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May 13, 2014

Pondering QE

Today’s news brings another indication that low inflation rates in the euro area have the attention of the European Central Bank. From the Wall Street Journal (Update: via MarketWatch):

Germany's central bank is willing to back an array of stimulus measures from the European Central Bank next month, including a negative rate on bank deposits and purchases of packaged bank loans if needed to keep inflation from staying too low, a person familiar with the matter said...

This marks the clearest signal yet that the Bundesbank, which has for years been defined by its conservative opposition to the ECB's emergency measures to combat the euro zone's debt crisis, is fully engaged in the fight against super-low inflation in the euro zone using monetary policy tools...

Notably, these tools apparently do not include Fed-style quantitative easing:

But the Bundesbank's backing has limits. It remains resistant to large-scale purchases of public and private debt, known as quantitative easing, the person said. The Bundesbank has discussed this option internally but has concluded that with government and corporate bond yields already quite low in Europe, the purchases wouldn't do much good and could instead create financial stability risks.

Should we conclude that there is now a global conclusion about the value and wisdom of large-scale asset purchases, a.k.a. QE? We certainly have quite a bit of experience with large-scale purchases now. But I think it is also fair to say that that experience has yet to yield firm consensus.

You probably don’t need much convincing that QE consensus remains elusive. But just in case, I invite you to consider the panel discussion we titled “Greasing the Skids: Was Quantitative Easing Needed to Unstick Markets? Or Has it Merely Sped Us toward the Next Crisis?” The discussion was organized for last month’s 2014 edition of the annual Atlanta Fed Financial Markets Conference.

Opinions among the panelists were, shall we say, diverse. You can view the entire session via this link. But if you don’t have an hour and 40 minutes to spare, here is the (less than) ten-minute highlight reel, wherein Carnegie Mellon Professor Allan Meltzer opines that Fed QE has become “a foolish program,” Jeffries LLC Chief Market Strategist David Zervos declares himself an unabashed “lover of QE,” and Federal Reserve Governor Jeremy Stein weighs in on some of the financial stability questions associated with very accommodative policy:


You probably detected some differences of opinion there. If that, however, didn’t satisfy your craving for unfiltered debate, click on through to this link to hear Professor Meltzer and Mr. Zervos consider some of Governor Stein’s comments on monitoring debt markets, regulatory approaches to pursuing financial stability objectives, and the efficacy of capital requirements for banks.

Photo of Dave AltigBy Dave Altig, executive vice president and research director of the Atlanta Fed.


May 13, 2014 in Banking, Capital Markets, Economic conditions, Federal Reserve and Monetary Policy, Monetary Policy | Permalink

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April 22, 2013

Too Big to Fail: Not Easily Resolved

As Fed Chairman Ben Bernanke has indicated, too-big-to-fail (TBTF) remains a major issue that is not solved, but “there’s a lot of work in train.” In particular, he pointed to efforts to institute Basel III capital standards and the orderly liquidation authority in Dodd-Frank. The capital standards seek to lower the probability of insolvency in times of financial stress, while the liquidation authority attempts to create a credible mechanism to wind down large institutions if necessary. The Atlanta Fed’s flagship Financial Markets Conference (FMC) recently addressed various issues related to both of these regulatory efforts.

The Basel capital standards are a series of international agreements on capital requirements reached by the Basel Committee on Banking Supervision. These requirements are referred to as “risk-weighted” because they tie the required amount of bank capital to an estimate of the overall riskiness of each bank’s portfolio. Put simply, riskier banks need to hold more capital under this system.

The first iteration of the Basel requirements, known as Basel I, required only 30 pages of regulation. But over time, banks adjusted their portfolios in response to the relatively simple risk measures in Basel I, and these measures became insufficient to characterize bank risk. The Basel Committee then shifted to a more complex system called Basel II, which allows the most sophisticated banks to estimate their own internal risk models subject to supervisory approval and use these models to calculate their required capital. After the financial crisis, supervisors concluded that Basel II did not require enough capital for certain types of transactions and agreed that a revised version called Basel III should be implemented.

At the FMC, Andrew Haldane from the Bank of England gave a fascinating recap of the Basel capital standards as a part of a broader discussion on the merits of complex regulation. His calculations show that the Basel accords have become vastly more complex, with the number of risk weights applied to bank positions increasing from only five in the Basel I standards to more than 200,000 in the current Basel III standards.

Haldane argued that this increase in complexity and reliance on banks’ internal risk models has unfortunately not resulted in a fair or credible system of capital regulation. He pointed to supervisory studies revealing wide disparities across banks in their estimated capital requirements for a hypothetical common portfolio. Further, Haldane pointed to a survey of investors by Barclays Capital in 2012 showing, not surprisingly, that investors do not put a great deal of trust in the Basel weightings.

So is the problem merely that the Basel accords have taken the wrong technical approach to risk measurement? The conclusion of an FMC panel on risk measurement is: not necessarily. The real problem is that estimating a bank’s losses in unlikely but not implausible circumstances is at least as much an art as it is a science.

Til Schuermann of Oliver Wyman gave several answers to the question “Why is risk management so hard?” including the fact that we (fortunately) don’t observe enough bad events to be able to make good estimates of how big the losses could become. As a result, he said, much of what we think we know from observations in good times is wrong when big problems hit: we estimate the wrong model parameters, use the wrong statistical distributions, and don’t take account of deteriorating relationships and negative feedback loops.

David Rowe of David M. Rowe Risk Advisory gave an example of why crisis times are different. He argued that the large financial firms can absorb some of the volatility in asset prices and trading volumes in normal times, making the financial system appear more stable. However, during crises, the large movements in asset prices can swamp even these large players. Without their shock absorption, all of the volatility passes through to the rest of the financial system.

The problems with risk measurement and management, however, go beyond the technical and statistical problems. The continued existence of TBTF means that the people and institutions that are best placed to measure risk—banks and their investors—have far less incentive to get it right than they should. Indeed, with TBTF, risk-based capital requirements can be little more than costly constraints to be avoided to the maximum extent possible, such as by “optimizing” model estimates and portfolios to reduce measured risk under Basel II and III. However, if a credible resolution mechanism existed and failure was a realistic threat, then following the intent of bank regulations would become more consistent with the banks’ self-interest, less costly, and sometimes even nonbinding.

Progress on creating such a mechanism under Dodd-Frank has been steady, if slow. Arthur Murton of the Federal Deposit Insurance Corporation (FDIC) presented, as a part of a TBTF panel, a comprehensive update on the FDIC’s planning process for making the agency’s new Orderly Liquidation Authority functional. The FDIC’s plans for resolving systemically important nonbank financial firms (including the parent holding company of large banks) is to write off the parent company’s equity holders and then use its senior and subordinated debt to absorb any remaining losses and recapitalize the parent. The solvent operating subsidiaries of the failed firm would continue in normal operation.

Importantly, though, the FDIC may exercise its new power only if both the Treasury and Federal Reserve agree that putting a firm that is in default or in danger of default into judicial bankruptcy would have seriously adverse effects on U.S. financial stability. And this raises a key question: why isn’t bankruptcy a reasonable option for these firms?

Keynote speaker John Taylor and TBTF session panelist Kenneth Scott—both Stanford professors—argued that in fact bankruptcy is a reasonable option, or could be, with some changes. They maintain that creditors could better predict the outcome of judicial bankruptcy than FDIC-administered resolution. And predictability of outcomes is key for any mechanism that seeks to resolve financial firms with as little damage as possible to the broader financial system.

