The Atlanta Fed's macroblog provides commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues.

Authors for macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.

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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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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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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.

Commercial Paper Outstanding

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).

Commercial Paper Outstanding

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).

Commercial Paper Outstanding

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.

Commercial Paper Outstanding

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.

October 28, 2008 in Capital Markets | Permalink


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Thank you for a very clear explanation of the situation. Speaking as just a plain old citizen trying to understand all that is going on this was very helpful.

Posted by: martyseattle | October 28, 2008 at 11:18 PM

You make a key point often omitted elsewhere:

"...which effectively turns short-term debt into long-term debt, but at short-term interest rates."

We are once again reminded that there is no free lunch. Since lenders would not choose to lend long term for short term rates, the borrowing was effectively from the Fed at artificially low interest rates. That is now ratified.

If such an arrangement is beneficial, we have had a highly inefficient financial system, based on pretense. If, as I suspect, it is not beneficial, we're simply getting ourselves deeper and deeper while hoping for some magical thinking (groundless confidence) to return.

I would welcome a thoughtful and realistic discussion of how the Fed extracts itself (and us) from its current position of primary lender at artificially low rates. Alternatively, the consequences of its never doing so voluntarily (meaning until that arrangement is no longer sustainable) ought to be explored.

Posted by: LAMark | October 29, 2008 at 01:03 PM

You omit the role played by the big banks in this market. Are there any issuers who don't have a liquidity backstop from a bank, if they fail to role their commercial paper issue?

Explaining this relationship is essential to understanding that the commercial paper "market" is in fact composed of undercapitalized bank liabilities.

Posted by: ccm | October 29, 2008 at 02:39 PM


The article saiid CP has traded just above OIS before September. 100/300 basis points above that to triple A companies is nothing to sneeze at then. Especially since it looks like yields have shot up due to the jitters of money market fund holders, not due to issues in the underlying companies. I'm doubting, for example, that GE will be defaulting any time soon.

Posted by: MW | October 29, 2008 at 03:35 PM

". . . companies use CP to finance day-to-day operations . . . [which] . . . gives a company more flexibility to meet short-term needs, and is usually cheaper than issuing long-term debt."

Businesses could chose to "finance" current expenses out of income rather than borrowing, yes? But then, they couldn't keep buying their shares back and their stock options above water.

Another way of looking at martyseattle's point, above, is to say we need a lot less CFO-quants taught by a bunch of business school mathematicians and econometricians.

First, we'll kill all the Professors of Finance.

Posted by: Ellen1910 | October 30, 2008 at 09:10 AM

I heard from a Republican Congressman from Michigan that GM was paying over 25% interest on their short term commercial paper for a while there!

I think Ellen misses the point. Many internal operations that the company does needs short term debt rather than utilizing cash flows. the interest you pay on the short term debt is less than the opportunity cost of using the cash flows.

It's not all about propping up stock options.

Posted by: Jeff | November 04, 2008 at 11:31 PM

Many institutions limit access to their online information. Making this information available will be an asset to all.

Posted by: Paper on Research | October 27, 2009 at 09:07 AM

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October 24, 2008

A home price index gets a new name (but it’s telling the same story)

Yesterday we got a peek at the latest home price data provided by the Federal Housing Finance Agency (FHFA). Never heard of it before? It’s the new agency that took conservatorship of Fannie Mae and Freddie Mac, the nation’s giant housing GSEs (government-sponsored enterprises). FHFA has also absorbed the Office of Federal Housing Enterprise Oversight, or OFHEO. So the popular OFHEO home price index is now the FHFA home price index. (Let me weigh in here—I like the sound of OFHEO better.)

The FHFA price index posted another sizeable decline in August (0.6 percent) and is down 6.5 percent from its peak in April 2007. Here’s what the home price index has done since 1991.

Evolution of the 2008 Blue Chip Consensus Growth Forecast

The national data mask some wide variations by region. While every part of the country has felt the decline in housing markets, the Pacific region has seen the largest price declines (off 21.5 percent since peaking in March 2007) and the East South Central (which includes Texas) has experienced the least slowing (off 1.7 percent since peaking in June of 2007). The South Atlantic Region, which includes much of the Atlanta Fed’s Sixth Federal Reserve District, has also been hit with an above national average decline as home prices are off about 7 percent since their peak in May 2007.

I suppose these regional variations aren’t too surprising. Stories of overbuilding and price speculation were most pronounced in areas such as California, Nevada, and Florida. These areas also rate tops among foreclosure rates according to data just released by RealtyTrac. Without getting into the thorny (albeit important) issue about what, exactly, constitutes a bubble, the “what goes up must come down” explanation may be a little overly simplistic.

Here’s a perspective published in the Federal Reserve Bank of Cleveland’s Commentary series a little more than a year ago. Davis, Ortalo-Magne, and Rupert say that home values, and especially relative home values, are really driven by fluctuations in the value of land. They argued that if you relax credit constraints, you unleash demand for housing, which because land is in fixed supply will produce a jump in home prices. And the subsequent declines we’ve seen to date? Well, constrain the credit, and the process works in reverse. The Davis et al. story works especially well if you think the housing boom and subsequent bust originated in the subprime market. Since these are exactly the homebuyers who were most credit constrained, the increased availability of credit significantly expanded the pool of potential home buyers.

Atlanta’s recent housing experience may be a good example of the relationship between land, demand, and home prices. As my boss, Atlanta Fed President and CEO Dennis Lockhart, noted in a speech earlier this week, Atlanta had a large expansion of new home building in the first half of this decade. The expansion in home building wasn’t impeded by natural barriers, like mountains and coastline. Atlanta has an abundance of low-cost land available for residential development, and in 2005 Atlanta’s single-family new home market was the strongest in the nation with 61,000 single-family housing permits. However, Atlanta did not experience the extreme home price appreciation seen in some areas, and Atlanta’s home price decline, while unpleasant, is much less than areas like Florida and the West Coast.

By Mike Bryan, vice president and economist at the Federal Reserve Bank of Atlanta


October 24, 2008 in Data Releases, Housing | Permalink


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October 22, 2008

The evolving economic outlook

I understand that economic forecasts are notoriously inaccurate. The last time I looked, the root mean square error of economists’ year-ahead growth forecasts was 1.4 percentage points. In other words, you’d expect the consensus forecast to be within about 1½ percentage points of the actual outcome only about two-thirds of the time (and individual forecasts tend to be even worse than the consensus).

Accurate or not, predictions of the future are an essential input into decisions made throughout the economy, and the negative tone in the incoming data has led most forecasters to sharply cut their growth expectations through 2009. The first chart below shows how the Blue Chip consensus growth forecast for 2008–2009 has evolved.

