July 03, 2009
A funny thing happened on the way to the federal funds market
Since the beginning of this year, the effective funds rate in the market for reserve balances has varied between zero and about 15 basis points below the interest rate the Federal Reserve pays on those reserve balances (see chart below, which runs through July 2). A vexing issue has been the fact that the interest paid on reserve balances at the Fed has not set a floor on the funds rate traded in the funds market, but rather it has acted more like a magnet (see, for example, this PrefBlog post from early this year).
On July 2, the Federal Reserve Board’s latest amendments to Regulation D (Reserve Requirement of Depository Institutions) went into effect. Included in these changes are two that could materially affect the fed funds market and that vexing gap between the fed funds market rate and the deposit rate.
The first is the authorization for correspondent banks to create Excess Balance Account (EBA) programs on behalf of their respondent financial institution clients. The second is the nullification of an exemption that allowed ineligible institutions (such as the Federal Home Loan Banks) to earn interest on their reserve balances as a result of providing reserve management services for banks.
This change is good news for the 20 or so bankers' banks that provide respondent banks, usually community banks, with services, such as managing the respondent’s reserve balances at the Fed. Prior to the change in Regulation D, a bankers' bank was required to pool all the respondent’s reserve deposits into its own reserve account. This task is a bit of a problem when excess reserves are at high levels because reserves are a bank asset that counts against regulatory capital-to-asset ratios. Partly because of this financial leverage concern, bankers’ banks have had to sell some of their respondent excess reserves into the fed funds market and earn less than the 25 basis points offered for reserve balances at the Fed. But with the change in Reg. D, they will be able to deposit respondent balances at the Fed in the EBAs, and this approach will alleviate their balance sheet pressure.
What does this change mean for the funds market? Well, one source of supply of funds will be reduced, and that should put upward pressure on the fed funds rate. That’s good news for closing the deposit/market rate spread, although it should be said that bankers’ banks represent only a small fraction (about 5 percent) of daily fed funds market activity, so the impact will probably be equally small.
The second change could be a more significant one and will tend to put downward pressure on the effective funds rate. Nine of the 12 Federal Home Loan Banks (FHLBs) provide respondent banking services (like bankers’ banks) for some of their member institutions. These FHLBs had been pooling their own reserve balances with their respondents’ balances, thus earning interest on their own reserves as well. Technically, the FHLBs, like other government-sponsored enterprises, are ineligible to earn interest on their own reserve balances held at the Fed, but the FHLBs were given an exemption under the interim rule published last year, which did not distinguish between an FHLB’s own reserve balances and those of their respondents. With the amended Reg. D, the pooling of reserves will no longer be allowed. Thus, the FHLBs will not be able to earn interest on their own reserve balances.
Will this change matter to them? A look at the FHLB consolidated balance sheet suggests it could. For instance, as of Sept. 30, 2008, the FHLBs were sellers of some $94 billion of fed funds and held zero on deposit at the Fed. But as of Dec. 31, 2008, after the Fed started paying interest on reserves, the FHLBs sold only $40 billion of fed funds and held $47 billion on deposit at the Fed. In a funds market that has been experiencing relatively light volumes in 2009 year to date, the potential additional supply of dollar reserves by the FHLBs could materially affect rates in the fed funds market.
What happened when the regulation changes took effect yesterday? Well, the fed funds effective rate yesterday declined from 20 to 17 basis points. Thus, it appears the softer funding conditions expected as a result of the changes generally failed to materialize. But it still may be too early to determine the full impact of the regulation changes, and more definitive changes in trading could materialize in coming days. Fed funds market nerds stay tuned.
By John Robertson, vice president in research at the Atlanta Fed
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November 25, 2008
How should we think about the monetary transmission mechanism?
That’s always a relevant question, but it takes on some added importance in times like these when the federal funds rate—the standard policy target for the Federal Open Market Committee—approaches its lower bound of zero. The recent introduction of a policy to pay banks interest on the reserves they hold on account with the Federal Reserve—which presumably (though puzzlingly not yet operationally) puts a floor on the federal funds rate independent of how much liquidity the central banks pumps into the economy— raises the question afresh.
A week or so back, Glenn Rudebusch, associate research director at the San Francisco Fed, offered his view on this topic:
“Although the funds rate target cannot be lowered much further—and certainly not below zero—it is not the case that the Federal Reserve is necessarily 'on hold.' Indeed, the Fed has already started to employ alternative means for conducting monetary policy in order to stimulate the economy.
