18th Annual Hyman P. Minsky Conference on the State of the U.S. and World Economies
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Showing posts with label minsky. Show all posts
Showing posts with label minsky. Show all posts
5 May 2009
4 May 2009
The End of Ponzi Prosperity ~ Satyajit Das
04.05.2009
Lessons of the Global Financial Crisis: 1. The End of Ponzi Prosperity
By: Satyajit Das
We Are All Keynesians Now!
In January 1971, Richard Nixon recanted years of opposition to budget deficits declaring: "Now, I am a Keynesian." Nixon had borrowed the line from Milton Friedman who had used it in 1965. Then, we embraced Monetarism and flirted with "supply side" economics, christened "voodoo economics" by President George Bush Senior. Now, in the wake of the Global Financial Crisis ("GFC"), it seems that we are all Keynesians again.
The GFC is really a "Minsky moment". In Stabilizing an Unstable Economy (1986), Hyman Minsky outlined a hypotheses that excessive risk taking, driven in part by stability lead to market breakdowns - stability is itself destablising.
The current crisis is financial, economic, social and increasingly ideological. Nikolas Sarkozy, President of France, has pronounced the death of laissez-faire capitalism: "c’est fini". World leaders have penned fevered attacks on neo-liberalism. Even religious leaders have spoken out.
Dead economists have been resurrected in support of political positions. As Keynes himself observed: "The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back."
No "pure" economic model has been implemented in living memory, except perhaps in North Korea. The theories themselves rarely work. John Kenneth Galbraith is reported as saying: "Milton’s [Friedman’s] misfortune is that his policies have been tried."
Criticisms of the ancien regime are substantive and deserved. There have been undoubtedly egregious market failures, management excesses and errors in the lead up to the GFC. But the key lessons of the crisis may be subtler than first evident.
Growth has been driven by cheap and abundant debt and uncosted carbon emissions and other forms of pollution. The reality is that this period of growth may be coming to an end.
All brands of politics and economics have been informed by assumptions about the sustainability of high levels of economic growth and the belief that governments and central bankers can exert a substantial degree of control over the economy. Harry Johnson, the famed Chicago economist, writing about England in the 1970s with his wife Elizabeth in (1978) The Shadow of Keynes provides a vivid description of this pre-occupation: "…faster economic growth is the pancea for all..economic and for all that matter political problems and that faster growth can be easily achieved by a combination of inflationary demand-managementpolocies and poltically appealing fiscal gimmickry."
Goldilocks Economy
P.J.O’Rourke writing in Eat The Rich (1998) observed that: "Economics is an entire scientific discipline of not knowing what you’re talking about."
Recent global prosperity derived from a fortunate confluence of low inflation and low interest rates. In the 1980s, brutally high interest rates and recessions squeezed inflation out of the economy facilitating lower interest rates. Low energy prices, following the first Gulf War, helped keep inflation low and fuelled growth.
The fall of the Berlin Wall in 1989 and the reintegration of the command economies of Eastern Europe, China and India into global trade provided low cost labour helping maintain the supply of cheap goods and services. Emerging economies provided substantial new markets for products and capital driven by the very high levels of savings in these countries.
Deregulation of key industries, such as banking and telecommunications, fostered growth by increasing access to finance and improved essential infrastructure. Adoption of new technologies, such as information technology and the Internet, improved productivity and assisted growth, though the extent is disputed.
Many countries switched from employer or government pension schemes to private retirement saving arrangements underwritten by generous tax incentives. Rapid growth in this pool of investment capital was also a factor in growth.
Governments, irrespective of political persuasion, benefited from the favourable economic environment. The ability of governments and central banks to control and "fine tune" the economy with a judicial mixture of monetary and fiscal policy became an article of accepted faith. Voters were lulled into false confidence by a mixture of rising wealth, improved living standards and stability.
Elegant theories about the "Great Moderation" or "Goldilocks Economy", with the benefit of hindsight, seem to be little more than narrative fallacies where a convincing but meaningless story is shaped to fit unconnected facts and coincidence is confused with causality.
Ponzi Prosperity
Growth, in reality, was founded on a series of elegant Ponzi schemes.
Consumption rather than investment drove growth, particularly in the developed world. Debt fuelled consumption became the norm. In the new economy, there were three kinds of people – "the haves", "the have-nots", and "the have-not-paid-for-what-they-haves".
The consumption was financed by borrowings supplied by a deregulated financial system. Many workers’ earnings fell in inflation adjusted terms as a result of global competition and associated outsourcing and off shoring practices. The ability to borrow against the appreciation in owner occupied houses and other financial assets underpinned consumption.
Investors, central banks with large reserves, pension funds and asset managers channeling privatised retirement savings, eagerly purchased the debt. Borrowing fueled higher asset prices allowing even greater levels of borrowing against the value of the asset. This virtuous cycle – a "positive feedback loop" – fueled the "doctor feel good" economy of recent years.
