Tag Archive for 'Federal Reserve'

Terrible news from Apple (AAPL)

Published on 25 January 2012 in Academia, Economics, Europe, Finance, UK and USA. Tags: , , , , , , , , . 0 Comments

Apple just reported their profits for 2011Q4.  It turns out that they made rather a lot of money.  So much, in fact, that they blew past/crushed/smashed expectations as their profit more than doubled on the back of tremendous growth in sales of iPhones and iPads.  [snark] I’ll bet nobody’s talking about Tim Cook being gay now. [/snark]

It’s an incredible result; stunning, really. I just wish it didn’t make me so depressed.

I salute the innovation and cheer on the profits. That is capitalism at its finest and we need more of it.

It’s that f***king mountain of cash (now up to $100 billion) that concerns me, because it’s symptomatic of what is holding America (and Britain) in the economic doldrums.

The return Apple will be getting on that cash will be miniscule, if it’s positive at all, and conceivably negative.  Standing next to that, their return on assets excluding cash is phenomenal.

Why aren’t they doing something with the cash? Are they not able to expand profits still further by expanding quantities sold, even in new markets? Are there no new internal projects to fund? No competitors to buy out? Why not return it to shareholders via dividends or share buybacks?

Logically, a company holds cash for some combination of three reasons: (a) they use it to manage cash flow; (b) they can imagine buying an outside asset (a competitor or some other company that might complement them) in the near future and they want to be able to move quickly (and there’s no M&A deal that’s agreed upon faster than an all cash deal); or (c) they want to demonstrate a degree of security to offset any market perceived risk with their debt.

Apple long ago surpassed all of these benefits.  The net marginal value of Apple holding an extra dollar of cash is negative because it returns nothing and incurs a lost opportunity cost.  So why aren’t their shareholders screaming at them for wasting the opportunity?

The answer, so far as I can see, is because a significant majority of AAPL’s shareholders are idiots with a short-term focus. They have no goddamn clue where else the money should be and they’re just happy to see such a bright spot in their portfolio.  Alternatively, maybe the shareholders aren’t complete idiots — Apple’s P/E ratio has been falling for a while now – but the fundamental point is that they have a mountain of cash that they’re not using.

In 2005 that wouldn’t have been as much of a problem because the shadow banking system was in full swing, doing the risk/liquidity/maturity transformation thing that the financial industry is meant to do and so getting that money out to the rest of the economy.[*] Now, the transformation channel is broken, or at least greatly impaired, and so nobody makes any use of Apple’s billions. They just sit there, useless as f***, while profitable SMEs can’t raise funds to expand and 15% of all Americans are on food stamps.

Don’t believe me?  Here’s a graph from the Bank of England showing year-over-year changes in lending to small- and medium-sized enterprises in the UK.  I can’t be bothered looking for the equivalent data for the USA, but you can rest assured it looks similar.  The report it’s from can be found here (it was published only a few days ago).  The Economist’s Free Exchange has some commentary on it here (summary:  we’re still in trouble).

So what is happening to all that money?  Well, Apple can’t exactly stick it in a bank account, so they repo it, which is a fancy way of saying that they lend it to a bank (or somebody else in the financial industry) and temporarily take some high quality asset like a US government bond to hold as collateral.  They repo it because that’s all they can do now — there are no AAA-rated, actually safe, CDO tranches being created by the shadow banking system any more, they’re too big to make use the FDIC’s guarantee (that’s an excellent paper, btw … highly recommended) and so repo is all they have left.

But the financial industry is stuck in a disgusting mess like some kid’s hair with chewing gum rubbed through it. They’re all just as scared as the next guy (especially of the Euro problems) and so they’re parking it in their own accounts at the Fed and the BoE.  As a result, “excess” reserves remain at astronomical levels and the real economy makes no use of Apple’s billions.

That’s a tragedy.

 

 

 

[*] Yes, the shadow banking industry screwed up. They got caught up in real estate fever and sent (relatively) too much money towards property and too little towards more sustainable investments. They structured things in too opaque a manner, failed to have public price discovery and operated under distorted incentives. But they operated. Otherwise useless cash was transformed into real investment and real jobs. Unless that comes back, America and the UK will stay in their slow, painful household deleveraging cycle for another frickin’ decade.

