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.
By Paula Tkac, vice president and senior economist, and
Larry Wall, director of the Center for Financial Innovation and Stability, both in the Atlanta Fed’s research department
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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.
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).
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
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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.
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:
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:
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
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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.
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.
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
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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.
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.
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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.
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.
Commercial paper yield spreads have also narrowed considerably for both asset-backed and financial paper since the introduction of the CPFF last fall:
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.
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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:
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
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:
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
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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.
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.
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
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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.
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.
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.
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.
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October 28, 2008
The Commercial Paper Market and the Fed’s Commercial Paper Funding Facility: Part 1 of a 2-part Series
The current financial crisis is a good reminder of how interconnected our financial system really is. The financial tsunami has engulfed seemingly unconnected and obscure corners of the credit market, making them front of mind for a general public that had probably never heard of them before (think SIVs, auction rate securities, monoline insurers, credit default swaps, variable rate demand notes, commercial paper, etc).
Recently, we have heard a lot [here, here, and here] about the issues in the very important but relatively unglamorous commercial paper market. Commercial paper (CP) is a short-term debt instrument issued by large banks and corporations with a maturity of one to 270 days.
Traditionally, companies use CP to finance day-to-day operations, borrowing cash they need to meet payroll or buy materials. Borrowing short-term money gives a company more flexibility to meet short-term needs, and is usually cheaper than issuing long-term debt. Companies can, and often do, roll over their CP as it matures, which effectively turns short-term debt into long-term debt, but at short-term interest rates.
In the past few years the commercial-paper market has grown dramatically, increasing by about 56 percent from 2005 until its peak in August 2007. Much of this growth has been in asset-backed commercial paper (ABCP), which jumped 76 percent over the same period. [Here is the Board’s most recent CP report.] In contrast to unsecured CP, which is backed by the name and assets of an entire company, ABCP is backed by a pool of specific assets, such as credit card debt, car loans, and/or mortgages.
CP generally carries low risk because of its short duration. With unsecured CP, the primary risk is some negative event that threatens the viability of an issuing company's business. But for ABCP, the primary risk is a shock to the value of the underlying asset—such as higher-than-expected mortgage defaults, and an uncertain trajectory for defaults in the future. Recently, both unsecured (especially financial firms) and asset-backed (especially mortgage-backed) CP markets have come under considerable stress.
Money market funds are significant buyers of CP because it typically offers a slightly higher yield than, say, short-term Treasury securities. Money market mutual funds and other institutional investors purchase about 60 percent of commercial paper in the market, according to mutual-fund tracking firm Crane Data.
Following the failure of a number of financial institutions and increased uncertainty about the quality of assets underlying some of the asset-backed paper, the problems in the CP market intensified in September. On the one hand, the demand from money market funds declined as they were faced with a rise in redemptions. This development contributed to a sharp decline in CP outstanding (see chart above). At the same time, investors began demanding higher interest rates in order to buy CP, which contributed to a widening of their spreads relative to the risk-free Treasury rate in September (see chart below).
Furthermore, there was a significant shortening in the maturity of new CP issued with only the most trusted programs able to issue out as far as six months at favorable rates, resulting in many firms needing to roll over their paper every day (see chart below).
In response to the deteriorating conditions, the Fed created the Commercial Paper Funding Facility (CPFF) in early October, which went operational yesterday (10/27). According to the Board of Governors, the new facility “is intended to improve liquidity in short-term funding markets and thereby increase the availability of credit for businesses and households.” The Board also said that “By eliminating much of the risk that eligible issuers will not be able to repay investors by rolling over their maturing commercial paper obligations, this facility should encourage investors to once again engage in term lending in the commercial paper market.”
In the CPFF, the New York Fed will lend to a Special Purpose Vehicle (SPV) which will purchase eligible highly-rated (A-1, P-1, F-1) 3-month CP and ABCP from U.S. issuers. According to the New York Fed, the rate charged on unsecured commercial paper will be the three-month overnight index swap (OIS) rate plus 100 basis points per annum, and the rate for ABCP will be three-month OIS plus 300 basis points per annum. Additionally, for unsecured commercial paper, the New York Fed said “a 100 basis points per annum unsecured credit surcharge must be paid on each trade execution date.” Looking back before September, three-month CP rates typically traded very close to three-month OIS rates. The jump in CP rates in September led them to trade much wider than the SPV spread.
Short-term debt markets have been under considerable strain in recent weeks as money market mutual funds and other investors have had difficulty selling assets to satisfy redemption requests and meet portfolio rebalancing needs. The CPFF is intended to support the issuers of CP by providing liquidity and supporting term lending in the CP markets. On Oct. 21, the Fed announced the creation of the Money Market Investor Funding Facility, which supplements the previously announced Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, to free balance sheets at money market funds and to encourage them to resume their traditional role in securities lending and participation in other financing markets. This will be the topic of Thursday’s blog.
By Mike Hammill and Andrew Flowers in the Federal Reserve Bank of Atlanta’s Research Department.
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