"Financial engineering" replaced "real engineering" in many countries. Entire cities (London and New York) and economies (Iceland) become dominated by the rapidly growing financial services industry. In the US, financial services’ share of total corporate profits increased from 10% in the early 1980s to 40% in 2007. The stockmarket value of financial services firms increased from 6% in the early 1980s to 23% in 2007.
The reliance on financial innovation proved disastrous. In A Short History of Financial Euphoria (1994), John Kenneth Galbraith noted that: "Financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design . . . The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version."
Financially engineered growth extended into international trade flows. Since the 1990s, there has been a substantial build-up of foreign reserves in central banks of emerging markets and developing countries that became the foundation for a trade finance scheme.
Many global currencies were pegged to the dollar at an artificially low rate, like the Chinese Renminbi, to maintain export competitiveness. This created an outflow of dollars (via the trade deficit driven by excess US demand for imports based on an overvalued dollar). Foreign central bankers purchased US debt with dollars to mitigate upward pressure on their domestic currency. The recycled dollars flowed back to the US to finance the spending on imports.
The process relied on the historically unimpeachable credit quality of the USA and large, liquid markets in dollars and dollar investments capable of accommodating the very large investment requirements. This merry-go-round kept US interest rates and cost of capital low encouraging further borrowing to finance consumption and imports to keep the cycle going.
Foreign central banks holding reserves were lending the funds used to purchase goods from the country. The exporting nations never got paid at least until the loan to the buyer (the vendor finance) was paid off. Essentially, growth in global trade was also debt fuelled.
Moderate debt levels are sustainable provided the value of the asset supporting the borrowing is stable and significantly higher than the amount of the loan. The borrower or the collateral for the loan must generate sufficient income to service and repay the borrowing. In the frenzied market environment of low interest rates and ever rising asset prices, the level of collateral cover and ability to service the loans deteriorated sharply. In 2005, rising interest rates and a cooling in the US housing market set the stage for the GFC.
Sigmund Freud once remarked that: "Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces." The GFC was the reality on which the fake pleasure of the Great Moderation and Goldilocks economy was smashed.
Taking the Cure
There is currently confusion between the disease and the cure. The "disease" is the excessive debt and leverage in the financial system, especially in the US, Great Britain, Spain and Australia. The "cure" is the reduction of the level of debt that is now underway (the great "de-leveraging").
The initial phase of the cure is the reduction in debt within the financial system. Some of the debt created during the Ponzi prosperity years will not be repaid. Non-repayment of this debt, in turn, has caused the failure of financial institutions. The process destroys both existing debt and also limits the capacity for further credit creation by financial institutions.
Total losses from the GFC to financial institutions, according the latest estimates, will be in excess of US$ 2 trillion. Banks need additional capital to cover assets that were parked in the "shadow banking system" (the complex of off-balance sheet special purpose vehicles) but are now returning to the mother ship’s balance sheet. The global banking system, in aggregate, is close to technically insolvent.
Commercial sources for recapitalisation are limited as losses mount and the outlook for the financial services industry has deteriorated. Government ownership or de facto nationalisation is the only option to maintain a viable banking system in many countries.
Even after recapitalisation the capital shortfall in the global banking system is likely to be around US$ 1-3 trillion. This equates to a forced contraction in global credit of around 20-30% from existing levels.
The second phase of the cure is the effect on the real economy. The problems of the financial sector have increased the cost and reduced availability of debt to borrowers for legitimate business purposes. The scarcity of capital means that banks must reduce their balance sheets by reducing their stock of loans. Normal financing and loans are now being effectively rationed in global markets.
This forces corporations to reduce leverage by cutting costs, selling assets, reducing investment and raising equity. This also forces consumers to reduce debt by selling assets (where available) and reducing consumption.
"Negative feedback loops" mean reduction in investment and consumption lowers economic activity, placing stresses on corporations and individuals setting off bankruptcies that trigger losses for the financial system that further reduces lending capacity. De-leveraging continues through these iterations until overall levels of debt reach a sustainable level determined by lower asset prices and cash flows available to service the debt.
Within the financial sector, de-leveraging is well advanced. In the real economy it is in the early stages. The process echoes Joseph Schumpter’s famous maxim of "creative destruction".
© 2009 Satyajit Das All Rights reserved.
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).
This article draws on the ideas first published in Satyajit Das "Built to Fail" in The Monthly (April 2009) 8-13
http://www.eurointelligence.com/article.581+M553774d2c37.0.html
Lessons of the Global Financial Crisis: 1. The End of Ponzi Prosperity
By: Satyajit Das
We Are All Keynesians Now!
In January 1971, Richard Nixon recanted years of opposition to budget deficits declaring: "Now, I am a Keynesian." Nixon had borrowed the line from Milton Friedman who had used it in 1965. Then, we embraced Monetarism and flirted with "supply side" economics, christened "voodoo economics" by President George Bush Senior. Now, in the wake of the Global Financial Crisis ("GFC"), it seems that we are all Keynesians again.