For the first time since 2004q4, US household debt is less than 100% of disposable income

Published on 10 October 2011 in USA. Tags: , , , . 0 Comments

In today’s story of household “deleveraging” in America (okay, so this is very, very late since the data were released in August. Still … ):

2011q2 was the first time since 2004q4 that U.S. Household debt was less than 100% of Disposable Personal Income (click on the image for a less squished version):

2005q1 and 2011q1 were both at 100% exactly, or close enough.

In the period 1999q2 to 2006q3, distressed household debt averaged 4.35% and was never higher than 5.06%. Distressed household debt was at 9.86% in 2011q2, having peaked at 11.98% in 2009q4.  As the Fed’s credit conditions report highlights, that was the 6th straight quarter of improvement.  However, the quarter-to-quarter falls have been quite low:  0.04 percentage points (2009q4 to 2010q1), 0.58 p.p., 0.26 p.p., 0.31 p.p., 0.31 p.p. and 0.62 p.p. (2011q1 to 2011q2).  If we assume a continuing fall of 0.4 percentage points per quarter, it’ll take another 14 quarters – that’s 2014q4 – to return to the pre-crisis average.

Of course, a resumption of growth in consumption is not contingent on that happening (maybe we’ll see a jump in incomes for some reason – I’m looking at you, policy makers), but it’s still pretty depressing.

Crucially, too, everything here only looks at aggregate, or average, numbers and if you think the balance-sheet recession story carries any weight at all, you should be very, very interested in the distributional effects.

Some brief thoughts on QE2

Published on 4 November 2010 in Economics, Finance and USA. Tags: , , , , , , , , . 0 Comments
  • Instead of speaking about “the interest rate” or even “the yield curve”, I wish people would speak more frequently about the yield surface:  put duration on the x-axis, per-period default risk on the y-axis and the yield on the z-axis.  Banks do not just borrow short and lend long; they also borrow safe and lend risky.
  • Liquidity is not uniform over the duration-instantaneous-default-risk space.   Liquidity is not even monotonic over the duration-instantaneous-default-risk space.
  • There is still a trade-off for the Fed in wanting lower interest rates for long-duration, medium-to-high-risk borrowers to spur the economy and wanting a steep yield surface to help banks with weak balance sheets improve their standing.
  • By keeping IOR above the overnight rate, the Fed is sterilising their own QE (the newly-injected cash will stay parked in reserve accounts) and the sole remaining effect, as pointed out by Brad DeLong, is through a “correction” for any premiums demanded for duration risk.
  • Nevertheless, packaging the new QE as a collection of monthly purchases grants the Fed future policy flexibility, as they can always declare that it will be cut off after only X months or will be extended to Y months.
  • It seems fairly clear to me that the announcement was by-and-large expected and so “priced in” (e.g. James Hamilton), but there was still something of a surprise (it was somewhat greater easing than was expected) (e.g. Scott Sumner).
  • Menzie Chinn thinks there is a bit of a puzzle in that while bond markets had almost entirely priced it in, fx-rate markets (particularly USD-EUR) seemed to move a lot.  I’m not entirely sure that I buy his argument, as I’m not entirely sure why we should expect the size of the response to a monetary surprise to be the same in each market.

Paying interest on (excess) reserves (Updated)

Published on 28 July 2010 in Economics, Finance and USA. Tags: , , , , , , , , , . 0 Comments

The U.S. Federal Reserve is currently paying 0.25% interest on the reserve accounts of depository institutions.  This is therefore, at present, the primary rate of policy concern (as opposed to the Fed Funds rate):  if a bank can’t get a rate of return that, when adjusted for risk, is greater than 0.25%, they will stick their money in their reserve account at the Fed.  Among others, Scott Sumner [blog] has called this policy a mistake.

There is an economic cost to the policy.  0.25% isn’t much, but it’s the risk-free aspect that complicates things.  If banks’ risk aversion or their perception of the risks associated with investments are high, then a truely risk-free 0.25% could look quite attractive.  With the interest rates on US treasuries so low, there’s certainly reason to believe that risk aversion is still abnormally high at the moment.  Whether the demand for loans is coming from particularly risky projects, or is perceived to be, I don’t know (is there any way of knowing?).

