Keynesian traps and flooding the building

A frequent correspondent sent me a link to Phillip's Economic Computer, a wonderful analogue device designed to illustrate the flow of money within the economy. And that got me thinking...

A very rough and brutal sketch of Keynes' classical account of the savings trap is that if people save too much, rather than consume, then the velocity of money drops, inventory builds up, growth falls (and even goes negative) as businesses cut back on production. A standard account of the liquidity trap by Krugman is here.

How does the Phillip's device help? Well, it points out a truth that is often hard to see, namely that money can only be created or destroyed by the central bank. Credit cannot be 'created' without funding; money cannot disappear. These days, rather little money is stored in mattresses or bank vaults: most of it is in the form of bank deposits, securities, or other investments. And of course those assets are someone else's liabilities, i.e. funding for them. Thus these days your choice is not between putting your cash under the bed and spending it: it is between putting it in a bank - which will lend it to someone else - and spending it. In this sense saving is not quite as bad as in the classical Keynesian account, as it provides funding for corporations and individuals who do want to engage in economic activity. Even buying government bonds is not useless as the government spends the money on something.

Now of course the increase in economic activity provided by a dollar of spending on goods may be rather more than that provided by a dollar of bank deposits. But it is worth noting that the dollar of bank deposits are not useless: the bank has to do something with your money, and that something probably has positive economic value. Anything else would cause funds to build up rather too fast at the bank - something the Phillip's computer would model as water flooding out...

Excess Liquidity

Ian Campbell, on breakingviews.com, has a nice statement of a view I have had for a while.

in their anti-deflationary fervour, central banks may be creating more money than depressed economies require. The surplus creates "excess liquidity" - which may be feeding a new series of stock, commodity, property and bond bubbles...

Sebastian Becker, an economist with Deutsche Bank in Frankfurt, defines excess liquidity as money supply that is surplus to the needs of real economic activity, and therefore free to be invested in financial assets. Becker combines monetary growth figures for the US, Japan, the eurozone, the UK and Canada and finds excess liquidity - measured as a rising stock of money to GDP - in these economies is now being created more rapidly than in the late 1990s stock-market bubble, or during the subsequent house price boom.

Excess liquidity is a really hard thing to estimate, as it is the difference between two really big numbers: the supply of money, and the economy's demand for money. But this really is a Goldilocks situation: you want the money supply to be just right for economic needs. If, perhaps because you are worried about the banking system's access to liquidity, you supply too much, then it is just going to be invested in financial assets, creating a bubble. Are we, I wonder, in the early phases of the first post Crunch bubble?

Tucking in

Bank of England’s Deputy Governor Paul Tucker gave a speech yesterday which FT alphaville picked up. He is surprised by something that doesn't shock me in the least:

...it would be good if regulators, internationally, required all banks regularly to turn over a meaningful share of their ’stock liquidity’ in the market on a reasonably regular basis. That would also help to put banks in a position to reap the benefits of the Bank’s Discount Window Facility, through which, as I have described, sound banks can borrow gilts. Frankly, it has been shocking over the past year or so to discover how many medium-sized banks and building societies did not hold government bonds or other very high quality assets; or, if they did, how many did not have a regular presence in the gilt repo market or even had no capacity to repo at all. Turning up in the core secured-funding markets for the first time for years is an absolute give away of distress. All that has to change.

Gilts trade well under Libor. The gilt repo market is sleepy and sometimes not particularly efficient. Is the Deputy Governor really that surprised that that smaller banks choose not to dabble in a market that will likely lose them money, and which has been something of an insider's club? I know the Bank believes that gilts are the cornerstone of the market, but from the late 90s to 2007 it was the Libor market, not the Gilt market, that was by far the most important source of interbank funding for most players. The only way that the Bank is going to change that is by getting FSA to require banks to buy gilts - which is exactly what they are doing.

On transaction liquidity

Naked Capitalism has a typically engaging post on transaction liquidity.

One of the arguments apparently being made in Washington by those who oppose regulation of credit default swaps is that it would reduce liquidity and that of course would be a terrible thing.

Fair enough. A priori it is not clear if having transaction liquidity is a good or a bad thing.

One of the comments I have heard from debt market participants in the bubble era was that they were faced with a 'wall of liquidity", tons of money looking for places to park it. And some of that appeared to be the direct result of credit default swaps. CDS allowed banks in Europe to circumvent capital requirements, enabled investment banks to accelerate profits from deals into the current period by (in theory) defeasing risk, allowed banks to extend bigger loans than they would have otherwise by hedging some of the risk.

Let us look at these one by one.

• Capital. That was the regulator's fault and not the banks'. And it had little to do with liquidity. So yes, it was a bad thing, but it has nothing to do with either CDS per se or with transaction liquidity.
  