The GFC is really a "Minsky moment". In Stabilizing an Unstable Economy (1986), Hyman Minsky outlined a hypotheses that excessive risk taking, driven in part by stability lead to market breakdowns - stability is itself destablising.
The current crisis is financial, economic, social and increasingly ideological. Nikolas Sarkozy, President of France, has pronounced the death of laissez-faire capitalism: "c’est fini". World leaders have penned fevered attacks on neo-liberalism. Even religious leaders have spoken out.
Dead economists have been resurrected in support of political positions. As Keynes himself observed: "The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back."
No "pure" economic model has been implemented in living memory, except perhaps in North Korea. The theories themselves rarely work. John Kenneth Galbraith is reported as saying: "Milton’s [Friedman’s] misfortune is that his policies have been tried."
Criticisms of the ancien regime are substantive and deserved. There have been undoubtedly egregious market failures, management excesses and errors in the lead up to the GFC. But the key lessons of the crisis may be subtler than first evident.
Growth has been driven by cheap and abundant debt and uncosted carbon emissions and other forms of pollution. The reality is that this period of growth may be coming to an end.
All brands of politics and economics have been informed by assumptions about the sustainability of high levels of economic growth and the belief that governments and central bankers can exert a substantial degree of control over the economy. Harry Johnson, the famed Chicago economist, writing about England in the 1970s with his wife Elizabeth in (1978) The Shadow of Keynes provides a vivid description of this pre-occupation: "…faster economic growth is the pancea for all..economic and for all that matter political problems and that faster growth can be easily achieved by a combination of inflationary demand-managementpolocies and poltically appealing fiscal gimmickry."
Goldilocks Economy
P.J.O’Rourke writing in Eat The Rich (1998) observed that: "Economics is an entire scientific discipline of not knowing what you’re talking about."
Recent global prosperity derived from a fortunate confluence of low inflation and low interest rates. In the 1980s, brutally high interest rates and recessions squeezed inflation out of the economy facilitating lower interest rates. Low energy prices, following the first Gulf War, helped keep inflation low and fuelled growth.
The fall of the Berlin Wall in 1989 and the reintegration of the command economies of Eastern Europe, China and India into global trade provided low cost labour helping maintain the supply of cheap goods and services. Emerging economies provided substantial new markets for products and capital driven by the very high levels of savings in these countries.
Deregulation of key industries, such as banking and telecommunications, fostered growth by increasing access to finance and improved essential infrastructure. Adoption of new technologies, such as information technology and the Internet, improved productivity and assisted growth, though the extent is disputed.
Many countries switched from employer or government pension schemes to private retirement saving arrangements underwritten by generous tax incentives. Rapid growth in this pool of investment capital was also a factor in growth.
Governments, irrespective of political persuasion, benefited from the favourable economic environment. The ability of governments and central banks to control and "fine tune" the economy with a judicial mixture of monetary and fiscal policy became an article of accepted faith. Voters were lulled into false confidence by a mixture of rising wealth, improved living standards and stability.
Elegant theories about the "Great Moderation" or "Goldilocks Economy", with the benefit of hindsight, seem to be little more than narrative fallacies where a convincing but meaningless story is shaped to fit unconnected facts and coincidence is confused with causality.
Ponzi Prosperity
Growth, in reality, was founded on a series of elegant Ponzi schemes.
Consumption rather than investment drove growth, particularly in the developed world. Debt fuelled consumption became the norm. In the new economy, there were three kinds of people – "the haves", "the have-nots", and "the have-not-paid-for-what-they-haves".
The consumption was financed by borrowings supplied by a deregulated financial system. Many workers’ earnings fell in inflation adjusted terms as a result of global competition and associated outsourcing and off shoring practices. The ability to borrow against the appreciation in owner occupied houses and other financial assets underpinned consumption.
Investors, central banks with large reserves, pension funds and asset managers channeling privatised retirement savings, eagerly purchased the debt. Borrowing fueled higher asset prices allowing even greater levels of borrowing against the value of the asset. This virtuous cycle – a "positive feedback loop" – fueled the "doctor feel good" economy of recent years.
"Financial engineering" replaced "real engineering" in many countries. Entire cities (London and New York) and economies (Iceland) become dominated by the rapidly growing financial services industry. In the US, financial services’ share of total corporate profits increased from 10% in the early 1980s to 40% in 2007. The stockmarket value of financial services firms increased from 6% in the early 1980s to 23% in 2007.
The reliance on financial innovation proved disastrous. In A Short History of Financial Euphoria (1994), John Kenneth Galbraith noted that: "Financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design . . . The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version."
Financially engineered growth extended into international trade flows. Since the 1990s, there has been a substantial build-up of foreign reserves in central banks of emerging markets and developing countries that became the foundation for a trade finance scheme.