So why have it at all?  I suppose I support the paying of interest on required reserves.  The banks don’t get a choice with them, so it seems only fair that they be compensated.  But for excess reserves, there would need to be an offsetting benefit to justify the policy.  One benefit will be that the interest is paid with new money, so it’s a way of quietly helping banks improve their balance sheets.  There’s currently about US$1 trillion in excess reserves, so that’s about US$2.5 billion per year.  That may be a lot of money to you and me, but it’s not much more than a rounding error to the US banking system as a whole.  Still, it’s something.  Another benefit, depending on your point of view, is that by attracting all that money into excess reserves, the Fed sterilised the QE they engaged in last year.  If you feel that the sterilised QE has caused lower long-term interest rates and hold that those rates are the ones that most significantly drive the economy and distinctly dislike inflation, then you’d probably judge the affair to have been a success [I include the weasel words because I am no longer certain].  A third benefit, which is really a further justification of the second, is that there is evidence that the Fed’s QE appears to have lowered not just US rates, but foreign rates as well.  In that case, then you probably want to sterilise the fraction going to other countries (bad enough, one might think, that America is fixing the rest of the world; it would be unthinkable if America also had to suffer inflation by doing so).

Anyway, all of that is by way of getting around to this point:  via Bruce Bartlett, I’ve just discovered that Sweden also pays interest on reserve deposits, normally 0.75 percentage points lower than their repo rate.  But, crucially, their repo rate is currently only 0.50%, which means that their deposit rate is negative, at -0.25%.

For myself, I tend to think that the interest rate on excess reserves should be lowered.  My argument is similar to what I imagine Scott Sumner would say, so I should also explain his view a little, to the extent that I understand him.  With nominal GDP at US$14 trillion, the US$1 trillion sitting in excess reserves is a very, very large amount of money.  If it were released into the economy, it would be a huge stimulus (even if the money multiplier/velocity of money is temporarily low).  By choosing to sterilise their QE (presumably out of fear of inflation), the Fed has turned what could have been a tremendously effective stimulus into a mediocre one at best.  Scott is rather more sanguine about inflation in general than I am (he favours targeting NGDP; I suspect that this graph would make him want to tear his hair out), but even if the Fed wishes to target inflation of, say, the near-universally accepted benchmark of 2%, then with actual current inflation down at 0.5% and expected future inflation below 1.5% for most of the next 10 years and falling, the sterilisation has been excessive.

Update 6 Aug 2010:

The FT’s Alphaville has gathered the arguments for and against.  Here are three arguments (and their counter-arguments) for keeping the Interest on Reserves (IoR) unchanged:

First, from Ben Bernanke himself, made in recent congressional testimony:

The rationale for not going all the way to zero has been that we want the short-term money markets like the federal funds market to continue to function in a reasonable way because if rates go to zero there will be no incentive for buying and selling federal funds, overnight money in the banking system, and if that market shuts down … it’ll be more difficult to manage short-term interest rates, for the Federal Reserve to tighten policy sometime in the future. So there’s really a technical reason having to do with market function that motivated the 25 basis points interest on reserves.

I think this is silly. It’ll be more difficult to manage short-term interest rates in the future only if, following an effective shut-down of the federal funds market, it becomes costly to start it back up again. I seriously doubt that the banks are going to take their existing staff, processes and infrastructure dedicated to this and throw them out the window. Heck, in a Q&A session after his testimony, Mr Bernanke stated that lowering the interest rate on reserves is a (serious) option in the event that the FMOC decides that further stimulus is warranted:

But broadly speaking, there are a number of things we could consider and look at; one would be further changes or modifications of our language or our framework describing how we intend to change interest rates over time — giving more information about that, that’s certainly one approach. We could lower the interest rate we pay on reserves, which is currently one-fourth of 1%.

A second viewpoint, put forward by Dave Altig (of the Atlanta Fed) and Joseph Abate (of Barclays Capital), is that

If banks didn’t get interest from the Fed they would shift those funds into short-term, low-risk markets such as the repo, Treasury bill and agency discount note markets, where the funds are readily accessible in case of need. Put another way, Abate doesn’t see this money getting tied up in bank loans or the other activities that would help increase credit, in turn boosting overall economic momentum.

I think that Jim Hamilton’s response to this is excellent, so let me just quote it in full:

But Dave doesn’t quite finish the story. If I as an individual bank decide that a repo or T-bill looks better than zero, and use my excess reserves to buy one of these instruments, I simply instruct the Fed to transfer my deposits to the bank of whoever sold it to me. But now, if that bank does nothing, it would be left with those reserve balances at the end of the day on which it earns nothing, whereas it, too, could instead get some interest by going with repos or T-bills. The reserves never get “shifted into short-term, low-risk markets”– instead, by definition, they are always sitting there, at the end of the day, on the balance sheet of some bank somewhere in the system.

