We have a national crisis and the instead of focusing on the issue at hand we see politician load up the Treasury bail-out (TARP)plan with tax breaks of all types. Included in the bill are things like: a repeal of the 39 cent children's arrow tax, tax breaks for alternative energy, corporate tax write-offs, incentives for investing in Indian reservations Notice that all of these are not even focused on the housing markets which were the initial problem of the credit crisis. Without those Christmas ornaments, the bill would not have passed.
Leadership from both presidential candidates who have both stated that they are for cutting waste and earmarks agreed with the bill. No one said stop the process, so not only are we going to pay for a bail-out but we are going to cut revenue to make up for the the debt shock.
Why can't we get a clean bill on a single topic so that we have clarity on what is being passed and a national focus on the direct problem on hand?
"Disciplined Systematic Global Macro Views" focuses on current economic and finance issues, changes in market structure and the hedge fund industry as well as how to be a better decision-maker in the global macro investment space.
Sunday, October 5, 2008
Unintended consequences and deposit insurance
Save the banks! Save the depositors! We need to protect them, so let's increase the level of deposit insurance from $100,000 to $250,000. There is no question that increasing the deposit insurance for bank clients will stem withdrawals from risky banks to the Treasury market. Any reduction in deposit outflow will allow for less delevering of the banking system which will reduce the credit crunch. Unfortunately, the overall impact on markets will not be clear as the investors react to the change.
First, the increase in deposit insurance will allow poorly managed and capitalized banks to continue to exist. At 8,000, there are still too many banks in the US. If depositors are protected, we will allow some of these institutions to continue when there may be a reason for closure. Of course, the government may want to slow and control this process and not have the extra fright from more bank failures. Nevertheless, there are some institutions whose aggressive practices are responsible for this mess and they should not be allowed to fall under the insurance umbrella
Second, we are going to see more cross border moves in banks because of changes in deposit insurance polices across countries. Ireland has insured all deposits which will clearly cause some savvy depositors to move money to Ireland to take advantage of the benefit. These insurance scheme will accentuate the risk differs in banks. Risk shifting will move from the private institutions to government institutions.
Three, the increase was necessary because money market mutual funds were given insurance by the Treasury Department so they would not break the buck. If the Treasury was willing to give insurance to money funds for a three month period, these funds were given a better insurance deal than banks. The banks, of course, would want a better deposit insurance scheme.
The actions of the government will cause portfolio rebalancing effects which may shift money to areas which were not originally intended. The funds which are left out of any insurance scheme will be at a disadvantage to all others and will move to those places where there is a guarantee. It is not clear that this is what the government wants to happen.
First, the increase in deposit insurance will allow poorly managed and capitalized banks to continue to exist. At 8,000, there are still too many banks in the US. If depositors are protected, we will allow some of these institutions to continue when there may be a reason for closure. Of course, the government may want to slow and control this process and not have the extra fright from more bank failures. Nevertheless, there are some institutions whose aggressive practices are responsible for this mess and they should not be allowed to fall under the insurance umbrella
Second, we are going to see more cross border moves in banks because of changes in deposit insurance polices across countries. Ireland has insured all deposits which will clearly cause some savvy depositors to move money to Ireland to take advantage of the benefit. These insurance scheme will accentuate the risk differs in banks. Risk shifting will move from the private institutions to government institutions.
Three, the increase was necessary because money market mutual funds were given insurance by the Treasury Department so they would not break the buck. If the Treasury was willing to give insurance to money funds for a three month period, these funds were given a better insurance deal than banks. The banks, of course, would want a better deposit insurance scheme.
The actions of the government will cause portfolio rebalancing effects which may shift money to areas which were not originally intended. The funds which are left out of any insurance scheme will be at a disadvantage to all others and will move to those places where there is a guarantee. It is not clear that this is what the government wants to happen.
Friday, October 3, 2008
The new world of forward FX prices -less liquidity
The dollar has been one of the few assets which have shown strength. Of course, the European would think differently with their falling euro. Yet, the credit debacle has problems on the most liquid market in the world. This is due not the lack of credit to trade FX but associated with the pricing of forward which are tied to banks funding costs.