Many global currencies were pegged to the dollar at an artificially low rate, like the Chinese Renminbi, to maintain export competitiveness. This created an outflow of dollars (via the trade deficit driven by excess US demand for imports based on an overvalued dollar). Foreign central bankers purchased US debt with dollars to mitigate upward pressure on their domestic currency. The recycled dollars flowed back to the US to finance the spending on imports.
The process relied on the historically unimpeachable credit quality of the USA and large, liquid markets in dollars and dollar investments capable of accommodating the very large investment requirements. This merry-go-round kept US interest rates and cost of capital low encouraging further borrowing to finance consumption and imports to keep the cycle going.
Foreign central banks holding reserves were lending the funds used to purchase goods from the country. The exporting nations never got paid at least until the loan to the buyer (the vendor finance) was paid off. Essentially, growth in global trade was also debt fuelled.
Moderate debt levels are sustainable provided the value of the asset supporting the borrowing is stable and significantly higher than the amount of the loan. The borrower or the collateral for the loan must generate sufficient income to service and repay the borrowing. In the frenzied market environment of low interest rates and ever rising asset prices, the level of collateral cover and ability to service the loans deteriorated sharply. In 2005, rising interest rates and a cooling in the US housing market set the stage for the GFC.
Sigmund Freud once remarked that: "Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces." The GFC was the reality on which the fake pleasure of the Great Moderation and Goldilocks economy was smashed.
Taking the Cure
There is currently confusion between the disease and the cure. The "disease" is the excessive debt and leverage in the financial system, especially in the US, Great Britain, Spain and Australia. The "cure" is the reduction of the level of debt that is now underway (the great "de-leveraging").
The initial phase of the cure is the reduction in debt within the financial system. Some of the debt created during the Ponzi prosperity years will not be repaid. Non-repayment of this debt, in turn, has caused the failure of financial institutions. The process destroys both existing debt and also limits the capacity for further credit creation by financial institutions.
Total losses from the GFC to financial institutions, according the latest estimates, will be in excess of US$ 2 trillion. Banks need additional capital to cover assets that were parked in the "shadow banking system" (the complex of off-balance sheet special purpose vehicles) but are now returning to the mother ship’s balance sheet. The global banking system, in aggregate, is close to technically insolvent.
Commercial sources for recapitalisation are limited as losses mount and the outlook for the financial services industry has deteriorated. Government ownership or de facto nationalisation is the only option to maintain a viable banking system in many countries.
Even after recapitalisation the capital shortfall in the global banking system is likely to be around US$ 1-3 trillion. This equates to a forced contraction in global credit of around 20-30% from existing levels.
The second phase of the cure is the effect on the real economy. The problems of the financial sector have increased the cost and reduced availability of debt to borrowers for legitimate business purposes. The scarcity of capital means that banks must reduce their balance sheets by reducing their stock of loans. Normal financing and loans are now being effectively rationed in global markets.
This forces corporations to reduce leverage by cutting costs, selling assets, reducing investment and raising equity. This also forces consumers to reduce debt by selling assets (where available) and reducing consumption.
"Negative feedback loops" mean reduction in investment and consumption lowers economic activity, placing stresses on corporations and individuals setting off bankruptcies that trigger losses for the financial system that further reduces lending capacity. De-leveraging continues through these iterations until overall levels of debt reach a sustainable level determined by lower asset prices and cash flows available to service the debt.
Within the financial sector, de-leveraging is well advanced. In the real economy it is in the early stages. The process echoes Joseph Schumpter’s famous maxim of "creative destruction".
© 2009 Satyajit Das All Rights reserved.
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).
This article draws on the ideas first published in Satyajit Das "Built to Fail" in The Monthly (April 2009) 8-13
http://www.eurointelligence.com/article.581+M553774d2c37.0.html
8 November 2008
Debt Trap
The economy lost 651,000 jobs in three months. Auto sales have collapsed, and retail sales have “fallen off a cliff.” And there is at this point little indication that Credit Availability will normalize anytime soon for household, corporate or municipal borrowers. While the extraordinary efforts by the Fed and global central bankers have loosened the clogged up inter-bank lending market, risk markets remain hopelessly paralyzed. The unfolding collapse of the leveraged speculating community continues to overhanging the marketplace. Securitization markets are still essentially closed for business.
We can continue to analyze developments in the context of two overarching themes: First, there is the implosion of contemporary “Wall Street finance.” Second, the bursting of the Credit Bubble has initiated what will be an arduous and protracted economic adjustment. Each week provides additional confirmation of the interplay between the breakdown of Wall Street risk intermediation and the bursting of the U.S. Bubble Economy. This process has gained overwhelming momentum.
I know some analysts are anticipating an eventual return to “normalcy.” The thought is that it is only a matter of time before “shock and awe” policymaking and Trillions of newly created liquidity entice investors and speculators back into risk assets. This view is too optimistic, and history offers an especially poor guide in this respect. By and large, the unprecedented growth in Federal Reserve and global central bank balance sheets is (scarcely) accommodating de-leveraging. Between the hedge funds, global “proprietary trading” and other leveraged speculators, it is not unreasonable to contemplate an overhang of (prospective forced and deliberate sales) of upwards of $10 Trillion.