The implicit bottom line in the Abate story is that the yields on repos and T-bills adjust until they, too, look essentially to be zero, so that banks in fact don’t care whether they leave a trillion dollars earning no interest every day.

The essence of this world view is that there are two completely distinct categories of assets– cash-type assets which pay no interest whatever, and risky investments like car loans that banks don’t want to make no matter how much cash they hold.

But I really have trouble thinking in terms of such a two-asset world. I instead see a continuum of assets out there. As a bank, I could keep my funds overnight with the Fed, I could lend them in an overnight repo, I could buy a 1-week Treasury, a 3-month Treasury, a 10-year Treasury, or whatever. Wherever you want to draw a line between available assets and claim those on the left are “cash” and those on the right are “risky”, I’m quite convinced I could give you an example of an asset that is an arbitrarily small epsilon to the right or the left of your line. Viewed this way, I have a hard time understanding how pushing a trillion dollars at the shortest end of the continuum by 25 basis points would have no consequences whatever for the yield on any other assets.

Finally, back with Dave Altig, there is the argument that:

the IOR policy has long been promoted on efficiency grounds. There is this argument for example, from a New York Fed article published just as the IOR policy was introduced:

“… reserve balances are used to make interbank payments; thus, they serve as the final form of settlement for a vast array of transactions. The quantity of reserves needed for payment purposes typically far exceeds the quantity consistent with the central bank’s desired interest rate. As a result, central banks must perform a balancing act, drastically increasing the supply of reserves during the day for payment purposes through the provision of daylight reserves (also called daylight credit) and then shrinking the supply back at the end of the day to be consistent with the desired market interest rate.

“… it is important to understand the tension between the daylight and overnight need for reserves and the potential problems that may arise. One concern is that central banks typically provide daylight reserves by lending directly to banks, which may expose the central bank to substantial credit risk. Such lending may also generate moral hazard problems and exacerbate the too-big-to-fail problem, whereby regulators would be reluctant to close a financially troubled bank.”

Put more simply, one broad justification for an IOR policy is precisely that it induces banks to hold quantities of excess reserves that are large enough to mitigate the need for central banks to extend the credit necessary to keep the payments system running efficiently. And, of course, mitigating those needs also means mitigating the attendant risks.

But, to me, this really sounds like an argument for having higher reserve requirements, not an argument for encouraging excess reserves.  I’m all for paying interest on required reserves and setting the fraction required at whatever level you judge necessary to ensure the operation of the payments system.  But don’t try to shoe-horn that argument into keeping interest payments on excess reserves.

Nassim Taleb takes bat, ball; goes home

Published on 1 December 2009 in Economics, Epistemology and USA. Tags: , , , , . 2 Comments

The author of The Black Swan doesn’t approve of the looming reappointment of Ben Bernanke as chairman of the US Federal Reserve.  Writing in the Huffington Post, he says:

What I am seeing and hearing on the news — the reappointment of Bernanke — is too hard for me to bear. I cannot believe that we, in the 21st century, can accept living in such a society. I am not blaming Bernanke (he doesn’t even know he doesn’t understand how things work or that the tools he uses are not empirical); it is the Senators appointing him who are totally irresponsible — as if we promoted every doctor who caused malpractice. The world has never, never been as fragile. Economics make[sic] homeopath and alternative healers look empirical and scientific.

No news, no press, no Davos, no suit-and-tie fraudsters, no fools. I need to withdraw as immediately as possible into the Platonic quiet of my library, work on my next book, find solace in science and philosophy, and mull the next step. I will also structure trades with my Universa friends to bet on the next mistake by Bernanke, Summers, and Geithner. I will only (briefly) emerge from my hiatus when the publishers force me to do so upon the publication of the paperback edition of The Black Swan.

Bye,
Nassim

That’s quite a god complex Taleb’s got going on there (“he doesn’t even know he doesn’t understand how things work”).

The contradictory joys of being the US Treasury Secretary (part 2)

Published on 16 November 2009 in Economics, Finance, Politics, Trade and USA. Tags: , , , , , , , , , , , , . 0 Comments

In my last post, I highlighted the apparent contradictions between the USA having both a “strong dollar” policy and a desire to correct their trade deficit (“re-balancing”).  Tim Geithner, speaking recently in Tokyo, declared that there was no contradiction:

Geithner said U.S. efforts to boost exports aren’t in conflict with the “strong-dollar” policy. “I don’t think there’s any contradiction between the policies,” he said.

