8.8 billion) which means that the dollar is being artificially propped up by foreign central banks to avert a disorderly unwinding of the currency.
Foreign investors and central banks are no longer providing the capital to support the US $700 billion current account deficit. They have lost confidence in America’s ability to bounce back from the credit crisis which has swept through the financial system and is now hammering away at the broader economy. That means the demand for US debt will eventually fall and the prospect of hyperinflation will grow. Even if the dollar is able to weather the storm ahead (and the nation can avoid a funding crisis) the massive deficits brought on by Bernanke’s “emergency” spending spree will force interest rates upwards and tighten credit even more.
Lately and nominally euro depreciated against $, jpy, cny, $ against jpy, cny against jpy, sar against euro and jpy (not cny) plus there are 3 “interesting” spikes in cny/$. But all these don’t count, it’s the RERs and the pairs that do.
Anyway, it was never a bad thing that the West’s intellectual bubble deflated. Its legacy did not.
It’s being, kindly, held-up. Thank You for that gesture.
For you maybe!
Yes, when the price has dropped further I shall buy London.
baychev,
The Washington Consensus retains the hopelessly deranged concept that the Chinese economy will collapse without US Consumer demand. Somehow the US Consumer is doing the average Chinese migrant worker a favor exchanging fiat US Dollars printed in unlimited quantity by the Bernanke Fed for tangible manufactured products of “real economic industrial wealth”. Under US Dollar hegemony enforced by global Pentagon military power projection and control of strategic energy resources especially Middle East oil reserves, the US Consumer gets to consume for free and the Chinese gets to work for free. While the US still retains some comparative advantage in high-tech products, those exports are mostly embargoed to China under existing National Security regulations. The Cold War with the Soviet Union may be over, so China is now designated by US Intelligence Agencies as the pre-eminent national security threat in order to boost the defense budget for new stealth bombers and missiles. Nothing could be further from the truth that the current global financial architecture benefits the average Chinese.
Arthur Kroeber writes from the Dragonomics China Insight
http://www.dragonomics.net/
In the latest edition from 15 October (before the 08Q3 release), he writes:
“… China’s economy is slowing, both because of the global crisis and for domestic cyclical reasons. But the slowdown will be modest, and in the main provides a welcome and necessary opportunity for industrial consolidation, rather than posing a more existential risk. A few sectoral problems — notably in high-end property and low-end exports — will tend to erode bank profits from their current very high levels over the next couple of years, but with the possible exception of one or two small and under-capitalized banks the financial system faces no significant balance sheet risk. However, hopes that demand from China will substitute for falling OECD demand and rescue the world from recession will prove ill-founded. And commodity prices have incorporated a too optimistic view of medium-term Chinese demand growth and will need a further downward re-rating. ”
We expect that China will post real GDP growth of around 9.5% in 2008, followed by growth in the range of 8-8.5% in 2009-2010. These growth rates are considerably below the 11-12% growth rates of the last two years, but are very strong by any other reasonable standard, and only a shade below the long-term trend rate. They are supported by underlying trends in demographics, productivity and urbanization. The structural problems that contributed to the previous two Chinese recessions (1989-90 and 1998-99) simply do not exist any more. Hence the current cyclical downturn will be milder than the earlier ones.
The reasoning is that China’s financial system is insulated from the rest of the world by its focus on the domestic economy, the Chinese economy in real terms remains fairly closed, bank balance sheet risk is small, and — while the property market at the high end is problematic — it remains solid at the low end. “
ttnk: sar against euro and jpy (not cny)
googled SAR.
1st thing i got was the sons of the american revolution website.
2nd thing i got was:
http://tinyurl.com/58p5hh
thought you would appreciate that.
(and if either of these were the acronyms you were referring to, both of them may have spiked even higher than the yen, lately and nominally.)
but if it was a currency acronym, were you referring to the hong kong dollar peg or the saudi riyal?
“If the US doesn’t insist on balanced trade, no one is going to stop the wealth drainage from the US for them.”
It is no longer in the interests of American voters to allow this to continue. If that means the end of catering to the Chinese and their peg and their intellectual property ripoffs, so be it. Let the financiers who led this outsourcing charge find a home somewhere else. Anybody want our financial elites? They’re going, and I mean going, for a song.
DJC,
i agree with you that the chinese populace does not benefit from the present situation.
it is the chinese government that benefits most: providing employment for previously rioting masses, forcing them to work for really low wages, and enriching themselves in the process (ref. Neil Bush dealing with Jiang Zemin’s son).
however, suggesting (as per the article) that china will weather a crisis seems unreasonable (avg wage <$200 a month).
and they have a serious housing problem coming as well. do not forget that the $2tn currency reserve is 2/3 in treasuries and a far cry from being called liquid:
http://online.wsj.com/article/SB122478601140563277.html
The flip side of the stronger dolalr means inflation for the EM in the form of commodities. Thoughts on why cooperation remians the best alternative here?
Here are some discussions I hear these days about the future of China’s surplus/reserves etc. Curious what the pros in this forum think about it.
What we are seeing is the burst of two bubbles, the American credit bubble and the commodity bubble. It’s bloody and no one knows what’s going to happen in the next few months, except pains everywhere.
Once it settles, the Chinese have two choices: 1.) buy more treasuries; 2.) invest in the resource-rich emerging economies.
The first choice is a continuation of the old mode, and depends on American profligacy. As many have said, Chinese currency reserves will produce losses. They are holding treasuries because they don’t really have much choice. They are already holding too much.
The second choice is to invest in the emerging economies. Although the commodity bubble bursted, it did raise a keen awareness in China that commodity price could go up, substantially and over a short period of time. In the long run, Chinese economy needs access to raw materials, which could be very cheap in the next few years. The problem here is the potential political risks in these developing countries.
But can the increasing trade among such emerging countries (China included) counter the recession in the developed economies? Is China’s reserve big enough to make a difference and to meaningfully help emerging economies through this difficult period? And, what could be the geopolitical implications from an American perspective?
DavidHK,
this could be the answer:
http://kommersant.com/p-13439/Russia_foreign_relations/
there is another article on at least 15 year deal for oil supply.
i personally think there is a strong political will among the BRIC to raise themselves in relevance and increase trade inbetween to lessen their dependence on the US/EU markets.
“i personally think there is a strong political will among the BRIC to raise themselves in relevance and increase trade inbetween to lessen their dependence on the US/EU markets.”
impt thing to remember: BRIC is a acronym coined by goldman sachs.
i/o/w BRIC is a BRIC only to certain perspectives (which some here have argued are quite limited and limiting and perhaps one of the proximate roots of our current conundrum).
baychev,
The Chinese populace does not benefit from the present situation, nor does the Chinese government. The G7 club led by the US government specifically excludes the Chinese government from any participation in global economic affairs. Japan is given a “window dressing” role in the G7 given its subservient position since the WW2 defeat. Little Holland retains a larger voting share at the IMF than 1.6 billion population China. The current global financial architecture is entirely a construct of the Washington Consensus. I can assure you that Chinese government interests are never taken into account by the US government.
Thankfully, the Chinese government retains a large surplus of foreign reserves to tell the IMF to “get lost”. Among the developing nations of the world, the IMF is notorious for its punitive financial sanctions that enrich Wall Street banks while impoverishing billions of people. During the late 1990’s Asian Economic Crisis, under orders from the Clinton-Rubin administration, CIA paramilitary squads executed upwards of 15,000 ethnic-Chinese across Indonesia to eliminate Chinese influence across the region. Politically connected Wall Strret banks reportedly profited $100 billion from the orchestrated rape and pillage of Southeast Asian economies.
Deficit will be smaller (oil prices) and could become negligible (new Admin. ends war, perhaps raises taxes on wealthy) What then ? Would this help fix things up ? What about the dollar ?
Also any other good blogs on trade/currency issues ?
Thanks !
bsetser: It is harder to see the fundamental case for dollar appreciation though.
Actually there is. The US is powerful enough so that anything that wrecks the US economy will hurt other nations more than the US. It’s bizarre. It’s perverse. But it is true.
DavidHK: Once it settles, the Chinese have two choices: 1.) buy more treasuries; 2.) invest in the resource-rich emerging economies.