It’s popular to label Federal Reserve operations as a massive effort to “print money.” Yet it is important to recognize that, at least to this point, the expansion of the Fed assets (“Fed Credit”) is counterbalanced by the collapsing balance sheets of leveraged financial operators. The inflationary effects – the increased purchasing power created by the expansion of Credit – occurred back when the original loan was made, securitized, and leveraged by, say, a hedge fund. Today’s ballooning central bank holdings (and TARP spending) may very well stem financial system implosion. This is, however, a far cry from engendering a meaningful increase in either the market’s appetite for risk assets or the expansion of new system Credit in the real economy.
I don’t want to imply that unprecedented monetary policy measures aren’t having an impact. Overnight lending rates (Libor) were quoted at 0.33% today, down from a spike to almost 7.00% in late September. And at 2.29%, three-month Libor has dropped from early October’s 4.82%. Other measures of systemic risk and liquidity premiums (including the 2- and 10-year dollar swap spreads) have dropped dramatically over the past month.
The problem is that the “unclogging” of inter-bank and “money” markets has had little effect on the Pricing and Availability of Credit for the vast majority of borrowers operating throughout the real economy. After ending September at about 650, junk bond spreads have surged to 950 bps. Investment-grade bond spreads are also higher today than at the end of the third quarter. Benchmark MBS spreads have changed little, while Jumbo mortgage borrowing rates remain elevated. Risk premiums for municipal borrowings have been reduced only somewhat from extreme levels. Unsound borrowers everywhere have little hope of borrowing anywhere.
There are complaints out of Washington that, despite oodles of bailout funding, the banks are refusing to lend. Well, total bank Credit has expanded $575bn over the past 10 weeks, or 32% annualized. Importantly, the asset-backed securities (ABS), collateralized debt obligation (CDO), and securitization markets generally remain closed for new business.
The heart of the matter is not so much that banks are refusing to extend Credit but that the entire mechanism of Wall Street risk intermediation has collapsed. After ballooning into multi-Trillion dollar avenues for Credit expansion, intermediation through the ABS and CDO markets is basically over. The convertible bond market has also badly malfunctioned, along with the “private-label” MBS marketplace. Wall Street’s “auction-rate securities” has ceased as a mechanism for Credit expansion, along with myriad other avenues for securitization. And, importantly, derivatives markets, having evolved into an essential element of contemporary risk intermediation and Credit expansion, have suffered a devastating crisis of confidence. Scores of leveraged strategies are no longer viable. Indeed, Monetary Processes essential for funding broad cross-sections of the economy have completely broken down.
Even if banks had a desire to make the same types of risky loans Wall Street financed throughout the boom (which they clearly don’t), it is difficult to envisage how bank Credit could today adequately compensate for the interrelated collapses in Wall Street risk intermediation and leveraged speculation. And unlike previous crises, no amount of rate cuts, liquidity injections, or policymaker jawboning will revive leveraged speculation. That historic Bubble and mania has burst, and it is now only a matter of waiting to dissect the devastation wrought by the unfolding run on the industry. A typical Federal Reserve-induced return to risk-taking in the Credit markets will be stymied for some time to come by an unrivaled inventory of debt instruments overhanging the markets.
The critical issue then becomes how the system can generate sufficient new Credit to keep our asset markets and Bubble economy from completely imploding. Well, we can assume at this point that the Fed will continue to accommodate de-leveraging through the ballooning of its balance sheet. At the same time, the federal government will soon be running Trillion dollar annual deficits. GSE balance sheets will likely commence a period of aggressive expansion. And, importantly, the banking system will have no alternative than to expand rapidly. At this point, timid banks equate to a Bubble Economy spiraling into depression.
If the markets cooperate, perhaps over the coming months the now breakneck economic contraction will somewhat stabilize. I fear, however, that current dynamics are setting the stage for yet another stage of this vicious crisis. Some analysts believe – and certainly it is the Fed’s intention – for ultra-low interest rates to assist in the recapitalization of the banking system. The early 1990’s provides a nice example: aggressive rate cuts and a steep yield curve provided a backdrop for troubled banks to quietly convalesce by raising cheap deposits and sitting on a safe portfolio of longer-term government debt securities. Why can’t a similar operation bail the banks out of their current predicament?
One should note the stark contrasts between today’s environment and that from the early nineties. First of all, 10-year government yields averaged about 7.8% in the three years 1990 through ’92. Bond markets back then were commencing a historic bull run and, strangely enough, the price of government debt ran higher in the face of huge deficits. There are reasons these days to fear an emergent bond bear. Second, from the Fed’s “flow of funds” report, we know that “Total Net Borrowing and Lending in Credit Markets” averaged $770 billion annually during the ’90-’92 period. “Total Net Borrowing…” last year approached a staggering $4.40 TN. The important point is that today’s Bubble Economy Dynamics were not in play in the early nineties. Sustaining the system required a fraction of today’s Credit creation, thus there was little prevailing pressure on the banks back then to lend amid their “convalescing.”