“There are three key strategies for a central bank to stimulate the economy when short-term interest rates are fixed at zero or near zero. The first is to attempt to lower longer-term interest rates and boost other asset prices by managing market expectations of future policy actions. Specifically, a credible public commitment to keep the funds rates low for a sustained period of time can push down expectations of future short-term interest rates and lower long-term interest rates and boost other asset prices. Such a public commitment could be unconditional, such as 'maintained for a considerable period' or it could be conditional, such as 'until financial conditions stabilize.' The FOMC made such a commitment in 2003 after the funds rate was lowered to 1 percent and the economy remained weak. With the funds rate currently quite low, the Fed may revisit this strategy. If so, there would appear to be considerable scope for such a strategy to work, as the 10-year U.S. Treasury bond yield remains around 4 percent. When the Bank of Japan promised in 2001 to keep its policy rate near zero as long as consumer prices fell, it was able to help push the rate on 10-year government securities down below 1 percent.”
Rudebusch goes on to discuss the other two strategies—worth reading and examining here at a later time—but I think it is interesting to contrast this first statement of strategy with the following, from Tobias Adrian and Hyun Song Shin (of the Federal Reserve Bank of New York and Princeton University, respectively):
“We find that the level of the Fed funds target is key. The Fed funds target determines other relevant short term interest rates, such as repo rates and interbank lending rates through arbitrage in the money market. As such, we may expect the Fed funds rate to be pivotal in setting short-term interest rates more generally. We find that low short-term rates are conducive to expanding balance sheets. In addition, a steeper yield curve, larger credit spreads, and lower measures of financial market volatility are conducive to expanding balance sheets. In particular, an inverted yield curve is a harbinger of a slowdown in balance sheet growth, shedding light on the empirical feature that an inverted yield curve forecasts recessions.”
That empirical feature is in fact documented by Rudebusch and John Williams. Adrian and Shin continue:
“These findings reflect the economics of financial intermediation, since the business of banking is to borrow short and lend long…
“… our results suggest that the target rate itself matters for the real economy through its role in the supply of credit and funding conditions in the capital market. As such, the target rate may have a role in the transmission of monetary policy in its own right, independent of changes in long rates.”
Interestingly, the “considerable period of time” episode referred to in the Rudebusch excerpt above coincided with an increase in long-term interest rates and a steepening of the yield curve:
So, if stimulative monetary policy is what we are after, should we be looking for lower long-term rates or higher long-term rates? Discuss.
By David Altig, senior vice president and director of research at the Atlanta Fed
Because of the Thanksgiving holiday, today’s posting will be the only macroblog posting for this week.
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September 16, 2008
The left and right of it all
What a wild day it was on Monday in U.S. and global financial markets. We heard it quipped that the problem with financial institution balance sheets is that “on the left hand side nothing is right and on the right hand side nothing is left.” This is clearly an exaggeration, but it does raise the question: What do people look at when gauging the rightness or leftness of balance sheets?
A lot of the discussion about asset quality has focused on mortgage backed securities (MBS). The size of the MBS market has experienced phenomenal growth over the last decade or so—MBS issuance grew from around $500 billion in 1997 to over $2 trillion in 2007. As the name suggests, an MBS is a bond that is backed by the collateral of mortgages—either by mortgages guaranteed by Freddie Mac or similar institutions or other pools of mortgages. The MBS, or pieces of it, are then sold to investors, with the principal and interest payments on the individual mortgages used to pay investors.
Underlying the performance of MBS is the performance of mortgages themselves. Mortgage delinquency has been rising for some time, and especially for subprime mortgages.
One of the features of the U.S. financial system is that the debt of financial institutions tends to be weighted toward long-term obligations while the financing has been predominately from short-term borrowing. As the performance of the assets has deteriorated the need for liquidity has risen sharply.
The demand for cash was especially acute on Monday, as can be seen in the large intra-day variability in the federal funds market. Federal funds are the reserve balances of depository institutions held at the Federal Reserve. At times on Monday the federal funds rate traded well above the target of 2 percent before the New York desk intervened with an additional $50 billion injection of reserves. This Bloomberg news story describes Monday’s large movements in the federal funds market.
