I'm still penciling through some recent bank financial reports, and I keep coming back to JPMorgan Chase CEO Jamie Dimon's shareholder letter. Around page thirty on, there are plenty of good nuggets.
He notes that banks today, driven by backward-looking regulation, are part of a banking system "that is stronger than it ever has been." Yet, the bond market, and particularly the Treasury market, could be the venue for an event-driven crisis in any one of three or four hotspots around the world.
Regulation has made market making in bonds less profitable, and although bond market spreads have come down and stayed low, the market depth has actually declined. The letter says, "..the market depth of 10-year Treasuries (defined as the average size of the best three bids and offers) today is $125 million, down from $500 million in 2007." This despite the fact that today's Treasury market is $12.5 trillion as opposed to $4.4 trillion in 2007. Dealer inventories are down 75% from their 2007 levels. There's no need to run a complex stress test to see that this is not a healthy market for the asset of choice in a global crisis.
For all the talk about a "flash crash" in stocks, the October 15th, 2014 one day move of 40 bp in Treasuries was a much more serious "shot across the bow." As the CEO's letter points out, this was a move of 7-8 standard deviations!
Bond investors like Blackrock and others have been writing about the need to innovate these markets for some time, but the point is now that the time to formulate a new structure, agree among the market participants, issuers and regulators will be years in this political environment. A crisis could come in the fall, as they often do.
The supply of Treasuries available for sale is relatively small, given the large size of the stock and the burgeoning demand. Total Treasuries outstanding are said to be $13 trillion. At least $6 trillion are tied up in central bank forex holdings, another $2.5 trillion on the Fed balance sheet, and another $0.5 trillion held by big banks as liquid assets. Take out this $9 trillion, and about $4 trillion are potentially available to be traded.
The Japanese central bank, for currency and other economic reasons, has published aggressive targets for purchasing Treasuries on top of the $1.238 trillion which they already hold.
In the event of a typical run, driven by the next crisis, global investors will look to U.S. Treasuries as they did in the last crisis, when more than $2 trillion in demand was created by the fire sales of risky assets.
On April 6th, Wall Street Journal correspondent Michael Casey's lead sentence was "The bond market is malfunctioning." In a full-blown flight from risk, this could be an understatement.
Showing posts with label Money Markets. Show all posts
Showing posts with label Money Markets. Show all posts
Monday, April 27, 2015
Friday, April 4, 2014
The Yellen Fed Doesn't Sound Like A Central Bank
Too much was made over the choice of successor to former Fed Chairman Bernanke. Making the choice a political or gender equity issue would not have been a good thing, and it seemed logical that someone who had been a longstanding partner to Bernanke would assure continuity, thereby assuaging nervous markets.
Unfortunately, the early "communications" issues have unsettled even the most experienced Fed watchers I know and respect. John Cochrane, AQR Professor of Finance at Chicago Booth School of Business, has identified the underlying problem as being that central banking globally has morphed into something that it is not, claiming powers that it does not have.
That was made manifest recently, in Fed Chair Yellen's public pronouncement about the Fed focusing its policies on labor markets and unemployment.
Given that macroeconomic models don't incorporate any kind of realistic financial sector, and given our very weak recovery, in its fifth year, had its origins in the financial sector and asset markets, no responsible economist could claim that the Fed has the understanding or tools to address failures and frictions in the labor market.
As we've written about many times, unconventional monetary policies such as quantitative easing and unbounded periods of low interest rates have have essentially done nothing for the economy, as evidenced by the unemployment rates. Again, as we warned from the outset, these novel constructions would have unintended consequences given our lack of experience with their mechanism of action.
Former BIS Economic Adviser William White's paper, which we've cited before, is still worth reading. Focusing on the shadow banking system, he cites research suggesting the shadow banking system was procyclical in the credit upturn, which seems well agreed upon; he also suggests that it may be procyclical in the credit downturn, which is debated. In a simple model, he shows that the behavior of this sector and our financial sector as a whole, may be a powerful mechanism for increasing inequality of both income and wealth.
Right now, we have a disconnect between expectations for what central banks can achieve (remember Mario Draghi?) and what they really can do. Dodd-Frank has made the Fed the de facto Regulator-in-Chief of the financial sector, and the guardian of asset prices, housing prices, and architect of financial stability. To this we are adding labor markets and unemployment.