Indeed, banking system impairment and resulting Fed policymaking engendered the emergence of Wall Street finance in the early nineties – from the Wall Street firms, the GSEs, securitizations, derivatives and leveraged speculation. All were more than happy to take up the slack in bank Credit creation – relating both the overall and banking systems.
With the Bursting of the Bubble in Wall Street Finance, the banking system will today have no alternative than to lend and expand Credit aggressively. The banks provide the only hope for reflation, and there will be no room for nineties-style risk-free spread government carry trades. Instead, it will now be the banking system’s role to take up enormous systemic Credit slack and rapidly expand its portfolio of risk assets. Especially at this precarious stage of the Credit cycle, the banking system’s predicament ensures the ongoing need for hugely expensive government funded industry recapitalizations.
In today’s interest rate and market environment, massive government deficits don’t worry the bond market. I view the marketplace as quite complacent when it comes to the scope of unfolding Treasury and agency debt issuance. Actually, the Treasury, the GSEs and the banking system have in concert succumbed to Debt Trap Dynamics. With Wall Street risk intermediation now out of the equation, the system is down to four principal sources of “money” creation – the Fed, Treasury, GSEs and the Banks. It’s that old “inflate or die” dilemma that’s already smothered Wall Street finance.
The good news is these sources of Credit creation do today retain the capacity to somewhat stabilize financial and economic systems. The bad news is that going forward all four must expand aggressively – in collaboration - to forestall acute systemic crisis. All four must expand aggressively to bolster a highly maladjusted economic system, in the process sustaining confidence in the value of their liabilities. At some point, one would expect a crisis of confidence with respect to the quality of these Credit instruments. And, you know, the way things have unfolded, Murphy’s Law would only seem to dictate a destabilizing jump in market yields.
nolan
We can continue to analyze developments in the context of two overarching themes: First, there is the implosion of contemporary “Wall Street finance.” Second, the bursting of the Credit Bubble has initiated what will be an arduous and protracted economic adjustment. Each week provides additional confirmation of the interplay between the breakdown of Wall Street risk intermediation and the bursting of the U.S. Bubble Economy. This process has gained overwhelming momentum.
I know some analysts are anticipating an eventual return to “normalcy.” The thought is that it is only a matter of time before “shock and awe” policymaking and Trillions of newly created liquidity entice investors and speculators back into risk assets. This view is too optimistic, and history offers an especially poor guide in this respect. By and large, the unprecedented growth in Federal Reserve and global central bank balance sheets is (scarcely) accommodating de-leveraging. Between the hedge funds, global “proprietary trading” and other leveraged speculators, it is not unreasonable to contemplate an overhang of (prospective forced and deliberate sales) of upwards of $10 Trillion.
It’s popular to label Federal Reserve operations as a massive effort to “print money.” Yet it is important to recognize that, at least to this point, the expansion of the Fed assets (“Fed Credit”) is counterbalanced by the collapsing balance sheets of leveraged financial operators. The inflationary effects – the increased purchasing power created by the expansion of Credit – occurred back when the original loan was made, securitized, and leveraged by, say, a hedge fund. Today’s ballooning central bank holdings (and TARP spending) may very well stem financial system implosion. This is, however, a far cry from engendering a meaningful increase in either the market’s appetite for risk assets or the expansion of new system Credit in the real economy.
I don’t want to imply that unprecedented monetary policy measures aren’t having an impact. Overnight lending rates (Libor) were quoted at 0.33% today, down from a spike to almost 7.00% in late September. And at 2.29%, three-month Libor has dropped from early October’s 4.82%. Other measures of systemic risk and liquidity premiums (including the 2- and 10-year dollar swap spreads) have dropped dramatically over the past month.
The problem is that the “unclogging” of inter-bank and “money” markets has had little effect on the Pricing and Availability of Credit for the vast majority of borrowers operating throughout the real economy. After ending September at about 650, junk bond spreads have surged to 950 bps. Investment-grade bond spreads are also higher today than at the end of the third quarter. Benchmark MBS spreads have changed little, while Jumbo mortgage borrowing rates remain elevated. Risk premiums for municipal borrowings have been reduced only somewhat from extreme levels. Unsound borrowers everywhere have little hope of borrowing anywhere.
There are complaints out of Washington that, despite oodles of bailout funding, the banks are refusing to lend. Well, total bank Credit has expanded $575bn over the past 10 weeks, or 32% annualized. Importantly, the asset-backed securities (ABS), collateralized debt obligation (CDO), and securitization markets generally remain closed for new business.