Unfortunately, some of the discussion during the TBTF panel also made it apparent that Chairman Bernanke is right: TBTF has not been solved. The TBTF panel discussed several major unresolved obstacles, including the complications of resolving globally active financial firms with substantial operations outside the United States (and hence outside both the FDIC and the U.S. bankruptcy court’s control) and the problem of dealing with many failing systemically important financial institutions at the same time, as is likely to occur in a crisis period. (A further commentary on these two obstacles is available in an earlier edition of the Atlanta Fed’s Notes from the Vault.)

Thus, the Atlanta Fed’s recent FMC highlighted both the importance of ending TBTF and the difficulty of doing so. The Federal Reserve continues to work with the FDIC to address the remaining problems. But until TBTF is a “solved” problem, what to do about these financial firms should and will remain a front-burner issue in policy circles.

Photo of Paula Tkac By Paula Tkac, vice president and senior economist, and

Photo of Larry Wall Larry Wall, director of the Center for Financial Innovation and Stability, both in the Atlanta Fed’s research department

April 22, 2013 in Capital and Investment, Capital Markets, Financial System | Permalink

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Yes, solving the Too Big to Fail problem is really, really difficult if the people making policy don't want to solve it, as they evidently don't. Clearly, the political influence of such organizations is at work impeding the process. Sadly, the regulators/enablers (both international and domestic) are terrified of imposing the kind of "dumb but simple" workable solution that would drastically impact the business models of these very politically powerful organizations. No, let's keep putting increasingly sophisticated band aids on tumors--that's the spirit, fellows!

Posted by: William Meyer | April 23, 2013 at 09:37 AM

Nice summary of the problems here. In addition to the problems you mention, I worry about a couple of others. One was noted recently by Sarah Gordon in the FT. She writes:


There is a compelling body of evidence suggesting that the people most likely to go into the riskier areas of financial services are precisely those least suited to judging risk. Susan Cain’s recently published book Quiet cites a series of studies that suggest that extroverts tend to be attracted to the high-reward environments of investment banking, deals and trading. And, troublingly, these outgoing people also tend to be less effective at balancing opportunity and risk than some of their more introverted peers. (http://www.ft.com/intl/cms/s/0/a917de18-abef-11e2-9e7f-00144feabdc0.html#axzz2Rxxxb9nc)

A second thing that makes me nervous is the fact, as you point out, that the FDIC an exercise its new powers to resolve a systemically important institution only if the Fed and the Treasury agree to let it do so. Would the Treasury really be able to resist political pressures and make such a decision objectively? Even the Fed, independent though it is, might find it hard to do so.

Posted by: Ed Dolan | April 30, 2013 at 12:56 PM

There is waiting in the Platonic cave a critically important paper that derives Campbell's Law and Goodhart's Law from Goedel's incompleteness theorem. As long as we allow a financial system to exist in which ever more complex debt instruments are allowed to be created, then for every control regime devised by some Basel XXXIV or whatever, there will be a new class of derivatives that escapes those regulations and destabilizes the system.

There are three possible ways to escape this endless escalation of risk-creating games: (1) impose a formal language for creating financial instruments that has been proven to be sub-Turing in its expressive power, (2) implement institution-scale TBTF, preventing any single institution or implicit consortium of institutions from acquiring enough significance to endanger the system as a whole, or (3) implement sovereign TBTF, preventing the failure of any nation-state from endangering the financial systems of others. It's not too late to start considering mechanisms to allow the Eurozone to spin off disruptive members in the same way that a lizard sheds its tail when in mortal danger. Cyprus is almost there already.

Unfortunately the US cannot spin off insolvent states, much as some of them might wish to leave. If only we could let North Carolina go, and take the Bank of America with it!

Good luck!

Posted by: George McKee | April 30, 2013 at 10:04 PM

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November 04, 2010

Some in Europe lag behind

Since around June, news of European fiscal deficits, financial markets stresses, potential sovereign debt defaults, or even a breakup of the euro zone has faded. The focal points of global economic policy have shifted to the sluggish recovery in developed countries and potential for further unconventional monetary stimulus.

A cursory look at a few key data reflects an improved European economic outlook from this summer. The simple dollar/euro exchange rate (see chart 1) shows that since June 1 the euro has appreciated nearly 15 percent against the dollar. While many different factors affect exchange rates—and increasing expectation of further monetary stimulus in the United States has helped the euro appreciate against the dollar—some of the appreciation seems to reasonably reflect the relative improvement of market sentiment about the fiscal situation in several European countries. Similarly, looking at the major stock indexes (mostly in Western European nations) shows a steady improvement from the lows of this summer, with the Euro Stoxx 50 index rising nearly 11 percent since June 1 (see chart 2). Thus, looking at most aggregate European data paints a picture of relative improvement, though most forecasters expect sluggish growth going forward. It's when one examines individual countries that it becomes clear some are lagging behind.

Chart 1
110410a
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Chart 2
110410b
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While the early stages of the European sovereign debt crisis centered on the fiscal scenario in Greece, market stress eventually spread to all the so-called PIIGS (Portugal, Ireland, Italy, Greece, and Spain) and even appeared to threaten the wider euro zone. Following an assortment of unprecedented interventions—highlighted by the 750 billion euro (approximately $1.05 trillion) rescue package from the European Union (through the European Financial Stability Facility) and support from the International Monetary Fund—market confidence slowly grew, and since this summer, various measures of financial market functioning have stabilized.

But while the threat of wider European contagion appears contained, fragilities remain. As has been documented in a variety of media reports, the recent improvement masks the individual euro zone peripheral countries' struggles with implementing fiscal consolidation, improving labor competiveness, resolving fragile banking systems, and staving off a crisis of confidence in sovereign debt markets.

Both bond spreads of individual European sovereign debt (over German sovereign debt) and credit default swap spreads show some stabilization for a few of the euro zone countries, but spreads in three countries—Greece, Ireland, and Portugal—are distinctly more elevated than the others (see charts 3 and 4).

Chart 3
110410c
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Chart 4
110410d
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The reasons for rising financing costs in these countries vary. In Ireland, for example, concerns about the Irish banking system (and the resolution of Anglo Irish Bank, in particular) were initially the driving cause. In Portugal, it was doubt over the implementation of necessary economic reforms that drove investor reluctance to provide financing; the recent adoption of austerity measures into the 2011 budget should alleviate some worry. But now much of the market action in both Irish and Portuguese bonds is focused on tough new bailout rules being implemented by the European Union.

On one hand, the renewed financing pressure brought upon these countries is less worrisome because of the backstop of the European Financial Stabilization Facility (EFSF). In fact, Moody's thinks it is unlikely there will be a euro zone default. Should market financing become too expensive for Greece, Ireland, or Portugal, the special purpose vehicle (SPV) imbedded within the EFSF could help by providing financing up to 440 billion euros ($616 billion).

But on the other hand, as part of the wider crisis prevention following the introduction of the EFSF, most European governments are implementing some level of fiscal austerity measures. From a political perspective, the implementation of these austerity measures varies widely, as demonstrated recently by the strikes in France over legislation trying to raise the retirement age. In addition to the uncertainty of implementing fiscal consolidation, there is pressure from the administrators of the EFSF to enforce burden-sharing on private bondholders in the event of any future bailout. This pressure is the primary impetus causing investors to shun the weaker peripheral countries.

One important player in this saga is the European Central Bank, which began buying European bonds for Greece, Ireland, and Portugal (among others) in conjunction with the EFSF announcement. Yet in recent weeks this bond buying has abated, and with money market pressures remaining in Europe, "something clearly has to give way," as Free Exchange wrote recently.