There are usually dozens of choices. The one that sounds most reasonable to me is to do some massive investments in health and education in China. Start by training lots of food inspectors.
DavidHK: But can the increasing trade among such emerging countries (China included) counter the recession in the developed economies?
I doubt it. The thing about China is that it is large enough so that it’s business cycles are somewhat out of synch with those in the West.
DJC: The current global financial architecture is entirely a construct of the Washington Consensus.
It’s actually not. The Washington Consensus has been dead for about ten years. It was only very influential from 1991 to 1995.
DJC: I can assure you that Chinese government interests are never taken into account by the US government.
They are when they happen to be similar to other people’s interests. For example, the decision to bail out Freddie and Fannie. The US wants China to do lots of things, and that often gives China leverage over the US.
I’m pretty sure we get the worst case forecasts we’ve seen come true next year.
There is only one thing that could happen to makes things worse. We get invaded by space aliens and find out that they are NOT friendly, nor here to solve all our problems for us. They are here because they need a breeding stock planet to transform into a layover port for their inter-galactic cruise lines. They will be pleasantly surprised with the ample supply of plump Americans and the incredible number of tasty Asians for in between mealtime snacks.
And we all know being eaten by space aliens is the worst thing that can happen to the global economy and financial system. (ref: Greenspan musings)
Barring that scenario, we have a popping credit bubble and massive financial deleveraging, which has to result in a global shrinkage of GDP. If China is immune to that, I’ll believe it when I see it. Manufacturing based economies have a lot of corporate debt invested in capital equipment and are generally hurt worse by downturns than service economies. I doubt they can make up the shortfall by increasing domestic consumption. Chinese people may get spending averse in a recession. It’s possible the region does do a replay of the 1997 currency crisis. The only things better now is Chinese corporate loans are not in appreciating dollars, as was the case with affected Asian countries back then. But the rest of Asia still has the problem today, with loans in dollars and yen. Sure reserves may be higher, but we are seeing this could be another allusion because EMs have FDI pulling out and rapidly making reserves look not so large.
The other thing better back then was the US was in relatively good shape, but now it looks like a very big EM, headed towards being the first Banana Republic with no bananas. Where savings and investment ultimately heads in this scenario is the $64 trillion dollar question.
p.s. SAR = South African Rand
Twofish: For example, the decision to bail out Freddie and Fannie. The US wants China to do lots of things, and that often gives China leverage over the US.
DJC: The China PBoC holds a large percentage of GSE securities through London bank intermediaries specifically to avoid expropriation by the US government. The US government can’t just default on the China PBoC without also defaulting on everyone else on the entire planet. The decision to bailout the GSEs was made solely to protect the US financial system. Chinese government interests were never taken into account.
Cedric,
Let’s see what’s causing all the mayhem so that we can guesstimate when and how it will end.
Back to some hedgonomics:
Hedge funds book a nice profit by going short in credit derivative swaps. (in my previous blog last night I explained the difference between a ‘real’ and ‘notional’ loss in the mortgage market)
Some borrowers default, causing a total ‘brick and mortar’ loss of at most around $200b over the last 6 quarters.
The losses to hedge funds and other FIs who’re short in CDS are huge and practically inestimable.
This is because a CDS works somewhat like a bet on the outcome of a baseball game or on the upcoming elections.
The same funds are also heavily into the carry trade.
To get out of their situation, they need to book some profits on their carry trade.
The resultant unwinding causes the currency movements, such as the recent rally in USD.
Some people are imagining that this has something to do with ‘de coupling’ among global economies.
Now coming to what will happen:
OFHEO data shows a decline in the rate of decline in housing prices.
Also Sheila Bair and others are working to reduce home loan defaults.
Soon the winners in the CDS game will be flush with a good amount of money. Some of the winners (such as Warren Buffett and the SWFs) must already be going long in equities now. Once more CDS settlements are through, the winners will go long in equities.
The game starts all over again.
gracias, cedric. tho i can’t see right now how s.africa factors into ttnk’s fractal equations.
hopefully, he’ll be a dove & clarify at some point.
been thinking about the aliens myself lately. all jokes aside, it seems that the paradoxes are so nested within paradoxes that the only way through to the other side is a complete global transformation of some sort that no one is even considering.
to wit:
“There is a paradox in the idea of transformation. If a transformation is deep-seated enough, it might also transform the very criteria by which we could identify it, thus making it unintelligible to us. But if it is intelligible, it might be because the transformation was not radical enough. If we can talk about the change then it is not full-blooded enough; but if it is full-blooded enough, it threatens to fall outside our comprehension. Change must presuppose continuity – a subject to whom the alteration occurs – if we are not to be left merely with two incommensurable states; but how can such continuity be compatible with revolutionary upheaval?”
(from terry eagleton via zizek’s ideology 1: no man is an island)
http://www.lacan.com/zizwhiteriot.html
p.s. hawaii has bananas.
of course, most of them have been infected with baunchy top disease and root rot.
…the metaphors continue to spread…
chidam — with all due respect, you remind me of the guy at about 0:10 of this video (he’s on the right of the screen) –
http://www.youtube.com/watch?v=P0Fi1VcbpAI
(sorry for the bit of snark, but given brad’s title today, i thought it might be considered within bounds.)
Everyone knew the basic tools to get out of the recession: fiscal spending and loose monetary policy. The only difference is how to construct a smart policy and carry out. From what I see now, China’s initial steps are generally correct. More to be seen.
Also, anyone think the 8% growth is a given bottom line for China? Nobody seems to doubts that claim: China certainly fell below 8% in 1990s and nothing happened. Why do the media so obssessed with such number? Becasue 8 is the lucky number in China?
Cedric: Manufacturing based economies have a lot of corporate debt invested in capital equipment and are generally hurt worse by downturns than service economies.
One has to be very careful not to generalize.
Chinese companies tend to have very little debt. You either have large state owned enterprises that got seed capital from the state, or private enterprises in which most of the capital comes from private equity investments.
Cedric: Chinese people may get spending averse in a recession.
True, but getting a Chinese government official to spend money on capital investment is the easiest thing in the world. The bigger the project, the bigger the office and the nicer the car.
DJC: The China PBoC holds a large percentage of GSE securities through London bank intermediaries specifically to avoid expropriation by the US government.
No they don’t, and it would useless anyway since any situation in which the US would seize Chinese assets would almost certainly result in the UK doing likewise.
DJC: The US government can’t just default on the China PBoC without also defaulting on everyone else on the entire planet. The decision to bailout the GSEs was made solely to protect the US financial system. Chinese government interests were never taken into account.
We live in a connected world. Ultimately it’s impossible to take into account your own interests without at least thinking about the interests of everyone else on the planet.
Chid:
I agree the extent of the US mortgage default problem is “small” relative to the extent of the global financial shock we are seeing. And it was greatly magnified by leveraging up the problem by the financial industry.
I’ve seen the “real”, not notational, losses in CDS estimated at $1 trillion. So they’ve compounded the $200B cost by a factor of 5. But the media references to the around $50T or so in CDS outstanding did cause some fear factor.
Still, I think this was just the fuse that detonated the bomb. Since 2002 we had a synchronized effort among global CBs to re-flate the global economy. It resulted in the US shipping their phony home equity to Asia. Europe now has a problem with Eastern and South Eastern Europe living above their means, and a unraveling there is also stressing European, Nordic, and British banks. This also seems to be a perennial problem in South and Central America.
So now the impact will be on the real world economy, which was sized for unsustainable consumption.
Don’t think equities are coming back anytime soon, since they are highly leveraged against corporate earnings (PEs).
The losers dollars already far outpace the winners dollars.
Stock market -$8T
Warren Buffet +$50B
And the real economy game is just getting started.
SAR = Saudi Arabian Riyal.
ZAR = South African rand (Zuid Afri … )
or so i think.
Twofish — I see you buy Stephen Jen’s argument that the worse the US does, the better the dollar does. Or maybe you independently arrived at the same conclusion. I am not 100% sure — as I don’t think deleveraging has finished so we don’t know what a delevered world looks like. One hypothesis is that the us current account deficit cannot be financed so it has to shrink; another is that China continues to finance (somewhat smaller) US deficit.