The heart of the matter is not so much that banks are refusing to extend Credit but that the entire mechanism of Wall Street risk intermediation has collapsed. After ballooning into multi-Trillion dollar avenues for Credit expansion, intermediation through the ABS and CDO markets is basically over. The convertible bond market has also badly malfunctioned, along with the “private-label” MBS marketplace. Wall Street’s “auction-rate securities” has ceased as a mechanism for Credit expansion, along with myriad other avenues for securitization. And, importantly, derivatives markets, having evolved into an essential element of contemporary risk intermediation and Credit expansion, have suffered a devastating crisis of confidence. Scores of leveraged strategies are no longer viable. Indeed, Monetary Processes essential for funding broad cross-sections of the economy have completely broken down.
Even if banks had a desire to make the same types of risky loans Wall Street financed throughout the boom (which they clearly don’t), it is difficult to envisage how bank Credit could today adequately compensate for the interrelated collapses in Wall Street risk intermediation and leveraged speculation. And unlike previous crises, no amount of rate cuts, liquidity injections, or policymaker jawboning will revive leveraged speculation. That historic Bubble and mania has burst, and it is now only a matter of waiting to dissect the devastation wrought by the unfolding run on the industry. A typical Federal Reserve-induced return to risk-taking in the Credit markets will be stymied for some time to come by an unrivaled inventory of debt instruments overhanging the markets.
The critical issue then becomes how the system can generate sufficient new Credit to keep our asset markets and Bubble economy from completely imploding. Well, we can assume at this point that the Fed will continue to accommodate de-leveraging through the ballooning of its balance sheet. At the same time, the federal government will soon be running Trillion dollar annual deficits. GSE balance sheets will likely commence a period of aggressive expansion. And, importantly, the banking system will have no alternative than to expand rapidly. At this point, timid banks equate to a Bubble Economy spiraling into depression.
If the markets cooperate, perhaps over the coming months the now breakneck economic contraction will somewhat stabilize. I fear, however, that current dynamics are setting the stage for yet another stage of this vicious crisis. Some analysts believe – and certainly it is the Fed’s intention – for ultra-low interest rates to assist in the recapitalization of the banking system. The early 1990’s provides a nice example: aggressive rate cuts and a steep yield curve provided a backdrop for troubled banks to quietly convalesce by raising cheap deposits and sitting on a safe portfolio of longer-term government debt securities. Why can’t a similar operation bail the banks out of their current predicament?
One should note the stark contrasts between today’s environment and that from the early nineties. First of all, 10-year government yields averaged about 7.8% in the three years 1990 through ’92. Bond markets back then were commencing a historic bull run and, strangely enough, the price of government debt ran higher in the face of huge deficits. There are reasons these days to fear an emergent bond bear. Second, from the Fed’s “flow of funds” report, we know that “Total Net Borrowing and Lending in Credit Markets” averaged $770 billion annually during the ’90-’92 period. “Total Net Borrowing…” last year approached a staggering $4.40 TN. The important point is that today’s Bubble Economy Dynamics were not in play in the early nineties. Sustaining the system required a fraction of today’s Credit creation, thus there was little prevailing pressure on the banks back then to lend amid their “convalescing.”
Indeed, banking system impairment and resulting Fed policymaking engendered the emergence of Wall Street finance in the early nineties – from the Wall Street firms, the GSEs, securitizations, derivatives and leveraged speculation. All were more than happy to take up the slack in bank Credit creation – relating both the overall and banking systems.
With the Bursting of the Bubble in Wall Street Finance, the banking system will today have no alternative than to lend and expand Credit aggressively. The banks provide the only hope for reflation, and there will be no room for nineties-style risk-free spread government carry trades. Instead, it will now be the banking system’s role to take up enormous systemic Credit slack and rapidly expand its portfolio of risk assets. Especially at this precarious stage of the Credit cycle, the banking system’s predicament ensures the ongoing need for hugely expensive government funded industry recapitalizations.
In today’s interest rate and market environment, massive government deficits don’t worry the bond market. I view the marketplace as quite complacent when it comes to the scope of unfolding Treasury and agency debt issuance. Actually, the Treasury, the GSEs and the banking system have in concert succumbed to Debt Trap Dynamics. With Wall Street risk intermediation now out of the equation, the system is down to four principal sources of “money” creation – the Fed, Treasury, GSEs and the Banks. It’s that old “inflate or die” dilemma that’s already smothered Wall Street finance.
The good news is these sources of Credit creation do today retain the capacity to somewhat stabilize financial and economic systems. The bad news is that going forward all four must expand aggressively – in collaboration - to forestall acute systemic crisis. All four must expand aggressively to bolster a highly maladjusted economic system, in the process sustaining confidence in the value of their liabilities. At some point, one would expect a crisis of confidence with respect to the quality of these Credit instruments. And, you know, the way things have unfolded, Murphy’s Law would only seem to dictate a destabilizing jump in market yields.
nolan
16 October 2008
Uncle Sam's A.R.M.~ ......Dude, where's the Dharma?
As many home-owners have or are in the process of discovering, adjustable rate mortgage (A.R.M.s) payments can quickly become unmanageable when rates reset. As interest charges double or triple the wisdom of a long term fixed rate mortgage becomes clear.