• Profits. There are arguments in both directions for fair value vs. accrual, but again this has nothing to do with either CDS or liquidity.
  
• Hedging. Here's the nub. A lower cost of capital is good for the economy when it is growing. But if it is created by over-leveraging the financial system, then clearly it is dangerous.

Let us turn back to NC:

Behavioral finance studies have found that even in simple bidding setting, participants create bubbles. Low transaction costs and the appearance of abundant liquidity supports short-term, momentum based trading strategies, with participants believing they can find the exits when they need to... Higher frictional costs lead investors to think twice about adding and exiting positions.

This is also a good point. Transaction liquidity supports the development of crowded trades, but often there is not enough to support their closing. I wonder if we should consider some form of frequency based regulation, whereby more frequent traders require more capital.

Personally, then, I think the case remains tantalisingly unproven. In traditional equity markets, abundant liquidity supports price discovery, permits speedy asset reallocation, and lowers everyone's cost of capital. But patchy liquidity, whereby there are periods of liquidity which can suddenly disappear, as in the ABS market and some other areas of credit, is deeply unhelpful. What we really need is more constant liquidity, so that liquidity assessment is possible for the life of a trade. Perhaps market maker requirements have a place here: obliging firms to provide liquidity in good times and bad - a feature of the equity but the credit markets - could help to even things out. And certainly if we are going to intervene to improve liquidity (as in the TALF), then we need to consider the possible negative effects of too much liquidity.

A recent trade explained

Why did I sell short dated Wells Fargo bonds at a small loss recently? Because as Bloomberg reveals today, Banks’ Bondholders May Be Next to Share Bailout Pain. Do I think that senior debt holders will take a haircut soon? Probably not. But probably not wasn't good enough, especially when Geithner can turn on a pin. If investors stay well away from bank debt of any kind until the dust has cleared, I wouldn't blame them. Of course, if they do that, then banks' funding problems will only get worse...

Real Solvency and Fantasy Solveny

There is a `the banks are insolvent' meme going around at the moment. It's rubbish, but something close to it may be true.

The reason it is rubbish is that solvency means assets > liabilities under the firm's accounting standards. This is clearly true for all the large banks.

What the commentators mean by `the banks are insolvent' really, then, is `under my idea of what accounting standards should be, the banks would be insolvent'. Clearly this is a little different, however rational the particular accounting counterfactual concerned is.

Let's look at some of the choices in the space of accounting methods.

• Pure accrual accounting would value every asset and liability under accrual accounting, with whatever loan loss reserves the firm can get past its auditors being taken. Under this measure pretty much every bank is solvent.
  
• Pure rigourous fair value would use fair value for everything, with prudent valuation adjustments being taken wherever there is uncertainty. Under this measure, many banks would be insolvent.

Most banks definitions of solvency are closer to the first than the second of these at the moment, of course. I suspect that most commentators who say that the banking system is insolvent are implicitly thinking of something like pure rigourous fair value. In any event, there are many, many accounting standards between these two extremes, of which any given bank's choice is one.

Two more things to note.

First, insolvency implies that the bank is not capitally adequate, but capital adequacy is a stronger constraint. It implies solvency* plus capital > capital requirements**. Losses challenge both solvency and capital adequacy as they erode capital, but the capital adequacy test is hit before the solvency one.

Second, solvency or insolvency have nothing to do with liquidity. A bank can be insolvent and perfectly able to fund itself (if that fact is well enough hidden) and highly solvent but unable to fund.

For further reading, see a good if long post by John Hempton here.

*Actually this is not quite true as the regulatory notion of solvency is not quite the same as the accounting one. Regulators apply a few (typically minor, in the big scheme of things) valuation adjustments to GAAP.

**The definition of Capital is much more country specific than that of Capital requirements. The `Basel 2 capital requirement' is close to being the same everywhere (although there are some differences in national implementations). But the definition of capital varies significantly, especially in the treatment of things like deferred tax assets, goodwill, and unrealised gains on held to maturity positions.

Catatonic with fear

A bit of an exaggeration perhaps, but this Bloomberg article has a good point:

“With the banks in a state of catatonic fear now, they’re just sitting on the [TARP] capital,” Blinder [Princeton economics professor] said in an interview. “I don’t fault the banks one bit, since this shows Wall Street they’re safer, but then this doesn’t get you much improvement. If you’re taking money from the public purse, we should get something in return, and we’re really not.”

There is an easy way of fixing it. Make the banks pledge new retail and corporate loans as collateral at the window. For a billion of fresh cash, you must post five billion of lending made in the last month, something like that.