We watch spreads in the forward market very closely and have seen a significant increase in spreads and volatility which far exceeds the volatility in the spot market. Obviously, the volatility in the forward market is a combination of three things, the volatility of spot, interest differentials and the covariance between the two. The increase in interest differentials have not been offset by the covariance.
If fact, forward prices have become more jagged as short rate funding problems have carried over to pricing in ways that have not been seen in longer dates pricing. In fact, we would say that some of the dollar rally on certain days is associated with the high rates in the US relative to Europe even though the target rates in Europe are higher. These flows actually will change intraday as the Fed funds market clears. Even the most liquid markets in the world are seeing the effects of the credit crisis.
We watch spreads in the forward market very closely and have seen a significant increase in spreads and volatility which far exceeds the volatility in the spot market. Obviously, the volatility in the forward market is a combination of three things, the volatility of spot, interest differentials and the covariance between the two. The increase in interest differentials have not been offset by the covariance.
If fact, forward prices have become more jagged as short rate funding problems have carried over to pricing in ways that have not been seen in longer dates pricing. In fact, we would say that some of the dollar rally on certain days is associated with the high rates in the US relative to Europe even though the target rates in Europe are higher. These flows actually will change intraday as the Fed funds market clears. Even the most liquid markets in the world are seeing the effects of the credit crisis.
Forget the “Black Swan”, we should have seen the credit crisis coming
The magnitude of the credit problem is bigger than expected, but let’s not act like we are surprised by the the slowing economy. Let’s make three simple points about business cycles:
1. Lending standards were relaxed which increased the risk of default. Generally, lending standards are always relaxed as we move further away from the last recession. Bad behavior is discounted as we move further away from the last time poor lending practices were employed.
2. Interest rates came off significant lows which increased the cost of borrowing. While still low, the Fed fund rate went from 1% to 5.25 in a little over 2 years. As economies improve, rates go up which reduces lending.
3. A slowing economy from the commodity shock will increase credit risk. Higher credit risk, tightening credit standards, higher risk premiums are all part of the normal credit cycle. Credit spreads should be higher as the economy slows.
The three stylized facts about business cycles exist no matter what kind of regulation or even if there was no greed on Wall Street. A bail-out is not going to change the normal behavior of the credit cycle. There was no unforeseen event like Nassim Taleb’s “Black Swan”. (The stock market crash was a different story.) Firms are expected to fail. Given the central role finance has played in the US service economy, it should not be surprised that we have had bank and brokerage failures. This has happened in the recession of 1990. Citibank almost failed at that time. The saving and loan industry was almost destroyed when coupled with the excesses of the 1980’s.
Why are we bringing these issues up? Because whatever the policies or bail-out plans that are put forth, there will still be significant pain as the economy adjusts. We have to accept this truth.
1. Lending standards were relaxed which increased the risk of default. Generally, lending standards are always relaxed as we move further away from the last recession. Bad behavior is discounted as we move further away from the last time poor lending practices were employed.
2. Interest rates came off significant lows which increased the cost of borrowing. While still low, the Fed fund rate went from 1% to 5.25 in a little over 2 years. As economies improve, rates go up which reduces lending.
3. A slowing economy from the commodity shock will increase credit risk. Higher credit risk, tightening credit standards, higher risk premiums are all part of the normal credit cycle. Credit spreads should be higher as the economy slows.
The three stylized facts about business cycles exist no matter what kind of regulation or even if there was no greed on Wall Street. A bail-out is not going to change the normal behavior of the credit cycle. There was no unforeseen event like Nassim Taleb’s “Black Swan”. (The stock market crash was a different story.) Firms are expected to fail. Given the central role finance has played in the US service economy, it should not be surprised that we have had bank and brokerage failures. This has happened in the recession of 1990. Citibank almost failed at that time. The saving and loan industry was almost destroyed when coupled with the excesses of the 1980’s.
Why are we bringing these issues up? Because whatever the policies or bail-out plans that are put forth, there will still be significant pain as the economy adjusts. We have to accept this truth.
Subscribe to:
Posts (Atom)