Fortunately the wise men at the Treasury Department are well versed in such matters and didn't succumb to the temptation of "teaser" rates.
Right?
Wrong.
According to the US Treasury, as of June 2008 (thus not inclusive of the recent bail-outs and mortgage market nationalization), of the $2.72T in government debt owned by foreigners, $1.2T has a duration of under 2 years. In other words, interest rates on that $1.2T ($1.4T including interest payments) will be reset in the next 24 months.
Expanding the scope to include all US external debt, as of June 2008, of the $11.7T of debt owned by foreigners, $6.3T has a duration of under 2 years.
One of Hyman Minsky's claims to fame is his research on the transition from financial stability to fragility in a capitalist economy experiencing a bubble- the Financial Instability Hypothesis.
The Levy Institute, continuing Minsky's research, argues: The aim of these hypotheses is to show that the normal functioning of “a capitalist economy endogenously generates a financial structure which is susceptible to financial crises”because of the higher sensitivity of the economy to changes in income, cash commitments and asset prices. Thus, it is important to explain how the financial structure of the economy (or a sector) changes. This implies studying how it is affected by the prevailing convention regarding the appropriate balance-sheet and cash-flow structures, and by thedevelopments in the productive economy: both the expectation and actual sides of the economyaffect the financial structure of the economy.
The logic of this financial instability hypothesis is that during a prosperous economicperiod, there are forces that progressively lead the economy from conservative financialpositions (hedge positions) to positions for which the articulation of cash flows is high andbalance sheets are illiquid and highly leveraged (Minsky 1986a, 210-211):
The logic of this theorem is twofold. First, within a financial structure that is dominated by hedgefinance, there will be a plentiful supply of short-term funds, so that short-term financing is“cheaper” than long-term financing. Accordingly, firms will be tempted to engage in speculativefinance. Second, over a period of good times, the financial markets will become less averse torisk. This leads to the proliferation of financing forms that involve closer coordination of cashflows out with cash flows in—that is, narrower safety margins and greater use of speculative andPonzi financing. (Minsky 1986b, 5)
In other words, Minsky, a proponent of financial regulation, argued that unregulated finance was prone to succumb to the temptation of lower short term rates. Debt duration would decrease and financial stability would be lost.
And so it has.
With the fiscal deficit expected to rise dramatically over the next 2 years, the US Treasury will not only need to finance that expansion, it will also need to roll-over the maturing short term debt.
Good Luck.
Fortunately the wise men at the Treasury Department are well versed in such matters and didn't succumb to the temptation of "teaser" rates.
Right?
Wrong.
According to the US Treasury, as of June 2008 (thus not inclusive of the recent bail-outs and mortgage market nationalization), of the $2.72T in government debt owned by foreigners, $1.2T has a duration of under 2 years. In other words, interest rates on that $1.2T ($1.4T including interest payments) will be reset in the next 24 months.
Expanding the scope to include all US external debt, as of June 2008, of the $11.7T of debt owned by foreigners, $6.3T has a duration of under 2 years.
One of Hyman Minsky's claims to fame is his research on the transition from financial stability to fragility in a capitalist economy experiencing a bubble- the Financial Instability Hypothesis.
The Levy Institute, continuing Minsky's research, argues: The aim of these hypotheses is to show that the normal functioning of “a capitalist economy endogenously generates a financial structure which is susceptible to financial crises”because of the higher sensitivity of the economy to changes in income, cash commitments and asset prices. Thus, it is important to explain how the financial structure of the economy (or a sector) changes. This implies studying how it is affected by the prevailing convention regarding the appropriate balance-sheet and cash-flow structures, and by thedevelopments in the productive economy: both the expectation and actual sides of the economyaffect the financial structure of the economy.
The logic of this financial instability hypothesis is that during a prosperous economicperiod, there are forces that progressively lead the economy from conservative financialpositions (hedge positions) to positions for which the articulation of cash flows is high andbalance sheets are illiquid and highly leveraged (Minsky 1986a, 210-211):
The logic of this theorem is twofold. First, within a financial structure that is dominated by hedgefinance, there will be a plentiful supply of short-term funds, so that short-term financing is“cheaper” than long-term financing. Accordingly, firms will be tempted to engage in speculativefinance. Second, over a period of good times, the financial markets will become less averse torisk. This leads to the proliferation of financing forms that involve closer coordination of cashflows out with cash flows in—that is, narrower safety margins and greater use of speculative andPonzi financing. (Minsky 1986b, 5)
In other words, Minsky, a proponent of financial regulation, argued that unregulated finance was prone to succumb to the temptation of lower short term rates. Debt duration would decrease and financial stability would be lost.
And so it has.
With the fiscal deficit expected to rise dramatically over the next 2 years, the US Treasury will not only need to finance that expansion, it will also need to roll-over the maturing short term debt.
Good Luck.
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