I then said:

The only way to reconcile what Geithner’s saying with the laws of mathematics is to suppose that his “strong dollar” statements are political and relate only to the nominal exchange rate and observe that trade is driven by the real exchange rate. But that then means that he’s calling for a stable nominal exchange rate combined with either deflation in the USA or inflation in other countries.

Which, together with Nouriel Roubini’s recent observation that the US holding their interest rates at zero is fueling “the mother of all carry trades” [Financial Times, RGE Monitor], provides for a delicious (but probably untrue) sort-of-conspiracy theory:

Suppose that Tim Geithner firmly believes in the need for re-balancing.  He’d ideally like US exports to rise while imports stayed flat (since that would imply strong global growth and new jobs for his boss’s constituents), but he’d settle for US imports falling.  Either way, he needs the US real exchange rate to fall, but he doesn’t care how.  Well, not quite.  His friend Ben Bernanke tells him that he doesn’t want deflation in America, but he doesn’t really care between the nominal exchange rate falling and foreign prices rising (foreign inflation).

The recession-induced interest rates of (effectively) zero in America are now his friend, because he’s going to get what he wants no matter what, thanks to the carry trade.  Private investors are borrowing money at 0% interest in America and then going to foreign countries to invest it at interest rates that are significantly higher than zero.  If the foreign central banks did nothing, that would push the US dollar lower and their own currencies higher and Tim gets what he wants.

But the foreign central banks want a strong dollar because (a) they’re holding gazzilions of dollars worth of US treasuries and they don’t want their value to fall; and (b) they’re not fully independent of their political masters who want to want to keep exporting.   So Tim regularly stands up in public and says that he supports a strong dollar.  That makes him look innocent and excuses the foreign central banks for doing what they were all doing anyway:  printing local money to give to the US-funded investors so as to keep their currencies down (and the US dollar up).

But that means that the money supply in foreign countries is climbing, fast, and while prices may be sticky in the short term, they will start rising soon enough.  Foreign inflation will lower the US real exchange rate and Tim still gets what he wants.

The only hope for the foreign central banks is that the demand for their currencies is a short-lived temporary blip.  In that case, defending their currencies won’t require the creation of too much local currency and they could probably reverse the situation fast enough afterward that they don’t get bad inflation. [This is one of the arguments in favour of central bank involvement in the exchange-rate market.  Since price movements are sluggish, they can sterilise a temporary spike and gradually back out the action before local prices react too much.]

But as foreign central banks have been discovering [1], free money is free money and the carry trade won’t go away until the interest rate gap is sufficiently closed:

Nov. 13 (Bloomberg) — Brazil, South Korea and Russia are losing the battle among developing nations to reduce gains in their currencies and keep exports competitive as the demand for their financial assets, driven by the slumping dollar, is proving more than central banks can handle.

South Korea Deputy Finance Minister Shin Je Yoon said yesterday the country will leave the level of its currency to market forces after adding about $63 billion to its foreign exchange reserves this year to slow the appreciation of the won.
[...]
Brazil’s real is up 1.1 percent against the dollar this month, even after imposing a tax in October on foreign stock and bond investments and increasing foreign reserves by $9.5 billion in October in an effort to curb the currency’s appreciation. The real has risen 33 percent this year.
[...]
“I hear a lot of noise reflecting the government’s discomfort with the exchange rate, but it is hard to fight this,” said Rodrigo Azevedo, the monetary policy director of Brazil’s central bank from 2004 to 2007. “There is very little Brazil can do.”

The central banks are stuck.  They can’t lower their own interest rates to zero (which would stop the carry trade) as that would stick a rocket under domestic production and cause inflation anyway.  The only thing they can do is what Brazil did a little bit of:  impose legal limits on capital inflows, either explicitly or by taxing foreign-owned investments.  But doing that isn’t really an option, either, because they want to be able to keep attracting foreign investment after all this is over and there’s not much scarier to an investor than political uncertainty.

So they have to wait until America raises it’s own rates.  But that won’t happen until America sees a turn-around in jobs and the fastest way for that to happen is for US exports to rise.

[1] Personally, I think the central bankers saw the writing on the wall the minute the Fed lowered US interest rates to (effectively) zero but their political masters were always going to take some time to cotton on.