Evolution of the 2008 Blue Chip Consensus Growth Forecast

As of October 10 (before forecasters had seen most of the September data), the Blue Chip consensus forecast showed the economy entering a period of negative growth last quarter and remaining that way (or near it) until the second quarter of next year with subpar growth continuing through the end of next year.

Indeed, the current Blue Chip growth projection for the U.S. economy is a sharp deterioration from what economists had been anticipating when the year began. In January, the consensus outlook called for the year to start off a little sluggishly before gradually resuming a more typical growth path. As the year unfolded, however, and the deep problems affecting the housing market became more evident, growth prospects waned.

Want some good news? Economic forecasts are notoriously inaccurate. And they are especially inaccurate at turning points, which, according to the Blue Chip consensus, we’ve recently passed. Why do forecasts perform worst just when needed most? The shocks that hit the U.S. economy from time to time are complex and not very well behaved. The likelihood of extreme outcomes—so-called “tail risks”—vary from shock to shock. Moreover, there may be “nonlinearities” in response to these shocks, meaning economic relationships that operate one way when the economy is in an expansionary state may operate differently when the economy is in a recessionary state. So a model that may have worked well during the good times may not work so well during the bad.

Perhaps the evolution of the economic outlook during the previous business cycle is a useful example. Consider the next chart, which shows the evolution of the consensus forecast for 2001–2002, beginning with January 2002. As the data revealed the economy was in some distress, the economic outlook deteriorated—severely so when it became clear the U.S. economy was in recession (and in November 2002, the NBER officially declared that a recession had actually begun the previous March).

Evolution of the 2001-2002 Blue Chip Consensus  Forecast Recessionary Phase

But remember, there are (at least) two turning points in the business cycle. There’s the downturn and a recovery. So the same problems that make spotting recessions hard also make it hard to anticipate the rebound. Again, let’s look at what happened during the last business cycle. The next chart shows how the consensus forecast evolved as the economy transitioned from recession to expansion, which, coincidently, began in November 2001.

Evolution of the 2001-2002 Blue Chip Consensus  Forecast Expansionary Phase

Between November and May of that time, the incoming data revealed that the consensus forecasts made during the recessionary period were overly pessimistic. The onset of expansion occurred sooner, and with more strength, than economists initially expected.

I am not aware of any individual forecast that can consistently outperform the consensus. And this is not an argument denying the economy is facing difficult times. But perhaps it’s useful to keep in mind the limitations of economic forecasts in times like these.

By Mike Bryan, vice president and economist of the Federal Reserve Bank of Atlanta

October 22, 2008 in Data Releases, Forecasts | Permalink


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I like many things about the University of Michigan consumer sentiment data that came out a few days ago.

They use partial rotating paired groups in their methodology which makes their data a little more useful.

The latest results from them, the people who actually PURCHASE goods and services on a daily basis were not at all pretty.

It's a useful comparator with the data set above.


Posted by: Matt Dubuque | October 23, 2008 at 08:42 PM

Greenspan made it very clear last week that computer models could not be used to perfectly predict the future. And we all know this intuitively- we actually play athletic games rather than award the win to the higher ranked team because you never know what can happen in real life. (Evidence: Phillies and Rays- no computer would have predicted this!)

The question now becomes what do we do to soften the slump and get back to recovery. The choice requires assumptions because we don't have perfect information. We can look at the patterns of past recessions. Steve Forbes does this in his excellent new article (http://www.forbes.com/hcome/forbes/2008/1110/018.html). It is important to remember how powerful and resilient the market is when it is given the opportunity to preform. Like an undervalued player, the market can come through in the clutch when the manager gets out of the way and lets the play do its thing.

Posted by: Randy | October 26, 2008 at 09:29 PM

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October 16, 2008

The end of buy and hold?

I trust you will not judge me guilty of overstatement if I say that good news from equity markets has been hard to come by of late. So rough has been the ride that at least one (quite) famous pundit-analyst has taken measure of the landscape and concluded that the time has come to abandon the venerable “buy and hold” investment advice generally offered ordinary savers:

"It's time to unlearn a common myth about investing," Jim Cramer told viewers on Monday. "The best way to invest is not to buy a bunch of stocks and just sit on them."

As is usual in such cases, it is useful to have a look at the record. Though it’s not entirely clear what quantity constitutes “a bunch of stocks,” one reasonable definition would be a broad stock index. With that in mind, here is a look at the annualized three- and five-year rates of change in the S&P 500 index going back to 1941.

3-Month Libor less Effective Funds Rate

This is not the return on an investment in the index, of course, as holding the portfolio of equities in the index would also generate dividends over the holding period. But it does give some sense of how the recent past compares with the more distant past. While it is true that things look bleak at the moment, this is hardly an unprecedented circumstance. If the buy-and-hold strategy had merit before, it really isn’t that clear things had changed that much through this past September.

You might reasonably argue that buy-and-hold really applies to horizons that extend beyond five years. Here, then, is the same sort of chart as above with index growth for 10-, 15-, and 20-year holding periods.

3-Month Libor less Effective Funds Rate

True enough, the past 10 years have been a little ragged, though again not really unprecedented. And if you were lucky enough to be a long-term saver—that is, held the index for the past 15 to 20 years—good for you. (And note that returns over these horizons are, not surprisingly, substantially less volatile than over the shorter periods.)

Ok, I hear you. Why did I conveniently stop just short of the dramatic decline in the stock market since September. Sure enough, things look substantially worse when the stock market loses over a quarter of its value in a month. For the sake of argument, let’s assume that the S&P average for October ends up at 900, or near the low so far this month. Redoing the three-, five-, 10-, 15-, and 20-year growth calculations would yield annualized rates of –8.9 percent, –2.8 percent, –1.4 percent, 4.5 percent, and 6.1 percent, respectively. Even with the major reversal of the last month, the implied returns on the 15- and 20-year holding periods look pretty good.

Of course, the “buy-and-hold is dead” idea relies on the presumption that the next 10 years are going to look a lot like the last 10 years. Only time will tell if the current growth rate on the three- to10-year holding periods is a trend, or just evidence that you won’t do so well when you get out of the market at exactly the wrong time. I don’t know what the answer is—and I don’t offer investment advice—but the verdict of history is pretty clear.

By David Altig, senior vice president and research director of the Federal Reserve Bank of Atlanta

October 16, 2008 in Financial System | Permalink


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Dave, a very interesting post.

John Hussman regularly updates similar information, with a 'channel' of multi-year expected returns.

His weekly comment Monday indicated that this is the first time he has seen attractive valuations, for long-term growth, in several years.

His weekly update is at www.hussmanfunds.com

In any event, we're no more than 900 points from a bottom at this point...

Posted by: Murph | October 16, 2008 at 08:09 PM

"... the verdict of history is pretty clear."