We've written before that one of the greatest strategic blunders made by the Bernanke Fed was to effectively become an enabler for fiscal profligacy by his employers in the White House and Senate. The role of the Fed Chair historically was more 'big picture' focusing on rates, inflation, and the currency. This is a massive agenda in itself, but the Fed was never to be the engineer of policy. It provided the backdrop for markets to set the term structure of rates and for the economy to move forward with real economic growth.
When warranted, the Fed Chair would call for fiscal responsibility from the executive and legislative branches, and sometimes the Chair would have to 'lean against the wind,' even if only rhetorically. That's because the Fed was always independent of elections, politics, and of the noisy public square, including Wall Street.
Today, the Fed no longer makes any call for responsible fiscal policy, and now it is firmly in the camp of perpetuating the current status quo of discretion based, as opposed to rules based policies, which is disquieting to experienced Fed watchers who could always infer a path from Taylor Rules and the like. Now, all bets are off. So, financial markets continue to soar, our inflation rate is minimal, corporate profits are up, and the bubbles continue in corporate assets (companies) fueled by large appetites for investment grade corporate debt.
Meanwhile, the traditional financial sector, namely the six mega-banks are effectively becoming ensconced as the heart of our financial system, with no effective competition. We still don't know what systemically important means, as we randomly suggest that it applies to insurers like Met Life and to asset managers.
Because of the cynical way in which Dodd-Frank was passed, the regulations that will be at the heart of the future evolution of the system and the source of shocks, are being written away from the eyes of the electorate by anonymous lawyers and policy wonks, all aided and abetted by their favored activists and lobbyists.
The final problem facing central bankers is the IMF's incessant clarion call for national central banks to make their decisions in "a global framework." This sounds like an innocuous platitude, leading to many meetings at tony locations with lots of papers and meaningless declarations. John Cochrane adds that the real motive may be to pool together all the lenders of last resort and to spread the costs of carrying the weaker players among the stronger players. Our Federal Reserve and the taxpayers certainly doesn't need to take on that burden too.
Central bankers need to be independent of politicians and of Wall Street gunslingers, and their measured, predictable tweaks to the economic engine which enhance growth, moderate cycles and preserve the value of the currency are their most valuable contribution to Main Street.
Unfortunately, the early "communications" issues have unsettled even the most experienced Fed watchers I know and respect. John Cochrane, AQR Professor of Finance at Chicago Booth School of Business, has identified the underlying problem as being that central banking globally has morphed into something that it is not, claiming powers that it does not have.
That was made manifest recently, in Fed Chair Yellen's public pronouncement about the Fed focusing its policies on labor markets and unemployment.
Given that macroeconomic models don't incorporate any kind of realistic financial sector, and given our very weak recovery, in its fifth year, had its origins in the financial sector and asset markets, no responsible economist could claim that the Fed has the understanding or tools to address failures and frictions in the labor market.
As we've written about many times, unconventional monetary policies such as quantitative easing and unbounded periods of low interest rates have have essentially done nothing for the economy, as evidenced by the unemployment rates. Again, as we warned from the outset, these novel constructions would have unintended consequences given our lack of experience with their mechanism of action.
Former BIS Economic Adviser William White's paper, which we've cited before, is still worth reading. Focusing on the shadow banking system, he cites research suggesting the shadow banking system was procyclical in the credit upturn, which seems well agreed upon; he also suggests that it may be procyclical in the credit downturn, which is debated. In a simple model, he shows that the behavior of this sector and our financial sector as a whole, may be a powerful mechanism for increasing inequality of both income and wealth.
Right now, we have a disconnect between expectations for what central banks can achieve (remember Mario Draghi?) and what they really can do. Dodd-Frank has made the Fed the de facto Regulator-in-Chief of the financial sector, and the guardian of asset prices, housing prices, and architect of financial stability. To this we are adding labor markets and unemployment.
We've written before that one of the greatest strategic blunders made by the Bernanke Fed was to effectively become an enabler for fiscal profligacy by his employers in the White House and Senate. The role of the Fed Chair historically was more 'big picture' focusing on rates, inflation, and the currency. This is a massive agenda in itself, but the Fed was never to be the engineer of policy. It provided the backdrop for markets to set the term structure of rates and for the economy to move forward with real economic growth.
When warranted, the Fed Chair would call for fiscal responsibility from the executive and legislative branches, and sometimes the Chair would have to 'lean against the wind,' even if only rhetorically. That's because the Fed was always independent of elections, politics, and of the noisy public square, including Wall Street.