While aggregate market measures (exchange rates, stock indices, etc.) from Europe appear to be improving, a few specific countries face some hard challenges ahead.

By Andrew Flowers, senior economic research analyst in the Atlanta Fed's research department

 

November 4, 2010 in Capital Markets, Deficits, Europe | Permalink

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The problem is, if Portugal or other country Less pay your financial service, the investor loss lot of money, and system will be fast to underground.The unit money(Euro) game over.

Posted by: Adriano Oliveira | November 05, 2010 at 02:54 PM

Moody's thinks it is unlikely there will be a euro-zone default?? Highlighted? In 2007 Moody's rated Japan A2 and subprime pls AAA. Which do you think worked out better?

There may be no better indication that the system is about to implode.

Posted by: Rich888 | November 07, 2010 at 10:32 AM

The problem is there are simply way too many folks in China, Europe, and the UNITED STATES engaged in 'finance.' Having 'solved' the agricultural problem with the green revolution in the 1960s ( mass produced el cheapo fertilizer for all ) all these folks moved off the farm and went to work at the local bank/hedge fund/gambling hall ... and what they have designed is the perfect 'world financial casino' that is destined to blow itself up.

Posted by: European countries debt | November 11, 2010 at 05:31 AM

No two countries are exactly the same so by giving up their monetary policy independence to form the ECB these countries have lost the ability to steer their economies at will, each country has different macroeconomies and trying to solve them all with the same "pill" isn't working for countries which clearly have varying debt-GDP ratios.
There is a saying that a person is only as rich as the people around him or her and that is the case with the European Union where the booming economies have tax payers funding the struggling economies and by allowing the interbank rates to rise, the ECB is showing it's inability to sustain different economies at the same time. Increasing interest rates only end up reducing outputs in low debt-GDP Euro countries and having the opposite effect in high debt-GDP ones, it'll be a case of you win some, you lose some. The onus is left to the stronger economies, France and Germany, to keep supporting the struggling economies till those economies pick up

Posted by: Salewa Olawoye | November 19, 2010 at 09:13 PM

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April 29, 2010

Consumer credit: More than meets the eye

A lot has been made (here, for a recent example) of the idea that banks have shown a surprising amount of reluctance to extend credit and to start making loans again. Indeed, the Fed's consumer credit report, which shows the aggregate amount of credit extended to individuals (excluding loans secured by real estate), has been on a steady downward trend since the fall of 2008.

Importantly, that report also provides a breakdown that shows how much credit the different types of institutions hold on their books. Commercial banks, which are the single largest category, accounted for about a third of the total stock in consumer credit in 2009. The two other largest categories—finance companies and securitized assets—accounted for a combined 45 percent. While commercial banks have been the biggest source of credit, they have not been the biggest direct source of the decline.

042910a
(enlarge)

The chart above highlights a somewhat divergent pattern among the big three credit holders. This pattern mainly indicates that credit from finance companies and securitized assets has been on a relatively steady decline since the fall of 2008 while credit from commercial banks has shown more of a leveling off. These details highlight a potential misconception that commercial banks are the primary driver behind the recent reduction in credit going to consumers (however, lending surveys certainly indicate that standards for credit have tightened).

To put a scale on these declines, the aggregate measure of consumer credit has declined by a total of 5.7 percent since its peak in December 2008 through February 2010. Over this same time period, credit from finance companies and securitizations declined by 16.2 percent and 12.4 percent, respectively, while commercial bank credit declined by 5.5 percent. Admittedly, securitization and off-balance sheet financing are a big part of banks' activity as they facilitate consumers' access to credit. The decline in securitized assets might not be that surprising given that the market started to freeze in 2007 and deteriorated further in 2008 as many investors fled the market. Including banks' securitized assets that are off the balance sheet would show a steeper decline in banks' holdings of consumer credit.

A significant factor in evaluating consumer credit is the pace of charge-offs, which can overstate the decline in underlying loan activity (charge-offs are loans that are not expected to be paid back and are removed from the books). Some (here and here) have made the point that the declines in credit card debt, for example, reflect increasing rates of charge-offs rather than consumers paying down their balances.

How much are charge-offs affecting the consumer credit data? Unfortunately, the Fed's consumer credit statistics don't include charge-offs. However, we can look at a different dataset that includes quarterly data on charge-offs for commercial banks to get an approximation. We can think of the change in consumer loan balances roughly as new loans minus loans repaid minus net loans charged off:

Change in Consumer Loans = [New Loans – Loan Repayments] – Net Charge-Offs

Adding net charge-offs to the change in consumer loans should give a cleaner estimate of underlying loan activity:

  042910c

If the adjusted series is negative, loan repayments should be greater than new loans extended, which would lend support to the idea that loans are declining because consumers are paying down their debt balances. If the adjusted series is positive, new loans extended should be greater than loan repayments and adds support to the hypothesis that part of the decline in the as-reported loans data is from banks removing the debt from their books because of doubtful collection. Both the as-reported and adjusted consumer loan series are plotted here:

042910b
enlarge

Notably, year-over-year growth in consumer loans adjusted for charge-offs has remained positive, which contrasts the negative growth in the as-reported series. That is, the net growth in new loans and loan repayments shows a positive (albeit slowing) growth rate once charge-offs are factored in. Over 2009, this estimate of charge-offs totaled about $27 billion while banks' average consumer loan balances declined by about $25 billion. Thus, a significant portion of the recent decline in consumer loan balances is the result of charge-offs.

Nevertheless, in an expanding economy, little or no credit growth implies a declining share of consumption financed through credit. Adjusting consumer loans for charge-offs suggests that the degree of consumer deleveraging across nonmortgage debt is somewhat less substantial than indicated by the headline numbers.

All in all, the consumer credit picture is a bit more complicated than it appears on the surface. A more detailed look suggests that banks haven't cut their consumer loan portfolios as drastically as sometimes assumed. The large run-up in charge-offs has also masked the underlying dynamics for loan creation and repayment. Factoring in charge-offs provides some evidence that a nontrivial part of consumer deleveraging is coming through charge-offs.

By Michael Hammill, economic policy analysis specialist in the Atlanta Fed's research department

April 29, 2010 in Banking, Capital Markets, Financial System, Saving, Capital, and Investment | Permalink

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Very nice.

One can get a slightly broader data set by using FDIC statistics on all insured institutions (http://www2.fdic.gov/SDI/SOB/). It doesn't seem the results are substantially different: For end 2009 vs end 2008, an unadjusted drop of $29bn, vs an adjusted rise of $34bn.

Paul Kasriel recently did the same analysis for bank lending overall (full disclaimer - he mentions my website). http://web-xp2a-pws.ntrs.com/content//media/attachment/data/econ_research/1004/document/ec042910.pdf

Posted by: Jim Fickett | May 01, 2010 at 07:31 PM

you could have boiled off a lot of filler here and had quite a nice compact post
regardless well worth reading thanx

Posted by: paine | May 02, 2010 at 01:56 PM

A question: when there are charge-offs, do they include the late-payment penalties and other fees or only original principal?

Posted by: Daniil | May 03, 2010 at 10:21 AM

Two other general observations: First, although clearly implied by the post above, some readers commenting around the net have not noticed that we DON'T KNOW what the net growth in new consumer loans is, overall. Since charge-off data are available only for FDIC-insured institutions, we can't make the second graph above for the other categories of lending.