So it is! Consider how a hypothetical investor who continuously earned the worst returns ever recorded for the S&P 500 fared against the "safest investment on Earth!":


Posted by: Ironman | October 16, 2008 at 09:54 PM

Uh Dave,
You might want to mention that people who bought at the peak in 1929---it took them about 30 years to get back to even in nominal terms.

People who bought at the peak in the early 70s, it took them over 10 years to get back to even in nominal terms--and much longer in real terms of course.

People who bought the S&P 500 in 1998--ten years ago---are now just about even in nominal terms (not counting the meager dividends), but they are still down about 25 percent in real terms. And that's after 10 years of living in Greenspan's so-called "new economy" which was supposed to make us all rich.

When was the most recent peak? Oh yeah: October 9, 2007 (Dow = 14,000 and change). Uh oh. How long will it take to get back to even in real terms. 10 years? 20 years?

Stocks for the long run? Maybe, but the baby boom generation ain't got that much time Dave. And don't forget that we still have to come with around $65 trillion to pay for their promised Medicare benefits.

Posted by: Mr. Mojo Fallin | October 17, 2008 at 12:55 AM

The next ten years are much more likely to look like the last ten years of the Nikkei 225 than like the last ten years of the Dow or S&P 500.

I still remember tuning the TV in my hotel room to NHK during a Japan business trip circa 1989 and finding a stock market tout in a very expensive suit delivering a lecture on investment strategies to a group of archetypical Tokyo matrons, some of whom were clearly worried about talk of a "bubble" (appearing regularly in the newspapers at that time), and advising them that no one had ever lost money in Japan's stock market if they'd stayed invested for more than three years. The Nikkei was nearing its ultimate high of 40,000 at the time; in the last 10 years I don't think it's made it back above 20,000 even once.

Posted by: jm | October 17, 2008 at 02:13 AM

Mr. Mojo Fallin,

Are you suggeesting investing is like a one time purchase? Good investors do not buy "at the peak". They continually invest, buying MORE shares when stocks are on sale and LESS high priced shares.

"but the baby boom generation ain't got that much time Dave."

A boomer approaching 60 has how long? Seems more like long term than short term to me, especially if you don't want to outlive your investments (you will never make it in bonds).

Posted by: me | October 17, 2008 at 10:29 AM

You could get better investment advice watching the Food Network, than from Jim Cramer. If you follow his advice I predict you will be living with negative investment returns forever. If boomers only have 3-5 years before needing their cash, then yes, get into something safer. If your horizon was only 3-5 years, you bad, for leaving your nest egg in the wrong type of investment. People always get burned by their own greed.

Posted by: kevin | October 17, 2008 at 10:31 AM

Mr. Mojo Fallen wrote:

"You might want to mention that people who bought at the peak in 1929---it took them about 30 years to get back to even in nominal terms."

That's incorrect. You're assuming that there were any people who invested just once (say in September 1929, when the peak of the market was reached before the "Great Crash") and never invested in the stock market again.

You're also ignoring the effects of dividend reinvestment.

Neither assumption represents how investing in the real world works. As to the first case, please bear in mind that people who began investing in the aftermath of the Great Crash began making significant returns much sooner.

Ref: http://tinyurl.com/5sxn5o

As to the second, even factoring inflation into the picture, the longest ever recorded period of time in which a single investment in the S&P 500 was "underwater" is 21 years (not 30) thanks to dividend reinvestment. That single period ran from June 1911 to June 1932.

Ref: http://tinyurl.com/6e766e

Held less than a year longer, that single investment launched in June 1911 swung into positive territory.

Posted by: Ironman | October 17, 2008 at 10:45 AM

Technically my comment above that the Nikkei hadn't been back above 20,000 in the last ten years turns out to be wrong -- it briefly topped that level by a hair in 2000. But the correctness of the essence of the comment is well portrayed by this chart:


Posted by: jm | October 17, 2008 at 10:52 AM

As an economist you know well that your figures now need to be compared with bond returns. Some easily available information is the 10-year return on Vanguard's short term Treasury fund: 4.71%. Given that it took a long time for interest rates to fall from their early 80s high, it's almost certain that the 20 year return from rolling short-term treasuries is significantly higher than 4.71%.

I suspect that what we are seeing is the end of the index (and maybe even the mutual) fund bubble and of the equity premium myth. If you want to apply a buy and hold strategy to the stock market, you need to study your firms, pick them carefully based on the fundamentals and keep track of what management is doing over time -- just like your grandpa used to recommend.

Posted by: ccm | October 17, 2008 at 12:17 PM

Abandoning buy-and-hold doesn't mean becoming a market timer. It can mean abandoning stocks and bonds, entirely.

In hindsight -- and many had foresight -- investing in tangible inflation hedges (precious metals, commodities, real estate, coins and stamps, as examples) was the correct move in the period 1974-1982.

What's the alternative, today? Deflation and cash?

Posted by: Ellen1910 | October 17, 2008 at 01:21 PM

Are you seriously going to fade Warren Buffett?

And listen to Jim Cramer? Cramer was advising people to buy stocks in December 2007.

The analysis presented is weak.

Instead, look at the SP500 10-year P/E from Robert Shiller in his book Irrational Exuberance. The historical median is about 17. Use the SP500 10-year P/E as a measure of value. If people buy "the index" whenever the P/E is below 10 or 11, they make big bucks. Right now, the SP500 is still overvalued, based on the 10-year P/E.

Please check it out.

Posted by: Cornelius V. | October 17, 2008 at 02:34 PM

David, nice to have you back on Macroblog; I had almost given up on you.

Oh, and thanks to Jim Cramer for telling us buy-and-hold is dead AFTER the market crash...you could have told us in December 1999 and saved us a few headaches.

Posted by: Marcos, XP-75 | October 17, 2008 at 04:38 PM

A specious argument.

Contexts change and context-driven selection always occurs over time IN ANY THERMODYNAMIC SYSTEM. Hence, to outdo the mean, you either CAREFULLY select a subset of assets for buy&hold (e.g., Warren Buffet), or CAREFULLY select when to buy&sell a subset of assets (e.g., George Soros, Jim Rogers). For VERY long term selection, you CAREFULLY select the right country to emigrate to.
Name your poison & do your homework. There's no free lunch, but you can get lucky.

Posted by: Roger Erickson | October 17, 2008 at 04:56 PM


Shiller's 10-year P/E has some problems, but to make a long story short, the ten-year average of reported earnings that he uses is really a poor substitute for dividends.