The demand for liquidity at 1 and 3 month horizons also surged, as indicated by the dollar LIBOR spread over OIS at 1 and 3 month horizons. LIBOR (the London Inter-Bank Offered Rate) is the interest rate at which banks in London are prepared to lend unsecured funds to first-class banks. As such it is a guide world-wide for the rate banks use to lend to each other. In the U.S., it is usually not far off from the fed funds rate. But after the emergence of the financial turmoil last fall the LIBOR has risen relative to the fed funds rate. The OIS (Overnight Index Swap) rate is a measure of the expected overnight fed funds rate for a specified term (1 or 3 months, for example). The LIBOR/OIS spread can be used as measure of the amount of liquidity or stress in short-term unsecured cash markets.
LIBOR spreads edged higher last week amid uncertainty about financial firms, and both spreads jumped higher on Monday and Tuesday, with both at or close to new highs.
Tuesday is another day, but some things will remain the same, including the focus of attention on the left and right of financial institution balance sheets, and the debate about the appropriate role of government in all this.
By John Robertson and Mike Hammill in the Atlanta Fed’s research department
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August 26, 2008
Deep questions from Jackson Hole
If one were to judge importance by press attention, the key events of this past weekend’s annual Jackson Hole economic symposium hosted by the Federal Reserve Bank of Kansas City would be the bookend contributions of Fed Chairman Ben Bernanke’s opening address and Willem Buiter’s 141 pages worth of Fed criticism. Understandable, in the former case for obvious reasons and in the latter for the grand theoretical pleasure of Buiter’s (shall we say) forthright critique and discussant Alan Blinder’s equally forthright (and witty) defense of the Fed. (The session’s tone is nicely captured in the reports of Sudeep Reddy from the Wall Street Journal and Bloomberg’s John Fraher and Scott Lanman.) [Broken link to the Bloomberg article fixed.]
Though Professor Buiter’s (of the London School of Economics and Political Science) assertions were certainly provocative, for me the truly thought-provoking aspect of the symposium was the collective effort to address some deep questions that still seek answers. There are a lot of them, but here are a few at the top of my list.
How do you know “loose” monetary policy when you see it?
Charles Calomiris—whose paper received attention at Free exchange, and is summarized by the author himself at Vox—says it is the real (or inflation-expectations adjusted) federal funds rate. I suspect that conforms to the definition favored by many, but the significance of defining the stance of monetary policy in this way was hammered home by Tobias Adrian and Hyun Song Shin:
…some key tenets of current central bank thinking [have] emphasized the importance of managing expectations of future short rates, rather than the current level of the target rate per se. In contrast, our results suggest that the target rate itself matters for the real economy through its role in the supply of credit and funding conditions in the capital market.
There is a fair amount at stake in understanding which of these views is correct:
Are longer-term interest rates relatively high while the real federal funds rate is so low because policy is quite loose and inflation expectations are rising? Or are the elevated long-term rates a sign that policy is really restrictive? Or is the picture just a symptom of a combination of currently weak returns to capital (keeping short-term rates low), the prospect of better times ahead (and higher long-run returns to capital), and a return to more realistic pricing of risk, all of which would be consistent with the proposition current policy is neither too easy nor too tight? The question is not academic.
Is there crisis after subprime?
A primary component of Calomiris’ thesis is (in the words of his Vox piece) “loose monetary policy, which generated a global saving glut.” That global saving glut connection would come up again, most prominently in MIT professor Bengt Holmstrom’s discussion of the contribution by Gary Gorton (itself an essential read if you have any questions at all about the way subprime markets work, or what they have to do with SIVs, CDOs, and ABXs). The starting point of Holmstrom’s argument—a variation on earlier themes from Ben Bernanke (for the general audience) and Ricardo Caballero, Emmanuel Farhi, and Pierre-Olivier Gourinchas (for the economists in the crowd)—goes something like this: Surplus saving in emerging economies has driven up the demand for liquid assets. Liquidity being a specialty of the United States in particular, the excess demand drives down interest rates here, stimulates spending, and expands deficits on the country’s current account.
The story, I believe, goes back to the late 1990s. One important difference between then and now is that the liquid assets most in demand at the close of the past decade were highly concentrated in long-term Treasury securities. Another is the fact that the related private-asset appreciation in the late 1990s was manifested in equity markets. After the tech-stock bust, however, the fundamental global imbalances remained and found a new home in debt created by the subprime housing market. As Professor Holmstrom and others noted, collateralized debt markets, based as they are on leverage and low levels of information flows, are much more complicated animals than equity markets.