Second, and related, Felix Salmon did a post in March, linked to above, in which he concluded that consumers were not paying their cards down; in fact they were borrowing more. But the data he used, from CardHub, was mistaken -- it did not make the distinctions made in the post above, and applied the Fed charge-off rate, which is only for commercial banks, to the full revolving debt balance, from all sources. Many people are still under the impression of what Salmon wrote, but in fact we do not know whether it is true.

@Daniil: charge-offs are only principal. The accounting, in which the principal balance of loans outstanding is reduced by charge-offs, would not make sense otherwise.

Posted by: Jim FIckett | May 03, 2010 at 11:43 PM

@Jim My question is not about that. It's the following. There's a balance of $1000. I miss 3 payments and the bank assesses $200 worth of late charges and resets the interest rate after first missed payment so that after 3 months (let's say that's when the bank charges off the loan) my loan to the bank is $1300. So my total debt goes up. I don't know what's on banks books as a result of this. Do they discharge the 1000? 1300?
And even if 1300, then the total 'borrowing' might still be going up not because people are borrowing, but because they are falling behind.

Posted by: Daniil | May 05, 2010 at 04:54 PM

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December 18, 2009

October data indicate financial stress continuing to ease

Update: The numbers for T-bills and notes/bonds I am quoting refer to net official purchases only, not total net purchases by foreigners.

Original post:

The October Treasury International Capital (TIC) data, which report on U.S. cross-border financial flows, suggested continued unwinding of a massive flight to quality that took place in financial markets in the second half of 2008. (For a detailed overview of U.S. cross-border financial flows during the recent crisis, see a comprehensive report from the Federal Reserve Board.)

Cross-border private capital flows, which plummeted at the peak of the financial crisis in fall 2008, resumed as risk aversion in financial markets started to abate. On net, foreign private investors have again become buyers of U.S. assets, which has helped to increase the supply of capital in the United States.

Based on the TIC data, it appears that U.S. investors, too, are now channeling their savings abroad by buying foreign bonds and equities. Last fall as the global economy fell into a deep recession, U.S. investors sold, on net, foreign assets and repatriated capital at a record pace, partly offsetting outflows of foreign private capital. In recent months, U.S. investors on net bought foreign equities and bonds as foreign economic growth resumed and conditions improved in financial markets. The renewed purchases of foreign securities by U.S. investors shown in the data, however, represent an outflow of capital from the United States and, all else equal, increased U.S. reliance on foreign financing.

121709

The TIC data also show the easing of financial stress, which is reflected in the recent pick-up in foreign net buying of riskier U.S. assets, such as equities, and an increasing demand for agency bonds, including agency mortgage-backed securities, from foreign private investors. Also, foreign investors are rebalancing their portfolios from U.S. Treasury bills to longer-term Treasury securities.

As the financial crisis intensified in the fourth quarter of last year, foreign official investors bought on net a record $181 billion in Treasury bills while on net they sold $23.4 billion in Treasury bonds and notes. Although emerging markets' official reserves fell in the fourth quarter of 2008 (their central banks were selling dollars to support local currencies), net selling of longer-term Treasuries and a sharp sell-off in agency debt funded a surge in net buying of U.S. Treasury bills, based on the TIC data. Similarly, private investors' net buying of treasury bills soared in the second half of 2008. Buying short-term Treasuries allowed a shift to quality and safety in the most prudent way, leaving open the option to quickly reverse the flow. Now that the crisis has subsided, foreign official investors have tapered their purchases of Treasury bills and have increased their purchases of longer-dated Treasuries while private investors began on net selling Treasury bills in second quarter of this year.

Despite all these improvements, the influence of the financial crisis is still evident in the data that show persistent net selling of agency bonds by foreign official investors that began last year as well as continued net selling of long-term corporate debt by foreign private investors.

By Galina Alexeenko, economic policy analysis specialist in the Atlanta Fed's research department

December 18, 2009 in Capital Markets | Permalink

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If I go to the total liabilities page of the TIC data, I see holdings of bills went up about $250 billion in Q4? Where does the $181 come from?

http://www.treas.gov/tic/lb_99996.txt

Posted by: bobby | December 21, 2009 at 01:02 PM

Let me also add that I see net ADDITIONS of treasury bonds/notes in the fourth quarter of last year. Net purchases by foreigners was $32.872, -$25.815 and $14.97 billion in October, November and December respectively. Am I missing something?

Posted by: bobby | December 21, 2009 at 01:09 PM

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October 28, 2009

Selling stocks short: Ever controversial

Selling securities short has been a controversial practice as long as financial markets have existed, and the recent financial crisis brought short selling to the fore yet again. In the last week, a bill to impose new restrictions on short selling was introduced.

And earlier this month in its inaugural conference, the Atlanta Fed's new Center for Financial Innovation and Stability (CenFIS) provided a forum for discussing the topic of short selling.

Why does short selling have such a bad reputation? Financial economists generally have a positive view of short selling because short sellers take positions with risk of loss based on their view of a firm's prospects. Some others, though, generally do not take such a benign view of short selling.

Attitudes toward short selling reflect views about speculation. As Stuart Banner notes, a common historical view was that "[s]peculation was both productive and wasteful; it satisfied an evident demand, but its practitioners added no value to the community" (Banner 1998, p. 23). Banning short selling also has a long history. In the United Kingdom, "An act to prevent the infamous practice of stock-jobbing" was passed in 1734, an effort that attempted to ban short selling and was not repealed until 1860. In the United States, contracts to sell stock not owned at the time of sale were unenforceable in New York courts from 1792 to 1858.

Possibly short selling has a bad reputation partly because of its association with "bear raids." A bear raid is a set of trades in which a stock is sold short at a high price, negative rumors are spread to cause the price to fall, and then the short sales are covered by purchasing the stock at the lower price. Some discussions of bear raids suggest that buying stock on the way back up is a way of adding to the raider's profits from manipulating the stock price.

Bear raids are similar to speculators' manipulation of foreign exchange (Friedman 1953). Both are based on attempts to move a financial market price independent of any underlying development. Successful instances of bear raids and exchange-rate manipulation are similar in another way: They are far less frequent than complaints about them.

Selling securities short has a long and controversial history. While it's not clear whether proposed legislation on short selling will be enacted, it's a good bet that short selling's risks and benefits will be debated for quite some time.

By Gerald P. Dwyer, director of the Atlanta Fed's Center for Financial Innovation and Stability

References

Banner, Stuart. 1998. Anglo-American Securities Regulation. Cambridge: Cambridge University Press.

Friedman, Milton. 1953. "The Case for Flexible Exchange Rates." In Essays in Positive Economics, pp. 157-203. Chicago: University of Chicago Press.

October 28, 2009 in Capital Markets | Permalink

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Here is the problems with short selling. First, because of the idiosyncrasies involved with the reporting and borrowing of stock, players are able to short more stock than is actually available to short. Matt Taibbi has a good article on this in Rolling Stone of all places.

Secondly, the uptick rule gave good discipline to short sellers, since you were only able to short when someone was doing some buying. No uptick rule means that risk profiles are different. They favor the short sellers, since they can literally short at will. Because of the aforementioned stock reporting rules, they are in fact able to conduct bear raids on stocks.

Because the rules of the SEC are drawn to favor the big banks, there is no way for a company, or a group of shareholders to stop it. The short sale might start in a dark pool of liquidity, away from where the rest of the market can even see it. It might start on an order that has been internalized-and the price/volume isn't reported to the market for hours.