Since investors have historically bid up stock prices at 1.19X the rate that dividends per share have grown, this effect has two results:

1. Dividend Yields (D/P) have tended to decrease over time.

2. Price Earnings Ratios (P/E) has tended to increase over time.

The typical P/E for the stock market will, over time, drift slowly upward, as cash dividends are the drivers of stock prices, rather than top line earnings. This is why looking at the long-term historic average for P/E ratios over the entire post-Civil War history of the U.S. stock market isn't as revealing as you might hope it would be.

Posted by: Ironman | October 17, 2008 at 05:51 PM

Whoops! I forgot to include that reference link:


Best regards all!

Posted by: Ironman | October 17, 2008 at 05:54 PM

"Buy on weakness and sell on strength" is an alternative to market timing and to "buy and hold." If, instead of just the S&P index you invested in a mix of stocks and bonds and simply rebalanced annually, you would sell on strength and buy on weakness, at least on a relative basis.

Posted by: NutJob | October 17, 2008 at 06:56 PM

"Abandoning buy-and-hold doesn't mean becoming a market timer. It can mean abandoning stocks and bonds, entirely."

Right, I know many folks that lost on the tech bubble I never understood how a company with no earnings could be worth so much) and invested in real estate. How's that working out?

Posted by: me | October 17, 2008 at 07:01 PM

David, I believe strongly that buy and hold has been dead for 12 years or so.

I think the fallacy of composition renders your analysis somewhat wanting. As a stock picking practitioner, I have found that since the rise of momentum investing, technical trading, hedge funds etc., each security seems to get not just overpriced at some juncture, but bizarrely overpriced. If you don't sell or rebalance, you end up with poor returns.

A great example is Buffett's favorite company, Coca Cola. In 1998 it traded at a PE of 60! Earnings were about $1.30 per share. Now they are about $3.00 per share, and you are down 40% or so on your capital for a decade. [not including dividends]
Same with GE and all the large Pharma stocks. There are countless examples in all capitalization ranges. How are the Buffalo News and Washington Post holdings doing?

The stupidest thing Buffett ever said was that his "favorite holding period is forever." What he should have said was that his favorite holding period is "until some dumb schmuck will pay me some ridiculously unjustified price."

Posted by: Jay Weinstein | October 17, 2008 at 07:25 PM

Another academic ninny who does not understand the turkey problem. A turkey relies on past data for 364 days, and believes that the world in a fairly nice place. On the 365 day, Thanksgiving arrives and the turkey is beheaded.

The US markets will provide historical rates of return until they don't. And you will never know when that will be. People in Japan have been waiting for their stock market to rebound for 20 years.

Personally, I think it is ridiculous to assume that American markets will return historical rates even though America is now a mature, non-emergin economy. The returns of the past 10 years are far more indicative of what we can expect to earn.

Posted by: Incredulous | October 17, 2008 at 09:36 PM

But do the values of the individual stocks follow that same pattern? Does the S&P always consist of the same set of stocks?

Posted by: Patricia Shannon | October 17, 2008 at 10:57 PM

Hey, Mr. Altig: 6.1% pretax over 20 years to take equity-market risk is a "Good" investment? Thankfully you aren't a financial consultant. Try calc'ing the RISK FREE return on Treasurys compounded over that time frame...It's about the same and possibly even HIGHER on an absolute basis. Needless to say, on a risk adjusted basis anyone in index funds over the last 10, 15, 20 years is a Stone-cold Fool.

Posted by: Forward thinker | October 18, 2008 at 12:23 AM

It seems pretty clear from your shared insights & observations of the past few years 'the verdict of history" is NOT "pretty clear'. To the contrary, I believe the substance of your careful & well thought musings convincingly argue that whether we look to or rationalize away historical "lessons" seems pretty much determined by our predilections and predispositions.

Posted by: bailey | October 18, 2008 at 08:15 AM

I hate statistics. In the long run... This chart says.... Asset Allocation this... Warren B blah blah blah. How about using common sense. For example.

Right now cash is king. what you are seeing in the markets is everyone in the world is trying to lock in cash equivalent. Why? who cares but it is happening. Do you need to know why. I don't think so. What you need to know is who is going to want your cash in the near future.

Jim Crammer does care about your cash, he's paid by the financial industry. Advice is not free, what is his motive? The US govenment doesn't care about your cash, they are going to take it from you without even asking you and then give you 1-2% for it.

Belive it or not the market is already telling you who is going to want your cash in 3, 6 12 months. And further every day the market is telling you that these seekers of your cash are willing to pay you more for your cash than the day before. This has been true in all of Oct despite big gyrations in the stock markets up and down.

Hang on to your cash like everyone in the whole world is out to pick your pocket no matter how good their story sounds. If you mangage to break even, you are a lucky one. This may even be more true in a bull market when every story sounds so unbelievably fantastic.

When the now socialist USA sucks every last dime out of the system. (Thanks hank Paulson and congress. We have no choice in this, regardless of who is elected pres.) Any corporation or business that wants to operate and grow will need to borrow from where ever they can get the funds if there is any left after Paulson gives it to his friends.

Guess what happens to business earnings when you borrow at higher and higher rates. Therefore stocks are going to have a hard time. Or harder than in the free money period.

I'm 100% bonds of various types. It ain't gonna make me rich but the money will be their when I need it with a decent return.

Also, read peter Lynch's first book. It's about stocks. But the real insight of the book is how to look at the world around you as you move through it. If you had been paying attention last winter you would have notice that the parking lots in the malls we 30-40 more empty than the year before. This was 3 months before any analyst told you this. This information alone had you been able to undersand it probably would have saved you a big pile of money in 2008. Again you don't need to understand why the malls were empty, only that they were.

I have been doing this since Lynch's book first came out. It is not easy at first but you get better at it over time. I also moved money slowly into this strategy. Lynch's book also sounds to good to be true when you read it. With all the books I have read I can say it is one that has rewarded me the most andI have read far too many because most of them (guess what) do not deliver.

Posted by: Ed S | October 19, 2008 at 02:42 AM

I did a little experiment. The stock market, measured by Dow Jones index, reached its highest point in the first half of the 20th century in 1929. What followed can best be described as the biggest bear market ever recorded. Investors had to wait 25 years before the Dow Jones again reached the record level from 1929. Some casual observer will now say that investors waisted a quarter of the century waiting to break even. That seems logical, doesn't it?

On December 31st 1928, Mr. Unlucky walked into a broker's office on Wall Street with his yearly savings of $100. He wanted to invest in the stock market. On that day, his $100 bought him 0.33 shares of Dow Jones index at $300. His plan was to invest $100 at the end of the every year, and hope for the best. Over the next four years he experienced unimaginable anxiety as his portfolio sunk further and further into the abyss of the Great Depression. He decided he would continue to contribute $100 every year until the Dow Jones reached the level at which he started his investing venture. Over the years, Mr. Unlucky reinvested his dividends back into the Dow Jones.