The question that remains is obvious. What is there to stop the next crisis if global imbalances persist? And if they do, is “better” monetary policy—whatever that might be —a sufficient condition for avoiding future problems?
Which leads me to…
Is there a better way to prepare for future bouts of financial market turmoil?
One answer—shared by many at the symposium—is that we can do so imperfectly at best, and that ultimately governments or markets or both just have to clean up the mess afterward. That approach feels a bit costly at the moment, so it seems a prudent thing to explore proactive measures that may at least mitigate the impact when problems arise. On this front, the biggest buzz of the symposium was probably generated by Anil Kashyap, Jerome Stein, and Raghuram Rajan, who proposed the development of “insurance policies” that would infuse the banking sector with fresh capital when they need it most. I’ve run on too long now, so for further elaboration I will refer you again to Sudeep Reddy – or to the paper itself.
A related reading PS: You will find more on the Chairman’s speech at Free exchange, at Calculated Risk (here and here), and at the William J. Polley blog. On Professor Buiter’s session you will find no shortage of commentary. The Daily Reckoning, naked capitalism, Economic Policy Journal, and Equity Check provide what I am sure is just a sampling.
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July 03, 2007
The World According To Goldman Sachs (And Almost Everyone Else)
From my email, "A Tale of Two Tail Risks," from Goldman Sachs' Michael Vaknin:
- Sub-prime mortgage woes still hold centre-stage as housing fundamentals deteriorate further.
- A full-blown spillover from credit markets to other asset classes is unlikely as corporate sector and global macro fundamentals remain strong.
- Rather, credit market will feature less leverage, more convents, elevated volatility and gradual supply absorption.
- Upward risks to global inflation also remain high on the list of what investors worry about currently.
- On our baseline case, prudent monetary policy should limit a build-up of inflationary pressures.
From a fundamental standpoint, there are two conflicting forces to consider. First, the ongoing deterioration in the residential housing market will continue to weigh on the mortgage market. Recent housing market data point to further inventory accumulation, while price indicators suggest the deceleration in house prices has gained more traction recently. The Case-Shiller 10- and 20-city composite indexes have declined sharply in April (7?% on annualized basis). The resulting decline in housing equity, along with the recent widening of mortgage rates and tightening of contractual mortgage conditions are all likely to keep credit investors on high alert.
On the bright side, corporate fundamentals remain fairly robust. Corporate default fundamentals are in good health, and from a macro perspective, corporate earnings are still supported by broadly favourable global demand conditions. While measures of industrial activity (including our Global Leading Indicator) have been somewhat softer than expected recently, from a level perspective the global manufacturing cycle remains comparatively strong, and a more broad-based weakness in the data is needed to shift this perception. Today's US ISM and the upcoming US payroll data are highly important in this respect.
That ISM report was, of course, a good one, although today's news on pending home sales failed to break the string of lousy housing data and factory orders for May were primarily lauded for being less bad than expected. But put it together and the consensus seems to be that it all adds up to the Goldman Sachs story. That's what came through in yesterday's round-up of forecasts from the Wall Street Journal, and the story that we're sticking to appeared again today in Bloomberg's coverage of the housing sales and orders reports:
Economists and the Federal Reserve predict growth will accelerate from its first quarter pace, the weakest since 2002, even as housing remains a burden. Fed Chairman Ben S. Bernanke said last month there was no sign of "major spillovers'' from the housing slide. Industry reports for June show manufacturers are raising production as businesses spend on investment.
"The second half is coming together almost perfectly according to the Fed's plan,'' said Mark Vitner, senior economist at Wachovia Corp. in Charlotte, North Carolina. "Housing is going to be a drag but if we get some strength in business spending then the economy will be able to handle it.''
Though some of the forecasters in that Wall Street Journal survey -- about 20 percent --- put inflationary risks at the top of their wish-not list, GS's Vaknin wants to ease their minds:
As global activity continues to grow at an above-trend rate and commodity prices remain elevated, a re-acceleration in consumer price inflation, particularly in the major markets, remains a clear risk to the outlook for financial asset returns. Consider that, on a year-on-year basis, headline inflation in advanced economies has accelerated from 1.7% in Q4:06 to around 2.0% currently, driven largely by higher food and energy prices. Such acceleration comes on the back of extended tightness in production capacity: According to the OECD, the output gap in this group of countries is about to move into a positive territory by year-end after hovering in negative levels since mid-2001.