Making money from the TALF

Accrued Interest has a great post on the newly expanded TALF. An edited version follows:

Fed will loan funds for purchase of recently issued ABS. This [means] ABS issued after January 1, 2009 made up of loans no older than October 2007. The ABS must be rated AAA, and be made up of student loans, auto loans, small business loans, or credit cards.

Loans will be non-recourse and not marked-to-market.

The loan term will be up to 3-years.

The loan rate will be set at "yield spreads higher than in more normal market conditions but lower than in the highly illiquid market conditions that have prevailed during the recent credit market turmoil."

So, buy some ABS, repo it to term with the FED. Sit back and enjoy positive carry, no margin calls, and, err, that's it. Gentlemen, start your engines.

A new tool

There has been a lot of comment over John Gieve's comments to the BBC. The programme has not been broadcast yet, so let me confine myself to one point. Gieve apparently says

Maybe we need to develop something which bridges that gap and directly addresses the financial cycle and prevents the financial cycle and the credit cycle getting out of hand... I think we need to complement interest rates, which are a blunt instrument - you set one interest rate for the whole economy - with something which is more financial-sector specific."

I would suggest we have at least two such things already. One is capital requirements. The other is monetary policy, specifically the implementation of policy via the money supply, which collateral qualifies at the window and the exact rules concerning bank reserve balances.

Update. I have now seen the program: it is mostly a Robert Peston hagiography, which I had hoped was beneath the BBC. Still I suppose if Jonathan Ross can't get fired for what he did it is too much to expect the Corporation not to laud Peston's rumour mongering.

The most interesting remark in the program for me came from John Varley. Asked if banks had taken too much risk before the Crunch, he said that they did. But he then went on to say that regulators and politicians `acquiesced in this extraordinary boom'. As a judgement that struck me as very much on the money.

Your friend Ted

Margin Revolution has an interesting piece on the TED spread. They take St. Louis FED data on the 3 month T-bill series and 3m Eurodollar deposits (rather than BBA Libor) to get a long term view of the TED spread.That does put the current travails in perspective slightly.

Any old bonds

Any old bonds? Any old bonds?
Any, any, any old bonds?
You look neat. Talk about a treat!
You look so dapper from your napper to your feet.
Dressed in style, brand-new tile,
And your father's old repo on.
But I wouldn't give you tuppence for your old MBS,
Old MBS, old MBS.

This is one in a series of bad lyric interventions. In this case, inspiration comes from the ECB.

How to ungum the interbank market

I should have thought of this: FairEconomist did (via NakedCapitalism). The answer is of course for the central bank to require a certain amount of interbank lending as collateral at the window. There's no reason not to make interbank receiveables eligible given the other things that are, and by requiring that banks use them, the Central Bank forces their clients to lend.

Funding or capital?

I don't believe this post but I think it is interesting... John Hempton maintains that the US banking system has, or at least could soon have if it retained earnings, enough capital. [My first worry is that while this might be true on aggregate, some institutions are undercapitalised, and the market does not know who is know because they do not believe banks marks and they think there are hidden losses.]

He then maintains that the problem is funding. That is, given the banks reliance on wholesale funding, it is the inability to borrow that is sending the system to hell in a handcart - or at least sending the TED spread to 3%. Given the central bank liquidity flooding the system I don't believe this part either. I do think Hempton is right about confidence being key, but surely the cheapest way to buy some of that it to fix the underlying mortgages. Still, it is an interesting argument and I'd like to see a three way debate between John, the proponents of 'recapitalise the system' and those who think mortgage mods are the way to go.

Libor At Five Year High

It's probably more than five years... From Bloomberg:More at the Big Picture.

Mark to Paulson

Everyone is worried about the prices that Hank will pay with the taxpayer's money in his bailout plan. That is understandable, and I would be worried too if it was my money.

However there is some possibility that it won't be a disaster every time the MOAB buys an asset. Here's why.

On average, across the cycle, you are paid more to take credit risk than it costs you in defaults. So if you were arbitrarily well capitalised and could wait forever, simply buying a diversified pool of credit risky assets will make money. (Whether it has a decent ROE is another question.)

The reasons for this gap between fundamental long term buy and hold value and market value are numerous: cost of funds (not everyone funds at Libor flat), liquidity premiums, volatility of the spread (which requires capital to support it, at least for mark to market holders) and so on.

Now of course Hank isn't buying a diversified pool, and he is not buying across the cycle. He's buying what the banks want to sell, and he's buying in the next year or two.

Still, it is at least good to know that if you buy for more than the market price, and hold to maturity (or at least until the liquidity and funding premiums have fallen substantially), you _could_ (not will, but could) make money. (Bloomberg has more on the MOAB as a carry trade.)

Graph of the day year?