The contradictory joys of being the US Treasury Secretary

Published on 16 November 2009 in Economics, Finance, Politics, Trade and USA. Tags: , , , , , , , , , . 0 Comments

Tim Geithner, speaking at the start of the G-20 meeting in Pittsburgh:

Sept. 25 (Bloomberg) — Treasury Secretary Timothy Geithner said he sees a “strong consensus” among Group of 20 nations to reduce reliance on exports for growth and defended the dollar’s role as the world’s reserve currency.

“A strong dollar is very important in the United States,” Geithner said in response to a question at a press conference yesterday in Pittsburgh, where G-20 leaders began two days of talks.

Tim Geithner, speaking in Tokyo while joining the US President on a tour of Asian capitals:

Nov. 11 (Bloomberg) — U.S. Treasury Secretary Timothy Geithner said a strong dollar is in the nation’s interest and the government recognizes the importance it plays in the global financial system.

“I believe deeply that it’s very important to the United States, to the economic health of the United States, that we maintain a strong dollar,” Geithner told reporters in Tokyo today.
[...]
Geithner said U.S. efforts to boost exports aren’t in conflict with the “strong-dollar” policy. “I don’t think there’s any contradiction between the policies,” he said.

Which is hilarious.

There is no objective standard for currency strength [1].  A “strong (US) dollar” is a dollar strong relative to other currencies, so it’s equivalent to saying “weak non-US-dollar currencies”.  But when the US dollar is up and other currencies are down, that means that the US will import more (and export less), while the other countries will export more (and import less), which is the exact opposite of the re-balancing efforts.

The only way to reconcile what Geithner’s saying with the laws of mathematics is to suppose that his “strong dollar” statements are political and relate only to the nominal exchange rate and observe that trade is driven by the real exchange rate.  But that then means that he’s calling for a stable nominal exchange rate combined with either deflation in the USA or inflation in other countries.

Assuming my previous paragraph is true, 10 points to the person who can see the potential conspiracy theory [2] implication of Nouriel Roubini’s recent observation that the US holding their interest rates at zero is fueling “the mother of all carry trades” [Financial Times, RGE Monitor].

Hint:  If you go for the conspiracy theory, this story would make you think it was working.

Nov. 13 (Bloomberg) — Brazil, South Korea and Russia are losing the battle among developing nations to reduce gains in their currencies and keep exports competitive as the demand for their financial assets, driven by the slumping dollar, is proving more than central banks can handle.
[...]
Governments are amassing record foreign-exchange reserves as they direct central banks to buy dollars in an attempt to stem the greenback’s slide and keep their currencies from appreciating too fast and making their exports too expensive.
[...]
“It looked for a while like the Bank of Korea was trying to defend 1,200, but it looks like they’ve given up and are just trying to slow the advance,” said Collin Crownover, head of currency management in London at State Street Global Advisors

The answer to follow …

Update: The answer is in my next post.

[1] There better not be any gold bugs in the audience.  Don’t make me come over there and hurt you.

[2] Okay, not a conspiracy theory; just a behind-the-scenes-while-completely-in-the-open strategy of international power struggles.

[1] There better not be any gold bugs on this list.  Don’t make me
come over there and hurt you.

[2] Okay, not a conspiracy theory; just a behind-the-scenes-while-
completely-in-the-open strategy of international power struggles.

Is America recapitalising all the non-American banks?

Published on 17 March 2009 in Economics, Finance, Politics and USA. Tags: , , , , , , . 0 Comments

The recent naming of the AIG counterparties [press release, NY Times coverage] reminded me of something and this post by Brad Setser has inspired me to write on it.

Back in January, I wrote a post that contained some mistakes.  I argued that part of the reason that the M1 money multiplier in America fell below unity was because foreign banks with branches in America and American banks with branches in other countries were taking deposits from other countries and placing them in (excess) reserve at the Federal Reserve.

My first mistake was in believing that that was the only reason why the multiplier fell below one.  Of course, even if the United States were in a state of autarky it could still fall below one as all it requires is that banks withdraw from investments outside the standard definitions of money and place the proceeds in their reserve account at the Fed.

And that was certainly happening, because by paying interest on excess reserves, the Fed placed a floor under the risk-adjusted return that banks would insist on receiving for any investment.  Any position with a risk-free-equivalent yield that was less than what the Fed was paying was very rapidly unwound.

Nevertheless, I believe that my idea still applies in part.  By paying interest on excess reserves, the Fed (surely?) also placed a floor under the risk-adjusted returns for anybody with access to a US depository institution, including foreign branches of US banks and foreign banks with branches in America.  The only difference is that those groups would also have had exchange-rate risk to incorporate.  But since the US dollar enjoys reserve currency status, it may have seemed a safe bet to assume that the USD would not fall while the money was in America at the Fed because of the global flight to quality.