Despite these seemingly worrying observations, we that think inflation, particularly in the G-7, should accelerate only moderately before stabilizing at benign levels early next year. Granted, elevated food and energy prices may keep headline inflation above core measures for a bit longer. But this should be seen in the context of two important developments: (1) US core inflation is on a genuine deceleration path, and (2) Monetary policy stance remains prudent in other major economies where upside inflation risks are clearly higher.
The "monetary policy stance" is key, and it probably explains why so many commentators are taking their predictions of a policy-rate cut off the table for the time being.
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Tracked on Jul 4, 2007 10:53:11 AM
June 26, 2007
What's That Unpleasant Sound?
The United States faces a severe credit crunch as mounting losses on risky forms of debt catch up with the banks and force them to curb lending and call in existing loans, according to a report by Lombard Street Research.
The group said the fast-moving crisis at two Bear Stearns hedge funds had exposed the underlying rot in the US sub-prime mortgage market, and the vast nexus of collateralised debt obligations known as CDOs.
"Excess liquidity in the global system will be slashed," it said. "Banks' capital is about to be decimated, which will require calling in a swathe of loans. This is going to aggravate the US hard landing."...
Lombard Street’s warning comes as fresh data from the US National Association of Realtors shows that the glut of unsold homes reached a record of 8.9 months supply in May. Sales of existing homes slid to an annual rate of 5.99m.
The median price fell for the 10th month in a row to $223,700, down almost 14pc from its peak in April 2006. This is the steepest drop since the 1930s.
The Mortgage Lender Implode-Meter that tracks the US housing markets claims that 86 major lenders have gone bankrupt or shut their doors since the crash began.
The latest are Aegis Lending, Oak Street Mortgage and The Mortgage Warehouse.
It is worth noting that those are specifically mortgage-lending corporations not commercial banks, so I am not clear on the basis of this claim:
Lombard Street said the Bear Stearns fiasco was the tip of the iceberg. The greatest risk lies in the “toxic tranches” of lower grade securities held by the banks.
Much-trumpeted claims that banks had shifted off the riskiest credit exposure on to the asset markets was “largely a fiction”, said [Charles Dumas, the group's global strategist].
In fact, the article contains more assertions than facts. But I think it is agreed that if there is going to be a really big spillover effect from ongoing housing woes, this is where we'll find it.
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June 13, 2007
Still The Place To Run
Just when you think you have it figured out. From Bloomberg:
Treasurys rallied Wednesday, after recent sell-offs in bond prices sent the benchmark yield to a five-year high, attracting money from investors amid speculation the economy will continue to grow at moderate levels.
The buying spree occurred despite news of a jump in May retail sales, higher- than-expected import prices and a Federal Reserve Beige Book survey of regional economies that depicted an economy with tame inflation and moderate growth.
One explanation for the sudden reversal in the Treasury-yield trend is that there is no explanation required: On a day-to-day basis asset prices rise and asset prices fall. Unless you are one of the relatively few who makes his or her fortune vacuuming up the arbitrage pennies, it really is of no consequence. Still, it's fun (if not particularly productive) to speculate. One line of argument might be that the strong retail sales were really not quite as strong as they seem. From the Wall Street Journal Online:
We do not advise looking at either the very weak April or the robust May result alone, as neither is an accurate representation of underlying consumer spending… While May saw a bounce, the two months together don’t paint a particularly ebullient picture, particularly when looked at excluding large, price-related gains in gasoline purchases. –Joshua Shapiro, MFR, Inc.
But if you don't like that one, the Bloomberg article has plenty more:
"There are lots of rumors out there" to explain the unexpected rally, said
T.J. Marta, fixed income strategist at RBC Capital Markets. "Our rumor is that there was a huge purchase of 30-year notes by an Asian buyer."
After the purchase "a sheep-like mentality" set in, inspiring more buyers to return to the market, Marta said...
Kim Rupert, fixed-income strategist at Action Economics, attributed the day's gains to "an oversold condition."
"We've come a long way in a short time," she said.
Renewed concerns about the deteriorating subprime mortgage market may have spurred some safe-haven buying. BusinessWeek online Wednesday reported that a 10-month-old Bear Stearns Companies Inc. (BSC) hedge fund is down 23% for the year largely due to subprime problems.