I am not against short selling. I am for it-but with correct restrictions. Bring back the uptick rule. Don't allow excess shares to be shorted.

Secondly, change the market structure to make the playing field level. Outlaw dark pools of liquidity, payment for order flow, and internalization of orders, and ban dual trading. Make every order be competitively bid on an organized exchange in which all market participants can see price/volume.

Shorting would provide an economic benefit to the marketplace under those conditions.

Posted by: Jeff Carter | October 30, 2009 at 01:16 PM

Short selling is a positive thing for markets that is best appreciated in markets where it is absent. It helps to moderate - I stress moderate, not stop - euphoric markets and helps to manage falling markets - again, I stress manage, not stop. In falling markets without shorts there can be literally no buyer. In markets with shorts as the market falls, shorts tend to cover, providing liquidity to sellers. Some may find this argument tough to swallow given the vicious markets of the past year, but looking at even more aggressive falls and gaps in EM markets without shorts suggests the US markets would have had an even rougher ride w/o shorts.

None of the above is to argue that the practice of short selling should not be regulated to prevent market abuse...in the same vein as the need to regulate longs that aim to abuse markets, for example by trying to corner a security. My point is to avoid throwing the baby out with the bathwater.

Posted by: rfarris | November 01, 2009 at 04:57 AM

The U.S. necessarily has regulated capitalism, because of monopolies, etc., etc.

Savings used as financial transactions to sell stocks short doesn't add to the goods and services produced, it subtracts from the potential of new goods & services produced.

That should be reason enough to outlaw wasted speculation.

Posted by: flow5 | November 01, 2009 at 09:12 PM

Just wondering, why was Stock-jobbing allowed again?

Did they have a good reason, like see something amiss in the system? Or was it just politics?

Posted by: FormerSSResident | November 02, 2009 at 03:25 PM

Stock jobbing is now called High Frequency Trading, or day trading.
It's allowed, and it would be more expensive if they outlawed payment for order flow.

Posted by: jeff | November 03, 2009 at 04:33 PM

Short-selling also can help investors moderate the overall risk in their portfolios. Certainly, an investor with a long-short portfolio last year would have been better-positioned than one with a long-only portfolio. Piotroski (2000) showed the impressive returns that can be generated by a long-short portfolio based on value investing fundamentals (such as financial strength versus financial distress).

Posted by: David Pinsen | November 04, 2009 at 11:04 AM

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February 06, 2009

Contraction, not tightening

Over at Financial Crisis and Recession, Susan Woodward and Robert Hall start a recent post, titled "The Fed contracts," with this:

"The Fed has indicated that it plans to pursue a policy of quantitative easing, that is, expanding its portfolio by borrowing in financial markets at low rates and investing the proceeds in higher-yielding private investments…

"But... the Fed has engaged in quantitative tightening over the past month, reducing its borrowing and reducing its holding of higher-yielding investments…. So far, no explanation for the Fed's announcements of moving in an expansionary direction while actually contracting."

First, it is probably appropriate to point out that the use of the term "quantitative easing" is a bit out of synch with the policy approach embraced by "the Fed." This is from Chairman Bernanke's January 13 Stamp Lecture at the London School of Economics:

"The Federal Reserve's approach to supporting credit markets is conceptually distinct from quantitative easing (QE), the policy approach used by the Bank of Japan from 2001 to 2006. Our approach—which could be described as 'credit easing'—resembles quantitative easing in one respect: It involves an expansion of the central bank's balance sheet. However, in a pure QE regime, the focus of policy is the quantity of bank reserves, which are liabilities of the central bank; the composition of loans and securities on the asset side of the central bank's balance sheet is incidental… In contrast, the Federal Reserve's credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses."

At Economist's View, Tim Duy zeroed right in on the point:

"Woodward and Hall are confused because they do not recognize that the Fed has not initiated a policy of quantitative easing…because the Fed sees their actions as credit market related, they would have no problem with the balance sheet contracting if credit market conditions dictate."

What Woodward and Hall describe is credit easing in the Bernanke lexicon, as "expanding its portfolio by borrowing in financial markets at low rates and investing the proceeds in higher-yielding private investments" is a description of changes in the composition of Federal Reserve assets. But the intent they assume is that of quantitative easing—which in the end is all about expanding the size of the balance sheet (on the liability size specifically).

In our opinion—and we rush here to add that is only our opinion—the key to unwinding the Woodward-Hall "puzzle" is in the last sentence of the Bernanke quotation above: "the Federal Reserve's credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses."

It is instructive to examine the source of the recent reduction in the Fed's balance sheet.

020609b

Though several categories of Fed assets have declined in recent weeks, the really large changes have been in currency swaps and the Commercial Paper Funding Facility or CPFF. In simple terms, currency swaps are the provision of dollars to foreign central banks to help satisfy dollar-based liquidity needs in foreign financial markets, the CPFF is a Federal Reserve funding facility to assist in the functioning of domestic commercial paper markets.

As the Chairman suggested in his Stamp Lecture:

"…when credit markets and the economy have begun to recover, the Federal Reserve will have to unwind its various lending programs. To some extent, this unwinding will happen automatically, as improvements in credit markets should reduce the need to use Fed facilities."

At least in U.S. dollar interbank lending markets, liquidity pressures have abated, as LIBOR rates have fallen substantially since last fall and have held relatively steady in recent weeks, and term financing premia have similarly eased.

020609c

Commercial paper yield spreads have also narrowed considerably for both asset-backed and financial paper since the introduction of the CPFF last fall:

020609a

Interestingly, a large amount of maturing CPFF paper was not reissued into the CPFF or the market in late January. This decline could be a result of some borrowers shifting to other, cheaper sources of credit. From CNNMoney:

"The Fed's commercial paper funding facility was a popular alternative for cash-strapped corporations at the height of the credit crunch, but demand for funding through the program has waned. Another government sponsored program, the FDIC's Temporary Liquidity Guarantee Program backs financial institution debt issued up to 10 years, a more attractive alternative for many companies."

There is one additional wrinkle. Agency mortgage-backed securities—which the FOMC has authorized the purchase of, up to $500 billion—show up on the balance sheet at the time the trades settle. As of February 4, the Fed's balance sheet has $7.4 billion in Agency MBS. However, if you sum the purchases that the NY Fed posts on their Web site, the total is closer to $92 billion so far. Thus, roughly $85 billion in MBS the Fed has purchased have yet to show up on the balance sheet because the trades haven't settled. (Hat tip to our colleague Mike Hammill for bringing this to our attention.)

The central bank's balance sheet is in fact contracting. Maybe. But is it policy tightening? Doubtful.

By David Altig, senior vice president and research director, and John Robertson, vice president and senior economist at the Atlanta Fed

February 6, 2009 in Capital Markets, Federal Reserve and Monetary Policy | Permalink

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An analogy to this from the simple version of macroeconomics. Suppose the FED wanted market rates to decline by 50 bps but it also had information that the demand for money schedule had recently declined enough to lower market rates by 80 bps. We could see a slight decline in the money supply and a lowering of interest rates. Of course, this one is a bit more involved than the simple model. Speaking about going beyond the simple model, check out Nick Rowe's two wedges post:

worthwhile.typepad.com/worthwhile_canadian_initi/2009/02/is-lm-and-two-wedges-understanding-the-second-wedge.html

Posted by: pgl | February 07, 2009 at 06:43 AM

Ok, so is this good or bad? Good that there is less reliance on the Fed, or bad that less may be needed entirely? Good that the market is easing, or bad that it is contracting? More data needed.

