There’s additional chatter about financial regulatory reform today due to a luncheon speech that Paul Volcker’s giving on the subject. The debate continues to center around whether more stringent restrictions under the so-called Volcker Rule make sense, or whether capital requirements are a better way to go. The latter approach has some eloquent defenders, and seems to be favored by Asian and European regulators, but they should take heed of this new IMF study:
Using data for over 3,000 banks in 86 countries, we find that neither the overall index of BCP [Basel Core Principles on capital requirements] compliance nor its individual components are robustly associated with bank risk measured by Z-scores. We also fail to find a relationship between BCP compliance and systemic risk measured by a system-wide Z score.
And the band plays on…with each passing day it becomes more doubtful that something constructive will be done before the next financial crisis unfolds.
IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy.
A good deal is being made of subpar Treasury auctions this past week and whether they signify a turning point in the market’s appetite for U.S. government debt. It’s certainly possible, but we suspect that there’s a more nuanced and global explanation.
First off, a 10 year Treasury yielding almost 4% annually does not look like a bad deal given the intermediate growth outlook in the U.S., despite what so many other pundits are saying (unless you believe that we’re on the verge of persistent domestic inflation, i.e., a widespread USD surplus…anyone?).
Second, if Treasury auction participants came to market with only cash and held no other assets, then the prevailing theory would be harder to refute. However, the most important participants in treasury auctions are the New York Fed’s primary dealer banks, which are divisions of BNP, Bank of America, Barclays, Cantor, Citigroup, Credit Suisse, Daiwa, Deutsche Bank, Goldman Sachs, HSBC, Jefferies, JP Morgan, Mizuho, Morgan Stanley, Nomura, RBC, RBS, and UBS. These bank divisions and their parents already own large amounts of financial assets. Thus, they also need to manage risk when making purchase commitments. And one of the biggest risks of the past week was whether the Eurozone could agree on an assistance plan for Greece.
The following members of the Fed’s primary dealer banks are also primary dealers for Greek debt: Barclay’s, BNP, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JP Morgan, Merill Lynch (assumedly this is Bank of America), Morgan Stanley, Nomura, RBS, and UBS. This provides just a glimpse of the overall mosaic, as dealers also act as agents or conduits for public, and not just principals. However, it’s an important one, and it’s reported (and reasonable to assume) that several of them do own large slugs of Greek government debt.
Thus, given the uncertainty surrounding management of Greece’s funding crisis, and how it spiked again this past week as Germany dug in its heels, it’s quite possible that some of the usual buyers of U.S. Treasury debt are simply distracted and/or increasingly risk averse (even using low central bank interest rates to finance the purchase of protective credit default swaps, which probably offered more comfort in the immediate environment than new Treasuries).
Consider, for example, that French and German banks are believed to be exposed to $119B of Greek debt. Assuming sane leverage ratios of 10x (a dangerous assumption to make), the potential financial loss is equivalent to a significant percentage of the two countries’ annual GDP of $6T (e.g., a 15% decline in the value of Greek bond holdings, if unhedged, would equal roughly 3% of combined French and German GDP).
As tempting as the U.S.-Treasury-on-the-brink hypothesis is for the public debt Cassandras, we think ours does a better job of incorporating the sharp strengthening of the USD over the past week, and market behavior since yet another agreement began to take shape.
Combined with the fact that speculative credit markets are looking awfully frothy, some other strange market signs, and the likelihood of federal fiscal consolidation in 2011, we think you have a recipe for an eventual rally in Treasuries. It reminds us a little bit of the post 9/11 Treasury market selloff. Caveat venditor?
IMPORTANT DISCLOSURES: The author does not own shares of any companies mentioned. Clients of the firm own shares of ALBKY, SHY, TLT, MFG, and NBG. A principal of the firm owns shares of C, GS, and MS. Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy.
A cynical take on Sen. Dodd’s financial regulatory reform bill by Matt Koppenheffer for Motley Fool:
We can probably point to plenty of regulatory failures in the lead-up to the financial crisis. But I hardly think that they’re regulatory failures stemming from lack of regulators. As Valukas noted in his report, regulators were swarming on Lehman well before its collapse…
It seems to me that the issue never was whether there were people trying to address the problem, but rather that they were trying to regulate on a fuzzy mandate of not letting something bad happen within the bounds of a very permissive system. For the same reason that we have speed limit signs posted in our residential neighborhoods, we need to give regulators a clearer, tougher set of standards that they can impose on financial companies.