In 1954, the Dow Jones index finally reached the 1929 level. At the end of that year, Mr. Unlucky decided to pull out of the market. He did not want to go through this kind of roller coaster ever again. Ha had had enough of it. Over the last 26 years, he invested $2600 of his savings in the main index. He wanted his money back...

How do you think his portfolio performed between 1929 and 1954? This is the longest recorded period on the stock market where the main index stayed unchanged. In other words, this was the worst period to invest in the stock market. How did our Mr. Unlucky do during the worst period of the US stock market?

Well, his original portfolio of $2,600 grew to $16,354. The total return on invested capital turned out to be +529%! Is +7.33% per year, during the worst 25 years on the stock market, a bad return? Think about it...

Posted by: Penguin | October 19, 2008 at 10:39 AM

The essential point is that N-year returns are very much dependent on your entry point (as implied in some of the other comments).

Posted by: MW | October 19, 2008 at 11:42 AM

Buy-and-hold has *never* been a smart strategy for the average investor. And Cramer is the last person I would go to for advice.. the best way for an average person to invest his money is to use dollar-cost averaging on an index, like the S&P. This David Altig doesn't seem to know the first thing about investing..

Posted by: kint | October 19, 2008 at 03:25 PM

"Cut your losses quickly, let your profits run". No one seems to realize the asymmetry of percentage loss versus percentage gain needed to recover from the loss. A 50% loss needs a 100% gain just to get back to scratch. Such gains are not easy to come by. I think that extremely few dollar- cost- averaged in the 30s after being slaughtered in 1929.They neither had the money nor the inclination.

Posted by: Jock | October 19, 2008 at 08:13 PM

I'm so glad someone is discussing this! I'm a regular person who has made a hobby of learning about the economy for the past 10 months, and it's driving me nuts to hear the same standard financial planner advice about buy-and-hold from people like Clark Howard and Dave Ramsey, without factoring in the new information that the stock market is giving us now.

I'm of the opinion that regular people should be investing close to home now. Have a little food set aside. Buy future needs now, in case of inflation. Get out of debt, to prepare for the "stag" of possible stagflation. If you have a mortgage and you can sell assets to pay it off, pay it off ASAP, assuming you can keep the house and you want to continue to live there. Asset prices can come and go, as we have seen, but (bailouts excepted) debt (including mortgage) is forever until you pay it off. Paying off the mortgage is a safe bet, which is very valuable in an uncertain economic time like we have now. If you have more cash lying around, invest in green energy things around the home to prepare for a future of increased energy costs.

These investments are better than traditional retirement investments when the markets are crazy, like they are now. They are nearly risk-free. They reduce your cost of living in retirement, so you don't need as much money set aside in the future.

People talk about the long-term results of the stock market, and how a young person would do well to put some money in there and let it grow over the long term. But young people have expenses other than saving for retirement. They have college to pay for, and they should save for a house and money-saving tools and household investment purchases. They should have a little set aside for emergencies, or for raising children if they plan a family. If you don't have these things covered (including the mortgage being paid off in the current environment), you don't really have the money to risk in the markets.

I'm age 35, and I sure don't know anyone with their mortgage paid off. They are lucky if they have 80% equity and a fixed rate mortgage. Most have credit card debt and student loan debt. But I know a lot of people with money in the stock market.

And bonds in the current environment aren't exactly safe either, right? With Arnold saying that California needs a bailout, and Vallejo, California going bankrupt?

Posted by: Sara R | October 20, 2008 at 07:48 PM


Thanks for the link to your interesting article. Both the 1-year and the 10-year SP500 P/E are corecting, finally, and are at or below their historical averages. So is the price/dividend yield ratio, apparently, or at least it was in December 2007. Close enough.

So if the P/E drops below 10 or 11, buy and hold.

I dont really see any difference between normalizing price to earnings versus dividends, in terms of a buy and hold strategy, or in terms of valuing the market in general. Historically, and today, both methods apparently say the same thing at about the same time.

Posted by: Cornelius V. | October 21, 2008 at 02:31 AM

Cornelius V: Not necessarily. Stock prices are more closely tied to their underlying dividends, or perhaps more accurately, the stable component of their earnings.

Since topline earnings tend to be pretty volatile, using the growth rate of dividends as the normalizing metric to the growth rate of stocks cuts out a significant amount of noise. That's what Shiller tried to do with his 10-year inflation-adjusted earnings average in his P/E ratio, but which I find to be a needlessly complicated exercise. You get to the same place a lot faster and with a lot less work using dividends, which is the direct driver of stock prices in the first place.

Now, the practical result when the market is not going through a disruptive event (such as it has been since January 2008) is that you can get a really good indication of whether stocks are over or under valued at any given point in time. Stock prices will show a random (almost normal) variation about a central tendency and you can use the tools of statistical analysis to measure the market.

But that only works when order has emerged in the market (as recognized when both dividends per share and stock prices are growing at sustainable exponential rates over the period of time in question). When that order breaks down, those tools become useless as the market goes through a "reset".

During a reset (or disruptive event), the market is actually acting a lot like a electron orbiting a hydrogen atom. Energy is either being absorbed or emitted by the electron, which causes its orbit to rise or fall. In the case of the stock market, that's either money going in or coming out of the market.

Hopefully, the orbit where it finally settles is stable and order reemerges. When order reemerges, it will be at a different base level and a different relationship between the growth rate of stock prices and dividends per share will exist that what existed previously. And it will resume an "orderly" random walk until the onset of the next disruptive event.

In any case, that's a quick summary of the state of the art in understanding how the stock market works, at least as I've invented it since last December!...

Posted by: Ironman | October 22, 2008 at 09:33 AM

The thing that no one ever talks about is that in decades past, no one used equities for personal retirement investment.

Once you use an asset class (stocks) in a different way than in the past, you must assume that its properties will be altered as well, since the motivators behind its supply/demand curve have changed. So using the last 100 years of stock performance is not as bulletproof as it seems.

For years, retirement dollars have flooded into stocks without asking too many questions (typical 401K investor). When the boomers begin to slowly convert over to fixed income as they age, we could have years of very slow growth of equity prices.

Posted by: Sure, but... | October 28, 2008 at 08:27 PM

Yet another depressing example of the clueless Fed.
The verdict of history is in fact very clear. At some points in history "buy and hold" works and at other points it's an awful strategy.
A child can see what period we are in as this article shows:

Posted by: mickeyc | October 29, 2008 at 12:26 AM

"It's time to unlearn a common myth about investing," Jim Cramer told viewers on Monday. "The best way to invest is not to buy a bunch of stocks and just sit on them."

Got to love the guy, its usually a love/hate thing for me, but I always keep watching. On our end, we're looking for growth companies, some long term, some of course are pennies and we're also looking for some quick hits, part of the game.