Inicidentally, a world where China finances investment in the commodity exporting emerging world — allowing a fall in the US deficit — strikes me as a more healthy one than a world where China finances high levels of US consumption.
Twofish:
I am curious to see if China’s way ends up working better than everyone elses.
Fiscal spending their way out of a downturn seems like it would entail cashing in on foreign reserves, having the money make the jump from the PBoC to the other part of the government, and the total amount they get from treasuries would be $1000 per capita, or about 6 months income.
Unless they go the printing press route, or even government debt issuance.
I guess they could have their cake and eat it too. Keep the treasuries and issue Chinese government bonds to compete with treasuries.
That would really make things interesting.
ps. ZAR is rand. SAR is riyal That just jogged the old memory.
As Economist Marc Faber writes, Helicopter Bernanke can inflate the Dow to 100,000 and every McMansion to the million dollar level. But the purchasing power value of each dollar will be worth less than a sheet of toilet paper. Whatever happened to the principles of a “sound monetary policy”. Like Greenspan, Bernanke thinks the solution to every economic problem is the printing press. It’s exactly the reckless credit expansion problem that got us in this mess so Bernanke is doing more of the same monetary inflation hoping for better results this time.
LOL.
Cedric:
At this link you can find an introduction to how a CDS works:
http://en.wikipedia.org/wiki/Credit_default_swap
Also please see my earlier blog post on Brad’s blog last night:
The entire $1 trillion that’s estimated as a ‘real loss’ in CDS markets needs to be taken as a ‘notional loss’. The reasoning is that the CDS principal outstanding is itself a notional amount.
e.g. Suppose I feel very confident that Twofish will never default on a loan. And you don’t. I can book a profit by going short in a CDS referencing some notional amount while you go long on it.
Say Twofish has a home loan of $300,000. We enter into a $5 million CDS between us, with me booking a profit of say $50,000 from the premium you pay me.
If by any chance Twofish defaults $60,000 I end up losing $1 million.
There’s no ‘leveraged’ connection between the CDS loss and the amount of the actual default.
It’s similar to my having a bet with you for $1 million that the Yankees will win against Red Sucks. My gain or loss has nothing to do with the price of tickets to the game.
For Brad’s Eastern Europe readers:
Red Sucks is an American baseball team from Boston which gets coaching services on an outsourced basis from the Sumo Wrestlers Association in China. Their hitters are not allowed to bat unless they exhibit a weight gain of at least 87.9 pounds on an annualized basis.
For Indian and British folks:
Baseball is a game in which Americans indulge in irrational exuberance by playing a full 5-day cricket test match in around 4 hours; this is done on a leveraged basis by removing the wickets altogether; bowlers are not allowed a run up and they always have to bowl full tosses.
[...] From Brad Setser…. When the pound falls more in a week than it did during the week of Black Wednesday, the week when [...]
I think we may be saying the same thing, but it is confusing. CDS losses and mortgage defaults have nothing to do with each other, but CDS may have something to do baseball, and it is probably space aliens shorting the secondary market in CDS, causing lack of confidence in humans as a prelude to invasion.
bsetser: Twofish — I see you buy Stephen Jen’s argument that the worse the US does, the better the dollar does. Or maybe you independently arrived at the same conclusion.
It’s an empirical observation is that the currency flows in response to the latest crisis are the opposite that one would expect. There is a crisis in the US banking system and Pakistan and Iceland get slammed.
How long this lasts is anyone’s guess, but one thing about the United States is that because it has such a huge economy, it can withstand idiocy, incompetence, and foolishness that would have destroyed any other nation. I suspect that this is why people invest in US Treasuries. If you invest in Argentina, you are assuming that the political and economic leaders of Argentina are not incompetent, but with the United States you are likely to get your money back even if the leaders are incompetent.
bsetser: Incidentally, a world where China finances investment in the commodity exporting emerging world — allowing a fall in the US deficit — strikes me as a more healthy one than a world where China finances high levels of US consumption.
I don’t think so. China and the United States are basically adults, so anything disputes that occur between China and the United States are unlikely to be overly exploitative to either party.
When you deal with resource rich, third-world nations, you are often dealing from a highly unequal power relationship, and so what often happens is that large amounts of money pumped into those societies does a lot more harm than good.
DJC: Whatever happened to the principles of a “sound monetary policy”
It died in 1998-2000, after the Washington Consensus was shown to be bogus.
DavidHK: It’s bloody and no one knows what’s going to happen in the next few months, except pains everywhere.
And even that is not certain. It’s quite possible that everything goes back to boom by the end of 2009.
Cedric:
Yes I think we’re saying the same thing. But if we are it should be clear to you what the source of uncertainty and mistrust among the financial institutions is.
As I’ve said before simple examples with no complicated terminology can serve to make things very clear very quickly.
Twofish has a $300,000 loan and I feel very confident he’s never going to default. I’ve been giving out CDS contracts to all comers, with a notional principal of say $1 m each and charging a premium of say $ 50,000 each.
This is like a betting market where I’m taking a huge bet with the odds stacked against me.
But other than I, several others are also involved in the Twofish loan CDS market, both buyers and sellers.
Let’s say an impressive set of folks, including you, moldbug, Andrew, Macro Man, et al are also in this market and we are all either long or short in various high denomination bets at much smaller premia.
One fine day Twofish goes and actually defaults $60,000 out of his loan.
Now none of us really knows exactly who is owing how much.
The total of $1 trillion is the estimate of all the owings from all the FIs that are in short CDS positions.
This total is owed to other FIs, please remember that.
Given the situation none of us now trusts the other in normal transactions till the CDS settlements are all through.
An example is that all the Lehman-issued CDS contracts were put through for settlement and the total owing from them was close to $300b as I remember. (This settlement happened after they filed for bankruptcy protection, so they never actually paid this amount out in physical dollars)
At the same time my estimate of a $200b is actually very large for the actual losses that banks have had from the reduced recovery after home foreclosure.
This estimate I made simply to make the point that this amount is much much smaller than the trillions of dollars being reported in the same connection.
Twofish:
It’s an empirical observation is that the currency flows in response to the latest crisis are the opposite that one would expect. There is a crisis in the US banking system and Pakistan and Iceland get slammed.
The same funds that have issued CDS are also into carry trades.
They have unwinded their carry trades, to be able to book some profits and meet some of their obligations.
This explains the currency movements.
unwound
Chid:
Right. The actual numbers I read came from an RGE news item. Somehow, someone, estimated total CDS losses to be $1 trillion out of the $62T in CDS written against $11 trillion in mortgages. Besides being a little unbelievable that someone could accurately estimate it, it would be a moving target going forward with more foreclosures to come. And I think foreclosures correlate more closely with unemployment than with housing prices.
So we have the CDS market defined by the following computer model code (from a risk management model)
sizeof(Mortgage Market) = NOT sizeof(CDS Market)
sizeof(Mortgage Market Losses) = NOT sizeof(CDS Market Losses)
An interrupt in the operating system triggers for an individual CDS when a Credit Event happens. This is the only link with CDS and the mortgage market. There is no limit to the number of times a interrupt is triggered, at least relative to the number of mortgages.
I did come across a blog of a day trader trying to explain how to make money day trading CDS FUTURES. My eyes glazed over and I quickly clicked out before I went catatonic.
So in hindsight we are spending far more money than if the taxpayer simply bought up bad mortgages. Probably much worse than the $1 Trillion, when you consider the magical effects of banking balance sheets, where one mans asset is wholly another’s liability, and the knock on effects when an institution crumbles. Like Lehman, then next thing we know money markets freeze up worldwide.
So it is an issue if the partners in crime don’t trust each other anymore because they are not certain of a taxpayer bailout.
Since I don’t like that fix, I think they should just make all CDS null and void. The “premiums” would be a loss for some, and bad mortgages wouldn’t be insured anymore, for whatever that was worth. But that seems like much less damage than bankrupting the whole world over a casino game that got too big.
Wow Cedric, now we’re really talking …
LB:
I’ve also been wondering if MBS are “insured” with CDS, so I googled it and found this excerpt from a 2003 annual report from FSA.