The obvious question is to then ask how much money held in (excess) reserve at the Fed originated from outside of America.  Over 2008:Q4, the relevant movements were: [1]

Remember that, roughly speaking, the definitions are:

  • monetary base = currency + required reserves + excess reserves
  • m1 = currency + demand deposits

So we can infer that next to the $707 billion increase in excess reserves, demand deposits only increased by $148 billion and required reserves by $7 billion.

In a second mistake in my January post, I thought that it was the difference in growth between m1 and the monetary base that needed explaining.  That was silly.  Strictly speaking it is the entirety of the excess reserve growth that we want to explain.  How much was from US banks unwinding domestic positions and how much was from foreigners?

Which is where we get to Brad’s post.  In looking at the latest Flow of Funds data from the Federal Reserve, he noted with some puzzlement that over 2008:Q4 for the entire US banking system (see page 69 of the full pdf):

  • liabilities to domestic banks (floats and discrepancies in interbank transactions) went from $-50.9 billion to $-293.4 billion.
  • liabilities to foreign banks went from $-48.1 billion to $289.5 billion

I’m not sure about the first of those, but on the second that represents a net loan of $337.6 billion from foreign banks to US banks over that last quarter.

Could that be foreign banks indirectly making use of the Fed’s interest payments on excess reserves?

No matter what the extent of foreign banks putting money in reserve with the Fed, that process – together with the US government-backed settlements of AIGs foolish CDS contracts – amounts to America (partially) recapitalising not just its own, but the banking systems of the rest of the world too.

[1] M1 averaged 1435.1 in September and 1624.7 in December.  Monetary base averaged 936.138 in September and 1692.511 in December.  Currency averaged 776.7 in September and 819.0 in December. Excess reserves averaged 60.051 in September and 767.412 in December.  Remember that the monthly figures released by the Federal Reserve are dated at the 1st of the month but are actually an average for the whole of the month.

From tacit to (almost) explicit: inflation targetting at the Fed

Published on 19 February 2009 in Economics and USA. Tags: , , , , . 0 Comments

From the latest press release of the US Federal Reserve Board:

The central tendency of FOMC participants’ longer-run projections, submitted for the Committee’s January 27-28 meeting, were:

  • 2.5 to 2.7 percent growth in real gross domestic output
  • 4.8 to 5.0 percent unemployment
  • 1.7 to 2.0 percent inflation, as measured by the price index for personal consumption expenditures (PCE).

Most participants judged that a longer-run PCE inflation rate of 2 percent would be consistent with the dual mandate; others indicated that 1-1/2 or 1-3/4 percent inflation would be appropriate.

Speaking earlier in the day, Fed Chairman Ben Bernanke observed:

These longer-term projections will inform the public of the Committee participants’ estimates of the rate of growth of output and the unemployment rate that appear to be sustainable in the long run in the United States, taking into account important influences such as the trend growth rates of productivity and the labor force, improvements in worker education and skills, the efficiency of the labor market at matching workers and jobs, government policies affecting technological development or the labor market, and other factors. The longer-term projections of inflation may be interpreted, in turn, as the rate of inflation that FOMC participants see as most consistent with the dual mandate given to it by the Congress–that is, the rate of inflation that promotes maximum sustainable employment while also delivering reasonable price stability.

(Hat tip: Calculated Risk)

The (latest) bailout of Bank of America

Published on 16 January 2009 in Finance, Politics and USA. Tags: , , , , , , , , , . 0 Comments

Bank of America is being handed a butt-load of cash:

Bank of America will on Friday receive $20bn in fresh capital from the US government and a guarantee on most of a further $118bn of potential losses on toxic assets.

The emergency bail-out will help to cushion the blow from a deteriorating balance sheet at Merrill Lynch, the brokerage BoA acquired earlier this month.
[...]
The package is on top of the $25bn BoA received from Tarp funds last October, and underscores the depth of the financial difficulties affecting the world’s leading banks.

At this point, BofA has received US$45 billion in hard cash and – more importantly, to my mind – a guarantee against US$118 billion of CDOs and related assets that they hold, many of them from their takeover of Merrill Lynch.