I've never been one to buy and hold, (my dad is still mad at me), but I'll admit to a few blue chips on my side of the balance sheet, and like everyone, I got hit recently.

Like the blog, would love you to stop over sometime and comment on our side of the court.


Posted by: penny stocks | January 13, 2009 at 04:31 PM

I am happy to see this extremely useful report. I hope to see similar kinds of information in the future from this blog. Thanks

Posted by: verzilver hypotheek | March 12, 2009 at 12:30 PM

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October 14, 2008

How to build a better auction?

Though the bulk of the attention today has understandably turned to the U.S. Treasury announcement that $250 billion will be devoted to a U.S. bank recapitalization plan, there does still remain the notion that some of the government’s rescue funds will be devoted to purchasing troubled assets through some sort of auction mechanism. At least that’s the way it is according to Neel Kashkari, the Treasury’s point man on implementing the provisions of the Emergency Economic Stabilization Act of 2008. From Bloomberg:

“In addition to the stock-buying effort, other components of TARP include a whole loan purchase program, a mortgage-backed securities purchase program and an insurance program for those securities.

“[Kashkari] outlined three possible scenarios: ‘One, an auction purchase of troubled assets; two, a broad equity or direct purchase program; and three, a case of an intervention to prevent the impending failure of a systemically significant institution,’ he said.”

Thus, one of the more interesting logistical questions of the Treasury plan remains: How to design an auction that will generate “efficient” prices for assets that the government might purchase. A few days ago, Greg Mankiw linked to a proposal from University of Maryland professors Laurence Ausubel and Peter Cramton, which had earlier been noted by Felix Salmon. The key elements of the Ausebel and Cramton plan:

“An auction that determines a real price for a given security needs to require multiple holders of the security to compete with one another. This can be achieved if the Treasury purchases only some, not all, of any given security.

“Thus, a better approach [than a simple reverse auction for all eligible securities] would be for the Treasury to instead conduct a separate auction for each security and limit itself to buying perhaps 50% of the aggregate face value. Again, the auction starts at a high price and works its way down. If the security clears at 30 cents on the dollar, this means that the holders value it at 30 cents on the dollar. (If the value were only 15 cents, then most holders would supply 100% of their securities to be purchased at 30 cents, and the price would be pushed lower.) The auction then works as intended. The price is reasonably close to value. The ‘winners’ are the bidders who value the asset the least and value liquidity the most.”

Writing in Slate, Steve Landsburg offers up what I think is the same idea:

“Here's (roughly) how a ‘Bils-Kremer’ auction would work: First, put 10 similar distressed assets (such as a series of collateralized debt obligations) up for auction. At the close of the auction, the Treasury pays the winning bids for nine of these properties. The 10th property (chosen randomly) gets sold to the winning bidder.

“The advantage of a Bils-Kremer auction is that the Treasury buys assets and recapitalizes the firms holding those assets while paying only what some private bidder thought each property was worth. Now repeat with 10 more properties. And so on. Under this plan, nine-tenths of the liquidity comes from the Treasury, but ten-tenths of the price setting comes from the assessments of private investors with the incentive to bid judiciously. In other words, the prices can reasonably be considered fair.”

Anyone have a better option?

By David Altig, senior vice president and research director of the Federal Reserve Bank of Atlanta

October 14, 2008 in Financial System | Permalink


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I'm missing something pretty basic here.

Everyone keeps saying that we have a completely frozen market, with no bidders. Doesn't that mean we still have zero bidders in these auctions? If someone is willing to bid the hypothetical 15% of face value in some future auction, what stopped them from making that bid today? If they think 15% is a good price, they can offer it tomorrow morning and get all of them they can eat.

Seems like the fact that these securities haven't _already_ started selling is a problem. We know that an auction is going to happen, right? There's some uncertainty around how it's going to work, but presumably everyone thinks it's going to happen.

So why hasn't that fact, all by itself, caused the market to thaw? Surely someone's sitting on a pile of money, thinking to themselves "OK, I think the value in the future Fed auction is going to be three cheeseburgers. I'll go offer two-and-a-half cheeseburgers _right now_ and make a mint on these bad boys."

Seems like: a) it's is happening already, and the auctions won't matter much, or b) no one can figure out the value of these things, so there aren't any real bidders in the government auction either, or c) all of these things put together are worth something approximating three cheeseburgers, and are a waste of time to bid on.

Posted by: James Moore | October 14, 2008 at 09:48 PM

I don't understand Landsburg to be offering the same idea; in his construction, there are private buyers bidding to buy the security while the sellers bid to sell; it's like an "opening auction" on a stock exchange that does such a thing, and the US Treasury has put in a large order to buy at the market price. Ausebel and Cramton don't involve private buyers; it's just the sellers providing offering prices, and the treasury takes the nth lowest price.

Posted by: dWj | October 14, 2008 at 10:58 PM

The insane option is to form 10 (or so) corporations each with a (federal) corporate charter to buy a specific type (and grade, but with real grades this time) of asset. Sell preferred stock worth 20% of the corporation, but say 80% of the voting power on day to day items (i.e. not changing the focus or requirements). Then have the government buy in 80% at whatever level the stock sold for (using a google style auction IPO). Voila instant self guided money pools appropriate to market level. If the initially determined money pool is too small for a market segment you clone the corporation by doing the thing again.

Of course you would probably give the private investors a tiny nudge on the dividends. You'd also have to employ new style corporate governance, e-elections, no poison pills, instant no-confidence, etc.

Still this option avoids some of the pitfalls of the other options (where the private parties don't really have a reason to participate in the market except for nefarious ones, aside from the obvious collusion one, there is the hidden ability to use government money as leverage to "talk up" a market segment by overpaying). Not saying anyone would go for it of course.

Posted by: yasth | October 14, 2008 at 11:49 PM

If I held this mortgage paper, I would sort the customer database by zip code and add up the loan amounts by:

Gauging the value of the loans would be relatively easy as the segregated (by geographical region), measurement of the local market declines, are fairly accurate. I.e., zip codes in California & Florida would be marked down more than Kansas, etc.

This, of course, doesn't measure the credit worthiness of the borrower, rather the value of the debt instrument (house).

Presumably, the type of loan made by the lender, or their payment history, could be used to stratify anticipated mortgage payment returns. There are PhD's in Credit Management that could set up credit scoring.

I just can't believe that value of these securities can't be approximated with any accuracy.

Posted by: flow5 | October 15, 2008 at 04:07 PM

Let's keep it simple. Bernanke says he knows how to stop a deflation. The sequence of deflation fighting progressions was outlined in his infamous "It" speech of Nov. 21, 2002.