First and foremost, those standards need to address the lunatic business model that Lehman Brothers — and, really, most of the big financial companies — was operating on at the time of its demise.
Specifically, Lehman was increasingly building up large, illiquid, proprietary investments while primarily financing itself through very short-term agreements. What it became was a massive, teetering Jenga game right smack in the middle of our financial system that could be toppled in the blink of an eye if it lost the confidence of major counterparties…
That last paragraph echoes a beautiful turn of phrase by Bill Bernstein in the most recent Financial Analysts Journal, in which he refers to ”leveraging so unstable that it could not survive the slightest of economic breezes, let alone a 100-year storm.”
…the bill includes the Volcker Rule the way Cocoa Puffs include well-balanced nutrition. Little actually gets implemented in the text of the bill. Rather, specific regulations are supposed to come from a study on the rule’s potential impact. Not only is this likely to maximize the squishiness of the eventual rules, but it also gives lobbyists plenty of time to work their magic.
In the end, I don’t see the Fed folks as a bunch of incompetent bumblers. But when it comes to smothering the next Lehman, Fannie Mae…or AIG…I do think they’ll fail miserably because they’re being given a butter knife to regulate with when what they need is a buzzsaw.
A tangential riff: If we aren’t going to impose a hard, fast cap on leverage and other risky behaviors, then perhaps the power of network effects and private sector vigilance (vigilantism?) can help fill the gaps in our financial regulatory structure. For example, it seems reasonable to expect (OK, hope) that the next Harry Markopolos will be taken more seriously.
But when the issue is not fraud by a single market participant, but rather systemic levels of leverage and risk, then it seems unlikely that any kind of enforcement powers could be brought to bear if regulatory bodies haven’t purposefully enlisted private sector assistance beforehand.
As most of the country knows, the House of Representatives passed its latest version of healthcare reform yesterday, and emotions are running high on all sides as a result. Rep. Paul Ryan, a Republican from Wisconsin whom we sincerely admire, seemed to best embody his party’s core philosophical objections to the bill. Unfortunately, too many of the GOP’s arguments are stubbornly anachronistic and overly narrow. They don’t fully reflect the realities of healthcare, and they conveniently overlook the fact that we have had ‘socialized’ medicine in this country for quite some time – since Medicare and Medicaid became laws, and since the tax code and other regulations began to favor group insurance plans.
Our intent isn’t to cheer or take shots at either side. Instead, it’s to raise the level of discourse, something that neither party nor the press has done very well. With an issue as complicated and important as this one, political maturity is a must, and truth telling from leadership is absolutely vital. Unfortunately, Ryan’s speech was riddled with shallow thinking and empty slogans. Perhaps that suited its purpose, but it does little to move the debate or the electorate in constructive directions.
At 1:45 of the video:“Our founders got it right, when they wrote in the Declaration of Independence that our rights come from nature and nature’s God, not from government.”
For tens, perhaps hundreds of thousands of years, and in almost every part of the world, invoking divinity is how the powerful have justified their position (they still do in some parts of the world). So Jefferson may simply have been speaking the English monarchy’s language when he wrote that in the DOI.
More seriously, in today’s world, rational people ought to be able to agree that political rights are absolutely defined and managed by governments. The classical liberal principle of doing no harm to others is a great starting point, but the philosophical or religious beliefs that inform one’s political philosophy are not in and of themselves “rights”.
In fact, in a society of diverse religious and philosophical views, it’s absolutely vital that a government does just that.
1:57“Should we now subscribe to an ideology where government creates rights, is solely responsible for delivering these artificial rights, and then systematically rations these rights?”
Government does indeed create rights. It defined and allocated them in the Constitution without any mention of God as a source. And it has amended and reallocated them many times since. Calling them “artificial”, as in man made, is no more meaningful than the typical PETA slogan, or the idea that human creations, good and bad, are somehow ‘unnatural’.