I don’t really want to get into whether bailouts in general are worthwhile, or if this one in particular is worthwhile. What I want to rant about is the nature of this bailout and in particular, that guarantee.  It’s been done in a manner highly similar to the one given to Citigroup last year, so my criticism applies to that one as well.

Here is the joint Press Release from the US Federal Reserve, the US Treasury Department and the FDIC.

Here [pdf] is the term sheet for the deal with Bank of America.

The guarantee is against a pool of assets broken down as:

  • US$37 billion worth of cash assets
  • US$81 billion worth of derivatives (i.e. CDOs and other “troubled” assets)

Profits and losses for the pool will be treated as a whole. The fact that one third of the pool is cash (and cash equivalents) will have been insisted upon by the US government because they will almost surely generate at least a minor profit that will offset losses in the derivatives.

In the event of losses on the pool as a whole, BofA will take the first US$10 billion of losses; the US Government will take the next US$10 billion of losses; and any losses beyond that will be split 90/10: the US government will take 90% of them. That gives a theoretical maximum that the US government might be liable for as 10 + 90%*(118-20) = US$98.2 billion.  In all likelihood, though, the cash assets will hold or increase their value, so the maximum that the US government can realistically be imagined to be liable for is 10 + 90%*(81-20) = US$64.9 billion.

But kicker is this: There was no easy way for them to arrive at that number of $81 billion. The market for cash is massively liquid (prices are available because trades are occurring), so it is easy to value the cash assets. The market for CDOs, on the other hand, is (at least for the moment and for many of them, forever) gone. Unless I’m mistaken, there are no prices available to use in valuing them. Even if there were still a market, CDOs were always traded over-the- counter, meaning that details of prices and volumes were secret.

Instead, the figure of US$81 billion is “based on valuations agreed between [BoA] and the US [Government]” (that’s from the term sheet).

I want to see details of how they valued them.

When TARP was first envisaged and it was suggested that a reverse auction might take place, the rationale was for “price discovery” to take place. The idea – which is still a good one, even if reverse auctions are a bad way to achieve it – is that since nobody knows what the CDOs are really worth, confusion and fear reign and the market drys up. Since nobody can properly value banks’ assets, nobody can tell whether those banks are solvent or not.

The generalised inability to value CDOs remains, and will continue to remain, a core issue in the financial crisis.

Suppose that the true value of BoA’s CDOs is US$51 billion. At some point, we will collectively realise that fact. The market will become (at least semi-)liquid again and the prices will, at least approximately, reflect that value. But since the BoA and US government had agreed that they were worth US$81 billion, it will technically look like a $30 billion loss and so will trigger the US government handing $19 billion (= 10 + 90%*(30-20)) to BoA and unlike the $45 billion in direct capital injection, the government will get nothing in return for that money.

Therefore, BofA had an enormous incentive to game the US government. No matter what they privately believed that their CDOs were worth, they would want to convince the Treasury that they were actually worth much more.

The US government isn’t entirely stupid, mind you. That’s why the first $10 billion in losses accrue to BoA. That means that for the money-for-nothing situation to occur, the agreed-upon valuation would need to be out by over $10 billion. On other hand, that means that instead of telling a little white lie, BoA has an incentive to tell a huge whopper of a bald-faced lie in convincing the Treasury.

That is why I want to see details on how they valued them.

Felix Salmon thinks that both Citigroup and Bank of America should be nationalised:

[N]either institution is capable of surviving in its present form much longer. [Hank Paulson and Tim Geithner] should embrace the inevitable and just nationalize the two banks.
…
[T]his isn’t a bank run: Citi and BofA aren’t suffering from liquidity problems. They have all the liquidity they need, thanks to the Fed. The problem is one of solvency: the equity markets simply don’t believe that the banks’ assets are worth more than their liabilities.

The problem being, as I explained above, that nobody knows what the assets are really worth and the market is simply assuming the worst as a precautionary measure.

I’m not yet convinced that they should be fully nationalised. I just don’t think that the government should put itself in a situation where it promises to give them money for nothing in the event that their private valuation turns out to be too high (i.e. the market is correct in believing that they’re worth bugger-all).

Barry Ritholtz wants to know why the heads of Citi and BoA are still there:

Like Citi, the B of A monies are a terrible deal for the taxpayer — not a lot of bang for the buck, and leaving the same people who created the mess in charge.

Organ transplant medicine understands certain truths: You do not give a healthy liver to a raging alcoholic, as they will only destroy the organ via their disease/bad judgment/lifestyle.

In this, I agree with him entirely.