He is now down to the last item on the list: the "helicoptor drop" or "money gift". This was what TARP was supposed to accomplish. Therefore, all this talk about pricing mechanisms for the troubled assets is pure rubbish.

Posted by: Anonymous | October 15, 2008 at 11:50 PM

The problem with Steve's plan -- that 10% of the auction bids by private bidders go to private bidders -- is that it is subject to manipulation.

By submitting bids through proxies, a company could drive the price of its assets up without any costs. Winning 10% of the auctions just cycles money around in the company through its proxies, and the company makes a sizable profit on the other 90%.

The reverse auction is a better idea as long as the government can avoid accepting the high bids.

None of these mechanisms deal with the core problem with having the government purchase these so-called "toxic assets", that the scheme only helps the companies' balance sheets if the the government overpays for the assets. That raises the question of whether we should do it at all.

Posted by: Greg | October 16, 2008 at 10:30 AM

One thing that these auctions don't take into account is the counter party risk. Can the seller actually deliver? Do they have a balance sheet that can back up what they are selling?

It is a very difficult problem. Now that I have bought a security, how do I manage my risk associated with it? How do I resell it for a profit?

I like the idea of establishing a variety of central party clearing houses that will compete for the business. Each clearing house would certify the buyers and the sellers-ensuring that counter party risk is gone.

Buyers and sellers then can confidently make markets-and price in the risk to the asset they are bidding on accordingly without having to price in counter party risk. This should make for more competition in the bidding and offering, resulting in a better price.

Posted by: jeff | October 16, 2008 at 12:27 PM

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October 09, 2008

How high is financial risk today?

On a day as brutal as today, it is hard to find any port to hide from the storm. Maybe that is exactly the time for some perspective. At Businomics Blog, Bill Conerly does his best (hat tip, Mark Thoma), making a point that I have heard repeated more than a few times: Taken from the long view, many measures of risk that we take as symptomatic of extreme market stress are not entirely without historical precedent. Dr. Conerly uses this graph of the “TED spread”—the 3-month Libor rate minus the yield on 3-month Treasury bills—to drive the point home:

TED Spread

Here are a couple more graphs on the same theme: The spread between 3-month LIBOR rates and the effective funds rate (which I emphasized in an earlier post)…

3-Month Libor less Effective Funds Rate

… and the spread between yields on commercial paper and secondary-market 3-month Treasury bills.

Commercial Paper less 3-Month Treasury Yields

Comforting? Maybe not. As Conerly notes, your perceptions of the ugliness of the past month or so depends very much on what you believe to be the appropriate reference point. In the context of the period spanning the 60s and 70s the measures of risk and market stress depicted in these charts are not so impressive. However, if you believe that the world fundamentally changed in the 1980s—at the outset of the so-called “Great Moderation”—things are very dysfunctional at the moment.

For my part, I can’t help but recall the following exchange from the movie “No Country for Old Men” after two characters come across a gruesome murder scene.

Deputy Wendell: “It’s a mess, ain’t it sherriff.”

Sherriff Ed Tom Bell: “If it ain’t, it’ll do until the mess gets here.”

In other words, no matter what you compare it with the current environment is plenty challenging.

By David Altig, senior vice president and research director, Federal Reserve Bank of Atlanta

October 9, 2008 in Capital Markets, Financial System | Permalink


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Thank you for the historical perspective. However, the graphs do not appear (?) to be updated with the latest (and more disconcerting) data -

TED Spread is currently at 4.23,

LIBOR of 5.09 less effective funds rate of ~1 to 1.5 (actually less recently) is around 4 - this would be quite literally off the chart in your graph.

(The figures are from Bloomberg)...

Posted by: Murph | October 09, 2008 at 10:27 PM

Is it possible that the TED spread chart that you published is out of date? Bloomberg is currently showing the TED spread as being in excess of 4


Posted by: SalvatoreM | October 10, 2008 at 06:00 AM

The graphs do not, in fact, reflect the circumstances of the last, very dramatic, few weeks. The TED spread is just the graph from Businomics Blog, but the other ones reflect monthly averages. Hence the last observations are from September, and somewhat smoothed at that.

In case it wasn't clear, I am not much convinced by the claim that things are not that unusual just because we can find comparable spreads in many series if we go back to the 60s or 70s (which I believe was Dr. Conerly's point as well). That the latest daily spreads would look worse than what is in the charts only serves to strengthen that conviction, and makes it all the more difficult to maintain the contrary position -- if there is really anyone left who is inclined to do so.

Posted by: Dave Altig | October 10, 2008 at 08:32 AM

Been trading this crap. Unbelievable. Another measure of risk is volatility. The VIX hit a record high today. A guy that trades Eurodollar Options told me that vol was running 102% in the at the money straddle for the most liquid contract!

In 1987, I recall the TED spread springing out to unprecedented levels. It snapped back quickly. The disconnect in the TED has persisted for around a year. It floated in a little, but since last August, the spread has ben bid-and has been volatile.

This market reminds me more of a cancer-1987 was a heart attack.

The way out is to eliminate the counter party risk between banks by using a clearing house to get in between their trades. Then they don't have to worry about balance sheets-they just have to put up risk capital with the clearing house to hold the position.

Posted by: Jeff | October 10, 2008 at 04:19 PM

Fairly dramatic. However, it's worth recalling that the rate of inflation was considerably higher in the mid-to-late 1970s than it is today. So it might be interesting to adjust for that and look at the "real" TED spread.

Posted by: Donald A. Coffin | October 12, 2008 at 07:54 PM

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October 07, 2008

“Why is the Fed Paying Interest on Excess Reserves?”

That’s the question that perplexes Alex Tabarrok. But he has a theory (which is endorsed by William Polley):

“Today the Fed starts to pay interest on reserves. The zero interest on required reserves was an opportunity cost to banks, a tax if you like, so paying interest lifts the tax…

“More interesting is why the Fed will pay interest on excess reserves. In the long run, there are again efficiency gains but why would the Fed want to make it more profitable for banks to hold excess reserves now when we want every dollar in the credit markets? My best guess is that the Fed wants to play more Operation Twist and in Brad DeLong's terms this gives them an additional tool to do it on the Pan-Galactic scale.”

Operation Twist refers to monetary policies deliberately aimed at manipulating the prices of particular assets. The idea is for the central bank to “buy” the targeted assets with central bank money—reserves—or short-term government debt. In the original instance of Operation Twist, the targeted assets were long-term government debt. In the present instance, the assets are presumably the various classes of illiquid private assets that have been targeted by various Federal Reserve lending facilities.

To me, that explanation is just a little too complicated. We like to make it clear that we here at macroblog do not speak for the Federal Reserve, but in this case the Federal Reserve (Board) spoke for itself in a questions and answers document on interest on reserves:

“Why does the Federal Reserve want to pay interest on excess balances?