And political institutions absolutely ration individual rights. They always have, all the way back to our hunting and gathering days, so it’s an idea that we really ought to be used to by now. The challenge is to hold governments accountable for doing it in a way that approaches some social optimum. That’s what the Constitution has done rather well over two centuries, and it’s something that modern political institutions have tended to become more adept at over time.
2:09 “Do we believe that the goal of government is to promote equal opportunity for all Americans to make the most of their lives? Or do we now believe that government’s role is to equalize the results of people’s lives?”
Long ago, the federal government enacted some stupid ideas on how to finance health care coverage. For generations, those ideas have benefitted employees of large corporations, unions, and public sector employees. They have been subsidized, either through higher premiums, greater personal risk, or less health care, by the self-employed and entrepreneurs (which may be why politicians always try to kiss their rear ends), as well as those who do not qualify for private insurance coverage, Medicare, or Medicaid. From the get go, these ideas have promoted INEQUALITY.
Healthcare reform is aimed, in part, at finally addressing this situation, a situation that has stood in stark contrast to the principle of equal opportunity. Over the years, the GOP has developed some good ideas on this issue, but in session after session, they utterly failed to do anything about it. They punted repeatedly until the situation got bad enough that the Dems were finally able to run the ball down their throat. Tua culpa, GOP.
Furthermore, this legislation can’t be said to seek equal outcomes, and Ryan surely most know that. It does seek to extend the social safety net, i.e., to redefine the acceptable minimum outcome in personal health care coverage. It also seeks to impose responsibility, in that everyone must chip in in some way. Personally, I don’t care for that kind of thing, and I know I’m not alone in that. Compulsory anything tends to rub Americans the wrong way.
Unfortunately, as long as there is Medicaid, and as long as health care costs of the uninsured are borne socially (via welfare or higher costs for others), it doesn’t make any sense to avoid a minimum level of buy in. It’s similar to having to carry liability coverage on your automobile, except that we are all physical bodies, and thus all have to participate.
If that really rubs you the wrong way, you have a few options:
Start working on the technology that will provide the bodily equivalent of mass transit and other alternative modes of transport.
Work to repeal Medicaid (why not Medicare while you’re at it?).
2:24“The philosophy advanced on this floor by this majority today is so paternalistic, and so arrogant. It’s condescending. And it tramples upon the principles that have made America so exceptional.”
Both parties have been guilty of arrogant, condescending paternalism throughout their history. I’m not sure what makes this bill so special. And if we look at the trajectory of American greatness, it’s hard to say that it’s based solely on founding principles (though they’ve certainly made it possible, along with plenty of luck).
Did the U.S. become more exceptional or less after the Progressive movement, the New Deal, and the Great Society? My point is not to sing the usual lefty praises for those episodes, but to point out that they do not seem to have undermined American exceptionalism at all.
3:18 “As we march towards this tipping point of dependency, we are also accelerating toward a debt crisis, a debt crisis that is the result of politicians of the past making promises we simply cannot afford to keep. Deja vu all over again…It’s unconscionable what we are leaving the next generation.”
First I’ll note my love for Yogi Berra quotes. Then I’ll reiterate that there is no U.S. debt crisis.
We do have entitlement and dependency issues to face as a society. But the federal budget is unlike any other budget in our country. It’s not like personal, household, business, or state and local government budgets. In the world, the only budgets that operate in a truly similar fashion are Japan’s and the United Kingdom’s (and in a far more constrained fashion, the European Monetary Union’s). Japan is about ten years ahead of us on the demographic curve, and its net public debt has reached levels that all the deficit hawks in the U.S. now shudder about. What happened? Nothing – no debt crisis, no threat of default, no crowding out. Nothing but a handful of downgrades from the credit rating agencies, and trading floors littered with the bodies of almost two decades worth of misguided hedge fund managers.
And the worst debt to GDP projections, even if we overlook the uncertainty involved in forecasting a decade or more, don’t reach any kind of level that justifies the prevailing deficit anxieties — not for a large modern economy with monopoly power over issuance of the currency used to pay interest on and retire its debts. Until people no longer want to accept dollars (and it’s easy enough for anyone to test out that hypothesis), the government can create more of them. In other words, unlike the rest of us, the only budget constraint faced by the federal government is the socially acceptable level of inflation.