I guess the answer is many are, so the Chinese have nothing to worry about, and F&F is doing fine, which is a big relief to us taxpayers.
But the effects are probably only noticeable to those cognitively in the 5 Dimension, which would explain all the horrid news that we understand.
======================================
A solid year in the U.S. asset-backed market
For the year, FSA originated $178 million of PV premiums in the U.S. asset-backed (ABS) business. While this was 9.4% less than 2002’s results, the business was more diversified, and the group developed a number of new relationships, particularly in the consumer receivables area, that are expected to yield future business. During the second half of 2003, we also stepped up our activity in the collateralized debt obligation (CDO) sector, where we found opportunities to guarantee credit default swaps (CDS) on high credit quality collateralized loan obligations (CLOs). In doing this business, we are taking some mark-to-market volatility in the income statement. However, we believe there is no real economic gain or loss as long as the underlying credit performs. When we hold these contracts to term, as we intend, the mark-to-market charges will normally sum to zero. We expect this to remain a strong business area and to expand with the greater use of CDS on ABS and MBS. Our U.S. mortgage finance business was steady throughout the year. Across our new asset-backed business, 65% of net par insured was of Double-A or better quality.
http://www.fsa.com/financial/quartletter020504.php
Also, I just remembered that when F&F got taken over, the CDS market declared a “credit event”.
But I’m not sure what happened next, other than people started wondering about how the details and time frame of these things get worked out.
Brad-China trusting Russia and Brazil will be more dangerous trusting US(lesser of the evil).
Baychev- I dont believe metals( even precious metals) will be a good bet to protect against inflation because there is a glut in capacity
and ores are available in huge amount.
Regarding oil, oil is scarce given that oil production has increased by less than 1% given high oil prices in passt year.But prices are determined by Demand-supply gap.
If oil demand falls in US by 9% and rest of world is going follow soon on demand destruction, we may have 10% surplus capacity
which is worse than 1998 level. Prices could fall below 10$ over next year if present conditions prevail for another year. Add to that dollar based hedge fund who operate on leverage on oil futures market. prices could
fall back to low single digits.
So time is now to get out of commodity producers especially russia. I believe russia will be spending close to 400bn$ to support ruble in vain and then ruble is going to be in a free fall.
Non commodity surplus countries have some resistance but given the nature of exports from east asia most of them are discretionary
items like mobiles, plasma tv, other gadgets, clothing, shoes etc.Americans will be happy with 30 pairs of clothes than current 70 pairs of clothes each year.
I dont want to say about current account deficits countries except reserve currency countries as they are headed towards drain.
I think countries are better prepared in this order.
Reserve currency countries
Non commodity surplus countries
Non commodity deficit countries
Commodity countries.
Cedric:
Don’t you think it’s a tad late for you and I to be debating around the annulment of CDS at this stage?
I have three important words to say to you:
Follow the money!
Act II of the mythical crisis was when the FIs came together and borrowed from the Fed, plus borrowed from many of the world’s central banks to settle the CDS bets amongst themselves.
Go back and read Brad’s blog at this link:
http://blogs.cfr.org/setser/2008/10/16/foreign-central-banks-seek-safety-the-fed-by-contrast/
Brad:
The scale of the expansion of the Fed’s balance sheet is equally stunning. The Fed is currently provided at least $950b in dollar liquidity to the US financial system through various term facilities and its direct lending, and another $450b of dollar liquidity to European central banks — liquidity that is then lent to European financial institutions that are facing a shortage of dollars. Let there be no doubt that this is a systemic crisis.
Where do you think the $ 1350 b above went? To make out new loans to Joe the plumber?
Chid:
I did read that blog from Brad.
One of my comments from today is:
“So in hindsight we are spending far more money than if the taxpayer simply bought up bad mortgages. Probably much worse than the $1 Trillion, when you consider the magical effects of banking balance sheets, where one mans asset is wholly another’s liability, and the knock on effects when an institution crumbles. Like Lehman, then next thing we know money markets freeze up worldwide.”
I am even keeping score.
The bailouts and Fed lending total $1.8 Trillion so far, not including the swaps to other CBs, which in theory are supposed to come back. There are still CDS “alive and well” trading out there, or in suspended animation, and the only thing that is keeping IBs and “monoline insurers” from writing more is my sincere hope that no one buys them.
I just hate being the last one to find out about these things, except for government officials and regulators of course.
And bad mortgages are still a problem. Insured NOT !
Brad:
Can you please provide once again an estimate of NEW credit extended by the Fed to the global markets due to this crisis?
Also, is there an estimate of similar credit from other CBs to banks and FIs?
Reuters has this chronology:
Reuters
CHRONOLOGY-Fed actions to boost liquidity
10.14.08, 1:40 PM ET
United States – WASHINGTON (Reuters) – The U.S. Federal Reserve announced on Tuesday that its facility to buy commercial paper would start Oct. 27 and that U.S. bond fund management company Pacific Investment Management Co, or Pimco will serve as the asset manager.
The actions were the latest in a series of extraordinary steps by the Fed dating to August 2007 aimed at keeping strained credit markets from freezing up entirely.
Following is a chronology of the Fed’s actions:
Aug. 10, 2007: Fed notes banks are experiencing unusual funding needs and says it will provide funds as needed.
Aug. 17: Fed cuts discount rate; says it will act as needed to safeguard economy from financial market disruptions.
Nov. 26: Fed promises more than the usual year-end liquidity and says it will lift limits on how much can be lent to any one bank.
Dec. 12: Fed establishes Term Auction Facility (TAF) to provide funds over longer period to a wider range of banks. It also sets up foreign exchange swap lines with the European Central Bank and Swiss National Bank for up to six months, providing up to $20 billion for the ECB and $4 billion for the SNB.
Jan. 3, 2008: Fed raises TAF auction amounts to $30 billion from $20 billion for each of the two auctions in January.
Feb. 1: Fed says to continue TAF auctions in February.
Feb. 29: Fed sets two TAF auctions of $30 billion each in March and says intends to conduct auctions for as long as necessary.
March 7: Fed increases size of TAF auctions to $50 billion and starts a series of 28-day repurchase transactions with primary dealers expected to total another $100 billion.
March 11: Fed says to accept broader range of collateral in new program for primary dealers, the Term Securities Lending Facility (TSLF), to lend up to $200 billion for 28 days. It also increases swap lines with the ECB and the SNB to up to $30 billion and $6 billion, respectively; extends them through Sept. 30.
March 14: Fed says authorized JPMorgan Chase (nyse: JPM – news – people ) to borrow at discount window for Bear Stearns.
March 16: Fed cuts discount rate and announces new program to provide credit to primary dealers, the Primary Dealer Credit Facility (PDCF). PDCF to extend credit against broad range of investment-grade debt securities. It also increases maximum term of discount rate loans to 90 days from 30 days. Actions are taken in concert with decision to approve special financing to facilitate the purchase of Bear Stearns by JPMorgan Chase.
March 24: Fed details role in amended JPMorgan planned purchase of Bear Stearns. It says it will assume control of a portfolio of Bear Stearns assets valued at $30 billion. Any profit will accrue to Fed; JPMorgan will bear first $1 billion of any losses.
April 9: Fed says considering plan to have Treasury borrow in excess of its needs and deposit surplus at Fed. It says also considering whether to issue debt under its own name and whether to seek authority to immediately begin paying interest on commercial bank reserves.
May 13: Fed asks Congress to grant it immediate authority to pay interest on reserves.
July 13: Fed authorizes Fannie Mae (nyse: FNM – news – people ) and Freddie Mac (nyse: FRE – news – people ) to borrow from discount window. It also agrees to take on a consultative role in setting capital requirements and financial safety and soundness standards for the companies.
July 30: Fed extends the PDCF and TSLF through Jan. 30. It introduces 84-day TAF loans to complement existing 28-day loans. It increases swap line with the ECB to $55 billion from $50 billion, and extends swaps with both ECB and SNB through Jan. 30, 2009.