From the Short View on the FT, US bank borrowings from the FED over time:That really speaks for itself, doesn't it?

Drug policy

The ECB is taking steps to withdraw the crack cocaine of the Eurozone financial system, cheap liquidity. From the FT:

the cost of raising funds from the ECB against any kind of asset-backed bond or unsecured bank debt will rise, once the rules are implemented in February...

The most straightforward changes were an increase in the haircuts, or discount, applied to the worth of collateral. For asset-backed securities, such as mortgage-backed bonds, this was increased to a flat rate of 12 per cent from a base of 2 per cent. If a bank has created such a bond and kept it on balance sheet for repo purposes, a further 5 per cent haircut is added.

For normal unsecured bank debt, the haircut is also increased by 5 percentage points from a 1.5 per cent base.

As Willem Buiter points out, this is going to be interesting for those Eurozone banking systems that are suffering from a housing crash and a concomitant liquidity drought:

Between August 2007 and July 2008, the share of Spanish banks in the Eurosystem’s allocation of main refinancing operations and longer-term refinancing operations went up from about 4 percent to over 10.5 percent. The share of Irish banks went up from around 4.5 percent to 9.5 percent.

I still think Buiter is wrong on the central policy issue: the ECB should take (some limited) risk if by so doing it helps reliquify the financial system as a whole. But like him I applaud these steps towards stopping the gaming of the ECB's collateral facility. And I think this is a big signal to short Spanish and Irish banks with lots of 2005-2007 vintage mortgage exposure.

The biggest SIV in the world ponders its next move

The dumping-rubbish-ABS-into-the-ECB story is warming up nicely. The FT reports:

The European Central Bank faces an acute dilemma: on the one hand it needs to ensure that banks have access to adequate liquidity, but on the other it needs to prevent banks profiting unduly from central bank funding. Recent signs of banks undermining the ECB’s generous rules on collateral are worrying, and the ECB should address them promptly. What it cannot afford to do is cause a new storm in the markets. That is easier said than done...

Spanish banks are scaling up their use of mortgage-backed securities to obtain funding from the ECB – in place of investors willing to take them off their balance sheets.

So, ECB, what's it to be? Moral hazard and a subsidy to any bank that can brew up Euro ABS, or a Spanish banking crisis?

What is the bond/CDS basis?

Accrued Interest has a fascinating data point on the troubles of the financials at the moment: Citi's latest five year was done at 337 over Treasuries or roughly 235 over Libor.

AI then suggests that there is an arb between CDS at 160 over and the bond at 239 over. In ordinary conditions that would be true because in ordinary conditions a trader would assume he or she could fund the bond at Libor flat, buy the CDS at 160, be risk flat, and make 79 running. But... firstly at the moment there aren't many Libor flat funders. The C deal discussed is evidence enough of that. And second you are only risk free if the CDS is guaranteed to pay - and which counterparty can be sure of that for in a situation where Citigroup is in default? The 160 over then does not reflect the real cost of being sure of protecting Citi debt, but rather the credit weighted average cost across typical CDS counterparties: buying protection on C from Berkshire Hathaway, say, would probably be more expensive (it certainly ought to be if Warren's folks are sharp).

A trade like long the debt long CDS protection only makes sense if (Bond spread over Libor - my funding cost over Libor to term) > (CDS spread + cost of complete credit protection on CDS counterparty for CDS receivable). The 2nd and 4th terms are typically small in an ordinary market. But this ain't no ordinary market.

Liquifying the ECB balance sheet

The Economist points out an issue:

The European Central Bank (ECB), widely praised for providing banks with ample liquidity during the credit crunch, now has a problem: how to encourage banks to place freshly created asset-backed securities (ABS) with investors, rather than dumping them, like so much radioactive waste, in its vaults...

On the face of it there is no immediate problem. Only around 16% of the ECB's collateral so far is ABS. Banks are drinking from the liquidity fountain and keeping the cost of high-street mortgages contained at the same time, which they might not be able to do otherwise.

But it is not helping the revival of a publicly traded ABS market, and may be fostering the creation of even murkier securities. Many of today's ABS are even less transparent than those sold before the crisis—the ECB requires a rating by only one agency, not the usual two, and pre-sale reports are often sloppily prepared.

What's the answer? Well one obvious one is slowly, and with considerable vigilance over the market impact, to raise the haircuts. Countercyclical central bank window haircuts make sense. As matters improve, the ECB can tone down its roll as financer of first (and only) choice.

Another is to permit the assignment of the financing as I mentioned earlier. The ECB could allow banks to sell the securities and transfer the obligation to repay to a third party. Obviously that means the ECB would have to be willing to offer liquidity for a short period to firms who were not necessarily member banks. But if that helps restart the ABS market, it might be a small price to pay.