Posted by: Lord | February 09, 2009 at 05:52 PM

Notice how "other" makes up the largest part of the book?

"Other", in this case, means lower quality assets. The Fed has been swapping cash for crap.

I sure would hate to think our cash is backed by crap. I bet others feel the same way.

Posted by: K Ackermann | February 11, 2009 at 09:43 PM

Well if institutions are turning to cheaper sources of credit, why has the AMLF been expanded to April 30, 2008? Doesn't this imply that there is still a big credit problem and that the Fed is going to have to loan out a lot more money to simultaneously support money market mutual funds and the commercial paper market?

Posted by: T Bill | February 12, 2009 at 05:13 PM

A careful study of the chart on "Federal Reserve Assets", which is a stacked-up accumulation-type chart, contradicts the claim in the article that "Though several categories of Fed assets have declined in recent weeks, the really large changes have been in currency swaps and the Commercial Paper Funding Facility or CPFF."

The graph shows clearly that Federal Reserve Assets in total have declined from a peak of nearly $2300 billion to a current value of around $1950 billion. The drop is $350 billion.

The graph shows that none of that $350B drop is in the Treasuries portfolio. But it also shows that some $150 billion of it -- nearly half -- is in the "Other" category, which presumably we are not "supposed" to focus on. By contrast, the drop in currency swaps is actually smaller, about $100 billion. And the drop in Commercial Paper Funding Facility (CPFF) is also about $100 billion.

Thus it would seem that "really large changes have been in" the category Other.

Posted by: Wisdom Speaker | February 20, 2009 at 03:38 PM

Following up to my previous comment, here are some balance sheet changes from the "other" category which (relative to their prior size) have been proportionately larger than those in the CPFF and Currency Swaps:

Repurchase Agreements were nearly phased out. Regular Discount Window credit is down by around half. Primary Dealer Credit Facility is down by over half from its peak. Credit direclyt Extended to AIG is down by about half. The ABCPMMMFLF is nearly phased out. Overnight securities lending to dealers is phased out.

By comparison, the reduction in the central bank liquidity swaps ("currency swaps") is only 20-25%. The CPFF LLC is actually just about unchanged according to other data I'm seeing.

On the other side: there are large elements of "Other" that have not contracted. Term Auction Credit is about the same. The Maiden Lanes are about the same.

What we are seeing, in my opinion, is a regime change from some of the "crisis" facilities to some longer-term market support facilities. I'm not qualified to judge whether this is sensible policy but it's certainly not the case that all the change is in the CPFF or the currency swaps.


Posted by: Wisdom Speaker | February 20, 2009 at 03:57 PM

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January 07, 2009

Will tax stimulus stimulate investment?

Update: Reader Doug Lee points out that the fixed investment series above is dominated by the extraordinary decline in residential investment over the past several years. For that sector, the questions posed above are in a bit sharper focus. Are firms in the residential investment sector pessimistic about future prospects? Absolutely. Are compromised credit markets behind the low investment levels? Quite possibly, though given the large inventory overhang in housing it is improbable that activity in the sector would be robust in any case. Is the low investment/net worth ratio symptomatic of a general deleveraging within the nonfinancial business sector? Not so clear, as it is pretty hard to see through the effect in residential category.

Here, then is a chart of the history of nonresidential fixed investment relative to corporate net worth:

010709_update

The recent decline in the ratio, while still there, is much less dramatic and, in fact, seems to be part of a more persistent trend that commenced prior to the 2001 recession (and which may have been temporarily disguised by the housing boom that followed).

Was the nonfinancial nonresidential business sector ahead in the deleveraging game—ahead of residential construction businesses, financial firms, and consumers? And could this bode well for this sector when the recovery begins? Unfortunately, I have more questions than answers.

By David Altig, senior vice president and research director at the Atlanta Fed


Original post:

On Monday, the form of potential fiscal stimulus, 2009-style, took a step forward detail-wise. From the Wall Street Journal:

“President-elect Barack Obama and congressional Democrats are crafting a plan to offer about $300 billion of tax cuts to individuals and businesses, a move aimed at attracting Republican support for an economic-stimulus package and prodding companies to create jobs.

“The size of the proposed tax cuts—which would account for about 40% of a stimulus package that could reach $775 billion over two years—is greater than many on both sides of the aisle in Congress had anticipated.”

The plan appears to make concessions to both economic theory—which suggests that consumers will save a relatively large fraction of temporary increases in disposable income—and recent experience—which seems to suggest that what works in theory sometimes works in practice. Again, from the Wall Street Journal:

“Economists of all political stripes widely agree the checks sent out last spring were ineffective in stemming the economic slide, partly because many strapped consumers paid bills or saved the cash rather than spend it. But Obama aides wanted a provision that could get money into consumers’ hands fast, and hope they will be persuaded to spend money this time if the credit is made a permanent feature of the tax code.”

As for the business tax package:

“… a key provision would allow companies to write off huge losses incurred last year, as well as any losses from 2009, to retroactively reduce tax bills dating back five years. Obama aides note that businesses would have been able to claim most of the tax write-offs on future tax returns, and the proposal simply accelerates those write-offs to make them available in the current tax season, when a lack of available credit is leaving many companies short of cash.

“A second provision would entice firms to plow that money back into new investment. The write-offs would be retroactive to expenditures made as of Jan. 1, 2009, to ensure that companies don’t sit on their money until after Congress passes the measure.”

A relevant question here is really quite similar to the one we ask when the tax cuts are aimed at households: Will the extra cash be spent? This graph provides some interesting perspective:

010709

Relative to net worth (of nonfarm nonfinancial corporate businesses), private fixed investment has been in consistent decline since the second quarter of 2006. (The level of fixed investment has declined in each quarter, save one.) In fact, the investment/net worth ratio is currently at a postwar low.

Why? A couple of hypotheses come to mind. (1) Firms are extremely pessimistic about the outlook and see relatively few worthwhile projects in which to commit funds. (2) Credit markets are so impaired that the net worth of firms—a critical variable in mainstream models of the so-called “credit channel” of monetary policy—is supporting increasingly smaller levels of lending. (3) Nonfinancial firms, like financial firms, are deleveraging and hence not expanding.

Of course, even if one of these hypotheses is true, it need not be the case that marginal dollars sent in the direction of businesses will go uninvested. But it makes you wonder.

By David Altig, senior vice president and research director at the Atlanta Fed

January 7, 2009 in Capital Markets, Saving, Capital, and Investment, Taxes | Permalink

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Very interesting to see some real data on this, which seems to support recent anecdotal evidence. I have written up two separate but related thoughts on stimulating business investment:

1. Should the stimulus aim at boosting investment instead of consumption, and how? http://www.knowingandmaking.com/2009/01/stimulus-spend-invest-or-incentivise.html

2. Should central banks consider equity investments if debt instruments are not effective in routing funding to the non-financial sector? http://www.knowingandmaking.com/2009/01/private-investment-by-central-banks.html

Posted by: Leigh Caldwell | January 07, 2009 at 11:10 AM

The loss carry back provisions seem to me like a particularly poor way to encourage investment and seem to smack of political pork to produce big transfer payments to financial sector companies. An investment tax credit would be much better, but I suspect investment demand is inelastic with respect to the cost of capital so most of the credit would go to projects that would have been undertaken anyway. Summers touted investment tax credits for machinery and equipment at one time. Has he been intimidated by the comment that crushed his research findings on the topic?