“Paying interest on excess balances should help to establish a lower bound on the federal funds rate by lessening the incentive for institutions to trade balances in the market at rates much below the rate paid on excess balances. Paying interest on excess balances will permit the Federal Reserve to provide sufficient liquidity to support financial stability while implementing the monetary policy that is appropriate in light of the System’s macroeconomic objectives of maximum employment and price stability. For more information about the implementation of monetary policy with the payment of interest on required reserve balances and excess balances, please see the Federal Reserve Bank of New  York’s website at www.newyorkfed.org.”

A quick look at the data reveals pretty clearly why establishing the lower bound on the funds rate might be of particular interest at the moment. Below is a graph of the daily low in the effective federal funds rate since the end of April (when the federal funds rate target was cut to 2 percent, its current level)…

Effective Funds Rate, Daily Low

… and a graph showing the standard deviation of the daily rate over the same time period.

Effective Funds Rate, Daily Low

As these pictures clearly illustrate, since mid-September the daily effective funds rate lows have been consistently very low, often hitting zero, and the intraday volatility unusually high. This period corresponds to an accelerated use of the various Federal Reserve lending facilities—acquisitions of the Bear Stearns-related Maiden Lane LLC (ML), liquidity assistance to AIG, the Primary Dealer Credit Facility (PDCF), and the Money Market Mutual Fund Liquidity Facility (AMLF), in particular—which have expanded the reserves available to the banking system:

Effective Funds Rate, Daily Low

As noted at Real Time Economics

“The change will encourage banks to leave more money on deposit at the Fed, and that’ll give the Fed more maneuvering room to lubricate the financial system and lend to troubled institutions without increasing the total supply of credit in the economy and pushing down the federal funds interest rate, the Fed’s key interest rate tool.”

This description is just another way of saying what the Federal Reserve said in its questions and answers document released yesterday: “Paying interest on excess balances will permit the Federal Reserve to provide sufficient liquidity to support financial stability while implementing the monetary policy that is appropriate in light of the System’s macroeconomic objectives of maximum employment and price stability.”

Sometimes the simple explanation is the best one.

UPDATE: William Polley follows up.

October 7, 2008 in Federal Reserve and Monetary Policy | Permalink


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Great explanation, thank you - we looked at the same data a couple days ago (http://macrobuddies.blogspot.com/2008/10/steering-fed-funds-rate.html)

It will be interesting to see if the Standard Deviation starts to come down with this change.

Do you have any view on the other major monetary policy change, which allows the Federal Reserve to set the Required Reserve Ratio to any level (including zero), from its current rate of 10% (on larger deposits) ?

Posted by: Murph | October 07, 2008 at 04:18 PM

Reserves are not a tax. Add $1 bill of legal reserves to the banking system and the commercial banks then acquire $100+ bill in earning assets. Then the Treasury recaptures 97%? of the interest on these assets. A good game for all involved.

Legal reserves are a credit control device. The money supply can never be managed by any attempt to control the cost of credit.

Why not drop rates to zero? Just larger interest rate differentials or spreads (higher profits)for the borrowers.

Proper monetary policy involves getting the commercial banks out of the savings business (e.g. reductions, July 20, 1966 & Sept 6, 1966 in the 1966 housing crisis)-- the first reductions since Feb 1, 1935). There was an immediate increase in the supply of loan funds, reductions in long-term & short-term interest rates, increases in bank profits, reductions in inflation, & favorable effects on unemployment & production.

Posted by: flow5 | October 08, 2008 at 02:34 PM

Ive been following some of your post and like what you have done, i had a question/comment on your resent blog, i think its probably time for the government to step out of the picture and let the free markets rip appart all of the banks. I know that would cause havoc for a period of time but its better then the government trying to fix the private sector which it clearly has no ability to do.

Posted by: Free Refinance Guru | October 09, 2008 at 05:33 PM

Legal Reserves are NOT a tax. The only tax is INFLATION.

Posted by: flow5 | October 17, 2008 at 01:45 PM

Isn't one of the main objectives of all the Fed activity to get banks to lend in the market. So why make it more expensive to lend overnight? That's what needs to be explained.

Posted by: joebek | October 18, 2008 at 07:22 PM

very interesting explanation, thank you. I would like to update graph 3 on Federal reserve assets, but I don't know where I can get the data. I see they are from Fed Reserve Board H.4.1, but it is not possible to get the times series using the "data download program" available on the Board of Governors web site. Do you have any suggestions? Thanks a lot

Posted by: silvio | October 24, 2008 at 05:01 PM

Why isn't it working? FF's have traded at 1bp in two of the last four trading days?

Posted by: Ray Zemon | November 04, 2008 at 06:34 PM

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October 02, 2008

The ISM Index breaks the magic number

If you are weary of troubling news from the financial sector, the week thus far has provided no relief in the form of good news from the economy’s real side. Monday brought troubling signs from the August report on income and consumption, Tuesday more of the same dismal adjustment in house prices, and yesterday an eye-opening ISM manufacturing report that elicited the following sort of headlines (to which I’ve added the emphasis):

Stunning Decline in Manufacturing Sector (Mark Thoma, channeling Real Time Economics)

ISM manufacturing index plunges (Calculated Risk)

ISM Implodes (Mike Shedlock)

No doubt about it, a 6.4 index-point drop in one month gets people’s attention. How unusual is that large a change in the index? Pretty unusual:

Changes in ISM Index

Even so, the more important part of the story may be the level to which the index fell:

ISM Index

The index now stands at 43.5. Over the past 30 years, index levels below 45 have not failed to be associated with a recession, either contemporaneously or with a short lag. Throw that and the other indicators of the week in with the most recent “freefall” in auto sales, and it’s enough to make some smart guys despair.


October 2, 2008 in Data Releases, Economic Growth and Development, Labor Markets | Permalink


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I think the Fed needs to reprise Operation Twist, the open market operation they performed in the 1960s by SELLING T-bills and BUYING 5-year treasury notes.

The markets are screaming for this.

Matt Dubuque

Posted by: Matt Dubuque | October 02, 2008 at 08:24 PM

In other words, the elite economists of the USA, given vast data, computers and years of really, really hard training, have concluded that there's a good chance that we're in a recession.

Posted by: Barry | October 03, 2008 at 01:00 PM

Is your sense that this decline is due to the credit crunch or could it be related to something else, e.g., a strengthening dollar leading to a decline in exports?

Posted by: DaveinHackensack | October 03, 2008 at 11:36 PM

Just look how steep and sudden that drop is. Amazing, but I am afraid it'll continue to drop for quite a while.

Posted by: Rjecnik | October 17, 2008 at 02:11 AM

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