Sept. 14: Fed expands collateral accepted for emergency loans, allowing equities for the first time ever under its PDCF and expanding TSLF collateral to include all investment-grade debt securities. The Fed also expands TSLF program to $200 billion from $175 billion and announces more frequent auctions. Fed agrees temporarily to allow insured depository institutions to extend liquid funds to broker affiliates for assets that would normally be accepted in tri-party repurchase agreements. This provision expires Jan. 30, 2009.
Sept. 16: Fed agrees to lend up to $85 billion to American International Group (nyse: AIG – news – people ).
Sept. 17: Treasury says to begin auctions to raise funds for Fed.
Sept. 18: Fed expands swaps to $247 billion, increasing line with the ECB to $110 billion and line with SNB to $27 billion, while opening new lines with Bank of Japan for $60 billion, Bank of England for $40 billion, and Bank of Canada for $10 billion. Swaps authorized through Jan. 3O, 2009.
Sept. 19: Fed opens discount window to financial institutions to fund purchases of asset-backed commercial paper from money market mutual funds. It also says it will buy short-term debt obligations issued by Fannie Mae, Freddie Mac and the Federal Home Loan Banks from primary dealers.
Sept. 21: Fed approves applications of Goldman Sachs (nyse: GS – news – people ) and Morgan Stanley (nyse: MS – news – people ) to become bank holding companies, pending five-day antitrust waiting period, and authorizes extension of credit to their broker-dealer subsidiaries on same terms as discount window or PDCF. It makes similar collateral arrangement available to Merrill Lynch (nyse: MER – news – people ) and authorizes extension of credit to London-based broker-dealer subsidiaries of all three investment banks against same collateral that is accepted under the PDCF.
Sept. 22: Fed says Goldman Sachs’ and Morgan Stanley’s bank holding company applications may be consummated immediately.
Sept. 24: Fed establishes swaps with Australia, Denmark, Norway and Sweden, taking total to $277 billion. Swaps provide up to $10 billion for Australia and Sweden, and $5 billion for Denmark and Norway. They are authorized through Jan. 30, 2009.
Sept. 26: Fed expands swaps with ECB by $10 billion to $120 billion and with SNB by $3 billion to $30 billion. Total swaps now $290 billion. All swaps would expire Jan. 30, 2009.
Sept. 29: Fed increases swaps by $330 billion to $620 billion and extends them through April 30, 2009. It expands size of 84-day TAF auctions to $75 billion per auction from $25 billion and establishes new forward TAF auction program totaling $150 billion. Swaps now stand at $30 billion for the BOC, $80 billion for the BoE, $120 billion for the BOJ, $15 billion for Denmark, $240 billion for the ECB, $15 billion for Norway, $30 billion for the Reserve Bank of Australia, $30 billion for Sweden and $60 billion for the SNB.
Oct 6: Fed said it would begin paying interest on required and excess reserve balances that banks hold with the Fed. It said this would help it ease credit market conditions while keeping the federal funds rate close to its target.
Oct 6: Fed substantially increased Term Auction Facility to $150 billion for both the 28- and 84-day auctions. The increases will eventually lift outstanding amounts under the TAF to $600 billion. It also increased the two forward TAF auctions to $150 billion each, potentially meaning that $900 billion of TAF credit will be outstanding at year-end.
Oct 6: Fed Board exempts banks from limits on transactions with affiliates that will allow them to buy assets from affiliated money market mutual trust funds under certain circumstances.
Oct. 7: Fed creates a Commercial Paper Funding Facility to provide a backstop for U.S. issuers of commercial paper. It will purchase 3-month unsecured and asset-backed commercial paper from eligible issuers via a special purpose vehicle. The Fed has not said how large the facility will grow. It noted that there was $1.3 trillion of commercial paper eligible, but said it did not expect to purchase nearly that amount.
Oct. 8: Fed cuts its key federal funds lending rate by a half percentage point to 1.5 percent in a coordinated move with other central banks in Europe to stem a fallout from the financial crisis. It also lowered its discount rate by the same amount to 1.75 percent.
Oct. 13: Fed expands its currency swaps with the Bank of England, the European Central Bank and the Swiss National Bank so those banks can provide U.S. dollar funding “in quantities sufficient to meet demand” for dollars in short-term funding markets in those regions.
Oct. 14: Fed sets Oct. 27 as the start date for its Commercial Paper Funding Facility and says Pacific Investment Management Co, or Pimco will serve as the asset manager.
Cedric:
Sorry if I missed anything; I think I ended up posting the above blog just before you posted yours.
Cedric:
The bailouts and Fed lending total $1.8 Trillion so far, not including the swaps to other CBs, which in theory are supposed to come back.
There you have it!
CDS Winners:
+ $1.8 Trillion !!!
Waiting on the sidelines to go long in equities!
Cedric:
Am I missing something?
If the loss from reduced mortgage recoveries was somewhere in $100b to $200b range, and if new credit extended by the Fed amounts to $ 1.8 Trillion, that means nearly all of it is sitting out amongst the FIs, who’re either holding dollars or US Treasuries or whatever, and this cash needs to come back into the market…
right???
I think the treasury needs to borrow it, but that’s a glass half full, half empty argument.
Plus my $1.8T was a total of Treasury actions, like the F&F takeover, the direct purchase of MBS, FHA program, etc… I also included the more publicized actions by the Fed like the Bear deal,the AIG loan, new credit facilities that came with a dollar value on the program(these are short term, but they seem to roll over in ever larger amounts as your article indicates), and there was the opening of the Fed discount window to just about anyone that had just about anything for collateral. No dollar amount was budgeted for that, so I didn’t add it in.
So its not really an accurate accounting, especially taking into account maturity transformation, which we know is important.
But my interest was in trying to get a ballpark number for next years Treasury borrowing needs.
But bottom line on equities is I doubt Wall Street chases declining corporate profits from a economy entering recession, crazy as they sound at times.
satish,
commodities are beaten down now by demand destruction. but as long as the world turns, there will be demand for them.
on the other side, service based economies are doomed in the long term: you do not create wealth by just flipping money, unless you expand credit 18% yoy as the Fed allowed the past 3 years. but we see how all this ends up: central banks trying to reinflate the economy and maintain the illution this wealth was real. even if they succeed, it will rocket launch commodities to catch up.
this is the roots of the theory of capitalism: the resources that produce capital are the most important for an economy (although the merchants seem to earn more).
but for the service sector to be the most profitable? c’mon, this is simply not capitalism but a con game. you see how easy it is to outsource high value services (technology) and some lower value ones as well.
the health care, auto service, insurance, litigation systems are so overpriced relative to the EU that if they deflate to normal levels, 10% of US GDP could simply go away.
Cedric,
you are looking just from the treasury supply side. how about the demand side?
- if china’s trade surplus shrinks 2x;
- russia’s budget surplus evaporates;
- the gulf states budget surplus shrinks 5 times;
- equities holding at present level creating some 40-50% wealth loss perception among US savers;
who will be able to finance the treasury issuance?
the options are:
- treasury yields will skyrocket;
- the funding needs will not be met and there have to be spending cuts;
- printing money;
baychev:
That’s exactly why I’m keeping track.
But you can add to the list:
economy will suck
housing goes down more from higher rates
variable rate mortgages and variable HEW force more bankruptcies
more bailouts and stimulus programs proposed, and more funding questions arise
As one of the main reasons for the currency mayhem is the unwinding of the carry trade and is mentioned here, I’ll add the tail of this vehicle.
I recently read a brief comment on the “carry trade light”. They claim this active exchange rate policy implemented by fund managers aggravates the Yen appreciation (original source would be Thomas Stolper of GS – I didn’t find anything on Google).
I’ll try to explain and if someone would chime in to clarify more, I’d appreciate.
In the past an Australian fund manager who invested in Japanese assets could increase his return by 5 – 7 % by hedging against the Yen risk. A Japanese investor would have lost about the same return if he hedged the Australian dollar. Quite odd that one hedged against the less riskful currency but that was the selffullfilling prophecy of the carry trade.
Nowadays not only the carry trade but also the hedging unwinds and our Australian manager who saw his Japanese assets drop by 30 % only needs to rehedge the remaining 70 % (or doesn’t hedge anymore). The 30 % of Yen he sold forward, he buys on the spot market. And the Yen appreciates even more.