Posted by: don | January 07, 2009 at 02:00 PM

Since it seems to be a key question at the moment, can someone (Dave?) please explain to me why it matters whether a stimulus is saved or spent? Surely, in order to save it is necessary to find someone to lend to (even just holding a banknote is effectively an interest-free loan to the government). And they are not going to borrow unless they have a use for the money, so any money that is saved must be spent anyway.

Posted by: RebelEconomist | January 09, 2009 at 04:11 PM

Very interesting data indeed. Especially when you cross pollinate the data with Greg Mankiw's that shows that tax cuts have a greater effect on GDP than government spending.

We are in a deflationary time. Everything just gets cheaper. I don't view it as a spiral, because we were severely overleveraged. Once the leverage of the market reaches equilibrium, there should be some stable footing.

The government spending package will of course have a bunch of lard in it. Unfortunately, it will be too big, and because the government can't keep it up forever, people will save instead of spend. The jobs created for road building and bridge building are temporary. Once the road is built, the job goes away.
There will be some ancillary jobs that remain, but those will be small.

The way to really get business to invest is to make the cost of investing a lot cheaper. Businesses view taxes as a cost, so lower the corporate tax rate and the capital gains rate a bunch. This will spur business investment in long term capital projects that will encourage long term economic development.

But the bureaucrats in DC and Congress don't think that way.

Posted by: Jeff | January 12, 2009 at 08:46 AM

David,

Very clear analysis, and reasonable conclusion. It's nice to read something about the stimulus subject that isn't completely guided by preconceived notions and admits to ambiguity.

Posted by: Bob_in_MA | January 12, 2009 at 08:46 AM

How about redistributing purchasing power through the tax system?

Poor people generally spend more of an extra dollar than rich people do. So redistribution can be expected to boost aggregate demand without simultaneously boosting public deficits.

Even weak households can of course be expected to save some of the extra dollars. Given their indebtedness, that’s not a bad thing.

One may argue that poorer people spend their dollars differently from richer. But many products sold lately were anyway meant to satisfy needs for rather conspicuous consumption. More resources must be allocated to the satisfaction of (slightly) more basic demands.

Growing inequality is a major explanation for the crises. For many households credit growth has worked as a substitute for wage growth.

This process will have to be reversed one way or another. We must make sure that wage differentials decreases rather than the opposite. In addition to tax breaks for the weaker households, mortgage assistance is needed.

When you run out of helicopters, distribute fresh money through increased unemployment benefits. This will improve the bargaining power of the weakest employees. But make sure the informal economy doesn’t explode. ID-cards for all wage earners are needed!

Jan Tomas Owe
Norway

Posted by: Jan Tomas Owe | January 13, 2009 at 08:12 AM

"The way to really get business to invest is to make the cost of investing a lot cheaper. Businesses view taxes as a cost, so lower the corporate tax rate and the capital gains rate a bunch. This will spur business investment in long term capital projects that will encourage long term economic development.

But the bureaucrats in DC and Congress don't think that way."

I agree, but the politicians are intent on solving the wrong problem with the wrong tools. You mention "long term" economic development - everything the Democrats and Obama want to do is SHORT TERM.

If the 'problem' they have to fix is short-term recession fighting, then the only lever that works efficiently at that is federal reserve monetary policy, and they've already done the "flood the zone" approach with 0% interest rates and 'quantitative easing'. Even though unemployment is no higher than in 1992, they want to go far far beyond what has been done in previous recessions. Why? I can think of no reason other than a sense of panic among the political elites, or a desire to misuse a recession for political aggrandizement.

But the short-term is the WRONG PROBLEM TO SOLVE. The correct problem to solve is to set the country back on the path of stable long-term economic growth. When we look back in 2012 at what was done in 2009, we wont care if the Q4 2009 numbers were this or that, we WILL care if we are saddled with an extra trillion of foriegn debt that we can't easily pay back, suffering under subpar growth because our deficits and inflationary policies got out of hand and we had to 'fix' that with high-tax high-interest-rate stagflation-era policies.

It's a myth that govt deficits will reflate the economy. What ever happened to the 'rational expectations' refutation of this? Every attempt to grow the govt will be met by more private sector layoffs - as the private sector realizes they will bear the pain of paying for this mess the govt makes.

Keynes was wrong. In the long run we aren't dead, in the long run we look back, older and wiser, and say: "What the hell were we THINKING?!?"

Posted by: Travis Monitor | January 18, 2009 at 11:32 PM

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December 10, 2008

Credit storm hitting the high seas?

Now that the mystery has been solved concerning whether we are in recession or not, our attention can turn to monitoring the conditions that might signal the contraction’s end. A nice assist in this endeavor comes from the “Credit Crisis Watch” at The Big Picture, which includes an extensive list of graphs summarizing ongoing conditions in credit markets.

In case that list is not extensive enough for you, allow us to add one more item to the list: the condition of trade finance. International trade amounts to about $14 trillion and, according to the World Trade Organization (WTO), 90 percent of these transactions involve trade financing. Trade-related credit is issued primarily by banks via “letters of credit,” the purpose of which is to secure payment for the exporter. Letters of credit prove that a business is able to pay and allow exporters to load cargo for shipments with the assurance of being paid. Though routine in normal times, the letter of credit of process is yet another example of how transactions between multiple financial intermediaries introduce counterparty risk and the potential for trouble when confidence flags.

This is how it works: Company A located in the Republic of A wants to buy goods from Company B located in B-land. Company A and B draw up a sales contract for the agreed sales price of $100,000. Company A would then go to its bank, A Plus Bank, and apply for a letter of credit for $100,000 with Company B as the beneficiary. (The letter of credit is done either through a standard loan underwriting process or funded with a deposit and an associated fee). A Plus Bank sends a copy of the letter of credit to B Bank, which notifies Company B that its payment is available when the terms and conditions of the letter of credit have been met (normally upon receipt of shipping documents). Once the documents have been confirmed, A Plus Bank transfers the $100,000 to Bank B to be credited to Company B.

Letter of Credit Process

In general, exporters and importers in emerging economies may be particularly vulnerable since they rely more heavily on trade finance, and in recent weeks, the price of credit has risen significantly, especially for emerging economies. According to Bloomberg, the cost of a letter of credit has tripled for importers in China, Brazil, and Turkey and doubled for Pakistan, Argentina, and Bangladesh. Banks are now charging 1.5 percent of the value of the transaction for credit guarantees for some Chinese transactions. There have been reports of banks refusing to honor letters of credit from other banks and cargo ships being stranded at ports, according to Dismal Scientist.

These financial market woes are clearly spilling over to “global Main Street.” The Baltic Dry Index, an indirect gauge of international trade flows, has dropped by more than 90 percent since its peak in June as a result not only of decreased global demand but also availability of financing that demand, according to Dismal Scientist.

Baltic Dry Index

In the words of the WTO’s Director-General Pascal Lamy, “The world economy is slowing and we are seeing trade decrease. If trade finance is not tackled, we run the risk of further exacerbating this downward spiral.” Since about 40 percent of U.S. exports are shipped to developing countries, the inability of the importers in those countries to finance their purchases of U.S.-made goods can’t help the U.S. exports sector, which is already suffering from falling foreign demand as the global economy slows.

At VoxEU, Helmut Reisen sums up the situation thus:

“As a mid-term consequence of the global credit crisis, private debt will be financed only reluctantly and capital costs are bound to rise to incorporate higher risk. Instead, solvent governments and public institutions will become the lenders of last resort.”