Today, the Fed no longer makes any call for responsible fiscal policy, and now it is firmly in the camp of perpetuating the current status quo of discretion based, as opposed to rules based policies, which is disquieting to experienced Fed watchers who could always infer a path from Taylor Rules and the like. Now, all bets are off. So, financial markets continue to soar, our inflation rate is minimal, corporate profits are up, and the bubbles continue in corporate assets (companies) fueled by large appetites for investment grade corporate debt.
Meanwhile, the traditional financial sector, namely the six mega-banks are effectively becoming ensconced as the heart of our financial system, with no effective competition. We still don't know what systemically important means, as we randomly suggest that it applies to insurers like Met Life and to asset managers.
Because of the cynical way in which Dodd-Frank was passed, the regulations that will be at the heart of the future evolution of the system and the source of shocks, are being written away from the eyes of the electorate by anonymous lawyers and policy wonks, all aided and abetted by their favored activists and lobbyists.
The final problem facing central bankers is the IMF's incessant clarion call for national central banks to make their decisions in "a global framework." This sounds like an innocuous platitude, leading to many meetings at tony locations with lots of papers and meaningless declarations. John Cochrane adds that the real motive may be to pool together all the lenders of last resort and to spread the costs of carrying the weaker players among the stronger players. Our Federal Reserve and the taxpayers certainly doesn't need to take on that burden too.
Central bankers need to be independent of politicians and of Wall Street gunslingers, and their measured, predictable tweaks to the economic engine which enhance growth, moderate cycles and preserve the value of the currency are their most valuable contribution to Main Street.
Tuesday, September 4, 2012
Jeff Gordon of Columbia Law on Money Market Funds
Professor Jeff Gordon of Columbia Law School posted on a blog this morning about an issue we covered in yesterday's post, namely the failure to reform money market mutual funds (MMF).
Here's an excerpt from his post:
However, the bigger potential, systemic risk locus is in the repo market itself and in its mechanics. In particular, I refer to the risks posed to the two clearing banks in the event of a large broker-dealer's inability to get short-term funding and the dealer's subsequent failure.
MMF are one class of cash investors. which are but one element of the repo market. The broker-dealers perform a valuable service, but they too get a 'free ride' in the shadow banking system's repo market. A freezing up of their short-term financing poses significant systemic risk, as opposed to shareholder risks at the MMF.
All of this "reaching for yield" is exacerbated in the continuing low-interest rate environment, which is not attributed as social cost of the unconventional monetary policy of the Fed.
Here's an excerpt from his post:
"The core problem, which the SEC staff has identified, is that money funds hold risky assets but have no independent capacity to bear loss — no capital nor any other loss-absorbing layer. In times of systemic instability, money fund users will run, because being first in line to redeem may increase the chance of receiving 100 percent. A required “holdback” of a small percentage of deposited funds for a fixed period would reverse the run dynamics because it would mean that an investor’s best chance to avoid loss is from not running. That plus a small capital layer would add considerable stability to the money market fund industry.My take on this is different. The SEC's effort, and perhaps rightly so, was to focus on improving MMF transparency beyond the current level of additional disclosures, and to increase their capacity to bear loss. Additionally, a holdback in investor redemptions would have added an element of shareholder risk sharing, which partly addresses the 'free rider' problem. Good ideas.
Money market funds assemble diversified packages of short term credit claims, particularly short term claims issued by banks and other financial institutions. In their present fixed NAV form money funds can play a useful transactional role as a bank substitute, especially for large institutions with large cash balances that exceed the limits of deposit insurance guarantees. But stability of the financial system is a public good that cannot be sustained in the presence of pervasive free-riding. The present money fund structure is like a nuclear power plant atop an earthquake fault. The question of a disaster is not whether but when."
However, the bigger potential, systemic risk locus is in the repo market itself and in its mechanics. In particular, I refer to the risks posed to the two clearing banks in the event of a large broker-dealer's inability to get short-term funding and the dealer's subsequent failure.
MMF are one class of cash investors. which are but one element of the repo market. The broker-dealers perform a valuable service, but they too get a 'free ride' in the shadow banking system's repo market. A freezing up of their short-term financing poses significant systemic risk, as opposed to shareholder risks at the MMF.
All of this "reaching for yield" is exacerbated in the continuing low-interest rate environment, which is not attributed as social cost of the unconventional monetary policy of the Fed.
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