Finally, without proper context, the ‘debt on the backs of our grandchildren’ meme is so much claptrap. If more debt now means better economic outcomes overall, then we are imposing severe opportunity costs on future generations if we do not run larger deficits.
That said, it may be true that health care reform does not represent a social investment with positive ROI. It may also be true that simply rectifying distortions and making the system fairer could have been accomplished with far less than what this bill contains. The electorate has a little over seven months to reflect on it before rendering its judgement in November, and as we’ve noted here and here, this issue deserves a lot more philosophical honesty than it’s been getting. It’s difficult, complicated stuff, with no right or wrong answers – only some as-yet-unknown social optimum, which our sometimes messy political processes are helping us grope our way towards.
A couple more interesting pieces in the to-and-fro on whether the Fed and other central banks played a role in fostering asset bubbles in the early 2000s:
First, the Economist takes apart former and current Fed chairment Alan Greenspan and Ben Bernanke’s recent defenses of monetary policy:
…both [Greenspan and Bernanke] say there is no evidence that low short-term rates drove house prices upward. Mr Greenspan argues that the statistical relationship between house prices and long-term rates is much stronger than with the Fed’s policy rates, and that during the early 2000s the traditionally high correlation between policy rates and long-term rates fell apart. Mr Bernanke points to structural models which show that only a modest part of the house-price boom can be pinned on monetary policy.
…There is something odd about central bankers denying any responsibility at all for long-term rates, which are, in principle, based partly on an assessment of a stream of short-term rates. Nor is it clear that low short-term rates were as irrelevant as Messrs Bernanke and Greenspan suggest. Jeremy Stein of Harvard University, a discussant of Mr Greenspan’s Brookings paper, points out that low policy rates may have mattered a great deal for income-constrained borrowers. He points out that adjustable-rate mortgages were used much more in expensive cities, a trend that became more pronounced as the fund rates fell.
By looking only at the effect of monetary policy on house prices, Messrs Bernanke and Greenspan also take too narrow a view of the potential effect of low policy rates. Several economists have argued convincingly, for instance, that low policy rates fuelled broader leverage growth in securitised markets.
Second, the Bank of International Settlements has published a paper arguing emphatically that monetary policy in the form of low interest rates can and does contribute to speculative risk taking by banks:
Using a unique database that includes quarterly balance sheet information for listed banks operating in the European Union and the United States in the last decade, we find evidence that unusually low interest rates over an extended period of time contributed to an increase in banks’ risk. This result holds for a wide range of measures of risk, as well as macroeconomic and institutional controls…
It is a very bad thing when the leader and former leader of an institution as critical as the Fed decide to cover their asses instead of engaging in critical assessment and truth telling. Personally, I don’t find it surprising with Mr. Greenspan, as I’ve never held a high opinion of the man (in my limited view, his primary professional achievement seems to have been the elevation of personality cult management to new levels). We’re more disappointed in Mr. Bernanke – still think he’s the right man for the job though.
Neat article on country selection by Dan Richards, who recently asked an audience how they would allocate their equity investments in 1970 between Australia, Canada, Europe, Hong Kong, Japan, and the U.S. if they had a time machine. The responses and the data are pretty interesting. Richards’ key observations capture some timeless lessons for investors:
When looking at returns, don’t overlook volatility.
Understand the impact of currency rates; for example, over 20% of Europe’s outperformance versus the U.S. was due to exchange rate effects (the currency adjusted returns for Japan are even more dramatic — 74% by our calculations!).
The recent “lost decade” for equity investors has been largely a U.S. phenomenon.
Look before you leap; i.e., do your homework, base your decisions on evidence and data and not just feelings and opinions, and so on.
UPDATE 3/18/2010 – Unfortunately, Paramount has forced You Tube to take down the six seconds worth of alleged copyright infringement in the video above (really Paramount? Six seconds?). The audio clip is still out there, fortunately.
Short but interesting post from James Hamilton at Econbrowser on a recent conference re credit market dislocation. His main point is that many (if not most) economists are focusing on the Lehman collapse and its aftermath as problem, rather than symptom of a historic run up in credit. It’s accompanied by some straightforward eye candy.
There’s also a link in the comments section to this New Yorker profile of Ben Bernanke – like Hank Paulson’s recent tell (not quite) all, it’s an interesting story.