Could that really have a substantial impact?
Sigh, it’s gone even further than I expected and guess what ; still not benefitting from it, sigh… but frankly, most people shouldn’t be surprised at the pound’s precipitous decline- the real shocker is that it took so long for realism to set in (sorry, rebel, no gloating intended)
look at it this way, the faster things clear up, the faster we get back to some normality.
Hate to sound like some old fogey but hey, volatility means some people are still getting out of the market alive, it’s in the midst of real recession when you see the awful grind that you miss there being some life in the markets.
It is seems to me that China provides an object lesson into why it is very wise to liberalize the capital account very, very slowly. Consider this:
- the Chinese stock market has perfected cliff-diving throughout 2008;
- in any other emerging market, this would have translated in the currency cliff-diving as speculative inflows reversed;
- instead we have cliff climbing of the Chinese currency this week and others along with the USD and the JPY.
Think about what might have happened, had genius I-beat-the-index (someone wins the lottery every week) hedge fund managers been free to roam China.
As we move forward into what I suspect will be the worst world recession since the 1930s (balance sheet shrinking on a global scale will have serious consequences), China recently announced, I think, that it will introduce universal health care by 2012, and hopes to achieve 95% coverage by 2010. If I have understood correctly what they plan to do, this would be a most important policy move as it would directly impact into BW2 rebalancing: China knows that exports are out for a long time and moves to reduce households savings and thus provide massive domestic demand support. This suggests to me that one might want to be quite bold in predicting a substantial shrinkage of the Chinese trade surplus in the coming few years.
There is a simple solution to the dollar;s rise versus the currencies of the world’s weak export-oriented economies: THE FED SHOULD BUY FOREIGN CURRENCIES!
In other words, our central bank should be doing exactly what the Asian central banks have been doing for decades. Borrow dollars (long-term) and use the proceeds to build up a portfolio of foreign currencies.
This could be done by the Federal Reserve without requiring any new laws from Congress. Since 1962, the Federal Reserve has had the power to buy foreign currencies under its own account without being subject to any control by the US Treasury.
If the Fed would buy foreign currencies, it could stabilize currency markets while at the same time improving the competitiveness of American exports and building up currency reserves to protect against a future run on the dollar.
Howard Richman
http://www.tradeandtaxes.blogspot.com
i am riping to the idea that the scarcity of dollars, caused by all being sucked up to support highly levered usd investments creates deflation in every other asset class.
in any event the liquidity provided by the Fed would have been enough to alleviate everyone’s fears, had there not been enormous leverage throughout the global financial system.
moving gloabl trade into other currencies as well would be a good remedy to this dollar crunch.
Cedric:
Cedric Regula Says:
I think the treasury needs to borrow it, but that’s a glass half full, half empty argument.
Plus my $1.8T was a total of Treasury actions, like the F&F takeover, the direct purchase of MBS, FHA program, etc… I also included the more publicized actions by the Fed like the Bear deal,the AIG loan, new credit facilities that came with a dollar value on the program(these are short term, but they seem to roll over in ever larger amounts as your article indicates), and there was the opening of the Fed discount window to just about anyone that had just about anything for collateral. No dollar amount was budgeted for that, so I didn’t add it in.
Cedric have you analyzed … this money, $ 1.8 Trillion … where is it now?
Cedric: So in hindsight we are spending far more money than if the taxpayer simply bought up bad mortgages.
As far as CDS’s go, we aren’t. There are bombs out there, but they haven’t gone off.
Cedric: Since I don’t like that fix, I think they should just make all CDS null and void. The “premiums” would be a loss for some, and bad mortgages wouldn’t be insured anymore, for whatever that was worth.
That won’t work for two reasons. The second you lose your insurance, the value of your holdings drops, and so you end causing some people to go under. Second you have a huge moral hazard problem. Basically you end up punishing people that were rational and at least tried to buy insurance, and you financially reward people that issued bogus insurance policies. This is probably not a good thing since if you let people who issue bad insurance policies keep their money, then they’ll end up doing something else nasty. As it is, AIG got bailed out, but a lot of people that took stupid bets lost their jobs. If you just cancel policies, the people that took stupid bets end up looking like geniuses.
This is leaving aside the issue of how you even *can* cancel policies. For obvious reasons, the legal system makes it hard to cancel insurance policies when something bad happens.
The other problem is that the whole credit issue is a crisis of confidence. If you kill mortgage insurance (which by the way, was the main business of Freddie and Fannie) people will just stop issuing mortgages.
About CDS and derivative contracts. New York, London, and Hong Kong are all financial centers because they have English-based legal systems in which it is very difficult/impossible to cancel contracts.
Yeo: look at it this way, the faster things clear up, the faster we get back to some normality.
Or it may be that things won’t clear up and this is the “new normal.” Not necessarily a bad thing for people in the financial industry. If it becomes normal for the Dow to go up and down 800 points in a single day, this means lots of brokerage fees.
Twofish:
I would also think it’s really late now to think of annuling CDS, etc.
And by the way Twofish a CDS is not ‘mortgage insurance’.
And the settlement from the CDs doesn’t neccessarily go to the guy who originally lent the money out.
I’ve tried to clarify this repeatedly without much success.
after reading chid’s CDS 101 and the subsequent discussion, one question surfaced:
how many of these CDS’s are between parties neither whom have a direct exposure to the underlying instrument, other than the CDS itself?
of course, none of us really *know*.
but anyone care to speculate?
p.s. 2fish: whole credit issue is a crisis of confidence.
yes perhaps the whole global issue as well.
but what lies beneath confidence?
isn’t it trust?
if so, do you think that the english-based legal system has the design capabilities to handle that crisis?
p.p.s. cedric & 2fish — thanks for answering my question back in the last topic, both directly & enigmatically
4degrees north — i agree with you on capital account liberalization. I have always argued China should allow the RMB to appreciate but have never argued for capital account liberalization (unlike the Paulson treasury). I am a little less confident that the health care reform — while clearly a step in the right direction — will be big/ large enough to help with rebalancing. I am looking for a huge fiscal stimulus, highly front-loaded (and no use of export tax rebates); that would convince me that China is serious about supporting domestic demand.
Cedric: Also, I just remembered that when F&F got taken over, the CDS market declared a “credit event”. But I’m not sure what happened next, other than people started wondering about how the details and time frame of these things get worked out.
The aftermath was rather boring which is why it didn’t make the news. To redeem a CDS contract you have to present a security that is the subject of the contract. So to get a $1 in CDS return, you have to give them a bond from Freddie and Fannie, which because of the government guarantee was worth $1, and so there were lots of bookkeepping entries changing hands, but no real money.
This gets at one important point why CDS’s may not be quite the total mess that they seem at first. The bet *isn’t* “company X has a credit event and you get $1″. The bet *is* “company X has a credit event, you give me a $1 bond issued by that company and I give you $1.” This also means that how much is owned, isn’t independent of the real economy. It makes a large difference if a company is “slightly bankrupt” or “very, very bankrupt.”
Twofish:
Waht Cedric and I are discussing is that there’s actually no ‘credit crisis’ out there.
‘Credit crunch’ et al are just mythical words and what people are really discussing is that various folks were into some outrageous bets to the tune of something like $40 trillion, and they’ve lost around $1 trillion of those bets.
These bets were made in the CDS market and these amounts have nothing to do with the actual losses from reduced recovery from home loans.
gv — yes, those can of dynamics can have an impact. and the unbalanced nature of the hedging (Japanese investors in Australia don’t hedge b/c they want the carry — or don’t want to pay the cost of hedging when carry works against you — and aussie investors in Japan do hedge b/c it is cheap) is another manifestation of the global carry trade.
Stolpher incidentally is one of my favorite fx analysts.
Brad:
Glad to see you back …
I believe you would be able to throw some light on this:
From the number of mortgage foreclosure notices in Q3 2008 the total loss to banks due to reduced recovery from home loans can be estimated to be somewhere between $100 b to $200b over the last 6 quarters since home prices peaked. This is a very LARGE estimate of the reduced recovery loss.