That last one is the one that catches my eye, as it reflects a point that seems to prove itself over and over again: When the players get nervous, it's still to the U.S. Treasury market they run.
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June 08, 2007
What's Going On?
Geez, I leave the country and look what happens. From the Financial Times:
The benign credit conditions that have helped fuel the global buyout boom came under threat on Thursday as the yield on 10-year US government bonds registered its biggest daily jump in years...
The yield on the 10-year US government note hit 5.14 per cent in New York trading, marking the biggest one-day advance in several years, before settling back to 5.10 per cent. That brought 10-year yields above those on shorter-term Treasuries, restoring a more normal – that is, “steeper” – yield curve.
If you were wondering why, the FT article provides some hints:
... yields on US, European and Japanese government bonds have been climbing for a month, fuelled by strong economic data and, in places, fear of inflation.
The inflation theme got some play this week in the Wall Street Journal (page A1 in the June 6 print edition):
For the past decade, low-priced labor from China, India and Eastern Europe has helped much of the world enjoy economic growth without the sting of inflation. Now that damper on prices is beginning to reverse -- and global inflation pressure is starting to build.
Hmm. A few years back, the New York Fed's Jonathon McCarthy had a look at the impact of import prices on a country's inflation rate. Here's what he found:
The response of consumer prices to an import price shock is also positive and usually statistically significant, although smaller than the PPI response (Figure 6). In absolute terms, the pass-through is largest in Sweden, quite large in the US, and small in Japan.
That sounds promising, but when Jonathon looked a little further he found this:
... despite the appreciation of the US dollar and the decline in import prices, these factors had little effect on the US disinflation once the oil price decline is taken into account. Domestic price shocks also were a disinflationary factor in most of these countries...
[we investigate] whether pass-through to domestic inflation may have changed. When discussing the influence of exchange rates and import prices on domestic inflation,some analysts point to greater global integration as a reason for a greater pass-through of these factors... They suggest that exchange rates and importprices have not assumed a bigger role in domestic consumer price inflation in recent years, and may even have had a smaller role. The conclusion that the pass-through is modest still appears to hold in this later period.
And though I only have the data through Wednesday, to my eyes the market for inflation-protected Treasury securities doesn't reveal much in the way of a jump in inflation expectations:
All this may help explain comments like this one, from the aforementioned Wall Street Journal article:
In remarks to a bankers conference in South Africa yesterday, U.S. Federal Reserve Chairman Ben Bernanke said rising Chinese domestic costs could eventually feed through to U.S. imports, but likely would only have "modest" effect.
To be sure...
Still, he reiterated that risks to moderating inflation "remain to the upside" in the U.S. because demand is high relative to capacity.
... but that is not a development that arose in the last several days. So that leaves us to conclude that this week's run in bond yields are being "fuelled by strong economic data"? Interesting question, but my flight back home beckons. I'll ponder that one on my return.
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» Lessons from the yield curve from Econbrowser
The dramatic upward move of long-term interest rates gives me an opportunity to look back on some of the predictions made on the basis of the inversion of the yield curve, and what might be in store next. [Read More]
Tracked on Jun 14, 2007 11:24:25 PM
March 20, 2007
Where The Risk Is
And so it appears that the moment of truth is near, when we will finally see beyond the immediate fate of the housing market and determine the magnitude of the collateral damage (no pun intended). I think that there is a consensus that, if the worst is to come, some sort of substantial disruption to financial markets will be in the middle of it all. Nouriel Roubini covers about every inch of territory you can on this theme, even managing to juxtapose Alan Greenspan and Ben Bernanke with foreign-policy neo-conservatives. In somewhat more measured tones, Kash Mansori and Calculated Risk have begun to fret about the potential for spillover into the commercial banking sector. Says Kash:
In my previous post I explained why I think that the quantity of bad mortgages in the US economy may actually be enough to significantly affect the non-performance and write-off rates for the US banking system as a whole. Yesterday, Calculated Risk followed this up with a discussion of why he thinks that the health of commercial real estate loan portfolios may soon suffer the same fate that residential loan portfolios are currently experiencing.
Some of that is not speculation, as this story from own neck of the woods so clearly shows:
The quaking U.S. market for subprime mortgage loans is rattling National City Corp. too.