That process has begun. In the last 12 months, according to the WTO, export credit agencies have increased their business by more than 30 percent, with an acceleration since the summer. The increase in this activity, the WTO reports, is being backed by governments of some of the world’s largest exporters, such as Germany and Japan.

Most recently, to support exports of products from the United States and China to emerging economies, both countries decided on December 5 to provide a total of $20 billion through their export-import banks. The program will be implemented in the form of direct loans, guarantees, or insurance to creditworthy banks. Together, the United  States and China expect that these efforts will generate total trade financing for up to $38 billion in exports over the next year.

The sense one gets from The Big Picture charts is that at least some hopeful signs have emerged in developed-economy credit markets. Going forward, progress in markets directly related to trade flows between developed and emerging economies may well be an equally key indicator of how quickly we turn the bend toward recovery.

By Galina Alexeenko and Sandra Kollen, senior economic research analysts at the Federal Reserve Bank of Atlanta

December 10, 2008 in Capital Markets, Trade | Permalink

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Very good post. Glad that you explained the international trade credit situation. This needed to be addressed.

Posted by: Movie Guy | December 10, 2008 at 12:54 PM


The real problem is trade between "developing" countries.

There, neither party has the capacity to finance it through state sponsored agencies like Exim Banks.

Even the large, and relatively healthy large developing countries like India are struggling.

Posted by: D | December 10, 2008 at 03:38 PM

I would think that companies with monstrous cash positions like MSFT would be in good shape as well.

Posted by: K T Cat | December 12, 2008 at 07:07 PM

I have no doubt to say that the data presented here in this report is not only interesting but useful as well. Thanks for this update

Posted by: immo woning | March 19, 2009 at 12:00 AM

this is so true. Well i think this market is coming back. Wells fargo came out with a big profit. i hope this helps the credit market.

Posted by: forex forum | April 09, 2009 at 11:33 PM

Well this is hitting the economy of the whole world. All things have gone back to the 80s.

Posted by: Web design karachi | October 12, 2009 at 03:09 AM

I wonder what people reading this article would say now, 4 years later? Our economy was in fact a lie, built upon the consumer debt that came with an ever rising real estate market, with no real way of sustaining the growth. Four years later and people still have a hard time understanding credit and their own personal finances. Being one of the worlds largest economies means that when the USA crashes, so goes the rest of the world markets.

Posted by: C McCormick | January 30, 2013 at 04:49 PM

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October 30, 2008

MMMF, and AMLF, and MMIFF. Part 2 of a 2-part Series

On Tuesday we left off with a promise to do a post focusing on the Fed’s Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF) and Money Money Market Investor Funding Facility (MMIFF). We’re making good on that promise. Whereas the Commercial Paper Funding Facility (CPFF) was targeted primarily at issuers of commercial paper and intended to improve market conditions for businesses that rely on the CP market to finance themselves, both the AMLF and MMIFF are targeted at money market funds (MMFs) and helping them meet escalating redemption requests.

A Bloomberg article by Christopher Condon and Bryan Keogh does a nice job of describing the circumstances immediately preceding the creation of the AMLF:

While money funds were selling commercial paper in the past few months, the exodus accelerated after the bankruptcy of Lehman Brothers Holdings Inc. on Sept. 15 and the breakdown of the nation's oldest money-market fund the next day.”

“The $62.5 billion Reserve Primary Fund announced Sept. 16 that losses on debt issued by Lehman had reduced its net assets to 97 cents a share, making it the first money fund in 14 years to break the buck, the term for falling below the $1 a share that investors pay. Over the next two days, investors pulled $133 billion from U.S. money-market funds, according to IMoneyNet.” (emphasis added)

As has been publicized, the large withdrawals from money market funds were not without consequence. MMFs provide a link between investors looking to earn a return on their money and businesses looking to sell their short-term debt. A break in the link can lead to reduced business activity and pose risks to economic growth.

Conditions in the commercial paper market had already been under stress prior to the Reserve Primary Fund’s losses. Weak demand for CP and the massive outflows from MMFs forced some funds to sell the paper in an illiquid market—leading in some cases to losses, something that isn’t supposed to happen in MMFs.

Compounding the issues in the CP market was a reallocation of MMFs’ portfolios toward safer Treasury securities. In addition to the desire of MMFs to shed CP and other assets to meet redemptions, MMFs have been reallocating their assets toward safer, more liquid, Treasuries. MMFs were not alone. The general flight to safety among investors is immediately recognizable in the large drop in Treasury yields (particularly on shorter-dated securities) since Sept 15.

Commercial Paper Outstanding

The MMF outflows slowed after the Treasury announced on Sept 19 they would temporarily guarantee money market funds (on amounts held at the close on Sept 19), and after the Fed announced the AMLF on the same day.

The AMLF provides nonrecourse loans at the primary credit rate to U.S. depository institutions, bank holding companies, or U.S. branches and agencies of foreign banks. They can then use the loans to purchase eligible A-1/P-1/F-1 ABCP at amortized cost from MMFs. A bank that borrows under the program is at no risk for loss as credit risk is effectively transferred to the Fed. The chart below shows rates on 1, 2, and 3-month ABCP and the primary credit rate and can give an idea of what kind of spread a bank can earn through arbitrage (borrowing at the discount window and purchasing ABCP). So, if a MMF experiences redemptions, it can sell its ABCP to a bank without taking a loss and a bank can make a profit by earning the spread between the discount window rate and the rate on purchased ABCP. A secondary effect is that by reducing risk associated with lack of liquidity in the secondary market for CP, the AMLF provides an incentive for MMFs to resume their purchases of ABCP from issuers.

Commercial Paper Outstanding

AMLF borrowing from the Fed to finance ABCP purchases from MMF has grown markedly from $73 billion on Sept 24 to $108 billion on Oct 22. To compare, discount window lending, which has reached record levels, rose from $39 billion to $108 billion over the same period.

Commercial Paper Outstanding

To complement the AMLF, the Fed announced on Oct 21 the creation of the MMIFF which will provide funding up to $540 billion in financing to purchase U.S. dollar-denominated certificates of deposit (CDs), bank notes, and CP. Similar to the AMLF, the MMIFFF will support MMFs in meeting redemptions by purchasing assets which might otherwise need to be sold in an illiquid market. It differs from the AMLF primarily because it’s targeted at purchasing a broader set of assets, including unsecured CP. The MMIFF differs from the CPFF in that it aims to help money market funds rather than issuers of CP.

While the MMIFF start date is still being determined, the NY Fed provides a series of helpful FAQs explaining how the program will work.

Recovery in MMF and CP markets may be a significant factor in restoring normalcy to credit markets and should have broader, positive impacts. The Federal Reserve Board states: “Improved money market conditions will enhance the ability of banks and other financial intermediaries to accommodate the credit needs of businesses and households.”

Today’s Fed release showing the first increase in CP outstanding since mid-Sept is a good sign.

By Mike Hammill and Andrew Flowers in the Federal Reserve Bank of Atlanta’s Research Department.

October 30, 2008 in Capital Markets | Permalink

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Comments

I would like to see your take on counter party risk and it's role in asset prices in the credit market. I believe that no matter what TARP does, the amount of risk that you assume when trading in the OTC credit market is so great that it distorts the price you are willing to pay.

I don't think that the market can return to a semblance of an orderly market without an independent agency, like a clearing house, that takes care of the counter party risk problem.

Kind of like passing a stimulus package. You get one big umph, and then the air comes out of the balloon if the underlying structure is still bad.

Posted by: jeff | November 05, 2008 at 01:01 PM

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