On the other hand losses from CDS transactions are estimated to be at least around $1 Trillion.
Over the period of the ‘credit crisis’ Fed + Treasury have provided $ 1.8 Trillion in loans to banks and other FIs.
It would be useful to figure out the flows associated with this scenario, with an objective to see where the money actually is.
Twofish:
Please be clear whether you’re discussing gap insurance on a loan or a CDS contract.
A CDS contract can very well be structured exactly like a traditional gap insurance contract from the dinosaur economics world.
However in the practical hedgonomics world it’s not.
Twofish:
A CDS has a ‘referenced entity’ and a ‘credit event’. The principal amount on the CDS may or may not be the same as the principal on a particular bond.
The CDS may be for cash settlement or physical settlement.
If you have a CDS that has a physical settlement and if the notional principal is the same as that on an underlying bond, then it would be the same as a GAP insurance structurally.
Legally a CDS is OTC between two parties and the short position is subject to counterparty credit risk apart from credit risk of the referenced entity.
There’s a depository that registers CDS contracts but the parties to the contract may or not choose to register.
In a traditional gap insurance, regulation would ensure that the issuer has capital adequancy but in a CDS there’s no such requirement.
The parties to a traditional gap insurance can only be the lender or the borrower going short with the insurer going long.
In case of a CDS the parties to the contract may or may not have any connection with the underlying loan or the referenced entity.
Howard Richman,
You have seen the light! The US should indeed buy foreign currencies, as I have been saying for years – see eg http://reservedplace.blogspot.com/2008/04/us-economic-policy-shot-in-foot-2.html See also the discussion between myself and jkh on the previous thread.
It looked as if the US had missed its opportunity as the dollar sank, but now it has another chance.
By the way, exchange rate codes (SAR, ZAR etc) are defined by ISO standard 4217 – for a list see: http://en.wikipedia.org/wiki/ISO_4217
At this link you can see the most conservative estimate of the CDS market.
http://www.dtcc.com/news/press/releases/2008/tiw.php
DTCC Addresses Misconceptions About the Credit Default Swap Market
New York, October 11, 2008 – The idea that the industry lacks a central registry for over-the-counter (OTC) credit default swaps (CDS) is grossly misleading and has resulted in inaccurate speculation on a number of matters, including the overall size of the market, its role in the mortgage crisis, and the size of potential payment obligations under credit default swaps relating to Lehman Brothers. The extent to which such speculation has fueled last week’s market turmoil is difficult to determine. The facts are these:
Central Trade Registry
In November 2006, The Depository Trust and Clearing Corporation (DTCC) established its automated Trade Information Warehouse as the electronic central registry for credit default swaps. Since that time, the vast majority of credit default swaps traded have been registered in the Warehouse. In addition, all of the major global credit default swap dealers have registered in the Warehouse the vast majority all contracts executed among each other before that date.
Size of the Market
Reported estimates of the size of the credit default swap market have so far been based on surveys. These surveys tend to overstate the size of the market due to each party to a trade separately reporting its own side. Thus, when two parties to a single $10 million dollar trade each report their “side” of the trade, the amount reported is $20 million, which overstates the actual size by a factor of two since both reports relate to a single $10 million contract. When examining the outstanding amount of actual contracts registered in the Warehouse (not separately reported “sides”) as of October 9, 2008, credit default swap contracts registered in the Warehouse totaled approximately $34.8 trillion (in US Dollar equivalents). This is down significantly from the approximately $44 trillion that were registered in the Warehouse at the end of April this year.
Percentage of the Market Related to Mortgages
Less than 1% of credit default swap contracts currently registered in the Warehouse relate to particular residential mortgage-backed securities. Mortgage-related index products also have some components relating to residential mortgages and, as a whole, also constitute a relatively small fraction of total credit default swaps registered in the Warehouse.
Payment Obligations Related to the Lehman Bankruptcy
One of the many central servicing functions of the Trade Information Warehouse is to caculate payments due on registered contracts, including cash payments due upon the occurrence of the insolvency of any company on which the contracts are written. Calculated amounts are netted on a bilateral basis, and then, for firms electing to use the service, transmitted to CLS Bank (the world’s central settlement bank for foreign exchange) where they are combined with foreign exchange settlement obligations and settled on a multi-lateral net basis. Currently, all major global credit default swap dealers use CLS Bank to settle obligations under credit default swaps. It is expected that all major institutional players in the credit default swap market will use the same process for settlement by the end of 2009.
The payment calculations so far performed by the DTCC Trade Information Warehouse relating to the Lehman Brothers bankruptcy indicate that the net funds transfers from net sellers of protection to net buyers of protection are expected to be in the $6 billion range (in U.S. dollar equivalents).
DTCC has long supported the U.S. and global capital markets as a critical part of their operational infrastructure.We stand ready to play a constructive role in whatever overall regulatory environment ultimately emerges for the credit default swap market. We do believe, however, that whatever environment emerges should be based on assessment of the facts as they stand, rather than speculation.
About DTCC
DTCC, through its subsidiaries, provides clearance, settlement and information services for equities, corporate and municipal bonds, government and mortgage-backed securities, money market instruments and over-the-counter derivatives. In addition, DTCC is a leading processor of mutual funds and insurance transactions, linking funds and carriers with their distribution networks. DTCC’s depository provides custody and asset servicing for more than 3.5 million securities issues from the United States and 110 other countries and territories, valued at US$40 trillion. In 2007, DTCC settled more than US$1.86 quadrillion in securities transactions. DTCC has operating facilities in multiple locations in the United States and overseas.
DTCC Deriv/SERV LLC, a wholly-owned subsidiary of DTCC, provides automated matching and confirmation for OTC derivatives contracts, including credit, equity and interest rate derivatives. According to major market participants, over 90% of credit derivatives traded globally are electronically confirmed through Deriv/SERV. The Trade Information Warehouse, a service offering of Deriv/SERV launched in November 2006, is the market’s first and only comprehensive trade database and centralized electronic infrastructure for post-trade processing of OTC derivatives contracts over their lifecycles, from confirmation through to final settlement.
1.8 Trillion?
Increases in bank credit & the money stock can be offset by indirectly raising reserve ratios (pegs). Depending upon the FFR formula used for the payment of interest on “excess reserves”, the FED’s new tool can be used as a credit control device (FFR minus 75 basis points on Oct. 9, to (-)35 basis points on Oct. 23).
I.e., payment of interest on excess, & required reserves (inter-bank deposits, held in the Reserve Banks, owned by the member banks, or excess & legal reserves), is method by which the “trading desk” can raise commercial bank reserve requirements .
I.e., the higher the volume of discretionary or liquidity reserves held by the banks; where risk-free payments are applied, (excess reserves & required reserve balances), the lower the banking system’s “ expansion coefficient” , or weighed arithmetic average of reserve ratios applicable to deposit liabilities.
Presumably, the volume of inter-bank lending, and borrowing, will be reduced. I.e., the Reserve Banks will attract a disproportionately larger volume of (interest-bearing) unused, excess-balances, and this will displace trading in the FFR market (where the market risk is unknown).
These balances and potentially excess vault cash, excess clearing balances, and pass-through balances, may be increased, or redistributed, and add to the excess, interest-bearing reserves.
Since 1942 bankers have remained fully “lent up”, i.e., they held no excessive amount of excess legal lending capacity to finance business (or consumers). Excess reserves were used to acquire a piece of the national debt or other creditorship obligations that are eligible for bank investment. “Pushing on a string”?
Chid:
Re: DTCC clarifications of our misconceptions of the Shadow Insurance Industry.
Now I’m really confused.
“Less than 1% of credit default swap contracts currently registered in the Warehouse relate to particular residential mortgage-backed securities.”
I thought the worry was that CDS are written against MBS, or worse yet, CDOs. Then they could have puts and calls in the CDO futures market and a highly leveraged GS or hedge fund could naked short the global financial system down to zero.
But that’s not it.
There’s this instead!
“One of the many central servicing functions of the Trade Information Warehouse is to calculate payments due on registered contracts, including cash payments due upon the occurrence of the insolvency of any company on which the contracts are written.”