The parent of National City Bank of Pennsylvania has decided it won't try to sell $1.6 billion in subprime loans after all, due to "adverse market conditions," National City said in a securities filing Thursday. The loans "are currently not saleable at what management considers an acceptable price," the bank said.
Instead, Cleveland-based National City took a write-down of $11 million in February, and sometime this month will return to its portfolio the loans it had intended to sell. "A further write-down is likely," the filing said. Spokeswoman Kristen Adams would not elaborate...
Additionally, National City expects to add "on the order of $50 million" to its reserves for possible loan losses, the filing said.
But here's how the story ends:
National City shares closed yesterday at $35.99, up 30 cents.
Hmm. Frankly, I just don't think the traditional banking sector is where be the dragons. Instead, I worry about the answers to three questions: 1. Will a growing perception of risk begin to choke off lending to investment projects that are otherwise economically viable? 2. Will a growing perception of risk cause businesses to forgo or defer an increasingly large quantity of investment projects? 3. Have hedge funds, private equity funds, and specialty financial corporations become such important parts of the credit channel that there is scant relief to be found from a relatively unscathed traditional banking sector?
To question 1, we have this, from Bloomberg:
Risk premiums on investment-grade corporate bonds are at their highest level in more than three months on concern rising delinquencies by subprime borrowers will slow the U.S. economy...
"This period of volatility is likely to continue as long as there is divided opinion about the magnitude and resulting financial impact of the subprime problem,'' said Edward Marrinan, head of North American credit strategy at JPMorgan Chase & Co. in New York. "Subprime risks and accompanying fears of a spillover into the broader consumer sector are the catalysts for the heightened volatility currently exhibited by all risky asset classes,'' he said in an interview...
The 7-basis-point increase in investment-grade spreads is the index's worst three-week performance since the period ending May 20, 2005, Merrill data show. The increase means a company would pay $70,000 more in annual interest for every $100 million borrowed.
We might hold on to the belief that firms are partially insulated from rising borrowing costs (or restrictions on loan availability) due to the fact the corporate cash-flow to investment ratio remains relatively high...
... but there are two problems with seeking shelter in that picture. First, we have data only through the third quarter of 2006, which is pretty stale information at this point. Second, and more importantly, a high cash-flow to investment ratio may itself be a symptom of business's unwillingness to commit to fixed investment spending.
To question number 3, I have no idea what the answer is. And I wish I did.
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January 19, 2007
The Yield Curve: Still A Wild Card
Although the incoming data related to real activity in the U.S. may not prove the case against the 2007 crash-and-burn scenario, it sure is not providing much support for it. From housing starts, to retail sales, to industrial production, you have to actually work to generate some negative spin. One should always seek perspective, of course, and there are indeed reasons to restrain your optimism. Listen, for example, to Dean Baker:
The consensus estimate for retail sales growth in December was 0.5 percent. Naturally, people were surprised when growth was reported at 0.9 percent, as the NYT (among others) told us. Well, they really should not have been surprised, because the November numbers were revised down by 0.4 percent, which means that the December sales level was just where the consensus estimate put it.
You might make a similar case for the industrial production index, which grew more than expected in December, but was revised down (into negative growth territory) in both November and October. And you can always blame the weather for making things look too darn good.
Nonetheless, I think a fair-minded assessment -- if I may speak fair-mindedly myself -- would be "not bad."
Then there is the yield curve where, despite some recent movement, the spread between long-term and short-term interest rates remains stubbornly south of zero. Writing in the online version of the Cleveland Fed's Economic Trends feature, Joe Haubrich and Brent Meyer review a little history, and do a little extrapolating:
The slope of the yield curve has achieved some notoriety as a simple forecaster of economic growth. The rule of thumb is that an inverted yield curve (short rates above long rates) indicates a recession in about a year, and yield curve inversions have preceded each of the last six recessions (as defined by the NBER). Very flat yield curves preceded the previous two, and there have been two notable false positives: an inversion in late 1966 and a very flat curve in late 1998. More generally, though, a flat curve indicates weak growth, and conversely, a steep curve indicates strong growth...
While such an approach predicts when growth is above or below average, it does not do so well in predicting the actual number, especially in the case of recessions. Thus, it is sometimes preferable to focus on using the yield curve to predict a discrete event: whether or not the economy is in recession. Looking at that relationship, the expected chance of a recession in the next year is 43%.
Not everyone is convinced, of course, but right now it looks to me to be the bears' strongest suit.
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