So it’s all the companies in the world that they are pretending to insure against bankruptcy, with no capital requirement from the seller, just an implicit backstop from taxpayers.
At least there is the “sanctity of contracts” in the financial centers of the world which should give the buyers of credit swaps (not legal to call it insurance) a bit of confidence that moral hazard is still alive and working well.
Chid:
Here’s the list that adds up to $1.8B. I found it on the RGE site, posted by someone adding up the headline news. Like I say, it’s a combination of long term “investments”, and short term borrowing facilities. So it’s not spending, but the Treasury still needs to finance in the next year.
Also, it does not include an amount for expanded discount window borrowings(watch for that in the Fed balance sheet), nor the latest money market guarantees, or money market purchases by that brown nose PIMCO company, nor any other nationalizing of the S&P 500, or exchanges in other parts of the world for that matter.
Also no amount for swaps with foreign CBs, since we are holding their money in exchange. Tho as luck would have it, we might lose money on that one.
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—Up to $700 billion to buy assets from struggling institutions. The plan is aimed at sopping up residential and commercial mortgages from financial institutions but gives Treasury broad latitude.
—Up to $50 billion from the Great Depression-era Exchange Stabilization Fund to guarantee principal in money market mutual funds to provide the same confidence that consumers have in federally insured bank deposits.
—The Fed committed to make unspecified discount window loans to financial institutions to finance the purchase of assets from money market funds to aid redemptions.
—At least $10 billion in Treasury direct purchases of mortgage-backed securities in September. In doubling the program on Friday, the Treasury said it may purchase even more in the months ahead.
—Up to $144 billion in additional MBS purchases by Fannie Mae and Freddie Mac.The Treasury announced they would increase purchases up to the newly expanded investment portfolio limits of $850 billion each. On July 30, the Fannie portfolio stood at $758.1 billion with Freddie’s at $798.2 billion.
—$85 billion loan for AIG, which would give the Federal government a 79.9 percent stake and avoid a bankruptcy filing for the embattled insurer. AIG management will be dismissed.
—At least $87 billion in repayments to JPMorgan Chase for providing financing to underpin trades with units of bankrupt investment bank Lehman Brothers. Paulson said over the weekend he was adamant that public funds not be used to rescue the firm.
—$200 billion for Fannie Mae and Freddie Mac. The Treasury will inject up to $100 billion into each institution by purchasing preferred stock to shore up their capital as needed. The deal puts the two housing finance firms under government control.
—$300 billion for the Federal Housing Administration to refinance failing mortgage into new, reduced-principal loans with a federal guarantee, passed as part of a broad housing rescue bill.
—$4 billion in grants to local communities to help them buy and repair homes abandoned due to mortgage foreclosures.
—$29 billion in financing for JPMorgan Chase’s government-brokered buyout of Bear Stearns in March. The Fed agreed to take $30 billion in questionable Bear assets as collateral, making JPMorgan liable for the first $1 billion in losses, while agreeing to shoulder any further losses.
—At least $200 billion of currently outstanding loans to banks issued through the Fed’s Term Auction Facility, which was recently expanded to allow for longer loans of 84 days alongside the previous 28-day credits.
$1,800,000,000,000.00
RebelEconomist writes, “Howard Richman, You have seen the light! The US should indeed buy foreign currencies, as I have been saying for years.”
Although RebelEconomist and I disagree on whether the United States should oppose mercantilism, we agree on this issue completely. This one is a no-brainer.
Buying foreign currency right now would help to stabilize world currency markets while helping U.S. production and while giving the Fed currency reserves that could help in case of a run on the dollar.
Not only that, but it would likely be profitable. These currencies are irrationally low compared to the dollar at present. The Fed would buy the currencies and then use the proceeds to buy government bonds, just as the Asian countries have been buying dollars and then using the proceeds to buy U.S. Treasuries.
Howard Richman
http://www.tradeandtaxes.blogspot.com
HR- you are right FED must buy foreign currencies if it wants make china depeg its currency. But Brad argues china does not have
capital account convertability. Then buy japanese yen, swiss franc and euro. The excess dollar has to be mopped by china to defend its peg. If everybody blocks current account convertabilty, buy all the cash circulating in the market. It will squeeze liquidity completely out in the chinese banking system
and that will force them to depeg and then US can sell foreign currencies after defaulting on all their debt commitments to foreigners. US dollar will not fall in this case simply because defaulting and at the same time holding enough foreign currencies to make the transition to balanced economy will enable them to survive in the transition period. IT means all foreigners have given the goods to US essentially for free.
Chid,
You said CDS loss is likely to be over $1T+. This means about 2-3% loss of CDS notional, which seems to be between $35T-$55T.
I think your estimate is a bit too high. Here I try to explain why I think so.
- Lehman CDS outstanding notional was $400B but net was something between $4-8B (See Yves’ comment at the bottom http://www.nakedcapitalism.com/2008/10/mixed-news-on-credit-crunch-front-libor.html)
- Lehman CDS auction result was 8.6cents/dollar
- Means Lehman CDS loss was 0.9-1.8% of notional
- Not all loans CDS’s are written on went (or will go) as bad as Lehman’s case
- Which means total loss on CDS should be lower than the 0.9-1.8% estimated above.
Would appreciate your thoughts.
Also, Chid & Twofish,
I found contradicting comments from you two… Can either of you help me clarifying basic understanding CDS?
Chid’s example had writing $1M of CDS on Twofish’s $300,000 mortgage.
But, Twofish’s comment says, “To redeem a CDS contract you have to present a security that is the subject of the contract. So to get a $1 in CDS return, you have to give them a bond from Freddie and Fannie…”
So the question is:
- Let’s assume that the CDS buyers come up with the mortgage paper ($300,000) of Twofish. (Maybe they owned it before they bought the CDS or they bought it in the market afterward) Chid will pay.
What happens to the $700,000 remaining CDS?? Will Chid pay them too??
To forestall the chronic depreciation of our dollar, a “free fall”, it will be necessary to eliminate the trade deficit and operate with a trade surplus.
And a “over valued” dollar is the principal contributor to our burgeoning trade deficits.
This cannot be achieved by resorting to any type of financial gimmickry. Central bankers are powerless to alter long-term factors that determine the supply of, and the demand for, any particular country’s currency. The chronic and accelerating deficit in our balance of trade is one such factor.
If the dollar were really overvalued, speculators would quickly drive its price down to approximately its purchasing power parity level. Restrictions on, and the enforcement of, black market currency exchanges, are mere palliatives.
Since mid-1970, the foreign exchange value of the dollar has been determined in the open market subject to all of the vicissitudes of a competitive market.. In such a market, it is a contradiction of terms to say that the price of the dollar in terms of foreign currencies is either overvalued, or undervalued, in a chronic sense.
Foreign exchange markets register many unwarranted speculative fluctuations, and these destabilizing fluctuations, are caused by speculators, or by ill-timed, or ill-informed, central bank intervention. Such distortions depart from the underlying long-term supply and demand factors, but these also, are temporary conditions.
Central bankers can buy up the currency of the deficit country, and keep it off the market–temporarily. But these powers have a limited and short term effect. Soon or late central banks will have to reverse their positions. And then this country’s fundamental problems, will return in aggregated form.
To defend the dollar, our standard of living, and become effectively competitive in foreign markets, the U.S. needs to sell higher quality, & lower cost, goods & services. Inferior quality is not a good buy at any price. This declining competiveness of our manufactured goods in world markets, accounts for our mammoth trade deficits.
This is the first time that a reserve currency country could operate with chronic international deficits and not have its currency “dethroned”.
Unless the U.S. is able to make fundamental reforms requisite to successfully compete in international markets, the continued decline of the dollar will finally force a payments balance on us. Under these circumstances, we can expect a long- term deterioration in the stand of living of the vast majority of the people in this country. This country will be forced into economic isolation & into an increasingly totalitarian mold.
The FFR is 1.5% & (1.5% – .35 basis points = 1.15% or the interest rate on excess reserves). This compares to .96% for 3 month T-Bills on 10/23/08.
The required interest rate payment is 1.4%. This is of course more restrictive and is a disincentive to loan or invest.